Mod 08

Management Accounting Fundamentals [MA1]
Module 8: Flexible budgets and decentralization

Required readings
Chapter 11, pages 500-517

Note: On page 563, in the Sales mix variance calculation for Deluxe and Standard, "16.000" should be
"16,000" in both instances.
Overview
In Module 6, the budgeting process that you studied was based on the concept of a static budget, in which
actual results are measured against budgeted costs at the original level of budget activity. In this module, you
work with the concept of a flexible budget, which can be adapted for any level of activity within a certain
(relevant) range. The analysis of overhead variance is explained and illustrated. In Computer illustration 8-1,
you will use a spreadsheet program to prepare a flexible budget and to do a basic what-if analysis.
This module also looks at segment reporting. Responsibility accounting is addressed, and the importance of
decentralization in a responsibility accounting system is analyzed. The module looks at the difference
between cost centres, profit centres, and investment centres. It then looks at Return on Investment (ROI) and
residual income methods of evaluating performance.
Learning objectives
8.1 Prepare a flexible budget, and explain the advantages of the flexible budget approach over the
static budget approach. (Level 1)
8.2 Prepare a variable overhead performance report using the flexible budget to show only a spending
variance and to show both spending and efficiency variances. (Level 1)
8.3 Explain the significance of the denominator activity figure in determining the standard cost of a
unit of product. (Level 1)
8.4 Compute and properly interpret the fixed overhead budget and volume variances.(Level 1)
8.5 Construct a worksheet to prepare a flexible budget and perform a what-if analysis on a flexible
budget. (Level 1)
8.6 Prepare an income statement incorporating variance analysis.(Level 2)
8.7 Differentiate between cost centres, profit centres, and investment centres, and explain how
performance is measured in each. (Level 2)
8.8 Prepare a segmented income statement using the contribution format, and explain the difference
between traceable fixed costs and common fixed costs. (Level 1)
8.9 Analyze variances from revenue targets. (Level 1)
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8.10 Compute and interpret the return on investment and residual income and list the strengths and
weaknesses of each method. (Level 1)
Module 8: Flexible budgets and decentralization - Content Links
Required readings

Note: On page 563, in the Sales mix variance calculation for Deluxe and Standard, "16.000" should be
"16,000" in both instances.
8.1 Flexible budgets

LEVEL 1
It is important that you also review the material in Chapter 3 and Module 2 at this point to be sure you
understand the basic concept of overhead application.
The problems caused by the nature of overhead affect the analysis and design of systems. Flexible budgets
resolve one issue, namely, the effect of variations in volume on costs. Note the importance of relevant range.
The budget, if it is flexible, is "after the fact" as far as volume is concerned. (Flexible budgets are sometimes
called ex-post budgets.)
A flexible budget allows the variance of actual cost from budget to be broken down into volume as well as
spending components. The variance from a static budget mixes volume with spending effects and is therefore
more difficult for management to use.
A flexible budget is presented as a formula for overhead cost, which, when the activity is inserted, gives a
total consistent with any activity level.
The measure of activity (the base) should satisfy the three criteria suggested on page 505-506. These criteria
are also important when selecting an overhead base. Although the problems in the text tend to use
direct-labour hours, base measures such as units of production or machine-hours may also be used.
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8.2 Variable overhead variances

LEVEL 1
During analysis, variable overhead variances are usually divided into two categories: spending variances
and efficiency variances. The following schedule summarizes the two variable overhead variances you will
deal with in this module:
If desired, these totals can be broken down to show the two variances for each component of variable
overhead (for example, indirect labour, lubricants, and power in Exhibit 11-7). An efficiency variance is not
possible if a standard base is not calculated (for example, if production units were the activity base).
The overhead efficiency variance is the cost, in terms of budgeted variable overhead, of inefficiently using
the base. Each unit of base used changes the variable overhead if the base is properly selected.
Flexible budgets can also be used by companies that employ activity-based costing.
8.3 Overhead rates and standard costing

LEVEL 1
Fixed costs can be added into the flexible budget (Exhibit 11- 8), but these costs do not change with changes
in the base. The flexible budget can be used with an activity-based costing system or a more traditional
costing system.
In the analysis of fixed overhead, note the importance of fixed costs to unit costs. Observe also the
denominator activity level and its importance to the calculation of the predetermined overhead rate for
absorption costing purposes. This rate can be separated into fixed and variable elements. The variable rate is,
in effect, the same as the variable overhead flexible budget rate. Do not confuse a flexible budget for total
overhead with the unit standard costs for both fixed and variable overhead.
8.4 Fixed overhead budget and volume variances

LEVEL 1
Carefully study Exhibit 11-11. Notice that the budget variance is, in effect, a spending variance like that
obtained for variable overhead.
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The following comparison between the variances for variable and fixed overhead may be helpful:
The volume variance (sometimes called the denominator variance) is based on the difference between the
denominator base and the standard base multiplied by the standard fixed overhead rate.
The difference in fixed costs between the left and right columns in the schedule above of $68,000, ($308,000
– $240,000), is the same as illustrated in Exhibit 11-10. This difference equals the total underapplied
overhead, as explained in Chapter 3 of the textbook and in Module 2.
Exhibit 11-12 is a graphical analysis of fixed overhead variances. Follow the textbook example carefully on
pages 519-521 for a review of overhead variance analysis. The analysis could be viewed as follows:
In every case:
The flexible budget for variable overhead at standard hours is the same as the amount applied to work
in process.
The flexible budget for fixed overhead is a constant amount regardless of the level of activity.
Online chapter summary
This topic marks the end of the textbook coverage of flexible budgets and overhead analysis. To ensure you
understand this material and the corresponding terminology, read the summary on pages 518-519 and go to
the Online Learning Centre, click Contents, choose Chapter 11, select Chapter Summary and review the
material thoroughly. If you are unclear on how to access or use this site, refer to the Online Learning Centre
(OLC) Guide in the course navigation pane.
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8.5 Computer illustration 8-1: Fixed costs in a flexible budget

LEVEL 1
Chapter 11 of the textbook explains how to prepare flexible budgets and perform overhead analysis. This
computer illustration demonstrates how to prepare a flexible budget that contains fixed costs as well as
variable costs. Study Exhibit 11-8 carefully before attempting to work through this illustration. This
illustration uses the data from Exhibit 11-8 and demonstrates the preparation of overhead flexible budgets
using a spreadsheet program.
Material provided
A partially completed worksheet M8P1

A solution worksheet M8P1S
Required
Complete the worksheet M8P1 by entering appropriate formulas. Compare the results you obtain with the
overhead flexible budget in Exhibit 11-8. Using the data in Exhibit 11-8 perform the following what-if
analysis:
a. What is the effect on the predetermined overhead rate if the budgeted machine hours (cell B20) are
60,000 instead of 50,000, with an increment of 10,000?
b. What happens if you need to present the following machine-hours in the flexible budget: 40,000,
45,000, 50,000, and 55,000? For this part of the analysis, you will set the budgeted machine-hours in
cell B20 to 50,000, the increment in cell B19 at 5,000, and lower limit in cell B18 at 40,000 machine-
hours.
Procedure
1. Open the file MA1M8P1.
2. Click the M8P1 sheet tab and study the structure of the worksheet. Rows 6 to 23 contain the data table.
Rows 25 to 46 are set up to resemble Exhibit 11-8 and cells C44 to C45 are set up to calculate the
predetermined overhead rate.
3. Enter the appropriate formulas in rows 30 to 40 to complete the overhead flexible budget. Note the
formulas in row 28, which reference the data table. This is done to facilitate what-if analysis, as
specified in Parts (a) and (b). The formulas in rows 33, 36, 41, and 42 have been pre-entered for you.
4. For the formula in cell C44, use the HLOOKUP function. Refer to the explanation at the end of the
illustration. Use the HLOOKUP function to look up the value in cell B20 in order to determine the
total overhead costs for the budgeted machine hours.
5. Save your completed worksheet and print a copy.
6. Click the sheet tab M8P1S and compare the worksheet with your printout from step 5. If you do not
obtain the same results, print the formulas from your worksheet in the range C29 to F45. Compare
your formulas with those in the solution worksheet. Resolve any discrepancies.
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7. Use the solution worksheet to perform the what-if analysis specified in the "Required." You should
obtain the following results:
a. If the budgeted machine-hours (cell B20) are 60,000, the predetermined overhead rate will be
$6.50 per machine-hour (cell E45).
b. If the lower limit of machine-hour activity (cell B18) is set to 40,000 and the budgeted machine-
hours (cell B20) are 50,000, the predetermined overhead rate will be $7.50 per machine-hour
(cell E45). The total overhead costs will be:
in cell C42: $360,000

in cell D42: $367,500
in cell E42: $375,000
in cell F42: $382,500
Display your completed worksheet or the solution worksheet M8P1S. Move to cell C44 and study the
formula:
=HLOOKUP(B20,C36:F42,7)
This formula compares the value in cell B20 (budgeted machine-hours) to row 36 in columns C, D, E, and F
(being the top row of the range C36:F42). When a match is found between the value in cell B20 and one of
the values in C36 to F36, the =HLOOKUP function moves down to the 7th row (specified by 7 in the
formula) in the range and returns the value (total overhead cost in this case) in that cell as the result for the
formula. In the base case, cell B20 contained the value 50,000. The match is found in cell E36, and the
corresponding value 7 rows below is $375,000 in cell E42. =HLOOKUP is a very useful spreadsheet
function used to perform table lookups in worksheets.
8.6 Full income statement variance analysis

LEVEL 2
The following examples of variable costing and full absorption costing illustrate how flexible budgets,
standard costs, and the resulting variances are handled on the income statement. Work through the examples.
An implicit assumption in the original budget of this illustration (and in most illustrations in the textbook) is
that the budgeted level of activity is the same as the "normal" or "denominator" level of activity used to
establish the standard cost rate for fixed overhead. This is not always the case, particularly for budgets
covering short time periods. For example, the monthly budgeted level of activity would not necessarily be
1/12 of the normal annual level of activity used to establish the standard cost rate for fixed overhead. In such
cases, there would be a "budgeted volume variance" in some months.
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Notes on illustrative income statements:
1 The same logic that enables the separation of variances between standard and actual
costs into two components can be used to separate differences between budgeted and
actual amounts of other income statement items.
For example:
Sales volume variance = Difference in volume x Budgeted price
Sales price variance = Actual volume x Difference in price
Variable S&A volume variance = Difference in volume x Budgeted
spending
Variable S&A spending variance = Actual volume x Difference in spending
2 The fixed overhead volume variance is not an operating variance because both the
flexible budget and the actual results are based on the same level of activity.
8.7 Decentralization in organizations

LEVEL 2
Among other benefits, decentralization
spreads the decision-making burden

gives managers greater control over their segments
keeps decisions in the hands of people who see and understand the problems
serves as a motivating tool
enhances employee development
promotes job satisfaction
provides a basis for the evaluation of managers
Responsibility accounting is an objective of managerial accounting that concentrates on areas of

responsibility rather than costing a product or service. The organizational chart, rather than the inventory or
service, constitutes the focal point of the system.
Investment centres, profit centres, and cost centres provide a means of describing what the reports should
include and what is actually being controlled. For now, you should try to achieve a sense of the differences
between each type of centre.
Some ethical challenges posed by decentralization include
designing performance reporting and measurement so that it is fair to all concerned
managerial shirking of responsibilities and games playing at the expense of the organization
higher stress levels on managers and their units which may sometimes result in taking unethical
shortcuts or in expecting managers and their units to take on unfair burdens
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8.8 Segment reporting

LEVEL 1
To operate effectively, managers of a large organization usually need to break down the organization into
smaller segments. In the old section 1700, the CICA Handbook used to require that operations be segmented
first by industry and second by geographic area. The new Handbook section 1701 on segment disclosure now
requires that the segments used for internal management reporting also be used for external reporting
purposes. Segments could be defined by product line, by geographic area, by manufacturing facility, or in
any fashion deemed appropriate and useful by management.
Profits segmented by product, territory, salesperson, and so on, can provide useful information for
managerial decisions. The definition of a segment is made general enough to accommodate any of these
areas of interest. Some writers use the term "cost object" in the same way as segment.
One of the newer methods of defining segments is by the type of strategy followed by the company. These
"strategic business units" (SBUs) combine products, customer groups, or territories so the general manager
can approach the market with an internally consistent strategy. Fixed costs used to develop strategic
advantages (product quality, low-cost producer, brand recognition, and so on) are more likely to be traceable
to the SBU, thus avoiding or minimizing common fixed costs when reporting on the SBUs. Responsibility
for product groups may be changed frequently between SBUs as the company's overall strategy is adjusted to
suit the market.
Notice the structural breakdown of the income statement presented in Exhibit 12-2. The key to handling this
breakdown is making the distinction between common and traceable (sometimes called "direct") fixed costs.
If the breakdown is based on sales classifications, variable expenses do not create a problem because, by
definition, they are directly associated with the activity level (sales in this case).
Contribution margin is defined as sales less all variable expenses. Exhibit 12-2 is somewhat unclear
because it does not present variable selling and administrative expenses as such, but presents them as other
variable expenses. Since short run means short enough so fixed costs do not change, contribution margin is a
short-run planning tool.
Note the exact wording of the definition of traceable fixed costs (page 551). The phrase "incurred because
of the existence" enables you to identify what is common and what is traceable. If the costs disappear when
the segment disappears, the costs are deemed to be traceable. Another way to view this problem is to "treat
as traceable costs only those costs that are added as a result of the creation of a segment." These are costs
that are incurred only in relation to that segment. Therefore, the segment margin should be high enough to
recover these costs. Traceable fixed costs can be separated into two categories — discretionary and
committed. The segment manager may not be able to control committed traceable fixed costs. For example,
the segment's capital assets may be selected by senior management. Consequently, the segment manager
cannot control amortization expense.
For this reason, committed fixed costs sometimes form a separate classification and are deducted from the
segment's contribution margin. Note that what is common to a lower level segment may be traceable to a
higher level one. We may not be able to identify a cost as traceable to a particular product in a group, but we
may be able to treat it as a traceable cost of the SBU that handles that group of products.
Common fixed costs are not allocated because to do so creates an arbitrary allocation. Arbitrary allocations
are said to lack universality, that is, a given method cannot be defended against all alternative methods and
results that lead to multiple and possibly conflicting conclusions. Interestingly, generally accepted
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accounting principles require absorption costing for financial accounting purposes, even though it contains
arbitrary allocation procedures.
Segment margin is contribution margin less traceable fixed costs (technically expenses). This definition
implies that segment margin is a long-run measure of profitability. This view is misleading because it is a
"one term" number (no need for a present value) and it ignores the investment in the segment. More
specifically, segment margins suggest the long run incremental profit (the same as marginal profit in
economics). If incremental profit is negative, management should give serious consideration to shutting
down the segment unless "other factors" such as customer goodwill outweigh the loss. You will consider this
idea further in Topic 9.2. Remember the simplifications in CVP and the ideas of relevant range together with
some of the unusual cost behaviours explained in Topic 4.1. Capacity allocation will also enter into analysis
of segments (linear programming is needed for this).
8.9 Revenue variance and marketing expense analysis

LEVEL 1
In Module 7, you studied a general model of variance analysis for costs. In this topic, you consider an
example of variance reporting in the revenue area.
Notice that the sales price variance is calculated in the same manner as the material price variance. However,
the sales volume variance is much more complicated and is different from any variance you have studied up
to this point.
The sales volume variance is a misnomer in that it does not focus on sales revenue but on contribution
margin. It explains the difference between the original budgeted contribution margin (master budget) and the
expected contribution margin at the actual level of sales (flexible budget).
To properly analyze marketing expense, it is important to identify the cost drivers for the marketing costs. A
similar approach was used in Module 5 in analyzing overhead costs.
8.10 Rate of return and residual income

LEVEL 1
The return on investment (ROI) formula, margin multiplied by turnover, carries important messages for
managers as well as analysts.
ROI = Margin × Turnover
Net operating income Sales

= ×
Sales Average operating assets
Variations in this ROI formula will be found in practice and in textbooks, but the basic idea remains the
same. The formula suggests that managers can increase the return on their investment by either increasing
turnover (increasing sales or reducing assets) or increasing their profit margin (increasing markup or
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decreasing expenses).
Residual income is a useful alternative method for evaluation.
The text explanation focuses on a division competing with other divisions in a large corporation.
Alternatively, these numbers may be compared against industry statistics, which are often available through
trade associations or Industry Canada, to determine how effective management is compared with external
competition.
Online chapter summary
This topic marks the end of the textbook coverage of segment reporting. To ensure you understand this
material and the corresponding terminology, read the summary on page 575, work through the review
problem on pages 575-577 and go to the Online Learning Centre, click Contents, choose Chapter 12, select
Chapter Summary and review the material thoroughly. If you are unclear on how to access or use this site,
refer to the Online Learning Centre (OLC) Guide in the course navigation pane.
Audio lectures
Audio lectures are available for this module. System requirements and instructions on how to access the
online lectures are included.
Module 8 summary
Module 8 further examines in Topics 8.1 through 8.6 variance analyses and also deals, in the remaining
topics, with segment reporting as well as responsibility accounting as a result of decentralization.
Topic 8.1 introduces the concept of flexible budget and outlines its merits in allowing the breakdown of
variances into two primary components — volume and spending variances. Topic 8.2 illustrates this
breakdown with variable overhead and incorporates this partitioning into a performance report.
Topic 8.3 introduces fixed costs into the flexible budget and breaks the predetermined overhead rate down
into its variable and fixed components.
Topic 8.4 analyzes the fixed overhead variance into its two components: budget variance and volume
variance.
Topic 8.5 combines fixed cost variance analysis and sensitivity analysis following changes in activity and in
overhead rate.
Topic 8.6 incorporates variance analysis into the income statement by providing for each item data
associated with the static budget, flexible budget, and actual results. This format allows capturing planning
variances and operating variances. In turn, these variances are broken down into their elementary
components (price, rate, spending, budget, usage or efficiency, and volume variances).
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The remaining topics cover decentralization-related issues. Topic 8.7 discusses decentralization and
introduces issues pertaining to responsibility accounting: organization of a company in different business
units or centres and ethical issues pertaining thereto.
Topic 8.8 deals with segment reporting as a tool that is likely to facilitate performance control and
evaluation.
Topic 8.9 focuses on marketing-related variances, raises the issue of definition of valid drivers for marketing
costs, and highlights the selling price and sales volume variances.
To conclude the module, Topic 8.10 defines and contrasts the return on investment (ROI) and residual
income (RI) as metrics for evaluating the performance of managers.
Module 8 self-test
Question 1
Computer question
Durrant Company has had great difficulty in controlling overhead manufacturing costs. At a recent
convention, the president heard about a control device for overhead costs known as a flexible budget, and he
has hired you to implement this budgeting program in Durrant Company. After some effort, you have
developed the following cost formulas for the company's machining department. These costs are based on a
normal operating range of 10,000 to 20,000 machine-hours per month:
Cost Cost Formula

Utilities $0.70 per machine-hour
Lubricants $1.00 per machine-hour plus $29,000
Machine setup $0.20 per machine-hour
Insdirect labour $0.60 per machine-hour plus $12,000
Amortization $32,000 per month
During March, the first month after your preparation of the above data, the machine department worked
18,000 machine-hours and produced 9,000 units of product. The actual costs of this production were as
follows:
There were no variances in the fixed costs. The department had originally been budgeted to work 20,000
machine-hours during March.
Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Managerial Accounting,
Page 14 of 50
Sixth Canadian Edition, Problem P11-19, pages 531-532. Copyright © 2004, by McGraw-Hill Ryerson
Limited. Adapted with permission.
Required
Use the procedure described below to complete worksheet M8Q1. From this worksheet, answer the
following questions:
1. a. What is the budgeted total variable cost for 15,000 machine-hours?
b. What is the budgeted total fixed cost for 20,000 machine-hours?
2. What is the spending variance for machine setup on the overhead performance report for the month of
March?
3. What additional information would you need to have in order to compute an overhead efficiency
variance for the department?
4. Explain to the president how the flexible budget might be used for product costing purposes as well as
for cost control purposes.
Procedure
You have been provided with a partially completed worksheet M8Q1. After reading the problem, complete
the worksheet by following these steps:
1. Open the file MA1M8Q1.
2. Examine the layout of the worksheet. Rows 4 to 27 contain the data table. Rows 29 to 50 contain a
partially completed flexible overhead budget, and rows 53 to 74 contain a partially completed
overhead performance report.
To complete requirement 1
1. Enter in cells C34 to E34 the formulas for the activity levels to be presented in the flexible budget
based on the information in the data table.
2. Complete the overhead flexible budget by entering the required formulas in cells C36 to E49. Note that
the formulas in rows 40, 43, and 50 have been pre-entered for you.
To complete requirement 2
3. Enter the required formula in cell C57.
4. Complete the overhead performance report by entering the necessary formulas in rows 63 to 66 and
rows 70 to 72.
5. Save your completed worksheet.
6. Display the formulas in your completed worksheet.
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Solution
Question 2
Textbook, Problem 11-17, page 530.
Solution
Question 3
Textbook, Problem 12-15, pages 592.
Solution
Question 4
a. Textbook, Question 11-11, page 522.
b. Textbook, Question 11-19, page 522.
Solution
Question 5
Textbook, Problem 11-15, pages 528-529.
Solution
Question 6
Solution
Question 7
Solution
Self-test - Content Links
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Solution 1
Computer solution
a. The budgeted total variable cost for 15,000 machine-hours is $37,500.
b. The budgeted total fixed cost for 20,000 machine-hours is $73,000.
Requirement 2
The spending variance for machine setup on the overhead performance report for the month of March is
$(1,200) or $1,200 unfavourable.
Requirement 3
In order to complete an overhead efficiency variance, it would be necessary to know the standard hours
allowed for the 8,000 units produced during March in the machining department.
Requirement 4
The flexible budget can be used to develop predetermined overhead rates, which are used to apply overhead
costs to units of product.
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Solution printout
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Formula printout
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Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Solutions Manual to
accompany Managerial Accounting, Sixth Canadian Edition. Copyright © 2004, by McGraw-Hill Ryerson
Solution 2
Problem 11-17
1. The cost formulas below can be developed from the data in the problem using the simple high-low
method. The completed flexible budget over an activity range of 80 to 100% of capacity would be:
2. The cost formula for all overhead costs would be $40,000 per month plus $1.50 per machine-hour.
3.
Elgin Company
Performance Report
For the Month of May
Budgeted machine-hours 40,000

Standard machine-hours allowed 41,000
Actual machine-hours 43,000*
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Cost Budgeted
Formula Actual Cost Cost Spending
Overhead Costs per MH 43,000 MH 43,000 MH Variance
Variable overhead
costs:
Utilities $0.80 $ 33,540 ** $ 34,400 $ 860 F
Supplies 0.10 6,450 4,300 2,150 U
Indirect labour 0.20 9,890 8,600 1,290 U
Maintenance 0.40 14,190 ** 17,200 3,010 F
Total variable costs $1.50 64,070 64,500 430 F
Fixed overhead
costs:
Utilities 9,000 9,000 —
Maintenance 21,000 21,000 —
Supervision 10,000 10,000 —
Total fixed costs 40,000 40,000 —
Total overhead costs $104,070 $104,500 $ 430 F
* 86% of 50,000 MHs = 43,000 MHs

** $42,540 – $9,000 fixed = $33,540
$35,190 – $21,000 fixed = $14,190
4. Assuming that variable overhead really should be proportional to actual machine-hours, the
unfavourable spending variance could be the result either of price increases or of waste. Unlike the
price variance for materials and the rate variance for labour, the spending variance for variable
overhead measures both price and waste elements. This is why the variance is called a “spending”
variance. Total spending can be affected as much by waste as it can by prices paid.
5. Efficiency Variance = SR (AH – SH)

$1.50 per MH (43,000 MHs – 41,000 MHs) = $3,000 U
The overhead efficiency variance is really misnamed, since it does not measure efficiency (waste) in
use of variable overhead items. The variance arises solely because of the inefficiency in the base
underlying the incurrence of variable overhead cost. If the incurrence of variable overhead costs is
directly tied to the actual machine-hours worked, then the excessive number of machine-hours worked
during May has caused the incurrence of $3,000 in variable overhead costs that would have been
avoided had production been completed in the standard time allowed. In short, the overhead efficiency
variance is independent of any spillage, waste, or theft of overhead supplies or other variable overhead
items that may take place during a month.
Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Solutions Manual
to accompany Managerial Accounting, Sixth Canadian Edition. Copyright © 2004, by McGraw-Hill
Ryerson Limited. Reproduced with permission.
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Solution 3
Problem 12-15
1.
* $30,000 × 40%, 50%, and 10% respectively

** $4.50 per square metre × 889 square metres, 1,556 square metres, and 222 square metres respectively
2. a. No, the wheat cereal should not be eliminated. The wheat cereal product is covering all of its own
costs and is generating a $22,000 segment margin toward covering the company's common costs and
toward profits. (Note: Problems relating to the elimination of a product line are covered in more depth
in Chapter 13.)
b. No, it is probably unwise to focus all available resources on promoting the pancake mix. The
company is already spending nearly as much on the promotion of this line as it is on the other two
lines together. Furthermore, the pancake mix has the lowest contribution margin ratio of the three
products. Nevertheless, we cannot say for sure which product should be emphasized in this situation
without more information. If the equipment is being fully utilized, increasing the production of any
one product would probably require cutting back on one of the other products. In Chapter 13, we will
discuss how to choose the most profitable product when there is a production constraint that forces
such a trade-off between products.
3. At least three additional points should be brought to the attention of management:
i. Compared to the other two products, salaries are very high for wheat cereal. This should be thoroughly
investigated to find the reason for the wide difference in cost. If these salaries can be reduced, it would
greatly enhance the profitability of the wheat cereal, as well as the profitability of the company as a
whole.
ii. The company pays a commission of 10% on the selling price of any product. Consideration should be
given to revising the commission structure to base it on contribution margin, rather than on sales.
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iii. Management should consider JIT deliveries to reduce warehouse costs.
Limited. Reproduced with permission.
Solution 4
Question 11-11
a. In Chapter 3 we were dealing with a normal cost system, whereas in Chapter 11 we are dealing with a
standard cost system. Standard costing ensures that each unit of product bears the same amount of
overhead cost regardless of any variations in efficiency of the use of the application base.
Question 11-19
b. Capacity variance analysis typically explores the implications of fixed overhead costs of not producing
at denominator capacity. By examining practical capacity costs and those of theoretical capacity,
management can be shown what some of the implications are of operating at denominator capacity.
For example a single shift operation may reflect denominator capacity. Two shifts might be used as
practical capacity. Moving to the economics of three shifts, seven days per week can demonstrate what
the two shift choice costs the organization.
Limited. Reproduced with permission.
Solution 5
Problem 11-15
Requirement 1
1. Direct materials price and quantity variances:
Direct materials price variance = AQ (AP – SP)

78,000 metres ($3.75 per m – $3.50 per m) = $19,500 U
Direct materials quantity variance = SP (AQ – SQ)

$3.50 per m (78,000 metres – 80,000 metres*) = $7,000 F
*20,000 units × 4 metres per unit = 80,000 metres
Requirement 2
2. Direct labour rate and efficiency variances:
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Direct labour rate variance = AH (AR – SR)

32,500 DLHs ($11.80 per DLH – $12.00 per DLH) = $6,500 F
Direct labour efficiency variance = SR (AH – SH)

$12.00 per DLH (32,500 DLHs – 30,000 DLHs*) = $30,000 U
*20,000 units × 1.5 DLHs per unit = 30,000 DLHs
Requirement 3
3. a. Variable manufacturing overhead spending and efficiency variances:
Alternative solution:
Variable overhead spending variance = (AH × AR) – (AH × SR)

($68,250) – (32,500 DLHs × $2.00 per DLH) = $3,250 U
Variable overhead efficiency variance = SR (AH – SH)

$2.00 per DLH (32,500 DLHs – 30,000 DLHs) = $5,000 U
b. Fixed overhead budget and volume variances:
Alternative approach to the budget variance:
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$148,000 – $150,000 = $2,000 F
Alternative approach to the volume variance:
$6.00 per DLH (25,000 DLHs – 30,000 DLHs) = $30,000 F
Requirement 4
4. The total of the variances would be:
Notice that the total of the variances agrees with the $12,250 unfavourable variance mentioned by the vice
president.
It appears that not everyone should be given a bonus for good cost control. The materials price variance and
the labour efficiency variance are 7.1% and 8.3%, respectively, of the standard cost allowed and thus would
warrant investigation. In addition, the variable overhead spending variance is 5.0% of the standard cost
allowed.
The reason the company’s large unfavourable variances (for materials price and labour efficiency) do not
show up more clearly is that they are offset for the most part by the company’s favourable volume variance
for the year. This favourable volume variance is the result of the company operating at an activity level that
is well above the denominator activity level used to set predetermined overhead rates. (The company
operated at an activity level of 30,000 standard DLHs; the denominator activity level set at the beginning of
the year was 25,000 DLHs.) As a result of the large favourable volume variance, the unfavourable price and
efficiency variances have been concealed in a small “net” figure. Finally, the large favourable volume
variance may have been achieved by building up inventories.
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Solution 6
Problem 12-23
Requirement 1
1. The segmented income statement follows:
Requirement 2
District A District B District C

Contribution margin (a) $120,750 $212,500 $80,500
Number of orders (b) 3,000 1,500 500
Contribution margin per order (a) ÷ (b) $40.25 $141.67 $161.00
District A is taking many small orders, resulting in a contribution margin per order that is only one fourth
that of District C. Given the high variable administrative cost of processing an order ($5), the sales staff
should try to get customers to order less frequently in larger amounts. Apparently, it is possible to get fewer
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orders in larger amounts, as shown by the experience in both Districts B and C. If District A had written
large enough orders during March to provide a contribution margin of $150 per order, then only 805 orders
would have to be written during the month ($120,750 contribution margin ÷ $150 per order = 805 orders),
rather than 3,000 orders. This would have reduced variable order processing costs by $10,975 — enough to
put the company in the black for the month:
Orders actually written 3,000

Orders that could have been written, at $150 contribution
margin per order (above) 805
Difference 2,195
Variable cost to process an order × $5
Potential savings in processing costs $10,975
However, this approach is contrary to the JIT trend that emphasizes smaller, more frequent orders. A better
solution may be to use process re-engineering to reduce the costs of processing an order.
Requirement 3
Incremental sales $100,000

Contribution margin ratio × 0.425
Incremental contribution margin 42,500
Less incremental advertising expense 25,000
Incremental segment margin (and company
$ 17,500
net operating income)
Yes, the expenditures would be justified. Note that the contribution margin ratio should be used in the
computation, rather than the segment margin ratio. This answer assumes no change in the average size of an
order in District B.
Requirement 4
The following points should be brought to the attention of management:
a. The large number of orders in District A, as discussed above.

b. The sales staffs in Districts A and C are far less effective than the sales staff in District B, as shown
below:

District sales (a) $300,000 $500,000 $200,000
Number of salespersons (b) 6 5 4
Dollar sales per salesperson
$ 50,000 $100,000 $ 50,000
(a) ÷ (b)
c. Although District C has the least sales of any district, it has the highest district advertising expense.
This may be indicative of poorly directed or ineffective advertising. Perhaps the district advertising
programs should be coordinated through an advertising manager to ensure consistency and
effectiveness in overall advertising efforts.
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d. Districts B and C have high shipping costs compared to District A. Shipping costs per unit in the three
districts are:

Shipping expense (a) $11,250 $25,000 $15,000
Number of units sold (b) 15,000 25,000 10,000
Shipping costs per unit
(a) ÷ (b) $0.75 $1.00 $1.50
Perhaps company policy should determine the shipping method rather than allowing the
sales staff to specify the shipping method. This might avoid unnecessary use of the more
expensive shipping methods.
e. Districts A and C have lower contribution margin ratios than District B, as a result of the higher
ordering costs in District A and the higher shipping costs in District C. One advantage of the
segmented statement as shown in Part (1) above is that it permits the computation of contribution
margins and contribution margin ratios, as well as segment margins, thus providing management with
more detailed information.
f. Sales in both Districts A and C are substantially lower than in District B. This may be a result of the
low productivity per salesperson in these districts, combined with ineffective advertising in District C
and perhaps insufficient advertising in District A.
In conclusion, unprofitable operations may be caused by a number of small problems rather than a single,
large problem. Statements in the segmented format help to focus on potential small problem areas, such as
shown above.
Solution 7
Problem 12-25
Requirement 1
1. The segmented income statement follows:
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Requirement 2
2.
Requirement 3
3.
Requirement 4
4. The company has a contribution margin ratio of 40% ($20 CM per unit, divided by $50 selling price
per unit). Therefore, a $100,000 increase in sales would result in a new net operating income of:
Sales $1,100,000 100%
Less variable expenses 660,000 60%
Contribution margin 440,000 40%
Less fixed expenses 320,000
Net operating income $ 120,000
A change in sales affects both the margin and the turnover.
Requirement 5
5. Interest is a financing expense and thus is not used to compute net operating income.
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Requirement 6
6.
*Examples of assets that would not be included in the operating assets category would include land
held for future use. Therefore, $500,000 – $180,000 = $320,000.
Requirement 7
7.
Mid-term assignment
Note:
This assignment requires you to apply the knowledge you have gained in MA1 up to Module 8. This
assignment is worth 15% of your final grade.
Prepare the answers to these assignment questions in Word and save them as one document. See
"Submit assignments" under the How To tab for the recommended format and filename. When your file is
complete and you are ready to submit it for marking, click the link to the drop box for this assignment in the
navigation pane.
Overview
In a recent meeting Tony, the CEO of Allouette Dairy Products, and Cal, the Controller, discussed the final
quarter reports for the year. The results for Allouette’s three ice cream flavours are not as good as Tony had
hoped. While sales have increased, the reported profit margin for the vanilla product has not shown a
significant increase during this quarter. In the meeting, Cal emphasized to Tony that the main reason for
falling profit margins is the rising cost of ingredients. But Tony is not convinced they are at the mercy of
rising costs. He is convinced that a further analysis of the situation may be necessary.
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Company background
Allouette Dairy Products operates two separate divisions: the milk processing division and the ice-cream
division. The divisions share the same premises, but most of their resources and information systems are
separate. While the focus of this study is on the ice-cream division, pertinent facts relating to the milk
processing division are also provided as needed.
Currently, Allouette Dairy Products’ ice-cream division is operating at 80% capacity. The ice-cream
production line churns out about 1.5 million litres of ice cream per year, while the milk processing division
produces approximately 8 million litres of fluid milk annually. The company has a production staff of 30 and
an administrative staff of 10. Some of the staff work full time for the ice-cream division. Other staff
members work in both the milk processing division and the ice-cream division. Exhibit 1 illustrates the
functional responsibilities of the ice cream division.
Exhibit 1: Organization chart – Allouette Dairy Products ice-cream division
Ice-cream products
The main ingredients for ice cream are milk, cream, and sugar. The Canadian Food and Drugs Act sets
standards for some of the main ingredients of ice cream, such as milk solids and milk fat. A variety of
flavours can be added, but chocolate and vanilla tend to be the more popular flavours in the North American
market. Specialty ice cream can include extras like sauces, fruit, or nuts. Solid additions like fruit and nuts
are called particulates.
Allouette’s featured brand-name product is Allouette Natural Ice Cream.
AJ Major, Allouette’s Mix Master, used his experience in the industry combined with solid research to create
an organic low-fat ice cream in both vanilla and chocolate flavours that tastes just like the premium high-fat
varieties that are currently being marketed. Allouette has also ventured into specialty flavours by producing
“Hava Java,” which is a rich tasting coffee ice cream with chunks of coffee bean swirled throughout. To
date, no one has been able to copy Allouette’s recipe, and as a result its brand name continues to enjoy
steady growth across Canada. Customers like the all-natural ingedients in Allouette’s recipes.
Most Canadian grocery chains carry Allouette’s vanilla and chocolate Natural brand ice cream. The product
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is marketed in litre cartons and is normally shelved in the same area as premium ice creams. Currently the
Hava Java flavour is available only to restaurant and bistro chains, who order the ice cream as needed.
Manufacturing process
The manufacturing process for ice cream involves a series of steps. First, all ingredients other than the
flavour, sauces, and partculates are blended and pasteurized. The next step is homogenizing, in which further
blending occurs. The blended material is then cooled down to between 0 and 4 degrees Celsius. The
flavouring is added, and the product is cooled to -6 degrees. Then the product moves to a chunk feeder where
the particulate is added. Next, the flavoured sauces are added and the product is packaged in one-litre
containers. The containers then go to a hardening tunnel the ice cream is brought down to -35 degrees.
It takes about the same amount of effort and resources to produce chocolate ice cream as it does to produce
vanilla ice cream. As such, a process costing system is used.1 The batches are processed in a similar manner
and receive the same amount of direct labour costs, basic ingredients, and manufacturing overhead costs.
Therefore these costs are averaged over all batches. The production process involves several operations in
which conversion costs and ingredients are added to the product. Ingredients are added at the beginning of
each operation, requiring the basic mix, sauces, and particulates. Direct labour costs and overhead are added
evenly throughout the process.
While the Hava Java flavour is also processed in batches, it is special-ordered, and production runs are
scheduled based on demand. As a result, costs are assigned to a distinct batch using a job costing system.
Master budget
The master budget was developed by:
John Jackson, Marketing Manager

Rina Jey, Operations Manager
Cal Lim, Controller
Tony Jackson, President
These personnel are accountable for the plans and strategies for the company. They develop the master
budget based on input from their employees.
You should note the following:
Allouette Dairy Products’ fiscal year end is December 31.
The sales forecast is based on the previous year’s demand plus an additional percentage to account for
the forecast increase in demand.
Allouette uses a standard costing system to evaluate performance.
Sales demand is highest in summer with another peak in demand during the Christmas holiday season.
Beginning and ending finished goods and ingredients (raw materials) inventory remain fairly constant
throughout the year. As a result, inventory levels are not considered in the budget.
There is no work-in-process inventory. The batch process is complete when ice cream is packaged and
hardened. This process is normally complete at the end of each day.
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The budget is based on 80% operational capacity.
Manufacturing overhead is applied to the product based on direct labour dollars.
Research and development activities are currently concentrated on reducing the fat content while
maintaining the flavour and consistency of the existing products. As such, the costs of research and
development are considered to be manufacturing costs of the existing products and they are not
considered as period expenses.
You have been hired by the company controller, Cal Lim to assist in making preparations for the next
meeting.
1 Toreduce complexity in the case study, process costing is used. A batch system like ice-cream production
would normally use an operational costing system, which is a hybrid of process and job costing.
Question 1 (5 marks)
The first agenda item for the meeting is a review of the fourth quarter results.
The responsibility of coding the general ledger accounts and modeling the financial statements was passed to
a junior accounting clerk. The clerk did not have the experience to properly set up the accounts or
statements, but attempted to do so, with disappointing results. (See Table 1)
Table 1: Operating income
Allouette Dairy Products

Ice-cream division
Operating income for the quarter ended December 31
Sales in litres 382,000
Net sales $1,604,400
Cost of sales
Advertising and promotion $ 16,099
Commissions 38,773
Computer and supplies
95,103
(production scheduling)
Delivery and shipping 12,824
Direct labour 87,096
Plant utilities 38,473
Equipment maintenance 33,561
Ingredients purchases 670,410
Interest and bank charges 12,415
Cartons used 64,940
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Plant equipment amortization 67,123

Plant lease 85,131
Professional fees — administrative 7,913
Quality control 10,344
Research and development 48,023
Salaries – selling and administrative 118,393
Plant salary and wages (indirect) 70,859
Gross margin $ 1,477,480
Miscellaneous administrative expenses $ 3,230
Administrative computer services 8,503 11,733
Operating Income $ 115,187
The accounting clerk has not customized the interim financial statements to show beginning and ending
inventories for ingredients. Cal has provided you with the following account balances as of December 31.
(See Table 2)
Table 2: Account balances
Inventory Balance, October 1 Balance, December 31
Ingredients $48,550 $52,670
a. Define direct costs and indirect costs. Provide an example of each from Table 1. (1 mark)
b. Prepare in good form a schedule of cost of goods manufactured for the quarter ended December 31. (3
marks)
c. Explain how a schedule of cost of goods manufactured ties into an income statement. (1 mark)
One of the agenda items is a discussion regarding the concerns about gross margins. Tony, the CEO of the
division, watches the margins very closely and based on the annual results he wants to have a discussion on
how these margins could be improved. Most notable is the vanilla ice-cream product. While this flavour
shows the highest volume of sales, the report shows its gross margin to be the lowest at 18%. (See Table 3)
Table 3: Partial income statement

Partial income statement
For the year ended December 31
Hava
Vanilla Chocolate Total
Java
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Litre sales 700,000 466,667 233,333 1,400,000

Sales $2,821,000 $1,989,000 $1,063,000 $5,873,000
Ingredients costs $1,212,330 $855,872 $388,476 $2,456,678
Cartons used 119,000 79,333 39,667 238,000
Direct labour 152,320 101,547 50,773 304,640
Overhead 829,400 553,300 276,100 1,658,800
Total manufacturing
$2,313,050 $1,590,052 $755,016 $4,658,118
costs
Gross margin $507,950 $398,948 $307,984 $1,214,882
Gross margin % 18% 20% 29% 21%
One of the objectives of the meeting is to develop a list of actions that can be taken during the next quarter in
order to increase income. Cal is quite certain that the contribution margin per unit for vanilla, chocolate, and
Hava Java will remain stable (Table 4). John Jackson has provided him with the next quarter’s forecast in
units (Table 4). Cal is also certain that vanilla ice cream will sell at the budgeted price of $3.96 during this
period.
Table 4: Contribution margins and next quarter sales forecast
CM per unit Forecast units
Vanilla $1.55 160,000
Chocolate $1.81 110,000
Hava Java $2.44 63,000
Some informal discussions with Marketing and Operations have provided Cal with the following four
preliminary alternatives to improve the gross margins on vanilla ice cream.
John Jackson in Marketing is convinced that the reason for low profit margins is the lack of promotion.
He reckons, “We’re only selling to repeat customers. More consumers need to be aware of our
premium vanilla ice cream. It needs to be able to stand on its own like a specialty flavour instead of
being considered only as a complement to pie and cake. A $25,000 flyer promotion in major
community newspapers should increase the next quarter sales of vanilla ice cream by 10%.”
Christina Kumar in Production is very concerned about the rising costs of vanilla and sugar. She
argues, “We’ve had some unexpected cost increases in the ingredients that we use to make our ice
cream. Storms in Madagascar last year ruined the vanilla crops raising the cost of the premium vanilla
that is used to make our ice cream. And sugar prices have risen because our major suppliers in Brazil
are encouraged to sell their sugar to boost Brazil’s ethanol business that makes fuel from sugar cane.
We need to find cheaper sources of ingredients. I talked to Doug in Purchasing, and he is able to find
alternative sources for vanilla and sugar. If we go with these suppliers the cost of ingredients for
vanilla ice cream could be less, consequently reducing variable costs by 8%. My only concern is that
we will not be using a premium grade vanilla. John has told me that this may reduce our budgeted unit
sales for next quarter by 5%.”
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Tony Jackson is more concerned about price. He strongly feels that a decrease in the price would
encourage retailers to pass that savings on to their customers and increase volume sales. He believes
that the company’s success depends on vanilla ice cream and wants to increase operating income by
$60,000 for the fourth quarter by lowering the price to encourage more sales. Based on the
competition, he thinks that if the price is somewhere between $3.75 and $3.85, sales in units will
increase by 20%. He is concerned about determining what price should be charged in order to achieve
this goal.
Cal wants to consider other alternatives that would improve the operating income of the company. He
is convinced that a shift in sales that favours an ice-cream flavour with higher profit margins would
increase the company’s operating income. Allouette’s records currently indicate that the existing high-
profit margin flavour is Hava Java. Cal estimates that there should be a special campaign to promote
the sale of Hava Java to change the sales mix to 40% for vanilla, 30% for chocolate, and 30% for Hava
Java.
If the campaign is successful, he feels that the total sales volume would remain fairly stable, as existing
consumers of vanilla would switch to Hava Java. He wants to know the maximum amount he can spend on
advertising to achieve this sales mix and earn an additional first quarter operating income of $10,000 for the
coming year.
a. Distinguish between contribution margin and gross margin. (2 marks)
b. Assess each of the independent scenarios for the next quarter for Allouette Dairy Products. (16 marks)
i. Use cost volume profit analysis to assess John Jackson’s suggestion to develop an advertising
campaign promoting vanilla ice cream. Do you think the company should undertake this
advertising campaign? (4 marks)
ii. Use cost volume profit analysis to assess Christina Kumar’s suggestion to find lower-priced
sources of vanilla and sugar. By how much would income increase or decrease under this
option? What other qualitative factors should be taken into consideration? (4 marks)
iii. Use cost volume profit analysis to assess Tony Jackson’s suggestion to lower the price of vanilla
ice cream. Within his suggested price range would they be able to increase operating income by
$60,000 in the next quarter? (4 marks)
iv. Use cost volume profit analysis to assess Cal Lim’s suggestion to encourage more sales of Hava
Java ice cream by introducing an advertising campaign designed to change the sales mix of all
flavours. What concerns do you have about changing the sales mix weight in favour of Hava
Java? What is the maximum amount that can be spent on advertising? (4 marks)
When setting the current year’s master budget, the planning committee estimated that manufacturing
overhead would be $1,641,922 and direct labour costs would be $307,476. Any over- or under-allocated
overhead is applied at year end directly to each product line based on actual direct labour dollars for the year.
When the committee reviewed the actual year end figures (Table 3) it was noted that direct labour costs had
decreased from the budgeted amount.
Determine the effectiveness of the current manufacturing overhead application process by doing the
following:
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a. By using the current overhead application rate, will overhead be underapplied or overapplied before
the year-end adjustment? By how much? (3 marks)
b. Why do you think that Allouette Dairy Products uses the predetermined overhead rate rather than the
actual manufacturing overhead costs in applying overhead to jobs? (3 marks)
Standard costs are used to determine the ability of production departments to control resources. Actual
results for the year along with the static budget are shown in Tables 5, 6, 7, and 8.
a. What are the benefits gained from budgeting? (1 mark)
b. For vanilla ice cream, prepare a flexible budget for the activity level of 700,000 litres and compute the
flexible budget variances and sales volume variances. The flexible budget variance is the difference
between actual results and flexible budget, and sales volume variance is the difference between
flexible budget and static budget. Flexible budget variances are also referred to as operating variances,
and sales volume variances are also referred to as planning variances. You may find it helpful to use
Table 8 (provided below). An Excel spreadsheet, MA1AQ4B, has been started to facilitate this
process. You may also do this step manually. (5 marks)
c. What is the major advantage of performing an analysis using a flexible budget? Why are variances for
ingredients segregated into a price variance and a quantity variance? (2 marks)
d. Using the budgeted total ingredients based on standard cost for vanilla ice cream (Table 5) and the
actual results (Table 6), calculate the price and quantity variances of the costs of the following: (6
marks)
i. Cream
ii. Sugar
iii. Stabilizer and emulsifier
e. Using the budgeted direct labour hours and rate for vanilla ice cream and the actual results (Table 7),
calculate the rate and efficiency variance for direct labour. (2 marks)
Table 5: Standard costs for vanilla ice cream
Standard costs and standard usage

Vanilla ice cream
(based on standard costs)
Price Per Quantity Cost
Annual litre sales 664,000
Cream $4.00 Litre 106,240 $ 424,960
Sugar $0.68 Litre 46,812 31,832
Stabilizer and emulsifier $3.55 Litre 1,992 7,072
Fluid milk $58.20 Hectolitre+ 1,527.2 88,883
Milk powder $5.30 Kilogram 16,600 87,980
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Vanilla $71.00 Litre 7,636 542,156

Total cost of ingredients $1,182,883
+a hectolitre is equal to 100 litres
Table 6: Actual cost and usage
Actual cost and actual usage

Vanilla ice cream
Price Per Quantity Cost
Annual litre sales 700,000
Cream $4.00 Litre 115,500 $ 462,000
Sugar $1.10 Litre 49,350 54,285
Stabilizer and emulsifier $3.50 Litre 3,150 11,025
Fluid milk $58.20 Hectolitre+ 1,575 91,665
Milk powder $5.30 Kilogram 17,850 94,605
Vanilla $75.00 Litre 6,650 498,750
Total cost of ingredients $1,212,330
+a hectolitre is equal to 100 litres
Table 7: Standard and actual direct labour
Standard direct labour

Vanilla ice cream
Number of litres 664,000
Total labour hours 4,560
Total direct labour rate per hour $32.40
Total direct labour cost $147,744
Actual direct labour
Vanilla ice cream
Number of litres 700,000
Total labour hours 4,760
Total direct labour rate per hour $32.00
Total direct labour cost $152,320
Table 8: Flexible budget variance report
Actual Operating Flexible Planning Static

U/F U/F
results variance budget variance budget
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Units sold 700,000 664,000

Sales revenue $2,821,000 $2,629,440
Manufacturing
costs
Direct
materials costs
Cream $ 462,000
$ 424,960
Sugar 54,285 31,832
Stabilizer and
11,025 7,072
emulsifier
Fluid milk 91,665 88,883
Milk powder 94,605 87,980
Vanilla 498,750 542,156
Cartons used 119,000 112,880
Total direct
$1,331,330 $1,295,763
materials costs
Direct labour $ 152,320 147,744
Manufacturing
overhead costs
Variable
overhead
Plant utilities $ 70,500

$ 70,154
Equipment
61,500 62,466
maintenance
Fixed
overhead
Quality control 73,500 23,064
Computer and
147,000 153,762
supplies
Plant
equipment 123,000 115,321
amortization
Research and
88,000 86,491
development
Plant salary and
wages 109,900 127,334
(Indirect)
Plant lease 156,000 150,361
Total
manufacturing $ 829,400 $ 788,953
overhead costs
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Total
manufacturing $2,313,050 $2,232,460
costs
Gross Margin $507,950 $396,980
General and
administrative
costs
Variable
Commissions* 71,014 67,362
Delivery and
23,500 22,614
shipping*
Fixed general
and
305,200 294,470
administrative
costs
Total general
and
$ 399,714 $ 384,446
administrative
costs
Income $ 108,236 $ 12,534
*based on number of units sold
Naturally, profitability is a focus of all planning decisions that are made in the ice-cream division of
Allouette Dairy Products. Therefore it is important that the financial statements accurately reflect the income
of the division.
You have been asked to assist Cal in preparing an income statement for the last quarter of the year using both
the absorption and variable costing approaches. Currently, income statements are prepared using the
traditional approach. He provides you with a summary of last year’s costing data (see Table 9). The selling
price per litre is $4.02.
Table 9: Actual costs and inventory levels
Actual costs and inventory levels

For the quarter ended December 31
Vanilla ice cream
Number of litres produced 191,000
Manufacturing costs
Variable costs per unit $ 2.3185
Fixed costs per unit $ 0.9609
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Total manufacturing cost per unit $ 3.2794
Selling and administrative expenses

Variable costs $ 25,245.00
Fixed costs $ 83,930.00
Beginning inventory – Litres 16,000

Manufacturing costs
Ending inventory – Litres 20,000

Manufacturing costs
a. Identify two advantages and one disadvantage of absorption costing when compared with variable
costing. (1 mark)
b. Address Cal’s concern about inventory costing by preparing an income statement for vanilla ice cream
for the last quarter using the variable costing method. Use the costing data provided in Table 9. The
selling price per litre is $4.02. (2 marks)
c. Address Cal’s concern about inventory costing by preparing an income statement for vanilla ice cream
for the last quarter using the absorption costing method. Use the costing data provided in Table 9. The
selling price per litre is $4.02. What effect will this method of reporting have on operating income? (2
marks)
d. Prepare a schedule reconciling the net incomes for the year under the variable and absorption costing
methods. (2 marks)
e. Explain the difference in how product costs are deferred under variable costing and absorption costing.
(1 mark)
While the next meeting focuses on Allouette Dairy Products’ ice-cream division, there is one topic that must
be addressed that concerns both the ice-cream and milk processing divisions. This topic is the allocation of
service departments’ costs between both divisions.
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Research and development costs
Allouette Dairy Products’ ice-cream division produces natural ice cream. Many consumers like both the taste
of the Allouette brand and the fact that the ingredients come from dairy cows that are given natural vitamin
supplements instead of synthetic additives. The research and development department ensures that
Allouette’s ice cream contains a lower percentage of fat than the competitors’ products.
The fluid milk processing division of Allouette Dairy Products also relies on continuous research. The
division’s objective is to produce a natural product with high nutritional value. Various technologies to
purify and homogenize milk are constantly being tested to ensure that the product not only tastes good, but is
also high in vitamins, and has a long shelf life.
The company has realized that creating two separate research and development departments would not be
cost effective. As a result, it has created one department that services both divisions. Currently total research
and development costs are allocated between the two divisions at 75% to the ice-cream division and 25% to
the milk processing division. The reason for the difference is that the ice-cream division has three products
while the milk processing division has only one. This method of allocation is now being questioned by the
ice-cream division personnel, whose performance evaluation is based on both productivity and cost. They
argue that all three product lines in the ice-cream division use the same equipment for most of the process.
Therefore costing based on product lines unfairly increases costs for the ice-cream division.
Both the milk processing division and the ice-cream division are willing to explore changes to the allocation
method.
Cal has gathered the following data (see Table 10) on research and development costs and hours.
Table 10: Research and development costs and hours
Budgeted research and development costs

Budget Actual
Fixed costs $ 180,000 $ 175,600
Variable costs 60,000 63,700
Total costs $ 240,000 $ 239,300
Research and development usage (hours)

Budget Actual
Milk processing division 250 455
Ice-cream division 1,100 940
Total hours 1,350 1,395
Custodial and human resources costs
Both the milk processing division and the ice-cream division receive custodial and human resource services
from within the company. While Allouette Dairy Products does not keep specific accounts for these services,
periodically Cal will allocate the appropriate administrative costs to these two pools. He then allocates these
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costs to each division in order to determine profitability. This analysis is performed on a regular basis using
the direct method.
Cal would like to review this method with management to ensure that the direct method continues to fairly
report the cost of the resources used by the milk processing and ice-cream divisions. The custodial costs are
allocated based on floor space and the human resources costs are allocated based on the percentage of use.
Unfortunately, the accounting records do not distinguish between fixed and variable costs and only total
department cost figures are available (see Table 11).
Table 11: Department costs
Custodial and human resources costs and activity driver levels

Annual Custodial (square feet Human resources
Department
cost of floor space) (% usage)
Custodial $60,000 5%
Human resources $48,000 1,000
Milk processing
64,000 50%
division
Ice-cream
35,000 45%
division
Total $108,000 100,000 100%
a. Provide two reasons why service department costs must be allocated to operating departments. (2
marks)
b. Research and development costs

Assume that it is the end of the year. Management would like data to assist in comparing actual
performance to planned performance in the milk and ice cream divisions. How much of the research
and development costs should be allocated to the ice-cream division and how much to the milk
processing division during the year based on usage? (1 mark)
c. Custodial and human resources costs

Allocate the custodial and human resource cost pools to the milk processing and ice-cream divisions
using the following methods: (6 marks)
i. Direct allocation method
ii. Step method (rank custodial costs first and then human resources costs)
iii. Reciprocal method
Cal wants to quantify the organization’s success with an analysis of the ice-cream division’s profitability. A
summary of the revenues and costs are provided in Table 12. Cal has researched several different methods
for evaluating overall performance for the division and decided to use the following three measures:
Return on investment (ROI)

Residual income (RI)
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Margin
Each of these measures provides a slightly different approach to profitability analysis. Cal wants to provide
an accurate assessment of how well the division has utilized its investment of $2,600,000 in assets. The
division expects a return of 9% on its investments.
Table 12: Revenues and costs

Ice-cream division
Litre sales 1,400,000
Sales $ 5,873,000
Manufacturing costs
Direct manufacturing costs $ 2,999,318
Manufacturing overhead 1,658,800
Total manufacturing costs 4,658,118
Gross margin $ 1,214,882
General and administrative costs $ 799,428
Net operating Income $ 415,454
a. What is meant by the terms “net operating income” and “operating assets”? (1 mark)
b. What are the three basic approaches to improving return on investment? (1 mark)
c. Compute the following: (3 marks)
i. Return on investment
ii. Residual income
iii. Margin
d. Is the ice-cream division operating profitably? Explain. (2 marks)
While most of the overhead cost drivers are easy to identify, Cal is not sure how equipment maintenance
costs should be allocated. Popular theory is split between using labour hours and machine hours. While he is
able to gather some historical data, (Table 13) he is unsure how it should be analyzed.
Table 13: Historical data
Month Equipment maintenance Labour hours Machine hours

January $ 8,650 97 491
February 9,600 98 535
March 10,100 97 574
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April 10,200 94 570

May 11,300 101 645
June 11,200 104 566
July 11,350 97 657
August 10,300 102 566
September 9,900 91 574
October 10,300 100 594
November 10,700 107 578
December 9,400 93 535
Total $123,000 1181 6885
a. Using the high-low method, develop the cost formula for predicting equipment maintenance costs
using the following: (4 marks)
i. Labour hours
ii. Machine hours
b. Costs should be allocated based on the activity that drives the total cost. While in some cases this is
easy to determine, in others it may be necessary to use regression analysis to find the activity that
drives costs. Perform a least-squares regression analysis to determine the appropriate driver for
Allouette Dairy Products’ equipment maintenance costs. Use Excel and run two separate regressions:
(5 marks)
i. one for equipment maintenance cost and labour hours
ii. one for equipment maintenance cost and machine hours
iii. Determine each driver’s goodness of fit. Which is the appropriate cost driver? Provide your
rationale. Submit Excel regression outputs.
c. Using the results of your analysis derive a cost function for maintenance expense using the cost driver
you have chosen. (1 mark)
Regression analysis: A least-squares regression analysis can be performed manually or using a software
spreadsheet. Steps to perform a regression analysis using Excel are given below.
Goodness of fit or R Square explains how much of the change in cost is explained by the independent
variable. In the Allouette Dairy Products’ case, direct labour hours and machine hours are the two
independent variables. Test each independent variable against maintenance costs to determine which drives
machine costs better.
Procedure for Part i:
1. Open the file MA1BQ8 and click the AQ8B labour hours sheet tab.
2. Study the layout of the worksheet. Rows 4 to 18 form the data table, and the rest of the worksheet is
blank.
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3. Perform a least-squares regression analysis to derive a cost formula for equipment maintenance
expense using labour hours.
4. Choose Tools>Data Analysis. If this option is not displayed on your Tools menu, under the How To
tab, click “Use software in the course,” select “Use Excel,” then select “Installing Solver Add-In and
Analysis ToolPak” and follow the instructions given to add Data Analysis.
5. Choose “Regression” and click OK. Type D5:D17 in the Input Y Range text box. This range
corresponds to the dependent or “explained” variable (Equipment maintenance expense).
6. Click the “Input X Range” text box and select the range B5:B17, which corresponds to the
independent or explanatory variable (labour hours).
The column labels are included in the range so that they appear in the regression output when the
Label option is selected. Next select "Label."
7. Select “Output Range.” Type the output range A21 in the text box and click OK to place the regression
output starting in the cell A21.
8. Cut and paste your regression analysis solution into your Word document. See the How To tab
instructions on how to insert the Excel material into your solution document.
9. Proceed to the regression analysis of the equipment maintenance expense and machine hours.
Procedure for Part ii:
1. Click on the sheet tab AQ8Bmachine hours
2. Choose Tools>Data Analysis.
3. Choose “Regression” and click OK. Type: D5:D17 in the “Input Y Range” text box. This range
corresponds to the dependent or “explained” variable (equipment maintenance expense).
4. Click the “Input X Range” text box and select the range C5:C17, which corresponds to the
independent or explanatory variable (machine hours). Select "Label."
5. Select “Output Range.” Type the output range A21 in the textbox and click OK to place the regression
output starting in cell A21.
6. Cut and paste the regression output into your solution document.
7. Compare the results obtained in Part i and Part ii, then answer Part iii and Part c.
Once the management team fully understands how the overhead is currently applied to product lines, Cal
wants to spend some time presenting an alternative approach to costing the overhead. While the vanilla ice-
cream product does not appear to be as profitable as the others, Cal feels that the current overhead
application approach does not tell the entire story. The production of vanilla ice cream consists of fewer
steps than the other flavours, yet the profit margins are lower. Cal is convinced that this is not due to
inefficiencies in the manufacturing process; instead he feels the current costing process needs to be reviewed.
He has researched activity-based costing systems and wants to demonstrate that this approach will more
Page 47 of 50
accurately cost the three product lines.
To begin the activity-based analysis, Cal decided to observe the manufacturing activities, interview the
personnel involved in operations, and map out the activities that consume the overhead resources. Based on
his findings, Cal has identified the following activity pools:
Running machines
Production scheduling
Machine setup
Product administration
Research and development
Inspection
Table 14 summarizes the ice-cream division’s activities, associated activity measures, and total costs. Table
15 provides information on the activities associated with each product.
Cal recognized that the plant lease cost is a facility sustaining cost, and as such should not be considered in
the comparison of gross margins among the three product lines. He has therefore excluded the plant lease
cost in the activity analysis.
Table 14: Budgeted activity analysis
Overhead Total
Activity measure
costs activity
Running machines 520,000 Machine hours 6,885
Production scheduling 346,090 Production runs 350
Machine setup 102,910 Machine setup hours 817
Number of product
Product administration 54,800 3
lines
Research and
188,444 Research hours 940
development
Number of
Inspection 134,556 875
inspections
Total 1,346,800
Table 15: Production activities and costs
Actual levels of activity

Vanilla Chocolate Hava Java
Machine hours 2975 2808 1102
Production runs 175 117 58
Machine setup hours 175 468 174
Number of product lines 1 1 1
Research and development 0 470 470
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Number of inspections 350 351 174
a. What are the three different methods of determining an objective rate for overhead allocation and
when is each appropriate? (3 marks)
b. Identify one benefit of activity-based costing compared with a traditional costing system. (1 mark)
c. Identify one limitation of activity-based costing. (1 mark)
d. Prepare an analysis of the overhead costs assigned to the three ice-cream flavours for the year using
the activity-based costing model. Redraft the partial income statement using activity based costing.
Use the activities that Cal has suggested. How does the activity-based gross margin compare with the
information in Table 3? Use Excel spreadsheet MA1AQ9D and the procedures below to complete this
part. (5 marks)
Procedure for completing part d:
1. Open the file MA1AQ9D.
2. The range A4 to H24 comprises the data table. The relevant data from the problem have been
reproduced here.
3. Enter the formulas in cells E31, F31, and G31 to enter the direct materials costs into the appropriate
place in the template.
4. Enter the formulas into cells E32, F32, and G32 to bring the direct labour costs into the template from
the data table. Be sure to note that the amounts are for 1000 litres.
5. Using the information contained in the data table range C17 to H22 and bearing in mind that these
amounts are based on the budgeted volume of 664,000 litres, enter the required formulas in the range
E33 to G33 to calculate the manufacturing overhead costs for each product under the activity-based
method.
6. In cells E34 to G34 enter the formulas to calculate the production costs\unit. Note that this amount
should be for 1,000 litres of each product.
7. Note that cells E38 to G38 have already been completed to calculate the selling price of 1,000 litres for
each product based on the information in the data table.
8. Enter the formulas in cells E39 to G39 to complete the template to calculate the gross margin per unit.
(Remember a unit in this case is 1,000 litres).
9. Note that the formulas have been entered in cells E40 to G40 to calculate the gross margin\unit.
10. Go to cell C48. Note that the sales amounts have already been entered. Enter the formulas into cells
D49 to F49 to calculate the cost of goods sold for the total volume.
11. Enter the formula in cell C49 to total the cost of goods sold.
12. The gross margins in cells C50 to F50 will automatically calculate. Go to cells C52 to F52 and enter
the formula to calculate the gross margin percentage. How do these percentages compare to those in
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Table 3?
13. Cut and paste cells A25 to H53 into your assignment solution.
Cal wants to give some thought to alternative performance measures, specifically the balanced scorecard
approach to addressing the key objectives and how it initiates appropriate action plans and assesses strategy.
He wants you to provide the following information for this purpose:
a. What is the balanced scorecard? (1 mark)
b. Identify the four perspectives of the balanced scorecard and for each perspective provide: (4 marks)
i. Two objectives
ii. A quantifiable measure for each of the planned objectives
Currently the sales division receives orders from customers with a lead time for delivery of about 3 to 4
weeks. As all sales are based on FOB destination, Cal anticipates a discussion regarding the production,
delivery, and sale during the last few weeks of the year with the view to have a desirable income for the year.
He thinks that there will be some pressure from some managers to adjust the timing of production, delivery,
and sales. Specifically, he thinks that if the sales of the year are expected to be within an acceptable level, the
division could delay the production, delivery, and sale to the next year. If the sales are not expected to be
within an acceptable level, the division could rush through the production and delivery before the year-end to
ensure that the sales are captured in the current year. This could even require overtime.
Discuss the ethical implications of this approach.
Drop box: Mid-term assignment

Note to supplemental, deferred and challenge examination writers:
The course examination is worth 100% of your final course mark. If you choose to participate in quizzes and
assignments, the marks you receive will not count toward your final course mark.
You must be online to view this course component.
Quiz 4
You must be online to view this course component.
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Management Accounting Fundamentals [MA1]

Module 8: Flexible budgets and decentralization

Chapter 11, pages 500-517

8.6 Prepare an income statement incorporating variance analysis.(Level 2)

8.9 Analyze variances from revenue targets. (Level 1)

Module 8: Flexible budgets and decentralization - Content Links

Chapter 11, pages 500-517

8.1 Flexible budgets

8.2 Variable overhead variances

8.3 Overhead rates and standard costing

8.4 Fixed overhead budget and volume variances

Online chapter summary

8.5 Computer illustration 8-1: Fixed costs in a flexible budget

A partially completed worksheet M8P1

1. Open the file MA1M8P1.

5. Save your completed worksheet and print a copy.

in cell C42: $360,000

8.6 Full income statement variance analysis

Notes on illustrative income statements:

8.7 Decentralization in organizations

Among other benefits, decentralization

spreads the decision-making burden

Responsibility accounting is an objective of managerial accounting that concentrates on areas of

Some ethical challenges posed by decentralization include

designing performance reporting and measurement so that it is fair to all concerned

8.8 Segment reporting

8.9 Revenue variance and marketing expense analysis

8.10 Rate of return and residual income

ROI = Margin × Turnover

Net operating income Sales

Residual income is a useful alternative method for evaluation.

Online chapter summary

Cost Cost Formula

1. a. What is the budgeted total variable cost for 15,000 machine-hours?

b. What is the budgeted total fixed cost for 20,000 machine-hours?

1. Open the file MA1M8Q1.

3. Enter the required formula in cell C57.

5. Save your completed worksheet.

6. Display the formulas in your completed worksheet.

Textbook, Problem 11-17, page 530.

Textbook, Problem 12-15, pages 592.

a. Textbook, Question 11-11, page 522.

b. Textbook, Question 11-19, page 522.

Textbook, Problem 11-15, pages 528-529.

Textbook, Problem 12-23, pages 597-598.

Textbook, Problem 12-25, pages 599-600.

Self-test - Content Links

a. The budgeted total variable cost for 15,000 machine-hours is $37,500.

b. The budgeted total fixed cost for 20,000 machine-hours is $73,000.

Budgeted machine-hours 40,000

* 86% of 50,000 MHs = 43,000 MHs

5. Efficiency Variance = SR (AH – SH)

* $30,000 × 40%, 50%, and 10% respectively

3. At least three additional points should be brought to the attention of management:

iii. Management should consider JIT deliveries to reduce warehouse costs.

1. Direct materials price and quantity variances:

Direct materials price variance = AQ (AP – SP)

Direct materials quantity variance = SP (AQ – SQ)

*20,000 units × 4 metres per unit = 80,000 metres

2. Direct labour rate and efficiency variances:

Direct labour rate variance = AH (AR – SR)

Direct labour efficiency variance = SR (AH – SH)

*20,000 units × 1.5 DLHs per unit = 30,000 DLHs