Chapter Nine- Activity-Based Costing

Chapter Nine- Activity-Based Costing
Study Tips
• The purpose of activity-based costing is the same as any other overhead allocation method: to
attach overhead costs to the products being made.
• The mechanics of activity-based costing are the same as any other overhead allocation
method.
• The implementation of activity-based costing, as any other business decision, should be
subject to cost/benefit analysis.
Summary
In earlier chapters, direct material and direct labor costs were traced directly to the job. The
overhead costs were attached to each job by using a predetermined overhead rate and multiplying
that rate by the number of basis (cost driver) units used. If the predetermined overhead rate was
$7 /DLH and a particular job needed 120 DLH to be completed, then the overhead allocated to
that job would be $840 ($7 x 120 DLH).
Use of a single plant-wide overhead rate is standard for many manufacturing cycles. The single
plant-wide rate is the easiest to implement and the least expensive to use. However, in some
cases this broad-based average is not sufficiently accurate, especially where the company has to
bid on a variety of jobs.
For a more accurate picture of overhead costs per product, many companies have switched to a
department based method of overhead allocation. This involves accumulating overhead costs, as
a cost pool for each department. A cost driver (basis) is selected for each department and the
costs in the cost pool are divided by the total estimated number of basis (cost driver) units to
obtain a departmental overhead rate for each department. As a product passes through the manufacturing
process, each department's overhead is allocated to the product by multiplying
the departmental overhead rate times the number of basis units.
As a division of Metal works, Inc., Department A is a labor intensive department for which the
overhead rate is $9 per direct labor hour ($9/DLH); in Department B, a machine intensive
department, the overhead rate is $14 per machine hour ($4/MHR). Job #3 is processed for six (6)
DLH in Department A and ten (1 0) MHR in Department B. The overhead allocated to Job #3
would be $54 ( 6 x $9) in Department A and $140 (1 0 x $14) in Department B, for a total of $194
($54 + $140). Separate accumulation of department costs facilitates selection of the most
appropriate cost driver for each department, DLH for Department A and MHR for Department B.
Use of a single plant-wide system would force management to use one cost driver to the
exclusion of the other, though some overhead costs would have little relationship to the selected
cost driver.
At times, depending on the production process, a departmental system of allocating overhead
costs is too broad based. Smaller, more homogeneous cost pools within the department,
afford management an opportunity to determining a more specific relationship between cost
and cost driver. An activity-based costing system provides this specificity. Within each
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department there may be several activities, such as, setting up machines, drilling holes in a
sheet of metal, and inserting components into that metal sheet, with some insertions done by
hand and some by machine. Development of a separate cost pool for each activity is more
time consuming and costly, but the improved accuracy of overhead allocation might
outweigh the additional cost.
In Metalworks, Inc., Division B the overhead rate was $14/MHR; this rate was
predetermined by comparing the estimated overhead costs, $140,000, to the estimated
number of machine hours, 10,000 ($140,000/1 0,000 MHR). Additional analysis led
management to identify cost pool components as follows: $30,000 to machine set-up activity;
$70,000 to hole drilling activity; $25,000 to machine insertion activity and $15,000 to
manual insertion activity. Cost drivers selected were (respectively) number of set-ups,
number of holes drilled, number of machine insertions, and number of manual insertions. An
overhead rate can be computed for each activity, as follows.
When processing Job #3 in Department Bit is now necessary to keep track of how many set-ups
took place, how many holes were drilled, how many machine insertions took place, and how
many manual insertions took place. The allocation process involves multiplying the overhead
rate for each activity times the respective number of cost driver units. Overhead allocation Job #3
is based on the following information: number of set-ups, 8; number of holes drilled, 1 0; number
of machine insertions, 6; number of manual insertions, 3.
Logistics for allocating overhead are the same whether one plant-wide rate, a department based
system, or activity-based costing is used. Determine an overhead rate by estimating the cost pool
and dividing it by the estimated level (number of units) of the cost driver. To allocate overhead
costs to a particular job, multiply the overhead rate times the number of cost driver units used on
the job. The difference between the various methods (plant-wide, department based or activity-based)
lies in the homogeneity and size of the cost pools and the variety of cost drivers.
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Questions
Mark each of the following questions as True (T) or False (F).
1. Activity-based costing is preferred to traditional costing methods.
2. A death spiral refers to a situation of decreasing rather than to increasing demand.
3. Using a department allocation method, as opposed to a plant-wide allocation method, would
provide greater accuracy but at a greater cost.
4. Using a plant-wide allocation method, as opposed to activity-based costing, would provide
greater accuracy at a lesser cost.
5. In activity-based costing, a separate cost driver must be developed for each cost pool.
6. The term "cost hierarchy" refers to the primacy of the material and labor costs.
7. Computing the cost driver rate involves exactly the same type of computation necessary to
compute any predetermined overhead rate.
8. Activity-based costing often provides managers with specific information to help them better
manage costs.
9. Complexity is costly.
10. Activity-based costing is specialized in use to the manufacturing area.
Answers to True/False Questions
1. False. The decision to implement an ABC system should be based on cost vs. benefit.
2. False. If future demand is automatically assumed; this, too, can lead to negative results.
3. True. There is greater accuracy because there are more cost pools, but there is greater cost to
track this more complicated system.
4. False. There is less cost; there is also less accuracy.
5. True. This is what provides the greater accuracy. Each cost pool is more homogeneous than
before and can be more accurately allocated to the products.
6. False. The term refers to volume, batch, product and facility based costs.
7. True. The computation is made several times, once for each cost pool, but it is the same type
of computation as before.
8. True. ABC analysis often leads to a better understanding of what causes costs to change,
which in turn often leads to better management of those costs.
9. True. Think of managing the production often blue pens versus the production of five blue
pens and five red pens. The opportunity for error is greater in the second case and more costly.
10. False. The principles of ABC can be applied anywhere.
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Chapter Eleven- Service Department and Joint Cost Allocation
Study Tips
• Service department costs increase the cost of the product and these costs should be attached
to the products.
• Different allocation methods are based on different assumptions: (1) direct allocation, no
service department provides service to any other service department; (2) step allocation,
service departments can provide service to other service departments but cannot, at the same
time, receive service from other service departments; (3) reciprocal method, full reciprocity
between service departments.
• Judgments must be made considering the difference between the necessity of joint cost
allocation for financial statements and the irrelevancy of such allocation for decision making.
Summary
Continuing the discussion of product cost determination, first there is a focus on service
departments, why and how these costs relate to production. The remainder of the chapter is
devoted to discussion of joint cost allocation.
Service Department Cost Allocation
The primary function of a service department is to provide service to other departments.
Examples of a service department include a cafeteria, the buildings and grounds group, the
computer center, and human resources. These service departments provide service to the
producing departments (e.g., stamping, assembly, or finishing) and to non-producing
departments (e.g., all the other service departments). The service department is a cost used by the
production department; all costs of production should be attached to the products.
Because there is usually no direct, traceable relationship to the products being manufactured, the
service cost attachment process must be an indirect one. Relevant service department costs are
allocated to the producing departments, which increases that department's overhead. This in turn
will increase the producing department's overhead rate which, when applied to the products, will
attach a portion of the service department's costs to each product.
Assume that Kennesaw Manufacturing Company has two production departments, Assembly and
Finishing; there are two service departments, the cafeteria and the buildings and grounds.
Job #62 requires 400 machine hours in Assembly and 100 direct labor hours in Finishing. The
amount of overhead applied to Job #62 would be $1,600 (400 x $3 + 100 x $4).
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When the service department costs are added, the production department cost is increased. The
cafeteria costs are $24,000 and building and ground costs are $36,000. How should the service
department costs be apportioned to the production departments and then to the products?
Two methods are commonly used to allocate the service department costs to the producing
departments; the step-down method, the direct method. A third, the reciprocal method, is more
representative but requires a complicated set of simultaneous equations. The most simple
(mathematically) to implement is the direct method. This method allocates the service
department costs directly to the production departments and ignores any relationship to any other
service departments. An allocation basis with a causal relationship should be selected.
Direct Method
For the Kennesaw cafeteria, it is logical to use the number of employees in each department as
the allocation basis. The greater a department's number of employees, the greater the demand
that department puts on the cafeteria. Assume there are twenty employees in the Assembly
department and thirty employees in the Finishing department. Then 40% (20/50) of the cafeteria
costs would be allocated to Assembly and 60% (30/50) would be allocated to Finishing.
When allocating Kennesaw maintenance costs, a basic assumption is that larger departments
require more maintenance; a common basis for allocating this type of cost is square footage.
Consider the Assembly department has 48,000 square feet; the Finishing department has 12,000
square feet.
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Analyze the overhead rates computed prior to and after service departments costs were included.
Initially the rates were $3 per machine hour for Assembly and $4 per direct labor hour for
Finishing. Including service costs increases the rates: $6.84 per machine hour for Assembly and
$5.08 per direct labor hour for Finishing. With Job #62 requiring 400 machine hours in
Assembly and 100 direct labor hours in the Finishing Department the overhead applied, using the
new rates would now be $3,244.
Step Method
Although the direct method is straightforward and easy, it is theoretically less than accurate. The
Kennesaw employees in B & G often eat in the cafeteria and B & G employees sometimes
provide maintenance to the cafeteria. The step (step-down) method partially addresses this
cross-provision of services.
The step method allows for service department provision to other service departments, but only
in one direction. If the cafeteria is considered the primary service department, then the step
method assumes that Building and Grounds (B&G) provides no service to the Cafeteria. In
practical terms, costs are "stepped-down"; once a service department's costs have been
allocated to the other department it does not receive service from other service department.
Under the step method the order of allocation (which service department costs are allocated first,
which second, etc.), affects the overhead rate. Following are calculations which first demonstrate
cost allocation with cafeteria service at the top of the hierarchy. Then, service costs are allocated
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under the assumption that B & G service costs are at the top of the hierarchy. In data presented to illustrate
the direct method, note that the basis for allocation of Kennesaw cafeteria costs was the
number of employees and the basis for allocation of buildings & grounds was square footage.
Additional information indicates that Kennesaw's cafeteria has 20,000 square feet and there are
ten employees in the B & G service department
Notice in the step-down method that not all the cafeteria costs were allocated to the production
departments. The $4,000 allocated to the Building and Grounds department must be included in
B & G costs thereafter allocated to the production departments. Once a department's costs have
been allocated that department no longer receives an allocation of another department's costs.
The procedure to allocate B & G costs to the producing departments is the same as under the
direct method (80% to Assembly, 20% to
Finishing).
Now, assume Building and Grounds (B & G) costs at the top of the hierarchy.
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And the overhead rate computation would be:
Below is a summary comparison of the direct and step-down methods used in the examples.
Reciprocal Method
The reciprocal method is theoretically the best method because it allows for simultaneous
intra-department services. Computationally it is more difficult; the method requires setting up
simultaneous equations using the relative weights developed in the step method, assuming each
service department goes first. Using the example of Kennesaw Cafeteria and B & G service
departments, the equations would be:
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Solve the last two equations first, then substitute these values (C = 34,435; B&G = 41,739) in the
first two equations. The results are the total overhead for Assembly, $66,522, and the total
overhead for Finishing, $103,478. The ease of using spreadsheets has resulted in use of the
reciprocal method becoming more prevalent. A comparison of the methods follows:
Joint Cost Allocation
Two or more products of relatively equal value resulting from one common process are
identified as joint products. If two or more products result from a process but one product is
significantly more valuable than the other(s), the valuable one is called the main product and the
other( s) is called the by-product. If the second product is worthless, it is called scrap. These
definitions may change over time as tastes and/or technology change. For example, at one time
old and outdated equipment was left to rust and deteriorate, but now it is either sold to
third-world countries to be used in the manufacturing process or is recycled as scrap iron.
The point at which the various products become identifiable is called the split-off point. All costs
incurred prior to the split-off point are called joint costs; these costs are common to all the
outputs. Think of processing poultry; if the bones were discarded, the cost to process the chicken
would not decrease. In such a situation joint costs are unavoidable.
Two questions arise with regard to joint costs: how should they appear in financial statements
and how do they affect decisions. The relevant accounts for financial statements are Cost of
Goods Sold on the Income Statement, and Inventory on the Balance Sheet.
Poultry processing yields edible products, as well as feathers used for bedding and non-edible
parts used for fertilizer. Assume that split off occurs when the poultry is disassembled; joint costs
incurred before the split-off point are $1,200. At disassembly point (split-off) the poultry can be
identified as 200 pounds of edible product (meat) and 400 pounds of bones (fertilizer). The
feathers are considered a by-product. Assume that meat at the split-off point sells for $12 per
pound and the bones for $1.50 per pound. Joint costs can be allocated using the physical quantity
method or the net realizable value method (essentially, sales value at split off).
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The physical quantity method allocates the joint costs in the same ratio as the physical quantities
produced, in this case measured in pounds. This procedure of allocation (shown below) is the
same used to allocate service department costs, but now the basis for allocation is pounds.
The following income statement depicts gross margin if 80% of the meat were sold at $12 per
pound and 60% of the bones for $1.50 per pound.
The revenue for meat is 80% x 200 lbs x $12 and the revenue for bones is 60% x 400lbs x $1.50.
The cost of goods sold is the relevant percentage (80% for meat, 60% for bones) multiplied by
the joint cost allocated to that product, $800 to meat and $1 ,600 to bones. This method works in
the sense that it is consistent and there is logic to it, but it makes little sense in this case because
meat is much more valuable than soup bones and should probably bear more cost than the bones.
In our example, the bones are not generating a profit. Perhaps they should just be thrown away?
If they were discarded, no costs would be attached; the full $2,400 would attach to the meat.
Now when 160 pounds of the meat is sold the revenue would be unchanged, $1 ,920, but the cost
of goods sold would be $1,920 (80% x $2,400) and the gross margin would be zero. The joint
costs are not incremental costs with regard to any one of the joint products. The only way to
reduce the joint costs is to get rid of all of them, i.e., stop production before the split-off point.
Perhaps a better method of allocating the joint costs is based on the relative economic value of
the products at the split-off point; this method, the net realizable method considers the relative
demand for each product. Calculate the economic sales value of the products at the split-off point
and use these values as the basis for allocating the joint costs:
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Now assume sales of80% of the meat and 60% of the bones, the income statement improves:
Computation of ending inventory on the balance sheet is also dependent on which method of
joint cost allocation is used. Using the physical quantities method $800 was allocated to meat
and $1,600 to bones. When 80% of the meat and 60% of the bones were sold this meant that
20% of the meat and 40% of the bones were still left in inventory. The cost of this ending
inventory would be, $800 (20% x $800 + 40% x $1 ,600). Of the joint costs of $2,400; $1,600
appeared on the income statement and the remaining $800 is a current asset on the balance sheet.
In the net realizable value method the ending inventory amount would be $576 (20% x $1,920
+ 40% x $480). Note that the total joint cost, $2,400 minus the cost of goods sold, $1,824, is
equal to the ending inventory, $576.
Questions
Mark each of the following questions as True (T) or False (F).
I) The only departments that use service departments' service are production departments.
2) A crucial decision for service department cost allocation is which basis to use.
3) In the direct method, the order of departments allocated will have no effect on the allocation.
4) In the step method, the order of departments allocated will have no effect on the allocation.
5) The reciprocal method is the theoretically superior method of allocation.
6) Joint products are forever linked; there cannot be one without the other.
7) Joint cost allocation is necessary for financial statement presentation.
8) Individual products are not identifiable before the split-off point.
9) For the sell-or-process-further decision, joint cost allocation is always irrelevant.
1 0) Because by-products are relatively important accountants have developed several ways of accounting
for them.
Answers to True/False Questions
1. False. Any department, including other service departments, may be serviced.
2. True. Service costs may be significant and if the allocation is not logical there may be a negative
behavioral effect.
3. True. Since the service departments are not recipients of any allocation, the order in which their costs
are allocated will not affect the result.
4. False. Since the service departments are recipients of some allocation, the order in which their costs are
allocated will affect the result.
5. True. The reciprocal method recognizes that service departments often exchange services.
6. True. By the nature of the physical process one cannot exist without the other.
7. True. Joint cost allocation is necessary to develop the cost of goods sold value for the income statement
and the inventory value for the balance sheet.
8. True. The split-off point is defined to be the first point where the individual products can be identified.
9. True. Since part of the joint costs is unavoidable, the allocation is irrelevant.
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10. False. By-products are relatively unimportant; the method of accounting for them has negligible impact
on the financial statements.
Chapter Twelve - Fundamentals of Management Control Systems
Study Tips
• Because most large firms are decentralized their owners must think the advantages of
decentralization outweigh any disadvantages.
• Explore carefully the pyramid-type hierarchy of subunit structure: cost and revenue centers at the bottom,
then profit centers, and, at the top, investment centers.
• Distinguish between evaluating a subunit and evaluating its manager.
Summary
Often a situation arises where the decision maker may have a conflict between doing what is best
for the employee versus what is best for the organization. Geographic diversity makes it is
impossible for top management to always be on-site; this necessitates decentralization, the
delegation of decision-making authority to a subordinate. Decision making is pushed down to
lower levels of the organization and out to more geographically remote locations. There are
advantages and disadvantages of decentralization.
Advantages of Decentralization
The advantages of decentralization include: (1) better use of local knowledge, (2) expedites
response time, (3) more focused use of top management's time, (4) reduction of problems to
manageable size, and (5) training and motivation of local managers.
Because company headquarters is usually distanced from geographically dispersed subunits a
local manager is better prepared to make immediate decisions (with some constraints) and can
respond far more quickly than top-level managers. Modem communications tools have led to a
certain amount of re-centralization, but local managers still may have a better working knowledge of local
economy and customs. Training opportunities for subordinates can also be a
stepping stone to promotion. Another advantage of decentralization is that it removes top
management from daily decisions and provides more time to focus on long-term strategic
decisions.
Disadvantages of Decentralization
Lack of goal congruence can be a major disadvantage of decentralization. "Self-interest"
managers may work in their own best interests, which may be inconsistent with the company's
best interests. An example of this dysfunctional decision making, or lack of goal congruence,
might be where the company wants a division to report high net income and the division
manager, in order to decrease expenses, discontinues routine maintenance. A reduction in any
expense increases the division net income; but in the long term, lack of maintenance will harm
the division and the company. In the near term the manager may be sufficiently impressive to
receive a bonus or promotion but no benefit has accrued to the company.
Management Control Systems
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Structure and procedures used to implement the organizational strategies is basic to a
management control system; this limits the amount of dysfunctional decision making. The
management control systems consist of three elements: (1) delegated decision authority,
(2) performance evaluation and measurement systems and (3) compensation and reward systems.
Empowerment of lower-level employees results when decision making authority is moved
downward in the organization (delegated decision authority). The essence of this decentralization
process is that performance evaluation is linked to the compensation and reward system;
managers are then encouraged to align their personal goals with the goals of the organization.
Responsibility Accounting
Performance evaluation of organization subunits is central to responsibility accounting. Major
models for a subunit are: (1) cost center, (2) revenue center, (3) profit center and 4) investment
center. The major difference in the structure of the subunits is the degree of authority vested in
the manager. In a cost center the manager is responsible for control of costs and perhaps the
quality and timing of the output. A manufacturing unit would usually be organized as a cost
center. The performance evaluation would be based on a budget; operating within the budget is a
high priority.
A revenue center is evaluated similarly to that of a cost center. Generation of revenues is under
the control and responsibility of the manager. A marketing division is an example of a revenue
center. With goals of improving price and quantity, the sales budget is determined; then the
manager's performance is compared to the budget.
Both revenues and costs are the responsibility of a profit center manager, with the ability to
manipulate both revenues and expenses. A highly visible measure of performance is the
subunit's net income. A profit center manager does not have control over investment in the
division's assets.
Greatest responsibility is that of the manager of an investment center with responsibility for
divisional revenues and costs and the responsibility for investment in the division asset base. The
usual measure of performance in an investment center is return on investment (ROI), linking net
income to the investment base.
Evaluating Performance
Evaluating a manager may be different from evaluating the organization sub-unit. An automobile
manufacturing sub-unit has been unprofitable for many years. Top management selects a
manager who has documented experience in a different manufacturing sector and after a
reasonable period of time the sluggish sub-unit begins to shown signs of break-even. The
sub-unit is not successful in absolute terms, break-even is not a profitable situation, but in
relative terms the sub-unit performance is much improved. The new manager should be amply
rewarded.
Compensation Systems
Both positive and negative behavior can result from a compensation and reward system.
Compensation can take two forms: fixed compensation or contingent compensation. Fixed
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compensation is not usually directly linked to a performance measure; an example is that of a
salaried employee. Contingent compensation is based on measured performance, an example is a
sales commission based on quantity of sales.
Behavioral consequences of a compensation system may be undesirable. Assume that the sales
staff in the cosmetic department receives a 25% commission on every product sold. As an
accommodation, a member of the sales staff allows the customer to purchase two similar
products with the suggestion that one can be returned without penalty. The salesperson helps the
customer, secures a sale for the company and receives a double commission for making two
sales. Good news travels fast and other customers line up for such a good deal. The health
department becomes interested in what appears to be the resale of used cosmetics. The company
receives negative publicity. Sales increase to the company, the sales person is motivated by the
commission, but at what price!
When a manager's compensation is based on departmental performance, how that perfom1ance is
measured is of personal importance. Because cost allocations affect the department performance.
they often become items of contention. Best practice is that a department's cost allocation should
depend on that department's actions and should not be affected by another department's actions.
Faircloth & Associates is a company with three divisions, A, B and C.; common cost is allocated on the
basis of division sales. In the first year of operation sales, commission and net income
were as follows:
Total common cost, $70,000, is 35% of total sales, $200,000. To allocate the cost multiply each
division's sales by 35%.
Assume that in the second year of operation sales for Division C drop to $40,000 while the rest
of the company stays the same as in the first year.
The managers of Division A or B have reason for concern. Sales in Year 2 are identical to sales
in Year l but division net income has decreased due to the increase in cost allocation caused by
the decrease in Division C's sales. Division A and B managers are being held responsible for
costs over which they have no control. What a disincentive! A dual rate allocation system based
upon cost analysis would serve to ameliorate such a negative outcome.
Under a dual rate system, fixed costs are allocated using a variety of allocation bases. Fixed costs
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are usually allocated at the beginning of the period and are not dependent on the actual activity
of the period, whereas variable costs are allocated as the service is provided.
Assume a computer center provides service to two departments, A and B. The fixed costs of
operating the computer center are $45,000 per month and variable costs are $2 per hour used. 1n
January, both depm1ments used l 0.000 hours of computer time; in February, A used l 0,000
hours but B used only 5,000 hours.
On the basis of estimated long term usage, the fixed costs are allocated 1/3 to A and 2/3 to B.
Each hour of usage is charged $2 (the variable rate per hour). In January, because each
department used l 0,000, each was charged with identical variable cost of $20,000 (I 0,000 hours
x $2 per hour). In addition A would he charged one-third of the fixed costs and B would he
charged two-thirds of the fixed costs. The total allocation for January follows:
Note that total costs allocated ($85,000) equal total incurred: $45,000 of fixed costs and $40,000
of variable costs.
Note that allocation to Department A does not vary from month to month; performance is not
affected by B's activity.
Questions
Mark each of the following questions as True (T) or False (F).
1. In a decentralized firm, local managers have little decision making authority.
2.Centralized organizations are smaller than decentralized organizations.
3. In a decentralized firm, delegation of many decisions allows top managers to focus on
strategic decisions.
4. Cost centers are just as likely as investment centers to be found at all levels of an organization.
5. Goal congruence occurs when workers work in their own best interests.
6. A manager may be evaluated differently from that of the responsibility center.
7. Fixed compensation is superior to contingent compensation for motivating employees.
8. Corporate cost allocation systems may be a disincentive to the recipient divisions.
9. Pressuring employees to perform well may lead them to make illegal or unethical
decisions.
I 0. The emphasis on short term results is a major contributing factor in the pressure to
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commit fraud.
Answers to True/False Questions
1. False. This is one of the advantages of decentralization: local managers, who are closer to the
local scene, do have decision making authority.
2. False. Not necessarily so; the U.S. armed forces are a centralized organization.
3. True. This is a major advantage of decentralization.
4. False. Cost centers are more likely to be found at lower levels of an organization, investment
centers are more likely to be found at higher levels of an organization.
5. False. Goal congruence occurs when the workers' interests are aligned with the firm's
interests.
6. True. A manager might be doing a good job and still not be able to make the responsibility
center successful.
7. False. Fixed compensation is determined independent of performance; therefore it has minimal
motivating force.
8. True. If the recipient has no control over allocation then the system may appear arbitrary. If
this allocation, in large part, determines the sub-unit's reported performance the manager may
assume personal efforts are unimportant.
9. True. Too much pressure to meet goals may lead to poor decision making.
10. True. Evaluation and bonuses are often tied to short term results, which may in fact be
unrealistic. Manipulation may occur--to the detriment of the company.
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Chapter Thirteen - Planning and Budgeting
Study Tips
• A major advantage of budgeting is that it forces people to think ahead .
• Budgeting should lead to coordination of goals across the organization .
• Dysfunctional decision making may occur if managers work to meet their own particular
budget without any regard for the goals of the company as a whole.
Summary
Most companies are involved in strategic planning, a long term vision of where the company
wants to be in the future. The long-term vision is then implemented in shorter time periods. The
master budget is a one year plan developed to assist the company in achieving its long term
goals. The master budget is usually led by a sales forecast and then, based on that sales budget, a
production budget and pro forma (estimated) financial statements follow.
The sales forecast is extremely important because other budgets are linked to the expected
product demand. Considerable resources- monetary, time and staff expertise- are devoted to
developing the sales budget. Salespeople have a wealth of experience and can use that
knowledge to estimate future sales. One caution when asking salespeople to set their own budget
is to be aware that they know that they will be evaluated by comparing their actual performance
to that stipulated in the budget.
Often outside resources and techniques are used to improve the budget forecast. Market
researcher firms can add a different perspective or the use of a Delphi model could encourage
consensus. The Delphi technique has each group member submit a forecast anonymously. The
group then discusses each forecast and attempts to narrow the differences. This discussion is
followed by each member again submitting a new forecast; the process continues until consensus
is reached.
Another technique used for sales budgeting is to predict future performance based on past trends.
Trend analysis can be as informal as using a graph of past sales or as formal as applying
sophisticated statistical analysis to past sales data. It is crucial to recognize that the integrity of
the data inputs is essential for valid results.
Questions
Mark each of the following questions as True (T) or False (F).
1) Budgets are useful only to large companies.
2) There are no negative aspects to using budgets.
3) Critical success factors are the competition's strengths.
4) The strategic plan is a short term plan to implement the master budget.
5) Because they are quantitative, budgets are independent of human behavior.
6) A claimed benefit for participative budgeting is that it enhances employee motivation.
7) The first step in preparing the master budget is to prepare a sales forecast.
8) Software packages produce results based on the quality of the input data.
9) Manufacturing companies have more types of inventory than do retailers.
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1 0) Service organizations have no inventory; therefore they have no need to use budgets.
Answers to True/False Questions
1. False. Budgets can be useful to any organization, large or small.
2. False. Budgets may encourage dysfunctional decision making.
3. False. Critical success factors are a company's strengths.
4. False. The master budget is a one year plan to help implement the (long term) plan.
5. False. Budgets are quantitative plans for the future but human beings must implement them
and human beings are complex individuals.
6. True. Participation increases the likelihood that the budget will be accepted.
7. True. The sales forecast is crucial for budgeting production, purchases, cash flow, etc.
8. True. If the input data are not reliable then the results cannot be reliable, no matter how
authoritatively they are pronounced.
9. True. Retailers do not have work-in-process or raw materials inventories.
10. False. Service organizations have no inventories, but they still need budgets to schedule
volunteers, contain costs and meet objectives.
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Chapter Sixteen - Fundamentals of Variance Analysis
Study Tips
• Re-examine the benefits of budgeting and the consequences of not budgeting for every
line item on the income statement and the balance sheet
• The ability to re-budget at the point and time when expectations change is crucial; this is
termed flexible budgeting.
• Relationships between variances may be co-dependent or independent; it is important for
management to understand these relationships.
• A favorable variance does not necessarily indicate a favorable economic situation.
Summary
Budgets are crucial to planning. These tools assist management in coordinating sales, production,
purchases and other divisional activities. Management uses budgets as control mechanisms to
compare variances (differences) between actual performance and budgeted performance. When
net income is greater than budgeted the difference is identified as a favorable variance. When
expenses exceed the budget, an unfavorable variance is created. A favorable variance exists as
the result of revenue exceeding budgeted revenue.
Cost Variances
Alpha and Omega Company is planning for the upcoming year. The expectation is that 30,000
units will be produced each month at a cost of $3 per unit, a total of $90,000. During the month
of January, actual production is 20,000 units and actual cost for the month was $80,000. This
might seem to be a favorable variance but when production quantity is considered, it becomes
obvious that the production cost is excessive.
A closer look at the situation indicates the budgeted cost of $90,000 was for production of
30,000 units, not 20,000 units. It is not logical to compare the actual performance to a budget for
a different level of production. The January production cost is $4 per unit ($80,000/20,000),
which is much more than the expected cost of $3 per unit. The information is more useful when the budget
is adjusted to the actual level of production. This adjusted budget is termed a flexible
budget because it "flexes" to different levels of production. The original budget is called a static
budget in that it represents only one level of production. Static budget information is useful
because it reflects the best understanding of the relationship between volume (levels of
production) and cost. Once these relationships are known, the static budget can be modified to
prepare budgets for several levels of activity.
Questions
Mark each of the following statements as True (T) or False (F).
1. Budgets provide a benchmark against which to measure actual performance.
2. An unfavorable variance increases operating profits, holding all other things constant.
3. A favorable variance is not necessarily good.
4. Static budgets are prepared before production; flexible budgets are used afterwards.
5. Cost variances are important for measuring productivity and controlling costs.
6. If the price variance is favorable then the efficiency variance must be unfavorable.
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7. The direct labor price variance is based on the time actually taken compared to the time
that should have been taken.
8. Computation of all variable cost variances uses the same calculus formula.
9. The production volume variance is always zero.
10. The fixed overhead efficiency variance is always zero.
Answers to True/False Questions
1. True. This is one of their most important functions. Budgets communicate goals and then act
as benchmarks to measure progress towards those goals.
2. False. An unfavorable variance decreases profits.
3. True. Further investigation may uncover the cause of the variance, which may change the
interpretation of the variance. Favorable versus unfavorable depends on whether expenses or
revenues are being analyzed.
4. True. If actual quantity is different; a new budget must be prepared.
5. True. The comparison to the budget provides information needed for cost control.
6. False. There is no necessary cause and effect relationship between the two variances.
7. False. It is the labor efficiency variance that would reflect the difference in time.
8. True. All variable costs behave in a similar fashion.
9. False. The volume variance measures the difference between the budgeted fixed overhead and
the fixed overhead applied. This may be zero, but usually isn't.
10. True. Since fixed cost in any budget is always the same, the difference is always zero.
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Appendix: Capital Budgeting
In determining which capital budgeting techniques are appropriate for a specific decision, it is
helpful to review some basic characteristics of four often-used techniques. Three are cash basis
techniques; one is an accrual basis technique.
• Payback Period
• Net Present Value
• Accounting Rate of Return
• Internal Rate of Return
The payback period technique is probably the easier to use. It is simply a calculation in which
cash used for the project is divided by future cash inflows. It is a faulty technique in that the time
value of money is not considered.
Net Present value is probably the most beneficial of the capital budgeting techniques. It involves
using an imputed interest rate to discount future net cash inflow(s) to the present value. In order
to use the technique, management must decide if the future cash flow(s) are a one-time only cash
flow and/or if the cash flow is a series (annuity). Once the future cash flows have been
discounted to the present value, they are compared to the initial cash outflow to determine if
there is a positive net present value. If the net present value is negative, management should not
automatically reject the project; rather, the imputed interest rate should be analyzed to determine
if the rate used is realistic.
The accounting rate of return is one with which most managers (and students) are most familiar.
It involves the use of accrual basis net income as compared to the value of the asset investment.
It normally does not consider the time value of money.
The internal rate of return is used when future net cash flows are known, but the interest rate
(cost of capital) has to be determined. A quick estimation of internal rate of return can be
determined by use of present value tables provided in most accounting textbooks. Simply take a
Southward direction down the relevant present value table to the time period appropriate to the
decision. Follow the interest data columns in an Eastward direction. When the payback period
(or close approximation) is located, follow that column in a Northward direction to the head of
the column. The internal rate of return approximates the interest rate caption at the top of the
column. If the payback period is located between two columns, use of algebraic interpolation can
be used to determine a more exact value.
Each of the four techniques provides value to any decision regarding long-term economic value.
In an international environment, managers should use all assessment tools available.
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