Management Acc PDF

CHAPTER I
Managers working with any commercial, social or government entity have an important common
objective. They must make good decisions to obtain and use the organization’s resources –
including people, money, inventory, fixed assets, investments, technology and equipment in the
most effective way so as to contribute in enhancement of wealth of the owners.
Management decisions concerning the acquisition provides answers to questions namely:
1. What products or services should be sold?

2. Where should they be sold?
3. What are the responsibilities of each management position?
4. Who should be hired to fill these positions?
5. How much does it cost to produce a product or offer a service?
6. What is the most profitable combination of products or service?
7. What will happen to profits if selling prices increased or decreased?
8. How much operating capacity I needed in the form of people, funds, inventory, and
fixed assets?
9. How should the organization finance its various activities?
The general purpose financial statements are available to the managers of a business, but they
have limited utility from the management angle. Managerial accounting is an important branch
of accounting that provides the information needed by managers to determine how resources
should be obtained, organized and controlled in any type of business, large or small.
Comparison of Financial Accounting with Managerial Accounting
Although the emphasis is different, both managerial and financial accounting involve three types
of functions:
(1) Record keeping of financial transactions.
(2) Performance evaluation on the basis of reports that are compiled on classification and
summarization of the financial results.
(3) Decision making that is performed by a wide variety of interested parties (both
external and internal to the firm) who must choose between alternative courses of action
regarding the business’s future.
Despite important similarities identified above, there are several important differences between
the two types of accounting. These differences narrated below to learn the scope and utility of
managerial accounting.
Financial Account Managerial Accounting
User Orientation Both external/internal users Exclusively for internal Users

Freedom of choice Mandatory to follow the Complete freedom of choice
Current IFAS
Main time focus Historical – quarterly, half Futuristic – according to
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yearly, yearly etc. specific needs of the entity.
Accounting entity Mainly whole firm Mainly firm’s one or more
segments under investigation.
Reporting frequency Well defined schedule Whenever needed.
Degree of precision Objective principle More subjective
Other discipline used Little use Used often
Characteristics of Managerial Accounting.
The two important terms “data” and “information” are often used synonomously by accountants,
a useful distinction can be drawn between them. Data are recorded facts; information is data that
have been processed in some prescribed manner so they are more useful to a potential user. In
order to make managerial accounting information to serve the desired utility to the managers, it
should possess the following important characteristics:
1. Relevance
2. Accuracy
3. Timeliness
4. Understandability
5. Cost effectiveness
Role of the Controller
When a firm commits itself to managerial accounting, the position of controller usually is created
and a person with an appropriate credentials and experience is assigned the responsibilities for
the organization’s entire accounting function. The specific responsibilities of a controller vary
significantly from firm to firm. Some of the important responsibilities that a controller normally
undertake to discharge are:
1. Planning, evaluating, and controlling operations for all levels of management;

2. Safeguarding the organization’s assets and;
3. Communicating with interested parties outside the organizations such as shareholders,
and regulatory bodies.
Code of conduct for Management Accountants
A management accountant is not obliged to observe the IASB, but he has ethical responsibilities
which are grouped in four broad areas:
i) To maintain a high level of professional competence. How it can be achieved:
a) By maintaining an appropriate level of professional expertise by continually
developing knowledge and skill.
b) Perform professional duties in accordance with relevant laws, regulations and
technical standards.
c) Provide decision support information and recommendations that are accurate,
clear, concise and timely.
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d) Recognize and communicate professional limitations or other common
constraints.
ii) To treat sensitive matters with confidentiality:
a) Keep information confidential except when disclosure is authorized or legally
required.
b) Inform all relevant parties regarding appropriate use of confidential informational.
c) Refrain from using confidential information for unethical or illegal advantage.
iii) To maintain personal integrity.

a) Mitigate actual conflicts of interest. Advise all parties of any potential conflicts.
b) Refrain from engaging in any conduct that would prejudice carrying out duties
ethically.
c) Abstain from engaging in or supporting any activity that might discredit the
profession.
iv) To disclose information in credible fashion.

a) Communicate information fairly and objectively.
b) Disclose all relevant information that could reasonably be expected to influence
an intended user’s understanding of the reports, analyses or recommendations.
c) Disclose delays or deficiencies in information, timeliness, process or internal
controls in conformance with organization policy and/or applicable law.
Cost Classification by Business Functions
Costs are incurred in all types of organizations – service, merchandizing and manufacturing to
secure revenues. The specific cost items incurred by a given organization and the way they are
classified will depend on the business functions performed by the firm.
A manufacturing firm is generally has the most complex types of accounting data because it
involves a manufacturing function, a selling function and an administrative function. The costs
incurred by them can be classified on the basis of manufacturing, selling and administrative.
Manufacturing costs include all costs needed to acquire basic raw material from a supplier and
converting them into finished products that are salable in different forms. Selling costs are all
costs incurred to market and deliver the finished products including advertising, sales salaries,
free samples, salesmen commission, transportation charges etc. Administrative costs are all costs
needed for the general management of the organization and includes executive salaries,
accounting services cost, office supplies etc.
Product Costs include all costs that are incurred to make a product. In the case of manufacturing
goods, these costs consist of raw materials, direct labour, and manufacturing overhead. An
important characteristic of product cost is that they are inventoried as assets until the products
are sold. When the goods are sold, the costs are released from inventory as expense, also termed
as “cost of goods sold” and matched against sales revenue.
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Period Cost are all costs that are not product cost. It includes both selling and administrative
costs of an entity of the given period. Period costs are not added to product cost or manufacturing
cost of goods, instead period cost are assigned to the income statement in the period in which
they are incurred on accrual basis of accounting.
Prime Cost & Conversion Cost
Manufacturing cost can further be classified into two distinct heads – prime cost and conversion
cost. Prime cost is the sum of direct material and direct labour. Conversion cost which is
involved to convert the direct material into the finished goods and hence comprises of direct
labour cost and manufacturing overhead.
Prime Cost Conversion Cost

Direct Material + Direct Labour Direct Labour + Factory Overhead
Variable Cost : A variable cost is a cost that varies, in total, in direct proportion to changes in
the level of activity. The level of activity can be expressed in many ways such as units produced,
units sold, miles driven, beds occupied etc. The most common example of variable cost is raw
material. The cost of direct material used during a period will vary in total, in direct proportion to
the number of units that are produced. Other examples of variable costs include items such as
shipping cost, sales commission and some elements of manufacturing overhead such as
lubricants etc. The direct labour is also considered to be a variable cost but in many instances, it
acts as a fixed cost.
Fixed Cost: A fixed cost is a cost that remains constant, in total, regardless changes in the level
of activity. Unlike variable costs, fixed costs are not affected by changes in activity.
Consequently, as the level of activity rises or falls, total fixed costs remains constant unless
influenced by some outside forces such as price changes. Rent is a good example of fixed cost.
Very few costs are completely fixed. Most costs will change if the activity changes beyond a
certain range. For example the capacity of an X ray machine at Services hospital is 100 X rays a
day. If the number of patients are increasing and it would be necessary to rent an additional
machine, there will be an increase in the fixed costs. When we say that the cost is fixed, we mean
it is fixed within some specified range of activity.
Direct Cost : A direct cost is one that can easily and conveniently be traced to a specified cost
object. The most frequent direct cost is direct material and direct labour, but there are other
examples of direct cost like salary of sales manager etc.
Indirect cost: Indirect cost is a cost that cannot be easily and conveniently traced to a specified
cost object. For example in an assembly plant, the salary of the factory manager is an indirect
cost. Why the manager’s salary is termed as indirect cost because it cannot be related directly to
any specific product of the factory. In fact the salary cost of the factory manager is shared by the
entire products produced by a factory. Such costs are also termed as common cost. In other
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words a common cost is a cost that is incurred to support a number of cost objectives but cannot
be traced to them individually. Indirect cost are peculiar examples of common cost.
Differential Cost and Revenue : The element of differential cost or revenue is involved when
choosing between available alternatives. In business decisions each alternative will have cost and
benefit that must be compared to the cost of benefit of the other available alternatives.
A differential cost is also known as an incremental cost, although technically an incremental cost
should refer only to an increase in cost from one alternative to another, a decrease in cost can be
referred as decremental costs. Differential cost is broader term, encompassing both cost increases
and cost decreases between alternatives.
Relevant costs are future expected costs that will differ in a decision depending on the
alternative selected. For example, if two new sewing machines are being evaluated and the cost
of thread for each machine is significantly different, than the cost of thread is relevant.
Irrelevant costs are those costs that remain unaffected regardless of the alternative chosen in a
given decision. If the two new sewing machines use the same thread in production of a pair of
jeans, the cost of thread will be irrelevant.
Opportunity cost : Opportunity cost is the potential benefit that is given up when one
alternative is selected over another. Opportunity cost are not usually found in the accounting
record of an organization, but they are costs that must be explicitly considered in every decision
made by managers.
Sunk cost: A sunk cost is a cost that has already been incurred and that cannot be changed by
any decision made now or in the future. Because sunk costs cannot be changed by any decision,
they are not differential costs. And because only differential costs are relevant in a decision, sunk
cost can and should be ignored.
Controllable costs : It is a cost that can be regulated or influenced by a given level of

management decision during a specified time frame. The manager of Sewing Department would
be responsible for the direct materials and direct labour used in her department because both
items are controllable.
Uncontrollable costs : It is a cost that cannot be regulated or influenced at a given level of

management decision during a specific time period. The depreciation on a particular sewing
machine is uncontrollable by the Sewing Department manger once the machine has been
purchased.
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Multiple Choice Questions
1. A cost which is incurred for a period and which, within certain output and turnover
limits, tends to be unaffected by fluctuation in the levels of activity (output/turnover) is
termed as:
a) Historical costs
b) Conversion cot
c) Fixed cost
d) Prime cost
The answer is (c) because fixed cost remains fixed within certain output and turnover limits.
2. The term “discretionary cost” refers to those:

a) Costs which management decides to incur in the current period to enable the
company to achieve objectives other than filling of customer’s orders.
b) Costs which are likely to respond to the amount of attention devoted to them by a
specified manager.
c) Costs which are governed by past decisions that established the present levels of
operating and organizational capacity and which only change slowly in response to
small changes in capacity.
d) Costs which can be unaffected by current managerial decisions.
The answer is (a). A discretionary cost refers to such types of costs which can be changed with
the management’s decision during the current period, but it does not relate with the cost of the
product. For example entertainment expenses. The management may decide to reduce or fixed
entertainment expenses at a certain level.
3. The term “cost” refers to:

a) An asset that has given benefit and is now expired.
b) The price of products sold or services rendered.
c) The value of the sacrifice made to acquire goods or services.
d) An asset that has not given benefit and is now expired.
e) The present value of future benefits.
The answer is (c). Here sacrifices mean the price made or cost incurred to acquired an asset.
4. A cost that may carry components of both variable and fixed cost is termed as:
a) Variable cost c) Fixed cost
b) Prime Cost d) Conversion cost
e) Mixed Cost
The answer (e) because mixed cost comprises of both fixed cost and variable cost.
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5. The term “sunk costs” refers to :
a) Past costs that are now irrevocable.
b) Costs that are directly influenced by unit managers.
c) Costs that should be incurred in a particular production process.
d) Costs that many be eliminated if some economic activity is changed or deleted.
The answer is (a). A sunk cost is one which has already been incurred on the basis of past
decisions and cannot be eliminated or avoided by current decisions.
6. The management of X’s budgeted production of 800,000 units at a cost of Rs.1,600,000.

If actual production was 800,000 units at a cost of Rs.2,000,000, then Xs production
performance shall be regarded as :
a) Effective c) Efficient
b) Both effective and efficient d) Neither effective nor efficient
The answer is (a). We cannot regard it as efficient because they have incurred extra cost than
what was budgeted.
7. Which of the following is “cost appropriate to a specific management decision”?

a) Production cost c) Joint cost
b) Product cost d) Relevant cost
The answer is (d). In decision making the cost which must have important bearing is termed as
relevant cost.
8. Which of the following is the difference in total cost between alternatives calculated to
assist decision making.
a) Indirect cost c) Product cost
b) Conversion cost d) Differential cost
The answer is (d). In case of choice between two cost alternatives, it is the differential cost which
is significant and important.
9. Which of the following is the cost of one unit of product or service which would be
avoided if that unit were not produced or provided?
a) Marginal cost c) Prime cost
b) Estimated cost d) Conversion cost
The answer is (a). The marginal cost is the cost of producing an additional product which can be
avoided if that unit were produced or provided.
10. Which of the following is the value of benefit sacrificed in favour of alternative course of
action?
a) Opportunity cost c) Indirect cost
b) Direct cost d) Standard cost
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The answer is (a). In case of alternative course of action, it is the opportunity cost that has to
sacrificed while selecting a certain course of action.
Exercise 1
The following cost and inventory data are taken from the accounting records of Mason Company
for the year just completed:
Cost Incurred
Direct labour cost $ 70,000
Purchase of raw materials 118,000
Indirect labour 30,000
Maintenance, factory equipment 6,000
Advertising expense 90,000
Insurance factory equipment 800
Sales salaries 50,000
Rent, factory facilities 20,000
Supplies 4,200
Depreciation, office equipment 3,000
Depreciation, factory equipment 19,000
Beginning of End of
The year year
Inventories
Raw materials $ 7,000 $15,000
Work in Process 10,000 5,000
Finished goods 20,000 35,000
Required :
1. Prepare a schedule of cost of goods manufactured in good form
2. Prepare the cost of goods sold section of Mason Co.’s income statement for the year.
Answer 1
Schedule of Cost of Goods Manufactured

Direct material
Raw material inventory (opening) $ 7,000
Purchases 118,000
Raw material available for use 125,000
Less material inventory (closing) 15,000
Raw material consumed 110,000
Direct labour 70,000
Manufacturing overhead
Maintenance, factory equipment 6,000
Insurance, factory equipment 800
Rent, factory facilities 20,000
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Depreciation – factory equipment 19,000 75,800
Total Manufacturing cost 255,800
Add Work in Process Inventory (beginning) 10,000
265,800
Less Work in Process Inventory (closing) 5,000
Cost of goods manufactured 260,800
Schedule of Cost of Goods Sold

Finished goods Inventory (Beginning) 20,000
Add Cost of goods manufactured 260,800
Cost of goods available for sale 280,800
Less Cost of goods Inventory (Closing) 35,000
Cost of goods sold 245,800
Exercise 2
Income Statement for Broad Corporation for four years are presented below:
Income Statement
Sales ? ? 240,000 225,000

Finished goods, beginning inventory 32,500 ? ? ?
Work in Process, beginning inventory 10,000 ? ? 7,500
Raw material used 44,500 47,500 30,000 42,500
Direct labour cost ? 52,500 50,000 27,500
Manufacturing overhead 50,500 ? 37,500 30,000
Work in Process, ending inventory 15.000 ? ? ?
Cost of goods manufactured ? ? 112,500 95,000
Finished goods, ending inventory 42,500 ? ? 11,500
Cost of goods sold 145,500 144,500 121,000 ?
Gross Profit 137,500 ? ? 105,000
Operating Expenses 42,500 37,500 ? 35,000
Net Income ? 90,000 60,000 ?
Required : Fill in the missing information (Hint 1990 data provide information required to find
1989 unknown).
Answer 2
Income Statement
1987 1988 1989 1990
Raw material used 44,500 47,500 30,000 42,500
Direct labour cost 65,500 52,500 50,000 27,500
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Manufactured overhead 50,500 44,500 37,500 30,000
Total Manufacturing Cost 160,500 144,500 117,500 100,000
Add Work in Process
Beginning 10,000 15,000 12,500 7,500
170,500 159,500 130,000 107,500
Less Work in Process Closing 15,000 12,500 7,500 12,500
Cost of goods manfuactured 155,500 147,000 122,500 95,000
Add Finished goods
Beginning 32,500 42,500 45,000 36,500
Cost of goods available for
Sale 188,000 189,500 167,500 131,500
Less Finished Goods closing 42,500 45,000 36,500 11,500
Cost of Goods Sold 145,500 144,500 131,000 120,000
Sales 283,000 272,000 240,000 225,000

Cost of Goods Sold 145,500 144,500 131,000 120,000
Gross Margin 137,500 127,500 109,000 105,000
Operating Expenses 42,500 37,500 59,000 35,000
Net Income 95,000 90,000 50,000 70,000
1990
Net Income = 105,000 – 35,000 = 70,000
Cost of goods sold = Sales - Gross Profit
225,000 – 105,000 = 120,000
Cost of goods manufactured =
Total Mfg. Cost + WIP (Beg) - WIP (End)
95,000 = (42,500 + 27,500 + 30,000) + 7,500 - ? = 12,500
Finished goods beginning
Cost of goods sold = Cost of goods Mfg. + Finished goods (Beg.) - Finished goods (End)
120,000 = 95,000 + ? - 11,500 = 36,500
1989
Sales - Cost of goods sold = Gross Profit
240,000 - 121,000 = 119,000
Cost of goods Manufactured
Total Mfg. Cost + WIP (Beg) - WIP (End)
112,500 = 30,000 + 50,000 + 37,500 + ? - 7,500 = 2,500
Cost of goods sold = Beg. Finished goods Inventory + Cost of Goods Manufactured – Ending
Finished Goods Inventory
121,000 = ? + 112,500 - 36,500 = 45,000
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Exercise 3
Visic Corporation, a manufacturing company, produces a single product. The following

information has been taken from the company’s production, sales and cost records for just
completed year.
Production in units 29,000

Sales in units ?
Ending finished goods inventory in units ?
Sales in dollars $1,300,000
Costs
Advertising $105,000
Entertainment and travel 40,000
Raw materials purchased 480,000
Building rent (production uses 80% of the
space; adm. & sales uses the rest) 40,000
Utilities factory 108,000
Royalty paid for use of production
Patent, $1.50 per unit produced ?
Maintenance, factory 9,000
Rent for special production equipment,
$ 7,000 per year plus $ 0.30 per unit produced)
Selling and Adm. Salaries 210,000
Other selling and Adm. Expenses 17,000
Beginning End of
of the year year
Inventories
Raw materials $ 20,000 $ 30,000
Work in Process 50,000 40,000
Finished goods 0 ?
The finished goods inventory is being carried at the average unit product cost for the year. The
selling price of the product is $ 50 per unit.
Required :
1. Prepare a schedule of cost of goods manufactured for the year.
2. Compute the following :
a. The number of units in the finished goods inventory at the end of the year.
b. The cost of units in the finished goods inventory at the end of the year.
3. Prepare an income statement for the year.
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Answer 3
1.
Schedule of Goods Manufactured
Direct Material
Raw Material opening 20,000
Raw material purchased 480,000
Raw material available for use 500,000
Less Raw material closing 30,000
Raw Material used 470,000
Building rent 32,000
Utilities – factory 108,000
Rent for patent on units produced 43,500
Maintenance factory 9,000
Rent for special product (7,000 + 8,700) 15,700
Other factory overhead 6,800 300,000
Total manufacturing cost 860,000
Add Work in Process (beginning) 50,000
910,000
Less Work in Process (ending) 40,000
2(a) Units in Finished Goods Inventory

Total units produced 29,000
Less units sold
(Sales/unit price) 1,300,000/50 26,000
Units in finished goods inventory 3,000
2(b) Cost of Finished Goods Inventory

Number of units produced 29,000
Cost per unit (870,000/29,000) 30
Cost of finished goods inventory (3,000 x 30) 90,000
c)
Income Statement
Sales (26,000 x 50) 1,300,000

Less Cost of goods sold (26,000 x 30) 780,000
Gross Margin 520,000
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Operating Expenses
Advertising 105,000
Entertainment 40,000
Building 8,000
Selling & Adm. Expenses 210,000
Total Operating Expenses 17,000 380,000
Net Income 140,000
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CHAPTER II
Predetermined Overhead Rate

As against direct material and direct labour, the overhead cost of a job is difficult to determine
especially when that job is completed and needed to be invoiced. In order to manage this
situation many organizations typically base their predetermined rates on the estimated, or
budgeted amount of the allocation base for the upcoming period. An example will help to
understand why it is used and helpful in practice. Suppose a company acquired a CD duplicating
machine which is capable of producing a new CD every 10 seconds from a master CD. The lease
cost is $180,000 per year, and this is the company’s only manufacturing overhead cost. With
allowances for set ups and maintenance, the machine is theoretically capable of producing upto
900,000 CDs per year. However, due to weak retail sales of CDs, the company’s commercial
customers are unlikely to order more than 600,000 CDs next year. The company uses machine as
the allocation base to apply manufacturing overhead to CDs. These data are summarized below:
Total manufacturing overhead cost $ 180,000

Allocation base – machine time per CD 10 seconds per CD
Capacity 900,000 CDs per year
Budgeted output for next year 600,000 CDs
Here using the capacity of the machine for estimating manufacturing overhead rate will provide
incorrect data. Instead the estimated budgeted output of the machine shall reflect a more accurate
information to the management.
Predetermined = Estimated total manufacturing overhead cost

overhead rate Estimated total amount of the allocation base
$ 180,000
600,000 x 10 seconds per CD
0.03 per second
Since each CD requires 10 seconds of machine time, each CD will be charged for $0.30 of
overhead cost.
In general the actual factory overhead may not agree with applied factory overhead. When the
applied factory overhead turns out to be more than the actual factory overhead for the respective
period, the excess amount is called over applied factory overhead. Similarly the factory overhead
charged during the period may be less than the actual amount of overhead, the situation will then
be termed as under applied factory head.
Exercise 4
Fancy Potteryworks makes a variety of pottery products that it sells to retailers. The
manufacturing process has two departments, molding and painting. The company uses
predetermined overhead rate based on machine hours in the molding department, and the rate in
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painting department is based on direct labour cost. At the beginning of the year, the company’s
management made the following estimates:
Department
Molding Painting
Direct labour hours 12,000 60,000
Machine hours 70,000 8,000
Direct material cost $510,000 $650,000
Direct labour cost $130,000 $420,000
Manufacturing overhead cost $602,000 $735,000
Job 120 was started on June 1 and completed on June 10. The company’s cost records show the
following information concerning the job.
Department
Molding Painting
Direct labour hours 30 85
Machine hours 110 20
Materials placed into production $470 $332
Direct labour cost $290 $680
Required :
1. Compute the predetermined overhead rate used during the year in the Molding
Department. Compute the rate used in Painting Department.
2. Compute the total overhead cost applied to Job 120.
3. What would be the total cost recorded for Job120? If the job contained 50 units, what
would be the unit product cost?
4. At the end of the year, the records of Fancy Pottery works revealed the following actual
costs and operating data for all jobs worked on during the year.
Department
Molding Painting
Direct labour hours 10,000 62,000
Machine hours 65,000 9,000
Materials placed into production $430,000 $680,000
Manufacturing overhead $570,000 $750,000
What was the amount of under or overapplied overhead in each department at the end of the
year.
Answer 4
i) Predetermined overhead rate

Molding Department $ 602,000/70,000 = $8.60 per machine hours
Painting Department $ 735,000/420,000 = $ 1.75 per direct labour cost
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ii) Applied overhead
Molding = 110 x $ 8.60 = $ 946
Painting = $680 x 1.75 = $ 1,190
Total applied overhead cost $ 946 + 1,190 = $ 2,136
iii)
Department
Molding Painting
Direct material cost 470 332
Direct labour cost 290 680
Manufacturing overhead cost 946 1,190
Total Cost 1,706 2,202
Total product cost 50 units 1,706 + 2,202 = ,3,908

Cost per unit 3,908/50 = $78.16
iv) Applied overhead for the year

Molding Actual $ 570,000
Applied 559,000 (65,000 x 8.60)
Underapplied 11,000
Painting Actual $ 750,000
Applied 763,000 (436,000 x 1.75)
Overapplied 13,000
Exercise 5
M/s ‘B’ makes furniture using the latest automated technology. The company uses a job order
costing system and applies manufacturing overhead cost to products on the basis of machine
hours. The following estimates were used in preparing the predetermined overhead rate at the
beginning of the year.
Machine hours 75,000

Manufacturing overhead cost $900,000
During the year due to excessive imports from China, the sale was badly affected resulting in
cutting back product and build up of furniture in the company’s warehouse. The company’s cost
records revealed the following actual cost and operating data for the year:
Machine hours 60,000

Manufacturing overhead cost $ 850,000
Inventories at year end:
Raw materials $30,000
Work in Process (includes overhead $100,000
Applied $36,000)
Finished goods (includes overhead $500,000
Applied $180,000)
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Cost of goods sold (includes overhead $1,400,000
Applied 504,000)
Required :
1. Compute the company’s predetermined overhead rate.
2. Compute the under or overapplied overhead.
3. Assume that the company closes any under or overapplied directly to Cost of Goods
Sold. Compute the revised cost of goods sold.
4. Assume that the company allocates any under or overapplied overhead to Work in
Process, Finished goods, and Cost of Goods Sold on the basis of the amount of ovherhead
applied that remains in each account at the end of the year. Compute the amount to be
adjusted to all the three inventories.
5. How much higher or lower will net operating income be if the under or overapplied
overhead is allocated rather than closed to Cost of Goods Sold?
Answer 5
i) Predetermined overhead rate : $900,000/75,000 = $ 12 per machine hr.

ii) Applied overhead
Machine hours : 60,000
Rate $ 12 per machine hr.
Overhead applied 60,000 x $12 = $720,000
Actual Overhead cost $ 850,0000
Overhead under applied $ 850,000 – 720,000 = $ 130,000
iii) Cost of goods Sold $1,400,000

Add overhead under applied $130,000
Revised cost of goods sold $1,530,000
iv) Overhead cost allocated to all inventories including cost of goods sold
Work in Process 36/720 x 130,000 $ 6,500
Finished Goods 180/720 x 130,000 32,500
Cost of goods sold 504/720 x 130,000 91,000
Total 130,000
WIP Overhead 36,000 36/720

Finished Goods overhead 180,000 180/720
Cost of goods sold overhead 504,000 504/720
Total 720,000
v) Overhead underapplied transferred to

Cost of goods sold under part (iii) $ 130,000
Overhead underapplied transferred to
Cost of goods sold under part (iv) 91,000
Difference 39,000
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The net operating income will be higher by $ 39,000 by using the method (iv).
Service Department Allocations
Most of the organizations have both operating department and service departments. The main
function like manufacturing is carried out by the operating department. Whereas service
departments do not directly engage in operating activities, instead, provide services or assistance
to the operating departments to accomplish their tasks.
The overhead costs of operating departments commonly include allocations of costs from the
service departments. To the extent that service department costs are classified as production
costs, they should be included in unit production costs and thus must be allocated to operating
departments in process costing systems.
Three approaches are used to allocate the costs of service departments to other departments: the
direct method, the step down method and reciprocal method.
Direct Method: It is the simplest of the three allocation methods. It ignores the services
provided by a service department to other service department and allocates all service
department costs directly to operating departments. Even if a service department (such as
personnel) provides a large amount of service to another service department (such as the
cafeteria), no allocations are made between the two departments. Rather all costs are allocated
directly to the operating departments, by passing the other service departments.
Step Down Method: Unlike the direct method, the step down method allocates service
department’s costs to other service departments, as well as to operating departments. The step
down method is sequential. The sequence typically begins with the department that provides the
greatest amount of service to other service departments. After its costs have been allocated the
process continues, step by step, ending with the department that provides the least amount of
services to other service departments. This method of allocating cost is termed as step down
method.
Reciprocal Method : The reciprocal method gives full recognition to interdepartmental services.
Under the step down method discussed above partial recognition of interdepartmental services is
possible. The step down method always allocates costs forward never backward. The reciprocal
method by contrast, allocates services department costs in both directions. Since this method is
more complicated, its use is restricted to highly organized and cost sensitive institutions.
18
Exercise 6
Karachi University has provided the following data to be used in its service department cost
allocation.
Service Departments Operating Departments
Facility Undergraduate Graduate
Administration Service Programme Programme
Departmental cost
Before allocations $2,400,000 $1,600,000 $26,800,000 $5,700,000
Student credit hours 20,000 5,000
Space occupied – 25,000 10,000 70,000 30,000
Square feet
Required :
Using the direct method, allocates the cost of the service departments to the two operating
departments. Allocate administrative costs on the basis of student credit hours and facility
services costs on the basis of space occupied.
Answer 6
Facility Undergraduate Graduate
Administration Service Programme Programme
Departmental cost
Before allocations $2,400,000 $1,600,000 $26,800,000 $5,700,000
Administration cost -2,400,000 $ 1,920,000 $ 480,000
Facility Service -1,600,000 $ 1,120,000 $ 480,000
Total Cost Allocation 0 0 $28,112,000 $6,660,000
Cost allocation Administration : 20,000/25,000 x 2,400,000, 5,000/25,000 x 2,400,000

Cost allocation Facility Serv. : 70,000/100,000 x 1,600,000, 30,000/100,000 x 1,600,000
Exercise 7
The Oxford Publishing House has three service departments and two operating departments.
Selected data from a recent period on the five department follow:

Administrat. Janitorial Maintenance Binding Printing Total
Overhead costs $140,000 $105,000 $ 48,000 $275,000 $430,000 $998,000

No. Employees 60 35 140 315 210 760
Square feet of space 15,000 10,000 20,000 40,000 100,000 185,000
occupied
Hours of press time 30,000 60,000 90,000
19
The company allocates service department costs by direct method in the following order:
Administration (number of employees), Janitorial (space occupied) and maintenance (hours of
press time).
Repeat the same using the step down method, allocates the service department cost on the same
line mentioned above.
Answer 7
Direct Method

Overhead costs $140,000 $105,000 $ 48,000 $275,000 $430,000 $998,000
Administration -140,000 84,000 56,000 140,000

Janitorial -105,000 30,000 75,000 105,000
Maintenance -48,000 16,000 32,000 48,000
Total cost after
Allocation -0- -0- -0- 405,000 593,000 998,000
Administration : Binding 315/525x140,000 Printing 210/525x140,000

Janitorial : Binding 40,000/140,000x105,000 Printing 100,000/140,000x105,000
Maintenance : Binding 30,000/90,000x48,000 Printing 60,000/90,000x48,000
Step Down Method

Overhead costs $140,000 $105,000 $ 48,000 $275,000 $430,000 $998,000

Administration -140,000 7,000 28,000 63,000 42,000 140,000
Janitorial -112,000 14,000 28,000 70,000 112,000
Maintenance -90,000 30,000 60,000 90,000
Total cost after
Allocation -0- -0- -0- 396,000 602,000 998,000
Administration : 35/700x140,000, 140/700x140,000, 315/700x140,000, 210/700x140,000

Janitorial : 20,000/160,000x112,000, 40,000/160,000x112,000, 100,000/160,000x112,000
Maintenance : Binding 30,000/90,000x90,000 Printing 60,000/90,000x48,000
20
CHAPTER III
COST BEHAVIOUR ANALYSIS AND USE
We have so far discussed the various types of costs. Under cost behavior analysis we shall study
how a cost would change as the level of activity changes. The understanding of this behavior is
relevant because it provides an insight to the managers that an increase or decrease in production
not necessary results in increasing cost or decreasing income. Let us first recapitulate the three
cost elements which are involved in production process.
Variable Cost : A variable cost is a cost whose total dollar amount varies in direct proportion to
changes in the activity level. If the activity level doubles, the total variable cost also doubles. If
the activity decreases to one half, the variable cost will also decrease by 50%.
A cost to be variable, it must be variable with respect to something. That “something” is its
activity base. An activity base is a measure of whatever causes the changes in variable cost. An
activity base is some time called the cost driver. Some of the most activity base are direct labour
hours, machine hours, unit produce and unit sold. Other examples of activity bases include the
number of miles driven by salespersons, the number of pounds of laundry cleaned by a hotel
number of calls handled by technical support staff at a software company, and the number of
beds occupied in a hospital. The undernoted chart shall help to understand the variable cost
drivers in different types of organizations.
Types of Organization Costs that are normally variable

with respect to output - Drivers
1. Merchandizing company Cost of goods (merchandise)

2. Manufacturing company Direct material
Direct labour
Variable elements of manufacturing overhead
Indirect materials
Lubricants
Supplies
Power
3. Both merchandizing & Variable elements of selling and
Manufacturing administrative costs like commission, shipping
Sales in Dollars
No. of units sold
4. Service Organization Variable elements of variable cost e.g. Banks
No. of accounts
Cheques handled per day
21
True Variable versus Step Variable Costs
Not all variable costs have exactly the same behavior pattern. Some variable costs behave in a
true variable or proportionately variable pattern. Other variable costs behave in a step variable
patterns.
True Variable Costs : Direct materials is a true or proportionately variable cost because the
amount used during a period will vary in direct proportion to the level of production activity.
Step Variable Costs : The cost of a resource that is obtainable only in large chunks and that
increases or decreases only in response to fairly wide change in activity is known as a step-
variable cost. For example, the wages of skilled repair technicians are often considered to be a
step variable.
Fixed Costs : A fixed costs is one that remains constant within a relevant range of activity. Since
fixed costs remain constant in total, the average fixed cost per unit decreases with the level of
activity. For example a group of 20 student have occupied a room in a hotel at a monthly rent of
Rs.5,000. The average rent per student would be Rs.250 per month. If the number of students
were increased to 50, the average rent per student would drop to Rs.100.
Types of Fixed Cost : Fixed costs are sometimes referred to as a capacity costs, since they
results from outlays made for buildings, equipment, skilled professional employees, and other
items needed to provide the basic capacity for operations. For planning purposes, fixed costs can
be viewed to either committed or discretionary.
Committed Fixed Costs : Investment in facilities, equipments and the basic organization that
cannot be significantly reduced even for short periods of time without making fundamental
changes are referred to as committed fixed costs.
Discretionary Fixed Costs : Discretionary fixed costs (often referred to as managed fixed costs)
usually arise from annual decisions by management to spend on certain fixed cost items.
Examples of discretionary fixed costs include advertising, research public relations, operating
system, special software etc.
To make the fixed cost more identifiable, a discretionary fixed cost is short term in nature,
usually a single year. By contrast committed fixed costs have planning horizon that is spread
over several years. Secondly, discretionary fixed costs can be cut for short periods of time with
minimal damage to the long run goals of organization, but committed fixed costs cannot be
altered without making major changes in the organization set up and operation.
Mixed Costs
A mixed cost contains both variable and fixed cost elements. Mixed costs are also known as semi
variable costs. For example in banks the teller’s salary is a fixed cost but the cost of cheque
books issued is a variable cost depending upon the number of transactions in a particular
22
account. Since mixed cost has a relationship with the level of activity, it can be expressed with
the undernoted equation:
Y = a + bX
In this equation,
Y = The total mixed cost
a = The total fixed cost (the vertical intercept of the line)
b = The variable cost per unit of activity (the slope of the line)
X = The level of activity.
Since the variable cost per unit equals the slope of the straight line, the steeper the slope, the
higher the variable cost per unit.
Y
Maintenance Cost Variable Cost
│
│
│
│
│
│_______________________________ Fixed Cost
│
│
│
│
│______________________________ X
No. of patients
Methods to Separate Mixed Cost into Fixed & Variable
Cost behavior with the help of Scattergraph Plotting
The first step in analyzing the cost and activity data is to plot the data on a scattergraph. This plot
immediately reveals any non-linearities or other problems with the data. The scattergraph of
maintenance costs versus patient day at Services Hospital is shown below:
Month Activity level Maintenance

Patient Type Cost incurred
January 5,600 $ 7,900
February 7,100 8,500
March 5,000 7,400
April 6,500 8,200
May 7,300 9,100
23
June 8,000 9,800
July 6,200 7,800
1. The total maintenance cost, Y, is plotted on the vertical axis. Cost is known as the
dependable variable. Since the amount of cost incurred during a period depends on the
level of activity for the period.
2. The activity, X (patient days in this case) is plotted on the horizontal axis. Activity is
known as independent variable, since it causes variations in the cost.
Y
Maintenance Cost
16000 │
14000 │
12000 │
10000 │
8000 │
6000 │
4000 │
2000 │
│_____________________________ X
2000 4000 6000 8000 10000
No. of Patients
From the scattergraph, it is evident that maintenance costs do increase with number of patient
days. In addition, the scattergraph reveals the relation between maintenance costs and patient
days is approximately linear. In other words, the points lie more or less along a straight line.
Such a straight line has been drawn using a ruler. Cost behavior is considered linear whenever a
straight line is a reasonable approximation for the relation between cost and activity. Note that
the data points do not fall exactly on the straight line. This will almost always happen in practice.
The relation is seldom perfectly linear.
Note that the straight line has been drawn through the point representing 7,300 patient days and a
total maintenance cost of $ 9,100. Drawing the straight line through one of the data points helps
make a quick and dirty estimate of variable and fixed costs. The vertical intercept when the
straight line crosses the Y axis in this case, about $ 3,300 – is the rough estimate of the fixed
cost. The variable cost can be quickly estimate by subtracting the estimated fixed cost from the
total cost at the point lying on the straight line.
Total maintenance cost for 7,300 patient days

(a point line on straight line) $ 9,100
Less estimated fixed cost (the vertical intercept 3,300
Estimated total variable cost for 7,300 patient days 5,800
The average variable cost per unit at 7,300 patient days is computed as follows:
Variable cost per unit = 5,800 ÷ 7,300 patient days

= $0.79 per patient day (rounded)
24
High and Low Method
The other method which is more commonly used for estimating the fixed and variable cost is
called the high and low method. Assuming that the scattergraph plot indicates a linear
relationship between the cost and activity, a fixed and variable cost element of a mixed cost can
be estimated using the high low method or the least square regression method. The high and low
method is based on the rise over run formula for the slope of a straight line.
Variable cost = Slope of the line = Rise = Y2 - Y1

Run X2 - X1
To analyse mixed cost with the high-low method, begin by identifying the period with the lowest
level of activity and the period with the highest level of activity. The period of lowest activity is
selected as the first point in the above formula and the period with the highest activity is selected
as the second point.
Variable cost = Cost at the high activity level - Cost at the low level of activity
High activity level - Low level of activity
Variable cost = Changes in cost

Changes in activity
9,800 - 7,400 = 2,400 = $ 0.80 per day

8,000 - 5,000 3,000
Fixed cost element = Total Cost – Variable cost element

$ 9,800 - $0.80 per patient x 8,000 patient days
$ 3,400
Both the variable and fixed cost elements have been isolated. The cost of maintenance can be
expressed as $ 3,400 per month plus 80 cents per patient a day or as:
Y = $3,400 + $0.80 X
Least Square Regression Method: It is a more accurate cost estimation technique because it
mathematically determines the straight line (called the regression line) that minimizes the sum of
the squared differences between that line and the various data point. When only two variables are
considered (as is the case the number of patients and maintenance cost), the analysis is referred
to as simple linear regression analysis. When more than two variables are considered, multiple
linear regression analysis is needed.
The mathematics involved in linear regression analysis can be reduced to the solution of the
following two equations that are derived from the basic equation for a straight line (y = a +bx).
Variable cost = b = ∑(x - x mean)(y – y mean)

∑(x – x mean)2
25
Where b represents variable cost
X The level of activity
X mean Average level of activity
Y Total mixed cost
Y mean Average level of mixed cost
After determining the value the fixed cost can be computed with the help of original equation i.e.
Y = a + b.
Note : For the purpose of calculating fixed cost the mean value of Y will be used in the equation
and not actual value.
1. Over applied factory overhead will always result when a predetermined factory overhead
rate is employed and:
a. Production is greater than budgeted capacity.
b. Actual overhead costs are more than expected.
c. Defined capacity is less than normal capacity.
d. Actual overhead incurred is less than applied overhead.
2. If a predetermined factory over head rate not employed and the volume of production is
reduced from the level planned, the cost per unit would be expected to:
a. Remain unchanged for fixed cost and increase for variable cost.
b. Increase for fixed cost and remain unchanged for variable cost.
c. Increase for fixed cost and decrease for variable cost.
d. Decrease for fixed cost and decrease for variable cost.
3. Factory overhead should be allocated on the basis of:

a. An activity basis which relates to cost incurrence.
b. Direct labour hours
c. Direct labour cost
d. Machine hours.
4. When a manufacturing company has highly automated manufacturing plant producing

many different products, the most appropriate basis for applying factory overhead to
work in process is:
a. Direct labour hours
b. Direct labour costs
c. Machine hours
d. Cost of material used
5. Which of the following should not be on a monthly cost control report of a department
manager?
a. Departmental labour cost
b. Departmental supplies cost
26
c. Depreciation on departmental equipment
d. Cost of materials used in the department
6. Periodic internal performance reports based upon a responsibility accounting system

should not:
a. Distinguish between controllable and uncontrollable costs
b. Be related to the organization chart
c. Include allocated fixed overhead in determining performance evaluation
d. Include variances between actual and controllable costs
7. The concept of management by exception refers to management’s:

a. Lack of a predetermine plan;
b. Consideration of only rare events;
c. Consideration of items selected at random;
d. Consideration of only those items which vary materially from plans.
Management by exception means when the costs incurred by on a specified head depart
significantly from the standards fixed by the management, managers investigate the discrepancy
to find the causes of problem and eliminate it. This process is called management by exception.
8. Of most relevance in deciding how much cost should be assigned to a responsibility

centre is :
a. Avoidabiliy
b. Causality
c. Controllability
d. Variability
9. An example of discretionary fixed costs would be:

a. Executive salaries
b. Rent
c. Insurance
d. None of the above
10. What effect does an increase in volume have on fixed cost:

a. Unit fixed cost would increase
b. Total fixed cost would decrease
c. Unit fixed cost would decrease
d. Total fixed cost would increase
Answers 1(a), 2(b), 3(a), 4(c), 5(b), 6(c), 7(d), 8(c), 9(d), 10(c)
27
Exercise 8
Hot Coffee Points operates a number of coffee stands in busy suburban malls. The fixed weekly
expenses of a coffee stand is $ 1,200 and the variable cost per cup of coffee served is $0.22.
Required: Fill in the following table with your estimates of total costs and cost per cup of coffee
at the indicated levels of activity for a coffee stand. Round off the cost of a cup of coffee to the
nearest tenth of a cent.
Cups of Coffee Served in a Week

2,000 2,100 2,200
Fixed Cost ? ? ?
Variable cost ? ? ?
Total cost ? ? ?
Cost per cup of coffee served ? ? ?
Does the cost per cup of coffee served increased, decrease ore remain the same as the number of
cups of coffee served in a week increase? Explain.
Answer 8
Cups of Coffee Served in a Week

2,000 2,100 2,200
Fixed Cost 1,200 1,200 1,200
Variable cost 440 462 484
Total cost 1,640 1,662 1,684
Cost per cup of coffee served 0.82 0.79 0.77
The cost per cup of coffee is decreasing because with the increase in coffee sales, the fixed cost
per cup is declining. As regards variable cost that remains constant at all level of production and
has no role in the price of the cup.
Exercise 9
The Seerna Hotel’s guest days of occupancy and custodial supplies expenses over the last seven
months were:
Guest Days of Custodial Supplies

Occupancy Expenses
March $4,000 7,500
April 6,500 8,250
May 8,000 10,500
June 10,500 12,000
July 12,000 13,500
August 9,000 10,750
September 7,500 9,750
28
Guest days is a measure of the overall activity at the hotel. For example, a guest who stays at a
hotel for three days is counted as three guest days.
Required:
Using the high low method estimate a cost formula for custodial supplies expenses.
Using the cost formula you derived above what amount of custodial supplies expense would you
expect to be incurred at an occupancy level of 11,000 guest days.
Answer 9
Mixed cost = Changes in cost y2 – y1

Changes in activity x2 – x1
13,500 - 7,500 = 6,000

12,000 – 4,000 8,000
0.75
Y = a + b(x)
13,500 a + 12,000(0.75)
a 13,500 – 9,000 = 4,500
Y = a + b(x)
7,500 a + 4,000(0.75)
a = 7,500 – 3,000 = 4,500
c) Y = a + b(x)
4,500 + 11,000 (0.75)
12,750
Exercise 10
A controller is interested in an anlaysis of the fixed and variable cost of electricity as related to
direct labour hours. The following data has been accumulated.
Months Electricity Cost Direct labour hours

January Rs. 15,480 297
February 16,670 350
March 14,050 241
April 15,340 280
May 16,000 274
June 16,000 266
July 16,130 285
August 16,350 301
29
Required :
The amount of fixed overhead and the variable cost using:
a) The high and low points method
b) The method of least square
Answer 10
a) High and Low Method

Changes in Cost = 16,670 - 14,050
Changes in activity 350 - 241
= 2,620 ÷ 109 = Rs.24.037 per labour hr.

Y = a + bX
16,670 = a + 350 (24.037)
16,670 = a + 8,413
a = 8,257
b) Method of least square method
Months Labour Electricity (x – x mean) (y – y mean) (x – x mean)2

(x-x mean)
(y–y mean)
___________________________________________________________________________
January 297 15,480 10.25 -272.50 105.06 -2,793.13
February 350 16,670 63.25 917.50 4,000.56 58,031.88
March 241 14,050 -45.75 -1,702.50 2.093.06 77,889.38
April 280 15,340 - 6.75 -412.50 45.56 2,784.38
May 274 16,000 -12.75 247.50 162.56 -3,155.63
June 266 16,000 -20.75 247.50 430.56 -5,135.63
July 285 16,130 1.75 377.50 3.06 - 660.63
August 301 16,350 14.25 597.50 203.06 8,514.38
∑ 2,294 126,020 0 0 7,043.48 135,475.00
X mean = 2,294 = 286.75 hours

8
Y mean = 126,020 = Rs.15,725.5
8
Variable cos per hour = b ∑(x-x mean) (y-y mean)
∑ (x-x mean)2
=
135,475/7,043.48 = Rs.19.23 per hour
Y = a + b(x)
a = 15,752.5 – (19.23 x 286.75)
= Rs. 10,238.5
15,725.50 = 10,238.50 + 5,514.20
30
Exercise 11
AAB Company is planning its capacity for the year 2004 at 90% of the rated capacity. For the
purpose of estimating ‘other FOH expenses’ company uses 5 years history and ‘simple
regression analysis’ method. Data in hand is as under:
Five years history of ‘other FOH expenses’ is as under:
Other FOH Direct labour

Year Expenses (Rs.) Hours
1999 90,775 23,750
2000 83,125 18,750
2001 84,800 20,000
2002 99,084 21,000
2003 84,860 19,750
In the year 2002 other FOH expenses include a penalty of Rs. 12,734 on non compliance of
certain labour laws.
Required :
You are required to calculate fixed and variable portion of estimated other FOH expenses at
planned capacity.
Answer 11
Labour Other FOH (x-x mean) (y-y mean) (x-x mean)2 (x-x mean)
Years hrs Rs. (y-y mean)
1999 23,750 90,775 3,100 4,793 9,610,000 14,858,300
2000 18,750 83,125 -1,980 -2,857 3,610,000 5,428,300
2001 20,000 84,800 - 650 - 1,182 422,500 768,300
2002 21,000 86,350 350 368 122,500 128,800
2003 19,750 84,860 - 900 -1,122 810,000 1,009,800
∑ 103,250 429,910 0 0 14,575,000 22,193,500
X mean = 103,250 = 20,650 hours

5
Y mean = 429,910 = 85,892
5
Variable cost per hour = b ∑(x-x mean) (y-y mean)
∑ (x-x mean)2
22,193,500 = Rs.1.5227 hrs
31
14,575,000
Y = a + b(x)
85,892 = a + 1.5227 (23,750)
a = 85,892 – 36,164
= Rs.49,728
High & Low Method
Variable cost = Changes in cost

Changes in activity
= 90,775 - 83,125
23,750 – 18,750
= 7,650 / 5,000 = Rs.1.53
Y = a + b(x)
90,775 = a + 23,750(1.53)
a = 90,775 – 36,338 = 54,437
32
CHAPTER IV
MARGINAL AND ABSORPTION COSTING

The most commonly accepted theory of product costing holds that the cost of producing a
product includes direct material, direct labour and allocated portion of factory overhead. This
method of costing is termed as absorption costing. Since absorption costing includes all costs of
production as product cost, it is also termed as full costing method or traditional costing method.
Marginal costing contrary to the approach stated above is a technique under which costs of
production that vary with output are treated as product cost. This would usually include direct
material, direct labour and variable portion of manufacturing overhead. Fixed manufacturing cost
is not treated as product cost, rather it is treated as period cost and hence charged against sales
revenue in the period in which the revenue is earned like selling and administrative expenses.
Marginal costing is some time referred to as direct costing or variable costing as well.
Why marginal costing is more frequently used by management accountants? Because under this
approach the operating results of an entity are compiled after recognizing variable cost and fixed
cost separately. Since fixed cost is not controllable at many times, the evaluation of performance
and fixing of responsibility for variances from approved budgets becomes more accurate and
logical under marginal costing.
The following illustration helps to understand the costing technique under each head:
Example :
Data
Beginning Inventory 0 Variable cost (per unit)
Production (units) 10,000 Direct Material $ 2
Sales (units) 9,000 Direct Labour 1
Selling Price $ 8.00 Factory overhead 0.30
Selling Expenses 0.20
Fixed Cost
Factory overhead $ 6,000
Selling expenses 15,000
Administration Expenses 12,000
Solution
Product Unit Cost
Absorption Costing Marginal Costing
Direct Material $ 2.00 Direct Material $ 2.00
Direct Labour 1.00 Direct Labour 1.00
Factory overhead (variable) 0.30 Factory overhead 0.30
Factory overhead (fixed) 0.60 (variable)
($ 6,000/10,000) ____ ____
Total 3.90 Total 3.30
33
Income Statement (Absorption Costing)
Sales (9,000 x $8.00) $ 72,000

Cost of Goods Sold
(10,000 x $ 3.90) 39,000
Less ending inventory
(1,000 x $ 3.90) 3,900
Gross Margin 36,900
Selling & Administrative Expenses
Selling (15,000 + 1,800) 16,800
Administrative 12,000 28,800
Net Income 8,100
Income Statement (Marginal Costing)
Sales (9,000 x $8.00) $ 72,000

Cost of Goods Sold
(10,000 x $ 3.30) 33,000
(1,000 x $ 3.30) 3,300
Manufacturing Margin 42,300
Less Selling Expenses (Variable) 1,800
Contribution Margin 40,500
Less Fixed Cost
Factory overhead 6,000
Selling Expenses 15,000
Administrative Expenses 12,000 33,000
Net Income 7,500
Reconciliation
Difference of profit under two methods $ 8,100 – 7,500 = 600
Inventory 1,000 Units

Fixed Manufacturing overhead $ 0.60 per unit
Total fixed cost included in closing inventory $ 600
34
Exercise 12
The selected data of M/s Kiran Company’s operation for the last year is as follows. All currency
values are in thousand of rupees.
Units beginning inventory 0

Units produced 250
Units sold 225
Units in ending inventory 25
Variable costs per unit

Direct material Rs. 100
Direct labour 320
Variable manufacturing overhead 40
Variable selling and administrative 20
Fixed costs
Fixed manufacturing overhead Rs.60,000
Fixed selling and administrative 20,000
Required:
1. Assume that the company uses absorption costing. Compute the unit product cost per
unit.
2. Assume that the company uses variable costing. Compute the unit product cost per unit.
Answer 12
Unit Product Cost Absorption Costing Direct Costing

Direct material Rs. 100 Rs.100
Direct labour 320 320
Variable Mfg. overhead 40 40
Fixed Mfg. overhead
Rs.60,000/250 240 ____
Unit Product cost 700 460
Exercise 13
The following data is collected from the books of Amir Corporation for the month of September:
No. of units sold 100 units

Selling price per unit $ 20
Variable manufacturing cost/unit $ 5
Fixed manufacturing costs $ 300
Variable selling & administrative cost per unit $ 4
Fixed selling and administrative costs $ 110
35
Required: Prepare an Income Statement for the month of September using Absorption Costing
(traditional) and direct costing (contribution margin) format separately.
Answer 13
Direct Costing/Contribution Margin Costing
Sales (100 x $20) $ 2,000

Less Variable manufacturing cost (100 x $5) 500
Manufacturing margin 1,500
Less variable selling & Adm. Cost (100 x $4) 400
Less Fixed manufacturing cost 300
Selling & Adm. Cost 110 410
Net Income 690
Absorption Cost / Traditional Costing
Sales (100 x $20) $ 2,000

Less Variable manufacturing cost (100 x $5) 500
Fixed manufacturing cost 300 800
Gross Margin 1,200
Less Selling & Adm. Cost Variable (100 x $4) 400
Selling & Adm. Cost (fixed) 110 510
Net Income 690
Exercise 14
M/s Lyna Co. manufactures and sells a single product. The following costs were incurred during
the company’s first year of operations:
Variable cost per unit:

Manufacturing
Direct materials $6
Direct labour 9
Variable manufacturing overhead 3
Variable selling and administrative 4
Fixed costs per year
Fixed manufacturing overhead $300,000
Fixed selling and admin. Expenses 190,000
During the year, the company produced 25,000 units and sold 20,000 units. The selling price of
the company’s product is $ 50 per unit.
36
Required :
i) Assume that the company uses the absorption costing method:

a) Compute the unit product cost.
b) Prepare an income statement for the year.
ii) Assume that the company uses the variable costing method:
a) Compute the unit product cost.
b) Prepare an income statement for the year.
Answer 14
Absorption Costing Method
United Product Cost

Direct Material $ 6
Direct labour 9
Variable Mfg. overhead 3
Fixed Mfg. overhead
($300,000/25,000) 12
Total 30
Income Statement (Absorption Costing)
Sales (20,000 x $50) 1,000,000

Cost of goods Sold
Cost of goods manufactured
(25,000 x $30) 750,000
(5,000 x $30) 150,000 600,000
Gross Margin 400,000
Operating Expenses
Selling & Adm. Expenses (Variable)
(20,000 x $ 4) 80,000
Selling & Adm. Expenses (Fixed) 190,000 270,000
Net Income 130,000
Variable Costing/Direct Costing Method
United Product Cost

Direct Material $ 6
Direct labour 9
Variable Mfg. overhead 3
Total 18
37
Income Statement (Variable Costing)
Sales (20,000 x $50) 1,000,000

Cost of goods Sold
Cost of goods manufactured
(20,000 x $18) 360,000
Manufacturing margin 640,000
Less variable selling & adm. Expenses
(20,000 x $ 4) 80,000
Operating Expenses
Fixed manufacturing overhead 300,000
Fixed selling and administrative expenses 190,000 490,000
Net Income 70,000
Reconciliation
Difference in net income ($130,000 - 70,000) $ 60,000
Inventory in units 5,000
Fixed Mfg. overhead per unit $ 12
Difference in net income (5,000 x $12) $ 60,000
1. A system of costing which helps in tracing all manufacturing costs (direct and indirect,
fixed and variable) which contribute to the production of the product and traced to output
and inventories is:
a) Job order costing c) Process costing
b) Absorption costing d) direct costing
2. The term that is most relevant of the type of cost accounting often called direct costing is
a) Fixed costing c) Variable costing
b) Relevant costing d) Prime Costing
3. The basic premise on which direct costing is based with respect to fixed cost is that a
fixed cost is:
a) A controllable cost c) A product cost
b) An irrelevant cost d) A period cost
4. Operating income computed using direct costing would generally exceed operating
income using absorption costing if,
a) Units sold exceeds units produced;
b) Units sold are less than units produced;
c) Units sold equal units produced;
d) The unit fixed cost is zero.
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Explanation : When units sold exceeds units produced it implies that the units sold included
beginning inventory which do not contain any fixed cost since the same has already been
charged to the income statement of the previous year. As a result of this the cost of goods sold
will be lower and the margin of profit will be higher.
As against this under absorption costing the beginning inventory would also include fixed cost,
the cost of goods sold will be higher and the margin of profit will be less.
5. A company has operating income of Rs.60,000 using direct costing for the given period.
Beginning and ending inventories for the period were 10,000 and 12,000 units,
respectively. If the fixed factory overhead application rate is Rs.5 per unit, the operating
income using absorption costing will be:
(a) Rs.50,000 c) Rs.60,000

(b) Rs.70,000 d) Rs.65,000
6. Absorption costing differs from direct costing in respect of the following:

a) Standard costing can be used with absorption costing but not with direct costing.
b) It is the internationally recognized method of reporting of income.
c) The ending inventory reflects a more conservative cost.
d) Amount of fixed costs is treated as period cost.
7. When a firm uses direct costing:

a) The cost of a unit of a product changes because of changes in the number of units
manufactured;
b) Profit fluctuates with sales;
c) An idle capacity variance calculated by a direct costing system;
d) Product costs include variable administrative cost.
Explanation: Under direct costing the product cost includes only variable cost. The higher the
number of units sold, higher the level of profit.
8. Under the direct costing concept, unit product cost would most likely be increased by:
a) A decrease in the remaining useful life of factory machinery depreciated by the sum
of the production method.
b) A decrease in the number of units produced.
c) An increase in the remaining useful life of factory machinery depreciated by the sum
of the years digits method.
d) An increase in the commission paid to sales person for each unit sold.
Explanation : When the machinery is depreciated on the basis of sum of years digit method, it
will become variable cost. The inclusion of depreciation will increase product cost.
9. When using direct costing information, the contribution margin discloses the excess of:
a) Revenue less fixed cost.
b) Projected Revenue over the break even point.
c) Revenue less variable cost.
d) Variable cost less fixed cost.
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10. Income computed under absorption costing and marginal costing is:
a) Always the same
b) Sometimes different
c) Always higher under absorption costing
d) Always the same or higher under absorption costing.
Explanation : Income differs only when there is an ending inventory. If there is no ending
inventory income under both the methods would be uniform.
11. Which of the following conditions would cause absorption costing net income to be
lower than variable costing net income?
a) Units sold exceeded units produced.
b) Units sold equaled units produced.
c) Units sold were less than units produced.
d) Selling price decreased.
12. Yearly income reported under absorption and variable costing income:
I) Yearly income reported under absorption costing will differ from income reported
under variable costing, if production and sales volumes differ.
II) Long run total income reported under absorption costing will often be close to that
reported under variable costing.
III) Differences in income under absorption and variable costing can normally be
reconciled by multiplying the changes in inventory (in units) by the variable
manufacturing overhead cost per unit.
Which of the above statement is true.
(a) I
(b) II
(c) III
(d) I & II
(e) II and III
13. William Sons reported Rs.65,000 of net income for the year using absorption costing.
The company had no beginning inventory, planned and actual production of 20,000 units
and sales of 13,000 units, standard variable manufacturing costs were Rs.20 per unit and
total budgeted fixed manufacturing overhead was Rs.100,000. If there were no variances,
net income under variable costing would be:
Answer :
Absorption Costing Variable Costing
Sales 390,000 Sales 390,000

Cost of goods sold Cost of goods sold 260,000
Variable cost Manufacturing margin 130,000
(13,000 x 20) 260,000
40
Fixed cost 65,000 325,000 ↑ Fixed cost 100,000
(13,000 x 5)
Net Income 65,000 Net Income 30,000
Difference 65,000 - 30,000 = Rs.35,000
Ending Inventory 7,000 units

Fixed cost per unit Rs.5
Difference income 7,000 x Rs.5 = Rs. 35,000
14. Classic Tiles reported Rs.28,000 of net income for the year by using variable costing. The
company had no beginning inventory, planned and actual production of 30,000 units and
sales of 25,000 units. Standard variable manufacturing costs were Rs. 15 per unit and
total budgeted fixed manufacturing over head was Rs.150,000. If there were no variances,
net income under absorption costing would be:
Answer :
Fixed manufacturing overhead cost Rs.150,000

No. of units produced 30,000
Fixed manufacturing overhead cost applied Rs. 150,000/30,000 = Rs.5 per unit
Income under variable costing Rs.28,000

Add difference of fixed cost charged
under variable costing
Variable costing (full amount) 150,000
Under absorption costing
(25,000 x 5) 125,000 25,000
Income under absorption costing 53,000
15. Blue lines income under absorption costing was Rs.15,000 higher than under variable
costing. During the year, the company met anticipated manufacturing figures, producing
20,000 units. If total variable production costs were Rs.80,000 and fixed manufacturing
overhead was Rs.40,000, how many units were sold?
Answer :
Total fixed manufacturing overhead Rs.40,000

Total number of units produced 20,000 units produced
Fixed manufacturing cost per unit 40,000/20,000 = Rs. 2 per unit
Difference of profit under two methods Rs.15,000

Fixed manufacturing cost per unit Rs.2
Ending inventory Rs.15,000/2 = 7,500 units
Total units produced 20,000 units
41
Less units in ending inventory 7,500 units
Units sold 20,000 – 7,500 = 12,500 units
16. For external reporting purposes, generally accepted accounting principles require that net
income be based on:
a) Absorption costing d) Variable costing
b) Direct costing e) Semi variable costing
c) Activity based costing
17. The fixed overhead volume variance under variable costing:

a) Coincides with the fixed manufacturing overhead that was applied to production.
b) Is deducted on the income statement.
c) Will equal the fixed overhead budget variance.
d) Must be unfavourable.
18. Which of the following differs between absorption costing and variable costing?
a) The number of units produced.
b) The fixed overhead volume variance.
c) The treatment of variable manufacturing overheads
d) Sales volume.
19. All of the following costs are inventoried under absorption costing except:
a) Direct materials
b) Direct labour
c) Variable manufacturing overheads
d) Fixed manufacturing overheads
e) Fixed administrative overheads
Answer 1 (a), 2 (c), 3 (d), 4(a), 5(b), 6(b), 7(b), 8(a), 9(c), 10(b), 11(a), 12(d), 16(a)
17 (c), 18 (b), 19(e)
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CHAPTER V
COST VOLUME PROFIT RELATIONSHIP
Cost-volume profit (CVP) analysis is an effective tool that assists managers to understand the
relationship among cost, volume and profit. Cost volume analysis focuses on how profit of an
entity is affected by the following factors:
1. Selling price
2. Sales volume
3. Unit variable costs
4. Total fixed costs
5. Mix of product sold
Since CVP analysis acts as important tool to understand how profits are affected by these key
cost elements, it is a vital tool in many business decisions. These decisions include what products
and services are to be offered at what prices with what cost structure.
Some important terms used in CVP analysis and the meaning which they carry are as under:
Break-Even Analysis
Break even analysis refers to ascertainment of level of operations where total revenues equal to
total costs. The breakeven analysis requires that all costs should be segregated in fixed and
variable components. Variable cost per unit and selling price per unit are assumed to be constant.
The total fixed cost component is considered to be constant for analysis only.
Break-Even Point or Level

Breakeven point helps in assessing the viability of the organization and to take decisions on
profit planning and cost control.
Breakeven point indicates the level of operating capacity and sales to be achieved to recover all
costs. The firm should always maintain its level of activity above the breakeven level to earn
profits.
P.V. Ratio
PV ratio reveals the contribution as a percentage of sales turnover. It helps in assessing the
profitability of business. P.V. ratio per unit of sales or per unit of production will indicate the
most profitable item, when other conditions are kept constant.
Margin of Safety
Margin of safety refers to sales in excess of break even sales. A low margin of safety indicates
high fixed costs. The higher margin of safety is necessary to run the business profitably and to
improve the profitability.
43
Assumption of break-even CVP Analysis
The break even CVP analysis is based on the major assumption that costs can be classified into
fixed and variable components. The fixed cost will remain constant irrespective of level of
activity, but the variable cost change proportionately to the change in volume or level of activity.
CVP Relationship in Graphic Form
The relationships among revenue, costs, profit, and the volume are illustrated on cost volume
profit CVP graph. A CVP graph highlights CVP relationship over wide range of activity. To
understand this relationship we have used the following data to draw a CVP graph for M/s ‘X’
Enterprises.
Total Per Unit

Sales (351 units) $ 87,750 $ 250
Variable expenses 52,650 150
Contribution Margin 35,100 100
Fixed Expenses 35,000
Net Operating Income 100
1. Draw a line parallel to the volume axis to representing total fixed expenses.
2. Choose some volume of unit sales and plot the point representing total expenses (fixed
and variable) at the activity level you have selected. We have used the undernoted
expenses at that at 600 units:
Fixed Expense $ 35,000

Variable expenses (350 x $150) 52,500
Total Expense 87,500
After the point has been plotted, draw a line through it back to the point where the fixed
expense line intersects the dollar axis.
3. Again choose some volume of unit sales and plot the point representing total sales dollars
at the activity level you have selected. Sales at that activity level total $ 150,000 (600
units x $250 units). Draw a line through this point back to the origin.
The break even point is where the total revenue and total expense lines cross.
44
$150,000 Total revenue
125000
100000 Variable
Breakeven Expenditure $150
Point at 350 per unit
75000 units or
$ 87500
50000 Total
Expense
________________________________________
25000 Total Fixed
Expenses $35,000
0 ______________________________
100 200 300 400 500 600 700
Volume in units sold
Contribution Margin Ratio
CMR shows how the contribution margin will be affected by a change in total sales. We use the
following data to compute the CM ratio.
Total Per Unit Percentage of
Sales
Sales $100,000 $ 250 100%
Variable Expenses 60,000 150 60%
Contribution Margin 40,000 100 40%
Fixed Expenses 35,000
Net operating income 5,000
CM Ratio = Contribution Margin

Sales
= $ 40,000_ = 0.40 or 40%
100,000
The CM ratio can also be computed on a per unit basis as follows:
= $ 100 = 0.40 or 40%

250
45
Break-even Computation
The break-even point can be computed using either the equation method or the contribution
margin method. The result by each method will, however, be uniform:
The Equation Method: The under noted equation is used to compute the break-even point.
Sales = Variable Expenses + Fixed Expenses
Using the earlier data it will appear as follows:
$250 = $150Q + 35,000

$100Q = 35,000
Q = 35,000/100 = 350 units
Q = Quantity of units sold

$ 250 = Unit Selling Price
$ 150 = Unit variable expense
$35,000 = Total Fixed Cost
The Contribution Margin Method : It is a short cut version of the equation method used
earlier. This approach centers on the idea that certain amount of contribution margin that goes
toward covering fixed costs. To find how many units must be sold to break even, divide the total
fixed expenses by the unit contribution margin:
Break even point in units sold = Fixed Expenses

Unit Contribution Margin
In the above example each unit generates a contribution margin of $ 100 ($250 selling price, less
$ 150 variable expenses). Since the total fixed expenses are $ 35,000, the break even point in unit
sales is computed as follows:
Fixed Expenses = $ 35,000 = 350 units

Unit Contribution Margin $100 per unit
A variant of this method uses the CM ratio instead of the unit contribution margin. The result is
the break even point in total sales dollars rather than in total units sold.
Break even point in total sales dollars = Fixed Expenses

CM ratio
= $ 35,000 = $ 87,500
0.40
46
Target Profit Analysis
CVP formula can be used to determine the sales volume needed to achieve targeted profit.
Suppose the entity wishes to earn a target profit of $ 40,000.
Sales = Variable Expenses + Fixed Expenses + Profits
$250Q = $150Q + $35,000 + $40,000

$100Q = $ 75,000
Q = 75,000/100 = 750 units
Contribution Margin Approach : A second approach involves expanding the contribution

margin formula to include the target profit:
Units sale to attain target profit = Fixed Expenses + Target Profit

Unit contribution margin
= $35,000 + $ 40,000 = 75,000

$ 100 per unit 100
750 units
Dollar sales to attain target profit = Fixed Expenses + Target Profit

CM Ratio
= $35,000 + $40,000 = 75,000

0.40 0.40
$ 187,500
The Margin of Safety
The margin of safety is the excess of budgeted (or actual) sales dollars over the break-even
volume of sales dollars. It is the amount by which sales can drop before losses are incurred. The
higher the margin of safety, the lower the risk of not breaking even and incurring a loss. The
formula for the calculation is:
Margin of safety = Total Budget or actual sales - Breakeven sales
Margin of safety as percentage = Margin of safety in dollars

Total budget (or actual) sales in dollars
The calculation of the margin of safety of the above entity is:
Sales (at the current volume of 400 speakers) $ 100,000

Break even sales (at 350 speakers) 87,500
Margin of safety 12,500
47
Margin of safety as percentage of sales 12,500 x 100
100,000
12.50 %
Operating Leverage
A lever is an instrument for multiplying the force of an activity. Using a lever a massive object
can be moved with only a modest amount of force. In business operating leverage serves a
similar purpose. Operating leverage is a measure of how sensitive net operating income is to
given percentage change in dollar sales. Operating leverage acts as a multiplier. A firm with a
large contribution margin will benefit greatly from an increase in volume because a significant
portion of each additional sale is available to contribute to cover fixed costs and add to profit. In
contrast a firm with a small contribution margin will experience little benefit from each
additional sales dollar because the related variable cost is so high that it leaves a very small
margin towards appropriation of fixed cost. In short if operating leverage is high, a small
percentage increase in sales can produce a much larger percentage increase in net operating
income.
Degree of operating leverage = Contribution Margin

Net operating Income
The data of two firms given below is being used to understand the concept of operating leverage.
Firm ‘A’ Firm ‘B’

Sales (actual) $100,000 $100,000
Fixed Expenses 30,000 60,000
Contribution margin ratio + 0.40 +0.70
Contribution in dollars 40,000 70,000
Net Income 10,000 10,000
Breakeven in total sales dollar $ 75,000 $ 85,714
Current Sales $100,000 $100,000

Breakeven sales 75,000 85,714
Margin of safety 25,000 14,286
Degree of operating leverage: 40,000 70,000

10,000 10,000
4 7
Increase in sales 10% 10%

Increase in net operating profit 10 x 4 10 x 7
40% 70%
The degree of operating leverage can be used to quickly estimate what impact various percentage
changes in sales will have on profits, without the necessity of preparing detailed income
48
statements. If a company is near its breakeven point, then even a small percentage increases in
sales can yield large percentage increase in profits. For example if the degree of operating
leverage is 5 then a 6% increase in sale would translate into a 30% increase in profit.
Financial Leverage
A firm uses financial leverage whenever it finances a portion of its assets by borrowing or by
issuing preferred stock. Issuing bonds to finance the purchase of plant assets is an example of
using financial leverage. Debt of the firm carries two obligations: one to make interest payments
on the specified dates and the other to repay the principal when it matures for payment. If a firm
fails to meet these commitments, the bondholders can force the firm into bankruptcy. Thus
borrowing increases the risk of default. The positive financial leverage accrues to the common
stockholders if the return on borrowed funds is greater than the cost of debt. As a result, the
managers, long term creditors, short term creditors and stockholders are all concerned with the
amount of financial leverage a firm is enjoying.
Some of the ratios which can assist to analyze the solvency of a firm are as under:
Debt to Total Assets

Total Liabilities
Total Assets
A high debt to total assets ratio indicates a greater risk of default and less protection for the
creditors. This percentage is important to long term creditors and stockholders, since creditors
have a prior claim to assets in the event of liquidation.
Time Interest Earned
The time interest earned ratio is an indication of the firm’s ability to satisfy periodic interest
payments from current earnings. The rough rule of thumb is that the company should earn three
to four times its interest requirements. Since current interest charges are normally paid from
funds provided by current operations, analysts frequently compute the relationship between
earnings and interest with the help of under mentioned ratio.
Net Income + Interest Expense + Income Tax Expense (EBIT)

Interest Expense
Exercise 15
Metro Store has a single product olive oil whose selling price is $ 15 per kg and whose variable
cost is $ 12 per unit. The company’s monthly fixed expenses are $ 4,200.
Required :
1. Solve for the company’s breakeven point in unit sales using the equation method.
49
2. Solve for the company’s breakeven point in sales dollars using the equation method and
CM ratio.
3. Solve for the company’s break-even point in unit sales using the contribution margin
method.
4. Solve for the company’s breakeven point in sales dollars using the contribution margin
method and the CM ratio.
Answer 15
i) Selling Price = Variable Expenses + Fixed Expenses

$15Q = $12Q + $ 4,200
Q = 4,200 /3 = 1400 kg
ii) Break even sales

Sales in dollars = CM ratio + Fixed Expenses
X = 0.20X + $ 4,200
X = 4,200/0.20** = $21,000
iii) Fixed Cost = $4,200

Contribution margin
Per Kg = $15 - $12 = 3
Breakeven in units = Fixed Cost
CM per unit
Break even in units = $4,200 = 1,400 kg
$3
iv) Selling Price $ 15 (per unit)

Variable cost = $ 12
Contribution margin = $ 3
Contribution margin ratio = 3/15 = 0.2**
Break even in dollars = Fixed Cost

CM ratio
$4,200 = $ 21,000
0.2
50
Exercise 16
Modern Corporation is a distributor of a fancy umbrella used at resort hotels. Data concerning
the next month’s budget appear below:
Selling price $ 30
Variable expense $ 20
Fixed Expense $ 7,500
Unit sales 1,000 units per month.
Required :
1. Compute the company’s margin of safety.
2. Compute the company’s margin of safety as a percentage of its sales.
Answer 16
Contribution margin = Selling Price - Variable Expense

$ 30 - 20 = $ 10
Break even sales = Fixed Cost/CM
in units 7,500/10 = 750 units
Break even sale in $ = 750 x $30 = 22,500
Margin of safety = Sales – Break even sales
1000 ($30) - 22,500 = 7,500
Margin of safety % = 7,500/30,000 = 25%
Exercise 17
M/s Fast Battery Co. is experiencing difficulty for some time due to wide fluctuation in the sales
volume. The company’s contribution format income statement for the most recent month is given
below:
Sales (19,500 units x $ 30 per unit) $585,000

Variable expenses 409,500
Contribution margin 175,500
Fixed expenses 180,000
Net operating loss ( 4,500)
Required
1. Compute the company’s CM ratio and its breakeven point in both units and dollars.
2. The president believes that a $16,000 increase in the monthly advertising budget,
combined with an intensified effort by sales staff, will result in an $80,000 increase in
monthly sales. If the president is right, what will be the effect on the company’s monthly
net operating income. (use the incremental approach in preparing your answer).
3. The sales manager is convinced that a 10% reduction in the selling price, combined an
increase of $60,000 in the monthly advertising budget, will cause unit sales to double.
What will the next contribution format income statement.
51
4. The marketing department thinks that a fancy new package for the product would help
sales. The new package would increase packaging costs by 75 cents per unit. Assuming
no other changes, how many units would have to be sold each month to earn a profit of
$9,750?
Answer 17
1) Selling Price (per unit) $ 30

Variable Expenses 21
(409,500/19,500) ____
Contribution margin per unit 9
CM ratio 9/30 = 0.30
Break even points in units Fixed expenses/Contribution margin per unit

180,000/9 = 20,000 units
Break even sale in dollars 180,000/0.30 = $600,000
2)
Sales ($585,000 + 80,000) $ 665,000
Variable Expenses
(22,167 x 21 + 16,000) 481,507
Fixed cost 180,000
Net Income 3,493
Units = 665,000/30 = 21,667
3)
Selling Price ($27 x 39,000) $ 1,053,000
Variable Expenses
($ 21 x 39,000) 819,000
Fixed Cost
(180,000 + 60,000) 240,000
Net Loss (6,000)
4)
Selling price per unit $ 30
Less Variable cost
($21 + 0.75) 21.75

Contribution margin 8.25
$30Q = $21.75Q + $180,000 + $9,750

$8.25Q = $189,750
Q = $189,750/8.25 = 23,000 units
52
Income Statement
Sales (23,000 x $30) 690,000
Less variable cost
(23,000 x 21.75) 500,250
Fixed Cost 180,000
Net Income 9,750
Exercise 18
Silver Corn Ltd. is engaged in exports of corn. The company grows three variety of corns which
is denoted by A, B and C. Budgeted sales by product and in total for the coming month are
shown below:
Product
A B C Total
Percentage of total Sales 20% 52% 28% 100%
Sales Rs. 150,000 390,000 210,000 750,000
Less variable cost 108,000 72% 78,000 20% 84,000 40% 270,000
Contribution margin 42,000 312,000 126,000 480,000
Less fixed cost 449,280
Net operating income 30,720
Breakeven point 449,280/0.64 = Rs.702,000
As shown by these data net operating income is budgeted at Rs.30,720 for the month and break
even sales at Rs.702,000.
Assume that actual sales for the month total Rs.750,000 as planned. Actual sales by product are
A Rs. 300,000, B Rs. 180,000 and C Rs. 270,000.
Required
1. Prepare a contribution format income statement for the month based on actual sales data.
Present the income statement in the format shown above.
2. Compute the break even point in sales dollars for the month based on your actual data
and determine the shortfall under each category in Rs.
53
Answer 18
1. Product
A B C Total
Percentage of total Sales 40% 24% 36% 100%
Sales Rs. 300,000 180,000 270,000 750,000
Less variable cost 216,000 72% 36,000 20% 108,000 40% 360,000
Contribution margin 84,000 144,000 162,000 390,000
Less fixed cost 449,280
Net operating income (59,280)
CM Ratio 390,000/750,000 = 0.52

2.
Breakeven sales = 449,280/0.52 = Rs.864,000
40% 24% 36% 100%
Breakeven sales Rs. 345,600 207,360 311,040 864,000
Actual sales 300,000 180,000 270,000 750,000
Shortfall in sales -45,600 -27,360 -41,040 -114,000
Exercise 19
The Karachi Machine Tool Factory manufactures a variety of machine tools. The following are
taken from the budget for 2012.
Sales (20,000 units) Rs.400,000

Variable costs 240,000
Fixed costs 90,000
a) What is the break-even point in units in 2012?

b) What sales volume would be necessary to earn an after tax net income of Rs.42,000 if the
income tax rate is 40 per cent.
c) What sales volume would be necessary to earn a profit before tax equal to 10 per cent of
sales?
d) What effect would a 10% price increase have on the break even point?
e) What are the principal assumptions underlying the break-even and cost-volume-profit
calculations made in the above?
Answer 19
a) Unit sale price Rs.400,000/20,000 = Rs.20
Variable cost Rs.240,000/20,000 = Rs.12
Breakeven point Fixed Cost
Selling price – variable cost
90,000 = 11,250 units
20 – 12
54
b) Target income sales volume = Fixed cost + {Net icome /(1-Tax rate)
Selling price - Variable cost
= 90,000 + {42,000/(1-0.40)}
20 – 12
= 20,000 units
c) Target income sales volume = Fixed cost

Selling price – Variable Cost – (10%) (Rs.20)
= 90,000
20 - 12 – (10%(Rs.20)
= 90,000/6 = 15,000 units
Sales (15,000 x 20) = Rs.300,000

Less variable cost = 180,000
Contribution margin = 120,000
Fixed cost = 90,000
Net Income = 30,000
10% of sales
d) New breakeven point in units = 90,000/(22 – 12) = 9,000 units. The increase in unit CM
due to the increase in unit sale price will cause the breakeven point to drop to 9,000 units
from 11,250 units.
Exercise 20
M/s Polka Co. is a wholesale distributor of candy. The company serves grocery and retail outlets
in the city of Karachi. Small but steady growth in sales has been achieved by the company over
the past few years, while candy prices have been increasing. The company is formulating its plan
for the coming fiscal year. Presented below are the data used to project the current year’s after
tax net income of $ 110,400.
Average sales price per box Rs. 4.00

Average variable costs per box
Cost of candy Rs. 2.00
Selling expenses 0.40
Total 2.40
Annual fixed cost
Selling Rs.160,000
Administrative 280,000
Total 440,000
Expected annual sales volume (390,000 boxes) Rs.1,560,000
Tax Rate 40%
55
Candy manufacturers have announced that they will increase prices of their products by an
average of 15 percent in the coming year due to increases in materials and labour costs. They
expect that all other costs will remain at the same level as the current year.
Required :
a) Determine the breakeven point in boxes of candy for the current year.
b) Calculate the sales price per box that the company must charge to cover the 15 per cent
increase in the cost of candy and still maintain the current contribution margin ratio.
c) Determine the volume of sales in dollars the company must achieve in the coming year to
maintain the same net income as projected for the current year if the sales price of candy
remains at Rs.4 per box and the cost of candy increases 15 per cent.
Answer 20
a) Break even sales in boxes of candy = 440,000 = 275,000 boxes

Rs.4 - 2.40
b) Current CM ratio = 4 - 2.40 = 1.60

1.60/4.00 = 0.40
New Selling price = Variable Cost + Increase by 15%
1 – CM Ratio
= 2.40 + 0.30
1 - 0.40
= 4.50
** Rs. 2 is the variable cost which is increased by 15%
Or Rs.2.40 variable cost – selling price = Rs.4

Rs.2.70 variable cost – selling price = 4/2.4 x 2.7 = 4.50
c) Sales volume in dollars to maintain $ 110,400 tax income

Current net income
Sales (390,000 x 4) 1,560,000
Less Variable cost (390,000 x 2.40) 936,000
Fixed Cost 440,000
Net Income 184,000
Tax 40% 73,600
Net Income 110,400
Selling Price Rs. 4.00
Variable cost (2.40 + 0.30) 2.70
Contribution Margin 1.30 0.325 Ratio
New Sales in dollars Fixed Cost + Required Profit

New CM Ratio
440,000 + 184,000
0.325
Rs.1,920,000
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1. A large margin of safety indicates:

a) Over production
b) Over capitalization
c) The soundness of business
d) Under production
2. Angle of incidence is:

a) The angle between sales line and the X-axis.
b) The angle between the sales line and Y-axis.
c) The angle between the sales line and the total cost line.
3. Selling price per unit Rs.12 : variable cost Rs. 7 per unit; Fixed cost Rs.18,000, Break
even production in units:
a) 6,300
b) 3,600
c) 3,900
4. Sales Rs.10,000; variable cost Rs.6,000 fixed cost Rs.3,000. Break even sales in value:
a) Rs. 7,500
b) Rs. 5,700
c) Rs. 750
5. Fixed cost Rs.40,000; variable cost Rs.20 per unit; selling price Rs.100 per unit. Turnover
required for a profit of Rs.30,000.
a) Rs.78,500
b) Rs.58,750
c) Rs.87,500
6. Sales Rs.12,000; variable costs Rs.7,200; fixed costs Rs.2,000 P/V ratio is:
a) 80%
b) 40%
c) 15%
7. Sales Rs.20,000; variable overhead Rs.12,000, net profit Rs.2,000. Fixed cost is.
a) Rs. 5,000
b) Rs. 6,000
c) Rs. 8,000
8. P/V ratio is 30% and margin of safety is Rs.330,000 The amount of profit is:
a) Rs. 88,000
b) Rs. 99,000
c) Rs. 77,000
Margin of safety x PV ratio 0.30
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9. Total sales Rs.1,000,000; fixed expenses Rs.200,000; P/V ratio 40%; break even capacity
in percentage is.
a) 40%
b) 60%
c) 50%
Fixed expenses/PV ratio = break even capacity
10. Breakeven point occurs at 40% of total capacity. Margin of safety will be:
a) 40%
b) 60%
c) 80%
Total capacity – Break even capacity = Margin of safety
Answer 1 (a), 2(b), 3(b), 4(a), 5(c), 6(b), 7(b), 8(b), 9(c), 10(b)
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CHAPTER VI
ACTIVITY BASED COSTING & RESPONSIBILITY ACCOUNTING
The traditional absorption costing is designed to provide data for external financial reports. In
contrast activity based costing is designed to be used for internal decision making. As a
consequence thereof, activity based costing differs from traditional costing accounting in three
ways:
Difference between ABC and Traditional cost accounting

1. In traditional cost accounting it is assumed that cost objects consume resources whereas
in ABC it is assumed that cost objects consume activities.
2. Traditional cost accounting mostly utilizes volume related allocation base while ABC
uses drivers at various levels.
3. Traditional cost accounting is structure oriented whereas ABC is process oriented.
Cost Pools
An activity cost pool is a grouping of overhead costs assigned to an activity identified in an

activity based costing system. Under ABC, cost pools are created for each activity and such
activities are related with each type of product to determine the cost of such product.
Cost Drivers
The important activities in a business are known as cost drivers. Cost drivers are those activities
or transactions that are significant determinants of cost. The activity cost driver rates are
identified as means of tracing the cost of each activity to product cost. Cost drivers are used as an
absorption rate.
Steps for Implementing Activity Based Costing
Step 1 Identify the Activities
The first step in implementing an ABC system is to identify the activities that will form the
foundation of the system. This is difficult, time consuming, and involves a great deal of
judgment. A common procedure used is to collect the information through interviewing people
who work in overhead departments and ask them to describe their major activities.
Some major cost pools and its drivers used by managerial accountants are given below:
Activity Cost Pool Cost Driver

Customer orders Number of customer orders
Product design Number of product design
Order size Machine hours
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Customer relations Number of active customers
Ordering cost Number of orders
Maintenance costs Number of setups or production hours
Step 2 Assign Overhead Costs to Activity Pool
On the basis of interviews conducted at stage 1 cost is distributed across cost pools. For example
factory equipment depreciation is distributed 20% to customers, 60% to order size, and 20% to
the other cost pools. Once the percentage of distribution has been established it is easy to allocate
costs to the activity pools.
Step 3 Calculate Activity Rate
The activity rates that will be used for assigning overhead costs to products and customers are
computed. The ABC team determines the total activity for each cost pool that would be required
to produce the company’s present mix and to serve its present customers.
Step 4 Assign Overhead Cost to Cost Objects
At this stage the overhead cost computed at stage 3 is assigned to products and customers on the
basis of activity.
Step 5 Prepare Management Reports
The most common management reports prepared with ABC data are product and customer
profitability reports. These reports help companies channel their resources to their most
profitable growth opportunities while at the same time highlighting products and customers that
drain profits.
1. In traditional cost accounting it is assumed that cost objects consume resources whereas
in activity based costing it is assumed that:
a) Cost objects consumed resources c) Cost objects consume overhead
b) Cost objects consume materials d) Cost objects consume activities
2. Traditional cost accounting mostly utilizes volume related allocation based while ABC
uses.
a) Drivers at various levels c) Direct material
b) Direct labour d) None of the above
3. Activity based costing is process oriented whereas traditional cost accounting is:
a) Structure oriented c) Profit oriented
b) Market oriented d) None of the above
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4. The difference over a period of time between actual factory overhead and applied factory
overhead will usually be minimal when the predetermined overhead rates based on:
a) Normal capacity c) Direct labour hours
b) Designed capacity d) Machine hours
5. If a predetermined factory overhead rate not employed and the volume of production is
reduced from the level planned, the cost per unit would be expected to:
a) Remained unchanged for fixed cost and increase for variable cost.
b) Increase for fixed cost and remain unchanged for variable cost.
c) Increase for fixed cost and decrease for variable cost.
d) Decrease for fixed cost and decrease for variable cost.
6. A spending variance for factory overhead is the difference between actual factory
overhead cost and factory overhead cost that should have been incurred for the actual
hours worked and result from:
a) Price differences for factory overhead costs.
b) Quantity differences for factory overhead costs.
c) Price and quantity differences for factory overhead costs.
d) Differences caused by production volume variance.
7. Factory overhead should be allocated on the basis of:

a) An activity basis which relates to cost incurrence.
b) Direct labour hours
c) Direct labour cost
d) Machine hours
8. The most appropriate method of allocating buildings rent costs would be:
a) To share them out equally amongst all departments.
b) On the basis of value of assets.
c) On the basis of number of employees.
d) On the basis of floor area of each department.
9. A cost centre is:

a) An area for which costs are accumulated.
b) The part of the business where all costs are paid to suppliers.
c) A production department where all production costs are aggregated.
d) An area of the business accountable for both costs and revenue.
10. The full cost of a product will include:

a) Production cost only.
b) Production cost plus non production overhead.
c) Production cost plus prime cost.
d) Prime costs only plus a percentage of prime costs to cover overheads.
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11. Activity based costing would assign overheads to product on the basis of:
a) Amount of labour time incurred.
b) The specific activity that causes the cost.
c) Number of products made.
d) The cost driver that causes the cost.
12. Which of the following would not be considered as a support activity?

a) Setting up machines c) Assembling the product
b) Ordering stock d) Dealing with customer enquiries
13. In terms of high volume products it is argued that:

a) Activity based costing will apportion a higher cost to these than traditional absorption
costing.
b) Both methods will apportion the same level of costs.
c) Activity based costing will apportion a lower cost to these than traditional absorption
costing.
d) Under activity based costing these will incur more overheads as activity is greater.
14. Which of the following is not classed as an activity cost driver?

a) Intensity drivers c) Productivity drivers
b) Transaction drivers d) Duration drivers
15. If activity based costing is used, materials handling would be classified as a:

a) Unit level of activity c) Product sustaining activity
b) Batch level activity d) Facility sustaining activity
16. Which of the following are not unit based cost driver?
a) Machine hours c) Number of units
b) Number of batches d) Direct labour hours
17. An activity based cost system:

a) Differs from a functional based cost system in the nature and number of the cost
drivers used.
b) Uses both unit based and non-unit based cost drivers that reflect a cause and effect
relationship.
c) Can trace cost accurately to cost objects other than products.
d) Does all of the above.
18. What is the initial step in implementing an activity based costing system?
a) Assigning costs to activities.
b) Assigning costs to products.
c) Identifying activities and attributes
d) Dividing activity costs by activity drivers.
19. Which of the following are true regarding activity based costing?
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a) A primary goal of using ABC is a more useful allocation of manufacturing overhead
to product lines.
b) Under ABC, direct labour hours are never used to allocate overhead cots to activity
pools or product line.
c) The use of ABC is indicated when it is suspected that each of a firm’s product lines
consumes approximately the same amount of overhead resources but the current
allocation scheme assigns each line a substantially different amount.
d) ABC can be used in conjunction with process costing.
e) (a), (c) & (d)
20. Which of the following would be the most appropriate basis for allocating the cost of
plant insurance that covers equipment theft and damage?
a) Direct labour hours
b) Value of equipment
c) Machine hours
d) Square feet of plant space
21. Using ABC to allocate manufacturing overhead can help managers to:
a) Identify what activities driver overhead costs.
b) Set product prices.
c) Locate identification in the production process.
d) Do all of the above.
Answers
1. d), 2. a), 3. a), 4. a), 5. b) 6. c), 7. a), 8. d), 9. a), 10. b), 11. b), 12. c) 13. c),
14. c), 15. b), 16. b), 17. d), 18. c) 19. e) 20. b) 21. d)
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Exercise 21
In what fundamental ways does activity based costing differs from traditional costing, describe?
Answer 21
Activity based costing differs from traditional costing systems in a number of ways. In activity
based costing, non-manufacturing as well as manufacturing costs may be assigned to products.
And, some manufacturing costs – including the costs of idle capacity may be excluded from
product costs. An activity based costing typically includes a number of activity cost pools, each
of which has its unique measure of activity. These measures of activity often differs from the
allocation bases used in traditional costing system.
Exercise 22
M/s Farooq Corporation makes a single product – a high quality fire resistant commercial filing
cabinet that it sells to business houses in need of secured cabinets. The company has a simple
ABC system that it uses for internal decision making. The company has two overhead
departments whose costs are listed below:
Manufacturing overhead $ 500,000

Selling and administrative overhead 300,000
Total overhead cost 800,000
The company’s ABC system has the following activity cost pools and activity measure.
Activity cost pool Activity measure

Assembling units Number of units
Processing orders Number of orders
Supporting customers Number of customers
Others Not applicable
Cost assigned to the “other” activity cost pool have no activity measure; they consist of the costs
of unused capacity and organization-sustaining costs – neither of which are assigned to orders,
customers or the product.
M/s Farooq Corporation distributes the costs of manufacturing overhead and of selling and
administrative overhead to the activity cost pools based on employee interviews, the result of
which are reported below:
Distribution of Resource Consumption Across Activity Cost Pools

Assembling Processing Supporting
Units Orders Customers Others Total
Manufacturing overhead 50% 35% 5% 10% 100%
Selling & Adm. Overhead 10% 45% 25% 20% 100%
Total activity 1,000 250 100
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Required:
1. Perform the first stage allocation of overhead costs to the activity cost pool.
2. Compute activity rates for the activity cost pools.
3. During the period M/s Farooq Corporation supplied 80 cabinets in total to one of the
customer M/s Smart Investment House on four different times. Prepare a schedule
showing the overhead costs attributed to these supplies.
4. The selling price of a filing cabinet is $595. The cost of direct material is $180 per filing
cabinet, and direct labour is $ 50 per filing cabinet. What is the margin of profit against
the cabinet.
Answer 22
1. First stage allocation of costs to the activity cost pools appear below:
Assembling Processing Supporting

Units Orders Customers Others Total
Manufacturing overhead $250,000 $175,000 $ 25,000 $ 50,000 $ 500,000
Selling & Adm. Overhead 30,000 135,000 75,000 60,000 300,000
Total activity 280,000 310,000 100,000 110,000 800,000
2. Activity rates for the activity cost pools are:

(a) (b) (a) ÷ (b)
Activity Cost Pools Total Cost Total Activity Activity Rate
Assembly units $ 280,000 1,000 units $280 per unit
Processing orders $ 310,000 250 units $1,240 per unit
Supporting customers $ 100,000 100 units $1,000 per unit
3. Overhead customer attributable to Office Smart would be computed as under:
Activity Cost Activity Rate Activity ABC Cost

(a) (b) (a x b)
Assembling units $ 280 per unit 80 units $22,400
Processing orders $1,240 per order 4 orders 4,960
Supporting order $1,000 per customer 1 customer 1,000
4. The customer margin can be computed as under:
Sales (80 x $595) $ 47,600

Costs
Material (80 x $180) $ 14,400
Labour (80 x $50) 4,000
Overhead cost
Assembly (80 x $280) $ 22,400
Order Processing cost 4,960
Supporting customers 1,000 28,360 46,760
Customer margin $ 840
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Exercise 23
The operation vice president of Gold Star Bank has been interested in investigating the efficiency
of bank’s operations. The Central Branch has submitted the following data for the last year:
Teller wages $ 160,000

Assistant branch manager salary 75,000
Branch Manager salary 80,000
The other costs of the branch – rent, depreciation, utilities and so on – are organization sustaining
costs that cannot be meaningfully assigned to individual customer transaction such as depositing
checks.
In addition to the cost data above, the employees of the Central Branch have been interviewed
concerning how their time was distributed last year across the activities included in the activity
based costing study. The result of those interviews appear below:
Distribution of Resources across activities
Opening Process Deposits Processing Other Total

Accounts and Withdrawals other Transactions Activities
Teller wages 5% 65% 20% 10% 100%

Assistant Branch 15% 6% 30% 50% 100%
Manager’s salary
Branch Manager’s 5% 0% 10% 85% 100%
Salary
Required : Prepare the first stage allocation of the overhead cost using the above data to the
activity cost pools.
Answer 23
Teller wages $ 160,000

Assistant branch manager salary 75,000
Branch Manager salary 80,000
Total $315,000
Opening Process Deposits Processing Other Total

Accounts and Withdrawals other Transactions Activities
________________________________________________________
Teller wages $ 8,000 $ 104,000 $ 32,000 $ 16,000 $ 160,000
Assistant Branch 11,250 4,500 22,500 37,500 75,000
Manager’s salary
Branch Manager’s 4,000 0 8,000 68,000 80,000
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Total 23,250 108,500 62,500 121,500 315,000
Exercise 24
M/s ‘Y’ Corporation makes ultra lightweight backpacking tents. Data concerning the company’s
two product lines appear below:
Deluxe Standard
Direct materials per unit $ 60 $ 45
Direct labour per unit $ 9.60 $ 7.20
Direct labour hours per unit 0.8 DLHs 0.6 DLH
Estimated annual production 10,000 units 70,000 units
The company has a traditional costing system in which manufacturing overhead is applied to
units based on direct labour hours. Data concerning manufacturing overhead and direct labour
hours for the upcoming year appear below:
Estimated total manufacturing overhead $290,000

Estimated total direct labour hours 50,000 DLHs
Required :
1. Determine the unit product costs of the Deluxe and Standard products under the
company’s traditional costing system.
2. The company is considering replacing its traditional costing system for determining unit
product costs for external reports with an activity based costing system. The activity
based costing system would have the following three activity cost pools:
Activities and Activity Estimated Expected Activity

Measures Overhead Deluxe Standard Total
Supporting D.Labour (direct labour hrs) $150,000 8,000 42,000 50,000
Batch setups (set up) 60,000 200 50 250
Safety testing (tests) 80,000 80 20 100
Total manufacturing overhead 290,000
Determine the unit product costs of the Deluxe and Standard products under the activity based
costing system.
Answer 24
1.
The predetermined overhead rate is computed as follows:
Predetermined overhead rate = $290,000 = $ 5.80

50,000 DLHs
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The unit product costs under the company’s traditional costing system are computed as follows:
Deluxe Standard
Direct materials $ 60.00 $ 45.00
Direct labour 9.60 7.20
(0.8 DLH x $ 5.80 Delux) 4.64
(0,6 DLH x $ 5.80 Standard) 3.48
Unit Product cost 74.24 55.68
2.
The activity rates are computed as follows:
(a) (b) (a) ÷ (b)

Estimated Total Activity
Overhead Expected Activity Rate
Supporting direct
Labour $150,000 50,000 DLHs $ 3 per DLH
Batch set ups $ 60,000 250 set ups $ 240 per set up
Safety testing $ 80,000 100 tests $ 800 per test
Manufacturing overhead is assigned to the two products as follows:
Deluxe Product (a) (b) (a) x (b)

Activity Cost Pool Activity Rate Activity ABC Cost
Supporting direct labour $ 3 per DLH 8,000 hrs $ 24,000
Batch set ups $ 240 per set ups 200 set ups $ 48,000
Safety testing $ 800 per test 80 tests $ 64,000
Total $136,000
Standard Product (a) (b) (a) x (b)

Activity Cost Pool Activity Rate Activity ABC Cost
Supporting direct labour $ 3 per DLH 42,000 hrs $126,000
Batch set ups $ 240 per set ups 50 set ups $ 12,000
Safety testing $ 800 per test 20 tests $ 16,000
Total $154,000
Activity based costing unit product costs are computed as follows:
Deluxe Standard
Direct materials $ 60.00 $ 45.00
Direct labour 9.60 7.20
Manufacturing over head
($136,000/10,000 units) 13.60
($154,000/70,000 units) 2.20
Unit product cost 83.20 54.40
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Exercise 25
Sind Manufacturing makes two products titanium Hubs and Sprockets. Data regarding the two
products is as follows:
Direct Labour Annual
Hours per unit Production
Hubs 0.80 10,000 units
Sprockets 0.40 40,000 units
Additional information about the company follows:

a. Hubs require $ 32 in direct materials per unit, and Sprockets require $ 18.
b. The direct labour wage rate is $ 15 per hour.
c. Hubs are more complex to manufacture than Sprockets and they require special
equipment.
d. The ABC system has the following activity cost pools.
Estimated
Overhead Activity
Activity Cost Pool Activity Measure Cost Total Hub Sprockets
Machine setups Number of setups $72,000 400 100 300
Special Processing Machine hours $200,000 5,000 5,000 -
General Factory Direct labour hrs. $816,000 24,000 8,000 16,000
Required :
1. Compute the activity rate for each activity cost pool.
2. Determine the unit cost of each product according to the ABC system, including
direct materials and direct labour.
Answer 25
1. Activity rate is computed as follows:
Estimated Expected (a) ÷ (b)
Activity Cost Pool Overhead Cost Activity Rate
Machine set ups $ 72,000 400 $ 180 per setup
Special Processing $ 200,000 5,000 $ 40 per MH
General factory $ 816,000 24,000 $ 34 per DLH
2. Overhead is assigned to the two commodities as follows:

Hub Activity (a) ÷ (b)
Activity Cost Pool Rate Activity ABC Cost
Machine set ups $ 180 100 $ 18,000
Special Processing $ 40 5,000 $ 200,000
General factory $ 34 8,000 $ 272,000
Total 490,000
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Sprockets
Activity (a) ÷ (b)
Activity Cost Pool Rate Activity ABC Cost
Machine set ups $ 180 300 $ 54,000
Special Processing $ 40 0 $ 0
General factory $ 34 16,000 $ 544,000
Total 598,000
Unit Cost
Hub Sprockets
Direct material $ 32 $ 18
Direct Labour
(0.80 x $ 15) 12
(0.40 x $ 15) 6
Overhead
($490,000/10,000 units) 49.00
($598,000/40,000 units) 14.95
Unit Cost $ 93.00 $ 38.95
Exercise 26
Two products X and Y are made using similar equipments and methods. The data for the last
period are:
X Y
Units produced 6,000 8,000
Labour hours per unit 1 2
Machine hours per unit 4 2
Set ups in period 15 45
Orders handled in the period 12 60
Overheads for the period

Relating to production set ups $ 179,000
Relating to order handling 30,000
Relating to machine activity 55,000
Total 264,000
Required:
a) Calculate overhead rate based on based on labour hour absorption rate.

b) Calculate overhead rate based on ABC.
70
Answer 26
a) Overhead rate based on absorption costing

Total overhead cost = $264,000
Total labour hours = 6,000 x 1 + 8,000 x 2 = 22,000 hours
Overhead rate = $264,000/22,000 = $ 12
b) Overhead rate based on ABC

Production set ups = $179,000/(15 + 45) = $2,983.33 per set up
Order handling = $30,000/(12 + 60) = $416.67 per order
Machine activity = $55,000/(4 x 6,000) + (2 x 8,000)
$1.375 per machine hour
Responsibility Accounting
The responsibility accounting can be defined as an approach which links decision making
authority with accountability for the outcomes of those decision. The responsibility accounting
can be used in any part of an organization whose managers has control over and are accountable
for cost, profit or investments.
Objectives of Responsibility Accounting:
The responsibility accounting is also called profitability accounting and activity based
accounting. Responsibility accounting, as a control device, is relevant to divisional performance
measurement, whereas other control devices are applicable to the organization as a whole. The
objectives of responsibility accounting are summarized below:
To determine the contribution that a division makes to total organization.

To provide a basis for evaluating the quality of the divisional manager’s performance.
To motivate the divisional managers to operate his division in a manner consistent with
the basic goals of the organization as a whole.
A responsibility Centre is a unit in the organization which is responsible for over costs, revenues
and or investment funds. For the purpose of measuring divisional performance, the responsibility
centers are divided into the following types:
Cost Center : The manager of a cost center has control over costs, but not over revenue or the
use of investment funds. Service departments such as accounting, finance, general
administration, legal and personnel are usually classified as cost centers. The managers of cost
centers are expected to minimize costs while providing the level of products and services
demanded by other parts of the organization.
Profit Center : The manager of a profit center has control over both costs and revenue, but not
over the use of investment funds. For example, the manager in charge of Departmental Store
would be responsible for both the revenues and costs, and hence the profits of the store, but may
71
not have control over major investments in the store. Profit center managers are often evaluated
by comparing actual profit to targeted or budgeted profit.
Investment Center : The manager of an investment center has control over cost, revenue and
investments in operating assets. For example, the vice president of the Truck Division at General
Motors would have a great deal of discretion over investments in the division. Once the budget is
approved for a particular investment, the investment managers would then be responsible for
making sure that the investment must pays off as planned.
Responsibility Accounting Systems
One of the first requirements in developing a good responsibility accounting is a sound

organization chart. The next step is to develop a chart of accounts that will collect data not by
products or types of expense but by the degree of responsibility assigned to each center.
Responsibility Accounting Reports
Responsibility accounting reports are prepared according to responsibility levels shown in the
organization chart. At each level the direct costs incurred by the unit manager are listed and then
the costs incurred by each of the subordinate unit manager are shown. Finally the report would
include the total cost for the company, that is the cost of the president’s office plus the cost of the
immediate subordinates, like vice presidents of each center.
Exercise 27
M/s Douglass Company has two territories which are assigned to four Managers, Mr. A, Mr. B,
Mr. C and Mr. D. The segment wise margin and assets held at their disposal are as under:
Territory East West

East West │ Mr. A Mr. B │ Mr. C Mr. D
Segment Margin $ 66,000 34,000 │ 47,000 19,000 │ 14,000 20,000
Segment Assets $ 660,000 160,000 │ 336,000 324,000 │ 20,000 140,000
Required : Compute the return on investment of each Manager.
Answer 27
Return on Investment
Territory East
$ 66,000/ $ 660,000 = 10%
Mr. A = $ 47,000 / 336,000 = 13.99%

Mr. B = $ 19,000 / 324,000 = 5.86%
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Territory West
$ 34,000 / $ 160,000 = 21.25%
Mr. C = $ 14,000 / $ 20,000 = 70%

$ 20,000 / $ 140,000 = 14.29%
Comments : A comparison of ROI on basis of territory reveals that the ‘West’ is contributing
better return on investment as compared to the territory ‘East’.
As regards the individual contribution of the manager of each territory Mr. C and Mr. D’s
performance are superior than the Managers of the territory East.
Exercise 28
M/s Saleem Ahmed, President of First Prudential Bank is concerned about the decreasing profit
in 2003. The following cost information is available for the past two years.
2002 2003
Interest Cost $ 400,000 $ 390,000
Advertising cost 70,000 70,000
Promotion costs 5,000 6,000
Tellers salaries 50,000 50,000
Vice President’s salary 40,000 43,000
President’s salary 75,000 125,000
Analyze the above data and advise the President of First Prudential Bank the real factor
responsible for the decline in the profit of the bank.
Answer 28
First Prudential Bank

Cost Information by Function
Percentage
2002 2003 Increase/
Decrease
________________________________________________________________________
Operating Cost
Interest Cost $ 400,000 $ 390,000
Teller’s salaries 50,000 $ 450,000 52,000 442,000 - 1.77%
Selling Cost
Advertising 70,000 70,000
Promotion 5,000 75,000 6,000 76,000 1.33%
Administrative Cost
V. President 40,000 43,000
President’s salary 75,000 115,000 125,000 168,000 46.09%
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The analysis of changes in the cost during the last two year reveals that the bank’s administrative
cost has sharply increased in the year 2003 which is affecting the profitability of the bank.
Exercise 29
What is the relationship between responsibility accounting and cost control?
Answer 29
There is a direct relationship between responsibility accounting and cost control. Since
responsibility accounting provides required data to the departmental heads, they remain aware
when the cost overruns and can adopt corrective measures to control them.
Exercise 30
What items should be excluded from an assembly line foreman’s responsibility accounting report
or performance report?
Answer 30
Non-controllable costs such as depreciation, insurance, property taxes, rent and his own salary
should not be a part of foreman’s responsibility report.
Exercise 31
One of your client who operates a large retail service grocery stores that has a full range of
departments. Their management is encountering difficulty in using accounting data as a basis for
decision making to control costs concerning departments, products, marketing and so forth. List
several overhead costs, or costs not applicable to particular departments and explain how the
existence of such costs (sometimes called common costs or joint costs) complicates and limits
the use of accounting data in making decision in such establishments.
Answer 31
There are many examples of “common costs” of a self service grocery store which falls under
such type of costs. Some are rent, supervision, trucking and advertising.
Common costs are usually apportioned on various arbitrary basis to the various departments, but
for managerial decisions such apportionments produce misleading results. Decisions such as
discontinuing a department, adding a department, enlarging a department, or decreasing a
department cannot be made on the data produced from the apportionments. For example, if a
department is needed to be discontinued because it appears to be unprofitable, factors such as
discontinuation will increase the cost of other departments as a result of having to absorb more of
the shared of the common costs must be taken into consideration. Thus the overall operating
results will be less favourable if the unprofitable department is discontinued. For decision
making purposes, the incremental approach is more appropriate to arrive at correct decision
under such conditions.
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CHAPTER VII
BUDGETING PROCESS
A budget is a detailed plan that shows how resources are expected to be acquired and used
during a specified time period. In other words budget is a quantitative expression of management
objectives and means of monitoring progress towards achievement of the same. An effective
budget must be well coordinated with related management and accounting system.
Initially, budgeting identifies certain financial and operating targets that become management’s
goals for the future. These targets which provide direction for the entity’s activities and
transactions, is expected to lead to satisfactory profitable results. As the actual performance
occurs, it is monitored and checked against the related targets for control purposes. If significant
variances between the actual and planned performance are found, they are investigated and
corrected whenever possible using the concept of management by exception.
Benefits of Budgeting
An entity’s financial performance must be planned and controlled through sound budgeting
procedures in order to achieve and maintain acceptable profit results. To ensure that budgets are
effectively used, both their benefits and limitations must be carefully considered. The benefits of
budgeting are:
1. Planning : Budgeting forces management to plan ahead and systematically anticipate the
future. Since managers are mostly preoccupied in their day-to-day business operations,
they avoid formalized plans unless budgeting is part of their job. The budgeting forces
managers to formalize their thinking about the future and participate in the firm’s goals
setting activities.
2. Organization. Budgeting assist in (1) placing economic and human resources in the most
financially rewarding areas and (2) making the various managers aware of the scarcity of
resources.
3. Controlling: Budgeting provides managers with realistic performance targets against
which actual results can be compared. Management by exception is performed by
identifying significant variances that require corrective action if the firm is to achieve its
goals.
4. Coordination : Budgeting coordinates the various segments of the organization and
makes each manager aware of how the different activities fit together. Goal congruence
of an organization can be achieved by the unifying efforts through budgeting.
5. Communication: Budgeting serves as a communication device that the various managers
use to (1) exchange information concerning goals, ideas, and achievements and (2)
interact and develop an awareness of how their activities contributes to the firm’s overall
operation.
6. Motivation: Budgeting provides managerial motivation in the form of goals. Few people
work for the sheer joy of it; most of us need some form of stimulus to work hard and
maintain an enthusiastic attitude towards our jobs. Budget goals and periodic reports
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comparing actual performance with the goals serve as an important stimulus whenever
budgeting is properly used.
Limitations of Budget
1. In many cases, a budget tends to oversimplify the facts of a real world situation and does
not truly represent the complexities faced by management.
2. A budget may emphasize results (actual net income compared with amount budgeted) but
not reasons (e.g. explanations for why marketing costs were higher than expected), when
both are important.
3. The participative theme of budgeting demands complete management support and
involvement. If managers are not convinced of budgeting’s benefits they are not likely to
spend the time required to use it successfully.
4. The budget may undermine management’s initiative by discouraging new developments
and actions not covered in the budget.
5. If excess pressure is applied to individual managers for the achievement of budget goals,
the managers may react with decisions that adversely affect organizational goals.
6. The budgeting process is not an exact science and good judgment plays an essential role.
Thus, budgeting is somewhat subjective and is based on best information available.
Constant revision is needed as new facts become known.
Master Budget
The master budge is a set of separate but closely interrelated budget representing a
comprehensive plan of action for a specified time period. This budget is typically prepared for
the 12 month period representing a firm’s calendar or fiscal year. It is then subdivided into
shorter periods (such as month or quarters) to facilitate time comparisons of actual and budgeted
results.
The master budget consists of two components (1) the operating budget and (2) the financial
budget. The operating budget is a detailed description of the revenues and costs required to
achieve satisfactory profit results. The financial budget shows the cash flows and financial
position expected with the planned operations. The master budget for a manufacturing firm
would contain the following budgets:
Master Budget
Operating budget Financial budget

Sales budget Capital Expenditures budget
Production budget Budgeted Balance Sheet
Direct material budget Budgeted statement of cash flows
Manufacturing overhead budget
Cost of goods sold budget
Selling Expenses Budget
Administrative expenses budget
Budgeted Income statement
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Types of Budgets
Functional Budget
A functional budget relates to any of the functions of an undertaking. Functional budgets are
subsidiary to the master budget. The operating budgets listed above are examples of functional
budgets.
Zero Based Budget

Zero Based budgeting can be defined as a planning and budgeting process which requires each
manger to justify his entire budget request in detail from scratch (hence the zero based) and shifts
the burden of proof to each manager to justify why he should spend any money at all i.e. taking
zero as the base and the budget is based on the basis of likely activities for the future period.
Fixed Budget (Static Budget)

When a budget is drawn for one level of activity and one set of conditions on the assumption that
there will no change in the budget level of activity, it is called a fixed budget.
Flexible Budget
A flexible budget gives different budget costs for different levels of activity. It is a budget
designed to change in accordance with the level of activity actually attained. It is a tool that is
extremely useful in cost control. The flexible budget is characterized as follows:
1. It is geared toward a range of activity rather than a single level of activity.

2. It is dynamic in nature rather than static. By using the cost volume formula, a series of
budgets can be easily developed for various levels of activity.
The basic steps used to prepare a flexible budget are:
1. Select the measure of activity to be used to prepare the budget, e.g. units of production.
2. Define the relevant range of activity for the budgeted performance based on the measure
of activity selected in step 1.
3. Identify the cost items to be included in the budget.
4. Determine the cost behavior of each cost item over the relevant range.
5. Separate the cost items into variable and fixed cost categories (a mix cost is split between
the two).
6. Select the specific levels of activity to be budgeted.
7. Use the cost behavior patterns identified in step 4 to estimate the budgeted amounts for
each cost item.
Control Aspects of Budgeting
The control aspect of budgeting consists of three major steps:

1. Comparing the actual financial performance results with the budget estimates.
2. Identifying any significant variances (differences between the actual performance and
budget estimates).
3. Deciding what management action should be taken – corrective or adaptive.
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The Complete Periodic Budget
A complete set of budget generally consists of:

1. Sales estimates by:
a. Territory and product or
b. Territory, customer group, and product.
2. Estimates of inventory, production, labour, and factory overhead combined into a cost
of goods sold schedule.
3. Estimates of materials, labour and factory overhead combined into a cost of goods
sold schedule.
4. Detailed expense budget for marketing and administrative expenses.
5. A budget of major repairs, replacements, and improvements of plant and machinery,
and research and development expenditures.
6. A cash budget showing cash receipts and disbursements.
7. A forecast income statement.
8. A forecast balance sheet showing the estimated financial position of the company at
the end of the budget period.
Budgeting in Service Firms like Banks
The absence of inventory in a service firm does not eliminate the need for budgeting but it does
alter the focus of its applications. Service firms such as banks, accounting firms, legal
practitioners, medical clinic, architectural firm, etc. are typically labour intensive because their
most important resources are the people who perform the revenue producing services. These
people often engage in numerous non-repetitive activities because no two jobs are exactly alike.
The lack of similarity of the services to be performed complicates the projection of the revenues
and costs associated with the services.
The primary financial consideration is ensuring that the professional staff is kept busying,
thereby generating enough revenue to support the operation. Consequently, the budgeting
emphasis is on the labour budget to provide an adequate but not excessive amount of labour to
satisfy the demand for services being performed.
The budget of a service firm is usually developed on the basis of a “bottom-up approach”,
unlikely manufacturing firms which use “top-down procedure”. In case of manufacturing
concern the forecast of sales demand is the first step in the development of master budget, which
in turn determines the resources needed to produce and sell the products involved. Thus, the
budgeting process flows from revenues to costs and is referred to as “top down approach”. In
contrast the size and composition of the professional staff of a service firm are relatively fixed
for a particular budget period. The basic concern is an efficient and effective utilization of the
professional staff in the performance of the services offered. The total labour cost is the starting
point for determining how much revenue must be earned from the labour capacity available to
absorb all costs and return an acceptable amount of profit to the owners of the firm. Thus we
have a “bottom-up approach” as the budget process flows from costs to revenue.
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1. Budgetary control is a system designed:

a) To plan and control all quantifiable aspects of business activity
b) To budget and control cash flows of a business
c) To monitor results of business
d) None of above
2. Production budget comprises:

a) Plant capacity and utilization plan
b) Production plan (quantities)
c) Production cost budget
d) All of the above
3. Unabosorbed or over absorbed cost means:

a) Under charging or over charging of overheads costs to cost of products manufactured.
b) Less or excess overhead cost incurred as compared to last year.
c) Less or excess overhead cost incurred as compared to budget.
4. Starting point for budgeting is:

a) Production forecast
b) Capacity forecast
c) Sales forecast
d) Manpower level forecast
5. A flexible budget is also called:

a) A variable budget
b) A seasonal budget
c) A budget with loose controls
d) A document yet to be finalized
6. A flexible budget is:

a) Not appropriate when costs and expenses are affected by fluctuation in volume limits.
b) Appropriate for any relevant level of activity.
c) Appropriate for control of FOH but not for control of direct material and direct labour
d) Appropriate for control of direct material and direct labour but not for control of FOH
7. A flexible budget is:

a) In which monthly variations are accommodated
b) Having a technique to adjust itself to current conditions
c) Various bases and cost allocations used by different departments of a company
d) None of the above
8. A standard cost system may be used in:

a) Job order but not process costing.
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b) Either job order costing or process costing.
c) Process costing but not job order costing.
d) Neither process costing nor job order costing
9. A budget in which a responsibility centre manager must justify each planned activity and
its estimated total cost is called a:
a) Conventional budget
b) Master budget
c) Program planning and budget system
d) Zero based budget
10. Standard costs provide the building blocks for a:

a) Variable cost
b) Unit cost
c) Budgeted cost
d) Overhead cost
11. In responsibility accounting system each cost must be assigned to:

a) A division
b) An individual
c) A profit centre
12. The important reason for measuring performance of a division can be associated with:
a) Motivating personal managers
b) Public reporting
c) Determining divisional contribution to net earnings
13. The situation when the goals of a division or an individual are in harmony with the broad
goals of the company is known as:
a) Management by exception
b) Goal congruence
c) Division goal analysis
14. In divisional performance analysis, the sum of earnings of all the divisions of a company:
a) Will be the same as the net earnings of the enterprise as a whole.
b) Probably will not be the same as the net earnings of the enterprise as a whole.
c) Is called the return on investment.
15. Modern divisional performance reporting system give attention to:

a) Costs
b) Costs and revenues
c) Costs, revenues and investment
16. The use of responsibility accounting focuses attention on:

a) Management by objective
b) Management by domination
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c) Management by exception
Answer 1(a), 2 (b), 3 (c), 4 (c), 5 (a), 6(b), 7(b), 8(b), 9(d), 10(c), 11(b), 12(c), 13(b),
14(b), 15(c), 16(a)
Exercise 32
The following data on production, materials required for products X and Y, and inventory pertain
to the budget of Pioneer Company.
Product X Product Y
Production Units 2,000 3,000
Materials (per Unit)
A 3.00 1.00
B 4.00 6.50
Beginning Desired Price/Unit

Ending (Rs.)
Material Inventory
A 2,000 3,000 2.00
B 6,000 6,000 1.20
Required :
a) Determine the number of units needed to produce products X and Y.
b) Calculate the cost of materials used for production.
c) Determine the number of material units to be purchased.
d) Calculate the cost of materials to be purchased.
Answer 32
Material A Material B
a) Number of units product X to be produced 2,000 2,000
Units needed to produce X 3 4
Total 6,000 8,000
Number of units product Y to be produced 3,000 3,000

Units needed to produce Y 1 6.5
Total 3,000 19,500
Total number of material units needed to 9,000 27,500

Produce product X and Y (6,000+3,000)
b) Total number of material units 9,000 27,500
Unit price 2 1.20
Cost of materials used for production 18,000 33,000
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c) Total number of units needed for production 9,000 27,500
Add desired ending inventory 3,000 6,000
Total material needed 12,000 33,500
Less beginning inventory 2,000 6,000
Materials to be purchased 10,000 27,500
d) Material to be purchased 10,000 27,500
Unit Price 2 1.20
Cost of material to be purchased 20,000 33,000
Exercise 33
M/s Saima Corporation manufactures and sells products that has peak sales in the third quarter of
the year. The following information concerns operations for Year 2 and the first quarter of the 3rd
year.
a) The company’s single product sells for $ 8 per unit. Budgeted sales in units for the next
six quarters are as follows:
Year 2 (Quarter) Year 3 (Quarter)

1 2 3 4 1 2
Budgeted unit sales 40,000 60,000 100,000 50,000 70,000 80,000
b) Sales are collected in the following pattern: 75% in the quarter the sales are made and the
remaining 25% in the following quarter. On January 1, Year 2, the company’s balance
sheet showed $ 65,000 in accounts receivable, all of which will be collected in the first
quarter of the year. Bad debts are negligible and can be ignored.
c) The company desires as ending finished goods inventory at the end of each quarter equal
to 30% of the budgeted unit sales for the next quarter. On December 31, Year 1, the
company has 12,000 units on hand.
d) Five pounds of raw materials are required to complete one unit of product. The company
requires ending raw materials inventory at the end of each quarter equal to 10% of the
following quarter’s production needs. On December 31, Year 1 the company had 23,000
pounds of raw material on hand.
e) The raw material costs $ 0.80 per pound. Raw material purchases are paid for in the
following pattern. 60% paid in the quarter the purchases are made, and the remaining
40% paid in the following quarter. On January 1, Year 2, the company’s balance sheet
showed $81,500 in accounts payable for raw material purchases, all of which will be
paid for in the first quarter of the year.
Required:
Prepare the following budgets and schedule for the year, showing both quarterly and total
figures.
1. A sales budget and a schedule of expected cash collections.
2. A production budget.
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3. A direct material budget and schedule of expected cash payments for purchases of
materials.
Answer 33
1. The sales budget is prepared as follows :
Year 2 Quarter
1 2 3 4 Year
Budgeted unit sales 40,000 60,000 100,000 50,000 250,000
Selling Price per unit x $8 x $8 x $8 x $8 x $8
Total sales $320,000 480,000 $800,000 $400,000 $2,000,000
Based on the budgeted sales above, the schedule of expected cash collection is prepared
as follows:
2 Quarter
1 2 3 4 Year
Accounts receivable, beginning balance $65,000 $ 65,000
First quarter sales ($320,000 x 75%, 25%) 240,000 $80,000 320,000
Second quarter sales ($480,000x75%,25%) 360,000 $120,000 480,000
Third sales ($800,000 x 75%, 25%) 600,000 200,000 800,000
Fourth quarter sales ($400,000 x75%) 300,000 300,000
Total cash collections 305,000 440,000 720,000 500,000 1,965,000
2. Based on the sales budget in units, the production budget is prepared as follows:
Year 2 Quarter Year 3 Quarter
1 2 3 4 Total 1 2
Budgeted units in sales 40,000 60,000 100,000 50,000 250,000 70,000 80,000
Add desired ending inventory 18,000 30,000 15,000 21,000 21,000 24,000
Total inventory needed 58,000 90,000 115,000 71,000 271,000 94,000
Less beginning inventory 12,000 18,000 30,000 15,000 12,000 21,000
Required Production 46,000 72,000 85,000 56,000 259,000 73,000
Note : Ending inventory 30% of the following quarter’s sales in units
4th quarter ending inventory is computed from the sales of 1st quarter of the third year’s sale
Beginning inventory of 1st quarter is based on the ending inventory of the previous year which is
given in the question.
Beginning inventory of subsequent quarter is based on the closing inventory of the previous
quarter.
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3. Based on the production budget, raw materials will needed to be purchased during the
year as follows:
Year 2 Quarter Year 3 Quarter

1 2 3 4 Total 1
Required production (units) 46,000 72,000 85,000 56,000 259,000 70,000
Quantity per unit x 5 x 5 x 5 x 5 x 5 x 5
Product needs in Pounds 230,000 360,000 425,000 280,000 1,295,000 35,000
Add desired ending inventory 36,000 42,500 28,000 35,000 35,000
Total inventory needed 266,000 402,500 453,000 315,000 1,330,000
Less beginning inventory 23,000 36,000 42,500 28,000 23,000
Raw material to be purchased 243,000 366,500 410,500 287,000 1,307,000
Ending inventory is equivalent to 10% of the following quarter’s demand.

4th quarter ending inventory is computed on the data of 1 quarter of 3rd year.
Beginning inventory of the first quarter is based on the closing inventory of the previous quarter.
Based on the raw material purchases above, expected cash payments are as follows:
Year 2 Quarter
1 2 3 4 Total
Raw materials to be purchased 243,000 366,500 410,500 287,000 1,307,000
Cost per unit x $0.80 x $0.80 x $0.80 x $0.80 x $0.80
Cost of raw material $ 194,400 293,200 328,400 229,600 1,045,600
Accounts Payable (Beg.) 81,500 81,500

First quarter purchases
($194,400x60%, 40%) 116,640 77,760 194,400
2nd quarter purchases
($293,200x60%, 40%) 175,920 117,280 293,200
3rd quarter purchases
($328,400x60%, 40%) 197,040 131,360 328,400
4th quarter purchases
($229,600 x60%) 137,760 137,760
Total cash requirements $ 198,140 253,680 314,320 269,120 1,035,260
Exercise 34
A cash budget, by quarters, is given below for a retail company in thousands. The company
requires a minimum cash balance of at least $ 5,000 to start each quarter.
Cash Balance, beginning $ 6 $ ? $ ? $ ? $ ?

Add collections from customers ? ? 96 ? 323
Total cash available 71 ? ? ? ?
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Less Disbursements
Purchase of inventory 35 45 ? 35 ?
Operating expenses ? 30 30 ? 113
Equipment purchases 8 8 10 ? 36
Dividends 2 2 2 2 ?
Total disbursements ? 85 ? ? ?
Exces(deficiency) of cash
Available over disbursements (2) ? 11 ? ?
Financing
Borrowings ? 15 - - ?
Repayments (including interest) - - (?) (17) (?)
Total financing ? ? ? ? ?
Cash balance, ending ? ? ? ? ?
Answer 34
Cash Balance, beginning $ 6 $ 5 $ 5 $ 5 $ 6

Add collections from customers 65 70 96 92 323
Total cash available 71 75 101 97 329
Less Disbursements
Purchase of inventory 35 45 48 35 163
Operating expenses 28 30 30 25 113
Equipment purchases 8 8 10 10 36
Dividends 2 2 2 2 8
Total disbursements 73 85 90 72 320
Exces(deficiency) of cash
Available over disbursements (2) (10) 11 25 9
Financing
Borrowings 7 15 - - 22
Repayments (including interest) - - (6) (17) (23)
Total financing 7 15 (6) (17) (1)
Cash balance, ending 5 5 5 8 8
Exercise 35
Pearl Product Ltd. manufactures and exports toys. Three cubic centimeters (cc) of solvent H300
are required to manufacture each unit of Supermix, one of the company’s products. The company
is now planning raw materials need for the third quarter, the quarter in which peak sales of
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Supermix occur. To keep production and sales moving smoothly, the company has the following
inventory requirements.
a) The finished goods inventory on hand at the end of each month must be equal to 3,000
units of supermix plus 20% of the next month’s sales. The finished goods inventory on
June 30 is budgeted to be 10,000 units.
b) The raw materials inventory on hand at the end of each month must be equal to one half
of the following month’s production needs for raw materials. The raw materials inventory
on June 30 is budgeted to be 54,000 cc of solvent H300.
c) The company maintains no work in process inventories.
A sale budget for Supermix for the last six months of the year follows:
Budgeted sales in Units

July 35,000
August 40,000
September 50,000
October 30,000
November 20,000
December 10,000
Required:
1. Prepare a production budget for Supermix for the month July, August, September and
October.
2. 2. Examine the production budget that you prepared. Why will the company produce
more units than it sells in July and August, and less than it sells in September and
October?
3. Prepare a direct material budgets budget showing the quantity of solvent H300 to be
purchased for July, August, September and for the quarter in total.
Answer 35
1. Production Budget
July August September October November December

Sales 35,000 40,000 50,000 30,000 20,000 10,000
Ending Inventory 11,000 13,000 9,000 7,000 5,000
46,000 53,000 59,000 37,000 25,000
Less beginning
Inventory 10,000 11,000 13,000 9,000 7,000
Required Prod. 36,000 42,000 46,000 28,000 18,000
2. Ending Inventory 3,000 units plus 20% of next months sales

3. The entity is producing more in July and August to build inventory to match the higher
level of sale in September and produces less in September because reduced demand in
October.
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Direct Material Budget
July August September October November December

Required Prod 36,000 42,000 46,000 28,000 18,000 10,000
Quantity per unit x 3 x 3 x 3 x 3 x 3
Production
Requirements 108,000 126,000 138,000 84,000 54,000
Add End. Inventory 63,000 69,000 42,000 27,000
Total material needed 171,000 195,000 180,000 111,000
Less beginning
Inventory 54,000 63,000 69,000 42,000
Material Purchased 117,000 132,000 111,000 69,000
Total Purchases = 117,000 + 132,000 + 111,000 = 360,000
Exercise 36
Modern Company is a wholesale distributor of Swiss chocolates. The company’s balance sheet
as of April 30 is given below:
Modern Company
Balance Sheet
April 30
Assets
Cash $ 9,000
Accounts Receivable 54,000
Inventory 30,000
Building and equipment, net of depreciation 207,000
Total Assets 300,000
Liabilities and Stockholder’s Equity
Accounts Payable $ 63,000
Notes Payable 14,500
Capital stock, no par 180,000
Retained earning 42,500
Total liabilities and stockholder’s equity 300,000
The company is in the process of preparing budget data for May. A number of budget items have
already been prepared as stated below:
1. Sales are budgeted at $200,000 for May. Of these sales, $60,000 will be for cash, the
reminder will be credit sales. One half of a month’s credit sales are collected in the month
the sales are made, and the reminder is collected in the following month. All of the April
30 accounts received will be collected in May.
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2. Purchases of inventory are expected to total $120,000 during May. These purchases will
all be on account. Fifty per cent of all purchases are paid for in the month of purchase, the
reminder are paid in the following month. All of the April 30 accounts payable to
suppliers will be paid during May.
3. The May 31 inventory balance is budgeted at $40,000.
4. Operating expenses for May are budgeted at $72,000, exclusive of depreciation. These
expenses will be paid in cash. Depreciation is budgeted at $ 2,000 for the month.
5. The note payable on the April 30 balance sheet will be paid during May, with $100 in
interest (All of the interest relates to May).
6. New refrigerating equipment costing $6,500 will be purchased for cash during May.
7. During May, the company will borrow $20,000 from its bank by giving a new note
payable to the bank for the amount. The new note will be due in one year.
Required :
1. Prepare a cash budget for May. Support your budget with a schedule of expected cash
collections from sales and schedule of expected cash disbursements for merchandise
purchases.
2. Prepare a budgeted income statement for May. Use the absorption costing income
statement format.
3. Prepare a budgeted balance sheet of May 31.
Answer 36
Schedule of Cash Receipts

Collection of Accounts Receivable (April 30) 54,000
Cash Sales for May 60,000
Credit Sales (50% of 140,000) 70,000
Total Cash collection 184,000
Schedule of Cash Payments

Payment of Accounts Payable 63,000
Purchase of Inventory (50% down payment) 60,000
Total Cash Payments 123,000
Cash Budget for the month of May

Cash Balance opening 9,000
Add cash receipts from customers 184,000
Total cash available 193,000
Less disbursements during the month
Payment to suppliers 123,000
Payment of expenses 72,000
Payment of refrigerator 6,500 (201,500)
Excess/shortfall of cash - 8,500
Financing
Payment of note payable - 14,500
Interest on note payable - 100
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Borrowing from Bank 20,000 5,400
Balance (Shortfall) 3,100
Budgeted Income Statement

Sales 200,000
Cost of goods sold
Opening Inventory 30,000
Purchases 120,000
Goods available for sale 150,000
Less closing inventory 40,000 110,000
Gross Margin 90,000
Operating Expenses
Selling & Adm. 72,000
Depreciation 2,000
Interest 100 74,100
Net Income 15,900
Budgeted Balance Sheet

Assets
Accounts Receivable 70,000
Inventory 40,000
Building & Equipment 205,000
Office Equipment 6,500 321,500
Liabilities
Bank Balance (Cr.) 3,100
Accounts Payable 60,000
Notes Payable (Bank Loan) 20,000
Capital Stock 180,000
Retained Earning 58,400
Total Liabilities & Owner’s Equity 321,500
Exercise 37
M/s Modern Garment is ready to begin its third quarter in which peak sales occur. The company
has requested a $40,000, 90 days loan from its bank to help meet cash requirements during the
quarter. Since the company has experienced difficulty in paying off its loan in the past, the loan
officer at the bank has asked the company to prepare a cash budget for the quarter. In response to
the bank’s requirement the following data have been assembled.
a. On July 1, the beginning of the third quarter the following will have a cash balance of
$44,500.
b. Actual sales for the last two months and budgeted sales for the third quarter follow (all
sales are on account).
May (actual) $ 250,000
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June (actual) 300,000
July (budgeted) 400,000
August (budgeted) 600,000
September (budgeted) 320,000
Past experience shows that 25% of a month’s sales are collected in the month of sale,
70% in the month following sale, and 3% in the second month following sale. The
reminder is uncollectable.
c. Budgeted merchandise purchases and budgeted expenses for the third quarter are
given below:
Merchandise purchases $ 240,000 $ 250,000 $ 175,000

Salaries and wages 45,000 50,000 40,000
Advertising 130,000 145,000 80,000
Rent payments 9,000 9,000 9,000
Depreciation 10,000 10,000 10,000
Merchandise purchases are paid in full during the month following purchase. Accounts
payable for merchandise purchase on June 30, which will be paid during July, total
$180,000.
d. Equipment costing $10,000 will be purchased for cash during July.
e. In preparing the cash budget, assume that the $40,000 loan will be made in July and
repaid in September. Interest on the loan will total $1,200.
Required:
1. Prepare a schedule of expected cash collections for July, August and September and
for quarter in total.
2. Prepare a cash a cash budget, by month and in total for the third quarter.
3. If the company needs a minimum cash balance of $ 20,000 to start each month can
the loan be repaid as planned?
Answer 37
Schedule of Cash Collections

July August September
Accounts Receivable
May 3% 250,000 7,500
June 70%, 3% 300,000 210,000 9,000
Sale for July (25%, 70%, 3%) 400,000 100,000 280,000 12,000
Sale for August 600,000 150,000 420,000
Sale for September 320,000 80,000
Total Cash collections 317,500 439,000 512,000
Cash Budget Month

July August September
Cash Balance – Opening 44,500 28,000 23,000
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Add collections during the month 317,500 439,000 512,000
Total cash available 362,000 467,000 535,000
Less Cash disbursement

Payment for Accounts Payable for June 180,000
Payment for purchases 240,000 350,000
Salaries and Wages 45,000 50,000 40,000
Advertising 130,000 145,000 80,000
Rent Payments 9,000 9,000 9,000
Purchase of Equipments 10,000 - -
Total Cash disbursements 374,000 444,000 479,000
Excess / Shortfall of cash -12,000 23,000 56,000
Financing
Bank Loan 40,000
Repayment
Total Financing 40,000 - -41,200
Cash Balance Closing 28,000 23,000 14,800
Exercise 38
Hero Cycle Co. has prepared the following incomplete flexible budget:
Standard Direct Labour Hours

Manufacturing overhead Rate per hour 20,000 24,000 28,000 32,000
Variable Costs
Indirect labour $ 45,000
Maintenance 64,200
Utilities 30,800
Total 140,000
Fixed Costs
Supervisory salaries 52,000
Rent 32,000
Insurance 14,500
Depreciation 48,500
Total 147,000
Total manufacturing overhead 287.000

Required:
Complete the flexible budget
Answer 38
Standard Direct Labour Hours
Manufacturing overhead Rate per hour 20,000 24,000 28,000 32,000
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Variable Costs
Indirect labour $ 2.25 $ 45,000 54,000 63,000 72,000
Maintenance 3.21 64,200 77,040 89,880 102,720
Utilities 1.54 30,800 36,960 43,120 49,280
Total 140,000 168,000 196,000 224,000
Fixed Costs
Supervisory salaries 52,000 52,000 52,000 52,000
Rent 32,000 32,000 32,000 32,000
Insurance 14,500 14,500 14,500 14,500
Depreciation 48,500 48,500 48,500 48,500
Total 147,000 147,000 147,000 147,000
Total manufacturing overhead 287.000 315,000 343,000 371,000
Note
Rate computation variable cost = $ 45,000/20,000, 64,200/20,000, 30,800/20,000
Fixed cost will remain unchanged for all the three levels of production unless additional fixed
cost is needed for additional level.
Exercise 39
M/s Burns Food Co. produces special Beryani pack for lunch. The firm uses flexible budget for
planning and controlling costs. Below are budget and actual production data for the previous
year.
Budgeted Budgeted Actual
Number of packs 70,000 90,000 82,500
Supervision $30,000 $38,000 $73,500
Materials 28,000 36,000 33,500
Maintenance 9,000 11,000 11,000
Depreciation 18,000 18,000 18,000
Utilities 7,000 9,000 8,500
Required :
c. Determine the cost behavior pattern for each mixed cost.
d. Prepare a flexible budget performance report for the last year.
Answer 39
By using high and low method variable and fixed cost is segregated as under.
Supervision = 38,000 – 30,000/(90,000 – 70,000) = $0.40 variable cost rate

Fixed cost = 38,000 – 90,000 (0.40) = $ 2,000
Materials = 36,000 - 28,000/(90,000 – 70,000) = $0.40 variable cost rate

Fixed cost = 36,000 – 90,000(0.40) = 0
92
Maintenance = 11,000 – 9,000 /(90,000 – 70,000) = 0.10 variable cost rate
Fixed cost = 11,000 – 90,000(0.10) = $ 2,000
Utilities = 9,000 - 7,000/(90,000 – 70,000) = 0.10 variable cost rate

Fixed cost = 9,000 – 90,000(0.10) = 0
Burns Food Company

Flexible Overhead Budget
Cost Variable cost Fixed

Supervision $ 0.40 $ 2,000
Materials 0.40 -0-
Maintenance 0.10 2,000
Depreciation -0- 18,000
Utilities 0.10 -0-
Burns Food Company

Flexible Budget Report
Budgeted Actual Variance
Number of Packs 82,500 82,500
Costs
Supervision $35,000 73,500 $ 38,500 U
Material $ 33,000 33,500 500 U
Maintenance 10,250 11,000 750 U
Depreciation 18,000 18,000 -0-
Utilities 8,250 8,500 250 U
Computation :
Supervision (82,500 x 0.40) + 2,000 = $35,000
Material (82,500 x 0.40) + 0 = $33,000
Maintenance (82,500 x 0.10) + 2,000 = $10,250
Utilities (82,500 x 0.10) + 0 = $8,250
Exercise 40
M/s Gold Company provides the following budget that were prepared at the beginning of the
year. Budgeted capacity was set at 20,000 units.
20,000 units 27,500 units
Direct materials $30,000 $41,250
Direct labour 22,000 30,250
Factory utilities 60,000 82,500
Sales Promotion 10,000 13,750
Production supervision salaries 12,000 12,000
Marketing Manager’s salary 8,000 8,000
93
Administration salaries 32,000 32,000
Total 174,000 219,750
At the end of the month, analysis of the cost record reveals that Gold incurred the following costs
and expenses for producing and selling 21,600 units.
Direct materials $ 33,000

Factory utilities 64,900
Production supervisor salaries 12,500
Sales Promotion 11,300
Marketing manager salary 7,800
Administrative salaries 32,700
Total 187,300
Required :
a. Determine the flexible budget formula for all expenses, expressing variable cost on per
unit basis.
b. Compute the factory overhead application rate.
c. Determine variances for each line item using a flexible budget, indicating whether the
variances are favourable or unfavourable.
Answer 40
Fixed cost
Production Supervisor’s salary $ 12,000
Marketing Manager’s salary 8,000
Administrative salaries 32,000
Total fixed cost 52,000
Variable cost
Direct material ($30,000/20,000 = $ 1.50)
Direct labour ($22,000/20,000 = $ 1.10)
Factory utilities ($60,000/20,000 = $ 3.00)
Sales Promotion ($10,000/20,000 = $ 0.50)
Total variable cost $ 6.10
b. Flexible budget formula = $ 6.10 per unit Fixed cost $ 52,000
c.
Actual cost Budget for 21,600 units Variance
Direct material $ 33,000 32,400 ($1.50 x 21,600) $ 600 U
Direct labour 25,100 23,760 ($1.10 x 21,600) $ 1,340 U
Factory Utilities 64,900 64,800 ($3.00 x 21,600) $ 100 U
Production Supervisor 12,500 12,000 $ 500 U
Sales Promotion 11,300 10,800 ($0.50 x 21,600) $ 500 U
94
Market Manager’s S. 7,800 8,000 $ 200 F
Administrative Sal. 32,700 32,000 $ 700 U
Total 187,300 183,760 3,540 U
Exercise 40
In the first quarter of 2006, Griffin Manufacturing Company projects its sales in units to be as
follow:
January 3,270
February 2,965
March 3,315
In addition, it desires to have the following units of finished goods inventory in hand:
January 1 2,975
January 31 2,705
February 2,650
March 3,000
Required : Prepare a production budget for the first quarter 2006.
Answer 40
Production Budget
Griffin Manufacturing Co.
January February March

Sales $ 3,270 2,965 3,315
Add Ending Inventory 2,705 2,650 3,000
Total production 5,975 5,615 6,315
Less Beginning Inventory 2,975 2,705 2,650
Required Production 3,000 2,910 3,665
Exercise 41
The Pelican Company provided the following information from their annual budget for 2003.
Products Expected Sales Estimated Sale Required material

Price Per unit Per unit
A B
Tribolite 80,000 $ 1.80 1 kg 2 kg
Polycal 40,000 2.00 2 kg -
Power X 100,000 0.80 - 1 kg
Estimated inventories at the beginning and desired quantities at the end of the year :
Material Beginning Ending Purchase Price

Per Kg
95
A 10,000 kg 12,000 kg $ 0.20
B 12,000 kg 15,000 kg $ 0.10
Product Beginning Ending Direct labour hours

Per 1,000 units
Tribolite 5,000 6,000 50
Polycal 4,000 2,000 125
Power X 10,000 8,000 12.5
The direct labour cost is budgeted as $ 8 per hour and variable factory overhead at $ 6.00 per
hour of direct labour. Fixed factory overhead, estimated to be $ 40,000, is a common cost and is
not allocated to specific products in developing the manufacturing budget for internal
management use.
Required :
1. Prepare a production Budget.
2. Prepare a purchase budget for each material.
3. Prepare a budget of manufacturing costs by products and in total.
Answer 41
Production Budget
Tribolite Polycal Power X

Budgeted Sales 80,000 40,000 100,000
Add ending inventory 6,000 2,000 8,000
Total units required 86,000 42,000 108,000
Less beginning inventory 5,000 4,000 10,000
Purchase Budget – Material A

Required material per unit x 1 kg x 2 kg -
Required material 81,000 kg 76,000 kg -
Total material required 81,000 + 76,000 = 157,000 kg
Add ending inventory 12,000
169,000
Less beginning inventory 10,000
Material to be purchased 159,000
Rate per kg $ 0.20
Budgeted purchased Price $ 31,800
96
Purchase Budget – Material B
Required material per unit x 2 kg - x 1 kg
Required material 162,000 kg - 98,000
Total material required 162,000 + 98,000 = 260,000 kg
Add ending inventory 15,000
275,000
Less beginning inventory 12,000
Material to be purchased 263,000
Rate per kg $ 0.10
Budgeted purchased Price $ 26,300
Manufacturing Budget
Material A (81,000 x 1 x 0.20) $ 16,200
(38,000 x 2 x 0.20) 15,200 $ 31,400
Material B (81,000 x 2 x $0.10) 16,200
(98,000 x 1 x $0.10) 9,800 26,000 $ 57,400
Direct labour
Tribolite 81 x 50 hr x $8 = 32,400
Polycal 38 x 125 hr x $8 = 38,000
Power X 98 x 12.5 hr x $8 = 9,800 80,200
Variable 81 x 50 hr x $6 = 24,300
38 x 125 hr x $6 = 28,500
98 x 12.5 hr x $6 = 7,350
60,150
Fixed Manufacturing overhead 40,000 100,150
Total manufacturing cost 237,750
Note : For Manufacturing budget actual material required for production is taken into account to
compute the total manufacturing cost.
Exercise 42
Karen Vance is a highly successful attorney specializing in automobile insurance claims

settlements. She has a staff consisting of four attorneys and three clerical workers. The staff
attorneys are paid $ 4,000 per month and the clerical workers are paid $1,400. Other operating
expenses are fixed at $ 9,800 per month. Ms. Vance charges her clients based on the number of
hours worked. The fee structure is as follows:
Charges per hour

K. Vance $ 90.00
Staff attorneys 60.00
Clerical Staff 16.00
97
Ms. Vance’s practice has been seasonal in the past. Due to snow and ice during the winter, a
dramatic increase in automobile accidents occurs from November to February. Below is an
analysis of the average hours charged to clients per month.
November – February March – October

K. Vance 160 hrs 100 hrs each
Staff attorneys 170 hrs each 110 hrs each
Clerical staff 150 hrs each 80 hrs each
Required :
Prepare an annual budget of revenue and expenses for the law firm. Separate the budget into
quarter periods and summarize the result in annual budget.
Answer 42
Karen Vance, Attorney at Law

Schedule for Annual Budget
Revenue
1st Quarter 2th Quarter
Jan Feb Mar Total April May June
K. Vance 160 160 100 420 100 100 100 300
Charges per hr. $ 90 $ 90
$37,800 $27,000
3rd Quarter 4th Quarter

July Aug Spt. Total Oct. Nov. Dec. Total
100 100 100 300 100 160 160 420
$ 90 $ 90
$27,000 $ 37,800
Total = $37,800 + 27,000 + 27,000 + 37,800 = $ 129,600
Staff Attorney (4) 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Hours 1,800 1,320 1,320 1.800
Rate $ 60 $ 60 $ 60 $ 60
$ 108,000 $79,200 $79,200 $108,000
Total $ 108,000 + 79,200 + 79,200 + 108,000 = $ 374,400
Attorney hours = 1st quarter 170 + 170 + 100 = 450 x 4 = 1,800 hrs
Rest may be calculated in the same way
98
Clerical Staff (4) 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Hours 1,140 720 720 1.140
Rate $ 16 $ 16 $ 16 $ 16
$ 18,240 $11,520 $11,520 $18,240
Total $ 18,240 + 11,520 + 11,520 + 18,240 = $ 59,520
Staff hours = 1st quarter 150 + 150 + 80 = 380 x 3 = 1,140 hrs

Rest may be calculated in the same way
Expenses
Salaries
Attorneys 4 x $ 4,000 x 4 = $ 64,000
Clerical Staff 3 x $ 1,400 x 4 = $ 16,800
Operating Expenses $ 9,800 x 4 = $ 39,200
Karen Vance Attorney At Law

Annual Budget of Revenue and Expenses
1st 2nd 3rd 4th Total

Revenue
Karen Vance $37,800 27,000 27,000 37,800 129,600
Staff Attorney 108,000 79,200 79,200 108,000 374,400
Clerical Staff 18,240 11,520 11,520 18,240 59,520
Total Revenue 164,040 117,720 117,720 164,040 563,520
Expenses
Salaries
Attorneys 16,000 16,000 16,000 16,000 64,000
Clerical Staff 4,200 4,200 4,200 4,200 16,800
Operating Expenses 9,800 9,800 9,800 9,800 39,200
Total expenses 30,000 30,000 30,000 30,000 120,000
Net Income 134,040 87,720 87,720 134,040 443.520
99
CHAPTER VIII
STANDARD COST AND ANALYSIS OF VARIANCES
A standard is a benchmark for measuring performances. Standards are observed everywhere. In

manufacturing and service institutions standards are set for each major input such as raw
materials and labour time. The performance thereafter is evaluated by comparing the actual
results with the predetermined standards. If either the quantity or price or other inputs departs
significantly from the standards, managers investigate the discrepancy to find out the cause of
the problem and eliminate it. This process is called management by exception.
Ideal versus Practical Standards
Ideal Standards can be defined as a standard which can be attained only under the best
circumstances. They allow for no machine break down or any other work interruptions, and they
call for a level of effort that can be attained only by the most skilled and efficient employees
working at peak effort 100% of the time.
Practical Standards are standards that are “tight but attainable”. They allow for normal machine
downtime and employee rest periods and they can be attained through reasonable though highly
efficient, efforts by the average workers. In real life ideal standards cannot be used for practical
applications, because they do not allow for normal inefficiencies and result in unrealistic
forecasts.
Standard cost system have a number of advantages.
1. Standard costs are a key element in a management by exception approach. If costs

conform to the standards, managers can focus on other issues. When costs are
significantly outside the standards, managers investigate the causes for that problem. This
approach helps them to focus on important issues.
2. Standards that are viewed as reasonable by employees can promote economy and
efficiency in the working.
3. Standard costs can greatly simplify bookkeeping. Instead of recording actual costs for
each job, the standard costs for direct materials, direct labour and factory overhead can be
charged to jobs.
4. Standard costs fit naturally in an integrated system of “responsibility accounting”.
Material Variance
Material variance comprises of two components. i) Material Price Variance. It evaluates the
actual unit price paid for an item and the standard price, multiplied by the quantity purchased. ii)
Material quantity variance. The difference between the actual quantity of material used in
production and the standard quantity allowed for the actual output, multiplied by the standard
price per unit of materials.
100
(1) (2) (3)
Actual Quantity Actual Quantity Standard Quantity
of input in put allowed for actual output
at actual price at standard price at standard price
(AQ x AP) (AQ x SP) (SQ x SP)
│ │ │
│ Price Variance │ Quantity Variance │
│ (1) - (2) │ (2) - (3) │
│ │ │
│ │ │
The above working can be presented with the help of the following equation.
Material Price Variance = (AQ x AP) – (AQ x SP) = AQ (AP – SP)

Material Quantity Variance = (AQ x SP) - (SQ x SP) = SP (AQ – SQ)
Labour Variance
Another important variance is termed as labour variance. The labour rate variance measures any
deviation from standard in the average hourly rate paid to direct labour workers. The labour
efficiency variance attempts to measure the productivity of direct labour. The management,
therefore, keenly watches these variances because they believe that increasing direct labour
productivity is vital to reducing cost.
(1) (2) (3)

Actual Hours Actual Hours Standard Hours
at actual Rate at standard rate at standard rate
(AH x AR) (AH x SR) (SH x SR)
│ │ │
│ Rate Variance │ Efficiency Variance │
│ (1) - (2) │ (2) - (3) │
│ │ │
│ │ │
The equation for the labour rate variance and labour efficiency variance is expressed as follows:
Labour Rate Variance = (AH x AR) – (AH x SR) = AH (AR - SR)

Labour Efficiency Variance = (AH x SR) - (SH x SR) = SR (AH - SH)
101
Variable Manufacturing Overhead Variance
The variable portion of manufacturing overhead can also be analyzed using the same basic
formula as direct material variance and direct labour variance. The variances are, however,
termed as variable overhead spending variance and variable overhead efficiency variance.
(1) (2) (3)

│ │ │
│ Spending Variance │ Efficiency Variance │
│ (1) - (2) │ (2) - (3) │
│ │ │
│ │ │
Variable Overhead Spending Variance = (AH x AR) – (AH x SR) = AH (AR - SR)
Variable Overhead Efficiency Variance = (AH x SR) - (SH x SR) = SR (AH - SH)
Other Variances (Formula):
The undernoted variances are helpful in computing variances relating to sales volume, selling
price variance and variable volume variance in order assess the operating performance of an
entity.
Sale Volume Variance (Actual Sales in units - Budgeted Sales in units) x

Budgeted variable margin
Selling Price Variance (Actual Selling Price - Budgeted Selling Price) x

Actual Units Sold
Variable Volume Variance Actual Cost per Unit - Budgeted Cost per Unit) x
Actual units sold
1. A basic objective of standard costing is to:

a) Determine the breakeven production level.
b) Control costs.
c) Eliminate the need for subjective decision by management.
d) Allocate cost more accurately.
102
2. In standard costing standard hours allowed is a mean of measuring:
a) Standard output at standard hours
b) Actual output at standard hours
c) Standard hours at actual hours
d) Actual output at actual hours.
3. Material price variance is:

a) (Actual quantity – Standard quantity) x Actual price
b) (Actual quantity – Standard quantity) x Standard Price
c) (Actual price – Standard price) x Standard quantity
d) (Actual price – Standard price) x Actual quantity
4. Labour rate variance:

a) (Actual hours – Standard hours) x Actual rate
b) (Actual hours – Standard hours) x Standard rate
c) (Actual rate – Standard rate) x Standard hours
d) (Actual rate – Standard rate) x Actual hours
5. In standard costing when FOH are applied to the production:

a) FOH applied is debited and WIP is credited
b) FOH applied is credited and WIP is debited
c) FOH control is debited and cost of goods sold is credited
6. Standard is an important tool for:

a) Cost control
b) Pricing
c) Price regulation
7. Managerial cost includes the discussion on:

a) Cost volume profit analysis
b) Breakeven analysis
c) Both of the above two
d) None of the above.
8. Internal financial control methods include:

a) Internal check
b) Internal audit
c) Internal check as well as internal audit
9. The type of cost presented to management for elimination of a product line should be
limited to:
a) Relevant costs
b) Standard costs
103
c) Controllable costs
d) Conversion costs
10. An understatement of work in process inventory at the end of a period will:

a) Understate cost of goods manufactured in that period.
b) Overstate current assets.
c) Overstate goods profit from sales in that period.
d) Understate income for that period.
Understatement of work in process inventory will increase the cost of goods

manufactured which in turn will increase the cost of finished goods ending inventory. An
increase in cost of goods ending inventory will reduce cost of goods sold and increase the
profit of the entity.
Answers :
1 (b), 2(b), 3(d), 4(d), 5(b), 6(a), 7(c), 8(c), 9(a), 10(b)(c)
Exercise 43
M/s X Company produces a single product. Variable manufacturing overhead is applied to

products on the basis of direct labour hours. The standard costs for one unit of product are as
follows:
Direct material 6 ounces at $0.50 per ounce $ 3

Direct labour 1.8 hours at $ 10 18
Variable manufacturing ovherad 1.8 hours at $ 5 per hr. 9
Total standard variable cost per unit $30
During June, 2000 units were produced. The costs associated with June’s operations were as
follow:
Material purchased 18,000 ounces at $ 0.60 per ounce $ 10,800

Material used in production 14,000 oz
Direct labour 4,000 hours at $9.75 per hours $ 39,000
Variable manufacturing overhead costs incurred $ 20,800
Required : Compute the direct materials, direct labour and variable manufacturing overhead
variances.
104
Answer 43
Direct material Variance
(1) (2) (3)

Actual Quantity Actual Quantity Standard Quantity
at actual price at standard price at standard price
(AQ x AP) (AQ x SP) (SQ x SP)
18,000 x $0.60 18,000 x $0.50 12,000 x $ 0.50
= $10,800 = $ 9,000 = $ 6,000
│ │ │
│ Price Variance │ Quantity Variance │
│ (1) - (2) │ (2) - (3) │
│$10,800 – 9,000 = 1,800U │ │
│ │ │
14,000 x $ 0.50 = 7,000 │
│ │
│ │
│$ 7,000 – 6,000 = 1,000 U │
│Quantity variance │
Standard quantity = 6 ounce x 2,000 units = 12,000 ounce
Using the formula the material variance can be computed as follows:
Material price variance = AQ (AP – SP)

18,000 ($0.60 – $0.50) = $ 1,800 U
Material quantity variance = SP(AQ - SQ)

$0.50 (14,000 – 12,000) = $ 1,000 U
Note : While computing quantity variance, actual quantity consumed is used and not actual
quantity purchased.
105
Direct Labour Variance
(1) (2) (3)
4,000 hrs x $ 9.75 4,000 hrs x $10.00 3,600 hrs x $ 10.00
= $39,000 = $40,000 $ 36,000
│ │ │
│ Rate Variance │ Efficiency Variance │
│ (1) - (2) │ (2) - (3) │
│ $1,000 F │ $4,000 U │
│ │ │
The formula for the labour rate variance and efficiency variance is expressed as follows:
Labour Rate Variance = AH (AR - SR)

4,000 ($9.75 - $10.00)
$ 1,000 F
Labour Efficiency Variance = SR(AH - SH)

$10.00 (4,000 – 3,600)
$4,000 U
Total units produced = 2,000 units

Actual hours used 4,000 hrs.
Actual hours per unit 4,000/2,000 = 2 hr per unit
Standard hours per unit 1.8 hrs (given)
Permissible standard hours 2,000 x 1.8 = 3,600 hrs
Variable Manufacturing Overhead Variance
(1) (2) (3)

4,000 x $5.2 4,000 x $ 5 3,600 x $ 5
=$ 20,800 $20,000 $18,000
│ │ │
│ Spending Variance │ Efficiency Variance │
│ (1) - (2) │ (2) - (3) │
│ $ 800 U │ $ 2,000 U │
│ │ │
106
Using the formulas the variable manufacturing overhead variance would be computed as follows:
Variable overhead spending variance = AH (AR – SR)

4,000 ($5.20 - $5.00) = $ 800 U
Variable overhead efficiency variance = SR (AH – SH)
$ 5.00 (4,000 hrs – 3,600 hrs) = 2,000 U
Actual hours used 4,000

Variable manufacturing cost incurred $20,800
Actual variable manufacturing rate $20,800/4,000 = $5.2
Exercise 44
Wales Ice Cream Ltd. makes premium handcrafted chocolates. The owner of the company is
setting up a standard cost system and has collected the following data for one of the company’s
products, Chocolate Brand. This product is made with the fine white chocolate and various
fillings. The data below pertain only to the white chocolate used in the product.
Material requirements, kilograms of white chocolate per dozen 0.70 kilograms

Allowance for waste, kilograms of white chocolate per dozen 0.03 kilograms
Allowance for rejections, kilograms of white chocolate per dozen 0.02 kilograms
Purchase price, finest grade white chocolate $ 7.50 per kilograms
Purchase discount 8% of purchase price
Shipping cost from the supplier $0.30 per kilogram
Receiving and handling cost $0.04 per kilogram
Required :
1. Determine the standard price of a kilogram of white chocolate.
2. Determine the standard quantity of white chocolate for a dozen pack.
3. Determine the standard cost of the white chocolate in a dozen pack.
Answer 44
Standard Price of a kilogram white chocolate

Material $ 7.50
Less discount @ 8% 0.60
Net material cost 6.90
Shipping cost 0.30
Receiving and handling cost 0.04
Standard Price per kg. $ 7.24
Standard Quantity for a dozen pack
Material 0.70 kg
107
Allowance for wastage 0.03
Allowance for rejection 0.02
Standard Quantity for a dozen pack 0.75 kg
Standard Cost per dozen pack
Standard Price x Standard Quantity

$ 7.24 x $ 0.75 = $ 5.43
Exercise 45
Fuji toys Ltd. produces toys. The company has recently established a standard cost system to
help control costs and has established the following standards for the manufacture of a new
series of toys:
Direct materials 6 microns per toy @ $0.50 per micron

Direct labour 1.3 hours per toy at $ 8 per hour
During July, the company produced 3,000 toys. Production data for the month on the toy
follows:
Direct material : 25,000 microns were purchased at a cost of $ 0.48 per micron. 5,000 of these
microns were still in inventory at the end of the month.
Direct labour: 4,000 direct labour hours were worked at a cost of $36,000.
Required
1. Compue the following variances for July:
a. Direct materials price and quantity variances.
b. Direct labour rate and efficiency variances.
2. Prepare a brief explanation of the possible cause of each variance.
Answer 45
a. Material Price variance

AQ (AP - SP)
25,000 ($0.48 – $0.50) = $ 500 F
Material Quantity variance
SP (AQ – SQ)
$0.50 (20,000 – 18,000) = $ 1,000 U
Total material variance

$ 500 F - $1,000 U = $ 500 U
108
Note : While calculating material price variance, the entire quantity purchased is taken for
computation of variance. While computing quantity variance, the quantity actually consumed is
considered for computing the variance.
Standard quantity = 3,000 toys x 6 microns per toy = 18,000 microns
b. Direct labour variance

AH (AR – SR)
4,000 ($9 - $8) = $4,000 U
SR (AH – SH)
$8 (4,000 – 3,900) = $ 800 U
Total labour variance

$4,000 U + $800 U = $4,800 U
2. The manufacturing department could not achieve the standards both in respect of material as
well as for labour. As for as material variance, the quantity consumed was higher than the
specified standard. However, the variance was low. Whereas in case of labour the actual hours
used as well as the rate for hiring the labour was unfavourable from the approved standard. The
unfavour variance of the labour must be investigated to control the high level of inefficiency or it
should be revised to an attainable level.
Exercise 46
Bell Corporation has decided to accumulate standard costs, in addition to actual costs, for the
next accounting period (Year 2010). The following data have been collected:
Projected Production for 2010 – 30,000 units direct materials, required to produce one unit 2
tons. Price per ton of direct materials based on annual order of:
1 – 25,000 tons $ 200 per ton

25,000 – 50,000 tons $ 190 per ton
50,000 – 74,000 tons $ 185 per ton
Direct labour requirements

Shaping time per ton 3 hours
Welding time per ton 10 hours
Average rate per hour for:

Shaper $ 11
Welders $ 15
Factory overhead is applied on direct labours:
Budgeted variable overhead $120,000
Budgeted fixed overhead 57,600
Bell Corporation uses a process cost system to accumulate costs.
109
Required :
a. Calculate the following standards
1. Direct material price per unit
2. Direct materials efficiency per unit
3. Direct labour price per hour
4. Direct labour efficiency per unit
5. Variable factory overhead application rate per direct labour hours.
6. Fixed factory overhead application rate per direct labour hour.
b. Complete the total standard cost per unit.
Answer 45
a.1 Standard Direct material

30,000 units x 2 tons per pound = 60,000 tons
Per ton unit price as the basis of annual purchase of 60,000 tons falls in the
range 50,000 – 75,000 tons at the rate of $ 185 per ton.
Direct material price per unit = $ 185 per ton x 2 = $370
a.2 Direct material efficiency per ton

Required material per unit = 2 Tons
Required material = 2 x 30,000 units = 6,000 tons
a.3 Direct labour price per standard hr

Shaping 3 hrs x 2 tons @ $ 11 = $ 66
Welding 10 hrs x 2 tons @ $ 15 300
Total labour cost per unit 366
Total hours 26 hrs**
Rate per standard hour 366/26 = $ 14.07
a.4 Direct efficiency labour per unit

Shaping per unit (3 hr x 2 tons) 6 hours
Welding (10 hrs x 2 tons) 20 hours
Total 26 hours**
a.5 Variable factory overhead application rate:

Shaping (30,000 units x 2tons x 3 hrs) 180,000 hrs
Welding (30,000 units x 2 tons x 10) 600,000 hrs
Total 780,000 hrs
Budgeted variable overhead $120,000
Standard Rate 120,000/780,000 hrs = $ 0.154 per hour
Fixed factory overhead $ 57,600

Stand Rate per unit 57,600/780,000 = $ 0.07
110
b. Total Standard cost per unit
Direct material ($ 185 x 2) $ 370.00
Direct labour ($14.07 x 26 hrs) 365.82
Factory overhead
Variable ( $ 0.154 x 26 hrs) 4.00
Fixed Factory overhead ($0.07 x 26) 1.82
Total Standard price 741.64
111
CHAPTER IX
DECISION MAKING BASED ON RELEVANT INFORMATION
Managers at different levels of an organization make decisions continuously as they plan

activities, organize resources, direct operations and control performance. Decision making
involves a choice between alternative courses of actions, and that choice is usually made on the
basis of some measure of profitability or cost savings. Examples of management decisions are:
What product to produce?

How to produce them?
How to sell them?
What prices to charge?
Where to buy raw materials?
When to replace equipment?
How to allocate scarce resources?
Whether to expand production capacity?
In the normal course, the quality of decision making depends on the quality of the information
available for the decision making. Good information typically leads to correct decisions and
therefore, leads to desired results. In contrast, incomplete information usually leads to incorrect
decisions and undesirable results.
Use of Differential Analysis
Differential analysis, or incremental analysis, is a decision model that can be used to evaluate the
differences in costs and revenues associated with alternative courses of action. The costs
considered in differential analysis are not necessarily those used in conventional financial
reporting. For decision making purposes, relevant costs, differential costs, unavoidable costs,
sunk costs and opportunity costs are important factors that needed consideration.
Costs Relevant to Decision Making
Relevant costs are the expected future costs that will differ between the alternatives being
considered in decision making. The difference between the relevant costs of two or more
alternative is called differential costs. For example if a manager is deciding which of the two
generators to buy if they carry same price tag, the amount of fuel consumption and maintenance
cost of each generators is the relevant cost factor that should be considered. A comparison of
relevant cost shall help to make the correct decision in selection of the equipment.
Similarly sunk costs are not relevant in decision making because they already have been incurred
and cannot be changed. An example of a sunk cost is the book value of a machine that a business
considering to replace. Assume that the machine does not have any residual value. If it is
replaced, its book value will be written off in the period of the disposal. If it is kept, the same
amount will be depreciated over the remaining life of the asset. In either event, the book value
will be expensed out, so it is sunk cost that is irrelevant.
112
An opportunity cost is the benefit forfeited by rejecting one alternative while accepting another.
Opportunity costs are not found in the general ledger, but they are considered either formally or
informally when most decisions are made. For example, if a student decides to attend summer
school instead of accepting a job that will pay $ 2,400, the true cost of attending school is more
than just books, tuition, meals and conveyance. The opportunity cost of $2,400 must be added to
these costs to determine the true costs of making the decision to attend the summer school.
Joint Processing cost. A joint production is one in which the processing of a common input
results in two or more distinct products known as joint products. A special decision that
commonly arises in the context of the joint process is the decision whether or not to process
further one of the joint products into a different product. The proper approach for making this
type of decision is the compute the incremental benefits from further processing with the
incremental costs.
The allocated joint processing costs are irrelevant when making a decision as to whether a joint
product should be sold at the split off point or processed further. The total joint cost will not
change as a result of the decision to process further, and therefore it is irrelevant to the decision.
The proper approach to making a production decision when limited resources are involved is to
maximize production of the product that has the highest contribution margin per unit of scarce
resource.
The contribution margin per unit of scarce resource is a producer’s unit contribution margin
divided by the number of units of the scarce resource required to produce one unit of the product.
For example, if a product’s contribution margin per unit is Rs.5 and it requires two hours of
labour to produce one unit, the contribution margin per direct labour hour is Rs. 2.50.
1. Which of the following to income measurement is an extremely useful tool for selecting
the best source of action in a non-routine decision problem?
a. The contribution approach c) Book keeping
b. Depreciation d) Job costing
2. There are three primary approaches to alternative choice problems. They are the total
project approach, the opportunity cost approach and;
a. The process cost c) Incremental (differential) cost approach
b. The unit cost d) The cost of goods sold
3. Which of the following in a decision are expected future costs that differ between the
alternatives being considered?
a. Relevant costs c) Total cost
b. Sunk costs d) Joint cost
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4. A sunk cost is___________________in alternative choice problems.
a. Relevant c) Future cost
b. Irrelevant d) None of the above
5. The contribution approach to pricing or the variable pricing model is:

a) Method of total product cost c) Method of inventory valuation
b) Method of pricing special orders d) None of the above
6. Make-or-buy decisions depend on both qualitative factor and:

a) Quantitative factors c) Political factors
b) Internal factors d) None of the above
7. It is the stage of production at which the different joint product are individually
recognized.
a) Work in process c) Split off point
b) Selling point d) All of the above
8. _____________is irrelevant in the sell or process further decision.

a) Joint cost c) Variable cost
b) Total cost d) None of the above
9. When there are two or more products with limited capacity, the way to maximize total
contribution margin of a firm is to manufacture the product.
a) With the lowest contribution margin per unit of that limited capacity.
b) With the highest contribution margin per unit of that limited capacity.
c) With the highest total cost.
d) All of the above.
10. It will always be profitable to process joint products beyond the split off point as long as:
a. The incremental revenue from such processing exceeds of the incremental costs.
b. The incremental cost from such processing exceeds the incremental revenue.
c. The incremental revenue from such processing equals the incremental costs.
d. None of the above.
11. The final decision as to whether to keep an old product line depends primarily on the
impact the decision will have on the incremental revenue:
a. True
b. False
c. None of the above
12. The book value of old equipment is irrelevant for future replacement decisions:
a. True
b. False
c. None of the above.
114
13. Fixed costs are always irrelevant, whereas variable costs are relevant.
a. True
b. False
c. None of the above.
14. An avoidable cost is the same as a sunk cost:

a. True
b. False
c. None of the above
15. Which of the following is a fixed cost which results from decisions of prior period? The
amount of committed cost is fixed by decisions which are made in the past and is not
subject to managerial control in the present on a short run basis. Example of committed
cost are depreciation, insurance premium, rent etc.
a) Future costs c) Opportunity cost
b) Committed cost d) Variable cost
16. This is the specific costs of an activity or sector of a business which would be avoided if
that activity or section did not exist.
a) Avoidable cost c) Joint cost
b) Indirect cost d) Direct cost
17. This the cost of one unit of product or service which would be avoided if that unit were
not produced or provided.
a) Marginal cost c) Estimated cost
b) Prime cost d) Conversion cost
18. This is the cost of ensuring and assuring quality, as well as loss incurred when quality is
not achieved. Quality costs are classified as prevention cost, appraisal cost, internal
failure cost and external failure cost.
a) Historical costs c) Quality related cost
b) Replacement cost d) Standard cost
19. It is “costs appropriate to a specific management decision”.

a) Production costs c) Product cost
b) Joint cost d) Relevant costs
20. It is “tangible and intangible costs and losses sustained by third parties or the general
public as a result of economic activity, e.g. pollution by industrial effluent.”
a) Conversion costs c) Social Responsibility cost
b) Replacement cost d) Prime cost
Answers
1 (a), 2 (c), 3(a), 4(b), 5(d), 6(a), 7(c), 8(a), 9(b), 10(a), 11(b), 12(a), 13(b),
14 (b), 15(b), 16(a), 17(a), 18(c), 19(d), 20(c)
115
Exercise 46
Troy Engine Ltd., manufactures a variety of engines for use in heavy equipment. The company
always produced all the necessary parts for its engines, including carburetors. An outside
supplier has offered to sell one type of carburetor to Troy Engine Ltd. at a cost of $35 per unit.
To evaluate this offer, Troy Engines Ltd., has gathered the following information relating to its
own cost of producing the carburetor internally:
Per Unit 15,000 units

per year
Direct materials $ 14 $ 210,000
Direct labour 10 150,000
Variable manufacturing overhead 3 45,000
Fixed manufacturing overhead 6** 90,000
Fixed manufacturing
overhead allocated 9 135,000
**One third supervisory salaries, two thirds depreciation of special equipment (no resale value)
Required :
1. Assuming that the company has no alternative use for the facilities that are now being
used to produce the carburetors, should outside supplier’s offer be accepted. Show
computation.
2. Suppose that if the carburetors were purchased. Troy Engines Ltd., could use the freed
capacity to launch a new product. The segment margin of the new product would be
$150,000 per year. Should Troy Engines Ltd. accept the offer to buy the carburetors for
$35 per unit? Show all computations.
Answer 46
Produce Buy
Cost of buying carburetors (15,000 x $35) $ 525,000
Cost of Manufacturing carburetors
Direct material (15,000 x 14) $ 210,000
Direct labour (15,000 x 10) 150,000
Variable MOH (15,000 x 3) 45,000
Fixed manufacturing Overhead
(1/3 supervisor’s salary) 30,000
Total cost 435,000
Difference in favour of producing internally 90,000 _______
Total 525,000 525,000
Only supervisor’s salary is avoidable. Depreciation is a sunk cost and is not relevant for decision
making. Therefore depreciation is not considered as product cost.
116
Produce Buy
Cost of buying carburetors (15,000 x $35) $ 525,000
Cost of Manufacturing carburetors $435,000
Add opportunity cost 150,000
Saving from purchases from outside source _______ 60,000
Total cost 585,000 585,000
Exercise 47
The XYZ Company requires 10 machine hours per unit in the cutting department. The following
costs are assumed to be related to the operating of a cutting machine at a normal capacity of
10,000 units per year (with a maximum capacity of 12,000 units per year).
Variable Costs
Electricity (10,000 units x 10 MH x $ 5 per MH) $500,000
Repairs and maintenance (10,000 units x $ 2 per 10 MH) 200,000
Depreciation ($2,000,000/5 years) 400,000
Insurance 100,000
Total costs 1,200,000
(Note MH represents machine hours)
Required:
a) What are the variable and fixed costs per unit if the normal production of 10,000 units per
year is achieved.
b) What are the variable, fixed and total costs per unit if only 8,000 units are produced?
c) What are the implications of producing fewer units (8,000 units) than normal capacity
(10,000 units) for decision making?
d) Which costs are relevant and which costs are irrelevant to a decision to expand
production from normal capacity (10,000 units) to maximum capacity (12,000 units)?
e) Suppose a second cutting machine, identical in every respect to the first one, is under
consideration for possible purchase. Total production for the year is expected tto be equal
to normal capacity (10,000 units) with the first cutting machine accounting for 6,000
units and the second cutting machine accounting for 4,000 units.
1. What is the total cost of operating two machines?
2. What are the variable, fixed and total costs per unit of each machine?
3. What costs are relevant and what costs are irrelevant to the decision to acquire a
second cutting machine?
4. Under what condition would both the variable cost and fixed costs be relevant in a
decision to require a second machine.
117
Answer 47
Per unit
a) Variable cost
Electricity (10 MH x $ 5 per MH) $ 50.00
Repairs & Maintenance ($2 per 10 MH) 20.00
Total variable cost 70.00
Fixed Cost
Depreciation $ 400,000
Insurance 100,000
Total fixed cost 500,000
Fixed cost per unit ($500,000/10,000) $ 50.00
Total cost per unit ($70.00 + 50.00) $ 120.00
b) Variable cost
Electricity (10 MH x $ 5 per MH) $ 50.00
Repairs & Maintenance ($2 per MH) 20.00
Total variable cost per unit 70.00
Fixed cost
Depreciation $ 400,000
Insurance 100,000
Total 500,000
Fixed cost per unit ($500,000/8,000) $ 62.50
Total cost per unit ($70.00 + 62.50) $132.50
c) If few than 10,000 units are produced, the variable constant per unit will remain constant
but the fixed cost per unit will increase from $ 50 to $62.50. The company will either
have to settle for lesser profit or increase its selling price. Increase in selling price will
affect the sale volume which in turn will result in lesser profit.
d) The variable cost i.e. electricity, repair and maintenance costs are relevant for decision
making. The increase in production by additional 2,000 units will increase the
profitability because the fixed cost has already been covered by the existing production.
The profit will increase be the amount of contribution margin per unit multiplied with the
additional number of units produced.
e) 1. Machine 1 Machine 2
Electricity
6,000 units x 10 MH x $ 5 MH $300,000
4,000 units x 10 MH x $ 5 MH $200,000
Repair & Maintenance
6,000 units x 10 MH units x $2 MH 120,000
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4,000 units x 10 MH units x $2 MH 80,000
Depreciation 400,000 400,000
Insurance 100,000 100,000
Total cost of operating two machines 920,000 780,000
2.
Variable cost per unit $ 70.00 $ 70.00
($420,000/6,000 units)
($280,000/4,000 units)
Fixed cost per unit
($500,000/6,000 units) 83.33 125.00
($500,000/4,000 units) __ ______
Total cost per unit 153.33 195.00
3.
If the second machine is not purchased, the additional fixed cost of $ 500,000 can be
avoided. In this situation the fixed cost of the new machine is relevant because total fixed
cost is increasing without any corresponding increase in production, thereby decreasing
profitability.
4.
If the first machine would have been working at full capacity, the second machine would
have been viable. Again the new machine must be utilized for production above the
breakeven level to add to the profitability of the firm.
Exercise 48
Woodside Company part No. 347 uses in one of its main product. Normal annual production for
part 347 is 100,000 units. The cost per 100 unit is as follows:
Direct materials $ 260

Direct labour 100
Manufacturing Overhead
Variable 120
Fixed 160
Total cost per 100 units 640
Caesar Company has offered to sell Woodside all 100,000 units if needed during the company
year for $ 600 per 100 units. If Woodside accepts the offer from Caesar, the facilities used to
produce part 347 could be used to produce 483. This change would save Woodside $90,000 in
relevant costs. Also a $100,000 cost item included in the fixed factory overhead that is
significantly related to part 347 would be eliminated. Should Woodside accept the offer from
Caesar Company.
119
Answer 48
Make Buy
Purchase Price
(100,000 units @ 600 per unit $600,000
Cost of Production
Variable production cost
(100,000 units @ 480 per 100 units) $ 480,000
Fixed Cost 100,000
Total Mfg. Cost 580,000
Add opportunity cost 90,000
Net saving in purchasing the parts 70,000
Total cost 670,000 670,000
Variable cost
Direct material $ 260
Direct labour 100
Factory overhead 120
Total 480
In this case fixed cost amounting to $ 100,000 is relevant in decision making because it directly
relates to the part being produced and as stated in the question will be eliminated if the product is
purchased from outside.
Exercise 49
Imperial Jewelers is considering a special order for 20 handcrafted gold bracelets to be given as
gifts to members of a wedding party. The normal selling price of a gold bracelet is $189.95 and
its unit price cost is $149.00 as show below:
Direct materials $ 84.00

Direct labour 45.00
Manufacturing overhead 20.00
Unit product cost 149.00
Most of the manufacturing overhead is fixed and unaffected by variations in how much jewelry
is produced in any given period. However, $ 4 of the overhead is variable with respect to the
number of bracelets produced. The customer who is interested in the special bracelet order would
like special monogram applied to the bracelets. This monogram would require additional
materials costing $ 2.00 per bracelet and would also require acquisition of a special tool costing
$ 250 that would have no other use once the special order is completed. This order would have
no effect on the company’s regular sales and the order could be fulfilled using the company’s
existing capacity without affecting any order.
120
Required :
What effect would accepting this order have on the company’s net operating income if a special
price of $169.95 per bracelet is offered for this order? Should the special order be accepted at
this price?
Answer 49
Incremental Cost Incremental Revenue

Incremental revenue (20 x $169.95) $ 3,399
Incremental cost
Direct material (20 x $84) $ 1,680
Direct labour (20 x $45) 900
Mfg.overhead variable (20 x $4) 80
Special material (20 x $2) 40
Cost of special equipment 250
Total cost 2,950
Net increase in income 449
($3,399 – 2,950)
Special order should be accepted.
Exercise 50
Barron Co. manufactures three products: A, B, and C. The selling price, variable costs, and
contribution margin for one unit of each product follow:
Product
A B C
Selling Price $180 $270 $240
Less variable expenses
Direct materials 24 72 32
Other variable expenses 102 90 148
Total variable expenses 126 162 180
Contribution Margin 54 108 60
Contribution margin 30% 40% 25%
The same raw material is used in all three products. Barron company only 5,000 pounds of raw
material on hand and will not be able to obtained any more of it for several weeks due to a strike
in its supplier’s plant. Management is trying to decide which product(s) to concentrate on ext
week in filling its backlog of orders. The material costs $ 8 per pound.
121
Required:
1. Compute the amount of contribution margin that will be obtained per pound of material
used in each product.
2. Which orders would you recommend that the company work on next week – the orders
for product A, product B, or product C? Show computation.
3. A foreign supplier could furnish Barron with additional stocks of raw material at a
substantial premium over the usual price. If there is unfilled demand for all three product,
what is the highest price that Barron Company should be willing to pay for an additional
pound of materials. Explain.
Answer 50
a) Product
A B C
Contribution per unit 54 108 60
Direct material cost per unit 24 72 32
Direct material rate per pound 8 8 8
Direct material per unit (24/8, 72/8, 32/8) 3 9 4
Contribution margin per pound of material
(54/3, 108/9, 60/4) 18 12 15
b)
Contribution margin on 5,000 pounds 90,000 60,000 75,000
(5,000 x 18, 5,000 x 21, 5,000 x 15)
In view of highest contribution margin of product ‘A’, product ‘A’ should be produced.
c)
Material cost per pound 8 8 8
Add contribution margin 18 12 15
Total maximum price acceptable 26 20 23
The maximum price which the company will be willing to pay for one pound of material is $26.
Exercise 51
Maqbool Company manufactures three products from a common input in a joint processing
operation. Joint processing costs up to the split-off point total $350,000 per quarter. The
company allocates these costs to be joint products on the basis of their relative sales value at the
split off point. Unit selling price and total output at the split off point are as follows:
Product Selling Price Quarterly Output

A $16 per pound 15,000 pounds
B $ 8 per pound 20,000 pounds
C $ 25 per gallon 4,000 gallons
122
Each product can be processed further after the split off point. Additional processing requires no
special facilities. The additional processing costs (per quarter) and unit selling prices after further
processing are given below:
Additional
Product Processing Cost Selling Price
A $ 63,000 $20 per pound
B $ 80,000 $13 per pound
C $ 36,000 $32 per pound
Required :
Which product or products should be sold at split off point and which product or products should
be processed further? Show computation.
Answer 51
A B C
Sales revenue after additional processing $ 300,000 $ 260,000 $ 128,000
Sales revenue before additional processing 240,000 160,000 100,000
Increase in revenue 60,000 100,000 28,000
Increase in cost 63,000 80,000 36,000
Additional revenue - 3,000 20,000 - 8,000
Computation
Sales revenue after processing A, 15,000 x $20, B 20,000 x $13, C 4,000 x $32
Sales revenue before processing A 15,000 x 16, B 20,000 x 8, C 4,000 x $25
Product B should be processed further, whereas product A and C should be sold before
additional processing to maximize revenue.
Exercise 52
For many years Modern Company purchased the starters that it installs in its farm tractors. Due
to a reduction in output, the company has idle capacity that could be used to produce starters.
The chief engineer has recommended against this move, however, pointing out that the cost to
produce the starters would be greater than the current $ 8.40 per unit purchase price.
Per Unit Total

Direct materials $ 3.10
Direct labour 2.70
Supervision 1.50 $ 60,000
Depreciation 1.00 40,000
Variable manufacturing overhead 0.60
Rent 0.30 12,000
Total production cost 9.20
A supervisor would have to be hired to oversee production of the starter. However, the company
has sufficient idle tools and machinery that no new equipment would have to be purchased. The
123
rent charge above is based on space utilized in the plant. The total rent on the plant is $ 80,000
per period. Depreciation is due to obsolescence rather than wear and tear.
Required :
Prepare computations showing how much profit will increase or decrease as a result of making
the starter rather than purchasing them.
Answer 52
Cost of producing one starter

Direct material $ 3.10
Direct labour 2.70
Supervisor’s salary 1.50
Variable Mfg. overhead 0.60
Depreciation -
Rent -
____
Total cost per unit 7.90
Cost of purchasing 8.40
Saving per unit 0.50
Rent is an allocated cost and has no impact on production cost of the starter. Similarly
depreciation is a sunk cost and the machinery must be depreciated in the usual way irrespective
of the company’s decision to opt for production or otherwise.
The company should produce the starter at its own facility.
Exercise 53
Mighty Company that manufactures sneakers has enough idle capacity available to accept a
special order of 20,000 pairs of sneakers at $ 6 a pair. The normal selling price is $ 10.00 per a
pair. Variable manufacturing costs are $ 4.50 a pair, and fixed manufacturing costs are $ 1.50 a
pair. Mighty will not incur any selling expenses as a result of the special order. What would be
the effect on net income if Mighty accepts the special order?
Answer 53
Incremental revenue (20,000 x $6) $120,000

Incremental cost (variable)
Manufacturing cost (20,000 x $4.50) $ 90,000
Incremental Revenue 30,000
The fixed manufacturing cost of $ 1.50 is not relevant for accepting the special order. Since
special order is adding $ 30,000 to the firm’s revenue, it should be accepted.
124
Exercise 54
Rice Corporation currently operates two divisions. The operating results of both the units for the
year ended December 31, 2011 are as follows:
West Division East Division

Sales $ 600,000 $ 300,000
Variable costs 310,000 200,000
Contribution margin 290,000 100,000
Fixed costs for the division 110,000 70,000
Operating margin 180,000 30,000
Allocated corporate costs 90,000 45,000
Operating income 90,000 (15,000)
Since East Division has sustained a loss of $15,000, the Rice President is considering the
elimination of this division. If East Division is eliminated from January, 2012 what would have
been Rice Corporation’s operating income for the year 2012.
Answer 54
Rice Corporation
East Division
Forgone revenue $ 300,000

Cost saving
Variable costs $200,000
Fixed Cost 70,000 270,000
Decrease in operating income 30,000
Exercise 55
The Morris Meat Company produces three joint products, hamburger, steak and roast beef from a
joint process. Total joint costs equal to $ 43,000. Each of three joint products can be (1) sold at
the split off point to a competing meat company or (2) further processed at Morris Company and
sold to the retailers.
Relevant costs and revenue appear below:
Total Sales Total additional Total

Product Value at Split off Processing cost Final Sales Value
Hamburger $ 10,000 $ 2,000 $ 14,000
Steak 14,000 3,000 20,000
Roast beef 13,000 6,000 17,000
125
Which product should be sold at the split off point and which product should be processed
further?
Answer 55
Hamburger Steak Roast Beef

Incremental Revenue $ 4,000 $ 6,000 $ 4,000
Incremental cost 2,000 3,000 6,000
Increase/decrease in income 2,000 3,000 (2,000)
Hamburger and Steak should be processed further. Roast Beef should be sold at split off point.
Working of incremental Revenue
Hamburger Steak Roast Beef

Revised Revenue $ 14,000 $ 20,000 $ 17,000
Original Revenue (10,000) (14,000) (13,000)
Incremental Revenue 4,000 6,000 4,000
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CHAPTER X
EVALUATING INVESTMENT PROJECT
The primary objective of financial management is to maximize the value of the firm’s stock. The
stocks value depends, together with other factors, on the timing of the cash flows the investors
expect to receive from an investment – a dollar expected soon is worth more than dollar expected
in the distant future. Therefore, it is essential for financial managers to have a clear
understanding of discounted cash flow analysis and its impact on the value of the firm.
Future Value : A dollar in hand today is worth more than a dollar to be received next year,
because, if we have it now, we could invest it, earn interest and end up next year with more than
one dollar. The process of going from today’s values, or present value (PVs) to future values
(FVs) is called compounding.
Suppose we had $100 which we deposited in a bank’s saving account that paid 5 per cent interest
compounded annually. How much would we have at the end of 1 year?
FVn = FV1 = PV + i
= PV(1 + i)
FV1 = $100(1 + 0.05) = $100(1.05) = $105
PV = $ 100 = Present value

i = interest rate the bank pays on the account per year
FV = future value, or ending amount at the end of a year
n = the number of period
Our account shall earn $5 of interest, so we will have $ 105 at the end of the year. What would
we end up with if we left $100 in the account for five year years?
0 1 2 3 4 5
_____________________________________
Initial Deposit -100 FV1 FV2 FV3 FV4 FV5
Interest Earned 5 5.25 5.51 5.79 6.08
Amount at the end 105 110.25 115.76 121.55 127.63

of each period= FVn
This can computed more conveniently with the help of following equation:
127
FV5 = PV(1 + i)5
= $100 (1 + 0.05)5
= $127.63
Present Value : Present value is inverse of future value. In general, the present value of a sum
due n years in the future is the amount which if it were on hand today, would grow to equal the
future sum when invested at the opportunity cost rate. Suppose $100 would grow to $127.63 in 5
years at a 5 per cent rate, $ 100 is defined to be the present value of $ 127.63 due 5 years in the
future when the appropriate interest rate is 5 per cent.
PV = FVn
(1 + i) n
= 127.63
(1.05)5
= 127.63
1.2763
= $100
Exercise 56
Mr. ‘X’ needs $ 400 to buy textbooks next year. He can earn 7 per cent on his money. How
much does he put today to grow $400?
Answer 56
PV = FV
(1 + i)n
PV = 400
(1 + 0.07)
= $373.83
Note : Since the desired future value is computed for one year, there is no compounding factor.
Exercise 57
Imperial Corporation has unfunded pension liability of $ 825 million that must be paid in 20
years. To assess the value of the firm’s stock, financial analysts want to discount the liability to
the present. If the relevant discount rate is 8 per cent, what is the present value of the liability?
Answer 57
PV = FV
(1 + i)n
128
PV = 825
(1 + 0.08)20
= $825/4.661
= $177.00
Exercise 57
Mr. ‘X’ needs to have $ 1,000 in two years. If he can earn 7 per cent, how much does he need to
invest today to make sure that he will have $ 1,000 at the end of the second year?
Answer 57
PV = FV
(1 + i)n
= 1,000
(1 + 0.07)2
= 1,000/1.1449
= $873.44
Exercise 58
Bank A pays 8 percent interest compounded quarterly, on its money market account. The
managers of Bank ‘B’ want its money market account to equal Bank A’s effective annual rate
but interest is to computed monthly. What nominal, or quoted rate must Bank set?
Answer
Bank ‘A’
Rate of Interest = 8% p.a.
Compounded quarterly = 2 p.a for 4 years
= (1 + 0.08/4)4 – 1 = 1.0824 – 1
= 8.24%
Bank ‘B’
( 1 + i )12 - 1.0 = 0.0824
12
( 1 + i )12 = 1.0824
12
(1 + i) = (1.0824)1/12
12
(1 + i) = 1.00662
12
i = 1 – 1.00662
12
129
i = 0.0062 x 12 = 0.07944
i = 7.94 %
Thus, the two banks have different quoted rates – Bank A’s quoted rate is 8%, while Bank B’s
quoted rate is 7.94 per cent, however, both banks have the same effective annual rate of 8.24 per
cent. The different in their quoted rates is due to the difference in compounding frequency.
Exercise 59
Universal Bank pays 7 per cent interest, compounded annually, on the time deposits. Regional
Bank pays 6 percent interest compound quarterly.
Based on effective rates, in which bank would you prefer to deposit your money.
Answer 59
Universal Bank
Rate of interest = 7% p.a.
Compounded annually = Effective rate 7%
Regional Bank
Rate of interest = 6% p.a
Compounded quarterly = 1.5 p.a. for 4 periods
= (1.015)4 – 1
= 1.0613 – 1
= 6.14 %
Finding the Discount Rate
We frequently turn to determine what discount rate is implicit in an investment. We can do this
by looking at the basic present value equation:
PV = FV
(1 + i)n
Exercise 60
Mr. Y is considering an investment of $ 1,250 for one year that will grow to $1,350 at the end of
the year, what is the interest rate?
Answer 60
PV = FV
(1 + i)
$1,250 = $1,350
(1 + i)
130
(1 + i) = $1,350/$1,250
i = 1.08 - 1
or 8%
Exercise 61
Suppose you can buy a security at a price of $ 78.35 and it will pay you $100 after five years.
What is the rate of return on this investment.
Answer 61
FVn = PV (1 + i)n
100 = 78.35 (1 + i)5
100 = (1 + i)5
78.35
1.276 = (1 + i)5
(1 + i)5 = 1.276
1+ i = 1.276 (1/5)
1 +i = 1.050
i = 0.05 = 5%
Find the number of period
Exercise 62
Suppose you are interested in purchasing an asset costs $50,000. You currently have $25,000. If
you can earn 12 per cent on this $25,000, how long do we let it invest until we get our target of
$ 50,000.
Answer 62
PV = FV
(1 + i)n
$25,000 = 50,000
(1 + 0.12)n
(1 + 0.12)n = 50,000/25,000
1.12n =
2
nLN(1.12) = LN(2)
n0.1133 = 0.693
n = 0.693/0.1133
= 6.1188
Exercise 63
Suppose ‘X’ invests $ 78.35 at an interest rate of 5 percent per year. How long will it take the
investment to grow to $ 100?
131
Answer 63
Here we know PV, FV and i but we do not know n, the number of periods. It can be solved as
under:
Equation FV = PV (1 + i)n
$100 = 78.35 (1 + 0.05)n
Transform to $100/78.35 = (1 + 0.05)n
$1.276 = (1 + 0.05)n
Take the natural log of both sides, and then solve for n:
nLN(1.05) = LN(1.276)
n = LN(1.276)/LN(1.05)
n = 0.2437/0.0488
= 5
Exercise 64
You expect to receive $ 60,000 at graduation in two years. You plan on investing it at 7 percent
until you have $120,000. How long will you wait from now?
Answer 64
Equation FV = PV (1 + i)n
$120,000 = 60,000 (1 + 0.07)n
Transform to $120,000/60,000 = (1 + 0.07)n
$2 = (1 + 0.07)n
Take the natural log of both sides, and then solve for n:
nLN(2) = LN(1.07)
n = LN(2)/LN(1.07)
n = 0.693/0.0676
= 10.25 years
Present value with Multiple Cash Flows
Suppose you need $1,000 in one year and $ 2,000 more in two years. If you can earn 9 per cent
on your money, how much do you have to put up today to exactly cover these amounts in the
future? In other words, what is the present value of the two cash flows today at 9 per cent?. The
present value of $ 2,000 in two years at 9 per cent is:
PV
132
(1 + i)2
$ 2,000/(1.09)2 = $1,683.36
The present value of $ 1,000 in one year is:
$ 1,000/1.09 = $ 917.43
Therefore the total present value is:
$ 1,683.36 + 917.43 = $ 2,600.79
Exercise 65
You are offered an investment that will pay $ 200 in 1st year, $ 400, the 2nd year, $ 600 the 3rd
Year and $ 800 at the end of the 4th year. You can earn 12 per cent on a similar investment . How
much you should pay now for this investment.
Answer 65
$ 200 / (1.12) = $ 178.57

$ 400 / (1.12)2 = 318.87
$ 600 / (1.12)3 = 427.07
$ 800 / (1.12)4 = 508.41
Total present = 1,432.93
Value
Exercise 66
You are offered an investment that requires you to put up $ 10,000 today in exchange for $
50,000, 15 years from now. What is the annual interest rate?
Answer 66
PV = FV(1 + i)n
10,000 = 50,000 / (1 + i)15
50,000/10,000 = (1 + i)n
5 = (1 + i)15
(1 + i) = 5 1/15
(1 + i) = 1.1133
i = 0.1133 or
11.33%
133
Annuity
An annuity is a series of equal payment made at fixed intervals for a specified number of periods.
A deferred annuity is another name of an annuity. For example $100 at the end of each of the
next three years is a three year annuity. The payments are given the symbol PMT, and they can
occur at either at the beginning or the end of each period. If the payment occurs at the end of
each period, the annuity is called an ordinary or deferred annuity. Payment on mortgages, car
loans, and students loans are typically set up as ordinary annuities. If payments are made at the
beginning of each period, the annuity is called annuity due. Rental payments for an apartment,
life insurance premiums are typically set up as annuities due.
A perpetuity is a series of payments for a fixed amount that last indefinitely. In other words a
perpetuity is an annuity where n equals infinity. Consol is another term used for perpetuity.
Consols were originally bonds issued by England in 1815 to consolidate past debts.
If you deposit $100 at the end of each year for three years in a saving account that pays 5 per
cent interest per year, how much will you have at the end of the three years?
Time Line
Year 0 -
1 100 will be held for 2 years and will receive compound interest for
2 years
2 100 will be held for 1 year will receive interest for 1 year
3 100 will be deposited at the end of the third year and will not
receive any interest.
Year 1 100 will grow to 110.25

2 100 will grow to 105
3 100 100
FVA3 315.25
This can be solved with the help of following equation:
= PMT (1 + i)n - 1
i
100 (1 + 0.05)3 - 1
0.05
100 (3.1525) = 315.25
Exercise 67
Find the present values of the following cash flow streams. The appropriate interest rate is 8%
percent.
134
Year Cash steam A Cash Stream B
1 $ 100 $ 100
2 400 400
3 400 400
4 400 400
5 300 100
Answer 67
Cash Stream A
Year Annuity factor Cash Stream Present Value
1 0.9259 $100 92.59
2 0.8573 400 342.92
3 0,7938 400 317.52
4 0.7350 400 294.00
5 0.6805 300 204.15
1,251.18
Cash Stream B
Year Annuity factor Cash Stream Present Value
1 0.9259 $300 277.77
2 0.8573 400 342.92
3 0,7938 400 317.52
4 0.7350 400 294.00
5 0.6805 100 68.05
1,300.26
Annuities Due
Suppose that $100 payments has been made at the beginning of each year and the rate of return is
5 per cent, the annuity would have been an annuity due. On the time line, each payment would
be shifted to one year earlier, so each payment would be compounded for one extra year.
Time Line
Year 0 -
1 100 will be held for 3 years and will receive compound interest for
3 years.
2 100 will be held for 2 year will receive compound interest for 2
year.
3 100 will be held for one year and will receive interest for one year.
Year 1 100 will grow to 1.1576 115.76

2 100 will grow to 1.1025 110.25
3 100 1.05 105.00
FVA3 3.3101 331.01
We can solve this :

PVAn (Annuity due) = PMT(PIVFAi n) (1 + i)
135
Future Value Annuity factory for year =
Ordinary Annuity Year 1 1.1025
Year 2 1.0500
Year 3 1.0000
3.1525
100 (3.1525)(1.05) = 331.01
Exercise 68
If you deposit $2,000 at the end of each of the next 20 years into an account paying 9.5 per cent
interest, how much money will you have in the account in 20 years? How much if you keep
depositing for 40 years.
Answer 68
This is an ordinary annuity
= PMT (1 + i)n - 1
i
2,000 (1 + 0.095)20 - 1
0.095
2,000 (54.122) = 108,244
Finding the Payment (Amortization)
Suppose you have to borrow $100,000 from a bank to start a business. You believe that you have
a good business idea and you would be able to pay back the loan in a time say (five year equal
payments). If the interest rate is 18 per cent, what will be the amount of installment.
1
1 - __________
(1 + i)n
= ______________________
PMT
i
1
_________
1-
(1.18)5
___________________
$ 100,000 = PMT
0.18
= PMT 0.5628
0.18
PMT = 100,000/3.1266 = 31,983
136
Exercise 69
a) Set up an amortization schedule for a $25,000 loan to be repaid in equal installments at

the end of each of the next 5 years. The interest rate is 10 per cent.
b) How large must each annual payment be if the loan is for $ 50,000? Assume that the
interest rate remains at 10% and that the loan is paid of over 5 years.
c) How large amount each payment be if the loan is $ 50,000, the interest rate is 10%, and
the loan is paid off in equal installments at the end of each of the next 10 years? This loan
is for the same amount as the loan in part b, but the payment are spread out over twice as
many periods.
Answer 69
a)
1
__________
1 -
(1 + i)n
= ______________________
PMT
i
1
_________
1 -
(1.10)5
___________________
$ 25,000 = PMT
0.10
= PMT 0.3790
0.10
PMT = $ 25,000/3.79 = $ 6,596
Year Payment Interest Repayment of Remaining

Principal Balance
1 6,596 2,500 4,096 20,904
2 6,596 2,090 4,506 16,398
3 6,596 1,640 4,956 11,442
4 6,596 1,142 5,454 5,988
5 6,596 599 5,998 - 10
The difference of $ 10 is due to rounding of the amount.
b) If the amount of loan is $ 50,000 the annual installment will be :
PMT $ 50,000/3.79 = $ 13,193
137
c)
1
_________
1 -
(1.10)10
___________________
$ 50,000 = PMT
0.10
= PMT 0.6.145
0.10
PMT = $ 50,000/6.145 = $ 8,136.70
Exercise 70
Baltimore Bank offers you a $ 25,000, seven year term loan at 12 percent annual interest rate.
What will be your annual payment.
Answer 70
a)
1
_________
1 -
(1.12)7
___________________
$ 25,000 = PMT
0.12
= PMT 0.5475 =
0.12
PMT = $ 25,000/4.562 = $ 5,480
138
Summary equations
FV (Future Value) = PV (1 + i)
FV (compounding) FVIF = PV (1 + i)n
PV (Present value) PVIF = FVn

(1 + i)n
FV (Annuity) FVIFA = (1 + i)n - 1

I
PV (Annuity) PVIFA 1
__________
1 -
(1 + i)n
______________________
= PMT
i
PV (Annuity Due) = PVIFi n (1 + i)
1
__________
1 -
(1 + i)n
______________________
Amortized Loans = PMT
i
Exercise 71
The Penguin Corporation issued a new series of bonds on January 1, 1981. The bonds were sold
at part ($1,000), have a 12 per cent coupon and mature in 30 years on December 31, 2010.
Coupon payments are made semi-annually (on June 30th and December 31).
a. What was the YTM of Penguin Corporation’s bonds on January 1, 1981?

b. What was the price of the bond on January 1, 1986, five year later, assuming that the
level of interest rates had fallen to 10 percent?
c. Find the current yield and capital gain yield on the bond on January 1, 1986, given the
price as determined in part b.
Answer 71
a) The Penguin Corporation’s bond were sold at part, therefore, the original YTM equaled
the coupon rate of 12%.
139
b)
1
__________
1 -
(1 + 10)50
= PMT ___________________2___ + 1,000
0.10 (1 + 0.10 )50
2 2
= 60 (18.255) + 1,000 (0.872)
= $1,095.30 + 87.20 = $ 1,182.50
c) Current yield = Annual coupon payment/price
$ 120/1,182.50 = 0.1015 or 10.15%
Capital gain yield Total yield - Current yield

10% - 10.15% = -0.15%
Exercise 71
A government bond is currently selling for $ 950 and pays $ 80 per year in interest for five years,
when it matures. If the redemption value of this bond is $ 1,000, what is the yield to maturity if
purchased today for $ 950?
Answer 71
There is an ordinary annuity of $ 80 i.e. an inflow of $ 80 for five years and one lump sum
payment of $ 1,000 of the principal at the end of the fifth year.
$ 950 = 80 x PVIFA 5 + 1,000{1/1 + YTM)5 }
It can be computed by trial and error, we first compute the value at 10%
= 80 x 3.7908 + 1,000 x 0.6209
= 303.26 + 621 = 924,26
The value is below the amount invested by $25.74, we will try again at 9%
= 80 x 3.8897 x 1,000 x .6499

= 311.18 + 650 = 961
It is short by $ 11, the amount of investment, it implies that the YTM is 9 %.
140
Exercise 72
Suppose the government bond described above in problem above is held for three years and
then the bank acquiring the bond decides to sell it at a price of $950. What is the average annual
yield the bank will have earned on the investment.
Answer 72
$ 950 = 80 x PVIFA 3 + 950{1/1 + YTM)3 }
It can be computed by trial and error, we first compute the value at 8%
= 80 x 2.5771 + 950 x 0.7938
= 206.17 + 754.11 = 960.28
We, therefore, estimate the YTM to be close to 8%.
Exercise 73
US Treasury bills are available for purchase this week at the following price (based upon $100
par value) and with the indicated maturities.
a. $ 97.25, 182 days

b. $ 96.50, 270 days
c. $98.75, 91 days
Calculate the discount rate (DR) on each bill if held to maturity.
Answer 73
a. 100 – 97.25 x 360 = 0.0544 or 5.44%

100 182
b. 100 – 96.50 x 360 = 0.04655 or 4.655%

100 270
c. 100 – 98.75 x 360 = 0.04945 or 4.945%

100 91
141
Exercise 74
Nigeria Corporation has issued bonds that a 9 percent coupon rate, payable semi-annually. The
bonds mature in 8 years, have a face value of 1,000 and yield to maturity of 8.5 per cent. What is
the price of the bond.
Answer 74
1
__________
1 -
(1 + 8.5)16
= PMT __________________ 2___ + 1,000
0.085 (1 + 0.085)16
2 2
= 45 (11.44) + 1,000 (0.5138)
= $514.80 + 513.80 = $1,028.60
142
CHAPTER XI
CAPITAL BUDGETING
Capital budgeting involves important decisions that managers undertake to identify those
projects that add to the firm’s value, and as such it is the most important task faced by financial
managers. A successful capital budgeting process commences with the development of the firm’s
strategic direction, e.g. moving into new products, services, or markets, that must be followed by
large amount of capital expenditure. The result of these decisions has long term financial impact
which may affect the profitability of the entity for many years in the future. Conversely poor
capital budgeting can have serious consequences and may lead to collapse and ultimate winding
up.
A firm’s growth, and even its ability to remain competitive and to survive, depends on a constant
flow of ideas like introducing new products, improving existing products, and selecting options
to economize cost. If a firm has capable and imaginative executives and employees, and if its
incentive system is working properly, many ideas for capital investment will come forward from
within the institution. Some ideas will be good ones, but others will not. Therefore, companies
must screen projects for those that add value to the entity.
Project Classification
Analyzing capital expenditure proposal is not a costless operation, but benefits can be gained at a
fraction of the cost of the proposed capital expenditure. For certain types of projects, a relatively
detailed analysis may be warranted, for others, simpler procedure would suffice. Accordingly
firms generally categorize projects and then analyze those in each category some what
differently.
1. Replacement/maintenance of business. Replacement of worn out or damaged equipment

is necessary if the firm is to continue its business. The only issue here are should this
operation be continued and should we continue to use the same production process. If the
answers are yes, maintenance decisions are normally made without any elaborate
decision process.
2. Replacement cost reduction. These projects lower the costs of labour, materials,
equipments etc. These decisions are discretionary in nature and needed large capital
outflow to implement. Detailed analysis is needed to implement these decisions.
3. Expansion of existing products or markets. Expenditures to increase output of existing
products, or to expand retail outlets or distribution facilities in markets now being served
are included here. These decision are more complex because they require an explicit
forecast of growth in demand, so a more detailed analysis is required. Also, the final
decision is generally made at a higher level within the firm.
143
Capital Budgeting Decision Rules
Payback period
The payback period, defined as the expected number of years required to recover the original
investment, is the first formal and simplest method used to evaluate capital budgeting process.
Suppose a firm has a choice between two projects with the following cash flows:
Cash Flow Project Cumulative Project Cumulative

S NCF L NCF
Year 0 -1,000 -1,000 -1,000 -1,000
1 500 -500 100 -900
2 400 -100 300 -600
3 300 200 400 -200
4 100 300 600 400
The shorter the payback period, the better. Therefore, if the firm required a payback of three
years or less, Project S would be accepted and the project L would be rejected. If the projects
were mutually exclusive, S would be ranked over L, because S has the shorter back. Mutually
exclusive means that if one project is taken on the other must be rejected.
Discounted Payback Period
Some firms use a variant of the regular payback, the discounted payback period, which is similar
to the regular payback period except that the expected cash flows are discounted by the project’s
cost of capital. Thus, the discounted pay back is defined as the number of years required to
recover the investment from the discounted net cash flows.
Considering the same example, if the cost of capital is 10 percent, the result will emerge as
under:
Cash Flow Project Discounted Cumulative Project Discounted Cumulative

S NCF at 10% NCF L NCF at 10% NCF
Year 0 -1,000 -1,000 -1,000 -1,000 -1,000 -1,000
1 500 455 -545 100 91 -909
2 400 331 -214 300 248 -661
3 300 225 11 200 301 -360
4 100 68 79 600 410 50
-1,000 +1,079 -1,000 + 1,050
An important drawback of both the payback and discounted payback methods is that they ignore
cash inflows that are received after the payback period. For example, suppose project L had an
additional cash flow of $ 5,000 at year 5, commonsense suggests that Project L would be more
144
valuable than Project S, yet its payback and discounted payback make it look worse than Project
S. Consequently, both payback methods have serious deficiencies.
Net Present Value (NPV)
Net present value method relies on discounted cash flow techniques. To implement this
approach, we proceed as follows:
1. Find the present value of each cash flow, including all inflows and outflows, discounted
at the project’s cost of capital.
2. Sum these discounted cash flows, this sum is defined as NPV.
3. If the NPV is positive, the project should be accepted while, if NPV is negative, it should
be rejected. If two projects with positive NPVs are mutually exclusive, the one with the
higher NPV should be chosen.
Internal Rate of Return (IRR)
The IRR is defined as the discount rate that equates the present value of a project’s expected cash
inflows to the present value of the project costs. Thus we have an equation with one unknown
IRR, and we need to solve for IRR.
The IRR of a project is its expected rate of return. If the internal rate of return exceeds the cost of
the funds used to finance the project, a surplus will accrue which will increase shareholder’s
wealth, thereby supporting to adopt the project. On the other hand, if internal rate of return is less
than the cost of capital, then taking on the project will impose a cost on the wealth of the
shareholders, and hence suggesting to reject the project.
Profitability Index
Another method used to evaluate project is profitability index (PI).
PI = PV of future cash flows

Initial cost
It is computed by dividing the PV of future cash flows with the initial cost. A project is
acceptable if its PI is greater than 1, and the higher the PI, the higher the project’s ranking.
PIs = $ 1,079 = 1.079

$1,000
Thus, on a present value basis, Project S is expected to produce $ 1.079 for each $ 1 of
investment. Project L, with a PI of 1.050, should produce $ 1.050 for each dollar invested.
A project is acceptable if its PI is greater than 1.0 and the higher the PI, the higher the project’s
ranking. Therefore, both S and L would be accepted by the PI criterion if they were independent,
and S would be ranked ahead of L if considered mutually exclusive.
145
Exercise 75
Offshore Drilling Product Inc. imposes a payback cutoff of three years for its international
investment projects. If the company has the following two projects available, should it accept
either of them?
Year Cash Flow (A) Cash Flow (B)

0 - $ 38,000 - $ 60,000
1 25,000 10,000
2 12,000 15,000
3 18,000 20,000
4 5,000 250,000
Answer 75
Payback period
Year Cash Flow (A) Cumulative cash flow

0 - $ 38,000 -38,000
1 25,000 -13,000
2 12,000 - 1,000
3 18,000 17,000
4 5,000 22,000
Project A = 2 years + 1,000/(18,000/12=1,500 ) = 0.67 months

2 years and one month
Payback period
Year Cash Flow (B) Cumulative cash flow

0 - $ 60,000 -60,000
1 10,000 -50,000
2 15,000 -35,000
3 20,000 -15,000
4 250,000 235,000
Project B = 3 years + 15,000/(250,000/12 = 20,833) = 0.72 months

3 years and one month
Exercise 76
Your division is considering two investment projects, each of which requires an up-front
expenditure of $ 15 million. You estimate that the investments will produce the following net
cash flows:
146
Year Project A Project B
1 $5,000,000 $20,000,000
2 10,000,000 10,000,000
3 20,000,000 6,000,000
What are the two projects’ net present values, assuming the cost of capital is 10 percent? 5 per
cent? 15 percent?
Answer 76
Project A
Year Cash Flow Discounted Cash Flow
5% 10% 15%
0 - $15,000,000 -15,000,000 -15,000,000 -15,000,000
1 $5,000,000 4,762,000 4,545,500 4,348,000
2 10,000,000 9,070,000 8,264,000 7,561,000
3 20,000,000 17,276,000 15,026,000 13,150,000
NPV 16,108,000 12,835,500 10,059,000
Project B
Year Cash Flow Discounted Cash Flow
5% 10% 15%
0 - $15,000,000 -15,000,000 -15,000,000 -15,000,000
1 $20,000,000 19,048,000 18,182,000 17,392,000
2 10,000,000 9,070,000 8,264,000 7,561,000
3 6,000,000 5,182,000 4,958,400 3,945,000
NPV 18,300,000 16,404,400 13,898,000
Exercise 77
Davis Industries must choose between a gas powered and an electric powered fork lift truck for
moving materials in its factory.
Since both forklifts perform the same function, the firm will choose only one. (They are mutually
exclusive investments). The electric powered truck will cost more, but it will be less expensive to
operate; it will cost $ 22,000, whereas the gas powered truck will cost $ 17,500. The cost of
capital applies to both investment is 12 per cent. The life for both types of truck is estimated to
be 6 years, during which time the net cash flows for the electric powered truck will be $ 6,290
per year and those for the gas powered truck will be $5,000 per year. Annual net cash flows
include depreciation expenses. Calculate the NPV and IRR for each type of truck and decide
which to recommend.
147
Answer 77
NPV (Electric powered) = -22,000 + 6,290 (Annuity for 6 years)

= Cost of capital
1
__________
1 -
(1 + 12)6
__________________ ___
= PMT = 4.1108
0.12
-22,000 + 6,290 (4.1108) = 3,856.93
NPV (Gas powered) -17,500 + 5,000 (4.1108) = 3,054
The firm should purchase electric powered truck.
IRR
IRR is the rate that forces the NPV to equal zero.
IRR for electric powered project is computed at different rates until it is close to zero.
At 15% = -22,000 + 6,290 (3.7844) = 1,804

At 17% = -22,000 + 6,290 (3.5892) = 576
At 18% = -22,000 + 6,290 (3.4976) = 0
IRR for gas powered project is computed at different rates until it is close to zero.
At 15% = -17,500 + 5,000 (3.7844) = 1,422

At 17% = -17,500 + 5,000 (3.5892) = 3
Exercise 78
The Perez Co. has the opportunity to invest in one of two mutually exclusively machines that
will produce a product it will need for the foreseeable future. Machine A costs $ 10 million but
realizes after tax inflows of $ 4 million per year for 4 years. After 4 years, the machine must be
replaced. Machine B costs $15 million and realizes after tax inflows of $ 3.5 million per year for
8 years, after which it must be replaced. Assume that machine prices are not expected to rise
because inflation will offset by cheaper components used in the machines. If the cost of capital is
10 per cent, which machine should the company use?
148
Answer 78 Discounted Cash Flow
Year Cash Flow PVIF at 10%
Machine A 0 - $ 10,000,000 - 10,000,000
1 4,000,000 0.9091 3,636,400
2 4,000,000 0.8264 3,305,600
3 4,000,000 0.7513 3,005,200
4 4,000,000 0.6830 2,732,000
3.1698 2,679,200
Machine B 0 - $ 15,000,000 - 15,000,000

1 3,500,000 0.9091 3,181,850
2 3,500,000 0.8264 2,892,400
3 3,500,000 0.7513 2,629,550
4 3,500,000 0.6830 2,390,500
5 3,500,000 0.6209 2,173,150
6 3,500,000 0.5645 1,975,750
7 3,500,000 0.5132 1,796,200
8 3,500,000 0.4665 1,632,750
5.3349 3,672,150
Machine ‘A’ has a payback period of 2.5 years whereas Machine ‘B’ has a payback period of
4.2857 years. Since ‘A’ has an early payback period, the amount released can be reinvested for
generating additional revenue. Accordingly machine ‘A’ is a better choice.
Exercise 79
Bill Murphy, the President of Murphy Enterprises has received the following investment
proposals with their expected rate of returns:
Proposal 1 Proposal 2 Proposal 3 Proposal 4

Initial cash outlay -100,000 -140,000 -220,000 -275,000
Present value of cash
flow at 14% 145,000 135,000 240,000 350,000
Internal rate of return 20% 13% 17% 18%
Each project has the same risk. The required rate of return specified by the president is 14%.
Required:
a. Using the internal rate of return technique which projects are profitable? Which is the
most attractive?
b. Using the present value technique which projects are profitable? Which is the most
attractive project?
c. Which project, if any, should the president select?
149
Answer 79
a. According to the IRR, a project is considered feasible when its internal rate of return is
greater than the rate of return required. Since the required rate of return is 14%, proposal
1, 3 and 4 are acceptable.
b.
Proposal 1 Proposal 2 Proposal 3 Proposal 4
Present value of cash
flows at 14% 145,000 135,000 240,000 350,000
Initial cash outlay 100,000 140,000 220,000 275,000
NPV 45,000 -5,000 20,000 75,000
Accordingly to NPV criteria, the NPV of project 1, 3, and 4 are positive and they may be
accepted if they are exclusive.
c.
Accordingly to IRR criteria the proposal 1 is the most feasible and should be selected. But on the
basis of NPV, project 4 is more desirable. Since both the criteria gives conflicting result, the
project which is contributing highest amount to NPV may be selected.
Exercise 80
Frank’s Toys is going to buy a new molding machine that it believes will increase productivity.
The initial net cash outflow is $ 11,560. The cash flow associated with the acquisition of the new
molding machine is as follows:
Year Cash flow from operations

1 $ 5,160
2 4,560
3 3,960
4 3,360
5 2,760
Required: Assuming a required rate of return of 10%.

a. Compute the net present value for this project.
b. Compute the profitability index.
c. Compute the payback period.
d. Compute the internal rate of return
150
Answer 80
Net Present value

Year Cash flow PVIF at 10% Present
from operations p.a. Value
0 -11,560 11,560
1 5,160 0.9091 4,691
2 4,560 0.8264 3,768
3 3,960 0.7513 2,975
4 3,360 0.6830 2,295
5 2,760 0.6209 1,714
Present value of cash from operations $ 15,443

Less Initial net cash outlays 11,560
NPV 3,880
Index of Profitability 15,443 = 1.34

11,560
Pay back period
Year Cash flow Cumulative Cash Flow

0 -11,560 -11,560
1 5,160 - 6,400
2 4,560 - 1,840
3 3,960 2,120
4 3,360 5,480
5 2,760 8,240
The cash flow from operations turns positive in the third year. Average monthly cash in the third
year = 3,960/12 = 330. Therefore the company will reach the target of $ 1,840 in 1,840/330 =
5.57 months or 6 months apporx.
Payback period = 2 years and 6 months.
151
CHAPTER XII
PRICING OF BUSINESS LOANS
Every banking institution earns its major revenue from interest and mark up income by lending
funds to business firms and customers to different walks of life. As such they might be tempted
to charge a high rate of interest to enhance their profitability, but considering the high level of
competition in the market and to keep the borrower’s repaying ability within manageable limits,
the pricing of loan poses a great challenge to the banking institutions. Some of the most popular
techniques used for pricing of loans are discussed below:
The Cost plus Loan Pricing Model
The simplest and most commonly used loan pricing model assumes that the rate of interest
charged on any specific loan must cover the undernoted four costs. These include:
(1) The raising of deposits to finance the demand for funds entails cost in the form of
adequate return to the depositors. Besides there is some mandatory costs as well, like
CRR and SLR levied by the Central Bank from time to time.
(2) The processing of loan requests and subsequent disbursement involves non-fund
operating costs (like salaries paid to loan handling staff and the cost of physical facilities
used in granting and administrating a loan) which must be recovered from the borrower
as part of the loan cost.
(3) Default risk: Every loan carries some level of default risk. This risk must be
compensated by adding a default risk premium to the proposed rate of interest.
(4) And the last is the desired level of profit margin. The main objective of each entity is
to enhance the wealth of the stakeholders. The desired profit margin is added to the
interest rate to achieve this objective.
The undernoted equation presents a summarized view of the points discussed above:
Loan Interest = Marginal cost + Non-fund + Default + Desired

Rate of raising loan- operating Risk Profit
able funds cost Premium Margin
For example, Bank ‘A’ has received a request from one of its corporate customers for a loan of $
5 million. If the bank has to raise fresh deposit to finance this loan, the cost of raising fresh
deposits will be termed as the marginal cost which we assume in this case as 5 per cent per
annum. The bank’s credit administration may desires adding 2 per cent and 1 per cent
respectively to cover the non-fund operating cost and default risk premium on the proposed loan.
Finally the profit margin policy of the bank may demand 1 per cent profit over and above the
other costs listed earlier. Thus the loan will be offered to the prospective borrower at the rate of 9
percent (5 % + 2% + 1% + 1%).
152
The Price Leadership Model
The Cost plus Loan Pricing model discussed earlier has one important draw back. It anticipates
that the bank will be aware of all the costs accurately and hence pricing of loan will not pose any
challenge for handling different types of customers/loans. But in real life it is difficult to estimate
the anticipated cost which is required to be added to marginal cost, the price leadership model
has been evolved as an improved technique to manage this situation. The price leadership model
uses a uniform rate as a bench mark which is known as the prime rate. The desired risk premium
and term risk premium is added up to arrive at the applicable rate of interest charged to a
particular borrower.
Loan Interest = Base or + Default + Term Risk

Rate Prime Rate Risk Premium -
plus desired Premium seeking loan term
profit (added for loan
each borrower
independently)
The risk premiums attached to a loan are often referred collectively as mark up. Banks can
expand or contract their loan portfolio by simply contracting or expanding their mark ups. In
Pakistan KIBOR is used as the bench mark for pricing of loans and banks are adding the risk
premium according to the risk profile of the respective customer. The above equation is,
therefore, modified as under:
Loan Interest Rate = KIBOR + Default Risk Premium + Profit Margin
In case of loan with maturity extending to more than one year, the term risk premium is also
added which is applicable on long term loans.
KIBOR : is the average rate for the relevant tenor published by the financial market association.
Banks in Pakistan are free to decide the relevant tenor of KIBOR and spread. Presently KIBOR
quotes rates from one week to 3 years (bid & offer). In terms of SBP directives, the banks/DFIs
may use KIBOR as a benchmark for determining pricing of all Rupee Corporate/Commercial
lendings. The objective of benchmarking with KIBOR is to encourage transparency and promote
consistency in the market based pricing of loans.
Since KIBOR may fluctuate wildly, depending upon market conditions, the interest rate is
capped at certain upper limit on the loan as per mutual arrangement with the borrowers. The
capping of interest rate serves as a source of protection to the borrower and indicates the
maximum cost of loan under adverse conditions.
153
Customer Profitability Analysis
With the increasing use of advanced information system by banks with a view to keep track of
their services, a new loan pricing technique appeared which is known as customer profitability
analysis (CPA). This loan pricing method brings with it the assumption that the bank should take
the whole customer into account while pricing each loan request. The CPA focuses on the rate of
return from the entire customer relationship, calculated with the help of the following formula:
Net Income before = Revenue from loans - Expenses from providing

Tax from the whole and other services loans and other services
Customer relationship provided to the customer to the customer
Net loanable funds used in excess of the customer’s deposit
Sources of Revenue expected from loans and services to a customer are:

Interest income from loan
Loan commitment fee
Fee for managing customer’s deposits
Funds transfer charges
Fee for trust and other services rendered
Total revenue
Costs Expected to be incurred in servicing the customer

Interest on Mandatory Deposit payable to the lender
Cost of funds on respective lending
Activity cost for customer’s account
Cost of funds transfer
Cost of processing the loan
Bookkeeping cost
Total expenses
Net amount of the Bank’s Reserves expected to be drawn by the customer this year
Average amount of credit committed to customer xxx
Less average amount of deposit balance (net of required reserves xxx
Net amount of loanable reserves committed to customers xxx
Exercise 81
M/s Alpha Bank has approved a $ 3 million line of credit to M/s Red Carpet Services for a
period of one year. Assuming that the Red Carpet uses the full line of credit and maintains a 20
per cent compensating deposit with the bank, compute the customer’s profitability analysis. Total
annualized revenue and cost expected during the period from the said customer are $ 321,000
and $233,000 respectively.
154
Answer 81
Annualized before tax return = Revenue expected - Cost expected

over costs from the entire Net amount of loanable funds supplied
Bank – customer relationship
= ($ 321,000 - 233,000) = 0.035 or 3.5%

(3,000,000 - 600,000)
Exercise 82
As a loan officer of First National Bank, you have been responsible for the bank’s relationship
with Sony Traders, a major producer of electronic equipments. Sony Traders has just filed a
request for renewal of its $ 10 million line of credit, which will spread over a period of 10 to 12
months. Sony Traders also regularly uses several other services offered by the bank. Using the
most recent year as a guide, you estimate that the expected revenue from the loan and expected
costs to the bank for serving this customer will consist of the following:
Expected Revenue Expected Costs

Annual interest income for the Interest paid on customer’s
requested Loan (assuming KIBOR Deposit accounts ( @ 9%) 25,000
10 % + 1%) 1,100,000 Cost of funds raised 975,000
Loan commitment fee @ 1% 100,000 Account activity cost 19,000
Deposit management fee 4,500 Wire transfer costs 1,300
Wire transfer fee 3,500 Loan processing costs 12,400
Fee for agency services 8,800 Recording keeping costs 4,500
The Bank’s credit analyst has estimated the customer will keep an average deposit balance of $
2,125,000 for the year in which the line will remain active. The CRR rate is 10%.
Required:
What is the expected net rate of return from this proposed loan renewal if the customer actually
draws down the full amount of the required line?
Answer 82
Sources of Revenue Sources of Cost

Annual interest income 1,100,000 Interest paid on borrower’s
at 11% p.a. Deposit accounts ( @ 9%) 25,000
Loan commitment fee 100,000 Cost of funds raised 975,000
Deposit management fee 4,500 Account activity cost 19,000
Wire transfer fee 3,500 Wire transfer costs 1,300
155
Fee for agency services 8,800 Loan processing costs 12,400
_________ Recording keeping costs 4,500
Total revenue 1,216,800 Total cost 1,037,200
Net amount to be drawn by the customer

Average amount of line of credit $ 10,000,000
Less average customer’s deposit 1,912,500 **
Net amount of loanable reserve committed 9,087,500
To customer
Annual before tax income = 1,216,800 - 1,037,200 = 0.01987 or 1.99%

9,087,500
**Borrower’s deposit balance 2,125,000

Less 10% CRR 212,500
1,912,500
Exercise 83
William Sons who operates a small retail store in the shopping centre adjacent to the bank’s
branch office has asked for a personal loan of $ 4,500. William wants to keep the principal of the
loan for full year and pay the interest at the end. However, the bank insists on monthly
amortization of the loan, with a 13% annual rate. Under these terms, how much interest will
William pay in a year. How much interest would he may have paid if he had gotten the loan on
his terms.
Answer 83
Payment as per Bank’s schedule
1
___________
1 -
(1 + 0.13)12
___________ 12_____
$ 4,500 = PMT
0.13/12
1 - 0.8790 = 11.20
0.0108
= 4,500/11.20 = 401.78
Month Installment Interest Principal Outstanding

0 4,500
1 402 49 353 4,147
2 402 45 357 3,790
156
3 402 41 361 3,429
4 402 37 365 3,064
5 402 33 369 2,695
6 402 29 373 2,322
7 402 25 377 1,945
8 402 21 381 1,564
9 402 17 385 1,179
10 402 13 389 790
11 402 8 394 396
12 402 3 399 3
Total Repayment 402 x 12 = 4,824

Principal = 4,500
Interest cost = 324
Payment at the end of the period

Interest @ 13% on 4,500 = 4,500 x 0.13 = Rs.585
Payment as per Bank’s conditions requires lesser amount as interest. But on bank’s term the
entire amount of loan was not available for use by the borrower during the currency of the
facility. Whereas on the borrower’s terms he would be utilizing the entire amount of loan and
repaying the same at the end of the period.
Exercise 84
Mr. Frank wants to start his own business, an auto repair shop located at a busy intersection. He
has asked the bank for a $10,000 loan. The bank has a policy of making discount rate loans on
new ventures at prime rate plus 2. The prime rate is currently posted at 12.5 per cent). If Mr.
Frank’s loan is approved for the full amount, what net proceeds he will have to work with? What
is the effective interest rate on this loan for one year.
Answer 84
Prime Interest Rate = 12.50 %

Plus premium = 2.00 %
Total = 14.50 %
Amount Advanced = $10,000

Less Interest @ 14.50% = 1,450
Amount disbursed = 8,550
Effective interest rate = 1,450 x 100
8,550
16.96 %
157
Exercise 85
A government bond is currently selling for $ 900 and pays $ 80 per year in interest for five years
when it matures. If the redemption value of this bond is $1,000, what is its yield to maturity if
purchased for $ 950?
Answer 85
In order to determine the yield to maturity we substitute the interest rate to find a value that
forces the sum of the PV equals $ 950 i.e. purchase price.
First we use the rate of 10%
950 = $ 80 (PVIFAn5) + 1,000 (PVIFn5)

80 x 3.7908 + 1,000 x .6209
950 = 303.26 + 620.90 = 924.16
In order to improve the PV, we now try at 9%.
950 = $ 80 (PVIFAn5) + 1,000 (PVIFn5)

80 x 3.8897 + 1,000 x .6499
950 = 311.18 + 649.90 = 961.88
The above two working leads to the conclusion that the rate is between 10 and 9%. Let us try at
9.50%.
950 = $ 80 (PVIFAn5) + 1,000 (PVIFn5)

80 x 3.8396 + 1,000 x .6353
950 = 307.17 + 635.30 = 942.47
YTM is, therefore, 9.50%
Exercise 86
US Treasury Bills are available for purchase this week at the following price (based upon $100
par value) and with the indicated maturities.
a. $ 97.25 182 days

b. $96.50 270 days
c. $98.75 91 days
Calculate the Discount rate on each bill.
158
Answer 86
DR = (100 – Purchase price of TB) x 360

100 182
= 100 - 97.25 x 360 = 0.0544 or 5.44%

100 182
= 100 - 96.50 x 360 = 0.04655 or 4.65%

100 182
= 100 - 98.75 x 360 = 0.04945 or 4.94%

100 91
Please note that the above working is used to compute the discount rate and not yield on
investment.
159
CHAPTER XII
FINANCIAL STATEMENTS – BANKING INSTITUTIONS
In view of the specialized nature of banking business, and to provide security and safety to
public funds, regulators are particularly keen that bank’s financial statements should be compiled
on standard format and must contain required disclosures and explanations to assess their
financial strengths and weaknesses. Prudential Regulations has also made it mandatory that
every bank must get itself credit rated by a credit rated agency on the approved panel of State
Bank of Pakistan which should be made public within seven days of the notification of rating by
the credit rating agency.
The Income Statement and Balance Sheet of ‘X’ Bank Ltd. prepared in accordance with the
guideline contained in Second Schedule to the Banking Companies Ordinance 1962 (Sec. 34) is
given below:
BANK 'X' LTD.

FOR THE YEAR ENDED DECEMBER 31, 200X Rupees
(in
millions)
Markup/Return/Interest Earned 2,684
Markup/Return/Interest Expensed (1,312)
Net Mark up/Interest Income 1,372
Provision against non-performing 135
Loans & advances
Provision for diminution in the value of securities -
Bad debts written off directly 1 (136)
Net Mark up/Interest Income after provisions 1,236
Non-Mark up / Interest Income
Fee, Commission and Brokerage Income 323
Dividend Income 29
Income from dealing in foreign currencies 145
Other Income 154
Total non-mark up /interest income 651
Non-Mark up / Interest Expenses
Administrative Expenses 662
Other provisions/write off -
Other charges 3
160
Total non-mark up/interest expense (665)
Extra ordinary /unusual items -
Profit before taxation 1,222
Taxation – Current 547
Deferred 2
Prior (4) (545)
Profit after taxation 677
Unappropriated profit brought forward 11
Profit available for appropriation 688
Appropriations :
Transfer to
Statutory Reserve 136
Capital Reserve -
Revenue Reserve 300
Proposed cash dividend 200 (636)
Unappropriated profit / loss carried forward 52
Components of Income Statement
Mark Up & Interest Income
Interest & Mark up income are the two primary sources of income of every banking institution and
constitutes about 70% of their revenue on the average. It is the counterpart of sales which is the main
revenue of a traditional business houses. The interest and mark up paid to the depositors is the cost of
doing business, and the counterpart of cost of goods sold. The different of these two heads is termed as
Net Mark up & Interest income and corresponds to gross margin under the traditional income statement.
Since bank’s income is infected by defaults and diminution to the value of securities held by them due to
market fluctuation, the provision against non-performing loans and unrealized losses on investments are
adjusted directly from the net interest and mark up income at the very first stage.
Non Mark up & Interest Income
Other sources of revenue to a banking institution accrue from non-mark up incomes like fees,
commission, dividend income etc. Banks now a days are striving to increase non-mark up income to
reduce the impact of non-performing loans. Other ancillary business provided by banks to supplement
their income includes the following:
i) agency services and issuing guarantees;

ii) investment in government and other trading securities;
iii) general utility services;
iv) underwriting of loans raised by government, public bodies or joint stock companies;
161
v) providing specialized services to customers, including international trade financing;
vi) assisting their customers in asset management and investment decisions.
Non-Mark up & Interest Expenses
Like any other business organization, operating expenses i.e. administrative and management cost are the
second major cost of banking operation. It is subtracted from the total mark up and non-mark up income
to arrive at the operating income. Other non-operating income and recognition of taxes is also carried out
at this stage. The residual amount is available for transfer to retained earning, after under noted mandatory
and policy adjustments:
i) Statutory Reserve
ii) Capital Reserve
iii) Revenue Reserve
Like wise the balance sheet of a bank exhibits different components of assets and liabilities. The balance
sheet of ‘X’ Bank Ltd. is reproduced hereunder:
X' BANK LTD.

BALANCE SHEET
AS ON DECEMBER 31,
ASSETS
Cash & balances with treasury banks 3,295
Balances with other banks 607
Lending to financial institutions 3,896
Investments 17,959
Advances 32,230
Other Assets 652
Operating Fixed Assets 343
Deferred tax assets -
Total Assets 58,982
LIABILITIES
Bills Payable 940
Borrowing from financial Institutions 13,155
Deposits and other accounts 39,338
Subordinated loans -
Liabilities against assets subject to finance lease -
Other liabilities 983
Deferred tax liabilities 758
162
Total Outside Liabilities 55,174
Net Assets 3,808
Represented by :
Share Capital 1,000
Reserves 1,699
Unappropriated profit 54
2,753
Surplus on revaluation of assets 1,055
3,808
Components of Balance Sheet
Assets
Banks are supposed to maintain a risk free liquidity position to uphold depositor’s confidence and to
maintain market integrity. Most of their liquid assets resultantly comprises of the following:
Cash and deposits held with Treasury Banks

Balances with other Banks
Lending to Financial Institutions
Investments
Apart to meet depositor’s withdrawals on a regular basis, banks are required to maintain a specified cash
balance with the Central Bank in proportion of their time and demand liabilities, known as Cash Reserve
Requirement (CRR). Banks also maintain nostro accounts to handle customer’s transactions through
correspondent banks which also consume a certain amount of liquid resources. The excess liquidity
thereafter is now available for their normal business operations.
After liquid and semi liquid assets, advances constitutes as the largest component of bank’s assets. These
assets comprise of both short term and long term advances. The quality of these assets and effective
management is primarily responsible for the success or failure of any bank. A certain percentage of
resources are also invested in securities to diversify their risk.
The size of operating assets of banks is considerably small in relation to investments and advances. With
the advent of new technology, the amount of these assets is also on the rise due to large investments
needed to adopt rapid changes in information technology.
Liabilities
The principal liability of any bank is its obligation against deposits, representing claims held by
businesses, households and government against the bank. Borrowing from inter-bank market is another
163
important source of raising funds by banks. Besides these, other new avenues of raising funds are also
emerging like Euro Dollar Deposits, Global Certificates of Deposit, Commercial Papers, Repurchase
arrangement etc.
Capital
The capital account represents the owner’s stake in the business. State Bank of Pakistan is implementing
the recommendations of Basel Accord on the local banking sector to strengthen the banking sector.
Accordingly banks are now complying two capital requirements, one is Minimum Capital Requirement
(MCR) and the other is Capital Adequacy Ratio (CAR). The current directive of State Bank of Pakistan
in respect of MCR is as under:
December 31, 2009 Rs. 6 billion

December 31, 2010 7 billion
Consequent upon compliance to MCR, banking sector in Pakistan is in the process of amalgamation and
consolidation. It may have both positive and negative impact on the working of Banks. From the positive
angle there will be fewer but financially more strong banks operating in the market in the future. On the
negative side, the business will be monopolized and the customers will lose the opportunity of better
services due to lack of competition and fair play.
Ratios Specific to Analyzing Banking Business
In addition to traditional ratios used by accountants for financial analysis, the following ratios are
particularly helpful to evaluate the performance of financial institutions.
Net Interest Margin (NIM)
This ratio shows how profitably the bank’s assets have been employed. It also shows the difference
between interest earned on loans and interest paid on the funds borrowed to extend those loans. The
difference between the two is something akin to the contribution margin earned by a manufacturing
establishment. Therefore, the higher a bank’s NIM, the higher the prospects of better return, all other
costs, particularly operating cost remain unchanged. For the ‘X’ Bank Ltd. the NIM has been computed
as under:
Mark up & Interest earned = 2,684 (m)

Less Mark up & Interest expensed = 1,312 (m)
Net mark up Income = 1,372 (m)
Total Assets = 58,982
NIM = Interest Revenue – Interest Expenses

Total Assets
NIM = 1,372/58,982 = 2.326%
164
Interest Spread
This ratio shows the return on interest bearing (earning) assets as compared to cost incurred to raise the
funds for those earning assets. The formula used to compute interest spread is as follows:
Interest Spread = Interest revenue - Interest Expense

Total earning assets Total interest bearing liabilities
For the ‘X’ Bank Ltd., interest spread is computed as under:
Mark up & Interest earned = 2,684 (m)

Mark up & Interest expensed = 1,312 (m)
Earning Assets
Cash & Balances with Treasury Banks = 3,295 (m)
Balances with other banks 607
Lending to Financial Institutions 3,896
Investments 17,959
Advances 32,230 54,692 (m)
Total Earning Assets 57,987
Interest bearing Liabilities

Bills Payable 940 (m)
Borrowing from financial 13,155
institutions
Deposits & other accounts 39,338
Total interest bearing liabilities 53,433
Interest spread = 2,684 - 1,312

57,987 53,433
= 4.63 % - 2.46 % = 2.17 %
Non Interest Margin
In view of large risk associated with lending business, banks always try to enhance non-interest income to
provide some level of safety. Non-interest income includes commission and fees earned on guarantees
and exchange profit earned on foreign exchange business. Non-interest income also includes dividends
and interest earned on investments. The total of these earnings is divided by total assets employed by the
institution to arrive at non-interest margin. Non interest margin of ‘X’ Bank Ltd. is computed below:
Non Interest Income

Fees & Commission 323 (m)
Dividend 29
Income from Foreign Exchange 145
Other Income 154
Total 651
Non Interest Margin = Total Non-Interest Income/Total Assets

Non Interest Margin 651 / 58,982 = 1.10%
165
Return on Equity
One of the most important ratios from the perspective of investors for measuring bank’s performance is
‘Return on Equity (ROE)’. This ratio helps investors to make investment decisions and in turn has direct
bearing on the market value of the respective share. It can be computed as under:
ROE = Net Income x Total operating revenue x Total assets

Total operating Total assets Total owners
Revenue equity
‘X’ Banks return on equity is computed as under:
= 52 x 2,023 x 58,982
2,023 58,982 3,808
= 0.026 x 0.034 x 15.49
= 0.014 or 1.4 %
Exercise 87
Groupwise Balance Sheet and Income Statement of Banks in Pakistan for the year ended December 31,
2009 is also given below for analysis:
Balance Sheet
(million Rupees)
Assets PSCB LPB FB SB All Banks
Cash & Balances with Treasury Banks 106,636 369,899 34,783 3,330 514,649
Balances with other Banks 33,560 108,675 16,270 11,279 169,784
Lending to Financial Institutions 24,172 183,600 32,118 233 240,123
Investments – Net 310,664 1,373,560 52,373 14,610 1,753,206
Advances – Net 621,063 2,444,099 90,451 92,594 3,248,207
Operating Fixed Assets 29,581 206,345 3,580 5,070 244,575
Deferred Taxes 15,268 35,445 5,229 3 55,945
Other Assets 88,310 195,665 6,653 11,643 302,271
Total Assets 1,229,284 4,919,287 241,456 134,762 6,528,760
Liabilities
Bills Payable 8,694 55,098 3,596 2,195 69,583
Borrowing from Financial Institutions 64,374 490,763 16,722 86,695 658,554
Deposits & other Accounts 953,373 3,655,609 160,755 16,993 4,786,729
Sub-ordinated loans - 48,625 - 3,405 52,031
Liabilities against Finance Lease 63 60 - 12 135
Deferred Liabilities 2,809 4,279 353 106 7,547
Other Liabilities 64,030 172,573 24,141 31,850 292,594
Total Liabilities 1,093,343 4,427,007 205,567 141,256 5,867,173
Net Assets 135,912 492,281 35,889 (2,494) 661,587

Net Assets Represented by:
Share Capital 21,339 250,067 34,884 15,507 321,797
166
Reserves 33,241 128,593 76 3,447 165,359
Unappropriated Profit 54,558 68,058 1,036 (25,163) 98,489
Shareholder’s Equity 109,141 446,718 35,996 (6,209) 595,645
Surplus/Deficit on Revaluation 26,771 45,462 (106) 3,715 75,942
Of Assets
Total 135,912 492,281 35,889 (2,494) 661,587
Profit & Loss Statement (million rupees)
Mark up/Return/Interest Earned 98,734 459,702 22,207 10,463 591,106

Mark up/Return/Interest Expensed 62,336 248,699 12,188 5,031 328,254
Net Mark up/Interest Income 36,398 211,003 10,020 5,432 262,852
Provision & Bad Debts written off 12,440 67,567 4,609 523 85,139
Net Mark up/Interest Income 23,958 143,436 5,411 4,908 177,713
After Provision
Fees, commission & Brokerage income 9,765 31,167 2,022 99 43,053

Dividend Income 3,000 5,114 9 83 8,206
Income from dealing in F.Exchange 3,236 12,635 3,541 - 19,412
Other Income 5,725 18,429 (44) 5,718 29,828
Total Non-Mark up/Interest Income 21,726 67,346 5,527 5,901 100,499
45,684 210,782 10,938 10,809 278,212
Administrative Expenses 27,629 136,694 11,780 6,307 182,411

Other Expenses 1,033 3,892 263 (30) 5,158
Total Non-Mark up/Interest Expense 28,663 140,586 12,044 6,276 187,569
Profit before Tax Ex.ordinary items 17,021 70,196 (1,106) 4,532 90,644
Extra ordinary & unusual items - - 385 (664) (299)

Profit before Taxation 17,021 70,196 (721) 3,868 90,365
Taxation 6,634 26,933 (34) 2,597 36,130
Profit after Tax 10,388 43,263 (687) 1,271 54,235
Required: Comments on the Performance of the Banks as reflected from the above mentioned
consolidated Balance Sheet and Profit & Loss Account.
(Note PSCB stands for Public Sector Commercial Banks, LPB stands for Local Private Commercial
Banks, FB stands for Foreign Banks, and SB for Specialized Banks)
Answer 87
Assets
i) Banks in Pakistan held about Rs. 684.433 (m) in cash and cash equivalent as on 31st December, 2009.
These funds were intended to meet the cash withdrawal requirements of the customers, Cash Reserve
Requirements fixed by State Bank of Pakistan and funds in nostro accounts to manage customer’s
transactions routed through correspondent banks. The amount collectively constitutes about 10.48 % of
167
the value of their total assets. Banks either earn no income on these deposits or if any, the same is very
nominal. In view of high cost of holding these funds, banks strive to reduce its level within manageable
limit.
ii) Banks also invest their surplus funds in the interbank market. These investment are short term in nature
and provides a window to earn reasonable return on investable funds. Banks also avail the opportunity by
borrowing from interbank market at lower rate and lending at higher rate, thereby making gain through
swap deals.
iii) Investments: Banks invest a certain amount of their resources in securities to diversify their business
risk. These investments include both government backed securities held as per SLR requirement, highly
liquid securities which can be quickly converted into cash in case of need and other investments to earn
dividend and capital return. Investment portfolio comprises of 26.85% of the value of total assets. Part of
cash and cash equivalent is supplemented with investment to reduce the opportunity cost of funds held
under head one.
iv) The main assets of banks are in fact loans and advances. The total advances as on 31st December stood
at 3,248,207 (m) which amounted to 49.75% of the total assets. In the free market only those banks can
flourish who can use their resources for advances which are repaid as per terms of finance and adequately
secured with collaterals to fall back upon in case of default.
In the year 2008 banks deposit/advances ratio touched to an alarming level of around 80% which created
liquidity problem and resulted a run on certain banks in the private sector. Thereafter, State Bank issued
directives to reduce this ratio to 70%. From the above statistics, it reflects that the banks advance to
deposit ratio as at the close of the year 2009 was 67.85% which was within satisfactory limit.
v) Other assets comprise of 9.23% of the total assets and include operating fixed assets and other assets to
manage their regular operation.
Liabilities
i) Banks major liabilities originates from deposits and other accounts followed by borrowing from
financial institutions. By 31st December, 2009 these liabilities stood at 81.58% and 11.22% with reference
to total outside liabilities respectively. After 1990, money market started growing rapidly in Pakistan and
now a days almost all banks use this market to avert immediate liquidity problems and also for diverting
surplus funds to improve profitability.
ii) In order to meet the Minimum Capital requirement, Banks are raising their capital on a regular basis.
With higher level of equity, banks are in a better position to sustain losses and to provide improved
security to the depositors.
Profit & Loss Account
Banks major earning accrues from interest and mark up. The net mark up income as on 31st December 09
stood at Rs. 177,713 (m) which constituted at 63.88% of the total mark up and interest income and non
markup income of the banks collectively. Non-mark up income is also improving on a regular basis and
was 36.12% on that date. After interest and mark up expenses, non-mark up expenses of banks includes
administrative and operating expenses. In view of rapid changes in technology, banks operating cost is on
the rise to keep pace with rapidly changing technology.
168
After payment of taxes, the net amount available for appropriation was Rs.54,235 (m). In terms of return
on assets it stood at 0.83%.
A trend analysis of major indicators of banking business in Pakistan are also given below for comparison
and better understanding of growth pattern
.
(in billions Rupees)
CY 04 CY 05 CY 06 CY 07 CY 08 CY 09
(Dec.)
Total Assets 3,043 3,660 4,353 5,172 5,627 6,529

Investments (net) 679 800 833 1,276 1,080 1,753
Advances (net) 1,574 1,991 2,428 2,688 3,183 3,249
Deposits 2,393 2,832 3,255 3,854 4,217 4,787
Equity 202 292 402 544 563 662
Profit after tax 35 63 84 73 43 54
Non Performing Loans 59 41 39 30 109 125
The percentage of growth under various heads based on the above statistics is given below:
Total Assets 100 120.27 143.04 169.96 184.92 214.56

Investments (net) 100 117.82 122.68 187.92 159.06 258.17
Advances (net) 100 126.49 154.26 170.78 202.22 206.42
Deposits 100 118.35 136.02 161.05 176.22 200.04
Equity 100 146.00 199.00 269.31 278.71 327.72
Profit after tax 100 180.00 240.00 208.57 122.86 154.29
Net Performing Loans 100 69.49 66.10 50.84 184.74 211.86
The above statistics shows that banking business, during the entire period from 2004 to 2009, has
achieved major growth. Deposits rose by 100% and advances by 106.42% from the base year 2004.
Banks are now investing larger amount on investments in contrast to their past policy of greater
dependence on advances. Although the size of business of the bank has almost doubled during this period,
the profitability of the banks has only registered improvement by 54.29%. The growth in profit was
lesser due to higher operating cost and large amount of investments made in information technology
during this period. Equity has registered highest growth due to mandatory capital requirement fixed by
State Bank of Pakistan. The figure of non-performing loans shows that the bank’s quality of advances had
improved in 2005 and 2006 but deteriorated from 2008 onward due to world wide recession which also
had adverse impact on the Pakistan’s economy.
Selected Ratios
NIM = (591,106 – 328,254) / 6,528,760

262,852 / 6,528,760 = 4.03%
Interest Spread = 591,106 - 328,254

5,925,969 5,566,897
0.0997 - 0.0589 = 0.0408 or 4.08%
Non-interest Margin = 100,499 / 6,528,760 x 100 = 1.54%
169
Revenue equity
ROE = 54,235 x 691,605 x 6,528,760

691,605 6,528,760 661,587
= 0.08 x 0.106 x 9.868 = 0.084

or 8.4 %
Exercise 88
Following is the financial high lights of a commercial bank in Pakistan.
(amount in millions)
2006 2005 2004 2003 2002
Total Income 1,071 809 540 571 658
Net Mark up Income 332 288 283 211 238
Profit after tax 295 272 286 162 157
Paid up Capital 3,242 2,162 2,162 2,162 2,103
Shareholders Equity (net) 4,058 2,962 2,735 2,375 2,202
Review the above data and offer your comments on each item especially mentioning percentage
increase/decrease.
Answer 88
Comments
1. Total Income: Total income of the bank has been registering major improvement since 2005. By 2006
it has increase by 62% from the base year. In the year 2003 and 2004 the bank faced major set back, when
their total income reduced by 13.22% and 17.93 respectively. They were able to reverse this trend in 2005
and now it is well on the path of growth. If we assume 2004 as the base year, then in 2005 the total
income grew by 49.81% and 98.33% in 2006.
2. Net Mark up Income: Net mark up income is showing regular growth during the entire period except in
the year 2003 when it dropped by 27 million. The major improvement can be witnessed in the year 2006,
where it grew by 39.50% from the base year.
3. Profit after tax: The increase in total income and net mark up income has resulted in improvement in
profit after tax year after year. After tax growth in profit for the year 2006 stood at 87.89%.
4. Paid up Capital: The Bank has raised its paid up capital in 2003 and again in 2006. Major rise in capital
has taken place in 2006 which shows increasing stake of the owners and the management’s resolve to
comply with minimum capital requirement fixed by State Bank of Pakistan. The paid capital in 2006
stood at 154.16% from the base year.
170
5. Share Holder’s Equity: Shareholders equity is growing regularly during the entire period. It shows both
capitalization of profit and fresh equity injected by the owners. By 2006 it has grown to 184.28% from the
base year.
Exercise 89
The under noted figures have been extracted from the financial statement of a bank for the period ended
December 31, 2009.
2007 %
(Rupees in thousand)
Income from banking services 15,088,220
Cost of Services (2,200,432)
Value added by banking services 12,887,788
Non-banking income 14,297
Provision against non-performing assets (2,874,226)
10,027,859
Salaries, allowances & other benefits 3,733,127 37.2
Income Tax 1,876,918 18.7

Dividend 2,827,843 28.2
Depreciation/Amortization 341,656 3.4
Retain in Business 1,248,315 12.4
10,027,859 100
Use your judgment to briefly describe:
1. Income from banking services

2. Cost of services
3. Provision against non performing assets
4. Distribution to owner and government
5. Retained in business
Answer 89
1. Income from Banking services. Under this head the income earned by the bank from interest and
mark up together with non-mark income has been pooled together. In fact most banks derive major part of
their income from interest and mark up followed by non-mark up and interest income like fees,
commission, dividend etc. The non-banking income of Rs.14,297 is assumed to be income from other
non-banking activities like income from disposal of assets etc.
2. Cost of Services: It covers the cost incurred by the bank on account of interest and mark up on
deposits mobilized for their banking activities.. Since most of the funds used by banks in their business
activities are borrowed funds, interest and mark up comprises major part of their total expenses. In fact
interest and mark up paid is the counter part of the cost of goods sold of a traditional business house.
3. Provision for non-performing assets: Banks major business can be grouped under two heads lending
and investment. In lending business failure of the counterparty is one of the major factors causing losses
to the banks. According to SBP directive all loans where the counter party failed to pay principal or
171
interest 90 days past due date is termed as non-performing loan. All banks are accordingly required to
provide against those advances in the following ratios:
Substandard 25%
Doubtful 50%
Losses 100%
4. Distribution to owners and Government: It means payment of taxes as applicable under the rules and
distribution of profit to the stockholders in the form of dividend. Regarding taxes, these are mandatory
and must be paid as per current rules. Dividend is, however, not mandatory and depends upon the
decision of the directors and share holders. Despite availability of profit, the same may be capitalized in
the best interest of the institution.
5. Retained in business: When profit is not distributed and transferred to reserves, it constitutes that the
same has been retained in business. Distribution of profit reduces equity and capitalization strengthens
equity. Banks in Pakistan are required to transfer a prescribed percentage of their profit each year to
statutory reserve and at the same time they also maintain several other reserves to meet various
contingencies.
Exercise 90
Financial Statements of two commercial banks operating in Pakistan are given below:
Profit & Loss Accounts

For the year ended 31 December, 2008
Bank ‘A’ Bank ‘B’

(Rupees in millions)
Mark-up/return/interest earned 18,393 31,046
Mark/return/Expensed 10,651 20,331
Net Mark up/Interest Income 7,742 10,715
Provision against non-performing loans and advances 3,824 2,035

Provision for impairment in the value of investments 1 1,479
Bad Debts written off directly 247 29
4,072 3,543
Net mark-up/interest income after provisions 3,670 7,172
Non-mark up/interest income

Fees, Commission and brokerage income 1,258 2,539
Dividend income 174 300
Income from dealing in foreign currencies 874 915
Gain on sale of securities – net 37 424
Unrealized gain on revaluation of investments 22 (181)
Other income 342 1,248
Total non-mark up / interest income 2,707 5,245
6,377 12,417
Non-mark up/interest expenses
Administrative expenses 5,904 10,471
Other provisions /write offs 1 30
Other charges 11 122
172
Total non-mark up/interest expenses 5,916 10,623
Extra ordinary / unusual expenses -
Profit before taxation 461 1,794
Taxation – Current year 17 1,730

Prior year (50) (223)
Deferred 108 (1,014)
75 493
Profit after taxation 386 1,301
Balance Sheet
As at December 31, 2008 Bank ‘A’ Bank ‘B’
(Rupees in millions)
Assets
Cash & balances with Treasury Banks 16,030 32,687
Balances with other Banks 3,955 21,581
Lending to financial institutions 4,480 3,316
Investments 35,678 75,973
Advances 128,818 192,672
Operating fixed assets 8,266 13,773
Deferred tax assets - -
Other assets 8,964 8,989
206,191 348,991
Liabilities
Bills Payable 2,585 3,452
Borrowings 15,190 13,690
Deposits and other accounts 167,677 300,733
Sub-ordinated loans 2,996 2,572
Liabilities against assets subject to finance lease - -
Deferred tax liabilities 13 208
Other liabilities 4,759 11,291
193,220 331,946
Net Assets 12,971 17,045
Represented by
Share Capital 4,059 7,995
Reserves 7,667 3,166
Un-appropriated profit 309 3,447
Surplus on revaluation of assets 936 2,437
12,971 17,045
Required: Compare their individual performance and give your comments thereon.
173
Answer 90
Some selected ratios computed with the help of data contained in their respective financial statements are
as under:
Bank ‘A’ Bank ‘B’
NIM = (18,393 – 10,651) / 206,191 (31,046 – 20,331) / 348,991
3.75 % 3.07 %
Interest Spread = 18,393/188,961 - 10,651/188,448 31,046/326,229 – 20,331/320,447

9.73 % - 5.65 % 9.52 % - 6.34 %
4.08 % 3.18 %
Non-interest Margin= 2,707 / 206,191 5,245 / 348,991

1.31 % 1.51 %
Income/Expense Ratio = (18,393 + 2,707)/5,916 (31,047 5,245)/10,623

3.57 times 3.42 times
Advances/Deposits Ratio = 128,818 / 167,677 192,671 / 300,733

76.83 % 64.07 %

Revenue equity
Bank ‘A’
ROE = 386 x 21,100 x 206,191
21,100 206,191 12,971
0.018 x 0.102 x 15.90
= 2.92 %
Bank ‘B’
ROE = 1,301 x 36,291 x 348,991
36,291 348,991 17,045
0.036 x 0.104 x 20.47
7.66 %
174
Comments
Net Interest Margin and Interest Spread
Bank A’s net interest margin works out as 3.75% as against 3.07% of Bank ‘B’. It indicates that bank ‘A’
has been more successful in securing deposits at a lesser cost which is being directed for lending and
investment. It shows that Bank A’s mobilization campaign is more successful since they are able in
securing less costly deposits which speak about the confidence enjoyed by them in the public and trade
circles.
The same result is reflected in interest rate spread as well. Bank A’s interest spread is 4.08% where as
Bank ‘B’ is 3.18%. When the cost of securing deposit is low the prospects of better interest spread is
naturally inherent.
Non-Interest margin
Regarding non-interest margin bank ‘B’ is performing better. Bank B’s non-interest margin was 1.51 %
as compared to 1.31 % of Bank ‘A’. It implies that bank ‘B’ has been able to secure and handle more
ancillary business as compared to Bank ‘A’. In view of highly volatile market, banks are placing more
emphasis on non-interest income to reduce unsystematic risk.
Interest Expenses Ratio
On this front Bank ‘A’ has better performance level. It indicates better management of operational cost,
reflecting higher level of use of technology and better control on operating expenses. Bank ‘A’ interest
expenses ratio stood at 3.57% as against 3.42% of Bank ‘B’. Effective and better control of expenses
provides an edge to compete more aggressively in the market.
Advances Deposit Ratio
Bank ‘A’ has a deposit advances ratio of 76.83 % as against 64.07 of Bank ‘B’. It gives two important
signals. Number 1 that Bank ‘A’ is acting more aggressively in the market. Secondly, it is taking higher
level of risk than prescribed by State Bank of Pakistan which requires deposit advances ratio of 70%.
This type of strategy is very risky in case of unexpected run on a bank. In 2008 few private commercial
banks in Pakistan faced critical liquidity crisis due to high advances and deposit ratio.
Return on Equity
Since Bank ‘B’ has a larger size of assets in relation to the bank ’A’ which enabled them to earn greater
level of operating income and net income, its return to equity ratio has produced better result which was
7.66 % as against 2.92 % of Bank ‘A’.
As a whole both bank’s performance is not very impressive. They have interest spread between the ranges
of 4% as against 7% on the average in the banking industry. It speaks that they are poorly rated banks
and to survive in the market attracting deposits at a very high cost. Amount of non interest margin also
point out their low capacity to secure ancillary business from the market.
175
Exercise 91
‘X’ Bank Ltd. have ratio of equity to total assets of 7.5 percent. In contrast ‘Y’ Bank Ltd. reports equity to
asset ratio of 6 per cent. What is the value of equity multiplier for each of these banks? Suppose that both
banks have an ROA of 0.85 per cent, what must each bank’s return on equity will be? What do these
calculations tell about the benefits of a bank having as little equity as regulations or market may permit?
Answer 91
‘X’ Bank Ltd. ‘Y’ Bank Ltd.
Equity Multiplier 100/equity to asset ratio

100/7.5 100/6
13.33 16.67
ROE 13.33 x 0.85 16.67 x 0.85

11.33% 14.16%
Since Bank ‘Y’ has larger equity multiplier than ‘X’ Bank, the return on equity of Bank ‘Y’ is better. It
implies that a bank with smaller size of equity and larger size of assets can produce better results.
However, the quality of assets is extremely significant for achieving better operating results. At the same
time it is relevant to keep in mind that a low level of equity reduces the scope of an institution to sustain
probable losses. In terms of Basel Accord, Central Banks in every country are, therefore, placing more
emphasis on strengthening of equity base of banks which is also in the process of implementation in
Pakistan.
Exercise 92
The First State Bank of Nigeria reports a net interest margin of 3.25 per cent in its most recent
financial report, with total interest revenue of $ 88 million and total interest expense of $ 72
million. What volume of earning assets must the bank hold?
Answer 92
The Net Interest Margin (NIM) is equal to :
NIM = Net Interest Revenue - Net Interest Expense

Total Assts
0.325 = $ 88 million - $ 72 million = 16 million

Total Assets
Total Assets = 16 million / .0325 = $492 million
Exercise 93
If a bank’s net interest margin, which was 2.85 per cent, doubles and its total assets, which stood
at $ 545 million, rise by 40 percent, what change will occur in the bank’s net interest income.
176
Answer 93
Original Net Interest Income
NIM = Net Interest Income

Total Assets
0.0285 = Net Interest Income

$ 545
NIM = $ 545 x 0.0285 = $15.5 million
New NIM = 2.85 x 2 = 5.7% New Assets = $ 545 x 1.4 = $763 million
New Net Interest Income
0.057 = Net Interest Income

$ 763
= $763 x 0.057 = $ 43.491 m
Increase in net income = $ 43.49 m - $ 15.5m = $27.99 m
177

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CHAPTER I

Management decisions concerning the acquisition provides answers to questions namely:

1. What products or services should be sold?

Comparison of Financial Accounting with Managerial Accounting

Financial Account Managerial Accounting

User Orientation Both external/internal users Exclusively for internal Users

Characteristics of Managerial Accounting.

Role of the Controller

1. Planning, evaluating, and controlling operations for all levels of management;

Code of conduct for Management Accountants

iii) To maintain personal integrity.

iv) To disclose information in credible fashion.

Cost Classification by Business Functions

Prime Cost & Conversion Cost

Prime Cost Conversion Cost

Controllable costs : It is a cost that can be regulated or influenced by a given level of

Uncontrollable costs : It is a cost that cannot be regulated or influenced at a given level of

2. The term “discretionary cost” refers to those:

3. The term “cost” refers to:

6. The management of X’s budgeted production of 800,000 units at a cost of Rs.1,600,000.

7. Which of the following is “cost appropriate to a specific management decision”?

Schedule of Cost of Goods Manufactured

Schedule of Cost of Goods Sold

Sales ? ? 240,000 225,000

Sales 283,000 272,000 240,000 225,000

Visic Corporation, a manufacturing company, produces a single product. The following

Production in units 29,000

2(a) Units in Finished Goods Inventory

2(b) Cost of Finished Goods Inventory

Sales (26,000 x 50) 1,300,000

Predetermined Overhead Rate

Total manufacturing overhead cost $ 180,000

Predetermined = Estimated total manufacturing overhead cost

i) Predetermined overhead rate

Total product cost 50 units 1,706 + 2,202 = ,3,908

iv) Applied overhead for the year

Machine hours 75,000

Machine hours 60,000

i) Predetermined overhead rate : $900,000/75,000 = $ 12 per machine hr.

iii) Cost of goods Sold $1,400,000

WIP Overhead 36,000 36/720

v) Overhead underapplied transferred to

Service Department Allocations

Cost allocation Administration : 20,000/25,000 x 2,400,000, 5,000/25,000 x 2,400,000

Service Departments Operating Departments

Overhead costs $140,000 $105,000 $ 48,000 $275,000 $430,000 $998,000

Service Departments Operating Departments

Administration -140,000 84,000 56,000 140,000

Administration : Binding 315/525x140,000 Printing 210/525x140,000

Step Down Method

Service Departments Operating Departments

Overhead costs $140,000 $105,000 $ 48,000 $275,000 $430,000 $998,000

Administration : 35/700x140,000, 140/700x140,000, 315/700x140,000, 210/700x140,000

COST BEHAVIOUR ANALYSIS AND USE

Types of Organization Costs that are normally variable

1. Merchandizing company Cost of goods (merchandise)

Methods to Separate Mixed Cost into Fixed & Variable

Cost behavior with the help of Scattergraph Plotting

Month Activity level Maintenance

Total maintenance cost for 7,300 patient days

Variable cost per unit = 5,800 ÷ 7,300 patient days

Variable cost = Slope of the line = Rise = Y2 - Y1

Variable cost = Changes in cost