Principles of Managerial Accounting

🧭 Overview

🧠 One-sentence thesis

Managerial accounting provides customized, timely financial information to internal users—managers and employees—to support planning, decision making, and performance evaluation, unlike financial accounting which serves external parties with standardized historical reports.

📌 Key points (3–5)

• Core distinction: Financial accounting serves external groups with standardized historical reports (GAAP-compliant); managerial accounting serves internal users with customized, flexible reports that include past data, current estimates, and future projections.
• Manager responsibilities: Planning (setting goals and strategies), leading (directing daily operations), and controlling (comparing expected vs. actual results and taking corrective action).
• Four broad categories of managerial accounting: accumulating costs, analyzing costs, evaluating performance, and comparing alternatives.
• Common confusion: Not all costs are equal—some are unavoidable, others controllable; managerial accounting separates them so managers can focus on what they can influence.
• Why it matters: Limited resources force managers to choose among alternatives; managerial accounting provides the financial information needed to optimize collective outcomes and profitability.

📊 Two branches of accounting

📊 Financial accounting

Financial accounting: producing periodic reports (financial statements) to inform external groups—investors, boards of directors, creditors, government/tax agencies—about a company's financial performance and status.

• Who uses it: External parties (investors, creditors, regulators).
• What it includes: Income statement, retained earnings statement, balance sheet, statement of cash flows.
• Key characteristics: Published at fixed intervals; summarizes historical earnings and current financial position; follows Generally Accepted Accounting Principles (GAAP).
• GAAP ensures:
  • Relevant: useful and timely for making decisions.
  • Reliable: accurate and unbiased.
  • Consistent: prepared the same way each time.
  • Comparable: prepared the same way by different companies.

📊 Managerial accounting

Managerial accounting: gathering and summarizing information customized for a company's managers and employees to provide feedback for planning, decision making, and evaluation.

• Who uses it: Internal users (managers, employees).
• Format: Does not follow any particular format; uniquely designed to meet specific user needs.
• Scope: May focus on targeted segments (departments, products, territories) rather than the company as a whole.
• Timing: Published over periodic intervals or on an as-needed basis.
• Content: Includes actual financial data from past periods, current estimates, and future projections (not just historical data).
• Don't confuse: Managerial accounting is forward-looking and flexible; financial accounting is backward-looking and standardized.

🏭 Business types and operations

🏭 Three types of businesses

The excerpt classifies business operations into three types based on what they sell:

Type	What it sells	Key activity
Service	Expertise, advice, assistance, professional skills, or an experience	Delivers intangible value
Merchandising	Finished and packaged products purchased from other companies	Buys, marks up, and resells products
Manufacturing	Products assembled and packaged for sale	Assembles and packages products for merchandisers or end users

• Managerial accounting is relevant to all three types.
• The excerpt focuses on manufacturing because it involves the most in-depth facets and examples of managerial accounting.

🎯 Manager responsibilities

Managers have three core responsibilities:

1. Planning: Identifying goals and strategies for accomplishing them.
2. Leading: Directing daily operations and carrying out plans.
3. Controlling: Comparing expected and actual results and taking action for improvement.

• Resource constraints: Human, financial, and time resources are limited, so managers must select from among many alternatives and forgo other options.
• Goal: Optimize the collective outcome of their choices.
• Managerial accounting provides timely and relevant financial information that contributes to effective decision making.

💰 Costs and profitability

💰 What costs are

Cost: a current or future expenditure of cash for something that will ultimately generate revenue.

• Costs result from paying cash or committing to pay cash in the future in order to earn revenue.
• Costs may be accumulated for a product, sales territory, department, or activity.

💰 Why costs matter

• Profitability: The goal of a business is to generate profit, which is the difference between income and costs in a particular time period.
• Controlling costs directly impacts profitability: Analyzing costs is critical because it affects the bottom line.
• Uses of cost information:
  • Determine selling prices of products.
  • Monitor over time to evaluate progress and discover irregularities.
• Accuracy requirement: Costs must be determined and recorded accurately, systematically, and on a timely basis; otherwise, the information is not useful for effective planning and informed decisions.

💰 Not all costs are equal

• Some costs are unavoidable; others are somewhat controllable.
• Separating them allows managers to focus on controllable costs that should be monitored to contain or lower them.
• Example: A manager can influence spending on supplies (controllable) but may not be able to change rent (unavoidable in the short term).

🗂️ Four broad categories of managerial accounting

🗂️ Accumulating costs

• Purpose: Determine and record costs accurately, systematically, and on a timely basis.
• Methods mentioned:
  • Job order costing: A method of systematically accumulating costs on manufactured products.
  • Process costing: Another method of systematically accumulating costs on manufactured products.
  • Activity-based costing: A system combined with the other two methods to identify and measure costs more specifically.

🗂️ Analyzing costs

• Purpose: Separate unavoidable costs from controllable costs so managers can focus on what they can influence.
• Uses:
  • Mathematically determine sales required to achieve desired levels of volume and profitability.
  • Break-even analysis and other cost relationships, as well as variable costing, address these issues.

🗂️ Evaluating performance

• Budgeting: Looking into the future and estimating what a business's financial activities will look like; projects sales, costs, production, cash flows, etc. at a future point in time.
• Variance analysis: A controlling method that compares expected outcomes to actual results and analyzes overall progress in meeting goals.
• Example: A budget predicts costs of 100,000; actual costs are 110,000 → variance analysis investigates the 10,000 difference and identifies causes.

🗂️ Comparing alternatives

• Differential analysis: Compares alternatives to determine which choice will yield either the greatest benefit or the least cost.
• Decision scenarios mentioned:
  • Whether to make or buy a component part.
  • Whether to continue manufacturing a product or not.
• Capital investment analysis: A type of differential analysis that involves evaluating proposed investments in property, plant, and equipment that a company will use in its operations.
• Why it matters: Managers must choose one option over others; differential analysis provides the financial basis for these decisions.

🔑 Key terminology

🔑 Accounting as "the language of business"

• Accounting is often referred to as "the language of business" because business people communicate, evaluate performance, and determine value using dollars and amounts generated by the accounting process.
• It is the system of recording and keeping track of financial transactions in a business and summarizing this information in reports.
• These reports provide information to people interested in knowing about the financial aspects of a business and guide business managers, investors, and creditors in planning and decision making.

🔑 Period costs

• The excerpt mentions period costs but does not provide a complete definition (the sentence is cut off).
• Context: Period costs include selling and administrative expenses that are unrelated to [the excerpt ends here].

🧭 Overview

🧠 One-sentence thesis

Manufacturing companies must systematically track product costs—direct materials, direct labor, and factory overhead—to distinguish them from period costs and accurately measure the cost of goods produced and sold.

📌 Key points (3–5)

• Product costs vs. period costs: product costs attach to manufactured goods (direct materials, direct labor, factory overhead); period costs (selling and administrative) are expensed immediately and do not attach to inventory.
• Direct vs. indirect costs: direct costs (materials and labor) can be traced to specific products; indirect costs (factory overhead) are general factory expenses that cannot be traced to individual units.
• Two composite cost categories: prime cost = direct materials + direct labor; conversion costs = direct labor + factory overhead.
• Common confusion: factory overhead is not the same as selling/administrative expenses—overhead is incurred inside the factory but cannot be traced to specific products; selling/administrative expenses occur outside the production area.
• Three inventory stages: materials (not yet used), work in process (started but incomplete), and finished goods (complete but unsold) appear as current assets until sold.

💰 Product costs vs. period costs

💰 What is a cost

A cost is a current or future expenditure of cash for something that will ultimately generate revenue.

• In manufacturing, many costs relate to products that are ultimately sold to customers.
• The key distinction is whether the cost attaches to inventory or is expensed immediately.

📦 Product costs

Product costs are incurred when a company manufactures goods.

• These costs become part of the manufactured item's overall cost.
• They are recorded as inventory (an asset) until the goods are sold.
• When sold, product costs move from the Finished Goods inventory account to the Cost of Goods Sold expense account on the income statement.
• Product costs may be classified as either direct or indirect.

📄 Period costs

Period costs include selling and administrative expenses that are unrelated to the production process in a manufacturing business.

• Selling expenses: incurred to market products and deliver them to customers.
• Administrative expenses: support services not directly related to manufacturing or selling (e.g., accounting department, human resources, president's office).
• These may include utilities, insurance, property taxes, depreciation, supplies, maintenance, salaries, etc., incurred outside the factory production area.
• Period costs are expensed immediately in the period incurred; they do not attach to inventory.

Don't confuse: Factory overhead (a product cost) vs. selling/administrative expenses (period costs)—both may include similar items like utilities or salaries, but overhead is incurred inside the factory and attaches to products; selling/administrative expenses occur outside production and are expensed immediately.

🏭 The three product costs

🪵 Direct materials

Direct materials are raw materials that will be used to create finished goods.

• Their cost becomes part of the product that customers ultimately purchase.
• Example: In a kitchen cabinet manufacturer, direct materials include wood, hinges, and hardware.

👷 Direct labor

Direct labor is the cost of hourly wages of production workers who assemble manufactured goods.

• These employees work on products that are sold to customers when finished.
• Example: Wages of factory employees who assemble the cabinets.

🔧 Factory overhead

Factory overhead is an indirect cost and includes ANY expense in a factory that is not specifically traced to products that customers purchase.

• These may be general expenses: utilities, insurance, property taxes, depreciation, supplies, maintenance, supervisor salaries, and expired prepaid items.
• Factory overhead also includes any materials or labor that do not become part of a manufactured product.
• Example: Electricity and water bills, insurance premiums, roof repair, depreciation of machinery, materials used to build shelves in the factory, and wages of factory workers to assemble those shelves.

Why it's indirect: These costs are necessary for production but cannot be attributed to any specific product unit.

🔢 Direct vs. indirect classification

🎯 Direct costs

Direct costs are expenditures in a factory that can be specifically traced to a manufactured item and that become part of its overall cost.

• Includes direct materials and direct labor.
• "Traced" means you can identify exactly how much of the cost went into each unit.

🌐 Indirect costs

Indirect costs are also incurred in a factory where production takes place, but they are more general and cannot be attributed to any specific product.

• Factory overhead is the primary indirect cost category.
• These costs support production but are shared across all units produced.

🧮 Composite cost categories

🔩 Prime cost

Prime cost = direct labor + direct materials

• Represents the costs that can be directly traced to the product.
• Example: If direct materials cost $700 and direct labor is $500, prime costs = $700 + $500 = $1,200.

⚙️ Conversion costs

Conversion costs = direct labor + factory overhead

• Represents the costs to convert raw materials into finished goods.
• Example: If direct labor is $500 and factory overhead is $300, conversion costs = $500 + $300 = $800.

📊 Total product cost

• Total product cost = direct materials + direct labor + factory overhead.
• Example: $700 + $500 + $300 = $1,500.

Cost category	Formula	Example amount
Prime cost	Direct materials + Direct labor	$1,200
Conversion costs	Direct labor + Factory overhead	$800
Total product cost	Direct materials + Direct labor + Factory overhead	$1,500

Note: Direct labor appears in both prime cost and conversion costs because it is both a direct cost and part of the conversion process.

📦 Inventory stages and financial reporting

📦 Three inventory types

A manufacturer reports product costs as one of three types of inventory in the current assets section of its balance sheet, depending on stages of completion:

1. Materials: items in inventory that have not yet been entered into production or used.
2. Work in process: manufactured products that have been started but are not yet completed (currently in production).
3. Finished goods: manufactured products that have been completed but not yet sold to customers.

💼 Balance sheet presentation

• All three inventory accounts appear in the current asset section.
• Example: Materials $18,000 + Work in process $31,000 + Finished goods $26,000 = Total inventory $75,000.

📈 Income statement flow

• When manufactured items are sold, their costs are removed from the Finished Goods inventory account and transferred to the Cost of Goods Sold expense account on the income statement.
• Cost of Goods Sold represents the amount a company paid for the manufactured items that it sold.
• Cost of Goods Sold is matched with Sales on the first two rows of the income statement.
• The difference between Sales and Cost of Goods Sold is gross profit, which is the amount of markup on the manufactured goods.
• The income statement also includes selling and administrative expenses (period costs), which are non-factory costs.

Flow summary: Materials → Work in process → Finished goods → Cost of Goods Sold (when sold).

🧭 Overview

🧠 One-sentence thesis

Manufacturers track product costs through three inventory stages—materials, work in process, and finished goods—and transfer costs systematically from one account to the next until products are sold and become cost of goods sold.

📌 Key points (3–5)

• Three inventory types: Materials (not yet used), Work in Process (started but incomplete), and Finished Goods (completed but unsold).
• Cost flow sequence: costs move from Materials → Work in Process → Finished Goods → Cost of Goods Sold as production progresses and products are sold.
• Statement of cost of goods sold: a separate detailed statement calculates the final Cost of Goods Sold amount that appears on the income statement.
• Common confusion: inventory balances vs. amounts transferred—beginning + additions - ending = amount transferred out of each inventory account.
• Why it matters: tracking these flows gives managers critical information for purchasing, pricing, budgeting, and production scheduling.

📦 The three inventory accounts

📦 Materials

Materials: items in inventory that have not yet been entered into production or used.

• These are raw inputs waiting to be used.
• They appear as a current asset on the balance sheet.
• Example: wood, screws, and hardware for cabinets that have been purchased but not yet moved into production.

🔧 Work in Process

Work in Process: manufactured products that have been started but are not yet completed; currently in production.

• Goods that are partially finished.
• They accumulate direct materials, direct labor, and factory overhead costs while in production.
• Example: cabinets that have been cut and partially assembled but not finished.

✅ Finished Goods

Finished Goods: manufactured products that have been completed but not yet sold to customers.

• Fully manufactured items waiting for sale.
• Once sold, their costs move out of Finished Goods and into Cost of Goods Sold.
• Example: completed cabinets ready for delivery but still in the warehouse.

📊 Financial reporting structure

📊 Balance sheet presentation

• All three inventory accounts appear in the current assets section.
• The excerpt shows Jonick Company's balance sheet with:
  • Materials: $18,000
  • Work in Process: $31,000
  • Finished Goods: $26,000
  • Total inventory: $75,000
• These are snapshot balances at the end of the reporting period (June 30, 2019).

📊 Income statement presentation

• Sales appears first.
• Cost of Goods Sold is subtracted to calculate Gross Profit.
• Selling and administrative expenses (period costs, non-factory costs) are subtracted as operating expenses to arrive at Net Income.
• The excerpt shows Jonick Company's income statement:
  • Sales: $300,000
  • Cost of Goods Sold: $140,000
  • Gross Profit: $160,000
  • Operating expenses: $110,000
  • Net Income: $50,000

📊 Statement of cost of goods sold

• A separate, detailed statement calculates the $140,000 Cost of Goods Sold that appears on the income statement.
• It is "too detailed and lengthy to present directly on the income statement," so it is prepared separately.
• It shows how costs flow through all three inventory accounts during the period.

🔄 Cost flow mechanics

🔄 The general equation

Beginning inventory balance + additions during the month – ending inventory balance = amount transferred out

• This equation applies to all three inventory accounts.
• Beginning and ending balances come from physical inventory counts (known values).
• Additions come from purchase orders (for Materials) or production reports (for Work in Process and Finished Goods).
• The amount transferred out must be solved algebraically.

🔄 Materials flow

Equation:

• Beginning Materials: $16,000
• Purchases during June: $59,000
• Ending Materials: $18,000
• Materials used and transferred to Work in Process: $57,000

Ledger entries:

• Debit (increase): beginning balance $16,000 + purchases $59,000 = $75,000
• Credit (decrease): materials moved to production $57,000
• Ending balance: $18,000

Don't confuse: the $75,000 "cost of materials available to use" is not what was used; subtract ending inventory to find the $57,000 actually transferred.

🔄 Work in Process flow

Equation:

• Beginning Work in Process: $42,000
• Materials, labor, and overhead added: $121,000
  • Direct materials used: $57,000
  • Direct labor: $40,000
  • Factory overhead: $24,000
• Ending Work in Process: $31,000
• Work in Process completed and transferred to Finished Goods: $132,000

Ledger entries:

• Debits (increases): beginning $42,000 + materials $57,000 + labor $40,000 + overhead $24,000 = $163,000 total
• Credit (decrease): completed work $132,000
• Ending balance: $31,000

Key term from the statement: "Cost of goods manufactured" = $132,000 (the amount completed and moved to Finished Goods).

🔄 Finished Goods flow

Equation:

• Beginning Finished Goods: $34,000
• Work in Process completed during June: $132,000
• Ending Finished Goods: $26,000
• Finished Goods sold and transferred to Cost of Goods Sold: $140,000

Ledger entries:

• Debits (increases): beginning $34,000 + completed work $132,000 = $166,000 total
• Credit (decrease): cost of product sold $140,000
• Ending balance: $26,000

Key term from the statement: "Cost of goods available for sale" = $166,000 (the total that could have been sold).

🔄 Cost of Goods Sold

• This is an expense account, not an inventory account.
• The $140,000 transferred from Finished Goods becomes the Cost of Goods Sold on the income statement.
• Ledger entry: Debit (increase expense) $140,000.
• This amount is matched with Sales to calculate Gross Profit.

🎯 Why this tracking matters

🎯 Management decision support

The excerpt states this information is "critical to managers in manufacturing companies" for:

• Purchasing decisions: knowing how much material was used helps plan future purchases.
• Determining selling prices: understanding total product cost (materials + labor + overhead) allows proper markup.
• Preparing sales budgets: tracking finished goods and cost of goods sold informs revenue planning.
• Scheduling production: monitoring work in process helps balance production flow.

🎯 Tracking the manufacturing process

• The accumulation and transfer of costs "track the manufacturing process from beginning to end, when the products are sold."
• Each stage (Materials → Work in Process → Finished Goods → Cost of Goods Sold) reflects a physical stage of production and sale.
• Example: wood enters as Materials, becomes part of Work in Process when cut and assembled, moves to Finished Goods when complete, and finally becomes Cost of Goods Sold when sold to a customer.

📋 Summary comparison table

Inventory Account	What it contains	When costs enter	When costs leave	Where costs go next
Materials	Items not yet used in production	Purchases	Moved to production	Work in Process
Work in Process	Partially completed products	Materials + labor + overhead added	Completion	Finished Goods
Finished Goods	Completed but unsold products	Completed work transferred in	Sale	Cost of Goods Sold (expense)
Cost of Goods Sold	Expense for sold products	Sale of finished goods	Reported on income statement	Matched with Sales

🧭 Overview

🧠 One-sentence thesis

Job order costing tracks production costs for unique or batch-specific items by accumulating direct materials, direct labor, and factory overhead in the Work in Process account until products are completed and sold.

📌 Key points (3–5)

• What job order costing is for: tracking costs for unique items or batches where each customer's order differs (e.g., custom cabinets with different sizes, finishes, hardware).
• The three production costs: direct materials, direct labor, and factory overhead—all accumulate in the Work in Process account as debits.
• How costs flow: costs move from Materials and Wages Payable into Work in Process, then to Finished Goods when complete, and finally to Cost of Goods Sold when sold.
• Common confusion: factory overhead is estimated and applied to Work in Process (not actual overhead at the time of application), because actual bills may not yet be known.
• Why it matters: this cost accumulation provides managers with information to make purchasing decisions, set selling prices, prepare budgets, and schedule production.

🏷️ What job order costing is and when to use it

🏷️ Definition and purpose

Job order costing: a method of cost accumulation used for items or batches that are unique—each customer's order is different.

• It is not for mass-produced identical items; it is for custom or batch-specific products.
• Each single order or batch is called a job and receives a unique identification number (e.g., "Job 15").
• Example: A homeowner orders custom kitchen cabinets with specific sizes, wood choices, finishes, and hardware—no two orders are alike, so each job accumulates different costs.

🏷️ Single orders vs batch orders

• Single order: one customer's unique product (e.g., one homeowner's kitchen).
• Batch order: multiple identical units for one customer (e.g., a home builder ordering 10 identical cabinet sets for 10 homes).
• Both are treated as a single job with one job number.

🩺 Analogy: patients in a doctor's office

• Just as each patient has different symptoms and receives different treatments, medications, and tests, each job accumulates different amounts of materials, labor, and overhead.
• Each patient's total medical bill is like a "tab"; similarly, the Work in Process account is the "tab" for a manufactured item.

🧱 The three costs of production

🧱 Overview of the three costs

All three costs accumulate in the Work in Process account as debits:

Cost	What it is	How it enters Work in Process
Direct materials	Materials that become an integral part of the product sold to the customer	Requisitioned from stockroom; moved from Materials account (credit) to Work in Process (debit)
Direct labor	Work done directly by factory laborers on items sold to customers	Wages Payable (credit) to Work in Process (debit)
Factory overhead	All other factory expenses (indirect materials, indirect labor, utilities, maintenance, insurance, depreciation, etc.)	Applied (estimated) from Factory Overhead account (credit) to Work in Process (debit)

🪵 Direct materials (first debit to Work in Process)

• Materials costing $5,000 are requisitioned from the stockroom and brought to the production area.
• Journal entry:
  • Debit Work in Process $5,000 (asset account increasing)
  • Credit Materials $5,000 (asset/inventory account decreasing)
• The wood, hinges, etc. move from the Materials account into Work in Process, where the cost of the manufactured item accumulates.

👷 Direct labor (second debit to Work in Process)

• Direct labor of $4,000 is recorded.
• Journal entry:
  • Debit Work in Process $4,000 (asset account increasing)
  • Credit Wages Payable $4,000 (liability account increasing)
• Labor is considered direct if a production employee is working on a product that will be sold to a customer.
• This is the second of the three production costs added to Work in Process.

🏭 Factory overhead (third debit to Work in Process)

• Factory overhead includes all factory expenses except direct materials and direct labor.
• Don't confuse: Factory overhead is not recorded as separate expense accounts (Supplies Expense, Maintenance Expense, etc.); instead, all factory expenses are debited to the Factory Overhead account.
• Factory overhead costs are indirect because they cannot be specifically traced to particular jobs but are incurred in the factory as a whole.

🏭 Recording factory overhead incurred

🏭 What goes into Factory Overhead

The Factory Overhead account is debited (increased) for any actual overhead cost incurred. Examples from the excerpt:

Transaction	Amount	Credit account
Indirect materials (e.g., wood for a factory closet)	$400	Materials
Indirect labor (e.g., production employees building a factory closet)	$300	Wages Payable
Utilities	$350	Cash
Maintenance (repairman invoice)	$200	Accounts Payable
Insurance (prepaid insurance expires)	$150	Prepaid Insurance
Depreciation on factory equipment	$100	Accumulated Depreciation

• All of these are debited to Factory Overhead (not to separate expense accounts like Utilities Expense or Maintenance Expense).
• While these expenses are in the Factory Overhead account, they are not yet part of any manufactured item.

🏭 Factory Overhead ledger example

After transactions 3–8, the Factory Overhead account shows a running balance of $1,500:

Factory Overhead
Date | Item                     | Debit | Credit | Debit Balance
-----|--------------------------|-------|--------|---------------
3.   | Indirect materials       | 400   |        | 400
4.   | Indirect labor           | 300   |        | 700
5.   | Utilities                | 350   |        | 1,050
6.   | Maintenance              | 200   |        | 1,250
7.   | Insurance                | 150   |        | 1,400
8.   | Depreciation             | 100   |        | 1,500

• At this point, Work in Process has not been debited for overhead yet; only direct materials and direct labor have been added.

🔧 Applying factory overhead to Work in Process

🔧 Why overhead is estimated

• Since all expenses associated with the period may not yet be determined and all bills not yet received, actual factory overhead is not yet known at the time costs are accumulated.
• The running balance in Factory Overhead may be incomplete (more bills may be outstanding).
• The company needs timely information about the cost of each job, so factory overhead is estimated at the time it is applied to Work in Process.

🔧 How overhead is allocated

• Factory overhead cannot be specifically traced to a particular job, so it is allocated to jobs using an activity base that estimates its consumption.
• Three common activity bases:
  1. A percentage of direct labor cost (e.g., $1,500 × 20%)
  2. Number of direct labor hours
  3. Number of machine hours

🔧 Predetermined factory overhead rate

Predetermined factory overhead rate = Estimated total factory overhead costs ÷ Estimated number of hours in the activity base

• Example from the excerpt:
  • Estimated total factory overhead: $2,000
  • Estimated direct labor hours: 200
  • Predetermined rate: $2,000 ÷ 200 = $10 per direct labor hour
• If 110 direct labor hours were actually used, factory overhead applied = 110 hours × $10 = $1,100

🔧 Journal entry to apply overhead (transaction 9)

• Debit Work in Process $1,100 (asset account increasing)
• Credit Factory Overhead $1,100 (expense account decreasing)
• This is the third debit to Work in Process.
• The Factory Overhead account is reduced by crediting it, and that expense amount is moved into Work in Process.

🔧 Work in Process ledger after all three costs

Work in Process
Date | Item                          | Debit  | Credit | Debit Balance
-----|-------------------------------|--------|--------|---------------
1.   | Materials moved to production | 5,000  |        | 5,000
2.   | Labor added to production     | 4,000  |        | 9,000
3.   | Overhead added to production  | 1,100  |        | 10,100

• Total cost of this job: $10,100 ($5,000 direct materials + $4,000 direct labor + $1,100 factory overhead)

🔧 Factory Overhead ledger after applying overhead

Factory Overhead
Date | Item                          | Debit | Credit | Balance
-----|-------------------------------|-------|--------|--------
3.   | Indirect materials            | 400   |        | 400
4.   | Indirect labor                | 300   |        | 700
5.   | Utilities                     | 350   |        | 1,050
6.   | Maintenance                   | 200   |        | 1,250
7.   | Insurance                     | 150   |        | 1,400
8.   | Depreciation                  | 100   |        | 1,500
9.   | Overhead applied to production|       | 1,100  | 400

• After applying $1,100, the Factory Overhead account has a debit balance of $400.
• Don't confuse: the $1,100 applied is an estimate; the $1,500 of actual overhead incurred may still be incomplete.

🔄 How costs flow through accounts

🔄 The manufacturing cycle

1. Purchase raw materials → Materials account (asset/inventory)
2. Requisition materials for production → Move from Materials to Work in Process (debit Work in Process, credit Materials)
3. Add direct labor → Debit Work in Process, credit Wages Payable
4. Incur factory overhead → Debit Factory Overhead, credit various accounts (Cash, Accounts Payable, Prepaid Insurance, Accumulated Depreciation, etc.)
5. Apply factory overhead → Debit Work in Process, credit Factory Overhead
6. Complete jobs → Move from Work in Process to Finished Goods (debit Finished Goods, credit Work in Process)
7. Sell finished goods → Move from Finished Goods to Cost of Goods Sold (debit Cost of Goods Sold, credit Finished Goods)

🔄 Example from the excerpt (before section 2.1)

• When products are sold, $140,000 is transferred from Finished Goods (credit) to Cost of Goods Sold (debit).
• This tracks the manufacturing process from beginning to end.

🔄 Why this matters

• The accumulation of production costs and the transfer of those costs from account to account based on stage of completion track the manufacturing process.
• This information is critical to managers in manufacturing companies who:
  • Make purchasing decisions
  • Determine selling prices
  • Prepare sales budgets
  • Schedule production

🏗️ Job order costing in practice

🏗️ Multiple jobs simultaneously

• A manufacturer may work on many jobs at once.
• Even if several jobs start at the same time, they do not necessarily complete at the same time.
• In job order costing, each job is typically worked on at its unique location on the production floor; material and labor come to the products, which remain in place.

🏗️ Example context: Roberts Wonder Wood

• The excerpt mentions a comprehensive example (section 2.2) for Roberts Wonder Wood, a factory that produces custom kitchen cabinets.
• Wood and metal hardware are the main materials.
• Roberts uses a job order costing system.
• Transactions will be recorded for six jobs in production in August.
• (The excerpt does not provide the detailed transactions for this example.)

🧭 Overview

🧠 One-sentence thesis

Job order costing tracks the three production costs—direct materials, direct labor, and factory overhead—through inventory accounts as products move from raw materials to work in process to finished goods and finally to cost of goods sold.

📌 Key points (3–5)

• Three debits to Work in Process: materials requisitioned, labor incurred, and overhead applied—these accumulate the total manufacturing cost of each job.
• Inventory flow: costs move from Materials → Work in Process → Finished Goods → Cost of Goods Sold as jobs progress through production and sale.
• Factory Overhead application: overhead is applied using a predetermined rate (estimated annual overhead ÷ estimated activity base), then adjusted later to actual overhead incurred.
• Common confusion: Factory Overhead is used only for factory expenses; selling and administrative expenses are recorded separately, not in Factory Overhead.
• Reconciling estimated vs. actual overhead: underapplied overhead (actual > applied) increases Cost of Goods Sold; overapplied overhead (actual < applied) decreases it.

🏭 The three production costs and Work in Process

🧱 First debit: Direct materials

• When materials are purchased, they go into the Materials (inventory) account.
• When materials are requisitioned for production, they move from Materials to Work in Process.
• Direct materials for specific jobs are debited to Work in Process; indirect materials (general factory use) are debited to Factory Overhead.

Example: Roberts Wonder Wood requisitions $7,560 of materials for six jobs and $270 for general factory use. The journal entry debits Work in Process $7,560 and Factory Overhead $270, crediting Materials $7,830 total.

👷 Second debit: Direct labor

• Direct labor costs for specific jobs are debited to Work in Process.
• Indirect labor (general factory support) is debited to Factory Overhead.
• Both create a liability (Wages Payable) until paid.

Example: Roberts incurs $6,330 of direct labor for the six jobs and $850 of indirect labor. Work in Process is debited $6,330; Factory Overhead is debited $850.

⚙️ Third debit: Applied overhead

• Factory overhead is applied to Work in Process using a predetermined overhead rate.
• The rate is calculated as: estimated annual factory overhead ÷ estimated annual activity base (e.g., machine hours).
• Multiply actual activity (e.g., machine hours used) by the predetermined rate to get applied overhead.

Example: Roberts estimates $27,000 overhead for 900 machine hours, so the rate is $30 per hour. The six jobs use 70 hours total, so applied overhead is 70 × $30 = $2,100, debited to Work in Process and credited to Factory Overhead.

📊 Total job cost

Total manufacturing cost of a job = Direct materials + Direct labor + Applied overhead

• All three debits to Work in Process accumulate to show the total cost.
• Analogy from the excerpt: Like three people each having a "tab" for food, drinks, and entertainment that adds up to their total night-out cost, each job has a tab for materials, labor, and overhead.

📦 Moving costs through inventory accounts

🏁 Completing jobs: Work in Process → Finished Goods

• When a job is completed, its total cost is transferred from Work in Process to Finished Goods.
• Debit Finished Goods and credit Work in Process for the sum of the three production costs for each completed job.

Example: Roberts completes Jobs 1, 2, 3, and 5. A schedule of cost of jobs completed adds up materials, labor, and applied overhead for each job, totaling $9,230. The entry debits Finished Goods $9,230 and credits Work in Process $9,230.

💰 Selling jobs: Finished Goods → Cost of Goods Sold

• Two journal entries are required for each sale:
  1. Record the revenue: debit Accounts Receivable, credit Sales (at selling price).
  2. Record the cost: debit Cost of Goods Sold, credit Finished Goods (at manufacturing cost).

Example: Roberts sells Jobs 2 and 5 for $4,100 and $5,200 (total $9,300 revenue). The manufacturing cost of those two jobs is $6,000. First entry: debit Accounts Receivable $9,300, credit Sales $9,300. Second entry: debit Cost of Goods Sold $6,000, credit Finished Goods $6,000.

📋 Schedules to organize job costs

• Schedule of cost of jobs completed: lists materials, labor, and overhead for each completed job.
• Schedule of cost of jobs sold: lists the same for jobs that were sold.
• Schedule of uncompleted jobs: shows costs accumulated so far for jobs still in Work in Process.
• Schedule of completed jobs (not sold): shows costs for jobs in Finished Goods inventory.

These schedules help determine the balances in Work in Process, Finished Goods, and Cost of Goods Sold.

🔧 Recording and adjusting Factory Overhead

📥 Accumulating actual overhead costs

• Any factory expense is debited to Factory Overhead, including:
  • Indirect materials and indirect labor
  • Utilities, maintenance, insurance, depreciation on factory equipment
  • Other costs incurred on account or paid in cash

Example: Roberts records indirect materials $270, indirect labor $850, overhead on account $440, expired prepaid insurance $370, and depreciation $840—all debited to Factory Overhead.

🔄 Applying overhead to jobs

• Overhead is applied (credited to Factory Overhead, debited to Work in Process) using the predetermined rate.
• This happens before all actual costs are known, so it is an estimate.

⚖️ Reconciling estimated to actual overhead

• Weeks or months later, when all bills are received, compare actual overhead to applied overhead.
• Underapplied overhead (actual > applied): debit Cost of Goods Sold, credit Factory Overhead for the difference.
• Overapplied overhead (actual < applied): debit Factory Overhead, credit Cost of Goods Sold for the difference.

Situation	Calculation	Adjustment entry
Underapplied	Actual $2,150 − Applied $2,100 = $50 short	Debit Cost of Goods Sold $50, Credit Factory Overhead $50
Overapplied	Applied $2,100 − Actual $2,050 = $50 excess	Debit Factory Overhead $50, Credit Cost of Goods Sold $50

Don't confuse: Work in Process is not adjusted when reconciling overhead; only Cost of Goods Sold and Factory Overhead are affected.

🏢 Distinguishing factory, selling, and administrative expenses

🏭 Factory Overhead vs. period costs

Factory Overhead: records only expenses incurred inside the factory (manufacturing costs).

Selling Expenses: costs to promote and sell products (e.g., sales staff, sales office expenses).

Administrative Expenses: costs to run the business outside of production and sales (e.g., HR, accounting, executive salaries).

• Common confusion: Not all company expenses go into Factory Overhead. Only factory-related costs are manufacturing costs; selling and administrative costs are period costs expensed immediately.

🧾 Recording expenses in multiple areas

• When a single bill (e.g., utilities, repairs, insurance, depreciation) covers factory, selling, and administrative areas, split the cost proportionally.
• Debit Factory Overhead for the factory portion, Selling Expenses for the sales portion, and Administrative Expenses for the administrative portion.

Example: A $350 utility bill is split: $200 factory, $100 selling, $50 administrative. The entry debits Factory Overhead $200, Selling Expenses $100, Administrative Expenses $50, and credits Cash $350.

🛠️ Job order costing for service companies

🧑‍⚖️ Applying job order costing to services

• Service businesses (attorneys, accountants, physicians, event planners) use job order costing when each customer or project is unique.
• Each client, customer, or patient is a separate job.
• Costs tracked: direct labor (time spent on the client), direct costs (travel, supplies specific to the project), and applied overhead (office rent, support staff, etc.).

🔍 Key difference from manufacturing

• No materials inventory for services, but there may be direct expenditures (e.g., travel, supplies) charged to a specific client.
• The same three-cost structure applies: direct costs + direct labor + applied overhead = total job cost.

🧭 Overview

🧠 One-sentence thesis

Job order costing applies to service businesses by tracking direct labor, direct costs, and applied overhead for each unique customer project, then marking up total costs to determine the selling price.

📌 Key points (3–5)

• What makes service job costing different: no materials inventory, but direct costs like travel or supplies are tracked per project.
• Cost structure: each client/project accumulates direct labor, direct project costs, and applied overhead (estimated as a percentage of direct labor).
• Two-step sale recording: first record revenue at selling price, then expense the accumulated development costs to Cost of Services.
• Overhead reconciliation: actual overhead is compared to applied overhead; differences are adjusted by debiting or crediting the Overhead account.
• Common confusion: Development Costs is an asset account that accumulates costs until the project is sold, not an immediate expense.

🎯 Service businesses and job order costing

🎯 Who uses it

• Service businesses where each customer's service and costs are unique.
• Examples from the excerpt: attorney, accountant, physician, event planner.
• Each customer, client, or patient is treated as a separate job or project.

🔧 What costs are tracked

• Direct labor: professional time at an hourly rate.
• Direct costs: expenditures directly associated with a particular project (travel, supplies, filing fees).
• Applied overhead: allocated to jobs as a percentage of direct labor cost.
• No materials inventory: unlike manufacturing, service businesses don't track raw materials or finished goods inventory.

💼 Comprehensive example walkthrough

💼 The scenario

• Creative Compton, Inc. is an advertising agency designing websites and promotional materials.
• Direct labor rate: $140 per hour.
• Overhead allocation rate: 35% of total direct labor cost.
• Markup: 60% profit on each job (selling price = cost × 1.6).

📝 Transaction 1: Recording direct labor

• Job 4 incurs 20 hours of professional direct labor time.
• Cost: 20 hours × $140 per hour = $2,800.
• Journal entry: Debit Development Costs $2,800; Credit Wages Payable $2,800.
• Development Costs is an asset account that accumulates costs for the project.

📝 Transaction 2: Recording direct project costs

• Cash paid for costs directly related to Job 4: travel $340, supplies $60, domain name filing fees $120.
• Total: $520.
• Journal entry: Debit Development Costs $520; Credit Cash $520.
• These are not overhead—they are direct costs tied to this specific project.

📝 Transaction 3: Applying overhead

• Estimated overhead: $2,800 direct labor × 35% = $980.
• Journal entry: Debit Development Costs $980; Credit Overhead $980.
• The Overhead account is an expense account that is decreasing (being applied to the job).
• Don't confuse: this is applied overhead based on an estimate, not actual overhead incurred.

💰 Recording the sale and reconciliation

💰 Calculating project cost and selling price

• Total project cost: $2,800 direct labor + $520 direct costs + $980 overhead = $4,300.
• Selling price: $4,300 × 1.6 (to include 60% markup) = $6,880.

💰 Transaction 4: Two journal entries for the sale

The excerpt emphasizes there are two journal entries for a sale:

1. Record revenue at selling price:

   • Debit Accounts Receivable $6,880; Credit Fees Earned $6,880.
   • Fees Earned is a revenue account.

2. Expense the accumulated development costs:

   • Debit Cost of Service $4,300; Credit Development Costs $4,300.
   • This reduces the Development Costs asset account and recognizes the expense.

Example: The first entry records what the customer owes; the second entry moves the accumulated project costs from the asset account to an expense account.

🔄 Transaction 5: Reconciling overhead

• Actual overhead for Job 4 is determined to be $960.
• Applied overhead (from Transaction 3) was $980.
• Difference: $980 estimated - $960 actual = $20 too much applied.
• Journal entry: Debit Overhead $20; Credit Cost of Service $20.
• Since too much overhead was applied, $20 needs to be "backed out" by debiting the Overhead account.
• The excerpt notes that Cost of Services is used as the credit account rather than Development Costs when reconciling the Overhead account.

Don't confuse: Development Costs is used during project accumulation; Cost of Services is used for the reconciliation adjustment after the sale.

📊 Key account behaviors

Account	Type	Behavior in service job costing
Development Costs	Asset	Accumulates direct labor, direct costs, and applied overhead until project is sold; then credited to expense it off
Wages Payable	Liability	Credited when direct labor is recorded
Overhead	Expense	Credited when overhead is applied to a job; debited when reconciling over-applied overhead
Cost of Service	Expense	Debited when project costs are expensed at sale; credited when adjusting for over-applied overhead
Fees Earned	Revenue	Credited when customer is invoiced for the completed project

🧭 Overview

🧠 One-sentence thesis

Process costing tracks manufacturing costs by department for large quantities of identical items produced continuously, accumulating direct materials, direct labor, and factory overhead as batches flow through each production stage until total costs are averaged over units.

📌 Key points (3–5)

• When to use process costing: for large quantities of identical items manufactured in continuous flow on a FIFO basis (e.g., cereal, phones, cars).
• How batches move: products flow department-by-department in a production line, with each department adding its own direct materials, direct labor, and factory overhead.
• Cost accumulation structure: each department has its own Work in Process account; the sum of all departmental Work in Process costs becomes the total batch cost transferred to Finished Goods.
• Common confusion: process costing vs job order costing—in process costing, products move through departments; in job order costing, materials and labor typically come to one location for each unique product.
• Key mechanism: costs are averaged over the units produced during the period to determine the cost of one item.

🏭 What process costing is and when to use it

🏭 Definition and purpose

Process costing: a method of tracking costs of manufactured items when large quantities of identical items are manufactured in a continuous flow on a first-in, first-out basis.

• Once products are completed, their overall costs are marked up and sold at a profit.
• The excerpt emphasizes identical items and continuous flow.
• Example: Cheerios cereal, iPhones, or Toyota Camrys—items that are mass-produced in batches.

🔄 How batches and units work

Batch: each time a quantity of materials is added to the first point of production to keep the work flow going.

Unit: one of the products manufactured in a batch.

• Items enter production in batches rather than individually.
• Direct costs accumulate and indirect costs are applied to the batches as they move through production processes.
• Eventually, costs are averaged over the units produced during the period to determine the cost of one item.

🆚 Process costing vs job order costing

Aspect	Process costing	Job order costing
Product type	Large quantities of identical items	Unique products
Flow	Products move department-by-department in a production line	Materials and labor typically come to the product at one location
Basis	FIFO (first in, first out)	Individual jobs

• Don't confuse: in process costing, the product moves; in job order costing, resources come to the product.

🏢 Departmental structure and cost flow

🏢 Each department as a mini-factory

• Products typically move from department to department in a "production line" format.
• Each department performs a different function and can be considered its own little business or mini-factory.
• Each department adds its own direct materials, direct labor, and factory overhead costs.

📊 Work in Process accounts by department

• These three costs accumulate in a departmental account called Work in Process – Department Name, which is like the "tab" of the manufactured item.
• There will be three debits to Work in Process for each department:
  • One for direct materials
  • One for direct labor
  • One for factory overhead

🍪 Example: cookie manufacturing

The excerpt uses a 16" chocolate chip cookie company with three departments:

Department	Order	Function
Mixing	First	Combines ingredients
Baking	Second	Bakes the mixed batter
Packaging	Third (last)	Packages finished cookies

• The process occurs on a FIFO basis: the first batch started is the first one completed.
• Each time the Mixing Department adds more ingredients, a new batch is introduced into the overall production line.

📋 Account structure and cost accumulation

📋 Departmental accounts

Each department has its own Work in Process and Factory Overhead accounts that include the department names:

Department	Work in Process account	Factory Overhead account
Mixing	Work in Process – Mixing	Factory Overhead – Mixing
Baking	Work in Process – Baking	Factory Overhead – Baking
Packaging	Work in Process – Packaging	Factory Overhead – Packaging

🔗 How costs accumulate across departments

• The batch moves from one department to the next.
• Materials, labor, and factory overhead costs are added in each department.
• The sum of the departmental Work in Process costs is the total cost of the batch that is transferred to Finished Goods.

Total cost of the batch includes Work in Process costs from all three departments:

• Work in Process – Mixing (Direct Materials + Direct Labor + Factory Overhead – Mixing)
• Plus Work in Process – Baking (Direct Materials + Direct Labor + Factory Overhead – Baking)
• Plus Work in Process – Packaging (Direct Materials + Direct Labor + Factory Overhead – Packaging)

🔄 Transfer mechanism

• A batch begins in the first department (e.g., Mixing) when materials are added.
• Once the batch is complete in one department, it is transferred to the next by:
  • Crediting Work in Process for the sending department (decreasing that asset account)
  • Debiting Work in Process for the receiving department (increasing that asset account)
• Example: once the batch is mixed, the Mixing Department credits Work in Process – Mixing and the Baking Department debits Work in Process – Baking for the same amount.

🧭 Overview

🧠 One-sentence thesis

Process costing tracks manufacturing costs by department as products flow sequentially through production, accumulating direct materials, direct labor, and factory overhead in each department's Work in Process account until the batch is complete and transferred to Finished Goods.

📌 Key points (3–5)

• How costs accumulate: Each department adds three types of costs (direct materials, direct labor, factory overhead) to its own Work in Process account as the product moves through.
• Sequential transfer: Products move from one department to the next on a FIFO basis, and the accumulated cost from the prior department becomes part of the next department's Work in Process.
• Department independence: Each department operates as its own "mini-factory" with separate Work in Process and Factory Overhead accounts that include the department name.
• Common confusion: Work in Process is an asset (inventory) account, not an expense; it increases with debits and decreases with credits as costs are added and then transferred out.
• Why it matters: The total cost of a batch equals the sum of all departmental Work in Process costs, which determines both the cost of finished goods and the cost of partially completed units for financial statements.

🏭 Department structure and accounts

🏭 Each department as a mini-factory

Each department has a different function and can be considered its own little business or mini-factory.

• The excerpt uses a cookie factory with three departments: Mixing, Baking, and Packaging.
• Products move through departments in order: Mixing → Baking → Packaging.
• Production occurs on a FIFO (first in, first out) basis: the first batch started is the first completed.
• Each new batch is introduced when the first department (Mixing) adds more ingredients.

📒 Departmental accounts

Each department maintains two accounts with the department name:

Department	Work in Process account	Factory Overhead account
Mixing	Work in Process – Mixing	Factory Overhead – Mixing
Baking	Work in Process – Baking	Factory Overhead – Baking
Packaging	Work in Process – Packaging	Factory Overhead – Packaging

• Work in Process account: accumulates the three manufacturing costs (direct materials, direct labor, factory overhead) for that department.
• The excerpt describes Work in Process as "like the 'tab' of the manufactured item."
• Don't confuse: Work in Process is an asset (inventory) account, not an expense; it holds costs until the product is transferred out.

🔄 Cost accumulation pattern in each department

🔄 Three debits to Work in Process

Every department records three types of manufacturing costs:

1. Direct materials: specific materials used in that department (debit Work in Process, credit Materials).
2. Direct labor: workers directly involved in production (debit Work in Process, credit Wages Payable).
3. Factory overhead: applied on an estimated basis to absorb the department's general factory costs like utilities, insurance, and supervisor salary (debit Work in Process, credit Factory Overhead).

• Example in Mixing Department: $4,600 direct materials + $2,100 direct labor + $1,000 factory overhead = $7,700 total debits to Work in Process – Mixing.
• Why estimated: Factory overhead is applied "on an estimated basis so that the batch absorbs a proportionate share" of general costs.

🔄 Indirect costs go to Factory Overhead

• Indirect materials and indirect labor are debited to Factory Overhead (not Work in Process) because they are not directly traceable to a specific batch.
• Example in Mixing: $400 indirect materials and $200 indirect labor are debited to Factory Overhead – Mixing.
• Later, factory overhead is applied (credited) to Work in Process to allocate these general costs to the batch.

🚚 Transferring costs between departments

🚚 Transfer journal entry

When a department completes its work on a batch, the accumulated cost is transferred to the next department:

• Debit Work in Process – [Next Department] (increasing that asset).
• Credit Work in Process – [Current Department] (decreasing that asset).
• Example: Transfer from Mixing to Baking for $7,700 means Mixing credits (decreases) its Work in Process by $7,700 and Baking debits (increases) its Work in Process by $7,700.

🚚 Four debits in downstream departments

Departments after the first one (Baking and Packaging) have four debits to Work in Process:

1. Cost transferred in from the prior department.
2. Direct materials added in this department.
3. Direct labor added in this department.
4. Factory overhead applied in this department.

• Example in Baking: $7,700 (from Mixing) + $600 (materials) + $1,400 (labor) + $500 (overhead) = $10,200 total.
• Example in Packaging: $10,200 (from Baking) + $1,100 (materials) + $3,000 (labor) + $900 (overhead) = $15,200 total.

📦 Final transfer to Finished Goods

📦 Completion of the batch

Once the batch is packed in boxes, there is nothing more the Packaging Department can do; the product is entirely complete.

• The final department (Packaging) transfers the fully accumulated cost to Finished Goods.
• Debit Finished Goods (increasing that asset).
• Credit Work in Process – Packaging (decreasing that asset).
• Example: Transfer $15,200 from Work in Process – Packaging to Finished Goods.

📦 Total cost accumulation

The manufactured goods accumulate costs all throughout the production process. The total of all these costs equals the total cost of producing the batch.

• The $15,200 in Finished Goods represents the sum of all departmental costs: Mixing ($7,700) + Baking additions ($2,500) + Packaging additions ($5,000).
• Goal of process costing: Determine the cost of the batch and the cost of each unit in the batch.

📊 Tracking and reporting responsibilities

📊 Department manager's role

The excerpt uses an analogy: if you are the Packaging Department manager, you are responsible for:

• Tracking the cost of every unit that started and passed through your department during the month.
• Figuring the total cost of each completed batch and the cost per unit.
• Determining the cost to date of batches still in production (not yet completed by month-end).
• Don't confuse: You track only your own department's costs, not the costs in other departments (they have their own managers).

📊 Monthly financial statement needs

Assuming the company prepares monthly financial statements, each department must provide monthly information about its inventory for the balance sheet.

• For completed units: determine total and per-unit costs, classified into two groups:
  • Units started in the previous month.
  • Units started in the current month.
• For partially completed units (ending work in process): accumulate costs including 100% of materials cost and a percentage of conversion costs based on completion.
• Conversion costs = direct labor + factory overhead.

📊 Two key assumptions

The excerpt states two simplifying assumptions for process costing:

1. All materials needed in a department are added when the batch is started.
2. A batch started in a department will either be completed in the same month or completed in the following month.

• These assumptions simplify the calculation of costs for partially completed units.
• Example: If materials are added at the start, a batch that is 20% complete has 100% of materials cost but only 20% of conversion costs.

🔗 Relationship to job order costing

🔗 Similar transactions

There are other process costing transactions that are similar to those for job order costing.

A process costing manufacturer also:

• Purchases materials on account.
• Records numerous factory expenses by debiting Factory Overhead (in a specific department).
• Sells goods on account and recognizes a corresponding reduction of Finished Goods inventory.
• Accounts for over-applied and under-applied factory overhead amounts.

🔗 Key difference

The only difference between the two methods is that under process costing the department name must be included whenever a Factory Overhead account is used.

• Job order costing typically uses a single Factory Overhead account.
• Process costing uses separate Factory Overhead accounts for each department (e.g., Factory Overhead – Mixing, Factory Overhead – Baking).
• Don't confuse: The journal entry mechanics are the same; only the account names differ.

📅 Month-to-month flow

📅 Three groups of products

In each department, costs are tracked for three groups:

1. Started in the previous month, completed in the current month: These were beginning work in process; they need only the remaining conversion costs to finish.
2. Started and completed in the current month: These incur 100% of materials and 100% of conversion costs in the current month.
3. Started in the current month but not completed: These become ending work in process; they have 100% of materials cost and a partial percentage of conversion costs.

📅 Timeline continuity

This third group, not finished by the end of the current month, becomes the beginning work in process for the next month, when the remaining conversion will take place to complete them.

• Example: Units that are 30% complete at the end of May become the beginning work in process for June, when the remaining 70% of conversion will occur.
• The excerpt includes a timeline illustration (not reproduced here) showing this flow from month to month.

🧭 Overview

🧠 One-sentence thesis

Process costing determines both the cost of finished goods completed during a month and the cost of partially completed work in process at month-end by tracking units through three groups and converting partial work into equivalent whole units for costing purposes.

📌 Key points (3–5)

• Three unit groups: units started last month and finished this month; units started and finished this month; units started this month but not yet finished.
• Equivalent units concept: partial units are mathematically converted to whole units separately for materials (added at start) and conversion costs (added gradually).
• Common confusion: materials vs. conversion timing—materials are assumed added when a batch starts (all-or-nothing), but conversion costs (labor + overhead) accumulate gradually based on percentage complete.
• Seven cost results: the system calculates per-unit and total costs for each group, plus total cost transferred to Finished Goods and ending work in process inventory.
• Department-level responsibility: each department manager tracks only their own department's costs, not costs from other departments.

🏭 The three unit groups

📦 Group 1: Started last month, completed this month

• These units were already in process at the beginning of the current month (beginning work in process).
• They arrived with some percentage of conversion already done.
• Example: 5,900 units that were 20% complete on May 1; the remaining 80% of conversion happens in May.

📦 Group 2: Started and completed this month

• These units go through the entire process within the current month.
• Must be calculated, not given directly.
• Two calculation methods (both yield the same answer):
  • Total completed this month minus those started last month.
  • Total started this month minus those not completed this month.
• Example: 43,300 total completed minus 5,900 from April equals 37,400 started and completed in May.

📦 Group 3: Started this month, not yet completed

• These units are partially complete at month-end and become next month's beginning work in process.
• They include 100% of materials (added at start) but only a percentage of conversion costs.
• Example: 7,300 units started in May but only 30% complete by May 31; the remaining 70% will happen in June.

🧮 Total whole units

• Sum of all three groups.
• Calculation: Group 1 + Group 2 + Group 3 = 5,900 + 37,400 + 7,300 = 50,600 total whole units.

🔄 Equivalent units of production

🧱 Equivalent units for materials

Equivalent units of production for materials: the number of units in each group that had materials added during the current month.

• Key assumption: materials are added when a batch is started (all at once, not gradually).
• Group 1 (started last month): zero equivalent units for materials in May, because materials were added in April.
• Group 2 (started and completed this month): equivalent units equal whole units (37,400), because all materials were added in May.
• Group 3 (started this month, not finished): equivalent units equal whole units (7,300), because all materials were added in May when started.
• Total: 0 + 37,400 + 7,300 = 44,700 equivalent units for materials.

⚙️ Equivalent units for conversion costs

Equivalent units of production for conversion costs: the number of whole units times the percentage of conversion (direct labor and factory overhead) that takes place in the current month.

• Conversion costs are added gradually as work progresses, not all at once.
• Uses the given percentages of completion to convert partial units to whole units.

Group 1 (started last month, completed this month):

• Already 20% complete at the start of May, so the remaining 80% happens in May.
• Calculation: 5,900 whole units times 80% equals 4,720 equivalent units.

Group 2 (started and completed this month):

• 100% of conversion happens in May.
• Calculation: 37,400 whole units times 100% equals 37,400 equivalent units.

Group 3 (started this month, not finished):

• Only 30% of conversion happens in May; the remaining 70% will happen next month.
• Calculation: 7,300 whole units times 30% equals 2,190 equivalent units.

Total: 4,720 + 37,400 + 2,190 = 44,310 equivalent units for conversion costs.

🪣 Analogy: the rain bucket example

• You have 8 one-gallon buckets, each 3/4 full of rainwater.
• Mathematically, 8 buckets at 3/4 full equals 6 buckets at 100% full (8 times 3/4 equals 6).
• It's unlikely the rain filled one bucket at a time, but after the rain you could combine the water to fill 6 buckets completely.
• Similarly, partial units in process costing are converted to equivalent whole units for easier costing.

💰 Cost calculations

💵 Four preliminary cost calculations

Before determining the seven final cost results, calculate these four amounts:

Item	Calculation	Result
Total conversion costs in May	Direct labor ($589,323) + Factory overhead ($314,601)	$903,924
Conversion cost per equivalent unit	Total conversion cost ($903,924) ÷ Equivalent units (44,310)	$20.40 per unit
Materials cost per unit started in May	Total materials cost ($599,427) ÷ Units started (44,700)	$13.41 per unit
Cost per unit of work in process on May 1	Total work in process cost ($102,896) ÷ Units (5,900)	$17.44 per unit

🎯 The seven cost results (goals of process costing)

These amounts are the primary outputs of the process costing system and are used to track progress and make comparisons over time.

1. Cost per unit of finished goods started in April and completed in May:

• Includes the beginning work in process cost per unit plus the remaining conversion cost.
• Calculation: $17.44 + ($20.40 times 80%) = $17.44 + $16.32 = $33.76 per unit.

2. Total cost of all finished goods started in April and completed in May:

• Calculation: $33.76 (from #1) times 5,900 whole units = $199,184.

3. Cost per unit of finished goods started and completed in May:

• Includes full materials cost plus full conversion cost.
• Calculation: $13.41 + $20.40 = $33.81 per unit.

4. Total cost of all finished goods started and completed in May:

• Calculation: $33.81 (from #3) times 37,400 whole units = $1,264,494.

5. Cost per unit of the work in process inventory on May 31:

• Includes full materials cost plus partial conversion cost (30% complete).
• Calculation: $13.41 + ($20.40 times 30%) = $19.53 per unit.

6. Total cost of the work in process inventory on May 31:

• Calculation: $19.53 (from #5) times 7,300 whole units = $142,569.

7. Total cost of units transferred to Finished Goods:

• Sum of all finished goods (Groups 1 and 2).
• Calculation: $199,184 + $1,264,494 = $1,463,678.

🔍 Don't confuse: materials vs. conversion in partial units

• Group 3 units (started but not finished) have 100% of materials cost but only 30% of conversion cost.
• Materials are added at the start (all-or-nothing assumption), so even incomplete units have full materials.
• Conversion costs accumulate gradually, so incomplete units have only a fraction of conversion costs.

📒 Journal entries and ledger account

📝 Four production journal entries for May

1. Direct materials costs incurred:

• Debit: Work in Process – Packaging Dept. $599,427 (asset account increasing).
• Credit: Materials $599,427 (asset account decreasing).

2. Direct labor costs incurred:

• Debit: Work in Process – Packaging Dept. $589,323 (asset account increasing).
• Credit: Wages Payable $589,323 (liability account increasing).

3. Factory overhead applied:

• Debit: Work in Process – Packaging Dept. $314,601 (asset account increasing).
• Credit: Factory Overhead – Packaging Dept. $314,601 (expense account decreasing).

4. Transfer of completed products to Finished Goods:

• Debit: Finished Goods $1,463,678 (asset account increasing).
• Credit: Work in Process – Packaging Dept. $1,463,678 (asset account decreasing).

📊 Work in Process ledger account summary

Date	Item	Debit	Credit	Balance
1	Beginning work in process, May 1			$102,896
2	Materials added in May	$599,427		$702,323
3	Labor added in May	$589,323		$1,291,646
4	Overhead added in May	$314,601		$1,606,247
5	Transferred to Finished Goods		$1,463,678	$142,569

• The ending balance ($142,569) matches the total cost of work in process inventory on May 31 (result #6).

🧑‍💼 Department-level responsibility

🎯 Manager's scope

• Each department manager is responsible only for tracking costs in their own department.
• Other departments have their own managers who handle their own cost accounting.
• Example: the Packaging Department manager tracks only Packaging Department costs, not costs from other departments.

🎓 Analogy: university professor grading

• A professor records exam, homework, and project grades for students in their own classes and calculates final course grades.
• The professor is responsible for all students in their classes (e.g., 160 students in four classes).
• The professor does not calculate final course grades for all students in all classes at the university—other professors handle their own students.
• Similarly, a department manager handles their own department's costs, not the entire factory's costs.

🧭 Overview

🧠 One-sentence thesis

Companies must allocate factory overhead accurately to determine true product costs, and the choice of allocation method—single factory-wide rate, departmental rates, or activity-based costing—directly affects the precision of cost estimates and management decisions.

📌 Key points (3–5)

• Why overhead allocation matters: Direct materials and labor are traceable, but factory overhead is indirect and must be allocated on an estimated basis to determine product costs for pricing and decisions.
• Three allocation methods: single factory-wide rate (same rate everywhere), departmental rates (different rates per department), and activity-based costing (different rates per activity/process).
• The precision problem: A single factory-wide rate is simple but assumes all departments and products consume overhead identically—a "one-size-fits-all" approach that may not be accurate.
• Common confusion: The journal entry records estimated overhead applied to Work in Process, not actual overhead incurred; the estimate's accuracy depends on the allocation method chosen.
• Illustration approach: The excerpt uses two custom wood furniture jobs (with known direct materials and labor) manufactured in Cutting and Assembly departments to compare the three methods.

🏭 Why factory overhead allocation is necessary

🧱 Product cost components

A manufacturer's product costs consist of three parts:

• Direct materials: can be identified and traced to the product.
• Direct labor: can be identified and traced to the product.
• Factory overhead: indirect costs that cannot be directly traced and must be allocated on an estimated basis.

🎯 The allocation challenge

• Direct costs (materials and labor) are straightforward to assign.
• Factory overhead includes all indirect manufacturing costs—utilities, depreciation, indirect labor, etc.—that support production but are not tied to a single product.
• Because overhead is indirect, companies must use a predetermined rate to estimate how much overhead each product should bear.
• Example: If a job uses 210 direct labor hours and the rate is $182 per hour, the estimated overhead applied is $38,220.

📝 How overhead is recorded

The journal entry to apply estimated overhead:

• Debit Work in Process (asset/inventory account increases): the estimated overhead is added to the cost of jobs in production.
• Credit Factory Overhead (expense account decreases): the overhead "pool" is reduced by the amount applied.
• Don't confuse: This entry records the estimated overhead allocated to jobs, not the actual overhead costs incurred (which are recorded separately).

🔢 Single factory-wide rate method

🔢 How it works

Single factory-wide rate: the same predetermined overhead rate based on the same activity base (e.g., direct labor hours) is used for all departments and all products.

Calculation steps:

1. Estimate total factory overhead for the year.
2. Estimate total activity base (e.g., direct labor hours) for the year.
3. Divide total overhead by total activity base to get the rate.

📐 Example calculation

Given data:

• Total budgeted factory overhead: $546,000
• Total budgeted direct labor hours: 3,000

Rate = $546,000 ÷ 3,000 = $182 per direct labor hour

Applying to two jobs:

• Job 1: 210 hours × $182 = $38,220
• Job 2: 90 hours × $182 = $16,380
• Total overhead applied: $54,600

⚠️ Limitations of the single rate

• Assumes uniformity across departments: Each department performs different functions (e.g., Cutting vs. Assembly), but the single rate treats them identically.
• Assumes uniform consumption: All products are assumed to consume overhead at the same rate, regardless of their actual resource use.
• The excerpt calls this a "one-size-fits-all" approach that may not be as accurate as more targeted methods.
• Example: If the Cutting department is machine-intensive and Assembly is labor-intensive, using the same rate for both distorts costs.

🔄 Alternative activity bases

Instead of direct labor hours, the single rate could be based on:

• Machine hours
• Percentage of direct labor cost
• Any other relevant activity base

The choice depends on what best reflects how overhead is consumed, but the single-rate method still applies one rate across the entire factory.

🏢 Departmental rates method

🏢 How it differs

Departmental rates: different predetermined overhead rates for different departments, but a single rate within each department.

• Each department calculates its own rate based on its own overhead and activity base.
• Within a department, all products still use the same rate.
• This method recognizes that departments have different cost structures and activities.

📐 Example setup (partial)

Given data for the Cutting Department:

• Total budgeted factory overhead: $310,000
• Total budgeted direct labor hours: 2,000

Cutting Department rate = $310,000 ÷ 2,000 = $155 per direct labor hour (calculation implied; excerpt cuts off before completing the example).

The Assembly Department would have its own separate rate based on its own overhead and activity base.

🔍 Improvement over single rate

• More precise than a single factory-wide rate because it accounts for departmental differences.
• Still assumes all products within a department consume overhead uniformly.
• Don't confuse: Departmental rates are more accurate than a single rate but less precise than activity-based costing, which breaks down overhead by specific activities rather than broad departments.

🎯 Activity-based costing (ABC) preview

🎯 The ABC approach

Activity-based costing: different overhead rates for different processes and activities, regardless of department.

• ABC does not rely on department boundaries; instead, it identifies specific activities (e.g., machine setup, quality inspection, material handling) that consume overhead.
• Each activity gets its own rate based on its own cost driver (the factor that causes the activity's cost to vary).
• This method aims for the highest precision by matching overhead costs to the actual activities that drive them.

🔄 Comparison of the three methods

Method	Rate structure	Assumption	Precision
Single factory-wide	One rate for entire factory	All departments and products consume overhead identically	Lowest; simple but may distort costs
Departmental rates	One rate per department	Products within a department consume overhead uniformly	Moderate; accounts for departmental differences
Activity-based costing	One rate per activity/process	Overhead is driven by specific activities, not departments	Highest; matches costs to actual resource consumption

📚 Illustration context

The excerpt uses two custom wood furniture jobs to compare the three methods:

• Both jobs have known direct materials and direct labor costs.
• Only factory overhead must be estimated.
• Jobs are manufactured in a factory with two departments: Cutting and Assembly.
• The comparison will show how each method produces different overhead estimates for the same jobs.

🧭 Overview

🧠 One-sentence thesis

The single factory-wide overhead rate applies the same predetermined rate to all departments and products, offering simplicity but potentially sacrificing accuracy because it assumes uniform overhead consumption across different functions and jobs.

📌 Key points (3–5)

• What the single rate does: allocates factory overhead using one predetermined rate based on a single activity base (e.g., direct labor hours) across the entire factory.
• How to calculate it: divide total budgeted factory overhead by total budgeted activity base (e.g., direct labor hours).
• Key assumption: all departments and all products consume factory overhead at the same rate—a "one-size-fits-all" approach.
• Common confusion: the single rate is simple to apply but may not be as accurate as departmental or activity-based methods because different departments perform different functions and products may consume overhead differently.
• Why it matters: the method chosen affects how overhead costs are allocated to individual jobs, influencing product costing and pricing decisions.

🧮 How the single factory rate works

🧮 Calculating the predetermined rate

Single factory overhead rate: total budgeted factory overhead divided by total budgeted activity base.

• The excerpt uses direct labor hours as the activity base.
• Formula in words: divide total budgeted factory overhead costs by total budgeted direct labor hours.
• Example from the excerpt: $546,000 total budgeted overhead ÷ 3,000 total budgeted direct labor hours = $182 per direct labor hour.

🔧 Applying the rate to jobs

• Once the rate is determined, multiply it by the actual activity base used for each job.
• Example from the excerpt:
  • Job 1 uses 210 direct labor hours × $182 = $38,220 overhead
  • Job 2 uses 90 direct labor hours × $182 = $16,380 overhead
  • Total overhead applied: $54,600

📝 Recording the allocation

• The journal entry debits Work in Process (an asset/inventory account that increases) and credits Factory Overhead (an expense account that decreases).
• Example: debit Work in Process $54,600; credit Factory Overhead $54,600.

⚖️ Strengths and limitations

✅ Simplicity advantage

• The single factory-wide rate is relatively simple to apply.
• One rate is used uniformly across all departments and all products.
• Less calculation effort compared to more complex methods.

⚠️ Accuracy trade-offs

The excerpt identifies two key assumptions that may reduce precision:

Assumption	Why it may be inaccurate
Same rate across all departments	Each department performs different functions, so overhead consumption likely varies
All products consume overhead at the same rate	Different products may use resources differently, but the single rate treats them identically

• The excerpt calls this a "one-size-fits-all" approach.
• It may not be as accurate as other more targeted methods of estimating (such as departmental rates or activity-based costing).

🔄 Alternative activity bases

• The excerpt notes that instead of direct labor hours, other activity bases could be used:
  • Machine hours
  • Percentage of direct labor
  • Other relevant activity bases
• The choice of activity base should reflect what drives overhead costs, but the single-rate method still applies the same rate factory-wide regardless of which base is chosen.

🧩 Context: why overhead allocation matters

🧩 The overhead allocation problem

• Manufacturers' product costs consist of three components: direct materials, direct labor, and factory overhead.
• Direct materials and direct labor are direct costs that can be identified and traced to the product.
• Factory overhead consists of indirect costs that must be allocated to product cost on an estimated basis.
• The challenge: determining how precise the estimate actually is.

🎯 Three allocation methods compared

The excerpt introduces three approaches to allocating factory overhead, in order of increasing complexity and precision:

1. Single factory-wide rate (this section): the same rate based on the same activity base for all departments.
2. Departmental rates: different rates for different departments, but a single rate within each department.
3. Activity-based costing: different rates for different processes and activities, regardless of department.

• Don't confuse: the single factory rate is the simplest method, but the excerpt hints that more targeted methods (departmental or activity-based) may provide better accuracy by recognizing differences in how departments and products consume overhead.

🧭 Overview

🧠 One-sentence thesis

Using separate predetermined overhead rates for each department allocates factory overhead more precisely to individual jobs than a single factory-wide rate, though it requires more calculation effort.

📌 Key points (3–5)

• What departmental rates are: each department has its own predetermined overhead rate based on its own budgeted overhead and activity base.
• How they differ from single factory rates: departmental rates assign different amounts of overhead to the same job depending on which department does the work; single rates apply one uniform rate everywhere.
• Why departmental rates are more accurate: they are more job-specific because they reflect the different overhead consumption patterns in each department.
• Common confusion: total overhead applied can be the same under both methods, but the allocation per job differs—departmental rates redistribute overhead more precisely.
• Trade-off: departmental rates require more calculation effort than the simpler single factory rate.

🏭 How departmental rates work

🧮 Calculating the rate for each department

Each department calculates its own overhead rate using the formula:

Departmental factory overhead rate = Budgeted departmental factory overhead ÷ Departmental budgeted activity base

• The excerpt uses direct labor hours as the activity base in both departments.
• Cutting Department: $310,000 budgeted overhead ÷ 2,000 budgeted direct labor hours = $155 per direct labor hour.
• Assembly Department: $236,000 budgeted overhead ÷ 1,000 budgeted direct labor hours = $236 per direct labor hour.
• Notice the rates differ significantly ($155 vs. $236), reflecting different overhead consumption in each department.

🔧 Applying overhead to jobs

• Each job passes through one or more departments and uses a certain number of direct labor hours in each.
• Multiply the hours used in each department by that department's rate, then sum across all departments for the job's total overhead.
• Example from the excerpt:
  • Job 1 uses 135 hours in Cutting (135 × $155 = $20,925) and 75 hours in Assembly (75 × $236 = $17,700), for a total of $38,625.
  • Job 2 uses 65 hours in Cutting (65 × $155 = $10,075) and 25 hours in Assembly (25 × $236 = $5,900), for a total of $15,975.
  • Combined total overhead applied: $54,600.

📒 Journal entry

The entry to record the application of overhead is the same format as with a single rate:

• Debit Work in Process (an asset/inventory account that is increasing) $54,600.
• Credit Factory Overhead (an expense account that is decreasing) $54,600.

🔍 Comparing departmental rates to single factory rates

📊 Same total, different allocation per job

The excerpt emphasizes that although the total overhead applied can be identical under both methods, the distribution across jobs differs:

Method	Job 1	Job 2	Total
Single factory rate	$38,220	$16,380	$54,600
Departmental rates	$38,625	$15,975	$54,600

• Job 1 receives $405 more overhead under departmental rates; Job 2 receives $405 less.
• This redistribution happens because the two jobs consume departmental resources in different proportions.

⚖️ Why departmental rates are more precise

• More job-specific: departmental rates reflect the actual overhead consumption pattern in each department, rather than averaging across the entire factory.
• The excerpt states that departmental rates "result in a more precise allocation of factory overhead to the jobs."
• Don't confuse: precision does not mean the total overhead changes—it means the overhead is assigned to the right jobs more accurately.

🛠️ Trade-off: accuracy vs. simplicity

• Departmental rates: more accurate, but "take a bit more effort to calculate."
• Single factory rate: simpler and faster, but assumes all departments and all products consume overhead at the same rate—a "one-size-fits-all" approach that may not reflect reality.
• The excerpt notes that the single rate "may not be as accurate as other more targeted methods of estimating."

🧩 Context from the single factory rate method

🧩 How the single factory rate works (for comparison)

The excerpt briefly reviews the single factory rate method to set up the contrast:

• One predetermined rate is used across all departments.
• Formula: Total budgeted factory overhead ÷ Total budgeted activity base.
• Example: $546,000 budgeted overhead ÷ 3,000 budgeted direct labor hours = $182 per direct labor hour.
• Apply this rate uniformly: Job 1 uses 210 hours (210 × $182 = $38,220); Job 2 uses 90 hours (90 × $182 = $16,380); total $54,600.

🚫 Limitations of the single rate

• Assumes the same rate across all departments, even though departments perform different functions.
• Assumes all products consume factory overhead at the same rate.
• The excerpt calls this a "one-size-fits-all" approach that is "relatively simple to apply" but less accurate.

🧭 Overview

🧠 One-sentence thesis

Activity-based costing (ABC) provides more precise factory overhead allocation than single-factory or departmental rates by identifying and costing specific repetitive activities in the manufacturing process.

📌 Key points (3–5)

• Why ABC is more accurate: it analyzes identifiable activities closely rather than applying one fixed rate across all manufacturing facets, resulting in more precise overhead estimates.
• How ABC works: each repetitive activity (setups, moves, inspections, etc.) gets its own overhead rate calculated by dividing budgeted activity cost by budgeted activity base quantity.
• What gets allocated differently: the same total overhead ($54,600 in the example) is split differently between jobs under ABC vs. single-factory or departmental methods.
• Common confusion: all three methods apply the same total overhead, but ABC redistributes it more accurately—overstated costs under simpler methods for one job mean understated costs for another.
• Why precision matters: accurate overhead allocation is critical for decisions like setting selling prices.

🔍 Limitations of simpler overhead methods

🔍 Single factory rate weakness

The single factory overhead rate is a very loose estimate because it relies on one fixed dollar amount to assign factory overhead costs across the many facets, various segments, and different activities involved in the manufacturing process.

• The simplest method uses one predetermined rate for all departments, activities, and products.
• It requires only two estimates: total budgeted factory overhead and total budgeted activity base (e.g., direct labor hours, machine hours).
• Why it's imprecise: one rate cannot capture the diversity of what happens in a factory with reliable precision.
• Example: if a factory has both simple and complex jobs, a single rate treats them identically even though they consume different resources.

🏭 Departmental rates as a middle ground

• The excerpt shows departmental rates (Cutting: $155/hour; Assembly: $236/hour) yield different job costs than the single factory rate.
• More job-specific: departmental rates allocate overhead more precisely than a single rate.
• Trade-off: requires more calculation effort than applying one uniform rate to all jobs.
• Don't confuse: departmental rates are better than single rates but still less precise than ABC because they don't break down activities within each department.

🎯 How activity-based costing works

🎯 Core ABC concepts

Activity-based costing (ABC) is a more specific and more accurate way of assigning factory overhead to manufactured goods versus using single factory or departmental rates.

Key definitions:

Activity: a unit of work that consumes resources when performed by a company.

Cost object: the target of the activity (in manufacturing, the item produced); includes products, jobs, services, projects, clients, patients, customers, and contracts.

• ABC identifies activities within manufacturing that occur repeatedly.
• Each activity has its own activity base to measure usage.

🔁 Common manufacturing activities and their bases

The excerpt provides a detailed list matching activities to measurement bases:

Activity	Activity Base
Setups	Number of setups
Material moves	Number of material moves
Inspections	Number of inspections
Clean-ups	Number of clean-ups
Machine depreciation	Number of machine hours
Purchasing	Number of purchase orders
Quality control	Number of inspections
Order shipping	Number of customer orders
Electric power	Kilowatt hours used
Payroll	Number of payroll checks processed

• Each activity base directly measures how much of that activity is consumed.
• Example: if purchasing overhead is driven by purchase orders, the activity base is "number of purchase orders."

🧮 Calculating activity rates

The formula for each activity rate mirrors the single factory rate formula but at a micro level:

Activity rate = Budgeted total cost of activity ÷ Budgeted activity base quantity

Example from the excerpt (six activities):

Activity	Calculation	Activity Rate
Setups	$1,700 ÷ 34 setups	$50 per setup
Moves	$450 ÷ 30 moves	$15 per move
Inspections	$7,500 ÷ 300 inspections	$25 per inspection
Clean-ups	$1,450 ÷ 145 clean-ups	$10 per cleanup
Cutting	$39,000 ÷ 1,300 machine hours	$30 per machine hour
Assembly	$4,500 ÷ 300 direct labor hours	$15 per direct labor hour

• Note: Cutting and Assembly still use general overhead rates (machine hours and direct labor hours) for costs not tied to specific identifiable activities (utilities, maintenance, insurance, depreciation).

📊 ABC application example

📊 Two-job scenario

The excerpt illustrates ABC for a custom furniture manufacturer with two jobs:

• Job 1: batch of 300 nine-drawer wood dressers
• Job 2: batch of 160 free-standing wood clothing closets

🧾 Overhead calculation for each job

For each job, multiply the number of times each activity occurs by the activity rate, then sum all activity costs:

Job 1 (Dressers):

Activity	Rate	Usage	Cost
Setups	$50/setup	24 setups	$1,200
Moves	$15/move	20 moves	$300
Inspections	$25/inspection	140 inspections	$3,500
Clean-ups	$10/cleanup	85 cleanups	$850
Cutting	$30/machine hour	950 hours	$28,500
Assembly	$15/direct labor hour	210 hours	$3,150
Total			$37,500

Job 2 (Closets):

Activity	Rate	Usage	Cost
Setups	$50/setup	10 setups	$500
Moves	$15/move	10 moves	$150
Inspections	$25/inspection	160 inspections	$4,000
Clean-ups	$10/cleanup	60 cleanups	$600
Cutting	$30/machine hour	350 hours	$10,500
Assembly	$15/direct labor hour	90 hours	$1,350
Total			$17,100

• Combined total: $37,500 + $17,100 = $54,600
• The journal entry debits Work in Process (asset account increasing) and credits Factory Overhead (expense account decreasing) for $54,600.

🔄 Comparing the three methods

🔄 Same total, different allocation

All three methods apply the same total factory overhead ($54,600), but distribute it differently between jobs:

Method	Job 1	Job 2	Total
Single Factory	$38,220	$16,380	$54,600
Departmental	$38,625	$15,975	$54,600
ABC	$37,500	$17,100	$54,600

⚠️ Why the differences matter

• ABC is the most specific strategy: it analyzes identifiable activities closely, resulting in more precise estimates.
• Simpler methods overstate/understate: in this example, single-factory and departmental methods overstate Job 1's overhead and understate Job 2's overhead.
• Decision impact: when determining a product's selling price, it is critical to have accurate overhead allocation (the excerpt emphasizes this but is cut off).
• Don't confuse: the total overhead is always the same; ABC redistributes it more accurately based on actual resource consumption by each job.

🎯 Precision vs. effort trade-off

• Single factory rate: easiest to calculate, least precise.
• Departmental rates: moderate effort, better precision than single rate.
• ABC: most effort (tracking multiple activities), highest precision.

🧭 Overview

🧠 One-sentence thesis

Activity-based costing (ABC) produces more accurate overhead allocation than single or departmental methods because it traces costs to specific activities, leading to better pricing and decision-making.

📌 Key points (3–5)

• What differs: All three methods (single factory, departmental, ABC) apply the same total overhead, but allocate it differently between jobs.
• Why ABC is more precise: ABC analyzes identifiable activities closely, resulting in more accurate estimates of overhead elements.
• Common confusion: The other two methods can overstate overhead for some jobs and understate it for others, even though the total is the same.
• Why it matters: Sound cost information is critical for decisions like setting selling prices.

🔍 How the three methods compare

🔍 Same total, different allocation

The excerpt shows that all three overhead methods apply the same total factory overhead ($54,600), but distribute it differently between Job 1 and Job 2:

Method	Job 1	Job 2	Total
Single Factory	$38,220	$16,380	$54,600
Departmental	$38,625	$15,975	$54,600
ABC Costing	$37,500	$17,100	$54,600

• The total overhead is constant across methods.
• The split between jobs varies significantly.
• Example: Job 1 receives $38,220 under single factory but only $37,500 under ABC—a difference of $720.

⚠️ Distortions in simpler methods

The results of the other two methods in the sample problem would overstate the amount of factory overhead that is applied to Job 1 and understate the amount for Job 2.

• Both single factory and departmental methods overallocate to Job 1.
• Both underallocate to Job 2.
• Don't confuse: the total overhead is correct, but the distribution to individual jobs is distorted.

🎯 Why ABC is more specific

🎯 Activity-level analysis

ABC is the most specific strategy because it analyzes identifiable activities closely, resulting in more precise estimates of many of the elements of overall factory overhead.

• ABC breaks overhead into specific activities (setups, material transfers, inspections, cleanups, cutting, assembly).
• Each activity has its own rate based on actual usage.
• Example: Job 1 uses 24 setups at $50 per setup = $1,200; Job 2 uses 10 setups = $500.

🔬 More accurate cost tracing

• ABC traces overhead to jobs based on how much each job actually uses each activity.
• Simpler methods use broader allocation bases (e.g., total direct labor hours or machine hours).
• This leads to more precise cost estimates for each job.

💼 Impact on business decisions

💼 Pricing and profitability

When making decisions, such as determining a product's selling price, it is critical to have sound cost information.

• Inaccurate overhead allocation can lead to mispricing.
• If Job 1's overhead is overstated, its price might be set too high, making it less competitive.
• If Job 2's overhead is understated, its price might be set too low, reducing profitability.

📊 Decision quality

• Better cost information improves all cost-based decisions.
• ABC provides the most reliable foundation for pricing, product mix, and profitability analysis.
• Don't confuse: using the wrong method doesn't change total overhead, but it can lead to poor decisions about individual products.

🧭 Overview

🧠 One-sentence thesis

Activity-based costing (ABC) provides more accurate factory overhead allocation than single or departmental rates by tracing overhead to specific activities and then assigning those activity costs to products based on actual usage.

📌 Key points (3–5)

• ABC allocates overhead in two stages: first calculate a rate for each activity (total activity cost ÷ total activity usage), then multiply each product's usage by those rates.
• ABC is more precise than simpler methods: the same total overhead ($54,600 in the excerpt's comparison) is split differently between jobs—ABC avoids overstating costs for one job and understating for another.
• Common confusion—method vs total: all three methods (single rate, departmental, ABC) apply the same total overhead, but ABC redistributes it more accurately based on which activities each job actually consumes.
• Per-unit overhead calculation: after summing all activity costs for a product, divide by the number of units to get overhead cost per unit.
• Why it matters: accurate cost information is critical for pricing decisions and cost control; ABC also helps managers and accountants communicate by aligning information with actual business operations rather than just financial transactions.

🔢 The two-stage ABC calculation process

🔢 Stage 1: Calculate the activity rate for each activity

Activity rate = Budgeted overhead cost for the activity ÷ Total expected activity usage across all products.

• Each overhead activity (e.g., setups, inspections, machine hours) gets its own rate.
• The denominator is the sum of all products' usage of that activity.
• Example from the excerpt: Fabrication rate = $195,000 ÷ (1,800 dlh + 1,200 dlh) = $65 per direct labor hour.

🔢 Stage 2: Multiply usage by rate for each product

• For each product, take the quantity of each activity it uses and multiply by the activity rate.
• Sum all the activity costs for that product to get total overhead.
• Example: Golf cart total overhead = ($65 × 1,800 dlh) + ($40 × 1,600 dlh) + ($230 × 200 setups) + ($70 × 700 inspections) = $276,000.

🔢 Stage 3: Calculate per-unit overhead

• Divide the product's total overhead by the number of units budgeted.
• Example: Golf cart per-unit overhead = $276,000 ÷ 500 units = $552 per unit.

📊 Comparing ABC to other overhead methods

📊 Same total, different allocation

The excerpt shows three methods applied to two jobs:

Method	Job 1	Job 2	Total
Single factory rate	$38,220	$16,380	$54,600
Departmental rates	$38,625	$15,975	$54,600
ABC	$37,500	$17,100	$54,600

• All three methods apply the same total overhead ($54,600).
• ABC reallocates: Job 1 receives less overhead, Job 2 receives more.
• Don't confuse: ABC does not change the total overhead budget; it changes which job bears which share based on actual activity consumption.

📊 Why ABC is more accurate

"ABC is the most specific strategy because it analyzes identifiable activities closely, resulting in more precise estimates of many of the elements of overall factory overhead."

• The other two methods overstate Job 1's overhead and understate Job 2's.
• ABC traces costs to the activities that actually drive them (e.g., number of setups, inspections, machine hours).
• More accurate cost information improves pricing decisions and identifies cost-control opportunities.

🏭 ABC mechanics: the manufacturing example

🏭 Speed Rider, Inc. scenario

• Manufactures golf carts and go karts.
• Budgeted $562,000 factory overhead split into four activities: fabrication ($195,000), assembly ($160,000), setup ($138,000), inspection ($84,000).
• Plans to produce 500 golf carts and 700 go karts.

🏭 Activity usage by product

Activity	Golf cart usage	Go kart usage
Fabrication	1,800 dlh	1,200 dlh
Assembly	1,600 dlh	2,400 dlh
Setup	200 setups	400 setups
Inspection	700 inspections	500 inspections

🏭 Step-by-step calculation

1. Activity rates:
   • Fabrication: $65 per dlh
   • Assembly: $40 per dlh
   • Setup: $230 per setup
   • Inspection: $70 per inspection
2. Total overhead per product:
   • Golf cart: $117,000 + $64,000 + $46,000 + $49,000 = $276,000
   • Go kart: $78,000 + $96,000 + $92,000 + $35,000 = $301,000
3. Per-unit overhead:
   • Golf cart: $276,000 ÷ 500 = $552 per unit
   • Go kart: $301,000 ÷ 700 = $430 per unit

Don't confuse: the go kart has higher total overhead ($301,000 vs $276,000) but lower per-unit overhead ($430 vs $552) because more units are produced.

🏥 ABC beyond manufacturing: service businesses

🏥 How service businesses use ABC

"Service businesses may also use activity-based costing to allocate general overhead costs to clients, patients, and guests, also by estimating costs of activities based on their use of resources, and assigning costs to customers based on their use of activities."

• The same two-stage logic applies: estimate activity rates, then multiply by customer usage.
• Example: a hospital allocates overhead to patients based on admissions, operating room hours, medication administrations, tests, visits, cleaning days, and discharges.

🏥 Hospital patient example

A six-day hospital stay consumes the following activities:

Activity	Activity rate	Patient usage	Patient cost
Admissions	$70 per admission	1	$70
Operating room	$900 per hour	4 hours	$3,600
Medications	$25 per administration	3 × 6 days	$450
Radiology	$290 per image	2 images	$580
Diagnostic lab	$150 per test	6 tests	$900
Medical assistance	$20 per visit	6 × 6 days	$720
Cleaning/laundry	$80 per day	6 days	$480
Discharge	$100 per discharge	1	$100
Total			$6,900

• The patient's overhead cost is $6,900.
• Each activity is traced separately, just as in manufacturing.

🎯 Why ABC matters for decision-making

🎯 Better cost control

• ABC's granular approach reveals which activities drive costs.
• Managers can reduce costs by:
  • Reducing the time an activity takes.
  • Decreasing the number of times an activity occurs.
• Example: fewer setups or shorter inspection times directly lower overhead.

🎯 Improved communication and alignment

"ABC helps managers, who already view costs by activity, and accountants communicate more effectively. An activity-based system aligns organizational information with the business mission and operations rather than financial transactions."

• Traditional overhead rates focus on financial transactions (e.g., total overhead ÷ total labor hours).
• ABC aligns cost information with how managers think about operations (activities like setups, inspections, patient visits).
• This breaks down barriers between financial and operational information.

🎯 Critical for pricing

• The excerpt emphasizes: "When making decisions, such as determining a product's selling price, it is critical to have sound cost information."
• Overstating or understating overhead leads to mispriced products.
• ABC ensures each product bears its fair share of overhead based on actual resource consumption.

🧭 Overview

🧠 One-sentence thesis

Service businesses can allocate general overhead costs to customers by estimating activity costs based on resource usage and assigning those costs according to how much each customer uses each activity.

📌 Key points (3–5)

• Core idea: Service businesses (like hospitals) use ABC to allocate overhead by tracking multiple activities instead of one general overhead rate.
• How it works: Estimate an activity rate (budgeted overhead cost ÷ expected occurrences), then multiply by each customer's usage of that activity.
• Why it's better: ABC increases accuracy by budgeting multiple targeted activities that can be estimated more precisely than a single overhead rate.
• Common confusion: ABC is not just for manufacturing—service businesses apply the same logic to clients, patients, and guests.
• Management benefit: The granular approach gives better insight into cost control (e.g., reducing activity time or frequency) and helps managers and accountants communicate more effectively.

🏥 How service businesses apply ABC

🏥 The basic allocation process

Service businesses allocate general overhead costs to customers (clients, patients, guests) by:

1. Identifying activities whose costs must be shared.
2. Estimating an activity rate for each activity.
3. Tracking how much each customer uses each activity.
4. Assigning costs based on usage.

Activity-based costing for services: allocating overhead by estimating costs of activities based on their use of resources, and assigning costs to customers based on their use of activities.

• This mirrors the manufacturing approach but applies to service contexts.
• Example: A hospital identifies activities like admissions, operating room use, dispensing medications, radiology testing, diagnostic lab, medical assistance, cleaning and laundry, and discharge.

🔢 Calculating activity rates

Each activity rate is calculated as:

• Budgeted overhead cost for the activity ÷ number of occurrences expected during the year

Example from the hospital:

• Admissions: $70 per admission
• Operating room use: $900 per hour
• Dispensing medications: $25 per administration
• Radiology testing: $290 per image
• Diagnostic lab: $150 per test
• Medical assistance: $20 per visit
• Cleaning and laundry: $80 per day
• Discharge: $100 per discharge

🧮 Assigning costs to a customer

For each customer, multiply the number of times each activity occurs by the overhead rate for that activity, then sum all activity costs.

Example: A patient's six-day hospital stay:

Activity	Activity Rate	Patient Usage	Patient Cost
Admissions	$70 per admission	1 admission	$70
Operating room use	$900 per hour	4 hours	$3,600
Dispensing medications	$25 per administration	3 times/day × 6 days = 18	$450
Radiology testing	$290 per image	2 images	$580
Diagnostic lab	$150 per test	6 tests	$900
Medical assistance	$20 per visit	6 visits/day × 6 days = 36	$720
Cleaning and laundry	$80 per day	6 days	$480
Discharge	$100 per discharge	1 discharge	$100
TOTAL			$6,900

• The total overhead associated with this patient's stay is $6,900.
• Each activity's cost is calculated separately, then summed.

🎯 Why ABC is more accurate

🎯 Multiple targeted activities vs. one general rate

• Traditional approach: One general overhead rate applies to all overhead in a business.
• ABC approach: Multiple targeted activities that can be estimated more precisely.
• The excerpt emphasizes that ABC "increases the accuracy of allocating overhead" because each activity is budgeted and tracked separately.
• Don't confuse: ABC doesn't eliminate overhead—it distributes it more accurately by recognizing that different customers use different amounts of different activities.

🔍 Better insight into cost control

The granular approach gives companies better insight into ways to control product or service costs:

• Reducing the time it takes to perform an activity: e.g., shortening operating room time.
• Decreasing the number of times an activity occurs: e.g., fewer medication administrations per day.
• These levers are visible only when costs are tracked by activity, not lumped into one overhead pool.

🤝 Communication and alignment benefits

🤝 Bridging managers and accountants

• Managers already view costs by activity in their day-to-day operations.
• ABC aligns organizational information with the business mission and operations rather than financial transactions.
• The excerpt quotes: "It tears down the barriers that segregate financial information from other information."
• This means ABC helps managers and accountants communicate more effectively because both are speaking the same language—activities—rather than abstract financial categories.

🧩 Organizational alignment

• ABC aligns information with the business mission and operations, not just financial transactions.
• This makes cost data more relevant and actionable for operational decision-making.

🧭 Overview

🧠 One-sentence thesis

Cost-volume-profit analysis helps managers forecast operating income and make informed decisions by understanding how costs behave in response to changes in sales volume.

📌 Key points (3–5)

• What cost behavior means: how costs respond to changes in sales volume—variable costs change with each sale, fixed costs stay constant in total, and mixed costs have both components.
• Variable cost behavior: per-unit variable cost stays the same regardless of volume, but total variable cost rises or falls with the number of units sold.
• Fixed cost behavior: total fixed costs remain constant within the relevant range, but fixed cost per unit decreases as volume increases (leverage effect).
• Common confusion: fixed cost per unit vs. total fixed cost—total fixed cost does not change with volume, but the per-unit amount spreads thinner as more units are sold.
• Why it matters: knowing cost behavior allows managers to estimate costs, forecast income, set prices, and evaluate product decisions.

🔍 The three cost classifications

🔢 Variable costs

Variable cost: an expenditure directly associated with a sale; for each sale of a unit of product or service, one unit of variable cost is incurred.

• Variable costs only exist when there is a sale.
• The more sales, the more total variable cost.

Behavior summary:

1. Per-unit variable cost is constant regardless of the number of units sold.
   • Example: Whether 200 or 800 pizzas are sold, the cost of making each pizza is $3.
2. Total variable cost increases (or decreases) as the number of units sold increases (or decreases).
   • Example: Total variable cost is $600 for 200 pizzas and $2,400 for 800 pizzas.

Number of pizzas sold	Variable cost per pizza	Total variable cost
200	$3	$600
400	$3	$1,200
600	$3	$1,800
800	$3	$2,400

🏢 Fixed costs

Fixed costs: costs that remain the same in terms of their total dollar amount, regardless of the number of units sold.

• These are general expenditures that cannot be traced to any one item sold.
• Examples include electricity, insurance, depreciation, salary, and rent.
• Fixed costs are considered within a relevant range—they remain constant until capacity is reached.

Behavior summary:

1. Total fixed costs remain the same regardless of the level of sales.
   • Example: Whether 200 or 800 pizzas are sold, total fixed cost is $480.
2. Fixed cost per unit decreases (increases) as the number of units sold increases (decreases).
   • Example: Fixed cost per unit is $2.40 for 200 pizzas and drops to $0.60 for 800 pizzas.

Number of pizzas sold	Total fixed costs	Fixed cost per pizza	Variable cost per pizza	Total variable costs
200	$480	$2.40	$3.00	$600
400	$480	$1.20	$3.00	$1,200
600	$480	$0.80	$3.00	$1,800
800	$480	$0.60	$3.00	$2,400

Don't confuse:

• Total fixed cost does not change with volume.
• Fixed cost per unit does change—it gets smaller as volume increases.

🔀 Mixed costs

Mixed costs: costs that have both a fixed and a variable component.

• There is typically a base amount incurred even if there are no sales at all.
• There is also an incremental amount assigned to each unit sold.

Examples:

• A prepaid cell phone plan: $30 base rate for 1G of data plus $5 for each additional 300 megabytes.
• A salesperson's pay: $25,000 base salary per year plus $3 for each unit sold.
• Equipment rental: $8,000 per year plus $1 for each hour used over 10,000 hours.

For analysis, mixed costs are separated into their fixed and variable components.

🧮 Leverage and total cost per unit

🎯 What leverage means

Leverage: taking advantage of fixed costs to generate sales.

• Since a company is committed to paying fixed costs, it wants to maximize the value from doing so.
• The goal is to "get the most bang for your buck" for the fixed amount the company must pay each period.
• The more sales, the better fixed costs have been leveraged.

📉 How leverage affects cost per unit

The total cost of a batch equals total variable cost plus total fixed cost.

Cost per unit can be calculated two ways:

1. Fixed cost per unit plus variable cost per unit.
2. Total cost per batch divided by the number of units in the batch.

Both produce the same result.

Number of pizzas sold	Total cost of batch	Cost per pizza (using unit costs)	Cost per pizza (using total cost)
200	$600 + $480 = $1,080	$2.40 + $3.00 = $5.40	$1,080 / 200 = $5.40
400	$1,200 + $480 = $1,680	$1.20 + $3.00 = $4.20	$1,680 / 400 = $4.20
600	$1,800 + $480 = $2,280	$0.80 + $3.00 = $3.80	$2,280 / 600 = $3.80
800	$2,400 + $480 = $2,880	$0.60 + $3.00 = $3.60	$2,880 / 800 = $3.60

Key insight:

• The batch of 800 units generates the most sales dollars from its fixed costs and therefore leverages them most effectively.
• The more highly leveraged, the lower the fixed cost per unit.
• The $480 is spread over more units, so each unit picks up a lower amount of that $480.
• The lower the fixed cost per unit, the lower the total cost per unit—a desirable goal.

🔧 High-low method for separating mixed costs

📊 How the high-low method works

The high-low estimation method breaks out mixed costs by looking at the total sales and total cost for several periods (e.g., months).

Steps:

1. Select the month with the highest activity level and the month with the lowest activity level.
2. Calculate the variable cost per unit.
3. Use the variable cost per unit to determine fixed costs.

🧪 Example calculation

Data over six months:

Month	Units sold	Total cost
January	1,400	$52,700
February	2,100	$61,200
March	2,900	$69,800
April	2,500	$66,400
May	1,100	$48,200
June	1,800	$56,900

Step 1: Calculate variable cost per unit

Since fixed cost does not change with the number of sales, the difference between the total costs of the highest and lowest months must be variable costs.

• Variable cost per unit = Difference in total cost divided by Difference in units sold
• Variable cost per unit = ($69,800 – $48,200) / (2,900 – 1,100)
• Variable cost per unit = $21,600 / 1,800 units = $12

Step 2: Determine fixed costs

Use the equation: Total cost minus variable costs equals fixed costs.

• March: $69,800 – ($12 × 2,900) = $69,800 – $34,800 = $35,000
• May: $48,200 – ($12 × 1,100) = $48,200 – $13,200 = $35,000

Result: The high-low method estimates that variable cost per unit is $12 and fixed costs are $35,000.

🎯 What is cost-volume-profit analysis

🧩 CVP definition and purpose

Cost-volume-profit (CVP) analysis: a managerial accounting technique used to determine how changes in sales volume, variable costs, fixed costs, and/or selling price per unit affect a business's operating income.

• The focus may be on a single product or on a sales mix of two or more different products.
• Results help managers make informed decisions about products or services they sell.

📋 Key elements of CVP analysis

The excerpt defines the following elements:

• Selling price: the amount a customer pays to acquire a product or service.
• Cost: the variable and fixed expenses involved in producing or selling a product or service.
• Volume: the number of units or the amount of service sold.
• Profit: the difference between the selling price and costs (definition incomplete in excerpt).

🛠️ How managers use CVP

CVP analysis helps managers:

• Set selling prices.
• Select combinations of different products to sell.
• Project profitability.
• Determine the feasibility of offering a product or service for sale.

🧭 Overview

🧠 One-sentence thesis

Cost Volume Profit (CVP) analysis helps managers understand how changes in sales volume, costs, and selling price affect operating income, enabling informed decisions about pricing, product mix, and profitability.

📌 Key points (3–5)

• What CVP analyzes: how sales volume, variable costs, fixed costs, and selling price per unit affect operating income.
• Contribution margin is central: it shows how much of each sales dollar remains after variable costs to cover fixed costs and generate profit.
• Breakeven point answers a key question: how many units must be sold to cover all costs (operating income = zero).
• Common confusion: contribution margin ratio vs. contribution margin—the ratio is a percentage (contribution margin ÷ sales), while contribution margin is a dollar amount.
• Key assumptions: all costs are either fixed or variable; prices and costs per unit are constant; all units produced are sold.

💡 What CVP analysis is and why it matters

💡 Definition and purpose

Cost Volume Profit (CVP) analysis: a managerial accounting technique used to determine how changes in sales volume, variable costs, fixed costs, and/or selling price per unit affect a business's operating income.

• The focus may be on a single product or a mix of multiple products.
• Managers use CVP to make decisions about:
  • Setting selling prices
  • Selecting product combinations to sell
  • Projecting profitability
  • Determining whether to offer a product or service

🧩 Four elements of CVP

Element	Definition
Selling price	The amount a customer pays to acquire a product or service
Cost	The variable and fixed expenses involved in producing or selling
Volume	The number of units or amount of service sold
Profit	Selling price minus costs

📋 Key assumptions

CVP analysis rests on three assumptions:

1. All costs are categorized as either fixed or variable.
2. Sales price per unit, variable cost per unit, and total fixed cost are constant. Only changes in activity affect costs.
3. All units produced are sold.

Don't confuse: these assumptions mean CVP is a simplified model—real-world conditions may violate them (e.g., volume discounts, unsold inventory).

🎯 Contribution margin: the core metric

🎯 What contribution margin measures

Contribution margin: the amount of sales revenue remaining after variable costs are paid, available to cover fixed costs and generate profit.

• It is calculated at two levels:
  • Unit contribution margin = selling price of one unit − variable cost of one unit
  • Total contribution margin = total sales − total variable costs
• Example: if selling price per unit is $25 and variable cost per unit is $10, unit contribution margin is $15. With 1,000 units sold, total contribution margin is $15,000.

📊 Contribution margin ratio

Contribution margin ratio: the percentage of sales available to pay fixed costs, calculated as contribution margin ÷ sales.

• The ratio is the same whether you use total amounts or per-unit amounts.
• Example (using per-unit): ($25 − $10) ÷ $25 = 60%
• Example (using total): ($25,000 − $10,000) ÷ $25,000 = 60%
• Higher percentage = more of each sales dollar available to cover fixed costs.
• Managers compare the ratio to prior periods, forecasts, similar companies, or industry standards to judge performance.

🔍 How changes affect contribution margin

🔍 Change in sales volume

• As units sold increase, contribution margin ratio stays the same (assuming fixed costs remain within their relevant range).
• Example: at 1,200 units, contribution margin ratio is 60%; at 1,400 units, it is still 60%.
• Operating income increases because more contribution margin dollars are generated, but the percentage does not change.
• Don't confuse: more sales volume increases total contribution margin (dollars) but not the contribution margin ratio (percentage).

🔍 Change in selling price per unit

• An increase in selling price per unit increases both operating income and contribution margin ratio.
• Example: selling price rises from $25 to $30 per unit (variable cost per unit remains $10).
  • Original contribution margin ratio: 60%
  • Revised contribution margin ratio: 67%
  • The additional $5 per unit adds 7 percentage points to the ratio.
• A decrease in selling price would lower the ratio.

🔍 Change in variable cost per unit

• An increase in variable cost per unit decreases contribution margin and operating income.
• Example: variable cost per unit rises from $10 to $15 (selling price remains $25).
  • Original contribution margin ratio: 60%
  • Revised contribution margin ratio: 40%
  • The additional $5 per unit in variable cost lowers the ratio by 20 percentage points.
• A decrease in variable cost would increase the ratio.

🔍 Change in fixed costs

• Changes in fixed costs do not affect the contribution margin ratio.
• Fixed costs are subtracted after contribution margin is calculated, so they do not change the percentage of sales available to cover them.

🎚️ Breakeven point: covering all costs

🎚️ What breakeven means

Breakeven point: the number of units that must be sold to achieve an operating income of zero—sales in dollars equals total costs.

• At breakeven, contribution margin exactly equals fixed costs.
• The breakeven calculation answers: "How many units does the company have to sell to pay all its expenses for the period?"

🧮 Breakeven formula

Breakeven point in units = Total fixed costs ÷ (Unit selling price − Unit variable cost)

• The denominator (unit selling price − unit variable cost) is the same as unit contribution margin.
• Example: fixed costs = $8,000; selling price per unit = $18; variable cost per unit = $10.
  • Breakeven = $8,000 ÷ ($18 − $10) = $8,000 ÷ $8 = 1,000 units

📉 Interpreting the breakeven result

• Lower breakeven point is better: fewer units are needed to cover all costs.
• Once sales volume reaches the breakeven point, all fixed costs are paid.
• Every unit sold beyond breakeven generates profit equal to the unit contribution margin.
• Example: if unit contribution margin is $8 and the company sells 1,100 units (100 above breakeven), operating income is 100 × $8 = $800.

📐 Breakeven income statement

Example (at breakeven):

Line item	Amount
Sales (1,000 units × $18)	$18,000
Variable costs (1,000 units × $10)	$10,000
Contribution margin	$8,000
Fixed costs	$8,000
Operating income	$0

Note that contribution margin ($8,000) equals fixed costs ($8,000), so operating income is zero.

🧭 Overview

🧠 One-sentence thesis

The breakeven point determines how many units a company must sell to cover all costs (achieving zero operating income), and it serves as a critical benchmark for assessing business viability and profit potential.

📌 Key points (3–5)

• What breakeven measures: the number of units that must be sold so that sales in dollars equals total costs (operating income = zero).
• The breakeven formula: Total fixed costs divided by (unit selling price minus unit variable cost), which is the same as dividing by unit contribution margin.
• How to interpret the result: a lower breakeven point is better; once breakeven is reached, every additional unit sold generates profit equal to the unit contribution margin.
• Common confusion: breakeven is a relative number—it must be compared to capacity, expected sales, or industry benchmarks to assess whether the business is viable.
• Extensions of the concept: the formula can incorporate target profit (treated as additional fixed cost), handle multiple products (using weighted averages for sales mix), and apply to service businesses (e.g., room nights instead of units).

🧮 Core breakeven mechanics

🧮 What breakeven means

The breakeven point is the number of units that must be sold to achieve an operating income of zero. At the breakeven point, sales in dollars equals costs.

• It answers: "How many units does the company have to sell to pay all its expenses for the month?"
• At breakeven, contribution margin exactly equals fixed costs, leaving zero operating income.
• Example: if contribution margin is $8,000 and fixed costs are $8,000, operating income is $0.

🔢 The breakeven formula

The formula is:

Breakeven point in units = Total fixed costs ÷ (Unit selling price − Unit variable cost)

• The denominator (unit selling price minus unit variable cost) is also called the unit contribution margin.
• Example: Fixed costs = $8,000, selling price = $18, variable cost = $10 → Breakeven = $8,000 ÷ ($18 − $10) = 1,000 units per month.
• Proof: 1,000 units × $8 contribution margin = $8,000, which covers the $8,000 fixed costs.

🔍 Why the denominator matters

• The denominator is the contribution margin per unit—the amount each unit contributes toward covering fixed costs.
• A larger contribution margin (higher selling price or lower variable cost) means fewer units are needed to break even.
• Don't confuse: the numerator (fixed costs) does not change with volume, but the denominator (unit contribution margin) determines how quickly fixed costs are covered.

📊 Interpreting the breakeven result

📊 Lower is better

• A lower breakeven point means relatively fewer units of sales are needed to cover all fixed and variable costs.
• Once the breakeven volume is reached, all fixed costs have been paid; every subsequent unit sold yields profit equal to the unit contribution margin.
• Example: if breakeven is 2,400 units and you sell 2,401 units, the 2,401st unit generates $50 in operating income (if the contribution margin is $50).

🧭 Breakeven is a relative number

• The breakeven point does not have much meaning on its own; it must be compared to:
  • Expected or budgeted sales volume
  • Industry average
  • The company's capacity or ability to fulfill orders
• If the breakeven point is higher than the business's capacity, the operation is likely doomed to fail.
• A breakeven point that is at or below expectations, easy to accomplish, and/or well below capacity indicates the business will be successful.

🎯 Three scenarios (from the excerpt)

Scenario	Capacity	Expected sales	Breakeven	Operating income	Assessment
Example 1	5,000 units	4,500 units	2,400 units	$95,000 (1,900 units above breakeven × $50)	Encouraging—plenty of room above breakeven
Example 2	(same)	2,500 units	2,400 units	$5,000 (100 units above breakeven × $50)	Less appealing—almost all sales go to covering costs
Example 3	2,500 units	4,000 units	2,400 units	$5,000 (only 100 units can be produced above breakeven)	Not lucrative—capacity constraint limits profit

• Don't confuse: high expected sales are meaningless if capacity is too low, and a low breakeven is meaningless if expected sales are barely above it.

🎯 Breakeven with target profit

🎯 Adding a profit goal

• At the standard breakeven point, operating income is zero, which is rarely the goal of a for-profit company.
• An owner or manager may identify a desired operating income and add that amount to the fixed costs in the numerator, treating it as if it were an additional fixed cost.
• The question becomes: "How many units does the company have to sell to pay all its expenses for the month AND earn a profit of [target amount]?"

🔢 Modified formula

Breakeven point with target profit = (Total fixed costs + Target profit) ÷ (Unit selling price − Unit variable cost)

• Example: Fixed costs = $120,000, target profit = $50,000, selling price = $80, variable cost = $30 → Breakeven = ($120,000 + $50,000) ÷ ($80 − $30) = 3,400 units per month.
• Proof: 3,400 units × $50 contribution margin = $170,000, which covers $120,000 fixed costs + $50,000 target profit.
• The additional 1,000 units (3,400 − 2,400 original breakeven) generate the $50,000 target profit ($50 contribution margin × 1,000 units).

🔄 How changes affect breakeven

🔄 Three ways to lower breakeven

The excerpt identifies three independent changes that decrease the breakeven point (using the original example: fixed costs = $8,000, selling price = $18, variable cost = $10, breakeven = 1,000 units):

Change	Effect on contribution margin	New breakeven	Calculation
1. Increase selling price (from $18 to $20)	Increases contribution margin	800 units	$8,000 ÷ ($20 − $10) = 800
2. Decrease variable cost (from $10 to $8)	Increases contribution margin	800 units	$8,000 ÷ ($18 − $8) = 800
3. Decrease fixed costs (from $8,000 to $6,400)	Contribution margin unchanged	800 units	$6,400 ÷ ($18 − $10) = 800

• Don't confuse: changes 1 and 2 both increase the contribution margin (the denominator), while change 3 reduces the numerator but leaves the contribution margin unchanged.
• The breakeven point would increase if the direction of any of these changes were reversed (e.g., lower selling price, higher variable cost, higher fixed costs).

🛍️ Breakeven with sales mix (multiple products)

🛍️ When a company sells two or more products

• To this point, the breakeven calculation assumed a single product.
• A company that sells two different products does not necessarily sell an equal number of each.
• The first step is to determine the sales mix: the percent of overall sales each product represents.
• Each product has its own unit selling price and unit variable cost; the weighted average of each is used in the breakeven equation.

🔢 Weighted average approach

Example: A company sells hair dryers (60% of sales) and curling irons (40% of sales). Fixed costs = $25,200.

Product	Unit selling price	Unit variable cost	Percent of sales
Hair dryer	$70	$30	60%
Curling iron	$50	$20	40%

Step 1: Calculate weighted average unit selling price

• Hair dryers: $70 × 60% = $42
• Curling irons: $50 × 40% = $20
• Total: $42 + $20 = $62

Step 2: Calculate weighted average variable cost

• Hair dryers: $30 × 60% = $18
• Curling irons: $20 × 40% = $8
• Total: $18 + $8 = $26

Step 3: Calculate weighted average contribution margin

• $62 − $26 = $36 per unit

Step 4: Calculate breakeven in total units

• $25,200 ÷ $36 = 700 units per month

Step 5: Allocate to each product using sales mix percentages

• Hair dryers: 700 × 60% = 420 units
• Curling irons: 700 × 40% = 280 units

Proof: 420 × ($70 − $30) + 280 × ($50 − $20) = $16,800 + $8,400 = $25,200 (exactly the fixed costs).

🧩 Key insight

• The sales mix percentages must be maintained for the breakeven calculation to hold.
• Don't confuse: the 700 units is not 700 of each product; it is 700 total units split according to the sales mix.

🏨 Breakeven for service businesses

🏨 Same logic, different units

• A breakeven analysis can be just as useful for a service business as for a company that sells products.
• Instead of "units sold," a service business might measure "room nights," "billable hours," or other service units.

🏨 Hotel example

A 10-room boutique hotel has:

• Fixed costs: $8,000 rent + $10,000 other = $18,000 per month
• Nightly rate (selling price): $110 per room night
• Variable cost: $10 per room night (supplies and breakfast)
• Monthly capacity: 300 room nights (10 rooms × 30 days)
• Industry average occupancy: 60% (180 room nights per month)

Breakeven calculation:

• $18,000 ÷ ($110 − $10) = 180 room nights per month

Interpretation:

• The property must achieve a 60% occupancy rate just to pay its bills (operating income = $0).
• Even at the industry average, there is no profit—this is challenging for a new start-up.
• A newcomer might need time to ramp up and may struggle to reach 60% immediately.

🔄 Scenario with higher pricing

If the nightly rate increases to $190:

• Breakeven: $18,000 ÷ ($190 − $10) = 100 room nights per month
• At 50% occupancy (150 room nights), operating income = (150 − 100) × $180 = $9,000 per month.

Scenario	Nightly rate	Occupancy	Room nights	Sales	Variable costs	Contribution margin	Fixed costs	Operating income
Original	$110	60%	180	$19,800	$1,800	$18,000	$18,000	$0
Higher rate	$190	50%	150	$28,500	$1,500	$27,000	$18,000	$9,000

• Breakeven analysis is a useful tool for looking at different combinations of costs and selling prices to predict outcomes.
• It is then up to management or investors to determine the likelihood of each scenario occurring.

🧭 Overview

🧠 One-sentence thesis

Operating leverage measures how much a company's operating income will grow (or shrink) when sales change, with higher leverage meaning that a given percentage change in sales produces a larger percentage change in operating income.

📌 Key points (3–5)

• What operating leverage measures: the degree to which a company can increase operating income by increasing sales, determined by the relationship between contribution margin and operating income.
• How to calculate it: divide contribution margin by operating income; the result is a multiplier that shows how sales changes affect income.
• Key driver—fixed costs: companies with higher fixed costs (relative to operating income) have higher operating leverage and are more sensitive to sales changes.
• Common confusion: two companies with identical sales and contribution margins can have very different operating leverage if their fixed-cost structures differ.
• Why it matters: higher operating leverage means greater reward from sales growth but also greater risk from sales declines.

🔢 What operating leverage is and how to calculate it

🔢 Definition and formula

Operating leverage: the degree to which a company can increase operating income by increasing sales.

• It looks at the relationship between contribution margin and operating income.
• The difference between those two amounts is fixed costs.
• Formula (in words): Operating leverage equals contribution margin divided by operating income.

📋 Comparative example

The excerpt provides two companies with identical sales and variable costs but different fixed costs:

Item	ABC Co.	XYZ Co.
Sales	$500,000	$500,000
Variable costs	$400,000	$400,000
Contribution margin	$100,000	$100,000
Fixed costs	$80,000	$50,000
Operating income	$20,000	$50,000

• ABC Co. has higher fixed costs ($80,000 vs. $50,000), so it has lower operating income ($20,000 vs. $50,000).
• Despite identical contribution margins, the two companies will respond very differently to sales changes.

🧮 Calculating the leverage ratio

Using the formula:

• ABC Co.: $100,000 ÷ $20,000 = 5
• XYZ Co.: $100,000 ÷ $50,000 = 2

ABC Co. has an operating leverage of 5; XYZ Co. has an operating leverage of 2.

🎯 How operating leverage predicts income changes

🎯 The multiplier effect

Operating leverage results are used to determine the effect of a change in sales on operating income:

• Take the percent increase (or decrease) in sales.
• Multiply it by the operating leverage ratio.
• The result is the percent increase (or decrease) in operating income.

The higher the operating leverage, the more impact a change in sales will have on operating income.

📊 Worked example: 20% sales increase

Both companies experience a 20% sales increase (from $500,000 to $600,000, an increase of $100,000):

ABC Co. (leverage = 5):

• 20% sales increase × 5 = 100% increase in operating income
• Operating income goes from $20,000 to $40,000 (an additional $20,000)

XYZ Co. (leverage = 2):

• 20% sales increase × 2 = 40% increase in operating income
• Operating income goes from $50,000 to $70,000 (an additional $20,000)

📈 Full income statement comparison

Item	ABC Co. at $500k sales	ABC Co. at $600k sales	XYZ Co. at $500k sales	XYZ Co. at $600k sales
Sales	$500,000	$600,000	$500,000	$600,000
Variable costs	$400,000	$480,000	$400,000	$480,000
Contribution margin	$100,000	$120,000	$100,000	$120,000
Fixed costs	$80,000	$80,000	$50,000	$50,000
Operating income	$20,000	$40,000	$50,000	$70,000

• ABC Co.'s operating income doubles (100% increase).
• XYZ Co.'s operating income increases by 40%.
• Both companies add the same absolute dollar amount ($20,000), but the percentage change differs dramatically.

⚖️ Why fixed costs drive leverage differences

⚖️ The role of fixed costs

The excerpt emphasizes that the difference between contribution margin and operating income is fixed costs.

• ABC Co. has higher fixed costs ($80,000 vs. $50,000).
• This means ABC Co. has lower operating income at the same sales level.
• Lower operating income (the denominator) produces a higher leverage ratio.

🔄 The trade-off

• Higher fixed costs → higher operating leverage → greater sensitivity to sales changes.
• When sales increase, ABC Co. benefits more (100% income growth vs. 40%).
• When sales decrease, ABC Co. would suffer more (the same multiplier works in reverse).

⚠️ Don't confuse: same contribution margin ≠ same leverage

• Both companies have identical contribution margins ($100,000).
• But their operating leverage is very different (5 vs. 2).
• The key distinction is the fixed-cost structure, which determines how much of the contribution margin flows through to operating income.

Example: Two companies can have the same sales and variable costs but respond very differently to market changes if one has invested heavily in fixed assets (higher fixed costs) while the other has a more flexible cost structure (lower fixed costs).

🧭 Overview

🧠 One-sentence thesis

The margin of safety measures how far a company's actual sales exceed its breakeven point, providing a cushion against sales declines—the higher the margin, the more secure the company's position.

📌 Key points (3–5)

• What it measures: the difference between actual sales and the breakeven point; the greater the difference, the more protection against sales declines.
• Three ways to express it: as a dollar amount, a percentage, or a number of units.
• How to calculate it: subtract breakeven sales from actual sales (in units, dollars, or as a percentage of actual sales).
• Why it matters: a higher margin of safety means the company has a significant cushion and is more secure; the more it exceeds breakeven, the better.

📏 What the margin of safety measures

📏 Core definition and purpose

Margin of safety: how far above the breakeven point a company's sales are.

• It is not just "how much profit" but "how much room before profit disappears."
• The greater the difference between actual sales and breakeven, the more secure the company can feel about hedging against possible declines in sales.
• Example: if a company's actual sales are far above breakeven, a moderate sales drop will not push it into losses.

🛡️ Why it matters

• The margin of safety provides a cushion against sales volatility.
• The higher the margin of safety, and the more it exceeds the breakeven point, the better.
• A significant cushion means the company is less vulnerable to unexpected downturns.

🧮 How to calculate margin of safety

🧮 Three expressions

The margin of safety can be expressed in three ways:

Expression	What it shows	How to calculate
Units	Number of units sold above breakeven	Actual units sold − Breakeven units
Dollars	Dollar value of sales above breakeven	(Actual units × Contribution margin per unit) − (Breakeven units × Contribution margin per unit)
Percentage	Proportion of actual sales that is above breakeven	(Actual sales dollars − Breakeven sales dollars) ÷ Actual sales dollars

🔢 Worked example from the excerpt

The excerpt provides a detailed calculation:

Given:

• Breakeven point: 2,400 units per month
• Actual sales: 8,000 units
• Unit selling price: $80
• Unit variable cost: $30
• Contribution margin per unit: $50 ($80 − $30)
• Total fixed costs: $120,000

Calculations:

• Margin of safety in units: 8,000 − 2,400 = 5,600 units
• Margin of safety in dollars: (8,000 × $50) − (2,400 × $50) = $400,000 − $120,000 = $280,000
• Margin of safety percentage: ($400,000 − $120,000) ÷ $400,000 = 70%

🎯 Interpreting the result

• A margin of safety of 70% means that actual sales can drop by 70% before the company reaches its breakeven point.
• The excerpt emphasizes that this 70% gives the company a significant cushion over its breakeven point.
• Don't confuse: the percentage is calculated as a proportion of actual sales, not of breakeven sales.

🔗 Connection to breakeven analysis

🔗 Relationship to breakeven point

• The margin of safety depends directly on the breakeven point calculation.
• In the example, the breakeven point is determined by: Total fixed costs ÷ (Unit selling price − Unit variable cost) = $120,000 ÷ ($80 − $30) = 2,400 units per month.
• Once breakeven is known, the margin of safety simply measures how far actual performance exceeds that threshold.

📊 Practical use

• Managers can use the margin of safety to assess risk: a low margin means the company is operating close to breakeven and is more vulnerable.
• A high margin of safety indicates strong performance and greater resilience to sales fluctuations.
• Example: if a company's margin of safety is only 10%, a small sales decline could quickly eliminate profits; if it is 70%, the company has substantial room for error.

🧭 Overview

🧠 One-sentence thesis

Variable costing separates variable costs from fixed costs on the income statement to help managers analyze controllable expenses and contribution margin, whereas absorption costing (required by GAAP) treats all manufacturing costs—including fixed factory overhead—as product costs.

📌 Key points (3–5)

• Core difference: Under absorption costing, fixed factory overhead is allocated to inventory and expensed when the product is sold; under variable costing, fixed factory overhead is treated as a period cost and deducted from gross profit immediately.
• Income statement structure: Variable costing deducts all variable expenses from revenue to get contribution margin, then subtracts all fixed expenses; absorption costing separates expenses into Cost of Goods Sold and Selling & Administrative Expenses.
• Why managers use variable costing: Variable costs are typically more controllable than fixed costs, so isolating them helps management analyze and improve operations.
• Common confusion: Contribution margin (variable costing) is often higher than gross profit (absorption costing) because many production and selling/administrative expenses are fixed, so variable costing reduces cost of goods sold more than it increases operating expenses.
• GAAP requirement: Absorption costing is required for external reporting; variable costing is an internal management tool.

📊 Two costing methods compared

📊 Absorption costing (GAAP-required)

Absorption costing: a method that treats all manufacturing costs—both variable and fixed—as product costs, which are included in inventory until the product is sold.

• Structure: Sales minus Cost of Goods Sold equals Gross Profit; then subtract Selling and Administrative Expenses to get Operating Income.
• Cost of Goods Sold includes:
  • Direct materials (variable)
  • Direct labor (variable)
  • Factory overhead (both variable and fixed)
• Selling and Administrative Expenses may include both variable and fixed costs.
• Fixed factory overhead treatment: Allocated to finished goods inventory on the balance sheet; expensed to Cost of Goods Sold only when the product is sold.
• External reporting: Required under generally accepted accounting principles (GAAP).

📊 Variable costing (internal management tool)

Variable costing: a method that includes only variable manufacturing costs in finished goods inventory and Cost of Goods Sold; fixed factory overhead is treated as a period cost.

• Structure: Sales minus Variable Cost of Goods Sold equals Manufacturing Margin; minus Variable Selling and Administrative Expenses equals Contribution Margin; minus Total Fixed Costs equals Operating Income.
• Variable Cost of Goods Sold includes only:
  • Direct materials (variable)
  • Direct labor (variable)
  • Variable factory overhead
• Fixed factory overhead treatment: NOT allocated to inventory; NOT expensed to Cost of Goods Sold when the product is sold; instead, deducted as a period cost below contribution margin.
• Purpose: Helps managers isolate and analyze controllable (variable) costs.

🔍 Side-by-side comparison

Feature	Absorption Costing	Variable Costing
Fixed factory overhead	Allocated to inventory; expensed when product sold	Treated as period cost; expensed immediately
Cost of Goods Sold	Includes all manufacturing costs (variable + fixed)	Includes only variable manufacturing costs
Key metric	Gross Profit	Manufacturing Margin → Contribution Margin
Variable selling/admin expenses	Grouped with fixed selling/admin	Grouped with variable production costs
Fixed costs presentation	Mixed into COGS and Selling/Admin	Shown together below contribution margin
External reporting	Required by GAAP	Not allowed for external reporting

🧮 Variable costing income statement structure

🧮 Step-by-step calculation

The excerpt provides this structure:

1. Sales (total revenue)
2. Minus Variable Cost of Goods Sold (only variable manufacturing costs)
3. Equals Manufacturing Margin
4. Minus Variable Selling and Administrative Expenses
5. Equals Contribution Margin (amount available to pay all fixed costs)
6. Minus Total Fixed Costs:
   • Fixed manufacturing costs
   • Fixed selling and administrative expenses
7. Equals Operating Income

📐 Key differences from absorption costing

The excerpt lists five specific differences:

1. Only variable production costs are included in Cost of Goods Sold.
2. Manufacturing margin replaces gross profit.
3. Variable selling and administrative expenses are grouped with variable production costs (both contribute to calculating contribution margin).
4. Contribution margin is listed after deducting all variable costs from sales.
5. Fixed production costs are shown below the contribution margin with fixed operating costs.

💡 Why contribution margin is often higher than gross profit

• Many production costs and most selling/administrative expenses are fixed.
• Variable costing reduces Cost of Goods Sold (by excluding fixed factory overhead) more than it increases general operating expenses.
• Net result: contribution margin (variable costing) tends to be higher than gross profit (absorption costing).
• Don't confuse: this is a presentation difference, not a difference in total operating income when units manufactured equal units sold.

🔢 Illustrative scenario: units manufactured equal units sold

🔢 Given data

The excerpt provides sample data for three scenarios (A, B, C differ only in units produced):

• Units sold: 15,000
• Selling price per unit: $50
• Variable manufacturing cost per unit: $25
• Fixed manufacturing costs: $150,000 (total)
• Variable selling and administrative cost per unit: $5
• Fixed selling and administrative costs: $50,000 (total)

🔢 Example A: 15,000 units produced and sold

When units manufactured equal units sold (15,000 = 15,000):

Variable Costing Income Statement:

• Sales: 15,000 × $50 = $750,000
• Variable Cost of Goods Sold: 15,000 × $25 = $375,000
• Manufacturing Margin: $375,000
• Variable Selling and Administrative Expenses: 15,000 × $5 = $75,000
• Contribution Margin: $300,000
• Fixed manufacturing costs: $150,000
• Fixed selling and administrative expenses: $50,000
• Total Fixed Costs: $200,000
• Operating Income: $100,000

Key calculation notes:

• Variable Cost of Goods Sold = units sold × variable manufacturing cost per unit
• Variable Selling and Administrative Expenses = units sold × variable amount per unit
• Fixed costs are deducted in total, not per unit

🔍 What happens when production ≠ sales

The excerpt mentions that the three scenarios differ only in units produced (15,000 for A, 20,000 for B, 10,000 for C), implying that the treatment of fixed factory overhead will create differences between absorption and variable costing income when production and sales volumes diverge—though the detailed calculations for scenarios B and C are not fully shown in this excerpt.

🧭 Overview

🧠 One-sentence thesis

When the number of units manufactured equals the number of units sold, variable costing and absorption costing produce identical operating income because inventory levels remain unchanged.

📌 Key points (3–5)

• The scenario: 15,000 units produced and 15,000 units sold—no inventory buildup or drawdown.
• Key difference in cost treatment: variable costing separates variable and fixed costs; absorption costing combines variable manufacturing cost per unit with a per-unit share of fixed manufacturing costs.
• Operating income is identical: both methods yield $100,000 operating income when units manufactured equal units sold.
• Common confusion: the two methods show different intermediate subtotals (contribution margin vs. gross profit), but final operating income matches only when production equals sales.
• Why income matches: no change in inventory means all fixed manufacturing costs are expensed in the current period under both methods.

🧮 The two costing methods side by side

🧮 Variable costing structure

• Sales: 15,000 units × $50 = $750,000
• Variable cost of goods sold: 15,000 units × $25 = $375,000
• Manufacturing margin: Sales minus variable cost of goods sold = $375,000
• Variable selling and administrative expenses: 15,000 units × $5 = $75,000
• Contribution margin: Manufacturing margin minus variable selling and administrative expenses = $300,000
• Fixed costs (listed separately):
  • Fixed manufacturing costs: $150,000
  • Fixed selling and administrative expenses: $50,000
  • Total fixed costs: $200,000
• Operating income: Contribution margin minus total fixed costs = $100,000

🧮 Absorption costing structure

• Sales: 15,000 units × $50 = $750,000
• Cost of goods sold: 15,000 units × ($25 variable + $10 fixed per unit) = $525,000
  • The $10 per unit comes from $150,000 total fixed manufacturing cost ÷ 15,000 units produced
• Gross profit: Sales minus cost of goods sold = $225,000
• Selling and administrative expenses: (15,000 units × $5 variable) + $50,000 fixed = $125,000
• Operating income: Gross profit minus selling and administrative expenses = $100,000

🔍 Key calculation differences

Element	Variable Costing	Absorption Costing
Variable cost of goods sold	15,000 × $25 = $375,000	Included in cost of goods sold
Fixed manufacturing cost	$150,000 shown as period cost	$10 per unit absorbed into cost of goods sold
Cost of goods sold	Only variable manufacturing	Variable + fixed per unit: 15,000 × $35 = $525,000
Intermediate subtotal	Contribution margin: $300,000	Gross profit: $225,000
Operating income	$100,000	$100,000

🔑 Why operating income is identical

🔑 No inventory change

When the number of units manufactured equals the number of units sold, there is no change in the number of units in inventory.

• The beginning and ending inventory are the same.
• All units produced in the period are sold in the same period.
• Example: if you start with zero inventory, produce 15,000, and sell 15,000, you end with zero inventory again.

🔑 All fixed costs expensed this period

• Under variable costing: the entire $150,000 fixed manufacturing cost is expensed immediately as a period cost.
• Under absorption costing: the $150,000 is divided by 15,000 units produced = $10 per unit; since all 15,000 units are sold, all $150,000 is expensed through cost of goods sold.
• Result: both methods expense the same total fixed manufacturing cost in the current period, so operating income matches.

⚠️ Don't confuse intermediate subtotals with final income

• Contribution margin (variable costing) is often higher than gross profit (absorption costing).
• Reason: variable costing removes many fixed production costs from cost of goods sold and lists them separately below the contribution margin.
• But when production equals sales, the final operating income is always the same.
• Example: contribution margin is $300,000 vs. gross profit of $225,000, yet both methods arrive at $100,000 operating income after all costs are deducted.

📊 The data used in this scenario

📊 Given information

Item	Value
Units sold	15,000
Selling price per unit	$50
Units produced	15,000 (Example A)
Variable manufacturing cost per unit	$25
Fixed manufacturing costs	$150,000
Variable selling and administrative cost per unit	$5
Fixed selling and administrative costs	$50,000

📊 Why this scenario is the baseline

• The excerpt presents three scenarios (A, B, C) that differ only in the number of units produced.
• Example A (this section): 15,000 produced and 15,000 sold—the simplest case where production equals sales.
• The excerpt notes that Examples B and C will show 20,000 and 10,000 units produced, respectively, to illustrate what happens when production does not equal sales.
• Understanding this baseline is essential before comparing the other scenarios.

🧭 Overview

🧠 One-sentence thesis

When more units are manufactured than sold, operating income under absorption costing is higher than under variable costing because fixed factory overhead for unsold units remains in inventory rather than being expensed immediately.

📌 Key points (3–5)

• The scenario: 20,000 units manufactured but only 15,000 sold, leaving 5,000 units added to inventory.
• Variable costing stays unchanged: the entire variable costing income statement remains the same regardless of production volume (only sales volume matters).
• Absorption costing income rises: operating income increases from $100,000 to $137,500 when production exceeds sales.
• Common confusion: the difference arises because variable costing expenses all fixed factory overhead in the period, while absorption costing only expenses the portion attached to units sold.
• Key mechanism: under absorption costing, fixed overhead per unit drops when more units are produced (same total fixed cost spread over more units), and unsold units carry their share of fixed overhead into inventory.

🔢 The numbers: production exceeds sales

🔢 Scenario setup

• Units manufactured: 20,000
• Units sold: 15,000
• Units added to inventory: 5,000 (20,000 − 15,000)
• Total fixed manufacturing cost: $150,000 (unchanged)
• Variable manufacturing cost per unit: $25
• Selling price per unit: $50
• Variable selling & administrative per unit: $5
• Fixed selling & administrative: $50,000

📊 Income comparison table

Line item	Variable costing	Absorption costing
Sales	$750,000	$750,000
Cost of goods sold	$375,000	$487,500
Gross profit / Manufacturing margin	$375,000	$262,500
Variable selling & admin	$75,000	—
Contribution margin	$300,000	—
Fixed manufacturing costs	$150,000	(included in COGS)
Selling & admin expenses	$50,000	$125,000
Operating income	$100,000	$137,500

• Key observation: absorption costing shows $37,500 higher operating income.

🧮 How fixed overhead is allocated

🧮 Fixed manufacturing cost per unit

• Under variable costing: fixed manufacturing costs are not assigned to units; the entire $150,000 is expensed in the period.
• Under absorption costing: fixed manufacturing costs are spread over units produced.

Fixed manufacturing cost per unit (absorption) = Total fixed manufacturing cost ÷ Units produced

• In this scenario: $150,000 ÷ 20,000 units = $7.50 per unit
• Compare to the earlier scenario (15,000 units produced): $150,000 ÷ 15,000 = $10 per unit
• More production → lower fixed cost per unit (same total fixed cost spread thinner).

🧮 Cost of goods sold calculation

Variable costing:

• 15,000 units sold × $25 variable cost per unit = $375,000
• Fixed manufacturing costs of $150,000 are expensed separately (not in COGS).

Absorption costing:

• 15,000 units sold × ($25 variable + $7.50 fixed) = 15,000 × $32.50 = $487,500
• Only the fixed overhead attached to the 15,000 sold units is expensed: 15,000 × $7.50 = $112,500
• The remaining fixed overhead (5,000 units × $7.50 = $37,500) stays in inventory.

🔍 Why operating income differs

🔍 The core mechanism

• Variable costing: expenses the entire $150,000 fixed manufacturing cost in the current period, regardless of how many units were produced or sold.
• Absorption costing: expenses only the fixed overhead attached to units sold ($112,500 in this case); the rest ($37,500) is deferred in inventory.

Result: Absorption costing shows higher operating income because $37,500 of fixed cost is not expensed this period.

🔍 The inventory effect

• When inventory increases (production > sales), absorption costing "hides" some fixed overhead in ending inventory.
• The excerpt states:

Operating income under variable costing is lower than under absorption costing when inventory increases.

• Don't confuse: this is not because variable costing is "wrong"—it simply expenses all fixed manufacturing costs immediately, while absorption costing defers the portion tied to unsold units.

🔍 Example walkthrough

• An organization produces 20,000 widgets but sells only 15,000.
• Under variable costing: all $150,000 fixed factory overhead is expensed → operating income $100,000.
• Under absorption costing: only $112,500 of fixed overhead (for 15,000 sold units) is expensed; $37,500 remains in the 5,000 unsold units → operating income $137,500.
• The $37,500 difference is the fixed overhead "trapped" in inventory.

🔄 What stays the same

🔄 Unchanged items

The excerpt notes that when production volume changes (20,000 vs. 15,000 units manufactured), two things remain unchanged:

1. The entire variable costing income statement: because variable costing depends only on units sold (15,000), not units produced.
2. Selling and administrative expenses on the absorption costing statement: these are the same ($125,000) because they depend on units sold and fixed amounts, not production volume.

🔄 Why variable costing is stable

• Variable costing treats fixed manufacturing costs as a period cost (expensed in full each period).
• Production volume does not affect the income statement; only sales volume matters.
• Example: whether 10,000, 15,000, or 20,000 units are produced, the variable costing operating income remains $100,000 as long as 15,000 units are sold.

📉 Contrast: when production is less than sales

📉 The opposite scenario (section 6.4 preview)

The excerpt briefly introduces the case where 10,000 units are manufactured and 15,000 are sold:

• Inventory decreases by 5,000 units (selling more than produced means drawing from existing inventory).
• Fixed cost per unit under absorption costing: $150,000 ÷ 10,000 = $15 per unit (higher than the $7.50 when 20,000 were produced).
• Absorption costing COGS: 15,000 × ($25 + $15) = $600,000 (excerpt shows $575,000, likely a typo or rounding).
• Operating income under absorption costing: drops to $50,000 (lower than variable costing's $100,000).

📉 The reversal

• When inventory decreases (production < sales), absorption costing shows lower operating income than variable costing.
• This is because units sold include inventory from prior periods, which carry higher fixed overhead per unit (since fewer units were produced in the current period).
• Don't confuse: the direction of the income difference flips depending on whether inventory increases or decreases.

🧭 Overview

🧠 One-sentence thesis

When fewer units are manufactured than sold, variable costing produces higher operating income than absorption costing because variable costing expenses only the fixed overhead for units produced, while absorption costing expenses fixed overhead for the larger number of units sold.

📌 Key points

• The scenario: 10,000 units manufactured but 15,000 units sold means 5,000 units came from beginning inventory, causing inventory to decrease.
• Income statement differences: variable costing shows $100,000 operating income while absorption costing shows $50,000—a $50,000 gap.
• Why variable costing is higher: fixed factory overhead is expensed only for the 10,000 units produced, not for all 15,000 units sold.
• Why absorption costing is lower: fixed overhead is included in the cost of all 15,000 units sold, resulting in higher total expenses.
• Common confusion: when inventory decreases (units sold > units manufactured), the income relationship reverses compared to when inventory increases—variable costing yields higher income, not lower.

📊 The scenario and inventory impact

📦 What happens when units sold exceed units manufactured

• In this example: 10,000 units manufactured, 15,000 units sold.
• The difference (5,000 units) must come from beginning inventory.
• Result: ending inventory is smaller than beginning inventory—inventory decreases.

🔄 Contrast with inventory increase

• When units manufactured > units sold: inventory increases, and absorption costing shows higher income.
• When units manufactured < units sold: inventory decreases, and variable costing shows higher income.
• Don't confuse: the direction of the income gap flips depending on whether inventory grows or shrinks.

💰 Income statement comparison

📋 Variable costing income statement (10,000 manufactured / 15,000 sold)

Line item	Amount	Calculation
Sales	$750,000	15,000 × $50
Variable cost of goods sold	$375,000	15,000 × $25
Manufacturing margin	$375,000
Variable selling & admin expenses	$75,000	15,000 × $5
Contribution margin	$300,000
Fixed manufacturing costs	$150,000	Total fixed cost for period
Fixed selling & admin expenses	$50,000
Total fixed costs	$200,000
Operating income	$100,000

📋 Absorption costing income statement (10,000 manufactured / 15,000 sold)

Line item	Amount	Calculation
Sales	$750,000	15,000 × $50
Cost of goods sold	$575,000	See breakdown below
Gross profit	$175,000
Selling & admin expenses	$125,000	(15,000 × $5) + $50,000
Operating income	$50,000

Cost of goods sold breakdown:

• 5,000 units from beginning inventory: 5,000 × ($25 + $10) = $175,000
• 10,000 units from current production: 10,000 × ($25 + $15) = $400,000
• Total COGS: $575,000

Note: Fixed manufacturing cost per unit is $15 for current production ($150,000 ÷ 10,000 units).

🔍 What remains unchanged

Regardless of whether 10,000, 15,000, or 20,000 units are manufactured (when 15,000 are sold):

1. The entire variable costing income statement stays identical.
2. Selling and administrative expenses on the absorption costing statement remain the same.

🧮 Why variable costing shows higher income

💡 The fixed overhead treatment difference

Under variable costing, fixed factory overhead for all units produced is expensed during the period, regardless of whether the units were sold.

• In this scenario: only $150,000 fixed overhead is expensed (for 10,000 units produced).
• The 5,000 units sold from beginning inventory carry their own fixed overhead from a prior period—not expensed again.

💡 Absorption costing's higher expense

Under absorption costing, fixed factory overhead is expensed for the units sold.

• All 15,000 units sold carry fixed overhead in their cost.
• This results in higher overall expenses and therefore lower operating income.
• Example: the 5,000 units from beginning inventory include fixed overhead from when they were produced; that overhead is now expensed as part of COGS.

📉 The income gap

• Variable costing operating income: $100,000
• Absorption costing operating income: $50,000
• Difference: $50,000
• This gap equals the fixed overhead embedded in the 5,000 units drawn from beginning inventory.

🎯 The general rule for inventory decreases

📐 When inventory decreases

Operating income under variable costing is higher than under absorption costing when inventory decreases.

Why this happens:

• Variable costing expenses fixed overhead only for current production (fewer units).
• Absorption costing expenses fixed overhead for all units sold (more units), including those from prior periods' inventory.
• More fixed overhead flows through COGS under absorption costing → higher expenses → lower income.

⚖️ Comparison with inventory increase

Inventory change	Units manufactured vs sold	Which method shows higher income?
Inventory increases	Manufactured > Sold	Absorption costing
Inventory decreases	Manufactured < Sold	Variable costing

Don't confuse: The method that shows higher income switches depending on inventory movement—absorption costing wins when inventory grows; variable costing wins when inventory shrinks.

🧭 Overview

🧠 One-sentence thesis

Under variable costing, operating income remains constant regardless of production levels when sales are fixed, whereas under absorption costing, operating income fluctuates with inventory changes due to how fixed factory overhead is allocated, making variable costing more reliable for analyzing period profitability.

📌 Key points (3–5)

• Variable costing stability: When sales are constant, operating income under variable costing stays the same regardless of how many units are produced, because fixed overhead is expensed as a flat amount each period.
• Absorption costing variability: Operating income under absorption costing changes when production differs from sales, because fixed overhead is spread across units produced and only expensed when those units are sold.
• Common confusion: The two methods yield the same operating income only when units produced equal units sold; otherwise, absorption costing income is higher when inventory increases and lower when inventory decreases.
• Why it matters: Absorption costing can distort operating performance by tying income to inventory changes rather than actual sales performance, while variable costing provides a clearer picture of profitability for a given period.
• Contribution margin: Under variable costing, contribution margin (sales minus variable costs) is the key metric showing what's available to cover fixed costs and generate profit.

📊 Comparative analysis of the two methods

📊 When units produced equal units sold

When all units manufactured are sold, operating income under absorption costing is the same as under variable costing.

• In the example: 15,000 units produced and 15,000 units sold → both methods show $100,000 operating income (variable costing) vs. $50,000 (absorption costing) after adjustments.
• Under both methods, the same $150,000 of fixed factory overhead is deducted, just in different places:
  • Variable costing: $150,000 appears as a flat amount after contribution margin
  • Absorption costing: $150,000 is embedded in cost of goods sold ($10 per unit × 15,000 units sold)
• Don't confuse: The line items differ, but the total fixed overhead expensed is identical when production equals sales.

📈 When units produced exceed units sold

Scenario: 20,000 units produced, 15,000 units sold (5,000 added to inventory)

• Variable costing: Operating income remains $100,000
  • Fixed overhead expensed: flat $150,000
• Absorption costing: Operating income rises to $137,500
  • Fixed cost per unit: $150,000 ÷ 20,000 = $7.50 per unit
  • Fixed overhead in cost of goods sold: $7.50 × 15,000 sold = $112,500
  • Result: $37,500 less expense → $37,500 higher operating income

Why the difference: Under absorption costing, some fixed overhead ($37,500) stays in ending inventory instead of being expensed, artificially boosting income.

📉 When units produced are less than units sold

Scenario: 10,000 units produced, 15,000 units sold (5,000 drawn from beginning inventory)

• Variable costing: Operating income remains $100,000
  • Fixed overhead expensed: flat $150,000
• Absorption costing: Operating income drops to $50,000
  • Fixed cost per unit: $150,000 ÷ 10,000 = $15 per unit
  • Fixed overhead in cost of goods sold: $15 × 15,000 sold = $225,000
  • Result: $75,000 more expense → $75,000 lower operating income

Why the difference: Under absorption costing, fixed overhead from both current production and beginning inventory units is expensed, increasing total expenses.

🔍 Key insight: inventory changes and income distortion

🔍 Variable costing: production-neutral

The excerpt presents three variable costing income statements with different production levels (15,000; 20,000; 10,000 units) but identical sales (15,000 units):

Production level	Sales	Operating income
15,000 units	$750,000	$100,000
20,000 units	$750,000	$100,000
10,000 units	$750,000	$100,000

• All three statements show identical results: sales, variable costs, contribution margin, fixed costs, and operating income are the same.
• Why: Production affects inventory (a balance sheet account), not the income statement. Fixed manufacturing costs are always expensed as $150,000 in the period incurred.
• Example: Producing 20,000 units but selling only 15,000 means 5,000 units go into ending inventory, but this does not change the period's operating income.

🔍 Absorption costing: inventory-sensitive

The same three scenarios under absorption costing yield different operating incomes:

Production level	Sales	Cost of goods sold	Operating income
15,000 units	$750,000	$575,000	$50,000
20,000 units	$750,000	$487,500	$137,500
10,000 units	$750,000	$575,000	$50,000

• Why: Fixed overhead is allocated per unit produced, so the amount expensed depends on how many units are sold and their embedded fixed cost.
• When inventory increases (production > sales), less fixed overhead is expensed → higher income.
• When inventory decreases (production < sales), more fixed overhead is expensed → lower income.

⚠️ Managerial implication

Under absorption costing, operating income changes based on increases or decreases in inventory due to producing more or fewer units than were sold in a period. Such changes are unrelated to a company's operating performance.

• Managers need to recognize this distortion: absorption costing can make income appear better or worse simply by changing production levels, not by improving sales or efficiency.
• Variable costing avoids this problem, making it more reliable for analyzing profitability for an accounting period.

🧮 How fixed overhead is handled

🧮 Variable costing approach

• Fixed factory overhead is expensed as a flat amount every period, regardless of production or sales volume.
• In the example: $150,000 fixed overhead appears as a single line item after contribution margin.
• This amount never changes with production levels.

🧮 Absorption costing approach

• Fixed factory overhead is allocated to each unit produced, creating a per-unit fixed cost.
• Formula: Fixed cost per unit = Total fixed overhead ÷ Units produced
• The fixed overhead expensed in cost of goods sold = Fixed cost per unit × Units sold

Three scenarios:

Units produced	Fixed cost per unit	Units sold	Fixed overhead in COGS
15,000	$150,000 ÷ 15,000 = $10	15,000	$10 × 15,000 = $150,000
20,000	$150,000 ÷ 20,000 = $7.50	15,000	$7.50 × 15,000 = $112,500
10,000	$150,000 ÷ 10,000 = $15	15,000	$15 × 15,000 = $225,000

• Don't confuse: The total fixed overhead incurred is always $150,000, but the amount expensed varies depending on how many units are produced and sold.

💡 Contribution margin in variable costing

💡 What contribution margin represents

Contribution margin is what is left over from sales after paying variable costs; it is the amount or percentage of sales available to pay fixed costs and contribute to operating income.

• Once fixed costs are covered, any remaining contribution margin represents profit.
• This metric is central to variable costing income statements and provides clear insight into profitability.

💡 Uses for contribution margin analysis

Managers can analyze contribution margin from multiple perspectives:

• By product
• By geographic area
• By salesperson
• By customer
• By distribution method (e.g., in-store vs. online)

Purpose: Identify strengths to capitalize on and weaknesses to address within different segments of the company.

💡 Example setup

The excerpt introduces a scenario for contribution margin analysis:

• A company manufactures two products (Product 1 and Product 2)
• Sells in two regions (East and West)
• Serves two customers present in both regions
• Has four salespeople per region
• Sales channels: in-store or online

Sample data provided:

Region	Product 1 sales	Product 2 sales	Total sales
East	$120,000	$40,000	$160,000
West	$60,000	$100,000	$160,000
Total	$180,000	$140,000	$320,000

• Variable manufacturing costs and variable selling expenses are also broken down by product and region.
• The excerpt mentions a company-wide contribution margin ratio of 45.4%, calculated from total sales and total variable costs.
• (Note: The excerpt cuts off before showing the full calculation and detailed segment analysis.)

🧭 Overview

🧠 One-sentence thesis

Contribution margin analysis reveals how much sales revenue remains after variable costs to cover fixed costs and generate profit, enabling managers to compare performance across products, regions, salespeople, and other segments to identify strengths and weaknesses.

📌 Key points (3–5)

• What contribution margin is: the amount left from sales after paying variable costs, available to cover fixed costs and contribute to operating income.
• How to use it for decisions: managers compare contribution margin ratios across segments (products, regions, salespeople, customers, distribution channels) to find what performs best.
• Common confusion: highest contribution margin in dollars does not always mean highest contribution margin ratio—managers must evaluate both perspectives.
• Planning applications: forecasting sales volume, unit prices, and unit variable costs allows managers to model different scenarios and see the impact on contribution margin.
• Why it matters: once fixed costs are covered, any remaining contribution margin represents profit; the analysis helps optimize pricing, product mix, and resource allocation.

🧩 Core concept and calculation

🧩 What contribution margin measures

Contribution margin: what is left over from sales after paying variable costs; the amount or percentage of sales available to pay fixed costs and contribute to operating income.

• It is not total profit—it is the intermediate step between sales and operating income.
• Once fixed costs are covered, any remaining contribution margin becomes profit.
• Example: if sales are $320,000, variable costs are $174,600, contribution margin is $145,400; if fixed costs are $100,000, operating income is $45,400.

🔢 Contribution margin ratio

• Formula (in words): contribution margin divided by sales.
• The excerpt shows: contribution margin of $145,400 divided by sales of $320,000 equals 45.4%.
• Interpretation: for every $1.00 of sales, a little over $0.45 remains after variable costs to apply toward fixed costs and profit.
• Don't confuse: a higher ratio is favorable relative to a lower one, but the dollar amount also matters for covering fixed costs.

📊 Segment comparisons

📦 By product

The excerpt compares two products with the same company-wide data:

Metric	Product 1	Product 2	Company
Sales	$180,000	$140,000	$320,000
Contribution margin	$68,400	$77,000	$145,400
Contribution margin ratio	38.0%	55.0%	45.4%

• Product 2 has lower sales but a 17% higher contribution margin ratio because its production and selling costs are proportionately lower.
• Managerial insight: managers may look for ways to contain variable costs for Product 1 and incentivize sales staff to promote Product 2 more.

🌍 By region

The excerpt compares East and West regions with equal sales:

Metric	East	West
Sales	$160,000	$160,000
Contribution margin	$67,600	$77,800
Contribution margin ratio	42.3%	48.6%

• At the same sales level, the East has higher variable costs for both production and selling.
• Managerial insight: management may examine the product mix in each region to determine if cost differences are product-related or if action is needed to contain costs in the East.

👤 By salesperson

The excerpt drills down to four salespeople in the East region:

Salesperson	Sales	Contribution margin	Contribution margin ratio
Adams	$32,000	$14,700	45.9%
Bell	$40,000	$13,400	33.5%
Crew	$51,000	$22,100	43.3%
Davis	$37,000	$17,400	47.0%

• The sales mix (percentage of each product sold) affects variable expenses and the resulting contribution margin ratio.
• Key observation: the highest contribution margin in dollars (Crew: $22,100) does not result in the highest contribution margin ratio (Davis: 47.0%).
• Managerial insight: managers must evaluate returns on sales from both dollar and ratio perspectives when making decisions.

🛒 By customer and distribution channel

The excerpt presents two additional segment types without detailed data:

By customer:

Metric	Customer 1	Customer 2
Sales	$190,000	$130,000
Contribution margin ratio	43.8%	47.8%

By distribution channel:

Metric	In-Store	Online
Sales	$150,000	$170,000
Contribution margin ratio	44.1%	46.6%

• These comparisons show additional ways to investigate operational performance.

🔮 Planning and forecasting

🔮 Scenario modeling

Contribution margin analysis is useful for planning by forecasting four variables:

1. Sales volume (units)
2. Unit selling price
3. Unit variable cost of production
4. Unit variable cost of selling

• Managers can change one or more variables to see the impact on contribution margin.
• The excerpt shows six projections with different assumptions (changes in bold in the original table).

📈 Comparing projections

Example comparison from the excerpt:

Metric	Projection 1	Projection 6
Sales quantity	100,000	110,000
Selling price per unit	$8.00	$8.30
Variable production cost per unit	$2.50	$2.75
Variable selling cost per unit	$1.75	$1.90
Contribution margin	$375,000	$401,500
Contribution margin ratio	46.9%	44.0%

• Key insight: a higher contribution margin ratio alone is favorable (46.9% > 44.0%), but if fixed costs are $375,000, Projection 1 only breaks even, whereas Projection 6 yields operating income of $26,500.
• Don't confuse: the ratio and the dollar amount serve different purposes; many decisions require a combination of analyses to determine the optimal outcome.

🎯 Planned vs. actual comparison

Managers compare projected to actual amounts to evaluate performance:

Metric	Projected	Actual
Sales quantity	90,000	110,000
Selling price per unit	$8.50	$8.00
Variable production cost per unit	$2.80	$2.70
Variable selling cost per unit	$1.60	$1.80
Contribution margin	$369,000	$385,000

• Actual contribution margin is $16,000 higher than projected, partially due to more unit sales than anticipated and a net decrease in unit variable cost.
• Although sales revenue is higher, the selling price per unit was lower than projected—worth investigating; it is feasible that the price concession spurred the higher sales quantity.

🏨 Application to service businesses

🏨 Variable costing for services

Variable costing applies to service businesses even though manufacturing costs are not involved.

Example: a small hotel

• Revenue source: renting rooms.
• Variable costs: food and beverage expense for breakfast, supplies expense, selling expense, incremental utilities expense for occupied rooms.
• Fixed costs: rent expense for the property, salaries expense, depreciation expense, insurance expense.

📋 Hotel income statement example

The excerpt shows Jonick Inn with a room rate of $120 per night and 700 room nights during the month:

Line item	Calculation	Amount
Rooms revenue	700 × $120	$84,000
Variable costs (total)	(700 × $24) + (700 × $10) + (700 × $8) + (700 × $5)	$32,900
Contribution margin	Revenue minus variable costs	$51,100
Fixed costs (total)	Rent + salary + depreciation + insurance	$38,900
Operating income	Contribution margin minus fixed costs	$12,200

• The rate per unit for each variable cost is shown (e.g., selling expense $24 per room night, food and beverage $10 per room night).
• Other service businesses: hospitals, banks, restaurants, and airlines would also benefit from variable costing.

🧭 Overview

🧠 One-sentence thesis

Budgets are quantitative, written action plans that help companies forecast future operations and maintain financial control by combining historical performance data with insights into current trends and environments.

📌 Key points (3–5)

• What a budget is: a quantitative, written statement of a company's action plan for a future period.
• Purpose: budgets serve as planning tools to determine future activities and keep financial control of operations.
• Two timing approaches: fixed-interval budgets (reviewed/revised annually) vs. continuous budgets (rolling 12-month window adjusted monthly).
• Common confusion: budgets are not just historical summaries—they combine past performance with forward-looking insights into consumer trends and economic/legal/social/political environments.
• Foundation: historical financial statements and managerial reports provide the integral starting point for forecasting and strategy development.

📋 What budgets are and why they matter

📋 Definition and core purpose

Budget: a quantitative, written statement of a company's action plan for a future period of time.

• Budgets translate strategy into numbers for a specific timeframe.
• They are planning tools that help determine future activities.
• They provide financial control over operations by setting benchmarks.

🔄 How budgets connect past and future

• Financial statements and managerial reports summarize historical transactions to evaluate past performance.
• This historical information is "an integral part of the process of moving forward."
• Managers combine past data with insights into:
  • Consumer trends
  • Current economic environment
  • Legal environment
  • Social environment
  • Political environment
• This combination enables forecasting future operations and developing strategies to achieve projected goals.

Don't confuse: Budgets are not merely backward-looking summaries; they use historical data as input but focus on planning and controlling future activities.

⏰ Budget timing approaches

📅 Fixed-interval budgets

• Prepared at fixed intervals (e.g., annually).
• Reviewed and revised once a year.
• Example: A company prepares a budget in December for the entire following calendar year and does not adjust it until the next December.

🔄 Continuous (rolling) budgets

• Extend for one year but are adjusted each month.
• Reflect activities for the upcoming 12 months at all times.
• How it works: When a current month passes, its financial information is removed and data for the new month that is 12 months in the future is added.
• Example: In January, the budget covers January through December; in February, it covers February through the following January, and so on.

Budget type	Review frequency	Time horizon	Key feature
Fixed-interval	Once per period (e.g., annually)	Fixed period (e.g., one year)	Set and revised at fixed times
Continuous	Monthly	Rolling 12 months	Always looks 12 months ahead

🎯 Why timing matters

• Fixed-interval: simpler to prepare but may become outdated as conditions change during the year.
• Continuous: requires more frequent updates but keeps the budget current and responsive to changing conditions.

🧭 Overview

🧠 One-sentence thesis

A static budget fixes costs for a single activity level without adjusting for actual volume changes, which often limits its usefulness because it cannot distinguish whether cost overruns result from inefficiency or simply from processing more units than originally assumed.

📌 Key points (3–5)

• What a static budget is: a budget prepared for a fixed amount of activity that does not change regardless of actual production volume.
• Core limitation: it does not specify the number of units to be processed, making it difficult to determine if actual costs are reasonable.
• Common confusion: actual costs exceeding the static budget may look unfavorable, but could actually be positive if more units were processed than anticipated.
• Vague assumptions: even if a unit quantity is stated (e.g., 10,000 units), the budget remains unchanged whether actual production is higher or lower.
• Why it matters: the lack of detail behind how numbers are derived often limits the usefulness of static budget information for performance evaluation.

📋 What a static budget is

📋 Definition and structure

A static budget is prepared for a period of time based on a fixed amount of activity.

• It itemizes both fixed and variable costs for a department or operation.
• The budget covers a specific time period (e.g., "For the Year Ended December 31, 2019").
• Example structure from the excerpt:
  • Variable costs: packing materials, direct labor, variable utilities
  • Fixed costs: supervisor salary, depreciation, machine rental
  • Total budgeted costs: sum of variable and fixed costs

🔢 Example from the excerpt

The Packing Department budget shows:

• Total variable costs: $50,000
• Total fixed costs: $70,000
• Total budgeted costs: $120,000

Key issue: This budget does not specify how many units will be processed, making it a "fixed amount of activity" without clear volume assumptions.

⚠️ Core limitation of static budgets

⚠️ Difficulty evaluating actual performance

• The excerpt states: "This departmental budget does not specify the number of units to be processed, making it difficult to determine if actual costs are reasonable and within budget."
• Without knowing the assumed production volume, managers cannot tell whether cost variances are due to:
  • Inefficiency or waste, or
  • Simply processing more (or fewer) units than planned

🔄 The volume problem

• Even if the number of anticipated units is stated (e.g., 10,000 units), the budget remains unchanged if production volume is higher or lower.
• The static budget does not adjust for actual activity levels.
• Example: If the budget assumes 10,000 units but actual production is 12,000 units, the budget still shows the same $120,000 total—no adjustment is made.

🤔 Common confusion: over-budget may be favorable

🤔 Misleading cost comparisons

The excerpt provides a specific scenario:

• Actual costs: $130,000
• Budgeted costs: $120,000
• At first glance: $130,000 exceeds $120,000, so it looks unfavorable (over budget by $10,000).

✅ Why it might actually be positive

• "However, more units may have been processed than were considered in preparing the budget."
• "In that case, being over budget may actually be a positive outcome since additional production costs were the result of more sales orders."
• Don't confuse: Higher costs ≠ poor performance if volume increased. The static budget cannot separate volume effects from efficiency effects.

🧩 Why static budgets have limited usefulness

🧩 Vague assumptions

• The excerpt emphasizes: "The assumptions underlying the static budget are a bit vague."
• Even when a unit quantity is mentioned, the budget does not show how costs would change at different activity levels.
• Managers lack the detail needed to understand cost behavior.

🧩 Lack of detail

• "The lack of detail behind how the numbers are derived often limits the usefulness of the static budget information."
• Static budgets do not break down:
  • How variable costs scale with volume
  • How fixed costs remain constant across volumes
• This makes it hard to use the budget as a control tool for evaluating actual performance.

🧩 Contrast with flexible budgets

The excerpt briefly mentions that a flexible budget addresses the shortcoming of the static budget by providing budgeted amounts at various quantity levels, but that discussion belongs to the next section (7.3).

🧭 Overview

🧠 One-sentence thesis

A flexible budget overcomes the limitations of a static budget by providing budgeted amounts at multiple activity levels, allowing managers to compare actual costs against appropriate benchmarks for the actual volume produced.

📌 Key points (3–5)

• What a flexible budget is: a budget that shows budgeted amounts at various quantity levels, not just one fixed level.
• Why it's better than static budgets: it allows meaningful cost comparisons at different production volumes instead of locking in one unchanging number.
• How it works: variable costs change with volume while fixed costs remain constant across all activity levels.
• Common confusion: a flexible budget is not a single adjustable budget—it's essentially "a menu of static budgets" to select from based on actual units.
• What it enables: managers can accurately assess whether they are over or under budget by matching actual costs to the appropriate activity level.

🔍 What a flexible budget solves

🔍 The static budget problem

• A static budget uses one anticipated production volume (e.g., 10,000 units) and does not change if actual production is higher or lower.
• This lack of flexibility limits usefulness: if actual volume differs from the planned volume, comparing actual costs to the static budget becomes meaningless.
• The excerpt notes that "the lack of detail behind how the numbers are derived often limits the usefulness of the static budget information."

✅ How a flexible budget addresses this

Flexible budget: a budget that provides budgeted amounts at various quantity levels.

• Instead of one fixed number, the flexible budget shows what costs should be at multiple production levels.
• Example: the Packing Department budget shows four possible levels—10,000, 12,000, 16,000, and 20,000 units—with corresponding budgeted costs for each.
• This allows managers to pick the right benchmark: if 12,000 units were actually produced, compare actual costs to the 12,000-unit column, not the 10,000-unit column.

📊 Structure and behavior of costs

📊 Variable costs change with volume

The excerpt's Packing Department example shows three variable cost categories:

Variable cost item	10,000 units	12,000 units	16,000 units	20,000 units
Packing materials	$30,000	$36,000	$48,000	$60,000
Direct labor	$15,000	$18,000	$24,000	$30,000
Variable utilities	$5,000	$6,000	$8,000	$10,000
Total variable	$50,000	$60,000	$80,000	$100,000

• Variable costs increase proportionally with production volume.
• Example: packing materials rise from $30,000 at 10,000 units to $60,000 at 20,000 units (doubling as volume doubles).

🔒 Fixed costs stay constant

The same budget shows three fixed cost categories:

Fixed cost item	All activity levels
Supervisor salary	$60,000
Depreciation	$7,000
Machine rental	$3,000
Total fixed	$70,000

• Fixed costs do not change regardless of production volume.
• Don't confuse: total fixed costs remain $70,000 whether the department produces 10,000 or 20,000 units.

🧮 Total budgeted costs

• Total budgeted costs = variable costs + fixed costs.
• At 10,000 units: $50,000 + $70,000 = $120,000.
• At 20,000 units: $100,000 + $70,000 = $170,000.
• The increase in total cost comes entirely from the variable portion.

🎯 How managers use a flexible budget

🎯 Comparing actual to budgeted costs

The excerpt provides two scenarios to illustrate:

Scenario 1: On budget

• Actual costs: $130,000; actual units: 12,000.
• The flexible budget shows $130,000 for 12,000 units.
• Result: "the budget would have accurately predicted actual costs."

Scenario 2: Over budget

• Actual costs: $130,000; actual units: 10,000.
• The flexible budget shows $120,000 for 10,000 units.
• Result: "the department would have been over budget by $10,000."

📋 "A menu of static budgets"

A flexible budget is basically a menu of static budgets to select from based on the number of actual units involved.

• This phrase clarifies the concept: it's not one budget that "flexes" automatically; it's multiple pre-calculated budgets at different volumes.
• Managers select the appropriate column based on actual production and compare actual costs to that column.
• This approach makes variance analysis meaningful because it isolates spending differences from volume differences.

🔗 Connection to broader budgeting

🔗 Pro forma financial statements

• The excerpt notes that the same formats used for historical financial statements (like the income statement) can be used to project future performance.
• Sales and cost line items can each be budgeted independently based on the company's action plan.
• Collectively, these projections result in a pro forma income statement that projects future net income.
• A flexible budget fits into this framework by providing detailed cost projections at multiple activity levels.

🔗 Relationship to master and operating budgets

The excerpt briefly introduces (without full detail):

• Master budget: a collection of all separate budgets combined into one report, including both operating budgets (sales, cost of goods sold) and financial budgets (cash, capital expenditures).
• Operating budgets: include sales budget, cost of goods sold budget, and selling/administrative budget; these feed into the budgeted income statement.
• The flexible budget concept applies to any of these components where costs vary with activity levels.

🧭 Overview

🧠 One-sentence thesis

The master budget integrates all separate budgets—operating budgets for income statement items and financial budgets for balance sheet items—into one comprehensive report that projects a company's future financial performance.

📌 Key points (3–5)

• What a master budget is: a collection of all separate budgets combined into one report covering both operating and financial budgets.
• Two main components: operating budgets (sales, cost of goods sold, selling & administrative) and financial budgets (cash, capital expenditures).
• Operating budgets culminate in: a budgeted income statement showing projected net income.
• Common confusion: master budget vs. flexible budget—a flexible budget shows costs at multiple activity levels (like a "menu of static budgets"), while a master budget combines all budget types into one comprehensive plan.
• Why it matters: the master budget provides a complete financial roadmap for a future period, linking operational goals to financial outcomes.

🏗️ Structure and components

🏗️ What the master budget contains

Master budget: a collection of all the separate budgets for different elements of a business combined into one report.

• It is not just one budget; it is a comprehensive package of multiple budgets.
• Two main categories:
  • Operating budgets: goals for sales and associated production costs → budgeted income statement.
  • Financial budgets: cash budgets and capital expenditures budgets → budgeted balance sheet.
• The master budget ties together operational plans (what to sell, what to produce) with financial projections (income, assets, liabilities).

📊 Operating budgets vs. financial budgets

Budget type	What it includes	Where it appears
Operating budgets	Sales, cost of goods sold, selling & administrative expenses	Budgeted income statement
Financial budgets	Cash budgets, capital expenditures	Budgeted balance sheet

• Operating budgets focus on income statement line items (revenue and expenses).
• Financial budgets focus on balance sheet items (cash, capital assets).
• Together they provide a complete picture of projected financial position and performance.

📋 Operating budget breakdown

📋 Three key line items

The excerpt states that operating budgets include separate budgets for three key line items on the income statement:

1. Sales budget
2. Cost of goods sold budget
3. Selling and administrative budget

• Each line item has its own detailed budget.
• The results of all individual operating budgets are combined to present a budgeted income statement.
• The budgeted income statement culminates with the anticipated amount of net income.

🏭 Cost of goods sold: five supporting budgets

For a manufacturer, preparing the cost of goods sold budget requires five supporting budgets in sequence:

Supporting budget	What it requires	Purpose
a. Production budget	Sales budget result	Determines how many units to produce
b. Direct materials purchases budget	Production budget result	Determines how much material to buy
c. Direct materials cost budget	Materials purchases budget result	Calculates total material cost
d. Direct labor cost budget	Production budget result	Calculates total labor cost
e. Factory overhead budget	Independent of previous budgets	Estimates overhead costs

• Sequential dependency: each budget builds on the previous one (except factory overhead, which is independent).
• Example: you cannot prepare a production budget without knowing the sales budget; you cannot prepare a materials purchases budget without knowing the production budget.
• Don't confuse: the order matters—sales → production → materials purchases → materials cost; direct labor also depends on production.

🔗 How operating budgets connect

• The sales budget drives the production budget (you produce to meet sales goals plus desired inventory).
• The production budget drives both materials purchases and direct labor (you need materials and labor to produce).
• All three cost components (materials, labor, overhead) combine to form the cost of goods sold budget.
• Sales budget + cost of goods sold budget + selling & administrative budget → budgeted income statement → projected net income.

🎯 Illustration approach in the excerpt

🎯 Two side-by-side examples

The excerpt introduces two distinct master budget examples for 2019:

1. Statue Souvenirs: one product (42" art deco Statue of Liberty replica), one direct material (metal).
2. Bicycle and Ski Helmets: two products (bicycle helmets, ski helmets), two direct materials (plastic, foam lining), two departments (forming, assembly).

• The excerpt recommends reviewing the simpler example first (statue souvenirs) to understand basic concepts.
• The helmet example is more complex but follows the same structure.
• Both examples will prepare: sales budget, production budget, direct materials purchases budget, direct materials cost budget, direct labor cost budget, factory overhead budget, selling & administrative budget, and budgeted income statement.

📦 Data provided for budgeting

The excerpt lists detailed data for each company, including:

• Estimated sales volume and selling price per unit.

• Beginning and ending inventory levels (finished goods, work in process, raw materials).

• Material requirements per unit and material prices.

• Direct labor time per unit and labor rates.

• Factory overhead costs (supervisor salary, utilities, indirect materials, depreciation).

• Selling costs (advertising, commissions, utilities).

• Administrative costs (salaries, utilities, office supplies).

• Estimated tax rate.

• This data serves as the input for preparing all the individual budgets.

• Example: knowing "3,000 units estimated sales volume" and "2,600 units beginning inventory" and "600 units desired ending inventory" allows calculation of how many units to produce.

🔄 Context: flexible budget vs. master budget

🔄 Flexible budget recap

The excerpt briefly reviews the flexible budget before introducing the master budget:

Flexible budget: addresses the shortcoming of the static budget by providing budgeted amounts at various quantity levels.

• A flexible budget is like a "menu of static budgets" to select from based on actual units produced.
• Example: the Packing Department budget shows four possible production levels (10,000; 12,000; 16,000; 20,000 units) with corresponding variable and fixed costs.
• Variable costs change with production volume (packing materials, direct labor, variable utilities).
• Fixed costs remain unchanged across all activity levels (supervisor salary, depreciation, machine rental).
• If actual units were 12,000 and actual costs were $130,000, the flexible budget would have accurately predicted costs; if actual units were 10,000 and costs were $130,000, the department would be over budget by $10,000.

🔄 How flexible budget differs from master budget

• Flexible budget: focuses on one department or cost category at multiple activity levels; helps compare actual costs to budgeted costs at the actual volume.
• Master budget: integrates all budgets (sales, production, materials, labor, overhead, selling, administrative, cash, capital) into one comprehensive report for a single planned activity level.
• Don't confuse: a flexible budget is a tool for variance analysis (comparing actual to budget at different volumes); a master budget is a complete financial plan for the entire organization.

🧭 Overview

🧠 One-sentence thesis

Operating budgets break down the income statement into separate budgets for sales, cost of goods sold, and selling/administrative expenses, which together project future net income.

📌 Key points (3–5)

• What operating budgets include: three key line items—sales budget, cost of goods sold budget, and selling and administrative budget.
• How cost of goods sold is built: manufacturers prepare five supporting budgets in sequence (production → materials purchases → materials cost, labor cost, and overhead).
• Sequential dependency: many budgets require the results of prior budgets (e.g., production budget needs sales budget results).
• Common confusion: the five supporting budgets are not independent—four depend on earlier results, but factory overhead is independent of the previous budgets.
• End result: all individual operating budgets combine into a budgeted income statement that projects net income.

📋 The three main operating budgets

📋 Sales budget

• The first budget prepared; estimates the number of units that will be sold.
• Considers:
  • Budgeted and actual sales from the previous year
  • Economic conditions
  • Shifts in trends
  • Customer feedback
  • Pricing changes
• Must also determine the expected unit selling price for each product by examining previous pricing, profitability, current costs, and other factors.

📋 Cost of goods sold budget

• For manufacturers, this budget requires five supporting budgets prepared in a specific order.
• These five budgets feed into each other sequentially (see next section).

📋 Selling and administrative budget

• Covers estimated selling costs (advertising, sales commissions, utilities, salaries, telephone, travel).
• Covers estimated administrative costs (office salaries, depreciation, office supplies, miscellaneous office expenses).
• Example from the excerpt: Statue Souvenirs estimates advertising expense $16,300, sales commissions $14,100, utilities $12,000 for selling; salaries $87,700, utilities $11,400, office supplies $5,600 for administrative.

🏭 The five supporting budgets for cost of goods sold

🏭 Production budget (step a)

Production budget: requires the sales budget result.

• Cannot be prepared until the sales budget is complete.
• Determines how many units must be produced to meet sales goals and desired ending inventory.
• Example: if sales budget shows 3,000 units will be sold, the production budget calculates how many to manufacture based on beginning inventory (2,600 units) and desired ending inventory (600 units).

🏭 Direct materials purchases budget (step b)

Direct materials purchases budget: requires the production budget result.

• Cannot be prepared until the production budget is complete.
• Calculates how much raw material must be purchased.
• Example: Statue Souvenirs uses 8.6 pounds of metal per unit; if production budget shows 1,000 units needed, this budget calculates total pounds of metal to purchase, adjusted for beginning inventory (1,800 pounds) and desired ending inventory (300 pounds).

🏭 Direct materials cost budget (step c)

Direct materials cost budget: requires the materials purchases budget result.

• Cannot be prepared until the materials purchases budget is complete.
• Applies the price per unit of material to the quantities from the purchases budget.
• Example: if metal costs $6 per pound and the purchases budget shows a certain quantity needed, this budget calculates the total dollar cost.

🏭 Direct labor cost budget (step d)

Direct labor cost budget: requires the production budget result.

• Depends on the production budget (not on the materials budgets).
• Calculates labor hours and labor cost based on units to be produced.
• Example: Statue Souvenirs estimates 5 hours of direct labor per unit at $10 per hour; if production budget shows 1,000 units, labor cost is 5,000 hours × $10 = $50,000.

🏭 Factory overhead budget (step e)

Factory overhead budget: independent of previous budgets.

• Don't confuse: this is the only supporting budget that does not require results from earlier budgets.
• Includes supervisor salaries, utilities, indirect materials, depreciation, indirect factory wages, insurance, property tax, etc.
• Example: Statue Souvenirs estimates supervisor salary $7,600, utilities $1,900, indirect materials $1,700, depreciation $800.

🔗 Sequential dependencies and flow

🔗 The dependency chain

The excerpt emphasizes that most budgets cannot be prepared independently:

Budget	Requires result from
Production budget	Sales budget
Direct materials purchases budget	Production budget
Direct materials cost budget	Materials purchases budget
Direct labor cost budget	Production budget
Factory overhead budget	Independent

• Why this matters: you must prepare budgets in order; skipping steps or preparing them out of sequence will produce incorrect results.
• Example: you cannot calculate how much material to purchase until you know how many units to produce; you cannot know how many units to produce until you know how many units will be sold.

🔗 Combining into the budgeted income statement

• After all individual operating budgets are complete, they are combined.
• The result is a budgeted income statement that projects net income.
• This statement includes:
  • Sales revenue (from sales budget)
  • Cost of goods sold (from the five supporting budgets)
  • Selling and administrative expenses (from the selling and administrative budget)
  • Net income (after applying the estimated tax rate, e.g., 20% or 25%)

🏢 Illustration: two manufacturing companies

🏢 Statue Souvenirs (simpler case)

• One product: 42" art deco replica of the Statue of Liberty.
• One direct material: metal (8.6 pounds per unit at $6 per pound).
• Sales: 3,000 units at $200 per unit.
• Direct labor: 5 hours per unit at $10 per hour.
• Inventory targets: beginning finished goods 2,600 units, ending 600 units; beginning metal 1,800 pounds, ending 300 pounds.
• The excerpt recommends reviewing this simpler case first to understand the basic concepts.

🏢 Bicycle and Ski Helmets (more complex case)

• Two products: bicycle helmets (2,600 units at $50 each) and ski helmets (4,800 units at $130 each).
• Two direct materials: plastic (0.8 pounds per bicycle helmet, 1.6 pounds per ski helmet at $4 per pound) and foam lining (0.3 pounds per bicycle helmet, 0.6 pounds per ski helmet at $2 per pound).
• Two departments: forming and assembly, each with different labor hours and rates.
• More complex inventory tracking: separate beginning and ending inventories for each product, each material, and work in process for each product.
• Don't confuse: the principles are the same as the simpler case, but the calculations involve more line items and more detailed breakdowns.

🔄 Relationship to the master budget

🔄 Operating budgets within the master budget

Master budget: a collection of all the separate budgets for different elements of a business combined into one report.

• Operating budgets (sales, cost of goods sold, selling and administrative) are one part of the master budget.
• The master budget also includes financial budgets such as cash and capital expenditures budgets, which appear on the budgeted balance sheet.
• Operating budgets result in the budgeted income statement; financial budgets result in the budgeted balance sheet.

🔄 Action plan and pro forma statements

• Operating budgets "can be budgeted independently based on a company's action plan for a future period."
• Collectively, they produce a pro forma income statement that projects future net income.
• Don't confuse "independently": the excerpt clarifies that while operating budgets as a group can be prepared based on the action plan, within the operating budgets, most individual budgets depend on prior budgets (as shown in the five-step sequence).

🧭 Overview

🧠 One-sentence thesis

The sales budget is the first budget prepared in the master budget process and drives all subsequent budgets by establishing expected unit sales and revenue for each product based on historical data, market conditions, and pricing analysis.

📌 Key points (3–5)

• Prepared first: the sales budget is the starting point of the entire budgeting process.
• Two key estimates: requires determining both the number of units to be sold and the expected selling price per unit.
• Multiple factors analyzed: adjusts prior-year data for economic conditions, trends, customer feedback, pricing changes, costs, market demand, and competitor pricing.
• Flows downstream: total sales revenue from the sales budget transfers directly to the budgeted income statement and drives production and cost budgets.
• Common confusion: the sales budget estimates what will be sold, not what will be produced—production planning comes next in the production budget.

📋 What the sales budget contains

📊 Core components

The sales budget shows three key figures for each product:

• Unit sales value: the estimated number of units that will be sold
• Unit sales price: the expected selling price per unit
• Total sales: unit sales value multiplied by unit sales price

Sales budget: the first budget prepared, estimating the number of units that will be sold and the revenue those sales will generate.

🧮 Calculation formula

The budgeted sales in dollars equals:

• Expected sales volume (units) × Expected selling price per unit
• This calculation is performed for each product
• The sum of all products' sales becomes total sales revenue

Example: If bicycle helmets have estimated sales of 2,600 units at $50 per unit, total sales = 2,600 × $50 = $130,000.

🔍 How estimates are developed

📈 Starting point: historical analysis

The process begins by:

• Looking at budgeted sales from the previous year
• Comparing actual sales from the previous year
• Using these amounts as the baseline for adjustments

⚙️ Adjustment factors for unit sales

The historical baseline is adjusted to reflect:

• Economic conditions: broader market environment changes
• Shifts in trends: changes in consumer preferences or industry patterns
• Customer feedback: input from buyers about needs and preferences
• Pricing changes: how price adjustments will affect demand

💰 Determining selling price per unit

The expected unit selling price is set by examining:

• Previous pricing and profitability: what prices were charged and what margins were achieved
• Current costs: what it costs to produce the product now
• Market demand: how much customers want the product
• Competitors' pricing: what rival companies charge for similar products

Don't confuse: pricing analysis considers both internal factors (costs, past profitability) and external factors (demand, competition).

🔗 Role in the master budget

🎯 First in sequence

• The sales budget must be prepared first before other budgets
• All subsequent budgets depend on the sales estimates
• This is because production, materials, labor, and overhead all flow from expected sales volume

📤 Downstream connections

Budget component	How it uses the sales budget
Budgeted income statement	Total sales revenue is transferred directly
Production budget	Uses estimated units to be sold to determine manufacturing needs
Cost of goods sold budget	Built from production requirements driven by sales estimates

🧩 The broader process

After the sales budget:

1. Five shorter, more targeted budgets are prepared
2. These feed into the cost of goods sold budget
3. The production budget is the next step, estimating units to manufacture
4. Direct materials purchases budget follows to estimate material spending

Example: The excerpt shows that after establishing sales of 2,600 bicycle helmets and 4,800 ski helmets, the production budget then determines how many units must be manufactured (accounting for beginning and ending inventory).

📊 Illustrated example from the excerpt

🏢 Two companies shown

The excerpt provides sales budgets for:

• Souvenir Statues: metal statues product line
• Headgear: bicycle helmets and ski helmets product lines

📋 Souvenir Statues sales budget

• Metal statues: 3,000 units × $200 per unit = $600,000 total sales

📋 Headgear sales budget

• Bicycle helmets: 2,600 units × $50 per unit = $130,000
• Ski helmets: 4,800 units × $130 per unit = $624,000
• Total sales revenue: $754,000

🔄 What happens next

For Headgear, the production budget then takes the estimated units to be sold (2,600 bicycle, 4,800 ski) and:

• Adds desired ending inventory
• Subtracts estimated beginning inventory
• Calculates total units to be produced (2,640 bicycle, 4,760 ski)

This shows how the sales budget's unit estimates drive the next stage of planning.

🧭 Overview

🧠 One-sentence thesis

The cost of goods sold budget consolidates direct materials, direct labor, and factory overhead from their supporting budgets, then accounts for beginning and ending inventories to calculate what was actually sold during the period.

📌 Key points (3–5)

• What it consolidates: pulls amounts from three supporting budgets (direct materials, direct labor, factory overhead) to calculate total manufacturing costs.
• The flow logic: starts with what was available (beginning inventory + manufactured), then subtracts what remains (ending inventory) to find what transferred out.
• Two inventory layers: tracks both work-in-process (unfinished goods) and finished goods separately before arriving at cost of goods sold.
• Common confusion: "transferred out from finished goods" means a sale occurred—don't confuse ending inventory (still on hand) with cost of goods sold (what left the company).
• Why it matters: provides the key cost figure needed for the budgeted income statement's gross profit calculation.

🏗️ Structure and data sources

🏗️ What feeds into this budget

The cost of goods sold budget depends on five previously prepared targeted budgets:

• Direct materials budget: provides the total cost of raw materials used.
• Direct labor budget: provides the total labor cost for production.
• Factory overhead budget: provides all indirect manufacturing costs (supervisor salaries, utilities, depreciation, insurance, etc.).
• Beginning and ending inventory data: for both work-in-process and finished goods.

Example: Souvenir Statues pulls $51,600 (direct materials), $50,000 (direct labor), and $12,000 (factory overhead) directly from their respective supporting budgets.

📋 The budget's two-column format

• Left column: lists the three manufacturing cost components individually.
• Middle column: shows subtotals and the final cost of goods sold.
• The layout mirrors the manufacturing cost flow: raw materials → work in process → finished goods → sold.

🔄 The manufacturing cost flow

🔄 Step 1: Total manufacturing costs for the year

Total manufacturing costs for the year = Direct materials + Direct labor + Factory overhead

• This is the sum of all three cost types incurred during the period.
• Example: Headgear's total manufacturing costs = $46,208 + $124,032 + $73,000 = $243,240.

🏭 Step 2: Work-in-process calculation

The excerpt describes this as "begin with what was available at the beginning of the period, add what was transferred in during the period, and deduct what was remaining at the end of the period."

Formula in words:

• Beginning work-in-process inventory (what was unfinished at the start)
• Plus: Total manufacturing costs for the year (what was added during the period)
• Equals: Total work in process during the year (everything available)
• Minus: Ending work-in-process inventory (what is still unfinished)
• Equals: Cost of goods manufactured (what was completed and moved to finished goods)

Example: Souvenir Statues had $25,100 beginning WIP, added $113,600 in manufacturing costs, totaling $138,700 available; after subtracting $3,100 ending WIP, the cost of goods manufactured is $135,600.

📦 Step 3: Finished goods calculation

Formula in words:

• Beginning finished goods inventory (completed products from prior period)
• Plus: Cost of goods manufactured (completed products from current period)
• Equals: Cost of finished goods available for sale (everything ready to sell)
• Minus: Ending finished goods inventory (what was not sold)
• Equals: Cost of goods sold (what actually left as sales)

Example: Headgear had $33,040 beginning finished goods, added $260,290 manufactured, totaling $293,330 available; after subtracting $29,790 ending finished goods, cost of goods sold is $263,540.

Don't confuse: "Available for sale" is not the same as "sold"—you must subtract what remains on hand.

🧮 Supporting calculations for inventory values

🧮 How unit costs are determined

The excerpt provides a detailed table showing how Headgear's inventory amounts were derived:

Inventory type	Units	Cost per unit	Total
Beginning finished goods (bicycle helmet)	110	$24	$2,640
Beginning finished goods (ski helmet)	320	$95	$30,400
Beginning WIP (bicycle helmet)	450	$15	$6,750
Beginning WIP (ski helmet)	520	$70	$36,400
Ending WIP (bicycle helmet)	610	$10	$6,100
Ending WIP (ski helmet)	500	$40	$20,000
Ending finished goods (bicycle helmet)	150	$25	$3,750
Ending finished goods (ski helmet)	280	$93	$26,040

📝 Why show this detail

The excerpt notes: "This level of detail is not necessary to show in the statement of cost of goods manufactured, but it is useful in understanding how amounts in that statement were derived."

• The main budget shows only the totals.
• The supporting calculations explain where each inventory dollar amount comes from.
• Different products and different stages (WIP vs finished) have different unit costs.

🎯 Connection to the budgeted income statement

🎯 What this budget provides

The excerpt states: "The sales and cost of goods sold budgets provide key information necessary to arrive at the budgeted gross profit amount."

The link:

• Sales budget → provides revenue figure.
• Cost of goods sold budget → provides the cost figure.
• Gross profit = Sales minus Cost of goods sold.

Example: Souvenir Statues' budgeted income statement shows Sales $600,000 minus Cost of goods sold $162,900 equals Gross profit $437,100.

🔗 Role in the overall budgeting process

• The cost of goods sold budget is one of the "operating budgets."
• It culminates the manufacturing-related budgets.
• It feeds directly into the budgeted income statement, which is the final operating budget before moving to financial budgets (cash budget, capital expenditures budget).

Don't confuse: Operating budgets (like cost of goods sold) focus on profit and loss; financial budgets (like cash budget) focus on liquidity and balance sheet accounts.

🧭 Overview

🧠 One-sentence thesis

The selling and administrative cost budget consolidates all operating expenses on a line-by-line basis to provide the total non-manufacturing costs needed for the budgeted income statement.

📌 Key points (3–5)

• What it lists: all operating expenses broken down line-by-line, separated into selling expenses and administrative expenses.
• Two main categories: selling expenses (sales commissions, advertising, travel, etc.) and administrative expenses (salaries, office supplies, depreciation, etc.).
• How it fits the budget process: it is a supporting budget that feeds directly into the budgeted income statement, alongside sales and cost of goods sold budgets.
• Common confusion: selling and administrative costs are operating expenses, not manufacturing costs—they do not appear in cost of goods sold or cost of goods manufactured.
• Why it matters: these expenses are subtracted from gross profit to determine income before taxes, so accurate budgeting here is essential for profit planning.

📋 What the budget contains

📋 Structure and categories

The selling and administrative cost budget is organized into two main sections:

• Selling expenses: costs directly related to selling activities.
• Administrative expenses: costs related to general office and management functions.

Each section lists individual expense line items, then totals them separately. The two totals are then summed to arrive at total selling and administrative expenses.

🛒 Selling expenses

Selling expenses include costs incurred to generate sales and deliver products to customers:

• Sales commissions expenses
• Advertising expense
• Travel expense (selling)
• Telephone expense (selling)
• Utilities expense (selling-related)

Example: In the Headgear budget, selling expenses total $200,400, including $129,200 in sales commissions and $60,800 in advertising.

🏢 Administrative expenses

Administrative expenses cover general office operations and management support:

• Office salaries expense
• Depreciation expense (office equipment)
• Office supplies expense
• Telephone expense (administrative)
• Utilities expense (administrative)
• Miscellaneous administrative expense

Example: In the Souvenir Statues budget, administrative expenses total $104,700, with $87,700 in salaries expense as the largest component.

🔗 How it connects to other budgets

🔗 Supporting the budgeted income statement

Budgeted income statement: a financial statement for the year that combines sales, cost of goods sold, and selling and administrative cost budgets.

The selling and administrative cost budget is one of three supporting budgets that feed into the budgeted income statement:

1. Sales budget → provides the sales revenue figure
2. Cost of goods sold budget → provides the cost of goods sold figure
3. Selling and administrative cost budget → provides the operating expenses figure

The excerpt states: "The sales, cost of goods sold, and selling and administrative cost budgets are supporting budgets that are combined to produce a budgeted income statement for the year."

📊 Income statement flow

The budgeted income statement uses the selling and administrative cost budget as follows:

Line item	Source	Calculation
Sales	Sales budget	Revenue figure
Cost of goods sold	Cost of goods sold budget	Manufacturing costs
Gross profit	Calculation	Sales minus cost of goods sold
Selling and administrative expenses	This budget	Total operating expenses
Income before taxes	Calculation	Gross profit minus operating expenses
Income taxes	Tax calculation	Based on income before taxes
Net income	Final result	Income before taxes minus taxes

Example: In the Souvenir Statues budgeted income statement, gross profit of $437,100 minus total selling and administrative expenses of $147,100 equals income before taxes of $290,000.

⚠️ Key distinctions

⚠️ Operating vs. manufacturing costs

Don't confuse: Selling and administrative costs are not part of manufacturing costs or cost of goods sold.

• Manufacturing costs (direct materials, direct labor, factory overhead) → appear in the cost of goods sold budget
• Selling and administrative costs (sales commissions, office salaries, advertising) → appear in the selling and administrative cost budget

The excerpt shows this separation clearly: manufacturing costs are totaled first to arrive at cost of goods sold, then selling and administrative expenses are listed separately and subtracted from gross profit.

⚠️ Selling vs. administrative

Within operating expenses, the budget distinguishes between:

• Selling expenses: directly tied to sales activities (commissions, advertising, sales travel)
• Administrative expenses: support general management and office functions (office salaries, office supplies, administrative utilities)

Some expense types (like utilities or telephone) may appear in both categories, but they are separated based on their function. Example: Headgear shows "Telephone expense – selling" ($4,100) and "Telephone expense – administrative" ($900) as separate line items.

🎯 Purpose and use

🎯 Why prepare this budget

The selling and administrative cost budget serves several purposes:

• Detailed planning: forces management to estimate and justify each operating expense line-by-line.
• Cost control: provides a benchmark for monitoring actual spending against budgeted amounts.
• Profit planning: essential for calculating budgeted net income, since these expenses directly reduce profit.
• Completion of operating budgets: the excerpt notes that "the operating budgets culminate with the budgeted income statement," and this budget is a required input.

🎯 What comes next

After the budgeted income statement is prepared using the selling and administrative cost budget:

• Financial budgets may be prepared next, which "look at critical aspects of a business that are not directly operational but that impact a company's ability to pay its obligations."
• Examples include the cash budget and capital expenditures budget.

The excerpt emphasizes that operating budgets (including this one) focus on income statement items, while financial budgets address balance sheet and cash flow concerns.

🧭 Overview

🧠 One-sentence thesis

The budgeted income statement combines sales, cost of goods sold, and selling and administrative cost budgets to project a company's net income for the year.

📌 Key points (3–5)

• What it is: a projected income statement that consolidates three supporting budgets (sales, COGS, and selling/administrative costs).
• How it's built: starts with sales revenue, subtracts cost of goods sold to get gross profit, then deducts selling and administrative expenses to arrive at income before taxes and net income.
• Where it fits: the budgeted income statement is the culmination of all operating budgets.
• What comes next: after operating budgets, companies prepare financial budgets (e.g., cash budget, capital expenditures budget) that focus on balance sheet accounts and cash obligations.

📋 What the budgeted income statement is

📋 Definition and purpose

Budgeted income statement: a projected income statement for the year that combines the sales, cost of goods sold, and selling and administrative cost budgets.

• It is not a single standalone budget; it is the result of combining three supporting budgets.
• The excerpt emphasizes that operating budgets "culminate" with this statement—it is the final output of the operating budget process.

🧱 The three supporting budgets

The budgeted income statement pulls information from:

1. Sales budget: provides total sales revenue.
2. Cost of goods sold budget: provides the cost of goods sold amount.
3. Selling and administrative cost budget: provides total operating expenses (both selling and administrative).

Each of these budgets must be prepared first; the budgeted income statement simply assembles them into a standard income statement format.

🧮 How the budgeted income statement is structured

🧮 Line-by-line format

The excerpt shows two example companies (Souvenir Statues and Headgear) with the same structure:

Line item	Calculation	Purpose
Sales	From sales budget	Starting revenue
Cost of goods sold	From COGS budget	Subtracted from sales
Gross profit	Sales − COGS	Profit before operating expenses
Total selling and administrative expenses	From selling/admin budget	Operating expenses
Income before taxes	Gross profit − operating expenses	Profit before tax
Income taxes	Calculated on income before taxes	Tax obligation
Net income	Income before taxes − taxes	Final projected profit

🔢 Example walkthrough (Souvenir Statues)

• Sales: $600,000
• Cost of goods sold: −$162,900
• Gross profit: $437,100
• Selling and administrative expenses: −$147,100
• Income before taxes: $290,000
• Income taxes: −$58,000
• Net income: $232,000

🔢 Example walkthrough (Headgear)

• Sales: $754,000
• Cost of goods sold: −$263,540
• Gross profit: $490,460
• Selling and administrative expenses: −$228,100
• Income before taxes: $262,360
• Income taxes: −$65,590
• Net income: $196,770

Don't confuse: Gross profit is not the same as net income. Gross profit only accounts for cost of goods sold; net income also subtracts operating expenses and taxes.

🔄 What happens after the budgeted income statement

🔄 Transition to financial budgets

The excerpt states:

• Operating budgets culminate with the budgeted income statement.
• After that, companies may prepare additional budgets that relate to balance sheet accounts.

Financial budgets: budgets that look at critical aspects of a business that are not directly operational but that impact a company's ability to pay its obligations.

💰 Examples of financial budgets

The excerpt mentions two types (with limited discussion promised):

1. Cash budget: estimates cash receipts and cash payments for one or more periods; focuses on the availability and commitment of cash.
2. Capital expenditures budget: (mentioned but not detailed in this excerpt).

Why the distinction matters: Operating budgets focus on revenue and expenses (income statement items); financial budgets focus on cash flow and balance sheet accounts (assets, liabilities, equity).

💡 Key insight

The budgeted income statement is the endpoint of operating budgets but not the end of the entire budgeting process—financial budgets address liquidity and capital needs that the income statement does not capture.

🧭 Overview

🧠 One-sentence thesis

The cash budget estimates cash receipts and payments over one or more periods to help management plan for the availability and commitment of cash, which is critical to operational success.

📌 Key points (3–5)

• What a cash budget does: estimates cash receipts (from sales, collections, asset sales, financing) and cash payments (for costs, purchases, debt, dividends) to show cash availability.
• Most common cash flows: receipts come mainly from customer sales; payments go mainly to sales-related costs and vendor purchases.
• Timing matters: cash collections and payments often span multiple months (e.g., collecting receivables over two months after the sale).
• Common confusion: distinguish between sales (when revenue is recognized) and cash collections (when cash actually arrives)—they rarely happen in the same period for credit sales.
• Why it matters: the cash budget consolidates all cash transactions to show whether the company can meet its obligations and how cash balances change month by month.

💰 What the cash budget covers

💰 Definition and purpose

Cash budget: provides relevant information by estimating cash receipts and cash payments for one or more periods.

• It is a financial budget (not an operating budget) that looks at critical aspects impacting a company's ability to pay obligations.
• The excerpt emphasizes that "availability and commitment of cash is critical to management planning and operational success."
• The budget consolidates the frequency and amount of cash transactions.

💵 Sources of cash receipts

Cash inflows come from:

• Cash sales
• Collection of accounts receivable
• Other revenue sources
• Sales of assets
• Issuance of stocks and bonds

💸 Uses of cash payments

Cash outflows occur due to:

• Incurring costs and expenses
• Paying invoices on account
• Purchasing assets
• Paying off debts
• Paying interest and dividends

🛒 Cash collections from sales

🛒 How sales translate to cash

The excerpt uses Jonick Corporation (starting January 1, 2019) to illustrate:

• 20% of sales are cash sales → collected immediately in the same month.
• 80% of sales are on account (credit sales) → collected over time:
  • 40% collected in the month of sale
  • 50% collected in the following month
  • 10% collected in the second month after the sale

Don't confuse: total sales in a month vs. cash collected in that month—they differ because credit sales are collected over multiple periods.

📊 Example calculation for collections

For January sales of $68,000:

• Cash sales: $13,600 (20% of $68,000) → collected in January
• Sales on account: $54,400 (80% of $68,000)
  • $21,760 (40%) collected in January
  • $27,200 (50%) collected in February
  • $5,440 (10%) collected in March

Month	Cash sales	Current month A/R	Prior month A/R	Two months ago A/R	Total collections
January	$13,600	$21,760	$0	$0	$35,360
February	$18,000	$28,800	$27,200	$0	$74,000
March	$24,800	$39,680	$36,000	$5,440	$105,920
April	$27,800	$44,480	$49,600	$7,200	$129,080

🏭 Cash payments for purchases

🏭 How purchases translate to cash

The excerpt shows a similar pattern for vendor purchases:

• 30% of purchases are cash purchases → paid immediately in the same month.
• 70% of purchases are on account → paid over time:
  • 60% paid in the month of purchase
  • 30% paid in the following month
  • 10% paid in the second month after the purchase

📊 Example calculation for payments

For January purchases of $34,000:

• Cash purchases: $10,200 (30% of $34,000) → paid in January
• Purchases on account: $23,800 (70% of $34,000)
  • $14,280 (60%) paid in January
  • $7,140 (30%) paid in February
  • $2,380 (10%) paid in March

Month	Cash purchases	Current month A/P	Prior month A/P	Two months ago A/P	Total payments
January	$10,200	$14,280	$0	$0	$24,480
February	$13,500	$18,900	$7,140	$0	$39,540
March	$18,600	$26,040	$9,450	$2,380	$56,470
April	$21,000	$29,400	$13,020	$3,150	$66,570

🔧 Other cash transactions

🔧 Non-operating cash flows

The excerpt lists additional transactions for Jonick Corporation:

• Financing: issue stock for $50,000 cash (January)
• Investing: purchase equipment for $8,000 (January) and $12,000 (February); sell equipment for $3,000 (March)
• Dividends: pay $1,000 cash dividends (March)

These are consolidated with operating cash flows to form the complete cash budget.

📋 The complete cash budget

📋 Structure and format

The cash budget shows:

1. Estimated cash receipts (by source)
2. Estimated cash payments (by category)
3. Cash increase (receipts minus payments)
4. Cash at beginning of the month (ending balance from prior month)
5. Cash at end of the month (beginning + increase)

📊 Jonick Corporation example

Item	January	February	March	April
Receipts:
Cash sales	$13,600	$18,000	$24,800	$27,800
Collection of A/R	54,400	72,000	99,200	111,200
Issuance of stock	50,000	—	—	—
Sale of equipment	—	—	3,000	—
Total receipts	$118,000	$90,000	$127,000	$139,000
Payments:
Cash purchases	$10,200	$13,500	$18,600	$21,000
Payment of A/P	23,800	31,500	43,400	49,000
Purchase of equipment	8,000	12,000	—	—
Payment of dividends	—	—	1,000	—
Total payments	$42,000	$57,000	$62,000	$71,000
Cash increase	76,000	33,000	65,000	68,000
Cash at beginning	0	76,000	109,000	98,000
Cash at end	$76,000	$109,000	$98,000	$133,000

🔍 What the budget reveals

• January shows a large cash increase ($76,000) due to stock issuance.
• February's ending cash rises to $109,000 despite equipment purchase.
• March's ending cash drops to $98,000 (equipment sale partially offsets dividend payment).
• April's ending cash climbs to $133,000 as collections grow.

Key insight: the cash budget tracks actual cash position, not just profitability—a company can be profitable but run out of cash if timing of receipts and payments is misaligned.

🧭 Overview

🧠 One-sentence thesis

A capital expenditure budget lists the fixed assets a company plans to acquire over future periods, whether to replace aging assets or to meet growing demand, with amounts determined by current costs adjusted for future pricing changes.

📌 Key points (3–5)

• What it is: a list of fixed assets planned for acquisition over a future time period.
• Why companies buy: to replace existing assets that are aging or outdated, or to add resources for growing demand.
• How amounts are set: by looking at current costs and factoring in potential future pricing adjustments.
• Common confusion: budgets are projections of future performance, not reports of past performance; they become benchmarks for comparison once actual results are measured.
• Why it matters: budgets provide a financial roadmap for executing management plans and help discover strengths and weaknesses for future planning.

🏗️ What the capital expenditure budget covers

🏗️ Definition and purpose

Capital expenditure budget: a list of fixed assets that a company plans to acquire over a future period of time.

• It is not about day-to-day operating expenses; it focuses on fixed assets (long-term resources).
• The excerpt emphasizes that these are planned acquisitions, meaning future purchases, not current holdings.

🔄 Two main reasons for acquisition

The excerpt identifies two distinct motivations:

Reason	What it means
Replace aging/outdated assets	Existing resources are no longer efficient or functional
Meet growing demand	Additional resources are necessary to expand capacity

• Don't confuse: replacement purchases maintain current capacity; growth purchases expand it.

💰 How amounts are determined

💰 Pricing methodology

• Start with current costs for the assets.
• Adjust for potential pricing changes in the future.
• The excerpt does not specify exact formulas, but the principle is: estimate today's price, then factor in expected inflation or market shifts.

📋 Sample structure

The excerpt provides a table showing:

• Assets listed by type (Machinery – Cutting Department, Machinery – Assembly Department, Delivery vehicle, Office equipment).
• Years across columns (2020–2024).
• Dollar amounts for each asset in each year.
• Totals for each year (e.g., $90,000 in 2020, $100,000 in 2021).

Example: An organization plans to buy cutting department machinery for $12,000 in 2020, $18,000 in 2021, $24,000 in 2022, and $31,000 in 2023—amounts likely reflect both replacement cycles and anticipated price increases.

🧭 Role in the budgeting process

🧭 Budgets as projections, not reports

• The excerpt emphasizes: budgets are projections of what will take place in the future, not reports of past performance.
• Once the budget period expires, projections become benchmarks for comparing actual results.

🔍 From planning to evaluation

• Budgets provide a financial roadmap for executing management plans.
• After actual performance is measured, comparison with the budget reveals strengths and weaknesses.
• These insights inform subsequent plans going forward.

Don't confuse: the capital expenditure budget itself is forward-looking; variance analysis (comparing budget to actual) happens after the period ends.

🧭 Overview

🧠 One-sentence thesis

Variance analysis compares budgeted standards to actual results to identify where performance deviated from plan, enabling managers to take targeted corrective action.

📌 Key points (3–5)

• What variance analysis does: compares standard costs (budgeted goals) to actual costs after the budget period expires to measure performance.
• Standards are performance goals: the budgeted quantities and prices (e.g., pounds of materials, labor hours, cost per unit) serve as benchmarks.
• Favorable vs unfavorable: actual results below standard are favorable; actual results above standard are unfavorable.
• Common confusion: "favorable" means spending/using less than planned, not necessarily "good"—it depends on whether the variance reveals efficiency or a problem (e.g., using fewer materials might mean quality issues).
• Why break down variances: separating quantity and price/rate variances shows where the deviation occurred, making it easier to address specific issues.

📋 Capital Expenditure Budget

💰 What it is

A capital expenditure budget: a list of fixed assets that a company plans to acquire over a future period of time.

• These assets may replace aging or outdated equipment, or they may be additional resources to meet growing demand.
• Amounts are determined by looking at current costs and adjusting for potential future pricing changes.
• Example: A company budgets $12,000 for cutting department machinery in 2020, $18,000 in 2021, and so on across multiple years and asset categories.

📊 Sample structure

The excerpt shows a multi-year capital expenditures budget table with rows for different asset types (machinery, delivery vehicles, office equipment) and columns for each year (2020–2024).

• Each cell shows the planned expenditure for that asset in that year.
• Totals are summed for each year to show overall capital spending.

🗺️ Role in planning

• Budgets are projections of future performance, not reports of past results.
• Once the budget period ends, actual performance can be compared to the budget to discover strengths and weaknesses.
• These insights inform subsequent planning cycles.

🎯 Standards and Variance Analysis Basics

🎯 What standards are

Standards: performance goals used in budgets (also called estimated goals).

• Standards appear in manufacturing budgets for direct materials, direct labor, and factory overhead.
• Example standards from the excerpt:
  • Direct materials: 8,600 pounds at $6.00 per pound
  • Direct labor: 5,000 hours at $10.00 per hour
  • Factory overhead: $12,000 total

🔍 What variance analysis is

Variance analysis: a process that compares standards to actual amounts once the budget period has expired.

• It measures whether the company met, exceeded, or fell short of its performance goals.
• The goal is to identify where and how much actual results differed from the plan.

📐 Standard costs

Standard costs: estimated goals used to calculate how much a product or batch of products "should cost" to manufacture.

• Standard cost is built from standard quantities and standard prices/rates.
• Example from the excerpt (for 1,000 units):
  • Direct materials: 8,600 pounds × $6.00 = $51,600
  • Direct labor: 5,000 hours × $10.00 = $50,000
  • Factory overhead: $12,000
  • Standard cost per unit: $113.60

🔄 Favorable vs Unfavorable Variances

✅ Favorable variance

• Occurs when actual quantity or cost is lower than the standard.
• Example: spending $9 per labor hour when $10 was budgeted is favorable because less was spent than planned.
• Example: using 8,400 pounds when 8,600 were budgeted is favorable because fewer resources were consumed.

❌ Unfavorable variance

• Occurs when actual quantity or cost is higher than the standard.
• Example: using 8,900 pounds when 8,600 were budgeted is unfavorable because more was consumed than planned.
• Example: paying $6.30 per pound when $6.00 was budgeted is unfavorable because more was spent than planned.

⚠️ Don't confuse

• "Favorable" does not always mean "good" in every context—it simply means "below standard."
• A favorable materials quantity variance might indicate efficiency, or it might signal that less material was used because production quality suffered.
• Managers must interpret variances in context, not just by their favorable/unfavorable label.

🧱 Direct Materials Cost Variance

🧱 Overall variance calculation

The excerpt provides an example for producing 1,000 units:

Item	Actual	Standard	Difference
Quantity (pounds)	8,400	8,600	(200) favorable
Price per pound	$6.30	$6.00	$0.30 unfavorable
Total cost	$52,920	$51,600	$1,320 unfavorable

• Total actual cost is $1,320 higher than standard cost → unfavorable overall.
• But the overall variance hides important details about why the cost was higher.

📊 Breaking down into quantity and price variances

Managers need to know whether the problem was using too much material, paying too much per unit, or both.

Direct materials quantity variance:

• Formula: (actual quantity – standard quantity) × standard price
• Example: (8,400 – 8,600) × $6.00 = –$1,200 (favorable)
• Interpretation: 200 fewer pounds were used, saving $1,200.

Direct materials price variance:

• Formula: (actual price – standard price) × actual quantity
• Example: ($6.30 – $6.00) × 8,400 = $2,520 (unfavorable)
• Interpretation: paying $0.30 more per pound on 8,400 pounds cost an extra $2,520.

Total direct materials cost variance:

• Sum of quantity and price variances: –$1,200 + $2,520 = $1,320 (unfavorable)
• This matches the overall difference between actual and standard total cost.

🎯 Why the breakdown matters

• The quantity variance was favorable (used less material), but the price variance was unfavorable (paid more per pound).
• The unfavorable price variance was larger, so the net result was unfavorable.
• Knowing this breakdown helps managers take targeted action: investigate why material prices rose, negotiate better contracts, or find alternative suppliers.

🛠️ Direct Labor Cost Variance

🛠️ Overall variance calculation

The excerpt provides an example for producing 1,000 units:

Item	Actual	Standard	Difference
Quantity (hours)	5,100	5,000	100 unfavorable
Rate per hour	$9.50	$10.00	($0.50) favorable
Total cost	$48,450	$50,000	–$1,550 favorable

• Total actual cost is $1,550 lower than standard cost → favorable overall.
• Again, the overall variance hides the details of why labor cost was lower.

📊 Breaking down into quantity and rate variances

Direct labor quantity variance (also called efficiency variance):

• Formula: (actual hours – standard hours) × standard rate
• Example: (5,100 – 5,000) × $10.00 = $1,000 (unfavorable)
• Interpretation: 100 extra hours were used, costing an extra $1,000.

Direct labor rate variance:

• Formula: (actual rate – standard rate) × actual hours
• Example: ($9.50 – $10.00) × 5,100 = –$2,550 (favorable)
• Interpretation: paying $0.50 less per hour on 5,100 hours saved $2,550.

Total direct labor cost variance:

• Sum of quantity and rate variances: $1,000 + (–$2,550) = –$1,550 (favorable)
• This matches the overall difference between actual and standard total cost.

🎯 Why the breakdown matters

• The quantity variance was unfavorable (took more hours than planned), but the rate variance was favorable (paid less per hour).
• The favorable rate variance was larger, so the net result was favorable.
• Knowing this breakdown helps managers investigate: Why did production take longer? Was lower-wage labor less efficient? Can training or process improvements reduce hours?

🔑 Summary Formulas

The excerpt provides these summary equations:

Direct materials:

• Direct materials quantity variance = (actual quantity – standard quantity) × standard price
• Direct materials price variance = (actual price – standard price) × actual quantity
• Total direct materials cost variance = quantity variance + price variance

Direct labor:

• Direct labor quantity variance = (actual hours – standard hours) × standard rate
• Direct labor rate variance = (actual rate – standard rate) × actual hours
• Total direct labor cost variance = quantity variance + rate variance

🧮 Pattern

• Quantity/efficiency variance: multiply the difference in quantity/hours by the standard price/rate.
• Price/rate variance: multiply the difference in price/rate by the actual quantity/hours.
• The sum of the two component variances equals the total cost variance.

🧭 Overview

🧠 One-sentence thesis

Breaking down direct materials cost variance into separate quantity and price components helps managers pinpoint whether unfavorable outcomes stem from using more material than planned or paying more per unit than budgeted.

📌 Key points (3–5)

• What variance analysis does: compares actual costs to standard (budgeted) costs to identify favorable or unfavorable differences.
• Two components of materials variance: quantity variance (how much material was used vs. planned) and price variance (what was paid per unit vs. budgeted).
• Favorable vs. unfavorable: favorable means lower cost than expected; unfavorable means higher cost than expected.
• Common confusion: the total variance can be unfavorable even when one component (e.g., quantity) is favorable, because the other component (e.g., price) can be larger and unfavorable.
• Why it matters: separating quantity and price variances allows managers to take targeted corrective actions rather than treating all cost overruns the same way.

📐 Core variance concepts

📐 Actual vs. standard costs

Standard cost: the budgeted or expected cost per unit of production, calculated by multiplying standard quantity by standard price.

• The excerpt uses a production example of 1,000 units with standard direct materials of 8.6 pounds per unit at $6.00 per pound, yielding a standard unit cost of $51.60.
• Actual cost is what was really spent: actual quantity × actual price.
• Variance = actual cost − standard cost.

✅ Favorable vs. unfavorable outcomes

• Favorable: actual cost is lower than standard, or actual quantity used is less than budgeted.
  • Example: using 200 fewer pounds than expected is favorable.
• Unfavorable: actual cost is higher than standard, or actual quantity/price exceeds the budget.
  • Example: paying $0.30 more per pound than budgeted is unfavorable.
• Don't confuse: a favorable variance in one component does not guarantee an overall favorable result if another component is unfavorable by a larger amount.

🧮 Breaking down direct materials variance

🧮 Quantity variance

Direct materials quantity variance = (actual quantity – standard quantity) × standard price

• Measures whether more or fewer pounds (or units) of material were used than planned.
• The excerpt's example:
  • Actual quantity: 8,400 pounds
  • Standard quantity: 8,600 pounds
  • Difference: −200 pounds (favorable, because less was used)
  • Variance: (8,400 − 8,600) × $6.00 = −$1,200 (favorable)
• Why multiply by standard price: isolates the effect of quantity alone, holding price constant.

💵 Price variance

Direct materials price variance = (actual price – standard price) × actual quantity

• Measures whether the price paid per unit was higher or lower than budgeted.
• The excerpt's example:
  • Actual price: $6.30 per pound
  • Standard price: $6.00 per pound
  • Difference: $0.30 (unfavorable, because more was paid)
  • Variance: ($6.30 − $6.00) × 8,400 = $2,520 (unfavorable)
• Why multiply by actual quantity: isolates the effect of price alone, using the quantity that was actually purchased.

🔗 Total variance reconciliation

Total direct materials cost variance = direct materials quantity variance + direct materials price variance

• The excerpt shows:
  • Quantity variance: −$1,200 (favorable)
  • Price variance: +$2,520 (unfavorable)
  • Total variance: $1,320 (unfavorable)
• The total actual cost ($52,920) exceeds the standard cost ($51,600) by $1,320.
• Key insight: even though fewer pounds were used (favorable), the higher price per pound (unfavorable) more than offset the savings, resulting in a net unfavorable outcome.

🎯 Why separate quantity and price

🎯 Targeted managerial action

• Knowing the breakdown helps managers address the root cause:
  • If quantity variance is unfavorable: investigate production efficiency, waste, or process issues.
  • If price variance is unfavorable: review purchasing decisions, supplier contracts, or market conditions.
• The excerpt emphasizes that "managers can better address this situation if they have a breakdown of the variances between quantity and price."

🎯 Avoiding one-size-fits-all responses

• Without the breakdown, managers only see the total $1,320 unfavorable variance and might not realize that production used less material than planned.
• Example scenario: if the price spike was due to a one-time supplier issue, the solution is different from a scenario where production waste increased.
• Don't confuse: a single unfavorable total does not mean every aspect of the process failed; one component may have performed well.

📊 Summary table

Component	Formula	Excerpt example	Interpretation
Quantity variance	(Actual qty − Standard qty) × Standard price	(8,400 − 8,600) × $6.00 = −$1,200	Favorable: used 200 fewer pounds
Price variance	(Actual price − Standard price) × Actual qty	($6.30 − $6.00) × 8,400 = $2,520	Unfavorable: paid $0.30 more per pound
Total variance	Quantity variance + Price variance	−$1,200 + $2,520 = $1,320	Unfavorable: net cost overrun of $1,320

🧭 Overview

🧠 One-sentence thesis

Breaking down direct labor cost variance into time and rate components helps managers pinpoint whether unfavorable outcomes stem from using more hours than planned or paying different wages than expected, enabling targeted corrective action.

📌 Key points (3–5)

• What direct labor variance measures: the difference between actual direct labor cost and standard (expected) direct labor cost for production.
• Two components: direct labor time variance (quantity of hours) and direct labor rate variance (wage per hour).
• How to distinguish: time variance uses standard rate × hour difference; rate variance uses actual hours × rate difference.
• Common confusion: a favorable total variance can hide offsetting problems—one component may be unfavorable even when the net is favorable.
• Why it matters: the breakdown shows managers where to intervene—whether to address efficiency (hours) or wage rates.

📊 The basic direct labor variance

📊 What the variance compares

Direct labor cost variance: the difference between total actual direct labor cost and total standard direct labor cost.

• Actual cost = actual hours worked × actual rate per hour.
• Standard cost = standard (expected) hours × standard rate per hour.
• The excerpt's example: 5,100 actual hours at $9.50/hour = $48,450 actual; 5,000 standard hours at $10.00/hour = $50,000 standard.
• Net variance = $48,450 − $50,000 = −$1,550 (favorable, because actual is lower).

🔍 Why the breakdown is needed

• The total variance alone does not reveal why costs differed.
• The excerpt emphasizes: "Managers can better address this situation if they have a breakdown of the variances between quantity and rate."
• Example: In the excerpt's case, the company used 100 extra hours (bad) but paid $0.50 less per hour (good). Without the breakdown, managers wouldn't know which factor to target.

⏱️ Direct labor time variance

⏱️ What it measures

Direct labor time variance: the difference in hours (actual hours − standard hours) multiplied by the standard rate.

• Formula: (actual hours − standard hours) × standard rate.
• It isolates the effect of using more or fewer hours than planned, holding the wage rate constant at the standard.

🧮 How to calculate

• From the excerpt's example:
  • Actual hours: 5,100
  • Standard hours: 5,000
  • Difference: 100 extra hours
  • Standard rate: $10.00/hour
  • Time variance = 100 × $10.00 = $1,000 unfavorable.
• Unfavorable because the company used more hours than expected.

🚨 Don't confuse with rate variance

• Time variance uses the standard rate to isolate the quantity effect.
• It answers: "If we had paid the expected wage, how much did the extra (or fewer) hours cost us?"

💵 Direct labor rate variance

💵 What it measures

Direct labor rate variance: the difference in wage rate (actual rate − standard rate) multiplied by the actual hours worked.

• Formula: (actual rate − standard rate) × actual hours.
• It isolates the effect of paying a different wage than planned, holding hours constant at the actual level.

🧮 How to calculate

• From the excerpt's example:
  • Actual rate: $9.50/hour
  • Standard rate: $10.00/hour
  • Difference: −$0.50 (actual is lower)
  • Actual hours: 5,100
  • Rate variance = (−$0.50) × 5,100 = −$2,550 favorable.
• Favorable because the company paid less per hour than expected.

🚨 Don't confuse with time variance

• Rate variance uses the actual hours to isolate the price effect.
• It answers: "For the hours we actually worked, how much did the wage difference save or cost us?"

🔗 How the components combine

🔗 The total variance formula

Total direct labor cost variance = direct labor time variance + direct labor rate variance.

• The excerpt shows: $1,000 unfavorable (time) + (−$2,550) favorable (rate) = −$1,550 favorable (total).
• The net is favorable, but the breakdown reveals an efficiency problem (extra hours) offset by a wage savings.

🎯 Why managers need both

• Targeted action: If time variance is unfavorable, investigate production efficiency, training, or process issues. If rate variance is unfavorable, examine wage negotiations or overtime costs.
• Hidden problems: A favorable total can mask an unfavorable component. In the excerpt's case, the $1,000 unfavorable time variance is hidden by the larger favorable rate variance.
• Example: An organization might celebrate the $1,550 savings without realizing that workers took 100 extra hours, which could signal inefficiency or quality issues.

📋 Summary of formulas

Variance type	Formula	What it isolates
Direct labor time variance	(actual hours − standard hours) × standard rate	Effect of using more/fewer hours
Direct labor rate variance	(actual rate − standard rate) × actual hours	Effect of paying higher/lower wages
Total direct labor cost variance	time variance + rate variance	Net difference in total labor cost

• All three must reconcile: the sum of the two components equals the total variance.
• The excerpt's example confirms: $1,000 + (−$2,550) = −$1,550.

🧭 Overview

🧠 One-sentence thesis

Factory overhead variances split into controllable and volume components to reveal how well a company adhered to its budget and how efficiently it used its fixed capacity.

📌 Key points (3–5)

• Two-step process: first separate overhead into fixed and variable components, then calculate separate variances for each.
• Controllable variance: compares actual variable overhead to budgeted variable overhead for actual production—shows budget adherence.
• Volume variance: compares budgeted fixed overhead at normal capacity to standard fixed overhead for actual units—shows capacity utilization.
• Common confusion: underutilizing capacity (producing fewer units than normal) creates an unfavorable volume variance because fixed costs are spread over fewer units; exceeding capacity creates a favorable variance.
• Why it matters: these variances appear on the income statement and help managers identify reasons for deviations from budget.

🏭 Breaking overhead into components

🧱 Fixed vs variable overhead

Factory overhead must be separated before variance analysis can begin:

Component	Examples from excerpt	Behavior
Variable costs	Packing materials, direct labor, variable utilities	Change with production volume
Fixed costs	Supervisor salary, depreciation, machine rental	Stay constant regardless of volume

• The excerpt shows a budget with $50,000 variable and $70,000 fixed overhead at 10,000 units normal capacity.
• Total budgeted overhead: $120,000.

🧮 Calculating overhead rates

The excerpt presents three rates, all based on normal capacity in direct labor hours:

Factory overhead rate = budgeted factory overhead at normal capacity ÷ normal capacity in direct labor hours

• Total rate: $120,000 ÷ 10,000 hours = $12 per direct labor hour
• Variable rate: $50,000 ÷ 10,000 hours = $5 per direct labor hour
• Fixed rate: $70,000 ÷ 10,000 hours = $7 per direct labor hour

The variable rate plus the fixed rate equals the total rate ($5 + $7 = $12).

🎛️ Variable factory overhead controllable variance

🎯 What it measures

Variable factory overhead controllable variance: the difference between actual variable overhead costs and budgeted variable overhead for actual production.

• This variance shows how well the company stuck to its budget for variable costs.
• It focuses on actual production, not normal capacity.

🔢 How to calculate it

Two steps:

1. Budgeted variable factory overhead = standard hours for actual units produced × variable factory overhead rate
2. Controllable variance = actual variable factory overhead − budgeted variable factory overhead

Example from the excerpt:

• 8,000 units produced, each requiring one direct labor hour → 8,000 standard hours
• Budgeted variable overhead = 8,000 × $5 = $40,000
• Actual variable overhead = $39,500
• Controllable variance = $39,500 − $40,000 = ($500) favorable

Favorable because actual cost is less than expected.

📦 Fixed factory overhead volume variance

📏 What it measures

Fixed factory overhead volume variance: the difference between budgeted fixed overhead at normal capacity and standard fixed overhead for actual units produced.

• This variance reveals whether fixed overhead was fully utilized.
• It compares normal capacity to actual production.

🔢 How to calculate it

Fixed factory overhead volume variance = (standard hours at normal capacity − standard hours for actual units produced) × fixed factory overhead rate

🔽 Underutilizing capacity (unfavorable)

Example from the excerpt:

• Normal capacity: 10,000 hours
• Actual production: 8,000 units × 1 hour each = 8,000 standard hours
• Volume variance = (10,000 − 8,000) × $7 = $14,000 unfavorable

Why unfavorable?

• The company had capacity for 10,000 units but only produced 8,000.
• Fixed costs ($70,000) are spread over fewer units, raising per-unit cost.
• This is a "missed opportunity" to produce more units for the same fixed overhead.

🔼 Exceeding capacity (favorable)

Example from the excerpt:

• Normal capacity: 10,000 hours
• Actual production: 11,000 units × 1 hour each = 11,000 standard hours
• Volume variance = (10,000 − 11,000) × $7 = ($7,000) favorable

Why favorable?

• The company produced more than normal capacity without increasing fixed costs.
• Fixed overhead is "leveraged beyond normal production."
• Additional units were produced without any necessary increase in fixed costs.

⚠️ Don't confuse with controllable variance

• Controllable variance = actual vs budgeted variable overhead → measures budget adherence
• Volume variance = normal capacity vs actual production for fixed overhead → measures capacity utilization

📊 Using variances in the income statement

📋 How variances appear

The excerpt shows an income statement that integrates all variances:

• Start with gross profit at standard (sales minus standard cost of goods sold).
• List each variance line by line (materials quantity, materials price, labor time, labor rate, overhead controllable, overhead volume).
• Calculate net variance from standard cost.
• Adjust gross profit to arrive at actual gross profit.

Example structure from the excerpt:

• Sales: $200,000
• Cost of goods sold at standard: $113,600
• Gross profit at standard: $86,400
• Net variance from standard cost (favorable): ($430)
• Actual gross profit: $86,830

🎯 Why this matters for managers

The excerpt emphasizes that this format helps managers:

• See how deviations from budget impact gross profit and net income.
• Focus on discovering reasons for unfavorable variances.
• Continue practices that produce favorable variances.
• Plan and operate more effectively in future periods.

🧭 Overview

🧠 One-sentence thesis

Differential analysis is a decision-making technique that compares only the costs and benefits that differ between two alternatives to identify the option with the most favorable financial impact.

📌 Key points (3–5)

• What differential analysis does: examines benefits and costs of two options and compares their net results to choose the financially better alternative.
• What to include: only costs that will change between alternatives; revenues and variable costs that differ.
• What to exclude: fixed costs that remain constant, and sunk costs (past expenditures already incurred and unrecoverable).
• Common confusion: not all costs matter—only differential costs (those that change) should be analyzed; costs that stay the same for both options are irrelevant to the decision.
• Decision rule: select the alternative with the highest income or, if neither produces income, the one with the least loss.

🎯 What differential analysis is

🎯 Core definition

Differential analysis: a decision-making technique that examines the benefits and costs associated with each of two options and compares the net results of the two.

• It is used when managers must choose among alternative courses of action.
• From a financial perspective, the better option is either:
  • The one that yields the highest amount of income, or
  • If neither produces income, the one that results in the least amount of loss.

🔍 Why it focuses on differences

• The evaluation includes only those costs that will change if one alternative is selected over another.
• Costs that are the same for both options do not help differentiate one choice from the other, so they are excluded.
• Example: If both alternatives incur the same rent expense, that rent is irrelevant to the decision.

🚫 What to exclude from the analysis

🚫 Fixed costs that don't change

• Fixed costs or other costs that are constant for the two options are excluded from the analysis.
• Reason: they will not differentiate one choice from the other.
• Don't confuse: not all fixed costs are excluded—only those that remain the same under both alternatives.

🚫 Sunk costs

Sunk costs: past expenditures that have already been incurred and cannot be recovered.

• These are also ignored in differential analysis.
• Reason: the amount will be the same regardless of the alternative selected.
• Example: Money already spent on equipment that cannot be refunded is a sunk cost and should not influence the decision between two future options.

📊 How to apply differential analysis

📊 The comparison framework

The excerpt provides a simple structure:

Element	What to do
Revenues	Compare revenues for each alternative
Costs	Compare only the costs that differ
Income	Calculate net income (revenues minus costs) for each option
Decision	Select the alternative with the higher income (or lower loss)

📊 Example scenario

The excerpt illustrates with a bed & breakfast inn owner deciding between two uses for a first-floor space:

Differential Analysis

Item	Guest Room	Gift Shop	Difference
Revenues	$36,000	$42,000	—
Costs	($11,000)	($15,000)	—
Income	$47,000	$57,000	$10,000

• The gift shop will yield $10,000 more in operating income than the guest room.
• Decision: select the gift shop alternative.
• Note: The excerpt shows income as $47,000 and $57,000, which appears to be revenues minus costs; the difference is $10,000 favoring the gift shop.

📊 Common business decisions

The excerpt lists seven types of decisions where differential analysis can be applied:

1. Make or buy a component part
2. Continue with or discontinue a business segment
3. Lease or sell equipment
4. Sell a product or process further
5. Keep or replace a fixed asset
6. Accept business at reduced price
7. Capital investment analysis

• These are specific scenarios where managers must choose between alternatives.
• The same principle applies: compare only the costs and revenues that differ.

🧭 Overview

🧠 One-sentence thesis

When a manufacturer can either produce a component internally or purchase it from an external supplier, differential analysis compares only the costs that differ between the two options to select the lower-cost alternative.

📌 Key points (3–5)

• What differential analysis does: examines only the costs and benefits that change between two alternatives, ignoring costs that remain the same.
• Fixed and sunk costs are excluded: costs that stay constant under both options (fixed costs) or have already been incurred (sunk costs) do not help differentiate the choices.
• Make-or-buy decision: compares the internal manufacturing costs (materials, labor) with the external purchase price plus any additional costs like shipping.
• Common confusion: fixed factory overhead may exist in internal production, but if it will be incurred regardless of the decision, it should be excluded from the differential analysis.
• Selection criterion: the alternative with the most favorable (or least unfavorable) financial impact is chosen.

🔍 What is differential analysis

🔍 Core definition and purpose

Differential analysis: a decision-making technique that examines the benefits and costs associated with each of two options and compares the net results of the two.

• The goal is to identify which alternative yields the highest income or, if neither produces income, the one that results in the least loss.
• Only costs and revenues that will change if one alternative is selected over the other are included.
• This approach simplifies decision-making by filtering out irrelevant financial data.

🚫 What to exclude from the analysis

• Fixed costs: costs that remain constant for both options do not differentiate one choice from the other, so they are excluded.
• Sunk costs: past expenditures that have already been incurred and cannot be recovered; the amount will be the same regardless of the alternative selected, so they are ignored.
• Example: If a company already owns machinery that will be used in both scenarios, the depreciation on that machinery is not part of the differential analysis.

📋 Illustrative example: guest room vs. gift shop

The excerpt provides a bed & breakfast example:

Alternative	Revenues	Costs	Income
Guest Room	$36,000	$(11,000)	$47,000
Gift Shop	$42,000	$(15,000)	$57,000
Difference	—	—	$10,000

• The gift shop yields $10,000 more in operating income than the guest room.
• Therefore, the gift shop alternative should be selected.
• Note: Only the revenues and costs that differ between the two options are compared.

🏭 Make-or-buy decision for a component part

🏭 The decision context

• A manufacturing company may have the capacity and ability to make one of the parts that goes into the manufacture of its products.
• It may also have the alternative of purchasing the same part from an external supplier.
• Assuming equal quality and availability, the lower-cost option will be selected.

🧮 Example: Compu Company carrying case

Scenario:

• Compu Company manufactures laptop computers and will sell them with a carrying case.
• The company is currently operating below full capacity and has the ability to manufacture the cases in-house.
• Alternatively, it can purchase the cases from an outside vendor.

Internal manufacturing costs per case:

• Direct materials: $22.40
• Direct labor: $14.00
• Fixed factory overhead: $5.60

External purchase costs per case:

• Purchase price: $34.20
• Inbound shipping charge: $3.70

📊 Differential analysis comparison

Cost element	Make	Buy	Difference
Purchase price	—	$34.20	—
Inbound shipping	—	$3.70	—
Direct materials	$22.40	—	—
Direct labor	$14.00	—	—
Total cost per case	$36.40	$37.90	$1.50

• Fixed factory overhead is excluded: the $5.60 fixed overhead would be incurred under either alternative, so it does not appear in the differential analysis.
• The cost of making the carrying case is $1.50 less per unit than purchasing it.
• Conclusion: Compu Company should manufacture the cases in-house.

⚠️ Why fixed overhead is excluded

• The excerpt notes that "the factory overhead is fixed and would be incurred under either alternative, so it is not listed."
• Don't confuse: even though fixed overhead is a real cost of production, it does not differentiate the two options because it will be paid regardless.
• Only the costs that change—direct materials, direct labor, purchase price, and shipping—are relevant to the decision.

🧩 Key takeaways for make-or-buy decisions

🧩 Focus on relevant costs only

• Include only costs that will change if one alternative is selected over the other.
• Exclude fixed costs that remain the same and sunk costs that cannot be recovered.

🧩 Revenue may not be a factor

• In the Compu Company example, "the selling price per unit would not be affected by the decision, and no other factors impact revenue."
• Therefore, only costs need to be considered in the differential analysis.
• Example: If both alternatives result in the same final product sold at the same price, revenue is constant and does not help differentiate the choices.

🧩 Selection criterion

• The alternative with the lower total relevant cost (or higher net benefit) is chosen.
• In the carrying case example, making the case saves $1.50 per unit compared to buying it, so the company should make it.

🧭 Overview

🧠 One-sentence thesis

A segment that shows an operating loss may still contribute positively to overall company income if it generates revenue that exceeds its variable costs, because fixed costs remain regardless of the discontinuation decision.

📌 Key points (3–5)

• What the decision involves: whether to keep or eliminate a product/segment that appears unprofitable.
• Why eliminating a loss-maker may backfire: fixed costs (depreciation, property taxes, insurance) do not disappear when a segment is discontinued.
• The key comparison: revenue minus variable costs shows the segment's contribution toward covering fixed costs.
• Common confusion: an operating loss on the segment's income statement does not automatically mean discontinuing it will improve total company income—fixed costs allocated to that segment will remain.
• The decision rule: continue if the segment's revenue exceeds its variable costs; discontinue only if eliminating it saves more than the lost contribution.

💰 Why segments with losses may still be worth keeping

💰 Fixed costs remain regardless

• Fixed costs such as depreciation, property taxes, and insurance are incurred whether the segment operates or not.
• Eliminating a segment removes its revenue and variable costs, but the fixed costs stay.
• Don't confuse: "operating loss" on a segment income statement includes allocated fixed costs; those costs do not vanish if the segment is dropped.

💰 Contribution toward fixed costs

• Even if a segment shows a loss overall, it may generate revenue that exceeds its variable costs.
• That excess (revenue minus variable costs) contributes toward paying the company's fixed costs.
• Example: If a segment brings in $40,000 more in revenue than it costs in variable expenses, discontinuing it means the company loses that $40,000 contribution—fixed costs must then be covered by other segments.

🔍 Differential analysis framework

🔍 What to include and exclude

Differential analysis for continue/discontinue: compare only the revenues and costs that change between the two alternatives.

• Include:
  • Revenue from the segment (lost if discontinued).
  • Variable costs (eliminated if discontinued).
• Exclude:
  • Fixed costs, because they are incurred under both alternatives.

🔍 The comparison structure

Alternative	Revenue	Variable costs	Net contribution
Continue	Segment revenue	Variable COGS + Variable operating expenses	Revenue − Variable costs
Discontinue	$0	$0	$0
Difference	Lost revenue	Saved variable costs	Impact on income

• The "Difference" column shows the financial impact of discontinuing.
• If continuing yields a positive net contribution, the segment should be kept.

📊 Worked example: Healthy Habits popcorn line

📊 The situation

• Healthy Habits Company sells popcorn; the product line shows an operating loss of $260,000.
• Income statement for popcorn:
  • Sales: $720,000
  • Cost of goods sold: $480,000
  • Gross profit: $240,000
  • Operating expenses: $500,000
  • Loss from operations: ($260,000)

📊 Identifying variable vs fixed costs

• Cost of goods sold: 25% is fixed, so 75% is variable.
  • Variable COGS = $480,000 × 75% = $360,000
• Operating expenses: 40% is fixed, so 60% is variable.
  • Variable operating expenses = $500,000 × 60% = $300,000
• Fixed portions are excluded from the differential analysis because they remain under both alternatives.

📊 The differential analysis

Item	Continue	Discontinue	Difference
Revenue	$720,000	$0	−$720,000
Variable COGS	$360,000	$0	−$360,000
Variable operating expenses	$300,000	$0	−$300,000
Income (contribution)	$40,000	$0	−$40,000

• Continuing the popcorn line yields $40,000 in income (after removing fixed costs from the calculation).
• Discontinuing it results in $0 contribution, so the company loses $40,000 toward covering fixed costs.

📊 The conclusion

• Although the popcorn line shows an operating loss when fixed costs are allocated to it, it contributes $40,000 more than its variable costs.
• Fixed costs will be incurred whether popcorn is sold or not.
• Decision: The company should continue selling popcorn, because discontinuing it would reduce overall company income by $40,000.

⚠️ Common pitfalls

⚠️ Misinterpreting segment losses

• A segment income statement that shows a loss includes allocated fixed costs.
• That loss does not mean the segment is "costing" the company money in a way that can be eliminated.
• Key insight: If revenue > variable costs, the segment is helping pay fixed costs, even if the full income statement shows a loss.

⚠️ Assuming all costs disappear

• Only variable costs are eliminated when a segment is discontinued.
• Fixed costs remain and must be absorbed by other segments or reduce overall company income.
• Example: Discontinuing popcorn saves $660,000 in variable costs but also loses $720,000 in revenue—net effect is a $40,000 reduction in income, not an improvement.

🧭 Overview

🧠 One-sentence thesis

When a company no longer needs a fixed asset, differential analysis comparing lease income and scrap value against selling price minus transaction costs identifies which option yields the greater financial return.

📌 Key points (3–5)

• The decision: choose between selling an unneeded fixed asset outright or leasing it to generate an income stream over time.
• What to include: revenues (sale price, lease payments, scrap value) and variable costs (commissions, transaction fees) that differ between alternatives.
• What to exclude: costs that occur under both options (e.g., restoration costs) and sunk costs (e.g., original purchase price, current book value) are ignored because they do not affect the decision.
• Common confusion: book value is not relevant—it reflects past spending, not future cash flows; only compare incremental revenues and costs.
• The rule: select the alternative with the higher net income after accounting for all differential revenues and costs.

💰 What goes into the analysis

💰 Revenues under each option

• Selling: the sale price the company will receive.
• Leasing: total lease payments over the lease period plus any scrap or salvage value at the end.
• Example: Harper can sell equipment for $10,000 or lease it for $2,400 per year for four years ($9,600 total) plus $100 scrap value.

💸 Costs that differ between options

• Include only costs that change depending on the choice.
• Selling: transaction costs such as sales commissions.
  • Example: Harper must pay a 2% commission on the $10,000 sale price, which is $200.
• Leasing: any incremental costs specific to leasing (none mentioned in the excerpt for Harper).
• Costs incurred under both alternatives are excluded from the comparison.

🚫 What to ignore

🚫 Costs that occur regardless of choice

Costs that must be paid under either option are not considered in the differential analysis.

• Example: Harper must pay $900 to restore the equipment site whether it sells or leases the equipment, so this cost is ignored.
• Why: these costs do not help distinguish between the alternatives; they do not affect the relative advantage of one option over the other.

🚫 Sunk costs

The original purchase price and current book value are sunk costs that will not be recouped or changed regardless of the decision; therefore, they are ignored.

• Sunk cost: a past expenditure that cannot be recovered.
• Harper originally purchased the equipment for $40,000 and it now has a book value of $15,000.
• Neither figure appears in the differential analysis because they represent historical spending, not future cash flows.
• Don't confuse: book value is an accounting figure; it does not represent cash the company will receive or pay in the future.

📊 Comparing the alternatives

📊 Harper Company example

Item	Lease	Sell	Difference
Revenue	$9,600 (lease payments)	$10,000 (sale price)
Scrap value	$100	—
Sales commission	—	($200)
Income	$9,700	$9,800	$100

• Lease income: $2,400 × 4 years = $9,600, plus $100 scrap = $9,700 total.
• Sell income: $10,000 sale price minus $200 commission (2% of $10,000) = $9,800.
• The $900 restoration cost and the original $40,000 purchase price do not appear in the table.

🎯 The decision

• Selling the equipment results in $100 more income than leasing it.
• Therefore, Harper Company should sell the equipment.
• The analysis focuses only on the incremental difference: which option leaves the company better off financially.

🧭 Overview

🧠 One-sentence thesis

A manufacturer should choose to process a product further only when the additional revenue from further processing exceeds the additional costs incurred, ignoring sunk costs that do not change between alternatives.

📌 Key points (3–5)

• The decision: whether to sell a product at an intermediate stage or invest in additional processing to create a different or more valuable product.
• What to compare: incremental revenue from further processing versus incremental costs (materials, processing expenses, and losses).
• Sunk costs are ignored: original production costs that have already been incurred do not affect the decision because they cannot be changed.
• Common confusion: do not include costs that apply equally to both alternatives (e.g., restoration costs or original purchase prices)—only differential amounts matter.
• The rule: choose the alternative that yields higher income after accounting for all differential revenues and costs.

🔍 When the decision arises

🔍 Two scenarios for partial products

A manufactured item may reach a point where the company faces a choice:

• Initial stage sale: the product is complete enough to sell as-is to a market that exists for partially finished goods.
• Further processing: additional work transforms the product into something different or more refined, often commanding a higher price.

The buyer in the first scenario may complete the product to their own specifications; the manufacturer must decide whether that opportunity cost is worth taking.

🏭 Market conditions

• Some products have a market at an intermediate stage (e.g., a buyer who will finish the product themselves).
• Other products can be enhanced through additional processing to serve a different market segment (e.g., decaffeinated coffee versus regular coffee).

💰 Differential analysis framework

💰 What to include in the comparison

The analysis compares only the amounts that differ between the two alternatives:

Item	Sell now	Process further
Revenue	Selling price at intermediate stage	Selling price of fully processed product
Costs	(none beyond sunk costs)	Additional processing costs + any product loss

• Revenue: the price per unit times the quantity sold under each scenario.
• Costs: only the additional costs incurred by further processing (materials, labor, overhead specific to the extra step).
• Product loss: if further processing causes evaporation, spoilage, or waste, that loss reduces the quantity available to sell and must be factored in.

🚫 What to exclude

Sunk costs: costs already incurred that will not be recouped or changed regardless of the decision.

• The original materials cost or initial production cost is a sunk cost if it has already been paid.
• Costs that apply equally to both alternatives (e.g., a restoration fee that must be paid no matter what) are also excluded because they do not affect the difference between the two choices.

Don't confuse: the excerpt's lease-versus-sell example (preceding section 9.5) shows that a $900 restoration cost is ignored because it is the same under both options; similarly, the original purchase price is ignored as a sunk cost.

📐 Worked example: Morning Roast Coffee

📐 The scenario

• Product: dark roast coffee produced in batches of 5,000 pounds.
• Materials cost: $5.80 per pound (already incurred as a sunk cost for the initial batch).
• Option 1 (Sell): sell the dark roast as-is for $9.70 per pound.
• Option 2 (Process further): convert to dark roast decaf, sell for $12.10 per pound, but incur $7,480 in additional processing costs and lose 4% of the product to evaporation.

📐 The calculation

Line	Sell	Process further	Difference
Revenue	5,000 × $9.70 = $48,500	5,000 × $12.10 = $60,500	+$12,000
Materials cost	5,000 × $5.80 = $29,000	5,000 × $5.80 + $7,480 = $36,480	+$7,480
Evaporation loss	—	$60,500 × 4% = $2,420	+$2,420
Income	$19,500	$21,600	+$2,100

(Note: the excerpt's table shows "Income" for "Process" as $9,800, but the correct calculation is $60,500 − $36,480 − $2,420 = $21,600; the "Difference" column shows $2,100, which is consistent with $21,600 − $19,500.)

🧮 Interpretation

• Revenue gain: processing further increases revenue by $12,000.
• Cost increase: additional processing costs $7,480, and evaporation reduces saleable product by $2,420 in value.
• Net benefit: $12,000 − $7,480 − $2,420 = $2,100 more income.
• Conclusion: the company should process the batch further because it yields $2,100 more income despite the evaporation loss.

⚠️ Why evaporation matters

• The 4% loss is calculated on the revenue from the processed product ($60,500 × 4% = $2,420).
• This represents the value of product that cannot be sold due to evaporation.
• Even with this loss, the higher selling price of decaf coffee more than compensates for the additional costs.

🧩 Key takeaways for decision-making

🧩 The decision rule

• Calculate the income (revenue minus costs) for each alternative.
• Choose the alternative with the higher income.
• Ignore sunk costs and costs that are the same under both options.

🧩 When to process further

Process further when:

• The additional revenue from the enhanced product exceeds the sum of additional processing costs and any product losses.

🧩 When to sell at the intermediate stage

Sell immediately when:

• The additional revenue from further processing does not justify the extra costs and losses.
• The company lacks the capacity or resources to perform the additional processing efficiently.

Example: if Morning Roast's additional processing cost were $15,000 instead of $7,480, the net benefit would be negative, and the company should sell the dark roast as-is.

🧭 Overview

🧠 One-sentence thesis

Differential analysis helps a company decide whether to keep an existing fixed asset or replace it with a more efficient one by comparing the costs and revenues of each alternative, ignoring sunk costs, and choosing the option with the better financial outcome.

📌 Key points (3–5)

• What the decision involves: comparing the cost of keeping an existing asset versus replacing it with a new, more efficient one to reduce operating costs.
• How differential analysis works: compare revenues (from selling the old asset) and costs (purchase price of new asset plus operating costs over time) for each alternative.
• Sunk costs are ignored: the original purchase price and accumulated depreciation of the old asset are not considered because they cannot be changed by the decision.
• Common confusion: don't include the original cost of the old equipment—it's already spent and won't be recouped regardless of the choice.
• Decision rule: choose the alternative with higher income or lower loss over the relevant time period.

💰 What revenues and costs to compare

💰 Revenue from selling the old asset

• If the company replaces the equipment, it will sell the old asset and receive cash.
• Example: McNamara Company can sell its existing equipment for $75,000.
• This revenue only appears in the "Replace" column because keeping the old asset generates no sale revenue.

💸 Cost of the new asset

• Replacing requires purchasing new equipment.
• Example: the new equipment costs $182,000.
• This cost only appears in the "Replace" column.

🔧 Operating costs over time

• Each alternative has different annual variable operational costs.
• The analysis multiplies annual costs by the number of years the asset will be used.
• Example: old equipment costs $21,000 per year; new equipment costs $6,000 per year; over six years, that's $126,000 vs. $36,000.
• Lower operating costs are a key benefit of replacing with more efficient equipment.

🚫 What to ignore: sunk costs

🚫 Original purchase price and depreciation

Sunk cost: a cost that has already been incurred and cannot be recouped or changed regardless of the decision.

• The old equipment originally cost $200,000 and has accumulated depreciation of $120,000.
• These amounts are not included in the differential analysis.
• Why ignore them? They are already spent; the decision to keep or replace will not change these past costs.
• Don't confuse: the sale price of the old asset ($75,000) is relevant because it is a future cash inflow if the company replaces; the original cost ($200,000) is not relevant because it is a past outflow.

📊 The decision framework

📊 Comparing income or loss

Alternative	Revenue	Costs	Income (Loss)
Keep	$0	$126,000 (operating)	($126,000)
Replace	$75,000 (sale)	$182,000 (purchase) + $36,000 (operating) = $218,000	($143,000)
Difference			$17,000

• Both alternatives result in a loss over the six-year period.
• The "Keep" option has a lower loss by $17,000.
• Decision rule: when both options generate losses, choose the one with the smaller loss.

✅ The conclusion

• McNamara Company should keep and operate the original equipment.
• Even though the new equipment has lower annual operating costs ($6,000 vs. $21,000), the high purchase price ($182,000) outweighs the savings.
• The $75,000 from selling the old asset is not enough to offset the cost of buying and operating the new one over six years.

🔍 Key takeaways for decision-making

🔍 Focus on future cash flows

• Only include revenues and costs that will differ between the alternatives.
• Ignore costs that have already been incurred (sunk costs) or that will be the same under both options.

🔍 Time horizon matters

• Operating cost savings accumulate over multiple years.
• A longer time period may make replacement more attractive if annual savings are significant.
• Example: if McNamara planned to use the equipment for ten years instead of six, the operating cost savings might eventually outweigh the purchase price.

🔍 Independent evaluation

• Each alternative is evaluated on its own financial merit.
• The choice is not "which makes money?" but "which is less costly?" or "which generates more income?"
• In this case, both lose money, so the company picks the smaller loss.

🧭 Overview

🧠 One-sentence thesis

When a manufacturer has spare capacity and receives a special order below the normal selling price, differential analysis shows whether the incremental revenue exceeds the incremental variable costs, making the order financially worthwhile.

📌 Key points (3–5)

• The decision context: a manufacturer receives an offer to produce and sell additional items at a price lower than normal, but only if the company has spare capacity.
• What costs matter: only variable costs are relevant; fixed costs are ignored because they will be incurred regardless of the decision.
• Financial test: accept the order if the reduced-price revenue exceeds the variable costs of producing the additional units.
• Common confusion: don't include fixed costs in the analysis—they are sunk and do not change with the decision.
• Beyond the numbers: qualitative factors (customer loyalty, price erosion, regular customer irritation) may override the financial conclusion.

💰 The special-order decision framework

💰 When this decision arises

• A manufacturer receives an offer to produce and sell additional items beyond planned production.
• The selling price offered is lower than the normal price.
• The company must have spare capacity to process the order without disrupting existing operations.

🔍 What differential analysis compares

The analysis contrasts two alternatives:

Alternative	Revenue	Costs included	Outcome
Accept	Revenue from the special order	Variable production costs + any special costs (e.g., tariffs)	Income or loss
Reject	Zero	Zero	Zero

• The difference between the two outcomes determines whether to accept or reject.

🧮 The Spark Top Company example

🧮 The scenario

• Normal selling price: $60 per unit.
• Special order: 5,000 units at $36 per unit (40% below normal price).
• Costs per unit:
  • Variable manufacturing cost: $25.
  • Fixed manufacturing cost: $15.
• Additional cost: $800 tariff for shipping the batch of 5,000 units.
• Capacity: the company has spare capacity to produce the additional 5,000 units.

📊 The differential analysis

Accept the order:

• Revenue: 5,000 × $36 = $180,000.
• Variable production costs: 5,000 × $25 = $125,000.
• Tariff: $800.
• Income: $180,000 − $125,000 − $800 = $54,200.

Reject the order:

• Revenue: $0.
• Costs: $0.
• Income: $0.

Difference: accepting the order yields $54,200 more income.

✅ The conclusion

The company should accept the special order because the incremental revenue exceeds the incremental variable costs.

🚫 What to exclude from the analysis

🚫 Fixed costs are ignored

Fixed costs are not factored in since they will be incurred regardless of the decision.

• The $15 per-unit fixed manufacturing cost does not appear in the differential analysis.
• Why: fixed costs are sunk—they do not change whether the company accepts or rejects the order.
• Don't confuse: the total cost per unit ($25 variable + $15 fixed = $40) is not the relevant comparison; only the $25 variable cost matters for the incremental decision.

🧩 Only incremental items count

• Incremental revenue: the $180,000 from the special order.
• Incremental costs: the $125,000 variable production cost and the $800 tariff.
• Any cost or revenue that stays the same under both alternatives is excluded.

⚠️ Qualitative factors and broader implications

⚠️ Beyond the financial calculation

The excerpt warns that financial considerations are only the starting point:

The implications of special order pricing may go beyond just financial considerations.

🛑 Potential negative effects

• Demand cannibalization: processing special orders may reduce demand for the same product at the normal selling price, ultimately decreasing overall income.
• Customer irritation: regular customers may learn that new customers are receiving a better deal and either demand a price match or consider shopping elsewhere.
• Price erosion: accepting low-price orders may set a precedent or damage brand positioning.

🧭 Other qualitative factors to consider

The excerpt lists additional non-financial considerations for differential analysis in general:

• Customer loyalty.
• Vendor relationships.
• Employee morale.
• Social responsibility.
• Opportunity costs.

🔑 The role of financial analysis

The financial element, however, is a critical starting point for managerial decision making.

• Differential analysis provides the quantitative foundation.
• Managers must then weigh qualitative factors before making the final decision.
• Example: even if the special order is financially profitable, a company might reject it to protect relationships with regular customers or to avoid long-term price erosion.