Planning & Budgeting

Compiled and edited by:

Dr. Mohamed Srour

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Table of Contents:
Chapter Title Page
Chapter 1 Master Budget – Basic Concepts 5
Chapter 2 Forecasting 33
Chapter 3 Components of a Master Budget 65
Chapter 4 Static Budgets and Variances Analysis 111
Chapter 5 Capital Budget - Evaluating of Investment 165
Proposals

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 Chapter One

Master Budget – Basic Concepts

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Learning Objectives:

After studying this chapter, the reader should be able to:

(1) Understand the difference between budget & budgeting.

(2) Understand the six functions of the budgets.

(3) Understand the difference between static budget & flexible budget.

(4) Understand the behavioral aspects of budgets.

(5) Understand the various components of master budget, and how are
they prepared.

(6) Understand the starting point of a master budget and why.

(7) Prepare the schedules of master budget (Sales budget, Production

budget, direct material purchases budget, direct labor budget, mfg OH
budget, cost of goods sold budget, and budgeted income statement).

(8) Prepare cash budget and its important in the master budgeting
process.

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Introduction:

Financial budgets such as pro forma income statements, statements

of cash flow, and balance sheets report expected results in ASPFJIFRS
compliant formats. Nonfinancial budgets report on both the timing and
quantity of resources required to achieve predicted financial results. The
key purpose of nonfinancial budgets is coordination of all business
functions in the value chain. With coordination comes control. Once in
place, the predicted outcomes can be compared against actual outcomes
with the goal of improving on any unfavorable actual performance
relative to what is expected in the budget. As one observer has said,

"Few businesses plan co fail, but many of those that flop failed to plan."

Budgets help managers:

1. Communicate directions and goals to different departments of a

company to help them coordinate the actions they must pursue to satisfy
customers and succeed in the marketplace.

2. Judge performance by measuring financial results against planned

objectives, activities, and timelines and learn about potential problems.

3. Motivate employees to achieve their goals.

This chapter presents the budgeting process used to create an

operating budget (reported as a pro forma income statement), a cash

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budget, and a pro forma balance sheet. These pro forma statements are
predictions, not historical outcomes; therefore, they are never audited.

1.1 The Terms Associated to the Budgets:

Budget:

A budget is an operational plan and a control tool for an entity that identifies
the resources and commitments needed to achieve the entity’s goals over a period.
Budgets are primarily quantitative, not qualitative. They set specific goals for
income, cash flows, and financial position.

A budget is the quantitative expression of a proposed plan of action by

management for a specified period, and an aid to coordinating what needs to be done
to implement that plan may include both financial and nonfinancial data

Budgeting:

Budgeting is undertaking the steps involved in preparing a budget. Along with

clear communication of organizational goals, the ideal budget also contains
budgetary controls.

Budgetary control:

Budgetary control is a management process to help ensure that a budget is

achieved by:

• instituting a systematic budget approval process

• coordinating the efforts of all involved parties and operations

• analyzing variances from the plan and providing appropriate feedback to

responsible parties

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 The goals identified in the budget must be perceived by employees as realistic
if those employees are to be motivated to achieve the goals.

Pro forma statement:

A pro forma statement is a budgeted financial statement based on historical

documents and appropriate forecasting techniques that is adjusted for events as if
they had occurred. Budgeted balance sheets, budgeted statements of cash flows, and
budgeted income statements are forecasts of goals for a future period that assist in
the allocation of resources.

The time period of budget:

The time period of budget covers a one year period corresponding to the fiscal
year of the firm. The yearly budget can be divided into four quarters. The quarterly
budget also, can be subdivided into monthly budget. Therefore, the time period of
budget may be yearly budget, quarterly budget, or monthly budget.

The committee of budget:

The committee of budget is responsible for preparing the budgeting. The

budget committee consists of the president of the firm, vice president and managers
of departments such as sales manager, production manager, purchasing manager, and
HR manager. The budget committee approves the final budget.

1.2 Budget Cycle

A budget cycle usually involves six key considerations:

1. A budget is created that addresses the entity, as well as its subunits.

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2. All the managers of the subunits agree to fulfill their part of the budget. This
management buy-in aligns subunits with overall company strategies.
3. the budget becomes the company’s performance benchmark. As such, actual
results are measured against budgeted expectations.
4. All variations from budget are closely analyzed to determine the root cause
of the variance.
5. Management uses the variance analysis to take all necessary corrective
action to re-direct future results to budget expectations wherever possible.
6. Further evaluation of performance is closely monitored. If conditions cannot
be altered to re-direct future results to budget expectations, management will
determine appropriate plans which identify future expectations given those
conditions. Since these revised plans consider significant changes in the
business and economic environment, they are often used in the development
of subsequent budgeting.

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1.3 Reasons for Budgeting
There are four main reasons a company creates a budget: planning,
communication and coordination, monitoring, and evaluation.

1.4 Characteristics of Successful Budgeting

No single factor developed in isolation can lead to a successful budget.
Many of the following factors must be considered together to develop a successful
budget:

• The budget must be aligned with the corporate strategy.

• The budget process should be kept separate but should flow from the
strategic planning and forecasting processes.
• The budget should be used to alleviate potential bottlenecks and to allocate
resources to those areas that will use the funds most efficiently and effectively.
• The budget must contain technically correct and reasonably accurate
numbers and facts.
• Management (including top management) must fully endorse the budget –
they must accept responsibility for reaching the budget goals.
• The budget must be perceived by employees as a planning, communication,
and coordinating tool, and not as a pressure or blame device.
• The budget must be characterized as a motivating tool to help employees
work toward organizational goals.
• The budget must be seen as an internal control device, and internal – use
budgets should base evaluations on controllable or discretionary costs.
• Sales and administrative budgets need to be detailed in order that key
assumptions can be better understood.

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Characteristics of a Successful Budget Process
The characteristics of a successful budget process include: the budget period,
the participants in the budget process, the basic steps in budgeting, and the use of
cost standards.

Budget Period
The time for a budget is the length of time appropriate for the purpose of the
budget. Short-term budgets are prepared for a one-year time that coincides with
the entity’s fiscal year. A master budget is usually for a one-year period. This can
be broken down to quarterly, monthly, and weekly budgets as needed. Long-term
budgets are often prepared for three-, five-, and ten-year time periods. This is
appropriate for a strategic plan. The shorter the time period, the more detailed the
budget will be.

Budget Process
Methods of budget preparation differ among companies, but all fall
somewhere on a continuum between entirely authoritative and entirely participative.

In an authoritative budget (top-down budget), top management sets

everything from strategic goals down to the individual items of the budget for each
department. Lower-level managers and employees are expected to adhere to the
budget and meet the goals.

In a participative budget (bottom-up or self-imposed budget), managers at

all levels and certain key employees cooperate to set budgets for their areas. Top
management usually retains final approval. The ideal budget process combines the
features of each and falls somewhere between these methods.
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Authoritative Approach Combination Approach Participative Approach
Top management Strategic goals are Strategic goals do not
incorporates strategic communicated top-down receive priority in the
goals into their budgets. and implemented bottom- budgetary process.
up.
Better control over Control retained and Expertise leads to
decisions. expertise gained at cost of informed budget
a slightly longer process. decisions.
Dictates instead of Two-way Communicates lower-
communicates. communication: top level perspective (of
management understands product/service or
participants` difficulties market) to management.
and needs. Participant
understand
management`s dilemmas.
Employees: Personal control leads to Employees:
Resentful acceptance, which leads Involved
Unmotivated to greater personal Empowered
commitment.
Stringent budgets may Ownership of budget and Easy or abdicated
not be strictly followed at thorough review leads to approval can lead to loose
lower levels. tight budgets that get budgets and budget
followed. slack.
Not a recommended Best for most companies; Best for responsibility
approach but could work provides balance between centers with highly
in small or slow-changing strategic and tactical variable situations where
environments. inputs. area manager has best
data

1.5 Budget slack or padding

Budget slack or padding occurs when budgeted performance differs from

actual performance because the manager built in some extra money in the budget to
deal with the unexpected. Budget slack is built-in freedom to fail, and cumulative
budget slack at each sublevel can result in a very inaccurate master budget.

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Budgetary slack works against goal congruence because the manager is budgeting
without taking the organization’s goals into account. Management may create
budgetary slack by overestimating costs or underestimating revenues.

On the positive side, budgetary slack can provide managers with a cushion
against unforeseen circumstances. This can limit managers’ exposure to uncertainty
and thereby reduce their risk aversion. The reduced anxiety about risk may help the
managers make decisions that are more closely congruent with the goals of senior
management. Or it may not. Budgetary slack creates more problems than it solves.

The negative results of budgetary slack are that it misrepresents the true profit
potential of the company and can lead to inefficient resource allocation and poor
coordination of activities within the company. The planning inaccuracy spreads
throughout the company.

The best way to avoid the problems of budgetary slack is to use the budget as
a planning and control tool, but not for managerial performance evaluation. Or, if
the company does use the budget to evaluate managers, it could reward them based
on the accuracy of the forecasts they used in developing their budgets. For example,
the company’s senior management could say that the higher and more accurate a
division manager’s budgeted profit forecast is, the higher will be the manager’s
bonus.

The five steps in a combined approach include:

1. Budget participants are identified, including representatives of all levels of

management, as well as key employees with expertise in particular areas.

2. Top management communicates the strategic direction to budget participants.

3. Budget participants create the first draft of their budget.

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4. Lower levels submit budgets to the next higher level for review in an iterative
process stressing communication in both directions.

5. Rigorous but fair review and budget approval sets the final budget.

1.6 Budget Participants

Three groups make or break a budget: the board of directors, top management,
and the budget committee. Middle and lower management also play a significant
role because they create detailed budgets based on upper management’s plan.
Depending on the size of the company and the type of budget being created, a budget
coordinator and process experts may be involved in budget development.

Board of Directors

The board of directors does not create the budget, but it cannot abdicate its
responsibility to review the budget and either approve or send it for revision. The
board usually appoints the members of the budget committee.

Top Management

Top management is ultimately responsible for the budgets, and the primary
means top managers have of exercising this responsibility is to ensure that all levels
of management understand and support the budget and the overall budget control
process.

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 Top managers should give their subordinates incentives for making truthful
and complete budgets, such as rewarding accuracy. A common problem that needs
to be avoided is budget slack.

Budget Committee

Large corporations usually need to form a budget committee composed of

senior management and often led by the chief executive officer (CEO) or a vice
president. The size of the committee will vary depending on the organization. The
committee directs budget preparation, approves budgets, rules on disagreements,
monitors the budget, reviews results, and approves revisions.

Middle and Lower Management

Middle and lower management do much of the specific budgeting work. These
managers follow budget guidelines, which are general guidelines for responsibility
centers preparing individual budgets set by either top management or the budget
committee. A responsibility center, cost center, or strategic business unit is a segment
of a company in which the manager is vested with the authority to make cost,
revenue, and/or investment decisions and therefore also set budgets.

The budget guidelines are formed around the company’s strategy and long-
term plans. The guidelines govern preparation methods, layout, and events that
should be considered, such as new downsizing needs or changes in the economy.

Budget Coordinator

The more people who are involved in a budget process, the greater the need
for an individual or team who can identify and resolve discrepancies between the
budgets of the various responsibility centers and between various portions of a
master budget.

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Process Experts

When participative budgeting is used, often certain key nonmanagerial

employees are added to the team. Team participants tend to be those who have a
detailed understanding of the costs for a particular area, especially those areas that
are extremely complex or variable.

Top-down budgeting

Top-down budgeting is imposed by upper management and therefore has less

of a chance of acceptance by those on whom the budget is imposed.

Bottom-up budgeting

Bottom-up budgeting is characterized by general guidance from the highest

levels of management, followed by extensive input from middle and lower
management. Because of this level of participation within the company, there is
usually a greater chance of acceptance.

1.7 Budgeting Steps

The steps that responsibility centers take in preparing their budgets include
the initial budget proposal, budget negotiation, review and approval, and revision.

1.8 Types of Standards

• Authoritative standards are determined solely by management. They are

more speedily set and can closely match overall company goals, but they may
be a cause for resentment or may not be followed at all.

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 • Participative standards are set by holding a dialogue between management
and all involved parties. They are more likely to be adopted than authoritative
standards, but they take more time because they require negotiation to ensure
that operating goals are still met. Specific types of standard costs include ideal
standards and reasonably attainable standards.

Ideal Standards

An ideal standard is a forward-looking goal that is currently attainable only if

all circumstances result in the best possible outcome. Ideal standards work into a
continuous improvement strategy and total quality management philosophies. They
allow for no work delays, interruptions, waste, or machine breakdown.

Ideal standards require a level of effort that can be attained only by the most
skilled and efficient employees working at their best efficiency all of the time. Some
firms use progress toward an ideal standard instead of deviations from the ideal to
measure and reward success. However, ideal standards are very difficult to attain,
and their frequent use can become frustrating. If difficult-to-attain ideal standards
are constantly required, they can be a disincentive to productivity, because workers
may not even attempt to meet such “impossible” goals.

Reasonably Attainable Standards

A reasonably attainable standard is closer to a historical standard because it

sets goals at a level that is attainable by properly trained individuals operating at a
normal pace. The standard is expected to be reached most of the time, and it allows
for normal work delays, spoilage, waste, employee rest periods, and machine
downtime.

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Question: Which one of the following best describes a reason why a company’s
budgeting should be based on the company’s strategic plans?

a. Helps control costs so that products can be sold profitably.

b. Identifies resources needed to reach strategic goals.

c. Identifies the external factors that have changed from the prior year and those
that remain the same.

d. Establishes standards to measure employee performance.

Question: An advantage of participatory budgeting is that it

a. minimizes the cost of developing budgets.

b. yields information known to management but not to employees.

c. encourages acceptance of the budget by employees.

d. reduces the effect on the budgetary process of employee biases.

Question: A company uses participative budgeting. In order to more easily meet

budgetary goals, the controller underestimates the amount of revenue and
overestimates fixed selling and administrative expenses. This is an example of

a. Flexible budgeting

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b. Budgetary slack

c. Zero-based budgeting

d. Budgetary variance

1.9 Types of Budgeting Methodologies:

An organizations’ master budget, also known as an annual business plan or

profit plan, is a comprehensive budget for a year or less. Every aspect of the
company’s revenue and cost flows is projected, starting with the sales budget, based
on its forecasted sales for the upcoming periods, and ending with a set of pro forma
financial statements, which include the income statement and balance sheet.

Every company needs some form of master budget. Depending on the types
of business, organizational structure, complexity of operations, and management
philosophy, a company can choose different approaches in formulating its master
budget. The company can even adopt different approaches for different pieces of its
master budget. Nine different budgeting systems that a company can use to create
its budgets are:

1. Project budgeting.
Used for creating a budget for specific projects rather than for an entire company.

Advantages include the ability to contain all of a project’s costs so that its
individual impact can be easily measured. Project budgets work well on both large
and small scales, and project management software can facilitate developing and
tracking these budgets.

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 Limitation of project budgets occurs when projects use resources and staff
that are committed to the entire organization rather than dedicated to the project.
In such situations, the budget will contain links to these resource centers, and
affected individuals may be reporting to two or more supervisors. Care must be
taken in dividing costs and lines of authority.

2. Activity-based budgeting.

Focuses on classifying costs based on activities rather than based on departments

or products whereas traditional budgeting focuses on input resources and expresses
budgeting units in terms of functional areas, ABB focuses on value-added activities
and expresses budgeting units in terms of activity costs. Traditional budgeting places
emphasis on increasing management performance; ABB places emphasis on
teamwork, synchronized activity, and customer satisfaction.

ABB proponents believe that traditional costing obscures the relationships

between costs and outputs by oversimplifying the measurements into such categories
as labor hours, machine hours, or output units for an entire process or department.
Instead of using only volume drivers as a measurement tool, ABB uses activity-
based cost drivers, such as number of setups, to make a clear connection between
resource consumption and output. ABB will also use volume-based drivers if they
are the most appropriate measurement unit for an activity.

A key advantage of ABB is greater precision in determining costs, especially

when multiple departments or products need to be tracked. This advantage comes at
a cost, and a potential drawback to ABB can occur if the cost of designing and
maintaining the ABB system exceeds the cost savings from better planning.

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 3. Incremental budgeting.

Starts with the prior year’s budget and produces increments into the future based
on the prior year’s results and coming year’s expectations.

The main drawback to using this type of budget (and the reason that some
companies use zero-based budgets) is that the budgets tend to only increase in size
over the years. A sense of entitlement may also arise with the use of an incremental
budget

4. Zero-based budgeting.

Starts each new budgeting cycle from scratch as though the budgets are prepared
for the first time

The strength of the zero-based budget is that it forces review of all elements of a
business. Zero-based budgets can create efficient, lean organizations and therefore
are popular with government and nonprofit organizations. A zero-based budget is a
way of taking a new look at an old problem.

Zero-based budgets have a major drawback in that they encourage managers to

exhaust all of their resources during a budget period for fear that they will be
allocated less during the next budget cycle. If a manager has incorporated budget
slack into the budget, a zero-based budget can encourage a significant amount of
waste and unnecessary purchasing.

5. Continuous (or rolling) budgeting.

Allows the budget to be continually updated by removing information for the

period just ended (e.g., March of this year) and adding estimated data for the same
period next year (e.g., March of next year)

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 The advantage is breaking down a large process into manageable steps.

Potential disadvantages of continuous budgets include the need to have a

budget coordinator and/or the opportunity cost of having managers use part of each
month working on the next month s budget. Continuous budgets are appropriate for
firms that cannot devote a large block of time to a once-a-year budget process.

These types of budgets are also useful for companies that want their managers
to have a longer-term view of the firm.

6. Static (Fixed)

The master budget is a Static budget because each item in it is developed for
one specific activity level. When variance reports are prepared that compare the
actual results to the master budget, one of the causes for each variance will usually
be that the actual volume achieved was different from the planned volume. Variances
between actual results and master budget amounts are not very useful for the
company because they do not let the company know how the actual results compared
to what the results should have been, based on the actual level of sales.

7. Flexible budgeting

A Flexible budget is a budget that is prepared after the actual level of activity
is known. A flexible budget for a production department will consist of the budgeted
variable amounts per unit adjusted to the actual volume of units produced. A flexible
budget for an income statement will be adjusted to the actual volume of units sold.

Serves as a control mechanism that evaluates the performance of managers by

comparing actual revenue and expenses to the budgeted amount for the actual
activities (and not the budgeted activities)

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 The benefits of using a flexible budget include the ability to make better use
of historical budget information to improve future planning. There are few
disadvantages to using flexible budgeting, but there is the potential for the firm to
focus principally on the flexible budget level of output and disregard the fact that the
sales target was missed. However, most businesses use flexible budgets because they
allow for extremely detailed variance analysis

Flexible budgeting establishes a base cost budget for a particular level of

output (a cost-volume relationship), plus an incremental cost-volume amount that
shows the behavior of costs at various volumes. Only the variable costs are adjusted;
fixed costs remain unchanged. The most common use of a flexible budget is to show
the budget that would have been made if the organization had exactly matched its
sales forecast.

While flexible budgets from prior periods can be helpful in determining how
to modify the next budget, a flexible budget that applies actual production output
cannot be used as a type of master budget because the actual production output is
not known until the period is complete. Therefore, flexible budgets are used more as
an analysis tool for determining variances from plan than for creating the original
budget.

For example: Robin Manufacturing Company uses flexible budgeting to

evaluate how closely its direct labor usage was to the budgeted amount (i.e., perform
a variance analysis). For the month of July, the company has projected a production
of 72,000 units each requiring 0.5 direct labor hours, with a budgeted hourly rate of
$15. However, the actual production turns out to be only 68,000 units, and the actual
hourly rate turns out to be $15.50.

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 Original budget VS. Actual Results
Original Budget Actual Results
(Fixed)
Production (Units) 72,000 68,000
DLH / Unit × 0.5 × 0.5
DLH (needs) or used 36,000 34,000
Hourly Rate × $15 × $15
Total Direct Labor $ 540,000 $ 527,000
Cost

Based on the information presented, it seems the company is $13,000 under

its direct labor budget for the month of July; However, this is misleading because
the company is not producing at its budgeted level of production. To truly evaluate
its performance, the company needs to create a flexible budget where the standard
cost per unit (and not the actual cost per unit) is applied to the actual production and
not the budgeted production.

Original Budget Flexible Actual

(Fixed) Budget Results
Production (Units) 72,000 68,000 68,000
DLH / Unit × 0.5 × 0.5 × 0.5
DLH (needs) or used 36,000 34,000 34,000
Hourly Rate × $15 × $15 × $15
Total Direct Labor $ 540,000 $510,000 $ 527,000
Cost

When evaluated at the actual production level of 68,000 units, Robin

Manufacturing Company is $17,000 over its direct labor budget, not $13,000 under
the budget

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 8. Kaizen Budget

Assume the continuous improvement of production and process. It requires

estimates of the effect of improvements and the cost of their implementation.

9. Life Cycle Budget

Estimates product’s revenue and expenses over its entire life cycle.

Budget Type Benefits Limitations

• Management can determine in • Projects must be planned
advance whether the project is over their entire life spans
and thus they should be
one that should be undertaken.
viewed as special
• The project budget enables commitments.
management to plan for • Budgeted amounts for
resources (personnel, effort, projects must be integrated
supervisors, and finances) that into the master budget of the
will be needed. company for the relevant
period or periods. Unless
• The project budget focuses that is done, the project
Project management’s attention on budget cannot be fully
Budgeting anticipated cash inflows and utilized.
outflows from the project and
the decisions that will affect the
cash flows.
• Project budgeting fosters
cooperation and coordination
among the various
responsibility centers that will
be affected by the project.
• A project budget covers an
identifiable project that has its
own time span.

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 • The process of preparing an • Activity-based budgeting
activity-based budget brings must be used in conjunction
out information about with activity-based costing.
• Both ABC and ABB require
opportunities for cost more work than a traditional
reductions and the elimination costing and budgeting
of wasteful activities. Thus, system and so are costlier to
activity-based budgeting implement. Costs include the
makes it possible to identify research needed to do the
and enhance high value-added cost allocations and the time
required to educate managers
activities and to eliminate low about the cost allocations.
Activity-Based value-added activities, which The more complex the cost
Budgeting promotes continuous allocations are, the higher the
improvement. costs to educate.
• It helps managers to identify
resources needed and changes
that will be needed in
resources if changes are made
in products offered, product
design, product mix,
manufacturing processes, and
so forth.
• Budgeted costs are based on
the costs for the resources
required to perform the
budgeted activities, which
defines a clear relationship
between resource
consumption, costs, and
output.
• Activity-based budgeting can
help to identify budgetary
slack.
• An activity-based budget
system makes clear the
relationship between activities
performed and out-put. When
changes are made to products,
product design, product mix,
manufacturing processes, and

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 so forth, managers are able to
examine the effects of the
changes on budgeted activities
and on the costs of those
activities.

• In zero-based budgeting, all The major limitation of zero-

of the activities a department based budgeting is that it can
require a nearly impossible
plans are identified and then amount of work
justified. Only revenues and to review all of a company’s
costs from activities that are activities every year.
justified are included in the
budget. Because the budget
is built up from zero, each
manager must justify all of
the expenses in his or her
department. The zero based
budgeting approach is
preferable to the incremental
approach because it enables
the company to identify
expenses that are not value-
adding or that should be
Zero-Based reduced due to some
Budgeting development in production
methods or something
similar.
• Having to justify every
activity forces a prioritizing
of activities because the
activities are ranked on the
basis of their cost-benefit
analyses in order to
determine which ones are
justified. This ranking
provides a systematic basis
for resource allocation.
• Because a manager needs to
examine every single

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 expenditure and activity
within the department, he or
she is more likely to develop
better or less costly methods
of accomplishing the same
objectives, or both. This
development of alternative
methods is the chief benefit
of zero-based budgeting.

Question: Which of the following budgeting methods might use a cost driver such
as number of setups to measure the costs of a batch mixing production job?

a. Activity-based budgeting b. Continuous (or rolling) budgeting

c. Flexible budgeting d. Incremental budgeting
e. Project budgeting f. Zero-based budgeting

Question: Which of the following budgeting methods establishes a base cost budget
for a level of output plus a marginal cost-volume amount that shows the behavior of
costs at various volumes?

a. Activity-based budgeting b. Continuous (or rolling) budgeting

c. Flexible budgeting d. Incremental budgeting
e. Project budgeting f. Zero-based budgeting

Question: Department B must justify each of its programs annually to its parent
agency, which then submits its budget request to the city council. Which budget
system is most appropriate?

a. Activity-based budgeting b. Continuous (or rolling) budgeting

c. Flexible budgeting d. Incremental budgeting
e. Project budgeting f. Zero-based budgeting

Question: Company D completed its reorganization three years ago and has
experienced steady sales in that time. It is now looking to add to its sales force,
marketing, and production but maintain its current organization and direction. What
budget method might be most appropriate?

a. Activity-based budgeting b. Continuous (or rolling) budgeting.

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c. Flexible budgeting d. Incremental budgeting
e. Project budgeting f. Zero-based budgeting'

Question: Company C is a consulting firm that designs customized marketing plans

and product launches for a variety of clients. Which budget system might work best
for the firm, and what might be its disadvantages?

Question: The type of budget that is available on a continuous basis for a specified
future period by adding a month, quarter or year in the future as the present month,
quarter or year ends is called a

a. Rolling budget.
b. Kaizen budget.
c. Activity-based budget.
d. Flexible budget.

Question: Which one of the following is not an advantage of activity-based

budgeting?

a. Better identification of resource needs

b. Linking of costs to outputs
c. Identification of budgetary slack
d. Reduction of planning uncertainty

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Chapter two

Forecasting

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2.1 Forecasting and Forecasts

Forecasting is a critical part of any business, and it involves looking into the
future and attempting to determine what future conditions and / or results will be.

Forecasts are the basis for business plans and budgets [A budget is a form of
forecasting]. Forecasts are used to project product demand, inventory levels, cash
flow, etc.

2.2 Methods of forecasting

1. Qualitative methods of forecasting rely on the manager’s experience and
intuition.
2. Quantitative methods use mathematical models and graphs.

2.2.1 Quantitative Methods:

When planning, a company faces some degree of uncertainty and will rely on
a variety of quantitative methods to help it make better decisions. This we will focus
on quantitative methods in three areas:

• Data analysis involves analyzing a given set of data to establish the relationship
and/or pattern in the data. These analyses can be used to predict the outcome
based on a given set of conditions such as regression analysis or based on an
established pattern.

• Model building involves creating a mathematical model that establishes the

relationship between different factors. Learning curve analysis is one type of
model that is used to determine how the amount of time required to produce a
product changes as the number of units produced changes.

34
• Decision theory deals with uncertainty by looking at various potential outcomes
that can happen in the future and the likelihood of these outcomes occurring.
Expected value is one method to deal with uncertainty.

[Link] Data analysis

Two basic forecasting methods are used:

1. Time series methods, which look only at the historical pattern of one variable
and generate a forecast by extrapolating the pattern using one or more of the
components (or patterns) of the time series, When time periods are plotted on
the x axis, the technique is time-series analysis.

2. Causal forecasting methods, which look for a cause-and-effect relationship

between the variable being forecasted (the dependent variable) and one or more
other variables (the independent variables). When some factor in the
organization’s environment is plotted on the x axis, the technique is causal
relationship forecasting.
Regression analysis

Linear regression analysis is a statistical method used to determine the impact one
variable (or a group of variables) has on another variable. It provides the best, linear,
unbiased estimate of the relationship between the dependent variable (Y) and one or
more independent variable (X or X`s). Linear regression is often used by
management accountants to analyze cost behavior (that is, determine the fixed and
variable portions of a total cost), or to forecast future amount such as sales dollars.

35
The assumptions underlying linear regression are:

▪ Linearity – The relationship between the dependent variable and the independent
variable(s) is linear.

▪ Stationary – The process underlying the relationship is stationary. The

assumption is often called the constant process assumption.

▪ The linear relationship established for x and y is only valid across the relevant
range (i.e., the range within which per-unit variable costs remain constant and
fixed costs are not changeable). The user must identify the relevant range and
ensure that (s)he does not project the relationship beyond it.

36
 ✓ A negative y intercept in the simple regression equation usually indicates that
it is outside the relevant range.

▪ The independent variables (X`s) in multiple regression analysis are independent

of each other. There is no multi – co linearity.

▪ The values of y around the regression line for a given value of x have a normal
distribution and a mean of zero.
✓ Moreover, the variances of the subpopulations of y are constant for different
values of x, i.e., homoscedasticity or constant variance.
✓ The values of y also must be statistically independent.

Regression analysis creates a linear equation based on the relationship between a

dependent variable and one or more independent variables. The dependent variable
(Y) is the value being forecast, such as sales or total costs. The independent variables
(X) are the forecasts that are assumed to influence or drive the variations seen in the
dependent variable. It is assumed that the relationship between the dependent
variable and the independent variable remains constant

There are two main types of regression analysis: a simple regression analysis,
which uses only one independent variable, and a multiple regression analysis,
which uses two or more independent variables.

Regression analysis equations systematically reduce estimation errors. Therefore,

it is also called least square regression. Regression analysis fits a line (the regression
line) through a set of data points—this line minimizes the difference between the
line (prediction) and the data point (actual).

37
Simple Linear Regression

Simple Regression is used given one independent variable. The simple regression
equation is the algebraic formula for a straight line:

y = a + bx
Where:

➢ y = annual sales; Total Cost; this is the dependent variable to be forecast. An

observed value uses a capital Y.(effect)
➢ a = Constant; amount of y when X = 0. This value is also called the y intercept,
because when
X = 0, y = a.
➢ b = slope of the line, also known as the variable coefficient. It represents the
“impact” X has on y. For every 1-unit change in X, y is expected to change by b
units.
➢ X = Quantity; value for the independent variable or the driver for the dependent
variable. (cause)

38
The best straight line that fits a set of data points is derived using calculus to
minimize the sum of the squares of the vertical distances of each point to the line
(hence the name least-squares method).

Example: A firm has collected observations on advertising expenditures and annual

sales.

Advertising Sales
($000s) ($000,000s)
71 26.3
31 13.9
50 19.8
60 22.9
35 15.1

y = $4,200,000 + 311.741x

The observations are graphed as follows:

39
The firm can now project the amount it will have to spend on advertising to generate
$32,000,000 in sales.
y = $4,200,000 + 311.741× X
$32,000,000 = $4,200,000 + 311.741× X
311.741 × X = $27,800,000
X = $89,177

Example: The table below represents the results of the simple linear regression
analysis performed on the given set of sales and marketing data for Build and Fix
company:

Regression Values for Marketing Costs as Predictor of Sales

Coefficients t-Value Standard
Error
Intercept $18,444,808.74 1.48 $12,460,200.96
Marketing $861. 31 4.98 $172. 93
costs

The regression equation is:

y = $18,444,809 + $861(X)

where X represents the marketing budget. This formula can be used to go beyond
the table and forecast sales with a marketing budget of $75,000.

40
y = $18,444,809 + $861(75,000) = $83,019,809 Forecast Sales

Regression analysis also provides several objective benchmarks that allow users to
evaluate the reliability of the regression equation. Four common measures are
goodness of fit, statistical reliability of each independent variable, standard error of
the estimate (SE), and correlation coefficient

1. Coefficient of determination or Goodness of Fit

R-squared (goodness of fit or coefficient of determination) is a value between zero
and one indicating the degree to which changes in a dependent variable can be
predicted by changes in independent variables. (R-squared tells us how much of
the variation in total cost is explained by the cost driver.) The coefficient of
determination is the square of the coefficient of correlation. It is represented by the
term R2, or r2, corresponding to the percentage of the total amount of change in the
dependent variable that can be explained by changes in the independent
variable.

An R2 above .50 would indicate that the forecast yielded by simple linear regression
analysis should be meaningful. A regression with an R-squared value closer to one
has more explanatory power than a regression with an R-squared value closer to zero.
Graphs of regressions with high R-squared values show data points lying near the regression
line, while regressions with low R-squared values show more widely scattered data points.

The R-squared value for our example of sales and marketing costs for Build and Fix
company is 0.7127. This means that approximately 71.27% of the variation is explained by
marketing costs.

41
2. Statistical Reliability of Each Independent Variable

Another quantitative measure of reliability is the statistical reliability of each

independent variable. This measure is called the t-value.
It measures if an independent variable (X) has a valid, long-term relationship to the
dependent variable (y). A good rule of thumb is that the t-value should be greater
than 2. A lower number indicates that there is little or no statistical relationship
between the variables.
For Build and Fix, the T-value is greater than 2 for the marketing costs, which
indicates that the impact marketing cost has on sales is statistically significant.

3. Standard Error of Estimate

The standard error of estimate (SE) measures the accuracy of y, the regression’s
estimate. It is a measurement of the dispersion around the regression line. A
relatively small SE is better than a large one. It implies that the actual value will lie
in the range of the estimate of y, plus or minus the SE.

42
4. Correlation Analysis (r)
It is used to measure the strength of the linear relationship between two or more
variables. [Correlation measures only linear relationships]. The coefficient of
correlation, represented by the letter R or r, is a numerical measure that measures
both the direction (positive or negative) and the strength of the linear association.
This amount of correlation, or coefficient of correlation, r, is expressed as a number
between - 1 and +1.

✓ A correlation coefficient, r, of +1 means there is a perfect positive (up sloping)

linear relationship between each value for x and its corresponding value for y.
✓ A correlation coefficient, r, of –1 means there is a perfect negative (down sloping)
linear relationship between each value for x and its corresponding value for y.
✓ A coefficient of correlation, r, which is close to zero, usually means there is no,
or very little, relationship between the variables.

Note: Always remember that correlation does not necessarily mean causation. Two
variables may be highly correlated historically, but if no actual cause-and-effect
relationship exists between them, the independent variable will not be a good
predictor of the dependent variable.
For example, a homeowner’s electric utility bill may be highly correlated with the
household’s level of ice cream consumption. But logically, there is no cause-and-
effect relationship between the two. Increased ice cream consumption does not cause
high electric bills, and high electric bills do not cause increased ice cream
consumption. However, a third factor such as outside temperature might easily be
affecting both. Always consider whether it is reasonable to assume that a cause-and-
effect relationship exists between the two variables when doing causal forecasting.

43
Advertising expenditures usually do have a logical cause-and-effect relationship to
sales. If historical advertising expenditures and historical sales are reasonably well
correlated, advertising expenditures should be a good independent variable to use to
forecast sales.

Question: In regression analysis, which of the following correlation coefficients

represents the strongest relationship between the independent and dependent
variables?
a. .75
b. -.89
c. 1.03
d. -.02

Question: A linear relationship between an independent and a dependent variable

means that
a. a graph of the two variables will result in a straight line within the relevant range.
b. when the independent variable increases, the dependent variable increases by the
same amount as the independent variable has increased.
c. the relationship between the two variables must be a direct one.
d. a forecast made using the historical data will be reasonably accurate.

Multiple Linear Regression

In the Build and Fix example, a simple linear regression analysis was used to
estimate the impact that the amount of money spent on marketing would have on the
company’s sales. Using a simple regression analysis, assumed that marketing

44
expenditures are the only factor that explain (or have an impact on) a company’s
sales level.

Based on the results of the analysis, the R-squared is 0.7127. That means only
71.27% of the variation in sales can be explained by changes in marketing
expenditures. The remaining 28.73% (100% – 71.27%) is explained by changes in
other factors that are not included in the regression model.

In forecasting sales, an organization would want to take into consideration not only
its marketing efforts but other factors, such as the economic conditions, its
competitors’ actions, its pricing strategy, etc.

All these other factors can be incorporated into a multiple regression model and
become the additional independent variables that can help to explain the other
28.73% in sales variation that is not explained by marketing expenditures.

The regression “line” for a multiple regression model is represented mathematically

as follows:
y = a + b1X1 + b2X2 + b3X3 + … bnXn

In addition to the R-squared, t-value, and standard error of the estimate (SE), a
multiple regression requires the user to evaluate the correlation between the
independent variables (X’s) to assure there is a lack of multi-collinearity. As a rule
of thumb, as long as the correlation between any two independent variables is 0.7 or
below then all the independent variables can be included in the regression. If the
correlation between two of the independent variables is 0.7 or above, then one of
them must be eliminated from the regression equation.
45
Benefits and Limitations of Regression Analysis

The benefits or advantages of regression analysis are:

✓ Regression analysis is a quantitative method and as such, it is objective. A given

data set generates a specific result. That result can be used to draw conclusions
and make forecasts.

✓ Thus, regression analysis is an important tool for use in budgeting and cost
accounting. In budgeting, it is virtually the only way to compute fixed and
variable portions of costs that contain both fixed and variables components
(mixed costs).

The shortcomings or limitations of regression analysis are:

✓ If historical data is not available, regression analysis cannot be used,

✓ If there has been a significant change in the conditions surrounding that data, its
use is questionable for predicting the future.

✓ If the choice of independent variable(s) is inappropriate, the results can be

misleading.

✓ The statistical relationships that can be developed using regression analysis are
valid only for the range of data in the sample.

46
 [Link] Model building

Learning curves

Learning curve analysis is a systematic method for estimating labor costs based on
increased learning by an individual person performing a task, such as the assembly
of a widget. The term “learning curve” refers to the concept that efficiency increases
as the amount of experience a person has with a given task increases. As a result,
the time required for performing the task decreases as increases occur in the number
of times the task has been performed. The learning curve concept has been called the
experience curve when applied to different business functions along the value
chain. Calculation of the learning curve is based on a learning rate. As output
doubles, the average time will decrease from the previous level based on a constant
percentage.

For example, a learning curve for a 20% reduction in time is called an 80% learning
curve; a 10% reduction occurs from a 90% learning curve.

Two learning-curve models are commonly used:

1. The cumulative average-time learning model assumes that the cumulative

average time required per unit declines at a constant rate each time the cumulative
quantity of units produced doubles. The cumulative average-time learning model
can be used to estimate the average time per unit required to produce all of a given
number of units produced.

2. The incremental unit-time learning model assumes that the incremental

amount of time required to produce the last unit declines at a constant rate each

47
 time the cumulative quantity of units produced doubles. The incremental unit-time
learning model can be used to estimate the time needed to produce the last unit in
a quantity of units.

Note: Only the cumulative average-time learning model is tested on the CMA exam.
The incremental unit-time learning model is introduced here only to show that other
models may also be used.

Cumulative Average-Time Learning Model

The cumulative average-time learning model (also called the Wright method or
traditional method). This is the generally accepted model. The model calculates
the cumulative total time by multiplying the incremental unit produced by the
cumulative average time per unit. The Cumulative Average-Time Learning Model
uses a constant percentage of declines in average time per unit each time that the
cumulative quantity of units produced doubles.

In other words, if a plant that manufactures automobiles is subject to an 80% learning

curve, and if the time required to build the first automobile is 10 hours, then the total
time required to manufacture the first 2 autos will be 80% of (10 hours * 2) or 16
hours, which equates to an average of 8 hours for each automobile. Note that this
model measures total time required, which includes the time for the first unit, and
uses that total time to determine average time per unit for the entire amount
produced.

The cumulative average-time learning model can be used to calculate three things:

48
1. The estimated average time per unit for the entire quantity produced, from the
very first unit to the very last unit produced, or the “cumulative average.”

2. The estimated total time required for the entire quantity produced, from the very
first unit to the very last unit produced.

3. The estimated total production time required for a certain block of units can
be calculated by finding the total time required for all the units produced through
the end of that block and subtracting from that the total time required for the units
up to that block.

Mathematically, two methods can be used to calculate the estimated total time
required for all units produced and the estimated average time required per unit for
all units produced using the cumulative average model:

1. Calculate the estimated total time required for all units produced, then use the
estimated total time to calculate the estimated cumulative average time per unit.

2. Calculate the estimated cumulative average time per unit, and then use the
estimated cumulative average time per unit to calculate the estimated total time
required for all units produced.

49
Method 1: Calculate the estimated total time required for production, then use
the estimated total time to calculate the estimated cumulative average time per
unit:

Estimated required time for all unit produce = Time required for first unit × (2
× LC)n

When:

LC = learning curve percentage

n = Number of doubling of unit produce to date

Estimated cumulative average time per unit required for all units produced =

Estimated required time for all unit produce

Total Number of unit produce

Example: A plant that manufactures cars is subject to an 80% learning curve. Ten
hours are required to produce the first car of a new model. According to the
cumulative average-time learning model, the estimated total time required to
manufacture the first two cars will be 80% of the total time it would have taken to
produce two cars if no learning had taken place.
If no learning had taken place, then estimated production time for the first two cars
would be 20 hours. With an 80% learning curve, the estimated total time required to
produce two cars will be 80% of 20 hours, or 16 hours (10 × [2 × 0.8]), which equates
to an estimated cumulative average of 8 hours for each of the first two cars (16 ÷
2). The mathematical process is shown for the first three doublings of production.

50
The first doubling (to produce a total of 2 units):
1. Estimated total time required for units 1 and 2 = 10 × (2 × 0.80)1 = 10 × 1.6 =
16 hours
2. Estimated cumulative average time per unit for units 1 and 2 = 16 ÷ 2 = 8 hours

The second doubling (to produce a total of 4 units):

1. Estimated total time required for units 1 through 4 = 10 × (2 × 0.80)2
= 10 × 2.56 = 25.6 hours
2. Estimated cumulative average time per unit for units 1 through 4 = 25.6 ÷ 4 =
6.4 hours

The third doubling (to produce a total of 8 units):

1. Estimated total time required for units 1 through 8 = 10 × (2 × 0.80)3
= 10 × 4.096 = 40.96 hours
2. Estimated cumulative average time per unit for units 1 through 8 = 40.96 ÷ 8 =
5.12 hours
And so on.

Notice that with each doubling, multiplying the previous estimated total time by 2
and then by 80% results in the new estimated total time. For example, 25.6 estimated
total hours required for the first 4 units multiplied by 2 and then multiplied by 80%
equals 40.96 hours, the estimated total hours required for the first 8 units.

51
Method 2: Calculate the estimated cumulative average time per unit for all units
produced, then use the estimated cumulative average time per unit to calculate
the estimated total time required for all units produced:

Estimated cumulative average time per unit for all units produced =
Time required for the first unit × LCn

Estimated total time required for all units produced =

Estimated cumulative average time per unit for all units produced × Total
number of units produced

Example: The following doublings refer to the same plant from the previous
example. It manufactures cars and is subject to an 80% learning curve. The time
required to produce the first car is 10 hours.

• The first doubling:

1) Estimated cumulative average time per unit for units 1 and 2 = 10 × 0.801
= 10 × 0.80 = 8 hours
2) Estimated total time required for units 1 and 2 = 8 × 2 = 16 hours

• The second doubling:

1) Estimated cumulative average time per unit for units 1 through 4 = 10 × 0.802
= 10 × 0.64 = 6.4 hours
2) Estimated total time required for units 1 through 4 = 6.4 × 4 = 25.6 hours

52
 • The third doubling:
1) Estimated cumulative average time per unit for units 1 through 8 = 10 × 0.803
= 10 × 0.512 = 5.12 hours
2) Estimated total time required for units 1 through 8 = 5.12 × 8 = 40.96 hours

Example: The cost accountant for Ray Lighting Manufacturing Company is

planning production costs for a new lamp. Production of the new lamp will be
subject to a 60% learning curve since it involves only minimal adjustments to
established processes. The initial lot, of 500 lamps is expected, to require 1,000
hours of labor. Costs are as follows:

Direct Labor $20/hr.

Direct Materials $50/DLH
Variable OH $25/DLH
Applied Fixed OH Applied $2,000/lot manufactured

(1) What is the cumulative average time per unit after 8 lots have been
manufactured, if the cumulative average-time model is used?

With a 60% learning curve, when the quantity of units produced doubles, the
cumulative average; time per unit for the doubled number of units is 60% of the
cumulative average time per unit for the original number of units.

In this case, we are working with lots of 500 rather than units. However, the question
asks for average time per unit, and there are 500 units in each lot.

The first doubling will occur when the second lot of 500 has been produced. The
second doubling will occur when the fourth lot of 500 has been produced. The third
doubling will occur when the eighth lot of 500 has been produced.

53
Therefore, the total number of labor hours required for 8 lots of 500 lamps is:

1,000 × (2 × 0.60) × (2×0.60) × (2 × 0.60) = 1,000 × (2 × 0.60)3

1,000 × 1.2 3= 1,728 total labor hours required for 8 lots.

Next, we calculate the average number of labor hours required per lot for 8 lots,
and then we can determine the average number of labor hours per unit for 8 lots.
1,728 total labor hours required ÷ 8 lots = average of 216 labor hours per lot.
Average 216 labor hours per lot ÷ 500 lamps per lot = 0.432 cumulative average
number of labor hours required per lamp for 8 lots of 500 lamps each.

(2) What is the total cost for the eighth lot?

To determine an incremental cost under the cumulative average-time learning

model, set up a chart such as the following:

No. Avg. Total time Additional

of time/lot Cum. Cost
lots
1 1,000 = 1,000 × $95 + $2000 × 1 = $97000 $97,000
2 600 = 1,200 ($95 × 1,200) + ($2,000 × 2) 21,000
= $118,000
3 360 = 1,440 ($95 × 1,440) + ($2,000 × 4) 26,800
= $144,800
4 216 = 1,728 ($95 × 1,728) + ($2,000 × 8) 35,360
= $180,160

Addition to Cumulative Cost is the cumulative cost of the total number of lots
manufactured. The total number of lots manufactured is in the first column. Here,
54
that is $118,000 after the second lot. Subtract the previous cumulative cost, which
was $97,000 after the first lot, from it, and you will have the cost of only Lot 2.

The Addition to Cumulative Cost for Lots 3 and 4 (the third doubling) is $144,800
minus $118,000, or $26,800. Since there are 2 lots (Lots 3 and 4) that have cost a
total of $26,800, the cost of each lot is 1/2 that amount. Thus, Lot 3 costs $13,400
and Lot 4 costs $13,400.

The total cost for the final 4 lots (Lots 5, 6, 7 and 8) is $35,360, which is $180,160
minus $144,160. Thus, the total cost for just the eighth lot is 1/4 of that, or $8,840.

Benefits of Learning Curve Analysis:

Decisions such as the following can be aided by learning curve analysis:

▪ Make or buy decisions - the analysis of the cost to make will be affected.
▪ Life-Cycle costing - in calculating the cost of a contract, learning curve analysis
can ensure that the cost estimates are accurate over the life of the contract, leading
to better bidding.
▪ Cost-Volume-Profit analysis - in determining a breakeven point. If learning is
not considered, the result may be overstatement of the number of units required
to break even.
▪ Development of standard costs - labor costs should be adjusted regularly in
recognition of the fact that learning causes standard costs to change over time.
▪ Capital budgeting - costs can be projected more accurately over the life of the
capital investment when expected improvements in labor productivity due to
learning are included.
▪ Development of production plans and labor requirements - production and labor
budgets should be adjusted to accommodate learning curves.

55
▪ Management control - recognizing that higher costs will occur in the early phase
of the product life cycle allows more effective evaluation of managers.

Limitations of learning curve analysis

There are three limitations and problems associated with learning curve
analysis:

1. Learning curve analysis is appropriate only for labor-intensive operations

involving repetitive tasks where repeated trials improve performance. If the

production process is designed to have fast set-up times using learning to take
place.

2. The learning rate is assumed to be constant. In real life, the decline in labor time

might not be so constant. It might be that the learning rate would decline at the
rate of 70% for the first 75,000 units, followed by 80% for the next 50,000 units
and 95% for the next 25,000 units.

3. The reliability of a learning curve calculation can be jeopardized because an

observed change in productivity might be associated with factors other than

learning. An increase in productivity might be due to a change in the labor mix,
a change in the product mix or other factors. If that is the situation, a learning
model developed using this historical data would produce inaccurate estimates of
labor time and cost.

Question: Reeves Inc. has developed a new production process to manufacture its
product. The new process is complex and requires a high degree of technical skill.
However, management believes there is a good opportunity for the employees to
improve as they become more familiar with the production process. The production

56
of the first unit requires 100 direct labor hours. If a 70% learning curve is used, the
cumulative direct labor hours required to produce a total of eight units would be
a. 196 hours
b. 274 hours
c. 392 hours
d. 560 hours

[Link] Decision theory

Expected value

Expected value of an action is found by multiplying the probability of each outcome

by its payoff and summing the products. The expected value is the weighted average
of all the possible values of the random variable. The weights are the probabilities
for each of the values. The expected value is the mean value, also known as the
average value.

Expected value is a means of associating a dollar amount with each of the possible
outcomes of a probability distribution. It should be distinguished from a
deterministic approach, which assumes that a value is known with certainty.
▪ The outcome yielding the highest expected monetary value (which may or may
not be the most likely one) is the optimal alternative.
▪ Note that:
a. The decision alternative is under the manager’s control.
b. The state of nature is the future event whose outcome the manager is
attempting to predict.
c. The payoff is the financial result of the combination of the manager’s decision
and the actual state of nature.

57
▪ The expected value of an event is calculated by multiplying the probability of
each outcome by its payoff and summing the products.
Expected Value (EV) = ∑ 𝑺 × 𝑷𝐬

Example: The management of Digital Age, a computer store, needs to know how
many computers are sold each day to forecast sales for the coming year. The budget
analyst groups together the number of computers sold each day to show how many
days in a year the store made no sales at all, how many days it made one sale, and
so on. The maximum number of computers Digital Age has sold in any one day is
10. The store is open 6 days per week, or 312 days per year. The budget analyst sets
up a table with historical data for one year. The following table is called a frequency
distribution.
No. of No. of days
sales (Frequency)
0 17
1 23
2 29
3 35
4 41
5 47
6 41
7 29
8 23
9 17
10 10
Total 312

58
Next, the analyst creates the following probability distribution based on the above
frequency distribution (some of the probabilities have been adjusted to compensate
for rounding differences so that the probabilities will sum to 1.00):

No. of No. of days Probability

sales (Frequency)
0 17/312 0.06
1 23/312 0.08
2 29/312 0.09
3 35/312 0.11
4 41/312 0.13
5 47/312 0.15
6 41/312 0.13
7 29/312 0.09
8 23/312 0.08
9 17/312 0.05
10 10/312 0.03
Total 1.00

Based on the above probability distribution, the probability that Digital Age will sell
no computers in each day is 6%. The probability that it will sell 10 computers in any
one day is 3%. The probabilities can be summed to calculate the probability of
a range of sales. For example, the probability that the store will sell 4, 5 or 6
computers in any one day is 13% + 15% + 13%, or 41%. All the probabilities sum
to 100%. Therefore, the probability that the store will sell between 0 and 10
computers, inclusive, on any given day is 100%.

59
The management of Digital Age calculates the expected value of sales to determine
the number of computers the store can expect to sell on an “average” day. Each
possible number of computers that could be sold in a day is multiplied by the
probability of making that number of sales. The sum of the products is the expected
value of computer sales on an average day.

No. of Probability Sales× Pro.

sales
0 0.06 0.0
1 0.08 0.08
2 0.09 0.18
3 0.11 0.33
4 0.13 0.52
5 0.15 0.75
6 0.13 0.78
7 0.09 0.63
8 0.08 0.64
9 0.05 0.45
10 0.03 0.30
Expected Value = 4.58
WA = Mean

The store will never sell exactly 4.58 computers in each day since it cannot sell a
portion of a computer. But over the long term, the average number of computers the
store can expect to sell per day is 4.58.

60
Question: The table below shows the estimated probabilities of the percent of
defective units resulting from a production run.

Percent Probability
Defective
2% 30%
3% 50%
4% 20%

The expected percent defective for a production run would be

a. 1.50%
b. 2.30%
c. 2.90%
d. 3.00%

Value of perfect information

Perfect information: is the knowledge that a future state of nature will occur with
certainty.

Expected value of perfect information =

Expected value with perfect information under certainty - Expected value of

the best choice under uncertainty

61
Example:

Event Act
Level of Probability Direct Tele- Mass-
demand mail market marketing
Light 0.10 $ 25,000 -10,000 -125,000
Moderate 0.70 400,000 440,000 400,000
Heavy 0.20 650,000 740,000 750,000

Expected value under uncertainty (Available Information)

Direct- mail = 0.10 × 250,00 + 0.70 × 400,000 + 0.20 × 650,000

= 2,500 + 280,000 + 130,000 = $ 412,500
Tele 0.10 × -10,000 + 0.70 × 440,000 + 0.20 × 740,000 =
=
marketing $455,000
Mass- 0.10 × -125,000+ 0.70 × 400,000 + 0.20 × 750,000 =
=
marketing $417,500

Expected value under certainty (With Perfect Information)

= 25,000 × 0.10 + 440,000 × 0.70 + 750,000 × 0.20

= 2,500 + 308,000 +150,000 = $460,500

Expected Value of Perfect information (EVPI) = 460,500 – 455,000=$5,500

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Benefits and shortcomings of expected value techniques:

Benefit:

• Helps an organization determine the average outcome of an event when faced with
uncertainties.

Shortcomings

• The expected value calculation is only as good as the estimated potential outcomes
for each scenario and the probability assigned to each scenario.

• Does not consider risk of the decision maker. It assumes the decision maker is risk
neutral.

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64
 Chapter Three

Components of a Master Budget

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66
 3.1 Components of a Master Budget:

The master budget is the plan of operations for a company or business unit
over a year, an operating period, or a shorter duration. The master budget sets
quantitative goals for all operations, including detailed plans for raising the required
capital.

The master budget is a map showing where the company is heading. If it is

properly designed, it will show the company heading in the same direction as the
strategy and the long-term plan. The budget is more precise and of shorter duration
than long-term plans. It is more focused on responsibility centers than longer-term
planning tools. A master budget is broken down into an operating and a financial
budget.

• An operating budget identifies resources that are needed for operations and is
concerned with the acquisition of these resources through purchase or
manufacture. Operating budgets include production budgets, purchasing budgets,
sales promotion budgets, and staffing budgets. It is building blocks leading to the
creation of the budgeted income statement.
Basic Operating Budget Steps
[Link] the revenues budget.
[Link] the production budget (in units).
[Link] the direct materials usage budget and direct materials purchases budget.
[Link] the direct manufacturing labor budget.
[Link] the manufacturing overhead costs budget.
[Link] the ending inventories budget.
[Link] the cost of goods sold budget.

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 [Link] the operating expense (period cost) budget.
[Link] the budgeted income statement.

• A financial budget matches sources of funds with uses of funds in order to

achieve the goals of the firm. This includes budgets for cash inflows and
outflows, financial position, operating income, and capital expenditures. It is
building blocks based on the operating budget that lead to the creation of the
budgeted balance sheet and the budgeted statement of cash flows.
Basic Financial Budget Steps
Based on the operating budgets:
[Link] the capital expenditures budget.
[Link] the cash budget.
[Link] the budgeted balance sheet.
[Link] the budgeted statement of cash flows.

The company may use another types of budgets as follow:

• A capital budget is used to plan how resources will be used to support significant
investments in projects that have long-term implications. These projects could
include the purchase of new equipment or investment in new facilities.

• A budget manual describes how a budget is to be prepared. Include a budget

planning calendar and distribution instructions for all budget schedules

• Budget planning calendar is the schedule of activities for the development and
adoption the budget, it includes a list of dates indicating when specific
information is to be providing to other.

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3.2 The Schedules of Master Budget:

3.2.1 Sales Budget

Sales forecasts should use statistical analysis techniques such as regression

analysis and rely on sales managers’ knowledge about their market and customer
needs. Once a company has determined its forecasted sales level, based on its long
and short-term objectives, it forms a sales budget to accomplish its goals. The two
key components of the sales budget are the projected number of units of sales and
the projected selling prices for the upcoming periods.

For example: The sales budget of Robin Manufacturing Company for the third
quarter.

Sales Budget

July August September Quarter

Sales in Units 70,000 72,000 77,000 219,000
Selling Price $110.8 $110.8 $112 -
Per Unit
Total Sales $7,756,000 $7,977,600 $8,624,000 $24,357,600

Note: For the exam, candidates may need to know the order in which the different
operating budgets are prepared because some of the questions may be based on the
order of preparation. It is critical to produce the Sales Budget first so that the
company knows how many units will need to be produced or purchased.

The first Operating Budget to be prepared is always the Sales Budget, because
the Production Budget and all the other budgets for the company are derived from
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the Sales Budget. If sales are expected to be low, the company does not need as much
inventory or as many salespeople, and so on. On the other hand, if sales are expected
to be high, more of each of these resources will be required.
The Sales Budgets should be developed for each responsibility center individually
or possibly for each salesperson, depending on the nature of the business. The Sales
Budget needs to be based on realistic estimates of sales, since the Sales Budget will
be the driver behind all of the remaining budgets.

• If the Sales Budget is too optimistic, production will be too high, inventory will
be too high, and problems such as cash shortfall may result.
• If the Sales Budget is too low, production and inventory will be too low, and sales
may be lost because of a lack of product to sell.

The Sales Budget is probably the most difficult budget to produce because it relies
entirely on information and estimations that are outside of the direct control of the
company. The company has no direct control over the economy as a whole or over
competitors and technological advances that may affect sales of the company’s
product.

If demand is greater than the company’s production capacity, the Sales Budget
should not reflect the amount the company could sell if it were able to increase
production to meet the demand. Unless the company has specific plans in its Capital
Expenditures Budget to increase production facilities due to the expected increased
demand, the Sales Budget will need to be adjusted to the quantity that will be
available to be sold. Thus, it follows that the Sales Budget will need to incorporate
information about sales revenues expected from any capital projects that are
expected to begin generating sales during the coming year.
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3.2.2 Production Budget
Budgeted Production = Budgeted Sales + Desired Ending Inventory -
Beginning Inventory
Production Budget

July August September Quarter

Budgeted sales in units 70,000 72,000 77,000 219,000
+ Desired ending inventory of finished 10,000 11,000 12,000 12,000
goods
Total units needed 80,000 83,000 89,000 231,000
- Beginning inventory of finished 8,000 10,000 11,000 8,000
goods
Budgeted production in units 72,000 73,000 78,000 223,000

3.2.3 Direct Material Budget

Direct Materials Purchased = Direct Materials Used in Production + Desired

Ending Inventory of Direct Materials - Beginning Inventory of Direct Materials
Direct Material Budget

Production requirement July August September Quarter

Budgeted Production 72,000 73,000 78,000 223,000
Pounds of resin per unit of product ×5 ×5 ×5 ×5
Total pounds of resin required 360,000 365,000 390,000 1,115,000
Pounds of resin in beginning 35,000 35,000 35,000 35,000
inventory
Cost per pound × $13.00 × $13.00 × $13.00 × $13.00
Total cost of beginning inventory $455,000 $455,000 $455,000 $455,000
Total cost for direct material $4,680,000 $4,745,000 $5,135,000 $14,560,000
purchase
Cost of resin available for $5,135,000 $5,200,000 $5,590,000 $15,015,000
production
Desired ending inventory in pounds 35,000 35,000 40,000 40,000
Cost of desired ending inventory × $13.00 × $13.00 × $13.00 × $13.00
per pound
Total cost of desired ending $455,000 $455,000 $520,000 $520,000
inventory
Cost of resin used in production
(cost Available for Production- Cost $4,680,000 $4,745,000 $5,070,000 $14,495,000
of Desired Ending Inventory)

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 Direct Material Purchase Budget

July August September Quarter

Total Direct Material needed 360,000 365,000 390,000 1,115,000
in production
Add: Desired ending 35,000 35,000 40,000 40,000
inventory
Total direct material required 395,000 400,000 430,000 1,155,000
Less: Direct material 35,000 35,000 35,000 35,000
beginning inventory
Direct material purchases 360,000 365,000 395,000 1,120,000
Purchase price per pound $13.00 $13.00 $13.00
Total cost for direct material $4,680,000 $4,745,000 $5,153,000 $14,560,000
purchase

3.2.4 Direct Labor Budget

Direct Labor Requirement = (Expected Production × Direct Labor
Hours per Unit)

Budgeted Direct Labor Cost = Direct Labor Requirement × Direct Labor

Cost per Hour
Direct Labor Budget
July August September Quarter
Budget Production 72,000 73,000 78,000 223,000
DLH required per unit 0.5 0.5 0.5
DLH need 36,000 36,500 39,000 111,500
Hourly rate $15 $15 $15
Total wage for direct labor hour $540,000 $547,500 $585,000 $1,672,500

3.2.5 Overhead Budget (Factory Overhead Budget)

All other production costs that are not in the direct materials and direct labor budgets
are in the overhead budget, sometimes called a fixed costs budget because most of
the costs in this category do not vary with the rise and fall of production. Rent and
insurance, for instance, remain stable even if production goes up or down. However,

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there are some overhead costs that do vary with production—variable costs such as
batch setup costs or the costs of electricity and other utilities. Fixed costs are easy to
budget, but variable costs require forecasting the number of units to be produced,
the production methods used, and other external factors.

Factory Overhead Budget

Rate per July August September Quarter
DLH
Total DLHs 36,000 36,500 39,000 111,500
Variable factory overhead
Supplies $0,20 $7,200 $7,300 $7,800 $22,300
Fringe benefits 4,10 147,600 149,650 159,900 457,150
Utilities 1,00 36,000 36,500 39,000 111,500
Maintenance 0,50 18,00 18,250 19,500 55,750
Total variable factory overhead $5,80 $208,800 $211,700 $226,200 $646,700
Fixed factory overhead
Depreciation $20,000 $20,000 $20,000 $60,000
Plant insurance 800 800 800 2,400
Property taxes 1200 1200 1200 3600
Salary supervision 10,000 10,000 10,000 30,000
Indirect labor 72,000 72,000 72,000 216,000
utilities 4,000 4,000 4,000 12,000
maintenance 900 900 900 2,700
Total fixed factory overhead 2.93 $108,900 $108,900 $108,900 $326,700
Total factory overhead $8.73 $317,700 $320,600 $335,100 $973,400

Standard Cost Sheet Development

A standard cost sheet shows the resources needed and the costs of those resources
to manufacture one unit of a product.
A cost sheet may be used to value inventory, to measure contribution margin, to set
selling prices, and, as will be seen in a later topic, to measure the performance of
departments within the purchasing and production functions.

Resources includes the physical units (such as pounds or linear feet or gallons) of
each item of direct material required to produce one unit of product. The unit of
measure used on the standard cost sheet can vary by industry and/or product.

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 Product Cost Sheet

Cost Component Units of Cost/Unit Cost/Unit of

Resource/Unit of Resource Production
of Production
Direct Material 5.00 lb/unit $13. 00/lb $65.00/unit
Direct labor 0. 5 hr/unit 15. 00/hr 7. 50
Variable Overhead 0. 5 hr/unit 5.80/hr 2.90
Total Variable Cost $75.40/unit
Fixed Overhead 0. 5 hr/unit $2.93/hr 1.465
Total Cost $76. 865/unit

The cost sheet shows the product cost is $75.40 per unit in a variable costing income
statement and $76.865 in an absorption costing income statement. Looking ahead to
the pro forma income statement, shows that Robin Manufacturing uses an
absorption costing income statement to conform with GAAP. We know this because
the income statement shows cost of goods sold rather than total variable and total
fixed costs.

3.2.6 Cost of Goods Sold Budget

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 Cost of Goods Sold Budget

July August September Quarter

Direct Material used $4,680,000 $4,745,000 $5,070,000 $14,495,000
Direct labor used $540,000 $547,500 $585,000 $1,672,500
Manufacturing Overhead $317,700 $320,600 $335,100 $973,400
Cost of Goods Manufactured $5,537,000 $5,613,100 $5,990,100 $17,140,900
(COGM)
Add: Beginning finished good (8,000 units@$76.865) $614,920
inventory 1 July year 1
Less: Ending finished good inventory (12,000 units@$76.865) $922,380
1 July year 1
Cost of Goods Sold (COGS) $16,833,440

3.2.7 Selling and Administrative Expense Budget

July August September Quarter

Research/design $95,000 $95,000 $100,000 $290,000
Marketing 240,000 280,000 290,000 810,000
Shipping 135,000 140,000 150,000 425,000
Product support 90,000 90,000 95,000 275,000
Administration $185,000 190,000 192,000 567,000
Total $745,000 $795,000 $827,000 $2,367,000

3.2.8 Pro Forma (or Budgeted) Income Statement

For example: the pro forma income statement for Manufacturing Company
compiled using information from the sales budget, the cost of goods sold budget,
and the S&A expense budget. In addition, the company is expected to pay an interest
expense of $140,361 and a tax installment of $1,702,165 for the quarter.

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 Pro Forma Income Statement
Sales $24,357,600
Less: Cost of goods sold 16,833,400
Gross margin $7,524,200
Less: S&A expenses 2,367,000
Operating income $5,157,200
Less: Interest expenses 140,361
Earnings before taxes $5,015,839
Less: Taxes 1,702,165
Net income $3,314,674

Pro forma statements represent a company’s projected financial statements. They

are useful in the company’s planning process because these statements support three
major functions. They help a company to:

1. Assess whether its anticipated performance is in line with its established targets.
2. Anticipate the amount of funding needed to achieve its forecasted sales growth.
3. Estimate the effects of changes in assumptions of key numbers by performing
Sensitivity analysis.

Sensitivity analysis (i.e., what-if analysis) helps to identify potential conditions

that could lead to major problems for the company. This enables the company to
plan for appropriate actions in case such an event should occur. In addition,
sensitivity analysis also provides the company with the opportunity to analyze the
impact of changing its operating plans.

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Comprehensive Illustration:
The budgeting task force of Santiago Pants arrived at the following sales budget:
Estimated sales = Estimated number of units × Budgeted price per unit
$7,200,000 = 160,000 × $45.00
Sales consist of two parts, volume and price. Estimated sales equal the
estimated number of units times the budgeted price per unit. For Santiago Pants, the
budgeted number of units of 160,000 times $45.00 per unit provides estimated sales
of $7,200,000.
Forecasting Production
A production budget is a plan of resources needed to meet current sales demand
and ensure that inventory levels are sufficient for future sales.
If Santiago Pants budgeted sales at 160,000 units, desires 15,000 units in ending
inventory, and has 5,000 units in beginning inventory, required production
is ???????????? units.
Production Budget
Santiago Pants
Production Budget
For the Budget Year Ended December 31
(in units)

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Direct Materials Example

Santiago Pants
Estimated Production
Materials Data

Yards needed:

Cotton = (170,000 ×3.0) + 15,000 –10,000 = 515,000 yards

Fine cotton = (170,000 ×0.2) + 1,000 –1,000 = 34,000 yards

Santiago Pants
Partial Direct Materials Budget
For the Budget Year Ended December 31

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Direct Labor Example
Santiago Pants
Direct Labor Budget
For the Budget Year Ended December 31

Overhead Example
Santiago Pants
Schedule of Budgeted Manufacturing Overhead
For the Budget Year Ended December 31

80
Cost of Goods Sold Example

Santiago Pants
Budgeted Statement of Cost of Goods Sold
For the Budget Year Ended December 31

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Marketing and Administrative Budget Example

Santiago Pants
Scheduled of Budgeted Marketing and Administrative Costs
For the Budget Year Ended December 31

Income Statement Example

Santiago Pants
Budgeted Income Statement
For the Budget Year Ended December 31

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Example (1): (Production Budget)

Regal Products manufactures and distributes toys to retail outlets. One of the
company’s products, Supermix, requires 3 pounds of material (A) in the
manufacture of each unit. The company is now planning raw material needs for the
third quarter of 2019, the quarter in which peak sales of Supermix occur. To keep
production and sales moving smoothly, the company has the following inventory
requirement:

1- The finished goods inventory on hand at the end of each month must be equal to
5,000 units plus 25 percent of the next month’s sales. The finished goods inventory
on June 30 is budgeted to be 13,750 units.

2- 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 54,375 pounds.

3- The company maintains no work in process inventories.

A sales budget for Super mix for the last six months of 2019 is given below

Budgeted Sales (In Units)

July 35,000
August 40,000
September 50,000
October 30,000
November 20,000
December 15,000

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Require:
1. Prepare a Production Budget for the months July – September and for the third
quarter.
2. Prepare a Material Budget showing the quantity of material A to be purchased
for the months July-September and for the third quarter.

Answer

[1] Production Budget:

July August September Total

Expected sales 35,000 40,000 50,000 125,000
+ Desired End inv. FG 15,000 17,500 12,500 12,500
Total needs 50,000 57,500 62,500 137,500
- Expected Beg. Inv. FG (13,750) (15,000) (17,500) (13,750)
Units to be produced 36,250 42,500 45,000 123,750

[2] Material Budget:

July August September Total

Material used 10,8750 127,500 135,000 371,250
+ Desired End inv. M 63,750 67,500 41,250 41,250
Total DM needed 172,500 195,000 176,250 412,500
- Beg. Inv. M (54,375) (63,750) (67,500) (54,375)
DM to be purchased 118,125 131,250 108,750 358,125

Note: For October:

Sales 30,000
+ Desired End 10,000
Total need 40,000
- Expected Beg. (12,500)
Total unit to be purchased 27,500× 3 = 82,500 DM needed.

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Example (2):

85
Required:

Answer

86
87
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3.3 The Cash Budget
Maintaining adequate liquidity is a requirement for staying in business, and a
cash budget is a plan to ensure liquidity. Because cash is needed in all areas of
operations, the cash budget gets data from all parts of the master budget. A cash
budget is divided into Five sections: the cash receipt section, the cash disbursement
section, the cash excess or deficiency section, the financing section and Desired
Ending cash balance.

Cash Budget form

Quarters Total Year
Q1 Q2 Q3 Q4
Beginning Cash Balance
Add: Collection from Customer
Add: Sale of capital Equipment
1-Total Cash Available
Minus: Disbursement
Direct Material
Payroll
Manufacturing Overhead (exclude Depreciation)
S, G&A (exclude Depreciation)
Equipment Purchase (Capital Expenditure)
Cash Dividends
Interest
Income Taxes
2-Total Disbursement
3-Cash Excess (Deficit)
Financing:
Borrowing
Repayment
Investment
5-Total Effect of Financing
4-Desired Ending Cash Balance

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Case (1): (Sales collection Budget)
Greenup, Inc., produces a product which has peak sales in March of each year. The
company’s budgeted sales for the first quarter of 2019 are given below:

January February March Total

Budget Sales $50,000 $65,000 $75,000 $190,000

In order to have data available for preparing a Cash Budget, the company is anxious
to determine the budgeted cash collections from sales. To this end, the following
information has been gathered:

Collections on Sales:
60% in month of sales
30% in month following sale
8% in second month following sale
2% uncollectible

The company gives a 2 percent cash discount for payments made by customers
during the month of sales. The Accounts Receivable Balance to start the year is
$22,000 of which $4,000 represents uncollected November sales and $18,000
represents uncollected December sales.

Required:
1) What were the total sales for November? For December?
2) Prepare a schedule showing the budgeted cash collections from sales, by month
and total, for the three-month period.

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 Answer

Cash Inflows for Month

= (Month zero % Collected × Sales Current Month)
+ (Month one % Collected × Sales Last Month)
+ (Month two % Collected × Sales Two Months Ago)
+ (Month three % Collected × Sales Three Months Ago)

January February March Total

Sales (60% × 98% × S) (60% × 98% × S) (60% × 98% × S)
29,400 38,220 44,100 111,72
First Month 13,500 15,000 19,500 48,000
Second Month 3,200 3,600 4,000 10,800
Total cash collection 46,100 56,820 67,600 170,520

Note:

1- From December >> 18,000 uncollectible

So, December sales = 18,000 ÷ 40% = $45,000

2- From November >> 4,000 uncollectible

So, November sales = 4,000 ÷10% = $40,000

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Case (2):

A cash budget by Quarter is given below. Fill in the missing amounts. The company
requires a minimum cash balance of at least $5,000 to start each quarter.

Quarter Year
1 2 3 4
Beginning Cash balance $6 ? ? ? ?
+ collection from ? ? 96 ? 323
customers
Total Cash available 71 ? ? ? ?
Disbursements:
Purchase of inventory 35 45 ? 35 ?
Operating expenses ? 30 30 ? 113
Equipment purchase 8 8 10 ? 36
Cash Dividends 2 2 2 2 ?
Total Disbursements ? ? ? ? ?
Excess (Deficiency) of (2) ? 11 ? ?
Cash
Financing:
Borrowing ? 15 - - ?
Repayments - - (?) (17) ?
Total financing ? ? ? ? ?
Cash Balance Ending ? ? ? ? ?

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Case (3):
ABC Company needs a cash budget for the month of September. The following
information is available:

1- The cash balance on September 1 is $7,500.

2- Actual sales for July and August, and expected sales for September are:

July August September

Cash Sales $5,000 $5,250 $6,500
Credit Sales $25,000 $30,000 $35,000
Total Sales $30,000 $35,250 $41,500

Credit sales are collected over a three-month period in the ratio 60%, 30%, 9%,
with 1% uncollectible.

3- Purchases of inventory will total $18,000 for September. 70% of a month’s

purchases are paid during the month of purchase. Accounts Payable for August
purchases total $6,150 which will be paid in September.

4- Selling and Administrative expenses are budgeted at $14,000 for September of

this amount, $5,000 is for depreciation.

5- Dividends of $5,000 will be paid during September, and equipment costing

$12,000 will be purchased.

6- The company must maintain a minimum cash balance of $5,000.

An open line of credit is available from the company’s bank to support the cash
position as needed

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Required: Prepare a cash budget for the month of September. Indicate in the
financing section any borrowing that will be necessary during the month.

Answer

Sales:
Cash $ 6,500
Credit (35,000×60%) =
21,000
Credit (August) (30,000×30%) = 9,000
Credit (July) (25,000×9%) = 2,250
Total sales $ 38,750
collection

Cash budget:

Beg. Cash balance 7,500

Collection from 38,750
customers
Total Cash available 46,250
Disbursements:
Purchases Invy. (18,000×70%) + 6,150 =
18,750
Selling 9,000
Dividends 5,000
Purchases equipment 12,000
Total disbursement 44,750
Surplus(deficit) 1,500
Financing:
Borrowing 3,500
Cash balance ending $5,000

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Relationship Among Cash Budget, Capital Expenditure Budget, and Pro
Forma Financial Statements

The cash budget combines the results of the operating, cash collections, and cash
disbursements budgets to provide an overall picture of where an organization
expects its cash to come from and be paid to for a given period. The capital
expenditure budget is a line item that is included in the cash disbursements section
of the cash budget.
A pro forma income statement is completed to demonstrate that an acceptable level
of income is possible. This estimated income and changes to the cash budget are
used to create a pro forma balance sheet. The pro forma cash flow statement
classifies all of the cash receipts and disbursements based on activity: that is,
operating activities, investing activities, and financial activities.

Question 1: Holland Company is in the process of projecting its cash position at the
end of the second quarter. Shown below is pertinent information from Holland’s
records.

Cash balance at end of 1st quarter $36,000

ed
Cash collections from customers for 2 $1,300,000
quarter
Accounts payable at end of 1st $100,000
ed
Accounts payable at end of 2 $75,000
ed
All 2 quarter costs and expenses $1,200,000
(accrual basis)
Depreciation (accrued expense included $600,000
above)
Purchases of equipment (for cash) $50,000
Gain on sale of asset (for cash) $5,000
Net book value of asset sold $35,000
Repayment of notes payable $66,000

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From the data above, determine Holland’s projected cash balance at the end of the
second quarter.
a) Zero b) $25,000
c) $60,000 d) $95,000

Question 2: Which one of the following statements regarding selling and

administrative budgets is most accurate?

a) Selling and administrative budgets are usually optional.

b) Selling and administrative budgets are fixed in nature.
c) Selling and administrative budgets are difficult to allocate by month and are best
presented as one number for the entire year.
d) Selling and administrative budgets need to be detailed so that the key assumptions
can be better understood.

Question 3: Which one of the following items should be done first when
developing a comprehensive budget for a manufacturing company?

a) Determination of the advertising budget.

b) Development of the sales budget.
c) Development of the cash budget.
d) Preparation of a pro forma income statement.

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Question 4: large manufacturer’s forecast of total sales revenue for a year is least
likely to be influenced by

a) the seasonal pattern of sales revenues throughout the year.

b) anticipated interest rates and unemployment rates.
c) expected shortages of key raw materials.
d) input from sales personnel.

Question 5:
In an organization that plans by using comprehensive budgeting, the master budget
refers to:
a) a compilation of all the separate operational and financial budget schedules of the
organization.
b) the booklet containing budget guidelines, policies, and forms to use in the
budgeting process.
c) the current budget updated for operations for part of the current year.
d) a budget of a not-for-profit organization after it is approved by the appropriate
authoritative body.
Question 6:
RedRock East Company uses flexible budgeting for cost control. RedRock
produced 10,800 units of product during March, incurring cost of $13,000 for
indirect materials. Its master budget for the year reflected an indirect material cost
of $180,000 at a production volume of 144,000 units. A flexible budget for March
should reflect indirect material costs of:

a) $13,975
b) $13,500
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c) $13,000
d) $11,700

Question 7:
Butteco has the following costs for 100,000 units of product:
Raw materials $200,000
Direct labor 100,000
Manufacturing overhead 200,000
Selling/administrative expense 150,000

All costs are variable except for $100,000 of manufacturing overhead and $100,000
of selling/administrative expenses. The total costs to produce and sell 110,000 units
are:

a) $650,000
b) $715,000
c) $695,000
d) $540,000

Question 8: Based on experience, a company has developed the following budget

formula for estimating its shipping expenses. The company’s shipments average 12
lbs. per shipment:

Shipping costs = $16,000 + ($0.50 x lbs. shipped)

The planned activity and actual activity regarding orders and shipments for the
current month are given in the following schedule:

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 Plan Actual
Sales orders 800 780
Shipments 800 820
Units shipped 8,000 9,000
Sales $120,000 $144,000
Total pounds shipped 9,600 12,300

The actual shipping costs for the month amounted to $21,000. The appropriate
monthly flexible budget allowance for shipping costs for the purpose of performance
evaluation would be:

a) $20,680
b) $20,800
c) $22,150
d) $20,920

Question 9: Barnes Corporation expected to sell 150,000 board games during the
month of November, and the company’s master budget contained the following data
related to the sale and production of these games:

Revenue $2,400,000
Cost of goods sold:
Direct materials 675,000
Direct labor 300,000
Variable factory overhead 450,000
Contribution $ 975,000
Fixed overhead 250,000
Fixed selling/administration 500,000
Operating income $ 225,000

Actual sales during November were 180,000 games. Using a flexible budget, the
company expects the operating income for the month of November to be:

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a) $225,000
b) $420,000
c) $510,000
d) $270,000

Question 10: The Jung Corporation’s budget calls for the following production,
in number of units:
Qtr. 1 – 45,000 units Qtr. 2 – 38,000 units
Qtr. 3 – 34,000 units Qtr. 4 – 48,000 units
Each unit of product requires 3 pounds of direct material. The company's policy is
to begin each quarter with an inventory of direct materials equal to 30% of that
quarter's direct material requirements. Budgeted direct materials purchase for the
third quarter are:

a) 38,200 pounds.
b) 89,400 pounds.
c) 114,600 pounds.
d) 29,800 pounds.

The following information is for the next two questions: Berol Company, which
plans to sell 200,000 units of finished product in July, anticipates a growth rate in
sales of 5% per month. The desired monthly ending inventory in units of finished
product is 80% of the next month's estimated sales. Berol Company has 150,000
finished units in inventory on June 30. Each unit of finished product requires 4
pounds of direct materials at a cost of $1.20 per pound. There are 800,000 pounds
of direct materials in inventory on June 30.

Question 11: Berol Company’s production requirement in units of finished product

for the 3-month period ending September 30 is:
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a) 712,025 units.
b) 638,000 units.
c) 665,720 units.
d) 630,500 units.

Question 12: Assume Berol Company plans to produce 600,000 units of finished
product in the 3-month period ending September 30, and to have direct materials
inventory on hand at the end of the 3-month period equal to 25% of the use in that
period. The estimated cost of direct materials purchases for the 3-month period
ending September 30 is:

a) $2,200,000 b) $2,880,000
c) $2,640,000 d) $2,400,000

The following information is for the next two questions: Daffy Tunes
manufactures a toy rabbit with moving parts and a built-in voice box. Projected sales
in units for the next 5 months are as follows:

Month Projected Sales in unit

January 30,000
February 36,000
March 33,000
April 40,000
May 29,000

Each rabbit requires basic materials that Daffy purchases from a single supplier at
$3.50 per rabbit Voice boxes are purchased from another supplier at $1.00 each.
Assembly labor cost is $2.00 per rabbit and variable overhead cost is $0.50 per

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rabbit. Fixed manufacturing overhead applicable to rabbit production is $12,000 per
month. Daffy's policy is to manufacture 1.5 times the coming month’s projected
sales every other month, starting with January (in other words, odd-numbered
months) for February sales, and to manufacture 0.5 times the coming month’s
projected sales in alternate months (in other words, even-numbered months). This
allows Daffy to allocate limited manufacturing resources to other products as needed
during the even-numbered months.

Question 13: The unit production budget for toy rabbits for January is:

a) 45,000 units.
b) 54,000 units.
c) 16,500 units.
d) 14,500 units.

Question 14: The dollar production budget for toy rabbits for February is:

a) $327,000
b) $127,500
c) $113,500
d) $390,000

The following information is for the next three questions: Rokat Corporation is
a manufacturer of tables sold to schools, restaurants, hotels, and other institutions.
Rokat manufactures the table-tops, but an outside supplier sells the table legs to
Rokat. The Assembly Department takes a manufactured table tops and attaches the
4 purchased table legs. It takes 20 minutes of labor to assemble a table. The company
follows a policy of producing enough tables to ensure that 40% of next month's sales
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are in the finished goods inventory. Rokat also purchases sufficient raw materials
to ensure that raw materials inventory is 60% of the following month’s scheduled
production. Rokat’s sales budget in units for the next quarter is as follows:

July 2,300
August 2,500
September 2,100

Rokat’s ending inventories in units for June 30 are:

Finished goods 1,900

Raw materials (legs) 4,000

Question 15: The number of tables to be produced during August is:

a) 1,900 tables.
b) 1,440 tables.
c) 2,340 tables.
d) 1,400 tables.

Question 16: Assume the required production for August and September is 1,600
and 1,800 units respectively, and the number of table legs in the July 31 raw
materials inventory is 4,200 units. The number of table legs to be purchased in
August is:

a) 2,200 legs
b) 6,520 legs.
c) 6,400 legs.
d) 9,400 legs.

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Question 17: Assume that Rokat Corporation will produce 1,800 units in the month
of September. How many employees will be required for the Assembly Department?
(Fractional employees are acceptable since employees can be hired on a part-time
basis. Assume a 40-hour week and a 4-week month.)

a) 3.75 employees.
b) 60 employees.
c) 15 employees.
d) 600 employees

The following information is for the next two questions: Wellfleet Company
manufactures recreational equipment and prepares annual operational budgets for
each department. The Purchasing Department is finalizing plans for the fiscal year

ending June 30, 20X9, and has gathered the following information regarding 2 of
the components used in both tricycles and bicycles. Wellfleet uses the first in, first-
out inventory method.

Question 18: The budgeted dollar value of Wellfleet Company’s purchases of

component A19 for the fiscal year ending June 30, 20X9 is:

a) $309,000
b) $540,600
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c) $2,017,800
d) $538,080

Question 19: If the economic order quantity of component B12 is 70,000 units, the
number of times that Wellfleet Company should purchase this component during
the fiscal year ended June 30, 20X9 is:

a) Eight times. b) Nine times.

c) Four times. d) Five times.

Question 20: DeBerg Co. has developed the following sales projections for the
year:

May $100,000 August $160,000

June $120,000 September $150,000
July $140,000 October $130,000

Normal cash collection experience has been that 50% of sales are collected during
the month of sale and 45% are collected the following month. The remaining 5% of
sales is never collected. DeBerg’s budgeted cash collections for the third calendar
quarter are:

a) $450,000
b) $440,000
c) $414,000
d) $360,000

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The following information is for the next two questions: Information about
Noskey Corporation’s sales revenue is presented in the following table.

November (Actual) December (Budget) January (Budget)

Cash Sales $ 80,000 $ 100,000 $ 60,000
Credit sales $ 240,000 $ 360,000 $ 180,000
Total sales $ 320,000 $ 460,000 $ 240,000

Management estimates that 5% of credit sales will become credit losses. Of the credit
sales that are collectible, 60% are collected in the month of sale and the remainder
in the month following the sale. Purchases of inventory are equal to next month’s
sales and gross profit margin is 30%. All purchases of inventory are on account; 25%
are paid during the month of purchase, and the remaining 75% are paid during the
month following the purchase.

Question 21: Noskey Corporation’s budgeted cash collections in December from

November credit sales are:

a) $136,800
b) $91,200
c) $144,000
d) $96,000

Question 22: Noskey Corporation’s budgeted total cash receipts in January are:

a) $294,000
b) $239,400
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c) $299,400
d) $240,000

The following information is for the next two questions: The Raymar Company
is preparing its cash budget for the months of April and May. The firm has
established a $200,000 line of credit with its bank at a 12% annual rate of interest on
which borrowings for cash deficits must be made in $10,000 increments. Interest is
to be paid monthly. Principal repayments of the draws (loans) against the line of
credit are to be made in any month in which Raymar has a surplus of cash.
Whenever the line of credit has no outstanding balances, Raymar will invest any
cash in excess of its desired end-of-month cash balance in U.S. Treasury bills. The
line of credit has no outstanding loan balance on April 1. Raymar intends to
maintain a minimum balance of $100,000 in cash at the end of each month by either
borrowing for deficits below the minimum balance or investing any excess cash.
Monthly collection and disbursement patterns are expected to be:
• Collections: 50% of the current month’s sales budget and 50% of the previous
month’s sales budget.
• Accounts Payable Disbursements: 75% of the current month’s accounts payable
budget and 25% of the previous month’s accounts payable budget.
• All other disbursements occur in the month in which they are budgeted.

Budget Information
March April May
Sales $40,000 $50,000 $100,000
Accounts payable 30,000 40,000 40,000
Payroll 60,000 70,000 50,000
Other disbursements 25,000 30,000 10,000

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Question 23: In April, Raymar’s budget will result in:

a) $45,000 in excess cash.

b) A need to borrow $50,000 on its line of credit for the cash deficit.
c) A need to borrow $100,000 on its line of credit for the cash deficit.
d) A need to borrow $92,500 on its line of credit for the cash deficit.

Question 24: In May, Raymar will be required to:

a) Borrow an additional $30,000 principal and pay $1,000 interest.

b) Repay $90,000 principal and pay $100 interest.
c) Pay $900 interest.
d) Borrow an additional $20,000 and pay $1,000 interest.

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110
 Chapter Four

Static Budgets and Variances Analysis

111
112
Learning Objectives

1. Understand static budgets and static-budget variances

2. Examine the concept of a flexible budget and learn how to develop it

3. Calculate flexible-budget variances and sales-volume variances

4. Explain why standard costs are often used in variance analysis

5. Compute price variances and efficiency variances for direct cost categories

6. Understand how managers use variances

7. Describe benchmarking and explain its role in cost management

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114
Introduction:

In Chapter 4, you saw how budgets help managers with their planning
function. We now explain how budgets, specifically flexible budgets, are used to
compute variances, which assist managers in their control function. Flexible budgets
and variances enable managers to make meaningful comparisons of actual results
with planned performance, and to obtain insights into why actual results differ from
planned performance. They form the critical final function in the five-step decision-
making process by making it possible for managers to evaluate performance and
learn after decisions are implemented. In this chapter and the next we explain how.

The operating plans and budgets are implemented at the start of the new year.
Then the process of accounting for actual results begins. The actual results are
compared to budget, which results in variances that enable management to evaluate
performance.

The standard costs for each of the firm’s products are established during the
annual budget process. Then that standard is used as the basis for comparison. The
standard costing system enables the management to measure performance on a
current basis and to pinpoint the organizational function, department, or manager
responsible for any variances from standard.

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4.1 Static Budgets and Variances

A variance is the difference between actual results and expected

performance. The expected performance is also called budgeted performance,
which is a point of reference for making comparisons.

4.1.1 The Use of Variances

Variances lie at the point where the planning and control functions of
management come together. They assist managers in implementing their strategies
by enabling management by exception. This is the practice of focusing
management attention on areas that are not operating as expected (such as a large
shortfall in sales of a product) and devoting less time to areas operating as expected.
In other words, by highlighting the areas that have deviated most from expectations,
variances enable managers to focus their efforts on the most critical areas. Consider
scrap and rework costs at a Maytag appliances plant. If actual costs are much higher
than budgeted, the variances will guide managers to seek explanations and to take
early corrective action, ensuring that future operations result in less scrap and
rework. Sometimes a large positive variance may occur, such as a significant
decrease in manufacturing costs of a product. Managers will try to understand the
reasons for this decrease (better operator training or changes in manufacturing
methods for example), so these practices can be appropriately continued and
transferred to other divisions within the organization.
Variances are also used in performance evaluation and to motivate managers.
Production-line managers at Maytag may have quarterly efficiency incentives linked
to achieving a budgeted amount of operating costs.
Sometimes variances suggest that the company should consider a change in
strategy. For example, large negative variances caused by excessive defect rates for
a new product may suggest a flawed product design. Managers may then want to

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investigate the product design and potentially change the mix of products being
offered.
Variance analysis contributes in many ways to making the five-step decision-
making process more effective. It allows managers to evaluate performance and
learn by providing a framework for correctly assessing current performance. In turn,
managers take corrective actions to ensure that decisions are implemented correctly
and that previously budgeted results are attained. Variances also enable managers to
generate more informed predictions about the future, and thereby improve the
quality of the five-step decision making process.
The benefits of variance analysis are not restricted to companies. In today’s
difficult economic environment, public officials have realized that the ability to
make timely tactical alterations based on variance information guards against having
to make more draconian adjustments later. For example, the city of Scottsdale,
Arizona, monitors its tax and fee performance against expenditures monthly. Why?
One of the city’s goals is to keep its water usage rates stable. By monitoring the
extent to which water revenues are meeting current expenses and obligations; while
simultaneously building up funds for future infrastructure projects, the city can avoid
rate spikes and achieve long-run rate stability.
How important is variance analysis? A survey by the United Kingdom’s
Chartered Institute of Management Accountants in July 2009 found that variance
analysis was easily the most popular costing tool in practice and retained that
distinction across organizations of all sizes.
4.1.2 Static Budgets and Static-Budget Variances
The static budget, or master budget, is based on the level of output planned
at the start of the budget period. The master budget is called a static budget because
the budget for the period is developed around a single (static) planned output level.

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 The static-budget variance is the difference between the actual result and the
corresponding budgeted amount in the static budget.
A favorable variance—denoted F in this book—has the effect, when considered in
isolation, of increasing operating income relative to the budgeted amount. For
revenue items, F means actual revenues exceed budgeted revenues. For cost items,
F means actual costs are less than budgeted costs. An unfavorable variance—
denoted U in this book—has the effect, when viewed in isolation, of decreasing
operating income relative to the budgeted amount. Unfavorable variances are also
called adverse variances in some countries, such as the United Kingdom.

Static-budget variance for

operating income = Actual result - Static-budget amount
= 35,760 – 270,000 = 234,240 U

What can be learned from this initial comparison and variances? The number
of units sold was significantly under plan. That could be expected to depress
operating income, but by how much is not known. The revenue is significantly less
than plan; however, whether this is simply the result of fewer units sold or deviations
of actual selling price from planned selling price is not clear.

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Note: Positive and negative signs don’t by themselves indicate whether a variance
is favorable or unfavorable. A favorable (F) variance exceeds the planned
amount of earnings or is less than the planned costs. An unfavorable (U)
variance is the opposite.

Comparing the actual results to a static budget (Master budget) doesn’t

provide answers on exactly why the results were different. So, A flexible Budget is
used to adjust the master budget to standards based on the Actual units sold.

4.2 Flexible Budget

Flexible budgets are a restatement of the original budgets that have been
adjusted to the actual level of activity, in this case, it is the actual level of units sold.
Flexible budgets help to measure actual performance in a manner that is fair to the
organizational unit or individual whose performance is being measured and is
consistent with standards of performance that have already been agreed to in the
master budget.

Establishes a base cost budget for a particular level of output (a cost-volume

relationship), plus an incremental cost-volume amount that shows the behavior of
costs at various volumes. Only the variable costs are adjusted; fixed costs remain
unchanged. The most common use of a flexible budget is to show the budget that
would have been made if the organization had exactly matched its sales forecast.

The benefits of using a flexible budget include the ability to make better use
of historical budget information to improve future planning and to conduct detailed
variance analysis.

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 Sales Volume Flexible Budget
Variance Variance

Static Budget
Variance

4.2.1 Static Budget Variance:

The difference between the actual and the static budget results. This can be
broken down into the following.
▪ Flexible Budget Variance: The difference between the actual results and the
flexible budget which was adjusted to actual output.
This variance identifies the difference in operating income when the budget is
adjusted to the actual level of sales.

Flexible budget
variance = Actual result - Flexible-budget amount
35,760 - 78,000 = 42,240 U

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 ▪ Sales Volume Variance: The difference between the flexible budget and the
static budget.
This variance provide information on how operating income is affected by the
difference in the volume of budgeted sales compared to the volume of actual
sales.

Sales-volume
variance for
operating income = Flexible-budget amount - Static-budget amount
= 78,000 – 270,000 = 92,000 U

4.3 Management by Exception

Determining what should be investigated comes with experience. However,

managers quickly learn to focus attention on the largest variances, both unfavorable
and favorable, those that occur frequently, and what might be called
“controllability.”

Labor efficiency can have significant variations from period to period, but
consistency is expected in material purchase prices from period to period. The
thresholds for which variances to investigate often are combinations of absolute
amounts and a percentage of variance from budget. The acceptable percentage
variation for labor efficiency might be set at a higher value than the acceptable
percentage variation for material price.

Management by exception could be described as employing the 80–20 rule

(Pareto’s principle). The Italian mathematician Vilfredo Pareto discovered that a
small number of large items almost always account for a high percentage of total
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value in almost any mathematical distribution. For example, a large percentage of
total invoice value is often accounted by a small percentage of the total of all
invoices. This principle seems true of the distribution of variances as well.

4.3.1 Benefits of Management by Exception

• Management can focus its time in areas where it has identified problems by
means of unfavorable variances.
• Management can look into the departments and divisions that have favorable
variances, too. It is possible that one of the departments has adopted a new policy
or procedure that might be beneficial if used in other departments.

4.3.2 Limitations of Management by Exception

• Negative trends may be overlooked at earlier stages because the variances may
not be great enough to come to management’s attention.
• If too many deviations from the budget occur, management by exception can
become a very confusing and complex process of trying to fix all the problems at
once. Management would need to decide which variances are the most important.
• If favorable variances are overlooked because they are favorable, management
might miss the opportunity to implement positive changes throughout the
company.
Management by exception focuses attention on the significant variances from the
budget, both favorable and unfavorable. What to flag may be based on:

1. Size and frequency of variance – a particular threshold cost or percentage,

such as variances over $10,000 or 5% of budgeted cost (note that relative size
is often more important than absolute size).
2. Trends – a cost that continuously increases or decreases over time.
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 3. Level of control over the variance – Ex. not paying as much attention to a
cost that is rising solely due to market demand.

Properly implemented exception tracking can reduce future costs when causes
for unfavorable variances are removed or when causes for favorable variances can
be extended. Ex. if management believes that a rising raw material cost cannot be
controlled and therefore does not flag the cost, it might be overlooking an alternative
such as finding a different vendor or a replacement material.

4.4 Standard Cost

Is an estimate of what a cost should be under normal operating conditions
based on accounting and engineering studies. These Standard Costs are usually
expressed in per unit amounts and determined before actual costs are available.

4.4.1 Advantages of Standard Cost system:

1. To help management in cost planning, cost control, performance evaluation
through determining the variance causes (reasons).
2. To help management in decision making process through investigating and
deciding the corrective actions in the coming period.
3. To motivate the workers (employees) where the standard is considered a goal for
expected performance, such motivate employees to achieve this goal.

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4.5 Variance Analysis
Importance of Variance Analysis
1. Assignment of Responsibility, the goal is to assign responsibility for variances
to those most likely to have information that will enable management to find
solutions. So, the main purpose is to promote learning and continuous
improvement rather than assign blame
2. Variance analysis is useful in evaluating manager’s performance.

The following is a general guide to each variance and the functional area
responsible for the variance. The manager of the functional area should be able to
explain why the variance(s) occurred.

Functional Possible Explanation

Variance
Area/Department
Change in customer
Selling or demand.
Sales Price
Marketing Increase in production
costs
Human Resources
Hired more skilled
Direct Labor Rate &
workers
Production
New inexperienced
Direct Labor Efficiency/
Production workers
Usage
Machine breakdown
Vendor increased their
price
Direct Material Price Purchasing
Purchased higher-quality
materials
Purchased lower-quality
materials
Direct Material Usage Production
New inexperienced
workers

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 Increased equipment
Variable Overhead
Production repairs due to machine
Spending
breakdowns
Variable Overhead Used more or less of the
Production
Efficiency cost driver than budgeted
Fixed Overhead
Production Increased costs
Spending
Produced more or less
Production Volume Production
units than budgeted

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1 4.5.1 Direct Material Variances

2 4.5.2 Direct Labor Variances

3 4.5.3 Variable Factory Overhead Variances

126
Example 1:
Company X estimated output for the period of 18,000 Units. However actual
output was 16,500 units. Standard direct material per unit were estimated at 7.5, but
the actual usage was 6.5 per unit. The standard price was budgeted at $6.75, but the
actual price was $7. The direct material variances are?

Example 2:
ABC Company produced toys for national distribution, the standard on particular
toy are:
Material 12 pieces per toy at $2.5/piece.
Labor 2 hours per toy at $8/hour
During the month of August, the company produced 1,000 toys. Data for the month
is:
Material 17,500 pieces were purchased at a total $44,500, of which
4,500 pieces were still in inventory at the end of the month.
Labor 2,200 hours were worked at a cost of 18,200.
Required: Calculate all variances for the month

127
Direct Material Variance

Direct Labor Variance

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Example 3:
Top Line Company manufactures a single product the standard cost of one unit is:
DM 6 feet at $1 $6
DL 1 hour at $4.5 $4.5
V O/H 1 hour at $3 $3
During October, 6000 units were produced, data were as following:
Material purchased 60,000 feet $57,000
Material used 38,000 feet
Direct labor ???? Hour $29,500
V O/H cost incurred $20,457
V O/H efficiency variance $1,500U
The variable O/H rate is based on direct labor hour.
Required: Compute all variance for October.
Direct Material Variance

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Direct Labor Variance

Efficiency Variance is 1,500 UF, we can conclude Actual DL Hours as follows

Factory Overhead Variance

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Direct Labor Variance

Note:
➢ If variable overhead is applied on the basis of output, not inputs, no efficiency
variance arises.
➢ The variable overhead efficiency variance is related to the labor efficiency
variance if overhead is applied to production on the basis of direct labor hours.
➢ For example, if the labor efficiency variance is unfavorable, the overhead
efficiency variance also is unfavorable because it is based on the same number
of input hours.

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Variances Meaning - Direct Material Variance - Quantity Variance
Favorable: Unfavorable:
• May indicate that workers are • Always the responsibility of the
efficient and reducing normal production department
spoilage • The hiring of unskilled labor which
• May indicate that workers are will lead to a higher spoilage
producing low quality products by • May indicate also theft of material
consuming less quantity of material • The usage of lower-quality
So Favorable Variance is not always material purchased by the
desirable purchasing dep. at lower prices

Variances Meaning - Direct Material Variance - Price Variance

Favorable: Unfavorable:
• May mean that the purchasing dep. • It is usually the responsibility of the
Did well in finding low-priced purchasing department
material but it has to be linked to • It may simple indicate that prices in
the Quantity variance to make sure the industry have risen and
if the low-prices caused lower standard costs should be updated
quality
• It may simple indicate that prices in
the industry have fallen and
standard costs should be updated

132
Variances Meaning - Direct Labor Variance - Efficiency Variance
Favorable: Unfavorable:
• Is almost always desirable. It • Means that workers are spending
means that the employees are too much time on a production
working efficiently. process caused by:
• Hiring low skilled workers in
It is considered a production which case the labor rate variance
department efficiency may be favorable
• Using low quality material in
which case material price variance
may be favorable.

Variances Meaning - Direct Labor Variance - Price Variance

Favorable: Unfavorable:
• Caused by using less skilled low- • Caused by assigning skilled
rate workers. This would be workers to a production process.
desirable if the workers are • New union contract resulted in a
qualified for the job. This favorable higher wage to workers, in which
variance can be offset by an case the standard costs should be
unfavorable Efficiency variance. updated.

Variances Meaning – V. Factory Overhead Variance – Efficiency Variance

Favorable: Unfavorable:
• It is always related to the labor • It is always related to the labor
efficiency if the VFOH was efficiency if the VFOH was
allocated based on Labor hours. allocated based on Labor hours.

Variances Meaning – V. Factory Overhead Variance – Spending Variance

Favorable: Unfavorable:
• Means that the production • Means that the production
department was able to accomplish department was able to accomplish
its task while spending less than its task while spending more than
expected. expected.

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4.5.4 Mix & Yield Variance
Mix Variance Yield Variance

It is any possible combination of Results from the difference between

materials or labor inputs. The mix the total quantity of the inputs that
variance is the part of the quantity were actually used to produce the
variance that results because the mix actual output and the quantity that
of material actually used was different should have been used to produce the
from the mix that should have been actual output.
used.

Mix and Yield variance is used when a product has two or more ingredients or
labor costs that can be substituted for one another.

Yield Variance = (TSQ - TAQ) X WASP

TSQ ---- Total Standard Quantity
TAQ ---- Total Actual Quantity
WASP -- Weighted Average Standard Price of Standard Mix
(Total Standard Cost / Total Standard Quantity)

Mix Variance = TAQ X (WASP - WAAP)

TAQ ---- Total Actual Quantity
WASP -- Weighted Average Standard Price of Standard Mix
WAAP -- Weighted Average Standard Price of Actual Mix
(Total Cost using Actual Quantity and Standard Price / Total Actual
Quantity)

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Example 4:
A company produces cereal made up of different grains. The material prices in effect
for the fiscal year ending June 30 and the standard kg allowed for the output of April
are:

SP/Kg SKg/output S.C AP/Kg A A.C

usage
Corn $10 250 2,500 Corn $12 375 4,500
Wheat $8 250 2,000 Wheat $8.5 200 1,700
Rise $3 250 750 Rise $5.5 325 1,787.5

Using the above information, calculate the material price and quantity variances, and
also the material mix and yield sub variances.

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Yield variance = (TSQ – TAQ) × WASP

𝟐,𝟓𝟎𝟎+𝟐,𝟎𝟎𝟎+𝟕𝟓𝟎
= (750 – 900) × ( ) = -150 × 7 = (1050) UF
𝟕𝟓𝟎

Mix variance = (WASP – WAAP) × TAQ

𝟑,𝟕𝟓𝟎+𝟏,𝟔𝟎𝟎+𝟗𝟕𝟓
= (7 - ) × 900 = (7 – 7.0277) × 900 = (25) UF
𝟗𝟎𝟎

Materials Mix Variance $ 25 U + Materials Yield Variance $ 1,050 U = Total

Materials Quantity Variance $1,075 U

Question: The purpose of a flexible budget is to

A. Provide management with slack in their budget

B. Eliminate fluctuations in production reports
C. Compare actual and budgeted results at various levels of activity
D. Make the annual budget process more efficient
Question: Which variance would be added to the flexible budget variance to
arrive at the total static budget variance

A. Efficiency Variance
B. Price Variance
C. Sales Mix Variance
D. Sales Volume Variance

Question: What is meant by the term “Management by Exception”?

When using management by exception approach, managers focus their attention on

results that are different from what was expected. This approach assumes that results
that meet expectations don’t require investigation.

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Question: Combo company uses a standard costs system. Information for raw
material for product#4 for the month of June are as follows:

Standard price per pound of raw materials $1.60

Actual purchase price per pound of raw material $1.55
Actual quantity of raw material purchased 2,000 Pounds
Actual quantity of raw material used 1,900 Pound
Standard quantity allowed for actual production 1,800 Pound
What is the materials purchase price variance?

A. $90 Favorable
B. $90 Unfavorable
C. $100 Favorable
D. $100 Unfavorable

Material Price Variance = (SP - AP) X AQ

= ($1.60 - $1.55) X 2,000 = $100 F

Question: Craig corporation has provided the following data concerning its direct
labor costs for January:
Standard wage rate $13.30 per direct labor hour
Standard Hours 5.5 DLH per Unit
Actual wage rate $13.20 per DLH
Actual hours 45,880 DLHs
Actual Output 8,400 Units

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Question: Labor rate variance for January would be:

A. $4,588 Unfavorable
B. $4,588 Favorable
C. $4,620 Unfavorable
D. $4,620 Favorable
Labor Rate Variance = (SP - AP) X AQ
= ($13.30 - $13.20) X 45,880 = $4,588 F

Question: The following labor standards have been established for product T3 :

Standard labor hours per Unit of output 5 Hours

Standard Labor Rate $18.25 per hour

The following data are for product T3 for the month of July
Actual hours worked 9,800 Hours
Actual Total labor cost $176,400
Actual output 1,900 Units
What is the labor efficiency variance for the month?

A. $3,025 Unfavorable
B. $5,400 Unfavorable
C. $3,025 Favorable
D. $5,475 Unfavorable
Standard Hours = Standard hours/Unit X Actual Output
Standard Hours = 5 X 1,900 = 9,500
Labor Efficiency Variance = (SQ - AQ) X SP
= (9,500 - 9,800) X $18.25 = $5,475 U

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4.5.5 Fixed Factory Overhead Variance

What Causes Variances in Fixed Overhead?

The breakdown of fixed costs can highlight when certain variable costs are
misclassified as fixed costs, because changes in production volume will be
accompanied by changes in some portion of the fixed costs that may be
discretionary.

A fixed overhead spending variance shows that the budget procedure either missed
or failed to predict changes in certain fixed costs. Unfavorable spending variances
can also occur because of accidents and unexpected repairs, or if there is inadequate
control over departmental spending.

If a company made as many units in the period as they budgeted, there should be no
fixed overhead production volume variance. The production volume variance
reflects the company’s use of its capacity. When volume is low, the price per unit of
fixed overhead is higher and capacity is underutilized. The variance can occur when

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demand for a product change from what was expected, or from changes in strategy
or unexpected breakdowns.
Two, Three and Four-way analysis of overhead variance:

Example 5: ABC Company’s flexible budget (in condensed form) is given below:
Cost /DLH Direct Labor hours
8,000 9,000 10,000
$1.05
Variable overhead costs $8,400 $9,450 $10,500
Fixed overhead costs 24,800 24,800 24,800
Total overhead costs $33,200 $33,250 $33,300

The following information is available:

1. For 2019, a denominator activity of 8,000 direct labor-hours was chosen to
compute the predetermined overhead rate.
2. In working 8,000 standard direct labor-hours, the company should produce
3,200 units of the product.
3. During 2019, the company’s actual operating results were:
Number of units produced 3,500
Actual direct labor-hours 8,500
Actual variable overhead costs $ 9,860
Actual fixed overhead costs $25,100

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Compute the variable and fixed overhead variances.

Rate = 24,800 ÷ 8,000 = $3.1/Hour

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Comprehensive question of All Manufacturing Variances
▪ The standard number of machine hours allowed per unit = 5.
▪ The standard number of units of direct materials allowed per unit manufactured
= 6.
▪ The standard cost per unit of direct materials used = $3.
▪ The standard number of direct labor hours allowed per unit = 2 hours.
▪ The standard cost per hour of direct labor = $20 per hour.
▪ Overhead is applied based on machine hours.
▪ Budgeted production for the period is 1,000,000 units.
▪ Budgeted fixed overhead for the budgeted production of 1,000,000 units is
$10,000,000, and the predetermined fixed overhead rate is $10 per unit or $2 per
machine hour since 5 machine hours are allowed per unit manufactured.
▪ Budgeted variable overhead for the budgeted production of 1,000,000 units is
$5,000,000, or $5 per unit or $1 per machine hour allowed per unit manufactured.
▪ Actual production is 1,200,000 units.
▪ Actual direct materials used for the actual production is 8,000,000 units at an
actual cost of $2.50 per unit of direct materials.
▪ Actual direct labor used for the actual production is 2,300,000 hours at an actual
cost of $21 per hour.
▪ Actual fixed overhead incurred = $11,000,000.
▪ Actual variable overhead incurred for the actual production = $5,670,000.
▪ Actual number of machine hours used for the actual production = 6,300,000
hours.
Required: Compute all variances (DM – DL - O/H)

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Direct Materials Variances:

Price Variance: (AP – SP) × AQ

($3.00 − $2.50) × 8,000,000 = $4,000,000 F

Quantity Variance: (AQ – SQ) × SP

(7,200,000 – 8,000,000) × $3 = $(2,400,000) U

Direct Labor Variances:

Rate Variance: (AP – SP) × AQ

($20 – $21) × 2,300,000 = $(2,300,000) U

Efficiency Variance: (AQ – SQ) × SP

(2,400,000 – 2,300,000) × $20 = $2,000,000 F

Variable Overhead Variances:

Spending Variance: (AP – SP) × AQ

AP = $5,670,000 ÷ 6,300,000 = $.90 per machine hour

SP = $5,000,000 ÷ (5 MH per unit × 1,000,000 units) = $1.00 per MH

AQ = 6,300,000 MH

($1.00 − $0.90) × 6,300,000 = $630,000 F

Efficiency Variance: (AQ – SQ) × SP

SQ = 1,200,000 units produced × 5 MH/unit = 6,000,000 MH allowed

(6,000,000 – 6,300,000) × $1 = $(300,000) U

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Fixed Overhead Variances:

Spending (Flexible Budget) Variance:

Actual FOH Cost Incurred – Flexible/Static Budget FOH

$10,000,000 − $11,000,000 = $(1,000,000) U

Production-Volume Variance: Flexible/Static Budget FOH – FOH Applied

$12,000,000 – $10,000,000 = $2,000,000 F

Total Variance $2,630,000 F

Question: Under a standard costing system, the materials efficiency variances are
the responsibility of
A. Production and industrial engineering
B. Purchasing and Industrial Engineering
C. Purchasing and Sales
D. Sales and Industrial Engineering

Question: A favorable material price variance coupled with an unfavorable material

usage variance would most likely result from
A. Machine efficiency problems
B. Product Mix production changes
C. The purchase and use of higher than standard quality materials
D. The purchase of lower than standard quality materials

Question: Garland company uses a standard cost system. The standard for each
finished unit pf product allows for 3 pounds of plastic at $ 0.72 per pound During
December, Garland bought 4,500 pounds of plastic at $ 0.75 per pound and used
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4,100 pounds in the production of 1,300 finished units of product. what is the
materials price variance for the month of December?
A. $117 Unfavorable
B. $123 Unfavorable
C. $135 Unfavorable
D. $150 Unfavorable
Question: The following information is for the next three questions: Chemkings
uses a standard costing system in the manufacture of its single product. The 35,000
Units of raw material in inventory were purchased for $105,000 and 2 Units of raw
materials are required to produce 1 Unit of final product. In November, the company
produced 12,000 units of product, which was as budgeted. The standard allowed for
material was $60,000, and there was an unfavorable quantity variance of $2,500.

1. Chemking’s standard price for one unit of material is

A. $2
B. $2.5
C. $3
D. $5

2. The units of Material used to produce November output totaled

A. 12,000 Units
B. 12,500 Units
C. 23,000 Units
D. 25,0000 Units

3. The material price variance for the units used in November was
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A. $2,500 unfavorable
B. $11,000 unfavorable
C. $12,500 unfavorable
D. $3,500 unfavorable

4.5.6 Sales Variances

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1. Many of the sales variances are calculated using contribution margin per unit
instead of sales price per unit, because we want to analyze the effect of sales on
net operating income, and we assume that variable costs will move in line with
sales while fixed costs will remain constant.
Contribution margin = sales price − variable costs.

2. However, sales variances are also calculated individually for every line on a
variance report: revenue, variable costs, contribution margin, and so forth.
On an exam, it is critical to read the question carefully to make sure you know what
is called for. If it is not specified, use the contribution margin.

Example 6:

A newly created firm produces chairs and tables. The data are as follows (CM stands
as contribution margin/ Unit)

Budget CM Actual CM Budget Units Actual Units

Chairs $6 $5 15 10
Tables $25 $30 6 5

Calculate Sales Variances?

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4.4.7 Market Variance

In addition to the above breakdown of the sales volume variance, the sales quantity
variance can also be broken down as to why it occurred. The total level of sales may
be different from expected because the market was bigger or smaller than expected,
or because the company’s share of the market was bigger or smaller than expected.

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 Market Size Variances Market Share Variances
Is the difference in the budgeted Is the difference in the budgeted
contribution margin caused by the contribution margin caused by the
actual market size (in number of actual market share being different
from the expected market share.
Units) being different from the
expected market size (in number of
Units).

Advantages and Disadvantages of Variance Analysis

Advantages of variance analysis include that it

1. Identifies areas where actual results are different from budget and management
can take appropriate action
2. Provides a basis for investigation that promotes an understanding of operations
3. Promotes accountability among personnel
4. Evaluates performance of personnel
5. Identifies budget estimates requiring revision

Disadvantages of variance analysis include that

1. The length of time it takes to identify a problem may be too long for

management to effectively take action

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 2. There is a focus on the past without looking at the future

Question: Actual and budgeted information about the sales of a product are
presented for June as follows:

Actual Budget
Units 8,000 10,000
Sales Revenue $92,000 $105,000
The sales price variance for June was:

A. $8,000 favorable
B. $10,000 favorable
C. $10,000 unfavorable
D. $10,500 unfavorable
Question: An unfavorable direct labor efficiency variance could be a(n)

A. Unfavorable variable overhead spending variance

B. Unfavorable material usage variance
C. Unfavorable fixed overhead volume variance
D. Favorable variable overhead spending variance

Question: Under a standard cost system, labor price variances are usually not
attributable to:

A. Labor rate prediction

B. The use of a single average standard rate
C. Union contracts approved before the budget cycle.
D. The assignment of different skill levels of workers than planned

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Question: A company set the total budgeted direct labor cost at $75,000 for the
month for producing 5,000 Units. The following standard cost, stated in terms of
direct labor hours (DLH), was used to develop the budget for direct labor cost:
1.25 DLH × $12/DLH = $15/Unit produced

The actual operating results for the month were as follows:

Actual Units produced 5,200

Actual direct labor hours worked 6,600
Actual direct labor cost $77,220

The direct labor efficiency variance for the month would be

A. $4,200 unfavorable
B. $3,000 unfavorable
C. $2,220 unfavorable
D. $1,200 unfavorable

4.6 Variance Analysis for a Service Company

A service company’s “product” is the service it provides. An example of a pure

service company is a public accounting firm. The public accounting firm’s variable
cost for analysis purposes is the hourly rate paid to its accountants. Some other
service companies may offer a mixture of sales and service. For example, an
appliance repair company would sell repair parts for appliances and also install them.
The variable cost for its sales component is the variable parts cost, while the variable
cost for its service component is the hourly wage paid to its service technicians.

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A service company will have flexible budget and sales volume variances for
revenues and costs. If it provides multiple services at different unit prices, it will
have quantity and mix variances, just as a reseller has quantity and mix variances if
it sells multiple products. A service company also has overhead variances.
Depending on the type of business, variable overhead related to services provided
can be a large component of a service company’s costs, and it needs to be used in
making pricing and service mix decisions. For example, an appliance repair
company has variable costs of using its trucks to make service calls.

If a service company also sells products (such as replacement parts), its products
business can have the same types of variances. If the company provides both services
and sales of products, the company should segregate its service revenue and costs
from its sales revenue and costs in its accounting system. It can then analyze the
variances for sales and service separately. Variance analysis provides a way of
including these costs in pricing and product mix decisions.
Any company can also perform variance analysis on its selling, general, and
administrative overhead expenses, some of which are variable and some of which
are fixed.

A service organization may have very high fixed overhead costs. If revenue declines,
the fixed overhead costs remain, and the company can very quickly find itself in
financial trouble. Fixed overhead variance reporting can detect such impending
trouble early and may enable the company to make changes in its fixed cost structure
to respond to its decreased sales.

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Scenario for Essay Questions
Question 1:
The LAR Chemical Co. manufactures a wide variety of chemical compounds and
liquids for industrial uses. The standard mix for producing a single batch of 500
gallons of one liquid is as follows:

Liquid Quantity Cost Total

Chemical (in gallons) (per gallon) Cost
Maxan 100 2.00 $200
Salex 300 0.75 225
Cralyn 225 1.00 225
625 $650
There is a 20% less in liquid volume during processing due to evaporation. The
finished liquid is put into 10-gallon bottles for sale. Thus, the standard material cost
for a 10-gallon bottle is $ 13.00.
This actual quantity of raw materials and the respective cost the materials placed in
production during November were as follow:
Liquid Quantity Total
Chemical (in gallons) Cost
Maxan 8,480 $17,384
Salex 25,200 17,640
Cralyn 18,540 16,686
52,220 $51,710
A Total of 4,000 bottles (40,000 gallons) were produced during November.

Questions
1. Calculate the total raw materials variance for the liquid product for the month
of November and then further analyze the total variance into

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 a. Material price variance
b. Material mix variance
c. Material yield variance
2. Explain how LAR Chemical Co. could use each of the three materials
variances – price, mix, yield – to help control the cost to manufacture this liquid
compound.
Answers

S.C B.C A.C

[Link] [Link] [Link]
Maxan 100 × 2 × 80 8,480 ×2 $17,384
$16,000 $16,960 $17,384
Salex 300 × 0.75 × 80 25,200 × .75 17,640
$18,000 $18,900 17,640
Cralyn 225 × 1× 80 18,540 × 1 16,686
$18,000 $18,540 16,686
Total $52,000 $54,400 $51,710
Q.V = ($2,400) UF P.V = $2,690 F
Flexible Budget V. = 290 F

Yield Variance = (TSQ – TAQ) WASP

= (625 × 80 - 52,220) × (52,000 ÷ 625 × 80)
= (50,000 – 52,220) × 1.04
= (2,308.8) UF

Mix Variance = (WASP – WAAP) TAQ

= [1.04 - (54,400 ÷ 52,220)] ×52,220
= (1.04 – 1.041746) × 52,220
= (91.2) UF

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2- Before management can control costs, they need to know which costs are out of
line; within whose area of responsibility has the variance appeared. What is the
cause of the variance; and how has the responsibility to correct the cause.
Variances help management to answer these issues. Specifically, the variances
indicate where management should begin its investigation.

a) A. Price variation – the information to identify the causes of the price variance
usually can be obtained in the purchase department. A review of purchasing
producers and records would disclose whether the variance was caused by
permanent changes in prices, poor purchasing practices or poor production
scheduling requiring incurrence of extra costs to expedite shipments. The
information obtained will identify the department responsible for the extra costs
and provide clues to improve the control.

b) b. Mix and yield variance - the information to identify the causes of these
variance can be obtained in production. A review of material records and
handling procedure would disclose whether the mix variance was caused using
wrong proportions. Entering excess material into the process because of
carelessness, or adjustment of the mix to accommodate off-standard material
quality. Yield variance would often be explained by the same information.
Nonstandard proportions would result in nonstandard yields and excess material
inputs. The information obtained would identify the department responsible and
provide clues to improve control.

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Question 2:
Goma Company makes toys for children. The profit plan and actual results are as
follows:

Profit Plan Actual Results

Volume Dollars Volume Dollars
Sales 10,000 10,000 8,000 12,000
Cost of Goods
Sold
Raw material
(KG) 2,500 2,500 3,200 4,800
Labor (Hours) 150 1,200 250 2,500
Contribution
Margin 6,300 4,700
Other costs
Depreciation 2,600 3,000
Maintenance 700 900
Profit before
interest and tax 3,000 800

The plant manager, Rawan, has instructed the plant management accountant to prepare
a detailed report to be sent to corporate headquarters comparing each component’s
actual result with the amounts set forth above in the annual budget.
Required
1- Explain the difference between Gabriel's expected and actual profit, show your
workings.
2- Discuss some of the reasons for a direct material price and efficiency variance.
Give examples.

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Answer
1- Explaining the difference between the Gabriel's expected and actual profit:
The competitive effectiveness:
a- The impact of the change in sales volume:
The sales (market) variance = (actual volume – planned volume) × planed
price
The sales (market) variance = (8,000 – 10,000) × (10,000 ÷ 10,000)
The sales (market) variance = $2,000 (U)

b- The impact of the change in price:

The sales price variance = actual volume × (actual price - planed price)
The sales price variance = 8,000 × [(12,000 ÷ 8,000) - (10,000 ÷ 10,000)]
The sales (market) variance = $4,000 (F)

The operating efficiency:

c- The impact of the change in raw material:
• The efficiency (quantity) variance = (actual volume - planned volume)×
planned price
The efficiency (quantity) variance = (3,200 –2,500) × (2,500 ÷ 2,500)
The efficiency (quantity) variance = $700 (U)
• The spending variance = (actual price - planned price)× actual volume
The spending variance = [(4,800 ÷ 3,200) - (2,500 ÷ 2,500)] × 3,200 = $1,600
(U)

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 d- The impact of the change in labor:
• The efficiency (hours) variance = (actual hours - planned hours)× planned
labor rate
The efficiency (hours) variance = (250 - 150) × (1,200 ÷ 150)
The efficiency (hours) variance = $800 (U)
• The spending variance = (actual labor rate - planned labor rate)× actual
hours
The spending variance = [(2,500 ÷ 250) - (1,200 ÷ 150)] × 250 = $500 (U)
e- The impact of the change in other costs:
Profit Actual Variance
Item
Plan Results (£)
Maintenance 700 900 200 (U)
Depreciation 2,600 9,000 400 (U)
Total 600 (U)

The tree of Goma variance analysis:

Change in profits
2,200 (U)

Competitive effectiveness Operating efficiency

$2,000 (F) $4,200 (U)

Variance due to Variance due to Variance associated Variance associated

market (sales) selling price with direct costs with other costs
$2,000 (U) $4,000 (F) $3,600 (U) $600 (U)

Variance associated Variance associated

with direct material with direct labor
$2,300 (U) $1,300 (U)

Efficiency variance Spending variance Efficiency variance Spending variance

$700 (U) $1,600 (U) $800 (U) $500 (U)

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Goma Company showed an unfavorable change in profit of 2,200; $2,000 as a
favorable competitiveness variance and $4,200 as an unfavorable efficiency
variance.

2- Students should include in their discussion some of the following reasons:

Reasons for direct labor rate variance:
- Experience of workers
- Union contract
- Overtime
- Change in fringes
Therefore, human resources or management

Reasons for direct labor efficiency variance:

- Skills
- Motivation
- Supervision/scheduling
- Quality of materials
- Late time
Therefore, production, human resources, purchasing

159
 Question 3:

LENA Company makes A4 papers. The profit plan and actual results are as follows:

Actual Results Profit Plan

Volume $ Volume $
Sales (packages) 3,000 30,000 2,600 33,800
Cost of Goods Sold
Raw material 600 7,200 400 7,200
(KG)
Labor (Hours) 500 6,000 800 8,000
Contribution Margin 16,800 18,600
Other costs
Energy 2,000 2,500
Maintenance 2,000 3,000
Depreciation 1,800 2,900
Selling expenses 3,600 5,000
Advertising 3,000 2,800
Profit before interest 4,400 2,400
and tax

The plant manager, Kamil, whose annual bonus includes (among other factors)
40% of the net favorable profit variances, states that he increased the company's
profit by $2,000. He has instructed the plant management accountant to prepare
a detailed report to be sent to corporate headquarters comparing each
component’s actual result with the amounts set forth above in the annual budget
to prove the profit increments.
Required
1- How would you explain the difference between the LENA's expected and
actual profit?

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 2- What is meant by strategic profitability analysis? Describe how profit plans
can be used to evaluate strategic performance?
Answer:
1- Explaining the difference between the LENA's expected and actual profit:
The competitive effectiveness:
f- The impact of the change in sales volume:
The sales (market) variance = (actual volume – planned volume) × planed price
The sales (market) variance = (3,000 – 2,600) × (33,800 ÷ 2,600)
The sales (market) variance = $5,200 (F)

g- The impact of the change in price:

The sales price variance = actual volume × (actual price - planed price)
The sales price variance = 3,000 × [(30,000 ÷ 3,000) - (33,800 ÷ 2,600)]
The sales (market) variance = $9,000 (U)

The operating efficiency:

h- The impact of the change in raw material:
• The efficiency (quantity) variance = (actual volume - planned volume)×
planned price
The efficiency (quantity) variance = (600 - 400) × (7,200 ÷ 400)
The efficiency (quantity) variance = 200 × 18 = $3,600 (U)
• The spending variance = (actual price - planned price)× actual volume
The spending variance = (12 - 18)× 600 = $3,600 (F)

From this information, it can be concluded that LENA used 200 units of raw
material above the plan (standard) quantity for the tanks, this usage causes an
unfavorable material quantity variance of $3,600 at the $18 planned price. The actual
161
material used was purchased at $12below the planned price per Kg., $18, which
results in a $3,600 unfavorable material price variance (spending variance).

i- The impact of the change in labor:

• The efficiency (hours) variance = (actual hours - planned hours)× planned
labor rate
The efficiency (hours) variance = (500 - 800)×(8,000 ÷ 800)
The efficiency (hours) variance = 300× 10 = $3,000 (F)
• The spending variance = (actual labor rate - planned labor rate)× actual
hours
The spending variance = [(6,000 ÷ 500) - (8,000 ÷ 800)] ×500 = $1,000 (U)

The actual hours used were 300 less than planned, which results in a favorable
labor quantity variance of $3,000. The work crew earned $2 per hour above the plan,
which translates to a $1,000 unfavorable labor rate (spending) variance.

j- The impact of the change in other costs:

Actual Variance
Item Profit Plan
Results (£)
Energy 2,000 2,500 500 (F)
Maintenance 2,000 3,000 1,000 (F)
Depreciation 1,800 2,900 1,100 (F)
Selling expenses 3,600 5,000 1,400 (F)
Advertising 3,000 2,800 200 (U)
Total spending 3,800 (F)
12,400 16,200
Variance

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 The total overhead variance as the difference between total actual overhead
and total overhead applied to production. The total overhead variance provides
limited information to managers and for purpose of performance evaluation.

The difference between actual fixed overhead and applied fixed overhead is
the total fixed overhead variance and is equal to the amount of under-applied or over-
applied fixed overhead.

k- The tree of BETA variance analysis:

Change in profits
$2,000 (F)

Competitive effectiveness Operating efficiency

$3,800 (U) $5,800 (F)

Variance due to Variance due to Variance associated Variance associated

market (sales) selling price with direct costs with other costs
$5,200 (F) $9,000 (U) $2,000 (F) $3,800 (F)

Variance associated Variance associated

with direct material with direct labor
$0 $2,000 (F)

Efficiency variance Spending variance Efficiency variance Spending variance

$3,600 (U) $3,600 (F) $3,000 (F) $1,000 (U)

The Lena Company showed a favorable change in profits by $2,000 in total;$3,800

as an unfavorable competitiveness variance and $5,800 as a favorable efficiency
variance.

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2- The strategic profit analysis:
The purpose of strategic profitability analysis is to analyze the difference in
operating income between the profit plan and actual profits to assess successful
implementation of the firm’s strategy.

Performing a strategic profitability analysis will help LENA to explain why actual
profits ($4,400) were above the original profit plan ($2,400). This type of analysis
comprises two components, as defined by the following formula:

Strategic profitability = profit (loss) from competitive effectiveness + profit (loss)

from operating efficiencies.

These two terms – competitive effectiveness and operating efficiencies – drive

sales and operating expenses, respectively, on the profit wheel. Thus, for purposes of
strategic profitability analysis, the profit wheel categories can be relabeled by
substituting competitive effectiveness for sales, and operating efficiencies for
operating expenses.
Strategic Profitability Analysis Wheel:

Competitive
Effectiveness

Operating Strategic
Efficiencies Investment
Profitability
in Assets
Analysis

Strategic
Profitability

164
 Chapter Five
Capital Budget - Evaluating of
Investment Proposals

165
166
5.1 Introduction to capital budgeting:
5.1.1 Capital asset acquisition
In most business firms, investment decision must be made in two areas:
(1) Working capital assets (short–term assets) such as merchandise inventory,
supplies, and raw materials. These short–term investments can be planned within
operating budgeting.
(2) Capital assets (Long–term assets) which are used to generate additional
productive, marketing, and administrative capacity to generate future revenues or
cost savings. A capital asset can be a tangible fixed asset such as a piece of
machinery, equipment or building, a partial or complete acquisition of another firm
or an intangible fixed asset such as a capital lease or drug patent. These long-term
investments can be evaluated using capital budgeting.
Capital budgeting is an accounting tool or technique responsible for
evaluating and ranking capital investment proposals.
5.1.2 Definition & stages of capital budgeting:
Capital budgeting is the making of long–term planning decisions
for investments. It is used for evaluating and ranking investment or capital proposals.
It is a six–stage process. These six stages are:
Stage 1: Identification stage:
This stage aims to determine which investment proposal (capital asset) will
achieve the organizational objectives. For example, suppose that the firm (hospital)
is planned to acquire a new X-ray equipment. The goal is to improve the productivity
of the X-ray department by:
- Improving technology where the patients would need fewer X-rays.
- Reducing labor costs of operating inside X-ray dept.
- Increasing revenues of X-ray department.

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Stage 2: Search stage:
This stage aims to explore several alternative capital investments that will
achieve organizational goals. For example, the hospital can consider two
alternatives:
- Multipurpose X-ray equipment.
- Specialized X-ray equipment.
Stage 3: Information–acquisition stage:
This stage aims to consider the consequences of alternative capital
investments. The consequences of capital investments consist of two factors:
• Quantitative factors: are outcomes that are measured in numerical terms. The
quantitative financial factors related to X-ray equipment proposal are:
- The cash paid to buy the X-ray equipment.
- The lower labor costs of operating the X-ray equipment.
- The lower costs resulting from having to take fewer X-rays per patient.
• Qualitative factors: are outcomes that cannot be measured in numerical terms,
and difficult to express in financial terms such as:
- The quality of X-rays because higher-quality X-rays may lead to improved
diagnoses and better patient treatment.
- The safety of employees and patients.
- The ability of the hospital to attract better human resources.
- The social responsibility.
Stage 4: Selection stage:
This stage aims to choose investment project for implementation. There are
five methods or techniques for capital budgeting or evaluating of investment
proposals.

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Also, there are five factors using as a basis for comparing between the five capital
budgeting techniques:
- Time value of money.
- Rate of return.
- Cash flow.
- Returns during life of project.
- Discount rate.
Stage 5: Financing stage:
This stage aims to obtain investment project funding. Sources of financing include:
- Internally (within the firm) generated cash.
- The capital market (equity & debt securities).
Stage 6: Implementation & control stage:
This stage aims to put the investment project in motion and monitor performance.
5.1.3 The concept of time value of money
Time value of money should be taken into account with regard to evaluation
of investment proposals. Time value of money means that the monetary unit (dollar
– pound) received today is worth than the monetary unit received tomorrow. The
reason is that a pound received today can be invested to start earning interest. Time
value of money is the opportunity cost (interest forgone) from not having the money
today.

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5.1.4 Discounted cash flow (DCF)
Discounted cash flow measures the cash inflows and outflows of an
investment project as if they occurred at a single point in time so that they can be
compared in an appropriate way. DCF recognizes that the use of money has an
opportunity cost – interest forgone, because DCF depends on the concept of the time
value of money for long–run decisions such as capital budgeting.
DCF focuses on cash inflows and outflows instead of operating income as
used in conventional accrual accounting. Cash is invested now with the expectation
of receiving a greater amount of cash in the future.
5.1.5 Nominal or apparent rate of return & real rate of return
Suppose that L.E. 100,000 is invested in a good business in 2015 and it grows
to L.E. 150,000 in 2016 and then to L.E. 200,000 in 2017. The growth of money VS
time can be represented as follows:

It must be noted that the value of money in 2017 is lower than that in 2016 &
2015, that is, the purchasing power of L.E. 200,000 of 2017 is less than of 2015, due
to inflation. Therefore, although the money grows in two years from L.E. 100,000
to L.E. 200,000, the investor suffers at the same time a loss due to the inflation of
money in this period. The nominal or apparent rate of return is a result of the

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combined effects of inflation and the time value of money. The real rate of return
reflects only the time value of money.
5.2 Nondiscounting models for evaluating of capital investment projects:
5.2.1 The two major categories of capital investment decision models
The basic capital investment decision models can be classified into two major
categories:
• Nondiscounting models/methods that ignore the time value of money. These
nondiscounting models include two methods:
- The payback period method.
- The accounting rate of return (ARR) method.
• Discounting models/methods that explicitly consider the time value of money.
The discounting models include three methods:
- The net present value (NPV) method.
- The internal rate of return (IRR) method.
- The profitability index (PI) method.
5.2.2 The traditional payback period method
The payback period is the time required for a firm to cover its original
investment. In other words, the payback period is the time required for project’s cash
inflows to equal the original investment. If the cash inflows of a project are an equal
amount each period, the following formula be used to compute its payback period:

If, the cash inflows are unequal, the payback period is computed by adding
the annual cash inflows until such time as the original investment is recovered.
The management sets a maximum payback period. If the computed payback
period is <= preestablished maximum payback period, the project is acceptable and
vice versa.

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 Payback period can be used as a measure of risk, where the longer it takes to
cover the original investment, the greater the risk. Also, firms with liquidity
problems would be more interested in projects with quick paybacks.
Payback period method has three disadvantages, where it ignores:
- Cash inflows that occur after payback has been reached.
- Desired rate of return.
- Time value of money.
Exercise (1):
Suppose that a new wash facility requires an investment of L.E. 100,000 and has
two alternatives:
(1) Cash flows of first alternative is L.E. 50,000 per year.
(2) Annual cash flows of second alternative is as follows: 30,000, 40,000, 50,000,
60,000 & 70,000.
Required:
Calculate the payback period for each alternative.

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Exercise (2):
El-Nasr Manufacturing is considering the purchase of new production technology.
The new technology would require an initial investment of L.E. 750,000 and have
an expected life of 10 years. At the end of its life, the equipment would have no
value. By installing the new equipment, the firm’s annual labor and quality costs
would decline by L.E. 150,000.
Required:
(1) Compute the payback period for this investment (ignore tax).
(2) Assume that the annual cost savings would vary according to the
following schedule:

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Exercise (3):
An engineering firm is considering two different types of computer – aided design
(CAD) systems: System A & System B. Each system requires an initial outlay of
L.E. 150,000, has a five-year life, and displays the following annual cash inflows:
Project year-1 year-2 year-3 year-4 year-5
System A 90,000 60,000 50,000 50,000 50,000
System B 40,000 110,000 25,000 25,000 25,000
Required:
(1) Compare between the two capital investment projects using payback period.
(2) Evaluate payback period method.
The Solution
(1) Payback period for the two projects = 2 years Both projects have the same
payback period, but system A should be preferred over system B for two reasons:
- System A returns L.E. 90,000 in the first year, while system B returns only L.E.
40,000. The extra L.E. 50,000 could be invested in another project. It is better to
have a pound today than to have it tomorrow (time value of money).
- System A provides a much larger returns for years 3, 4, & 5 beyond the payback
period (150,000 Vs 75000).
(2) The main advantage of payback period is providing information to managers that
can be used as follows:
- To help control the risks associated with uncertainty of future cash flows.
- To help minimize the impact of an investment on a firm’s liquidity problems.
- To help control the risk of obsolescence.
But payback period method suffers significant deficiencies (disadvantages):
- It ignores a project’s total profitability.
- It ignores the time value of money.
- It ignores the desired rate of return.
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5.2.3 The accounting rate of return (ARR) method
Accounting rate of return (ARR) is an accounting measure of income divided by an
accounting measure of investment. This method is also called accrual accounting
rate of return (AARR) because it measures the return on a project in terms of
accounting income. Accounting income is not equivalent to income which is
computed according to cash flows because accrual basis not cash basis. ARR
computed by the following formula:

The average income of a project (the numerator) is obtained by adding the net
income for each year of the project and then dividing this total by the number years
of useful life of the project. The denominator of the formula is the net initial
investment of the project. Sometimes, the denominator is expressed as the average
in investment, rather than the net initial investment of the project.
• This method prefers projects with higher, rather than lower, ARR, if other factors
are equal.
Exercise (4):
A capital investment project requires an initial investment (outlay) of L.E.
100,000 and has a five-year life with no salvage value. The yearly cash flows are
L.E. 50,000, 50,000, 60,000, 50,000 & 70,000.
Required:
(1) Compute the annual net income for each of the five years.
(2) Compute the ARR.

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The Solution

Exercise (5):
Memorial Hospital decides to purchase the new X-ray equipment. The initial
equipment investment is L.E. 372,890. The current disposal price of old equipment
is L.E. 3790. The initial working capital investment is L.E. 10,000. The increase in
expected average annual operating savings is L.E. 100,000 for four years & L.E.
90,000 in the fifth year. The new equipment has a zero terminal disposal price.
Required:
(1) Compute ARR.
(2) Compute ARR under the average investment if the expected terminal disposal
price of the new equipment is zero and recovery of working capital investment
L.E.10,000.
(3) Evaluate ARR method.

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The Solution

(3) The advantages of ARR method are simple, easy to understand, and consistent
with the accounting model where uses profits shown on accrual – based financial
statements. ARR method has main disadvantage, where it ignores the time value of
money and treats future pounds as equal to present pounds.

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Exercise (6):
The following information pertains to a new service line being considered
by service firm Z:
• Beginning investment:
– Initial cost of equipment and software L.E. 80,000
– Additional working capital needed for the service line L.E. 40,000
• Return over life of project: Average increase in profits L.E. 20,000
• Return at end of project:
– Salvage value of equipment & software at the end of 10 years L.E. 8000
– Working capital released at the end of 10 years L.E. 40,000
Required: Compute ARR
The Solution

5.3 Discounting models for evaluating of capital investment projects:

5.3.1 Net present value (NPV) method
NPV is a DCF method of computing the expected net monetary gain or
loss from a project by discounting all expected future cash inflows and cash outflows
to the present point in time, using the required rate of return (RRR). In other words,
NPV is the difference between the present value of the cash inflows & outflows
associated with a project, using desired rate of return (DRR).
The RRR or DRR is the minimum acceptable rate of return. It is also referred
to as the discount rate, or hurdle rate, or (opportunity) cost of capital.
After computing NPV, it can be used to determine whether or not to accept
the capital investment project as follows:

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- If the NPV is greater than zero the project is profitable and, therefore acceptable.
A positive NPV means that:
(1) the initial investment has been recovered and
(2) the RRR or DRR has been also recovered, and
(3) a return in excess of (1) and (2) has been received.
- If the NPV equals zero, actual rate of return equals RRR or DRR, the decision
maker will find acceptance or rejection of the project equal. The project usually is
acceptance.
- If the NPV is less than zero, the project should be rejected because the earning
(actual rate of return) less than the RRR or DRR.
There are two steps to compute NPV for capital investment project:
(1) Identify the cash flows for each year through timeline. Timeline determines the
points in time where cash flows are expected to be received or paid. Cash inflows
are shown as positive amounts and cash outflows are shown as negative amount on
a timeline.

(2) Compute NPV using factors obtained from the present value tables. There are
two present value tables:
- Table 1 to compute PV of a single amount.
- Table 2 to compute PV of an annuity.

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Exercise (7):
A detailed market study revealed expected annual revenues of L.E. 300,000 for
new earphones. Equipment to produce the earphones will cost L.E. 320,000. After
five years, the equipment can be sold for L.E. 40,000. In addition to equipment,
working capital is expected to increase by L.E. 40,000 because of increases in
inventories and receivables. The firm expects to recover the investment in working
capital at the end of the project’s life. Annual cash operating expenses are estimated
at L.E. 180,000. The RRR is 12%.
Required: Estimate the annual cash flows & compute the NPV.
The Solution

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Exercise (8):
Helwan Mfg Company is considering the installation of an automated
product handling system. The initial cost of such system would be L.E.400,000.
This system would generate labor cost savings over its 10-year life as follows:
years Annual labor cost savings
1–2 70,000
3–5 85,000
6–8 86,400
9 – 10 62,000
The system will have no salvage value at the end of its 10-year life, and the
company uses a discount rate of 12%. What is the pretax NPV of this project?

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The Solution

Exercise (9):
El-Shorouk Industrial Firm is considering the installation of a L.E.
1,800,000 production technology system that would generate the following labor
cost savings over its 10-year life:
Years Annual labor cost savings
1–2 280,000
3–5 340,000
6–8 288,800
9 – 10 260,000
The system will have no salvage value at the end of its 10-year life, and the
firm uses a discount rate of 12%.
Required:
Using NPV method, do you accept or reject this capital investment project.
The Solution

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The decision: Based on the NPV method, this is an unacceptable investment
project because NPV is negative.
5.3.2 Internal rate of return (IRR) method
The internal rate of return (IRR) is the discount rate at which the present value
of expected cash inflows from a project equals the present value of expected cash
outflows of the project. That is, the IRR is the discount rate that makes NPV = 0.
Once the IRR for a project is computed, it is compared with the RRR or DRR (Hardle
Rate) of the firm:
- If the IRR is greater than the RRR, the project is deemed acceptable.
- If the IRR is less than the RRR, the project is rejected.
- If the IRR is equal to the RRR, the firm is indifferent between
accepting or rejecting the investment proposal. Usually, the project is acceptable.
The internal rate of return (IRR) is determined using trial & error method as
follows:

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 (2) Determine expected life of the investment project (8 years).
(3) Search about PV factor in PV table (table 2).
(4) Choose the percentage at the top of the column as an IRR (13%).

Exercise (10):
Assume that a hospital has the opportunity to invest L.E. 205,570.50 in a new
ultrasound system that will produce net cash flows of L.E. 50,000 at the end of each
of the next six years. Calculate the IRR
The Solution

Science the life of the project is 6 years. Go to sixth row in PV Table-2 and then
move across this row until PV factor 4.11141 is found. The corresponding interest
rate is 12%, which is the IRR.

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Exercise (11):
Sharm El-Sheakh Company is considering adding a new dock to its marina
facilities to be suitable for larger yachts. The facilities would cost $ 140,000 and
would generate $ 28,180 annually in new cash inflows. The expected life of the
project would be eight years, and there would be no expected salvage value. The
company’s cost of capital and discount rate are 10%.
Required:
(1) Calculate the IRR for the proposed project (round to the nearest whole percent;
(ignore tax).
(2) Based on your answer to part (a) should the company build the dock.
(3) How much annual cash inflow would be required for the project to be
minimally acceptable.
The Solution

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Comparison of NPV and IRR methods
NPV method is preferable comparing with IRR method because NPV has two
main advantages:
(1) The end result of NPV is in pounds “absolute measure” not a percentage
“relative measure” as the end result of IRR. Therefore, NPVs of individual
independent projects can be added then averaged to drive the NPV of the
combination of projects, while IRRs of individual independent projects cannot
be added then averaged to drive the IRR of the combination of projects.
(2) The NPV method is preferable in situation where there is not a constant RRR
(discount rate) for each year of the project. To understand this point, you are
required to differentiate between these two situations of Exercise – 12.
Exercise (12):
The hospital is considering the purchase of a new X-ray equipment. Net initial
investment L.E. 379,100. Annual cash inflows are L.E. 100,000 for 5 years of life
of the equipment.
Required:
(1) Compute NPV if the RRR is 8%.
(2) Compute NPV if the RRR is 8% in years 1, 2, & 3 and 12% in years 4 & 5.
The Solution

The decision: The project is acceptable.

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The decision: The project is not acceptable.
5.3.3: Profitability Index (PI) method
Profitability Index (PI) is a ratio comparing the present value of a project’s net
cash inflows to the project’s net investment. The PI is calculated as:

PV of net cash flow = PV of future cash inflows – PV of future cash outflows

The present value of net cash inflows represents an output measure of the
project’s worth, whereas the net investment represents an input measure of the
project’s cost. By relating these two measures, the PI measures efficiency of the use
of capital. The PI should be greater than or equal to 1. The higher the PI, the more
efficient is the capital investment.
Exercise (13):
Business firm is considering two investment proposals: a training program
for employees costing L.E. 720,000 and a series of internet servers costing L.E.
425,000. The firm has computed the present values of the proposals by discounting
all future expected cash flows at a rate of 12%. Present values of expected net cash
inflows are L.E. 900,000 for the training program and L.E. 580,000 for the servers.
Required:
(1) Compute NPV & PI for the two projects.
(2) Compare between the two methods.

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The Solution

(2) Although NPV of the first project is higher, The PI of the second project is a
more efficient use of capital. The higher PI reflects a higher rate of return on the
second project than on the first project. The higher PI, the more profitable per
investment pound.
Exercise (14):
Transportation company is considering adding a new bus. A bus has a life of 10
years and cost L.E. 500,000. The company expects that net cash inflows from the
bus would rise by L.E. 88,000 per year for the life of the bus. The company uses an
8% RRR for evaluating capital projects. No salvage value is expected from the bus
at the end of its life.
Required:
(1) Compute the PI of the bus investment.
(2) Should the company buy the new bus.
(3) What is the minimum acceptable value for the PI for an investment to be
acceptable.
The Solution
(1) PV of net cash flows (Table 2, 10 years, 8%)
= 88,000 × 6.7101 = 590,489

(2) The project is acceptable because the PI is > 1

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(3) At least 1
Exercise (15): Assumptions of capital budgeting methods:
For each of the following assumptions that underline the capital project
evaluation methods, indicate to which method, or methods, the assumption applies:
(1) Speed of investment recovery is a key investment criterion.
(2) Cash inflows can be reinvested at the hurdle rate.
(3) Cash inflows can be reinvested at the IRR.
(4) Timing and size of cash flows can be accurately predicted.
(5) Life of project can be accurately predicated.
(6) Risk is higher for cash flows in the more distant future.
(7) Key consideration in evaluating projects is their effects on accounting earnings.
Exercise (16): Limitations of capital budgeting methods:
For each of the following limitations of the capital project evaluation
methods, indicate to which method, or methods, the limitation applies:
(1) Cash flows are treated as deterministic.
(2) Ignores some cash flows.
(3) Ignores cash flow.
(4) Ignores the time value of money.
(5) Ignores effects on accounting earnings.
(6) Does not specifically consider cash flow preferences.
(7) Can provide multiple rates of return for the same project.
(8) Ignore dollar value of project benefits.
The Solution
Exercise (15):
(1) Payback period (2) NPV, PI (3) IRR (4) Payback period, NPV, PI, IRR (5) All
methods (6) Payback period (7) ARR.

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Exercise (16):
(1) Payback period, NPV, PI, IRR (2) Payback period (3) ARR (4) Payback period,
ARR (5) Payback period, NPV, PI, IRR (6) All methods (7) IRR (8) Payback,
ARR.
Basic concepts of capital budgeting methods & criteria

Exercise (17):
Cairo Hospital is considering the purchase of a new X-ray equipment. Net initial
investment L.E. 379,100. Annul cost savings are L.E. 130,000. Useful life of the
equipment is 5 years and has a zero salvage value. Year 5 cash inflow includes
L.E. 10,000 recovery of working capital. The RRR is 8%. Compute the following:
Payback period, ARR, NPV, IRR, & PI.
The Solution
Payback period

ARR

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NPV

IRR

Expected life of the project = 5 years

On the 5 year row of table – 2, the PV factor of 2.916 not found. The PV factor
2.916 is found between column of 20% and column of 25%. The logical question
is: What is the discount rate (IRR) at PV factor of 2.916?. The discount rate (IRR)
can be obtained using linear completing method as follows:

(1) The amount of decreasing in PV factor as a result of increasing in the discount

rate by 1%.

(2) The amount of increasing in the discount rate as a result of decreasing in the
PV factor by 0.075
= 0.075 × 0.166 = 0.0124 = 1.24%

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Or
The amount of increasing in discount rate as a result of decreasing in the PV factor
by 0.227
= 0.227 × 0.166 = 0.0376 = 3.76%
(3) The discount rate (IRR)
= 20% + 1.24% = 21.24%
Or = 25% - 3.76% = 21.24%
5.4 Special aspects for evaluating of capital investment projects:
5.4.1 Treatment of depreciation
Depreciation expense is not a cash flow item because it is a noncash expense.
Depreciation on capital assets affects cash flows by reducing income tax.
Depreciation provides a tax shield against the payment of taxes. Tax shield produces
a tax benefit equal to the amount of taxes saved (The amount of depreciation
multiplied by the tax rate). The concepts of tax shield (L.E. 75000) and tax benefit
(L.E. 30,000) are shown on the following income statements. The tax rate is assumed
to be 40%.

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Exercise (18):
i – Technology Company is considering an investment project that would have
an eight – year life and require a L.E. 2,400,000. At the end of 8 years, the project
would terminate and the project would have no salvage value. The company’s
discount rate is 12%. The project would provide net operating income each year as
follows:

Required:
(1) Compute the annual cash inflow from the project.
(2) Compute the project’s payback period.
(3) Compute the project’s ARR.
(4) Compute the project’s NPV. Is the project acceptable.
(5) Find the project’s IRR.
The Solution
(1) The annual net cash inflow can be computed by deducting the cash expenses
from sales revenue:

193
Or the annual net cash inflow can be computed by adding depreciation expense to
net operating income:

194
5.4.2 Impact of income tax
There is an impact of tax rates on after – tax cash flows and NPV. Based on
the NPV method, a decrease in the tax rate makes the capital investment project
more acceptable and vice – versa, an increase in the tax rate has the opposite effects
(the capital investment project will be unacceptable).
Therefore, the tax rate has a significant effect on the investment decision.
Exercise (19):
K-Mart is considering a L.E. 6,000,000 investment in a new point – of – sale
equipment for its store that will have a 10 – year economic life and produces
expected net annual cash operating savings of L.E. 850,000. The company’s after
– tax cost of capital is 5%.
Required:
(1) Using NPV criterion, do you accept or reject the previous project, in the light
of the three different situations of a tax rate:
- Tax rate of 30% (Actual rate in effect).
- Tax rate of 40%.
- Tax rate of 25%.
(2) “Tax rate has a positive effect on an investment decision”. Do you agree or
disagree this rule and why.

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The Solution

The decision: According to tax rate 30%, the project is unacceptable

because NPV < 0 (negative).

The decision: According to tax rate 25%, the project is acceptable

because NPV > 0 (positive).

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5.4.3 Using cost of capital as a discount rate
Discount rate is the minimum acceptable rate of return. It is also referred to
as the required rate of return (RRR) or desired rate of return (DRR) or hurdle rate
or opportunity cost of capital. Therefore, if you have not a discount rate, you must
depend on cost of capital as a discount rate.
Exercise (20):
Hazem, manager of Future Laboratory, is investigating the possibility of
acquiring some new test equipment. The equipment requires an initial outlay of
L.E. 300,000. To raise the capital, the manager of Lab will sell stock valued at L.E.
200,000 (the stock pays dividends of L.E. 24000 per year) and borrow L.E. 100,000
(interest rate 6%). The equipment is expected to have 20 years useful life and will
produce a cash inflow of L.E. 50,000 per year.
Required:
(1) Compute weighted average cost of capital.
(2) Compute the payback period, ARR, NPV, & IRR.
(3) Should the manager buy the equipment and why.

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4.4.4 Impact of inflation Real & nominal (apparent) rates of return
Inflation is the decline in the general purchasing power of the monetary unit.
Inflation requires to distinguish between the real rate of return and the nominal
(apparent) rate of return:
(1) Real rate of return is the rate of return demanded to cover investment risk and
achieve the time value of money. Real rate of return is measured by the pure
rate of return on risk-free long-term government bonds when there is no
expected inflation.
(2) Nominal (Apparent) rate of return is the total of real rate of return and any
anticipated decline in the general purchasing power of the money because of
inflation element.
If the real rate of return for the investment is 20% and the expected inflation rate
is 10%, the nominal rate of return can be computed as follows:

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Nominal rate of return = [(1 + Real Rate) (1 + Inflation Rate)] – 1
= [(1 + 0.20) (1 + 0.10)] – 1
= [(1.20) (1.10)] – 1
= 1.32 – 1 = 0.32 = 32%
Or
Nominal rate of return = Real rate of return 0.20
+ Inflation rate 0.10
+ Combination (0.20 × 0.10) 0.02*
0.32 = 32%
* The relationship between real, inflation, and nominal rates is multiplicative not
additive, where the combination part recognizes that inflation leads to decrease to
purchasing power of real of return earned during the year.

NPV can be computed by nominal rate of return or real rate of return. Nominal
rate of return is easier because this approach uses the same type of pound figures
that will be recorded in the accounting system – pounds that include the impact of
inflation.

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Exercise (21):
Network Communications is considering a high technology equipment. The
equipment would cost L.E. 750,000 immediately. It is expected to have a 4 year
useful life with a zero terminal disposal price. The equipment will be depreciated
using the double – declining balance (DDB) method. The predicated net cash inflows
from the equipment over the next 4 years, before any income tax payments, are:

The company requires an after – tax real rate of return of 20% from this project.
An annual inflation rate of 10% is expected over this 4-years period. The income
tax is 40%.
Required:
(1) Compute NPV using nominal rate of return.
(2) Compute NPV using real rate of return.
(3) Compare between nominal rate and real rate for evaluating investment
proposals.
The Solution
(1) NPV using nominal rate approach (32%)
• Convert real rate (20%) to nominal rate (32%).
• Convert real pounds of cash inflows to nominal pounds for the coming 4 years:

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