Cost drivers are measures of activities that require the use of resources and thereby cause costs.

A variable cost
changes in direct proportion to changes in the cost-driver level. A fixed cost is not immediately affected by
changes in the cost-driver level. Contribution Margin Format is: Sales – Variable cost = Contribution – Fixed
Cost = Net Profit. Key Assumptions of CVP Analysis are:
• We can classify costs into variable and fixed categories.
• We expect no change in costs due to changes in efficiency or productivity.
• The behavior of revenues and costs is linear over the relevant range. This means that selling prices per unit
and variable costs per unit do not change with the level of sales.
• In multiproduct companies, the sales mix is constant.
• In manufacturing companies, inventories do not change (units produced = units sold). Equation Method:

Formula Method: Unit sales to attain target profit =Target profit + Fixed expenses/Unit CM.
Unit Contribution Margin= Selling price Per unit – variable expense per unit.
Contribution Margin Ratio = (Selling price Per unit – variable expense per unit) / Selling price Per unit.
The per-unit variable cost remains unchanged regardless of changes in the cost-driver. Total fixed costs remain
unchanged regardless of changes in the cost-driver. The margin of safety in dollars is the excess of budgeted (or
actual) sales over the break-even volume of sales. Margin of safety in dollars = Total sales - Break-even sales
Margin of safety in units = Total Units Sold - Break-even Units.
Margin of safety in % = MOS/Total sales x 100. An advantage of a high fixed cost structure is that income
will be higher in good years compared to companies with lower proportion of fixed costs. A disadvantage of a
high fixed cost structure is that income will be lower in bad years compared to companies with lower proportion
of fixed costs. Operating leverage is a measure of how sensitive net operating income is to percentage changes
in sales. It is a measure, at any given level of sales, of how a percentage change in sales volume will affect profits.
A pessimistic, risk-averse management would most likely choose the
product has the highest margin of safety. If management is optimistic and
risk-aggressive, management would most likely choose the product has the
low margin of safety, it offers the highest level of operating leverage. Sales mix is the relative proportion in which
a company’s products are sold. Different products have different selling prices, cost structures, and contribution
margins. 4.) Determining the cost of the product is termed product costing. Computing Single Plantwide
Factory Overhead = Total Budgeted Direct labour hours are: (Total no of units *no of hours) * number
Of product. Factory overhead Cost per unit = Single Plantwide Factory Overhead *
Direct Labour hour per unit. Department Factory Overhead Rate: Total Budget a
assign to a Department / Total Budgeted Direct labour hour for each department.
To Calculate Factory overhead allocated per unit of each product using departmental factory overhead:
Product1: Department 1: Allocation Base usage per unit * Production Department factory overhead rate = A1
Department 2: Allocation Base usage per unit * Production Department factory overhead rate = A2
Total Factory overhead for product1 (A) = A1+A2.
The activity-based costing (ABC) method focuses on the cost of activities and then allocates these costs to
products using a variety of activity bases. The activity cost pools are assigned to products, using factory overhead
rates for each activity. These rates are called activity rates. Activity Rate = Budgeted Activity Cost /Activity
Base. Activity Cost for each product= Activity Base for that product X Activity rate.
Traditional systems were appropriate when: Direct costs were the dominant costs, Indirect costs were relatively
small, Information costs were high, there was a lack of intense global competition, A limited range of products
was produced. Volume-based allocation methods work best if the manufacturing environment includes mostly
unit-level costs. Activity-based costing provides an alternative to traditional methods. Activity-based costing
(ABC) is a costing model that identifies activities in an organization and assigns the cost of each activity resource
to all products and services according to the actual consumption by each. It is a product of the technological era.
Overhead costs can be classified at the unit-level, the product-level, the batch-level and the facility-level. Unit-
LEVEL COSTS are incurred each time a unit is produced. Examples: Supplies for factory, Depreciation of
factory machinery. Batch-LEVEL COSTS are incurred for batches of goods produced.
Examples: Salaries for purchasing, Depreciation for setup equipment. Product-LEVEL COSTS are incurred for
each type of product produced. Examples: Salaries of engineers, Product development costs. Facility-LEVEL
COSTS sustain general facility processes. Examples: Insurance and taxes, Salary of plant manager. Purchase
order processing is an example of a Batch-level activity. Arranging for a shipment of a number of different
products to a customer is an example of Customer-level activity. Testing a prototype of a new product is an
example of a Product-level activity. Worker recreational facilities is an example of a cost that would ordinarily
be considered to be Organization-sustaining. There are several benefits of ABC: Cost Accuracy Increases,
Better Control Through Identification of Costs, Better Day-To-Day Decision Making and Opportunities for
Continuous Improvement. Limitations of ABC: High Measurement Costs. Time Consuming with Multiple
Activity Pools and Cost Drivers. If the market dictates prices, ABC implementation costs may exceed the expected
benefits of more accurate data A decision model is any method used for making a choice, sometimes requiring
elaborate quantitative procedures. Absorption costing considers all indirect manufacturing costs (both variable
and fixed) to be product (inventoriable) costs that become an expense in the form of manufacturing cost of goods
sold only as sales occur. It is also used for external financial reporting. Contribution costing is an internal
(management accounting) reporting method that emphasizes the distinction between variable and fixed costs for
the purpose of better decision making. It is also used for internal planning and decision making. Unit product
cost for Absorption cost = Variable manufacturing costs total + Fixed Manufacturing overhead where Fixed
Manufacturing overhead per unit = Fixed Manufacturing overhead / number of Units sold. Unit product cost for
Variable cost = Variable manufacturing costs total. To Calculate the profit under marginal and absorption
costing we will first calculate unit product cost for absorption and variable cost and then calculate Sales = number
of units sold X selling price. then Cost of production for units sold will = Cost of Production p.u. X number of
units sold. Selling & Distribution Exp. Variable = Variable Selling and admin. Exp of p.u. sold X Number of units
sold. The Fixed Selling and distribution exp. for the absorption cost will remain same but for variable cost it will
be = Fixed Selling and distribution exp.+ Total fixed mfg. overhead per year. The profit = Sales - Cost of
production for units sold – (Selling & Distribution Exp. Variable + Fixed Selling and distribution exp).
The advantages of variable costing and the contribution approach include:
• The data required for CVP analysis can be taken directly from a contribution format income statement.
• Profits move in the same direction as sales, assuming other things remain the same.
• Managers often assume that unit product costs are variable costs. Under variable costing, this assumption
is true.
• Fixed costs appear explicitly on a contribution format income statement; thus, the impact of fixed costs
on profits is emphasized.
• Variable costing data make it easier to estimate the profitability of products, customers, and other
business segments.
• Variable costing ties in with cost control methods, such as standard costs and flexible budgeting.
• Variable costing net operating income is closer to net cash flow than absorption costing net operating
income.
Absorption costing still so prevalent because One reason (in addition to the external reporting issue) relates to
the matching principle. Advocates of absorption costing argue that its better matches costs with revenues. They
contend that fixed manufacturing costs are just as essential to manufacturing products as are the variable costs.
However, advocates of variable costing view fixed manufacturing costs as capacity costs. They argue that fixed
manufacturing costs would be incurred even if no units were produced. Differential cost (differential revenue)
is the difference in total cost (revenue) between two alternatives. For example, consider the decision about which
of two machines to purchase. Both machines perform the same function. The differential cost is the difference in
the price paid for the machines plus the difference in the costs of operating the machines. We call a decision
process that compares the differential revenues and costs of alternatives a differential analysis. An opportunity
cost is the maximum available benefit forgone (or passed up) by using a resource that a company already owns
or that it has already committed to purchase for a particular purpose. Target costing is not just a method of
costing, but rather a management technique wherein prices are determined by market conditions brought about by
several factors, such as homogeneous products, level of competition, no/low switching costs for the end customer,
etc. Target Costing = Selling Price – Profit Margin. Advantages of Target Costing:
• It shows management’s commitment to process improvements and product innovation to gain
competitive advantages.
• The product is created from the expectation of the customer and hence cost is also based on similar lines.
Thus, the customer feels more value is delivered.
• With the passage of time, the company’s operations improve drastically, creating economies of scale.
• The company’s approach to designing and manufacturing products becomes market-driven.
• New market opportunities can be converted into real savings to achieve the best value for money rather
than to simply realize the lowest cost.
Avoidable costs are costs that will not continue if an ongoing operation is changed or deleted. Unavoidable costs
are costs that continue even if an operation is halted. The equipment’s book value (or net book value) is the
original cost less accumulated depreciation. Relevance of Equipment Data: Book value of old equipment:
irrelevant because it is a past (historical) cost. Therefore, depreciation on old equipment is also irrelevant.
Disposal value of old equipment: relevant because it is an expected future inflow that usually differs across
alternatives. Cost of new equipment: relevant because it is an expected future outflow that will differ across
alternatives. Therefore, the initial cost of new equipment (or its allocation in subsequent depreciation charges) is
relevant. A budget is a detailed quantitative plan for acquiring and using financial and other resources over a
specified forthcoming time period. The act of preparing a budget is called budgeting. The use of budgets to
control an organization’s activities is known as budgetary control. Advantages of Budgeting: Budgets
communicate management’s plans throughout the organization. Budgets force managers to think about and plan
for the future. The budgeting process provides a means of allocating resources to those parts of the organization
where they can be used most effectively. The budget process can uncover potential bottlenecks before they occur.
Budgets coordinate the activities of the entire organization by integrating the plans of its various parts. Budgets
define goals and objectives that can serve as benchmarks for evaluating subsequent performance. Operating
budgets ordinarily cover a one-year period corresponding to a company’s fiscal year. Many companies divide
their annual budget into four quarters. A continuous or perpetual budget is a 12-month budget that rolls forward
one month (or quarter) as the current month (or quarter) is completed. This approach keeps managers focused on
the future at least one year ahead.
Total Budgeted Sales = Budgeted sales in unit * selling price per unit.
Expected Cash Collections: The first step in calculating cash collections is to insert the beginning accounts
receivable into the First month column. The second step is to calculate the April credit sales that will be collected
during each month of the quarter. The third step is to calculate the May credit sales that will be collected during
each month of the quarter. The fourth step is to calculate the June credit sales that will be collected during the
month of June. The fifth step is to calculate the total for each column in the schedule and the total for the quarter.
The Production Budget: The first step in preparing the production budget is to insert the budgeted sales in units
from the sales budget. The second step is to calculate the required production in units for April. To calculate the
required production in units, use following method: Budgeted Sales + Desired ending inventory = Total Needs.
Then Total Needs – Beginning inventory = Required Production. The third step is to calculate the required
production for May. The fourth step is to calculate the required production for June. The fifth step is to complete
the Quarter columns. For Quarter the Desired ending inventory will same of the last month (June) and Beginning
Inventory will same as of starting quarter month (April).
The Direct Materials Budget: The first step in preparing the direct materials budget is to insert the required
production in units from the production budget. The second step is to calculate the monthly and quarterly
production needs, which in this case are stated in terms of pounds of direct material. The third step is to calculate
the materials to be purchased for April. use following method: Required Production X Materials needed =
Production needed. Then Production needed + Desired ending inventory = Total Needs. Then Total Needs –
Materials at the beginning inventory = Material Required for Production. The fourth step is to calculate the
materials to be purchased for May. April’s desired ending inventory becomes May’s beginning inventory. The
fifth step is to calculate the materials to be purchased for June. The desired ending inventory for May becomes
the beginning inventory for June. For Quarter the Desired ending inventory will same of the last month (June) and
Beginning Inventory will same as of starting quarter month (April).
Expected Cash Disbursement for Materials: The first step in calculating cash disbursements is to insert the
beginning accounts payable balance into the April column of the cash disbursements schedule. The second step
is to calculate the April credit purchases that will be paid during each month of the quarter. The remaining steps
include calculating the May and June credit purchases that are paid during each month of the quarter. We also
calculate the totals for all columns in the schedule and the total for the quarter.
The Direct Labour Budget: The first step in preparing the direct labour budget is to insert the production in units
from the production budget. The second step is to compute the direct labour hours required to meet the production
needs. The third step, is to compute the direct labor hours paid each month and for the quarter to compute that we
follow: Units of Production X Direct Labour Hours = Labour Hours Required. The number of hours paid will be
the greater of the direct labor hours required, or labor hours guaranteed (minimum number of hours that will paid).
The fourth step is to compute the total direct labor cost which = The number of hours paid X hourly wage rate.
Manufacturing Overhead Budget: To calculate Manufacturing overhead Budget follow: Budget Direct labor
Hour X variable mfg. Overhead Rate = Variable mfg. Overhead costs. Variable mfg. Overhead costs + Fixed mfg.
Overhead costs = Total mfg. Overhead costs. Total mfg. Overhead costs – Non-cash costs = Cash Disbursement
for manufacturing Overhead.
Ending finished goods inventory budget: To Calculate the ending finished goods inventory budget Follow:
Direct Materials = Quantity X costs, Direct labour = Quantity X costs, Manufacturing Overhead = Quantity X
costs. Now Direct Materials + Direct labour + Manufacturing Overhead = Production costs per unit. Ending
inventory in units + Production cost per unit = Ending finished good inventory.
Selling and Administrative Expense Budget: To Calculate the Selling Administrative budget follow: Budgeted
sales X variable S& A rate per unit = variable expense. Variable expense + Fixed S&A Expense = Total S&A
expense. Total S&A expense – Non-cash expense = cash S&A expense. This need to be calculated for all months
and quarter.
Cash Budget: This budget should be broken down into time periods that are as short as feasible. It consists of
four major sections:
• Cash receipts section lists all cash inflows excluding cash received from financing.
• Cash disbursements section consists of all cash payments excluding repayments of principal and
interest.
• Cash excess or deficiency section determines if the company will need to borrow money or if it will be
able to repay funds previously borrowed.
• Financing section details the borrowings and repayments projected to take place during the budget
period.
To Calculate Cash Budget Follow: 1.) Beginning cash balance + Cash Collections = Total Cash available. 2.)
under Cash Disbursements: Materials + direct labour + Manufacturing overhead+ selling & admin + equipment
purchase + Dividend = Total Disbursements. 3.) Total Cash available -Total Disbursements = Excess (deficient)
4.) Under Financing: Borrowings + repayments + Interest = Total Financing. 5.) Ending Cash Balance = Total
Financing – Excess(deficiency).
Zero-based budgets require managers to build budgets from the ground up each year rather than just add a
percentage increase to last year’s numbers. Participatory budgeting starts with departmental managers and
then flows up through middle management and ultimately to top management. At each level, budget estimates
are prepared and then submitted to the next level of management, which has responsibility for reviewing the
budget and negotiating any changes that need to be made.
Merchandising Companies:
• While merchandising companies will prepare a sales budget, they will not prepare budgets for
production, direct material purchases, direct labor, or manufacturing overhead.
• They will prepare a purchases budget (for goods to be sold to customers) based on the projections in
the sales budget.
• In addition, many merchandising companies hold some level of merchandise inventory and will need
to estimate desired inventory balances and adjust sales projections accordingly.
• The preparation of selling and administrative expense budgets, cash budgets, and budgeted financial
statements in merchandising companies is similar to that in manufacturing companies.
A budget for a single unit of a product or a service is known as its standard cost. Just as the cost of a product
consists of three components—direct materials, direct labour, and manufacturing overhead —a standard cost
will be developed for each component.
An ideal standard is one that is attained only when near-perfect conditions are present. An ideal standard assumes
that every aspect of the production process, from purchasing through shipment, is at peak efficiency. A practical
standard should be attainable under normal, efficient operating conditions. Practical standards take into
consideration that machines break down occasionally, waste occurs in materials, etc.

Material Variances: Using the Factored Equations

• Materials price variance (MPV) = (Acutal Price – Selling Price) X Auctal

Qunatity pruchased.
• Materials quantity variance (MQV) = Selling Price X (Acutal Qunatity –
Selling Qunatity)
Labor Variances: Using the Factored Equations:

• Labor rate variance LRV = Actual Hour X [Actual Rate(per hour) – Selling
Rate(perhour)]
• Labor efficiency variance LEV = Selling Rate X (Actual Hour – Selling
Hour)