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Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 8
Measuring and Assigning Support
Department Costs
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 1
Chapter 8: Measuring and Assigning Support
Department Costs
Learning objectives







Q1: What are support departments, and why are their costs
allocated to other departments?
Q2: What process is used to allocate support department costs?
Q3: How is the direct method used to allocate support costs to
operating departments?
Q4: How is the step-down method used to allocate support costs
to operating departments?
Q5: How is the reciprocal method used to allocate support costs to
operating departments?
Q6: What is the difference between single- and dual-rate
allocations?
Q7: How do support cost allocations affect decisions and
managerial incentives?
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 2
Q1: Support versus Operating Departments
• The operating departments of an organization
produce products or services that generate
revenue.
• The support departments of an organization
produce products or provide services to the
operating and other support departments.
• The support department costs are common
costs that are shared between two or more
other departments.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 3
Q1: Reasons for Allocating Support
Department Costs
• External reporting
• Motivation
• appropriate consumption of support
department resources
• efficiency of support department
• monitor consumption of support
department services
• Decision making
• product pricing
• make or buy decisions
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 4
Q1: Support Department Allocation Process
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 5
Q2: Process for Allocating Support
Department Costs
1. Clarify allocation purpose
2. Identify cost pools
3. Assign costs to cost pools
4. Choose allocation bases for each cost pool
5. Choose allocation method; allocate support
department costs
6. Allocate updated operating department costs to
units of goods or services, if relevant
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 6
Q2: Process for Allocating Support
Department Costs
1. Clarify allocation purpose

if the purpose is to motivate the use of the services
of a newly formed department, perhaps no costs
should be allocated

if the purpose is to discourage operating department
managers from over-use of the services of support
departments, then a rate per unit of service might be
large and not based on actual costs

if the purpose is to determine the full cost of products
or services for long-term pricing decisions, then all
support costs should be allocated
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 7
Q2: Process for Allocating Support
Department Costs
2. Identify cost pools
• the purpose will determine whether both fixed
and variable support department costs
should be allocated
• the purpose will determine which costs
should be allocated
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 8
Q2: Process for Allocating Support
Department Costs
3. Assign costs to cost pools
• some costs will be direct to the cost pool
(e.g. toner cartridge costs would be direct to
the “variable copying costs” cost pool)
• some costs will be indirect to the cost pool
(e.g. rent costs for an entire facility would be
indirect to the “information technology costs”
cost pool)
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 9
Q2: Process for Allocating Support
Department Costs
4. Choose allocation bases for each cost pool
• an allocation base with a good cause-andeffect relationship with the cost pool provides
a reasonable allocation rate
• users of support department services will
carefully monitor their consumption of the
allocation base
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 10
Q2: Process for Allocating Support
Department Costs
5. Choose allocation method and allocate support
department costs
• in this chapter we cover three allocation
methods
• each of these three methods could be
implemented using
• a single- or dual-rate approach (covered later)
• actual or budgeted costs and allocation bases
(covered later)
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 11
Q2: Process for Allocating Support
Department Costs
6. Allocate updated operating department costs to
units of goods or services, if relevant
• for some decisions, this may not be relevant
• for long-term pricing decisions, this is likely to
be relevant
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 12
Q3: The Direct Method of Allocating
Support Department Costs
• The direct method ignores the fact that
support departments use each others’
services.
• Each support department’s costs are
allocated only to operating departments.
• This method is the easiest
computationally and the easiest to
explain.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 13
Q3: The Direct Method Example
Philco Toys makes metal and plastic toys in separate departments. It has
two support departments, Accounting and Information Systems. Philco has
decided to allocate Accounting department costs based on the number of
employees in each department and Information Systems costs based on
the number of computers in each department. Given the information below,
use the direct method to allocate support department costs.
Support Dep’ts
Total department costs
Number of employees
Number of computers
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Allocate costs:
Accounting
(48,000)
Information Systems
Totals
© John Wiley & Sons, 2011
(72,000)
$0
$0
27,789
20,211
$0
36,000
36,000
$0
$449,789
$238,211
$688,000
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 14
Q3: The Direct Method Example
Plastic Products is allocated
Plastic and Metal Product share
22/(22+16) of Accounting
Info Systems costs equally
department costs, and Metal
because they have the same
Products is allocated
number of computers in each
16/(22+16). Notice that the
department. Notice that the
number of employees in the
number of computers in the
support departments is ignored
departments
is ignored
Support Dep’ts support
Operating
Departments
under the direct method.
under the direct method.
Total department costs
Number of employees
Number of computers
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Allocate costs:
Accounting
(48,000)
Information Systems
Totals
© John Wiley & Sons, 2011
(72,000)
$0
$0
27,789
20,211
$0
36,000
36,000
$0
$449,789
$238,211
$688,000
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 15
Q4: The Step-Down Method of Allocating
Support Department Costs
• The step-down method allocates some (but not all)
support department costs to other support
departments.
• The first support department’s costs are allocated
to all operating and support departments that use
its services.
• Each subsequent support department’s costs are
allocated to all operating and support departments
that use its services, except any support
department whose costs were already allocated.
• Allocation order must be determined.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 16
Q4: The Step-Down Method Example
Given the information for Philco, use the step-down method to allocate
support department costs. Allocate the costs of the support department that
provides the largest percentage of its services to the other support
department first.
First determine
allocation order:
Accounting provided 4/(4+22+16) = 4/42
= 9.5% of its services to Info Systems.
Information Systems provided 4/(4+3+3) = 4/10 = 40% of its
services to Accounting, so Information Systems goes first.
Support Dep’ts
Total department costs
Number of employees
Number of computers
© John Wiley & Sons, 2011
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 17
Q4: The Step-Down Method Example
Given the information for Philco, use the step-down method to allocate
support department costs.
Now perform the allocation:
Support Dep’ts
Total department costs
Number of employees
Number of computers
Operating Departments
Metal
Plastic
Info
AccTotal
Products
ounting Systems Products
$48,000 $72,000 $386,000 $182,000 $688,000
45
16
22
4
3
16
3
3
6
4
Allocate costs:
Accounting
Information Systems
Totals
© John Wiley & Sons, 2011
(76,800)
(48,000)
28,800
$0
(72,000)
$0
44,463
27,789
32,337
20,211
$0
$0
21,600
21,600
21,600
$0
$0
$435,389
$452,063
$223,811
$235,937
$659,200
$688,000
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 18
Q4: The Step-Down Method Example
Info Systems costs are allocated
to Accounting, Plastic, & Metal
based on each department’s
number of computers compared
to total non-Info Systems
Support Dep’ts
computers: 4+3+3=10.
Total department costs
Number of employees
Number of computers
Accounting costs are allocated
only to Plastic & Metal based on
each department’s number of
employees compared to total
non-Accounting and non-Info
Operatingemployees:
Departments
Systems
22+16=38
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Allocate costs:
Accounting
Information Systems
Totals
(76,800)
28,800
$0
(72,000)
$0
44,463
32,337
$0
21,600
21,600
$0
$452,063
$235,937
$688,000
Total costs allocated out of Accounting are now higher because of
the Info Systems costs allocated to Accounting.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 19
Q4: The Step-Down Method Example
(22/38) x $76,800
(4/10) x $72,000
(16/38) x $76,800
(3/10) x $72,000
Support Dep’ts
Total department costs
Number of employees
Number of computers
(3/10) x $72,000
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Allocate costs:
Accounting
Information Systems
Totals
© John Wiley & Sons, 2011
(76,800)
28,800
$0
(72,000)
$0
44,463
32,337
$0
21,600
21,600
$0
$452,063
$235,937
$688,000
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 20
Q5: The Reciprocal Method of Allocating
Support Department Costs
• The reciprocal method allocates all support
department costs to other support
departments.
• The first step is to compute the total costs of
each support department when its usage of
other support department services is taken
into consideration.
• Support department costs are then allocated
to all other operating and support
departments that consume its services.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 21
Q5: The Reciprocal Method Example
Given the information for Philco, use the reciprocal method to allocate
support department costs.
First determine total costs for each support department by writing an equation for its
costs (use A and IS as abbreviations).
A = $48,000 + [4/(4+3+3)] x IS; IS = $72,000 + [4/(4+22+16)] x A
Then solve: A = $48,000 + (4/10) x [$72,000 + (4/42) x A]
A = $48,000 + $28,800 + (16/420) x A]
(404/420) x A = $76,800
A = $76,800 x (420/404) = $79,842
IS = $72,000 + (4/42) x $79,842 = $79,604
Support Dep’ts
Total department costs
Number of employees
Number of computers
© John Wiley & Sons, 2011
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 22
Q5: The Reciprocal Method Example
Given the information for Philco, use the reciprocal method to allocate
support department costs.
Now perform the allocation:
Support Dep’ts
Total department costs
Number of employees
Number of computers
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Allocate costs:
Accounting
Information Systems
Totals
© John Wiley & Sons, 2011
(79,842)
7,604
41,822
(79,842)
7,604
41,822
31,842 (79,604)
(79,604)
23,881
31,842
23,881
$0
$0 $451,703
$451,703
$0
$0
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
30,416
30,416
23,881
23,881
$0
$0
$236,297
$236,297
$688,000
Slide # 23
Q5: The Reciprocal Method Example
These numbers are the
solutions to the
simultaneous equations.
(4/42) x $79,842
(22/42) x $79,842
(16/42) x $79,842
Support Dep’ts
Total department costs
Number of employees
Number of computers
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Allocate costs:
Accounting
Information Systems
Totals
© John Wiley & Sons, 2011
(79,842)
7,604
41,822
(79,842)
7,604
41,822
31,842 (79,604)
(79,604)
23,881
31,842
23,881
$0
$0 $451,703
$451,703
$0
$0
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
30,416
30,416
23,881
23,881
$0
$0
$236,297
$236,297
$688,000
Slide # 24
Q5: The Reciprocal Method Example
(4/10) x $79,604
(3/10) x $79,604
(3/10) x $79,604
Support Dep’ts
Total department costs
Number of employees
Number of computers
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
Total
$48,000 $72,000 $386,000 $182,000 $688,000
3
4
22
16
45
4
6
3
3
16
Allocate costs:
Accounting
Information Systems
Totals
© John Wiley & Sons, 2011
(79,842)
7,604
41,822
(79,842)
7,604
41,822
31,842 (79,604)
(79,604)
23,881
31,842
23,881
$0
$0 $451,703
$451,703
$0
$0
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
30,416
30,416
23,881
23,881
$0
$0
$236,297
$236,297
$688,000
Slide # 25
Q6: Single- versus Dual-Rate Allocation
• In single-rate allocation, each cost pool
includes fixed and variable costs.
• In dual-rate allocation, fixed and variable
costs are in separate cost pools.
• Both methods can be employed with the
direct, step-down, or reciprocal methods.
• The prior three examples used the singlerate allocation method.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 26
Q6: Single- versus Dual-Rate Example
Philco has decided to use the direct method and allocate variable
Accounting costs based on the number of transactions and fixed
Accounting costs based on the number of employees. The Info Systems
variable costs will be allocated based on the number of service requests
and fixed costs will be allocated based on the number of computers. The
required information is presented below.
Support Dep’ts
Total department variable costs
Total department fixed costs
Number of transactions
Number of employees
Number of service requests
Number of computers
Operating Departments
AccInfo
Plastic
Metal
ounting Systems Products
Products
$20,000 $22,000 $186,000 $100,000
$28,000 $50,000 $200,000
$82,000
20
32
140
86
3
4
22
16
18
5
12
8
4
6
3
3
Now perform the allocation…
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 27
Q6: Single- versus Dual-Rate Example
Total department variable costs
Total department fixed costs
Number of transactions
Number of employees
Number of service requests
Number of computers
Support
Accounting
$20,000
$28,000
20
3
18
4
Dep’ts
Operating Departments
Info
Plastic
Metal
Systems Products
Products
$22,000 $186,000 $100,000
$50,000 $200,000
$82,000
32
140
86
4
22
16
5
12
8
6
3
3
(20,000)
12,389
7,611
13,200
8,800
$211,589
$116,411
16,211
25,000
$241,211
11,789
25,000
$118,789
$452,800
$235,200
Allocate variable costs:
Accounting
Information Systems
Total variable costs
Allocate fixed costs:
Accounting
Information Systems
Total fixed costs
Total fixed and variable costs
© John Wiley & Sons, 2011
(22,000)
$0
$0
(28,000)
$0
$0
(50,000)
$0
$0
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 28
Q7: Decision Making with Support Costs
• Support costs need to be considered when
evaluating decisions such as make/buy, keep/drop,
special order, and constrained resource
• Necessary to isolate relevant support costs
– This may not be the same as the allocated support costs
– For example, outsourcing an operating department may
not result in a reduction in support department costs
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 29
Q7: Establishing Transfer Prices for
Support Departments
• Transfer prices should be set to motivate efficient
use of the support department resources
– If transfer price is set too high, user departments may
outsource the service
– If transfer price is set too low, user departments may
utilize the support department inefficiently
• The best transfer pricing approach is the
Opportunity Cost approach
– Each department is charged an amount that reflects the
value of any opportunities forgone by not using the
service for its next best alternative use.
– This is often difficult in practice so most companies use a
cost based or market based transfer pricing policy
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 30
Q7: Estimated versus Actual
Support Costs and Rates
A department’s allocation
of support department costs
=
the allocation
rate
x
the department’s
consumption
of the allocation base
Either of these could be estimated or actual.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 31
Q7: Estimated versus Actual
Support Costs and Rates
the allocation
rate
x
the department’s
consumption
of the allocation base
Using actual rates and actual consumption provides the
best measure of the cost of support services; it is the
most accurate but the least timely.
The purpose of the cost allocation will determine
whether actual or estimated rates, and actual or
estimated consumption, should be used.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 32
Q7: Estimated versus Actual
Support Costs and Rates
• Actual rates and consumption may be
required for some types of government
contracts.
• Most federal grants to educational institutions
allow the use of estimates.
• Using an actual rate means that support
service users are affected by
• inefficiencies of support department managers
• changes in the consumption of support services by other
users
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 33
Q7: Other Common Cost Allocation Methods
• Other cost allocation purposes may require the
allocation to
• be perceived as “fair”
• be based on the user’s “ability to bear” the cost
• Under the stand-alone method, a common cost is
allocated based on information about the users’
consumption of the cost.
• Under the incremental cost allocation method, a
“primary user” is allocated the bulk of the common
cost and the secondary user is allocated only the
increment in cost that it caused.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 34
Q7: Stand-Alone versus Incremental Cost
Allocation Methods Example
Leslie has a job interview with Big Co. next month in New York City. Her
plane ticket cost $300, and she will need to spend $125/night for 2 nights in
a hotel. She estimates that she will spend $50 in cab fares and $50 for
food. Big Co. has promised to reimburse her actual costs. After this trip
was arranged, Small Co., also located in New York City, called her for an
interview. If she interviews with Small Co. while she’s there, she will spend
an additional $125 for another night at a hotel, and another estimated $40
in cab fares and food. Think of at least two ways to allocate Leslie’s travel
costs using the stand-alone method. Discuss the merits of each.
1. Compute the total cost of the trip and divide it by 2, since
there are 2 interviews.
2. Compute the total cost of the trip and allocate 2/3 of it to
Big Co. and 1/3 to Small Co. since she is spending 2 of
the 3 nights in NYC for the Big Co. interview.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 35
Q7: Stand-Alone versus Incremental Cost
Allocation Methods Example
Perform the calculations for your two versions of the cost allocation under
the stand-alone method. Then allocate the travel costs using the
incremental cost allocation method. Which is more appropriate? Why?
Estimated total costs:
Plane ticket
Hotel
Cab fares & food
Total
If shared equally, then this is
$300 $407.50 for each company; if
375 Big Co. is allocated 2/3 of the
140 cost then $543.33 is allocated
$815
to Big Co. and $271.67 is
allocated to Small Co.
Under the incremental cost allocation method, Big Co. is most
likely to be considered the primary user. Since Leslie’s budgeted
travel costs were $300 + $250 + $50 + $50 = $650 before she
was offered the Small Co. interview, Big Co. is allocated $650
and Small Co. is allocated $815 – $650 = $165.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 36
Q7: Fixed Price versus Cost-Based Contracts
• Under fixed price contracts, vendors provide
products or services for a specified price.
• Under cost-based contracts, the price is
computed based on the actual cost of the
products or services.
• may be necessary for research & new product development
• vendors are not motivated to control costs
• vendors may be motivated to inappropriately allocate
common costs
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 37
Appendix 8A: Excel Solver
and the Reciprocal Method
• Solving the simultaneous equations required for
the reciprocal method can be tedious when
there are 3 or more support departments.
• Excel Solver can be used to solve these
equations.
• Refer to Appendix 4A for help with using
Excel Solver.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 38
Appendix 8A: Excel Solver
and the Reciprocal Method
• Set up a “change cell” for each support
department’s total costs.
• The target function is the sum of the change
cells.
• The simultaneous equations are entered as
constraints; one constraint per equation.
© John Wiley & Sons, 2011
Chapter 8: Measuring and Assigning Support Department Costs
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 39
Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 9
JOINT PRODUCT AND BY-PRODUCT COSTING
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 1
Chapter 9: Joint Product and By-Product Costing
Learning objectives

Q1: What is a joint process, and what is the difference between a
by-product and a main product?

Q2: How are joint costs allocated?

Q3: What factors are considered in choosing a joint cost
allocation method?

Q4: What information is relevant for deciding whether to process a
joint product beyond the split-off point?

Q5: What methods are used to account for the sale of byproducts?

Q6: How does a sales mix affect joint cost allocation?

Q7: How do joint cost allocations affect decisions and
managerial incentives?
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 2
Q1: Joint Processes and Costs
• A process that yields one or more products is
called a joint process.
• The products are called joint products.
• The costs of the process are called joint costs.
• The split-off point is the stage in the joint process
where the separate products become
identifiable.
• Joints costs are incurred prior to the split-off point.
• Costs incurred past split-off are separable costs.
• Joint products that have minimal sales value
compared to the main product are called byproducts.
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 3
Q1: Joint Processes and Costs
Sawdust
Bark
Joint costs
include DM,
DL &
Overhead.
© John Wiley & Sons, 2011
Planks
If sawdust sells for a
relatively minimal amount,
it is a byproduct.
The costs of
processing
planks further
are separable
costs.
Wall
paneling
Joint products
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 4
Q2: Methods of Allocating Joint Costs
• Physical output methods
• Can be used only when joint products are
measured the same way (e.g. pounds or feet).
• Market-based methods
• Sales value at split-off method
• Often used when all products sold at split-off.
• Net realizable value (NRV) method
• NRV = Final selling price – Separable costs.
• Constant gross margin (GM) NRV method
• The two NRV methods can be used when
some products are processed past split-off.
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 5
Q2: Physical Volume Method Example
Pleasing Peaches grows peaches and processes three different peach
products that are sold to a canning company. The pounds produced for
each product, and the selling price per pound, is given below. The joint
costs of processing the 280,000 pounds of products were $70,000.
Allocate the joint costs to each product using the physical volume method.
Product
Peach halves
Peach slices
Peach purée
© John Wiley & Sons, 2011
Pounds
Produced
160,000
80,000
40,000
280,000
Selling Total Sales
Price per
Value at
Pound
Split-Off
$0.50
$80,000
$0.40
$32,000
$0.30
$12,000
$124,000
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Relative
Allocated
Weight Joint Costs
57.1%
$40,000
28.6%
$20,000
14.3%
$10,000
100.0%
$70,000
Slide # 6
Q2: Sales Value at Split-Off Method Example
Allocate the joint costs of $70,000 to each of Pleasing Peaches products
using the sales value at split-off method.
Product
Peach halves
Peach slices
Peach purée
© John Wiley & Sons, 2011
Pounds
Produced
160,000
80,000
40,000
280,000
Selling Total Sales
Price per
Value at
Pound
Split-Off
$0.50
$0.40
$0.30
$80,000
$32,000
$12,000
$124,000
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Relative
Sales
Allocated
Value Joint Costs
64.5%
25.8%
9.7%
100.0%
$45,161
$18,065
$6,774
$70,000
Slide # 7
Q2, 6: Compare the Physical Volume and
Sales Value at Split-Off Methods
Compute the gross margin for each product for each of the two allocation
methods. Discuss the differences between the two methods.
Total
Sales
Value at
Product
Split-Off
Peach halves $80,000
Peach slices
$32,000
Peach purée
$12,000
$124,000
© John Wiley & Sons, 2011
Allocated Joint
Costs
Sales
Physical Value at
Volume Split-Off
Method
Method
$40,000 $45,161
$20,000 $18,065
$10,000 $6,774
$70,000 $70,000
Gross Margin
Sales
Physical Value at
Volume Split-Off
Method
Method
$40,000 $34,839
$12,000 $13,935
$2,000 $5,226
$54,000 $54,000
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 8
Q2, 6: Compare the Physical Volume and
Sales Value at Split-Off Methods
Compute the gross margin ratio (GM/Sales) for each product under both of
the methods and discuss.
Product
Peach halves
Peach slices
Peach purée
© John Wiley & Sons, 2011
Total
Sales
Value at
Split-Off
$80,000
$32,000
$12,000
$124,000
Gross Margin
Sales
Physical Value at
Volume
Split-Off
Method
Method
$40,000 $34,839
$12,000 $13,935
$2,000 $5,226
$54,000 $54,000
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Gross Margin Ratio
Sales
Physical Value at
Volume Split-Off
Method
Method
50.0%
43.5%
37.5%
43.5%
16.7%
43.5%
43.5%
43.5%
Slide # 9
Q2: Net Realizable Value (NRV) Method Example
Pleasing Peaches could process each of its three products beyond split off.
It could can the peach halves itself, make the peach slices into frozen
peach pie, and make juice out of the peach purée. The retail value of the
new products and the separable costs for the additional processing are
given below. Compute the joint costs allocated to each of the products
using the NRV method.
Final
Sales Separable
Relative
Product
Value
Costs
NRV NRV
Canned peaches $180,000 $60,000 $120,000
64.2%
Peach pie
$120,000 $70,000
$50,000
26.7%
Peach juice
$50,000 $33,000
$17,000
9.1%
$350,000 $163,000 $187,000 100.0%
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Allocated
Joint
Costs
$44,920
$18,717
$6,364
$70,000
Slide # 10
Q2: Constant GM NRV Method
• Under the constant GM NRV method, all products
are allocated joint costs to achieve the same gross
margin ratio (GM%).
• First compute overall gross margin and GM%:
GM = Revenue – Joint costs – Separable costs
GM% = GM/Sales
• Then compute the GM for each product:
GM = Final sales value x GM%
• All products end up with the same gross margin ratio;
for each product solve for allocated joint costs:
Final sales value – joint costs – separable costs = GM
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 11
Q2: Constant GM NRV Method Example
Compute the joint costs that Pleasing Peaches would allocate to each of
the products using the constant GM NRV method.
First compute the overall GM and GM ratio:
GM = $350,000 – $163,000 – $70,000 = $117,000
GM% = $117,000/$350,000 = 33.43%
Allocated
Final
Sales Separable
Joint Gross
Product
Value
Costs
Costs Margin
Canned peaches $180,000 $60,000
$59,829 $60,171
Peach pie
$120,000 $70,000
$9,886 $40,114
Peach juice
$50,000 $33,000
$286 $16,714
$350,000 $163,000
$70,000 $117,000
Gross
Margin
Ratio
33.4%
33.4%
33.4%
Values are rounded as appropriate.
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 12
Q2, 6: Compare the NRV and
Constant GM NRV Methods
Compute the gross margin (GM) and the gross margin ratio (GM%) for each
product under NRV method. Compare this to the results of the constant
GM NRV method and discuss.
Product
Peach halves
Peach slices
Peach purée
Final
Sales
Value
$180,000
$120,000
$50,000
$350,000
Gross Margin
Gross Margin Ratio
Constant
Constant
NRV
GM NRV
NRV
GM NRV
Method
Method Method
Method
$75,080
$60,171
41.7%
33.4%
$31,283
$40,114
26.1%
33.4%
$10,636
$16,714
21.3%
33.4%
33.4%
$117,000 $117,000
33.4%
Values are rounded as appropriate.
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 13
Q3: Choosing a Joint Cost Allocation Method
• Allocated joint costs should not be used in
decision making.
• Still, avoid a method that shows one product
to be unprofitable.
• Under the physical volume method, the
product with the greatest relative physical
volume is allocated the most joint costs,
regardless of product’s sales value.
• Both of the NRV methods allocate joint
costs based on the products’ “ability to
bear the cost”.
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 14
Q4: Sell or Process Further Decisions
• Companies often can choose to sell a product
at the split-off point or to process it further.
• Compare the incremental revenue of
processing further to the product’s separable
costs.
• Incremental revenue of processing further
= Final sales value – Sales value at split-off
• Process further only when the incremental
revenue exceeds the separable costs.
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 15
Q4: Sell or Process Further Example
Peg’s Plastic Products makes the molded plastic parts for three model car
kits, A, B & C from a joint production process. The joint costs of this
process are $150,000. In each case, Peg could decide to make the entire
kit rather than just the plastic parts. Information about the sales values and
separable costs for each kit is given below. Determine which kits Peg
should sell at the split-off point and which she should process further.
Kit
A
B
C
Final
Sales
SepIncreSales
Value at arable
mental
Value
Split-Off Costs Revenue
$200,000 $180,000 $25,000 $20,000
$120,000 $60,000 $40,000 $60,000
$80,000 $40,000 $10,000 $40,000
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Incremental
Profit if
Process
Further
($5,000)
$20,000
$30,000
Sell at
Split-Off
or
Process
Further?
Sell
Process
Process
Slide # 16
Q5: Accounting for By-Products
• When by-products have no sales value, there
is no reason to account for them.
• Otherwise, there are two accounting methods
available:
• Recognize by-product value at time of
production
• Recognize by-product value at time of
by-product sale
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 17
Q5: Recognize By-Product Value
at Time of Production
• This method is also known as the offset approach or
the NRV approach.
• Joint cost of the main products is reduced by the
NRV of the by-products, even if by-products are not
yet sold.
• NRV of the by-products is kept in ending
inventory until sold.
• At sale of by-product, ending inventory is
reduced; there is no gain/loss on sale.
• This method allows managers to control by-products.
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 18
Q5: By-Product Value Recognized
at Time of Production Example
SJ Enterprises produces a main product and one by-product in a joint
process. The joint costs totaled $480,000. The main product sells for
$10/unit and the by-product sells for $1/unit. Information about the
production and sales of the 2 products is given below. Use the NRV
method to compute the production cost per unit for the main product.
Information in Units of Each Product
Beginning ProdEnding
Inventory uction Sales Inventory
Main product
0 100,000 95,000
5,000
By-product
0 10,000 3,000
7,000
Production costs
$480,000
Less: NRV of by-product
10,000
Net joint product cost
$470,000
Net product cost per unit
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
$4.70
Slide # 19
Q5: By-Product Value Recognized
at Time of Production Example
Prepare an income statement for SJ Enterprises and compute the costs
attached to ending inventory using the NRV method, assuming that nonmanufacturing costs totaled $250,000.
Revenue: 95,000 units at $10/unit
$950,000
Cost of goods sold: 95,000 units at $4.70/unit 446,500
Gross margin
503,500
Less: nonmanufacturing expenses
250,000
Operating income
$253,500
Ending inventory:
Main product: 5,000 units at $4.70
By-product: 7,000 units at $1
Value of ending inventory for balance sheet
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
$23,500
7,000
$30,500
Slide # 20
Q5: Recognize By-Product Value
at Time of Sale
• This method is also known as the Realized Value
Approach or the RV Approach.
• Joint cost of the main products is not reduced by
the NRV of the by-products, regardless if byproducts are sold.
• NRV of the by-products is not kept in ending
inventory.
• At sale of by-product, either Other Income is
recorded or Cost of Goods Sold is reduced.
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 21
Q5: By-Product Value Recognized
at Time of Sale Example
SJ Enterprises produces a main product and one by-product in a joint
process. The joint costs totaled $480,000. The main product sells for
$10/unit and the by-product sells for $1/unit. Information about the
production and sales of the 2 products is given below. Use the RV method
to compute the production cost per unit for the main product.
Information in Units of Each Product
Beginning ProdEnding
Inventory uction Sales Inventory
Main product
0 100,000 95,000
5,000
By-product
0 10,000 3,000
7,000
Production costs
Net product cost per unit
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
$480,000
$4.80
Slide # 22
Q5: By-Product Value Recognized
at Time of Sale Example
Prepare an income statement for SJ Enterprises and compute the costs
attached to ending inventory using the RV method, assuming that nonmanufacturing costs totaled $250,000. By-product sales is recorded as
other income.
Revenue: 95,000 units at $10/unit
$950,000
By-product sales: 3,000 units at $1/unit
3,000
Total revenue
953,000
Cost of goods sold: 95,000 units at $4.80/unit 456,000
Gross margin
497,000
Less: nonmanufacturing expenses
250,000
Operating income
$247,000
Ending inventory:
Main product: 5,000 units at $4.80
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
$24,000
Slide # 23
Q7: Decision Making & Joint Cost
• Joint cost information is required for
financial statement & tax return preparation
when production does not equal sales
(inventory and cost of goods sold).
• Allocated joint costs are irrelevant for most
decisions, especially regarding individual
products
• Joint cost information should not be
used to make product mix decisions.
© John Wiley & Sons, 2011
Chapter 9: Joint Product and By-Product Costing
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 24
Cost Management
Measuring, Monitoring, and Motivating Performance
Chapter 10
Static and Flexible Budgets
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 1
Chapter 10: Static and Flexible Budgets
Learning objectives

Q1: How do budgets contribute to the strategic management
process?

Q2: What is a master budget and how is it prepared?

Q3: What are flexible budgets and how can they be used for
sensitivity analysis?

Q4: How are budget variances calculated and used as
performance measures?

Q5: How do behavioral tensions influence the budgeting process?

Q6: What approaches exist for addressing the problems of
traditional budgeting?
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 2
Q1: Budgets & Strategic Management Process
• A budget is




A formalized financial plan.
A translation of an organization’s strategies.
A method of communicating.
A way to define areas of responsibility and
decision rights.
• The budget cycle is the series of
sequential steps followed to create and
use budgets.
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 3
Q1: Budgets & Strategic Management Process
• Budgeting process begins with the organizational
vision, core competencies, and risk appetite
• Organizational strategies designed to achieve the
vision will drive the capital expenditures and long
term financing plans
• Operating plans are then created in line with the
organizational strategies
• Actual results must be monitored, measured, and
analyzed compared to budgeted plans
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 4
Q1: Budgets & Levers of Control
Belief Systems
• Communicates
organizational
strategies and
goals
• Motivates
managers to
plan in
advance and
coordinate
activities
© John Wiley & Sons, 2011
Boundary
Systems
• Authorizes
employees to
engage in
planned
activities and
spend within
budget limits
• Ensures
sufficient cash
flow for
financial
viability
Interactive
Control Systems
Diagnostic
Control Systems
• Utilize
variances to
identify
opportunities
and threats to
the business
• Revaluate
strategies and
operating plans
as conditions
changes
• Assign
responsibility
and reward
employees for
achieving
budget targets
• Motivate
managers to
provide good
estimates and
use resources
appropriately
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 5
Q2: Master Budgets
• A master budget is
• A comprehensive plan for the upcoming
accounting period.
• Usually prepared for a one-year period.
• Is based on a series of budget assumptions.
• The master budget consists of several
subsidiary budgets, in two categories:
• Operating budgets.
• Financial budgets.
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 6
Q2: Operating Budgets
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 7
Q2: Operating Budgets
The operating budget is created by preparing
the following individual budgets, in this order:








Revenue budget
Production budget
Direct materials budget
Direct labor budget
Manufacturing overhead budget
Inventory and cost of goods sold budget
Support department budgets
Budgeted income statement
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 8
Q2: Financial Budgets
The financial budget is created by preparing
the following individual budgets, in this order:





Capital budget
Long-term financing budget
Cash budget
Budgeted balance sheet
Budgeted statement of cash flows
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 9
Q2: Operating Budget Example
Stanley J, Inc., makes a tool used by auto mechanics that sells for
$68/unit. It expects to sell 6,000 units in April and 7,000 units in May.
Stanley J prefers to end each period with a finished goods inventory
equal to 10% of the next period’s sales in units and a direct materials
inventory equal to 20% of the direct materials required for the next
period’s production. The company never has any beginning or ending
work-in-process inventories. There were 400 units in finished goods
inventory on April 1. Prepare the revenue and production budgets for
April.
Revenue budget
Budgeted sales in units in April
6,000
Budgeted selling price per unit
$68.00
Budgeted revenues
$408,000
© John Wiley & Sons, 2011
Production budget
Budgeted sales in units in April
Desired ending FG inventory
Total units required
Less: beginning FG inventory
Required production in units
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
6,000
700
6,700
(400)
6,300
Slide # 10
Q2: Operating Budget Example
Stanley J’s product uses 0.3 pounds of direct material per unit, at a cost
of $4/lb. There were 220 lbs. of direct material on hand on April 1.
Assume that budgeted production for May is 6,500 units. Prepare the
direct materials purchases and usage budget for April.
Direct materials budget
Required production in units
DM required per unit, in pounds
Total DM required, in pounds
Less: Beginning DM inventory
Plus: Desired ending DM inventory
Required DM purchases in pounds
Budgeted DM cost per pound
Budgeted cost of DM
6,300
0.3
1,890
(220)
390
2,060
$4.00
$8,240
Usage Budget = 1,890 pounds * $4 per pound = $7,560
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 11
Q2: Operating Budget Example
Stanley J’s product uses 0.2 hours of direct labor at a cost of $12/hr.
Prepare the direct labor budget for April.
Direct labor budget
Required production in units
DL required per unit, in hours
Total DL hours required
Budgeted cost per DL hour
Budgeted cost of DL
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
6,300
0.2
1,260
$12.00
$15,120
Slide # 12
Q2: Operating Budget Example
Stanley J’s budgeted fixed manufacturing overhead for April is $167,000,
and variable manufacturing overhead is budgeted at $6 per direct labor
hour. Prepare the manufacturing overhead budget for April.
Manufacturing overhead budget
Total DL hours required
Budgeted variable overhead per DL hour
Total budgeted variable overhead
Budgeted fixed overhead
Total budgeted overhead
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
1,260
$6.00
$7,560
$167,000
$174,560
Slide # 13
Q2: Operating Budget Example
Assume that Stanley J’s April 1 direct materials inventory had a cost of
$1,560. Prepare the April ending inventories budget for direct materials.
Ending inventories budgets
Budgeted cost of DM purchases
$8,240
Beginning DM inventory
$854
DM available for use
$9,094
Budgeted cost of desired ending DM inventory:
[6,500 units x 0.3 lbs/unit] x 20% x $4/lb
$1,560
Budgeted cost of DM to be used
$7,534
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 14
Q2: Operating Budget Example
Prepare the April ending inventories budget for finished goods.
Budgeted cost of DM to be used
Budgeted cost of DL
Total budgeted overhead
Total budgeted manufacturing costs
Required production in units
Budgeted manufacturing cost per unit
Budgeted ending FG inventory in units
Budgeted cost of ending FG inventory
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
$7,534
$15,120
$174,560
$197,214
6,300
$31.3037
700
$21,913
Slide # 15
Q2: Operating Budget Example
Assume that Stanley J’s April 1 finished goods inventory had a cost of
$12,146. Prepare the cost of goods sold budget for April.
Cost of goods sold budget
Beginning FG inventory
Total budgeted manufacturing costs
Cost of goods available for sale
Less: budgeted ending FG inventory
Budgeted cost of goods sold
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
$12,146
$197,214
$209,359
$21,913
$187,447
Slide # 16
Q2: Operating Budget Example
Stanley J’s budget for April includes $22,000 for administrative costs,
$34,000 for fixed distribution costs, $18,000 for research and
development, and $13,000 for fixed marketing costs. Additionally, the
budgeted variable costs for distribution are $0.75/unit sold and the
budgeted variable costs for marketing are 4% of sales revenue. Prepare
the support department budget for April.
Support department budget
Administration
$22,000
Distribution: Fixed costs
$34,000
Variable costs
$4,500 $38,500
Research & development
$18,000
Marketing: Fixed costs
$13,000
Variable costs
$16,320 $29,320
Total budgeted support department costs
$107,820
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 17
Q2: Operating Budget Example
Suppose that Stanley J’s income tax rate is 28%. Prepare the budgeted
income statement for April.
Budgeted income statement
Sales revenue
Cost of goods sold
Gross margin
Operating costs:
Administration
Distribution
Research & development
Marketing
Net income before taxes
Income taxes
Net income
© John Wiley & Sons, 2011
$408,000
$187,447
$220,553
$22,000
$38,500
$18,000
$29,320 $107,820
$112,733
$31,565
$81,168
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 18
Q4: Budget Variances
• Managers compare actual results to
budgeted results in order to
• Monitor operations, and
• Motivate appropriate performance.
• Differences between budgeted and
actual results are called budget
variances.
• Variances are stated in absolute value
terms, and labeled as Favorable or
Unfavorable.
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 19
Q4: Budget Variances
• Reasons for budget variances are
investigated.
• The investigation may find:
• Inefficiencies in actual operations that can
be corrected.
• Efficiencies in actual operations that can be
replicated in other areas of the
organization.
• Uncontrollable outside factors that require
changes to the budgeting process.
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 20
Q3: Static Budgets
• A budget prepared for a single level of
sales volume is called a static budget.
• Static budgets are prepared at the
beginning of the year.
• Differences between actual results and
the static budget are called static budget
variances.
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 21
Q3: Flexible Budgets
• A budget prepared for a multiple levels of sales
volume is called a flexible budget.
• Flexible budgets are prepared at the beginning
of the year for planning purposes and at the end
of the year for performance evaluation.
• Flexible budgets are also used for sensitivity
analysis and to manage risk due to uncertainty.
• Differences between actual results and the
flexible budget are called flexible budget
variances.
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 22
Q3, Q4: Flexible Budget Example
Tina’s Trinkets is preparing a budget for 2006. The budgeted selling price
per unit is $10, and total fixed costs for 2006 are estimated to be $5,000.
Variable costs are budgeted at $3/unit. Prepare a flexible budget for the
volume levels 1,000, 1,100, and 1,200 units.
Sales in units
Revenues
Variable costs
Contribution margin
Fixed costs
Operating income
© John Wiley & Sons, 2011
Volume Levels
1,000
1,100
1,200
$10,000 $11,000 $12,000
$3,000 $3,300 $3,600
$7,000 $7,700 $8,400
$5,000 $5,000 $5,000
$2,000 $2,700 $3,400
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 23
Q3, Q4: Static Budget Variances Example
Suppose that Tina’s 2006 static budget was for 1,100 units of sales. The
actual results are given below. Compute the static budget variances for
each row and discuss.
Static
Budget
Sales in units
1,100
Revenues
$11,000
$3,300
Variable costs
Contribution margin $7,700
Fixed costs
$5,000
$2,700
Operating income
© John Wiley & Sons, 2011
Static
Actual Budget
Results Variance
980
$9,604 $1,396
$311
$2,989
$6,615 $1,085
$4,520
$480
$605
$2,095
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Unfavorable
Favorable
Unfavorable
Favorable
Unfavorable
Slide # 24
Q3, Q4: Flexible Budget Variances Example
Compute the flexible budget variances for Tina and discuss the results.
Compare the flexible budget variances to the static budget variances on the
prior page.
Year-end
Flexible
Budget
Sales in units
980
Revenues
$9,800
Variable costs
$2,940
Contribution margin $6,860
Fixed costs
$5,000
Operating income
$1,860
© John Wiley & Sons, 2011
Flexible
Actual Budget
Results Variance
980
$9,604
$196
$2,989
$49
$6,615
$245
$4,520
$480
$2,095
$235
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Unfavorable
Unfavorable
Unfavorable
Favorable
Unfavorable
Slide # 25
Q3, Q4: Performance Evaluation
• A static budget variance includes effects from
output volume.
• A flexible budget variance removes these
output volume effects.
• Other adjustments to the year-end flexible
budget may be made for a fair performance
evaluation, such as
• Input price changes outside the control of the
manager under evaluation
• Fixed cost increases outside the control of the
manager under evaluation
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 26
Q5: Behavior Tensions in Budgeting
• Budgets used to evaluate performance and
compensation can create behavioral tension
• Participative budgeting – when managers who are
responsible for the budgets prepare the budget
forecasts
– Can result in budgetary slack – when managers set
targets so low that goals can be met easily (and bonuses
achieved)
• Budget ratcheting – when top managers set targets
– If targets unachievable, this can result in employees
having little motivation to meet targets
• Organizations must watch for budget manipulation
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 27
Q6: Other Budgeting Approaches
• Zero based budgets are prepared without using
past information as justification.
• Rolling budgets are prepared frequently for
overlapping time periods and actual results may be
used to update the budget for the next period.
• Kaizen budgets plan cost reductions over time.
• Activity based budgets use more cost pools and
cost drivers.
• GPK and RCA budgets identify fixed and variable
cost functions at the resource center level.
• Beyond budgeting uses external benchmarks to
evaluate managers’ performance
© John Wiley & Sons, 2011
Chapter 10: Static and Flexible Budgets
Eldenburg & Wolcott’s Cost Management, 2e
Slide # 28

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