.

CH. 16 BUDGETING: PROFITS, SALES, COSTS, & EXPENSES 485

an executive, department head, or foreman who should be held accountable

and responsible for expenses incurred. Those expenses for which the
department supervisor can be held directly responsible should be included
and clearly identified in his budget. If additional expenses for which he
has little or no direct responsibility are allocated to his department, these
expenses should be separately identified.
The department supervisor should be asked to submit an estimate of
his departmental expenses based on the projected activity of his depart-
ment for the budget period. Past costs are tempered by estimates about
the future. These estimates are reviewed in the light of other budgets, and
all estimates are coordinated. Any revision is submitted to the depart-
ment supervisor for review before incorporation in the overall budget.
This procedure is of great value psychologically. If the individual depart-
ment supervisor responsible for expenses incurred feels that the budget
figures are his estimates, he will cooperate more willingly in executing
the budget.
The factory overhead budget of a department is generally prepared
as a report which enables executive management and individual depart-
ment supervisors to make monthly comparisons of budgeted and actual
expenses. The report illustrated below presents end-of-month analysis.

Molding Department
Factory Overhead Budget
For July, 19

Budgeted Actual Over Under

Indirect labor $ 930
Oil
Fuel
Tools
Heat
Power and light
Repairs to machinery . .

Supervisor
Depreciation
Spoiled work
 :

486 PLANNING OF PROFITS, COSTS, AND SALES PART V

seasonal budget is highly valuable if expenses are to be analyzed for a

period shorter than twelve months. Each item of expense, such as heat,
light, repairs, or power, must be considered on a volume-of-activity
basis to make the monthly budget as nearly accurate as possible. Such
a comparision is accomplished through the use of flexible budgeting
(Chapter 18).

Budget of the Maintenance Department. Among the expenses com-

monly included in a departmental overhead budget is the item "Repairs
to machinery," which is based on the budget of the maintenance depart-
ment — a service department Chapter 11). The cost of repairs and
(see
maintenance is an important item in most companies. Because of the
nature of repairs and maintenance work, control of these costs is quite
frustrating. Disturbing factors are the irregularity of repair jobs, their
and
unpredictability, the impossibiUty of measuring their cost in advance,
the difficulty of determining their causes. Economical use of plant and
equipment is the joint responsibility of production and maintenance
personnel, such as the department supervisor who uses the equipment
and the maintenance force who repair and keep it in good condition.

BUDGETING COMMERCIAL EXPENSES

The company's chart of accounts is also the basis for cost ascertainment
and budgetary control of commercial expenses which include both market-
ing (often referred to as seUing or distribution expenses) and administrative
expenses. These expenses may be classified by primary accounts and by
functions. Classification by primary accounts stresses the nature or the
type of expenditure, such as salaries, commissions, repairs, light and heat,
rent, telephone and telegraph, postage, advertising, travel expenses, sales
promotion, entertainment, delivery expenses, freight-out, insurance,
donations, depreciation, taxes, and interest. Classification by function
emphasizes departmental activities, such as selling, advertising, ware-
housing, billing, credit and collection, transportation, accounting, purchas-
ing, engineering, and financing, and is consistent with the concept of
responsibility accounting.

Budgeting and Analyzing Commercial Expenses by Primary Accounts.

Budgeting and analyzing commercial expenses by primary accounts is the
simplest method of classification. Expenses are recorded on the books in
primary expense accounts and appear in the income statement in this

manner
 PROFITS, SALES, COSTS, & EXPENSES 487
CH. 16 BUDGETING:

Commercial expenses:
Marketing expenses:
Advertising ^,1'?2S
Sales salaries
\im\
Store supplies
Depreciation — store equipment
cAri,
5,4UU
Depreciation — delivery equipment 6,600
Depreciation — building (store area) 3,300
$40,000
Total marketing expenses

Administrative expenses:
Office salaries
Depreciation —
building (office area)
^'^'tnX
2,200
Bad debts expense '590
J
Insurance c'\r^
Miscellaneous general expenses 6,100

Total administrative expenses

"hOS^
$70,000
Total commercial expenses

are incurred, they are coded according to the chart

of ac-
As expenses
to ledger accounts, and then taken directly to the income
counts, posted
made or even attempted. At the end of
statement. No further allocation is

budgeted expenses or
a period actual expenses are compared either with
with expenses of the previous month or year.

Budgeting and Analyzing Commercial Expenses by Functions.

To control
activities
commercial expenses, it is necessary to group them by functional
of commercial expenses, often
or operating units. Such a classification
referred to as a departmental classification, can be
compared to collecting

factory overhead by departments or cost centers. A departmental classi-

fication of commercial expenses adds to rather than replaces the process

primary account
of classifying expenses by primary accounts, because
classifications are maintained within each department.
When a depart-
classification
mental classification system is used, it is important that the
conforms to the company's organization chart.
types of busi-
Since organizational structures vary so much in different
exactness the division
ness organizations, it is impossible to suggest with
that should exist for marketing and administrative expenses. In the first
will perform widely dif-
place, departments known by the same name
cost information vary
ferent functions. Also, requests by management for
from one company to the next depending upon the size and complexity of
training of the execu-
the sales organization and the experience, ability, and
tive staff. However, departmentalization should be carried out so that
every item of expense is appropriately charged to a department.
used in
Direct and indirect departmental expenses also exist as
those charged directly to a
factory cost procedures. Direct expenses are
 . :

488 PLANNING OF PROFITS, COSTS, AND SALES PART V

department, such as salaries, wages, supplies, travel expenses, and enter-

tainment expenses. Indirect expenses are general or service department
expenses that are prorated to benefiting departments. Expenses such as
rent, insurance, and utilities, when shared by several departments, consti-
tute this type of expense.
To an outlay of cash or the incurrence of a liability with a func-
identify
tion requires considerably more work than is required by the primary ac-
count method. However, the chart of accounts will normally provide the
initial breakdown of expenses. Usually the allocation of expenses to
departments and the identification of the primary account classification
within each department can be made at the time the voucher is prepared.
This procedure requires coding the expenditure at the time it is requis-
tioned for purchase. An increased expense caused by the use of this
functional method is more than offset by the advantages of improved
cost control.

Marketing Expenses Budget. A company's marketing activities can be

divided into two broad categories

1 Obtaining the order — involving the functions of selling, advertising, and

market analysis
2. Filling the order — involving the functions of order assembly, pack-
ing, warehousing, shipping, transportation, billing, and credit and
collection

The supervisors or department heads of functions connected with

marketing activities prepare budget estimates for the coming year. Some
estimates are based on individual judgment others on the cost experienced
;

in previous years, modifiedby expected sales volume. Expenses such as

depreciation and insurance depend upon the policy established by man-
agement. With all departmental budgets completed, the total estimated
marketing costs become part of the master budget. At the end of a month
or other period, budgeted expenses of all marketing functions are com-
pared with actual expenses to determine favorable or unfavorable trends,
and to take steps to remedy them.

Administrative Expenses Budget. Estimating administrative expenses

is often quite difficult. One difficulty deals with the problem of classifying
certain expenses as either production or administrative expenses. Expenses
such as purchasing, engineering, personnel, and research can be found in
either category, or in some cases allocated between the two as well as to
marketing costs. Management must decide how these expenses should be
classified so that they may be budgeted and properly controlled. Another
difficulty for expense items, such as donations, cafeteria, and patents, lies
 PROFITS. SALES. COSTS, A EXPENSES 489
CH. 16 BUDGETING:

for the incurrence and control of

in determining the persons responsible
these costs. However, an attempt should
be made to place every item of
expense under the jurisdiction and control of some
executive who estimates
section or division.
the administrative expenses for his
previously.
Administrative expenses include the same items as outlined
activity are those often
Additional expenses peculiar to the administrative
fees, franchise taxes,
Usted as corporate expenses; namely, directors'
professional services by ac-
capital stock taxes, donations, as well as
countants, lawyers, and engineers. In order to make these expenses the
functions may be
responsibihty of a department head, administrative
controller, general
divided as follows: company executive, treasurer,
incur certain expenses
accounting, and general office. Each function will
to all of them, such as salaries, depreciation of office equipment,
common
telephone and telegraph, etc., while other expenses are peculiar to a
particular department.
The above departmentalization liststhe section "general office." The

establishment of such a function is a recent development in office organiza-

employees classified
tion. The office manager is in charge and
supervises all

as filing clerks, mail clerks, librarians,

stenographers, secretaries, recep-
and more
better control
tionists, and switchboard operators. This permits
intense utilization of manpower in clerical jobs where overlapping and
overexpansion are common.
Expenses, such as donations to the Red Cross or United
Fund, occur at
accordingly. Donations
definite times during the year and can be budgeted
equal installments throughout the year. Gifts
may be pledged and paid in
should be budgeted over a period
to educational and charitable institutions
well-planned budgets.
of three to five years to create effective and

DISCUSSION QUESTIONS
1. Profit planning includes a complete financial and operational plan for all

phases and facets of the business. Discuss.

2. Diff"erentiate between long-range profit planning and short-range budgeting.

Discuss the three diff"erent procedures that a company's

management might
3.
follow to set profit objectives.

classical economic model of competition assumes

that the objective of
4 The
'

to maximize profits. The fundamental elements of ac-

the entrepreneur is
on the objective of measurmg the ownership
counting theory are based
interest and changes in the amount of the
ownership interest (e.g., profits)
 : :

490 PLANNING OF PROFITS, COSTS, AND SALES PART V

in the financial resources of the firm. How does this view relate to that of
current organization theorists with respect to (a) the nature of organization
objectives and (b) the estabUshment of such objectives?
(NAA adapted)

5. The development of a budgetary control program requires specific systems

and procedures needed in carrying out management's functions of planning,
organizing, and controlling. Enumerate these steps.

6. How is management's function of control executed through a budgetary

control system?
7. State the fundamental axiom of fixed and variable costs to the product.

8. Commercial expenses are generally identified as marketing and administra-

tive expenses. How are these expenses grouped for budgetary purposes?

EXERCISES
1. Profit Planning. Next year's budget of a company shows
Cost of goods sold $1,050,000
Administrative expenses 90,000
Sales 1,600,000
Financial expenses 31 ,000

The ratio of sales to invested capital is 2 to 1. A satisfactory profit for the

enterprise would be 15% on invested capital.

Required: The amount available for marketing expenses, not included in the
above estimates, if the required profit is to be attained.

2. Forecast Cost of Goods Sold Statement. Mendez, Inc. with $8,000,000 of

par stock outstanding, plans to budget net earnings of 6%, before income taxes,
on this stock.
The Marketing Department budgets sales at $12,000,000.

The budget director approves the sales budget and expenses as follows:
Marketing 1 5% of sales
Administrative 5% of sales
Financial 1% of sales

Labor is expected to be 50% of total manufacturing costs; raw materials

for the budgeted production will cost $2,500,000; therefore, any savings on
manufacturing costs will have to be in factory overhead.
Inventories are to be as follows
Beginning of Year End of Year
Finished goods $200,000 $500,000
Work in process 50,000 150,000
Raw materials 400,000 300,000

Required: The projected cost of goods sold statement, showing therein the
budgeted purchases of materials and the adjustments for inventories of raw
materials, work in process, and finished goods.
 , :

CH. 16 BUDGETING: PROFITS, SALES, COSTS, & EXPENSES 491

3. Quarterly Sales Budget by Districts; Inventory Schedule. Estimated sales for

the first three-month period of the coming year of the Swartz Company are:

District Jan. Feb. March Total

% % % %
Maine 50 30 20 100
New Hampshire 55 30 15 100
Vermont 50 25 25 100
Massachusetts 50 25 25 100

Estimated unit sales by districts for the three months are

Vnit
District Sales
Maine 20,000
New Hampshire 30,000
Vermont 10,000
Massachusetts 40,000
Total 100,000

The unit sales price is $2.

Company policy expects an inventory of 10,000 units at the beginning and
the end of each three-month period. The production schedule is:
January 55%
February 30%
March 15%
Required: (1) An estimate of sales by units and dollars for each of the first
three months for each district and in total,
(2) A schedule of the end-of-month inventories by units. The beginning
inventory is 10,000 units.

4. Sales Budget by District and Products. The Lambertson Wholesale Company

completed a survey of its prospective sales during the year 19B based on 19A
results. Summarized by product and by district, these estimates in units for the
year are:

Pennsylvania

Product A
Product B.
 : :

492 PLANNING OF PROFITS, COSTS, AND SALES PART V

5. Sales Budgets by Territories and Product Lines. Javierolon Electronics Cor-

poration has two product lines, high-speed printers and electronic typewriters.
The company's market research department prepared the following sales fore-
cast for the coming year:
High-Speed Electronic
Printers Typewriters

Industry's total sales forecast 25,000 75,000

Company's share of the market 20% 10%
Sales price per unit $1,800 $450

The sales force submitted these territorial sales estimates

New England Area 1,200 1,800
Middle Atlantic 3,000 4,200
Southern States 1,800 2,000

Total 6,000 8,000

To establish an acceptable forecast, the budget director averages the two

estimates. The resulting forecast is then broken down by territories in the same
ratio as reflected in the estimates of the sales force.

Required: A sales forecast showing unit sales and total sales revenue by sales
territory and by product lines.

6. Production Budget. The Penscot Company's sales forecast for the next
quarter, ending June 30, indicates the following:
Expected
Product Unit Sales

Ceno... 14,000
Nepo 37,500
Teno 54,300

Inventories at the beginning and desired quantities at the end of the quarter
are as follows
Units

Product March 31 June 30

Ceno... 5,800 6,200

Nepo 10,600 10,500
Teno 13,000 12,200

Required: A production budget for the second quarter.

7. Production Budget. The Metamora Canning Company produces frozen and

condensed soup products. Frozen soups come in three principal varieties:
snapper, shrimp, and pea. The condensed soups come in two principal varieties:
tomato and chicken noodle. The sales division prepared the following tentative
sales budget for the first six months of the coming year:

Product Number of Cans Budgeted for Sales

Frozen soups:
Snapper 250,000
Shrimp 150,000
Pea 350,000

Condensed soups:
Tomato 1,000.000
Chicken noodle 750,000
 :

CH. 16 BUDGETING: PROFITS, SALES, COSTS, & EXPENSES 493

The following inventory levels have been decided upon

fVork in Process Finished Goods

—Beginning
~ i-
Ending o
Beginning r i-
Ending
Units % Processed Units 'u> Processed Units Units

Frozen soups:
Snapper 5,000 80 4,000 75 15,000 20,000
Shrimp 3,000 70 3,000 75 8,000 5,000
Pea 4,000 75 5,000 80 20,000 20,000

Condensed soups:
Tomato 25,000 80 40,000 75 75,000 60,000
Chicken noodle. 15,000 60 25,000 80 30,000 20,000

Required: A production budget for the six-month period.

8. Production, Inventory, and Purchase Requirements. The following estimates

and information have been gathered as part of the budget preparation of the
Hobbynook Co. The company manufactures a hobbyshop sales item, con-
sisting of two types of material which the company precuts and preshapes for
sale to hobbyists. The sales for the second and third quarter of the coming year
have been estimated as follows:
Second Quarter Third Quarter
Philadelphia and suburban areas 10,000 kits 35,000 kits
Western Pennsylvania 8,000 kits 25,000 kits
State of Maryland 5,000 kits 20,000 kits

Total 23,000 kits 80,000 kits

It is decided that finished kits inventories are to be 25,000 at the end of the
:

second quarter, and 5,000 at the end of the third quarter. The inventory at the
start of the second quarter will consist of 8,000 finished kits.
Each kit is packaged in a colorful cardboard box and contains 2 units of
Material A and 5 units of Material B.

The inventory of materials at the beginning of the second quarter will be:
Boxes 125,000
Material A 1 5,000 units

Material B 45,000 units

There are sufficient boxes on hand for both quarters; none will be purchased
during the two periods.
Material A can be bought whenever needed and in any quantity desired. The
starting inventory of 15,000 units is considered to be an ideal quantity.
Material B must be purchased in quantities of 10,000, or multiples of 10,000.
It is desired that, at the end of both the second and third quarters, a minimum
quantity of 30,000 units be on hand, or as close thereto as the standard purchase
quantity will permit.

Required: (1) Schedule of ending inventories and budgeted production of

kits for each quarter.
(2) Schedule of production requirements and purchase requirements for
each quarter for each of the three types of materials.
494 PLANNING OF PROFITS, COSTS, AND SALES PART V

9. Labor Cost Budget. The Satzger Manufacturing Company produces nu-

merous related small parts. The Cost Department has always prepared a labor
budget in dollars only since no information regarding the number of parts manu-
factured is available. During the past year direct labor costs by quarters were
reported as follows:

Quarters
 : . .

CH. 16 BUDGETING: PROFITS, SALES, COSTS, & EXPENSES 495

June, 19 — July, 19 — August, 19 —

Sales on account $1,500,000 $1,600,000 $1,700,000
Cash sales 200,000 210,000 220,000
Total sales $1,700,000 $1,810,000 $1,920,000

All merchandise is marked up to sell at its invoice cost plus 25%. Mer-
chandise inventories at the beginning of each month are at 30% of that month's
projected cost of goods sold.

Required: (1) The cost of goods sold for June, 19 —

(2) Merchandise purchases for July, 19 —
(AICPA adapted)

12. Critique of Performance Report. The Kristina Company uses a fixed or fore-
cast budget to measure its performance against the objectives set by the forecast
and to help in controlling costs. At the end of a month, management received
the report below which compares actual performance with budgeted figures:

Items of Cost Actual Budget

Units produced 73,500 75,000

Direct materials $37,020 $39,000
Direct labor 5,950 6,000
Factory supplies 1 ,550 1 ,500
Indirect labor 710 726
Repairs and maintenance 2,300 2,250
Insurance and taxes 350 355
Rent 2,000 2,000
Depreciation 2,200 2,200
Total $52,080 $54,031

Required: Conclusions to be drawn from this report indicating weaknesses,

if any, of this type of budget.

PROBLEMS
16-1. Sales, Materials, Labor, and Inventory Budgets. A budget department
gathered the following data concerning future sales and budget requirements:

Anticipated Sales for 19— Expected Inventories Desired Inventories

Product Units Price January 1, 19 — December 31, 19 —
A 20,000 $55 8,000 units 10,000 units
B 50,000 50 15,000 units 15,000 units
C 30,000 80 6,000 units 6,000 units

Materials used in manufacture

Amount Used per Unit of Product
Stock No. Unit A B
110 Each 3 5
50 Each 2 1 3
41 Kilograms 2
30 Kilograms 3
40 Meters 5 4
496 PLANNING OF PROFITS, COSTS, AND SALES PART V

Anticipated Purchase Price Expected Inventories Desired Inventories

for Raw Materials January 1, 19 — December 31, 19 —
110 $3.00 each 21,000 each 25,000 each
50 2.00 each 17,000 each 23,000 each
41 2 50
. per kilogram 10,000 kilograms 15,000 kilograms
30 4.00 per kilogram 18,000 kilograms 18,000 kilograms
40 3.25 per meter 25,000 meters 30,000 meters

Labor requirements and rates (direct labor) :

Product Hours per Unit Rate Per Hour

A 4 $4.00
B 5 3.00
C 5 4.20

Overhead is applied at the rate of $2 per direct labor hour.

Required: (1) Sales budget (in dollars).

(2) Production budget (in quantities).
(3) Direct materials budget (in quantities).
(4) Direct materials purchase budget (in dollars).
(5) Direct labor budget (in dollars).
(6) Finished goods inventory, December 31, 19 — (in dollars).

16-2. Materials Purchases, Production, and Inventory Budgets. The purchasing

agent and the cost accountant of Animations, Inc. are trying to solve the
problem of scheduling purchases in connection with a planned expansion in the
production of rocking horses. All lumber used is procured in a standard size,
of which the following amounts, which include a due allowance for waste, are
used in one complete rocking horse:

Oak — 2 board feet

Pine — board
5 feet
Maple — 10 board feet

A sales budget has been approved, and the following production schedule
has been drawn up for I9A:

Quarter
 :

CH. 16 BUDGETING: PROFITS, SALES, COSTS, &. EXPENSES 497

Purchases of 1,500 board feet lots are restricted because of limited storage
facilities.At the present time there is sufficient space to store 3,000 board feet
of all types of lumber combined. During the early part of the year it is antici-
pated that a new shed will be constructed to store an additional 1,200 board feet.
It is expected that the total storage space of 4,200 board feet will be available
prior to the end of the second quarter.

Inventory of lumber on January 1, 19A is as follows:

Oak — 150 board feet

Pine — 600 board feet
Maple — 900 board feet

Required: Schedule, or schedules, indicating the materials production re-

quirements, materials purchases, and materials inventories for each type of
lumber, by quarter, expressed in board feet.

16-3. Materials Requirements and Purchases Budget. The Budget Department of

the Mifer-Jifson Manufacturing Company prepares an annual production and
materials requirement budget in which the first quarter of the year is on a
monthly basis and the balance of the year in totals by quarters. In the third
month of a quarter, detailed budgets are again prepared for the next quarter.
The company produces two products, Miff and Jiff, which require three raw
materials, XLO, YO, and ZMO, in the following quantities (kilograms)

Materials Requirement and Costs

Product XLO YO ZMO

Miff 1kg. 23^ kg. 132 kg.
Cost S1.50perkg $1 per kg. $2 per kg.
Jiff I kg. 2 kg. 1 2 kg.

Production schedule:
 : : S

498 PLANNING OF PROFITS, COSTS, AND SALES PART V

food that is sold in packages of two sizes —

lb. and 2 lb. The cereal is made
1

from two types of grain, called R (rye) and S (soy) for this purpose. There are
two operations: (a) processing and blending and (b) packaging. The grains are
purchased by the bushel measure, a bushel of R containing 70 lbs. and a bushel
of S containing 80 lbs. Three bushels of grain mixed in the proportion of 2R 1 :

produce 198 lbs. of finished product; the entire loss occurs in the first department.
To prepare estimated sales figures for the first six months of the coming year,
the budget committee first asked the salesmen to prepare sales estimates on
which the committee might base its own next six-month sales forecast. The
salesmen's budget in condensed form showed

Salesmen's Estimates of Sales in Units

TERRITORIES

I_
Ji JIJi Other 6 Months" Total

1-lb. package 10,000 15,000 12,000 613,000 650,000

2-lb. package 12,000 18,000 12,000 783,000 825,000

Total 22,000 33,000 24,000 1,396,000 1,475,000

The by the salesmen are analyzed by the budget committee

figures submitted
in the light of general business conditions. The company uses the Federal
Reserve Board Index together with its own trade index to prepare a trend per-
centage that exists in the business. The trend percentage indicates that a .91
general index figure should be applied to the salesmen's estimates in order to
arrive at the final sales figures. The monthly sales figure is to be set up as one
sixth of the total figure finally computed. The finished goods inventory is to be
kept at zero if possible; the work in process inventory near the present level,
which is about 160,000 lbs. of blended material.
Factory permit processing sales requirements as stated in the sales
facilities
budget. to accept the monthly sales figures for
The production manager decided
his production budget.

Purchases of grains in bushels have been arranged for delivery as follows

Type R Type S

Quantity (bu.) Price Quantity (bu.) Price

January 5,000 $1.30 2,000 $1.20

February 2,000 1.40 1,000 1.20
March —0— —0— 3,000 .1.25
April 8,000 1 50. 3,000 1 .00
May 3,000 1.50 —0— —0—
June 4,000 1.60 4,000 1.00

Beginning Inventory,
January 1 10,000 1.20 3,000 1.00

Raw materials are charged into production on the fifo basis.

Required: (1) A revised sales forecast based on the index.

(2) A
sales forecast on a dollar basis; the 1-lb. package sells for $.25 and the
2-lb. package for $.50.
(3) A schedule of raw materials purchases.
(4) A computation of raw materials requirements for production,
(5) A schedule of the raw materials account (fifo basis), indicating beginning
inventory, purchases, usage, and ending inventory for the six-month period
taken as a whole.
 CHAPTER 17

BUDGETING EXPENDITURES
AND CASH, FORECAST
STATEMENTS, BUDGETING FOR
NONMANUFACTURING
BUSINESSES AND NONPROFIT
ORGANIZATIONS, PERT/COST,
HUMAN BEHAVIOR

This second budget chapter discusses specific budgets such as capital

expenditures and research and development costs which play a most
significant and fundamental part in the long- and short-range plans of any
management. Closely related thereto is the cash budget that reveals
excesses and/or shortages of funds. The forecast annual statements serve
as a master budget and final check on the ultimate results expected from
the combined sales-cost-profit plan. Financial forecasts for external
users, budgeting for nonmanufacturing businesses and nonprofit organi-
zations, zero-base budgeting, the modern planning and control systems
(PERT and PERT /Cost), probabilistic budgets, and a discussion of human
behavior in budget building conclude the presentation.

CAPITAL EXPENDITURES BUDGET

Capital expenditures include long-term commitments of resources to
Budgeting capital expenditures is one of the most
realize future benefits.
important areas of managerial decision. The magnitude of funds involved
and the length of time required to recover the investment call for pene-
trating analysisand capable judgment. Decisions regarding current manu-
facturing operations can always be changed if a change is considered the

499
500 PLANNING OF PROFITS, COSTS, AND SALES PART V

best course of action. Capital expenditures, however, represent long-

term commitments. Because the benefits of a capital expenditure will be
reaped over a fairly extended length of time, managerial errors could be-
come quite costly for many years.
In order to minimize the number of capital expenditure
errors, manage-
ment of many firms has established and methods for
definite procedures
evaluating the merits of a project before funds are released (see Chap-
ter 26). Funds available for capital expenditures are normally limited.
Management must gear any facility improvements and plant expansion
programs to funds supplied by internal operations and external sources.
True control of capital expenditures is exercised in advance by requiring
that each request be based on evaluation analyses. Managerial control
requires facts regarding engineering estimates, expected sales volumes,
production costs, and marketing costs. Management usually has a firm
conviction as to what is consistent with long-range objectives of the busi-
ness. It is fundamentally interested in making certain that the project will

contribute to the earnings position of the company.

Short- and Long-Range Capital Expenditures. Capital expenditure

programs involve both short- and long-range projects. Provisions must be
made in the current budget for short-range capital expenditures. These
short-range projects must be examined in the light of their economic worth
as compared with other projects seeking final approval. The process of
budgeting provides the only opportunity to examine projects side by side
and to evaluate the contribution of each to future periods.
Long-range projects which will not be implemented in the current
budget period need only be stated in general terms, for the exchange and
addition of capital assets are only significant in the current budget period.
In the main, long-range capital expenditure plans remain as a management
responsibility and are translated into budget commitments only as
the opportune time for their implementation approaches. Timing is

most important to the achievement of the most profitable results in plan-

ning and budgeting capital expenditures.

RESEARCH AND DEVELOPMENT BUDGET

The research and development budget involves identifying program
components and estimating their costs. In recent years the management
of many firms has been acutely aware of the increased necessity for and
rapid growth of research and development activities. Management must
consider the cost of research and development activities from both the
long- and short-range points of view. From the long-range viewpoint,
management must assure itself that the program is in line with future
 : 2

CH. 17 BUDGETING EXPENDITURES AND CASH 501

market trends and demands and that the future cost of the program is not
at odds with forecasted economic and financial conditions. From the
short-range viewpoint, management must be assured that experimental
efforts are being expended on programs which promise a satisfactory
margin of return on the dollars invested.
The research and development staff must present its ideas to manage-
ment along with the data needed for making decisions. The controller's
staff will assist in the preparation of budgets with clearly defined goals
and properly evaluated cost data.i

Research and Development Defined. — Research and development

projects compete with other projects for available financial resources.
The value of the research and development program must be shown as
clearly as possible so that management can compare it with similar pro-
grams and with other investment opportunities. Therefore, the motiva-
tion and intent of the experimental activities must be carefully identified.
Definitions of these activities aid in their delineation for planning and
control.

1. Research is planned search or critical investigation aimed at discovery of

new knowledge with the hope that such knowledge will be useful in
developing a new product or service (hereinafter "product") or a new
process or technique (hereinafter "process") or in bringing about a
significant improvement to an existing product or process.

2. Development is the translation of research findings or other knowledge

into a plan or design for a new product or process or for a significant
improvement to an existing product or process whether intended for sale
or use. It includes the conceptual formulation, design, and testing of
product alternatives, construction of prototypes, and operation of pilot
plants. It does not include routine or periodic alterations to existing

products, production lines, manufacturing processes, and other on-going

operations even though those alterations may represent improvements
and it does not include market research or market testing activities.

The Research and Development Budget as a Planning Device. The budget

the most useful tool for planning research and development pro-
is still

grams. Other planning devices are used at times, but the budget is considered
best for (1) balancing the research and development program, (2) coordi-
nating the program with the company's other plans and projects, and (3)

'For a comprehensive treatment of the research and development subject, examine

Raymond Villers, Research and Development: Planning and Control, a research study and
report prepared for the Financial Executives Research Foundation (New York, 1964).

Robert E. Seller, Improving the Effectiveness of Research and Development (New York:
McGraw-Hill, Inc., 1965).
^Statement of Financial Accounting Standards No. 2, "Accounting for Research and Develop-
ment Costs," Financial Accounting Standards Board (Stamford, Connecticut: 1974), pp. 2-3.
 —

502 PLANNING OF PROFITS, COSTS, AND SALES PART V

checking certain phases ofnonfinancial planning. The budget forces manage-

ment to think in advance about planned expenditures, both in total amounts
and in each sphere of effort. It helps achieve coordination, for it presents
an overall picture of proposed research and development activities which
can be reviewed and criticized by other operating managers. Exchange of
opinions and information at planning meetings constitutes management's
best control over the program.
Another important purpose of research and development budgeting is
to coordinate these plans with theimmediate and long-term financial plans
of the company. Finally, the budget forces the research and development
director and his staff to think in advance about major aspects of the
program: personnel requirements must be examined, individual or group
work loads assessed, equipment requirements studied, special materials
procured, and necessary facihties provided. These phases of the re-
search and development program are often overlooked or duplicated.

Methods and Forms of a Research and Development Budget and /or

Project Requests. Management expects the executive in charge of research
and development to submit a complete and detailed budget which can be
evaluated as part of the entire planning program. Submission of data
takes many forms. Information regarding segmentation and allocation of
time and effort to various phases of the program is of particular interest to
executive management, as well as to divisional managers. The following
research and development balance sheet has been proposed i^

Research antd Development Balance Sheet

Program Planned for 19
(Percentages of Total Effort by Area of Inquiry and by Phase)

Phase Cost Reduction Improved Products New Products Total

A^BC Al£ AB£ 1% 3%

Applied research. 4% 3% 3% 2% 4% 4% 1% 25%
Development.... 5% 12% 3%, 4% 1% 2% 3% 30%
Basic research... 7% 6% 2% 5% 10% 15% 45%
Total by product ^ .^^„
lines 16% 21% 8% 11% 5% 4% 13% _1% 21% 100%

Total by area of
inquiry 45% 20% 35%

•A, B, and C refer to product lines.

3J. B. Quinn, "Study of the Usefulness of Research and Development Budgets," NAA Bul-
letin, Vol. XL, No. 1, pp. 79-90.
 . ^

CH. 17 BUDGETING EXPENDITURES AND CASH 503

The overall research and development program is supported by a

specific budget request which indicates the jobs or steps within each project,
the necessary man hours, the service department time required, and re-
quired direct departmental funds. Each active project is reviewed monthly,
comparing projected plans with results attained.

Accounting for Research and Development Costs. Accounting treat-

ment of research and development costs generally requires expensing in
the period incurred because of the uncertainty of the extent or length of
future benefit to the company. Exception to the expensing requirement
applies to costs of research and development expenditures that are (1)
conducted for others, unique to extractive industries, or (3) incurred
(2)
by a government-regulated enterprise such as a public utility which often
defers research and development costs because of the rate-regulated
aspects of its business. Equipment and purchased intangibles having al-
ternative future uses should be recorded as assetsand expensed through
depreciation or amortization. Research and development costs, when ex-
pensed, should be reported as one item in the operating expenses part of
the income statement.

CASH BUDGET
A cash budget involves detailed estimates of anticipated cash receipts
and disbursements for the budget period or some other specific period.
It has generally been recognized not only as an extremely useful but also
absolutely essentialmanagement tool. Planning cash requirements is basic
to good business management. Even if a company does not prepare ex-
tensive budgets for sales and production, it should set up a budget or
estimate of cash receipts and disbursements.

Purpose and Nature of a Cash Budget. More specifically, a cash budget:

1 Indicates the effect on the cash position of seasonal requirements, large
inventories, unusual receipts, and slowness in collecting receivables.
2. Indicates the cash requirements needed for a plant or equipment expan-
sion program.
3. Points up the need for additional funds from sources such as bank
loans or sales of securities and the time factors involved. In this connec-
tion it might also exert a cautionary influence on plans for plant expansion
leading to a modification of capital expenditures decisions.
4. Indicates the availability of cash for taking advantage of discounts.
5. Assists in planning the financial requirements of bond retirements,
income tax installments, and payments to pension and retirement funds.
6. Shows the availability of excess funds for short-term or long-term
investments.

'Statement of Financial Accounting Standards No. 2, op. cit., pp. 1-2, 6.

 : : :

504 PLANNING OF PROFITS, COSTS, AND SALES PART V

The period of time covered by a cash budget varies with the type of
business and its cash position. Generally, a cash budget should be pre-
pared by months for a year with changes made at the end of each month
in order to (1) incorporate deviations from the previous forecast and (2) add
a month to replace the month just passed so that a rolling cash budget
covering the next twelve months is always available. As the coming month
or week moves closer, weekly or even daily cash receipts and disburse-
ments schedules are considered necessary for prudent and efficient cash
management.
A cash budget includes no accrual items. For instance, payroll may
be accrued at the beginning and end of each month. If at the beginning
and end of a month accrued payroll amounts to $4,800 and $3,300 re-
spectively, and the budget shows that $18,000 in wages and salaries will
be earned by employees, the treasurer computes the monthly cash re-
quirement for the payroll as follows

Accrued payroll at beginning of month $ 4,800

Add payroll earned as per budget 18,000
$22,800
Deduct accrued payroll at end of month 3,300

Amount of cash to be paid out $19,500

Additional adjustments are necessary for deductions from employees'

earnings when these deductions are not remitted in the month withheld.

Preparation of a Cash Budget. Preparation of a cash budget may fol-

low either of two generally accepted procedures

1. The cash receipts and disbursements method
2. The adjusted profit and loss or income method

In the first method, all anticipated cash receipts, such as cash sales, cash
collections on accounts receivable, dividends, interest on notes and bonds,
proceeds from sales of assets, royalties, bank loans, stock sales, etc., are

carefully estimated. Likewise, cash requirements for materials purchases,

supplies, payroll,repayment of loans, dividends, taxes, purchases of plant
or equipment, etc., must be determined.
Data required to prepare a cash budget by the receipts and disburse-
ments method come from the
1. Sales budget.
2. Materials budget, which shows planned purchases.
3. Labor budget, which wages earned.
indicates
4. Various types of expense budgets, both manufacturing and commercial,
which indicate expenses expected to be incurred. Noncash expenses such
as depreciation are excluded.
 : : 2

CH. 17 BUDGETING EXPENDITURES AND CASH 505

5. Plant and equipment budget, which details cash needed for the purchase
of new equipment or replacements.

6. Treasurer's or executive's budget, which indicates requirements for

dividends, loans, donations, income taxes, etc.

These data sources are used in estimating cash receipts and disburse-
ments for each budgeted time period segment.

The primary sources of cash receipts are cash sales and collections of
accounts receivable. Estimates of collections of accounts receivable are
based on the sales budget and on the company's collection experience,
A study is made of a representative period to determine how customers
pay their accounts, how many take the discount offered, and how many
pay within 10 days, 30 days, and so forth. These experiences are set up in a
schedule of anticipated collections from sales. Collections during a month
will be the result of: (1) this month's sales, and (2) accounts receivable of
prior months' sales. To illustrate, assume that during each month collec-
tions on accounts receivable showed the following pattern

From this month's sales 10.8%

From prior months' accounts receivable:
Last month's sales 78,

2 months old 6.3

3 months old 2.1
4 months old 1.2
Cash discounts taken 1.2
Doubtful accounts .2

100.0%

On the basis of these percentages, collections for the month of July

are computed as follows

Month Credit Sales %

July $160,000
June 200,000
May 175,000
April 180,000
March 178,000
506 PLANNING OF PROFITS, COSTS, AND SALES PART V

commercial costs, the equipment budget, and the treasurer's budget for
items such as dividends, interest and payments on bonds and loans,
donations, or taxes as they relate to the timing of payments.
In the second method of preparing the cash budget the adjusted —
profit and loss or income method —
cash estimates come from the fore-
casted profit of the period adjusted for noncash transactions and for ex-
pected cash-oriented changes in asset and liability accounts not affected by
profit calculations. Using the forecasted profit for the month or fiscal
period as a starting point, various noncash transactions are added back
to net profit for the period. Noncash items are depreciation, doubtful ac-
counts receivable, expired insurance premiums, accruals for warranties or
guarantees, and income tax accruals. The next step is to add anticipated
decreases in assets or increases in liabilities and to deduct anticipated in-
creases in assets or decreases in liabilities. The expected cash position at
the end of a period is the cash balance at the beginning of the period plus
or minus the net casli increase or decrease as indicated by the analysis of
the forecast profit. This method is not as effective a planning and control
technique as is the cash receipts and disbursements method because it is

usually in terms of aggregate cash flows rather than in terms of detailed

cash receipt and disbursement components.
A cash budget is generally quite accurate when it covers a short period
of one or two months, but it requires constant attention. Most firms
recheck their cash budget at the end of each day, week, or month to make
allowances for new conditions.

PROJECTED OR FORECAST INCOME STATEMENT

A projected income statement (see page 507) contains summaries of
the sales, manufacturing, and expense budgets. Its purpose is to project
net income, the goal toward which all efforts are directed. No new esti-

mates are actually made; figures taken from various budgets are merely
arranged in the form of an income statement. The sales budget gives ex-
pected sales revenue; the manufacturing budget furnishes manufacturing
costs and cost of goods sold which, when deducted from sales, give the
estimated gross profit. Estimates from the marketing and administrative
expense budgets are subtracted from estimated gross profit to arrive at
the net operating income. Other income and expense items are either
added or deducted to determine net income before taxes. Finally, the
provision for income taxes is deducted to determine net income after
taxes. Preparation of a forecast income statement offers management the
opportunity to judge the accuracy of the budget work and investigate
causes for variances.
 : : : : : —

CH. 17 BUDGETING EXPENDITURES AND CASH 507

Projected Income Statement

By Months for Year Ending December, 19

January February December Totals

Sales S 480,000 $ 540,000 I

$420,000 $ 7,200,000
'i

Cost of goods sold

Raw materials used S 1 80,000 $ 180,000 !
$200,000 2,400,000
Direct labor 90,000 90,000 100,000 1,200,000
Factory overhead
Fixed 49,500 49,500
'

49,500 594,000
Variable 54,000 54,000 I 60,000 720,000
Cost of goods manufactured . . $ 373,500 $ 373,500 $409,500 $ 4,914,000
Add beginning finished goods
inventory (fifo) 630,000 667,500 491,400 630,000
$1,003,500 $1,041,000 ;
$900,900 $ 5,544,000
Less ending finished goods
inventory 667,500 664,000 ;
614,250 614,250
Cost of goods sold 336,000
'

$ $ 377,000 $286,650 $ 4,929,750

Gross profit S 144,000 $ 163,000 !
$133,350 $ 2,270,250

Commercial expenses
Marketing expenses: •

Fixed $ 25,000 $ 25,000 $ 25,000 300,000

Variable 12,000 13,500 I
10,500 180,000
Administrative expenses:
Fixed 20,000 20,000 20,000 240,000
Variable 8,000 9,000 7,000 120,000
Total commercial expenses. . . $ 65,000 $ 67,500 $ 62,500 $ 840,000
Net income from operations $ 79,000 $ 95,500 $ 70,850 $ 1,430,250

Other expenses
Bad debts expense $ 4,800 $ 5,400 4,200 72,000
Intereston notes payable 500 500 500 6,000
Sales discount 9,600 10,800 8,400 144,000
Total $ 14,900 $ 16,700 $13,100 $ 222,000

Other income
Interest income - - 1,250 7,500
Purchases discount 3,600 3,600 4,000 48,000
Other expenses (net) S 11,300 $ 13,100 $ 7,850 $ 166,500
Net income before taxes $ 67,700 $ 82,400 $ 63,000 $ 1,263,750
Less provision for income taxes
(50%) 33,850 41,200 31,500 631,875
Net income after taxes $ 33,850 $ 41,200 $ 31,500 $ 631,875

PROJECTED OR FORECAST BALANCE SHEET

A projected balance sheet (see page 508) estimated for the beginning of
the budget period is the starting point for the preparation of a forecast
balance sheet for the end of the budget period. It incorporates all changes
in assets, liabilities, and capital predicted in the budgets submitted by the
various departments.
 . —

508 PLANNING OF PROFITS, COSTS, AND SALES PART V

Projected Balance Sheet

By Months for Year Ending December, 19

Assets January 1 January 31 February 28 >

December 31
Cash $ 400,000 S 173,000 B 99,300 $ 245,675
Accounts receivable 250,000 153,400 180,100 149,500
Less allowance for doubtful
accounts (2,500) (1,300) (700) (2,500)
Inventories:
Raw materials 320,000 320,000 320,000 320,000
Finished goods 630,000 667,500 664,000 614,250
Plant and equipment 3,000,000 3,000,000 3,000,000 3,000,000
Less accum. depreciation . (600,000) (616,850) (633,950) (815,400)
Other assets 202,500 200,650 198,550 167,100
U. S. Government bonds 500,000
Interest receivable 7,500
Total assets $4,200.000 $3,896,400 $3,827,300 $4,186,125

LlABILFTIES AND CAPITAL

Current liabilities $ 770,000 231,000 77,000
Accounts payable (purchases). 32,400 32,400 $ 36,000
Accounts payable (factory
overhead and marketing and
administrative expenses) 134,800 136,800 137,600
Interest payable 500 1,000
Income taxes payable 33,850 75,050 118,650
Long-term debt 120,000 120,000 120,000
Capital stock 960,000 960,000 960,000 960,000
Retained earnings and surplus
reserves 2,350,000 2,383,850 2,425,050 2,933,875
Total liabilities and capital . . $4,200,000 $3,896,400 $3,827,300 $4,186,125

Numerous advantages result from the preparation of a forecast balance

sheet. One advantage is that a forecast balance sheet discloses unfavorable
ratios which management may wish to change for various reasons. Un-
favorable ratios can lower credit ratings or cause a drop in the value of the
corporation's securities. A second advantage of a projected balance sheet
is that it on the accuracy of all other budgets. Still another
serves as a check
advantage is that the projected balance sheet makes possible the computa-
tion of a return-on-investment ratio by relating net income to capital em-
ployed. An inadequate return on investment would suggest a need for
budget changes.

FINANCIAL FORECASTS FOR EXTERNAL USERS

The extensive use of budgets in the internal management of organiza-
tions is Recent years have seen increasing recognition
well recognized.
of the importance of financial forecasts for external users as well, because
 : ^

CH. 17 BUDGETING EXPENDITURES AND CASH 509

investors and potential investors seek to enhance the process of predicting

the future.
What has happened in the past, as reported in the financial statements,
may be looked to as an indicator of the future. Often, however, past
results may not be indicative of future expectations and may need to be
tempered accordingly.
The question of whether or not forecasts should be included in ex-
ternal financial statements is controversial. Opponents point out the un-
certainty of forecasts and the potential dangers of undue reliance upon
them. On the positive side, it has been argued that the inclusion of fore-
casts in external financial statements "should be provided when they will
enhance the reliability of users' predictions. "5 Furthermore, the assertion
has been made that

1. Forecasts should be presented with their significant underlying

. . .

assumptions, so that each user can evaluate them in the context of his
own needs. The underlying assumptions supporting forecasts, however,
should not be presented in such detail that they affect adversely the
enterprise's competitive position.

2. The use of ranges to supplement single numbers may be appropriate

. The limits of the range would indicate the uncertainty inherent in
. .

the forecast.

3. Forecasts should be updated periodically and ultimately compared

. . .

with actual accomplishments. The preparer should explain

. . . . . .

significant diff"erences between the original and revised forecasts and

between forecasts and actual results.

Securities and Exchange Commission regulations presently permit but

do not require inclusion of financial forecasts in external financial re-
porting.

PLANNING AND BUDGETING FOR

NONMANUFACTURING BUSINESSES AND
NONPROFIT ORGANIZATIONS
Nonmanufacturing Businesses. Many pay only industrial concerns still

lip service to these suggested steps, methods, and procedures. To an even

greater extent, nonmanufacturing businesses and especially nonprofit —

organizations —
generally lack an effective planning and control mecha-
nism. However, under the guidance of the National Retail Merchants
Association, department stores have followed merchandise budget pro-
cedures that have a long and quite successful history.

5AICPA, Study Group on the Objectives of Financial Statements, Objectives of Financial

Statements (1973), p. 46.
^Ibid., p. 47.
510 PLANNING OF PROFITS, COSTS, AND SALES PART V

A budget plan for a retail store is considered a necessity inasmuch as

the profit per dollar of sales is generally low —
usually from 1 to 3 per-
cent. Planning, and
budgeting, control administration are strongly
oriented toward profit control on a total store as well as on a depart-
mental basis. The merchandise budget is set up on predetermined sales
and profits, generally on a six-month basis following the two merchan-
dising seasons: spring-summer and fall-winter. The merchandise budget
includes sales, purchases, expenses, capital expenditures, cash, and annual
statements.
might seem quite logical for a department store or a wholesaler to
It

plan and budget its activities. What about banks, savings and loan associa-
tions, insurance companies, etc.? The functional classification for the
purpose of expense or responsibility control within these institutions is
discussed in Chapter 10. However, these types of businesses should also
create a long-range profit plan coordinating long-term goals and objectives
of the institution. Forecasting would deal with deposit size and mix, num-
ber of insured and mix of policies, capital requirements, types of earning
assets, physical faciUties, new, additional, or changed depositor or client
services, personnel requirements, and operational changes. The long-
range goal should be translated into short-range budgets, starting at the
lowest level of responsibility, building and combining the various organ-
izational units into one whole.

Nonprofit Organizations.Each January the President of the United

States sends his budget message to Congress. The total sum requested for
the fiscal year 1976 amounted to more than $350 billion —
an enormous
sum of money. Yet, in spite of the many decades in which governmental
budgeting has been practiced, the planning, control, and benefits received
have been severely criticized by the general public, responsible for the
money via payment of taxes. While the federal government might be un-
der more obvious attack, state, county, and municipal governments are
equally criticized not only for the lack of a satisfactory control system,
but also for the ill-conceived procedure for planning the costs and revenues
needed to govern.
The concept of a planning, programming, budgeting system, com-
monly referred to as PPBS, has received attention and acceptance in
governmental budgeting and accounting. PPBS might be defined as an
analytical tool to assist management: (1) in the analysis of alternatives
as the basis for rational decision making and (2) in allocating resources
to accomplish stated goals and objectives over a designated time period.
As an analytical tool, the analysis is focused upon the outputs or final
results, rather than the inputs, or the initial dollars expended. The out-
puts are directly relatable to the planned goals or objectives through use
CH. 17 BUDGETING EXPENDITURES AND CASH 511

The analysis technique is therewith closely

of performance budgets.
related to a cost-benefit analysis.
The system had its origin in the Defense Department's attempt to

quantify huge expenditures in terms of benefits derived from activities

and programs of the public sector. A private enterprise measures its
benefits in terms of increased revenues or decreased costs.
The public
sector might provide some benefits that are measurable; in general, how-
problem complicates
ever, the social this measurement. The idea that

governmental programs should be undertaken in the light of final benefits

has caused agencies active in the field of health, education, and welfare

services to examine the application of PPBS to their activities and pro-

grams. Throughout federal, state, and local governments, PPBS is still

in a developmental stage. The system needs a great deal of refinement

and innovation, an understanding of its aims and methods at many govern-
ment levels, and active participation of executive and middle management.
It is difficult to measure the benefits or outputs of any governmental
program. citizens are ever more critical of services re-
Yet the nation's
ceived for money spent. plan A
and budget program assuring them of a
managerial approach to any government's spending plan will go a long
way to pacify the taxpayer.

In the same way that governmental units have become budget and cost

nonprofit or not-for-profit organizations like hospitals,

conscious,
churches, school districts, colleges, universities, fraternal orders, libraries,
labor unions, etc. have been ever-increasingly compelled to put
their

financial houses in order by adopting strong measures of budgetary control.

In the past, efforts to control costs were generally exercised through
pres-

sure to reduce budget increases rather than through methods improve-

ments or program changes. Real long-range planning has seldom been

practiced. Management techniques should be adapted to fill the needs of

these nonprofit organizations.

programs to
Personnel practices, such as
train and improve the performance of the administrative
personnel, must
be made effective within these institutions.

Basically, the objectives of nonprofit organizations are directed toward

individuals or
the economic, social, educational, or spiritual benefit of
groups who have no vested interest in such organizations in the form of
ownership or investment. The presidents, boards of directors, trustees, or
administrative officers are charged with the stewardship of economic re-
sources like their counterparts in profit-seeking enterprises, except that
here their job is primarily to use or spend these resources instead of trying
objective that
to derive monetary gain. It is expressly for this nonprofit
these organizations should install adequate and effective methods and
procedures in planning, budgeting, and cost control.
512 PLANNING OF PROFITS, COSTS, AND SALES PART V

ZERO-BASE BUDGETING
Customarily, those in charge of an established budgetary program are
required to justify only the increase sought above last year's appropri-
ation. What they are already spending is usually accepted as necessary,
with little or no examination.
Beginning in the early 1970s, the concept of zero-base budgeting was
introduced in some governmental and business organizations. Zero-base
budgeting is a budget-planning procedure for the reevaluation of an or-
ganization's programs It requires each manager to
and expenditures.
justify his entire budget request and places the burden of proof
in detail

on him to justify why he should be authorized to spend any money at all.

It starts with the assumption that zero will be spent on each activity —
thus, the term "zero-base." What a manager is already spending is not
accepted as a starting point.
Each manager is asked to prepare for each activity or operation under
his control a "decision package" that includes an analysis of cost, pur-
pose, alternative courses of action, measures of performance, consequences
of not performing the activity, and benefits. The zero-base budgeting
approach asserts that in building the budget from zero, two types of
alternatives should be considered by managers: (1) different ways of
performing the same activity and (2) different levels of effort of per-
"^
forming the activity.

Sound budgeting procedures should always require a careful evalua-

tion of all operating facts each time the budget is prepared. Therefore,
the zero-base budgeting procedure is new and unique mainly in approach
rather than in basic planning and control philosophy.

PERT AND PERT/COST — SYSTEMS FOR

PLANNING AND CONTROL
The accountant's ever-increasing involvement in management planning
and control has in recent years led to the use of systems which use network
analysis and critical path methods for planning, measuring progress to
schedule, evaluating changes to schedule, forecasting future progress, and
predicting and controUing costs. These systems are variously referred to
as PERT (Program Evaluation and Review Technique) or CPM (Critical
Path Method), The origin of PERT is military; it was introduced in con-
nection with the Navy Polaris program, CPM's origin is industrial. Many
companies have been using these methods in planning, scheduhng, and
costing such diverse projects as construction of buildings, installation of
equipment, and research and development activities. Yet there is also an

7For a comprehensive treatment of zero-base budgeting, see Peter A. Pyhrr, Zero-Base Bud-
geting (New York: John Wiley &
Sons, Inc., 1973).
 : : — :

BUDGETING EXPENDITURES AND CASH 513

CH. 17

Opportunity for using PERT in the field of business administration

for
standard cost data,
tasks such as scheduling the closing of books, revising
scheduHng the time elements for the preparation of departmental budgets,
cash flows, and preparing the annual profit plan.s

The PERT System. Whether a military, industrial, or business ad-

ministration task, time is the fundamental element of any of the

projects
method the determination of the longest
cited. The major burden of the is

time duration for the completion of the entire project. This

calculation

is based on the length of time required

for the longest sequence of activities.

All of the individual tasks to complete a given job or program must be

visualized in a network which points out interrelationships

and com-
is

prised of events and activities. An event represents a specified accom-

plishment at a particular instant in time, such as B or E in the network

chart (page 514). An activity represents the time and resources

necessary

to move from one event to another; e.g., B >E in the chart.

Time estimates for PERT are made for each activity on a three-way
basis; i.e., optimistic (to), most hkely (tm), and
pessimistic (tp). From

these estimates an expected time (tg) is calculated for each activity based

on the formula

to + 4tn, + tp

expressed in time periods and often in units of one week. The three-way
basis appears on the network with three numbers on each
activity line.

from the Beta distribution. Referring to the

The formula is derived
flowchart, the activity D-F has a value of tg = 7 determined as follows

Ifto = 5;tm = 6;tp=13;

- 5+ 4(6)4- _
13 42 _^
^e 6 6

8For discussion of such uses of pert, see

Robert L. Shultis, "Applying PERT to Standard Cost Revisions," NAA Bulletin, Vol. XLIV,
No. 3, pp. 35-43.

James G. Case, "PERT — A Dynamic Approach to Systems Analysis," NAA Bulletin, Vol.

XLIV, No. 9, pp. 27-38.

Gordon B. Davis,"Network Techniques and Accounting — With an Illustration," NAA
Bulletin, Vol. XLIV, No. 11, pp. 11-18.
A. H. Russell, "Cash Flows in Networks," Management Science, Vol. 16, No. 5, pp. 357-373.
514 PLANNING OF PROFITS, COSTS, AND SALES PART V

PERT
Network

with Time
Estimates

in Weeks

Numbers under arrows represent the three time estimates;

te= expected time. Heavy arrows denote critical path (A-D-F-G).

The longest path through the network is known as the critical path
and is denoted on the flowchart by the line connecting A-D-F-G. All
other paths on the network are called slack paths. Shortening of total
time can be accomplished only by shortening the critical path rather than
a slack path. However, should the critical A-D-F-G which totals
path
nineteen weeks be shortened to fifteen weeks, A-C-F-G (assuming F-G
remains unchanged) would then become the critical path because it is

then the longest.

The PERT /Cost System. The PERT /Cost System is really an expan-
sion of PERT. It seems advisable to assign cost to time and activities,
thereby providing total financial planning and control by functional
responsibility. The predetermination of cost is in harmony with the ac-
countant's budgeting task and follows the organizational and procedural
steps used in responsibility accounting. The PERT /Cost estimates are
activity- or project-oriented.
The association of actual time and costs with the selected plan is im-
portant for control purposes. In the network chart (page 515), the activi-
ties noted by solid nodes represent completed events. The dollar figures
in the white blocks represent estimated costs e.g., $30,000 for activity F-G.
;

Figures in the tinted blocks to the right of the estimates are actual costs.
Letters tg represent estimated time while ta indicates actual time figures.
Dollars are expressed in thousands and time in weeks. Activities A-B,
A-C, and A-D have been completed. A-B required one half week more
CH. 17 BUDGETING EXPENDITURES AND CASH 515

Solid nodes indicate event completed; tinted dollar blocks denote actual
cost experienced; ta= actual time for the activity.

PERT/Cost Network with Time (in Weeks)

and Cost (in Thousands of Dollars)

time than planned; however, it is on a slack path and will not affect total
project duration. If excess time were such that a slack path became long
enough to be the critical path, then total time would be involved. The
actual activity cost of $10,000 for A-B compared to a budget of $12,000
indicates an underrun of $2,000. Activity A-C budget and actual figures
coincide for time and cost. A-D had
an overrun of $5,000 and a two-week
slippage. The slippage requires immediate attention because A-D is on the
critical path. Immediate investigation and corrective action seem needed

for B-E and C-E. According to the present status report both activities
have consumed the budgeted time and cost and still have not been com-
pleted.
Each activity is defined at a level of detail necessary for individual job
assignments and supervisory control. Control is on scheduled tasks, with
time and cost as the common control factors. New cost accumulation meth-
ods must be devised to be compatible with PERT/Cost control concepts.
PERT/Cost is an integrated management information system designed
to furnish management with timely information useful in planning and
controlling schedules and costs of projects to blend with existing manage-
ment information systems and to provide additional important data. In
conjunction with PERT and critical path techniques, computer systems are
providing top management with far better means for directing large-scaled,
complex projects. Management can now measure cost, time, and technical
performance on an integrated basis.
516 PLANNING OF PROFITS, COSTS. AND SALES PART V

PROBABILISTIC BUDGETS
The budget may be developed based on one set of assumptions as to
the most Ukely performance in the forthcoming period. However, there
is increasing evidence of management's evaluating several sets of assump-

tions before finalizing the budget. The PERT-like three-level estimates,

referred to as optimistic, most likely, and pessimistic, offer one possibility
and would involve estimating each budget component assuming the three
conditions stated. Probability trees can be used in which several variables
can be considered in the analysis; e.g., number of units sold, sales price,
and variable manufacturing and marketing costs.
To each discrete set of assumptions a probability can be assigned
based on past experience and management's best judgment about the
future, thus revealing to management not only a range of possible out-
comes but also a probability associated with each. Further statistical

techniques can then be applied, including an expected (weighted, com-

and the standard deviation for the various budget
posite) value, the range,
elements, such as sales, manufacturing, and marketing costs. For ex-
ample, the expected value for sales may be $960,000 with a range from a
low of $780,000 to a high of $1,200,000 and a standard deviation of
$114,600.
The computational capability of the computer facilitates the con-
sideration ofcomplex sets of assumptions and permits the use of simu-
lation programs, making it possible to develop more objectively deter-
mined probabiHties.9

BUDGET BUILDING AND HUMAN BEHAVIOR

In several instances the statement has been made that the assembling,
receiving, and approving of budget data is a cooperative effort. While
budgeting requires the participation of executive management, it iseven
more important to secure the participation and wholehearted cooperation
and understanding of the middle and lower management echelons. Any-
one who has ever been charged with the task of creating a budget and estab-
lishing budget figures, particularly of departmental overhead, must have

9An exhaustive treatment of these techniques is beyond the scope of this discussion. For ex-
panded discussion and illustrations, see:

William L. Ferrara and Jack C. Hayya, "Toward Probabilistic Profit Budgets," Manage-
ment Accounting, Vol. LII, No. 3, pp. 23-28.

Belverd E. Needles, Jr., "Budgeting Techniques: Subjective to Probabilistic," Manage-

ment Accounting, Vol. LIII, No. 6, pp. 39^5.
Hugh J. Watson, "Financial Planning and Control," Management Adviser, Vol. IX, No. 6,
pp. 43-48.
CH. 17 BUDGETING EXPENDITURES AND CASH 517

been aware of the irrational and often obstinate behavior of certain super-
visors with respect to the contemplated budget program, i^'
In some firms
budgeting perhaps the most unpopular management and /or accounting
is

device for planning and control.

In recent years considerable attention has been paid to the behavioral
implications 11 of accounting which are related to providing managers
with the data required for planning, coordinating, and controlling activi-
ties.Cost accounting and budgeting play an important role in influencing
behavior at all of the various stages of the management process including:
informing individuals what they must do to contribute
(1) setting goals; (2)
to the accomplishment of these goals; (3) motivating desirable perfor-
mance; (4) evaluating performance; and (5) suggesting when corrective
action must be taken. In short, accountants cannot ignore the behavioral
sciences (psychology, social-psychology, and sociology) because the "in-
formation for decision making" function of accounting is essentially a
behavioral function.
The individual manager's attitude toward the budget will depend
greatlyupon the existing good relationship within the management group.
By looking to the future, guided by the company plan, with an opportunity
for increased compensation, greater satisfaction,and eventually promotion,
the middle and lower management group might achieve remarkable results.
A discordant management group, unwilling to accept the budget's under-
lying figures, might show such poor accomplishment that it "compels the
administration to defer trying the planning and control idea until it has put
its house in order." 12 For budget building, Peirce suggests:

In the field of cost control, use the budget as a tool to be placed in the
foremen's hand — not as a club to be held over their heads. To implement
this rule, it may
be a good idea to design an educational program. Meetings
attended by line and staff" supervisors may prove an eff"ective vehicle. Cost
reduction must be placed on the basis of mutual eff'ort toward a common
aim. The creation of this atmosphere is an essential, definite step in budget
practice. 13

lOChris Argyris, The Impact of Budgets on People (New York: Financial Executives Research
Foundation; formerly, ControUership Foundation, Inc., 1952).

iiFor references explaining behavioral implications of accounting in some detail, see:

William J. Bruns, Jr., and Don T. DeCoster, Accounting and Its Behavioral Implications
(New York: McGraw-Hill, Inc., 1969).

Edwin H. Caplan, Management Accounting and Behavioral Science (Reading, Mass.:

Addison-Wesley Publishing Co., Inc., 1971).

i2James L. Peirce, "The Budget Comes of Age," The Harvard Business Review, Vol. 32, No. 3,
pp. 58-67.

13/W</., p. 65.
518 PLANNING OF PROFITS, COSTS, AND SALES PART V

Budget building means building people first.

The symptoms of budget irritations may point to deeper meanings in the

spiritual emancipation of mankind. We are beginning to learn that no tool
can be used effectively unless the hand that guides it is rightly motivated.
Like all other techniques of business, the budget should be a door open to
more satisfying and profitable work —
not an instrument of torture.
Then it will be known that what you can do without a budget you can
do better with one. It will be seen that the entire planning and control pro-
cedure is a device for freeing men to do their best work —
not a machine of
restriction and condemnation.
Planning is but another word for the vision that sees a creative achieve-
ment before it is manifest. Control is but a name for direction. The genius
of management cannot fail to turn the budget idea finally into positive
channels, so that people individually as well as business leadership generally
will reap the harvest that it promises, i^

DISCUSSION QUESTIONS
1. What is meant by a capital expenditure! How does a capital expenditure
differ from a revenue expenditure?
2. Research and development expenditures form a major element of cost in
many firms. These costs are controlled largely by management decision as
to their contribution to the overall, long-term benefit to the company. These
research and development expenditures are not necessarily governed by
current operating requirements or business volume but can be expanded or
contracted as management sees fit. Companies have now begun to establish
budgetary procedures that are to provide control and accounting systems
for research and development expenditures. What are such procedures
specifically designed to achieve?
3. Name (a) some purposes of and (b) some reasons for a research and develop-
ment program.
4. Name the two methods used for the preparation of a cash budget.
5. Managers of large or small industrial or commercial enterprises consider a
cash budget an extremely useful management tool. Why?
6. The forecast income statement may be viewed as the apex of budgeting. Ex-
plain this statement.
7. The projected balance sheet may indicate an unsatisfactory financial condi-
tion. Discuss.
8. What governing criterion has been suggested for determining whether or
not to include forecasts in external financial statements?
9. Discuss the need for planning and budgeting in (a) nonmanufacturing
businesses and (b) nonprofit organizations.
10. What is the objective of the control concept generally referred to as PPBS?

14/6/V/., p. 66.
 : : .

CH. 17 BUDGETING EXPENDITURES AND CASH 519

11. Select the answer that best completes the following statement: A perfor-
mance budget used in PPBS relates a governmental unit's expenditures to
(a) objects of expenditure; (b) expenditures of the preceding fiscal year;
(c) individual months within the fiscal year; (d) activities and programs.
(AICPA adapted)
12. What is the basic idea involved in zero-base budgeting?

13. PERT, Program Evaluation and Review Technique, is a method of planning,

replanning, and progress evaluation in order to exercise greater control
over any major program, project, job, or task in government or in business,
(a) What is one of the major advantages of PERT? (b) What common
denominator is used by this technique? (c) What is the purpose of a PERT
network? (d) What are the three time estimates used?
14. State the relationship between PERT and PERT /Cost systems.

15. Contrast the probabilistic budget and the traditional budget in terms of
information provided to management.

16. Discuss the manner in which budget building and human behavior are
related to each other.

17. Select the answer that best completes the following statement: The measure
of employee attitude toward objectives which is most relevant in participa-
tive budgeting is the level of (a) absorption; (b) appreciation; (c) arbitrari-
ness; (d) aspiration.
(AICPA adapted)

18. The budget is a very common instrument used by many businesses. While
it usually thought to be an important and necessary tool for management,
is

it has been subject to some criticism from managers and researchers studying

organizations and human behavior, (a) Describe and discuss the benefits
of budgeting from the behavioral point of view, (b) Describe and discuss
the criticisms leveled at the budgeting processes from the behavioral point
of view, (c) What solutions are recommended to overcome the criticisms
described in (b) ?
(NAA adapted)

EXERCISES
1. Cash Budget. A
treasurer gathered the following data related to the com-
pany's cash position for the next six months

Cash balance, January 1 $ 5,000

Monthly payroll —
estimated 40,000
Payroll accrued at end of year as well as at the end of each month. 4,000
Interest payable in June 500
Taxes payable in March 10,000

Other data
January February March April May June

Cash sales $15,000 $14,000 $12,000 $16,000

Purchases 12,000 16,500 14,000
Accounts payable 11,000 30,000 25,000
Credit sales 65,000 80,000 72,000
(November, $60,000) (December, $70,000)
 :

520 PLANNING OF PROFITS, COSTS, AND SALES PART V

Credit sales are collected 50% in the month sales are made, 45% in the month
following, and 5%
in the second month. Purchases and accounts payable are
paid in the month incurred.

Required: A cash budget, by months, for the period January through June.

2. Cash Requirements for Manufacturing Operations. Based on the sales forecast

for the season, the Planning Department has prepared the following production
schedule for the coming month 25,000 units of Product
: A
and 24,000 units of
Product B. The manufacturing specifications for the products are
Product A Product B
2 kilograms (kg.) material X @ $.30 3 kg. material W@ $.80
1/2 kilogram (kg.) material Y @ $.20 Ya kg. material Y@
$.20
2 man-hours of labor %6@ 1.5 man-hours of labor @ $6

To the direct labor man-hours, a 5% allowance for idleness should be added.

The indirect labor is estimated to be 5% of direct labor man-hours (excluding
idleness), and the wage rate is $5. The factory overhead estimate is based on the
flexible budget that is representative of expected actual costs, as follows:

Fixed Costs Variable Costs

Depreciation $ 6,900 $1.80 per direct labor hour (includes idle
Insurance (one year prepaid) 800 . time and indirect labor costs)
Superintendence 3,000
Total for a month $10,700

It is planned to increase the inventory of material X

4,000 kg. and to decrease
the inventory of material W
2,000 kg. as of the beginning of next month.

Required: An estimate of the amount of cash necessary for the manufacturing

operations of the month.

3. Cash Receipts and Disbursements Schedule. On April 1, Tuscon Office

Supplies has a cash balance of $18,400. Sales for the previous four months
were: December, $60,000; January, $55,000; February, $50,000; March,
$65,000; and forecast sales for April are $55,000. Collections from customers
conform to the following pattern: 60% in the month of sale; 30% in the month
following the sale; 8% in the second month following the sale; and un- 2%
collectible.
Materials purchases were: December, $35,000; January, $40,000; February,
$30,000; March, $45,000. Purchases for April are budgeted to be $50,000. All
purchases are paid within the terms of the discount period followed in the indus-
try of a 2% cash discount if paid 15 days from the end of the month purchased.
Payroll and other cash expenditures for the month of April are expected to
require $12,000.

Required: (1) Expected cash disbursements during April.

(2) Expected cash collections during April.
(3) Expected cash balance, April 30.

4. Cash and Purchases Budget. Tomlinson Retail seeks assistance in developing

cash and other budget information for May, June, and July of 19 On April — .

30, 19 —
the company had cash of $5,500, accounts receivable of $437,000,
,
 : : . .

CH. 17 BUDGETING EXPENDITURES AND CASH 521

inventories of $309,400, and accounts payable of $133,055. The budget is to

be based on the following assumptions:
Sales:
(a) Each month's sales are billed on the last day of the month.
(b) Customers are allowed a 3% discount if payment is made within 10 days after
the billing date. Receivables are recorded at the gross selling price.
(c) Sixty percent of the billings are collected within the discount period; 25% are
collected by the end of the month; 9%
are collected by the end of the second
month; and 6%
prove uncollectible.
Purchases:
(a) Fifty-four percent of all purchases of material and a like percentage of mar-
keting, general,and administrative expenses are paid in the month purchased
with the remainder paid in the following month.
(b) Each month's units of ending inventory are equal to 130% of the next month's
units of sales.
(c) The cost of each unit of inventory is $20.
(d) Marketing, general, and administrative expenses (of which $2,000 is deprecia-
tion) are equal to 15% of the current month's sales.

Actual and projected sales are as follows

19 — Dollars Units

March $354,000 11,800

April 363,000 12,100
May 357,000 11,900
June 342,000 1 1,400

July 360,000 12,000

August 366,000 12,200

Required: (1) Budgeted cash disbursements during June, 19—.

(2) Budgeted cash collections during May, 19 —
(3) Budgeted units of inventory to be purchased during July, 19 —
(AICPA adapted)

5. Production Budget; Forecast Income Statement. The Budget Department of

the Glencoe Manufacturing Company prepared these estimates for the coming
year:
Beginning Ending
Inventories (annual)
Raw materials (in units) 5,000 6,000
Finished goods (in units) 10,000 7,000
Sales (gross) 100,000 (units)
Average sales price per unit $4.00
Raw materials, unit usage rate and cost 2 units of material for each
finished unit, @ $.25 each
Direct labor, per unit of finished product $1.00
Factory overhead rate per unit of finished product 150% of direct labor cost

Marketing and administrative expenses are budgeted at 16% of gross sales.

Required: (1) A production budget (annual basis) indicating units to be

manufactured.
(2) A forecast income statement. (Present the cost of goods sold section
of the income statement in detail, including the beginning and ending
inventories.)
522 PLANNING OF PROFITS, COSTS, AND SALES PART V

6. Projected Income Statement. The Budget Department of the Crompton Ma-

chine Co. accumulates the following data for the coming year:

The Sales Budget shows expected revenue of $125,000.

The Production Budget reveals the following pertinent data:

Materials issued to work in process, $35,000
Labor, $30,000
Fixed factory overhead, $10,000
Variable factory overhead can be computed from the data given in the exercise.
Marketing and administrative expenses are estimated to be 25% of the cost of
goods sold.
Planned Planned
Inventories: January 1 December 31
Raw materials $5,000 $6,000
Work in process 6,000 8,000
Finished goods 6,000 5,000

The company's aim is a net income before taxes equal to 10% of sales.

Required: A projected income statement for the coming year with a schedule
showing in detail the computation of the cost of goods sold.

7. Departmental Forecast Budget. The plant manager of a company requests

advice about a department manufacturing machine tools of varying sizes. The
figures shown below are the actual results for the years indicated. He is con-
cerned with the recent decline in output and profit and the recent increases in
factory overhead. It has been company practice to use the actual factory over-
head to direct labor percentages of each year for costing products made in the
following year. Production for the next year will be 180,000 units.

Last Previous Best Normal

Year Year Year Year

Materials used (1) $30,000 $45,000 $40,000 $36,000

Direct labor (2) 60,000 90,000 80,000 72,000
Factory overhead (3) 50,000 67,500 52,000 48,000
Total $140,000 $202,500 $172,000 $156,000
Departmental profit for year 2,500 7,500 28,000 15,000
Sales value of output $142,500 $210,000 $200,000 $171,000

Output 200,000 300,000 400,000 360,000

Rate of factory
overhead (3) to direct labor cost (2).. 83.3% 75% 65% 66.6%
Estimated amount of fixed overhead
included in above factory overhead.. . $ 15,000 $ 15,000 $ 12,000 $ 12,000

Required: (1) A departmental budget for the coming year with the estimated
profit.
(2) An opinion on the factory overhead rate to be used.
(3) Any other comments of interest to the manager.
(The unit sales price, raw materials prices, and wage rates are expected to remain
the same as for last year.)
 —

CH. 17 BUDGETING EXPENDITURES AND CASH 523

8. Forecast Income Statement; Departmental Budget Allowances. The Kelso

Company annually prepares a budget for the coming year, a portion of which
is given below.

Forecast Income Statement

For Year Ending December 31, 19

Total

Sales (300,000 units)

Cost of goods sold (see Schedule 1)
Gross profit on sales
Commercial expenses:
Marketing expenses $150,000
Administrative expenses 75,000
Net operating profit
524 PLANNING OF PROFITS, COSTS, AND SALES PART V

on the statement. Marketing expenses are 50% fixed, and all administrative
expenses are fixed.
(2) The forecast budget allowances of the two producing departments and
the service department for the month of October. Budgeted service department
cost for October is distributed on the basis of the forecast direct labor hours for
the month.

9. PERT Network. A
budget department prepared the following time estimates
for a contemplated project with 36 days as the target date:

Event Activity "m.

1
CH. 17 BUDGETING EXPENDITURES AND CASH 525

Program Evaluation Review

Technique (PERT), the net-
work illustrated at the
right, has been developed.

All paths from the start point, Event 1, to the finish point, Event 6, repre-
sent activities or processes that must be completed before the entire project
(the building) will be completed. The numbers above the line segments repre-
sent expected completion times for the activities. The expected time is based
upon the commonly used three-estimate method, 1-4-1. For example, the three-
estimate method gives an estimated time of 4.2 to complete Activity 1-2.

Required: (1) The critical path.

The effect on the critical path resulting from an unfavorable time
(2)
variance of 1.9 for Activity 7-8. Explain.
(AICPA adapted)

12. PERT /Cost Network; Critical Path; Departmental Cost. The Rio Bravo
Company recently initiated a new product development project estimated to
cost $31,500. The list of activities constituting this project, together with esti-
mates of the number of weeks each activity would take and the cost to carry it
out, is illustrated in the table below. In this table each activity is identified by
a two-digit number, the first digit denoting the preceding event and the second
digit indicating the event that signals the end of the activity.
 : ,

526 PLANNING OF PROFITS, COSTS, AND SALES PART V

Required: (1) A
PERT /Cost network to represent the project.
Events through which the critical path passes and the number of weeks
(2)
which the project is expected to take.
(3) The cost assignable to each department.

PROBLEMS
17-1. Cash Budget. The Standard Mercantile Corporation ends its fiscal
year on December 31. In early January, 19B, the company's CPA was asked
to assist in the preparation of a cash forecast. This information is available
regarding the company's operations:

(a) Management believes the 19A sales pattern is a reasonable estimate of 19B
sales. Sales in 19A were:

January $ 360,000
February 420,000
March 600,000
April 540,000
May 480,000
June 400,000
July 350,000
August 550,000
September 500,000
October 400,000
November 600,000
December 800,000
Total $6,000,000

(b) On December 31, accounts receivable totaled $380,000. Sales collections are
generally made as follows

During month of sale 60%

In first subsequent month 30%
In second subsequent month 9%
Uncollectible accounts 1%

(c) The purchase cost of goods averages 60% of the selling price on December 3 1 ;

the cost of the inventory on hand is $840,000 of which $30,000 is obsolete.

Arrangements have been made to sell the obsolete inventory in January at half
of the normal selling price on a COD basis.
The company wants to maintain the inventory as of the 1st of each month at
a level of three months' sales as determined by the sales forecast for the next
three months. All purchases are paid for on the 10th of the following month.
On December 31, accounts payable for purchases totaled $370,000.

(d) Recurring fixed expenses amount to $120,000 per month including depreciation
of $20,000. For accounting purposes the company apportions the recurring
fixed expenses to the various months in the same proportion as that month's
estimated sales bears to the estimated total annual sales. Variable expenses
amount to 10% of sales.
 :

CH. 17 BUDGETING EXPENDITURES AND CASH 527

Payments for expenses are made as follows

During Month Following

Incurred Month

Fixed expenses 55% 45%

Variable expenses 70% 30%

(e) Annual property taxes amount to $50,000 and are paid in equal installments on
December 31 and March 31 The property taxes are in addition to the expenses
.

in (d) above.

(f) anticipated that cash dividends of $20,000 will be paid each quarter on the
It is
15th day of the third month of the quarter.

(g) During the winter, unusual advertising costs will be incurred that require cash
payments of $10,000 in February and $15,000 in March. These advertising
costs are in addition to the expenses in (d) above.

(h) Equipment replacements are paid for at the rate of $3,000 per month. The
equipment has an average estimated life of six years.

(i) The company must make a federal income tax payment of $60,000 in March.

(j) On December 31, 19A, the company had a bank loan with an unpaid balance
of $280,000. The loan requires a principal payment of $20,000 on the last day
of each month plus interest at Vi% per month on the unpaid balance at the
first of the month. The entire balance is due on March 31, 19B.

(k) On December 31, 19 A, the cash balance was $100,000.

Required: A
cash forecast statement by months for the first three months of
19B, showing the cash on hand (or deficiency of cash) at the end of each month.
Present all computations and supporting schedules in good form.

(AICPA adapted)

17-2. Estimated Operating Statement; Cash Receipts and Disbursements State-

ment; Estimated Balance Sheet. About three weeks before the end of each year
the Budget Department of the Tonkens Company prepares an operating budget
for the coming year. The budget for the year 19B showed the following figures:

Depreciation —buildings $ 5,625

Depreciation —machinery and equipment 23,750
Direct labor 1 21 ,875
General and administrative expenses 36,875
Factory insurance expense 12,000
Interest expense 9,000
Direct materials purchases 123,750
Provision for bad debts 9,750
Sales 462,500
Marketing expenses 71,500
 :

528 PLANNING OF PROFITS, COSTS, AND SALES PART V

The trial balance of the company as of December 31, 19A is:

Trial Balance
December 31, 19A

Cash in Bank $ 10,000.00

Accounts Receivable 145,000.00
Allowance for Uncollectible Accounts $ 22,500.00
Inventories of Raw Materials, Work in Process,
and Finished Goods at December 31, 19A 195,000.00
Prepaid Insurance 1,875.00
Prepaid Interest 1,250.00
Land 50,000.00
Buildings 187,500.00
Accumulated Depreciation — Buildings 30,000.00
Machinery and Equipment 120,000.00
Accumulated Depreciation — Machinery and
Equipment 65,000.00
Accounts Payable 70,000.00
Notes Payable 162,500.00
Accrued Payroll 3,750.00
Capital Stock 250,000.00
Retained Earnings 94,125.00
Sales 420,000.00
Cost of Goods Sold 323,330.00
General and Administrative Expenses 67,800.00
Bad Debts Expense 8,300.00
Interest Expense 7,820.00

Total $1,117,875.00 $1,117,875.00

expected that on December 31, 19B accounts receivable will amount to

It is
35% of the sales budget. Bad debts amounting to $7,000 will be charged to
Allowance for Uncollectible Accounts during the budget year and it is estimated
that $3,000 will be collected from accounts previously written off (to be treated
as income).
The inventories on December 31, 19B will amount to $172,500. Prepaid
interest on December 31, 19B will amount to $1,625 and prepaid insurance will
be $1,440.
It is expected that additions to fixed assets will be

Buildings $ 8,750
Machinery and equipment 10,500

Accounts payable on December 31, 19B are estimated at $77,500 and the
accrued payroll will be $2,190. A cash dividend of $15,000 will be paid during
the budget year.

Required: (1) An estimated operating statement as of December 31, 19B.

(2) A
statement of estimated cash receipts and disbursements for the year
ending December 31, 19B. Do not provide for any payments on notes payable
but show the amount available, if any, to reduce notes payable and yet maintain
the same bank balance as of December 31, 19 A, Income tax considerations are
to be ignored.
(3) An estimated balance sheet as of December 31, 19B.
 : :

CH. 17 BUDGETING EXPENDITURES AND CASH 529

17-3. Projected Income Statement; Cash Budget. The management of Moplacon

Products Corporation, a molded plastic container manufacturer, determined
in October, 19 A, that additional cash was needed to continue operations. The
company began negotiating for a one-month bank loan of $100,000 that would
be discounted at 6% per annum on November 1. In considering the loan, the
bank requested a projected income statement and a cash budget for November.
The following information is available
(a) Sales were budgeted at 120,000 units per month in October 19 A, December 19A,
and January 19B and at 100,000 units in November 19A. The selling price is $2
per unit. Sales are billed on the 15th and last day of each month on terms of
2/10, net 30. Past experience indicates sales are evenly spread through the month
and 50% of the customers pay the billed amount within the discount period. The
remainder pay at the end of thirty days; bad debts average Vi% of gross sales.
The estimated amounts for cash discounts on sales and losses on bad debts are
deducted from sales.

(b) The inventory of finishedgoods on October 1 was 30,000 units. The finished
goods inventory at theend of each month is to be maintained at 25% of sales
anticipated for the following month. There is no work in process.

(c) The inventory of raw materials on October 1 was 22,800 pounds. At the end of
each month the raw materials inventory is to be maintained at not less than 40%
of production requirements for the following month. Materials are purchased
as needed in quantities of 25,000 pounds per shipment. Raw materials purchases
of each month are paid in the next succeeding month on terms of net 30 days.

(d) All salaries and wages are paid on the 15th and last day of each month for the
period ending on the date of payment.

(e) All factory overhead and marketing and administrative expenses are paid on the
10th of the month following the month in which incurred. Marketing expenses
are 10% of gross sales. Administrative expenses, which include depreciation of
$500 per month on office furniture and fixtures, total $33,000 per month.

(f) The standard cost of a molded plastic container, based on normal production of
100,000 units per month, is as follows:

Materials — Vi pound $ .50

Labor 40
Variable factory overhead .20
Fixed factory overhead .10

Total $1.20

Fixed overhead includes depreciation on factory equipment of $4,000 per month.

Over- or underabsorbed factory overhead is included in cost of goods sold.

(g) The cash balance on November 1 is expected to be $10,000.

Required: Assuming the bank loan is granted, prepare

(a) Schedules computing inventory budgets by months for (1) finished goods
production in units for October, November, and December and (2) raw ma-
terials purchases in pounds for October and November.

(b) A projected income statement for the month of November. Ignore in-
come taxes.

(c) A
cash budget for the month of November, showing the opening bal-
ance, receipts (itemized by dates of collection), disbursements, and balance at
the end of the month.
(AICPA adapted)
530 PLANNING OF PROFITS, COSTS, AND SALES PART V

17-4. Forecast Income Statement. Blackrock Mining Company mines and

processes rock and gravel. The management is presently engaged in planning
and projecting operations for the coming year. The company's officers have
available the following information:

From books and records:

Mining properties $ 60,000
Accumulated depletion (one year) 3,000
Equipment 150,000
Accumulated depreciation (one year) 10,000
Sales 300,000
Production cost (including depreciation and depletion) 184,000
Administrati\e expenses 60,000

From market studies and cost analyses:

(a) The expected to increase 15% next year, and the
total yards of material sold are
average sales price per cubic yard will be increased from SI. 50 to SI. 60.
(b) When the mining properties were purchased, the recoverable rock and gravel
deposits were estimated at 4,000,000 cubic yards.
(c) The SI 84,000 production costs include direct labor of $1 10,000 of which $10,000
was due to labor inefficiencies experienced in the early stages of operation.
Beginning next year, the union contract calls for a 6% increase in hourly rates.
Other production costs except depreciation, depletion, and direct labor will
increase 5% in the next fiscal period.
(d) New
equipment costing 575,000 will be placed in operation during the second
half of the coming year. It is expected to result in a direct labor hour savings of
10%. The new equipment will have a twenty-year life. All depreciation is com-
puted on the straight-line method. The old equipment will continue in use.
(e) Depletion allowable on rock and gravel is to be calculated on the same basis
as for the previous year with consideration for the increase in materials sold.
(f) Administrative expenses will increase S8,000.

Required: A
forecast income statement for the coming year. Show compu-
tations to support the figures in the income statement.
(AICPA adapted)

17-5. Projected Gross Profit Statement. Chromalloy, Inc. manufactures and

markets a product under the trade name "Alchrome." The basic characteris-
tics of the company's operations and accounting are:

(a) Production is scheduled to maintain finished goods inventory at a constant

ratio (10%) to current sales.
(b) Production is spaced evenly during each period.
(c) Finished goods inventory at the end of the period is valued at the average cost
of manufacturing for the period.
(d) Inventories of work in process and raw materials are small and may be ignored.

Production and sales data and the manufacturing cost of goods sold for the
two preceding periods are:
Period

Units I 2

Beginning inventory 1 ,000 2.000

Production 21,000 31,000
22,000 3.3,000
Sales 20,000 30,000
Ending inventory 2,000 3,000
Amount
532 PLANNING OF PROFITS, COSTS, AND SALES PART V

time and costs. Analysis of the contract showed the following tasks with esti-
mates of cost and time:
Time Estimates ( Weeks) Cost Estimates
 : : :

CH. 17 BUDGETING EXPENDITURES AND CASH 533

Inventories (fifo system)

Beginning Inventories Ending Inventories

Raw Materials Units Unit Cost Units Unit Cost
Lumber (board feet) 22,000 $ .25 40,000 $ .25
Legs (sets) 1,500 2.00 2,000 2.00
Finishing compound (pints).. 1,600 1.25 2,000 1.25

Work in process : None at beginning or end of any month or quarter.

Finished goods Beginning Inventories Ending Inventories

Tables Units Unit Cost Units Unit Cost
Spanish style 500 $12.75 1,500 $14.25
Modern style 500 12.20 500 13.50
Early American style 1,000 12.50 500 13.75

The factory overhead includes ten supervisors, each earning $800 per month, and
building, supplies, and utility expenses of $30,000 a month. Total factory overhead
is equally distributed to the three departments and also shared equally by the tables
produced. The factory overhead rate in each department is $1 per table.

Marketing expenses: $25,000 per month.

Administrative expenses: $20,000 per month.

Income tax rate : 30% based on net income before taxes.

Lumber requirements per style: Spanish, 8 board feet; Modern, 5 board feet; and
Early American, 6 board feet. Lumber cost is $.25 per board foot.

Labor cost is $4.00 per hour for all workers.

Labor time requirements per table are

Cutting and Sanding Department, ^4 hour
Assembling Department, Vi hour
Finishing Department, V4 hour

Required: For the first quarter ending March 31, 19 — , prepare:

(a) A sales budget — by styles and by sales areas.

(b) A production budget — by styles (in units).
(c) A direct raw materials budget — by materials and by styles (in units).
(d) A purchases budget — by materials (in units and costs).
(e) The
cost of raw materials required for the quarter's production by —
materials and by styles.
(f) A
schedule of beginning and ending inventories by materials for raw —
materials and by styles for finished goods.
(g) A
direct labor budget —
by styles and by departments.
(h) A
factory overhead budget (overhead applied) totals to be broken —
into costs by styles and by departments,
(i) A
combined cost of goods manufactured and sold statement,
(j) A
combined income statement.

17-8. Hospital Budget. The administrator of Wright Hospital presents the

accountant with a number of service projections for the year ending June 30,
19— Estimated room requirements for inpatients by type of service are:
.
534 PLANNING OF PROFITS, COSTS, AND SALES PART V

Total Average Number of Percent of Regular Patients

Type of Patients Days in Hospital Selecting Types of Service
Patient Expected Regular Medicare Private Semiprivate Ward
Medical 2,100 7 17 10% 60% 30%
Surgical 2,400 10 15 15 75 10

Of the patients served by Wright Hospital, 10% are expected to be under

Medicare —
all of whom are expected to select semiprivate rooms. Both the
number and proportion of Medicare inpatients have increased over the past
five years. Daily rentals per inpatient are: $40 for a private room, $35 for a
semiprivate room, and $25 for a ward.
Operating-room charges are based on man-minutes (number of minutes the
operating room is in use multiplied by the number of personnel assisting in the
operation). The per man-minute charges are $.13 for inpatients and $.22 for
outpatients. Studies for the current year show that operations on inpatients
are divided as follows:

Type of
Operation
 .

CH. 17 BUDGETING EXPENDITURES AND CASH 535

Basis of allocations:
Maintenance of plant salaries — Administration — salaries
Operation of plant square feet — All others — 8^ ^ to operating room
Required: For the year ending June 30, 19 —
prepare schedules to show the:
,

(a) Projected number of patient days (number of patients X average

hospital stay) by types of patients and types of service.
(b) Projected operating-room man-minutes for inpatients and outpatients.
(For inpatients, show the breakdown of total operating-room man-
minutes by types of operations.)
(c) Projected gross revenue from routine services.
(d) Projected gross revenue from operating-room services.
(e) Projected cost per man-minute for operating-room services. (Assume
that the total man-minutes figured in (b) is $800,000 and that the step-
down method of cost allocation is used (i.e., costs of the general services
departments are allocated in sequence as listed in the problem data to —
the general services departments served by Wright Hospital and to the
revenue-producing departments. Once a department is allocated, no
costs are subsequently allocated to it.)
(AICPA adapted)

17-9. Revenue Projection for a School System. The Wood County School
Board bases its revenues budget for the fiscal year ending July 31, 19B, on
projections of receipts for the fiscal year ending July 31, 19 A. The receipts are
summarized by type and source as follows:

Wood County School Board

Actual Revenues Received
For Fiscal Year Ending July 31, 19B

Type and
Source

City A
City B
All other cities
Unincorporated areas.
Federal government .

State government . . .

Total
 : :

536 PLANNING OF PROFITS, COSTS, AND SALES PART V

CASE
Analysis of Budgeted Performance. Mr. George Johnson was hired on July 1,
19A, as assistant general manager of the Botel Division of Staple, Inc. It was
understood that he would be elevated to general manager of the division on
January 1, 19C, when the then current general manager retired; and this was
duly done. In addition to becoming acquainted with the division and his new
duties, George was specifically charged with the responsibility for development
of the 198 and 19C budgets. As general manager in 19C, he was obviously
responsible for the 19D budget.
Staple, Inc. is a highly decentralized multiproduct company. Each division
is quite autonomous. The corporate staff approves division-prepared operating

budgets but seldom makes major changes in them. The corporate staff actively
participates in decisions requiring capital investment (for expansion or replace-
ment) and makes the final decisions. The division management is responsible
for implementing the capital program. The major method used by Staple, Inc.
to measure division performance is "contribution return on division net invest-
ment." The budgets presented below were approved by the corporate staff.
Revision of the 19D budget is not considered necessary even though 19C actual
departed from the approved 19C budget.

Hotel Division (000 Omitted)

Actual Budget
Accounts 19A 19B 19C 19C 19D
Sales SI, 000 $1,500 $1,800 $2,000 $2,400

Less division variable costs:

Material and labor $ 250 $ 375 $ 450 $ 500 $ 600
Repairs 50 75 50 100 120
Supplies 20 30 36 40 48
Less division programmed fixed costs
Employee training 30 35 25 40 45
Maintenance 50 55 40 60 70
Less division committed fixed costs:
Depreciation 120 160 160 200 200
Rent 80 100 110 140 140

Total $ 600 $ 830 $ 871 $1,080 $1,223

Division net contribution $ 400 $ 670 $ 929 $ 920 $1,177

Division investment
Accounts receivable $ 100 $ 150 $ 180 $ 200 $ 240
Inventory 200 300 270 400 480
Fixed assets 1,590 2,565 2,800 3,380 4,000
Less accounts payable and wages payable (150 ) (225 ) (350 ) (300 ) (360)

Net investment $1,740 $2,790 $2,900 $3,680 $4,360

Contribution return on net investment 23% 24% 32% 25% 27%

Required: (1) Identification of George Johnson's responsibilities under the

management and measurement program described above.
Appraisal of George Johnson's performance in 19C.
(2)
Recommendation to the president of Staple, Inc. of any changes in the
(3)
responsibilities assigned to managers or in the measurement methods used to
evaluate division management, based on this analysis. (NAA adapted)
 CHAPTER 18

THE FLEXIBLE BUDGET,

COST BEHAVIOR ANALYSIS,
STATISTICAL CORRELATION
ANALYSIS

The budgets discussed and two previous chapters are

illustrated in the
known as fixed or forecast budgets. Sales and costs estimated for the com-
ing year are compared with actual results. When a company's activities can
be estimated within close limits, the fixed budget seems satisfactory. The
term "fixed" budget is actually misleading, since it is also subject to
revision. Fixed merely denotes that the budget is not adjusted to actual
volume attained. It represents a prefixed point with which actual results
are compared. Budgets are based on certain definite assumed conditions
and results. However, completely predictable situations exist in only a
few cases. change radically, causing actual opera-
If business conditions
tions to differ widely from fixed budget plans, this management tool cannot
be expected to be reliable or effective. The fact that costs and expenses are
affected by fluctuations in volume limits the use of the fixed budget and
leads to the use of the flexible budget.

THE FLEXIBLE BUDGET

The need for a flexible budget can be simply illustrated as follows The .

owner of an automobile knows that the more he uses his car per year the
more it costs him to operate it; he also knows that the more he uses his car
537
538 PLANNING OF PROFITS, COSTS, AND SALES PART V

the less it costs per mile. The reason for this lies in the nature of the ex-
penses, some of which are fixed while others are variable or semivariable.
Insurance, taxes, registration, and garaging are fixed costs which remain
the same whether the car is operated 1,000 or 20,000 miles. The costs of
and repairs are variable costs and depend largely upon the
tires, gas, oil,

miles driven. Obsolescence and depreciation result in a combined type of

semivariable cost which fluctuates to some degree but does not vary di-
rectly with the usage of the car. The cost of operating the automobile per
mile depends on the number of miles driven. Mileage constitutes the basis
for judging the activity of the automobile. If the owner prepares an esti-
mate of total costs and compares his actual expenses with the budget at
year end, he cannot tell how successful he has been in keeping his expenses
within the allowed limits without accounting for the mileage factor.
The underlying principle of a flexible budget is some norm
the need for
of expenditures for any given volume of business, which norm should be
known beforehand to provide a guide to actual expenditures. To recog-
nize this principle is to accept the fact that every business is dynamic,
ever-changing, and never static. It is erroneous, if not futile, to expect a
business to conform to a fixed, preconceived pattern.
Preparation of flexible budgets results in the construction of a series of
formulas, one for each department. Each series, in turn, has a formula
for each account in the department or cost center. The formu la for eac h
accQunMndjcates^Jhe_fi2ced_jLmount and /or a variable rate. The fixed
amount and variable rate remain constant witHiT prescribed ranges of
activity. The variable portion of the formula is a variable rate expressed
in relation to a base such as direct labor hours, direct labor cost, or ma-
chine hours.
Predetermination of the fixed expense total and the variable rate, as

well as the subsequent application of the rate to the level of activity actually
experienced, permits calculation of allowable expenditures for the volume
of activity attained. These budget figures are compared with actual costs
making possible a by the department
closer control of the performance
head than is the case with allowances based on a fixed budget. The end-of-
period comparison is used to measure the performance of each department
head. It is this ready-made comparison that makes the flexible budget a
valuable instrument for cost control. The flexible budget assists in evalu-

ating the effects of varying volumes of activity on profits and on the cash
position.

Originally, the flexible budget idea was applied principally to the con-
trol of departmental factory overhead. In recent years, however, the idea
has been applied to the entire budget so that production as well as mar-
keting and administrative budgets are prepared on a flexible budget basis.
CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 539

OBJECTIVES OF BUDGETARY CONTROL

Both the fixed and budget provide management with informa-
flexible

tion necessary to attain the major objectives of budgetary control:

1. An organized procedure for planning
2. A means for coordinating the activities of the various divisions of a
business
3. A basis for cost control

Planning is one of the primary functions of management. The fixed

budget provides an organized method of planning and a procedure for
measuring the nature and the extent of deviations from the preconceived
plan. It is means for formalizing and coordinating plans of
the organized
the many whose decisions influence the conduct of a business.
individuals
A budget plan requires and results in coordination between all man-
agement levels of a business. Production must be planned in relation to
expected sales, materials must be acquired in hne with expected production
requirements, facilities must be expanded as foreseeable future needs
justify, and finances must be planned in relation to the funds needed for

the expected volume of sales and production.

Cost control is predicated on the idea that actual costs will be compared
with budgeted costs, relating what did happen with what should have hap-
pened. To accomplish this, an acceptable measure of what costs should be
under any given set of conditions must be available. JThejmost important
factor aff'ec ting costs is volume or rat e^of activity. By predetermining the
expense allowable for any given rate of activity and then comparing such
allowances with actual expenses, a better measurement of the performance
of an individual department is achieved and control of costs is more readily
accomphshed.

CAPACITY AND VOLUME (ACTIVITY)

The discussion of the actual preparation of a flexible budget must be
preceded by some basic understanding of the term "capacity." The terms
"capacity" and "volume" (or activity) are used in connection with the con-
struction and use of both fixed and flexible budgets. Canacitv cons titutes
that fixed amount of filant-and-machinery-and,Ji3 jaoU. be discussed latai^of
personnel to whom management has^ committed, ilsjlLandJwith-wliorn it

expects to conduct thejmsiness. Vnlump is the ^riable faclorJaJbtiisiness.

It is related tn capanty b y the f^ rt tha t_ volume ^activity) attempts to
make fheiie&L-use of.,£xistin capacity. p;

Any budget is a forecast of expected sales, costs, and expenses. Ma-

terials, labor, factory overhead, marketing, and administrative expenses
must be brought into harmony with the sales volume. In discussing the
 540 PLANNING OF PROFITS, COSTS, AND SALES PART V

sales budgetit was pointed out that sales volume is measured not only by

sales the market could absorb, but also by plant capacity and machinery
available to produce the goods. A plant or a department may produce
1 ,000 units or work 10,000 hours, but the questions arise Is this volume (or
:

activity) compatible with the capacity of the plant or department ? Is the

production of 1,000 units or the working of 10,000 hours greater or smaller
than the amount of sales the company can safely expect to achieve in a
given market during a given period? Answers to these questions depend
upon decisions made regarding the capacity available for each department.

CAPACITY LEVELS
The following capacity levels require attention: theoretical, practical,
expected actual, and normal.

2 p* Theoretical Capacity. The theoretical capacity of a department is its

^o'^vr I
capacity to produce at full speed without interruptions. It is achieved if

j
the plant or department produces at 100 percent of its rated capacity.

Practical Capacity. It is highly improbable that any company can

operate at theoretical capacity. Allowances must be made for unavoid-
able interruptions, such as time lost for repairs, inefficiencies, breakdowns,
setups, failures, unsatisfactory materials, delay in delivery of raw materials
or supplies, labor shortages and absences, Sundays, holidays, vacations,
inventory taking, and pattern and model changes. The number of work
shifts must also be considered. These allowances reduce theoretical
capacity to the practical capacity level. Thi s reduction is caused bv internal

influences and does not consider thcLcliief external cause^Jack of custorners'

or-ders. Reduction from theoretical to practical capacity typically ranges
from 1 5 percent to 25 percent, which results in a practical capacity level of
75 percent to 85 percent of theoretical capacity.

Expected Actual Capacity. The use of expected actual capacity for each
period is often advocated, a concept that makes for a short-range outlook.
It is feasible with firms whose products are of a seasonal nature, and mar-
ket and style changes allow price adjustments according to competitive
conditions and customer demands.

Normal Capacity. Firms may modify the above capacity levels by

considering the utihzation of the plant or various departments in the
light of meeting average commercial demands or sales over a period long
enough to level out the peaks and valleys which come with seasonal and
cyclical variations. Finding a satisfactory and logical balance between
plant capacity and sales volume constitutes one of the important problems
of business management.
 .

CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 541

Once the normal (or average) capacity level has been agreed upon,
rates computed.
overhead costs can be estimated and factory overhead
rates wilLxause all overhead of the period to be absor bed,
Use ofliliese
UiFperiod.
provided nr^rm^l r^pa ntv^nd normal expenses prevail durinf
deviation from normal capacity and /or normal
overheaTwHl result
Any
in variances as already discussed in the factory
overhead chapters. It is

the ease and speed with which the actual results may be compared with
that make the flexible budget of inestimable value in
budgeted figures
analyzing end-of-period deviations.
use of prac-
Current Internal Revenue Service regulations permit the
assigning factory overhead
tical, expected actual, or normal capacity in

costs to inventories.
The of the various capacity levels on predetermined factory
effect
capacity level
overhead rates used is illustrated below. If the 75 percent
rate is $2.40
isconsidered to be the normal operating level, the overhead
rate lower due to fixed
per direct labor hour. At higher capacity levels the
is

overhead.

EFFECT OF VARIOUS CAPACITY LEVELS ON

PREDETERMINED FACTORY OVERHEAD RATES
Normal Practical Theoretical
Item Capacity Capacity Capacity

75% 85% 100%

Percentage of production capacity.

7,500 hrs. 8,500 hrs. 10,000 hrs.

Direct labor hours

Budgeted factory overhead:

$12,000 $12,000
Fixed
6,000 6,800
Variable
$18,000 $18,800
Total

Fixed factory overhead rate

$1.60
per direct labor hour
Variable factory overhead rate
.80 .80
per direct labor hour
Total factory overhead rate
$2.40 $2.21
per direct labor hour
 :

542 PLANNING OF PROFITS, COSTS, AND SALES PART V

(1) the entire budget system, (2) calculating factory overhead rates and
product standard costs, and (3) operating plans. However, other capacity
assumptions are sometimes used due to existing circumstances.

Factors Involved in Determining Normal Capacity. In determining the

normal capacity of a plant, both its physical capacity and average sales
expectancy must be considered; neither plant capacity nor sales potential
alone is sufficient. As previously mentioned, sales expectancy should be
determined for a period long enough to level out cyclical variations rather
than on the sales expectancy for a short period of time. It should also be
noted that machinery bought for future use and outmoded machinery
must be excluded from the considerations which lead to the determination
of the normal capacity level.
Calculation of the normal capacity of a plant is not a simple matter,
for it requires many different judgment factors. Normal capacity should
be determined first for the business as a whole and then broken down by
plants and departments. Determination of a departmental capacity figure
might indicate that for a certain department the planned program is an
overload while in another it will result in excess capacity. The capacities
of several departments will seldom be in such perfect balance as to produce
an unhampered flow of production. For the department with the overload,
often termed the "bottle-neck" department, actions such as the following
might have to be taken
1. Working overtime
2. Introducing an additional shift

3. Temporarily transferring operations from the department to another

where spare capacity is available
4. Subcontracting the excess load
5. Purchasing additional equipment

On the other hand, the department with excess facilities might have to
reduce them ; or the sales department might be asked to search for addi-
tional orders to utilize the spare capacity.

Idle Capacity vs. Excess Capacity. A distinctionmust be made be-

tween idle and excess capacity. Idle capacity results from the ternp orary
idleness of production or distr ibu tion facilities duejoj^s lowdown in pr o-
ducti on becausg_oLa tempor apLladLof orders. Idle facilities are restored
to full use as soon as the need arises. Their cost is usually part of the
expense total used in setting up the overhead rate and is at all times a part
of the product cost. However, as explained in the factory overhead and
standard cost chapters, the cost of idle capacity can be isolated both for
control purposes and for the guidance of management.
 :

CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 543

Excess capacity, on the_gthgLJiamLj'esults either fro iiLjrrfF'ntPr prnHnr

live capacity ^hanthec ompany could ever hojQgJojJse, or from un balanced
equi pment or machinery within dep artments. Unbalanced machinery
involves excess capacity of one machine in contrast with output of other
machines with which it must be sychronized. An.y_gxpense^isin£jrom
excess cap acity should^bfcjexrludpd fxom_the far.tory_Qy erhead ratfi-and
from the_prodjicta)st.~JIhe^xpejTse should he trgatedjs a deduction in Jjie
income jitatem&nt. In many instances, it seems wise to dispose of excess
plant and equipment.

Purposes of Establishing Normal Capacity. Once normal capacity has

been determined, it can be used for these purposes and aims
1. Preparation of departmental flexible budgets and computation of pre-
determined factory overhead rates
2. Compilation of the standard cost of each product
3. Establishment of sales prices
4. Establishment of a plant-wide budget
5. Scheduling production
6. Assigning cost to inventories
7. Measurement of the effects of changing volumes of production
8. Determination of the break-even point
^ 9. Control and possible reduction of costs

The normal capacity level fulfills both long- and short-term purposes.
The long-term utilization of the normal capacity level relates the marketing
phase and therewith the pricing policy of the business to the production
phase over a long period of time, leveling out fluctuations that are of short
duration and of comparatively minor significance. The short-term utiliza-
tion relates to the use made by management of the normal capacity level
in analyzing changes or fluctuations that occur during an operating year.
This short-term utilization measures temporary idleness and aids in an
analysis of its causes.

ANALYSIS OF COST BEHAVIOR

The success of a flexible budget depends upon careful study and analysis
of the relationship of expenses to volume of activity or production and
results in classifying expenses as (1) fixed, (2) variable, and (3) semivariable.

Fixed Expenses. A fixed expense remains the same in total as activity

increases or decreases. Fixed factory overhead includes the conventional
items such as depreciation (straight-fine basis), property insurance, and
real estate taxes. These and many_other e xpenses not inherently fixed ac-
-quire the fixed characteristic through the dictates of manageme nt poficy.
 :

544 PLANNING OF PROFITS, COSTS, AND SALES PART V

Yet, just as management decisions create fixed costs, other decisions can
alter the circumstances and change a fixed item both as to its classification
and amount. In other words, there is really nothing irrevocably fixed
with respect to any expense classified as fixed. The amounts of fixed ex-
penses remain valid only on the assumption that the underlying condi-
tions remain unchanged. In the long run, all expenses a j^ ypHahlp Some
fixed expenses, however, can be changed in the short run because of
changes in the volume of activity or for other reasons (e.g., the number
and salaries of the management groups, advertising, and research ex-
"
penses) and are sometimes called programmed fixed expen ses " Other
fixed expenses (e.g., depreciation or a long-term lease agreement) may
commit management for a much longer period of time they have ; there-
fore been labeled "committed^ xed expenses."

Variable Expenses. A variable expense is expected to increase pro-

portionately with an increase in activity and decrease proportionately with
a decrease in activity. Variable expenses include : supplies, indirect factory
labor, receiving, storing, rework, perishable tools,and maintenance of
machinery and A
measure of activity
tools. —
such as direct labor hours
or dollars, or machine hours —
must be selected as an independent vari-
able for use in estimating the variable expense (the dependent variable)
at specified levels of activity. A rate of variability per unit of activity is

thus determined.
Variable expenses are subject to certain fundamental assumptions if

they are to remain so classified. For instance, it is assumed that prices of

supphes or indirect labor do not change, that manufacturing methods
and procedures do not vary, and that efficiencies do not fluctuate. If con-
ditions change, the need for and use of variable expense items also change.
For these reasons, variable expenses require constant attention so that
revisions can be instigated from time to time.

Semivariable Expenses. A semivarjable pypep^^ Hkpl^ys b<^th fi"^^d

and j^^ariable charact eristics, as in: salaries of supervisors, accountants,

buyers, typists, clerks, janitors, employees' insurances, pension plans,
maintenance of buildings and grounds, purchased power, water, gas,
telephone and telegraph, office machine rentals, coal, fuel oil, some sup-

plies,and even membership dues in trade, professional, and recreational

organizations and clubs.
Three reasons for this semivariable characteristic of some expenses are
1. The need to have a minimum organization, or to consume a minimum
quantity of supplies or services in order to maintain readiness to operate.
Beyond this minimum cost which is fixed, additional cost varies with
volume.
 ^

CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 545

2 Accounting classifications based upon object of expenditure or function

commonly group fixed and variable items together. As an example, the
cost of steam may be charged to one account
although the cost of steam
used for heating is dependent upon weather and not production volume,
varies closely
while the cost of steam used in the manufacturing process
with volume of production in the factory.

3 Production factors are divisible into infinitely small units.

When such
costs are charted against their volume, their
movements appear as a series
situation is quite
of steps rather than as a continuous straight line. This
noticeable in moving from a one-shift to a two-shift or
from a two-shift
operation. Such moves result in definite steps in the cost
to a three-shift
fine because a complete set of foremen, clerks, etc., must be added at one
point.

The cost-line of a semivariable expense is depicted graphically below.

expense is
The chart illustrates that the fixed portion of this semivariable
in a straight line (Line B),
at $200 (Line A). The variable portion increases
indicating that for each increase in volume (the
independent variable),

a corresponding increase in the variable portion

of the expense
there is

(the dependent variable).

$1,000
UJ RELEVANT RANGE-
(0

2 $800 -
0.
X
m
$600-

< $400- ^^''''vARIABLE ELEMENT OF SEMIVARIABLE EXPENSE

E
< Line A
> $200-
UJ FIXED ELEMENT OF SEMIVARIABLE EXPENSE

$0 •~r~
10 20 30 40 50 60 70 80 90 100

BASE EXPRESSED AS A REALISTIC MEASURE OF ACTIVITY

(e.g., in sales dollars, units produced, labor dollars, or labor hours)

Fixed and Variable Elements of a Semivariable Expense

This straight line (Line B) is often stated as being in linear or propor-

tional relationship to the base. used and accepted in
This linearity is

expenses
most cost studies even though many semivariable and variable
that the
do not fluctuate in this manner. Thus, it must be understood
rate of variability in relation to volume does not necessarily take place

indiscriminately from zero to 100 percent. But the degree of error

is

relevant range,
negligible as long as activity remains within a reasonably

^NAiQA Bulletin, Vol. 30, No. 20, pp. 1224-1225.

546 PLANNING OF PROFITS, COSTS, AND SALES PART V

on the chart. Relevant range is defined as the range of

as illustrated
which the amount of fixed expense and the rate of variabiHty
activity over
remain unchanged and appHes to expenses that are either all fixed or all
variable as well as to those that are of the semivariable type.
Further, the expense at zero activity, calculated using the various
statisticalmethods discussed below, is a fixed expense only if the linear
relationship found in the range of observations extends back to zero
activity. Otherwise, the expense figure calculated at the zero activity level
is merely the value resulting from finding the point at which the regression
line computed from the available data intersects the vertical expense line.
In such a case, a given expense may be more accurately described, for
example, as fixed at $1,000 up to an activity level of say 2,000 direct labor
hours, with additional activity within a relevant range having a variable
rate of say $.60 per direct labor hour.
Thus, fixed and variable expenses are related to volume (activity)
within appropriate or relevant ranges of operations ; and the fixed expense
and rate of variability will depend upon the particular range of operations
under consideration.

DETERMINING THE FIXED AND VARIABLE

ELEMENTS OF A SEMIVARIABLE EXPENSE
Two approaches can be used to determine the fixed portion and the
degree of variability of a semivariable expense: (1) historical and (2)
analytical.It should be observed that these same procedures are used in

determining the rate of variability of expenses that are entirely variable.

In such cases, a variable rate is found; and the computed fixed portion is

simply zero. Moreover, an entirely fixed expense would yield a fixed

portion, with a zero variable rate.

Historical Approach. The historical approach makes use of the follow-

ing statistical methods: (1) high and low points method, (2) statistical
scattergraph method, (3) method of least squares, and (4) method of
least squares for multiple independent variables. These methods are
used in determining the fixed and variable elements of a semivariable
expense.

High and Low Points Method. This technique can best be explained
by using an example. To establish the fixed and variable elements of ma-
chine repair costs for a producing department, actual expenses incurred
during two different periods are listed on page 547. Periods (data points)
selected are the high and low periods as to activity level from the array of
historical data being analyzed. These periods are usually, but not neces-
sarily, also the highest and lowest figures for the expense being analyzed.
CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 547

Machine Repair Expenses For A Producing Department

Activity Level —
Dir ect Labor Hours Expenses

High 6,840 hours 100% $2,776

Low 2,736 hours 40% 1,750

Difference 4,104 hours 60% $1,026

Variable rate = $1,026 ^ 4,104 hours = $.25 per direct labor hour

High Low
Total expense $2,776 $1 ,750

Variable expense ($.25 per direct labor hour) . .

1,710 684

Fixed element $1^066 $1,066

having the highest or lowest activity levels are not the

same
If the periods
as those having the highest or lowest expense
being analyzed, the activity

level should govern in making the selection. These two periods are
two different activity levels.
selected because they represent conditions at
Care must be taken not to select data points distorted by abnormal
conditions.
The 60 percent difference between the activity levels selected is 4,104
rate is determined by
hours with a cost variation of $1,026. The variable
per
dividing $1,026 by the 4,104 hours, arriving at a variable costing rate
hour of $.25. The fixed portion in the total expense is found by
direct labor
activity hours (6,840)
subtracting the figure obtained by multiplying high
high activity cost ($2,776).
times the variable hourly rate ($.25) from the

The same answer is obtained when low activity hours and cost
are used.
ex-
With variable and fixed elements established, it is easy to calculate
factor in the con-
pense totals for various levels of activity, an important
determination of the budget
struction of the flexible budget and in the

allowance in standard cost accounting.

such as the
Expense levels may also be determined by the use of graphs
one shown on page 548.
expense and its fixed and variable
The graph shows not only the total
budget allowance
elements, but it also permits the quick calculation of any
the total expense
within the relevant range of activity i.e., for 4,000 hours,
;

is $2,066 composed of $1,066 fixed

cost and $1,000 variable cost. The
hours X $.25
budget allowance could also be computed as follows: 4,000
(the variable rate per hour) + $1,066 (fixed cost) = $2,066.
is that it
The calculations are simple, but the method's disadvantage
cost behavior based on only two data points and
assumes that
determines
548 PLANNING OF PROFITS, COSTS, AND SALES PART V

$3,066

$2,776 ._
.vf

$2,250 .

« $2,066
UJ
a.

"^
$1,750
(0 Fixed and
oc VARIABLE ELEMENT
I $1,500 -
Variable
UJ
oc
Elements in
z $1,066
z
u Machine
<
^ $750 - Repairs

FIXED ELEMENT

$0

1 ,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000

2,736 6,840
DIRECT LABOR HOURS

the other data points He on a straight line between the high and low
points. Because the high and low points method uses only two data
points, it may not yield answers that are as accurate as those derived when
a larger number of points are considered as is done in the statistical
scattergraph method and the method of least squares.

Statistical Scattergraph Method. A

technique widely used for analyzing semi-
variable expenses is the statistical scatter-
graph method. method various
In this
on a vertical line
costs are plotted the —
y-axis; and measurement figures (direct
labor dollars, direct labor hours, units of
output, or percentage of capacity) are
plotted along a horizontal Hne — the
X-axis. The data used for preparing the
statistical scattergraph on page 549 are
given at the right.
Each point on the statistical scatter-

graph represents the electricity expense

for a particular month. For instance, the
 :

CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 549

$800-

$700-
• Dec.
• Jan.
<o
• Feb.» Mar.
2 $600-
_^Apr., Noy
a.
X
UJ • Oct.
Sept. • • June
t
u
$500- ©a
Une^--^-^^ • July & Aug.
May
Line A~t VARIABLE ELEMENT
^ $440-
UJ $400-

$0-
10,000 20,000 30,000 40,000 50,000 60,000

DIRECT LABOR HOURS

Statistical Scattergraph Representing the Fixed and Variable

Elements for Electricity Expense

point labeled "Nov." represents the electricity expense for November

when 43,000 direct labor hours were worked. The x-axis shows the direct
labor hours, and the y-axis shows the electricity expense. In the scatter-
graph. Line B is plotted by visual inspection. The line represents the

trend shown by the majority of data points. G eneral ly, therp should be

asJmariXJJ3l3-r^'"^'' ahnY^_^^pl^^>^'»"-»^ [jjit^ Another Hne is drawn

parallel to the base line from the point of intersection on the y-axis, which
is read from the scattergraph as approximately $440. This Line A
represents the fixed element of the electricity expense for all activity

levels within the relevant range. The triangle formed by Lines A and B
shows the increase in electricity expense as direct labor hours increase.
The increase for electricity expense, based on direct labor hours, is

computed as follows

Fixed Expense per Month* = $440

Average Monthly _ Fixed _ Average Monthly Variable

Expense Element Element of Expense

$570 $440 $130

Average Monthly Variable Element of Expense _ Variable Cost Per

Average Monthly Direct Labor Hours
~ Direct Labor Hour

$130
= $.0037 per Direct Labor Hour
35,000 Hours

"As read approximately from the scattergraph.

550 PLANNING OF PROFITS, COSTS, AND SALES PART V

It is now possible to state that the electricity expense consists of $440

fixed expense per month and of a variable factor of $.0037 per direct hour.
Line B is drawn as a straight line even though the points do not follow
a perfect linear pattern. In most analyses, a straight line is adequate, be-
cause it is a reasonable approximation of cost behavior within the relevant
range. Mathematicians have worked out a technique, the "method of
least squares," for computing a more exact straight line called a "regres-
sion line."

Method of Least Squares. The method of least squares (sometimes

called "simple regression analysis") determines mathematically a line of
best fit or a regression line drawn through a set of plotted points so that
the sum of the squared deviations of the actual plotted points from the
point directly above or below it on the regression line is a minimum.
The following steps are required to arrive at the desired answer using
the method of least squares. (Data from page 548 are used for this illustra-
tion.)

1. First, determine the average direct labor hours and electricity expense.
Total direct labor hours are 420,000 which, when divided by 12, result
in an average of 35,000 hours per month. Total expense is $6,840, or
an average of $570 per month ($6,840 ^ 12).

2. Differences between actual monthly figures and the average monthly

figure computed in (1) above are tabulated in Columns 1 to 4 below.

Column I Column 2 Column 3 Column 4 Column 5 Column 6

Difference Difference
Direct from Elec- from Average
Labor Average of tricity of $570 Column 2 Column 2 X
Month Hours 35,000 lus. Expense Electricity Exp. Squared Column 4

January 34,000 1,000 S640 + 70 1,000,000 70,000

February.... 30,000 5,000 620 + 50 25,000,000 250,000
March 34,000 1,000 620 + 50 1,000,000 50,000
April 39,000 4,000 590 +
-
20 16,000,000 + 80,000
May 42,000 7,000 500 70 49,000,000 490,000
June 32,000 3,000 530 - 40 9,000,000 + 120,000
July 26,000 9,000 500 - 70 81,000,000 + 630,000
August 26,000 9,000 500 - 70 81,000,000 + 630,000
September... 31,000 4,000 530 - 40 16,000,000 + 160,000
October 35,000 550 - 20
November... 43,000 8,000 580 + 10 64,000,000 + 80,000
December... 48.000 13,000 680 + 110 169,000,000 + 1,430,000

512,000,000 2,270,000

3. Two multiplications must be made:(1) diff"erences computed in Column 2

are squared and entered in Column 5 and (2) the same diff^erences are
multiplied by differences in Column 4 and entered in Column 6.
CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 551

4. It is now possible to compute a variable rate for electricity expense:

Column
7^A ?
Columns
6 2,270,000
= gionnnnnn =
512,000,000 =„„.. ..^ „ . . ,^^ t^.
-0044 Or 44% or $.44 per 100 Direct
Labor Hours

5. Using the equation for a straight line, y = a +

bx, where "y" is the total
expense at an activity level "x," "a" is the "y" intercept (or fixed expense),
and "b" is the slope of the line (degree of variability, or variable rate),
the fixed expense computation is:

y = a + bx
Where: y = $570 Average Electricity Expense
2 270 000
^ = = ^-0044 Variable Rate of Electricity
<ionr>nnnn
5 1 2,000,000 ^=^
Expense per Direct Labor Hour

X = 35,000 Average Direct Labor Hours

Thus: $570 = a+ $.0044 (35,000)
$570 = a+ $154
$570 - $154 = a

a = $416 Fixed Element of Electricity Expense

per Month

The above answer differs somewhat from the figure determined by the
scattergraph method because visual inspection does not offer so accurate
an answer as this mathematical procedure. This preciseness injects a higher
degree of objectivity and lack of bias into the figures. Many accountants
and industrial engineers responsible for budget preparations prefer this
more scientific technique. However, it is still useful to plot the data first,
as illustrated on page 549, in order to verify visually the existence of a
reasonable degree of correlation. Whatever method is used, abnormal
data should be excluded.

Method of Least Squares for Multiple Independent Variables. Typi-

cally, cost behavior is shown as dependent on a single measure of volume
or on some other independent variable (e.g., the behavior of the dependent
variable, electricity expense, was described by the independent variable,
direct labor hours). However, a cost may vary because of more than one
factor.
In the method of least squares discussion above (simple regression
analysis), only one independent variable was considered. Multiple regres-
sion analysis is a further application and expansion of the method of
more than one independent
least squares, permitting the consideration of
variable. With multiple independent variables, the cost relationship can
no longer be shown on a two-dimensional graph.
 2

552 PLANNING OF PROFITS, COSTS, AND SALES PART V

The simple least-squares equation for a straight line, y = a bx, +

with "a" as the fixed element and "b" as the degree of variability for the
independent variable "x," can be expanded to include more than one
independent variable. For example, two independent variables are given
in the equation y = a + bx + cz with "c" as the degree of variability for
an additional independent variable "z."
The least-squares concept is fundamentally the same for several
independent variables asit is for only one. The arithmetical computations

become more complex, but the widespread availability of computer pro-

grams makes its use more feasible insofar as the numerical manipulations
are concerned.
If the cost behavior of a group of expenses in one or more expense
accounts is being described, an alternate to multiple variables (and hence
to the considerations necessitated by multiple variables when applying
the least squares method) may be possible. That is, expenses may be
grouped and classified in sufficient detail so that expenses in a particular
group are all largely related to only one independent variable. This
would allow the use of the method of least squares as earlier illustrated;
i.e., simple regression analysis. If this approach is not feasible (i.e., if the
final classification or grouping still finds more than one independent

variable required to describe the cost behavior), then multiple regression

analysis should be employed.

Statistical Correlation Analysis. Application of the statistical scatter-

graph method accomplishes visual verification of a reasonable degree of

correlation. would exist if all plotted points fell on the
Perfect correlation
regression line. Mathematical measurements may be used to quantify cor-
relation. Correlation means establishing the relation between the values
of two attributes; i.e., the relationship of the independent variable (x, or
direct labor hours in the illustration) and the dependent variable (y, or
electricity expense in the illustration), before arriving at the fixed cost
and the variable rate for semivariable expenses, or the variable rate for
entirely variable expenses.
In statistical theory the coefficient of correlation, known as a number
"r," is a measure of the extent to which two variables are related linearly.
When r = 0, there is no correlation; and when r = ± 1, the correlation is
perfect. As r approaches +1, the correlation is positive, meaning the de-
pendent variable (y) increases as the independent variable (x) increases;

and the regression fine would slope upward to the right. As r approaches
— 1, the correlation is negative or inverse, meaning the dependent variable

2For a comprehensive treatment, see Chapter 17, "Regression and Correlation: Multivariate
Analysis," Charles T. Clark and Lawrence L. Schkade, Statistical Analysis for Administrative
Decisions (Cincinnati: South-Western Publishing Co., 1974).
CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 553

(y) decreases as the independent variable (x) increases; and the regression
would slope downward to the right.
The coefficient of determination, known as the number "r^," is found
by squaring the coefficient of correlation. The coefficient of determination
is considered easier to interpret than the coefficient of correlation (r) be-
cause it represents the percentage of explained variance. The larger the
coefficient of determination, the closer it comes to the coefficient of correla-

tion until both coefficients equal The word "explained" does not mean
1.

that the variation in the dependent variable was caused by the variations
in the independent variable but that the fluctuations are related to the
fluctuations in the independent variable.
Applying the correlation analysis technique to the data on page 550,
less than .25 results (see page 554). This
a coefficient of determination of
means that less than 25% of the change in electricity expense is related
to the change in direct labor hours. The conclusion is that the cost is
related not solely to direct labor hours but to other factors as well, such
day for production or the season of the year. Furthermore,
as the time of
some other independent variable such as machine hours may afford better
correlation.
The illustrative data, formula, and the calculation of the coefficient
of correlation (r) and the coefficient of determination (r^) are presented
below.
 :

554 PLANNING OF PROFITS, COSTS, AND SALES PART V

nv;xy - (vx) (vy)

ni:x2 - (Sx)2 n>::y2 - (Sy)2

(12) (24 1,670.000) -(420,000) (6,840)

(12) (1 5,2 12,000,000) -(420,000) (420,000) (12) (3,939,600) -(6,840) (6,840)

2,900,040,000 - 2,872,800,000

182,544,000,000 - 176,400,000,000 ) (
47,275,200 - 46 ,785,600
j

27,240,000 27.240,000

(6,144,000,000) (489,600) 3,008,102,400,000,000

27,240,000
= + .49666 ; r2 = .24667
54,846,170

To illustrate a case in which a high degree of correlation exists, the cost

of electricity (y) from the previous example has been slightly altered with
direct labor hours remaining on the same level. The solution below indi-
cates an almost perfect correlation between the two attributes which would
argue for accepting this relationship for the calculation of the factory over-
head rate and the construction of the flexible budget.

Illustration of a better correlation

CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 555

nSxy - (2x) (2y)

n2x2 - (Sx)2 n2y2 - (2y)2

(12) (280,220,000) -(420,000) (7,860)

(12) (15,212,000,000) -(420,000) (420,000) (12) (5,202,200) -(7,860) (7,860)

3,362,640,000 - 3,301,200,000

/ ( 182,544,000,000 - 176,400,000,000 (62,426,400 - 61,779,600

j )

61,440.000

(6,144,000,000) (646,800)

61,440,000

3,973,939,200.000,000

61,440,000
6-3;039jF8 = + -^M''
^' = -m^

Analytical Approach. Historical procedures deal primarily with past

costs; thus, unusual conditions should have been eliminated to assure
working with reliable and comparable data. Yet, in spite of all caution,
values determined by any of the techniques illustrated might not fit the
situation expected to exist in the coming month or year. For this reason,
the analytical approach should be used in conjunction with the above
techniques in determining the variability of expenses.
Industrial engineers and operating personnel working with the con-
troller's staff study each function (activity, job) to determine (1) the
necessity of the function, (2) the most efficient method to do the job, and
(3) the proper cost of performing the work at various levels of production.
This approach is particularly appropriate for indirect labor as well as for
all expenses, for close scrutiny of every expense item will frequently reveal
conditions allowed to exist in the past without being known or questioned.
Therefore, findings based on historical data should be adjusted when future
conditions point to a change.
556 PLANNING OF PROFITS, COSTS, AND SALES PART V

Value of Determining Cost Behavior. The determination of fixed and

variable elements of a semivariable expense and the creation of itemized
as well as total fixed and total variable costs is necessary in order to plan,
analyze, control, measure, or evaluate:

1. Departmental expenses allowed at various levels of activity.

2. Operating efficiency of a department.
3. Contribution margin and direct costing.
4. Utilization of facilities.
5. Break-even point and cost-volume-profit situations.
6. Marketing profitability of territories, products, and customers.
7. Company profit structure.
8. Diff'erentialand comparative cost decisions.
9. Proposed capital expenditures.
10. Effect of alternative courses management might wish to follow.

The fixed-variable cost classification plays a major role in all subsequent

chapters deahng with profit planning, cost control, and decision making.

PREPARING A FLEXIBLE BUDGET

Considerable discussion has been devoted to the development of the
underlying details necessary for the preparation of a flexible budget. It

is not intended to convey the idea that the factory overhead budget on a
flexible basis outranks the budgets for other functions of the business,
because these other functions can also utilize the flexible budget concept.
Any increase or decrease in business activity must be reflected throughout
the enterprise. However, in some activities or departments changes will be
greater or smaller than in others. Certain departments have the ability to
produce more without much additional cost, while in others costs increase
or decrease in more or less direct proportion to production increases or
decreases. The flexible budget attempts to deal with this problem.
When the fixed dollar amount and the variable rate of an expense have
been determined, budget allowances for any level within a relevant range
of activity can be computed without difficulty. Illustrated on page 557 is
a budget allowances schedule for normal capacity that becomes the basis
for preparing a flexible budget for the Machining Department.
In the flexible budget on page 558, the factory overhead rate declines
steadily as production moves to the 100 percent operating level; then it in-
creases because items such as rework operations and supervision increase
faster than at lower levels and because overtime premiums and night
premiums are introduced. While such cost increases are revealed through
the flexible budget, the situation indicates a possible departure from the
use of the equations for a straight line, y = a + bx; in this case, $6,000
fixed expenses + 1 .00(x), for all levels However, it must be
of activity.
emphasized that one definite level must be agreed upon and used for setting
CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 557

the predetermined factory overhead rate for applying overhead cost to

production. Costs and base selected and the resulting rate will lead to
spending and idle capacity variances that might warrant a rate change in
the next period for the sake of more meaningful cost control and pricing
procedures. In any case, the effective use of cost data for planning, con-
trol, and decision-making purposes requires reasonably accurate knowl-
edge of cost behavior.
The flexible budget for the Machining Department with its fixed
expenses and its variable rate per direct labor hour for each variable or
semivariable expense item requires additional comment. The factory over-
head rate based on direct labor hours means that all variable expenses are
r ^^ TV^ vjt^ ufe. /far tW^ f\wv\ - '^^Vs'£>r; ^ I0<^ av>^ AVjl ^C V^J ^^,.
?V ^Od. 558 .
"^ PLANNING OF PROFITS, COSTS, AND SALES PART V
Cl-3V^J)^ f
,\ ^» rA
A-"^^J' A^^
ArV(<. Cr.K2
r.
VJM- cc^ ^'^\aD
<^^>^ tO ^^Z3ql, IV ^^
Flexible Budget for MACHiNaNC Department

Operating Level
CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 559

THROUGH ELECTRONIC
FLEXIBLE BUDGETING
DATA PROCESSING AND STEP CHARTS
The determination of the fixed and variable elements in each depart-
mental expense is a time-consuming task, particularly when computations,
calculations, and analyses are performed either manually or by a desk
calculator. The application of data processing techniques can ehminate
this tedious chore and at the same time provide the necessary tool for
budgetary control and responsibility reporting throughout the year.
Whenever increases or decreases in certain expenses due to change in
product or change in processing, etc., are anticipated, the projected over-
head amounts are adjusted accordingly; otherwise, the predetermined
rates are used. Some expenses are budgeted on a step-chart basis which
is in harmony with the relevant range idea mentioned previously.
^

The step charts indicate the allowance for nonproduction personnel

at various levels of production activity. Each bisected square is an indica-
tion as to the number of nonproduction personnel (upper left-hand corner)
and salary levels allowable (lower right-hand corner) at each step. In the
step chart for service departments (below), the levels are based on the
560 PLANNING OF PROFITS, COSTS, AND SALES PART V

Producing Departments
Department Metal Cutting Only

DEPARTMENTAL ALLOWANCE FOR NONPRODUCTION PERSONNEL

CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 561

Flexible Budget for Maintenance Department

Operating Level
562 PLANNING OF PROFITS, COSTS, AND SALES PART V

Flexible Marketing and Administrative Budget 1

CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 563

6. Why is it important to classify factory overhead as variable, fixed, and semi-

variable?

7. Why should a semivariable expense be separated into its fixed expense total
and itsvariable percentage?

8. What methods are available to separate semivariable expenses ?

9. In analyzing the relationship of total factory overhead with changes in direct

labor hours, this relationship was found to exist: y = $1,000 $2x. +
Select the answer which best completes each of the following statements:
(a) The above equation was probably found through the use of the mathe-
matical technique known as (1) linear programming; (2) multiple regres-
sion analysis; (3) the method of least squares (simple regression anal-
ysis); (4) dynamic programming; (5) none of these.

(b) The relationship shown above is (1) parabolic; (2) curvilinear; (3)
linear; (4) probabilistic; (5) none of these.
(c) The "y" in the above equation is an estimate of (1) total variable costs;
overhead; (3) total fixed costs; (4) total direct labor
(2) total factory
hours; (5) none of these.
(d) The $2 in the above equation is an estimate of (1) total fixed costs; (2)
variable costs per direct labor hour; (3) total variable costs; (4) fixed
costs per direct labor hour; (5) none of these.
(NAA adapted)

10. Explain the meaning of "multiple regression analysis."

11. What is the purpose of a statistical correlation analysis in cost behavior

analysis ?

12. The fixed-variable expense analysis is not valuable just for the preparation
of flexible budgets. It has received and should deserve major attention in
connection with many analytical processes. Name some.

13. Can service departments' expenses also be set up using flexible budget pro-
cedures? What makes the situation difficult? How are the expenses allo-
cated to producing departments ?
14. Select the answer which best completes each of the following statements:
(a) Flexible budgeting is a reporting system wherein the (1) budget stan-
dards may be adjusted at will; vary according to the
(2) reporting dates
activity levels reported upon; statements included in the budget
(3)
report vary from period to period; (4) planned activity level is adjusted
to the actual activity level before the budget comparison report is
prepared.
(b) If a company wishes to establish a factory overhead budget system in
which estimated costs can be derived directly from estimates of activity
levels, it should prepare a (1) capital budget; (2) flexible budget; (3)
cash budget; (4) discretionary budget; (5) fixed budget.
(c) The budget for a specific cost during a fiscal period was $80,000 while
the actual cost for the same period was $72,000. Considering these
facts, it can be stated that the plant manager has done a better than
expected job in controlling the cost if (1) the cost is variable and actual
production was 90% of budgeted production; (2) the cost is variable
and actual production equaled budgeted production; (3) the cost is
variable and actual production was 80% of budgeted production.
 : ;

564 PLANNING OF PROFITS, COSTS, AND SALES PART V

(d) The primary difference between a fixed budget and a flexible budget is
that a fixed budget (1) includes only fixed costs while a flexible budget
includes only variable costs; (2) is concerned only with future acquisi-
tions of fixed assets while a flexible budget is concerned with expenses
that vary with sales; (3) cannot be changed after a fiscal period begins
while a flexible budget can be changed after a fiscal period begins;
(4) is a budget for a single level of some measure of activity while a
flexible budget consists of several budgets or a range of budgets based
on some measure of activity.
(e) Of or no relevance in evaluating the performance of an activity
little
would be (1) flexible budgets; (2) fixed budgets; (3) the difference be-
tween planned and actual results; (4) the planning and control of future
activities.

(f) The concept of "the ideal capacity of a plant" as used in cost accounting
is its maximum capacity; (2) best capacity for normal
(1) theoretical
production; (3) capacity used for standard costing; (4) capacity below
which production should not fall.
(g) The variable factory overhead rate under the practical capacity, ex-
pected actual capacity, and normal capacity levels would be the (1)
same except for normal capacity; (2) same except for practical capacity;
(3) same except for expected actual capacity; (4) same for all three
levels.

(h) The term "relevant range" as used in cost accounting means the range
(1) over which costs may fluctuate; (2) over which cost relationships are
valid; (3) of probable production; (4) over which relevant costs are
incurred.
(i) The effect of changes in volume on semivariable costs may be approxi-
mated by means of a statistical technique employing (1) linear program-
ming; (2) calculation of expected value; (3) the method of least squares
(4) matrix algebra.
(j) Given actual amounts of a semivariable expense for various levels of
output, the method that gives the most precise measure of the fixed
and variable elements is (1) the use of Bayesian statistics; (2) linear
programming; (3) the statistical scattergraph method; (4) the method
of least squares.
(AICPA adapted)

EXERCISES
( 1. Factory Overhead Rates; Unabsorbed Fixed Overhead. The Frisco Com-
pany's management is considering the use of a flexible budget for variable factory
overhead and wishes a study of its operations based on the following data made
available by the Cost Department

Capacity (in percentages) 80% 90% 100% 110%

Direct labor hours 48,000 54,000 60,000 66,000
Variable factory overhead $96,000 $108,000 $120,000 $132,000

Fixed factory overhead is budgeted at $250,000 for each of the four levels of
activity.

Required: (1) The total factory overhead rate at the 80%, 100%, and 110%
capacity levels based on direct labor hours.
 :.

CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 565

The variable factory overhead rate for the same three capacity levels.
(2)
The amount of unabsorbed fixed overhead if the company operates at
(3)
80% of capacity, yet applies a rate based on the 100% capacity level.

2. Determining Variable and Fixed Budget Allowances. The supplies expense of

a department is budgeted with $5,000 at a level of 15,000 direct labor hours and
with $4,000 at a level of 10,000 direct labor hours.
Required: (1) The variable budget allowance per 100 direct labor hours.
(2) The fixed budget allowance for this expense.

3. Separating Fixed and Variable Costs; Statistical Correlation Analysis. A

controller is interested in an analysis of the fixed and variable costs of electricity
as related to direct labor hours. The following data have been accumulated

Electricity Direct
Month Cost Labor Hours

November $1,548 297

December 1,667 350
January 1,405 241
February 1,534 280
March 1,600 274
April 1,600 266
May 1,613 285
June 1,635 301

Required: (1) The amount of fixed overhead and the variable cost ratio
using (a) the high and low points method, (b) a scattergraph with trend line
fitted by inspection, and (c) the method of least squares.
(2) The coefficient of correlation (r) and the coefficient of determination
(r2).

4. Fixed and Variable Costs Analysis; Correlation Analysis. The management

of the Monterrey Hotel is interested in an analysis of the fixed and variable
costs in the electricity used in its relationship to hotel occupancy. The data
shown below have been gathered from books and records for the year 19 —
Guest Days Electricity Cost

January 1,000 $ 400

February 1,500 500
March 2,500 500
April 3,000 700
May 2,500 600
June 4,500 800
July 6,500 1,000
August 6,000 900
September 5,500 900
October 3,000 700
November 2,500 600
December 3,500 800

Year total 42,000 $8,400

Required: (1) The fixed and variable elements of electricity costs by (a) the
method of least squares, (b) the high and low points method, and (c) a scatter-
graph with trend line fitted by inspection. Compute the variable rate to four
decimal places.
Power
CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 567
 : .
. —

568 PLANNING OF PROFITS, COSTS, AND SALES PART V

Qj Flexible Budget. The Ontario Corporation operates its producing depart-

ments under a flexible budget with monthly allowances established for 20%
intervals. Capacity is based on direct labor hours with 2,500 direct labor hours
representing 100% normal capacity. -
.-

In the month of October the Shelving Department operated at the 87% level.
The exhibit shows budget allowances at the 80% and 100% levels.

Flexible Budget for Shelving Department

For October, 19

Percentage of Capacity 80% 100%

Direct labor hours 2,000 2,500

Direct labor costs $4,000 $5,000

Foreman's salary .'^'.X^. $ 500 $ 500

Indirect labor 1,350 1,500
Clerical salaries 700 750
Factory supplies 430 500
Depreciation 500 500
Taxes 250 250
Insurance 200 200
Maintenance 380 400
Power 360 400
Total indirect expenses $4,670 $5,000

Factory overhead rate $2,335 $2.00

Required: (1) A detailed flexible budget for the 87% level.

(2) The amount of underabsorbed fixed factory overhead.

11. Flexible Budget. A division manager is interested in obtaining the fixed

and variable costs relationship applicable to activity levels. Costs definitely
fixed in the amount of $60,000 are depreciation of plant, property, and equip-
ment. Marketing and administrative expenses of $125,000 are also of a relatively
fixed nature. Materials costs are $7 per unit with spoilage averaging of total 2%
materials costs. Labor costs are $2.25 per hour with 15 hours required to pro-
duce 10 units.
Other expenses which generally were considered wholly variable yet seem to
possess a fixed component are

At 30,000 Units At 80,000 Units

Expenses of Production of Production
Supervision $12,500 $20,000
Indirect labor 9,600 15,600
Payroll taxes 3,000 7,500
Heat, light, and power 8,000 1 8,000

Indirect materials 2,500 5,000

Maintenance of machinery . . 6,000 9,000
Miscellaneous factory costs. . 2,500 4,500
Total $44,100 $79,600
 :

CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 569

Total production has never exceeded 100,000 units in any one year.

Required: (1) A schedule indicating all fixed expenses in detail.

(2) A flexible budget for all expenses when the company is operating at both
the 30,000 and the 80,000 units of production levels.

PROBLEMS
The Cost Department of the Elco Electric
18-1. Statistical Correlation Analysis.
Company attempts to establish a flexible budget to assist in the control of
marketing expenses each month. An examination of individual expenses shows:

Item Fixed Portion + Variable Portion

Salesmen's salaries $1,200 none

Salesmen — retainers 2,000 none
Salesmen — commissions none 4% on sales values
Advertising 5,000 none
Travel expenses ? ?

Observations or a management decision cannot the travel expenses

split
satisfactorily into their fixed and variable portions. analysis is
Statistical
needed. Before beginning such an analysis, it is thought that the variable portion
of travel expenses might vary in accordance either with the number of calls
made on customers each month or the value of orders received each month.
Records reveal the following details over the past twelve months

Month Calls Made Orders Received Travel Expenses

January 410 $53,000 $3,000

February 420 65,000 3,200
March 380 48,000 2,800
April 460 73,000 3,400
May 430 62,000 3,100
June 450 67,000 3,200
July 390 60,000 2,900
August 470 76,000 3,300
September 480 82,000 3,500
October 490 62,000 3,400
November 440 64,000 3,200
December 460 80,000 3,400

Required: (1) The coefficient of correlation and coefficient of determination

between (a) travel expenses and the number of calls made and (b) travel expenses
and orders received.
(2) A comparison between the answers obtained in (la) and (lb).

(Based on an article in the NAA Bulletin)

18-2. Flexible Budget; Overhead Rate. The controller of the Mexicali Corpora-
tion decided to prepare a flexible factory overhead budget ranging from 80% to
110% of capacity for the next year with 50,000 hours as the 100% level. The
570 PLANNING OF PROFITS, COSTS, AND SALES PART V

data used in the construction of this budget were based on either past experi-
ences, shop supervisors' figures, or management's decisions. For expenses of a
semivariable nature, it was necessary to determine the fixed amount and the
variable rate via the high and low points method. The direct labor rate was
$2.50 per hour. Additional data are:

Factory overhead data available:

Annual fixed expenses:

Depreciation $ 9,000 per year
Insurance 1 ,500 per year
Maintenance costs (including payroll taxes and
fringe benefits) 12,000 per year
Property taxes 1 ,500 per year

Supervisory staff (including payroll taxes and

fringe benefits) 1 8,000 per year

Variable expenses:
Shop supplies S.IO per direct labor hour
Indirect labor (excluding inspection) S.15 per direct labor hour
Payroll taxes 5% of labor cost, direct and indirect
Fringe benefits 11 9c of labor cost, direct and indirect

Semivariable expenses:
(Figures constitute previous six years' experience)
CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 571

Variable Expenses Applicable to Each Department

Indirect labor 1 /3 of direct labor cost
Indirect materials 1 /4 of materials cost
Heat $.10 per direct labor hour
Light $.20 per direct labor hour
Power S.30 per direct labor hour
Miscellaneous 5% of total direct labor and direct materials
cost

Fixed Expenses Apportioned to Each Department

Superintendent $2,000 1 /5 Mixing, 2 /5 Processing, 2 /5 Finishing
Rent 1,500 1 /3 each
Insurance 600 1 /3 each

Required: (1) A factory overhead budget for each department.

(2) A manufacturing budget showing total costs as well as departmental
costs of the three cost elements.
(3) The total product unit cost.
(4) A
brief description of the procedure the company should follow if
demand drops to 600 units.

18-4. Flexible Budget; Cost Variability Analysis. The Cleves Chemical Com-
pany a small firm which manufactures cleaning fluid. Its management realizes
is
that, as a small company, it must strive constantly to control and reduce costs
in order to meet the competition by both large and small chemical firms. The
president is interested in a budget system which the company can use effectively
during the coming year, 19F, to help achieve some degree of control over costs.
The Accounting Department provided the following information:
Plant capacity: 2,250,000 liters of cleaning fluid per year.
Selling price will average an expected $.52 per liter next year.

Operation results for the past five years were as follows:

Liters of product sold

(thousands)
 :

572 PLANNING OF PROFITS, COSTS, AND SALES PART V

No budgets had ever been used by the company because it was felt that
budgeting was not feasible for such a small company where most of the opera-
tions were directly under the president and two assistants. Prior to his resigna-
tion, the former chief accountant had devised a standard labor cost for 19D at
$.10909 per liter for the entire process. An examination of the figures indicates
that they are quite adequate except for an expected rise of about 10% in wage
rates since 19D. Materials costs are expected to rise by 4% for the coming year
over 19E prices. The average cost of the mix of materials was $.25 per liter of
fluid. Materials usage seldom varies; the differences in materials costs over the
years represent changes in the cost of materials.

Required: A flexible budget in income statement form for the year 19F. The
statements should cover a range from 1,250,000 to 2,250,000 liters, with incre-
ments of 250,000 liters. Use the high and low points method in segregating the
fixed and variable elements of any semivariable expenses.

QS^S^^Budget Planning and Performance Comparison. At the end of 19 A, the

management of the Lukasek Manufacturing Company received the following
condensed income statement:

Income Statement — 1 9A
Sales $4,000,000
Cost of goods sold:
Direct materials $800,000
Direct labor 600,000
Variable factory overhead 240,000
Fixed factory overhead 400,000 2,040,000

Gross profit on sales $1,960,000

Less commercial expenses
Marketing expenses:
Variable $240,000
Fixed 360,000 $600,000
Administrative expenses:
Variable $320,000
Fixed 480,000 800,000 1,400,000

Net operating profit $ 560,000

The company's budget committee decided on the following changes for the
year 19B:
A 20% sales volume increase; no price changes
Fixed administrative expenses to increase $40,000
There are no other cost changes ; all costs classified as variable are ^omplete ly
variable.

At the end of the year 19B, the actual results were as follows:
Sales $4,600,000
Direct materials 940,000
Direct labor 700,000
Variable factory overhead 270,000
Fixed factory overhead 410,000
Variable marketing expenses 276,000
Fixed marketing expenses 364,000
Variable administrative expenses 380,000
Fixed administrative expenses 510,000
 : : —— .

CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 573

Required: (1) A budget report comparing 19B's forecast data with 19B's
actual results.
(2) A budget report which would adequately portray and appraise the
performance of those individuals charged with the responsibility of providing
satisfactory earnings and effective cost control. Sales prices did not change.
This report should make use of flexible budget procedures.

18-6. Budget Planning and Performance Comparison. The Melcher Co. produces
farm equipment at several plants. The business is seasonal and cyclical in
nature. The company has attempted to use budgeting for planning and con-
trolling activities, but the variable nature of the business has caused some
company officials to be skeptical of its usefulness. The accountant for the
Adrian Plant has been using a system she calls "flexible budgeting" to help her
plant management control operations.
The president asks her to explain what the term means, how she applies the
system at the Adrian Plant, and how it can be applied to the company as a
whole. The accountant presents the following data as part of her explanation.

Budget data for 19 — .•

Normal monthly capacity of the plant in direct labor hours 10,000 hours
Materials cost (6 @ $1.50)
lbs, $9 per unit
Labor cost (2 hours @ $3) $6 per unit

Factory overhead estimate at normal monthly capacity:

Variable factory overhead
Indirect labor $ 6,650
Indirect materials 600
Repairs 750
Total variable factory overhead $ 8,000

Fixed factory overhead

Depreciation $ 3,250
Supervision 3,000
Total fixed factory overhead $ 6,250

Total fixed and variable factory overhead. , . . $14,250

Planned units for January, 19 4,000

Planned units for February, 19 6,000

Actual data for January, 19 — .•

Hours worked 8,400

Units produced 3,800

Costs incurred:
Materials (24,000 lbs.) $36,000
Direct labor 25,200
Indirect labor 6,000
Indirect materials 600
Repairs 1,800
Depreciation 3,250
Supervision 3,000
Total $75,850

Required: (1) A manufacturing budget for January, 19 —

574 PLANNING OF PROFITS, COSTS, AND SALES PART V

(2) A report for January, 19 —

comparing actual and budgeted costs for
,

the month's actual activity, assuming that the units produced are to be the
measurement of activity used in preparing the "flexible budget."
(3) Can flexible budgeting be applied to the nonmanufacturing activities of
the Melcher Co.? Explain.
(NAA adapted)

18-7. Flexible Budget. Department A, one of 15 departments in the manu-

facturing plant, is involved in the production of all of the six products manu-
factured by Augustin Products, Inc. Because Department A
is highly mech-

anized, its output is measured in direct machine hours. Flexible budgets are
utilized throughout the plant in planning and controlling costs, but here the
focus is upon the application of flexible budgets only in Department A. The
following data covering a time span of approximately six months were taken
from the various budgets, accounting records, and performance reports (only
representative items and amounts are utilized here).
On March 15, 19A, the following flexible budget was approved for Depart-
ment A
to be used throughout the fiscal year 19A-B, beginning on July 1, 19A.
This flexible budget was developed through the cooperative eff"orts of Depart-
ment A's manager, his supervisor, and certain staff members from the Budget
Department.

Flexible Budget for Department A

FOR Fiscal Year 19A-B

Fixed Amount
Controllable Costs Per Month

Employees' salaries
Indirect wages
Indirect materials
Other costs
CH. 18 FLEXIBLE BUDGET, COST BEHAVIOR, CORRELATION ANALYSIS 575

Actual controllable costs incurred:

Employees' salaries $ 9,300
Indirect wages 20,500
Indirect materials 2,850
Other costs 7,510
Total $40,160

Required: The requirements below relate primarily to the potential uses of

March through September, 19A.
the flexible budget for the period
(a) What activity base is measure of volume in the budget for
utilized as a
Department A? Explain how
the range of the activity base to which the variable
rates per direct machine hour are relevant should be determined.
(b) The high and low points method was utilized in developing this flexible
budget. Using indirect wage costs as an example, illustrate how this method
would be applied in determining the fixed and variable components of indirect
wage costs for Department A. Assume that the high and low values for in-
direct wages are $19,400 at 20,000 direct machine ho'urs and $20,100 at 30,000
direct machine hours.
(c) Explain and illustrate how the flexible budget should be utilized:
(1) In budgeting costs when the annual sales plan and production budget
are completed (about May 5, 19A, or shortly thereafter).
(2) In budgeting a cost revision based upon a revised production budget
(about August 31, 19 A, or shortly thereafter).
(3) In preparing a cost performance report for September, 19A.
(AICPA adapted)

CASES
A. Setting Up a Budgetary Program. Jim Thomas was appointed budget
officer of the Washington Laundry Equipment Company in 19 He had no — .

previous budgeting background, and the president asked him to set up a bud-
getary program that worked eff"ectively. The president also told Jim that it

was his responsibility to see that actual expenses stayed within the amounts
specified in the budget.
Jim requested the Accounting Department to supply him with weekly bud-
get reports showing the budgeted amount of each expense for the week (com-
puted by dividing the annual budgeted amount by 52), actual expenses incurred
during the week, and the variance for each expense. He also informed all
supervisors that any continued excess of actual expenses over budgeted amounts
would be cause for dismissal.
The first week's budget report for the Sales Department was as follows:

Actual

Sales

Depreciation
Salespersons' travel
Telephone and telegraph.
Office supplies
576 PLANNING OF PROFITS, COSTS, AND SALES PART V

Jim was highly disturbed over the unfavorable expense variances and told
the sales manager that continued unfavorable variances would be sufficient
cause for his dismissal. The sales manager then discussed the situation with
the president, stating that "either the new budget officer leaves or I'm quitting."

Required: (I) Are the expenses for the Sales Department "unfavorable?"
Assuming you were president of the Washington Laundry Equipment
(2)
Company, which of the two men would you support? Explain your choice.
(3) Suggest means for improving the budgetary program.

B. Cost Behavior and the Flexible Budget. The Clark Company has a contract
with a labor union guaranteeing a minimum wage of $500 per month to each
direct labor employee with at least twelve years of service. At present, 100
employees qualify for this coverage. All direct labor employees are paid $5
per hour.
The direct labor budget for 19 — was based on the annual usage of 400,000
direct labor hours X Of this amount, $50,000
$5, or a total of $2,000,000.
(100 employees X $500) per month (or $600,000 for 19—) was regarded as
fixed expenses. Thus, the budget for any specific month was determined by the
formula: $50,000 +
$3.50 X direct labor hours worked.

Data on the performance for the first three months of 19 — are:

January February March

Direct labor hours worked 22,000 32,000 42,000
Direct labor costs —
flexible budget .... $127,000 $162,000 SI 97,000
Direct labor costs incurred 1 10,000 160,000 210,000

Variance ((/ — unfavorable;

F— favorable) 17,0O0F 2,000F 1 3,000 1/

The factory manager was perplexed by the results that showed favorable
variances when production was low and unfavorable variances when production
was high, because he believed that his control over labor costs was consistently
good.

Required: (1) Explanation and illustration of variances, using amounts and

diagrams as necessary.
(2) Explanation of this direct labor flexible budget as a basis for controlling
direct labor cost, indicating changes that might be made to improve control
over direct labor cost and to facilitate performance evaluation of direct labor
employees.

(AICPA adapted)
 CHAPTER 19

STANDARD COSTING:
SETTING STANDARDS AND
ANALYZING VARIANCES

Standard cost systems — having usefully served management since

their introduction many years ago as a method of uniting accounting and
industrial engineering — aid in planning operations, motivating em-
ployees, controlling costs, detecting above- or below-standard perfor-
mance, and in gaining an insight into the probable impact of managerial
decisions on cost levels and profits.

COMPARISON OF BUDGETS AND STANDARDS

The budget is considered one method of securing reliable and prompt
information regarding the operation and control of the enterprise. When
manufacturing budgets are based on standards for materials, labor, and
factory overhead, the strongest team for control and reduction of
costs is created.
Standards are almost indispensable in establishing a budget. Because
both aim same objective
at the —
managerial control —
it is often felt that

the two are one and the same and cannot function independently. This
opinion is supported by the fact that both methods use predetermined costs
for the coming period. Both budget and standard costs make it possible
to prepare reports which compare actual costs and predetermined costs
for management.

577
578 CONTROLLING COSTS AND PROFITS PART VI

Building budgets without the use of standard cost figures can never lead
to a real budgetary control system. The figures used in the illustrations in
the budget chapters are only fair estimates even though they have
been set with the greatest care and with the cooperation of those in-
volved. Under such conditions the budget is in a vulnerable position and
can hardly be considered as the basis against which actual results are to
be measured. This shortcoming is recognized within the budget area
itself; thus, the flexible budgetadded as a refinement.
is

With the use of standard costs, a budget becomes a summary of stan-

dards for all items of revenue and costs. When actual costs are superseded
by standard costs, the preparation of budgets for any volume and mixture
of products is more reliably and speedily accomplished.
The principal difference between budgets and standard costs lies in
their scope. The budget, as a statement of expected costs, acts as a guide-
post which keeps the business on a charted course. Standards, on the other
hand, do not what costs are expected to be, but rather what they will be
tell

if certain performances are achieved.A budget emphasizes the volume of

business and the cost level which should be maintained if the firm is to
operate as desired. Standards stress the level to which costs should be re-
duced. If costs reach this level, profits will be increased.

STANDARD COSTS DEFINED

A sfg^f^nrd ^^^^^ has tAy^ mmponents a standard and a : cost. A
standard is like a norm and whatever is considered normal can generally
be accepted as standard. For example : if a score of 72 is the standard for
is judged on the basis of this standard.
a golf course, a golfer's score In
industry the standards for making a desk, assembhng a radio, refining
crude oil, or manufacturing railway cars are based on carefully determined
quantitative and qualitative measurements and engineering methods.
A standard must be thought of as a norm in terms of specific items,
such as pounds of materials, hours of labor required, and hours of plant
i

capacity to be used. In many firms a standard can be operative for a long

time. A change is needed only when production methods or products
themselves have become obsolete or undesirable.
Calculation of a standard cost is based on physical standards.
Standard costs are the predetermined costs of manufacturing a single unit
or a number of product units during a specific period in the immediate
future. They are the planned costs of a product under current and /or
anticipated operating conditions. Ma^tmR^s R"'^ if^bor rp^ts; are penerallv

iJhe term "hours" in this chapter and in Chapter 20 means "direct labor hours."
 : :

CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 579

based ^gnjionpal, curre nt conditions__allQmQg fQjLalterations_QLprices

andjate s and tempered by jhg_^8ir^'^ pffJCJenc Yj evel. FactoiXiiY^lh£?d
is based on no rmal conditions-iiLefficiencv and volume,

STANDARDS — BASIC AND CURRENT

Two types of standards are often discussed: basic and current. A
basic staiidaxd_is_ a vardstick against wbich bot h expected and actual pe r-
formances are compared. It is si milar to^anindfijc number agaijis t which
all la ter results are measure d. Current standards are of three types

1. The expected actual standard set for a level of operations and costs
expected for the coming year. It is to be a reasonably close estimate of
hoped-for actual results.

2. The normal standard set for a level of operations regarded as normal and
representing an average figure intended to smooth out the absorption of
fixed factory overhead over the firm's economic or seasonal cycle. Advo-
cates of direct costing avoid thisproblem by treating fixed costs as period
costs to be written off at the end of the current fiscal period.

3. The theoretical standard set for a level of operations regarded as the

ideal or maximum level of efficiency. Such standards constitute goals to
be aimed for rather than performances that can be currently achieved.

PURPOSES OF STANDARD COSTS

Standard costs are used for
1. Establishing budgets.
2. Controlling costs and motivating and measuring efficiencies.
3. Promoting possible cost reduction.
4. Simplifying costing procedures and expediting cost reports.
5. Assigning costs to materials, work in process, and finished goods
inventories.
6. Forming the basis for establishing bids and contracts and for setting
selling prices.

These six purposes should be considered fundamental to the use of stan-

dard costs. The effectiveness of controlHng costs depends greatly upon a
knowledge of expected costs. Standards serve as a measurement which
calls attention to cost variations. Executives and supervisors become cost-
conscious as they become aware of results. This cost-consciousness tends
to reduce costsand encourages economies in all phases of the business.
The use of standard costs for accounting purposes simplifies costing
procedures through the reduction of clerical labor and expense. A com-
plete standard cost system is usually accompanied by standardization of
productive operations. Standard production or manufacturing orders,
 580 CONTROLLING COSTS AND PROFITS PART VI

calling for standard quantities of product and specific labor operations,

can be prepared advance of actual production. Materials requisitions,
in
labor time tickets, and operation cards can be prepared in advance of pro-
duction, and standard costs can be compiled. As orders tor a part are
placed in the shop, previously established requirements, processes, and
costs will apply. The more standardized the production, the simpler the
clerical effort. Reports can be systematized to present complete informa-
tion regarding standards, actual costs, and variances. Reports are inte-
grated and tie in with the financial accounts.
A complete standard cost file by parts and operations simplifies as-
signing costs to raw materials, work in process, and finished goods in-
ventories. The use of standard costs stabilizes the influence of materials
costs. Placing bids, securing contracts, and establishing selling prices are
greatly enhanced by the availability of reliable standards and the con-
tinuous review of standard costs.
r— The standard cost system may be used in connection with either the

I
process or job order cost accumulation method. However, it is more
1 often used in process cost accumulation because of the greater practicality
of setting standards for a continuous flow of like units than for unique
)
job orders.

SETTING STANDARDS
The success of a standard cost system depends on the reliability,
accuracy, and acceptance of the standards. Extreme care must be taken
to be sure that all factors have been considered in the establishment of
standards. In certain cases, averages of past experience taken from the
accounting records of previous periods are used as standards. However,
the most effective standards are set by the industrial engineering depart-
ment on the basis of a careful study of all products and operations and
genuine participation by those individuals whose performance is to be
measured by the standards.
Often standards are set after a more or less intensive study of past
costs. Time studies determine the time required to perform various
direct labor operations. Engineering studies should also be made of
quantitiesand types of materials needed.
Whatever method is used, standards must be established for a definite
period of time to be effective in the control and analysis of costs. Stan-
dards are usually computed for a six- or twelve-month period; a longer
period sometimes used, but rarely a shorter period.
is

Above
all, standards must be set, and the system implemented, in an

atmosphere that gives full consideration to human behavior characteristics

C:of managers and workers.
CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 581

STANDARD COST CARDS

Standard materials, labor, and factory overhead costs are kept on a
standard cost card that shows the itemized cost of each materials part and
labor operation as well as the overhead cost. A standard cost card, illus-

trated below, gives the standard unit cost of a product.

The master standard cost card is supported by individual cards that

indicate how the standard cost was compiled and computed. Each subcost
card represents a form of standard cost card.

Date of Standard
 :

582 CONTROLLING COSTS AND PROFITS PART VI

during the year are recorded in the price variance accounts. Prices will
be revised at inventory dates or whenever an important change in the
market price of any of the principal raw materials or parts takes place.
Price standards permit (1) checking the performance of the purchasing
department and (2) measuring the effect of price increases or decreases on
the company's profits.

Materials Quantity Standard and Variance. Quantity or usage stan-

dards are generally developed from materials specifications prepared by
the departments of engineering (mechanical, electrical, or chemical) or
product design. In a small or medium-sized company the superintendent
or even the foremen will state basic specifications regarding type, quantity,
and quality of materials needed and operations to be performed.
If the product to be manufactured has never been made or if past
records are not considered a reliable basis on which to predict future costs,
quantity standards may be
through an analysis of the most economical
set

size, shape, and quality of the product and the results expected from the

r— use of various kinds and grades of materials. The standard quantity should
\ also take into consideration allowances for acceptable levels of waste,
\ spoilage, shrinkage, seepage, evaporation, leakage, etc. In such cases the
Lstandard quantity is increased to include these factors. The determination
of the percentage of spoilage or waste should be based on figures that
prevail after experimental and developmental stages of the product have
been passed.
The materials quantity variance is computed by comparing the actual
quantity of materials used, priced at standard cost, with the standard
quantity allowed, priced at standard cost. The standard quantity allowe d
is found by muhiplvin g the quantity of materials that should be requi red
to produce__one unit (t he standa rd quanti]x.,Ber unit) times the actual
number ofjinits produced during the period fo r v^^TicKTKE^iriances are
bemg computed JThe units pr oduce d areme equivale n t units of pro ouc-
. tion for the-materials_c ost being analyzed.

Illustration. These data will be used for computing the materials

parlances

Standard unit price of Item Code 5-489 of

the standard cost card (page 581) $2.50
Purchased 5,000 pieces @ $2.47
Requisitioned 3,550 pieces
Standard quantity allowed for actual pro-
duction 3,500 pieces*

* 1,750 units produced X 2 standard pieces of Item Code 5-489

per unit of production.
 ;

CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 583

The materials purchase price variance is computed as follows

Pieces X Unit Cost = Amount
Actual quantity purchased. . . 5,000 $2.47 actual $12,350
Actual quantity purchased .. . 5,000 2.50 standard 12,500
Materials purchase
price variance 5,000 $(.03 ) $ (150) Credit or
•

favorable

The $150 credit is a favorable materials purchase price variance, and

$.03 expresses the unit cost difference. As an alternative, the rn ateriak
puixh4s^e_£ricevariance_£an be rec ^f^nJT'H ^vhp-n flip m atepal T ^rp \^e.(\

rather than when they are purchased and is then called the "materia ls
price usage varian ce" (see Chapter 20). lY\'^IiL-iJii'
The materials quantity (or usage) variance is computed as follows: cjUctvJr»Ti;\)(Ar.

Pieces X Unit Cost = Amount mQ^O — ^cSp *

Actual quantity used 3,550 $2.50 standard $8,875
Standard quantity allowed.. 3,500 2.50 " 8,750
Materials quantity variance. 50 2.50 standard $ 125 Debit or
^"^"^"^^ ^^^^^ unfavorable

The $125 debit is the dollar value of the unfavorable materials quantity
(or usage) variance. The 50-pieces figure is the physical amount variance.

LABOR COST STANDARDS

Two standards must also be developed for labor costs:
1. A rate (wage or cost) standard
2. An efficiency (time or usage) standard

Rate Standard and Variance. In many plants the standard is based on

rates estabhshed in collective bargaining agreements that define hourly
wages, piece rates, and bonus differentials. Without a union contract
rates are based on the agreed-upon earnings rate as determined between
the employee and the personnel department at the time of hiring. Since
rates are generally based on definite a priori agreements, labor rate vari-
ances are not too frequent. If they occur, they are generally due to unusual
short-term conditions existing in the factory. Setting standards for labor
is a problem which requires a detailed study of conditions under which
standards are to be used. Generahzations are impossible. Each situation
requires special attention with regard to all factors involved.
To assure fairness in rates paid for each operation performed, job rating
has become a recognized procedure in industry. When a rate is revised or
a change is authorized temporarily, it must be reported promptly to the
payroll department to avoid delays, incorrect pay, and faulty reporting.
Any difference between standard and actual rates gives rise to labor rate
(wage or cost) variances.
 584 CONTROLLING COSTS AND PROFITS PART VI

Efficiency Standard and Variance. Determination of labor efficiency

standards is a specialized function; therefore, they are usually estabhshed
by industrial engineers using time and motion studies. Standards are set
in accordance with scientific methods and accepted practices. They are
based on actual performance of a worker or group of workers possessing
average skill and using average effort while performing manual operations
or working on machines operating under normal conditions. Time factors
for acceptable levels of fatigue, personal needs, and delays beyond the
control of the worker are studied and included in the standard. Such al-
lowances are an integral part of the labor standard.
Establishment of time standards requires a detailed study of manufac-
turing operations. Standards based on operations (1) are understood by
the foreman, (2) can be used by the foreman as he knows the time allowed,
and (3) permit translation of individual operations into products, styles,

patterns, or parts. While personal factors are considered a part of direct

labor cost in most plants, time required for setting up machines, waiting,

I or breakdown are included in factory overhead instead of the direct labor

standard.
At the end of any agreed upon reporting period (day, week, or month)
actual hours worked are compared with standard hours allowed to arrive
at a labor efficiency (or time) variance. The standard hows allowed figuvQ
is found by multiplying the direct labor hours established or predeter-
mined to produce one unit (the standard labor hours per unit) times the
actual number of units produced during the period for which the variances
are being computed. The units produced are the equivalent units of pro-
duction for the labor cost being analyzed.

Illustration. The data used to compute the labor variances are based

on Operation 2-476 of the standard cost card (page 581).

Actual hours worked 1 ,880 hours

Actual rate paid S6.50 per hour

Standard hours allowed for actual production 1,590 hours*
Standard rate S6 per hour

*^^^ ""^^^ produced X 3 standard Operation 2-476 direct

X.
IS^T)^
J rr~)r
<aAj2_
,
labor hours per unit of production.

The labor rate variance is computed as follows:

A(|/^- A^i^
Time X Rate = Amount
Actual hours worked 1,880 $6.50 actual $12,220
Actual hours worked 1,880 6.00 standard 11,280
Labor rate variance 1,880 $ .50 $ 940 Debitor
unfavorable

The labor rate (wage) variance amounts to $940 and is unfavorable.

The difference in terms of the rate is $.50 per hour.
 :

CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 585

The labor efficiency variance is computed as follows

Mr^ ^

Time X Rate = Amount HN So „ -^ ^ o

Actual hours worked 1,880 $6 standard $1 1,280
"
Standard hours worked 1,590 $6 9,540
Labor efficiency variance ... . 290 $6 " $1,740 Debitor
^^^^^
unfavorable

The unfavorable labor efficiency variance is $1,740 due to the use of

290 hours in excess of standard hours allowed.

The recapitulation of the two labor variances is : Tpt'A ( J»i>f JoJ". "z:

Actual labor cost ..^!].(\^. . .)MP.X !o.:%? $ 1 2,220

Standard labor cost.^.^ C©. . .
\ ^f.O. .>c . ^ 9,540
Net labor variance ..".'. $ 2,680 Debit or
unfavorable

This unfavorable labor cost variance was the result of : ^(.jiO-j^ X/^\jj^ \vC^

V
Labor rate variance
Labor efficiency variance
$ 940 Debit (unfavorable)
1,740 Debit (unfavorable)
^ OoywO^i^
V
Net labor variance $2,680 Debit or
^^^"^^ unfavorable

The Learning Curve. When a new product or process is started, the

labor efficiency standard used for standard costing and budget develop-
ment should consider the learning curve phenomenon (see Chapter 14).
The learning curve may well be at least in part an explanation of the labor
efficiency variance associated with employees assigned to existing tasks
that are new to them. Labor-related factory overhead costs and perhaps
material usage might also be affected,

FACTORY OVERHEAD COST STANDARDS

Procedures used for establishing and using standard factory overhead
rates resemble the methods discussed in Chapters 9 and 10 deahng with
the estimated factory overhead and its application to jobs and products.
It will be recalled that an overhead budget provides budget allowances for
a specific anticipated level of activity, while a flexible budget provides
allowances that vary with activity. Both types of budgets aim for the con-
trol of variable overhead. Control is achieved by keeping actual expenses
within ranges established by the budget. The maximum limit of a range
is the amount set up However, for costing jobs or
in the flexible budget.
products it is necessary to establish a normal overhead rate based on total
factory overhead at normal capacity volume. Total overhead includes
fixed and variable expenses. The effect of volume on overhead cost per
unit is illustrated on the next page.
586 CONTROLLING COSTS AND PROFITS PART VI

^
FACTORY OVERHEAD BEHAVIOR PER UNIT OF PRODUCT
Production volume (units)
 : : . :

CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 587

may also be used; e.g., direct labor dollars or machine hours (see
Chapter 9). However^-difect labor h ours i^_the basis p;enera1]y used in
standard costing.
The data from Department 3's flexible budget (shown below) is used to

illustrate thecomputation of the standard factory overhead rate and the

overhead variances. Assuming that the 100% column represents normal
capacity, the standard factory overhead rate is computed as follows

Total Factory Overhead $8,000

$2 per Standard Direct Labor Hour
Direct Labor Hours $4,000

At the 100% capacity level, the rate consists of:

Total Variable Factory Overhead

^^2^ = $ 1 .20 Variable Factory
Direct Labor Hours $4,000 Overhead Rate
Total Fixed Factory Overhead ^ $3,200 _ .80 Fixed Factory
Direct Labor Hours
~ $4,000 Overhead Rate
Total Factory Overhead Rate at Normal Capacity. $2.00
= per Standard Direct
Labor Hour

Department 3
Monthly Flexible Budget
Capacity (expressed as a
percentage of normal 80% 100% i20%n r^,j^
J^^. n; L j
Standard production 800 1,000 1,200 -^ u''] c/ -f
Direct labor hours 3,200 4,000 4,800 " '^^7 ^ "^
Per Direct
Variable factory overhead Labor Hour
Indirect labor $1,600 $2,000 $2,400 $ .50
Indirect materials 960 1 ,200 1 ,440 .30
Supplies 640 800 960 .20
Repairs 480 600 720 .15
Power and light 160 200 240 .05

Total variable factory

overhead $3,840 $4,800 $5,760 $1.20

Fixed factory overhead

Supervisor $1,200 $1,200 $1,200
Depreciation of machinery 700 700 700
Insurance 250 250 250
Property taxes 250 250 250
Power and light 400 400 400
Maintenance 400 400 400

Total fixed factory over-

head $3,200 $3,200 $3,200 $3,200 per month

Total factory overhead

^=
$7,040
==
$8,000 $8,960
+
$3,200 per month
$1.20 per D.L.H.
 : :

588 , ^ CONTROLLING COSTS AND PROFITS PART VI

Overall (or Net) Factory Overhead Variance. Joh<; or proj-gsses a re

cha rged with costs applicable to them on the ba sJ^_Qj[^ tandar d hours

P
V A alTowed multiplied by the standard factory overhead ra te. The standard
. is found by multiplying the labor hours required to
hours allowed figure
^^

M ' produce one unit (the standard labor hours per unit) times the actual
^^amC number of units produced during the period. The units produced are the
(Kf^[oJ) /:j^ equivalent units of production for the factory overhead cost being ana-
lyzed. At the end of each month, overhead actually incurred is compared
. .

<AYvJ r<UA
^j^j^ ^j^g expenses charged into process using the standard factory over-
J>

Y ^'I'tt^Uu^head rate. The difference between these two figures is called the overall
"
YVflJr
^°^ ^^^^ factory overhead variance.

/ /V V<\r" Illustration. At the end of a month, the data for Department 3 are as
follows

Actual overhead $7,384

Standard hours allowed for actual production 3,400 hours*
Actual hours used 3,475 hours
Overall factory overhead variance $584

*850 units produced X 4 standard Department 3 direct

labor hours per unit of production.

The overall factory overhead variance —

the difference between actual
overhead incurred and overhead costed into production is computed —
and shown below.

Actual departmental overhead $7,384

Overhead charged to production (3,400 standard hours
allowed X $2 standard overhead rate) 6,800

Overall (or net) overhead variance $ 584 Debit or

unfavorable

This unfavorable overall overhead variance needs further analysis to

reveal detailed causes for the variance and to guide management toward
remedial action. Analysis of the net overhead variance may be made by
1. The two-variance method.
2. The three-variance method.
3. The four-variance method.

Two-Variance Method. The two variances are: (1) controllable vari-

ance and (2) volume variance. The controllable variance is fhp differgnre
between actual expenses in curred and the budget allow ance based on
standaj d hours allowed fo r]work_perfofttt&d. The volume"variance repre-
sents^the difference between the budget allowance and the standard ex-
penses charged to work in process (standard hours allowed X standard
overhead rate).
 : :

CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 589

(1) Controllable Variance: '^0^ ?D>^ ^

Actual factory overhead $7,384 iVs cW'-^ ^^

on standard hours
Budget allowance based
allowed:
UUu
j,
Ia^
, /
,4
x
A
Fixed expenses budgeted $3,200 U 5"Gj?-^Ju_^ ^r
Variable expenses (3,400 standard hours al- 7^
lowed X $ 1 .20 variable overhead rate) 4,080 7,280 "^V -2- >T, u*^..

Controllable variance $ 104 Debit or ^ \>

<^^^-^6^,^te.
^^^^^=^ unfavorable

The controllable variance nn nsists of var iahle expg ^is es on ly and can
also be computed as follows "^W^i \s Vov^
Actual variable expense ($7,384 actual factory overhead
— $3,200 of fixed expenses budgeted)
nTWii VW^
$4,184 v

Variable expenses for standard hours allowed 4,080 Co-wnowVc <^

Controllable variance $ 104 Debit or '."?

^^^^^^ unfavorable

The controllable variance is the responsibility of the department man-

ager to the extent that he can indeed exercise control over the costs to
which the variances relate.

(2) Volume Variance: ^K^^^slJ) -^^^^ .

Budget allowance based on standard hours allowed $7,280

Overhead charged to production 6,800
Volume variance $ 480 Debit or \
^^^"^^^
unfavorable

This variance consists of fixed expenses only and can also be computed
as follows

Normal capacity hours 4,000

Standard hours allowed for actual production 3,400 tuJC -v^/^DtLM)
Capacity hours not utilized, or not utilized eflfi- CJ^^^^^ ii_L-^ >«r\ ^ i)

ciently 600 ^**V«=^*^^:==WW>^

Volume variance (600 hours X $.80*) $480 Debit or
^""^^^
unfavorable

V^isilfl-Vl >^
*Fixed expense rate at normal capacity.

The volume variance indicates the cost of capacity available but not
utilized or not utilized efficiently and is considered the responsibility of
executive and departmental management.

Three-Variance Method. The three variances are: (1) spending vari-

ance, (2) idle capacity variance, and (3) efficiency variance. T-h£ spendin g
variance is the difference betweenjrtURJ expanses incurred and the budge t
allowaiLceJ3as£±xmI actuain oiu:&_a^rked. The idle capacit y variance is
 : :

590 CONTROLLING COSTS AND PROFITS PART VI

the difference between the b udggt_-aikma nce based onactual hours an d

actual hours worked m ultigligd-by the siandard^yerheadj;ate. These two
variances are identical with the spending and idle capacity variances
discussed in the factory overhead Chapters 9 and 10. The efficiency

variance is the difference between actual hours worked multiplied by

the standard overhead rate and the standard hours allowed times the
standard overhead rate.

(1) Spending Variance:

Actual factory overhead $7,384
Budget allowance based on actual hours worked
Fixed expenses budgeted $3,200
Variable expenses (3,475 actual hours X $1.20
variable overhead rate) 4,170 7,370

Spending variance $ 14 Debit or

unfavorable

The spending variance consists of variable expenses only and can also

be computed as follows
Actual variable expenses ($7,384 actual factory overhead
- $3,200 fixed expenses budgeted) .,... .... ... .^ v $4,184
.

Allowed variable expenses for actual hours .v.!.- y?. ^SHliJ 4, 1 70

Spending variance $ 14 Debit or
unfavorable

The spending variance is the responsibility of the department manager

I who expected to keep his actual expenses within the budget. By basing
is

the budget allowance on actual hours instead of on standard hours al-

lowed as shown in the controllable variance, the foreman receives a more
favorable budget allowance which reduces his variance from $104 to $14.

>joU ^^^ (2) Idle Capacity Variance:

t!<-;ok/
j^ifi} lo.
Budget allowance based on actual hours worked $7,370
= ^M'^S'^ 5^'^ Actual hours (3,475) X standard overhead rate ($2) 6,950

\JCi^ UsY -.r^ Idle capacity variance $ 420 Debit or

WslYM^^^^ ,tVL^C ^- US^ 0^ vT^l>lo^ Wlc^^ unfavorable

This variance consists of nxed expenses only and can also be com-
puted as follows: 4,000 hours - 3,475 hours = 525 hours X $.80 (fixed
expense rate) = $420.
An idle capacity variance indicates the amount of overhead that is

either under- oroverabsorbed because actual hours are either less or more
than the hours on which the overhead rate was based. Department 3
^ operated at 86.875% of normal capacity based on actual hours. The
.^.variance is the re s ponsibility of executjyejij anagem ent.
 .

CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 591

(3) Efficiency Variance:

Actual hours (3,475) X standard overhead rate ($2).^^. . $6,950
Overhead charged to production .fi^a(A/^i .'^/.\^. (^.
. . . 6,800

Efficiency variance $ 150 Debit or

^=^= unfavorable

This variance can also be computed as follows : 3,475 hours — 3,400

hours = 75 hours X $2 = $150.
^^— The efficiency variance consists of fixed and variable expenses and
\ resultsbecause actual hours used are more or less than standard hours
allowed. Causes for this variance are inefficiencies, inexperienced labor,
changes in operations, new tools, different types of materials, etc. This
J

:mdance an dits ca use reflect the_£fferi £> £ the labor efficiency variance o n
factory^^^oyerheaj[^_when^abo^ hou rs are_the basis^Jgr
applying factory overhead if marh[rip ; Y\n^^r<i g re the b asis^lhe varia.nce
relay s to efficiency^oTmachine^usage, and so forth for other overhe ad
application base s

Four-Variance Method. The four variances are : (1) spending variance,

(2) variable efficiency variance, (3) fixed efficiency variance, and (4) idle
capacity variance. Actually, these four variances merely add to the three-
variance method an analysis of the efficiency variance into its fixed and
variable components.

(1) Spending Variance:

Actual factory overhead $7,384
Budget allowance based on actual hours worked 7,370

Spending variance $ 14 Debit or

^^=^=^ unfavorable

This spending variance is identical with that of the three-variance

method.

(2) Variable Efficiency Variance:

Budget allowance based on actual hours worked $7,370
Budget allowance based on standard hours allowed 7,280

Variable efficiency variance $ 90 Debit or

'

unfavorable

This variance recognizes the difference between the 3,475 actual hours
worked and the 3,400 standard (or allowed) hours for the work performed.
~ Multiplying the diff'erence of 75 hours times $1.20 (variable expense rate)
results in $90. The sum of the spending and variable efficiency variances
_ equals the controllable variance, $104, of the two-variance method.
 .

'Hml VvxS>i 5^?=^ v^r,^-t^ ^/>CrjLfli>' VCS. ^O rvS Vo ©-\oS-'f^ ^ ^\^il U){\s

CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZINg'X/XrIANCES 59

V (3) Fixed Efficiency Variance- .^^^^\ji» y\\jf

3,475 actual hours X $.80 fixed overhead rate $2,780

3,400 standard hours allowed X $.80 fixed overhead
rate rv^oVib^ f •i>62 ^- - 1,12Q
. • •
Yh '* fk^^^
' . - 1^-^ i'

Fixed efficiency variance (75 hours X $.80) $ 60 Debit or

"^^"^^^^
unfavorable

The fixed efficiency variance and the idle capacity variance, shown
below, are split-offs of the $480 unfavorable volume variance of the two-
variance method which was computed by multiplying the 600 hours not
utilized by the $.80 fixed overhead rate. Th e fixed ^^'f^nsx^^rian ce
Jodicates how e ffectively or ineffectively a foreman hag_emp1oyedjvaj1abl^
_capa£ily.

(4) Idle Capacity Variance:

4,000 normal capacity hours X $.80 fixed overhead rate
"^^
3,475 actual hours worked X $.80 fixed overhead rate
.

.
. $3,200
2,780
^-^^"^'tS
Idle capacity variance (525 hours X $.80) $
—
420 Debit or
unfavorable

This variance is identical with the idle capacity variance of the three-
variance method and represents the idle or unused capacity; i.e., the differ-
ence between budgeted (normal) capacity and actual capacity utilized. It in -

fo rms manage ment that 525 hours otherwise available and expected to
be^ used, cost i ng $420 in terms of fi ^ce d expen sjes».j:£m ainedjd le during
the month.
The question might arise as to which factory overhead variance analy-
sis method is most frequently used in industry. Although all methods
are commonly used, the two-variance method seems to be favored. It
should be noted that at times the methods are intermingled, are given dif-
ferent titles, and involve additional analyses. A summary of the three
methods described in this chapter is given on page 592.

MIX AND YIELD VARIANCES

Basically, the establishment of a standard product cost requires the
determination of price and quantity standards. In a number of industries,
particularly of the process type, materials mix and materials yield play
significant parts in setting the final product cost and in effecting cost
reduction and profit improvement.
Materials specification standards are generally set up for various grades
of raw materials and types of secondary materials. In most cases speci-
fications are based on laboratory or engineering tests. Comparative costs
of various grades of materials are used in the process of arriving at a
satisfactory product mix, and changes are often made when it seems
possible to use less costly grades of raw materials or substitute materials.
594 CONTROLLING COSTS AND PROFITS PART VI

In addition, a substantial cost reduction can be acliieved througli the

improvement of tlie yield of good products in the factory. A variance
analysis program pointing out and evaluating causes of low yield aids
operating management in this endeavor.

Mix Variance. After the establishment of the standard specification,

a variance representing the difference between the standard of formula
materials and the standard cost of the materials actually used can be
calculated. This variance is generally recognized as a mix (or blend) vari-
ance. The mix {or blend) variance is the result of mixing basic raw materials
in a ratio different from standard materials specifications.

In a woolen mill, for instance, the standard proportions of the

grades of wool for each yarn number are reflected in the standard blend
cost. Any differences between the actual wool used and the standard
blend results in a blend or mix variance. Industries like textiles, rubber,
and chemicals whose products must possess certain chemical or physical
qualities find it quite feasible and economical to apply different combina-
tions of basic raw materials and still achieve a perfect product. In cotton
fabrics it is common to mix cotton from many parts of the world with
the hope that the new mix and its cost will contribute to improved cost
and profit. In many cases the new mix is accompanied by either a favor-
able or unfavorable yield of the final product. Such a situation makes
it difficult at times to judge correctly the origin of the variances. A favor-
able mix variance, for instance, may be offset by an unfavorable yield
variance, or vice versa. Thus, any apparent advantage created by one may
be canceled out by the other.

Yield Variance. Yield can be defined as the amount of prime product

produced from a given amount of materials. The yield variance is the
result of obtaining a yield different from the one expected on the basis of
input. In a gray iron foundry the materials charged into the cupola in-
clude raw materials, coke, flux material, and all alloy materials and in-
noculants used as ladle additions. Cupola operation involves the applica-
tion of heat to melt the metal as well as a complex thermochemical re-
action. This process results in yield, meaning good castings made from
the melted metal expressed as a percent of total metal charged.
It is important to recognize raw materials cost differences due to
differences in yield when costing or pricing individual castings or patterns.
In most instances the total cost of melted metal is divided by the yield
percentage to arrive at a cost which is to be charged to the next operation.
If, for example, the cost of melted pounds is $18 per 1,000 lbs. and the
yield is 90 percent, then dividing $18 by 900 lbs. (90 percent of 1,000 lbs.)
results in a cost of $20 to be charged to the next operation.
CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 595

In sugar refining a normal loss of yield develops when 96 pounds of

sucrose available in the standard 100 pounds of raw sugar is processed
into refined sugars. Part of this sucrose emerges as blackstrap molasses,
and a small percentage is completely lost. On the average it takes ap-
proximately 102.5 pounds of sucrose in raw sugar form to produce 100
pounds of sucrose in finished sugars.
In the canning industry it is customary to estimate the expected yield
of grades per ton of purchased or delivered to the plant. Should
fruit

actual yields deviate from predetermined percentages, cost and profit

of the grade will differ. The diff'erence may be due to a shift of the raw
materials into a different grade which has a lower selling value.
Since the final product cost contains not only materials but also labor
and factory overhead, the emergence of a yield gain or loss when the
finished product is transferred to the finished goods inventory also requires
the recognition of a yield variance for labor and factory overhead. The
actual quantities resulting from the processes are multiplied by the stan-
dard cost which includes all three cost elements. A labor yield variance
must be looked upon as the result of the quality and/or quantity of the
materials handled, while the factory overhead yield variance is due to the
greater or smaller number of hours worked. It should be noted that the
overhead yield variance may have a significant effect on the amount of
under- or overabsorbed factory overhead.

Problem Involving Mix and Yield Variances. The illustra-

Illustrative
tiveproblem presented shows the calculation of mix and yield variances
in connection with manufacturing chewing gum. It should be noted that
actual output is placed into finished goods inventory at the total standard
cost per unit. This method leads to yield variances not only for materials
but also for labor and factory overhead.
The Springmint Company, a manufacturer of chewing gum, uses a
standard cost system. Standard product and cost specifications for
1,000 lbs. of chewing gum are as follows:

$.25 per Ib.^

 : 1 :

596 CONTROLLING COSTS AND PROFITS PART VI

Materials records indicate:

Beginning Purchases Ending
Inventory inJanuary Inventory

Gum base 10,000 lbs. 162,000 lbs. @ $.24 15,000 lbs.

Corn syrup 12,000 lbs. 30,000 lbs. ^ .42 4,000 lbs.
Sugar 1 5,000 lbs. 32,000 lbs. (n . 1 11 ,000 lbs.

The company recognizes the materials price variances at the time

materials are purchased.
To lbs. of raw materials into 1,000 lbs. of finished product
convert 1,200
requires 20 hours at $6 per hour, or $.12 per lb. Actual direct labor hours
and cost for January are 3,800 hours at $23,104.
Factory overhead is applied on a direct labor hour basis at a rate of
$5 per hour ($3 fixed, $2 variable), or $.10 per lb. Normal overhead is
$20,000 with 4,000 direct labor hours. Actual overhead for the month is

$22,000. Actual finished production for the month of January is 200,000 lbs.
The standard cost per pound of finished chewing gum is
Materials $.30
Labor 12
Factory overhead -10

$.52 per lb.

ANALYSIS OF VARIANCES FOR JANUARY

Materials Variances:

Actual Standard Unit Price Price

Materials Quantity Price Price Variance Variance

Gum base.. 162,000 lbs. $.24 $.25 $(.01) $(1,620)

Corn syrup. 30,000 lbs. .42 .40 .02 600
Sugar 32,000 lbs. .11 .10 .01 320
Net materials purchase price variance $ (700 ) Credit or
favorable
Actual quantities at standard prices:
Gum base (157,000 lbs. (« $.25) $39,250
Corn syrup ( 38,000 lbs. (5 $.40) 15,200
Sugar ( 36,000 lbs. @ $. 10) 3,600 $58,050
231,000 lbs.

Actual quantity at standard materials cost

Actual input (23 1 ,000 lbs. X $.25*) $57,750
or
Standard (expected) output from actual input
[192,500 lbs. (1,000/1,200 or 5/6 of 231,000 lbs.)
X $.30*] $57,750 57,750

Materials mix variance $ 300 Debit or

unfavorable

Weighted average cost computed on page 595.

 : : ., :

CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 597

Actual quantity at standard materials cost (see

previous page) $57,750
Actual output quantity at standard materials cost:
Actual output (200,000 lbs. X $.30) $60,000

or
Input needed to produce 200,000 lbs. (240,000
lbs. X $.25) $60,000 60,000

Materials yield variance $ (2,250 ) Credit or

favorable

The materials purchase price variance is computed as shown on page

583. The materials quantity variance, also illustrated on page 583, can
be computed for each material as follows

Gum base: Unit

Unit X Cost = Amount
Actual quantity used. 157,000 lbs. $.25 $39,250
Standard quantity
allowed 160,000 lbs.* 25 40,000
Materials quantity variance (750) Credit or
favorable

*An output of 200,000 lbs. should require an input of

240,000 lbs., with a standard yield of 1,000 lbs.
output for each 1,200 lbs. input. Then the
^^^ ^^^' gum base portion of the
240,000 lbs. X
1,200 lbs.
formula = 160,000 lbs.

Corn syrup Unit

Unit X Cost = Amount
Actual quantity used. 38,000 lbs. $.40 $15,200
Standard quantity
allowed 40,000 lbs. .40 16,000
Materials quantity variance (800) Credit or
favorable
^"
"
The 240,000 lbs. X .. corn syrup portion

cf the formula = 40,000 lbs.

Sugar Unit
Unit X Cost = Amount
Actual quantity used.... 36,000 lbs. $.10 $3,600
Standard quantity
allowed 40,000 lbs.* .10 4,000
Materials quantity variance (400) Credit or
favorable

The 240,000 lbs. X ^^ j^^' sugar portion of

formula = 40,000 lbs.

Total materials quantity variance (1,950) Credit or

favorable
 : :

598 CONTROLLING COSTS AND PROFITS PART VI

The total materials quantity variance can also be found by comparing

actual quantities at standard prices, $58,050 ($39,250+ $15,200+ $3,600),
to actual output quantity at standard materials cost, $60,000 (200,000
lbs. X $.30) for a total favorable variance of $1,950. The mix and yield
variances separate the materials quantity variance into two parts

Materials mix variance S 300 Debit or unfavorable

Materials yield variance (2,250) Credit or favorable
Materials quantity variance
===
$(1,950) Credit or
favorable

The materials mix variance can be viewed in the following manner:

Actual
Quantity
Total Using
Actual Standard Actual Standard Quantity Standard Materials
Quantity Formula Quantity Formula Variation Unit Mix
(Lbs.) (Lbs.) X (Lbs.) = (Lbs.) (Lbs.) X Price = Variance
Gum base. 157,000 -|^ 231,000 154,000 3,000 S.25 S750

Corn syrup 38,000 -^ 231,000 38,500 (500) .40 (200)

Sugar 36,000 -^ 231,000 38,500 (2,500) .10 (250)

231,000 lbs. '

231,000 lbs. $300

The yield variance occurred because the actual production of 200,000

lbs. exceeded the expected yield or output of 192,500 lbs. (5/6ths of
231,000 lbs.) by 7,500 lbs.; and the yield difference multiplied by the

standard weighted materials cost per output pound of $.30 equals the
favorable yield variance of $2,250.

Labor Variances:
The expected output (yield) of 192,500 lbs. of chewing gum (231,000
lbs. of raw materials issued multiplied by the expected yield of 5/6ths

equals 192,500 lbs.) should require 3,850 standard labor hours (20 hours
per thousand pounds of chewing gum produced; and, similarly, the actual
output (yield) of 200,000 lbs. of chewing gum should require 4,000 stan-
dard labor hours. The computation of labor variances is as follows

Actual payroll $23,104

Actual hours (3,800) X standard labor rate ($6) 22,800
Labor rate variance $ 304 Debit or
^^'^^ unfavorable

Actual hours X standard labor rate $22,800

Standard hours allowed for expected output (3,850) X
standard labor rate ($6) 23,100
Labor efficiency variance $ (300) Credit or
^^^^^"^^ favorable
 :

CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 599

Standard hours allowed for expected output X stan-

dard labor rate $23, 100
Standard hours allowed for actual output (4,000) X
standard labor rate ($6) 24,000
Labor efficiency variance $ (900) Credit or
'^^'^^^ favorable

The labor rate variance is computed as shown on page 584. The

traditional labor efficiency variance, illustrated on page 585, is computed
as follows

Time X Rate = Amount

Actual hours worked 3,800 $ 6 $22,800
Standard hours allowed 4,000 6 24,000
Labor efficiency variance ( 200) $ 6 $ (1,200) Credit or
^^^^ =^^=^= favorable

The labor yield variance calculation identifies the portion of the labor
efficiency variance attributable to obtaining an unfavorable or, as in this
illustration, a favorable yield (3,850 standard hours allowed for expected
output — 4,000 standard hours allowed for actual output = 150 hours X
$6 standard labor rate = $900). The favorable labor efficiency variance of
$300 is the portion of the traditional labor efficiency variance that is at-
tributable to factors other than yield; and the sum of the two, $900 plus
$300, equals the $1,200 traditional labor efficiency variance.

Factory Overhead Variances:

Three- Variance Method (Adapted To Compute a Yield Variance)

Actual factory overhead $22,000

Budget allowance (based on actual hours):
Fixed expenses budgeted $12,000
Variable expenses (3,800 hours X $2) 7,600 19,600
Spending variance $ 2,400 Debit or
unfavorable

Budget allowance (based on actual hours) $19,600

Actual hours (3,800) X standard overhead rate ($5) 19,000
Idle capacity variance $ 600 Debit or
^^^^^^^^^^
unfavorable

Actual hours X standard overhead rate $19,000

Standard hours allowed for expected output (3,850) X
standard overhead rate ($5) 19,250
Overhead efficiency variance $ (250) Credit or
^^^^^^ favorable
Standard hours allowed for expected output X standard
overhead rate $19,250
Standard hours allowed for actual output (4,000) X
standard overhead rate ($5) 20,000
Overhead yield variance $ (750) Credit or
^"^^'^^ favorable
 :

600 CONTROLLING COSTS AND PROFITS PART VI

The spending and idle capacity variances are computed in the same
manner as discussed on page 590. The overhead efficiency variance and
the overhead yield variance, when combined, equal the efficiency vari-
ance discussed earlier in this chapter on page 591. The overhead yield
variance measures that portion of the total overhead variances resulting
from a favorable yield (3,850 hours - 4,000 hours = 150 X $5 = $750).

Two- Variance Method (Adapted To Compute a Yield Variance)

Actual factory overhead $22,000

Budget allowance (based on standard hours
allowed for expected output)
Fixed expenses budgeted $12,000
Variable expenses (3,850 hours X $2) . . . 7,700 19,700

Controllable variance
===$ 2,300 Debit or
unfavorable

Budget allowance (based on standard hours for expected

output) $19,700
Standard hours allowed for expected output (3,850)
X standard overhead rate ($5) 19,250

Overhead volume variance $ 450 Debit or

^==^=^= unfavorable

Standard hours allowed for expected output X stan-

dard overhead rate $19,250
Standard hours allowed for actual output (4,000) X
standard overhead rate ($5) 20,000

Overhead yield variance $ (750) Credit or

^^^"^"^^^
favorable

The unfavorable spending variance, $2,400, combined with the vari-

able part of the overhead efficiency variance (3,800 hours — 3,850 hours)
X $2 = $100 favorable, both from the three-variance method above,
equals $2,300 unfavorable, the controllable variance. The idle capacity

variance, $600 unfavorable, combined with the fixed part of the overhead
efficiency variance (3,800 hours — 3,850 hours) X $3 = $150 favorable,
both from the three-variance method shown above, equals $450 unfavor-
able, the overhead volume variance. The favorable overhead yield vari-
ance is the same as for the three-variance method and can be viewed as
consisting of $300 variable cost (3,850 standard hours allowed for ex-
pected output — 4,000 standard hours allowed for actual output) X $2,
and $450 fixed cost, (3,850 - 4,000) X $3.
The journal entries for the variances discussed on the previous pages
are illustrated in the next chapter.
CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 601

MANAGERIAL USEFULNESS OF VARIANCE ANALYSIS

Costs of production are affected by internal factors over which man-
agement has a large degree of control. An important job of executive
management is to make the members of various management levels

understand that all of them are part and parcel of the management team.
The task of imparting this cost control consciousness falls, in part, upon
standard costs with their variances. With their aid, management is in-

formed of the effectiveness of production effort as well as that of the

supervisory personnel.
Supervisors who often handle two thirds to three fourths of the dollar
cost of the product are made directly responsible for the variances which,
as the chapter discussion indicates, show up as materials variances (price,
quantity, yield, and scrap) or as direct labor variances (rate and efficiency).

Materials and labor variances can be computed for each materials item,
for each labor operation, and for each workman.
Factory overhead variances (spending, controllable, idle capacity,
volume, and efficiency) indicate the failures or successes of the control of
variable and fixed overhead expenses in each department.
Variances are not ends in themselves but, rather, springboards for
further analysis, investigation, and action. However, variances will also
permit the supervisory personnel to defend itself and its employees against
failures that were not their fault. A variance provides the yardstick to
measure the fairness of the standard, allowing management to redirect
its effort and to make reasonable adjustments. Action to eliminate the
causes of undesirable variances and to encourage and reward desired per-
formance lies in the field of management, but supervisory and operating
personnel rely on the accounting information system for facts which
make possible intelligent action toward the control of costs.

^ff DISCUSSION QUESTIONS

Recently a conference speaker discussing budgeted and standard costs made
the following statement: "Budgets and standards are not the same thing.
They have different purposes and are set up and used in different ways, yet
a specific relationship exists between them."
(a) Identify distinctions or differences between budgets and standards.
(b) Identify similarities between budgets and standards.

A team of management consultants and company executives concluded that

a standard cost installation was a desirable vehicle for accomplishing the
objectives of a progressive management. State a few uses of standard costs
that can be associated with the above decision.
602 CONTROLLING COSTS AND PROFITS PART VI

3. Is a Standard cost system equally applicable to job order costing and process
costing?

4. The problem of setting a standard cost generally leads to a discussion of

what should be included in and what should be excluded from standard
costs. What determines the final decision?

5. Does a standard cost system increase or decrease the amount of account-

ing and clerical effort and expense required to prepare cost reports and
financial statements?

6. What types of variances are computed for materials, labor, and factory
overhead ?

7. In a paper mill, materials specification standards are set up for various

grades of pulp and secondary furnish (waste paper) for each grade and kind
of paper produced. Yet at regular intervals the cost accountant is able to
determine a materials mix variance. Why?

8. How does the calculation of a mix variance differ from that of a quantity
variance ?

9. Yield often expressed as the percentage actually obtained of the amount

is
theoretically possible. The yield figure is a useful managerial control of
materials consumption. Explain.

10. A cost standard in a process industry is often based on an assumed yield

rate. Any difference in actual yield from standard yield will produce a
yield variance. Express this variance in formula form.

11. The isolation of a yield variance results in yield variances not only for
materials but also for labor and factory overhead. Why?

12. Select the correct answer for each of the following statements.
(a) The product cost determined in a standard cost accounting system is a
(1) direct cost; (2) fixed cost; (3) joint cost; (4) expected cost.
(b) A company employing very tight (theoretical) standards in a standard
cost system should expect that (1) a large incentive bonus will be paid;
(2) most variances will be unfavorable; (3) employees will be strongly
motivated to attain the standards; (4) costs will be controlled better
than if lower standards were used.
(c) A company controls its production costs by comparing its actual
monthly production costs with the expected levels. Any significant
deviations from these expected levels are investigated and evaluated as
a basis for corrective actions. The quantitative technique that most
probably is being used is (1) correlation analysis; (2) differential calculus;
(3) risk analysis; (4) standard cost variance analysis; (5) time series or
trend regression analysis.
(d) One purpose of standard costs may be described as (1) promoting and
measuring performance; (2) controlling and reducing costs; (3) simpli-
fying production operations; (4) setting cost to manufacture; (5) all of
the above; (6) none of the above.
(e) In a standard cost system the materials purchase price variance is ob-
tained by multiplying the (1) actual price by the difference between
actual quantity purchased and standard quantity allowed; (2) actual
quantity purchased by the difference between actual price and standard
 CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 603

price; (3) standard price by the difference between standard quantity

purchased and standard quantity allowed; (4) standard quantity pur-
chased by the difference between actual price and standard price.
(f) If the current standard calls for the use of 1,000 units @
$1 each and
the actual usage is 1,050 units @
$.90 each, the materials price variance
is $100; (2) $55; (3) $105; (4) $50, and the materials quantity vari-
(1)
ance (1) $100; (2) $55; (3) $105; (4) $50.
is

(g) Acompany has set its normal capacity at 24,000 hours for the current
year. Fixed overhead was budgeted for $18,000 while variable overhead
was budgeted for $24,000. Actual hours worked for the current year
were 22,000. The idle capacity variance for the current year is (1)
$1,750; (2) $2,000; (3) $3,500; (4) $1,500.
(AICPA adapted)

EXERCISES
Wherever variances are required in the following exercises, indicate
whether they are favorable or unfavorable.

\. Materials Variance Analysis. The Abrahamson Container Company uses

^ve pieces of metal, 2 meters by 1 meter, at $12 per piece as the standard for its
production of nonrust vats. During one month's operations, 4,900 vats were
produced at a cost of $1 1.75 per piece for 25,000 actual pieces of material.

Required: The materials price and quantity variances.

l) Labor Variance Analysis. Hidalgo County Rural Electric Cooperative has

determined that when ditch-digging equipment is used, the labor time per foot
of underground line installed should be 5 minutes and that the average hourly
labor pay rate should be $4.
In June two ditch-digging units installed 4,800 feet of line at a labor cost of
$1,435 and at an average hourly rate of $4.10.

Required: The labor rate and efficiency variances.

(3. Factory Overhead Variance Analysis. The Tejas Manufacturing Company

Employs a standard cost accounting system. The standard factory overhead
rate was computed based on normal capacity:
Budgeted variable expenses $12,000
Budgeted fixed expenses 8,000
Total $20,000

Factory overhead rate: ,^

•^
'
u
= $1-00 per direct labor hour
20,000 hours

Two labotiiours are required to manufacture each finished unit. During

the month, 8,750 units' were completed. There were no beginning or ending
work in process inventories. 18,400 labor hours were worked and actual
factory overhead was $18,250.

Required: An analysis of factory overhead using the two-, three-, and four-
variance methods.
604 CONTROLLING COSTS AND PROFITS PART VI

4.Factory Overhead Variance Analysis. The accountant for the McGee Com-
pany prepared the following flexible monthly factory overhead budget:

Direct Labor Hours Budgeted Factory Overhead

10,400 $21,600
9,600 20,400
8,800 19,200
8,000 (normal capacity) 18,000
7,200 16,800

In August the actual factory overhead was $21,200. The company operated
at 125% of normal capacity. Standard hours allowed for actual production
were 10,200.

Required: An analysis of factory overhead by (a) the two-variance method

and (b) the three-variance method.

5. Labor and Overhead Analyses. The Glenmore Company prepares a flexible

factory overhead budget and applies these budgeted expenses to production by
means of a normal capacity rate.

Flexible Budget — Glenmore Company

 : :

CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 605

The Laboratory has developed the following standards for performing

routine blood tests:

Materials (1 packet of chemicals @

$.50) $ .50
Labor (10 minutes @ $6 per direct labor hour) 1 .00
Overhead ($12 per direct labor hour)* 2.00

Standard cost per blood test $3.50

Based on 5,000 tests (or 833.3 direct labor S'OtJo tisTs QXlon^^.^ SOooO h^i) -r L^
hours per month; fixed, $4.80; variable, $7.20
3V
, 5 "? -?
per direct labor hour). " o _> 73 "U
Krt

During April, 4,800 blood tests were made; and the following costs were
incurred

Materials (5,000 packets $.52) @ $ 2,600

Labor (850 hours @
$6 per direct labor hour) 5,100
Overhead 9,200

Total $16,900

$16,900
„^-, ,
^ —
4,800 blood tests
= ^- ^»
$3.52 average cost per
blood test

Required: Two-variance analysis for materials, labor, and overhead.

7. Variance Analysis: Materials, Labor, and Overhead. The Highway Repair

Fund of the State of Ohio employs a standard cost system in accounting for its
expenditures. The standards were established by the engineers of the Capital
Improvements Department of the state on the basis of "per cubic yard" of
materials used.

Based on normal highway repair of 30,000 cubic yards per month, the
standards are:

Materials ($5 per cubic yard) $5.00

Labor (Vz hour at $2) 1.00

Overhead
Fixed ($1 per direct labor dollar) 1 .00*
Variable ($1 per direct labor dollar) 1 .00

Standard cost per cubic yard $8.00

*Total fixed overhead, $30,000.

The actual expenditures incurred for January were :

Materials (33,000 cubic yards) $168,300

Labor (17,000 hours) 33,150
Overhead 66,000

Required: An analysis of the materials, labor, and overhead variances,

using the two-variance method for overhead.
 :

606 CONTROLLING COSTS AND PROFITS PART VI

8. iFactory Overhead Variance Analysis. The Cherokee Corporation uses a

standard cost system. The following overhead costs and production data are
available for one of the producing departments:
Factory overhead in process at beginning
(6,000 standard direct labor hours) $13,200
Actual overhead for the month $90,230

Overhead budgeted for the month:

Fixed overhead $8,000
Variable overhead $2 per direct labor hour

Normal monthly direct labor hours 40,000

Actual direct labor hours worked 40,300
Standard (or allowed) direct labor hours
for the work completed and transferred out 39,500
Factory overhead in process at end of month 5,500 standard direct
labor hours

Required: (1) The standard factory overhead rate.

(2) The standard direct labor hours worked.
(3) The work in process factory overhead account showing the appropriate
debit and credit postings and the final inventory.
(4) The amount of the volume variance.

9. Variance Analyses: Materials, Labor, and Factory Overhead; Process Cost

Procedure. The Redman Company manufactures a product whose standard
product cost is as follows
Direct materials —24 kilograms (kg.) @ $3.00 per kg $72.00
Direct labor — 6 hours («; 3.25 per hour 19.50
Factory overhead — 6 hours (& .75 per hour 4.50
Total unit standard cost $96.00

The factory overhead was based on the following flexible budget:

80% 90% 100%, 110%

Hours (direct labor) 36,000 40,500 45,000 49,500

Variable expenses $18,000 $20,250 $22,500 $24,750

Fixed expenses 11,250 11,250 11,250 11,250
Total factory overhead $29,250 $31,500 $33,750 $36,000

Actual data for the month of November:

Planned production, 7,500 units.

Materials put into production, 192,410 kg. @
$3.04 per kg. (average cost).
Direct labor, 46,830 hours (§ $3.30 average labor cost.
Actual factory overhead, $36,340.

Other data:
Opening inventory, work 80 units, all materials,
in process, 50% converted.
Closing inventory, work 100 units, all materials,
in process, 50% converted.
Started in process during November, 7,850 units.

Required: A variance analysis of (a) the direct materials, (b) the direct labor
cost, and (c) the factory overhead (two-variance method).
 : : : :

CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 607

10. Variance Analyses — Materials, Labor, and Factory Overhead. The Brad-
town Furniture Company uses a standard cost system in accounting for its
production costs.

The standard cost of a unit of furniture follows

Lumber, 100 feet @ $150 per 1,000 feet $15.00

Direct labor, 4 hours @ $2.50 per hour 10.00
Factory overhead:
Fixed (30% of direct labor) $3.00
Variable (60% of direct labor) 6.00 9.00
Total unit cost $34.00

The following flexible monthly overhead budget is in effect

Direct Labor Hours Budgeted Overhead

5,200 $10,800
4,800 10,200
4,400 9,600
4,000 (normal capacity) 9,000
3,600 8,400

The actual unit costs for the month of December were as follows

Lumber used (110 feet @

$120 per 1,000 feet) $13.20
Direct labor (4}i hours @
$2.60 per hour) 1 1 .05
Factory overhead ($10,560 ^ 1,200 units) 8.80

Total actual unit cost $33.05

Required: An analysis of each element of the total variance from standard

cost for the month of December. Use the two- and the three-variance method
for factory overhead.
(AICPA adapted)

11. Quantity and Equivalent Production Schedules; Cost Variance Analyses.

The Rudell Corporation operates a machine shop and employs a standard
cost system. In September the firm was the low bidder on a contract to deliver
600 kartz by November 15 at a contract price of $200 each. Rudell's estimate
of the costs to manufacture each kartz was

40 lbs. of materials @
$1.50 per lb $ 60
20 hours of direct labor @
$2 per hour 40
Factory overhead (40% variable) 30

Total cost $130

On September 1the contract was obtained, 30 completed kartz were

when
still in work 70 kartz were in process with 2,800 lbs. of materials at
in process;
a cost of $4,200 and 60% processed; and 2,000 pounds of materials at a cost of
$3,000 were in raw materials inventory. All costs were at standard. In Septem-
ber, 500 kartz were started in production 480 kartz were transferred to finished
;

goods inventory. The work in process inventory at September 30 was 10%

processed with all materials added at the start of production. The materials
inventory is priced under the fifo method at actual cost.
608 CONTROLLING COSTS AND PROFITS PART VI

The following information is available for the month of September:

Materials purchased:

Pounds Amount
8,000 $12,000
8,000 12,000
4,000 5,600

Materials requisitioned and put into production: 21,000 lbs.

Direct labor payroll amounted to $18,648 for 8,880 hours.

Factory overhead was applied on the basis of allowed standard hours. Actual
factory overhead incurred was $13,140. Standard normal capacity was esti-
mated at 400 kartz per month.

Required: (1) A
quantity schedule.
(2) An equivalent production schedule.
(3) Variance analysis of (a) direct materials, (b) direct labor, and (c) factory
overhead using the two-variance method.
(AICPA adapted)

12. Price, Mix, and Yield Variances. The Zorba Manufacturing Company uses
a standard cost system. The standard cost card for one of its products shows
the following materials standards:

Material
Kilograms
(kg.)
 : :

610 CONTROLLING COSTS AND PROFITS PART VI

runs of 1,200 quarts each. The standard product mix for making 1,200 quarts of
Datrex is

Material R: 700 quarts (« $.25 per quart

Material S: 600 quarts ^i .20 per quart
Material T: 200 quarts C" .45 per quart

December's production of 6,000 quarts was as follows:

Material Actually Used Actual Price

R 3,400 quarts $.26 per quart

S 2,900 quarts .22 per quart
T 1,300 quarts .40 per quart

Required: The materials price, mix, and yield variances for Trexamatic's
December production run.

PROBLEMS
Wherever variances are required in the following problems, indicate
whether they are favorable or unfavorable.

19-1. Standard Cost Statement; Final Bid Price. The Arkansas Packaging
Corporation proposes to manufacture a standard box. Operations will be: (a)
cutting the plywood in Department 1, (b) assembling in Department 2, and (c)
attaching a purchased mechanism in Department 3.

Specifications and Standards

Dimensions of box with cover: 2' x 3' x U2'
Plywood to be purchased in panels 4' x 6' (In setting standard quantities of
plywood, allow for unavoidable waste.)
Quantity to be manufactured: 20,000 boxes
Bid price to be cost plus 10% profit

Price of plywood : $256 per M (thousand) square feet

Other materials required:

Corner angles, hinges, and handles in Department 2 ... .$6.30 per set
Mechanism Department
in 3 9.20 each
Screws, rivets, and glue:
Used in Department 2 34
Used in Department 3 10

Labor and factory overhead

Time Rate per Hour Factory Overhead

Department 1 .085 hour $2.40 100% direct labor cost

Department 2 1.100 hour 2.20 150% direct labor cost
Department 3 .250 hour 1.60 75% direct labor cost

Actual Performance

Purchased: 25,500 spruce plywood panels, 4' x 6' @ $256 per M sq. ft.

20,250 sets hardware $131,625

20,300 mechanisms 183,512
CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 611

Issued from stock: 18,928 ply panels

12,130 setshardware
10,064 mechanisms
$5,280 screws, etc.

Analysis of labor and factory overhead:

 : :

612 CONTROLLING COSTS AND PROFITS PART VI

Factory Overhead:
Compounding $3.00 per standard labor hour
Filling and packing $1.75 per standard labor hour
plus $.95 per gross

Required: (1) A standard cost sheet for one gross bottles of this product,
arranging the data under the five subheadings listed above. Calculations should
be made to the nearest cent per gross.
(2) The company expected to produce 1,000 gross of Lanosof Lotion in its
first week of production, but actually produced only 850 gross. Its direct la-
bor cost of filling and packing was: 825 hours —
$1,467.75. Prepare an analysis
of the labor variance from standard.
(AICPA adapted)

19-3. Materials and Labor Variance Analysis. The Emmerich Manufacturing

Company uses a standard cost system in accounting for the cost of its single
product. The standard was set as follows:
Standard output per month, 10,000 units
Standard direct labor per unit, 8 hours @ $1.30 per hour

Standard direct materials per unit:

Material P — 10 kilograms @ $.275 per kilogram

Material Q — 5 units @ $.64 per unit
Total standard cost per unit including overhead on a direct labor hour
basis, $23.55.
The following operating data were taken from the records for March:
In process of month, none
first
Completed during month, 8,000 units
In process end of month, 1,000 units, which are one-half complete as to labor
and overhead and have had all of Material P issued for them and sufficient
Material Q for one half of them.
Direct labor was $88,440, which was at a rate of $1.32 per hour.
Materials issued to production
94,000 kilograms of P @ $.26 per kilogram
42,600 units of Q @ $.65 per unit
Overhead for the month amounted to $61,640.

Required: A
schedule showing the variance of actual cost from standard cost
and an analysis of variances for labor and materials, separating each into the
factors that caused them. Compute two variances for each material and two
variances for labor. Show all computations.
(AICPA adapted)

19-4. Materials, Labor, and Overhead Variance Analysis. St. Paul Foundry,
Inc. produces gray iron castings for customers on a job-shop basis.
Raw materials necessary for production at standard costs are

Materials Standard Cost

Scrap iron $56.00 per gross ton (2,240 lbs.)
Pig iron 67.20 per gross ton
Coke 70.00 per ton (2,000 lbs.)
Flux 20.00 per ton
CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 613

Raw materials are loaded into the cupola in 500-lb. "charges" consisting of:

Materials Quantities

Scrap iron 425 lbs.

Pig iron 20 lbs.
Coke 45 lbs.
Flux 10 lbs.

500 lbs.

A "charge" is a load of materials dumped into the cupola.

The standard yield ofgood iron per charge is 430 lbs.
During the month, 600 charges were melted and yielded the standard amount
of good castings. The following amounts of raw materials were requisitioned
and used during the month:

Raw Materials Quantities Actual Cost

Scrap iron 256,800 lbs. $ 7,704.00
Pig iron 12,600 lbs. 315.00
Coke 26,400 lbs. 1,056.00
Flux 6,000 lbs. 60.00

The standard labor rate was $2.50 per hour, and 3,200 hours should have
been worked based on the production for this month. Actual direct labor cost
was $7,824 for an actual average labor rate of $2.40 per hour.
Total annual factory overhead including fixed overhead is $200,000 to be
applied on the basis of estimated 40,000 direct labor hours. The variable over-
head rate is $2.60 per direct labor hour. Actual overhead during January was
$15,800.

Required: (1) Materials price and quantity variances for each material.
(2)Labor rate and efficiency variances.
(3) Overhead variances (two-variance method).
(4) Standard materials cost per pound of iron (materials cost only) carried
to three decimal places.

19-5. Standard Cost Variances Analysis. The Tryon Manufacturing Company

manufactures the product TRYAD in standard batches of 100 units. A standard
cost system is used. The standard costs for a batch are:

Raw materials (70 lbs. @

$.50 per lb.) $ 35
Direct labor (40 hours @
$2.75 per hour) 110
Factory overhead (40 hours @
$1 .75 per hour) 70

Total standard cost per batch of 100 units $215

Production for November amounted to 210 batches. Relevant statistics are:

Normal capacity per month 24,000 units

Raw materials used 14,500 lbs.

Cost of raw materials used $ 8,000

Direct labor cost (8,600 hrs.) 23,000
Actual factory overhead 1 5,000

Fixed factory overhead at normal capacity 7,200

 . :

614 CONTROLLING COSTS AND PROFITS PART VI

The management has noted that actual costs per batch deviate from standard
costs per batch.

Required: A
variance analysis for materials, labor, and factory overhead
using the two- and three-variance methods for overhead.
(AICPA adapted)

19-6. Total, Labor, and Factory Overhead Spending Variance Analysis. The
Groomer Company manufactures two products, Florimene and Glyoxide, that
are used in the plastics industry. The company uses a standard cost system.
Selected data follow:

Florimene Glyoxide
Data on standard costs:
Raw materials per unit. . . 3 lbs. (q: $1 per lb. 4 lbs. @ $1.10 per lb.
Direct labor per unit 5 hrs. (S $2 per hr. 6 hrs. @ $2.50 per hr.
Variable factory overhead
per unit $3.20 per direct labor hr. $3.50 per direct labor hr.

Fixed factory overhead

per month $20,700 $26,520

Normal activity per month. 5,750 direct labor hrs. 7,800 direct labor hrs.

Units produced in September: 1,000 units 1,200 units

Costs incurred in September:

Raw materials 3,100 @ $.90 per lb.
lbs. 4,700 lbs. @ $1.15 per lb.

Direct labor 4,900 hrs. @ $1.95 per hr. 7,400 hrs. (« S2.55perhr.

Variable factory overhead. $16,170 $25,234

Fixed factory overhead . . $20,930 $26,400

Required: Select the correct answer for each of the following statements.
Support each answer with computations that are clearly labeled.
(a) The total variances to be explained for both products in September are:
(1) Florimene, $255 (favorable); Glyoxide, $909 (unfavorable).
(2) Florimene, $7,050 (favorable); Glyoxide, $6,080 (favorable).
(3) Florimene, $4,605 (favorable); Glyoxide, $3,131 (favorable).
(4) Florimene, $2,445 (unfavorable); Glyoxide, $2,949 (unfavorable).
(5) none of the above.

(b) The labor efficiency variances for both products in September are:
(1) Florimene, $195 (favorable); Glyoxide, $510 (unfavorable).
(2) Florimene, $1,700 (favorable); Glyoxide, $1,000 (favorable).
(3) Florimene, $200 (favorable); Glyoxide, $500 (unfavorable).
(4) Florimene, $195 (favorable); Glyoxide, $510 (favorable).
(5) none of the above.

(c) The labor rate variances for both products in September are
(1) Florimene, $245 (favorable); Glyoxide, $370 (unfavorable).
(2) Florimene, $200 (favorable); Glyoxide, $500 (unfavorable).
(3) Florimene, $1,945 (favorable); Glyoxide, $630 (favorable).
(4) Florimene, $245 (unfavorable); Glyoxide, $370 (favorable).
(5) none of the above.
 : ,

CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 615

(d) The spending variances for variable factory overhead for both products
in September are:
(1) Florimene, $720 (unfavorable); Glyoxide, $786 (favorable).
(2) Florimene, $167 (unfavorable); Glyoxide, $35 (unfavorable).
(3) Florimene, $170 (unfavorable); Glyoxide, $34 (unfavorable).
(4) Florimene, $1,900 (favorable); Glyoxide, $1,960 (favorable).
(5) none of the above.
(AICPA adapted)

19-7. Variance Analyses; Unit Manufacturing Cost. Bronson Company manu-

factures a fuel addhive with a stable selling price of $40 per drum. Since the
company lost a government contract, it has been producing and selling 80,000
drums per month (50% of normal capacity). For the coming fiscal year, man-
agement expects to increase production to 140,000 drums per month.
The following facts about the company's operations are available:
(a) Standard costs per drum of product manufactured:
Materials:
8 gallons of Miracle Mix $16
1 empty drum 1

"$17

Direct labor — 1 hour $5

Factory overhead $6

(b) Costs and expenses during September, 19 —

Miracle Mix:
500,000 gallons purchased @ $950,000; 650,000 gallons used

Empty drums:
94,000 purchased @ $94,000; 80,000 used

Direct labor:
82,000 hours worked @ $414,100

Factory overhead:
Depreciation of building and machinery (fixed) $210,000
Supervision and indirect labor (semivariable) 460,000
Other factory overhead (variable) 98,000
Total factory overhead $768,000

(c) Other factory overhead was the only actual factory overhead cost that
varied from the overhead budget allowance for the September, 19 —
level of actual production; other actual factory overhead was $98,000,
and the budgeted amount was $90,000.
(d) At a normal capacity of 160,000 drums per month, supervision and in-
direct labor costs are expected to be $570,000. All cost functions are
linear.
(e) None of the September, 19 —
cost variances is expected to occur
,

proportionally in future months. For the coming fiscal year, the Cost
Standards Department expects the same standard usage of materials
and direct labor hours. The average prices expected are: $2.10 per
gallon of Miracle Mix, $1 per empty drum, and $5.70 per direct labor
 :

616 CONTROLLING COSTS AND PROFITS PART VI

hour. The current flexible budget of factory overhead costs is considered

appHcable to future periods without revision.
(f) September, 19 — ,
production was 80,000 drums.

Required: (1) Variance analyses for September, 19 —

(a) materials purchase
:

price variance, (b) materials quantity (or usage) variance, (c) labor rate variance,
(d) labor efficiency (time or usage) variance, (e) controllable variance and
volume variance for factory overhead.
(2) The actual manufacturing cost per drum of product expected at produc-
tion of 140,000 drums per month, using these cost categories: materials, direct
labor, fixed factory overhead, and variable factory overhead.

(AICPA adapted)

19-8. Reconstruction of Records; Variance Analysis; Standard Cost Sheet. The

Sharpstown Company lost most of its factory cost records early in February,
19B, due to a fire.
The trial balance of the factory ledger at December 31, 19A follows:
Debit Credit

Inventories: Raw Materials $ 54,000

Finished Goods 65,900
Work in Process ——
General Ledger $119,900
$119,900 $119,900

All payments on behalf of the factory are made by the home office.

A
copy of the January 19B standard cost variance report was found showing
the following data:
Unfavorable Favorable

Raw materials — price variance $2,000

— quantity variance $ 480
Direct labor — rate variance 3,000
— efficiency variance 1 ,250

Factory overhead — spending variance 1 ,000

— capacity variance
idle 3,000
— efficiency variance 1,000

The executive to whom the variance report had been sent noted beside the
spending variance "Budget Allowance for January, $26,000" and wrote on the
top of the report "January Production, 25,000 units."
The following additional facts are made available
(a) Standard costs are revised annually at the beginning of each fiscal year. The
figures in the trial balance reflect 19B standards.
(b) The actual direct labor costs for January 19B were $33,000 based on 12,000
actual hours worked. This information as well as the fact that actual hours or
production represent 80*^ of normal hours or production was obtained from
the Payroll Department of the home office.
(c) The supplier of the single raw material used mailed copies of the January
invoices indicating that 25,000 units had been purchased at a cost of $38,000.
One unit of production requires two units of raw materials.
(d) Raw materials are carried at standard cost. No change was made at Janu-
ary 1, 19B.
 : . : .

CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 617

(e) Overhead is applied to production on the basis of standard direct labor hours.

(f) Sales in January 19B were 28,000 units.

(g) All production was completed in January 19B and forwarded to the finished
goods warehouse.

Required: (1) A detailed variance analysis of the three cost elements.

analysis method for factory
(2) The budget allowance if the two-variance
overhead had been used.
(3) The 19B product standard cost sheet.

19-9. Standard Costs for Lots; Variance Analysis of Cost Elements. Vincenti
stores.
Shirts, Inc. manufactures short- and long-sleeve men's shirts for large
Vincenti produces a single quality shirt in lots to each customer's order and
attaches the store's label to each. The standard costs for a dozen long-sleeve
shirts are

Direct materials 24 meters @ $ .55 $13.20

Direct labor 3 hours @ $2.50 7.50
Factory overhead 3 hours @ $2.25 6.75

Standard cost per dozen %HA5

During October, 19—, Vincenti worked on three orders for long-sleeve

shirts.Job cost records for the month disclose the following:

Lot Units in Lot Materials Used Hours Worked

30 1 000 dozen 24,100 meters 3,000 hours

31 1,650 " 40,440 " 5,130 "
32 1,200 " 28,750 " 2,870 "

The following information is also available

(a) Vincenti purchased 96,000 meters of materials during October at a cost of

$53,200. The materials price variance is recorded when goods are purchased
and all inventories are carried at standard cost.
(b) Direct labor incurred amounted to $28,600 during October. According to
payroll records, production employees were paid $2.60 per hour.

(c) Overhead is applied on the basis of direct labor hours. Factory overhead
totaling $25,500 was incurred during October.
(d) A total of $324,000 was budgeted for factory overhead for the year 19—, based
on estimated production at the plant's normal capacity of 48,000 dozen shirts
per year. Overhead is 40% fixed and 60% variable at this level of production.
(e) There was no work in process at October 1. During October Lots 30 and 31
were completed all materials were issued for Lot 32, and it was 80% completed
;

as to labor.

Required: (1) A
schedule computing the standard cost for October, 19—, of
Lots 30, 31, and 32.
(2) schedule computing the materials price variance for October, 19
A —
(3) For each lot produced during October, 19—, schedules computing the
(a) materials quantity variance in meters; (b) labor efficiency variance
in hours;

and (c) labor rate variance in dollars.

(4) Aschedule computing the total controllable and volume overhead
variances for October, 19 —
(AICPA adapted)
 :

618 CONTROLLING COSTS AND PROFITS PART VI

19-10. Materials Price, Quantity, Mix, and Yield Variance Analysis. Sudsall
Corporation manufactures a laundry detergent that requires three major
components —
A, B, and C.

A standard unit of input of 125 kilograms (kg.) consists of:

Material A 50 kilograms @ $ .80 per kg. $ 40.00

Material B 50 " @ .70 " 35.00
Material C 25 " @ 1.00 " 25.00
125 kilograms $100.00

A 20% shrinkage of the material put in process has been experienced.

Shrinkage takes place in the early stages of the process, so that any work in
process inventory will be considered completely shrunk.

The following data are available for the month of November

Work in process inventory, November 1 3,000 kg.

Input during the month:

Material A 4,800 kilograms @ $.84 actual cost

Material B 5,400 " @ .71
Material C 2,500 " @ .99

Output:

Finished product 9,900 kg.

Work in process inventory, November 30 3,200 kg.

Required: All materials variances, including the total quantity variance an-
alyzed as to mix and yield components, for November.

19-11. Price, Mix, and Yield Variances. Chocolate manufacturing operations

require close control of the daily production and cost data. The computer
printout for a batch of one ton of cocoa powder indicates the following materials
standards:

Quantities Unit Mix

Ingredients {Pounds) Cost Cost

Cocoa beans 800 $.45 $ 360

Milk 3,700 .50 1,850
Sugar 500 .25 125

Total batch 5,000 $.467 (weighted average) $2,335

On December 7, the company's Commodity Accounting and Analysis Section

reported the following production and cost data for the December 6 operations.

Ingredients put in process:

Cocoa beans 225,000 lbs. @ $.425 per lb. $ 95,625
Milk 1 ,400,000 lbs. @ .533 per lb. 746,200
Sugar 250,000 lbs. @ .240 per lb. 60,000
1,875,000 lbs. $901,825

Transferred to cocoa powder inventory: 387 tons

No work in process inventory
Required: Materials price, mix, and yield variances.
 : :

CH. 19 STAND. COSTING: SETTING STANDS.; ANALYZING VARIANCES 619

19-12. Materials, Mix and Yield, Labor, and Overhead Variances. The Brandon
Cement Manufacturing Company uses a standard cost system for its production
of cement. Cement is produced by mixing two major raw material components,
A (lime) and B (clay), with water and by adding a third raw material component
C, quantitatively insignificant.

Materials standards and cost for the production of 100 tons output are:
Percent of
Components Tons Cost Input Quantity Amount
Material A 55 $43.00 50% $2,365
Material B 44 35.00 40% 1,540
Material C _n_ 25.00 10% 275
Input 110 100% $4,180 = $38.00 per ton
Output 100 4,180 = $41.80 per ton

The monthly factory overhead budget for a normal capacity level of 16,500
direct labor hours is as follows

Fixed Overhead Variable Overhead

Plant manager $ 2,000

Supervisors 1 ,800

Indirect labor 2,220 $ 810

Indirect supplies 850 2,040
Power and light 300 2,200
Water 480 2,000
Repairs and maintenance 500 1,200
Insurance 450
Depreciation —production facilities. 3,775

Total $12,375 $8,250

To convert 1 10 tons of raw materials into 100 tons of finished cement requires
500 direct labor hours at $2.50 per direct labor hour or $12.50 per ton. Factory
overhead is applied on a direct labor hour basis.

Actual data for the month of April

Production of 3,234 tons of finished cement, with costs as follows:

Direct labor 15,800 hrs. @ $2.65 per hr.

Fixed factory overhead $1 1,075

Variable factory overhead $ 8,490

Materials Purchased Materials Requisitioned

Price
Quantity per Ton Quantity

Material A 2,000 tons $44 1,870 tons

Materials 1,200 tons 37 1,100 tons
Material C 500 tons 24 440 tons

No inventories of raw materials or work in process at the beginning of the

month of April existed. The materials price variance is assumed to be realized at
time of purchase.

Required: (1) Materials price, mix, and yield variances.

(2) Direct labor rate, efficiency, and yield variances.
(3) Factory overhead spending, idle capacity, efficiency, and yield variances.
 CHAPTER 20

STANDARD COSTING:
ACCUMULATING, REPORTING,
AND EVALUATING COSTS
AND VARIANCES

Standard costs should be incorporated into the regular accounting

system. The incorporation of standard costs into the records gives full
recognition to the true meaning of standard cost accounting. It permits
the most efficient use of a standard cost system and leads to a tie-in
with the accounting system as a whole, thereby making for savings and
increased accuracy in clerical work. Some companies prefer to keep stan-
dard costs for statistical purposes only. In either case, however, variances
can be analyzed for cost control; and standard costs can be used in devel-
oping budgets, bidding on contracts, and setting prices.

STANDARD COSTING METHODS

Standard costs should be viewed as costs which pass through the data
processing system into financial statements. Variations exist in the data
accumulation methods adopted for standard costs. Some systems employ
the partial plan, others the single plan. Both plans center around the
entries to the work in process account and under both the work in process
account can be broken down either by individual cost elements (materials,
labor, and factory overhead) and /or by departments.

The Partial Plan. In the partial plan the work in process account is

debited for the actual cost of materials, labor, and factory overhead and

620
CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 621

The Partial Plan The Single Plan

WORK IN PROCESS WORK IN PROCESS

Actual
cost
 : : : :

622 CONTROLLING COSTS AND PROFITS PART VI

3. Use a combination of the two methods in ( 1

) and (2). Calculate variances
when the materials are received, but defer charging variances to produc-
tion until the materials are actually placed in process. At that time only
the variance applicable to the quantity used will appear as a current
charge, the balance remaining as a part of the materials inventory. This
method results in two types of materials price variances: (1) a materials
purchase price variance originating at the time materials purchases are
first recorded and (2) a materials price usage variance arising at the time

materials are used; the occurrence of the materials price usage variance
is a reduction of the materials purchase price variance.

For control purposes the price variance should be determined at the

time the materials are received. If it is not computed and reported until

the materials are requisitioned for production, then remedial action is dif-

ficult because the time of computation is so far removed from the time
of purchase.

Illustrations. These different methods for recording materials pur-

chased are illustrated below. The data used for these methods are identical
with that used in the previous chapter

Standard unit price as per standard cost card $2.50

Purchased 5,000 pieces (q} $2.47
Requisitioned 3,550 pieces
Standard quantity allowed for actual production 3,500 pieces

Method 1. The journal entry at the time materials are received is:

Materials 12,500
Accounts Payable 12,350
Materials Purchase Price Variance 150

When materials are issued to the factory, the entry is

Work in Process 8,750

Materials Quantity Variance 125
Materials 8,875

Method 2. At the time materials are received, the entry is

Materials 12,350
Accounts Payable 12,350

No variance is computed. However, when materials are issued, the

journal entry is

Work in Process 8,750.00

Materials Quantity Variance 125.00
Materials 8,768.50
Materials Price Usage Variance 106.50
 : :

CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 623

Computations for this entry are

Pieces X Unit Cost = Amount

Actual quantity used 3,550 $2.47 actual $8,768.50
Actual quantity used 3,550 2.50 standard 8,875.00
Materials price usage variance 3,550 $(.03 ) $ (106.50) Credit or
~ favorable
Pieces X Unit Cost = Amount
Actual quantity used 3,550 $2.50 standard $8,875.00
Standard quantity allowed 3,500 2.50 standard 8,750.00
Materials quantity variance 50 $2.50 standard $ 125.00 Debit o/-
- unfavorable

In this method the materials price usage variance account appears on

the books after the materials are issued, and then only for the quantity
issued — not for the entire purchase. For this computation, the actual
cost used is $2.47 per piece. As no other cost is available and no other
purchases were made, this cost is correct. In practice, the actual cost used
would depend upon the type of inventory costing method employed, such
as fifo, lifo, or average costing.
The price variance occurred because the materials were purchased at
$.03 less than the standard price; the quantity variance because 50 pieces
were used in excess of the standard quantity allowed.

Method 3. This entry, identical with the first entry in Method 1, would
be made when the materials are received:
Materials 12,500
Accounts Payable 12,350
Materials Purchase Price Variance 1 50

When the materials are issued, two entries are made

Work in Process 8,750
Materials Quantity Variance 125
Materials 8,875

This entry recognizes the 50 pieces used beyond the standard quantity.
Materials Purchase Price Variance 106.50
Materials Price Usage Variance 106.50

This entry transfers $106.50 from the purchase price variance account
to the materials price usage variance account. Any balance remaining in
the materials purchase price variance account at the end of the accounting
period is used to adjust the inventory valued at standard cost to actual
cost. This balance takes on the aspect of a valuation account. The balance
sheet would show:
Materials (at standard cost) $3,625.00
Less materials purchase price variance 43.50
Materials (adjusted to actual) $3,581.50
624 CONTROLLING COSTS AND PROFITS PART VI

STANDARD COST ACCOUNTING PROCEDURES

FOR LABOR
As is computed on the basis
stated in the labor chapters, the payroll
of clock cards, job and other labor time information furnished to
tickets,

the payroll department. These basic records supply the data for the com-
putation of the labor variances in connection with standard costs.
The necessary journal entries are illustrated with the data used in the
previous chapter; i.e.:

Actual hours worked 1 ,880 hours

Actual rate paid $6.50 per hour

Standard hours allowed for actual production 1,590 hours
Standard rate $6 per hour

The following journal entry is made to set up the total actual direct
labor payroll, assuming there were no payroll deductions:
Payroll 12,220
Accrued Payroll 12,220

To distribute the payroll and to set up the variance accounts, the

journal entry is:

Work in Process 9,540

Labor Rate Variance 940
Labor Efficiency Variance 1,740
Payroll 12,220

STANDARD COST ACCOUNTING PROCEDURES

FOR FACTORY OVERHEAD
As explained in the previous chapter, factory overhead variances can
be computed by employing the two-variance, three-variance, or four-
variance methods.
Standard costs and budgetary control methods are closely related,
a relationship that is particularly important for the analysis of factory
overhead. Actual factory overhead is measured not only against the
applied overhead cost, but also against a budget prepared at the beginning
of the fiscal period and based on the capacity at which the company
expects to operate during the period as well as against actual and standard
activity allowed for actual production.
Again, the data in Chapter 19 are used to illustrate the journal entries:
Direct Overhead
Labor Total Rate
Hours Overhead per Hour
Normal capacity 4,000 S8,000 $ 2.00

Consists of: Fixed overhead $3,200 $ . 80

Variable overhead 4,800 1.20

Actual direct labor hours and actual overhead . . 3,475 $7,384

Standard hours allowed for actual production . . 3,400
 . : : : : :

CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 625

Two-Variance Method. The entries are :

1 For actual factory overhead

Factory Overhead Control 7,384
Various Credits 7,384

2. When overhead is applied to work in process:

Work in Process 6,800

Factory Overhead Control 6,800

(If the factory overhead applied account is used, it is subsequently transferred

to the factory overhead control account.)

3. The factory overhead control account now has a debit balance of $584
which can be analyzed and closed out as follows
Controllable Variance 104
Volume Variance 480
Factory Overhead Control 584

Three-Variance Method. The entries are

1. For actual factory overhead:

Factory Overhead Control 7,384
Various Credits 7,384

2. When overhead is applied to work in process:

Work in Process 6,800

Efficiency Variance 150
Factory Overhead Control 6,950

3. The factory overhead control account now has a debit balance of $434
which can be analyzed as spending and idle capacity variances and closed
as follows

Spending Variance 14
Idle Capacity Variance 420
Factory Overhead Control 434

As an alternative, Entry 2 may be recorded as a debit to Work in Pro-

cess and as a credit to Factory Overhead Control for $6,800. The balance
in Factory Overhead Control of $584 would then be closed as follows:
Spending Variance 14
Efficiency Variance 50
1

Idle Capacity Variance 420

Factory Overhead Control 584

Four-Variance Method. The entries are

1. For actual factory overhead:

Factory Overhead Control 7,384
Various Credits 7,384
 :

626 CONTROLLING COSTS AND PROFITS PART VI

2. When overhead is applied to work in process:

Work in Process 6,800
Variable Efficiency Variance 90
Fixed Efficiency Variance 60
Factory Overhead Control 6,950

3. The factory overhead control account now has a debit balance of $434,
which can be analyzed as spending and idle capacity variances and closed
as follows:

Spending Variance 14
Idle Capacity Variance 420
Factory Overhead Control 434

As an alternative, Entry 2 may be recorded as a debit to Work in Pro-

cess and Overhead Control for $6,800. The balance
as a credit to Factory
in Factory Overhead Control of $584 would then be closed as follows:

Spending Variance 14
Variable Efficiency Variance 90
Fixed Efficiency Variance 60
Idle Capacity Variance 420
Factory Overhead Control 584

STANDARD COST ACCOUNTING PROCEDURES

FOR COMPLETED PRODUCTS
Completion of production requires the transfer of costs from the work
in process account to the work in process account of another department;
or, in the case of the last department, to the finished goods account.
Transfers are at standard costs.
The journal entry for the transfer of finished products is as follows:

Finished Goods (at standard cost) xxxx

Work in Process (at standard cost) xxxx

The finished goods ledger card will show quantities only because the
standard costs of the units remain the same during a period unless severe
cost changes occur. When goods are shipped to customers, the entry is:

Cost of Goods Sold (atstandard cost) xxxx

Finished Goods (at standard cost) xxxx

JOURNAL ENTRIES FOR MIX AND YIELD VARIANCES

The journal entries for the mix and yield variances computed in the

previous chapter are

Entries for Direct Materials.

1. To record materials purchases:

Materials 55,700
Accounts Payable 55,000
Materials Purchase Price Variance 700
CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 627

2. To charge materials into production:

Work in Process 57,750
Materials Mix Variance 300
Materials 58,050

3. To transfer materials cost to finished goods:

Finished Goods 60,000
Materials Yield Variance 2,250
Work in Process 57,750

Entries for Direct Labor Cost.

1. To set up payroll liability:

Payroll 23,104
Accrued Payroll 23,104

2. To transfer payroll to work in process and to isolate variances:

Work in Process 23,100
Labor Rate Variance 304
Labor Efficiency Variance 300
Payroll 23,104

3. To transfer labor cost to finished goods:

Finished Goods 24,000
Labor Yield Variance 900
Work in Process 23,100

Entries for Factory Overhead (Tn'o-Variance Method).

1. To record actual overhead:

Factory Overhead Control 22,000
Various Credits 22,000

2. To apply factory overhead to products:

Work in Process 19,250
Factory Overhead Control 19,250

3. To set up controllable and volume variances:

Controllable Variance 2,300
Overhead Volume Variance 450
Factory Overhead Control 2,750

4. To transfer factory overhead to finished goods:

Finished Goods 20,000
Overhead Yield Variance 750
Work in Process 19,250

It should be noted that Work in Process is debited for the standard

production (yield) that should be attained from the input into the system
and not for the standard for the amount of actual production (output).
 .

628 CONTROLLING COSTS AND PROFITS PART V!

The resulting difference is the yield variance for each cost element. When
the transfer of the finished products to the warehouse or stockroom is re-

ported to the cost department, one compound journal entry in place of the
three individual entries for each element, as shown above, could be made:
Finished Goods(200,000 lbs. X $.52) 104,000
Work Process (192,500 lbs. expected yield
in X $.52). . 100,100
Yield Variance (7,500 lbs. gain X $.52) 3,900

The $3,900 favorable yield variance is comprised of:

Materials yield variance $2,250 favorable
Labor yield variance 900 "
Overhead yield variance 750 "

Expressed as a percentage, the yield gain is 3.89 percent.

200,000 lbs. ,^,

„^ 7,500 lbs. , „^_
,^^
= ^Q3.89or XlOO = 3.89%
192:500 lbs. j,,;3QQ^,^^

VARIANCE CONTROL AND RESPONSIBILITY

Variances are not ends in themselves. Rather, management scrutinizes
variances in an attempt to answer questions such as "Why did the vari-
ances occur?" And, if variances are unfavorable, "What corrective
actions can be taken?" Questions such as these must be answered if

management is to carry out an effective control process. The extent of

variance investigation should be based on the estimated cost of making
the investigation versus the value of the anticipated benefits. To be of
greatest value, variances should be identified quickly and reported as
frequently as possible (in some instances, daily), for the closer the reporting
to the point of incurrence, the greater the chance for control and remedial
action. Of course, there is no substitute for competent supervision, but
variance reporting should be an aid to the supervisor in carrying out his
control responsibilities.
Variances must be identified with the manager responsible for the
costs incurred. Reasons for the variances should be ascertained and
plans for necessary corrective action made either by discussing possible
causes with the supervisor or by examining underlying data and records.
Likewise, efficient and effective performance should be recognized and
rewarded. One explanation of variances may be out-of-date physical and
monetary standards, a possibility that should be considered here.
The purchasing department carries the primary responsibihty for
materials price variances, and control is obtained by getting several quota-
tions, buying in economical lots, taking advantage of cash discounts,
and selecting the most economical means of dehvery. However, eco-
nomic conditions and unexpected price changes by suppliers may be
CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 629

outside the limits of its control. Internal factors such as costly rush orders
necessitated by sudden changes in production plans requiring materials
at special prices would not be the fault of the purchasing department.
Materials quantity variances may result from many causes. If the
materials are of poor quality, the fault may be with the individual who
prepared the purchase requisition which informed the purchasing depart-
ment concerning the quality of materials to be purchased. If the purchas-
ing department varied from the purchase requisition specifications, the
fault may lie with that department. Or perhaps the faulty materials
resulted from a poor job of inspection when they were received. Other
causes include inexperienced or inefficient workers, faulty equipment,
changes in production methods, or faulty blueprints. The reasons must
be identified if the variances are to have meaning.
Labor rate variances tend to be fairly minor because labor rates are
usually based on union agreements. Rate variances may occur, however,
because of the use of a single average rate for a department, operation, or
craft, while several different rates exist for the individual workers. Then,
too, a worker may be assigned to a task that normally pays a different
rate. In this case the responsibility might be found within the planning or
scheduling of work assignments.
Labor efficiency variances may occur for a multitude of reasons:
faulty materials, inexperienced workers, faulty or poor equipment, equip-
ment breakdowns, changes in production methods, incorrect scheduling,
lack of materials, faulty blueprints. These and many other reasons can
be observed in factories.

Factory overhead variances are of two kinds : variable factory overhead

and fixed factory overhead. The spending or controllable variance is

basically the responsibility of the department head. Differences between

actual cost and the allowed budget figure, in turn, may be caused by
higher prices, different labor rates, etc.The idle capacity or volume
variance is generally ascribed to top management levels. The decision
with regard to the utilization of plant capacity and the setting of the
predetermined overhead rate's volume base rests with the planning group.
However, changes within the range of fixed costs occur due to changes
in depreciation rates, increase in insurance premiums, increases in salaries
of top-level managers, etc. The managerial significance and use of the
spending and idle capacity variances are discussed in more detail in
Chapter 9, pages 229-233. Responsibility for overhead efficiency vari-
ances (both the fixed and variable components) is generally attributed to
the department manager.
No significant variance, whether favorable or unfavorable, should be
without some kind of investigation and critical analysis. An unusual
630 CONTROLLING COSTS AND PROFITS PART VI

favorable variance also signals the need for investigation. Perhaps stan-
dards are out-of-date or the favorable variance more than
offset by a
is

related unfavorable variance (e.g., low cost materials of poor quality) or

necessary activities such as maintenance of equipment are being neglected,
causing lower expenditures and a favorable variance. Of course, man-
agement should use the occurrence of desirable favorable variances as an
opportunity to recognize and reward efficient and effective performance
of responsible managers and workers.
Analysis is necessary to highlight the significance of each variance in
terms of explaining the origin, the responsibility, and the cause of the
variance. Explanations of the reasons for the variances have limited use-
fulness in improving future control of costs because the explanations
seldom suggest corrective action. Variance analysis is not complete until
a decisionis made as to necessary corrective action. The results of imple-

mented corrective action must then be measured and reported,

TOLERANCE LIMITS FOR VARIANCE CONTROL

The control of standard cost variances and their incurrence is expected
However, some variance
to be the responsibility of a designated manager.
in cost measurements can be expected, due to the factors employed in
creating the basic physical and economic standard and the nature of the
variance. With an expected variance in mind, the question must be asked,
"How large a variance from standard should be tolerated before it is con-
sidered abnormal?" In other words, some tolerance limit or range should
be established so that if the cost variance falls within this range, it can be
considered acceptable; if the variance exceeds the range, an investigation
should be made, provided the cost of conducting it is reasonable.
A decision to investigate is based on cost reports indicating incurred
costs and deviations (variances) therefrom. The search for the reasons
for the variance follows the pattern described above whereby a manager
investigates the possible causes of the variance(s). This type of investi-
gation concentrates on the control of processes and individual per-
formances. What is needed now is the calculation of control limits for the
variances from the standard. Past data on established operations, tem-
pered by estimated changes in the future, usually furnish reliable bases for
estimating expected costs and calculating control limits that serve to
indicate good as well as poor periods of operation.

Illustration I. Assume that $10,000 is the value to appear in the factory

overhead budget for maintenance expenses. A significant range should
then be established, based on the assumption that actual maintenance
costs will be larger or smaller than the budget figure. The question is "By
CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 631

how much?" Assume the answer, again based on past experience and

future expectations, to be $2,000; i.e., the figure needed to judge the

±
significance of the cost variance.
indi-
At the end of the month actual maintenance expenses are $14,000
cating a variance of $4,000 ($14,000
- $10,000). Such an answer might
call for further investigation into the
causes of the variance. Suppose,

however, actual expenses are only $10,900. Then the variance

is $900.

at least
This is an acceptable deviation requiring no further
investigation,

at this time.Should the unfavorable variance persist in the next and other
report periods, the causes, which in the cumulative
may be judged signifi-

cant, should be looked into.

in the above
The cost classification, maintenance expenses, is used
example as a fixed cost which assumes that no deviation
from the basic
amount expected as a result of a change in the level of activity. However,
is

this cost is generally classified as a

semivariable expense; i.e., a fixed

amount plus a variable rate which depends, in this case, on direct

labor
between
hours as the source of activity or volume. Then, a relationship
the variance and volume must be established.

Illustration II. Assume a tolerance limit of $3,000 when activity is

10,000 direct labor hours. When direct labor hours increase or decrease,
the tolerance limit is $3,000 ±
$.05 per hour for any diff"erence in 10,000

direct labor hours and standard hours allowed for actual production.
Assuming that $10,000 the budget allowance for 12,700 direct labor
is

hours and the actual cost of $14,000 was incurred when

standard direct

labor hours allowed were 12,700, the tolerance limit would be $3,000 +
$.05(2,700) = $3,135. The $3,135 would be used to evaluate the $4,000
($14,000 - $10,000) variance.
order to
Control and investigation limits should be established in
that each variance is highlighted
present cost and variance information so
in a manner indicating whether or not the
variance is above the upper
control limit.
control limit, within the control limit, or below the lower
to accept
Such information enables the responsible manager or supervisor
valuable tool for the control of costs
the deviations from the standard as a
in his department and lessens the dangers of their being more averse to

risk than upper-level managers prefer. A manager, unduly concerned

about the penalty for even small variances, may perform in a manner that
hampers rather than enhances profitable operations.

DISPOSITION OF VARIANCES
Variances be disposed of in either of the following ways: (1) they
may
may be closed to Income Summary or (2) they may be treated as adjust-
ments to Cost of Goods Sold and to inventories.
 :

632 CONTROLLING COSTS AND PROFITS PART VI

Decisions with respect to the most acceptable treatment of variances

require considerations beyond the mere argument that only actual costs
should be admitted to the financial statements. The determination of an
actual cost is The use of a factory overhead rate as
almost impossible.
practiced in many companies indicates that management has accepted this
procedure and finds it workable. To argue that charging off variances in
which they arise might distort the net income figure reveals
the period in
a misunderstanding of standard costs. The treatment of variances de-
pends upon: (1) type of variance —
materials, labor, or factory over-
head, (2) size of variance, (3) experience with standard costs, (4) cause of
variance (e.g., incorrect standards), and (5) timing of the variance, (e.g.,
an unusual variance caused by seasonal fluctuations).

The disposition of variances can be summarized as follows

1. Any variances which are caused by inactivity, waste, or extravagance

should be written off" They should not be de-
as they represent losses.
ferred by capitalizing them in the inventory accounts. This would in-
clude quantity variances on materials and labor as well as idle time
(capacity) and efficiency variances on overhead.

2. An inventory reserve account should be established and charged with

part of the price (spending and rate) variances to an extent which would
bring the work in process and finished goods inventories up to, but not
in excess of, current market values. The rest of the price (spending and
rate) variance amounts should be written off", as they represent excess
costs. In this way, the inventory accounts themselves will be valued at
standard cost while the inventories on the balance sheet will, as a whole,
be shown at reasonable values through the use of the inventory reserve
account. In addition, losses caused by excessive costs and inefficiencies
will be shown in the operating statement for the period in which they
occur. 1

First Closed to Income Summary. Stating the work in process

Method :

and goods inventories and the cost of goods sold at standard

finished
costs allows comparison of sales revenue and standard cost by product
class. In these circumstances, the accepted procedure for handling cost
variances at the end of the month or year is to consider them as profit or
loss Unfavorable (or debit) manufacturing cost variances are
items.
deducted from the gross profit calculated at standard cost. Favorable (or
credit) variances are added to the gross profit computed at standard cost.
All variances shown on the income statement should be supported by a
variance analysis report. Variances, in effect, represent diflferences be-
tween the actual and standard costs of operations for the month or year.

iW. Wesley Miller, "Standard Costs and Their Relation to Cost Control," NA{C)A Bulletin,
Vol. XXVII, No. 15, p. 692.
 —

CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 633

Income Statement
For Year Ended December 31, 19

Sales ^^2,000
Cost of goods sold (at standard) — see Schedule 1 ^^'^^^
$28,000
Gross profit (at standard)
Adjustments for standard cost variances:
Debit
Balances

$ .200
Materials purchase price variance 1

Labor efficiency variance ^00

Controllable variance 720
Volume variance ^'^00
$ 3,720
Total debit variances .
^'^^^
••••••• $24,280
Gross profit (adjusted)
Less: Marketing expenses i'^iin s nnn
O'*^"^ i6,y}w
i

Administrative expenses
Net operating profit $ ^'^80

Schedule 1

Cost of Goods Sold

For Year Ended December 31, 19—
Materials purchased
^^^'nnn
'^'Q^"
Less inventory (ending)
Materials used ^In aaX
lO'OW
Direct labor
z\j,wu
Factory overhead
$46,000
^^'^^^
Less work in process (ending)
Cost of goods manufactured ^^2 nnn
^'^^^
Less finished goods inventory (ending)
$^4,000
Cost of goods sold

cost variances using this method is de-

The treatment of manufacturing
picted in the income statement illustrated above.
the income
Variance accounts are closed at the end of the period to
summary account by the following entry:
'^"
Income Summary •^'
,
^^.p.
Materials Purchase Price Variance ^
»^"JJ
Labor Efficiency Variance
°"J:
Controllable Variance 'jrJJ
''"^"^
Volume Variance

As an alternative, all variances may be closed to the cost of goods

income summary account. The
sold account rather than directly to the
total amount in Cost of Goods Sold (units sold at standard costs plus the
variances) would then be closed to Income Summary.

I
 :

634 CONTROLLING COSTS AND PROFITS PART VI

Accountants who use the above procedures believe that only standard
costs should be considered true costs. No variance is treated as an in-
crease or decrease in manufacturing costs but as a deviation from con-
templated costs due to abnormal inactivity, extravagance, inefficiencies
or efficiencies, or other changes of business conditions. This viewpoint
leads to debiting or crediting all variances to the income summary account
at theend of the month or at the end of the fiscal period. However,
some proponents of the above procedure suggest that the unused portion
of the materials purchase price variance should be linked with materials
still on hand and shown on the balance sheet as part of the cost of the
ending materials inventory.
If an adjustment is made for the materials purchase price variance
whereby a part of the variance is attached to the materials inventory to
place it on an actual cost basis, the following computation would be made:

Balance in materials inventory = S4,000 or 20'^ of purchases made

Materials purchase price variance = $1,200

20% of $1,200 or $240 of the variance would be transferred to the materials

account.

This method would increase the materials account and lower the cost
of goods sold, increasing the net operating profit from $6,280 to $6,520.
The journal entry would be:
Income Summary 3,480
Materials 240
Materials Purchase Price Variance 1,200
Labor Efficiency Variance 600
Controllable Variance 720
Volume Variance 1 ,200

The treatment of variances illustrated in this section is considered ac-

ceptable by independent auditors as long as standards are reasonably
representative of what costs ought to be.

Second Method: Adjustments to Cost of Goods Sold and Inventories.

A second method used for the distribution of variances distributes them
to inventories and Cost of Goods Sold. Accounting Research Bulletin
No. 43 states with respect to the costing of inventories that
Standard costs are acceptable if adjusted at reasonable intervals to re-
flectcurrent conditions so that at the balance sheet date standard costs
reasonably approximate costs computed under one of the recognized bases.
In such cases descriptive language should be used which will express this
relationship, as, for instance, "approximate costs determined on the first-in,

first-out basis," or, if desired to mention standard costs, "standard

it is

costs, approximating average costs. "^

2AICPA Committee on Accounting Procedures, "Inventory Pricing," Accounting Research

Bulletin No. 43, p. 30.
 :

CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 635

Current Internal Revenue Service regulations require inclusion in

inventories of an allocated portion of significant annual standard cost
variances. Where the amount involved is not significant in relation to
total actual factory overhead for the year, an allocation is not required
unless such allocation is made for financial reporting purposes. Also,

the taxpayer must treat both favorable and unfavorable variances con-
sistently. Regulations, however, do permit expensing of the idle capacity

variance. Cost Accounting Standards Board regulations also require in-

clusion of significant standard cost variances in inventories.
Using the previous figures and other data, the following computations
and prorations would be made when variances are distributed to inven-
tories and Cost of Goods Sold

PERCENTAGE OF COST ELEMENTS IN INVENTORIES

AND COST OF GOODS SOLD
 ——

636 CONTROLLING COSTS AND PROFITS PART VI

Income Statement
For Year Ended December 31, 19

Sales $52,000
Cost of goods sold (standard adjusted to actual) — see Schedule 1 25,800
Gross profit (actual) $26,200
Less: Marketing expenses $12,000
Administrative expenses 6,000 1 8,000
Net operating profit $ 8,200

Schedule 1

Cost of Goods Sold

For Year Ended December 31, 19

Standard Variance Actual

Materials available $20,000 $21,200
Materials purchase price variance $1,200
Less materials inventory (ending) 4,000 4,240
Materials purchase price variance 240

Materials used $1 6,000

Materials purchase price variance
Direct labor 10,000
Efficiency variance
Factory overhead 20,000
Controllable variance
Volume variance
Total manufacturing cost $46,000
Less work in process (ending) 16,000
Cost of goods manufactured $30,000
Less finished goods inventory (ending) 6,000
Cost of goods sold $24,000
 :

CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 637

REVISION OF STANDARD COSTS

Standards should be changed only when underlying conditions change
or when they no longer reflect the original concept. In fact, the idea that
standards should be changed more than once a year can only weaken their
effectiveness and increase operational details. However, standard costs
require continuous review and, at times, frequent change. Events, rather
than time, determine whether standard costs should be revised. Conditions
necessitating revision may be classified as internal or external. Techno-
logical advances, design revisions, method changes, labor rate adjustments,
and changes in physical facilities are among the internal conditions. Ex-
ternal conditions include materials price changes, market trends, customer
special requirements, and changes in the competitive situation. Sometimes
changes have already been incorporated in the standard costs being used
in order to reflect the new conditions. New materials prices and new labor
rates also aff'ect indirect materials prices and indirect labor rates which,
in turn, influence the standard overhead rate. Other overhead costs,
too, may change.
If standard costs are changed at the end of the
fiscal period, the change-
over is comparatively easy. When
such changes are made, any adjustment
to the next period's beginning inventory should be made with care so that
inventories are not "written up or down" arbitrarily. The National As-
sociation of Accountants off"ers the following answers to the question as
to whether or not the ending inventory should be adjusted for such
changes

1. If the new standard costs reflect conditions which affected the actual
cost of the goods in the ending inventory, most firms adjust inventory
to the new standard cost and carry the contra side of the adjusting
entry to cost of sales by way of the variance accounts. In effect, this
procedure assumes that the standard costs used to cost goods in the
inventory have been incorrect and that restatement of inventory cost
is needed to bring inventories to a correct figure on the books. Since
the use of incorrect standards has affected the variance accounts as
well as the inventory, the adjustment is carried to the variance
accounts.

2. If the standard costs represent conditions which are expected to pre-

vail in the coming period but which have not affected costs in the
past period, ending inventories are costed at the old standards. It
appears to be common practice to adjust the detailed inventory
records to new standard costs.
In order to maintain the control relationship which the inventory
accounts have over subsidiary records, the same adjustment is entered
in the inventory control accounts; and the contra entry is carried to
an inventory valuation account. Thus, the net effect is to state the
inventory in the closing balance sheet at old standard costs. In the
 3

638 CONTROLLING COSTS AND PROFITS PART VI

next period the inventory valuation account is closed to cost of sales

when the goods to which the reserve relates move out of inventories.
By use of this technique, the detailed records can be adjusted to new
standards before the beginning of the year while at the same time the
net charge to cost of sales in the new period is for old standard cost
since the latter cost was correct at the time the goods were acquired.

BROAD APPLICABILITY OF STANDARD COSTING

The use of standard costing is not limited to manufacturing situations.
This powerful working tool for planning and control can be used in other
aspects of business organizations (as discussed in Chapter 23, "Marketing
Cost and Profitability Analysis").
The nonprofit organization sector also aff'ords many opportunities to
utilize standard costing concepts and techniques in hospitals, govern-
mental agencies, etc., in harmony with the Chapter 17 discussion of bud-
gets for nonprofit organizations.
Though standard costs may not be formally recorded in the accounts,
many relatively small organizations such as automotive repair shops and
construction contractors can utilize the comparison of actual to standard
quantities, times, and costs for bidding, pricing of jobs or projects, plan-
ning of work, including staffing needs, and the planning and control of
routine operating activities.

^1. Some
DISCUSSION QUESTIONS
firms incorporate standard costs into their accounts; others maintain
them only for statistical comparisons without incorporation into the double-
entry system of cost records. Discuss.

2. The use of standard costs for costing finished goods and sales is considered
to have several advantages. What are these advantages?

3. The charging of overhead into work in process may be applied on the basis
of standard hours or standard labor dollars allowed for actual production.
At times a company might apply overhead on the basis of actual hours or
actual labor dollars. Discuss.

4. Diff'erences between actual costs and standard costs are found in the variance
accounts of which a great number are discussed in the chapter. What con-
siderations might determine the number of variance accounts?

5. Discuss the meaning of variance control and responsibility by various levels

of management.

3"How Standard Costs Are Being Used Currently," NA(C)A Standard Cost Research Series,
p. 64.
CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 639

6. The determination of periodic net income depends greatly upon the cost
assigned to raw materials, work in process, and finished goods inventories.
What considerations determine the costing of inventories at standard or at
approximately actual cost by companies using standard costs?

7. According to field studies, overhead variances are generally treated as period

costs. Why would this procedure exist?

8. The use of standard costs in pricing and budgeting is quite valuable since
decisions in the fields of pricing and budgetary planning are made before the
costs under consideration are incurred. Discuss.

9. Standard costing procedures are widely used in manufacturing operations

and, more recently, have become common in many nonmanufacturing oper-
ations.
(a) Define standard costs.
(b) What are the advantages of a standard cost system?
(c) Present arguments in support of each of the following three methods of
treating standard cost variances for purposes of financial reporting:
(1) They may be carried as deferred charges or credits on the balance sheet.

(2) They may appear as charges or credits on the income statement.

(3) They may be allocated between inventories and cost of goods sold.
(AICPA adapted)

10. Select the correct answer for each of the following statements.
(a) Which ofthese variances is least significant for cost control? (1) labor
rate variance; (2) materials quantity variance; (3) factory overhead
spending variance; (4) factory overhead volume variance; (5) labor
efficiency variance.
(b) At the end of the fiscal year, the Graham Company had several sub-
stantial variances from standard variable manufacturing costs. The
one for which there is the strongest justification for allocation between
inventories and cost of goods sold is the one attributable to (1) addi-
tional costs of raw material acquired under a speculative purchase
contract; (2) a breakdown of equipment; (3) overestimates of produc-
tion activity for the period, resulting from failure to predict an unusual
decline in the market for the company's product; (4) increased labor
rates won by the union as a result of a strike during the year.
(c) Standard costing will produce the same financial statement results as
actual or conventional costing when standard cost variances are dis-
tributed to (1) cost of goods sold; (2) an income or expense account;
(3) cost of goods sold and inventory; (4) a balance sheet account.

(AICPA and NAA adapted)

EXERCISES
Wherever variances are required in the following exercises, indicate
whether they are favorable or unfavorable.

1. Factory Overhead Analysis. The management of a company learned of the

possibility of computing overhead variances by isolating two or three variances.
90%
 : ,

CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 641

Yearly production budget is based upon normal plant operations of 20,000

hours with fixed factory overhead of $8,000. Inventories at January 1, 19
were:
—
Cotton cloth (2,000 yds. @ $1 per yd.) $2,000
Dye (1,000 pints @ $.50) 500
Work in process (1,000 units; 14th finished as to conversion; all ma-
terials issued) 2,875
Finished goods (500 @ $4 each) 2,000

Production for January

3,000 units completed
750 units Vid converted, all materials added

Transactions for January:

Cotton cloth purchased 5,000 yds.@ $1.10 per yd.
Dyes purchased @
2,500 pints $.49
Cotton cloth to factory 5,600 yards
Dyes issued to factory 2,700 pints
Direct labor payroll 1,550 hours @ $1.90 per hour
Actual factory overhead $1,700
Sales 3,100 sweatshirts@ $8 on account
Transferred completed Work in Process to Finished Goods.

Required: General journal entries to record the January transactions, ac-

counting for work in process at standard cost and recognizing variances in the
proper accounts. Use the two-variance method in computing materials, labor,
and factory overhead variances; recognize the materials price variance at the
time of purchase. Use separate inventory and variance accounts for each raw
material. Close all variances into Cost of Goods Sold.

4. Materials Variance Analysis and Journal Entries. Toronto Plastics Corpora-

tion produces kitchen utensils. The company uses a standard cost system for
controlling manufacturing costs. One of its finished products is a small salad
bowl. This product is manufactured from three distinct raw plastics Rexo, —
Zyco, and Durel. The Raw Materials section of the standard cost card for this
product, for use during this cost period, indicated the following standards for
the raw materials necessary to manufacture each job of 1,000 salad bowls.

Material Standard Quantity and Price Total

Rexo 1501bs. @$1 $150
Zyco 250 @ $2
lbs. 500
Durel 100 lbs. @ $3 300
Total standard materials cost per job $950

During the current cost period, the completed job orders included ten jobs
of 1,000 salad bowls each.
Cost data relative to materials for these ten jobs were:

Material Purchased Consumed

Rexo l,8001bs. @ $1.10 1,400 lbs.@ $1.10
Zyco l,000 1bs. @ $1.80 1,000 lbs. (^ $1.80
" 2,000 lbs. @ $2.00 1,600 lbs.@ $2.00
Durel 1 ,200 lbs. @ $3.20 850 lbs.@ $3.20
 :

642 CONTROLLING COSTS AND PROFITS PART VI

Required: (1) The amount of variations from standard, both price and
quantity, for each item of raw material under each of the following assump-
tions: (a) price variations are computed on materials purchased and (b) price
variations are computed on materials issued to production, using the fifo
costing method.
(2) General journal entries for the purchase and issue of materials under
the various assumptions given in (1).

5. Factory Overhead Variance Analysis; Journal Entries. The following over-

head data of the Ponca Company are presented for analysis of the variances
from standard:
Budget Data: (normal capacity)
Direct labor hours 20,000
Estimated overhead:
Fixed $ 8,000
Variable 15,000

Actual Results:
Direct labor hours 18,700
Overhead
Fixed $ 8,060
Variable 14,100
Standard hours allowed for actual production: 18,500

Required: (1) Overhead variances using the three-variance method.

(2) Overhead variances using the two-variance method.
(3) All journal entries based on the two-variance method.

6. Standard Cost Cycle with Entries. Pemberton Manufacturing Company

operates a cost accounting system based on standard costs which are incor-
porated in the manufacturing cost accounts. The differences between standard
costs and actual costs are reflected in appropriate variance accounts; namely,
Materials Purchase Price Variance, Materials Quantity Variance, Labor Rate
Variance, Labor Efficiency Variance, and three variances for factory overhead.
The company follows the plan of realizing the materials price variance at the
time of purchase, regardless of the time of usage. All variances are closed to the
cost of goods sold account.
Budgets are prepared to furnish production managers information as to
expected capacity. Normal capacity for a month is 60 job lots consisting of 100
widgets per lot.
Pemberton Manufacturing Company, using engineering standards, deter-
mined the following standard costs for the production of each lot (100 widgets):
Materials (300 lbs. of materials @ $3) $ 900
Labor (75 hours of direct labor @ $2,20) 165
Overhead (75 hours of factory overhead @ 52) 1 50
Total standard cost per 100 widgets $1,215
(Budgeted fixed overhead, $4,500)

During the period direct materials were purchased in the following quantities,
at the prevailing market prices, in economical lot sizes:
7,300 lbs. @;$2.90
7,000 lbs. @ $3.10
8,000 lbs. @ $3.00
 : : :

CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 643

At the completion of the period the production and cost records showed the
following results:
(a) Direct labor payroll costs were
2,000 hours @ $2.20
1,200 hours @ $2.15
850 hours @ $2.40
700 hours @$1.90
(b) Actual factory overhead costs incurred were $10,440.
(c) Materials requisitioned and used in the production process were tallied and
found to represent 17,870 lbs.
(d) There was no work in process inventory at the beginning or end of the account-
ing period.
(e) 58 lots were completed during the period.
(f) The sales manager stated that 5,700 widgets had been sold during the period at
a unit price of $21.
(g) Marketing expenses were $15,700.
(h) General and administrative expenses were $11,700.

Required: All entries associated with the information given.

7. Price, Mix, and Yield Variances; Journal Entries. Medicus, Inc. produces an
antiseptic powder which is sold in bulk to institutions such as schools, hospitals,
etc. The product's mixture is tested at intervals during the production process.
Materials are added as needed to give the mixture the desired drying and medi-
cating properties. The standard mixture with standard prices for a 100-lb.
batch is as follows

10 lbs. of hexachlorophene % $.45 per lb.

10 lbs. of para-chlor-meta-xylenol @ $.30 per lb.
30 lbs. of bentonite (aj $.08 per lb.
20 lbs. of kaolin %
$.10 per lb.
50 lbs. of talc %$.05 per lb.

During the month of January the following materials were purchased

1,500 lbs. of hexachlorophene (w, $.47 per lb.
1,100 lbs. of para-chlor-meta-xylenol fa] $.33 per lb.
4,000 lbs. of bentonite (ai $.07 per lb.
2,500 lbs. of kaolin fa; $.1 1 per lb.
6,000 lbs. of talc (dj $.04 per lb.

The materials price variance is recorded when materials are purchased.

Production for the month consisted of 10,700 lbs. of finished product.

There were no beginning or ending inventories of work in process.
The following actual materials quantities were put into production:
1,050 lbs. of hexachlorophene
1,125 lbs. of para-chlor-meta-xylenol
3,080 lbs. of bentonite
2,200 lbs. of kaolin
5,300 lbs. of talc

Required: (1) Calculation of all materials variances (price, mix, and yield).
Journal entries for (a) purchase, (b) usage, (c) completion of materials,
(2)
and (d) disposition of variances, assuming all completed units were sold.
 : : : : . : ,

644 CONTROLLING COSTS AND PROFITS PART VI

8. Disposition of Variances by Adjustments to Cost of Goods Sold and Inventories.

Dona Manufacturing Corporation uses a standard cost system which records
raw materials at actual cost, records the materials price variance at the time
that raw materials are issued to work in process, and prorates all variances at
the end of the year. Variances associated with direct materials are prorated,
based on the direct materials balances in the appropriate accounts; and vari-
ances associated with direct labor and factory overhead are prorated, based on
the direct labor balances in the appropriate accounts.
The following information is available for the year ended December 31,
19—:
Raw materials inventory at December 31, 19 — $ 65,000

Finished goods inventory at December 31, 19 —

Direct materials 87,000
Direct labor 130,500
Applied factory overhead 104,400

Cost of goods sold for year ended December 31, 19 —

Direct materials 348,000
Direct labor 739,500
Applied factory overhead 591,600

Directmaterials price variance (unfavorable) 10,000

Directmaterials quantity variance (favorable) 15,000
Directlabor rate variance (unfavorable) 20,000
Directlabor efficiency variance (favorable) 5,000
Factory overhead incurred 690,000

There were no beginning inventories and no ending work in process inven-

tory. Factory overhead is applied at 80% of standard direct labor.
Required: (1) The amount of direct materials price variance to be prorated
to finished goods inventory at December 31, 19 —
(2) The total amount of direct materials in the finished goods inventory at
December 31, 19 —after all variances have been prorated.
,

(3) The total amount of direct labor in the finished goods inventory at
December 31, 19 —after all variances have been prorated.
,

(4) The total cost of goods sold for the year ended December 31, 19 —
after all variances have been prorated.
(AICPA adapted)

9. Standard Cost Card; Income Statement. The Duncan-Geiler Company manu-

factures a product based on standard specifications and costs. At the end of the
month the following information is available
Inventories, April 1, 19 — Quantity Standard Cost

Materials 6,000 units $12,000

Finished goods 4,000 units 84,000

Actual and standard quantities and costs for the month are summarized
as follows
Quantities Costs
Actual Standard Actual Standard
Materials purchases (units) 100,000 $193,500 $200,000
Materials requisitions (units) 95,000 94,000
Direct labor (hours) 46,800 47,000 164,970 164,500
Factory overhead —actual 143,800
 : :

CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 645

The company's standard factory overhead rate is based on

Variable factory overhead: $2 per direct labor hour

Fixed factory overhead : $50,000 for 50,000 direct labor hours, considered
normal capacity

During the month the company planned 24,000 units, yet only 23,500 units
were produced and placed into finished goods inventory. There was no work in
process at the beginning or the end of the period. 21,000 units were sold for
$35 per unit. Marketing and administrative expenses amounted to $185,000.

Required: (1) The standard manufacturingcost card for the product.

(2) statement for the month. Variances for materials, labor, and
An income
factory overhead are closed out into Cost of Goods Sold. Use the two-variance
method for factory overhead.

10. Comparative Income Statement. The Budget Department of the Cardinal

Products Company prepares a forecast income statement for each month's
operations. At the end of the month a comparative income statement is sent to
management. For November, the following comparison was received:

Comparative Income Statement

Month of November
Budget Actual

Sales (10,000 units) $120,000 $120,000

Cost of goods sold 80,000 88,388

Gross profit $ 40,000 $ 31,612

Marketing and administrative expenses 25,000 28,000
Net operating profit $ 15,000 $ 3,612

The standard cost of a unit of product is as follows

Direct materials (8 items @

$.55 per item) $4.40
Direct labor (^4 hour @$2.80 per hour) 2. 10
Factory overhead (^4 hour @ $2 per hour) 1-^0

Total standard product cost per unit $8.00

The factory overhead rate, for a total of 10,000 units of normal production,
was based on:
Variable expenses $ 6,000
Fixed expenses 9,000
$15,000

Actual results for the month show:

Materials used: 2% above standard requirements; average cost $.58 per item.
Payroll: $24,960 for 7,800 hours worked.
Factory overhead $16,100.
:

Assume all marketing and administrative expenses are variable.

Assume 10,000 units were produced and sold.

Required: A
comparative income statement for November, accounting for
the difference between the budgeted and the actual net operating profit.
 : 7 :

646 CONTROLLING COSTS AND PROFITS PART VI

11. Overhead Variance Analysis; Budget Report. The Cost Department of

Sumner Products, Inc. prepared the following flexible budget for November:

Production based on standard 9,938 11,180 12,422 13,664

Labor hours 4,000 4,500 5,000 5,500
Capacity percentage 80% 90% 100% 110%

Factory overhead:

Fixed:

Superintendence $ 6,510 S 6,510 $ 6,510 S 7,100

Indirect labor 5,750 5,750 5,750 5,750
Manufacturing supplies 3,490 3,490 3,490 3,510
Maintenance 1,680 1,680 1,680 1,680
Heat, power, and light 110 110 110 110
Depreciation 675 675 675 675
Insurance 352 352 352 352

Total fixed overhead S18,567 S18,567 $18,567 S19,177

Variable

Indirect labor S 1,928 S 2,169 S 2,410 $ 2,651

Manufacturing supplies 1,720 1,935 2,150 2,365
Maintenance 628 707 785 864
Heat, power, and light 61 68 76 84

Total variable overhead $4,337 S 4,879 $5,421 $5,964

Total factory overhead $22,904 $23,446 $23,988 $25,141

At the end of the month of November, cost accounting tabulation showed

9,689 items manufactured, 4,150 labor hours worked, and actual factory over-
head as follows:
Superintendence $ 6,605
Indirect labor 7,512
Manufacturing supplies 5,450
Maintenance 2,3 1

Heat, power, and light 195

Depreciation 675
Insurance 352
Total factory overhead $23,106

Required: (1) Overhead variances using (a) the three- variance and (b) the
two-variance methods.
(2) An itemized budget report for the spending variance, including actual
factory overhead, budgeted factory overhead, and variances.

12. Monthly Income Statement; Variance Analysis. The Princeton King Pin
Company buys boards, one inch thick, of seasoned maple to manufacture
wooden pins that are sold in sets of 10 pins each at $45 per set. The maple
board is glued together under pressure and heat, then cut to appropriate size for
turning on a lathe. After turning, the pin is dipped into white lacquer, hung up
to dry, and finally painted with two red stripes around the neck of the pin. The
business is small and rather seasonal. For the month of August, in preparation
for the fall orders, the owner estimates costs and sales of 800 sets as follows
 : . :

CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 647

Sales (800 sets @ $45) $36,000

Cost of goods sold:

Materials (maple and others) $5 per set : $ 4,000
Labor: 8 hours X $3 per hour X 22 days X 20 workers. 10,560
Overhead: Fixed 8,800
Variable: $6 per set 4,800
Total cost of goods sold 28,160

Gross profit for August $ 7,840

Cost per set: $28,160 -^ 800 sets = $35.20 per set

At the end of August, these costs and other information are available

Actual production 760 (no inventory)

sets
Actual sales 720 @ $45
sets
« « 40 sets $43 %
Actual labor hours 3,360 hours
Average rate per hour $ 3.05
Overhead, fixed $8,800
Overhead, variable $4,680

Price of maple wood increased $.40 per set. Overhead is applied on the unit
of production basis.

Required: A
statement of gross profit for August, including significant
variances from predetermined production and sales.

PROBLEMS
Wherever variances are required in the following problems, indicate
whether they are favorable or unfavorable.

20-1. Conversion to Standard Cost; Entries; Variance Analysis. On May 1, 19—,

the trial balance of the factory ledger accounts of the Albany Company ap-
peared as follows

Raw Materials (1,000 kilograms) $ 620.00

Finished Goods (100 units) 3,100.00
General Ledger Control $3,720.00

$3,720.00 $3,720.00

The company desires to install and maintain a system of standard costs in

which inventories will be carried at standard cost. It has made the necessary
all
materials and labor studies which reveal for its only product:

Direct Materials: One raw material is used in the manufacturing process; 20 kg.
should be used for each unit of finished product and should cost $.60 per kg.

Direct Labor: Time studies indicate an allowance of 5 hours of direct labor at

an hourly rate of $2.50 for each unit of finished product.
5,000
 :

CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 649

Standard costs were based on 256,000 direct labor hours with a production
of 1,600 units. The standards are as follows:

Materials (100 lbs. @ $2) $200

Direct labor (160 hrs. @ $2.25) 360
Factory overhead (160 direct labor hours @ $1) 160

(The fixed portion of the overhead rate is $.40.)

Total standard cost per unit $720

A summary of the transactions for the year ended December 31, 19—, shows
the following:

Materials purchased (180,000 lbs. @. $2.20) $396,000

Direct labor (247,925 hrs. @$2.40) 595,020
Factory overhead 248,640
Materials issued to production 177,600 lbs.

Units processed:
Units completed 1 ,500
Units one-half complete 1 50
Units one-fourth complete 30

Required: (1) Ledger accounts with the above transactions recorded therein.
(2) Entries to adjust Finished Goods to actual cost
for materials. No adjust-
ment is needed for labor and factory overhead. No other accounts should be
used.
(3) Astatement showing details of the materials cost included in Work in
Process as adjusted to actual cost.
(AICPA adapted)

20-3. Journal Entries;Income Statement with Variances. The Gomez Company

makes unit M. The manufacturing ofunit M
is based on three successive and

continuous operations, namely, operations M-10 to M-12, inclusive, in which

the manufacturing cost of each unit is developed as shown by the following
tabulation of percentages of cost to manufacture

Percentage of Cost to Manufacture Unit M

Operation Materials Labor Overhead

M-10 20% 20% 40%

M-11 35 40
M-12 80 45 20
Total 100% 100% 100%

(Gomez does not record the actual labor charges applicable to each operation.)

The Gomez Company operates a cost accounting system based on standard

costs which are incorporated in the manufacturing cost accounts. The differences
between standard costs and actual costs are reflected in appropriate variance ac-
counts; namely, materials purchase price, materials usage, direct labor rate,
direct labor time, and overall factory overhead. The materials purchase price
variance is assumed to be realized at the time of purchase, irrespective of time
of usage. Three work in process accounts are maintained materials, labor,
:

and factory overhead.

 : : : :

650 CONTROLLING COSTS AND PROFITS PART VI

The inventories applicable to unit M

as of December 31, 19 A, stated in ac-
cordance with the foregoing schedule of standard costs, are as follows
Materials: Item M-a —
100 units; Item M-b —
100 units
Work in process: 50 units complete through operation M-10
Finished goods: none

The standard manufacturing costs used for unit M, based on a planned

monthly production ranging between 8,000 and 12,000 units, are as follows:
Per Unit M
Quantity Amount

Materials
Item M-a (issued in operation M-10) 1 $ .50
Item M-b (issued in operation M-12) 1 2.00

Direct labor (total for all operations at uniform rate of $5 per

hour) j^ hour 1.25

Factory overhead (applicable to operations as a whole)

Variable expenses .60
Fixed expenses .90

$5.25

Transactions and other facts during January, 19B, are:

Transactions:
Amoun t
Materials purchases:
Item M-a —12,000 units @
$ .55 per unit $ 6,600
Item M-b —12,000 units (a $2.10 per unit 25,200
Payroll for all operations:
Direct labor —
3,100 hours @
$1.2625 per i^ hour 15,655
Indirect labor 1,500
Factory overhead, other than indirect labor 1 5,000

Marketing, administrative, and general expenses 31 ,600

Other facts:

During January, 19B, 1 1,000 units of M

were transferred to the finished goods
warehouse and 10,500 units were sold at $10 per unit M.
As of January 31, 19B, 100 units of work in process are complete through
operation M-U, but all materials are in process.
Materials requisitions indicate issuances of materials items M-a and M-b in
the quantities required for the production through the respective operations
indicated. A supplementary materials requisition, however, indicates that
item M-a actually used was 2% in excess of standard quantity.

Required: (1) Journal entries of transactions for the month.

(2) An income statement showing appropriate manufacturing cost variances.

(AICPA adapted)

20-4. Standard Costing in the Accounts; Variance Disposition. Tolbert Manu-

facturing Company uses a standard cost system in accounting for the cost of
production of its only product, Product A. The standards for the production of
one unit of Product A are
 : : :

CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 651

Direct materials: 10 feet of Item 1 at $.75 per foot; and 3 feet of Item 2 at $1 per
foot
Direct labor: 4 hours at $3.50 per hour
Factory overhead: applied at 150% of standard direct labor costs

There was no inventory on hand at July 1, 19A. A summary of costs and

related data for the production of Product A during the year ended June 30,
19B, showed that:

(a) 100,000 feet of Item 1 were purchased at $.78 per foot.

(b) 30,000 feet of Item 2 were purchased at $.90 per foot.
(c) 8,000 units of Product A
were produced which required 78,000 feet of Item 1,
26,000 feet of Item 2, and 31,000 hours of direct labor at $3.60 per hour.
(d) 6,000 units of Product A were sold.
(e) At June 30, 19B, 22,000 feet of Item 1, 4,000 feet of Item 2, and 2,000 com-
pleted units of Product A
were on hand. (All purchases and transfers are re-
corded at standard.)

Required: (1) The total debits to the raw materials account for the purchase
of Item 1, for the year ended June 30, 19B.
(2) The total debits to the work in process account for direct labor, for the
year ended June 30, 19B.
(3) The balance in the materials quantity variance account for Item 2, be-
fore allocation of standard variances.
(4) Assuming that all standard variances are prorated to inventories and
Cost of Goods Sold, the amount of: (a) the materials quantity variance for
Item 2 to be prorated to raw materials inventory and (b) the materials purchase
price variance for Item 1 to be prorated to raw materials inventory.

(AICPA adapted)

20-5. Allocating Variances; Computing Standard and Actual Manufacturing

Costs; Inventory Schedules. The Calvin Corporation commenced doing busi-
ness on December 1, 19 —
The corporation uses a standard cost system for
.

the manufacturing costs of its only product, Haemex. The standard costs for a
unit of Haemex are

Raw materials 10 kilograms @

$.70 per kg. $ 7
Direct labor 1 hr. @$2 per hr. 2
Factory overhead (applied on the basis of $2 per direct labor hour) 2
Total $11

Additional information

(a) The following data were extracted from the corporation's books for the
month of December
Units Debit Credit

Budgeted production 3,000

Units sold 1,500
Sales $30,000
Sales discounts $ 500
Materials price usage variance 1,500
Materials quantity variance 660
Direct labor rate variance 250
Factory overhead spending variance 300
Purchases discounts lost 120
 : : : .

652 CONTROLLING COSTS AND PROFITS PART VI

The company records purchases of raw materials net of discounts. The

amounts shown above for purchases discounts lost and materials price usage
variance are applicable to raw materials used in manufacturing operations
during the month of December.
(b) Inventory data at December 31, 19 —
indicate the following inventories
,

were on hand

Raw materials None

Work in process 1,200 units
Finished goods 900 units

The work in process inventory was 100% complete as to materials and 50%
as to direct labor and factory overhead. The corporation's policy is to allocate
variances over the cost of goods sold and ending inventories; i.e., work in
process and finished goods.

Required: (1) A schedule allocating the variances and purchases discounts

lost to the ending inventories and to cost of goods sold.
(2) A schedule computing the cost of goods manufactured at standard cost
and at actual cost for December, 19 — . Amounts for materials, labor, and
factory overhead should be shown separately.

(3) A schedule computing the actual cost of materials, labor, and factory
overhead included in the work in process inventory and in the finished goods
inventory at December 31,1 9 —
(AICPA adapted)

20-6. Equivalent Production Schedules; Analyzing Differences of Actual and

Standard Materials Costs. Dexon Pharmaceutical Company processes a single
product, Mudexin, and uses a standard cost accounting system. The process
requires preparation and blending of three materials in large batches with a
variation from the standard mixture sometimes necessary to maintain quality.
The following information is available for the Blending Department.
The standard cost card for a 500-pound batch shows the following standard
costs
Unit
Quantity Price Total Cost
Materials
Mucilloid 250 pounds $ .14 $35
Dextrose 200 pounds .09 18
Other ingredients 50 pounds .08 4
Total per batch 500 pounds $ 57

Labor:
Blending 10 hours $3.00 30

Factory overhead:
Variable 10 hours $1.00 $10
Fixed 10 hours .30 3 13

Total standard cost per 500-pound

batch $100

During October 410 batches of 500 pounds each of the finished compound
were completed and transferred to the Packaging Department.
 : : :

CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 653

Blending Department inventories totaled 6,000 pounds at the beginning of

the month and 9,000 pounds at the end of the month. Both inventories were
completely processed but not transferred and consisted of materials in their
standard proportions. Inventories are carried in the accounts at standard cost
prices.
During the month of October the following materials were purchased and
put into production
Unit
Pounds Price Total Cost
Mucilloid 1 14,400 $ .17 $19,448
Dextrose 85,800 .11 9,438
Other ingredients 19,800 .07 1,386
Totals 220,000 $30,272

Wages paidfor 4,212 hours of direct labor at $3.25 per hour were $13,689.
Actual factory overhead costs for the month totaled $5,519.
The standards were established for a normal production volume of 200,000
pounds (400 batches) of Mudexin per month. At this level of production vari-
able factory overhead was budgeted at $4,000; and fixed factory overhead was
budgeted at $1,200.

Required: (1) A schedule presenting:

(a) The equivalent production computation for the Blending Department
for October production in both pounds and batches.
(b) The standard cost of October production itemized by components of
materials, labor, and factory overhead.

(2) Schedules computing the differences between actual and standard costs,
and analyzing the differences as materials variances (for each material) caused
by (a) price differences and (b) quantity differences.
(3) Explain how materials variances arising from quantity differences could
be further analyzed and prepare schedules presenting such an analysis.

(Note: No labor or overhead variances are to be calculated.)

(AICPA adapted)

20-7. Income Statement; Standard Process Costing; Variance Analysis. The

Belkraft Corporation manufactures Product G
which is sold for $20 per unit.
Raw Material M
is added before processing starts, and labor and overhead are

added evenly during the manufacturing process. Production capacity is bud-

geted at 1 10,000 units of G
annually. The standard costs per unit of are: G
Direct materials
M, 2 pounds @
$1 .50 per pound $ 3.00
Direct labor (1.5 hours per unit) 6.00
Factory overhead
Variable $1.50
Fixed 1.10 2.60

Total standard cost per unit $1 1.60

A process cost system is used employing standard costs. Inventories are

valued at standard cost. All variances from standard costs are charged or
credited to Cost of Goods Sold in the year incurred.
 . : : :

654 CONTROLLING COSTS AND PROFITS PART VI

Inventory data for the year 19 — Units

January 1 December 31
Raw materials: M
(pounds) 50,000 60,000
Work in process:
All materials, yi processed 10,000
All materials, }i processed 1 5,000
Inventory, finished goods 20,000 1 2,000

During 19 —
250,000 pounds of
, M
were purchased at an average cost of
$1,485 per pound; and 240,000 pounds were transferred to work in process
inventory. Direct labor costs amounted to $656,880 at an average labor cost
of $4.08.

Actual factory overhead for 19 —

Variable $181,500
Fixed 1 14,000

110,000 units of G were completed and transferred to finished goods inventory.

Marketing and administrative expenses were $651,000.

Required: An income statement for the year 19 —

including all manu-
,

facturing cost variances. (Use the two-variance method for factory overhead.)

(AICPA adapted)

20-8. Schedules Comparing Actual with Standard Costs; Adjusting Finished

Goods Cost or Market Values, Whichever is Lower. The Deakin Corporation
to
manufactures a single product which passes through several departments. The
company has a standard cost system. On December 31, 19 inventories at — -,

standard cost are as follows

Work in Process Finished Goods

Direct materials $75,000 $ 60,000

Direct labor 7,500 20,000
Factory overhead 15,000 40,000
Total $97,500 $120,000

No raw materials inventory existed.

Prior to any year-end inventory adjustments, the controller prepared the

preliminary income statement shown at the top of page 655 for the year ended
December 31, 19 —
All purchases discounts were earned on the purchase of raw materials. The
company has included a scrap allowance in the cost standards; the scrap sold
cannot be traced to any particular operation or department.

Required: (1) A
schedule computing the actual cost of goods manufactured.
The schedule should provide for a separation of costs into direct materials, direct
labor, and factory overhead.
(2) A
schedule comparing the computation of ending inventories at standard
cost and The schedule should provide for a separation of costs
at actual cost.
into direct materials, direct labor, and factory overhead.
(3) A schedule to adjust the finished goods inventory to the lower of cost or
market. Without prejudice to the solution to (2), assume that the finished
 : :

CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 655

Income Statement (Preliminary)

Sales $900,000
Cost of goods sold:
Standard cost of goods sold:
Direct materials $300,000
Direct labor 100,000
Factory overhead 200,000
Total $600,000
Variances
Direct materials $ 25,400
Direct labor 25,500
Overabsorbed factory overhead (16,500)

Total $ 34,400 634,400

Gross profit $265,600

Marketing expenses:
Sales salaries $ 28,000
Sales commissions 72,000
Shipping expenses 18,000
Other marketing expenses 7,000

Total $125,000
General and administrative expenses 50,000 175,000

Net income from operations $ 90,600

Other income:
Purchases discounts $ 8,000
Scrap sales 9,000 17,000

Net income before taxes $107,600

goods inventory was composed of 1,000 units with a cost of $180 each. The
current market price for the product is $250. The company, however, has an
old contract to sell 200 units at $175 each. The normal gross profit rate is
33H% of cost. The shipping expenses for the old contract will be $5 per unit;
the sales commission is 8%
of the sale.
(AICPA adapted)

20-9. Revision of Standard Costs; New Standard Costs Applied to Inventory.

The standard cost of Product MSY-2, manufactured by the New Orleans
Manufacturing Company, is as follows
Factory
Prime Cost Overhead 50% Total

Material A $10.00 $10.00

Materials 5.00 5.00
Material C 2.00 2.00
Direct labor — Cutting 8.00 $4.00 12.00
Direct labor — Shaping 4.00 2.00 6.00
Direct labor — Assembling 2 00
. 1.00 3 00
.

Direct labor — Boxing 1.00 .50 1.50

Total $32.00 $7.50 $39.50

The company manufactured 10,000 units of Product MSY-2 at a total cost

of $395,000 for the period under review. Materials A, B, and C are issued in the
Cutting Department.
Unit Cost
 : : :

CH. 20 STANDARD COSTING: ACCUMULATING; REPORTING; EVALUATING 657

(2) What would you recommend the company do to solve its problem with
Joan Daley and her complaint?
(NAA adapted)

B. Variance Analysis; Variance Control Responsibility. The Carberg Corpora-

tion manufactures and sells a single product. The company uses a standard
cost system, and the standard cost per unit of product is as follows:
Material (one pound plastic @
$2) $ 2.00
Direct labor (1.6 hours @
$4) 6.40
Variable factory overhead cost per unit 3.00
Fixed factory overhead cost per unit 1-45

$12.85

The factory overhead cost per unit was calculated from the following annual
overhead cost budget for a 60,000 unit volume
Variable factory overhead cost
Indirect labor (30,000 hours @ $4) $120,000
Supplies (Oil — 60,000 gallons @$.50) 30,000
Allocated variable service department costs 30,000

Total variable factory overhead cost $180,000

Fixed factory overhead cost

Supervision $ 27,000
Depreciation 45,000
Other fixed costs 15,000

Total fixed factory overhead cost $ 87,000

Total budgeted annual factory overhead cost for 60,000 units $267,000

The charges to the Manufacturing Department for November, when 5,000

units were produced, are:
Materials (5,300 pounds @$2) $10,600
Direct labor (8,200 hours @$4.10) 33,620
Indirect labor (2,400 hours @ $4.10) 9,840
Supplies (Oil —
6,000 gallons @
$.55) 3,300
Allocated variable service department costs 3,200
Supervision 2,475
Depreciation 3,750
Other fixed costs U^^O
Total $68,035

The Purchasing Department normally buys about the same quantity as is

used in production during a month. In November 5,200 pounds were pur-
chased at a price of $2.10 per pound.

Required: (1) Calculate these variances from standard costs for the data
given:
(a) materials purchase price variance; (b) materials quantity variance; (c)
direct labor rate variance (d) direct labor efficiency variance (e) total factory
; ;

overhead variance for 5,000 units of production, analyzed for each expense
classification.

(2) The company has dividedits responsibilities so that the Purchasing De-

partment responsible for the price at which materials and supplies are pur-
is
chased, while the Manufacturing Department is responsible for the quantities
658 CONTROLLING COSTS AND PROFITS PART VI

of materials used. Does this division of responsibilities solve the conflict be-
tween price and quantity variances? Explain.
(3) Prepare a report which details the factory overhead budget variance.
The report, which will be given to the Manufacturing Department manager,
should display only that part of the variance that is the manager's responsibility
and should highlight the information in ways that would be useful to that man-
ager in evaluating departmental performance and in considering corrective
action.
(4) Assume that the department manager performs the timekeeping function
and that, at various times, an analysis of factory overhead and direct labor
variances has shown
that he has deliberately misclassified labor hours (e.g.,
hours as indirect labor hours and vice versa) so that only one
listed direct labor
of the two labor variances is unfavorable. It is not economically feasible to
hire a separate timekeeper. What should the company do, if anything, to
resolve this problem?
(NAA adapted)

C. Theoretical Discussion of Standard Costs Variances, Capacity, and Variance

Allocation. Last year Mafco Corporation adopted a standard cost system. Labor
standards were set on the basis of time studies and prevailing wage rates. Mate-
rials standards were determined from materials specifications and prices then in
effect.In determining its standard for overhead, Mafco estimated that a total of
6,000,000 finished units would be produced during the next five years to satisfy
demand for its product. The five-year period was selected to average out
seasonal and cyclical fluctuations and allow for sales trends. By dividing the
annual average of 1,200,000 units into the total annual budgeted overhead, a
standard cost was developed for factory overhead.
At June 30, 19 —the end of the current fiscal year, a partial trial balance
,

revealed the following:

Debit Credit

Materials purchase price variance $25,000

Materials quantity variance $ 9,000
Labor rate variance 30,000
Labor efficiency variance 7,500
Controllable variance 2,000
Volume variance 75,000

Standards were set at the beginning of the year and have remained un-
changed. All inventories are priced at standard cost.

Required: (1) Conclusions to be drawn from each of the six variances shown
in the Mafco Corporation's trial balance.
(2) The amount of fixed factory overhead cost to be included in product cost
depends on whether or not the allocation is based on (a) ideal (or theoretical)
capacity, (b) practical capacity, (c) normal capacity, or (d) expected annual
capacity. Describe each of these allocation bases and give a theoretical argument
for each.
(3) Atheoretical justification for each of the following methods of accounting
for the net amount of all standard cost variances for year-end financial reporting:
(a) Presenting the net variance as an income or expense on the income
statement.
(b) Allocating the net variance among inventories and cost of goods sold.

(AICPA adapted)
 . :

CHAPTER 21

CONVENTIONAL
GROSS PROFIT ANALYSIS

The standard and analysis

cost discussion deals with the determination
of variances for each of the cost elements, materials, labor, and factory
overhead, which constitute the major portion of the cost of goods sold
section of the income statement. Subtracting the cost of goods sold figure
from sales results in the gross profit. Any deviation from the predeter-
mined standard cost is normally shown as an increase or decrease in the
gross profit. The adherence of the actual to the budgeted or standard gross
profit figure is highly desirable. Therefore, a careful analysis of unexpected
changes in gross profit is advantageous to a company's management.
Not only do the individual cost elements influence the gross profit figure,
but the sales figure itself must be held accountable for any change occur-
ring in the gross profit.

CAUSES OF GROSS PROFIT CHANGES

A change in the gross profit is due to one or a combination of the
following

1 Changes in selling prices of products

2. Changes in volume sold

3. Changes in cost elements

659
 :

660 CONTROLLING COSTS AND PROFITS PART VI

The second of the above three causes — changes in volume sold — may
be further divided into two parts

1. Changes in volume

2. Changes in types of products sold, often called product mix or sales mix

Volume refers to the number of physical units, while product mix

considers the change in the composition of goods sold.

GROSS PROFIT ANALYSIS

The determination of the various causes for an increase or decrease
in the gross profit can be made in a manner similar to that illustrated in con-
nection with the computation of standard cost variances. It should be
understood, however, that gross profit analysis is often possible without
the use of standard costs or budgets. In such a case, prices and costs of
the previous year, or any year selected as the basis for the comparison,
serve as the basis for the computation of the variances. When standard
costsand budgetary methods are employed, a greater degree of accuracy
and more effective results are achieved. Both methods are illustrated below.

Illustration I. This first illustration shows an analysis of gross profit

based on the previous year's figures.

The Silcon Manufacturing Company presents the following gross

profit sections of its operating statements for the years 19A and 19B:

19A 19 B Changes
Sales (net) $120,000 $140,000 +$20,000
Cost of goods sold 100,000 110,000 + 10,000

Gross profit on sales $ 20,000 $ 30,000 +$10,000 net increase

Additional data taken from various records indicate that the sales and
the cost of goods sold figures can be broken down as shown below and on
page 661.
 . ::

CH. 21 CONVENTIONAL GROSS PROFIT ANALYSIS 661

19B Sales 19B Cost of Goods Sold

Quantity Unit Price Total Unit Price Total

Product X = 10,000 units @ $6.60 $ 66,000 $4.00 $ 40,000

Product Y = 4,000 units @ 3.50 14,000 3.50 14,000
Product Z = 20,000 units @ 3.00 60,000 2.80 56,000

Total sales $140,000 Total cost $110,000

The illustration indicates that, in comparison with the year 19A, sales
in 19B increased $20,000 and costs increased $10,000, resulting in an in-
crease in gross profit of $10,000. What caused this increase?
The method shown below follows a procedure similar to the one em-
ployed in connection with the computation of standard cost variances.
Sales and costs of 19A are accepted as the basis (or standard) for all
comparisons. A sales price and a sales volume variance are computed first;
a cost price and cost volume variance are computed next. The sales
volume variance and the cost volume variance are analyzed further as a
third step to compute a sales mix and a final sales volume variance.

First Step. Computation of sales price and sales volume variances

Actual sales 19B $140,000
Actual 19B sales at 19A prices:
X = 10,000 units X $5.00 = $50,000
Y = 4,000 units X 4.00 = 16,000
Z = 20,000 units X 2.60 = 52,000 118,000

Favorable sales price variance $ 22,000

Actual 19B sales at 19A prices $1 18,000

Total sales 19A (used as standard) 120,000

Unfavorable sales volume variance $ 2,000

Second Step. Computation of cost price and cost volume variances

Actual cost of goods sold 19B $110,000

Actual 19B sales at 19A costs:

X = 10,000 units X $4.00 = $40,000
Y = 4,000 units X 3.50 = 14,000
Z = 20,000 units X 2.175 = 43,500 97,500

Unfavorable cost price variance $ 12,500

Actual 19B sales at 19A costs $ 97,500

Cost of goods sold 19A (used as standard) 100,000

Favorable cost volume variance $ 2,500

 : :

662 CONTROLLING COSTS AND PROFITS PART VI

At this point the above analysis shows the following results which
might explain the reason for the $10,000 increase in gross profit:

Favorable sales price variance $22,000

Favorable volume variance (neO consisting of:

$2,500 favorable cost volume variance
Less 2,000 unfavorable sales volume variance
Net $ 500 favorable volume variance 500
$22,500
Less unfavorable cost price variance 12,500
Increase in gross profit $10,000

Third Step. Computation of the sales mix and the final sales volume
variances
The net $500 favorable volume variance is a composite of sales volume
and cost volume variances and as such is rather meaningless. It can and
should be further analyzed into the more significant and valuable sales mix
and final sales volume variances. To accomplish this analysis, one addi-
tional figure must be determined —
the average gross profit realized on
the units sold in the base (or standard) year. The computation is as follows

Total Gross Profit of 19A Sales ^ $20,000 ^ ^ ^^^^

Total Number of Units Soldi 9A 35,000

The $.5714 represents the average gross profit realized on all units

sold in 19A. This gross profit per unit is multiplied by the total number of
units sold in 19B (34,000 units) resulting in $19,427, which is the total
gross profit that would have been achieved in 19B if all units had been
sold at 19A's average gross profit per unit.
The calculation of the sales mix and the final sales volume variances
can now be made:
19B sales at 19A prices $1 18,000
19B sales at 19A costs 97,500
Difference $ 20,500
19B sales at 19A average gross profit 19,427

Favorable sales mix variance $ 1,073

19B sales at 19A average gross profit $ 19,427

Total sales 19A (used as standard) $120,000
Cost of goods sold 19A (used as standard) 1 00,000

Difference 20,000

Unfavorable final sales volume variance $ 573

Check: Favorable sales mix variance $ 1,073

Unfavorable final sales volume variance 573

Net increase (favorable) $ 500

CH. 21 CONVENTIONAL GROSS PROFIT ANALYSIS 663

The sales mix variance can be viewed in the following manner:

Column 1 Column 2 Column 3 Column 4

Product
664 CONTROLLING COSTS AND PROFITS PART VI

Statement 1 VITT MANUFACTURING, INC.

Budgeted Income Statement

Product
 : : : :

CH. 21 CONVENTIONAL GROSS PROFIT ANALYSIS 665

basis of the budget, Product A is the most profitable product while Pro-
duct C is the least profitable per unit. Actually due to variations in sales
price and cost, Product B is the most profitable while Product C is the

least profitable per unit.

Statement 3 indicates that the average gross profit would have been
$2.41 per unit if the sales price and cost per unit had been according to the
budget. Changes in sales prices, sales volume, sales mix, and costs resulted
in a gross profit of only $1.93 per unit.
Had and units sold prevailed as budgeted, the gross
prices, costs,
profit would have been $26,250. Actual gross profit was only $20,110.
What caused this decrease of $6,140 in gross profit?
In the three steps shown, all figures are taken directly from the basic

statements mentioned with the exception of $26,062.50, which is computed

by multiplying the actual units sold by the average gross profit as per
Statement 1 ; i.e., 10,425 units X $2.50 = $26,062.50.

First Step. Computation of sales price and sales volume variances

Actual sales $142,233

Actual sales at budgeted prices 138,226

Favorable sales price variance $ 4,007

Actual sales at budgeted prices $138,226

Budgeted sales 142,000

Unfavorable sales volume variance $ 3,774

Second Step. Computation of cost price and cost volume variances

Cost of goods sold actual — $122,123

Budgeted costs of actual goods sold 1 13,093

Unfavorable cost price variance $ 9,030

Budgeted costs of actual goods sold $1 13,093

Budgeted costs of budgeted goods sold 115,750

Favorable cost volume variance $ 2,657

Third Step. Computation of the sales mix and the final sales volume
variances

In the above calculations two volume variances appear

Unfavorable sales volume variance $3,774

Favorable cost volume variance 2,657

Net unfavorable volume variance $1,117

666 CONTROLLING COSTS AND PROFITS PART VI

As Stated previously, the net volume variance figure should be further

analyzed into the sales mix and the final sales volume variance as follows:

Actual sales at budgeted prices $138,226.00

Budgeted costs of actual goods sold 11 3,093.00

Difference $ 25,133.00

Budgeted gross profit of actual goods sold

(10,425 X $2.50) 26,062.50
Unfavorable sales mix variance $ 929.50

Budgeted gross profit of actual goods sold $ 26,062.50

Budgeted sales $142,000
Budgeted costs of budgeted goods sold 11 5,750
Budgeted gross profit 26,250.00
Unfavorable final sales volume variance $ 187.50

Check: Unfavorable sales mix variance $ 929.50

Unfavorable final sales volume variance 187.50
Unfavorable volume variance $ 1,1 17.00

Again, the sales mix variance can be viewed in the following manner;
CH. 21 CONVENTIONAL GROSS PROFIT ANALYSIS 667

Recapitulation: Gains Losses

Gain due to increased sales prices $4,007

Loss due to increased cost $ 9,030.00
Loss due to shift in sales mix 929.50
Loss due to decrease in units sold 187.50
Total $4,007 $10,147.00
Less 4,007.00
Net decrease in gross profit $ 6,140.00

FURTHER REFINEMENT OFSALES

VOLUME ANALYSIS
In the above computation sales mix and final sales volume variances
were determined with the aid of an average gross profit figure and total
figures only. However, it is often necessary to trace the causes for a change
to the individual product lines.Using the figures from the income state-
ments of Vitt Manufacturing, Inc., an analysis by products can be made
in the manner shown below.

^^^^^^^^^^
^^^^^^^^^m
^ll"!* MANUFACTURING, INC.
Analysis By Product
^H^
-hhbi
668 CONTROLLING COSTS AND PROFITS PART VI

outline the remedies that should be taken to correct the situation, i In Illus-
tration II the gain due to higher prices is more than
offset by the increase in
cost, the shift to less profitable products, and the decrease in units sold.
As the planned gross profit is the responsibility of the marketing as well
as the manufacturing departments, the gross profit analysis brings together
these two major functional areas of the firm and points to the need for
further study by both of these departments. The marketing department
must explain the changes in sales prices, the shift in the sales mix, and the
decrease in units sold while the production department must account
for the increase in cost. To be of real value, the cost price variance should
be further analyzed into variances for materials, labor, and factory over-
head as explained in the two preceding standard cost chapters.

^M DISCUSSION QUESTIONS
1. Why is the gross profit figure significant?
2. What causes changes in the gross profit?
3. Explain the term "product mix" or "sales mix."
4. By what methods can a change in the gross profit figure be analyzed?
5. Illustrate how
the sales price variance is determined. If the sales price
variance were to be journalized in the books, how would such a journal
entry vary from an entry made for the materials purchase price variance?
6. How are the sales mix and the final sales volume variances computed ?
7. What is the significance of the average gross profit figure of the base or
standard ?
8. The gross profit analysis based on budgets and standards makes use of three
basic statements. Name them.
9. What important information is revealed by a gross profit analysis on a pro-
duct basis ?
10. Whose task is it to see that the planned gross profit is met?

EXERCISES
1. Price —Gross Profit Relationship. How much must be added to the cost
price to realize a gross profit on sales of: 50%, 40%, 35%o, 30%,, 25%o, 20%o,
15%, 121/2%, 10%, 8%, 5%?
2. Deciding on Correct Method. The accountant for Kyle, Inc. observed the
following change in sales revenue between two years:

iSee Raymond L. Kelso and Robert R. Elliot, "Bridging Communications Gap Between
Accountants and Managers," Management Accounting, Vol. LI, No. 5, pp. 41-44.
 : . :

CH. 21 CONVENTIONAL GROSS PROFIT ANALYSIS 669

19A 100 articles @ $3 = $300

19B 120 articles @ $4 = 480
$180 difference (increase)

Wishing to analyze the $180, he used the following method, with this result:

Method 1

Changes because of quantity increase 20 X $4 = $ 80

Changes because of price increase 100 X $1 = 100
$180

Somewhat doubtful of his answer, he tried another method, with this result

Method 2:
Changes because of quantity increase 20 X $3 = $ 60
Changes because of price increase 120 X $1 = 120
$180

Required: Selection and justification of the correct method.

3. Gross Profit Analysis. Actual and budget data for 19— for the Carver
Distributing Company are:

Product A Product B Total

Actual sales 60,000 units X $1 .00 20,000 units X $2.00 $100,000

Actual cost of goods sold. . 60,000 units X .80 20,000 units X 1.85 85,000
Budgeted sales 50,000 units X 1 .25 35,000 units X 2.50 150,000
Budgeted cost of goods sold 50,000 units X 1.00 35,000 units X 2.00 120,000

Required: (1) The computations ofthe following variances: (a) sales price;
(b) sales volume; cost price; (d) cost volume.
(c)
(2) An analysis of the total volume variance into the sales mix and final
sales volume variances.

4. Gross Profit Analysis. Bates Brothers Clothiers handles two lines of men's
suits —
The Bostonian and The Varsity. For the years 19A and 19B, Sam
Bates, the store owner and manager, realized a gross profit of $159,300 and
$159,570, respectively. He was puzzled because the dollar sales volume and
number of suits sold was higher for 19B than for 19A yet the gross profit had
remained about the same.
The firm's accounting records provided the following detailed information:
 A

670 CONTROLLING COSTS AND PROFITS PART VI

5. Gross Profit Analysis. The controller of Lowell Municipal Hospital prepared

the following statement of operations, comparing the years 19B to 19A.

19B 19

Inpatient service days 330,000 300,000

Patient service revenues $13,860,000 $12,000,000

Cost of services rendered:

Medicinals, linens, & other supplies $ 1,400,000 $ 1,000,000
Salaries — nurses, interns, residents, staff 9,000,000 7,500,000
Patient service overhead 1,500,000 1,500,000

Total cost of services rendered $11,900,000 $10,000,000

Gross profit $ 1,960,000 $ 2,000,000

Administrative expenses 2,013,000 1,800,000

Excess of revenues over expenditures $ (53,000) $ 200,000

Required: An analysis of the comparative statement of operations, listing

the causes of the 19B excess of expenditures over revenues and the causes of the
decline since 19A.

6. Gross Profit Analysis. Operating profits of the Volrath Manufacturing

Company for the years ending December 31, 19A and 19B, were as follows:

Year Ending December 31

Particulars 19A 19B
Net sales $482,961 $679,241
Cost of goods sold 434,665 503,645
Gross profit $48,296 $175,596
General expenses 76,258 89,533
Net operating profit (loss) $(27,962 ) $ 86,063

At 19A the management became convinced that an increase in the

the end of
selling price of theproduct was necessary if future losses were to be avoided.
Accordingly, a general increase of 15*^ was made on all selling prices, effective
January 1, 19B. At the same time a new plant manager was installed who gave
much of his attention during the year to reducing plant costs.
When the results for the year 19B became available, a dispute arose between
the plant manager and the vice-president in charge of sales. Both believed that
the increase in profits during 19B was due principally to the increase of 15% in
selling prices, but the plant manager insisted that savings in factory costs were
greater in amount than the increase in gross profits due to the increased volume
of sales (i.e., increased quantity of goods sold as distinct from the increase in
selling prices) while the vice-president was equally insistent that the opposite
was the case.

Required: An analysis accounting for the real reasons for the increase in
gross profit.
 :

CH. 21 CONVENTIONAL GROSS PROFIT ANALYSIS 671

7. Gross Profit Analysis. The 19A income statement of the Royer Corporation
showed
Sales (90,500 units) $760,200
Cost of goods sold 452,500
Gross profit $307,700

For 19B the management forecasts a sales volume of 100,000 units at a sales
For this range of activity, variable costs are estimated to
price of $8.20 per unit.
be $4.80 per unit. No fixed costs are included in the cost of goods sold.

Required: An analysis of the variation in gross profit between the two years
indicating the effects of changes in sales prices, sales volume, and unit costs.

(AICPA adapted)

PROBLEMS
21-1. Gross Profit Analysis. The Chapeau Company manufactures both men's
and women's The traditional selling price for men's hats has been $8 per
hats.
hat, whereas women's hats have sold for $7. The president was very pleased
with the performance of his company in 19A which, summarized, was as follows:

Gross sales (43,000 hats) $325,000

Cost of goods sold 200,000
Gross profit $125,000 (38%)
The president felt
that 38% gross profit was satisfactory; and, since the 43,000
hats sold was an increase of 8,000 over the previous year, he felt that the company
was enjoying a healthy growth.
The sales manager happily informed the president that expected sales for
19B were 45,000 hats. Based on this estimate, the controller submitted the
following budget for 19B to the president:

Sales
Units Amount Cost Gross Profit
Men's hats 30,000 $240,000 $ 32,000
1 $108,000
Women's hats 15,000 105,000 84,000 21,000
Total 45,000 $345,000 $216,000 $129,000

The president noted that this was an increase of $4,000 gross profit over last
year with the gross profit percentage remaining virtually unchanged.
At the end of 19B, actual results revealed that the expected 45,000 hats were
sold, but gross profit declined $35,000 instead of increasing $4,000. The results
were as follows:

Sales

Units Amount
Men's hats 25,000
Women's hats 20,000
Total 45,000

The
president, furious with the results and the apparently erroneous fore-
cast, summoned his staff for a conference and demanded an explanation. The
sales manager was quick to defend his position, pointing out that his department
 :

672 CONTROLLING COSTS AND PROFITS PART VI

met the sales quota of 45,000 hats and therefore was not to blame. He accused
the controller of allowing costs to get out of hand.
The controller, reaHzing he was not entirely to blame, explained that he was
not responsible for forecasting price changes when such changes are brought
about by competition. He also pointed out that a substantial portion of the
error was due to the sales manager's inability to maintain sales of the more
profitable men's hat line at the level estimated.
In order to settle the dispute, the president asked the controller to prepare
a complete analysis of the $39,000 variance from budgeted gross profit, along
with suggestions to correct the situation.

Required: The information requested in the preceding paragraph.

21-2. Gross Profit The Shell-Macke Mining Company mines

Analysis.
SLEMAC, a commonly used mineral. For the years 19A and 19B the company's
comparative report of operations showed

19A 19B
Net sales $ 840,000
Cost of goods sold 945,000
 . ,

CH. 21 CONVENTIONAL GROSS PROFIT ANALYSIS 673

year. The volume is apportioned between the three grades based upon the
prior year's product mix, again adjusted for planned changes due to company
programs for the coming year.
Given below are the company's budgeted income statement for 19 and —
the results of operations for 19 —
19 — Income Statement (Budgeted)

Grade I Grade 2 Grade 3 Total

Sales units 1,000 rolls 1,000 rolls 2,000 rolls 4,000 rolls
Sales dollars
(000 omitted) $1,000 $2,000 $3,000 $6,000
Variable expenses 700 1,600 2,300 4,600
Contribution margin . . $ 300 $ 400 $ 700 $1,400
Traceable fixed
expenses 200 200 300 700
Traceable margin $ 100 $ 200 $ 400 $ 700
Marketing and
administrative
expenses 250
Net operating profit $ 450

19 — Income Statement (Actual)

Grade 1 Grade 2 Grade 3 Total

Sales units 800 rolls 1,000 rolls 2,100 rolls 3,900 rolls
Sales dollars
(000 omitted) $810 $2,000 $3,000 $5,810
Variable expenses 560 1,610 2,320 4,490
Contribution margin . . $250 $ 390 $ 680 $1,320
Traceable fixed
expenses 210 220 315 745
Traceable margin $ 40 $ 170 $ 365 $ 575

Marketing and
administrative
expenses 275
Net operating profit $ 300

Industry volume was estimated at 40,000 rolls for budgeting purposes.

Actual industry volume for 19 —
was 38,000 rolls.

Required: (1) The profit impact of the final sales volume variance for 19
using budgeted contribution margins.
—
(2) The portion of the variance, if any, to be attributed to the present
condition of the carpet industry.
(3) The dollar impact on profits (using budgeted contribution margins) of
the shift in product mix from the budgeted mix.

(NAA adapted)
 :

674 CONTROLLING COSTS AND PROFITS PART VI

21-5. Estimated Gross Profit. Kelco Co. produces one principal product. The
income from sales of this product for the year 19A is expected to be $200,000.
Cost of goods sold will be as follows:

Materials used 540,000

Direct labor 60,000
Fixed overhead 20,000
Variable overhead 30,000

The company realizes that it faces rising costs and in December is attempt-
ing to plan its operations for the year 19B. It is believed that if the product is
not redesigned, the following changes in operations will result: materials prices
will average 5% higher; rates for direct labor will average 10% higher; variable
overhead will vary in proportion to direct labor costs if sales price is increased
;

to produce the same rate of gross profit as the 19A rate, there will be a 10%
decrease in the number of units sold in 19B.
product is redesigned according to suggestions offered by the sales
If the
manager, expected that a \0% increase can be obtained in the number of
it is

units sold with a 15% increase in sales price per unit. However, change in the
product would involve several changes in cost; i.e., a different grade of material
would be used, and 10% more of it would be required for each unit. The price
of this proposed grade of material has averaged 5% below the price of the ma-
terial now being used, and that 5% difference in price is expected to continue for
the year I9B. Redesign would permit a change in processing methods enabling
the company to use fewer skilled workers. It is believed that the average pay
rate for 19B would be 10% below the average for 19A due to that change.
However, about 20% more labor per unit would be required than was needed in
19A. Variable overhead is incurred directly in relation to production. It is
expected to increase 10% because of price changes and to increase an additional
amount in proportion to the change in labor hours.

Required: (1) A statement showing the estimated gross profit if the same
product is continued for 19B.

(2) A statement showing the estimated gross profit if the product is re-
designed for 19B.
(AICPA adapted)

CASES
A. Gross Profit Analysis of Time-Sharing Computer Programs. The senior
systems analyst of Sweetenall, Inc., Bob Canedy, developed in his spare time
three unique packages of computer programs: Package 1, Inventory Control;
Package 2, Sales Analysis; Package 3, Report Preparation. After realizing their
marketability, he struck out on his own, forming Data-Pack Co., a computer
time-sharing service bureau. He rented an adequate computer and leased some
data communication lines and terminals, then placed his packages on-line.
Once operational, he planned to sell the use of his packages to industrial cus-
tomers by the system-connect-hour; i.e., total time elapsing while customer's
terminal is directly connected to the central computer.
In the process of establishing profitable selling prices, Bob decided to project
his costs for the first year. Using processing information provided by the com-
puter salesman, Bob allocated total costs to the packages as follows
CH.
676 CONTROLLING COSTS AND PROFITS PART VI

Bob was pleased that his new firm had exceeded planned profits by $4,250.
However, it was evident that changes in demand for the packages and changes
in costs and selling prices had made this "gain" only coincidental.

Required: A
gross profit analysis to determine the effects of demand and
fluctuating prices on sales revenue so that a new price for the really profitable
package can be established.

B. Comparative Income Statement and Profit Analysis. The Navasota Manu-

facturing Company wishes an analysis of the comparative income statements
for 19A and 19B shown below:
19B 19A
Gross sales $12,000,000 $8,750,000
Less allowances and adjustments 1,500,000 500,000

Net sales $10,500,000 $8,250,000

Cost of goods sold:

Raw materials (special) $ 4,000,000 $2, 1 00,000
Materials (other) 800,000 300,000
Direct labor 4,800,000 2,700,000
Indirect factory overhead 400,000 1 50,000

Depreciation 1,200,000 1,200,000

$11,200,000 $6,450,000
Add beginning finished goods inventory 2,200,000 1,000,000

$13,400,000 $7,450,000
Less ending finished goods inventory 6,000,000 2,200,000

Cost of goods sold $ 7,400,000 $5,250,000

Gross profit $ 3,100,000 $3,000,000

General, administrative, and marketing expenses. . . 400,000 250,000

Net operating profit $ 2,700,000 $2,750,000

The company manufactures one single uniform product for sale in a com-
petitive market.
The management knows that wages have risen in its industry and in its plant
by an overall average of about 50^ from 19A to 19B. Special raw materials
used in the manufacturing process increased approximately 509c» and other
costs have risen in varying degrees. However, unit selling prices did not increase
in proportion to the costs. Although the number of units sold increased 20%
from 250,000 in 19A to 300,000 in 19B, the company did not expect the profit
for 19B to be as favorable as the statements indicate because of the adverse
conditions stated. However, the operating departments claimed large savings
due to technological manufacturing improvements and the shifting of super-
visors and personnel.
The management is faced with the necessity of making important decisions
with respect to the payment of dividends, the adjustment of executives' compen-
sation, and a program of plant expansion. Ahhough the income statement
indicates a favorable profit before taxes, the company's cash position is not
strong. The management, being at a loss to understand the apparent contradic-
tions presented by the increased costs and the results shown by the statements,
 ..

CH. 21 CONVENTIONAL GROSS PROFIT ANALYSIS 677

has requested an analysis of the statements and an examination of the factors

for the profit of 19B, assuming for the purpose of comparison that the year 19A
was a normal one for the company. It is requested that the analysis indicate
to what extent each factor influences the profit.
In addition to the above, the following information is available:

19B 19A
Beginning finished goods inventory 100,000 units 50,000 units
Ending finished goods inventory 200,000 units 100,000 units
Production 400,000 units 300,000 units
Direct labor man hours 2,845,000 hours 2,400,000 hours

Special raw materials used: Net Tons Amount

19A Gross weight 2,000 $2,600,000

Scrap recovered . . 500 500,000

Net weight used . . 1,500 $2,100,000

19B Gross weight 2,300 $4,450,000

Scrap recovered . . 300 450,000

Net weight used . . 2,000 $4,000,000

Depreciation was computed on a straight-line basis.

The company maintains a simple process cost system. Inventories are priced
at moving average costs computed monthly; that is, the cost used for inventory
pricing at the end of any month is computed at the average of the beginning
inventory and the cost of production for the month. It was noted that costs for
the latter months of 19B were considerably higher than for the early months of
the year as increased labor and materials costs became effective.
In-process inventories are not a factor in the foregoing statements.

Required: (1) An analysis showing the factors responsible for the 19B gross
and net profits as compared with the 19A gross and net profits.

(2) An
analysis of the extent to which the operating department has effected
savings in labor and raw materials costs.
 CHAPTER 22

DIRECT COSTING AND

THE CONTRIBUTION MARGIN

The factory overhead chapters presented the use of the factory over-
head rate for product costing and pricing. The method combined all
factory overhead costs, fixed and variable, into a composite rate. At the
time the rate is constructed, a capacity, volume, or activity level must be
decided upon so that all costs and expenses can be expected to be re-
covered over a certain period of time. This type of costing, known as
absorption, full, or conventional costing, assigns direct materials and direct
labor costs and a share of both fixed and variable factory overhead to
units of production.
At the end of each month or year, differences between actual and
applied overhead resulting from the use of a predetermined overhead
ToJc^r,^J CovQ^ rate are considered to be the over- or underapplied factory overhead and
°T
^—wJien expensed cause fluctuations in the unit product costs. Fixed costs
ox>Ji/- 1>^ included in over- or underapplied factory overhead contribute to the unit
tAv^a^^\^ J product cost fluctuations. Realizing the influence of fixed expenses upon
% Ci>>r- production costs, inventory values, and operating income, factory o\qt-
oSi^i^ head is divided into fixed and variable elements. \

^vw;d oO-c 'i f^ >^ C(r5 or- cu^ ^ ^sLcjr ^\-^AuJ p-ice_ i~f usL c,o^\^ -Ha '^^t
THE NATURE OF ABSORPTION COSTING ^v )^^is^^y

In responsibility accounting this division permits management to place

cost accountability on those individuals responsible for the incurrence of
these costs. The factory overhead rate used for product costing still in-
cludes both variable and fixed elements.

678
 i ,

CH. 22 DIRECT COSTING AND THE CONTRIBUTION MARGIN 679

In Standard cost accounting a dual factory overhead rate, one for vari-
able cost and one for fixed cost, can be employed. The rate is still on the
absorption costing basis however, the unit standard as to fixed cost with
;

its overhead based on standard volume will remain stable, and the stan-

dard cost of goods sold will generally be proportional to sales volume.

When a short-run standard volume is compared with the long-run or
normal capacity concept of the standard cost system, a difference is cal-
(1) volume variance or (2) idle capacity and fixed efficiency
'
culated: \ X I
^ variances. could be expected that such favorable or unfavorable
If it V^^
variances would balance out in the long run, they could be deferred and ) ^^^^if^ ij

the fixed costs included in the periodic cost of goods sold would vary di- (
^y\'^ ^
rectly and proportionately with sales volume. In the above cases, the fixed / Mif
overhead in its long-run, normal capacity concept behaves like the unit ^^^^i^^YVfi/

^, variable cost. However, if variances are expensed each period, fluctua- "^^ a^^lu
J
tions in the unit product cost occur. The unit p roduct cost will als o ^\Vc-3 6&s1j
fluctuate in cases in which the capacity le vel used to calculate the facto ry 'oo^ Wjl-
overheadraie IS ditlerent trom one^p eriod to the ne xt J^ggause^he fixed (X ooj-\'-Ui2-
part of tTie^'ate will be higher when a lower capa city level is used _and ^siy/is^ 'vM-SL .

lower when a hi gh er level is use d. Failure to use a predetermined factory r^Mi '

rj-

overhead rate also causes even wider unit product cost fluctuations be- . <J

"^cause fixed factory overhead is then allocated to production based on the ^'^-^ '^^^^^

actual activity level for the accounting period. -{^o^ V^

Information accumulated in NAA research studies over a period of \l.
v^JJLic*a»A
years indicates that the concept of long-range normal or standard unit
^)^ ^j)
cost for costing production, sales, and inventory is not often applied in . .
x

practice. The reasons given for the failure to carry out theory based on ^Mt-^^^ i>'^

the long-run concept of cost are: (\&^ ^sarWJJ \mJ^

1. Long-rangejTormal_^r_standard vnlum^ '-arn^t hp reliahlv determine d. DVU" "tV-*-*^
First, this is aconsequence of the fact that long-range volume for a ^_Jk _ -^
growing company with indefinite future life cannot be defined in con- ^'^"^^ " ^
Crete terms capable of being implemented by measurement techniques. uJjl. \\c{kU>~ ff
Second, long-range forecasts of future volume have, at best, a wide and . v, r;

unknown margin of error. XC^1~^ Ccjzi, irj

'
2. The services of manufacturing facilities and organization tend to expire
with the passage of time whether or not utilized to produce salable c/p(/»<5vn6?^
goods. Consequently, the period costs of these services also expire with i ,

time. To carry such costs forward to future periods results in mis- \^Xa~^ -H^
matching of costs with revenues because no benefits from such costs
jj
will be received in the future and nothing is contributed by the costs '^^^'aT fli\<y
toward production of future revenues. Thus, the practice of charging Mm'
a ]'£^U^
unabsorbed period cost against revenues of the current period has been
justified by reasoning that this charge measures cost of idle capacity (~
Lt^ ^^
and not cost of production. Similarly, apportionment of large over- ^^ - 4^^
absorbed balances reflects the opinion tliat unit production costs based -^-^"^
|

'

M
on standard volume have been overstated. p;--(cX/

'"Current Applications of Direct Costing," NAA Research Report No. 37, pp. 72-73.
 680 CONTROLLING COSTS AND PROFITS PART VI

The foregoing examination, the NAA study concludes, indicates that

"the concept of long-run unit cost of production is unsatisfactory in
measuring short-period income. The that the wrong
fault in this case is

cost concept was chosen for the purpose —

i.e., the long-run concept of

cost was used to measure short-run operations."^

It has been pointed out repeatedly that the normal capacity concept

used for establishing overhead rates is long-range in nature. Business-

persons, on the other hand, want monthly — and even weekly — earnings
reports. They want to know what was earned lastmonth. They do not
ask for a profit figure covering the firm's entire production and sales cycle.
Although the usefulness of costing methods for managerial purposes has
been aided immeasurably through the use of factory overhead rates and
flexible budgets, management always asks for more direct and under-
standable answers. Direct costing seeks to satisfy these demands.

DIRECT COSTING DEFINED

r* Direct costing charges the products with only those costs that vary
directly with volume. Only prime costs (direct materials and direct labor)
plus variable factory overhead expenses are used to assign costs to inven-
tories — both work in process and finished goods — and to determine the
..^ost of goods sold. Variable or direct costs such as direct materials, direct
labor, and variable factory overhead are examples of costs chargeable to
the product. Costs such as straight-line or accelerated depreciation, in-
surance, and factory and property taxes that are a function of time rather
than of production are excluded from the cost of the product. Also ex-
cluded are salaries of the executive and managerial staff', as well as those
of supervisors, foremen, and office and sales employees. Wages of certain
factory employees, such as maintenance crews, guards, etc., are also con-
sidered period costs rather than product costs.

FACETS OF DIRECT COSTING

upon the product and its costs. This
Direct costing focuses attention
r interest moves two directions: (1) to external financial reporting,
in
costing of inventories, income determination, and financial reporting and
(2) to internal uses of the fixed-variable cost relationship and the contri-
-^bution margin concept. The internal uses deal with the application of
direct costing in profit planning, pricing decisions, in other phases of
decision making, and in cost control. Diagrammatically, direct costing
can be presented as illustrated on page 681.

Hbid., p. 73.
CH. 22 DIRECT COSTING AND THE CONTRIBUTION MARGIN 681

COSTING OF
INVENTORY
 682 CONTROLLING COSTS AND PROFITS PART VI

Percentage
Item Per Unit Total of Sales

Sales (10,000 units) $70 $700,000 100

Less variable costs _42 420,000 60
Contribution margin $28 $280,000 40
Less fixed costs 175,000 25
Net operating income $105,000 15

The direct or variable cost and the contribution margin (sales revenue
— variable costs = contribution margin) allow quick and fairly reliable
decisions in short-run profit planning. In such situations, it is assumed
that the change or shift of a small segment within the total volume does
c not require major changes in capacity, which means in fixed costs. Gener-
ally, total period costs are subtracted from the contribution margin figure

to arrive at net operating income. Period costs that are specific or relevant
to a product, a product fine, or any segment of the business should be
isolated and attached to the product in order to increase the usefulness
of these costs for decision-making purposes.
Direct costing's variable and fixed costs aid management further in
planning and evaluating the profit resulting from a change of volume, a
change in the sales mix, in make-or-buy situations, and in the acquisition
of new equipment. A knowledge of the variable or out-of-pocket costs,
fixed costs, and the contribution margin provides guidelines for the selec-
tion of the most profitable products, customers, territories, and other
segments of the entire business. These uses are discussed in later chapters.

Direct Costing as a Guide to Product Pricing. The contribution margin

approach to costing, pricing, and planning receives increased attention by
economists, business managers, and accountants. The economist uses the
term "monopoUstic competition," a hybrid of pure competition and mo-
nopoly. This monopolistic competition creates a market which has certain
characteristics: (1) many firms sell the same or similar products, differen-
tiated only by name, by real or alleged quality, or by service, rather than by
price; (2) a firm cannot change the price without considering the reactions
of its competitors; and (3) a firm has little difficulty entering or leaving the
market. These characteristics are typical for most company situations.
How do these features of monopolistic competition aff'ect pricing and
costing methods?
Contribution margin, or as the economist calls it, "marginal income,"
is the result of subtracting variable costs from sales revenues. The best
or optimum price which will yield the maximum excess of total
is that
revenues over total cost. The volume at which the increase in total cost
due to the addition of one more unit of volume is just equal to the increase
in total revenue, or a zero increase in total profit, is the optimum volume.
 :

CH. 22 DIRECT COSTING AND THE CONTRIBUTION MARGIN 683

The price at which this volume can be obtained is the optimum price. A
higher price will lower the quantity demanded and
decrease total profit.
quantity sold and lead, conceivably, to
A lower price may increase the
by
abnormal manufacturing costs because of production
inefficiencies

requiring production during overtime, again decreasing total profit.

Management's thinking is generally in terms of the contribution mar-
market, prices
gin, or the direct costing approach. In a highly competitive
might be regulated through supply and demand, but to
what extent?
Management, it is contended, has little or no influence on demand which
certainly regulate supply; and,
rests with the consumer. However, it can
the stimulation of demand is not always beyond
management's
indeed,
influence.
In multiproduct pricing, management needs to know
whether each
contribute
product can be priced competitively in the industry and
still

to the contribution margin for fixed cost recovery

sufficiently
and profit.
The^ seful pa rt of a unit cost is the direct cosl_S£gm£ni^^ T^ ' t mn s i s ti of

tho se cost elements that arecomp a rable among firms in the same indust ry.
pricing policy should, however, make use of a full
product
_ A long-run
portion of fixed (capacity)
cost; i.e., a product cost which includes that
manufacturing process. (Other pricing methods
costs instrumental in the
are presented in Chapter 27.)
be on
Acceptance of direct costing by each business manager should
relevant cost information
the basis of simplicity and better presentation of
than on defects of absorption costing or allega-
for managerial uses rather
tions as to its failures.

Installation of a direct
Direct Costing for Managerial Decision Making.
segregation of fixed
costing system requires a study of cost trends and a
The identification and classification of costs as either
and variable costs.
properly subdivided into
fixed or variable, with semivariable expenses
their fixed and variable components, provide a
framework for the ac-
analysis of costs. This also provides a basis for the
study
cumulation and
of contemplated changes in production levels or
proposed actions con-
or special pro-
cerning new markets, plant expansion or contraction,
that a study of
motional activities. Of course, it is important to recognize
accomplished
cost behavior which identifies fixed and variable costs can be
without the use of a formal direct costing system.
NAAResearch Report No. 37 summarizes its findings on this
The
phase of direct costing as follows
costing's
Companies participating in this study generally feel that direct
of usefulness is in forecasting and reportmg mcome
for mternal
major field
which makes it
management purposes. The distinctive feature of direct costmg
purpose is the manner in which costs are matched with revenues.
useful for this
 ^

684 CONTROLLING COSTS AND PROFITS PART VI

The marginal income (contribution margin) figure, which resuhs from the
firststep in matching costs and revenues in the direct costing income state-
ment, is reported to be a particularly useful figure to management because it
can be readily projected to measure increments in net income which accom-
pany increments in sales. The theory underlying this observed usefulness of
the marginal income figure in decision making rests upon the fact that, within
a limited volume range, period costs tend to remain constant in total when
volume changes occur. Under such conditions, only the direct costs are
relevant in costing increments in volume.
The tendency of net income to fluctuate directly with sales volume was re-
ported to be an important practical advantage possessed by the direct costing
approach to income determination because it enables management to trace
changes in sales to their consequence in net income. Another advantage at-
tributed to the direct costing income statement was that management has a
better understanding of the impact that period costs have on profits when such
costs are brought together in a single group.

Direct Costing as a Control Tool. The direct costing procedure is

said to be the product of an allegedly incomprehensible income statement

prepared for management. The possible inverse fluctuations of production
costs and due to over- or underabsorbed factory overhead
sales figures
require a different type of costing procedure. By adopting direct costing,
management and marketing management in particular believe that a more
meaningful and understandable income statement can be furnished by the
accountant. But is the new type of income statement merely to serve the
marketing department ? Reports issued should serve all divisions of an
enterprise. It seems appropriate, therefore, also to prepare reports for all
departments or responsibility centers based on standard costs, flexible
budgets, and a division of all costs into their fixed and variable components,
the latter being considered fundamental in direct costing.

The marketing manager would receive a statement that places sales

and production costs in direct relationship to one another. Differences
between intended sales and actual sales caused by changes in sales price,
sales volume, or sales mix, which are the direct responsibility of the mar-
keting manager and his organization, are detailed for their analysis (as
discussed in Chapter 21).
Other managers can examine and interpret their reports with re-

spect to the cost variances originating in their respective areas of respon-

sibility. The production manager is able to study the materials quantity
variance, the labor efficiency variance, and the controllable overhead
variance. Variable expenses actually incurred can be analyzed by compar-
ing them with the allowable budget figure for work performed. The
purchasing agent or manager evaluates the purchase price variance. The
personnel manager can be held accountable for labor rate variances. Gen-
eral management which originally authorized and approved plant capacity

Hbid., pp. 84-85.

 CH. 22 DIRECT COSTING AND THE CONTRIBUTION MARGIN 685
<^

in the form of men and machines is primarily responsible for any fixed
overhead variances arising because of lower or higher utilization of existing
facilities. No variances should result in direct costing with respect to
fixed expenses, since all fixed costs are charged against revenue instead of to
the product; i.e., to inventories.
Reports constructed on the direct costing basis and augmented by the
additional information described become valuable control tools. A profit-
responsible management group iscontinually reminded of the original
profit objective for the period. Subsequent approved deviations from the
objective are revaluated in light of the current performance. Accounting
by organizational fines makes it possible to direct attention to the appro-
priate responsibility. Performance is no longer evaluated on the basis of
last month or last year, for now each period has its own standard.

EXTERNAL USES OF DIRECT COSTING

The proponents of direct costing beheve that the separation of fixed and
variable expenses, and the accounting for each according to some direct
costing plan, will simplify both the understanding of the income state-
ment and the assignment of costs to inventories.

The Chart of Accounts Modified for Recording and Reporting Purposes.

To keep fixed overhead out of the product costs, variable and fixed ex-
penses should be channeled into separate accounts. For this reason, it is

suggested that the chart of accounts be expanded so that every natural

expense classification has two accounts — one for the variable and one
for the fixed portion of the expense. Also, instead of one overhead con-
trol account, two have to be used Factory Overhead Control
: Variable —
Expenses and Factory Overhead Control —
Fixed Expenses. When
variable expenses are charged to work in process using an overhead rate,
the credit is to an applied overhead account now labeled Variable Factory
Overhead Applied. Differences between actual and applied variable over-
head constitute (1) controllable or (2) the spending and variable efficiency
variances when a standard cost system is used and a spending variance
when standard costing is not used. Because fixed expenses are not charged
to work in process, they are excluded from the predetermined overhead
rate. The total fixed expenses accumulated in the account Factory Over-
head Control —
Fixed Expenses are charged directly to Income Summary.

Effects of Direct Costing and Absorption Costing on Inventories and

Operating Profits. The following information is used to illustrate and
compare the effects of absorption costing and direct costing on gross
profit, inventory costing, and net operating income.
 :

686 CONTROLLING COSTS AND PROFITS PART VI

The normal capacity of a plant is 20,000 units per month, or 240,000

units a year. Variable costs per unit are: direct materials, $3; direct
labor, $2.25 ; and variable factory overhead, $.75 —a total of $6. Fixed
factory overhead is $300,000 per year, $25,000 per month, or $1.25 per
unit at normal capacity. The units of production basis is used for ap-
plying overhead. Fixed marketing and administrative expenses are
$5,000 per month, or $60,000 a year; and variable marketing and ad-
ministrative expenses are S3,400, $3,600, $4,000, and $3,000 for the first,

second, third, and fourth months, respectively.

is not given. The assumption is made
Actual variable factory overhead
that actual and applied variable overhead are the same; otherwise, vari-
able overhead variances could be computed. Likewise, no materials or
labor variances are assumed. All these variances would be the same in
either the absorption costing method or the direct costing method.
Actual production, sales, and finished goods inventories in units are

First Second Third Fourth

Month Month Month Month
Units in beginning inventory 3,000 1,000
Units produced 17,500 21,000 19,000 20,000
Units sold 17,500 18,000 21,000 16,500
Units in ending inventory 3,000 1,000 4,500
Sales price per unit : $10

The illustrations assume no work in process inventory.

Illustration I — Absorption Costing. In absorption costing fixed

factory overhead is included in the unit cost and also in the costs assigned
to inventory.
First Second Third Fourth
Month Month Month Month
Sales $175,000 $180,000 $210,000 $165,000
r Direct materials $ 52,500 $ 63,000 $ 57,000 $ 60,000
) Direct labor 39,375 47,250 42,750 45,000
V^ko^, Vl Variable factory overhead 13,125 15,750 14,250 15,000
^^ ^"f V Fixed factory overhead 21,875 26,250 23,750 25,000

P^^"^" Cost of goods manufactured $126,875 $152,250 $137,750 $145,000

Beginning inventory 21,750 7,250

Cost of goods available for sale $126,875 $152,250 $159,500 $152,250

Ending inventory 21,750 7,250 32,625

Cost of goods sold $126,875 $130,500 $152,250 $119,625

^^-v. Fixed (over-) or underapplied factory
_. ^p^ Y overhead 3,125 (1,250 ) 1,250

Cost of goods sold at actual $130,000 $129,250 $153,500 $119,625

^Y^
cli\ ovJjiJ
Gross profit on sales $ 45,000 $ 50,750 $ 56,500 $ 45,375
Marketing and administrative expenses . . 8,400 8,600 9,000 8,00
19"^ Net operating income for the month.... $ 36,600 $ 42,150 $ 47,500 $ 37,375
 :

CH. 22 DIRECT COSTING AND THE CONTRIBUTION MARGIN 687

Illustration 11 —
Direct Costing. In direct costing fixed factory overhead
is excluded from the unit cost and from the costs assigned to inventory.

First Second Third Fourth

Month Month Month Month
Sales $175,000 $180,000 $210,000 $165,000
^C Direct materials $52,500 $63,000 $57,000 $60,000
W^ Direct labor 39,375 47,250 42,750 45,000
I 1^ Variable factory overhead 13,125 15,750 14,250 1 5,000

Q Variable cost of goods manufactured $105,000 $126,000 $114,000 $120,000

Beginning inventory 18,000 6,000
j-^cvAa'.
^ Variable cost of goods available for sale . $ 1 05,000 $ 1 26,000 $ 1 32,000 $ 1 26,000
AiM^Ending inventory 18,000 6,000 27,000

Variable cost of goods sold $105,000 $108,000 $126,000 $ 99,000

Gross contribution margin $ 70,000 $ 72,000 $ 84,000 $ 66,000

Variable marketing and administrative

i expenses

Contribution margin
3,400

$ 66,600
3,600

$ 68,400
4,000

$ 80,000
3,000

$ 63,000
«=• •
Less fixed expenses
,%X, Factory overhead $ 25,000 $ 25,000 $ 25,000 $ 25,000
i. , Marketing and administrative expenses. 5,000 5,000 5,000 5,000

^^ Total fixed expenses

^ A>^
Net operating income for the month
.
$ 30,000

$ 36,600

The above example assigned standard costs to inventory

$ 30,000

^= ==
$ 38,400

in this case
$ 30,000

$ 50,000

—
= $ 30,000

$33,000

to finished goods only. Should work in process inventories be present,

they would be treated in the same manner. If standard costs are not
used, then an assumption as to flow of costs must be followed; e.g., aver-
age, fifo, lifo, etc. 'iJL Vm . 'j-^(^^ 'Cosh (^^$)^i> 4^ Taaj - ^a<X^ ifevx \j>'^t^

COMPARISON OF ABSORPTION COSTING u<h>>a\ ^<>^ k Hii?c*)

WITH DIRECT COSTING <sxdi^ ,^. Ttiw u .

m- ^Hc^f
The illustrations show three specific differences between absorption ^^ ascjiAou.

costing and direct costing: (1) gross profit vs. gross contribution margin, ^tr^ fU^^
(2) costs assigned to inventory, and (3) net operating income. ^'^ ^'^
Gross Profit vs. Gross Contribution Margin. The inclusion or exclusion UinJ
of fixed expenses from inventories and cost of goods sold causes the gross
profit to vary considerably from the gross contribution margin. The
gross contribution margin (sales revenue — variable manufacturing costs)
in direct costing is greater than the gross profit in absorption costing.
— This difference has resulted in some criticism of direct costing. It is argued
that a greater gross contribution margin might mislead the marketing
1 department into asking for lower prices or demanding higher bonuses or
 :

688 CONTROLLING COSTS AND PROFITS PART VI

L— benefits. In defense of direct costing, it is well to recognize the fact that

selling prices and bonuses are in most cases not based on gross profit but
on net income. This net income will be the same in each method when no
inventories exist or when no change in total cost assigned to inventory
occurs from the beginning to the end of the period. Although the two
illustrations were on a monthly basis, they could just as well have been
quarterly or annual. The shorter period is chosen to indicate more force-
fully the effects of each method.
As explained previously, managers favor direct costing because sales
figures guide cost figures. Variable cost of goods sold varies directly with

^JJVc^^ ^ sales volume. The influence of production on profit is eliminated. The

^<^ \ idea of "selling overhead to inventories" might sound plausible and ap-

-qJ.5C>1^Y pear pleasing at first; but when the prior month's inventories become this
\Lo^ / nionth's opening inventories, the apparent advantages cancel out. The
results of the second month with absorption costing offer a good example
^
.
^ I

I of the effects of large production with cost being deferred in inventories

>vJdiiA. p^ L into the next period. Illustration I (absorption costing) also demonstrates
;c io i^-the effect of expensing the fixed over- or underapplied factory overhead
,.j,j- ^ X resulting from production fluctuations.

Costs Assigned to Inventory. Changes brought about in inventory

costing have been the main point of attack by opponents of direct costing.
The illustrations show the following ending inventories
First Second Third Fourth
Month Month Month Month
Absorption costing $ -0- $21,750 $7,250 $32,625
Direct costing -0- 18,000 6,000 27,000

Differences $ -0- $ 3,750 $1,250 $ 5,625

Differences are caused by the elimination of fixed manufacturing ex-

penses from inventories in direct costing. In absorption costing, these
\ . fixed expenses are included as they form part of the predetermined factory
^^'^\'^overhead rate. The exclusion of this overhead from inventories and its
-
/^ offsetting effect on periodic income determination has been particularly

"^ ^>f^ L^}^JC^ii)/ The Position of the American Institute of Certified Public Accountants
CovXr^^ •
(AICPA). The AICPA's position toward direct costing for external re-
w\csj-a^,^
porting is almost wholly unfavorable. The basis for this position is Ac-
\aOv^ia>^'^ counting Research Bulletin No. 43, issued by the AICPA. Its "Inventory
'^^yc Pricing" chapter begins by stressing that "a major objective of accounting
^^^ a)?iv.iir^ for inventories is the proper determination of income through the process
V'^* j^ of matching appropriate costs against revenues."
^^^ N^-V cAl^^ ^,3^;^^ 5^ ^a- Qjf(s,^S^K^ Pfl^^siU^ ^A I- ^''^^^
CH. 22 DIRECT COSTING AND THE CONTRIBUTION MARGIN 689

The Bulletin continues by stating that "the primary basis of accounting

for inventories is cost, which has been defined generally as the price paid
or consideration given to acquire an asset. As applied to inventories,
cost means in principle the sum of the applicable expenditures and charges
directly or indirectly incurred in bringing an article to its existing condition
and location." In discussing the second point, the Bulletin states quite
emphatically that "it should also be recognized that the exclusion of all

overheads from inventory costs does not constitute an accepted accounting

procedure." This last statement seems to apply to direct costing. Pro-
ponents of direct costing might, however, argue that while the exclusion
of all overhead is not acceptable, by inference the exclusion of some is
acceptable. This argument might sound true, but it does not seem to have
any bearing on the Institute's acceptance of direct costing since in an
earlier discussion of cost the Bulletin states that "under some circum-
stances, items such as idle facility expense, excessive spoilage, double
freight, and rehandling costs may be so abnormal as to require treatment
as current period charges rather than as a portion of the inventory cost."
This appears to be the type of overhead that the AICPA recognizes as
excludable from inventories.
There is nothing to date indicating that the Financial Accounting
Standards Board (an independent private sector body, which in 1973 be-
gan its work of promulgating accounting standards) will take a position
on direct costing contrary to that of the AICPA.
Research studies conducted by the National Association of Accoun-
tants and the Financial Executives Research Foundation indicate that an
ever-increasing number of companies use direct costing for internal
responsibility reporting while others use it for profit planning, short-range
price setting, and management control. It should be noted that the man-
agement services divisions of CPA firms have been extremely active in
instaUing direct costing systems for internal management purposes. The
auditors of these firms adjust the year-end figures for income tax returns
and external reporting in harmony with the requirements of the Internal
Revenue Service (IRS) and the Securities and Exchange Commission
(SEC).

Internal Revenue Service (IRS) Regulations. The IRS refuses to ac- V^yf^ J~"
cept annual financial reports prepared on the basis of the direct costing _ i, •

method. Section 471 of the Internal Revenue Code provides two tests to 3-
'

which "each inventory must conform: (1) it must conform as nearly as ^^ ^^^rs
possible to the best accounting practice in the trade or business and (2) it <"^^ j29^)»<?'
must clearly reflect income." The regulations, however, also provide that '^--'^ S^rr\$^
consistency in inventory practice be given greater weight than is given to V^- +"1^^
any particular method of inventory costing so long as the method used is ^y\dsif^
'^vi?Sor-P'>^ UJoiUJ rjzymcL-^ m Z. X — h(^'i<i- Kac,Ij^ ^HX-D, Mr)o,v\ ctUq S oj- p'to/-^ "t
 690 CONTROLLING COSTS AND PROFITS PART VI

in accord with the regulations. The regulations define inventory cost in

the case of merchandise produced to be "(1) the cost of raw materials and
supplies entering into or consumed in connection with the product, (2)
expenditures for direct labor, and (3) indirect expenses incident to and
necessary for the production of the particular article, including in such
indirect production costs an appropriate portion of management ex-
penses." A 1973amendment to Section 471 specifically identifies the
direct costing method as "not in accord with the regulations."

The Position of the Securities and Exchange Commission (SEC). The

SEC, like the IRS, refuses to accept annual financial reports prepared on
the basis of the direct costing method. This refusal on the part of the
SEC is generally the result of (1) its policy to favor consistency among
reporting companies as far as possible and (2) its attitude that direct
costing is not generally accepted accounting procedure. In filing reports
with the SEC, a firm that uses direct costing must adjust its inventories
and reported net income to what they would have been had absorption
costing been used.

Net Operating Income. The difference in net operating income be-

tween absorption costing and direct costing is attributable to the fixed
cost charged to inventory as illustrated below. The data are from Illustra-
tions I and II on pages 686 and 687.

First Second Third Fourth

Month Month Month Month
Illustration I — Absorption Costing:
Net operating income for the month $36,600 $42,150 $47,500 $37,375
Illustration II — Direct Costing:
Net operating income for the month 36,600 38,400 50,000 33,000

Difference..^ $ -0- $ 3,750 $(2,500) $ 4,375

Illustration I —
Absorption Costing:
5o"YML Inventory change (ending less beginning
inventory) increase (decrease) $ -0- $21,750 $(14,500) $25,375
-Y(^
\v> A^^ Illustration II — Direct Costing:
+v i\-r Inventory change (ending less beginning
'>* ^-^ inventory) increase (decrease) -0- 18,000 (12,000) 21.000
Difference (inventory change in units X fixed
portion of overhead rate $1 .25) $ -0- $ 3,750 $(2,500) $ 4,375

The inventory change in this illustration is for finished goods only;

however, if there were work in process inventories, they too would be in-

cluded in inventory change in order to reconcile the difference in net

operating income. Alsg^anv over- or underapplied fij^£d_ia ctory ov er-
head deferred on the balance shee^jathe^han being currently exEcnged
 CH. 22 DIRECT COSTING AND THE CONTRIBUTION MARGIN 691

would be a reconciling item in explai ning the differe nce injiet^perating

income.
mventory
Ithas been observed that the amount of fixed cost charged to
produced but by the inventory costing
is affected not only by the quantities

n method employed —
a fact which is largely overlooked. The authors be-
\^^^^
lieve that a statement like "When production
exceeds sales (i.e., in-process _>^
i
^^^^
and finished inventories increasing), absorption costing shows
a higher
) ^ ^^J^^
profit than does direct costing; or when sales
exceed production (i.e., in-
)
absorption costing shows a Cb^
/ process and finished inventories decreasing),
correct, not uni-
1^ lower profit than does direct costing"^ is, although often
versally valid. The authors' analysis presents the differences in net oper-
costing in relation to
ating income under absorption costing and direct
four methods of inventory costing average —
costing, fifo, lifo, and

standard costing. that the usual generalizations about full

They show
direct costing hold only under the Ufo and
the standard costing
and
methods; however, under the fifo and the average costing methods, the
results are more complex than those
considered by the usual generaliza-

tions which therefore do not apply.

ADJUSTMENT OF DIRECT COSTING FIGURES

FOR EXTERNAL REPORTING
As long as the AICPA, and the SEC do not accept the direct
the IRS,

costing procedure for external reporting purposes,

some reconciliation to
results obtained by the absorption costing
method seems to be the only
differences between the
solution for a company using direct costing. The
operating income figures of each method are reconciled on page 690.
net
identical with
As previously noted, net operating income differences are
the differences in costs assigned to inventory
caused by the inclusion or
exclusion of fixed expenses.
Company practice indicates that comparatively simple procedures are
According
employed to determine the amount of periodic adjustment.
company reports that at the end
to the NAA Research Report No. 37, one
of each year period manufacturing costs are divided
by actual production to
create a costing rate which is applied to the units
on hand. Another com-
dollar of direct labor and
pany expresses period expenses as a rate per
direct expenses at normal volume. The dollar amount of direct labor
multiplied by the
and direct expenses in the year-end inventory is then
of the closing
foregoing rate to arrive at the period expense component
inventory.

4Yuji Ijiri.
L Livingstone. 'The effect of Inventory Costing
Robert K. Jaedicke, and John 63-74.
Methods on Full and Direct Costing," Journal of Accounting Research, Vol. 3, No. 1 pp.
,
 . ^

692 CONTROLLING COSTS AND PROFITS PART VI

A third company allocates all manufacturing overhead to production de-

partments with the result that period manufacturing cost is collected in seven
major pools corresponding to the company's major product lines. However,
the period costs are not allocated to individual products within product lines.
At the end of each month, period cost is transferred from inventory to cost of
sales on the basis of the relative amounts of direct cost in production and
sales. Since the amount of period cost associated with the several product
lines varies widely, it is thought desirable to make the segregation by product
lines for external reporting purposes.

DISCUSSION QUESTIONS
1 Differentiate between direct costs or expenses and direct costing.

2. Differentiate between differential costs and direct costing.

3. How does underapplied factory overhead come into existence?

4. Distinguish between period costs and product costs.

5. Why does the direct costing theorist state that fixed manufacturing costs
are not to be included in inventories?

6. Why should the chart of accounts be expanded when direct costing is used ?

7. Has the Internal Revenue Service approved direct costing for tax purposes ?
Explain.

8. A manufacturing concern follows the practice of charging the cost of direct

materials and direct labor to Work in Process but charges off all indirect
costs (factory overhead) directly to Income Summary. State the effects of
this procedure on the concern's financial statements and comment on the
acceptability of the procedure for use in preparing financial statements.

(AICPA adapted)

9. Why is it said that an income statement prepared by the direct costing

procedure is more helpful to management than an income statement pre-

pared by the absorption costing method?

10. In the process of determining a proper sales price, what kind of cost figures
are Hkely to be most helpful ?

11. A speaker remarked recently that even though direct costing has attractive
merits, there are certain items that should be considered before converting
the present system. What hidden dangers are present in direct costing?

12. Supporters of direct costing have contended that it provides management

with more useful accounting information. Critics of direct costing believe
that its negative features outweigh its positive attributes.

(a) Describe direct costing. How does it differ from conventional absorption
costing?

^''Current Applications of Direct Costing," NAA Research Report No. 37, pp. 94-95.
CH. 22 DIRECT COSTING AND THE CONTRIBUTION MARGIN 693

(b) List the arguments for and against the use of direct costing.

(c) Indicate how each of the following conditions would affect the amounts
of net income reported under conventional absorption costing and
direct costing, assuming a standard costing system is used.

(1) Sales and production are in balance at standard volume.

(2) Sales exceed production.
(3) Production exceeds sales.
(AICPA adapted)

13. Select the correct answer for each of the following statements.

(a) A basic cost accounting method in which the fixed factory overhead is
added to inventory is (1) absorption costing; (2) direct costing; (3)

variable costing; (4) process costing.

(b) Reporting under the direct costing concept is accomplished by (1) in-
cluding only direct costs in the income statement; (2) matching variable
costs against revenues and treating fixed costs as period costs; (3)
treating all costs as period costs; (4) eliminating the work in process
inventory account.

(c) Income computed by the absorption costing method will tend to exceed
income computed by the direct costing method if (1) units produced
exceed units sold; (2) variable manufacturing costs decrease; (3) units
sold exceed units produced; (4) fixed manufacturing costs decrease.

(d) When a firm uses direct costing, (1) the cost of a unit of product changes
because of changes in number of units manufactured; (2) profits fluc-
tuate with sales; (3) an idle capacity variation is calculated by a direct
costing system; (4) product costs include variable administrative costs;
(5) none of the above.

(e) When a firm prepares financial reports by using absorption costing, it

may find that (1) profits will always increase with increases in sales; (2)
profits will always decrease with decreases in sales; (3) profits may de-
crease with increased sales even if there is no change in selling prices
and costs; (4) decreased output and constant sales result in increased
profits; (5) none of the above.

(f) Under the direct costing concept, unit product cost would most likely
be increased by (1) a decrease in the remaining useful life of factory
machinery depreciated on the units-of-production method; (2) a de-
crease in the number of units produced; (3) an increase in the remaining
useful life of factory machinery depreciated on the sum-of-the-years'
-digits method; (4) an increase in the commission paid to salesmen for
each unit sold.

(g) Absorption costing differs from direct costing in the (1) fact that stan-
dard costs can be used with absorption costing but not with direct
costing; (2) kinds of activities for which each can be used to report;
(3) amount of costs assigned to individual units of product; (4) amount
of fixed costs that will be incurred.

(AICPA and NAA adapted)

 ::

694 CONTROLLING COSTS AND PROFITS PART VI

EXERCISES
1. Inventory Costs —
Absorption Costing vs. Direct Costing. As part of its in-
vestigation regarding the possible adoption of direct costing, the management
of the Garcia Company asks the controller what effect the adoption of such
procedures would have on inventories. In developing the answer to this ques-
tion, the following figures, representing operations for the past year, are used:

Units produced — 50,000, of which 15,000 were not sold

Direct materials $200,000
Direct labor 260,000
Factory overhead
Variable expenses 150,000
Fixed expenses 75,000

Required: (1) The cost to be assigned the 15,000 units in inventory using
absorption costing.
(2) The cost to be assigned the 15,000 units in inventory using direct costing.

( 2?)lncome Statements —
Absorption Costing vs. Direct Costing. The Levine
Corporation produced 24,000 units (normal capacity) of product during the
first quarter of 19 —
20,000 units were sold
. @
$22 per unit. Cost of this
production was
:^^^^coXaao.<=P uM
Vos
^>YaJ 7m W- c^^u^if^^
Materials $ 60,000
Direct labor 60,000
Factory overhead
Variable costs 120,000
Fixed costs 96,000

Marketing and administrative expenses for the quarter total $70,000; all
are fixed expenses.

Required: (1) An income statement using absorption costing.

(2) An income statement using direct costing.

3. Comparative Income Statement —

Absorption Costing vs. Direct Costing. On
April 1 Evergreen Lawn Sprinklers, Inc. began production of a new model.
During April and May the company produced 7,000 units each month; 6,000
units were sold in April and 7,500 units in May. The sales price is $10 per
sprinkler. Direct materials cost is $3 per unit, and direct labor cost is $4 per
unit. At the 7,000 unit operating level variable factory overhead is charged to
production at $1 per unit and the fixed factory overhead at $.60 per unit. There
was no over- or underapplied factory overhead in either month. Marketing
and administrative expenses were $5,000 each month. There were no work in
process inventories.

Required: Comparative income statements for April and May using (a) the
absorption costing method and (b) the direct costing method.

4. Direct Costing Statements; Gross Profit Analysis. The Duro-Auto Seat Cover
Corporation manufactures one style of automobile seat covers for mail order
houses.
 : :

CH. 22 DIRECT COSTING AND THE CONTRIBUTION MARGIN 695

The following information was received by management covering the past

three months:

January February March

Sales (at $10 per unit) $5.000 $2,000 $20,000

Beginning inventory —— $2,500 $ 6,500

Cost of goods manufactured in month $5,000 5,000 5,000

Cost of goods available for sale $5,000 $7,500 $1 1 ,500

Ending inventory 2,500 6,500 1,500

Cost of goods sold $2,500 $1,000 $10,000

Gross profit $2,500 $1,000 $10,000

Supplementary information
Sales price per unit $10
:

Units manufactured per month 1,000 :

Standard cost per unit at normal volume : $5

Total manufacturing costs:
Variable $3,000
Fixed 2,000

The Cost Department believes that perhaps a direct standard costing system
may be more helpful for management purposes than the standard absorption
system presently in use.

Required: (1) Income statements for each of the three months on the direct
standard cost basis.
(2) Computations explaining the differences in gross profit for each month.

5. jComparison of Absorption Costing with Direct Costing. Landon, Inc. pro-

"Huced 15,000 units of its product in 19 —
and sold 10,000 of these units. Actual
production costs were
Direct labor $90,000
Direct materials 60,000
Variable factory overhead 30,000
Fixed factory overhead 50,000

Assume the following:

(a) Anticipated labor cost is $6 per unit; direct labor cost is used as a basis for
applying overhead, 'i
'-
r. r v- '' - . .

(b) $120,000 direct labor is used in determining the factory overhead rate. At that
level the fixed cost is estimated to be $50,000 and the variable cost $40,000.
(c) Under- or overabsorbed factory overhead is closed to Cost of Goods Sold at
the end of the year.

Required: (1) Assuming that the company uses a predetermined factory

overhead rate based on absorption costing, compute the (a) factory overhead
rate, (b) factory overhead applied to production for the period, (c) total cost of
goods sold, and (d) ending inventory.
(2) Assuming that the company had used direct costing, compute the (a)
ending inventory and (b) cost of goods sold. Fixed factory overhead is not
closed to the cost of goods sold account.
 :

696 CONTROLLING COSTS AND PROFITS PART VI

6. Absorption Costing vs. Direct Costing; Income Statements. The following

data pertain to the operations of the McGreevey Manufacturing Company for
the year 19 —
Sales in kilograms: 75,000
Finished goods inventory, January 1, 19 —
12,000 kilograms :

Finished goods inventory, December 31, 19 17,000 kilograms — :

Sales price: $10

Manufacturing costs:
Variable costs per kilogram of production: $4
Fixed factory overhead $160,000 (normal capacity: 80,000 kilograms)
:

Marketing and administrative expenses:

Variable cost per kilogram of sales: $1
Fixed marketing and administrative expenses: $150,000

A standard costing system is used.

Required: (1) Income statement for 19 — under the (a) absorption costing
method and (b) direct costing method.
(2) An accounting for the difference in net operating income under the
two concepts.

7. Direct Costing Statements; Analysis of Profit Differences. The Travis Manu-

facturing Company's Cost Department prepares quarterly income statements
based on absorption costing. For the last two quarters of last year and the first
quarter of this year, the following income statements were sent to management:

Income Statements

3rd quarter 4th quarter 1st quarter

Sales ($20 per unit) $1,600,000 $1,600,000 $1,600,000

Cost of goods sold (at standard) $1,200,000 $1,200,000 $1,200,000

Fixed marketing and administrative
expenses 250,000 250,000 250,000
Factory overhead volume variance 100,000 250,000 (50,000 )

Total costs $1,550,000 $1,700,000 $1,400,000

Net operating income (loss) $ 50,000 $ (100,000 ) $ 200,000

Other cost, sales, and production data are:

(a) Beginning inventory, 3rd quarter 40,000 units

(b) Standard variable manufacturing costs 50% of sales price
(c) Normal sales demand 100,000 units per quarter
(d) Standard productive capacity utilization 100,000 units per quarter
(e) Actual sales and production in the three quarters:

Quarters Sales Production

Third 80% of normal 80% of normal

Fourth 80% of normal 50% of normal
First 80% of normal 1 10% of normal

Required: (1) Income statements for the three quarters based on direct
costing procedures.
 : :

CH. 22 DIRECT COSTING AND THE CONTRIBUTION MARGIN 697

(2) An explanation for the differences in net operating income for each
quarter.

8. Income Statements —
Absorption Costing vs. Direct Costing Analysis of ;

Profit Differences. The following annual flexible budget has been prepared by
Accuro, Inc. for use in making decisions relating to its Product X.
Flexible Budget — Product X
100,000 150,000 200,000
Units Units Units
Sales volume $800,000 $1,200,000 $1,600,000
Manufacturing costs

Variable $300,000 $ 450,000 $ 600,000

Fixed 200,000 200,000 200,000
Total manufacturing costs $500,000 $ 650,000 $ 800,000

Marketing and other expenses

Variable $200,000 $ 300,000 $ 400,000
Fixed 160,000 160,000 160,000
Total marketing and other expenses . $360,000 $ 460,000 $ 560,000
Net operating income (loss) $ (60,000 ) $ 90,000 $ 240,000

The 200,000 unit budget has been adopted and will be used for allocating
fixedmanufacturing costs to units of Product X. At the end of the first six
months, the following information is available:
Units
Production completed 1 20,000
Sales (at $8 per unit) 60,000

All fixed costs are budgeted and incurred uniformly throughout the year,
and all costs incurred coincide with the budget.
Over- and underapplied fixed manufacturing costs are deferred on the bal-
lance sheet until the end of the year.

Required: (1) The amount of fixed manufacturing costs applied to produc-

tion during the first six months under absorption costing.
(2) In income statement format (including ending inventory), (a) the net
operating income (loss) for the first six months under absorption costing; (b) the
net operating income (loss) for the first six months under direct costing.
(3) Computations explaining the difference in net operating income (loss).

(AICPA adapted)

PROBLEMS
22-1. Income Statements —
Absorption Costing vs. Direct Costing. The con-
troller of the Shriver Manufacturing Company has been encountering con-
siderable explaining to management the fluctuations in profits
difficulties
resulting from between the volume of sales and the volume of pro-
diff'erences
duction within an accounting period. Management tends to think of profits as
being directly related to the volume of sales and therefore finds it confusing
when this month's sales are higher than last month's, yet profits are lower be-
cause of underabsorbed fixed overhead.
 :

698 CONTROLLING COSTS AND PROFITS PART VI

To demonstrate the results more forcefully, the controller prepared the fol-
lowing data applicable to each four-month period:
Standard production volume 50,000 units
Selling price $2.50 per unit
Standard variable costs at standard volume $50,000
Standard fixed overhead 25,000

Results:
Jan. 1 — April 30 May 1 — Aug. 31 Sept. 1 — Dec. 31
Actual sales 40,000 units 50,000 units 60,000 units
Actual production 60,000 units 40,000 units 50,000 units

Actual costs equal standard costs in all situations.

Required: Income statements using direct costing and absorption costing for
each of the three periods.

22-2. Unit Product Costs and Comparative Gross Profit Statements Based on
Absorption Costing and Direct Costing. The Accounting Department of the
Hinckley Corporation gathered the following cost and other data:
Plant's normal annual activity: 40,000 direct labor hours
Annual total fixed manufacturing costs $60,000
:

Hours required to produce a unit of product: 5

Direct materials and direct labor cost per unit of product: $28
Variable factory overhead per unit of product: $5 (5 hrs. @ $1 per hour)
Selling price per unit of product: $45

Required: (1) Using the plant's normal activity level as the base, the total
manufacturing costs per unit of product based on (a) absorption costing and
(b) direct costing.
(2) Comparative gross profit statements using (a) absorption costing and
(b) direct costing, based on the following four situations

Year Produced Sold

1st
 : :

CH. 22 DIRECT COSTING AND THE CONTRIBUTION MARGIN 699

Actual sales and production results are:

Sales 160,000 units
Production 140,000 units
Opening inventory 25,000 units (priced at standard costs based
on absorption costing)
Unfavorable variances:
Labor efficiency variance $13,500
Controllable variance 9,200

Favorable variance:
Direct materials price variance 8,800

All variances are written off to Cost of Goods Sold.

Required: (1) Income statements using (a) absorption costing and (b)
direct costing.
(2) An explanation of the difference in net income under the two methods.
(3) The effect on retained earnings if the company decides to convert to
direct costing as of the beginning of the year covered by the above data.

22-4. Direct Costing Statement with Variance Analysis. The Holland Manu-
facturing Company operates a direct costing system. For the month of March
the following costs, sales, and other data are available

Production and sales data:

Units started 1,000
Units completed 900
Units in process, all materials, 50% labor and overhead 100
Units sold 800
Sales price per unit $150

Standard variable unit product cost:

Direct materials $10
Direct labor (5 hrs. X $4) 20
Variable factory overhead (5 hrs. X $1) 5
Total variable manufacturing cost $35
Variable product marketing expenses (10% of sales price) 15
Total direct variable cost $50

Cost data for the month of March

Standard Actual

Variable factory overhead $ 5,000* $ 5,400

Fixed factory overhead 1 5,000 1 5,000

Fixed marketing expenses 20,000 20,000

Fixed administrative expenses 30,(X)0 30,000
Labor hours in operations completed 5,075 hrs.
Direct labor used $20,550
Direct materials used 9,600

*For normal capacity of 1,000 units.

Required: (1) An income statement based on direct costing, including net

variances for the direct costs of manufacturing and marketing.
(2) The cost of the ending inventories for work in process and finished
goods, based on absorption costing in a standard cost system.
 :

700 CONTROLLING COSTS AND PROFITS PART VI

22-5. Comparative Statement of Cost of Goods Sold; Variance Analysis. The

standard cost card of the product MOLEN
of the Molenger Manufacturing
Company shows the following details:
Direct materials, 4 units of OLME @
$2 unit $ 8
Direct labor, 2 hours per finished product 9
Factory overhead, $3 per direct labor hour 6
Total manufacturing cost $23

The $3 factory overhead rate is based on $120,000 fixed cost and a $2

variable rate per direct labor hour.
Molenger's Cost Department reports that a process cost system with the
fifo method for work in process inventory is used and that the following in-
ventory, cost, and production data were experienced during the year:

Units in process:

January 1 : 2,000 units, all materials, 50% processed

December 31 : 1,000 units, all materials, 50% processed

Other data

Finished goods, January 1, 1,000 units; December 31, 1,500 units

Materials put in process: 260,000 units of OLME
Actual factory overhead: $398,700, including an increase of $15,000 in fixed
overhead during the year. 66,000 units of MOLEN
were transferred to the
warehouse.

The company's management stated that the present absorption standard

cost system should be changed to a direct standard cost system. Variable cost
variances are to be charged or credited to Cost of Goods Sold.

Required: A comparative cost of goods sold statement, using absorption

standard costing and direct standard costing.

22-6. Entries Based on Absorption Costing and Direct Costing. Ono Company
uses a standard cost accounting system based on the absorption costing theory.
The company manufactures one product, the standard cost of which is:

Direct materials gross weight allowed 4 1/6 lbs. @ $1 .92 = $ 8.00

Allowance for inherent loss (4%) 1 /6 lb.

Weight of finished product 4 lbs.

Direct labor 3 hours @ $1 .80 = 5.40
Factory overhead 3 hours @ $2.00 = 6.00
Total standard cost per unit of product $19.40

In developing the 19— budget and standards, company officials planned to

produce 41,000 units of product requiring 123,000 standard direct labor hours in
246 operating days. The annual factory overhead was analyzed as follows:
Per Hour
Nonvariable with production $1 10,700 $ .90
Variable directly with production in labor hours 135,300 1 -10

Total factory overhead for 1 9— anticipated $246,000 $2.00

 : :

CH. 22 DIRECT COSTING AND THE CONTRIBUTION MARGIN 701

The following account balances, among others, are in the general ledger at
May 31, 19 —
All of the external transactions for May have been journalized
.

and posted as have all accruals, deferrals, and other internal transactions ex-
cept those relating to Work in Process, Finished Goods, variances, and Cost of
Goods Sold.
Debit Credit

Finished Goods $ 48,500

Work in Process 1 3,240

Materials 74,310
Sales ($26 per unit) $421,200
Cost of Goods Sold 238,620
Direct Labor 20,160
Factory Overhead 22,375
Materials Price Variance 476
Materials Quantity Variance 960
Direct Labor Rate Variance 30
Direct Labor Efficiency Variance 180
Factory Overhead Spending Variance 50
Factory Overhead Efficiency Variance 200
Factory Overhead Idle Capacity Variance 450

The company carries materials inventory at actual cost and records the vari-
ances when charging Work in Process.
Production plans for May called for 1 1,000 direct labor hours in 22 working
days. On this basis, a flexible budget for factory overhead for the month had
been drawn as follows
Fixed overhead (22 days @ $450 per day)* $ 9,900
Variable overhead (1 1,000 hours @
$1.10 per hour) 12,100
$22,000

*The company divides the total fixed costs by the number of working days in the year and
charges overhead each month on the basis of the budgeted number of working days rather than
on the basis of 1/12 of the annual amount.
May production obtained, in terms of complete units, was
Units in process May 1 (materials complete, 3 /4 converted) 800
Units finished 3,800
Units in process May 31 (materials complete, 1 /2 converted) 1,000

Direct materials put into production weighed 16,580 lbs. and cost $32,082.
Actual direct labor hours totaled 1,200.
1

Required: (1) Journal entries to complete the general ledger record at

May 31, 19—.
(2) Journal entries to complete the general ledger record assuming that the
company had been using direct costing instead of absorption costing.

22-7. Income Statements —

Absorption and Direct Costing Profit and Break-
;

Even Analysis. Seller, Inc. has a maximum productive capacity of 210,000 units
per year. Normal capacity is regarded as 180,000 units per year. Standard
variable manufacturing costs are $11 per unit. Fixed factory overhead is
$360,000 per year. Variable marketing expenses are $3 per unit sold, and fixed
marketing expenses are $252,000 per year. The unit sales price is $20.
The operating results for 19 —
are: sales, 150,000 units; production, 160,000
units; beginning inventory, 10,000 units; and net unfavorable variance for
standard variable manufacturing costs, $40,000. All variances are written off as
additions to (or deductions from) standard cost of goods sold.
 :

702 CONTROLLING COSTS AND PROFITS PART VI

Required: (1) Income statements for 19 — under (a) absorption costing

and (b) direct costing.

(2) A brief account of the difference in net operating income between the
two income statements in (1).

(3) The break-even point expressed in sales dollars.

(4) Units to be sold to earn a net operating income of $60,000 per year.

(5) Units to be sold to earn a net operating income of 10% on sales.

For (3), (4), and (5), assume there are no variances from standards for manu-
facturing costs. (See Chapters 2 and 24 for a discussion of break-even analysis.)

(AICPA adapted)

22-8. Absorption Costing vs. Direct Costing. Norwood Corporation is con-

sidering changing its method of inventory costing from absorption costing to
direct costing and wants to determine the effect of the proposed change on its
19— financial statements.
The firm manufactures Gink, which is sold for $20 per unit. raw material, A
Marsh, is added before processing starts; and labor and factory overhead are
added evenly during the manufacturing process. Production capacity is bud-
geted at 1 1 0,000 units of Gink annually. The standard costs per unit of Gink are

Unit Cost

Marsh (2 lbs. © $1.50 per lb.) $ 3.00

Labor 6.00
Variable factory overhead 1 .00

Fixed factory overhead 110

Total unit cost $11.10

A process cost system is used employing standard costs. Variances from

standard costs are now debited or credited to Cost of Goods Sold. If direct
costing were adopted, only variances resulting from variable costs would be
debited or credited to Cost of Goods Sold.

Inventory data for 19 — are as follows: Units

January 1 December 31
Marsh (lbs.) 50,000 40,000
Work in process:
2/5ths processed 10,000
1 / 3d processed 1 5,000
Finished goods 20,000 12,000

During 19— 220,000 lbs. of Marsh were purchased, and 230,000 lbs. were
transferred to work in process inventory. Also, 110,000 units of Gink were
transferred to finished goods inventory. Annual fixed factory overhead, bud-
geted and actual, was $121,000. There were no variances between standard
and actual variable costs during the year.

Required: (1) Schedules for the computation of (a) equivalent units of pro-
duction for materials, labor, and factory overhead for the year 19 (b) number — ;

of units sold during 19 —

(c) standard unit costs under direct costing and
;

absorption costing; (d) over- or underapplied fixed factory overhead, if any,

for 19—.
CH. 22 DIRECT COSTING AND THE CONTRIBUTION MARGIN 703

(2) A comparative cost of goods sold statement for 19 — , using standard

direct costing and standard absorption costing.
(AICPA adapted)

22-9. Comparative Income Statements; Income Reconciliation; Direct Costing

Advantages and Disadvantages. S. T. Shire Company uses direct costing for its
internal management purposes and absorption costing for its external reporting
purposes. Thus, at the end of each year, financial data must be converted from
direct costing to absorption costing in order to satisfy external requirements.
At the end of 19 A, the company anticipated that sales would rise 20% the
next year. Therefore, production was increased from 20,000 units to 24,000
units to meet this expected demand. However, economic conditions kept the
sales level at 20,000 units for each year.

The following data pertain to 19A and 19B:

I9A 19B
Selling price per unit $30 $30
Sales (units) 20,000 20,000
Beginning inventory (units) 2,000 2,000
Production (units) 20,000 24,000
Ending inventory (units) 2,000 6,000
Total unfavorable materials, labor, and variable factory
overhead variances $5,000 $4,000

Standard variable costs per unit for 19A and 19B are:
Materials $ 4.50
Labor 7.50
Variable factory overhead 3.00
Total $15.00

Annual fixed costs for 19A and 19B (budgeted and actual) are:

Production $ 90,000
Marketing and administrative 100,000
Total $190,000

The factory overhead rate under absorption costing is based upon practical
plant capacity, which is 30,000 units per year. All variances and over- or
underabsorbed factory overhead are closed to Cost of Goods Sold. Income
taxes are to be ignored.

Required: (1) Income statements for 19B based on (a) direct costing and
(b) absorption costing. (The beginning and ending inventories need not be
shown on the income statements; i.e., show Cost of Goods Sold as one figure.)
(2) An explanation of the difference, if any, in the net operating income
figures and the entry, if necessary, to adjust the book figures to the financial
statement figures.
(3) The advantages and disadvantages attributed to direct costing for in-
ternal purposes, if the company develops its internal financial data on a direct
costing basis.
(4) The arguments for and against the use of direct costing in external re-
porting. (Many businesspersons believe direct costing is appropriate for
external reporting while others oppose its use for this purpose.)

(NAA adapted)
 CHAPTER 23

MARKETING COST
AND PROFITABILITY ANALYSIS

The concept of marketing means the matching of a company's products

with markets for the satisfaction of customers at a reasonable profit for
the firm. Marketing managers, in turn, must decide the (1) product selec-
tion, design, color, size, packaging, etc., (2) price(s) to be charged, (3)
advertising and promotion needed, and (4) physical distribution to be
followed. These numerous decisions require organization, planning, and
control. Marketing activities are usually organized by product or brand
lines or by territories or districts. The planning and control phases should

be based on a well-structured marketing cost and profitability analysis

system.
The preparation of and need for budgeting in planning and controlling
the marketing activity of a firm is discussed in Chapter 16. At the end of
each month, budget reports are issued that indicate the success or failure
of holding expenses within budgetary boundaries.
The problems associated with marketing costs do not end with these
budgetary procedures. Cost control at the departmental level is the im-
portant feature of any cost improvement program. In marketing, which
includes selling as well as other marketing-oriented phases of a company,
emphasis ordinarily rests on selling rather than on costs. To limit mar-
keting costs unreasonably might lead to a curtailment of sales activities,
which in turn could mean the gradual deterioration or elimination of

704
 . :

CH. 23 MARKETING COST AND PROFITABILITY ANALYSIS 705

certain types of sales; conversely, indiscriminate and wasteful spending

should not be sanctioned.

SCOPE OF MARKETING COSTS

The control and analysis of marketing costs must extend beyond the
scope of a departmental budget. This phase of cost accounting calls for

the determination of marketing costs for managerial decisions, thereby

making an integral part of business planning and policy formulation.
it

Management requires meaningful marketing cost information in order

to determine and analyze the profitability of (1) a territory or territories;
(2) certain classes of customers, such as wholesalers, retailers, institutions,
and governmental (3) products, product lines, or brands and (4)
units ; ;

promotional efforts by salespersons' calls, telephone, mail, television,

radio, etc.
Control and analysis of marketing costs complement each other.
Control begins with the assignment of marketing expenses to various cost-
ing groups such as territories, customers, and products. However, assigned
costs must be controlled through analysis within the jurisdictional function
in order to hold each marketing activity to the predetermined profitability
level.

Control and analysis are enhanced by (1) predetermining costs allowed

for marketing efforts and (2) estabhshing functional costing rates based
on standards and budgets designed to aid in achieving marketing objectives.
Until recently, marketing activities were restricted largely to fulfilling
existing demands today, the scope of marketing has been broadened and
;

expanded in its search for the creation and discovery of new demands for
a company's products and services. This new outlook requires the best
available working tools for management's use; yet, in many organizations
the marketing activity has not always received the management and ac-
counting attention rendered to other business operations. In today's
economy, the strategic importance and magnitude of marketing costs are
great enough to merit increased attention in every company.
The subject of marketing cost and profitability analysis will be pre-
sented under the following topics

1 Comparison of manufacturing and marketing costs

2. Marketing cost control
3. Control of functional activity by the flexible budget and standards
4. Marketing profitability analysis
5. The contribution margin approach
6. Robinson-Patman Act and marketing cost analysis
7. Illustrative marketing cost and profitability analysis problem
706 COST AND PROFIT ANALYSIS PART VII

It is important to note that general and administrative expenses and

research and development costs for manufacturing as well as other busi-
ness enterprises should also be planned, analyzed, and controlled. De-
partment stores and other merchandising businesses recognized the func-
tional cost control concept many years ago. The financial success of these
firms is in no small measure due and reducing
to extreme care in controlling
costs on a departmental-functional line basis.same concepts
In fact, the
and techniques are applicable to these other nonmanufacturing costs ex-
perienced in municipal, state, and federal units and agencies and other
nonbusiness organizations where functional cost control and analysis are
not only possible but, in many instances, positively necessary. For ex-
ample, municipal functions such as trash collection or street cleaning
should be placed on a departmental budget basis with a supervisor respon-
sible for the efficient operation of the function and accountable for the
cost control phase within the Hmits of the budget.

COMPARISON OF MANUFACTURING AND

MARKETING COSTS
The control and analysis of marketing costs present certain com-
plexities. First of all, logistic systems are many and varied. Manufacturers
of certain products use basically the same raw materials and machinery.
However, in marketing a product, the same companies may use vastly
different channels of distribution ranging from a direct simplex distribu-
tion to a complex marketing system. Promotional efforts may be directed
to narrow or broad customer groups. Every phase of the distribution
process may differ. Therefore, a meaningful comparison of the marketing
costs of one company with another is almost impossible.
Not only do distribution methods vary, but they are also extremely
flexible. A company may find that a change in market conditions neces-

sitates a change in its channels of distribution. Its tactics may change

several times before the best method is found. Even then, methods are
constantly on trial for quick revision or drastic changes. Such changes
would be disastrous in production. Once a factory is set up, management
is not likely to change its manufacturing techniques to any great extent;

therefore, standards once set for a particular machine do not require much
revision. However, distribution standards must be revised with every
change in the method of distribution.
The psychological factors present in selling a product are perhaps the
main reasons for differences between manufacturing and marketing
costing. Management can control cost of labor, hours of operation, and
number of machines operated; but management cannot tell what the
customer will do. Various salespersons may have different effects on the
CH. 23 MARKETING COST AND PROFITABILITY ANALYSIS 707

same customer who responds to varying appeals. Customer resistance is

the enigma in the problem of marketing cost analysis. The customer is a
controlling rather than controllable factor his wishes and his peculiarities
;

govern the method of doing business.

There is also the attitude of management itself. Although factory man-
agers are eager to measure their accompHshments in terms of reduced
cost per unit, most sales managers consider increased sales the yardstick
for measuring their efficiency, although they do not always mean greater
profits.

Cause and effect, generally obvious in the factory, are not so readily
discernible in the marketing processes. For example, many promotional
costs are incurred for future results, creating a time lag between cause and
eff"ect. Conversely, the effects of manufacturing changes are usually felt

quickly and matching between elTort and result usually can be determined.
;

Furthermore, manufacturing results are more readily quantified than are

marketing costs. For marketing costs, it is often not so easy to identify
quantities or units of activity with the cost incurred and results achieved.
Generally accepted accounting practice does not charge Cost of Goods
Sold and ending inventories with marketing and administrative expenses.
These and other nonmanufacturing expenses usually fall into the category
of period costs, even if variable, and as such are charged off" in total at the
end of the accounting period. Thus, marketing costs are generally charged
against the operations of the accounting period in which they are incurred
while production costs are held in inventory until the units are sold. This
practice is followed because it is felt that too much uncertainty exists as to
the probable results in future periods arising from incurred marketing
expenses. Marketing assets (such as delivery trucks) should, of course, be
expensed over their useful lives — not when acquired.
In the field of marketing costs, it is more common to speak of mar-
keting cost analysis rather than of marketing cost accounting. A tie-in

of marketing costing with the general accounts, desirable as it is, is often

not necessary. A rate for charging marketing expenses to operations
similar to the factory overhead rate is sometimes employed, but this pro-
cedure is not widely used.
Marketing cost control and analysis deals primarily with historical or
past costs, dealing chiefly with the evaluation of past performances as
related to standards and budgets. In connection with future policies, fore-
cast or predetermined figures are employed. In either case, whether
judging past performances or deciding on future activities, the possibility

of reducing costs and increasing profits through modern methods applied

to the marketing area presents a real challenge to management and the
accountant.
 :

708 COST AND PROFIT ANALYSIS PART VII

The control and analysis of marketing costs should follow these cost
control methods that serve factory management so well

1. Departmentalization of activities or functions

2. Assignment of responsibility for operations
3. Recognition of direct and indirect departmental expenses
4. Separation into fixed and variable expenses
5. Determination and establishment of bases such as direct labor cost,
direct labor hours, or machine hours used to apply factory overhead to
jobs, products, or processes
6. Comparison of actual with budgeted expenses for a continuous control
by responsible department supervisors and foremen
7. Flexible budgets and standard costs

MARKETING COST CONTROL

Functional Classification. The first step in the control of marketing
costs is the classification of natural expenses according to functions or
activities. It is and its associated expenses be
essential that each function
made the responsibility of an individual department head. Marketing
functions are of many types, depending on the nature of the business, and
its organization, size, andmethod of operation.
Each function should be a homogeneous unit whose activity can be
related to specific items of cost. A function might incur its particular pat-
tern of natural expenses, but most functions will have similar expenses
such as salaries, insurance, taxes, heat, light, power, supplies, etc. The
chart of accounts should be so designed that each function receives as
many of its charges as possible directly instead of through allocations.
Functional classifications of marketing costs might be structured in
the following manner:
1. Selling
2. Warehousing
3. Packing and shipping
4. Advertising
5. Credit and collection
6. General accounting (for marketing)

Direct and Indirect Expenses. Direct expenses are those expenses

that can be identified directly with a department, function, or activity, such
as the salary of the branch office manager or the depreciation of a delivery
truck. Expenses which can be identified with a territory, customer, product,
or definite type of sales outlet may also be considered direct costs.
The charging of these direct expenses to various marketing classifica-
tionsis highly desirable. The chart of accounts with its coding system
should be designed to permit the direct assignment of a marketing expense
to its point of incurrence.
 :

CH. 23 MARKETING COST AND PROFITABILITY ANALYSIS 709

Marketing expenses have been coded in the 500 series (500-599) in the
chart of accounts illustrated in Chapter 4. However, a three-digit number
is ordinarily not sufficient to permit the proper assignment of an expense.
For this reason, the original number might be expanded as follows

DIGITS
710 COST AND PROFIT ANALYSIS PART VII

(1) what bases should be used for the allocation and (2) how far should
the allocations be carried out? As a solution to the first, statements and
opinions stress the fact that the bases used should be fair and equitable;
they should be an ideal combination of efforts expended and benefits
reaped. The second question occurs because of doubts raised as to the
advantages of full allocation of all indirect expenses. Suggestions have
been made that certain expenses should be omitted from the allocation
procedure when they are not measurable in relation to the function or
activity. This is especially true when benefits are so widely dispersed over
many functions that any allocation is a mere guess.

Fixed and Variable Expenses. Representative fixed expenses are salaries

of executive and administrative sales staffs ; salaries of warehousing, ad-
vertising, shipping, billing, and collection departments; and costs of asso-
ciated permanent facilities, such as rent and depreciation. These fixed
costs have also been called capacity costs.
Variable marketing costs include the expenses of handling, ware-
housing, and shipping that tend to vary with sales volume. They have been
referred to as volume costs or as expenses connected with the filling of an
order. Another type of variable marketing cost originates in connection
with promotional expenses such as salespersons' salaries, travel, and enter-
tainment and some advertising expenses. These expenses are variable —
not so much because of a change in sales volume but because of manage-
ment decisions. In fact, once agreed to by management, these expenses
may be fixed —
at least for the budget period under consideration.
Management must examine these costs carefully in the planning stage,
for sales volume may have little influence upon their behavior. Proper
recognition of the fixed-variable cost classification is valuable in connec-
tion with managerial decisions dealing with the possible opening or closing
of a territory, new methods of packaging goods, servicing different types
of outlets, or adding or dropping a product line.

Selection of Bases for the Allocation of Functional Costs. The selection

of bases or units of measurement for allocation purposes can be compared
with the computation of overhead rates for factory expenses. Factory
overhead rates use a base which most definitely expresses the effort con-
nected with the work of the department, such as labor hours, machine
hours, or labor dollars. A similar procedure is to divide the total cost of
each marketing function by the units of functional service (the base) to
obtain the cost per unit.
The selection of bases or units of measurement requires careful thought
and analysis, for the degree to which the final rates represent acceptable
 :

CH. 23 MARKETING COST AND PROFITABILITY ANALYSIS 711

costs is greatly dependent upon the adequacy of the bases selected. Each
function must be examined with respect to that factor which most in-
fluences the volume of its work. Because of the varied services rendered
by the numerous functions, different bases are used. It is possible, how-
ever, to use one basis for two or more functions. Some of the bases are

FUNCTION
 : : , —

712 COST AND PROFIT ANALYSIS PART VII

of cultivating various outlets and forjudging the efficiency of sales methods

and policies. Budgets are set up to anticipate the amount of functional ex-
penses for the coming period and to compare them with the actual ex-
pense. Because of the influence of volume and capacity, a comparison of
actual costs with predetermined fixed budget figures does not always give
a fair evaluation of the activities of a function; and the use of flexible
budgets should be considered for the control of marketing costs.
The flexible budget for a distributive function such as billing might take
this form

Flexible Budget For Billing Department

For July, 19

Expenses
Functional Unit — Invoice Line
50,000 55,000 60,000 65,000

Clerical salaries 400 $ 400 $ 400 400

Supervision 300 300 300 300
Depreciation — building. . 75 75 75 75
Depreciation — equipment 125 125 125 125
Supplies 250 275 300 325

Total SI, 150 $1,175 $1,200 $1,225

A standard functional unit cost is then established for each activity or

function on the basis of normal capacity. These standard unit costs will

furnish bases for comparisons with actual costs, and spending and idle

capacity variances can be isolated.

Assuming that 60,000 invoice lines represent normal capacity, the fol-

lowing standard billing rate per invoice line would be computed:

$1,200
^r, r,r^ r T^ = $02 pCT
^ InVOlCe LlHC
60,000 Invoice Lines

Assuming $900 fixed expenses and $300 variable expenses, the variable
portion of the rate is

$300
= $.005 per Invoice Line
60,000 Invoice Lines

If actual sales required 63,000 invoice lines for a month at a total of

$1,250, the computation of the cost variances for billing expenses can be
made in a manner similar to that discussed in connection with factory
overhead (Chapter 9) and consistent with the basic idea of flexible
budgeting.
 : :

CH. 23 MARKETING COST AND PROFITABILITY ANALYSIS 713

The computation of the variance for the Billing Department is as

follows

Actual expenses $1,25

Spending variance (unfavorable)
Budget allowance:
Fixed expenses budgeted $900
Variable expenses ($.005 X 63,000 in-
voice lines) 315 $1,215'

Idle capacity variance (favorable) ^ $(45)

Standard cost charged-in
($.02 X 63,000 invoice lines) $1,260'

The increased volume leads to a favorable idle capacity variance due

to overabsorption of fixed expenses. On the other hand, the supervisor
overspent his $1,215 budget allowance by $35.
Journal entries could be made as for factory overhead

BillingExpenses Charged-In 1 ,260

Applied Billing Expenses 1 ,260

Actual Billing Expenses 1 ,250

Sundry Credits 1,250

Applied Billing Expenses 1 ,260

Billing Expenses —Spending Variance 35
Billing Expenses —
Idle Capacity Variance 45
Actual Billing Expenses 1,250

Accountants usually do not favor carrying this type of variance analysis

through ledger accounts. The analysis is usually statistical and is presented
to management in report form.

MARKETING PROFITABILITY ANALYSIS

The functional unit costs are used to analyze costs and determine the
profitability of territories, customers, products, and salespersons. In most
cases a continuous reshuffling or rearranging of expense items is needed to
find the required costs and profits. The possibiUty of improving marketing
cost and profitability analysis has been enhanced by the availabihty of
electronic data processing equipment capable of processing the great
amount of quantitative detail so characteristic of these analyses.

Analysis by Territories. Analysis by territories is perhaps the simplest.

When marketing activities are organized on a territorial basis, each
714 COST AND PROFIT ANALYSIS PART VII

identifiable geographical unit can be charged directly with the expenses

incurred within its area — thereby minimizing the proration of expenses.
Expenses that can be assigned directly to a territory are: salespersons'
salaries, commissions, and traveling expenses; transportation cost within
the delivery area; packing and shipping costs; and advertising specifically
Expenses that must be prorated to the ter-
identified with the territory.
ritory are: general management, general office, general sales manager,
credit and collection, and general accounting.
The identification of expenses by territories can lead to the preparation
of the income statement shown below. This comparative statement
permits control and analysis of expenses as well as the computation of prof-
it margins. When sales and /or expenses seem to be out of line, manage-
ment can take corrective action.

Income Statement by Territories

Territory

No. 1 No. 2 No. 3

Net sales $210,000 $80,000

Cost of goods sold 160,000

Gross profit S 50,000

Marketing expenses:
Selling S 15,000
Warehousing 3,600
Packing and shipping 1,500
Advertising 2,000
Credit and collection 800
General accounting 1,200

Total marketing expenses $ 24,100

Administrative expenses (equally) 5,000
Total marketing and administrative
expenses S 29,100

Net income (loss) per territory S 20,900

CH. 23 MARKETING COST AND PROFITABILITY ANALYSIS 715

analysis meaningful. An analysis of customers can be made (1) by ter-

ritories, (2) by of average order, (3) by customer-volume groups, or
size

(4) by kinds of customers.

Analysis of Customers by Territories. This type of analysis reflects

due to the customer's proximity to warehouses,
territorial cost differences
volume of purchases, service requirements, and the kinds of merchandise
bought. These factors can make certain sales profitable or unprofitable.
The analysis would proceed in the same manner outlined for territories
except that the costs would be broken down by customers or kinds of
customers within each territory.

The size of a customer's

Analysis of Customers by Size of Average Order.
order is The analysis
closely related to his profitabihty or nonprofitability.
might indicate that a considerable portion of orders comes from customers
who cost the company more in selling to them than the orders are worth
in terms of gross profit. Companies have therefore resorted to setting
minimum dollar values or minimum quantities for orders, thereby re-
ducing the number of transactions and increasing profits. Selective seUing
has found much favor among many executives. It requires changing
habits and routines, something which is often difficult to bring about.
In order to present management with a quick view of the situation
regarding size of average order in relation to number of customers, time
spent, and total dollar sales, the chart illustrated below might be helpful.

$100
to
$999

Less
than
$100
CUSTOMERS TIME SPENT
BY SALESPERSONS

Analysis of Customers by Size of Average Order

716 COST AND PROFIT ANALYSIS PART VII

Analysis by Customer-Volume Groups. An analysis of customers by

customer-volume groups is like that of the size-of-average-order analysis
with this exception. Instead of classifying customers by an order's dollar
value, the customer-volume group analysis is based on an order's quantity
or volume. This type of analysis yields information as to (1) the profit-
ability of various customer-volume groups and (2) the establishment of
price differentials. The analysis shown below indicates that only those
customers who buy more than 150 units during a week are profitable.
Though they represent about 46 percent of the customers, they purchase
over 95 percent of the units sold. Sales to these customers provide the
profits.

ANALYSIS BY CUSTOMER-VOLUME GROUPSi

CH. 23 MARKETING COST AND PROFITABILITY ANALYSIS 717

Delivery to such groups might be different; some delivery might be con-

tracted with outside truckers; another might be made by the firm's own
trucks. For analytical purposes, revenues and costs should be related to
each kind of customer.

Analysis by Products. Just as customers are grouped by territories,

order size, quantity of order, and kinds for purposes of analysis, products
sold can be grouped according to product hnes possessing common
characteristics.The grouping can also be by brands.
With the aid of functional costing rates, a product line (or brand line)
income statement can be prepared for the evaluation of profitable and un-
profitable product lines. The statement illustrated below relates the
actual contribution of each product line to total profits for the year.

Product Line Income Statement

718 COST AND PROFIT ANALYSIS PART VII

customer class or product group. The control and analysis of these ex-
penses should, therefore, receive management's closest attention. To
achieve this control, performance standards and standard costs should be
established. These standards are used not only for the control of costs
but also for determining the profitability of sales made by salespersons.
Therefore, the discussion is presented in two parts: (1) cost control;
(2) profitability analysis.

Cost Control. In the allocation table on page 711, selling expenses are
assumed to be allocated on the basis of calls made. A call or visit by a
salesperson is usually made for two reasons: to sell and to promote the
merchandise or products. The problem is to determine the cost of doing
each of these types of work and to compare the actual cost with the
standard cost allowed for a call.

A salesperson's call often involves several

kinds of work. He not only
callson the customer, but also helps the merchant with the display in the
store or window. This practice is common in cosmetic, pharmaceutical,
and fast-food businesses. Because the salesperson's time is consumed by
such activities, a standard time allowed per call is often very difficult to
establish. To obtain the necessary statistics for establishing such standards,
and to make comparisons, the salesperson might have to prepare a cus-
tomer or town report providing information regarding the type of calls
made as well as the quantity, type, and dollar value of products sold. This
information is the basis for much of the analysis discussed previously.

Profitability Analysis. Having obtained the means of controlling sales-

persons' activities, it is also possible to analyze sales in relation to profit-

ability. Sales volume alone does not tell the complete story. High volume
does not always insure high profit. Sales-mix plays an important part in

the final profit. Although a salesperson might wish to follow the line of
least resistance, management must strive to sell the merchandise of all
product groups, particularly those with the highest profit margins. As
sales territories are often planned for sales by product groups, it is neces-
sary that such anticipation be followed up by analyzing the salespersons'
efforts. The table on page 719 indicates how such an analysis can be
made.

THE CONTRIBUTION MARGIN APPROACH

Generally, the income statement shows a profit figure after all mar-
keting and administrative expenses have been deducted. This total cost
and approach assigns all the expenses, direct or indirect, fixed or
profit
variable, to each segment analyzed. The procedure is commonly used
CH. 23 MARKETING COST AND PROFITABILITY ANALYSIS 719
720 COST AND PROFIT ANALYSIS PART VII

Although sales volume remains the ultimate goal of most sales man-
agers, the trend has been toward a greater recognition of contribution
margin as the basis for judging the success and profitability of marketing
activities. The increased use of standard production costs has aided the

analysis of gross profit as discussed in Chapter 21. Even though a manu-

facturer might know the production costs, the question remains: "How
much can the company afford for marketing costs?" The problem of
determining allowable marketing expenses is intensified because once a
sales program gets under way, the majority of expenses become fixed
costs, at least in the short run.
The analysis discussed here combines the fixed and variable costs of
each functional group to arrive at a functional unit costing rate per activity.

But the allocation of joint expenses any type of analysis is often difficult
in

and uncertain. Proponents of the contribution margin approach point out

that only specific and direct costs, whether variable or fixed, should be
assigned to territories, customers, product groups, or salespersons with
a clear distinction as to their fixed and variable characteristics. More-
over, for the purpose of identifying costs with responsible managers, it is
desirable to identify each reported cost with its controllability by the
manager in charge of the reported activity.
The contribution margin approach has influenced the thinking of the
volume-minded sales manager or salesperson who must recognize that
profit is more beneficial than volume. The contribution margin is a better
indicator than sales as to the amount available for recovery of fixed manu-
facturing costs, fixed marketing and administrative expenses, and a profit.

EFFECT OF THE ROBINSON-PATMAN ACT ON

MARKETING COST ANALYSIS
The Robinson-Patman Act of June, 1936 amended Section 2 of the
Clayton Act, which was enacted to prevent large buyers from securing
excessive advantages over their smaller competitors by virtue of their size
and purchasing power. As the Clayton Act prohibited discrimination only
where it had a serious effect on competition in general, and as it contained
no other provisions for the control of price discrimination, it was felt that
an amendment to the Act was needed in order to insure competitive
equality of the individual enterprise in face of the threat of bigness to a
competitive society. The following clause of the Robinson-Patman Act is

of special interest in connection with marketing costs:

To make it unlawful for any person engaged in commerce to discriminate in price

or terms of sale between purchasers of commodities of like grades and quality;

to prohibit the payment of brokerage or commissions under certain conditions;
to suppress pseudo-advertising allowances; to provide a presumptive measure
 :

CH. 23 MARKETING COST AND PROFITABILITY ANALYSIS 721

of damages in certain cases; and to protect the independent merchant, the public
whom he serves, and the manufacturer who sells him his goods from exploita-
tion by unfair competitors.

The amendment does not imply that price discriminations in the sense
of price differentials are entirely prohibited or that a seller iscompelled or
required to grant any price differential whatever. A vendor may sell to
all customers at the same price regardless of differences in the cost of
serving them. At the core of the amendment are the provisions that deal
with charging different prices to different customers. Differentials granted
must not exceed differences in the cost of serving different customers.
Cost of serving includes cost of manufacturing, selling, and delivering,
which may differ according to methods of selling and quantities sold. The
burden of proof is on both the buyer and the seller and requires a definite
justification for the discounts granted and received. It is necessary to prove
that no discrimination took place with respect to:

1. Price differences 5. Advertising appropriations

2. Discounts 6. Brokerage or commissions
3. Delivery service 7. Consignment policies
4. Allowances for service

These discriminating possibilities fall chiefly into the field of marketing

costs. Many interesting problems have arisen and will continue to arise
because of the nature of these costs and the numerous variations and
combinations in the manner of sale and delivery. As indicated, it is dif-

ficult to apply many marketing costs to particular products. Therefore,

it is important for concerns performing distribution functions to accumu-
late cost statistics regarding their marketing costs because the Act makes
allowances for differences in costs. The Act has increased the interest in
marketing cost analysis and its part in the determination of prices. The
cost justification study on the next page serves to illustrate this point.
If a competitor believes that discrimination exists, he must make a
complaint substantiated by evidence acquired from published price lists

or from other persuasive evidence of this kind. The complaint is vaUd if

all of the following violations have been committed

1. There must be a price discrimination.

2. The discrimination must be between competitors.
3. The discrimination must be on products of like grades and quality.
4. The discrimination must be in interstate commerce.
5. There must be an injurious effect on competition.

The most effective method for a firm to answer any such complaint is

to have a functional unit cost system for marketing costs. In fact, no firm
should be placed in a situation of having to make a cost study after the
722 COST AND PROFIT ANALYSIS PART VII

COST JUSTIFICATION STUDY

A producer of a heavy bulk chemical, which sells f.o.b. point of manufacture
at $25 a ton in minimum quantities of a full rail carload (approximately 40 tons), is
offered a contract for 500 to 1,000 carloads a year if it will reduce its f.o.b. ship-
ping point price by 6 percent. The producer does not want to reduce the selling
price to other customers, to whom annual shipments range from 10 to 200 car-
loads. The only source of cost differences is sales solicitation and service expense.
The sales manager estimates (since exact records are not available) that
salespersons typically pursue the following call schedule:

Customer Size Annual Number

{in Carloads) of Sales Calls

10-40 12
41-80 24
81-150 36
151 and up 50

The sales manager further estimates that each sales call costs approximately
$50-$70 regardless of customer size. After questioning, he agrees that study
would probably show that calls on large customers (more than 100 carloads)
are longer in duration than calls on smaller customers. For study and testing
purposes, it was assumed that a call on a small customer costs $60 and a call on
a large customer costs $90. The cost-sales relationship illustrated in Exhibit 1
can now be developed.

Differential Cost
Large vs. Small Customers
Annual Carloads per Customer

25 50 100 200 500

Sales value $25,000 $50,000 $100,000 $200,000 $500,000

Number of sales calls 12 24 36 50 50
Assumed cost per call $ 60 $ 60 $ 90 $ 90 $ 90
Assumed cost of call per customer 720 1,440 3,240 4,500 4,500
Assumed cost of call as a percent of sales 2.9% 2.9% 3.2%, 2.25%, 0.9%,

Exhibit 1

Since the assumed differential costs are less than the 6 percent proposed
discount, it appears obvious that a discount of that magnitude is not susceptible
to cost justification. Indeed, it is possible that even a one percent discount to a
500-carload customer might be hard to justify since it is probable that more
exact costing would narrow the spread in the percentages among the various
classes.'

Experience has proven that such belated cost justification studies

citation.
seldom are successful. Therefore, the firm should (1) establish records

3Herbert G. Whiting, "Cost Justification of Price Differences," Management Services, Vol. 3,

No. 4, pp. 31-32.
CH. 23 MARKETING COST AND PROFITABILITY ANALYSIS 723

that show that price differentials are extended only to the extent justified
by maximum allowable cost savings and (2) maintain the cost data cur-
rently through spot checks conducted periodically to insure that the price
differentials are in conformance with current cost conditions. In justify-
ing price differentials, it important to note that marginal costing can
is

not be utilized; i.e., a plant operating at 80 percent capacity and wishing

to add an order to increase its capacity to 90 percent cannot restrict its

cost considerations to that incremental element of variable costs due to

the volume change. "^ (The reduced cost per unit resulting from the
greater volume must be spread over all units.)
In general, the Robinson-Patman Act seems to be working toward
greater equity between prices, inasmuch as pricing schedules appear to be
more carefully attuned to differences in marketing costs than they were
before the enactment of this particular type of control.
The accountant must be prepared to study the subject actively and
continuously to help management avoid unintentional price discrimina-
tions that might be in violation of the law. The marketing manager must
also follow the effect of any pricing policy to determine whether it is

profitableand produces the kind of business necessary to the wholesome

operation of the enterprise. The problem is one of continuous analysis.

ILLUSTRATIVE PROBLEM IN MARKETING COST

AND PROFITABILITY ANALYSIS
The Gardner-Michel Manufacturing & Equipment Co. manufactures
and sells a variety of small power tools, dies, drills, files, milling cutters,
saws, and other miscellaneous hardware. The company's catalog lists the
merchandise under sixteen major classifications. Customers fall into five
categories: retail hardware stores, manufacturers, public school systems,
municipalities, and public utilities. Territories include New Jersey and
Pennsylvania. The company's president beheves that in certain areas the
cost of marketing the products is too high, that certain customers' orders
do not contribute enough to cover fixed costs and earn a profit, and that
certain products are being sold to customers and in territories on an un-
profitable basis. Therefore, the president has instructed the controller to
review the firm's marketing costs and to study the steps, methods, and
procedures necessary to provide more accurate information about the
profitability of territories, products, and customers.

4John E. Martin, "Use of Costs for Justifying Price Differentials," Arthur Andersen Chronicle,
VoL XXIV, No. 4, pp. 33-40.
 :

724 COST AND PROFIT ANALYSIS PART VII

The and operated a standard marketing cost

controller has designed
system which gives management the desired information for the control
and analysis of marketing and administrative expenses. The preparation
and assembling of statistical and cost data were carried out in the fol-
lowing sequence

1. Total marketing expenses were estimated (or budgeted).

2. Six marketing functions (selling, warehousing, packing and shipping,
advertising, credit and collection, general accounting) were established.
3. Direct or functional (departmental) costs were assigned directly to func-
tions and indirect expenses were allocated via a measurement unit, such
;

as kilowatt-hour, footage, number of employees, etc.

4. Fixed and variable expenses were determined for each function.
5. Functional unit measurement bases were selected for the purpose of
assigning costs to the segments to be analyzed; i.e., territory or product.
6. Functional unit measurements or bases applicable to a territory or a
product were determined.
7. Unit standard manufacturing costs and standard product selling prices
were established.
8. Data regarding the types and number of units sold in the territories were
prepared.
9. Income statements by (a) territories and (b) product lines in one territory
were prepared for management.

Exhibit summarizes the results of the study prepared by the con-

1

troller. Column
1 shows the total budgeted expenses per function. Each
total is supported by a budget showing the amount for each individual
expense of the function. Columns 2 and 3 place total expenses in a vari-
able and fixed expense classification. Column 4 indicates the functional
unit measurement selected as being reliably applicable to that function.
Column 5 lists the quantity or value of the measurement unit used to
determine the functional unit costing rate. Columns 6, 7, and 8 indicate
the variable, fixed, and total functional unit costing rates.

Exhibits 2 and 3 list the details necessary for the preparation of (1) Ex-
hibit 1 and (2) the income statements (Exhibits 4 and 5). To simplify the
illustration, nonmanufacturing costs, other than marketing costs, have
been excluded.
The product-line income statement for the territory of Pennsylvania
(Exhibit 5) indicates that the volume and /or price of Product 1 is not suf-
ficient to result in a profit. This analysis is carried further with the aid of
a fixed-variable analysis of manufacturing costs and marketing expenses
to determine the contribution made by the product line to the total fixed
costs and profit (Exhibit 6). This exhibit assumes the nonexistence of
unallocated joint costs, fixed or variable. The product-line income state-
ment on page 717 illustrates a presentation with unallocated costs. Next,
 Determination of Functional Unit Costing Rates Functional
Functional Unit Unit Costing Rates
Budgeted Expenses Total
Measurement Base Quantity Variable Fixed
Total Variable Fixed (7) (8)
(5) (6)
(J) (S) (5) U)
Function
Gross sules dollar value of Jl,910,000 2% 3% «%
» SS.*"" S 38,200 $ 87,300
Selling product sold
375,000 $ .08 I .20
46,000 30,000 Weight of units shipped .17 .42
Warehousinp J«.000 25,500 Quantity product units sold 160,000
Packing nnd shipping. 63,000 37,500 160,000 .36 .98
54,000 Quantity product units sold
Advertising ".000 7,200 2.60 1.40 4.00
28,800 18,720 10,080 Number of customers' orders 1.88 3.28
Credit and collection. 16,000 1.42
.

*0.800 21,300 27,900 Number of times product items

General accounting. . .
appear on customers' invoices

Total functional dis-

$368,800 $180,720 $204,780
tribution expenses.

Exhibit 1

PRICE, COST, QUANTITY. WEIGHT, AND TRANSACTIONS OF PRODUCTS

DATA CONCERNING
Product 1 Product 2 Product 3
Produ ct Class
$10.00 $15.00 $18.00
Standard product selling price
Unit standard manufacturing cost 8-00 n.^ i .

80,000 50,000 20 OW
Quantity of product units sold
2.25 kg. 2.5 kg. 3.5 kg.
Weight Of units Shipped (kilograms)
Number of times product items appear on ^ 900
O'^"" , 'oqq
customers' invoices ,',^^ ,«U0
2,400 3,000 1
Number of customers' orders
Exhibit 2

Data Concerning Transactions in Territories

Number of Times Product^

Items Appear on Customers'
Number of
Invoices Customers' Orders
Quantity of Products Sold
Product Product Product Product Product Product
Product Product Product 2 3
2 3 1
2 3 1
Territory 1

2,900 1,000 1,000 1,900 900

55,000 30,000 16,000 4,000
Pennsylvania 900
2,800 1,900 1,400 1,100
20,000 4,000 2,400
New Jersey 25,000
Exhibit 3

Income Statement for All Product Classes

in the Two Territories
Territory

Total Pennsylvania New Jersey

Gross ,,^,
sales.
$19iW0 $1,288,000 $622,000
1430 000
i,4:>u,uuu 962,000 468,000
Less cost of goods sold ,"^ )CC^ ^t^iAnnn
480,00 $ 326,000 $154^0
Grossprofit _$
Less marketing expenses: ^^ $31,100
^^^ ^ ^44^^
Sf'''"S--;- 75'000 50,950 24,050
Warehousing..... '^'YY^
20 580
2U,.«^
63,000 ^2 42O
42,420
Packing and shipping
Advertising 600
70'finn
28 800 15 200 13
13
Credit and collection 6^^
4y^zuu
General accounting Jt'^- TTuTt^
.... $ 365,500 $ 235,242 $130,258
Tnt^x
^,,. $ 114,500
ii.t,^v/ $ 90,758- $23,742
Net income j>

Exhibit 4
 :

726 COST AND PROFIT ANALYSIS PART VII

Income Statement by Product Classes in the Pennsylvania Territory

Product Class
Total Product 1 Product 2 Product 3
Gross sales $1,288,000 $550,000 5450,000 $288,000
Less cost of goods sold 962,000 440,000 330,000 192,000
Gross profit $ 326,000 $110,000 $120,000 $ 96,000
Less marketing expenses:
Selling $ 64,400 $27,500 $22,500 $14,400
Warehousing 50,950 24,750 15,000 1 1 ,200
Packing and shipping 42,420 23,100 12,600 6,720
Advertising 36,360 19,800 10,800 5,760
Credit and collection 15,200 4,000 7,600 3,600
General accounting 25,912 13,120 9,512 3,280
Total $ 235,242 $112,270 $ 78,012 $ 44,960
Net income (loss) $ 90,758 $( 2,270 ) $ 41,988 $ 51,040

Exhibit 5

Income Statement of Product Class with Fixed- Variable Analysis

OF Manufacturing and Marketing Costs in the Pennsylvania Territory
Product 1

Gross sales $550,000

Less cost of goods sold (variable unit cost = 60% of $8) 264,000
Gross contribution margin $286,000
Less variable marketing expenses:
Selling $11,000
Warehousing 14,850
Packing and shipping 13,750
Credit and collection 2,600
General accounting 5,680 47,880
Contribution margin $238,120
Less fixed costs and expenses
Manufacturing costs — fixed $176,000
Marketing expenses — fixed:
Selling $16,500
Warehousing 9,900
Packing and shipping 9,350
Advertising 19,800
Credit and collection 1 ,400

General accounting 7,440 240,390

Net loss — Product Class — Pennsylvania
1 $ (2,270)

Exhibit 6

the steps required to bring about an improvement in the profitability of

this product line should be determined. Functional marketing cost anal-
ysis permits this type of analysis which should eventually lead to a selective
selling program supported by product break-even analyses and by cost-
volume-profit and differential cost analyses (see Chapters 24 and 25).
CH. 23 MARKETING COST AND PROFITABILITY ANALYSIS 727

DISCUSSION QUESTIONS
1. What general principles should be observed in planning a system of control
for marketing expenses?

2. On what bases would you assign the following marketing expenses to a

number of different types of commodities sold by a company:

(a) Salespersons' salaries (e) Advertising on national scale

(b) Salespersons' commissions (f) Expenses of company's own delivery
(c) Storing finished goods trucks
(d) Warehouse expenses (g) Sales manager's salary
(h) Sales office expenses

3. How are marketing expenses to be classified in order to find the cost of

selling jobs or products?

4. Outline a procedure for determining the marketing costs for a concern

manufacturing two products. This organization uses national advertising
and assigns salespersons to definite territories for contact with estabUshed
dealers and also to secure additional retail outlets.

5. A method still commonly used today in analyzing marketing expenses is

to relatethem to either the total factory costs or the total sales value.
This method is merely a relationship and not a scientific basis. Discuss.

6. The advertising poUcy of a company includes exhibition of the plant to

customers. Visitors are received and guides are supplied from the production
staff.

(a) How should this cost be treated in the records ?

(b) What adequate control of this expenditure can be provided from the
point of view of production and sales promotion?

7. A company with a national sales force divides the country into sales ter-
which are again divided into districts. The products are nationally
ritories,
advertised and are sold to retail shops. Assuming 1,000 sales per day with
an average of four items to each order, what marketing cost system should
be installed to build up:
(a) The necessary sales statistics to control sales by both territories and lines ?
(b) The expenses of such a sales force ?
(c) Records and statistical analyses for use in the preparation of sales bud-
gets and profit margins?

8. What are the objectives of profit analysis by sales territories in income

statements?
(AICPA adapted)

9. A firm employing its own transport service delivers its products up to a

distance of 130 miles from home in quantities varying from 1 to 20 cwt. On
the return trip empties are collected from certain customers and a quantity
of raw materials from suppliers. How would you distribute the cost in-
curred by this service ?

10. (a) On what basis would you propose to analyze sales expenses in order to
enable management to judge the effectiveness of this function?
(b) What cost data should be given to salespersons and for what purpose?
 :

728 COST AND PROFIT ANALYSIS PART VII

11. When and to what extent is the inclusion of marketing and administrative
expenses in inventory values justifiable?

1 2. Explain briefly the difference between the profit and the contribution margin
approach in marketing cost analysis.

13. For what reasons did the Robinson-Patman Act lead to the establishment of
marketing cost procedures in business?

EXERCISES
1. Comparative Statement — Applied vs. Actual Expenses. The management of
the Eldridge Company has requested the establishment and use of volume-
related standards for marketing cost analysis to allow management to know
what the marketing costs should have been as well as what they are. With
standard costing rates set for various functional costs, charges can be made on
the basis of these rates and applied to actual sales volume.
The assistant controller presents the following data supporting the analysis:

Planned sales
Number Number Sales
of Orders of Units Amount
Product A 2,000 4,000 $80,000
Product B 8,000 16,000 160,000
Total 10,000 20,000 $240,000

Standards for marketing expenses:

Advertising 4% of sales
Salespersons' salaries and expenses. . . 5% of sales
Order filling expenses $.30 per order
Order handling —Product A $.40 per unit
— Product B $.10 per unit

Actual results for the month:

Number Number Sales
of Orders of Units Amount
Product A 2,800 5,000 $100,000
Product B 6,000 12,000 120,000

Total 8,800 17,000 $220,000

Expenses for the month:

Deferred to Expenses
Total Next Month for Month
Advertising $8,700 $700 $8,000
Salespersons' salaries and expenses. 12,000 12,000
Order filling 2,850 2,850
Order handling 4,500 500 4,000

Required: An analysis of marketing expenses, showing applied expenses

contrasted with actual expenses and the resulting variances. (Compute only
one variance for each expense.)
 .. :

CH. 23 MARKETING COST AND PROFITABILITY ANALYSIS 729

2. Income Statement by Customer Classes. The Rochester Company assembles

a washing machine that is sold to three classes of customers: department
stores, retail appliance stores, and wholesalers. The data with respect to these
three classes of customers are shown below.

Customer Dollar Gross Number of Number of Number of

Class Sales Profit Sales Calls Orders Invoice Lines

Department
stores $180,000 $ 26,000 240 120 2,100
Retail appliance
stores 240,000 80,000 360 580 4,600
Wholesalers 300,000 71,000 400 300 3,300
Total $720,000 $177,000 1,000 1,000 10,000

Actual marketing costs for the year are

Function Costs Measure of Activity
Selling $65,000 Salespersons' calls
Packing and shipping 12,000 Customers' orders
Advertising 10,000 Dollar sales
Credit and collection. 15,000 Invoice lines
General accounting. . 18,000 Customers' orders

Required: An income statement by customer classes with functional distribu-

tion of marketing expenses. (When allocating the advertising expense, round to
the nearest $100.)

3. Territorial Income Statement; Managerial Decision-Making Costs. The

Golemme Company manufactures textile equipment. Sales are made by com-
pany salespersons directly to textile manufacturers in three sales territories.
The following information concerning territories was obtained from the
standard sales and marketing expense budgets for the year:

Item Territory 1 Territory 2 Territory 3 Total

Net sales $120,000 $100,000 $180,000 $400,000

Salespersons' salaries 6,000 5,000 9,000 20,000
Salespersons' traveling expenses 3,650 2,350 5,000 11,000
Warehouse expenses 1,200 1,000 3,300 5,500
Delivery expenses 2,000 3,000 6,000 11,000
Supplies 500 400 800 1,700

Other standard marketing expenses and methods used to allocate both

standard and actual expenses to territories are as follows: advertising, 5% of
net sales; credit and collection expenses, 2% of net sales; sales office expenses,
$15,000, distributed equally; general sales salaries, $16,000, distributed on basis
of net sales; sales commissions paid to salespersons, 8% of net sales. The cost
of manufacturing the looms sold is 60% of net sales.

Required: (1) A standard income statement comparing the standard net

sales, manufacturing cost, marketing expenses, and net income or loss for the
three territories.
 ..

730 COST AND PROFIT ANALYSIS PART VII

(2) An explanation of how the figures developed in (1) aid management in

determining:
(a) Whether a territory should be dropped or whether attempts should be made
to further develop such territory by increased advertising, service, etc.
(b) The responsibility for incurrence of marketing costs.
(c) Whether salespersons should discontinue calling on a certain class of
customer.

4. ProfitabilityAnalysis by Channels of Marketing; Variance Analysis. The

Litenpower Electric Company manufacturers small electrical home appliances
and distributes them via retailers, wholesalers, and department stores. The
company's marketing cost system employs functional standard marketing
costs that aid in charging and controlling marketing expenses by channels of
distribution.
During the month of December the Cost Department calculated the fol-
lowing standard unit costs for the coming year:

Selling $ 1.75 per salesperson's call

Warehousing 12.00 per 1,000 cubic feet of product sold
Packing and shipping 47.00 per 1,000 cubic feet of product sold
Advertising 1.25 per media circulation
Credit and collection .08 per invoice line
General accounting .35 per customer order

At the end of the year, actual activity and costs were:

Activitv

Total Depart-
Actiial Measure of Whole- ment
Function Costs Activity Retailers salers Stores

Selling $187,500 Salespersons' calls. 75,000 10,000 15,000

Warehousing 12,100 Cu. ft. of product 390,000 160,000 250,000
Packing and shipping. 35,900 Cu. ft. of product. 390,000 160,000 250,000
Advertising II ,200 Media circulation 4,000 1 ,000 5,000
Credit and collection.. 23,800 Invoice lines 115.000 75,000 60,000
General accounting.. . 9,300 Customers' orders. 18,500 2,000 4.500

Other actual data:

Sales $670,000 $310,000 $405,000
Gross profit percentage 25*^ 40% 30%

Required: An income statement by channels of marketing with:

(a) Functional marketing expenses at standard.
(b) The variances of actual from standard costs to arrive at actual net income.

5. Salespersons' Performance Reports. A corporate budget director designed a

control scheme in order to be able to compare and evaluate the efforts of the
company's three salespersons and the results attained. Specifically, each sales-
person is to make five calls per day; the budget provides for $20 per day per
salesperson for travel and entertainment expenses: each salesperson was as-
signed a sales quota of $200 a day. The Budget Department collects the data
on actual performance from the daily sales reports and the weekly expense
vouchers and then prepares a monthly report therefrom. This report includes
both variances from standard and performance indexes. For the performance
index, standard performance equals 100, 10% greater than standard equals
110, etc.
 : :

CH. 23 MARKETING COST AND PROFITABILITY ANALYSIS 731

The records for the month of November with 20 working days show
Sales Travel
Salesperson Calls Expenses Sales

Palmer, K 70 S500 S7,000

Thompson, J. . . 100 400 4,200
Weatherbil, O. . . 120 360 3,000

Required: A monthly report comparing the standard and actual perfor-

mances of the salespersons (including the performance indices) for (a) sales
calls, (b) travel expenses, (c) sales, and (d) sales revenue per call.

6. Cost Justification Study. Larson-Manss Distributors, Inc. has been accused

of discriminating against its small-order customers (25 to 50 cases) in Territory 1
as compared with the same class of customers in Territories 2, 3, and 4. The
company has broken down its marketing costs by territories and now desires
to prorate the territorial costs among classes of customers within each territory.
A tabulation of the average distribution costs per year in Territory 1 shows

Expense Amount
Advertising:
Direct-to-customer catalog S 3,600
Radio and newspapers 9,000
Salespersons' salaries 36,000
Salespersons' commissions 48,000
Delivery expenses 28,800
Traveling costs of salespersons 10,800
Collection costs 8,400

$144,600

The Accounting Department has tabulated the following to assist in pro-

rating costs in Territory 1 between small-, medium-, and large-order customers:

Small- Medium- Large-

Order Order Order
Customers Customers Customers

Net sales $1 50,000 $220,000 $350,000

Number of sales orders taken 2,500 2,000 1,500
Number of cases of product sold 1 00,000 1 50,000 250,000
Relative shipping cost (per order) $1 $2 $3
Number of customers 1,500 1,500 2,000
Relative number of miles traveled per day (per
sales person) 4 10 16
Number of salespersons 13 6 5

In the Collection Department, bookkeeping costs per order handled are about
ten cents. Each customer is mailed a statement of his account at the end of the
month, and the customers make single monthly remittances on account.
All salespersons are paid the same salary; each salesperson works with a
single class of customer.

Required: A
proration of the marketing costs of Territory 1 to the three
order-size classes of customers to justify costs. Indicate the base or bases on
which each proration is made.
 :

732 COST AND PROFIT ANALYSIS PART VII

PROBLEMS
23-1. Territorial Profit Contribution Report. The Shamblin Products Company
uses a "territorial profit contribution report" as an effective tool for marketing
cost analysis. The report is coordinated with the company's semiannual budget
by establishing the profit required from each sales territory to meet all branch
and head office operating expenses plus expected net income for each month.
This procedure gives the sales managers not only a sales budget in both quantity
and value but also the estimated profit required from each territory under their
supervision.
About two months before the beginning of the semiannual accounting
period, the Budget Department prepared the following forecast income
statement:

Forecast Income Statement

For Six Months Ended December 31, 19—
Net sales $10,000,000
Cost of goods sold 6,000,000
Gross profit $ 4,000,000
Sales territorial expenses:
Freight to customers $ 700,000
Salaries and commissions 1,500,000
Traveling expenses and miscellaneous 300,000 2,500,000
Territorial profit $ 1,500,000
General marketing and administrative expenses:
Marketing expenses $1,000,000
Administrative expenses 300,000 1,300,000
Net income $ 200,000

The sales forecast broken down by months and territories is as follows:

Territories

Month II ^ 11 Others Total

July $ 10,000 $ 8,000 $ 8,000 $ 974,000 $ 1,000,000

August 1 5,000 ,000
1 1 12,000 ,462,000
1 1 ,500,000

September 15,000 11,000 12,000 1,462,000 1,500,000

October 30,000 22,000 24,000 2,924,000 3,000,000
November 20,000 15,000 16,000 1,949,000 2,000,000
December 10,000 8,000 8,000 974,000 1,000,000
Total $100,000 $75,000 $80,000 $9,745,000 $10,000,000

(Territories 75, 42, and 55 are shown in detail; the others are in a total sum to
simplify the problem.)

According to the income statement, the territories are expected to contribute

$ 1 ,500,000 (recovery of marketing expenses, $ 1 ,000,000 administrative expenses,
;

$300,000; and net income, $200,000). This profit contribution of $1,500,000 is

prorated to each sales territory on the basis of the estimated sales for the same
period.
The budget of the territorial profit contribution for the three territories for
the three-month period ending September 30, 19
and expenses
—
showed the following costs
,
CH. 23 MARKETING COST AND PROFITABILITY ANALYSIS 733

Cost of Salaries and Travel

Territories Goods Sold Freight Commissions Expenses, Etc.

75 $24,890 $1,820 $6,500 $ 790

42 18,319 \,iAe 4,250 1,185
55 14,815 3,845 6,200 2,340

Actual results in the three territories for the same period were;

Cost of Salaries and Travel

Territories Sales Goods Sold Freight Commissions Expenses, Etc.

75 $44,250 $27,878 $2,212 $6,100 $1,437

42 33,465 24,710 2,245 3,900 1,420
55 18,865 11,378 3,329 5,820 1,940

Required: (1) A
territorial profit contribution report for the three territories
comparing (a) actual profit contribution with the budgeted amount and (b)
budgeted contribution to meet marketing and administrative expenses and net
income with actual results.
(2) Factors or a combination of factors that might have caused a loss or the
failure to fulfill budget requirements in any territory.

(Based on an NAA article)

23-2. Income Statements by Products and Order-Size Classes. The feasibility of

allocating marketing and administrative expenses to products or order-size
classes for managerial purposes has been considered by the management of the
Ard Co. It is apparent that some costs can be assigned equitably to these
classifications; others cannot. The company's cost analyst proposed the fol-
lowing bases for apportionment:

Apportionment Bases (Where Applicable) of Marketing Costs

For Product and Order-Size Analyses
Type of Analysis

Expense By Products By Order-Size Classes

Sales salaries Not allocated Sales dollars times number

of customers in class
Sales traveling Not allocated Number of customers in
class
Sales office Not allocated Number of customers in
class
Sales commissions Direct Direct

Credit management Volume of sales in dollars Number of customers in

class
Packing and shipping Weight times number of Weight times number of
units units
Warehousing Weight times number of Weight times number of
units units
Advertising Not allocated Not allocated
Bookkeeping and billing Volume of sales in dollars Number of orders

General marketing and

administrative Not allocated Not allocated
 :

734 COST AND PROFIT ANALYSIS PART VII

From books, records, and other sources, the following data have been compiled

Order-Size