Ch7. Cost and Managerial Accounting — Costing Methods, CVP, and Budgets

Cost Classification and Costing Systems

Cost classification by function:
Product costs (inventoriable):
  Direct materials + Direct labor + Manufacturing overhead
Period costs (expensed immediately):
  Selling, general, and administrative expenses (SG&A)

Cost behavior:
Fixed costs: total unchanged regardless of output
  (but fixed cost per unit decreases as output rises)
Variable costs: total changes proportionally with output
  (variable cost per unit is constant)
Mixed (semi-variable) costs: fixed component + variable rate
  (separate using High-Low Method or regression analysis)

Costing systems:
Job-order costing: accumulate costs by job/batch/contract
  (custom manufacturing, construction, professional services)
Process costing: accumulate costs by department/process
  for homogeneous mass-production
Activity-Based Costing (ABC): assign indirect costs to
  products/services using activity cost drivers

Standard Costs and Variance Analysis

Standard cost:
Predetermined cost per unit based on efficient operations
Compared to actual cost to compute variances

Direct Materials Variances:
Price variance: (Actual price − Standard price) × Actual qty purchased
Quantity (usage) variance: (Actual qty used − Standard qty allowed) × Standard price

Direct Labor Variances:
Rate variance: (Actual rate − Standard rate) × Actual hours
Efficiency variance: (Actual hours − Standard hours allowed) × Standard rate

Manufacturing Overhead Variances (4-variance method):
Spending (budget) variance: Actual OH − Budgeted OH at actual activity
Efficiency variance: (Actual hours − Std hours) × Std variable OH rate
Volume variance: Budgeted fixed OH − Applied fixed OH
  = Fixed OH rate × (Denominator hours − Standard hours allowed)

CVP Analysis (Cost-Volume-Profit)

Contribution Margin (CM):
Sales revenue − Variable costs = Contribution margin
CM ratio = CM ÷ Sales

Break-Even Point (BEP):
BEP in units = Fixed costs ÷ CM per unit
BEP in dollars = Fixed costs ÷ CM ratio

Target Profit:
Required units = (Fixed costs + Target profit) ÷ CM per unit
Required sales $ = (Fixed costs + Target profit) ÷ CM ratio

Margin of Safety:
Margin of safety = Actual (or budgeted) sales − BEP sales
Margin of safety ratio = Margin of safety ÷ Actual sales

Operating Leverage:
Degree of operating leverage (DOL) = CM ÷ Operating income
A 10% increase in sales → 10% × DOL = % change in operating income

Budget Management

Master Budget flow:
Sales Budget → Production Budget → Direct Materials Budget
  → Direct Labor Budget → Manufacturing OH Budget
  → Ending Inventory Budget → COGS Budget
  → SG&A Budget → Cash Budget → Pro Forma Financial Statements

Sales budget as the starting point:
All other operating budgets derive from the sales forecast
Cash budget derived from all operating budgets + financing plans

Capital Budget:
Long-term investment decision analysis
Apply NPV, IRR, payback period, and profitability index

Flexible Budget:
Recalculated budget at actual (or any) output level
Separates volume variance from spending/efficiency variances
Flexed budget formula: (Variable cost rate × Actual units) + Fixed costs

Contribution Margin = Sales minus Variable Costs ★★★★★ : CM is the amount available to cover fixed costs and generate profit. CM ratio = CM ÷ Sales. Memory hook: CM = revenue − variable costs (NOT minus fixed costs)

BEP = Fixed Costs ÷ CM per Unit ★★★★★ : The output level at which operating income = zero. Requires all fixed costs to be recovered before profit begins. Memory hook: BEP = fixed ÷ CM per unit

ABC = Activity-Based Indirect Cost Allocation ★★★★☆ : Assigns overhead to products based on each product’s consumption of cost-driver activities. Improves accuracy vs. volume-based allocation. Best for diverse product lines with complex overhead. Memory hook: ABC = activities drive costs

Practice Quiz

Q. When does absorption costing produce higher operating income than variable costing?

Absorption costing (US GAAP required for external reporting) includes fixed manufacturing overhead in product cost. When production exceeds sales, some fixed overhead is deferred in ending inventory rather than expensed, producing higher reported income than variable costing (which expenses all fixed manufacturing overhead in the period incurred). The income difference = (Ending inventory units − Beginning inventory units) × Fixed OH per unit.

Q. What are the advantages and limitations of Activity-Based Costing?

Advantages: Provides more accurate overhead allocation by tracing costs to activities and then to products based on actual activity consumption. Reduces cross-subsidy distortions common in volume-based allocation. Identifies non-value-adding activities for process improvement. Limitations: Costly and time-consuming to implement — requires identifying all activities, cost pools, and cost drivers. Impractical for small firms or simple, single-product operations. Particularly valuable in diverse, multi-product environments with high overhead ratios.