PRINCIPLES OF

MANAGERIAL
ACCOUNTING

Christine Jonick
University of North Georgia
 University of North Georgia
Principles of Managerial Accounting

Christine Jonick
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TABLE OF CONTENTS
Licensing

1: Managerial Accounting Concepts

1.1: Introduction to Managerial Accounting Concepts
1.2: Cost Terminology and Concepts
1.3: Inventory terminology and concepts

2: Job Order Costing

2.1: Introduction to Job Order Costing
2.2: Comprehensive Example of Job Order Costing Transactions for a Manufacturing Company
2.3: Job Order Costing for a Service Company

3: Process Costing
3.1: Introduction to Process Costing
3.2: Process Costing Transactions for a Manufacturing Company
3.3: Process Costing Calculations for a Department in a Manufacturing Company

4: Activity-Based Costing
4.1: Introduction to Activity-Based Costing
4.2: Single factory rate to estimate factory overhead
4.3: Departmental rates to estimate factory overhead
4.4: Activity-based costing for a manufacturing business to estimate factory overhead
4.5: Differences based on factory overhead method
4.6: Activity-based costing for a manufacturing business to estimate factory overhead
4.7: Activity-based costing for a service business to estimate factory overhead

5: Cost Volume Profit Analysis

5.1: Introduction to Cost Volume Profit Analysis
5.2: Cost Volume Profit Analysis (CVP)
5.3: Breakeven Point
5.4: Operating leverage
5.5: Margin of safety

6: Variable Costing Analysis

6.1: Introduction to Variable Costing Analysis
6.2: Units manufactured equals units sold
6.3: Units Manufactured Greater than Units Sold
6.4: Units manufactured less than units sold
6.5: Analysis of variable and absorption costing
6.6: Contribution Margin Analysis

7: Budgeting
7.1: Introduction to Budgeting
7.2: Static Budget

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 7.3: Flexible Budget
7.4: Master Budget
7.5: Operating Budget
7.6: Sales Budget
7.7: Cost of Goods Sold Budget
7.8: Selling and Administrative Cost Budget
7.9: Budgeted Income Statement
7.10: Cash Budget
7.11: Capital Expenditure Budget

8: Variance Analysis
8.1: Introduction to Variance Analysis
8.2: Direct Materials Cost Variance
8.3: Direct Labor Cost Variance
8.4: Factory overhead variances

9: Differential Analysis
9.1: Introduction to Differential Analysis
9.2: Make or buy a component part
9.3: Continue with or discontinue a product
9.4: Lease or Sell Equipment
9.5: Sell a Product or Process Further
9.6: Keep or Replace a Fixed Asset
9.7: Accept Business at Reduced Price
9.8: Capital investment analysis

Index
Index

Glossary
Detailed Licensing

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Licensing
A detailed breakdown of this resource's licensing can be found in Back Matter/Detailed Licensing.

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 CHAPTER OVERVIEW

1: Managerial Accounting Concepts

1.1: Introduction to Managerial Accounting Concepts
1.2: Cost Terminology and Concepts
1.3: Inventory terminology and concepts

This page titled 1: Managerial Accounting Concepts is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by
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detailed edit history is available upon request.

1
1.1: Introduction to Managerial Accounting Concepts
Accounting is the system of recording and keeping track of financial transactions in a business and summarizing this information
in reports. These reports provide information to people who are interested in knowing about the financial aspects of a business. The
information guides business managers, investors, and creditors in planning and decision making. In fact, accounting is often
referred to as “the language of business” because business peoplecommunicate, evaluate performance, and determine value using
dollars and amounts generated by the accounting process.
Financial accounting involves producing periodic reports called financial statements to inform such external groups as investors,
boards of directors, creditors, and government/tax agencies about a company’s financial performance and status. The income
statement, retained earnings statement, balance sheet, and statement of cash flows are published at fixed intervals to summarize the
historical earnings performance and current financial position of a company. Financial statements are prepared according to
Generally Accepted Accounting Principles (GAAP), which helps ensure the information is relevant (useful and timely for making
decisions), reliable (accurate and unbiased), consistent (prepared the same way each time information is reported), and
comparable (prepared the same way by different companies).
Managerial accounting is targeted more toward a company’s managers and employees. The information gathered and summarized
for these internal groups is customized to provide feedback for planning, decision making, and evaluation purposes. Managerial
reports do not necessarily follow any particular format, but instead are uniquely designed to meet the needs of specific users.
Analyses are often focused on targeted segments of a business rather than on a company as a whole. Information may be published
over periodic time intervals or on an as- need basis. Managerial accounting involves not only actual financial data from past
periods, but also current estimates and future projections.
A manager’s responsibilities in a business include making decisions related to planning (identifying goals and strategies for
accomplishing them), leading (directing daily operations and carrying out plans), and controlling (comparing expected and actual
results and taking action for improvement). Since human, financial, and time resources are limited, managers must select from
among many alternatives, foregoing other options. They try to optimize the collective outcome of their choices. Managerial
accounting provides timely and relevant financial information that contributes to effective decision making.
A business’s operations are classified as one of three types - service, merchandising, or manufacturing - depending on what it has
for sale. A service business sells expertise, advice, assistance, professional skills, or an experience rather than a physical product. A
merchandising business purchases finished and packaged products from other companies, marks up the costs of these items, and
sells them to customers. A manufacturing business assembles and packages products for sale to merchandisers or end users.
Managerial accounting is relevant to all three types of businesses. In this document, we will focus on manufacturing since that type
of business involves the most in-depth facets and examples of managerial accounting. We will also discuss managerial accounting
for service businesses where appropriate. Topics will fall into four broad categories: accumulating costs, analyzing costs,
evaluating performance, and comparing alternatives.
The goal of a business is to generate profit, which is the difference between income and costs in a particular time period. Costs are
the result of paying cash or committing to pay cash in the future in order to earn revenue. Costs may be accumulated for a product,
sales territory, department, or activity. It is critical to analyze costs because controlling them directly impacts profitability. Costs are
also used to determine selling prices of products, and they are monitored over time to evaluate progress and discover irregularities.

Accumulating Costs
Costs must be determined and recorded accurately, systematically, and on a timely basis. Unless cost information is correct and
reliable, it is not very useful to managers who depend on it to make effective plans and informed decisions.Job order costing and
process costing are two methods of systematically accumulating costs on manufactured products. Activity-based costing is a
system that is combined with the other two methods to identify and measure costs more specifically.

Analyzing Costs
Not all costs are created equal. Some are unavoidable; others are somewhat controllable. Separating them out allows managers to
focus on controllable costs that should be monitored in order to contain or lower them. Costs may also be used to mathematically
determine sales required to achieve desired levels of volume and profitability. Break even analysis and other cost relationships, as
well as variable costing, will address these issues.

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Evaluating Performance
Planning involves looking into the future and estimating what a business’s financial activities will look like. This process is called
budgeting and projects what sales, costs, production, cash flows, etc. will be in at a future point in time. Controlling methods such
as variance analysis compare expected outcomes to actual results and analyze overall progress in meeting goals.

Comparing Alternatives
Managerial decision making includes choosing one option over others, such as whether to make or buy a component part or
whether to continue manufacturing a product or not. Differential analysis compares alternatives to determine which choice will
yield either the greatest benefit or the least cost. Capital investment analysis is a type of differential analysis that involves
evaluating proposed investments in property, plant, and equipment that a company will use in its operations.

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1.2: Cost Terminology and Concepts
For a manufacturing company, a significant goal of managerial accounting is to keep track of the costs of the units that are
produced. A cost is a current or future expenditure of cash for something that will ultimately generate revenue. Inmanufacturing,
many costs relate to products that are ultimately sold to customers.
Period costs include selling and administrative expenses that are unrelated to the production process in a manufacturing business.
Selling expenses are incurred to market products and deliver them to customers. Administrative expenses are required to provide
support services that are not directly related to the manufacturing or selling activities. Administrative costs may include
expenditures for a company’s accounting department, human resources department, and president’s office. Selling and
administrative expenses may also include utilities, insurance, property taxes, depreciation, supplies, maintenance, salaries, etc., that
are incurred in a business, but outside of the factory production area.
Product costs are incurred when a company manufactures goods. Product costs may be classified as either direct or indirect.
Direct costs are expenditures in a factory that can be specifically traced to a manufactured item and that become part of its overall
cost. Indirect costs are also incurred in a factory where production takes place, but they are more general and cannot be attributed
to any specific product.
There are three product costs associated with a manufactured item:
1. Direct materials
2. Direct labor cost
3. Factory overhead
Direct materials are raw materials that will be used to create finished goods. Their cost becomes part of the product that customers
ultimately purchase.
Direct labor is the cost of hourly wages of production workers who assemble manufactured goods. These employees work on
products that are sold to customers when finished.
Factory overhead is an indirect cost and includes ANY expense in a factory that is not specifically traced to products that
customers purchase. These may be general expenses, such as utilities, insurance, property taxes, depreciation, supplies,
maintenance, supervisor salaries, and expired prepaid items. Factory overhead also includes any materials or labor that do not
become part of a manufactured product.
Product costs may be further categorized, as follows:
1. Prime cost = direct labor + direct materials
2. Conversion costs = direct labor + factory overhead

 Example

A manufacturing company produces kitchen cabinets. Direct materials include wood, hinges, and hardware. Direct labor is
the cost of wages of factory employees who assemble the cabinets. Factory overhead includes expendituresfor electricity and
water bills, insurance premiums, roof repair, depreciation of machinery, materials used to build shelves in the factory, and
wages of factory workers to assemble those shelves.
Assume that direct materials cost $700, direct labor is $500, and factory overhead is $300 for cabinets that have been
manufactured.

1. How much are prime costs? $700 + $500 = $1,200

2. How much are conversion costs? $500 + $300 = $ 800

3. What is the total cost of the product? $700 + $500 +$300= $1,500

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1.3: Inventory terminology and concepts
A manufacturer reports its product costs as one of three types of inventory in the current assets section of its balance sheet,
depending on stages of completion. Materials consist of items in inventory that have not yet been entered into production or used.
Work in process includes manufactured products that have been started but are not yet completed. In other words, they are
currently in production. Finally, finished goods are manufactured products that have been completed but not yet sold to customers.

1.3.1 Financial Reporting for a Manufacturer

The three inventory accounts, and their balances at the end of the month, appear in the current asset section of a manufacturer’s
balance sheet. A sample balance sheet follows.
Jonick Company Balance Sheet
June 30, 2019
Assets

Current assets:

Cash $40,000

Accounts receivable 25,000

Inventory

Materials $18,000

Work in process 31,000

Finished goods 26,000

Total inventory 75,000

Prepaid insurance 4,000

Prepaid rent 2,000

Total current assets $146,000

When manufactured items are sold, their costs are removed from the Finished Goods inventory account and transferred to the Cost
of Goods Sold expense account on the income statement. Cost of Goods Sold represents the amount a company paid for the
manufactured items that it sold. Cost of Goods Sold is matched with Sales on the first two rows of the income statement. The
difference between Sales and Cost of Goods Sold is gross profit, which is the amount of markup on the manufactured goods.
The income statement also includes expenses other than Cost of Goods Sold. Selling and administrative expenses are non-factory
costs that are classified as operating expenses. These period costs are necessary to operate the business and generate sales.
A sample income statement follows.
Jonick Company Income Statement For the Month Ended June 30, 2018
Sales $300,000

Cost of goods sold 140,000

Gross profits $160,000

Operating expenses:

Selling expenses $75,000

Administrative expenses 35,000

Total operating expenses 110,000

Net income $50,000

The Cost of Goods Sold amount on the income statement is determined by considering the changes in the three inventory account
balances during the period. The elements of its calculation contain important information for managers, but they are too detailed

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and lengthy to present directly on the income statement. Therefore, a separate statement of cost of goods sold is prepared to show
the details of the calculations. The final cost of goods sold amount from the statement of cost of goods sold is what appears on the
income statement.
The statement of cost of goods sold that follows presents how the $140,000 amount on the income statement is determined. The
statement is followed by an explanation of its sections.
Jonick Company Statement of Cost of Goods Sold For the Month Ended June 30, 2019
Finished goods inventory,
$34,000
June 1

Work in process inventory,

$42,000
June 1

Direct materials

Materials inventory,
$16,000
June 1

Purchases 59,000

Cost of materials
$75,000
available to use

Materials inventory,
(18,000)
June 30

Cost of direct
$57,000
materials used

Direct labor 40,000

Factory overhead 24,000

Total manufacturing costs

121,000
in June

Total manufacturing costs $163,000

Work in process inventory,

(31,000)
June 30

Cost of goods
132,000
manufactured

Cost of goods available for

$166,000
sale

Finished goods inventory,

(26,000)
June 30

Cost of goods sold $140,000

Three amounts that must often be solved for algebraically are the amounts of inventory transferred out of the Materials, Work in
Process, and Finished Goods inventory accounts during a period. These amounts may be determined with an equation similar to
that used for the periodic inventory system for merchandising. Beginning and ending inventory values are determined by taking
physical inventory counts, and, therefore, they are known. Amounts for inventory added during the period are available from
purchase orders and production reports that accumulate costs on manufactured goods. The following general equation summarizes
the calculation of inventory transferred out of the inventory accounts:
Beginning inventory balance + additions during the month – ending inventory balance
The equations that follow for each inventory account use the amounts from the statement of cost of goods sold to illustrate the
calculations for the amounts transferred out of Materials, Work in Process, and Finished Goods, respectively. The ledger account
that corresponds to each type of inventory uses these same amounts to show increases, decreases, and running balances. The ledger
accounts show the flow of manufacturing costs from Materials to Work in Process to Finished Goods to Cost of Goods Sold.

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 Materials
Beginning Materials balance $16,000

+ Purchases of materials during the period + 59,000

- Ending Materials balance (still in inventory) - 18,000

Materials used and transferred to Work in

= $57,000
Process

The following ledger also reflects the movement in and out of the Materials account, with a debit entry representing an increase
and a credit entry showing a decrease.
Materials
Date Item Debit Credit Debit Credit

1. Balance, June 1 16,000

Purchases of
2. 59,000 75,000
materials during June

Materials moved to
3. 57,000 18,000
production in June

The following excerpt from the statement of cost of goods sold presents the information shown in the equation and ledger for
Materials.

Direct materials

Materials inventory, June 1 $16,000

Purchases 59,000 $57,000 was transferred from one

Cost of materials available inventory account to the next:
$75,000 from Materials (credit) to Work in
to use
Process (debit)
Materials inventory, June 30 (18,000)

Cost of direct
$57,000
materials used

Work in Process
Beginning Work in Process balance $42,000

Materials, labor, and factory overhead added

+ + 121,000
to production

Ending Work in Process balance (still in

- - 31,000
inventory)

Work in Process completed and transferred to

= $132,000
Finished Goods

The following ledger also reflects the movement in and out of the Work in Process account, with a debit entry representing an
increase and a credit entry a decrease.
Work in Process
Date Item Debit Credit Debit Credit

1. Balance, June 1 42,000

Materials moved to
2. 57,000 99,000
production in June

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 Labor added to
3. 40,000 139,000
production in June

Overhead added to
4. 24,000 163,000
production in June

Work in process
5. 132,000 31,000
completed in June

The following excerpt from the statement of cost of goods sold presents the information shown in the equation and ledger for Work
in Process.

Work in process
$42,000
inventory, June 1

Total manufacturing $132,000 was

121,000
costs in June transferred from one
inventory account to
Total manufacturing
$163,000 the next: from Work
costs
in Process (credit) to
Work in process Finished Goods
(31,000)
inventory, June 30 (debit)

Cost if goods
132,000
manufactured

Finished Goods
Beginning Finished Goods balance $34,000

+ Work in Process completed during the period + 132,000

- Ending Finished Goods balance (not yet sold) - 26,000

Finished Goods sold and transferred to Cost of

= $140,000
Goods Sold

The following ledger also reflects the movement in and out of the Finished Goods account, with a debit entry representing an
increase and a credit entry a decrease.
Finished Goods
Date Item Debit Credit Debit Credit

1. Balance, June 1 34,000

Work in process
2. 132,000 166,000
completed in June

2. Cost of product
3. 140,000 26,000
sold in June

The following excerpt from the statement of cost of goods sold presents the information shown in the equation and ledger for
Finished Goods.

Finished goods $140,000 was trans-

$34,000
inventory, June 1 ferred from one inven-
tory account to the
Cost of goods
132,000 next: from Finished
manufactures
Goods (credit) to Cost
of Good Sold (debit)

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 Cost of goods
$166,000
available for sale

Finished goods
(26,000)
inventory, June 30

Cost of goods sold $140,000

Cost of Goods Sold:

$140,000 was transferred from one inventory account to an expense account when the product was sold: from Finished Goods
(credit) to Cost of Goods Sold (debit)
Cost of Goods Sold
Date Item Debit Credit Debit Credit

Cost of product sold

1. 140,000 140,000
in June

The accumulation of production costs, and the transfer of those costs from account to account based on stage of completion, track
the manufacturing process from beginning to end, when the products are sold. This information is critical to managers in
manufacturing companies who make purchasing decisions, determine selling prices, prepare sales budgets, and schedule
production.

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 CHAPTER OVERVIEW

2: Job Order Costing

2.1: Introduction to Job Order Costing
2.2: Comprehensive Example of Job Order Costing Transactions for a Manufacturing Company
2.3: Job Order Costing for a Service Company

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1
2.1: Introduction to Job Order Costing
Job order costing is a method of keeping track of the costs of manufactured items. Once products are completed, their overall costs
are marked up and sold at a profit to customers.
Job order costing is a method of cost accumulation that is used for items or batches of items that are unique – that is, each
customer’s order is different. Custom-made kitchen cabinets are an example of a manufactured product that is often customer-
specific. Each order is based on different sizes, layouts, wood choices, finishes, hardware, installation costs, customer preferences,
etc. No two orders are alike, so the total cost of each order will differ as a result. A single order might involve a homeowner
updating her kitchen for a new look. A batch order might be processed for a home builder who is constructing 10 identical homes
and therefore requires 10 of the same sets of cabinets. Each single or batch order is referred to as a job and is assigned a unique
identification number, such as “Job 15”.
Costs accumulate on manufactured goods while they are in production. The three costs of production are direct materials, direct
labor, and factory overhead. For unique products, each job accumulates different amounts of each of these three costs. An analogy
would be several patients in a doctor’s office - each person has different symptoms and therefore receives different treatments,
medications, and tests from the same doctor. Each person’s total medical bill is like a “tab” that the patient has run up with the
doctor.
The three costs of production accumulate in an account called Work in Process, which is like the ‘tab” for the manufactured item.
There are three debits to Work in Process - one for direct materials, one for direct labor, and one for factory overhead – as a result.
The total of these three costs equals the cost of producing the item.
The following Work in Process ledger for a single order assumes there is no beginning inventory and illustrates the three debits that
represent the three costs of production.
Work in Process
Date Item Debit Credit Debit Credit

Materials moved to
1. 5,000 5,000
production

Labor added to
2. 4,000 9,000
production

Overhead added to
3. 1,100 10,100
production

The total cost of this job is $10,100, as is shown in the final debit balance in Work in Process ledger.
A manufacturer may work on many jobs simultaneously. Even if several jobs are started at once, it does not necessarily mean that
they will all be completed at the same time. In job order costing, each job is typically worked on at its unique location on the
production floor as material and labor come to the products, which remain in place.
The following series of journal entries describe and illustrate job order costing transactions that are specific to accumulating the
three costs of production: materials, labor, and factory overhead.
1. Direct materials become an integral part of a manufactured product that is sold to a customer. They are requisitioned (asked
for) and brought from the stockroom to the production area so that they can be worked on.
Materials that cost $5,000 are requisitioned from the stockroom. This journal entry represents the first of the three debits to the
Work in Process account.

Account Debit Credit First debit to Work in Process

▲ Work in Process is an asset

Work in Process 5,000 (inventory) account that is
increasing
▼ Materials is an asset
Materials 5,000 (inventory) account that is
decreasing

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 Account Debit Credit First debit to Work in Process

The wood, hinges, etc. that are considered direct materials are moved from the Materials account (by crediting and reducing it)
to the Work in Process account (by debiting it and increasing it.) Work in Process is the asset account in which the cost of the
manufactured item accumulates, and materials is the first of the three production costs.
2. Direct labor involves work done directly by factory laborers on manufactured items that are sold to customers. This journal
entry represents the second of the three debits to the Work in Process account. In this case, direct labor is $4,000.

Account Debit Credit Second debit to Work in Process

▲ Work in Process is an asset

Work in Process 4,000 (inventory) account that is
increasing
▲ Wages Payable is a liability
Wages Payable 4,000
account that is increasing

Labor in the factory includes the hourly wages paid to production workers. It is considered direct if a production employee is
working on a product that will be sold to a customer. Direct labor costs are added to Work in Process by debiting that account
and increasing it. Work in Process is the asset account in which the cost of the manufactured item accumulates, and labor is the
second of the three production costs.
FACTORY OVERHEAD INCURRED
The following six entries represent transactions that are recorded as debits to the Factory Overhead account. This account is
used to record all factory expenses except direct materials and direct labor. Rather than Supplies Expense,Maintenance Expense,
Depreciation Expense, Insurance Expense, Wages Expense (indirect), etc., the Factory Overhead account is used to substitute
for any expense incurred in the factory. Factory overhead costs are indirect because they cannot be specifically traced to
particular jobs, but are instead incurred in the factory as a whole. Factory Overhead is debited (increased) for any actual
overhead cost incurred. While these expenses are in the Factory Overhead account, they are not yet part of any of the
manufactured items.
3. The company uses $400 of its raw materials to build a closet in the factory.

Recording an expense in the

Account Debit Credit
factory as Factory Overhead

▲ Factory Overhead is an
Factory Overhead 400 expense account that is
increasing
▼ Materials is an asset
Materials 400 (inventory) account that is
decreasing

Materials, such as wood, may be requisitioned for general factory use. These materials are considered an indirect cost since they
do not become part of a manufactured item. Materials is credited just like it was for the requisition of direct materials. In this
case, Factory Overhead is debited for the indirect materials rather than Work in Process.
Supplies Expense is not used because the indirect expense occurs in the factory, where all expenses are accounted for a Factory
Overhead.
4. Wages of $300 are incurred for production employees building a closet in the factory.

Recording an expense in the

Account Debit Credit
factory as Factory Overhead

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 Recording an expense in the
Account Debit Credit
factory as Factory Overhead

▲ Factory Overhead is an
Factory Overhead 300 expense account that is
increasing
▲ Wages Payable is a liability
Wages Payable 300
account that is increasing

If the same production employees also perform some general factory work, such as hanging the wood shelves, the labor is
considered indirect since the time is not spent working on an actual manufactured item. Wages Payable is credited just like it
was for the direct labor. In this case, Factory Overhead is debited for the indirect labor rather than Work in Process.
Wages Expense is not used because the indirect expense occurs in the factory, where all expenses are accounted for a Factory
Overhead.
5. The company pays $350 cash for one of its utility bills.

Recording an expense in the

Account Debit Credit
factory as Factory Overhead

▲ Factory Overhead is an
Factory Overhead 350 expense account that is
increasing
▼ Cash is an asset account that
Cash 350
is decreasing

Factory Overhead is debited rather than Utilities Expense since the expense occurs in the factory.
6. The company receives an invoice for $200 from a repairman who fixed a leak in the factory building.

Recording an expense in the

Account Debit Credit
factory as Factory Overhead

▲ Factory Overhead is an
Factory Overhead 200 expense account that is
increasing
▲ Accounts Payable is a liability
Accounts Payable 200
account that is increasing

Factory Overhead is debited rather than Maintenance Expense since the expense occurs in the factory.
7. $150 of the prepaid insurance that the company paid in advance expires.

Recording an expense in the

Account Debit Credit
factory as Factory Overhead

▲ Factory Overhead is an
Factory Overhead 150 expense account that is
increasing
▼ Prepaid Insurance is an asset
Prepaid Insurance 150
account that is decreasing

Factory Overhead is debited rather than Insurance Expense since the expense occurs in the factory.
8. The company records depreciation on factory equipment.

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 Recording an expense in the
Account Debit Credit
factory as Factory Overhead

▲ Factory Overhead is an
Factory Overhead 150 expense account that is
increasing
▲ Accumulated Depreciation is a
Accumulated Depreciation 150
contra asset account increasing

Factory Overhead is debited rather than Depreciation Expense since the expense occurs in the factory.
Factory expenses accumulate in the Factory Overhead account, as just shown in the journal entries (3) through (8). Notice that
the Work in Process was not used at all in these transactions, so at this point the third cost of manufacturing has not been added
to the cost of any job yet.
Assuming there were no previous balances in the Work in Process or Factory Overhead accounts, their ledgers would appear as
follows based on the previous eight transactions:
Work in Process
Date Item Debit Credit Debit Credit

Materials moved to
1. 5,000 5,000
production

Labor added to
2. 4,000 9,000
production

Factory Overhead
Date Item Debit Credit Debit Credit

3. For indirect materials 400 400

4. For indirect labor 300 700

5. For utilities 350 1,050

6. For maintenance 200 1,250

7. For insurance 150 1,400

8. For depreciation 100 1,500

So far there are only two entries in the Work in Process ledger account. The third cost of production, factory overhead, must be
added (or “applied”) to Work in Process to arrive at the total cost of the job(s). This final debit to Work in Process allocates an
estimated amount of the factory expenses from the Factory Overhead account to the cost of each unit manufactured.
Since all expenses associated with the period may not yet be determined and all bills not yet received, actual factory overhead is
not yet known. The running balance of $1,500 shown may be incomplete since more bills may be outstanding. The company
needs timely information about the cost of each job, so factory overhead is estimated at the time it is applied to Work in Process.
Also, since factory overhead cannot be specifically traced to a particular job, it is instead allocated to jobs using an activity base
that estimates its consumption. Each company uses a method of estimating that makes sense for them, so the process can vary
among companies. Three common activity bases used to allocate factory overhead costs are (1) a percentage of direct labor cost
(such as $1,500 x 20%) or the (2) number of direct labor hours or (3) number of machine hours. When units such as hours are

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used, a predetermined factory overhead rate is multiplied by the number of hours. The predetermined factory overhead rate
equals estimated total factory overhead costs divided by the estimated number of hours in the activity base.
In this example, assume total estimated factory overhead is $2,000. It will be allocated, or applied to jobs, using a
predetermined factory overhead rate that uses an activity base of an estimated 200 direct labor hours. Therefore, $2,000 / 200 =
a factory overhead rate of $10 per direct labor hour.
If 110 direct labor hours were actually used in this period’s operations, factory overhead applied to Work in Process would be
$1,100 (110 hours x $10 per direct labor hour). The journal entry that follows reflects this third cost of production being added
to the Work in Process and removed from the Factory Overhead account using this estimating process.
1. The company applied $1,100 of factory overhead to jobs in production.

Account Debit Credit Second debit to Work in Process

▲ Work in Process is an asset

Work in Process 1,100 (inventory) account that is
increasing
▼ Factory Overhead is an
Factory Overhead 1,100 expense account that is
decreasing

The Factory Overhead account is reduced by crediting it, and that expense amount is moved into the Work in Process (asset)
account by debiting it.
This journal entry represents the third of the three debits to the Work in Process account.
As shown in the ledger accounts that follow, there are now three entries in the Work in Process ledger account. The third
cost of production, factory overhead, has been added (or “applied”) to Work in Process to arrive at the total cost of the
job(s).
Work in Process
Date Item Debit Credit Debit Credit

Materials moved to
1. 5,000 5,000
production

Labor added to
2. 4,000 9,000
production

Overhead added to
3. 1,100 10,100
production

Factory Overhead
Date Item Debit Credit Debit Credit

For indirect
3. 400 400
materials

4. For indirect labor 300 700

5. For utilities 350 1,050

6. For maintenance 200 1,250

7. For insurance 150 1,400

8. For depreciation 100 1,500

Overhead added to
3. 1,100 400
production

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 The total cost of this manufactured item is the three debits to Work in Process: $5,000 for direct materials plus $4,000 for
direct labor plus $1,100 for factory overhead, totaling $10,100.

 ANALOGY

Assume three people go out on a Friday night (separately). Each will eat dinner, have some drinks, and enjoy some
entertainment – the three costs of going out. Yet the food, beverages, and entertainment will be different for each
person, and, therefore, the costs will not be the same. Each person has a “tab” – first the food, then the drinks, then the
entertainment – that adds up to the final cost of the night out.
Similarly, different products manufactured under job order costing each have a “tab” on which their three costs – direct
materials, direct labor, and factory overhead – accumulate. The costs are different for each product, so the final total for
each is different as well.

This page titled 2.1: Introduction to Job Order Costing is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by
Christine Jonick (GALILEO Open Learning Materials) via source content that was edited to the style and standards of the LibreTexts platform; a
detailed edit history is available upon request.

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2.2: Comprehensive Example of Job Order Costing Transactions for a Manufacturing
Company
The following example will expand upon the job order costing journal entries previously presented and add other transactions in
the manufacturing cycle. These include purchasing raw materials, recording jobs completed, selling finished jobs, and adjusting
estimated to actual factory overhead incurred. The new transactions will be marked as NEW and a brief explanation and/or
calculation will follow each.
Assume that Roberts Wonder Wood is a factory that produces custom kitchen cabinets. Wood and metal hardware are the main
materials used in production. Roberts uses a job order costing system. The transactions are to be recorded for six jobs in production
in August, Roberts’ first month of operations.
The following information relates to production costs and usage for Roberts during August.

Job Materials Factory Labor Machine hours

Job 1 $880 $750 6

Job 2 1,240 990 10

Job 3 670 510 8

Job 4 2,300 1,860 25

Job 5 1,560 1,490 14

Job 6 910 730 7

For general factory use 270 850

1. Materials are purchased on account for $9,400.

Account Debit Credit

▲ Materials is an asset
Materials 9,400 (inventory) account that is
increasing
▲ Accounts Payable is a liability
Accounts Payable 9,400
account that is increasing

Materials must first be acquired before they can be used in production or in the factory. The asset account, Materials, is debited
when materials are purchased. These items are “in stock” and available to be requisitioned (requested for use by someone in the
factory.) They are not yet in production or being worked on.
2. Materials are requisitioned from the stockroom based on the cost information shown in the table.

Account Debit Credit First debit to Work in Process

▲ Work in Process is an asset

Work in Process 7,560 (inventory) account that is
increasing
▼ Materials is an asset
Materials 7,560 (inventory) account that is
decreasing
▲ Factory Overhead is an
Factory Overhead 270 expense account that is
increasing
▼ Materials is an asset
Materials 270 (inventory) account that is
decreasing

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 Record any expense in the factory
as Factory Overhead

Materials for the six jobs: 880 + 1,240 + 670 + 2,300 + 1,560 + 910 = $7,560 Indirect materials: $270
3. Labor costs are incurred in the factory based on the cost information shown in the table.

Account Debit Credit Second debit to Work in Process

▲ Work in Process is an asset

Work in Process 6,330 (inventory) account that is
increasing
▲ Wages Payable is a liability
Wages Payable 6,330
account that is increasing
▲ Factory Overhead is an
Factory Overhead 850 expense account that is
increasing
▲ Wages Payable is a liability
Wages Payable 850
account that is increasing
Record any expense in the factory
as Factory Overhead

Labor for the six jobs: 750 + 990 + 510 + 1,860 + 1,490 + 730 = $6,330 Indirect materials: $850
4. Factory overhead indirect costs incurred on account are $440.

Record any expense in the factory

Account Debit Credit
as Factory Overhead
▲ Factory Overhead is an
Factory Overhead 440 expense account that is
increasing
▲ Accounts Payable is a liability
Accounts Payable 440
account that is increasing

5. Expired prepaid insurance for the month is $370.

Record any expense in the factory
Account Debit Credit
as Factory Overhead
▲ Factory Overhead is an
Factory Overhead 370 expense account that is
increasing
▼ Prepaid Insurance is an asset
Prepaid Insurance 370
account that is decreasing

6. Depreciation on factory equipment for the month is $840.

Record any expense in the factory

Account Debit Credit
as Factory Overhead
▲ Factory Overhead is an
Factory Overhead 370 expense account that is
increasing
▲ Accumulated Depreciation is a
Accumulated Depreciation 370
contra asset account increasing

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7. Factory overhead is applied to jobs in production at an estimated rate based on the number of machine hours. Estimated factory
overhead for the year is $27,000 and the estimated number of machine hours for the year is 900.

Account Debit Credit Third debit to Work in Process

▲ Work in Process is an asset

Work in Process 2,100 (inventory) account that is
increasing
▼ Factory Overhead is an
Factory Overhead 2,100 expense account that is
decreasing

a. Calculate the predetermined factory rate: $27,000 / 900 hours = $30 per machine hour
b. Add the number of machine hours for the six jobs: 6+10+8+25+14+7=70
c. Multiply total number of machine hour by the predetermined factory overhead rate: 70 x $30 = $2,100
8. Jobs 1, 2, 3, and 5 are completed.

Account Debit Credit

▲ Finished Goods is an asset

Finished Goods 9,230 (inventory) account that is
increasing
▼ Work in Process is an asset
Work in Process 9,230 (inventory) account that is
decreasing

Once a job is completed, it is no longer considered work in process. It instead must be reclassified as finished goods. To make
this transfer, debit Finished Goods to increase that inventory account and credit the Work in Process account to decrease it.
The amount of the transfer from Work in Process to Finished Goods is determined by adding the three costs of production for
each of the four jobs that were completed. The schedule of cost of jobs completed organizes this information. Each job has a
materials cost, a factory labor cost, and a number of machine hours that is multiplied by the predetermined factory overhead
rate of $30 per hour.
Schedule of Cost of Jobs Completed
Job completed Materials Factory Labor Machine hours Total job cost

Job 1 $880 $750 6 x $30 = $180 $1,810

Job 2 1,240 990 10 x $30 = 300 2,530

Job 3 670 510 8 x $30 = 240 1,420

Job 5 1,560 1,490 14 x $30 = 420 3,470

Totals $4,350 3,740 $1,140 $9,230

9. Jobs 2 and 5 are sold on account for $4,100 and $5,200, respectively.

Account Debit Credit

▲ Accounts Receivable is an
Accounts Receivable 9,300
asset account that is increasing
▲ Sales is a revenue account that
Sales 9,300
is increasing

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 ▲ Cost of Goods Sold is an
Cost of Goods Sold 6,000 expense account that is
increasing
▼ Finished Goods is an asset
Finished Goods 6,000 (inventory) account that is
decreasing

There are two journal entries for a sale. The first is to record the selling price of the product to customers. The second is to
reduce the inventory by its cost.
Add the selling prices of the two jobs sold: $4,100 + $5,200 = $9,300
Add the manufacturing costs of the two jobs sold: $2,530 + $3,470 = $6,000
The amount of the transfer from Finished Goods to Cost of Goods Sold is determined by adding the three costs of production
for each of the two jobs that were sold. The schedule of cost of jobs sold organizes this information. Each job has a materials
cost, a factory labor cost, and a number of machine hours that is multiplied by the predetermined factory overhead rate of $30
per hour.
Schedule of Cost of Jobs Sold
Job completed Materials Factory Labor Machine hours Total cost

Job 2 $1,240 $990 10 x $30 = $300 $2,530

Job 5 1,560 1,490 14 x $30 = 420 3,470

Totals $2,800 $2,480 $720 $6,000

10. a. Actual factory overhead is $2,150.

Not enough factory overhead

Account Debit Credit
was applied in transaction #7
▲ Cost of Goods Sold is an
Cost of Goods Sold 50 expense account that is
increasing
▼ Factory Overhead is an
Factory Overhead 50
expense account decreasing

This transaction may occur weeks or months after the product is manufactured and sold. When all bills for the period have
been received and all the actual costs are known, the company adjusts the amount of estimated factory overhead to the actual
amount.
Refer to transaction #7, recorded previously, and note that $2,100 of factory overhead was applied to Work in Process
based on an estimate using machine hours.
The company now knows that actual factory overhead is $2,150. Therefore, factory overhead was under applied by $50
($2,150 - $2,100) in transaction #7. Reconciling the estimated and the actual amounts requires an additional credit to
Factory Overhead for $50. The first credit of $2,100 (transaction #7) plus this follow-up credit of $50 in (transaction #10a)
equals the actual factory overhead of $2,150.
Notice that the Cost of Goods Sold account is debited to adjust factory overhead to its actual amount. The Work in Process
account is not used when reconciling estimated to actual factory overhead. If the difference between the two is unusually
large, the estimate may need to be revised in the future.
The following is an alternative to transaction 10a. (Only 10a or 10b would occur, not both.)
b. Actual factory overhead is $2,050.

Too much factory overhead was

Account Debit Credit
applied in transaction #7

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 ▲ Factory Overhead is an
Factory Overhead 50 expense account that is
increasing
▼ Cost of Goods Sold is an
Cost of Goods Sold 50
expense account decreasing

Refer to transaction #7, recorded previously, and note that $2,100 of factory overhead was applied to Work in Process at
that time based on an estimate using machine hours.
The company now knows that actual factory overhead is $2,050. Therefore, factory overhead was over applied by $50
($2,100 - $2,050) in transaction #7. Reconciling the estimated and the actual amounts requires a debit to Factory Overhead
for $50. The first credit of $2,100 (transaction #7) minus this follow-up debit of $50 (transaction #10b) equals the actual
factory overhead of $2,050.
Two other questions related to the cost of jobs remaining in inventory may also be asked:
1. What is the cost of the items remaining in Finished Goods?
Jobs 1, 2, 3, and 5 were completed. Of those, Jobs 2 and 5 were sold. Therefore,
Jobs 1 and 3 remain in Finished Goods.
Add the manufacturing costs of the two jobs that are completed but not sold: $1,810 + $1,420 = $3,230
Schedule of Completed Jobs
Job completed Materials Factory Labor Machine hours Total job cost

Job 1 $880 $750 6 x $30 = $180 $1,810

Job 3 670 510 8 x $30 = 240 1,420

Totals $1,550 $1,260 $ 420 $3,230

2. What is the cost so far of the jobs that are still in Work in Process?
Jobs 4 and 6 were not finished at the end of the period.
Add the manufacturing costs of the two jobs that are not completed yet: $4,910 + $1,850 = $6,760
Schedule of Uncompleted Jobs
Work in process Materials Factory Labor Machine hours Total cost

Job 4 $2,300 $1,860 25 x $30 = $750 $4,910

Job 6 910 730 7 x $30 = 210 1,850

Totals $3,210 $2,590 $960 $6,760

Assuming there were no previous balances, the inventory account ledgers would appear as follows based on the previous
transactions:
Materials
Date Item Debit Credit Debit Credit

1. Materials purchased 9,400 9,400

Materials moved to
2. 7,560 1,840
production

Work in Process
Date Item Debit Credit Debit Credit

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 Materials moved to
2. 7,560 7,560
production

Labor added to
3. 6,330 13,890
production

Overhead added to
7. 2,100 15,990
production

Transferred to
9. 9,230
finished goods

Finished Goods
Date Item Debit Credit Debit Credit

Transfer from work

8. 9,230 9,230
in process

Transfer to cost of
9. 6,000 3,230
goods sold

The balances of the three inventory accounts would appear in the current assets section of the balance sheet at the end of
the accounting period, as shown in the following example.
Jonick Company Balance Sheet June 30, 2019
Assets

Current assets:

Cash $8,000

Accounts receivable 3,000

Inventory:

Materials $1,840

Work in process 6,760

Finished goods 3,230

Total inventory 11,830

Prepaid insurance 2,000

Prepaid rent 1,000

Total current assets $25,830

2.2.1 Selling and Administrative Expenses

The previous problem deals only with the factory itself. Sometimes the factory is part of a larger business. Period costs may also be
required to generate revenue, although they not involved in the manufacturing process. There may be a sales staff and other
expenses to promote and sell the manufactured items. In general, these are classified as selling expenses. There may also be
activities that do not directly relate to production or sales but are necessary to run the business. These may include a human
resources department, an accounting department, a company president, secretarial support staff, etc. All are considered
administrative expenses, outside of the factory part of the business. Here are examples that involve selling, administrative and
factory expenses. Factory Overhead is used to record only factory expenses, but not selling or administrative costs.
1. The company uses some of its raw materials to build a closet in the factory ($200), shelving in the salespeople’s offices ($150),
and braces in the administrative area ($50), for a total of $400.

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 Recording an expense in and out
Account Debit Credit
of the factory
▲ Factory Overhead is an
Factory Overhead 200 expense account that is
increasing
▲ Selling Expenses is an expense
Selling Expenses 150
account that is increasing
▲ Administrative Expenses is an
Administrative Expenses 50 expense account that is
increasing
▼ Materials is an asset
Materials 400 (inventory) account that is
decreasing

2. The company incurs labor costs for the closet in the factory ($150), shelving in the salespeople’s offices ($100), and braces in
the administrative area ($50), for a total of $300.

Recording an expense in and out

Account Debit Credit
of the factory
▲ Factory Overhead is an
Factory Overhead 150 expense account that is
increasing
▲ Selling Expenses is an expense
Selling Expenses 100
account that is increasing
▲ Administrative Expenses is an
Administrative Expenses 50 expense account that is
increasing
▲ Wages Payable is a liability
Wages Payable 300
account that is increasing

3. The company pays cash for one of its utility bills for $350. Of this total, $200 is a factory expense, $100 is a selling expense,
and $50 is an administrative expense, for a total of $350.
Recording an expense in and out
Account Debit Credit
of the factory
▲ Factory Overhead is an
Factory Overhead 200 expense account that is
increasing
▲ Selling Expenses is an expense
Selling Expenses 100
account that is increasing
▲ Administrative Expenses is an
Administrative Expenses 50 expense account that is
increasing
▼ Cash is an asset account that
Cash 350
is decreasing

4. The company receives an invoice for repair to the building. Half of that is a factory expense, $60 is a selling expense, and $40 is
an administrative expense, for a total of $200.

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 Recording an expense in and out
Account Debit Credit
of the factory
▲ Factory Overhead is an
Factory Overhead 100 expense account that is
increasing
▲ Selling Expenses is an expense
Selling Expenses 60
account that is increasing
▲ Administrative Expenses is an
Administrative Expenses 40 expense account that is
increasing
▲ Accounts Payable is a liability
Accounts Payable 200
account that is increasing

5. Prepaid insurance that the company paid in advance has expired, as follows: factory expense, $50; selling expense, $60; and
administrative expense, $40.

Recording an expense in and out

Account Debit Credit
of the factory
▲ Factory Overhead is an
Factory Overhead 50 expense account that is
increasing
▲ Selling Expenses is an expense
Selling Expenses 60
account that is increasing
▲ Administrative Expenses is an
Administrative Expenses 40 expense account that is
increasing
▼ Prepaid Insurance is an asset
Prepaid Insurance 150
account that is decreasing

6. The company records depreciation on factory equipment ($70), sales equipment ($20), and equipment used for administrative
purposes ($10), for a total of $100.

Recording an expense in and out

Account Debit Credit
of the factory
▲ Factory Overhead is an
Factory Overhead 50 expense account that is
increasing
▲ Selling Expenses is an expense
Depreciation Expenses - Selling 60
account that is increasing
▲ Administrative Expenses is an
Depreciation Expenses -
40 expense account that is
Administrative
increasing
▲ Accumulated Depreciation is a
Accumulated Depreciation 150
contra asset account increasing

This page titled 2.2: Comprehensive Example of Job Order Costing Transactions for a Manufacturing Company is shared under a CC BY-SA 4.0
license and was authored, remixed, and/or curated by Christine Jonick (GALILEO Open Learning Materials) via source content that was edited to
the style and standards of the LibreTexts platform; a detailed edit history is available upon request.

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2.3: Job Order Costing for a Service Company
Job order costing is also used for service businesses where the service and costs are unique to each customer, such as those of an
attorney, accountant, physician, or event planner. Each customer, client, or patient is a separate job or project. Clients, customers,
and patients incur direct costs, direct labor and applied overhead costs. And while there are no materials related to inventory for a
service business, there may be expenditures associated directly with a particular project, such as travel or supplies.

2.3.1 Comprehensive Example of Job Order Costing Transactions for a Service Company
Creative Compton, Inc. is an advertising agency that designs web sites and promotional materials for medium-sized businesses. For
each client project, Creative Compton accumulates the direct labor costs of its professional designersat an hourly rate of $140. The
company allocates overhead costs to jobs at a rate of 35% of total direct labor cost incurred. Creative Compton, Inc. earns a 60%
profit on each job.
Journalize the journal entries for the direct labor, the overhead, the sale of the project, and the reconciliation of actual to estimated
overhead.
1. Job 4 incurs 20 hours of professional direct labor time (20 hours x $140 per hour).

Account Debit Credit

▲ Development Costs is an asset

Development Costs 2,800
account
▲ Wages Payable is a liability
Wages Payable 2,800
account that is increasing

2. The company pays cash for the following costs that are directly related to Job 4: travel, $340; supplies, $60; and domain name
filing fees, $120.

Account Debit Credit

▲ Development Costs is an asset

Development Costs 520
account that is increasing
▼ Cash is an asset account that
Cash 520
is decreasing

3. Estimated overhead costs incurred for Job 4 are $980. ($2,800 direct wages cost x 35%)

Account Debit Credit

▲ Development Costs is an asset

Development Costs 980
account that is increasing
▼ Overhead is an expense
Overhead 980
account that is decreasing

4. A customer is invoiced for the completed Job 4.

Account Debit Credit

▲ Accounts Receivable is an
Accounts Receivable 6,880
asset account that is increasing
▲ Sales is a revenue account that
Fees Earned 6,880
is increasing
▲ Cost of Services is an expense
Cost of Service 4,300
account that is increasing

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 ▼ Development Costs is an asset
Development Costs 4,300
account that is decreasing

There are two journal entries for a sale. The first is to record the project’s selling price to the customer. The second is to reduce
the development costs incurred and expense them off to Cost of Services.
Cost of the project: $2,800 direct labor + $520 direct costs + $980 overhead costs = $4,300
Selling price of the project: $4,300 costs x 1.6 to include the markup = $6,880
5. Actual overhead for Job 4 is ultimately determined to be $960.

Too much factory overhead was

Account Debit Credit
applied in transaction #3
▲ Overhead is an expense
Overhead 20 account that is increasingthat is
increasing
▼ Cost of Services is an expense
Cost of Service 20
account decreasing

In transaction #3, recorded previously, $980 of overhead was applied to Development Costs based on an estimate of 35% of
direct labor. The difference between applied factory overhead and estimated factory overhead is $20 ($980 estimated - $960
actual). Since too much had been applied, $20 now needs to be backed out by debiting the Overhead account. Cost of Services
is used as the credit account rather than Development Costs in reconciling the Overhead account.

This page titled 2.3: Job Order Costing for a Service Company is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated
by Christine Jonick (GALILEO Open Learning Materials) via source content that was edited to the style and standards of the LibreTexts platform;
a detailed edit history is available upon request.

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 CHAPTER OVERVIEW

3: Process Costing
3.1: Introduction to Process Costing
3.2: Process Costing Transactions for a Manufacturing Company
3.3: Process Costing Calculations for a Department in a Manufacturing Company

This page titled 3: Process Costing is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by Christine Jonick
(GALILEO Open Learning Materials) via source content that was edited to the style and standards of the LibreTexts platform; a detailed edit
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1
3.1: Introduction to Process Costing
Process costing is another method of keeping track of the costs of manufactured items. Once products are completed, their overall
costs are marked up and sold at a profit to customers. Process costing is used when large quantities of identical items are
manufactured in a continuous flow on a first-in, first-out basis. Examples of products that would use process costing are Cheerios
brand cereal, iPhones, or Toyota Camrys.
Items enter production in batches rather than individually. A batch is defined as each time a quantity of materials is added to the
first point of production to keep the work flow going. Direct costs accumulate and indirect costs are applied to the batches as they
move through the production processes. A unit is one of the products that is manufactured in a batch. Eventually, costs are
averaged over the units produced during the period to determine the cost of one item.
With process costing, products typically move from department to department in a “production line” format instead of the materials
and labor coming to the product at one location (as is typically the case in job order costing, where each product is unique). Each
department performs a different function and can be considered its own little business or mini-factory. As such, each department
adds its own direct materials, direct labor, and factory overhead costs. These three costs accumulate in a departmental account
called Work in Process – Department Name, which is like the “tab” of the manufactured item. There will be three debits to Work in
Process for each department - one for direct materials, one for direct labor, and one for factory overhead.
As an example, a company manufactures the 16” chocolate chip cookies (yum!) similar to those in the cookie shops in the malls.
The company’s factory has three departments: (1) Mixing, (2) Baking, and (3) Packaging. The products move through these
departments in order: Mixing first, Baking next, and Packaging last. The process occurs on a FIFO (first in, first out) basis where
the first batch started is the first one to be completed. The batch started behind the first batch is the next to be completed, and so
forth. Each time the Mixing Department adds more ingredients, a new batch is introduced into the overall production line.
Process costing involves recording product costs for each manufacturing department (or process) as the product moves through.
Each department has its own Work in Process and Factory Overhead accounts that include the department names, as follows:

Department Work in Process account Factory Overhead account

Mixing Work in Process – Mixing Factory Overhead – Mixing

Baking Work in Process – Baking Factory Overhead – Baking

Packaging Work in Process – Packaging Factory Overhead – Packaging

The batch moves from one department to the next. Materials, labor, and factory overhead costs are added in each department. The
sum of the departmental work in process costs is the total cost of the batch that is transferred to Finished Goods.

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3.2: Process Costing Transactions for a Manufacturing Company
Cost accumulation in each department and the transfer from one department to the next is recorded using the following series of
journal entries.

Mixing Department
A batch begins in the Mixing Department when materials are added.
1. Direct materials - ingredients such as flour, eggs, sugar, and (of course) chocolate chips - that cost $4,600 and indirect materials
that cost $400 are requisitioned.

Account Debit Credit

▲ Work in Process is an asset

Work in Process – Mixing Dept. 4,600 (inventory) account that is
increasing
▲ Factory Overhead is an
Factory Overhead – Mixing
400 expense account that is
Dept.
increasing
▼ Materials is an asset
Materials 5,000 (inventory) account that is
decreasing

2. Direct labor - workers combining ingredients, hand stirring the batter, and operating the mixers - costs $2,100 and indirect labor
for general factory use costs $200.

Account Debit Credit

▲ Work in Process is an asset

Work in Process – Mixing Dept. 2,100 (inventory) account that is
increasing
▲ Factory Overhead is an
Factory Overhead – Mixing
200 expense account that is
Dept.
increasing
▲ Wages Payable is a liability
Wages Payable 2,300
account that is increasing

3. Factory overhead of $1,000 is applied on an estimated basis so that the batch absorbs a proportionate share of the department’s
general factory costs, such as utilities, insurance, and supervisor salary.

Account Debit Credit

▲ Work in Process is an asset

Work in Process – Mixing Dept. 1,000 (inventory) account that is
increasing
▼ Factory Overhead is an
Factory Overhead – Mixing
1,000 expense account that is
Dept.
decreasing

Notice there are three debits to Work in Process - Mixing for the three costs of manufacturing in Mixing. These three debits total
$7,700 ($4,600 + $2,100 + $1,000).
Once the batch is mixed, there is nothing more the Mixing Department can do; in terms of mixing, the product is complete. The
mixed batch is then sent off to the Baking Department by crediting Work in Process - Mixing (decreasing that asset account) and

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 debiting Work in Process - Baking (increasing that asset account) for $7,700.
4. Transfer from the Mixing Department to the Baking Department, $7,700

Account Debit Credit

▲ Work in Process is an asset

Work in Process – Baking Dept. 7,700 (inventory) account that is
increasing
▼ Work in Process is an asset
Work in Process – Mixing Dept. 7,700 (inventory) account that is
decreasing

(Although not illustrated here because our journal entries are only tracking the first batch, as the work in process is transferred
from Mixing to Baking, a new batch of materials may be introduced into the Mixing Department to keep the flow of production
continuous.)

Baking Department
The batch is now in production in the Baking Department.
5. Direct materials - spray oil used to keep the cookies from sticking to the pans - that costs $600 and indirect materials that cost
$300 are requisitioned.

Account Debit Credit

▲ Work in Process is an asset

Work in Process – Baking Dept. 600 (inventory) account that is
increasing
▲ Factory Overhead is an
Factory Overhead – Baking
300 expense account that is
Dept.
increasing
▼ Materials is an asset
Materials 900 (inventory) account that is
decreasing

6. Direct labor - workers pressing the cookies onto sheets and operating machinery - costs $1,400 and indirect labor for general
factory use costs $100.

Account Debit Credit

▲ Work in Process is an asset

Work in Process – Baking Dept. 1,400 (inventory) account that is
increasing
▲ Factory Overhead is an
Factory Overhead – Baking
100 expense account that is
Dept.
increasing
▲ Wages Payable is a liability
Wages Payable 1,500
account that is increasing

7. Factory overhead of $500 is applied on an estimated basis so that the batch absorbs a proportionate share of the department’s
general factory costs, such as utilities, insurance, and supervisor salary.

Account Debit Credit

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 ▲ Work in Process is an asset
Work in Process – Baking Dept. 500 (inventory) account that is
increasing
▼ Factory Overhead is an
Factory Overhead – Mixing
500 expense account that is
Dept.
decreasing

Notice there are four debits to Work in Process – Baking. One is for the cost transferred in from the Mixing Department; the
others are the three costs of manufacturing added in the Baking Department. These four debits total $10,200 ($7,700 + $600 +
$1,400 + $500).
Once the batch is baked, there is nothing more the Baking Department can do; as far as what it is set up to do, the product is
complete. So, it transfers the baked batch to the Packaging Department by crediting Work in Process - Baking (decreasing that
asset account) and debiting Work in Process - Packaging (increasing that asset account) for $10,200.
8. Transfer from the Baking Department to the Packaging Department, $10,200

Account Debit Credit

▲ Work in Process is an asset

Work in Process – Packaging
10,200 (inventory) account that is
Dept.
increasing
▼ Work in Process is an asset
Work in Process – Baking Dept. 10,200 (inventory) account that is
decreasing

Packaging Department
The batch is now in production in the Packaging Department.
9. Direct materials - boxes and packing materials - that cost $1,100 and indirect materials that cost $900 are requisitioned.

Account Debit Credit

▲ Work in Process is an asset

Work in Process – Packaging
1,100 (inventory) account that is
Dept.
increasing
▲ Factory Overhead is an
Factory Overhead – Packaging
900 expense account that is
Dept.
increasing
▼ Materials is an asset
Materials 2,000 (inventory) account that is
decreasing

10. Direct labor - workers hand packing and sealing shipping boxes - costs $3,000 and indirect labor for general factory use costs
$700.

Account Debit Credit

▲ Work in Process is an asset

Work in Process – Packaging
3,000 (inventory) account that is
Dept.
increasing
▲ Factory Overhead is an
Factory Overhead – Packaging
700 expense account that is
Dept.
increasing

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 ▲ Wages Payable is a liability
Wages Payable 3,700
account that is increasing

11. Factory overhead of $900 is applied on an estimated basis so that the batch absorbs a proportionate share of the department’s
general factory costs, such as utilities, insurance, and supervisor salary.

Account Debit Credit

▲ Work in Process is an asset

Work in Process – Packaging
900 (inventory) account that is
Dept.
increasing
▼ Factory Overhead is an
Factory Overhead – Packaging
900 expense account that is
Dept.
decreasing

Notice there are four debits to Work in Process – Packaging. One is for the cost transferred in from the Baking Department; the
others are the three costs of manufacturing in Packaging. These four debits total $15,200 ($10,200 + $1,100 + $3,000 + $900).

Transfer from Packaging Department to finished Goods

Once the batch is packed in boxes, there is nothing more the Packaging Department can do; the product is entirely complete. The
packaged batch is transferred to Finished Goods at the overall accumulated cost of $15,200.
12. Transfer from the Packaging Department to Finished Goods, $15,200

Account Debit Credit

▲ Finished Goods is an asset

Finished Goods 15,200 (inventory) account that is
increasing
▼ Work in Process is an asset
Work in Process – Packaging
15,200 (inventory) account that is
Dept.
decreasing

The manufactured goods accumulate costs all throughout the production process. Each batch picks up materials cost, direct
labor cost, and factory overhead cost in each of the three departments. The total of all these costs equals the total cost of
producing the batch. Determining the cost of the batch and the cost of each unit in the batch is the goal of process costing.
The process costing journal entries illustrate the cost accumulation process through the three Work in Process accounts all the
way through to Finished Goods. There are other process costing transactions that are similar to those for job order costing. A
process costing manufacturer would also purchase materials on account, record numerous factory expenses by debiting Factory
Overhead (in a specific department), sell goods on account and recognize a corresponding reduction of finished goods
inventory, and account for over applied and under applied factory overhead amounts. Examples of these transactions are shown
under the Job Order Costing topic and will not be repeated here. The only difference between the two methods is that under
process costing the department name must be included whenever a Factory Overhead account is used.

Tracking Product Costs

There are three departments in the cookie factory example, and each one operates independently and does its own accounting.
Assuming the company prepares monthly financial statements, each department must provide monthly information about its
inventory for the balance sheet. We will now just look at the recordkeeping that occurs in a single department for a one-month
period.
We will now focus only on the Packaging Department in the month of May. Assume you are the Packaging Department manager.
You are responsible for keeping track of the cost of every unit that has been started and passes through your department during the

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month, whether the units have been finished by the end of May or not. For those units that have been completed, you must figure
the total cost of each batch and the cost of each unit in the batch. For those units that are in production but not yet completed by the
end of the month, you must determine the cost to date of that batch and each unit in the batch.
We will make two assumptions: (1) All materials that are needed to work on a batch of items in a department are added when the
batch is started; (2) When a batch is started in the department, it will either be completed in the same month or completed in the
following month.
Remember that there are three costs of a manufactured item: direct materials, direct labor, and factory overhead. Conversion costs
are simply direct labor PLUS factory overhead. For process costing, the two costs of a manufactured item will be referred to as
direct materials and conversion costs.

 ANALOGY

There are three departments in this factory. If you are the manager of the Packaging Department, your responsibility is limited
to tracking the costs of the units in your department, but not in any of the other departments. The other departments have their
own managers to take care of accounting for their costs. You don’t have to keep track of the cost of every item in EVERY
department - just your own.
Similarly, as a university professor, I have to report final course grades for the 160 students in my four classes. During the
semester I record exam, homework, and project grades for my students, and from those I mathematically calculate each
student’s final course grade. It is my responsibility to do this for every student in my classes, but I do not have to calculate the
final course grades for all students in all classes at the university!

In a process costing system, both the cost of units transferred out of each department and the cost of any partially completed units
remaining in the department must be determined.
In each department, we determine both the total and per-unit costs of the products that were completed in a given month. These
completed units are classified into two groups: those started in the previous month and those started in the current month. The per-
unit cost is not necessarily the same in the two groups, and any difference may be analyzed to see if unit cost is decreasing
(typically favorable) or increasing (unfavorable) over time.
We also accumulate costs for a third group of products: those started in the current month but not completed by the end of the
month. Their costs include 100% of the materials cost and a percentage below 100% of the conversion costsbased on how complete
they are to date. This third group, not finished by the end of the current month, becomes the beginning work in process for the next
month, when the remaining conversion will take place to complete them.
The following timeline illustrates the flow of product from month to month.

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3.3: Process Costing Calculations for a Department in a Manufacturing Company
Goals of process costing are to determine a manufacturing department’s cost of finished goods during a month and the cost of work
in process at the end of that month. An example of the process follows.
Information for production in the Packaging Department for May is as follows:

Beginning work in process, May 1: 5,900 units, 20% completed (1) $102,896

Direct materials costs in May for 44,700 units 599,427

Direct labor costs incurred in May 589,323

Factory overhead costs incurred in May 314,601

A grid is used to organize the unit (not dollar) information above and to calculate key amounts.
The first step is to classify the units into one of three groups in the whole units column based on when they were started and
completed according to the information given.

Equivalent Units of Production Equivalent Units of Production

Group Whole Units
for Materials for Conversion Costs

(1) Started in April; Completed in (1)

May 5,900

(2) Started in May; Completed in (2)

May 37,400

(3) Started in May; Completed in (3)

June 7,300

(4)
TOTAL
50,600

(1) Group 1 consists of 5,900 (given) units started the previous month and completed this month.
(2) Group 2 includes 37,400 units that are both started and completed this month. This amount must be calculated in one of two
ways.
a. Total completed in May (43,300) minus those started in April (5,900) = 37,400
b. Total started in May (44,700) minus those not completed in May (7,300) = 37,400 (Remember the assumption that the job is
started when materials are added.)
(3) Group 3 has 7,300 (given) units started this month to be completed next month.
(4) Total whole units equals the sum of the whole units in the three groups:
5,900 + 37,400 + 7,300 = 50,600
The second step is to classify the units into one of three groups in the equivalent units of production for materials column based
on when they were started and completed according to the information given. Remember the assumption is that materials are added
when a batch is started. Equivalent units of production for materials equals the number of units in each group that had materials
added in May.

Equivalent Units of Production Equivalent Units of Production

Group Whole Units
for Materials for Conversion Costs

(1) Started in April; Completed in (1) (5)

May 5,900 0

(2) Started in May; Completed in (2) (6)

May 37,400 37,400

(3) Started in May; Completed in (3) (7)

June 7,300 7,300

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 (4) (8)
TOTAL
50,600 44,700

The first group was started in April, so none of the whole units had materials added in May (all were added in April, when started).
The second and third groups were started in May, so all of the whole units had materials added in May.
(5) Group 1: The equivalent units of production for materials is zero.
(6) Group 2: The equivalent units of production is the same as the whole units amount, 37,400.
(7) Group 3: The equivalent units of production is the same as the whole units amount, 7,300.
(8) Total materials equals the sum of the materials in the three groups.
Calculation: 0 + 37,400 + 7,300 = 44,700
The third step is to classify the units into one of three groups in the equivalent units of production for conversion costs (direct
labor and factory overhead) column based on when they were started and completed according to the information given.

Equivalent Units of Production Equivalent Units of Production

Group Whole Units
for Materials for Conversion Costs

(1) Started in April; Completed in (1) (5) (9)

May 5,900 0 4,720

(2) Started in May; Completed in (2) (6) (10)

May 37,400 37,400 37,400

(3) Started in May; Completed in (3) (7) (11)

June 7,300 7,300 2,190

(4) (8) (12)

TOTAL
50,600 44,700 44,310

Equivalent units of production for conversion costs uses the percentages of conversion costs completed in May that are given to
mathematically convert partial units to whole units for costing purposes. The equivalent units of production for conversion costs
equals the number of whole units times the percentage of conversion that takes place in May.
(9) Group 1: The units were already 20% complete at the beginning of May, so the remaining 80% of the conversion costs are
incurred in May.
Calculation: 5,900 x 80% = 4,720
(10) Group 2: These units are started and completed in May, so 100% of the conversion costs takes place in May.
Calculation: 37,400 x 100% = 37,400
(11) Group 3: Only 30% of the conversion costs takes place in May. The remaining conversion will take place in June.
Calculation: 7,300 x 30% = 2,190
(12) Total equivalent units of production for conversion costs equals the sum of the three groups.
Calculation: 4,720 + 37,400 + 2,190 = 44,310

 Example

Think of equivalent units of production for conversion costs like this. You have 8 one-gallon buckets in your backyard. It starts
to pour rain. When the rain stops, you go out and see that each bucket is 3/4 full. Mathematically you can convert this to say
that the same amount of water would make 6 of the buckets 100% full (8 x 3/4). It is highly unlikely that it would rain in such a
way that only one bucket would fill at a time. But after the rain stopped, you could empty two of the buckets by filling the
other six.
(If you had to carry the water a mile and could only carry two buckets at a time, combining them would save you one trip! You
would only have to go three times rather than four!)

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The following dollar amounts should now be calculated from the information given, as follows:
1. Total conversion costs in May
Calculation: $589,323 (direct labor) + $314,601 (factory overhead) = $903,924
2. Conversion cost per equivalent unit
Calculation: $903,924 total conversion cost /44,310 equivalent units = $20.40 per unit
3. Materials cost per unit started in May
Calculation: $599,427 total materials cost / 44,700 units started = $13.41 per unit
4. Cost per unit of work in process on May 1 (100% of materials + 20% of conversion costs)
Calculation: $102,896 total work in process cost / 5,900 units started = $17.44 per unit
In a process costing system, the cost of units transferred out of each department must be determined as well as the cost of any
partially completed units remaining in the department. Based on the previous calculations, the following seven cost results can be
determined. These amounts are the goals of process costing and can be used to determine progress and for comparison purposes
over time.
1. Cost per unit of finished goods started in April and completed in May
Calculation: $17.44 + ($20.40 x 80%) = $17.44 + $16.32 = $33.76
2. Total cost of all finished goods started in April and completed in May
Calculation: $33.76 (from #1) x 5,900 whole units = $199,184
3. Cost per unit of finished goods started and completed in May
Calculation: $13.41 + $20.40 = $33.81
4. Total cost of all finished goods started and completed in May
Calculation: $33.81 (from #2) x 37,400 whole units = $1,264,494
5. Cost per unit of the work in process inventory on May 31
Calculation: $13.41 + ($20.40 x 30%) = $19.53
6. Total cost of the work in process inventory on May 31
Calculation: $19.53 (from #3) x 7,300 whole units = $142,569
7. Total cost of units transferred to Finished Goods
Calculation: $199,184 + $1,264,494 = $1,463,678
The following journal entries relate to the production activity for the Packaging Department in May.
1. Direct materials costs incurred for 44,700 units, $599,427 (given)

Account Debit Credit

▲ Work in Process is an asset

Work in Process – Packaging
599,427 (inventory) account that is
Dept.
increasing
▼ Materials is an asset
Materials 599,427 (inventory) account that is
decreasing

2. Direct labor costs incurred, $589,323 (given)

Account Debit Credit

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 Account Debit Credit

▲ Work in Process is an asset

Work in Process – Packaging
589,323 (inventory) account that is
Dept.
increasing
▲ Wages Payable is a liability
Wages Payable 589,323
account that is increasing

3. Factory overhead applied, $314,601 (given)

Account Debit Credit

▲ Work in Process is an asset

Work in Process – Packaging
314,601 (inventory) account that is
Dept.
increasing
▼ Factory Overhead is an
Factory Overhead – Packaging
314,601 expense account that is
Dept.
decreasing

4. Transfer of completed products to Finished Goods, $1,463,678

Account Debit Credit

▲ Finished Goods is an asset

Finished Goods 1,463,678 (inventory) account that is
increasing
▼ Work in Process is an asset
Work in Process - Packaging
1,463,678 (inventory) account that is
Dept.
decreasing

The Work in Process - Packaging ledger account summarizes these transactions and balances.
Work in Process – Packaging Department
Date Item Debit Credit Debit Credit

Beginning work in
1. 102,896
process, May 1

Materials added to
2. 599,427 702,323
production in May

Labor added to
3. 589,323 1,291,646
production in May

Overhead added to
4. 314,601 1,606,247
production in May

Transferred to
5. 1,463,678
Finished Goods

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 CHAPTER OVERVIEW

4: Activity-Based Costing
4.1: Introduction to Activity-Based Costing
4.2: Single factory rate to estimate factory overhead
4.3: Departmental rates to estimate factory overhead
4.4: Activity-based costing for a manufacturing business to estimate factory overhead
4.5: Differences based on factory overhead method
4.6: Activity-based costing for a manufacturing business to estimate factory overhead
4.7: Activity-based costing for a service business to estimate factory overhead

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1
4.1: Introduction to Activity-Based Costing
Companies must accurately determine the costs of their products and services to make sound management decisions, such as
determining their selling prices to customers. A manufacturer’s product costs consist of direct materials, direct labor, and factory
overhead. The materials and labor are direct costs that can be identified and traced to the product. Factory overhead, however, are
indirect and must be allocated to the product cost on an estimated basis.
We have already looked at applying factory overhead to work in process using a predetermined factory overhead rate in the
discussion of job order costing. We used a single factory overhead rate based on direct labor hours, total direct labor, or machine
hours.
The following journal entry is an example of allocating $2,100 of factory overhead to work in process.

Account Debit Credit

▲ Work in Process is an asset

Work in Process 2,100 (inventory) account that is
increasing
▼ Factory Overhead is an
Factory Overhead 2,100 expense account that is
decreasing

The issue we address now is how precise the estimate of $2,100 actually is. Three different ways of allocating factory overhead
will be looked at, as follows:
1. Single factory-wide rate – the same rate based on the same activity base for all departments
2. Departmental rates – different rates for different departments, but a single rate within a department
3. Activity-based costing – different rates for different processes and activities, regardless of department
An example of two different orders of custom wood furniture will be used to illustrate the three methods. Both the direct materials
and direct labor costs are known for each job; only the factory overhead must be estimated. Assume jobs are manufactured in a
factory with two departments, Cutting and Assembly.

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4.2: Single factory rate to estimate factory overhead
A single predetermined rate may be used to estimate factory overhead in all departments. The following amounts are given.
Estimated factory overhead is based on number of direct labor hours used.

Total budgeted factory overhead costs for the year $546,000

Total budgeted direct labor hours 3,000

The factory overhead rate is $182 per direct labor hour, determined as follows.
Total budgeted factory overhead $546,000
= $182
Total budgeted activity base 3,000

If 300 direct labor hours are used for the two jobs as follows, total estimated factory overhead is $54,600.

Job 1: 210 hours x $182 per direct labor hour = $38,220

Job 2: 90 hours x $182 per direct labor hour = 16,380

¯
¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯
¯
Total $54, 600

The journal entry to apply factory overhead of $54,600 to the jobs is as follows:

Account Debit Credit

▲ Work in Process is an asset

Work in Process 54,600 (inventory) account that is
increasing
▼ Factory Overhead is an
Factory Overhead 54,600 expense account that is
decreasing

Rather than direct labor hours, machine hours, percentage of direct labor, or other relevant activity base could be used to estimate
factory overhead.
The single factory-wide rate is relatively simple to apply, but it assumes the same rate across all departments, each of which
performs different functions. It also assumes all products consume factory overhead at the same rate. This “one-size-fits-all”
approach may not be as accurate as other more targeted methods of estimating.

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4.3: Departmental rates to estimate factory overhead
A different predetermined rate may be used to estimate factory overhead in each department. Within a department, the rate is the
same for all products. The following amounts are given.

Total budgeted factory overhead costs for the Cutting Department for
$310,000
the year

Total budgeted direct labor hours for the Cutting Department 2,000

Total budgeted factory overhead costs for the Assembly Department for
$236,000
the year

Total budgeted direct labor hours for the Assembly Department 1,000

The department factory overhead rate is $155 per direct labor hour in the Cutting Department and $236 per direct labor hour in the
Assembly Department, determined as follows.

Cutting Assembly

Budgeted departmental factory overhead $310,000 $236,000

Departmental budgeted activity base 2,000 = $155 1,000 = $236

Direct labor hours used and factory overhead estimated for this job are as follows:

Job 1: Cutting Department 135 direct labor hours x $155 = $20,925

Job 1: Assembly Department 75 direct labor hours x $236 = 17,700

¯
¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯
¯
Job 1: Total $38, 625

Job 2: Cutting Department 65 direct labor hours x $155 = $10,075

Job 2: Assembly Department 25 direct labor hours x $236 = 5,900

¯
¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯
¯
Job 2: Total $15, 975

Total $54,600

The journal entry to apply factory overhead of $54,600 to this job is as follows:

Account Debit Credit

▲ Work in Process is an asset

Work in Process 54,600
(inventory)
▼ Factory Overhead is an
Factory Overhead 54,600 expense account that is
decreasing

In the example so far, the use of departmental rates vs. a single factory rate yields different results in terms of how much factory
overhead is applied to each of the two jobs. Although the total factory overhead applied, $54,600, is the same under both methods,
the amount allocated to each job differs, as follows:

Single Factory Departmental

Job 1: $38,220 $38,625

Job 2: 16,380 15,975

Using departmental rates is more job-specific and therefore results in a more precise allocation of factory overhead to the jobs than
the single rate. However, it takes a bit more effort to calculate vs. using the single factory rate that is applied to all jobs uniformly.

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4.4: Activity-based costing for a manufacturing business to estimate factory
overhead
 Example

Recall that the simplest method for estimating factory overhead is to use the same predetermined rate in all departments, for all
activities, and for all products in a manufacturing facility. Two amounts must be estimated for the calculation, as follows:
Total budgeted factory overhead

Total budgeted activity base (such as direct labor hours, machine hours, etc.)

The single factory overhead rate is a very loose estimate because it relies on one fixed dollar amount to assign factory overhead
costs across the many facets, various segments, and different activities involved in the manufacturing process. It is unlikely that one
rate can capture all the diversity of what goes on in a factory with reliable precision.
Activity-based costing (ABC) is a more specific and more accurate way of assigning factory overhead to manufactured goods
versus using single factory or departmental rates. An activity is a unit of work that consumes resources when performed by a
company. A cost object (in the case of manufacturing, the item produced) is the target of the activity. Cost objects include products,
jobs, services, projects, clients, patients, customers, and contracts.
In a factory, ABC identifies activities within the manufacturing process that occur repeatedly, such as purchasing, production
scheduling, setups, moves, inspections, testing, clean-ups, and invoicing. Each activity has its own activity base to measure usage.
The following list matches common activities of a manufacturing company with their respective activity bases.

Accounting reports Number of accounting reports

Customer return processing Number of customer returns

Electric power Kilowatt hours used

Human resources Number of employees

Inventory control Number of inventory transactions

Invoice and collecting Number of customer orders

Machine depreciation Number of machine hours

Materials handling Number of material moves

Order shipping Number of customer orders

Payroll Number of payroll checks processed

Production control Number of production orders

Production setup Number of setups

Purchasing Number of purchase orders

Quality control Number of inspections

Sales order processing Number of sales orders

A factory overhead rate for each routinely-performed activity is calculated by dividing the total budgeted cost amount for the
activity for a period by the budgeted activity base quantity over the same time frame. The fraction for each activity is similar to the
one used for the predetermined single factory rate, except at a more micro level.
There may still be some factory overhead costs that are not associated with any particular activity for the cutting and assembly
processes. These may include factory expenses such as utilities, maintenance, insurance, and depreciation. These general overhead
costs must be applied to jobs on an estimated (or “budgeted”) basis. In this example, machine hours and direct labor hours will be
used as the activity base for cutting and assembly, respectively. Factory overhead amounts for the cutting and assembly processes
will be less than those under the single rate or departmental rate methods since the costs for identifiable activities have already been
separated out.

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The following information lists a company’s six production activities and a fraction for each that is used to determine the activity
rate in the right column. The denominator for each fraction is the activity base used. The amounts in the Calculation column are
estimates that are given, presumably prepared by management using available company data.

Activity Fraction Calculation Activity Rate

Budge te d total c ost of se tups $1,700
Setups Budge te d numbe r of se tups 34
$ 50 per setup

Budge te d total c ost of move s

Moves Budge te d numbe r of move s
$450

30
$ 15 per move

Budge te d total c ost of inspe c tions

Inspections Budge te d numbe r of inspe c tions
$7,500
$ 25 per inspection
300

Budge te d total c ost of c le an-ups $1,450

Clean-ups Budge te d numbe r of c le an-ups 145
$10 per cleanup

Budge te d total ge ne ral c utting c osts $39,000

Cutting Budge te d mac hine hours 1,300
$30 per machine hour

Budge te d total ge ne ral asse mbly c osts

Assembly Budge te d dire c t labor hours
$4,500
$15 per direct labor hour
300

The following example will illustrate ABC for estimating factory overhead for a custom furniture manufacturer whose production
takes place in its Cutting and Assembly departments. Identifiable activities include setups, moves, inspections, and cleanups.
The company uses ABC to estimate factory overhead for two jobs. Job 1 is a batch of 300 identical nine-drawer wood dressers. Job
2 is a batch of 160 identical free-standing wood clothing closets.
The usage amounts of these activities for each job are given in the following table. For each job, the number of times each activity
occurs is multiplied by the overhead rate for that activity. The sum of all the activity costs is the amount of factory overhead
applied to the job.

Activity Rate
Activity Dresser Usage Dresser Costs Closet Usage Closet Costs
(calculated above)

Setups $50 per setup 24 setups $50 x 24 = $1,200 10 setups $50 x 10 = $500

Material transfers $15 per move 20 moves $15 x 20 = 300 10 moves $15 x 10 = 150

Inspections $25 per inspection 140 inspections $25 x 140 = 3,500 160 inspections $25 x 160 = 4,000

Cleanups $10 per cleanup 85 cleanups $10 x 85 = 850 60 cleanups $10 x 60 = 600

$30 per machine hour

Cutting 950 mh $30 x 950 = 28,500 350 mh $30 x 350 = 10,500
(mh)

$15 per direct labor

Assembly 210 dlh $15 x 210 = 3,150 90 dlh $15 x 90 = 1,350
hour (dlh)

$ 37,500 $17,100

The journal entry to apply factory overhead of $54,600 ($37,500 + $17,100) to the two jobs using ABC is as follows:

Account Debit Credit

▲ Work in Process is an asset

Work in Process 54,600 (inventory) account that is
increasing
▼ Factory Overhead is an
Factory Overhead 54,600 expense account that is
decreasing

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4.5: Differences based on factory overhead method
Although the total factory overhead applied, $54,600, is the same for all three methods, how it is allocated between the two jobs
varies by method, as follows:

Single Factory Departmental ABC Costing

Job 1: $38,220 $38,625 $37,500

Job 2: 16,380 15,975 17,100

Total ¯
¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯
$54, 600
¯ ¯
¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯
$54, 600
¯ ¯
¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯
$54, 600
¯

ABC is the most specific strategy because it analyzes identifiable activities closely, resulting in more precise estimates of many of
the elements of overall factory overhead. The results of the other two methods in the sample problem would overstate the amount
of factory overhead that is applied to Job 1 and understate the amount for Job 2. When making decisions, such as determining a
product’s selling price, it is critical to have sound cost information.

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4.6: Activity-based costing for a manufacturing business to estimate factory
overhead
 Example

Speed Rider, Inc. manufactures golf carts and go karts. The company budgeted $562,000 for the year for factory overhead and
assigned it to four activities: fabrication, $195,000; assembly, $160,000; setup, $138,000; and inspection, $84,000. The
company plans to produce 500 golf carts and 700 go karts during the year.
The activity-base usage quantities for each product by each activity are as follows:

Fabrication Assembly Setup Inspection

Golf cart 1,800 dlh 1,600 dlh 200 setups 700 inspections

Go kart 1,200 2,400 400 500

Determine the activity-based factory overhead per unit for each product.
1. Calculate the rate for each activity

Fabrication $195,000 / (1,800 + 1,200) = $65 per direct labor hour

Assembly $160,000 / (1,600 + 2,400) = $40 per direct labor hour

Setup $138,000 / (200 + 400) = $230 per setup

Inspection $ 84,000 / (700 + 500) = $70 per inspection

2. Calculate the total overhead for each vehicle by adding its four overhead costs.

($70 x 700
($65 x ($40 x ($230 x
Golf cart + + + inspections
1,800 dlh) 1,600 dlh) 200 setups)
)

$117,000 + $64,000 + $46,000 + $49,000 = $276,000

($70 x 500
($65 x ($40 x ($230 x
Go kart + + + inspections
1,200 dlh) 2,400 dlh) 400 setups)
)

$78,000 + $96,000 + $92,000 + $35,000 = $301,000

3. Calculate the overhead per vehicle by dividing total cost for all units by the number of units budgeted.

Golf cart $276,000 / 500 units = $552 factory overhead per jet ski

$430 factory overhead per

Go kart $301,000 / 700 units =
snowmobile

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4.7: Activity-based costing for a service business to estimate factory overhead
Service businesses may also use activity-based costing to allocate general overhead costs to clients, patients, and guests, also by
estimating costs of activities based on their use of resources, and assigning costs to customers based on their use of activities.
A hospital, for example, might identify the following activities whose general costs must be shared among patients. Each activity
rate is estimated based on the activity’s budgeted overhead cost for the year divided by the number of occurrences expected during
the year. For each patient stay, the number of times each activity occurs is multiplied by the overhead rate for that activity. The sum
of all the activity costs is the amount of overhead applied to the cost of servicing the patient.
ABC costing for a patient’s six-day stay in a hospital is summarized in the following table.

Activity Activity Rate (estimated) Patient usage Patient Costs

Admissions $70 per admission 1 admission $70 x 1 = $70

Operating room use $900 per hour 4 hours $900 x 4 = 3,600

Dispensing medications $25 per administration 3 times per day / 6 days $25 x 3 x 6 = 450

Radiology testing $290 per image 2 images $290 x 2 = 580

Diagnostic lab $150 test 6 tests $150 x 6 = 900 = 900

Medical assistance $20 per visit 6 visits per day / 6 days $20 x 6 x 6 = 720

Cleaning and laundry $80 per day 6 days $80 x 6 = 480

Discharge $100 per discharge 1 discharge $100 x 1 = 100

TOTAL = $6,900

A total of $6,900 of overhead costs is associated with this patient’s hospital stay.
ABC increases the accuracy of allocating overhead by budgeting multiple targeted activities that can be estimated more precisely
than relying on one general overhead rate that applies to all overhead in a business This more granular approach also gives
companies better insight into ways to control the cost of a product, such as reducing the time it takes to perform an activity or
decreasing the number of times an activity occurs.
ABC helps managers, who already view costs by activity, and accountants communicate more effectively. “An activity-based
system aligns organizational information with the business mission and operations rather than financial transactions. It tears down
the barriers that segregate financial information from other information.” 1

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 CHAPTER OVERVIEW

5: Cost Volume Profit Analysis

5.1: Introduction to Cost Volume Profit Analysis
5.2: Cost Volume Profit Analysis (CVP)
5.3: Breakeven Point
5.4: Operating leverage
5.5: Margin of safety

Thumbnail: Image by olia danilevich from Pexels

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1
5.1: Introduction to Cost Volume Profit Analysis
Businesses focus on profitability and look for ways to improve operational performance by analyzing projected or actual financial
information. One relatively simple strategy is to look at cost behavior, which is how costs respond to changes in sales volume.
Knowing how costs behave helps managers forecast operating income based on sales volume. This insight also helps managers
estimate costs related to the decisions they make in the business.

Cost Classifications
Costs are classified as variable, fixed, or mixed.
A variable cost is an expenditure directly associated with a sale. For each sale of a unit of product or service, one unit of variable
cost is incurred.
The following are three examples. The sale of one manufactured desk for $200 includes the direct materials and direct labor costs
combined of $100. The sale of one pizza for $10 has the variable cost of $3 for the cost of the ingredients. The rental of one room
night at a hotel for $80 has the variable cost $5 for the guests’ breakfast that is included. There is only a variable cost if there is
sale. The more sales there are, the more total variable cost there is.
The following table illustrates the cost behavior of a variable cost using the pizza example.

Number of pizzas sold Variable cost per pizza Total variable cost for all pizzas sold

200 $3 $600

400 3 1,200

600 3 1,800

800 3 2,400

Variable cost behavior is summarized as follows:

1. Variable cost per unit is the same regardless of number of units sold Example: Regardless whether 200 or 800 pizzas are sold,
the cost of making each pizza is $3.
2. Total variable cost increases (or decreases) as the number of units sold increases (or decreases)
Example: Total variable cost is $600 for 200 pizzas sold and increases to $2,400 for 800 pizzas.
The more pizzas sold, the more the total variable cost is.
Fixed costs remain the same in terms of their total dollar amount, regardless of the number of units sold. These are general
expenditures that cannot be traced to any one item sold and may include electricity, insurance, depreciation, salary, and rent
expenses.
Fixed costs are considered within a relevant range. The costs remain the same regardless of the number of units sold until capacity
has been reached, at which time the company cannot produce or sell any more without spending money for expansion. We will
assume for our examples that the business is operating within its relevant range.
The following table illustrates fixed and variable cost behaviors using the pizza example.

Number of pizzas sold Total fixed costs Fixed cost per pizza Variable cost per pizza Total variable costs

200 $480 $2.40 $3.00 $600

400 480 1.20 3.00 1,200

600 480 0.80 3.00 1,800

800 480 0.60 3.00 2,400

1. Total fixed costs remain the same regardless of the level of sales. Example: Regardless whether 200 or 800 pizzas are sold, total
fixed cost is $480.
2. Fixed cost per unit decreases (increases) as the number of units sold increases (decreases)
Example: Fixed cost per unit is $2.40 for 200 pizzas sold and decreases to $.60 each for 800 pizzas.

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The term leverage relates to fixed costs in terms of their ability to generate sales. Since a company is committed to paying them, it
wants to maximize the value from doing so. The goal is to “get the most bang for your buck” for the fixed amount the company
must pay each period. Leverage is taking advantage of fixed costs to generate sales. The more sales, the better fixed costs have
been leveraged.
The table that follows summarizes the cost totals for the four quantities/ batches of pizza sold.

Number of pizzas sold (batch) Total cost of the batch of pizzas Cost per pizza using unit costs Cost per pizza using total cost

200 $600 + $480 = $1,080 $2.40 + $3.00 = $5.40 $1,080 / 200 pizzas = $5.40

400 1,200 + 480 = 1,680 1.20 + 3.00 = 4.20 1,680 / 400 pizzas = 4.20

600 1,800 + 480 = 2,280 0.80 + 3.00 = 3.80 2,280 / 600 pizzas = 3.80

800 2,400 + 480 = 2,880 0.60 + 3.00 = 3.60 2,880 / 800 pizzas = 3.60

The total cost of a batch of pizzas equals total variable cost plus total fixed cost. The cost per pizza in each batch can be determined
in two ways: (1) fixed cost per pizza plus variable cost per pizza or (2) total cost per batch divided by the number of pizzas in the
batch. Both calculations produce the same result.
The batch of 800 units generates the most sales dollars from its fixed costs and therefore leverages them most effectively. The more
highly leveraged, the lower the fixed cost per unit. In this case, the $480 is spread over more units, so each unit picks up a lower
amount of that $480. And the lower the fixed cost per unit, the lower the total cost per unit, which is a desirable goal.
Mixed costs have both a fixed and a variable component. There is typically a base amount that is incurred even if there are no sales
at all. There is also an incremental amount assigned to each unit sold.
The following are three examples of mixed costs. A prepaid cell phone plan might include a base rate of $30 for1G of data and $5
for each additional 300 megabytes of data. A sales person might earn a base salary of $25,000 per year plus $3 for each unit of
product he sells. Equipment rental may cost $8,000 per year plus $1 for each hour used over 10,000 hours.
For purposes of analysis, mixed costs are separated into their fixed and variable components. The high-low estimation method may
be used to break out the costs by looking at the total sales in dollars and the total cost of those sales for several periods, such as
months. The month with the highest activity level and the month with the lowest activity level are selected for the calculation.
The high-low method of separating costs is illustrated using the following information over a six-month period.

Month Units sold Total cost

January 1,400 $52,700

February 2,100 61,200

March 2,900 highest 69,800

April 2,500 66,400

May 1,100 lowest 48,200

June 1,800 56,900

Since the fixed cost does not change with the number of sales, the difference between the total costs of the month with the most
units sold (March) and the month with the fewest units sold (May) must be variable costs. Therefore, using data from these two
months,

Difference in total cost / Difference in units sold

Variable cost per unit =
(69,800 – 48,200) / (2,900 – 1,100)

Variable cost per unit = $21,600 / 1,800 units sold = $12

Now that the variable cost per unit is known to be $12, the fixed costs can be determined by used either the March (highest sales)
or May (lowest sales) using the following equation:
Total cost – variable costs = fixed costs

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 $69,800 – ($12 per unit x 2,900 units sold) = $69,800 - $34,800 =
March:
$35,000
$48,200 – ($12 per unit x 1,100 units sold) = $48,200 - $13,200 =
May:
$35,000

The high-low method estimates that variable cost per unit is $12 and fixed costs are $35,000.

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5.2: Cost Volume Profit Analysis (CVP)
Cost volume profit (CVP) analysis is a managerial accounting technique used to determine how changes in sales volume, variable
costs, fixed costs, and/or selling price per unit affect a business’s operating income. The focus may be on a single product or on a
sales mix of two or more different products.
The results of these analyses help managers make informed decisions about products or services they sell, such as setting selling
prices, selecting combinations of different products to sell, projecting profitability, and determining the feasibility of offering a
product or service for sale.
The elements of CVP analysis are defined as follows:
a. Selling price - the amount a customer pays to acquire a product or service
b. Cost - the variable and fixed expenses involved in producing or selling a product or service
c. Volume - the number of units or the amount of service sold
d. Profit - the difference between the selling price of a product (or service) minus the costs to produce (or provide) it
The following assumptions are made when performing a CVP analysis.
1. All costs are categorized as either fixed or variable.
2. Sales price per unit, variable cost per unit and total fixed cost are constant.
The only factors that affect costs are changes in activity.
3. All units produced are sold.

5.2.1 Contribution Margin

Managers must monitor a company’s sales volume to track whether it is sufficient to cover, and hopefully exceed, fixed costs for a
period, such as a month. Contribution margin is useful in determining how much of the dollar sales amount is available to apply
toward paying fixed costs during the period. Contribution margin is calculated at two different levels.
1. Unit contribution margin = selling price of one unit – variable cost of one unit
2. Total contribution margin = total sales – total variable costs
The following information relates to Jonick Company for the month of June:

Sales 1,000 units

Selling price per unit $25

Variable cost per unit $10

Fixed costs $8,000

1. Unit contribution margin = selling price of one unit – variable cost of one unit $15 = $25 - $10
The unit contribution margin is $15, which is the $25 sales price per unit minus the $10 variable cost per unit. With each sale,
$15 is left after the variable cost is paid to go toward paying down the fixed costs.
2. Total contribution margin = total sales – total variable costs

$15 x 1,000 units = $25 x 1,000 units - $10 x 10,000 units

$15,000 = $25,000 - 10,000

Sales $25,000

Variable costs 10,000

Contribution margin $15,000

Fixed costs 8,000

Operating income $7,000

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 Contribution margin may also be expressed as a ratio, showing the percentage of sales that is available to pay fixed costs. The
calculation is simply the contribution margin divided by sales. The same percentage results regardless of whether total or per
unit amounts are used.
selling price of one unit – variable cost of one unit
1. Unit contribution margin ratio = selling price of one unit
=
$25−$10

$25
= 60 %
$25,000−$10,000
2. Total contribution margin = total sales – total variable costs

total sales
=
$25,000
= 60 %

The higher the percentage, the more of each sales dollar that is available to pay fixed costs. To determine if the percentage is
satisfactory, management would compare the result to previous periods, forecasted performance, contribution margin ratios of
similar companies, or industry standards. If the company’s contribution margin ratio is higher than the basis for comparison, the
result is favorable.
The following three independent examples show the effects of increases in sale volume, selling price per unit, and variable cost per
unit, respectively.

 Example

Change in sales volume: effect on contribution margin ratio

As the number of units sold increases, so does operating income when fixed costs are within their relevant range and remain
the same. This is shown in the following two income statements with sales of 1,200 and 1,400 units, respectively.

1,200 units sold x $25 selling price 1,400 units sold x $25 selling price
1,200 units sold x $10 variable cost 1,400 units sold x $10 variable cost

Sales $30,000 Sales $35,000

Variable costs 12,000 Variable costs 14,000

Contribution margin $18,000 Contribution margin $21,000

Fixed costs 8,000 Fixed costs 8,000

Operating income $10,000 Operating income $13,000

(30,000 - 12,000) / 30,000 = 60% contribution margin (35,000 - 14,000) / 35,000 = 60% contribution margin

Contribution margin remains at 60% regardless of the sales volume. As sales increase, variable costs increase proportionately.

 Example

Change in selling price per unit: effect on contribution margin ratio

Alternatively, if the selling price per unit increases from $25 to $30 per unit, both operating income and the contribution
margin ratio increase as well. Variable cost per unit remains at $10 and fixed costs are still $8,000.

Original: $25 x 1,000 = $25,000 in sales Revised: $30 x 1,000 = $30,000 in sales

Sales $25,000 Sales $30,000

Variable costs 10,000 Variable costs 10,000

Contribution margin $15,000 Contribution margin $20,000

Fixed costs 8,000 Fixed costs 8,000

Operating income $7,000 Operating income $12,000

(25,000 - 10,000) / 25,000 = 60% contribution margin (30,000 - 10,000) / 30,000 = 67% contribution margin

The contribution margin ratio with the selling price increase is 67%. The additional $5 per unit in unit selling price adds 7% to
the contribution margin ratio.

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  Example

Change in variable cost per unit: effect on contribution margin ratio

Finally, if the selling price per unit remains at $25 and fixed costs remain the same, but unit variable cost increases from $10 to
$15, total variable cost increases. As a result, the contribution margin and operating income amounts decrease.

Original: $10 x 1,000 = $10,000 in variable cost Revised: $15 x 1,000 = $15,000 in variable cost

Sales $25,000 Sales $25,000

Variable costs 10,000 Variable costs 15,000

Contribution margin $15,000 Contribution margin $10,000

Fixed costs 8,000 Fixed costs 8,000

Operating income $7,000 Operating income $2,000

(25,000 - 10,000) / 25,000 = 60% contribution margin (25,000 - 15,000) / 25,000 = 40% contribution margin

The contribution margin ratio with the unit variable cost increase is 40%. The additional $5 per unit in the variable cost lowers
the contribution margin ratio 20%. Each of these three examples could be illustrated with a change in the opposite direction. A
decrease in sales quantity would not impact the contribution margin ratio. A decrease in unit selling price would also decrease
this ratio, and a decrease in unit variable cost would increase it. Any change in fixed costs, although not illustrated in the
examples, would not affect the contribution margin ratio.

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5.3: Breakeven Point
The breakeven point is the number of units that must be sold to achieve an operating income of zero. At the breakeven point, sales
in dollars equals costs. The breakeven calculation answers the question How many units does the company have to sell to pay all its
expenses for the month?
This slightly revised information relates to Jonick Company for the month of June and will be used to illustrate the breakeven
point.

Sales 1,000 units

Selling price per unit $18

Variable cost per unit $10

Fixed costs $8,000

The following income statement presents a breakeven situation.

Sales $18,000

Variable costs 10,000

Contribution margin $8,000

Fixed costs 8,000

Operating income $0

Note that the contribution margin of $8,000, the amount available to cover fixed costs, equals the fixed costs amount of $8,000.
Therefore, operating income is zero.
The number of units sold was given in the previous example. In many cases, that is the question that must be answered based on the
selling price per unit, the variable cost per unit, and the fixed cost given.
Breakeven analysis is a form of CVP that uses the equation for a line to determine the number of units that must be sold to break
even. The equation that follows proves the breakeven point in units is 1,000.
Breakeven point in units $=\frac{\text { Total fixed costs }}{\text { Unit selling price - unit variable cost }}=\frac{\$ 8,000}{\$ 18-
\$ 10}=1,000$ units per month
The denominator of unit selling price per unit minus the unit variable cost may also be stated as the unit contribution margin.

5.3.1 Interpreting the Breakeven Result

The lower the breakeven point, the better, since it takes relatively fewer units of sales to cover all the fixed and variable costs. Once
the volume of sales reaches the number of units needed to break even, all fixed costs have been paid. Every subsequent unit sold
yields profit equal to the amount of the unit contribution margin.
The breakeven point is a relative number; it does not have much meaning on its own. It must be compared to another breakeven
number, such as the expected or budgeted number of units to break even, an industry average, or the breakeven point for
comparable companies. If the breakeven point is higher than a business’s capacity or ability to fulfill, the operation of the business
is likely doomed to fail. A breakeven point that is at or below what was expected, easy to accomplish, and/or well beyond the
company’s capacity indicates that the business will be successful due to its ability to meet cost obligations and yield profit.

 Example

Brian is considering opening a small factory that makes a single product – widgets. Each unit will sell for $80. The variable
cost of manufacturing each unit is $30. Fixed factory overhead costs include rent, insurance, maintenance, supervisor salaries,
supplies, and depreciation, for a total of $120,000.
The breakeven point in units per month is determined as follows:
Total fixed costs $120,000
= = 2, 400 units per month
Unit selling price - unit variable cost $80−$30

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 Proof: 2,400 x ($80 – $30) = $120,000 – $120,000 = 0
The manufacturing capacity is 5,000 units per month. The maximum possible operating income per month is $110,000,
determined as follows:
5,000 units capacity - 2,400 units to break even = 2,600 units x $50 contribution margin = $130,000
Brian estimates his monthly sales will be 4,500 per month. The breakeven point of 2,400 per month is encouraging. The first
2,400 units sold would be applied toward paying the $120,000 in fixed costs. When 2,401 units are sold,there will be operating
income of $50 since the contribution margin on that one unit above breakeven is pure profit. From that point on, each
additional unit sold will generate $50 in operating income as well. Since Brian anticipates that he will sell 1,900 units above
the breakeven point of 2,400, he will generate operating income as follows:
1,900 units x $50 contribution margin = $95,000 operating income

 Example

The information from Example 1 remains the same, except Brian forecasts he will be able to sell 2,500 units per month. Now
the breakeven point of 2,400 is seems a less appealing outcome since anticipated sales are only 100 units more.
100 units x $50 contribution margin = $5,000 operating income
This amount of profit may not be worth the effort of operating the business. Almost all the sales volume must be used to cover
fixed and variable costs.

 Example

The information from Example 1 remains the same except the manufacturing capacity is 2,500 units per month. Brian may be
able to sell 4,000 units if he has them, but he is only able to produce 2,400. Again, the outcome does not seem very lucrative
with operating income of only $5,000.

5.3.2 Breakeven Point with Target Profit

One other element that might be included in the breakeven calculation is target profit, which can be built in to the equation as if it
were an additional fixed cost. At the breakeven point operating income is zero, which is rarely the goal of a for-profit company. An
owner or manager may identify a desired operating income and add that amount to the fixed costs in the numerator. The question
then becomes How many units does the company have to sell to pay all its expenses for the month AND earn a profit of $30,000?
The resulting number of sales units will generate this desired operating income.

 Example

Brian is considering opening a small factory that makes a single product – widgets. Each unit will sell for $80. The variable
cost of manufacturing each unit is $30. Fixed factory overhead costs include rent, insurance, maintenance, supervisor salaries,
supplies, and depreciation, for a total of $120,000. Brian would also like to generate a target profit of $50,000.
The breakeven point in units per month is determined as follows:
Total fixed costs $120,000+$50,000
= = 3, 400 units per month to break even
Unit selling price - unit variable cost $80−$30

Proof: 3,400 x ($80 – $30) = $170,000 – $170,000 = 0

Brian must sell an additional 1,000 units to generate enough contribution margin to cover both fixed costs and target profit.
The target profit of $50,000 equals the 1,000 additional number of units times the contribution margin per unit of $50.

5.3.3 Relationships in the Breakeven Equation

The breakeven equation uses fixed costs, the unit selling price, and the unit variable cost to determine the number of units. If one of
those amounts changes, the breakeven point does as well.
Referring to the previous data for Jonick Corporation, the breakeven point was 1,000 units, computed as follows.

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 Total fixed costs $8,000
= = 1, 000 units per month to break even
Unit selling price - unit variable cost $18−$10

The following three independent changes would decrease the breakeven point.
1. An increase in the selling price per unit, which also increases the contribution margin

Change: Unit selling price increases from $18 to $20

Result: Breakeven point decreases from 1,000 to 800 units

Total fixed costs $8,000

= = 800 units per month to break even
Unit selling price - unit variable cost $20−$10

2. A decrease in the variable cost per unit, which also increases the contribution margin

Change: Unit variable cost decreases from $10 to $8

Result: Breakeven point decreases from 1,000 to 800 units

Total fixed costs $8,000

= = 800 units per month to break even
Unit selling price - unit variable cost $18−$8

3. A decrease in fixed costs, in which case the contribution margin is unchanged

Change: Fixed costs decrease from $8,000 to $6,400

Result: Breakeven point decreases from 1,000 to 800 units

Total fixed costs $6,400

= = 800 units per month to break even
Unit selling price - unit variable cost $18−$10

The breakeven point in units would increase if the direction of any of the previous three changes were reversed.

5.3.4 Breakeven Point with Sales Mix

To this point the breakeven point has been calculated for a company that sells a single product. A sales mix must be considered
when calculating the breakeven point for companies that sell two or more products.
A company that sells two different products does not necessarily sell an equal number of each. The first step in calculating the
breakeven point in units is to determine the sales mix, which is the percent of overall sales each of the two products represents.
Each product has its own unit selling price and unit variable cost. The weighted average of each of the unit amounts is used in the
breakeven equation.
Carlie operates a specialty outlet that sells two products – hair dryers and curling irons. Related information is as follows:

Unit selling price Unit variable cost Percent of sales

Hair dryer $70 $30 60%

Curling iron 50 20 40

Fixed costs are $25,200 for the month.

The breakeven point divides the fixed costs by the contribution margin for the sales mix.
Total fixed costs

Unit selling price - unit variable cost

Only one unit selling price and one unit variable cost may be included in the denominator. Yet there is one of each for each product.
Therefore, a weighted average of each will be used to combine them proportionately.

Hair dryers Curling irons

Weighted average unit selling

= ($70 x 60%) + ($50 x 40%) = $42 + $20 = $62
price

Weighted average variable cost = ($30 x 60%) + ($20 x 40%) = $18 + $ 8 = $26

The weighted average contribution margin is $62 - $26, or $36 per unit.

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The breakeven calculation can now be performed using these weighted unit amounts.
Total fixed costs $25,200
= = 700 units per month to breakeven
Unit selling price - unit variable cost $62−$26

Finally, the sales mix percentages are used to determine how many of each product must be sold to break even. Since it was
determined that 60% of sales are hair dryers and 40% are curling irons, the calculations would be as follows.

Hair dryers: 700 units to break even x 60% = 420 hair dryers

Curling irons: 700 units to break even x 40% = 280 curling irons

Proof: 420 * ($70 - $30) + 280 * ($50 - $20) = $16,800 + $8,400 = $25,200, which is exactly the amount of the fixed costs!

5.3.5 Breakeven Analysis for a Service Business

A breakeven analysis can be just as useful for a service business as it is for a company that sells product. A simple example of a
rental property will be used as an illustration.
Max is considering opening a 10-room upscale boutique hotel. He found a facility suitable for this purpose and would rent the
building from its owner for $8,000 per month, which would be one of his fixed costs. Other fixed costs would include monthly
payments for salaries, utilities, insurance, maintenance and advertising and would be an additional $10,000 per month. The nightly
rate charged to guests would be $110, the going rate in the area. The variable cost perroom night would be $10 for room supplies
and breakfast food for the guests.
The monthly capacity is 300 room nights (10 rooms x 30 days). The average occupancy rate for similar properties in the area is
60%, which for this property would be 180 rooms per month.
Based on this information, the breakeven point in number of room nights per month would be as follows:
Total fixed costs $18,000
= = 180 room nights per month to break even
Unit selling price - unit variable cost $110−$10

Although the property has the capacity for 180 rooms per month, it would have to achieve a 60% occupancy rate – 180 rooms - just
to pay its bills. Even this might be challenging for a new start-up since existing properties tend to operate at this rate. A newcomer
might need a bit of time to ramp up the business and get the word out to potential guests.
Even at 60%, the property would not produce any operating income. Max would have to be very sure he could exceed the industry
average in the area before taking steps to start this business.
However, if Max can justify charging more per room night, the scenario may change. If he can charge guests $190 instead of $110,
his breakeven point will decrease to 100 room nights per month.
Total fixed costs $18,000
= = 100 room nights per month to break even
Unit selling price - unit variable cost $190−$10

If he is then able to achieve a 50% occupancy rate, 150 room nights, his venture may be viable. The business would yield operating
income of $9,000 for the month.

60% occ. 50% occ.

$110 $190

Sales $19,800 $28,500

Variable costs 1,800 1,500

Contribution margin $18,000 $27,000

Fixed costs 18,000 18,000

Operating income $0 $9,000

Breakeven analysis is a useful tool for looking at different combinations of costs and selling prices to predict outcomes. It is then
up to management or inventors to determine the likelihood of each scenario occurring.

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5.4: Operating leverage
Operatying leverage is the degree to which a company can increase operating income by increasing sales. It looks at the
relationship between the contribution margin and operating income. The difference between those two amounts is fixed costs.
The following is a comparative income statement for two companies.

ABC Co. XYZ Co.

Sales $500,000 $500,000

Variable costs 400,000 400,000

Contribution margin $100,000 $100,000

Fixed costs 80,000 50,000

Operating income $20,000 $50,000

In this example, sales, total variable costs, and contribution margin are the same for both companies. ABC Co. has higher fixed
costs, so as a result, it also has lower operating income.
A company’s operating leverage is determined as follows.
Contribution margin
Operating leverage =
Operating income

ABC Co. XYZ Co.

Contribution margin $100,000

Operating leverage =
Ope rating inc ome
$100,000
$50,000
= 2
= 5
$20,000

Operating leverage results are used to determine the effect on a change in sales on operating income. The percent increase
(decrease) in sales is multiplied by the operating leverage to find the percent increase (decrease) in operating income. The higher
the operating leverage, the more impact a change in sales will have on operating income.
In the example, both companies had sales of $500,000. An increase of 20%, or $100,000, to $600,000 in sales would affect each of
the two companies’ operating income as follows.

ABC Co. 20% x 5 = 100% increase in operating income ($20,000 x 100% = $20,000

XYZ Co. 20% x 2 = 40% increase in operating income ($50,000 x 40% = $20,000 additional)

An increase of 20% in sales to $600,000 brings operating income for ABC Co. from $20,000 to $40,000, a 100% increase. The
operating income of XYZ Co. increases from $50,000 to $70,000, or 40%.

$500,000 in sales $600,000 in sales

ABC Co. XYZ Co. ABC Co. XYZ Co.

Sales $500,000 $500,000 $600,000 $600,000

Variable costs 400,000 400,000 480,000 480,000

Contribution margin $100,000 $100,000 $120,000 $120,000

Fixed costs 80,000 50,000 80,000 50,000

Operating income $20,000 $50,000 $40,000 $70,000

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5.5: Margin of safety
The margin of safety looks at how far above the breakeven point a company’s sales are. The greater the difference, the more
secure a company can feel about hedging against possible declines in sales. The margin of safety can be expressed as a dollar
amount, a percentage, or a number of units.
As an example, a company’s breakeven point of 2,400 units per month is determined as follows:
Total fixed costs $120,000
= = 2, 400 units per month to break even
Unit selling price - unit variable cost $80−$30

Actual sales for the month were 8,000 units. The contribution margin per unit is $50 ($80 - $30).

Margin of safety in units: 8,000 – 2,400 = 5,600

Margin of safety in dollars: (8,000 x $50) – (2,400 x $50) = $400,000 - $120,000 = $280,000

Margin of safety percentage: ($400,000 – 120,000) / $400,000 = 70%

The margin of safety is 70%, which gives the company a significant cushion over its breakeven point. The higher the margin of
safety, and the more it exceeds the breakeven point, the better.

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 CHAPTER OVERVIEW

6: Variable Costing Analysis

6.1: Introduction to Variable Costing Analysis
6.2: Units manufactured equals units sold
6.3: Units Manufactured Greater than Units Sold
6.4: Units manufactured less than units sold
6.5: Analysis of variable and absorption costing
6.6: Contribution Margin Analysis

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1
6.1: Introduction to Variable Costing Analysis
Operating income on the income statement is one of the most important results that a manufacturing company reports on its
financial statements. External parties such as investors, creditors, and governmental agencies look to this amount to evaluate a
company’s performance and how it affects them. Managers and others within a company use operating income as a measure for
evaluating and improving operational performance.
We have been preparing income statements for manufacturers using this basic structure.
Absorption Costing Income Statement
Sales $750,000

Cost of goods sold 525,000

Gross profit $225,000

Selling and administrative expenses 125,000

Operating income $100,000

This format is referred to as an absorption costing income statement. Expenses are separated into two accounts: Cost of Goods
Sold, which are product costs of the manufactured goods themselves, and Selling and Administrative Expenses, which are general
operating costs.
Each of these two expense accounts includes both variable and fixed costs. Cost of Goods Sold is made up of the three costs of
manufacturing: direct materials and direct labor, which are variable, and factory overhead, which may be both variable and fixed.
Likewise, Selling and Administrative Expenses may include both variable and fixed costs.
Absorption costing is required under generally accepted accounting principles (GAAP) for external reporting. All manufacturing
costs, whether fixed or variable, must be treated as product costs and included in an inventory amount on the balance sheet until the
product is sold. When the product is sold, its cost is then expensed off as cost of goods sold on the income statement. Under
absorption costing, fixed factory overhead is allocated to the finished goods inventory account and is expensed to cost of goods
sold when the product is sold.
For managers within a company, it is also useful to prepare an income statement in a different format that separates out the
expenses that truly vary directly with revenues. Variable costs are typically more controllable than fixed costs, so it is useful to
isolate them so they can be analyzed by management. A variable costing income statement only includes variable manufacturing
costs in the finished goods inventory and cost of goods sold amounts on the financial statements. Under variable costing, fixed
factory overhead is NOT allocated to the finished goods inventory and is NOT expensed to cost of goods sold when the product is
sold. Instead, total fixed factory overhead is treated as a period cost that is deducted from gross profit. On a variable costing income
statement, all variable expenses are deducted from revenue to determine the contribution margin, from which all fixed expenses are
subtracted to arrive at operating income for the period.
The following is a sample variable costing income statement.
Variable Costing Income Statement
Sales $750,000

Variable cost of goods sold 375,000

Manufacturing margin $375,000

Variable selling and administrative expenses 75,000

Contribution margin $300,000

Fixed costs:

Fixed manufacturing costs $150,000

Fixed selling and administrative

50,000
expenses

Total fixed costs 200,000

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 Operating income $100,000

As is shown on the variable costing income statement, total sales is matched with the total direct costs of generating those sales.
The difference between sales and total variable costs is the contribution margin, which is the amount available to pay all fixed
costs.
Under both methods, direct costs (materials and labor) and variable factory overhead costs are applied to the cost of the product.
The difference between the two costing methods is how the fixed factory overhead costs are treated. Under variable costing, fixed
factory overhead costs are expensed in the period in which they are incurred, regardless of whether the product is sold yet. Under
absorption costing, fixed factory overhead costs are expensed only when the product is sold.
To recap, the variable costing income statement is different from the absorption costing income statement in several ways. (1) Only
variable production costs are included in cost of goods sold. (2) Manufacturing margin replaces gross profit. (3) Variable selling
and administrative expenses are grouped with variable production costs as part of the calculation of contribution margin. (4)
Contribution margin is listed after deducting all variable costs from sales. (5) Fixed production costs are shown below the
contribution margin on the income statement with fixed operating costs.
Contribution margin (variable costing) is often higher than gross profit (absorption costing because many production costs, and
most selling and administrative expenses, are fixed. Since variable costing tends to reduce cost of goods sold than it increases
general operating expenses, the net result is a higher contribution margin.
The following data will be used for three pairs of income statements that follow in sample problems. The only difference in the
three scenarios is the number of units produced.

Number of units sold 15,000

Selling price per unit $50

15,000 for Example A

Number of units produced 20,000 for Example B
10,000 for Example C

Variable manufacturing cost per unit $25

Fixed manufacturing costs $150,000

Variable selling and administrative cost per unit $5

Fixed selling and administrative costs $50,000

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6.2: Units manufactured equals units sold
The following is a side-by-side comparison of variable and absorption costing income statements when 15,000 units have been
manufactured and 15,000 units have been sold.
Units manufactured equals units sold Manufactured 15,000 units / Sold 15,000
Variable Costing Income
Statement

Sales $750,000 15,000 x $50

Variable cost of goods sold 375,000 15,000 x $25 • Variable cost of goods
sold equals the 15,000 units
Manufacturing margin $375,000
sold times the variable
Variable selling and manufacturing cost per unit
75,000 15,000 x $5
administrative expenses of $25.

Contribution margin $300,000

Fixed costs:
• Variable selling
Fixed manufacturing costs $150,000
and administrative
Fixed selling and expenses equals the 15,000
50,000
administrative expenses units sold times the
variable amount per unit of
Total fixed costs 200,000
$5.
Operating income $100,000

Units manufactured equals units sold Manufactured 15,000 units / Sold 15,000
Absorption Costing Income Statement

Cost of goods sold equals the

Sales $750,000 15,000 x $50
15,000 units sold times the sum
of the variable manufacturing
Cost of goods sold 525,000 15,000 x ($25 + $10) cost per unit of $25 plus the
fixed manufacturing cost per
unit of $10 ($150,000 total
Gross profit $225,000 fixed cost / 15,000 units
produced.)
Selling and administrative
Selling and administrative expenses equals the 15,000
125,000 (15,000 x $5) + 50,000 units sold times the variable
expenses
amount per unit
of $5 plus the fixed selling and
administrative expenses of
Operating income $100,000
$50,000.

Note that the operating income on both the variable costing and absorption costing income statements is the same, $100,000. This
will always be the case when the number of units manufactured equals the number of units sold because there is no change in the
number of units in inventory. The beginning and ending number of units in inventory are the same since the number of units added
is the same as the number removed.

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6.3: Units Manufactured Greater than Units Sold
The following is a side-by-side comparison of variable and absorption costing income statements when 20,000 units have been
manufactured and 15,000 units have been sold.
Units manufactured greater than units sold Manufactured 20,000 units / Sold 15,000
Variable Costing Income
Statement

Sales $750,000 15,000 x $50

Variable cost of goods sold 375,000 15,000 x $25

Manufacturing margin $375,000

Variable selling and administrative

75,000 15,000 x $5
expenses

Contribution margin $300,000

Fixed costs:

Fixed manufacturing costs $150,000

Fixed selling and administrative

50,000
expenses

Total fixed costs 200,000

Operating income $100,000

Units manufactured equals units sold Manufactured 20,000 units / Sold 15,000
Absorption Costing Income Statement

Sales $750,000 15,000 x $50

• Cost of goods sold equals the
Cost of goods sold 487,500 15,000 x ($25 + $7.50) 15,000 units sold times the sum of
the variable manufacturing cost
Gross profit $262,500
per unit of $25 plus the
Selling and administrative fixedmanufacturing cost per unit
125,000 (15,000 x $5) + 50,000
expenses of $7.50 ($150,000 total fixed cost
/ 20,000 units produced.)
Operating income $137,500

What is unchanged at 20,000 vs. 15,000 units manufactured:

1. The entire variable costing income statement
2. Selling and administrative expenses on the absorption costing income statement
When more units are manufactured than are sold, there are more units in ending inventory than there were in beginning inventory.
In this case, 5,000 of the units produced were not sold, so they were added to inventory. Operating income under variable costing is
lower than under absorption costing when inventory increases. This is because for variable costing the fixed factory overhead for
all units produced is expensed off during the period, regardless of whether the units produced were sold. Under absorption costing,
the fixed factory overhead is expensed off is only for the units sold, resulting in lower overall expenses and therefore higher
operating income.

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6.4: Units manufactured less than units sold
The following is a side-by-side comparison of variable and absorption costing income statements when 10,000 units have been
manufactured and 15,000 units have been sold.
Units manufactured greater than units sold Manufactured 10,000 units / Sold 15,000
Variable Costing Income
Statement

Sales $750,000 15,000 x $50

Variable cost of goods sold 375,000 15,000 x $25

Manufacturing margin $375,000

Variable selling and administrative

75,000 15,000 x $5
expenses

Contribution margin $300,000

Fixed costs:

Fixed manufacturing costs $150,000

Fixed selling and administrative

50,000
expenses

Total fixed costs 200,000

Operating income $100,000

Units manufactured equals units sold Manufactured 10,000 units / Sold 15,000
Absorption Costing Income
Statement

Sales $750,000 15,000 x $50

• Cost of goods sold equals the
5,000 x ($25 + $10) + 10,000 x
Cost of goods sold 575,000 15,000 units sold times the sum of
($25 + $15)
the variable manufacturing cost
Gross profit $175,000 per unit of $25 plus the fixed
manufacturing cost per unit of $15
Selling and administrative
125,000 (15,000 x $5) + 50,000 ($150,000 total fixed cost / 10,000
expenses
units produced.)
Operating income $50,000

What is unchanged at 10,000 vs. 15,000 units manufactured:

1. The entire variable costing income statement
2. Selling and administrative expenses on the absorption costing income statement
When more units are sold than are manufactured, there are fewer units in ending inventory than there were in beginning inventory.
Some of the beginning inventory had to be sold to fulfill the order for more than what was produced. In this case, 5,000 of the units
sold came from beginning inventory. Operating income under variable costing is higher than under absorption costing when
inventory decreases. This is because under variable costing the fixed factory overhead that is expensed off during the period is only
for units produced, even if more units are sold than were produced. Under absorption costing, the fixed overhead is included in the
higher number of units sold, resulting in higher overall expenses and therefore lower operating income.

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6.5: Analysis of variable and absorption costing
Sales were 15,000 units in each of the three variable costing and three absorption costing income statements just presented. It was
the number of units produced that varied among the three pairs of statements.
The three variable costing income statements at the different levels of production were exactly the same, each yielding operating
income of $100,000, as shown in the following comparative statements.
Comparative Variable Costing Income Statements
15,000 units 20,000 units 10,000 units

Sales $750,000 $750,000 $750,000

Variable cost of
375,000 375,000 375,000
goods sold

Manufacturing
$375,000 $375,000 $375,000
margin

Variable selling
and administrative 75,000 75,000 75,000
expenses

Contribution
$300,000 $300,000 $300,000
margin

Fixed costs:

Fixed
manufacturing $150,000 $150,000 $150,000
costs

Fixed
selling and
50,000 50,000 50,000
administrative
expenses

Total
200,000 200,000 200,000
fixed costs

Operating income $100,000 $100,000 $100,000

The number of units manufactured during the period – 15,000; 20,000; and 10,000; respectively — does not affect operating
income under the variable costing approach. This is as it should be, since production affects inventory, which is a balance sheet
rather than an income statement account. When more units are produced (20,000) than sold (15,000), ending inventory is 5,000
units higher than beginning inventory. When fewer units are produced (10,000) than sold (15,000), ending inventory is 5,000 units
lower than beginning inventory. Yet regardless of changes in inventory, operating income remains constant for a given level of
sales because variable cost of goods sold and fixed manufacturing costs are identical for all three variable costing scenarios.
Under absorption costing, however, operating income changes when the company’s inventory balance changes. The results from
the three absorption income statements presented earlier are shown again, as follows.
Comparative Absorption Costing Income Statements
15,000 units 20,000 units 10,000 units

Sales $750,000 $750,000 $750,000

Cost of goods sold 575,000 487,500 575,000

Gross profit $175,000 $262,500 $175,000

Selling and administrative

125,000 125,000 125,000
expenses

Operating income $50,000 $137,500 $50,000

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When all units manufactured (15,000) are sold (15,000), operating income under absorption costing is the same as it is under
variable costing, $100,000. Under both costing methods, $150,000 of fixed factory overhead costs is deducted to arrive at operating
income. It just appears in two different line items. Under variable costing, the flat amount of $150,000 follows the contribution
margin line. Under absorption costing, the $150,000 is included in cost of goods sold. The fixed cost per unit is $10, determined by
dividing the $150,000 total fixed factory overhead cost by the number of units produced, 15,000. The $10 per unit is then
multiplied by 15,000, the number of units sold.

Variable costing fixed manufacturing costs $150,000 fixed factory overhead

Absorption costing fixed manufacturing costs $10 fixed cost per unit x 15,000 units sold = $150,000

When more units are manufactured (20,000) than sold (15,000), operating income is higher under absorption costing ($137,500).
Under variable costing, fixed factory overhead is the flat amount of $150,000 that follows the contribution margin line. Under
absorption costing, $112,500 of fixed factory overhead cost is included in cost of goods sold. The fixed cost per unit is $7.50,
determined by dividing the $150,000 total fixed factory overhead cost by the number of units produced, 20,000. The $7.50 per unit
is then multiplied by 15,000, the number of units sold to get $112,500.

Variable costing fixed manufacturing costs $150,000 fixed factory overhead

Absorption costing fixed manufacturing costs $7.50 fixed cost per unit x 15,000 units sold = $112,500

Since there is $37,500 less in cost of goods sold under absorption costing, there is $37,500 more operating income as a result for
the same level of sales.
Conversely, when fewer units are manufactured (10,000) than sold (15,000), operating income is lower under absorption costing
($50,000). Under variable costing, fixed factory overhead is the flat amount of $150,000 that follows the contribution margin line.
Under absorption costing, $225,000 of fixed factory overhead cost is included in cost of goods sold. The fixed cost per unit is $15,
determined by dividing the $150,000 total fixed factory overhead cost by the number of units produced, 10,000. The $15 per unit is
then multiplied by 15,000, the number of units sold to get $225,000.

Variable costing fixed manufacturing costs $150,000 fixed factory overhead

Absorption costing fixed manufacturing costs $15 fixed cost per unit x 15,000 units sold = $225,000

Since there is $75,000 more in cost of goods sold under absorption costing, there is $75,000 less operating income as a result for
the same level of sales.
The point of this analysis is to illustrate that under absorption costing, operating income changes based on increases or decreases in
inventory due to producing more or fewer units than were sold in a period. Such changes are unrelated to a company’s operating
performance, and managers need to be aware of this type of distortion under absorption costing. On a variable costing income
statement, changes in inventory have no effect on operating income, making this method more reliable and desirable for analyzing
profitability for an accounting period.

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6.6: Contribution Margin Analysis
A key element of the variable costing income statement is contribution margin, which is what is left over from sales after paying
variable costs. In other words, contribution margin is the amount or percentage of sales available to pay fixed costs and contribute
to operating income. Once fixed costs are covered, any remaining contribution margin represents profit that results from the sales.
Contribution margin may be looked at from a variety of perspectives that often involve comparisons within different segments of a
company. Data may be isolated by product, geographic area, salesperson, customer, distribution method, etc. and analyzed in terms
of how individuals or entities within a segment perform in terms of contribution margin percentage. Managers may use these
targeted results to discover strengths that may be capitalized on and/or weaknesses that may need to be addressed.
As an example, a company manufactures two products and sells them in two regions, East and West, to two customers that have a
presence in both regions. There are four salespeople in each region. Sales in these regions may be either in- store or online.
The following sales and production information will be used to show comparisons of the contribution margin for a company as a
whole, by region, and by product.

East West Total

Sales

Product 1 $120,000 $60,000 $180,000

Product 2 40,000 100,000 140,000

TOTAL $160,000 $160,000 $320,000

Variable manufacturing costs

Product 1 $24,000 $12,000 $36,000

Product 2 4,800 12,000 16,800

TOTAL $28,800 $24,000 $52,800

Variable selling expenses

Product 1 $50,400 $25,200 $75,600

Product 2 13,200 33,000 46,200

TOTAL $63,600 $58,200 $121,800

The contribution margin ratio of 45.4% for the company as a whole is determined as follows.

Company

Sales $320,000

Variable cost of goods sold 52,800

Manufacturing margin $267,200

Variable selling expenses 121,800

Contribution margin $145,400

Contribution margin ratio 45.4%

For every $1.00 of sales, a little over $.45 remains after variable costs are covered to apply toward paying fixed costs and yielding
profit. The contribution margin is $145,400, and the contribution margin ratio is 45.4% ($145,400 / $320,000). If fixed costs were
$100,000, for example, operating income would be $45,400.

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The analysis by product shows that the contribution margin ratio for Product 1, 38.0%, is lower that of the company as a whole,
45.4%. The ratio for Product 2 is significantly higher than both those rates at 55.0%.

Product 1 Product 2

Sales $180,000 $140,000

Variable cost of goods sold 36,000 16,800

Manufacturing margin $144,000 $123,200

Variable selling expenses 75,600 46,200

Contribution margin $68,400 $77,000

Contribution margin ratio 38.0% 55.0%

Although sales of Product 2 are lower, its contribution margin ratio is 17% higher than that of Product 1. This is because the costs
of producing and selling Product 2 are proportionately lower.
Based on this information, managers may look for ways to contain variable costs associated with Product 1. They also might
encourage and incentivize sales staff to promote Product 2 to customers more than Product 1.
A comparison by sales region shows that the contribution margin ratio for the East, 42.3%, is lower that of the company as a whole,
45.4%. The ratio for the West is higher than both these rates at 48.6%.

East West

Sales $160,000 $160,000

Variable cost of goods sold 28,800 24,000

Manufacturing margin $131,200 $136,000

Variable selling expenses 63,600 58,200

Contribution margin $67,600 $77,800

Contribution margin ratio 42.3% 48.6%

At the same sales levels, the East has higher variable costs for both production and selling. Management may look at the mix of
products sold in each region to determine if differences in costs in the regions are product related or if action needs to be taken to
contain costs in the East.
At an even more micro level, the performance of each of the four sales people in a region may be determined. As an example, the
data for sales staff in the East - Annie Adams, Charles Bell, Valerie Crew, and Scott Davis – follows.

Adams Bell Crew Davis

Sales $32,000 $40,000 $51,000 $37,000

Variable cost of goods sold 5,800 7,500 8,600 6,900

Manufacturing margin $26,200 $32,500 $42,400 $30,100

Variable selling expenses 11,500 19,100 20,300 12,700

Contribution margin $14,700 $13,400 $22,100 $17,400

Contribution margin ratio 45.9% 33.5% 43.3% 47.0%

The sales mix in terms of the percentage of each product that each salesperson sold plays a role in the variable expenses incurred
and the resulting contribution margin ratio. Note that the highest contribution margin in dollars does not always result in the highest

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contribution margin ratio. Managers must evaluate returns on sales from both these perspectives when making decisions moving
forward.
Although specific data is not provided for the following two segments – customer and distribution channel – results are presented
here to show two additional types of comparisons that may be meaningful in investigating operational performance.

Customer 1 Customer 2 In-Store Online

Sales $190,000 $130,000 Sales $150,000 $170,000

Variable cost of Variable cost of

31,700 21,100 23,700 29,100
goods sold goods sold

Manufacturing Manufacturing
$158,300 $108,900 $126,300 $140,900
margin margin

Variable selling Variable selling

75,100 46,700 60,100 61,700
expenses expenses

Contribution Contribution
$83,200 $62,200 $66,200 $79,200
margin margin

Contribution Contribution
43.8% 47.8% 44.1% 46.6%
margin ratio margin ratio

Contribution margin analysis is also useful for planning purposes. For each product, sales volume, unit selling price, unit variable
cost of production, and unit variable cost of selling can be forecasted to estimate contribution margin.Subsequently, one or more of
these four variables may be changed to see the impact on contribution margin. The following table compares six projections based
on different data. Amounts in bold font are changes from Projection 1.

Projection 1 Projection 2 Projection 3 Projection 4 Projection 5 Projection 6

Sales quantity 100,000 120,000 100,000 100,000 95,000 110,000

Selling price per

$8.00 $8.00 $8.30 $8.00 $8.00 $8.30
unit

Variable
production cost 2.50 2.50 2.50 3.00 2.50 2.75
per unit

Variable selling
1.75 1.75 1.75 1.75 1.40 1.90
cost per unit

Sales $800,000 $960,000 $830,000 $800,000 $760,000 $913,000

Variable cost of
250,000 300,000 250,000 300,000 237,500 302,500
goods sold

Manufacturing
$550,000 $660,000 $580,000 $500,000 $522,500 $610,500
margin

Variable selling
175,000 210,000 210,000 175,000 133,000 209,000
expenses

Contribution
$375,000 $450,000 $405,000 $325,000 $389,500 $401,500
margin

Contribution
46.9% 46.9% 48.8% 40.6% 51.3% 44.0%
margin ratio

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Managers consider both the contribution margin dollar amount and the ratio in making decisions related to selling price and
projecting quantities sold. A higher contribution margin ratio alone is favorable relative to a lower one; the 46.9% for Projection 1
is greater than the 44.0% for Projection 6. Yet if fixed costs are $375,000, the contribution margin dollar amount for Projection 1
would only be enough to break even, whereas Projection 6 would yield operating income of $26,500. Many decisions require a
combination of analyses to determine the optimal outcome,but the results from separate measures can be insightful in determining
points of strength and weakness.
Finally, managers may use the elements of a variable costing income statement to compare planned to actual dollar amounts and
units sold.

Projected Actual

Sales quantity 90,000 110,000

Selling price per unit $8.50 $8.00

Variable production cost per unit 2.80 2.70

Variable selling cost per unit 1.60 1.80

Sales $765,000 $880,000

Variable cost of goods sold 252,000 297,000

Manufacturing margin $513,000 $583,000

Variable selling expenses 144,000 198,000

Contribution margin $369,000 $385,000

The actual contribution margin is $16,000 higher compared to what was projected, partially due to more unit sales than anticipated.
The net decrease in unit variable cost factors in as well. Although sales revenue is higher than expected, it would be worth looking
into why selling price per unit was lower than projected. It is feasible that the price concession spurred the higher sales quantity.
Variable costing may also be applicable to a service business, even though manufacturing costs are not involved. A small hotel, for
example, earns revenue from renting rooms. Variable costs may include food and beverage expense forbreakfast, supplies expense,
selling expense, and an incremental utilities expense amount for times when rooms are occupied. Fixed costs of rent expense for
the property, salaries expense, depreciation expense, and insurance expense are typical.
The following is an example of a variable costing income statement for a hotel. The room rate is $120 per night, and 700 room
nights are recorded during the month. The rate per unit for each variable cost is shown in the income statement.
Jonick Inn Variable Costing Income Statement For the Month Ended June 30, 2019
Rooms revenue (700 x $120) $84,000

Variable costs:

Selling expense (700 x $24) $16,800

Food and beverage expense (700 x $10) 7,000

Supplies expense (700 x $8) 5,600

Utilities expense (700 x $5) 3,500

Total variable costs 32,900

Contribution margin $51,100

Fixed costs:

Rent expense $14,000

Salary expense 12,600

Depreciation expense 10,900

Insurance expense 1,400

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 Total fixed costs 38,900

Operating income $12,200

Other service businesses that would benefit from variable costing are hospitals, banks, restaurants, and airlines.

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 CHAPTER OVERVIEW

7: Budgeting
7.1: Introduction to Budgeting
7.2: Static Budget
7.3: Flexible Budget
7.4: Master Budget
7.5: Operating Budget
7.6: Sales Budget
7.7: Cost of Goods Sold Budget
7.8: Selling and Administrative Cost Budget
7.9: Budgeted Income Statement
7.10: Cash Budget
7.11: Capital Expenditure Budget

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1
7.1: Introduction to Budgeting
Financial statements and managerial reports are often prepared to summarize historical transactions that occurred in a company to
evaluate past performance. This information is also used as an integral part of the process of moving forward. Combined with
insights into consumer trends and current economic, legal, social, and political environments, managers forecast future operations
and develop strategies for achieving projected goals.
A budget is a quantitative, written statement of a company’s action plan for a future period of time. Budgets are planning tools that
companies use to determine future activities and to keep financial control of operations. Budgets may be prepared at fixed intervals
of time, such as annually, where they are reviewed and revised once a year. Alternatively, continuous budgets extend for one year
but are adjusted each month to reflect activities for the upcoming 12 months. When a current month passes, its financial
information is removed and the data for the new month that is 12 months in the future is added.

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7.2: Static Budget
A static budget is prepared for a period of time based on a fixed amount of activity. For example, the Packing Department in a
manufacturing company may prepare a budget that itemizes fixed and variable costs.
Packing Department Budget For the Year Ended December 31, 2019
Variable costs:

Packing materials $30,000

Direct labor 15,000

Variable utilities cost 5,000

Total variable costs $50,000

Fixed costs:

Supervisor salary expense $60,000

Depreciation expense 7,000

Machine rental expense 3,000

Total fixed costs $70,000

Total budgeted costs $120,000

This departmental budget does not specify the number of units to be processed, making it difficult to determine if actual costs are
reasonable and within budget. Actual costs may wind up being higher than what was budgeted. For example, actual costs of
$130,000 might seem unfavorable since it exceeds total budgeted costs of $120,000. However, more units may have been
processed than were considered in preparing the budget. In that case, being over budget may actually be a positive outcome since
additional production costs were the result of more sales orders.
The assumptions underlying the static budget are a bit vague. Even if the number of anticipated units to be processed were stated,
such as a quantity of 10,000, the budget would remain unchanged if production volume were higher or lower. The lack of detail
behind how the numbers are derived often limits the usefulness of the static budget information.

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7.3: Flexible Budget
A flexible budget addresses the shortcoming of the static budget by providing budgeted amounts at various quantity levels. A
sample flexible budget follows.
Packing Department Budget For the Year Ended December 31, 2019
Planned number of
10,000 12,000 16,000 20,000
production units

Variable costs:

Packing materials $30,000 $36,000 $48,000 $60,000

Direct labor 15,000 18,000 24,000 30,000

Variable utilities cost 5,000 6,000 8,000 10,000

Total variable
$50,000 $60,000 $80,000 $100,000
costs

Fixed costs:

Supervisor salary
$60,000 $60,000 $60,000 $60,000
expense

Depreciation
7,000 7,000 7,000 7,000
expense

Machine rental
3,000 3,000 3,000 3,000
expense

Total fixed
$70,000 $70,000 $70,000 $70,000
costs

Total budgeted costs $120,000 $130,000 $150,000 $170,000

The flexible budget is more useful to managers since budgeted costs can be compared to actual costs for several activity levels. The
example of the flexible budget for the Packing Department shows four possible levels of production: 10,000; 12,000; 15,000; and
20,000 units. If actual costs were $130,000 and 12,000 units were processed, the budget would have accurately predicted actual
costs. If actual costs were $130,000 and 10,000 units were produced, the department would have been over budget by $10,000. A
flexible budget is basically a menu of static budgets to select from based on the number of actual units involved.
The same financial statement formats that summarize and present results of economic events from previous periods may also be
used to communicate quantitative projections of future performance. For example, the income statement includes sales and multiple
line items related to cost information, each of which can be budgeted independently based on a company’s action plan for a future
period. Collectively they result in a pro forma income statement that projects future net income.

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7.4: Master Budget
A master budget is a collection of all the separate budgets for different elements of a business combined into one report. Master
budgets contain operating budgets that include goals for sales and associated costs of production, which result in the budgeted
income statement. Financial budgets such as the cash and capital expenditures budgets are included on the budgeted balance sheet.

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7.5: Operating Budget
Operating budgets include separate budgets for each of three key line items on the income statement.
1. Sales budget
2. Cost of goods sold budget *
* To prepare the cost of goods sold budget, a manufacturer first prepares the following five supporting budgets:

a. production budget Requires sales budget result

b. direct materials purchases budget Requires production budget result

c. direct materials cost budget Requires materials purchases budget result

d. direct labor cost budget Requires production budget result

e. factory overhead budget Independent of previous budgets

3. Selling and administrative budget

The results of all the individual operating budgets are combined to present a budgeted income statement, which culminates with
the anticipated amount of net income.
To illustrate, two distinct master budgets for 2019 for two different manufacturing companies will be presented side by side.
The first company makes only one product, a 42” art deco replica of the Statue of Liberty, which it sells to wholesalers and
souvenir shops. Only one direct material, metal, is used in producing these statues.
The second company makes protective headgear and produces two products: bicycle helmets and ski helmets. Each type of
headgear requires two direct materials: plastic and foam lining.
The best approach is to first review the budgets for the statue souvenirs in the left column of the side-by-side budgets. It is the
simpler of the two since it covers only one product that uses one direct material. It illustrates the basic concepts. The budgets
for the helmets are similar to those for the statues, but they are a bit more complex since two products and two direct materials
are involved. The manufacture of the helmets occurs in two departments: forming and assembly.
The following information will be used to prepare a sales budget, production budget, direct materials purchases budget, direct
materials cost budget, direct labor cost budget, factory overhead budget, selling and administrative budget, and budgeted
income statement. The data in the left column is for the statue souvenirs; the information in the right column is for the helmets.
Statue Souvenirs (1 product and 1 direct material)
Estimated sales volume 3,000 units

Selling price per unit $200

Estimated inventory of completed units on Jan. 1 2,600 units

Desired inventory of completed units on Dec. 31 600 units

Number of pounds of metal per completed unit 8.6 pounds

Price per pound of metal $6

Estimated inventory of metal on Jan. 1 1,800 pounds, $10,800

Desired inventory of metal on Dec. 31 300 pounds, 1,800

Time spent for direct labor per completed unit 5 hours

Direct labor rate per hour $10

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Estimated factory overhead costs for the year:

Supervisor salary $7,600

Utilities 1,900

Indirect materials 1,700

Depreciation 800

Estimated work in process on Jan. 1 $25,100

Desired work in process on Dec. 31 3,100

Estimated finished goods on Jan. 1 $36,700

Desired finished goods on Dec. 31 9,400

Estimated selling costs for the year:

Advertising expense $16,300

Sales commissions expense 14,100

Utilities expense 12,000

Estimated administrative costs for the year:

Salaries expense $87,700

Utilities expense 11,400

Office supplies expense 5,600

Estimated tax rate 20%

Bicycle and Ski Helmets (2 products and 2 direct materials)

Estimated sales volume

Bicycle helmets 2,600 units

Ski helmets 4,800 units

Selling price per unit

Bicycle helmets $50 per unit

Ski helmets $130 per unit

Estimated inventory of completed units on Jan. 1

Bicycle helmets (@ $24 per unit) 110 units

Ski helmets (@ $95 per unit) 320 units

Desired inventory of completed units on Dec. 31

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 Bicycle helmets (@ $25 per unit) 150 units

Ski helmets (@ $93 per unit) 280 units

Number of pounds of plastic per completed unit

Bicycle helmets 0.8 pounds

Ski helmets 1.6 pounds

Number of pounds of foam lining per completed unit

Bicycle helmets 0.3 pounds

Ski helmets 0.6 pounds

Price per pound of plastic $4

Price per pound of lining $2

Estimated inventory of plastic on Jan. 1 120 pounds

Desired inventory of plastic on Dec. 31 90 pounds

Estimated inventory of foam lining on Jan. 1 100 pounds

Desired inventory of foam lining on Dec. 31 140 pounds

Estimated bicycle work in process on Jan. 1 (@$15) 450 units

Estimated bicycle work in process on Dec. 31 (@$10) 610 units

Estimated ski work in process on Jan. 1 (@$70) 520 units

Estimated ski work in process on Dec. 31 (@$40) 500 units

Number of direct labor hours of forming per completed unit

Bicycle helmets 0.2 hours

Ski helmets 0.4 hours

Number of direct labor hours of assembly per completed unit

Bicycle helmets 0.6 hours

Ski helmets 1.2 hours

Direct labor rate per hour for forming $15

Direct labor rate per hour for assembly $12

Estimated factory overhead costs for the year:

Indirect factory wages $59,900

Depreciation plant and equipment 8,700

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 Utilities 2,800

Insurance and property tax 1,600

Estimated selling costs for the year:

Sales salaries expense $129,200

Advertising expense 60,800

Telephone expense – selling 4,100

Travel expense – selling 6,300

Estimated administrative costs for the year:

Office salaries expense $22,700

Depreciation expense – office 2,600

Telephone expense – office 900

Office supplies expense 800

Miscellaneous office expense 700

Estimated tax rate 25%

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7.6: Sales Budget
The sales budget is prepared first by estimating the number of units that will be sold. This analysis looks at budgeted and actual
sales from the previous year and adjusts those amounts to reflect economic conditions, shifts in trends, feedback from customers,
and pricing changes.
In addition, the expected unit selling price for each product must be determined by examining previous pricing and profitability,
current costs, the market demand for the products, and competitors’ pricing.
The sales budgets for the two companies’ products are as follows.
Souvenir Statues
Sales Budget
Unit Sales Value Unit Sales Price Total Sales

Metal statues 3,000 x $200 = $600,000

Headgear
Sales Budget
Unit Sales Value Unit Sales Price Total Sales

Bicycle helmet 2,600 x $50 = $130,000

Ski helmet 4,800 x 130 = 624,000

Total sales revenue $754,000

The budgeted sales in dollars equals the expected sales volume times the expected selling price per unit for each product. The sum
of all products’ sales is ultimately transferred to the budgeted income statement.
Cost of goods sold is the next line item on the income statement. Five shorter, more targeted budgets are first prepared to arrive at
key elements of the cost of goods sold budget.
a. The production budget estimates the number of units of each product that will have to be manufactured to achieve the
anticipated sales and inventory levels. It begins with the estimated number of units to be sold from the sales budget. The
number of desired units in ending inventory is added to that to determine total number of units required. Since some of those
needed are already in stock, those do not need to be produced. The total units that do need to be produced are those needed for
sales and ending inventory minus those that are already in inventory at the start of the period.
The production budgets for the two companies’ products are as follows.
Souvenir Statues
Production Budget
Units

Estimated units to be sold 3,000

Desired ending inventory, December 31 + 600

Total units needed = 3,600

Estimated beginning inventory, January 1 - 2,600

Total units to be produced = 1,000

Headgear
Production Budget
Production Budget

Bicycle Ski

Estimated units to be sold 2,600 4,800

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 Desired ending inventory,
+ 150 + 280
December 31

Total units needed = 2,750 = 5,080

Estimated beginning
- 110 - 320
inventory, January 1

Total units to be produced = 2,640 = 4,760

b. The direct materials purchases budget estimates how much will be spent to buy the quantity of materials needed for
production. It begins with the total number of units to be manufactured from the production budget.Each statue requires 8.6
pounds of metal, so the total number of pounds for production can be calculated. Each helmet requires both plastic and foam
lining, and the total amount needed for production is determined for each type. The number of pounds that should remain in
ending inventory is added to total pounds needed for production. Then, the number of pounds of materials in beginning
inventory is deducted from total required since that amount is already in stock and does not need to be purchased. The number
of pounds that does need to be purchased is multiplied by the cost per pound to get the total cost of materials purchases.
The direct materials purchases budgets for the two companies’ products are as follows.
Souvenir Statues
Direct Materials Purchases Budget
Estimated units to be produced 1,000

Number of pounds per unit x 8.6

Pounds of metal required for production = 8,600

Desired ending inventory, December 31 + 300

Total pounds needed = 8,900

Estimated beginning inventory, January 1 - 1,800

Total pounds to be purchased = 7,100

Price per pound x $6

Total direct materials to be purchased = $42,600

Headgear
Direct Materials Purchases Budget
Units Lbs. per unit Plastic Lining Total

Units required for

production:

Bicycle helmet 2,640 0.8 2,112

Bicycle helmet 2,640 0.3 792

Ski helmet 4,760 1.6 7,616

Ski helmet 4,760 0.6 2,856

Desired ending
inventory, December 90 140
31

Total pounds needed 9,818 3,788

Estimated beginning
120 100
inventory, January 1

Total pounds to be
9,698 3,668
purchased

Price per pound $4 $2

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 Total direct materials
$38,792 $7,376 $46,168
to be purchased

c. The direct materials cost budget looks at the total cost of materials available to be used in production by adding what was
already on hand at the beginning of the year to what will be purchased during the year, taken from the direct materials purchases
budget. From that total the remaining direct materials at the end of the year are deducted, since they were not used, to arrive at
the cost of direct materials added to production during the year.
The direct materials cost budget can be presented in a summarized format, as shown for the souvenir statues, or with a greater
level of detail, as is the case for the helmets, which require two types of materials rather than just one. The direct materials cost
budgets for the two companies’ products are as follows.
Souvenir Statues
Direct Materials Cost Budget
Direct materials inventory, January 1 $10,800

Direct materials purchases + 42,600

Cost of direct materials available for use = 53,400

Direct materials inventory, December 31 - 1,800

Cost of direct materials added to production = $51,600

Headgear
Direct Materials Cost Budget
Pounds Price per lb Subtotal Total

Direct materials
inventory, January 1:

Plastic 120 $4 $480

Lining 100 $2 200

Total
$680
beginning inventory

Direct materials
purchases:

Plastic 9,698 $4 $38,792

Lining 3,688 $2 7,376

Total inventory
46,168
purchase

Cost of direct materials

$46,848
available for use

Direct materials
inventory, December 31:

Plastic 90 $4 $360

Lining 140 $2 280

Total ending
640
inventory

Cost of direct materials

$46,208
added to production

d. The direct labor cost budget estimates the second direct cost of a manufactured product, direct labor. It multiplies the number
of units to be produced, taken from the production budget, by the number of hours per unit. That result is then multiplied by the

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 labor rate per hour.
The direct labor cost budgets for the two companies’ products are as follows.
Souvenir Statues
Direct Labor Cost Budget
Total units to be produced 1,000

Production time per unit x 5

Hours required for production = 5,000

Labor rate per hour x $10

Total direct labor cost = $50,000

Headgear
Direct Labor Cost Budget
Units Hours/Unit Plastic Lining Total

Units required for

production

Bicycle helmet
2,640 0.2 528
(plastic)

Bicycle helmet
2,640 0.6 1,584
(lining)

Ski helmet
4,760 0.4 1,904
(plastic)

Ski helmet
4,760 1.2 5,712
(lining)

Total hours needed 2,432 7,296

Rate per hour $15 $12

Total direct labor

$36,480 $87,552 $124,032
cost

The direct labor cost budget for the helmets is a bit more detailed since it deals with two products that each require two different
direct materials.
e. The factory overhead cost budget estimates each of a number of fixed costs independently. The total of all the results is the
budgeted factory overhead cost. The factory overhead cost budgets for both companies follow.
Souvenir Statues
Factory Overhead Cost Budget
Supervisor salary 7,600

Utilities + 1,900

Indirect materials + 1,700

Depreciation + 800

Total factory overhead cost = $12,000

Headgear
Factory Overhead Cost Budget
Indirect factory wages $59,900

Depreciation + 8,700

Utilities + 2,800

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 Insurance + 1,600

Total factory overhead cost = $73,000

The five previous targeted budgets provide the information required for the cost of goods sold budget.

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7.7: Cost of Goods Sold Budget
Both cost of goods sold budgets that follow include beginning and ending work in process and beginning and ending finished
goods amounts. The calculations begin with what was available at the beginning of the period, add what was transferred in during
the period, and deduct what was remaining at the end of the period to determine what was transferred out. A transfer out from
finished goods, of course, indicates a sale and a move to cost of goods sold.
The cost of goods sold budgets for both companies follow. Direct materials, direct labor, and factory overhead amounts are taken
from their respective supporting budgets prepared previously.
Souvenir Statues
Cost of Goods Sold Budget
Finished good
inventory, January $36,700
1

Work in
process inventory, $25,100
January 1

Direct
$51,600
materials

Direct
+ 50,000
labor

Factory
+ 12,000
overload

Total
manufacturing = 113,600
costs for the year

Total work
in process during + $138,700
the year

Work in
process inventory, - (3,100)
December 31

Cost of goods
= 135,600
manufactured

Cost of finished
goods available = $172,300
for sale

Finished goods
inventory, - (9,400)
December 31

Cost of goods sold = $162,900

Headgear
Cost of Goods Sold Budget
Finished good
inventory, January $33,040
1

Work in
process inventory, $43,150
January 1

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 Direct
$46,208
materials

Direct
+ 124,032
labor

Factory
+ 73,000
overload

Total
manufacturing = 243,240
costs for the year

Total work
in process during + $286,390
the year

Work in
process inventory, - (26,100)
December 31

Cost of goods
= $260,290
manufactured

Cost of finished
goods available = 293,330
for sale

Finished goods
inventory, - (29,790)
December 31

Cost of goods sold = $263,540

The first step on the cost of goods sold budget is to list and total the three manufacturing costs: direct materials, direct labor, and
factory overhead. Their amounts are taken from their respective cost budgets and appear in the left column. Total manufacturing
costs for the year is the sum of the three, entered in the middle column.
Next, the manufacturing costs for the year are added to the work in process at the beginning of the year to arrive at the available
total work in process for the year. From that result, the ending work in process - the product that is still unfinished - is deducted to
determine the cost of goods manufactured.
Finally, the cost of goods manufactured is added to the finished goods at the beginning of the year to arrive at the cost of finished
goods available for sale. From that result, the finished goods that were not sold are deducted to arrive at the cost of goods that were
sold.
The following table shows the calculations for the work in process and finished goods amounts for the headgear manufacturing
company. This level of detail is not necessary to show in the statement of cost of goods manufactured, but it is useful in
understanding how amounts in that statement were derived.
CALCULATIONS - Cost of Goods Sold Budget
Units Cost/Unit

Finished goods
inventory, January
1:

Bicycle
110 x $24 = $2,640
helmet

Ski helmet 320 x 95 = 30,400

Total
beginning $33,040
inventory

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 Work in process
inventory,
January:

Bicycle
450 x $15 = $6,750
helmet

Skit helmet 520 x 70 = 36,400

Total
beginning work in $43,150
process

Work in process
inventory,
December 31:

Bicycle
610 x $10 = $6,100
helmet

Ski helmet 500 x 40 = 20,000

Total
ending work in $26,100
process

Finished goods
inventory,
December 31:

Bicycle
150 x $25 = $3,750
helmet

Ski helmet 280 x 93 = 26,040 $29,790

Total
ending inventory

The sales and cost of goods sold budgets provide key information necessary to arrive at the budgeted gross profit amount.

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7.8: Selling and Administrative Cost Budget
The selling and administrative cost budget lists operating expenses on a line-by-line basis and totals the amounts. The selling and
administrative cost budgets for both companies follow.
Souvenir Statues
Selling and Administrative Cost Budget
Selling expenses:

Sales commissions
$16,300
expenses

Advertising expense + 14,100

Utilities expense + 12,000

Total selling
= $42,400
expenses

Administrative expenses:

Salaries expense $87,700

Utilities expense + 11,400

Office supplies
+ 5,600
expense

Total
+ $104,700
administrative expenses

Total selling and

= $147,100
administrative expenses

Headgear
Selling and Administrative Cost Budget
Selling expenses:

Sales commissions
$129,200
expenses

Advertising expense + 60,800

Travel expense –
+ 6,300
selling

Telephone expense –
+ 4,100
selling

Total selling
= $200,400
expenses

Administrative expenses:

Office salaries
$22,700
expense

Depreciation
expense – office + 2,600
equipment

Telephone expense –
+ 900
administrative

Office supplies
+ 800
expense

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 Miscellaneous
+ 700
administrative expense

Total
+ 27,700
administrative expenses

Total selling and

= $228,100
administrative expenses

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7.9: Budgeted Income Statement
The sales, cost of goods sold, and selling and administrative cost budgets are supporting budgets that are combined to produce a
budgeted income statement for the year. The budgeted income statements for both companies follow.
Souvenir Statues
Budgeted Income Statement
Sales $600,000

Cost of goods sold - 162,900

Gross profit = $437,100

Total selling and administrative expenses - 147,100

Income before taxes = $290,000

Income taxes - 58,000

Net income = $232,000

Headgear
Budgeted Income Statement
Sales $754,000

Cost of goods sold - 263,540

Gross profit = $490,460

Total selling and administrative expenses - 228,100

Income before taxes = $262,360

Income taxes - 65,590

Net income = $196,770

The operating budgets culminate with the budgeted income statement.

Additional budgets may be prepared that relate to balance sheet accounts. Financial budgets look at critical aspects of a business
that are not directly operational but that impact a company’s ability to pay its obligations. The discussion will be limited to the cash
budget and the capital expenditures budget.

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7.10: Cash Budget
The availability and commitment of cash is critical to management planning and operational success. The cash budget provides
relevant information by estimating cash receipts and cash payments for one or more periods.
Cash receipts result from cash sales, collection of accounts receivable, other revenue sources, sales of assets, and issuance of stocks
and bonds. Cash payments occur due to incurring costs and expenses, paying invoices on account, purchasing assets, paying off
debts, and paying interest and dividends. The frequency and amount of these transactions are estimated and consolidated to form
the cash budget.
The most common reason for cash receipts is sales to customers, and the most frequent cash payments are due to sales-related
costs. The following example will illustrate the preparation of the cash budget.
Assume that Jonick Corporation begin operating on January 1, 2019. Projected sales to customers for the first four months are as
follows.
Estimated Sales
January February March April

Budgeted sales $68,000 $90,000 $124,000 $139,000

Budgeted cash sales

13,600 18,000 24,800 27,800
(20%)

Budgeted sales on
54,400 72,000 99,200 111,200
account (80%)

The company expects that 20% of each month’s sales will be for cash and the remainder on account. It anticipates that 40% of sales
on account will be collected in the month of sale, 50% will be collected in the following month, and the remaining 10% collected
during the second month after the sale.
The following table illustrates the budgeted cash collections from sales for each of the four months with corresponding
calculations.
Budgeted Cash Collections from Sales
January February March April

Cash
collections
from sales:

Cash
collected
$13,600 ($68,000 x 20%) $18,000 ($90,000 x 20%) $24,800 ($124,000 x 20%) $27,800 ($139,000 x 20%)
from cash
sales

Cash
collected
from this
21,760 ($54,400 x 40%) 28,800 ($72,000 x 40%) 39,680 ($99,200 x 40%) 44,480 ($111,200 x 40%)
month’s sales
on account
(40%)

Cash
collected
from last
0 - 27,200 ($54,400 x 50%) 36,000 ($72,000 x 50%) 49,600 ($99,200 x 50%)
month’s sales
on account
(50%)

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 Cash
collected
sales on
0 - 0 - 5,440 ($54,400 x 10%) 7,200 ($72,000 x 10%)
account two
months ago
(10%)

Total cash
collections $35,360 $74,000 $105,920 $129,080
from sales

Each month, the company expects to collect for cash sales plus for sales on account for the current month and for the previous two
months. In this example, cash collections are expected to be $35,360 for January, $74,000 for February, $105,920 for March, and
$129,080 for April.
Projected purchases from vendors for the first four months are as follows.
Estimated Purchases
January February March April

Budgeted purchases $34,000 $45,000 $62,000 $70,000

Budgeted cash
10,200 13,500 18,600 21,000
purchases (30%)

Budgeted purchases
23,800 31,500 43,400 49,000
on account (70%)

The company expects that 30% of each month’s purchases will be for cash and the remainder on account. It anticipates that 60% of
purchases on account will be paid in the month of sale, 30% will be paid in the following month, and the remaining 10% paid
during the second month after the sale.
The following table illustrates the budgeted cash payments to vendors for each of the four months with corresponding calculations.
Budgeted Cash Payments from Purchases
January February March April

Cash
payments
from
purchases:

Cash paid for

$10,200 ($34,000 x 30%) $13,500 ($45,000 x 30%) $18,600 ($62,000 x 30%) $21,000 ($70,000 x 30%)
purchases

Cash paid for

this month’s
purchases on 14,280 ($23,800 x 60%) 18,900 ($31,500 x 60%) 26,040 ($43,400 x 60%) 29,400 ($49,000 x 60%)
account
(60%)

Cash paid for

last month’s
sales on 0 - 7,140 ($23,800 x 30%) 9,450 ($31,500 x 30%) 13,020 ($43,400 x 30%)
account
(30%)

Cash paid for

purchases on
account two 0 - 0 - 2,380 ($23,800 x 10%) 3,150 ($31,500 x 10%)
months ago
(10%)

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 Total cash
collections $24,480 $39,540 $56,470 $66,570
from sales

Each month, the company expects to pay for cash purchases that month and for purchases on account for the current month and for
the previous two months. In this example, cash payments are expected to be $24,480 for January, 39,540 for February, $56,470 for
March, and $66,570 for April.
Jonick Corporation also anticipates the following cash-related transactions will take place during the first four months the business
operates.
1. The company will issue stock for $50,000 cash in January.
2. The company will purchase equipment for $8,000 cash in January.
3. The company will purchase equipment for $12,000 cash in February.
4. The company will sell equipment for $3,000 in March.
5. The company will pay $1,000 in cash dividends in March.
Based on the information about Jonick Corporation’s anticipated cash inflows and outflows, the following cash budget can be
prepared for the first four months of operations.
Cash Budget
January February March April

Estimated cash receipts:

Cash sales $13,600 $18,000 $24,800 $27,800

Collection of
54,400 72,000 99,200 111,200
accounts receivable

Issuance of stock 50,000

Sale of equipment 3,000

Total estimated
$118,000 $90,000 $127,000 $139,000
cash receipts

Estimated cash payments:

Cash purchases $10,200 $13,500 $18,600 $21,000

Payment of accounts
23,800 31,500 43,400 49,000
payable

Purchase of
8,000 12,000
equipment

Payment of
$1,000
dividends

Total estimated
$42,000 $57,000 $62,000 $71,000
cash payments

Cash increase 76,000 33,000 65,000 68,000

Cash at beginning of the

0 76,000 33,000 65,000
month

Cash at end of the month $76,000 $109,000 $98,000 $133,000

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7.11: Capital Expenditure Budget
A capital expenditure budget is a list of fixed assets that a company plans to acquire over a future period of time. These assets
may be purchased to replace existing assets that are aging or outdated, or they may be additionalresources necessary to meet
growing demand. Amounts for these expenditures are usually determined by looking at current costs and factoring in potential
pricing adjustments in the future.
A sample capital expenditures budget follows.
Capital Expenditures Budget
Asset 2020 2021 2022 2023 2024

Machinery –
$12,000 $18,000 $24,000 $31,000
Cutting Department

Machinery –
Assembly 57,000 43,000 18,000 15,000
Department

Delivery
35,000 42,000
vehicle

Office
21,000 4,000 7,000 1,000 3,000
equipment

Total $90,000 $100,000 $25,000 $67,000 $49,000

Budgets provide a financial roadmap for executing the plans management has developed. Keep in mind that they are projections of
what will take place in the future rather than reports of past performance. They can be compared to evaluate actual performance
once it can be measured. That assessment often leads to discovering strengths and weaknesses that can be considered when making
subsequent plans going forward.

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 CHAPTER OVERVIEW

8: Variance Analysis
8.1: Introduction to Variance Analysis
8.2: Direct Materials Cost Variance
8.3: Direct Labor Cost Variance
8.4: Factory overhead variances

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1
8.1: Introduction to Variance Analysis
Budgets are the result of planning efforts to estimate a company’s performance for a period of time in the future. They are tools that
guide managers and employees for keeping operations on track to achieve stated goals. Once a budget’s time period expires, its
estimates then serve as benchmarks against which actual results may be compared.
The discussion of budgeting for a manufacturing company included budgets for each of the three product costs: direct materials,
direct labor, and factory overhead. Those budgets were as follows.

Two key estimates are part of the direct materials production budget: the number of pounds needed for the desired level of
production and the price per pound. Likewise, the direct labor cost budget shows the number of labor hoursrequired to produce a
desired number of units and the labor rate per hour.
The factory overhead cost budget is prepared a bit differently, listing a dollar amount for each cost. Some factory overhead costs
may be further broken out into their fixed and variable components.
The amounts indicated by an arrow in the sample budgets are performance goals, also called standards. Variance analysis is a
process that compares these standards to actual amounts once the budget period has expired.
Standard costs are estimated goals that are used to calculate how much a product or batch of products “should cost” to
manufacture. Elements in bold below show standard costs taken from the previous budgets.

Direct materials: 8,600 pounds x $6.00 per pound = $51,600

Direct labor: 5,000 hours x $10.00 per hour = 50,000

Factory overhead: 12,000

Actual cost of production may be different than standard cost if any of the five goals listed above is either not met or exceeded. If
any one of the quantities or dollar amounts is higher than its standard, the result for that amount is said to be unfavorable since
more was consumed spent than was planned. An unfavorable outcome in this example would be if 8,900 pounds were used in
production when only 8,600 were budgeted. A quantity or unit cost is favorable when it is lower than what was anticipated. A
favorable result would be if $9 per labor hour were spent since it is lower than the anticipated amount of $10 per hour.
The following example conducts a variance analysis on the three costs of manufacturing. It involves the production of 1,000 units.
The standard quantities and prices per unit are as follows:

Production costs Standard price Standard quality Standard unit cost

Direct materials $6.00 per pound 8.6 pounds/unit $51.60

Direct labor $10.00 per hour 5 hours/unit 50.00

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 Factory overhead $12.00 per hour 1 hour/unit 12.00

Standard cost per unit $113.60

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8.2: Direct Materials Cost Variance
Actual and standard quantities and prices are given in the following table for direct materials to produce 1,000 units. Total actual
and standard direct materials costs are calculated by multiplying quantity by price, and the results are shown in the last row of the
first two columns.
Direct Materials Cost Variance
Actual Standard Difference

Direct materials
8,400 8,600 (200)
quantity in pounds

Direct materials price

$6.30 $6.00 $0.30
per pound

Total direct materials

$52,920 - $51,600 = $1,320
cost

The difference column shows that 200 fewer pounds were used than expected (favorable). It also shows that the actual price per
pound was $0.30 higher than standard cost (unfavorable). The total actual cost is $1,320 higher than the standard cost. The direct
materials used in production cost more than was anticipated, which is an unfavorable outcome.
Managers can better address this situation if they have a breakdown of the variances between quantity and price. Specifically,
knowing the amount and direction of the difference for each can help them take targeted measures forimprovement.
The following table is expanded to include this additional information.

The difference in the quantity is multiplied by the standard price to determine that there was a $1,200 favorable direct materials
quantity variance. This is offset by a larger unfavorable direct materials price variance of $2,520. The net direct materials cost
variance is still $1,320 (unfavorable), but this additional analysis shows how the quantity and price differences contributed to the
overall variance.
The following equations summarize the calculations for direct materials cost variance.
Direct materials quantity variance = (actual quantity – standard quantity) x standard price
Direct materials price variance = (actual price – standard price) x actual quantity
Total direct materials cost variance = direct materials quantity variance + direct materials price variance

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8.3: Direct Labor Cost Variance
Actual and standard quantities and rates for direct labor for the production of 1,000 units are given in the following table. Total
actual and standard direct labor costs are calculated by multiplying number of hours by rate, and the results are shown in the last
row of the first two columns.
Direct Labor Cost Variance
Actual Standard Difference

Direct labor quantity

5,100 5,000 100
in hours

Direct labor rate per

$9.50 $10.00 ($0.50)
hour

Total direct labor cost $48,450 - $50,000 = - $1,550

The difference column shows that 100 extra hours were used vs. what was expected (unfavorable). It also shows that the actual rate
per hour was $0.50 lower than standard cost (favorable). The total actual cost direct labor cost was $1,550 lower than the standard
cost, which is a favorable outcome.
Managers can better address this situation if they have a breakdown of the variances between quantity and rate. Specifically,
knowing the amount and direction of the difference for each can help them take targeted measures forimprovement.
The following table is expanded to include this additional information.

The difference in hours is multiplied by the standard price per hour, showing a $1,000 unfavorable direct labor time variance. This
is offset by a larger favorable direct labor rate variance of $2,550. The net direct labor cost variance is still $1,550 (favorable), but
this additional analysis shows how the time and rate differences contributed to the overall variance.
The following equations summarize the calculations for direct labor cost variance.
Direct labor time variance = (actual hours – standard hours) x standard rate
Direct labor rate variance = (actual rate – standard rate) x actual hours
Total direct labor cost variance = direct labor time variance + direct labor rate variance

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8.4: Factory overhead variances
Factory overhead costs are also analyzed for variances from standards, but the process is a bit different than for direct materials or
direct labor. The first step is to break out factory overhead costs into their fixed and variable components, as shown in the following
factory overhead cost budget.
Factory Overhead Cost Budget
Number of units at normal production capacity 10,000

Variable costs:

Packing materials $30,000

Direct labor 15,000

Variable utilities cost 5,000

Total variable costs $50,000

Fixed costs:

Supervisor salary expense $60,000

Depreciation expense 7,000

Machine rental expense 3,000

Total fixed costs $70,000

Total budgeted costs $120,000

This factory overhead cost budget starts with the number of units that could be produced at normal operating capacity, which in this
case is 10,000 units. Assume each unit consumes one direct labor hour in production. Total variable factory overhead costs are
$50,000, and total fixed factory overhead costs are $70,000. The following factory overhead rate may then be determined.
budgeted factory overhead at normal capacity $120,000
Factory overhead rate = = = $12 per direct labor hour
normal capacity in direct labor hours 10,000

The total factory overhead rate of $12 per direct labor hour may then be broken out into variable and fixed factory overhead rates,
as follows.
budgeted variable factory overhead at normal capacity $50,000
Variable factory overhead rate = =
normal capacity in direct labor hours 10,000

= $5 per direct labor hour

budgeted fixed factory overhead at normal capacity $70,000

Fixed factory overhead rate = = = $7 per direct labor hour
normal capacity in direct labor hours 10,000

The $5 fixed rate plus the $7 variable rate equals the $12 total factory overhead rate per direct labor hour.
Factory overhead variances can be separated into a controllable variance and a volume variance.
The variable factory overhead controllable variance is the difference between the actual variable overhead costs and the
budgeted variable overhead for actual production. The following calculations are performed.

Budgeted variable standard hours for variable factory

1. = x
factory overhead actual units produced overhead rate

If 8,000 units are produced and each requires one direct labor hour, there would be 8,000 standard hours.
Budgeted variable factory overhead = 8,000 x $5 per direct labor hour = $40,000

Variable factory
actual variable factory budgeted variable
2. overhead controllable = -
overhead factory overhead
variance

Assume actual variable overhead cost is $39,500

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 Variable factory overhead controllable variance = $39,500 - $40,000 = ($500), a favorable variance since actual is less than
expected.
The variable factory overhead controllable variance indicates how well the company was able to adhere to the budget.
The fixed factory overhead volume variance is the difference between the budgeted fixed overhead at normal capacity and the
standard fixed overhead for the actual units produced. The following calculations are performed.
Fixed factory overhead volume variance = (standard hours normal capacity – standard hours for actual units produced) x fixed
factory overhead rate
If 8,000 units are produced and each requires one direct labor hour, there would be 8,000 standard hours.
Fixed factory overhead volume variance = (10,000 – 8,000) x $7 per direct labor hour = $14,000
The 8,000 standard hours are less than the 10,000 available at normal capacity, so the fixed overhead was underutilized. This
results in an unfavorable variance due to the missed opportunity to produce more units for the same fixed overhead.
If 11,000 units are produced (pushing beyond normal operational capacity) and each requires one direct labor hour, there would be
11,000 standard hours.
Fixed factory overhead volume variance = (10,000 – 11,000) x $7 per direct labor hour = ($7,000)
When standard hours exceed normal capacity, the fixed factory overhead costs are leveraged beyond normal production. A
favorable fixed factory overhead volume variance results. Additional units were produced without any necessary increase in fixed
costs.
An income statement that includes variances is very useful for managers to see how deviations from budgeted amounts impact
gross profit and net income. These insights help in planning by addressing reasons for unfavorable variances and continuing with
line items that are favorable.
In this example, assume the selling price per unit is $20 and 1,000 units are sold. The standard cost per unit of $113.60 calculated
previously is used to determine cost of goods sold – at standard amount. Assume selling expenses are $18,300 and administrative
expenses are $9,100.
Income Statement with Variances
Sales $200,000

Cost of goods sold – at standard 113,600

Gross profits – at standard $86,400

Variances from standard cost:

Direct materials quantity ($1,200)

Direct materials price 2,520

Direct labor time 1,000

Direct labor rate (2,550)

Factory overhead controllable (600)

Factory overhead volume 400

Net variance from standard cost –

(430)
favorable

Gross profit $86,830

Operating expenses:

Selling expenses $18,300

Administrative expenses 9,100

Total operating expenses 27,400

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 Net income before income taxes $59,430

The net variance from standard cost and the line items leading up to it build deviations from standard amounts right into the income
statement. Managers can focus on discovering reasons for these differences to budget and operate more effectively in future
periods.

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 CHAPTER OVERVIEW

9: Differential Analysis
9.1: Introduction to Differential Analysis
9.2: Make or buy a component part
9.3: Continue with or discontinue a product
9.4: Lease or Sell Equipment
9.5: Sell a Product or Process Further
9.6: Keep or Replace a Fixed Asset
9.7: Accept Business at Reduced Price
9.8: Capital investment analysis

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1
9.1: Introduction to Differential Analysis
Managerial decision making often involves choosing among alternative courses of action. From a financial perspective, the better
of two options is either the one that yields the highest amount of income or, if neither produces income, the one that results in the
least amount of loss.
Differential analysis is a decision-making technique that examines the benefits and costs associated with each of two options and
compares the net results of the two. The alternative selected is the one with the most favorable (or least unfavorable) financial
impact. The evaluation includes only those costs that will change if one alternative is selected over another. Fixed costs or other
costs that are constant for the two options are excluded from the analysis since they will not differentiate one choice from the other.
Sunk costs, which are past expenditures that have already been incurred and cannot be recovered, are also ignored since the amount
will be the same regardless of the alternative selected.

 Example

A bed & breakfast inn owner uses differential analysis to decide whether to renovate a first-floor guest bedroom or to convert
that space to a gift shop. A summary of the year’s revenues and costs for the two alternatives follows.
Differential Analysis
Guest Room Gift Shop Difference

Revenues $36,000 $42,000

Costs (11,000) (15,000)

Income $47,000 $57,000 $10,000

Since the gift shop will yield $2,000 more in operating income than the guest room, the gift shop alternative should be selected.
Seven additional examples will be used to illustrate how differential analysis can be applied to specific business decisions.
1. Make or buy a component part
2. Continue with or discontinue a business segment
3. Lease or sell equipment
4. Sell a product or process further
5. Keep or replace a fixed asset
6. Accept business at reduced price
7. Capital investment analysis

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9.2: Make or buy a component part
A manufacturing company may have the capacity and ability to make one of the parts that goes into the manufacture of its
products. It may also have the alternative of purchasing the same part from an external supplier. Assuming equal quality and
availability, the lower-cost option will be selected.

 Example
Compu Company manufactures laptop computers and now will sell them complete with a carrying case. The company is
currently operating below full capacity and has the ability to manufacture the cases. The company may usedifferential analysis
to determine if it should make or buy the cases.
For this differential analysis, only costs need to be considered. The selling price per unit would not be affected by the decision,
and no other factors impact revenue.
The following are the costs of producing one carrying case in house.

Direct materials $22.40

Direct labor 14.00

Fixed factory overhead 5.60

Rather than manufacturing the carrying cases, the company can purchase them from an outside vendor for $34.20 each, plus a
transportation cost of $3.70 per case.
The following differential analysis compares the manufacturing costs per unit with the costs related to purchasing the carrying
case. Note that the factory overhead is fixed and would be incurred under either alternative, so it is not listed.
Differential Analysis
Make Buy Difference

Costs:

Purchase price $34.20

Inbound shipping charge 3.70

Direct materials $22.40

Direct labor 14.00

Total cost per case $36.40 $37.90 $1.50

The cost of making the carrying case is $1.50 less than purchasing it. Compu Company should manufacture the cases.

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9.3: Continue with or discontinue a product
A product, department, territory, or other segment of a company may not be performing to expectations and may even be
generating a loss. The company may consider discontinuing that segment to eliminate its variable costs and any operating losses
associated with the segment. However, fixed costs such as depreciation, property taxes, and insurance will not be reduced.
Therefore, eliminating a segment does not always result in higher income for the business as a whole. The decision as to whether to
continue with or discontinue a product, etc., is based upon the relative difference between the financial impacts.

 Example
Healthy Habits Company sells a variety snack food items. The following income statement information relates to the popcorn
product line for the previous year.

Sales $720,000

Cost of goods sold 480,000

Gross profit $240,000

Operating expenses 500,000

Loss from operations ($260,000)

It is estimated that 25% of the cost of goods sold amount is fixed and 40% of the operating expenses are fixed.
The following differential analysis compares the cost of continuing the popcorn product with the cost of discontinuing it. Note
that the fixed portions of the cost of goods sold and operating expenses would be incurred under either alternative, so they are
not included.
Differential Analysis
Continue Discontinue Difference

Revenue $700,000

Costs:

Variable cost of goods

$360,000
sold1

Variable operating
300,000
expenses2

Income $40,000 $40,000

1 $480,000 x 75%
2
$500,000 x 60%
Although continuing the sale of popcorn results in an operating loss for that product line, it does yield $40,000 in operating
income when fixed costs are eliminated from the calculation. Since fixed costs will be incurred regardless of whether popcorn
is sold or not, keeping it in the product offerings has a positive impact on the company’s earnings. Discontinuing popcorn
results in no revenue or variable costs at all, so the company would miss out on the $40,000 contribution toward paying fixed
costs. The company should continue selling popcorn.

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9.4: Lease or Sell Equipment
A company may have purchased and used a fixed asset, such as equipment, a vehicle, or a building, and finds it no longer needs
that item in its operations. The company may choose to sell the asset or lease it to another company to generate an income stream.
The company can use a differential analysis to determine the alternative that provides the greater financial return.

 Example
Harper Company purchased equipment for $40,000 several years ago. It currently has a book value of $15,000. Harper can sell
the equipment for $10,000. The company would have to pay a 2% commission on the sale. Alternatively, the company could
lease the equipment to Alden Company for $2,400 for each of four years. At the end of the lease period, the company could
return the equipment to its manufacturer for $100 for scrap. In both cases, it will cost Harper Company $900 to restore the
equipment site in the factory once it is removed.
Differential Analysis
Lease Sell Difference

Revenue1 $9,600 $10,000

Scrap value 100

Costs:

Sales commission2 200

Income $9,700 $9,800 $100

1
$2,400 x 4
2
$10,000 x 2%
The income from the four-year lease plus the scrap value is compared to the selling price minus the commission. The $900
restoration cost is not considered since it must be paid under either option. The original purchase price is a sunkcost that will
not be recouped or changed regardless of the decision; therefore, it is ignored as well. Since selling the equipment will result in
a $100 greater return, the company should sell the equipment.

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9.5: Sell a Product or Process Further
A manufactured item may be produced in various stages or processes. In some cases, the initial production yields one finished
product and processing it further results in a different product. In other cases, there may be a market for a partially completed
manufactured good, where the buyer ultimately completes the product to its own specifications. A manufacturer may have to
decide whether to sell a product at an initial stage or process it further. The preferred choice is the one that is more financially
beneficial.

 Example
Morning Roast Coffee, Inc. produces dark roast coffee in batches of 5,000 pounds. Materials cost is $5.80 per pound. The dark
roast coffee can be sold without further processing for $9.70 per pound or may be processed further to yield dark roast decaf,
which can be sold for $12.10 per pound. The processing into decaf requires additional costs of $7,480 per batch. The additional
processing will also cause a 4% loss of product due to evaporation.

Sell Process Difference

Revenue1 $48,500 $60,500

Costs:

Materials cost2 29,000 36,480

Evaporation3 2,420

Income $19,500 $9,800 $2,100

1
5,000 x $9.70 5,000 x $12.10
2
5,000 x $5.80 5,000 x $5.80 + $7,480
3
$60,500 x 4%
The differential analysis first considers the different revenues from each alternative and then the respective costs. Even with the
4% product loss from processing further, the decaf coffee results in higher income. The company shouldprocess the batch
further.

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9.6: Keep or Replace a Fixed Asset
A company may consider replacing a fixed asset it currently owns and operates with one that is more efficient to reduce operating
costs. The company can use differential analysis to compare the cost of keeping its original asset and the cost of replacing it with
something new.

 Example
McNamara Company is considering selling an existing piece of equipment for $75,000 and replacing it with new equipment
that will cost $182,000. The old equipment cost $200,000 and currently has accumulated depreciation of $120,000. The
estimated annual variable operational costs for the next six years are $21,000 for the old equipment and $6,000 for the new
equipment.
Differential Analysis
Keep Replace Difference

Revenue $75,000

Costs:

Purchase price 182,000

Operating costs1 $126,000 36,000

Income (loss) ($126,000) ($143,000) $17,000

1
$21,000 x 6 $6,000 x 6
Replacing the equipment will generate revenue from the sale of the original asset, but the cost of acquiring the new asset will
also be incurred. Each alternative has different annual operating costs. The purchase price of the original equipment is a sunk
cost that will not be recouped or changed regardless of the decision; therefore, it is ignored. Each alternative independently
generates a loss, so the choice with the lower loss is preferable. The company should keep and operate the original equipment.

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9.7: Accept Business at Reduced Price
A manufacturer may receive an offer to produce and sell additional items, but at a selling price lower than normal. If the company
has the capacity for the additional production, it may use differential analysis to determine if the order should be accepted or
rejected based on financial considerations.

 Example
Spark Top Company manufactures countertop toaster ovens and sells them for $60 per unit. An overseas wholesaler offers to
purchase 5,000 toaster ovens for $36 per unit, which would be additional production beyond what Spark Tophad planned for.
The company has the capacity to process this special order. The variable manufacturing cost per unit is $25, and the fixed
manufacturing cost per unit is $15. A tariff of $800 is charged to the company for shipping each batch of 5,000 toaster ovens.
Differential Analysis
Accept Reject Difference

Revenue1 $180,000

Costs:

Production costs2 125,000

Tariff 800

Income (loss) $54,200 $54,200

1
$5,000 x $36
2
$5,000 x $25

No additional revenue or variable costs will be recognized if the company rejects the special order. If it is accepted, revenue will
exceed variable costs. Fixed costs are not factored in since they will be incurred regardless of the decision. The company should
accept the special order.
The implications of special order pricing may go beyond just financial considerations. For example, processing special orders may
reduce demand for the same product at the normal selling price, ultimately decreasing overall income. In addition, regular
customers may be irritated to learn that new customers are receiving a better deal and either demand a price match or consider
shopping elsewhere.
As has been discussed and illustrated, differential analysis involves looking at the different benefits and costs that would arise
from alternative solutions to a particular problem. Much of the analysis is quantitative, but it is also important to consider
qualitative factors such as customer loyalty, vendor relationships, employee morale, social responsibility, and opportunity costs.
The financial element, however, is a critical starting point for managerial decision making.

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9.8: Capital investment analysis
One of a company’s most significant financial decisions involves the purchase of property, plant, and equipment that will be used in
business operations. The costs of these assets are often very high, and they will be in place for many years to come.
Before acquiring a capital asset such as equipment, machinery, or a building, which involves a large expenditure and long-term
commitment, a company should evaluate how effectively it is expected to generate a return on investment for the business. Capital
investment analysis is a form of differential analysis used to determine (1) whether a fixed asset should be purchased at all, or (2)
which fixed asset among a number of choices is the best investment. Three commonly used methods for evaluating capital
investments will be discussed.
The first two, the average rate of return method and the cash payback method, are relatively straightforward calculations that are
often used to determine whether a proposed investment meets a minimum standard for it even to be considered further.
The average rate of return method is the percentage return of net income from the proposed investment. It is calculated as
follows:
Average annual income

Average investment

Each of the two amounts must first be calculated independently.

Average annual income
Total estimated income over the asset's useful life
=
Number of years in the asset's useful life
(numerator)

Average investment Book value at the beginning of the first year

1
+ Book value at the end of the last year
2

=
2
(denominator)

1
The book value at the beginning of the first year is the asset’s cost.

2 The book value at the end of the last year is the asset’s residual value.
As an example, a new piece of equipment that is being considered for purchase costs $90,000 and has a residual value of $10,000.
It is expected to generate revenue of $75,000 over its estimated useful life of 5 years.
$75,000
Average annual income = = $15, 000
5

$110,000+$10,000
Average investment = = $60, 000
2

$15,000
Average investment =
$60,000
= 25 %

The average rate of return of 25% should then be compared to the minimum rate of return that management requires. If the average
rate of return is greater than the minimum acceptable rate, the equipment should be evaluated further since it seems promising. If it
does not even meet this standard, however, it should not be purchased.
The cash payback method looks at the annual net cash inflow from the use of an asset to determine how many years it will take to
recover the cost of the asset. Net cash flow includes all cash revenue generated minus all cash expenditures paid from using the
asset. Depreciation is not a cash expenditure, so it would not be considered in determining net cash flow.
As an example, a new piece of equipment that is being considered for purchase costs $80,000. It is expected to generate $25,000
cash revenue each year and require cash expenditures of $5,000 to maintain.
Cash payback period $=\frac{\text { cost }}{\text { Annual nest cash flow }}=\frac{\$ 80,000}{\$ 25,000-\$ 5,000}=4$ years
The cash payback period of four years should be compared to the maximum period that management desires. If the cash payback
period of four years is more than an acceptable payback period of three years, for example, the purchase should no longer be
considered. If a payback period of five years is acceptable, the purchase should be looked into further.
If annual net cash flows are not expected to be equal each year, the cash payback period is determined by adding the annual
expected cash flows year by year until the sum equals the initial cost of the asset.
For example, a new piece of equipment that is being considered for purchase costs $80,000. Its expected annual cash flows are as
follows:

Year Net Cash Flow Cash Flow to Date

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 1 $12,000 $12,000

2. 18,000 30,000

3 24,000 54,000

4 26,000 80,000

5 30,000 110,000

6 34,000 144,000

In this case, net cash flows recover the initial cost of $80,000 after four full years. The average rate of return and the cash payback
methods are relatively simple to calculate, yet they yield rather general results. Since neither considers the time value of money,
they are more effective for shorter-term investments. They are often used as an initial screening to see if an investment should be
immediately disqualified. If not, the investment may be analyzed further using more robust
analyses.
The net present value (NPV) method for evaluating a potential investment
also looks at estimated future net cash flows generated by the asset. It compares the purchase price (investment amount) to the
present value of all the future net cash flows from using the asset. The investment is considered viable if the present value of the
future net cash flows is greater than the purchase price. Otherwise, the investment should be avoided.
Present value factors the timing of future net cash inflows and the effect of a prevailing interest rate. An amount of cash received
in the future is worth less than the same amount of cash received today. This is because cash received now may be invested at a
given interest rate that causes its value to grow over time compounding, where interest is earned both on principal and on interest
that has already been earned. The opportunity to invest dollars received in the future rather than today is postponed, missing out on
time available to earn interest.
Determining the future value of a current amount is calculated by multiplying the amount by itself plus the interest rate. For
example, the future value of $1.00 in 3 years at an interest rate of 6% would be calculated as follows:
$1.00 x 1.06 = $1.06 x 1.06 = $1.12 x 1.06 = $1.19
Note that interest is calculated on interest previously earned. This process is called compounding.
Present value works in the opposite direction. An amount in the future is known or estimated (such as a net cash inflow), and the
calculation backs that amount up to its current value. The process is called discounting. For example, the present value of $1.00 to
be received in 3 years at an interest rate of 6% would be calculated as follows:
$1.00 $0.94 $0.89
= = = $0.84(rounded to the nearest cent)
1.06 1.06 1.06

The following table summarizes the present value of $1 for 10 periods for three interest rates: 6%, 8%, and 10%. Amounts are
rounded to five decimal places rather than to the nearest cent.
Present Value of $1
Period 6% 8% 10%

1 0.94340 0.92593 0.90909

2 0.89000 0.85734 0.82645

3 0.83962 0.79383 0.75132

4 0.79209 0.73503 0.68302

5 0.74725 0.68058 0.62093

6 0.70495 0.63017 0.56448

7 0.66505 0.58349 0.51316

8 0.62741 0.54027 0.46651

9 0.59190 0.50025 0.42410

10 0.55840 0.46319 0.38555

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Note that all amounts in the present value table are less than $1.00 since all represent a future cash receipt rather than the $1.00
today. The further into the future the $1.00 will be received for a given interest rate, the lower its present value.
Clearly not all future cash receipts are for $1.00. To get the present value of a different value, multiply the actual number of dollars
by the present value of $1 amount given in the table at the intersection of a specified interest rate and number of years.
Examples 1 and 2 illustrate the process of discounting the future net cash flows to determine their total and comparing it to the cost
of the asset.

 Example

A company is considering purchasing equipment #1 for $100,000. It is expected to provide net cash flows of $24,000 per year
for the next six years for a total of $144,000. The minimum desired rate of return on the investment is 6%.

Undiscounted Net Cash Present Value of $1 at Discounted Net Cash Since the undiscounted net
Year
Flow 6% Flow cash flow amount is the
same each year, the total
1 $24,000 0.94340 $22,642
discounted net cash flow
2 24,000 0.89000 21,360 could also be calculated
by using the present value
3 24,000 0.83962 20,151
of an annuity of $1, as
4 24,000 0.79209 19,010 follows:
$24,000 x 4.91731 =
5 24,000 074725 17,934
$118,016
6 24,000 0.70495 16,919 Rather than multiplying
$24,000 six times by six
Total $144,000 4.91731 $118,016
different factors, $24,000
can be multiplied once by
the sum of all the factors
Cost (100,000) (4.91731). The result is
NPV $18,016 the same.

In this case, the net present value of the future cash flows of $18,016 is greater than the cost of the asset, $100,000. The
investment may be accepted since it more than pays for itself over time.
If the cost of the asset had been $130,000 rather than $100,000, the net present value would have been ($11,984), which is
$118,016 - $130,000. In this case the NPV is negative and the proposed purchase should be rejected.

 Example

A company is considering purchasing equipment #2 for $100,000. It is expected to provide net cash flows of different amounts
each year for the next six years for a total of $144,000. The minimum desired rate of return on the investment is 6%.

Undiscounted Net Cash Present Value of $1 at Discounted Net Cash Since the undiscounted net
Year
Flow 6% Flow cash flow amounts are
different each year, the
1 $34,000 0.94340 $32,076
total discounted net cash
2 30,000 0.89000 26,700 flow must be calculated
using six individual
3 26,000 0.83962 21,830 calculations. Each year the
4 24,000 0.79209 19,010 undiscounted net cash
flow amount is multiplied
5 18,000 074725 13,451 by the present value of $1
6 12,000 0.70495 8,459 factor at 6%.

Total $144,000 $121,526

Cost (100,000)

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 NPV $24,526

In this case, the net present value of the future cash flows of $21,256 is greater than the cost of the asset, $100,000. The
investment may be accepted since it more than pays for itself over time.
Net present value can be used to perform differential analysis to compare results of two or more proposed investments to
determine which is more financially beneficial. Examples 3 and 4a show these comparisons.

 Example
A company is considering two different proposals for purchasing equipment. Both assets will be useful for six years. The first
piece of equipment costs $100,000, and the second costs $140,000. The undiscounted cash flows appear in the two tables that
follow.

Undiscounte Present Discounted Undiscounte Present Discounted

#1 Year d Net Cash Value of $1 Net Cash #2 Year d Net Cash Value of $1 Net Cash
Flow at 6% Flow Flow at 6% Flow

1 $34,000 0.94340 $32,076 1 $44,000 0.94340 $41,510

2 30,000 0.89000 26,700 2 39,000 0.89000 34,710

3 26,000 0.83962 21,830 3 34,000 0.83962 28,547

4 24,000 0.79209 19,010 4 31,000 0.79209 24,555

5 18,000 074725 13,451 5 23,000 074725 17,187

6 12,000 0.70495 8,459 6 16,000 0.70495 11,279

Total $144,000 $121,526 Total $187,000 $157,788

Cost (100,000) Cost (140,000)

NPV $24,526 NPV $17,788

The second piece of equipment has a higher estimated net cash flow each year, but it also costs more to purchase. Both assets
yield a positive net present value, but the first piece of equipment has a higher NPV, $21,526, vs. the NPV of the second piece,
$17,788. The first piece of equipment should be purchased based on this result.
It is possible that two different investments will span two different periods; that is, one may generate cash flows for more years
than the other. In order to perform a differential analysis, the number of years must be the same for both. To make them
comparable, the asset with the higher number of years of cash flows is adjusted to assume that it is sold for its residual value
amount in the last year that the other asset provides cash flows.

 Example

A company is considering two different proposals for purchasing equipment. The first asset provides cash flows for four years,
and the second one provides cash flows for six years. Both assets cost $100,000 and have a residual value of $10,000. Both
have undiscounted net cash flows of $124,000 as shown in the tables that follow.

Undiscounte Present Discounted Undiscounte Present Discounted

#1 Year d Net Cash Value of $1 Net Cash #2 Year d Net Cash Value of $1 Net Cash
Flow at 6% Flow Flow at 6% Flow

1 $38,000 0.94340 $35,849 1 $34,000 0.94340 $32,076

2 34,000 0.89000 30,260 2 32,000 0.89000 28,480

3 30,000 0.83962 25,189 3 26,000 0.83962 21,830

4 22,000 0.79209 17,426 4 22,000 0.79209 17,426

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 4 (residual) 10,000 0.79209 7,921

5 18,000 0.74725 13,451

6 12,000 0.70495 8,459

Total $124,000 $108,724 Total $124,000 $107,733

Cost (100,000) Cost (100,000)

NPV $8,724 NPV $7,733

Note that the cash flow period for the second piece of equipment is adjusted to four years to match that of the first piece of
equipment. There are two net cash flows for the second piece of equipment in year four: (1) the inflow from using the
equipment, and (2) the proceeds from selling it at its residual value. The cash flows for the fifth and sixth years for the second
asset are not considered and are therefore greyed out in the table.
Both assets yield a positive net present value, but the first piece of equipment has a higher NPV, $8,724, vs. the NPV of the
second piece, $7,733. The first piece of equipment should be purchased based on this result.
As a final illustration of two companies with different cash flow periods, note that the net present value would be identical if
the annual net cash flows were the same. In this case, all are equal in years 1, 2, and 3. In year 4, they also both equal $32000:
for the first asset the $32,000 is all operational cash flow, and for the second piece of equipment, the $32,000 includes $22,000
of operational cash flow and $10,000 selling price.

 Example

A company is considering two different proposals for purchasing equipment. The first asset provides cash flows for four years,
and the second one provides cash flows for six years. Both assets cost $100,000 and have a residual value of $10,000. Both
have undiscounted net cash flows of $124,000 as shown in the tables that follow.

Undiscounte Present Discounted Undiscounte Present Discounted

#1 Year d Net Cash Value of $1 Net Cash #2 Year d Net Cash Value of $1 Net Cash
Flow at 6% Flow Flow at 6% Flow

1 $34,000 0.94340 $35,076 1 $34,000 0.94340 $32,076

2 32,000 0.89000 28,480 2 32,000 0.89000 28,480

3 26,000 0.83962 21,830 3 26,000 0.83962 21,830

4 32,000 0.79209 25,347 4 22,000 0.79209 17,426

4 (residual) 10,000 0.79209 7,921

5 18,000 0.74725 13,451

6 12,000 0.70495 8,459

Total $124,000 $107,733 Total $124,000 $107,733

Cost (100,000) Cost (100,000)

NPV $7,733 NPV $7,733

Differential analysis is a useful planning tool for projecting relative results among alternatives. It encourages managers to think
ahead and analyze the components of alternative outcomes with the goal of more insightful decision making.

This page titled 9.8: Capital investment analysis is shared under a CC BY-SA 4.0 license and was authored, remixed, and/or curated by Christine
Jonick (GALILEO Open Learning Materials) via source content that was edited to the style and standards of the LibreTexts platform; a detailed
edit history is available upon request.

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Index
A F S
absorption costing flexible budget sales budget
6.1: Introduction to Variable Costing Analysis 7.3: Flexible Budget 7.6: Sales Budget
static budget
C J 7.2: Static Budget
capital investment analysis Job order costing
9.8: Capital investment analysis 2.1: Introduction to Job Order Costing W
work in process
2.1: Introduction to Job Order Costing

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Index
A F S
absorption costing flexible budget sales budget
6.1: Introduction to Variable Costing Analysis 7.3: Flexible Budget 7.6: Sales Budget
static budget
C J 7.2: Static Budget
capital investment analysis Job order costing
9.8: Capital investment analysis 2.1: Introduction to Job Order Costing W
work in process
2.1: Introduction to Job Order Costing
Glossary
Sample Word 1 | Sample Definition 1

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 8.1: Introduction to Variance Analysis - CC BY-SA 9.5: Sell a Product or Process Further - CC BY-SA 4.0
4.0 9.6: Keep or Replace a Fixed Asset - CC BY-SA 4.0
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