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Contribution Approach(direct costing)

Different from the Absorption approach(for GAAP, matching principle)
-takes fixed and variable costs into account for breakeven analysis

less: Variable Costs
=Contribution Margin
less: Fixed costs
= Net Income


Contribution Margin Ratio

Contribution Margin / Revenue


Absorption Approach

- GAAP, matching principle
-Product costs are NOT expensed until they are sold as Cost of goods sold

less: Cost of Goods Sold
= Gross Margin
less: Operating Expenses
= Net Income


Only difference between Contribution and Absorption Approach(other than format to get to net income)

Treatment of fixed factory overhead
- Under Absorption approach fixed factory overhead is a product cost(only expenses under GAAP when the unit is sold)
- Under Contribution approach fixed factory overhead is a period cost(not GAAP) and expensed immediately


Variable costing net income vs. Absorption costing net income

No change in inventory = same net income for both

Increase in inventory = Absorption net income is greater than variable net income

Decrease in inventory = Absorption net income is less than variable net income

-Absorption costing includes Fixed O/H per unit in inventory
-Variable costing excludes Fixed O/H per unit in inventory and treats it as a period cost


Breakeven Computation

Total fixed Costs/ Contribution Margin per unit* = Breakeven point

*Selling price of unit - variable cost per unit


Computing Breakeven in Sales Dollars

Method 1:Total Fixed Costs/ Contribution Margin Ratio* = Breakeven in Sales Dollars

*Contribution Margin/Sales

Method 2: If already know the Breakeven point in UNITS just multiply by Selling price per unit


Required Sales Volume for Target Formula

Sales = Fixed costs + Profit / Contribution Margin Ratio


Tax Considerations Formula

Earnings Before Tax x (1 - Tax Rate) = "target" Net Income

EBT x (1 - TR) = "target" NI


Predicting Profit Performance Formula

Page 10 B-2


Margin on Safety

- A cushion, excess sales over breakeven sales

-Margin of Safety percentage = Margin of Safety in dollars/ Total Sales


Incremental Costs

- also known as differential costs and prime costs
-are the additional costs to produce an additional amount of the unit over the present output and are therefore RELEVANT costs


Sunk Costs

Will not change, unavoidable costs because they occurred in the past and cannot be recovered as a result of the decision and are therefore considered IRRELEVANT costs


Opportunity Costs

Are the cost of foregoing the next best alternative, and are considered RELEVANT costs



Controllable Costs

-are considered RELEVANT costs because they can be controlled by "this" level of management, and will change as a result of selecting different alternatives.


Uncontrollable Costs

-are considered IRRELEVANT since they were authorized by management at a "different" level of management


Marginal Costs(memorize)

include all variable costs AND any avoidable fixed costs


Special Order Decisions

- opportunities that require a firm to decide if a specially priced order should be accepted or rejected.
- accept if profitable, if Revenue > Relevant Costs


Capacity Issues

-applied to a "Special Order Decision"

Presumed Excess Capacity
-Accept if Selling Price > Relevant Costs(variable costs)

Presumed Full Capacity
-Accept if Selling Price > Relevant Costs(variable costs) + Opportunity Costs*

*Contribution Margin in $(Forgo)/Size Special Order = Opportunity cost per unit
^(Only relevant at full capacity)


Make vs. Buy

-if the relevant costs to make something including any opportunity costs is less than any purchases price, then the company should make the product
-fixed costs that are uncontrollable(unavoidable) should be ignored in the calculation for making the product


Sell or Process Further

- if incremental revenue is greater than the incremental cost, then the company will process further
-"joint costs" are sunk costs since they are already incurred and should be ignored
-Separable costs which occur after split-off point are relevant



A product line


Keep or drop a Segment

-Any fixed costs that are controllable or avoidable are considered relevant
-IF they are unavoidable they should be ignored

# Keep the segment if the lost contribution margin exceeds the avoidable fixed costs

#Drop the segment if the lost contribution margin is less than the avoidable fixed costs


Sensitivity Analysis

part of techniques for forecasting and projection

Slope ∆DV/∆IV = ∆Total Cost / ∆Volume = Variable Cost per unit


Forecasting Analysis

Predicting future values for a Dependent Variable i.e Total Cost


Regression Analysis

Total Cost(DV) = Total Fixed Cost + (Variable Cost(slope) x Volume(IV))

Simple linear regression model: only one independent variable

Multiple regressions: more than one independent variable


Simple linear regression model

Simple linear regression model: only independent variable

y = A + Bx

y= the dependent variable , Total Cost

x =the independent variable, Volume

A = the y-intercept, Fixed Cost

B = the slope of the regression line, Variable Cost per unit


The coefficient of correlation(for regression analysis)

measures the strength of the relationship between the independent variable(x) and the dependent variable(y) and is denoted as "r".

When selecting "cost drivers" or IV, choose the one with the highest "r" or "r^2"

The Coefficient of determination = "R^2" the proportion of the total variation in the dependent variable(y) explained by the independent variable(x)


High-low Method

a technique that is used to estimate the fixed and variable portions of cost, usually production costs

-result enables us to come up with a flexible budget, by identifying total fixed costs and variable costs per unit



Have been referred to as per-unit budgets and are integral to the development of flexible budgets

-sometimes standards are set lower than expectations to encourage motivation and efficiency


Currently Attainable Standards

General Rule: Use with flexible budgets
-can be attained without "extraordinary" effort
-provisions are made for spoilage and downtime


Ideal Standards

-represent the costs that result from perfect efficiency and effectiveness
-no provision for downtime and spoilage
- can cause demotivation of employees since the standards are "unattainable"


Participatory vs. Authoritative Standards

-standards set exclusively by management
- pro: can be implemented quickly
- con: workers may not accept them

- employees and management take part in setting the standards
-pro: workers are more likely to accept the
con: are slower to implement


Master Budget

-"annual business plan"
-short term operating goals, usually less than a year
-provide comprehensive and "coordinated" budget guidance
-also known as a "static budget"(one level of planned activity)
-has both operating budgets and financial budgets, but sets out single level of activity(volume)
-Pro Forma Financial Statements - ultimate output
-problematic when a different volume actually occurs than projected when comparing actual to budget, and therefore flexible budgets are better


Mechanics of Master Budgeting

-"annual business plan procedures"

Operating Budgets
-created to describe resources needed aka DM,DL
- sales budgets, production budgets, SG & A

Financial Budgets
-detail sources and uses of funds
- Pro Forma Financial Statements(gets done last in master budget) - projected income statement, balance sheet, statement of cash flows
- Cash budget

Board of directors determines the mission and strategy


Sales budget

- falls under Operating Budgets
- it is the "Driver", drives everything else the production, SG & A
- foundation and step #1 of the entire budget process
-forecasted sales in both units and dollars


Production Budget

-part of Operating Budgets
- made up of the amounts spent for direct labor, direct materials, and factory overhead
- want to balance production so that there are no lost sales and enough inventory to cover demand

Budgeted Sales
+Desired Ending Inventory
- Beginning Inventory
= Budgeted Production


Direct Materials Budgets

- driven by Production Budget


Factory Overhead Budget

- Indirect Materials, Indirect Labor + any cost associated with the Factory
- Factory overhead is applied to inventory
- based on a representative statistic(cost driver)
- Frequently the rate is applied using direct labor hours . Or Machine hours, or Direct Labor dollars


Cost of Goods Manufactured and Sold Budget

- Under GAAP, pro forma financial statements
- two types of costs: product costs and period costs

Product Costs: Direct Labor, Direct Materials and Factory Overhead Applied

Cost of Goods Sold Formula(Memorize):

Cost of Goods Manufactured
+ Begininng Finshed Goods Inventory
- Ending Finished Goods Inventory
=Cost of Goods Sold(On Income Statement)


SG & A Budgets

- dependent on the sales budget


Cash Budgets

-detailed projections of cash inflows and outflows
- Usually divided into three sections:
1. Cash available
2. Cash Disbursements( use of cash)
3. Cash Financing(if there is a shortfall)

Cash disbursements- rents, utilities etc. but NOT depreciation since it is not a cash expense!


Cash Budget Formats

1. Beginning Cash
2. Cash Collections from sales(add)
3. Cash disbursements for purchases and operating expenses(subtract)
4. = Computed Ending Cash
5. Cash requirements to sustain operations(subtract); and
6. Working capital loans to maintain cash requirements.


Capital Budget

-detail the planned expenditures for capital items(non-current Assets which are PP &E)


Flexible Budgeting

-used with most budgets and most industries
* allows for adjustments for changes in production and sales
- starts with master budget and adjusts based on actual output for the period


Budget Variance Analysis

- comparison of actual results to the annual business plan is "the first and most basic level" of control and evaluation of operations
- usefulness is limited by the existence of variances from budget that may be strictly related to volume, variable costs are not relevant unless we adjust the volume from the actual and apply in to the budgeted to be the same


Direct Materials and Direct Labor Variances

DM Price Variance = Actual quantity purchases x (Actual price - Standard price)

DM quantity usage variance = Standard quantity x (Actually quantity used - Standard Quality allowed)

*STANDARD QUANTITY ALLOWED = Actual output x the standard allowed per unit

**You favor you right hand, if the right side is higher than you have a favorable result


Manufacturing Overhead Variance

- if the number on the right is greater than the left you have a FAVORABLE variance

* The sum of all 3 variances equals the net balance in the overhead account

** Three way variance = ABA BSA
Actual, then Budget amount based on actual hours, then Budge Amount based on Standard Hours, then Applied


Two way variance
Two BV or not two BV
BV = Budget than volume


Application of Overhead( for variance analysis) formula

1. Calculated Overhead Rate = Budgeted Overhead Costs / Estimated Cost Driver(either Machine Hours, Labor Hours or Labor Dollars)

2. Applied Overhead = Standard Cost driver x Overhead rate(from step 1)

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