Sources and References

Primary textbook — Garrison, R.H., Libby, T., Webb, A., Noreen, E.W., & Brewer, P.C. (2024). Managerial Accounting (13th Canadian ed.). McGraw-Hill Ryerson. Supplementary — Horngren, C.T., Datar, S.M., & Rajan, M.V. (2015). Cost Accounting: A Managerial Emphasis (15th ed.). Pearson. Online resources — MIT OpenCourseWare 15.501: Introduction to Financial and Managerial Accounting; CPA Canada practice resources.

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Chapter 1: Introduction to Managerial Accounting

1.1 What Is Managerial Accounting?

Managerial accounting differs fundamentally from financial accounting in both audience and purpose. Financial accounting produces reports — income statements, balance sheets, cash flow statements — intended for external stakeholders such as investors, creditors, and regulators, and it must conform to generally accepted accounting principles (GAAP). Managerial accounting, by contrast, generates information for internal decision-makers: managers, executives, and operational teams who need timely, relevant data to plan operations, control costs, and make strategic choices. There are no GAAP constraints on managerial reports; they are shaped by whatever format makes the information most useful.

The three core functions that managerial accounting serves are:

1. Planning — setting objectives and determining how to achieve them (e.g., preparing annual budgets, revenue forecasts, and production schedules).
2. Controlling — measuring actual performance against planned targets, identifying variances, and investigating their causes so that corrective action can be taken.
3. Decision-making — evaluating alternative courses of action using relevant cost and benefit information; examples include whether to make or buy a component, accept a special order, or drop a product line.

1.2 Managerial vs. Financial Accounting

Feature	Financial Accounting	Managerial Accounting
Primary audience	External parties (investors, creditors, regulators)	Internal managers at all levels
Reporting frequency	Quarterly and annually	As needed — daily, weekly, or on demand
Standards	GAAP / IFRS — mandatory	No mandatory external standards
Focus	Historical financial results	Future-oriented; forward-looking estimates
Scope	Entire organization as a whole	Segments, products, departments, decisions
Verification	External audit required	Not audited; internal review only
Non-financial data	Rarely included	Commonly included (quality rates, cycle times)
Time horizon	Past periods	Current and future periods

1.3 The Role of the Management Accountant

Management accountants (often called cost accountants or controllers at the divisional level) occupy a staff position in the organization. They advise line managers but do not issue directives. Their responsibilities include:

• Designing and maintaining cost accounting systems.
• Preparing budgets and coordinating the budgeting process.
• Analyzing variances between actual and budgeted results.
• Providing financial analysis for capital investment proposals.
• Ensuring internal controls are effective.

Professional bodies such as CPA Canada provide designations (CPA) and ethical guidelines that management accountants follow. Core ethical principles include competence, confidentiality, integrity, and objectivity (Horngren, Datar & Rajan, 2015, Ch. 1).

1.4 Cost Classifications Overview

Before any managerial analysis can occur, costs must be classified precisely. The same expenditure can belong to different categories depending on context.

Manufacturing vs. Non-Manufacturing Costs

Manufacturing costs are those incurred to produce a physical product:

• Direct materials (DM) — raw materials physically and conveniently traceable to the finished product (e.g., wood in furniture, steel in an automobile, flour in bread).
• Direct labour (DL) — wages of employees whose work can be directly and conveniently traced to specific units (e.g., assembly-line workers, machine operators).
• Manufacturing overhead (MOH) — all other production costs that cannot be directly traced, including factory rent, depreciation of machinery, indirect materials (lubricants, cleaning supplies), indirect labour (maintenance workers, factory supervisors), property taxes on the factory, and utilities.

Non-manufacturing costs (also called period costs) are expensed in the period incurred and never pass through inventory:

• Selling costs — advertising, sales commissions, shipping, sales force salaries.
• Administrative (general & administrative) costs — executive salaries, accounting department, legal fees, corporate office rent.

Product Costs vs. Period Costs

Prime Costs and Conversion Costs

• Prime costs = Direct materials + Direct labour (the most obviously traceable costs)
• Conversion costs = Direct labour + Manufacturing overhead (costs required to “convert” raw materials into finished goods)

These groupings appear frequently in process costing (Chapter 5).

The Cost of Goods Manufactured Schedule

Manufacturing firms use a Cost of Goods Manufactured (COGM) schedule to reconcile raw material purchases through to finished goods. The schedule flows as follows:

\[ \text{COGM} = \text{Beginning WIP} + \text{DM used} + \text{DL} + \text{MOH applied} - \text{Ending WIP} \]

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Chapter 2: Cost Behaviour and Cost Estimation

2.1 Fixed, Variable, and Mixed Costs

Understanding how costs respond to changes in activity is fundamental to managerial accounting. Activity is usually measured in terms of units produced, units sold, machine-hours, or direct labour-hours. The relationship between a cost and the chosen activity measure determines how that cost behaves.

The general equation for a mixed cost is:

\[ Y = a + bX \]

where \(Y\) is total cost, \(a\) is the total fixed cost component, \(b\) is the variable cost per unit of activity, and \(X\) is the level of activity.

Cost Behaviour Summary

Cost Type	Total Cost Behaviour	Per-Unit Behaviour
Variable	Increases proportionally with activity	Constant
Fixed	Constant within relevant range	Decreases as activity rises
Mixed	Increases, but less than proportionally	Decreases as activity rises
Step-fixed	Constant in steps; jumps at thresholds	Decreases within each step

2.2 The Relevant Range

Fixed costs are fixed only within a relevant range — the band of activity levels within which cost behaviour assumptions reasonably hold. Outside this range, fixed costs may step up (e.g., a second factory must be rented if production exceeds capacity) and variable costs may change (e.g., volume discounts on materials above a certain order size). Most managerial analysis implicitly assumes the relevant range.

2.3 Methods of Estimating Mixed Costs

The High-Low Method

The high-low method uses only the highest and lowest activity data points to estimate the variable rate and the fixed component:

\[ b = \frac{\text{Cost at high activity level} - \text{Cost at low activity level}}{\text{High activity level} - \text{Low activity level}} \]\[ a = \text{Total cost at high activity} - (b \times \text{High activity level}) \]

Weakness of the high-low method: It uses only two data points and is therefore sensitive to outliers. The high or low point may be an unusual observation unrepresentative of the typical cost relationship.

Least-Squares Regression

Regression analysis (also called the method of least squares) uses all available data points to determine the line of best fit by minimizing the sum of squared vertical deviations between the observed data and the regression line. It produces more reliable and statistically defensible estimates than the high-low method. Most spreadsheet software (e.g., Excel’s LINEST function or the Data Analysis add-in) performs this calculation automatically.

The regression output produces:

• Intercept (\(a\)) — the estimated fixed cost.
• Slope coefficient (\(b\)) — the estimated variable cost per unit of activity.
• R-squared (\(R^2\)) — the proportion of variance in cost explained by the activity measure; values close to 1.0 indicate a strong relationship.

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Chapter 3: Cost-Volume-Profit Analysis

3.1 The CVP Model

Cost-volume-profit (CVP) analysis examines the relationship among costs, volume, and profit to answer “what-if” planning questions such as: How many units must we sell to break even? How will a price change affect profit? What is the risk if sales fall short of budget? It is one of the most widely used tools in managerial accounting.

Assumptions of CVP Analysis

1. Selling price per unit is constant.
2. Costs are either perfectly fixed or perfectly variable within the relevant range.
3. In multi-product companies, the sales mix is constant.
4. In a manufacturing context, inventory levels do not change (units produced = units sold), or the analysis is conducted on a variable costing basis.

3.2 Contribution Margin

The CVP Income Statement

\[ \text{Net Operating Income (NOI)} = \text{Total CM} - \text{Fixed Costs} \]\[ = (\text{CM per unit} \times Q) - \text{Fixed Costs} \]

where \(Q\) is the number of units sold.

3.3 Break-Even Analysis

The break-even point (BEP) is the sales level at which total revenues exactly equal total costs — profit is zero.

\[ \text{BEP (units)} = \frac{\text{Total Fixed Costs}}{\text{CM per unit}} \]\[ \text{BEP (dollars)} = \frac{\text{Total Fixed Costs}}{\text{CM ratio}} \]

3.4 Target Profit Analysis

To find the required unit sales to achieve a specific target profit \(\pi\):

\[ Q_{\text{target}} = \frac{\text{Fixed Costs} + \pi}{\text{CM per unit}} \]

In dollar terms:

\[ \text{Target Sales \$} = \frac{\text{Fixed Costs} + \pi}{\text{CM ratio}} \]

If income taxes must be incorporated, convert the desired after-tax profit \(\pi_{\text{net}}\) to a pre-tax equivalent:

\[ \pi_{\text{pre-tax}} = \frac{\pi_{\text{net}}}{1 - t} \]

Then: \( Q = (\text{Fixed Costs} + \pi_{\text{pre-tax}}) / \text{CM per unit} \)

3.5 Margin of Safety

In the NorthStar example: Actual sales = $250,000; BEP = $200,000. Margin of safety = $50,000 (ratio = 20%). A 20% drop in sales would wipe out all profit.

3.6 Operating Leverage

If DOL = 5, a 10% increase in sales produces a 50% increase in NOI. Conversely, a 10% decrease in sales causes a 50% decrease in NOI. Firms with high fixed costs (e.g., airlines, manufacturers) tend to have high operating leverage; service firms with many variable costs have lower leverage.

3.7 Multi-Product CVP and Sales Mix

When a company sells multiple products, a sales mix assumption is required. The weighted-average contribution margin per unit (WACM) is:

\[ \text{WACM} = \sum_{i} (w_i \times \text{CM}_i) \]

where \(w_i\) is the proportion of product \(i\) in the total unit sales mix.

\[ \text{BEP (composite units)} = \frac{\text{Fixed Costs}}{\text{WACM}} \]

Individual product BEP units = Composite BEP units × that product’s sales mix proportion.

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Chapter 4: Job-Order Costing

4.1 Overview

Job-order costing is used when products or services are unique, custom, or produced in small, discrete batches (e.g., construction projects, custom furniture, law firms, film production, hospital patients). Each distinct job, project, or batch is treated as a separate cost object and assigned its own job cost sheet.

This contrasts with process costing (Chapter 5), which is appropriate when large quantities of identical or near-identical units are produced continuously (e.g., oil refining, cement, breakfast cereal).

4.2 The Job Cost Sheet

The job cost sheet (or job cost record) accumulates all costs charged to a specific job:

Job Cost Sheet — Job #214
Customer: Ridgeline Builders	Start date: March 1
Description: Custom oak cabinetry	Completion date: March 18
Direct Materials
Requisition #041 — Oak boards	$3,200
Requisition #042 — Hardware	$480
Total DM	$3,680
Direct Labour
Time tickets — 80 hours @ $22/hr	$1,760
Total DL	$1,760
Manufacturing Overhead Applied
80 DLH × $15/DLH (POHR)	$1,200
Total Job Cost	$6,640
Revenue billed	$9,500
Gross margin	$2,860

4.3 Cost Flows in Job-Order Costing — Full Journal Entries

The following journal entries trace the complete flow of costs through a job-order costing system. Assume the company purchased $50,000 of raw materials during the period, used $40,000 for direct materials on jobs, incurred $30,000 of direct labour, and applied $25,000 of overhead. Job #214 (cost $6,640) was completed and sold to Ridgeline Builders for $9,500 cash. Actual overhead costs incurred totalled $26,500.

Entry 1 — Purchase of Raw Materials:

Entry 2 — Requisition of Direct Materials to Production:

Entry 3 — Recording Direct Labour:

Entry 4 — Recording Actual Overhead Costs Incurred:

Entry 5 — Applying Manufacturing Overhead to Jobs:

Entry 6 — Completing Job #214 (Transfer to Finished Goods):

Entry 7 — Selling Job #214:

Entry 8 — Closing Underapplied Overhead:

4.4 Predetermined Overhead Rate (POHR)

Because actual overhead costs are not known until the end of the period, overhead is applied to jobs throughout the year using the POHR established at the beginning of the year.

\[ \text{POHR} = \frac{\text{Estimated Total Manufacturing Overhead Cost}}{\text{Estimated Total Allocation Base (e.g., DLH)}} \]

Common allocation bases:

• Direct labour-hours (DLH) — traditional and widely used in labour-intensive shops.
• Machine-hours — preferred in highly automated environments.
• Direct labour cost — simpler; used when labour rates are uniform.

4.5 Over- and Underapplied Overhead — T-Account Illustration

At year-end, the Manufacturing Overhead control account balance reveals over- or underapplied overhead:

Disposition methods:

1. Write-off to Cost of Goods Sold — simple; appropriate when the amount is immaterial.
2. Proration among WIP, Finished Goods, and COGS — theoretically more accurate; allocates the error in proportion to the overhead already included in each account balance.

4.6 Actual vs. Normal Costing

Under actual costing, DM and DL are charged at actual rates, and overhead is applied at the actual rate computed after the period ends. Under normal costing (the standard approach), DM and DL use actual rates but overhead is applied using the POHR. Normal costing avoids the delay of waiting for year-end overhead totals and smooths seasonal fluctuations in overhead rates.

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Chapter 5: Process Costing

5.1 When to Use Process Costing

Process costing is appropriate for industries that produce large quantities of homogeneous (identical) units through a series of continuous production steps or processes: oil refineries, chemical plants, food processing (e.g., breakfast cereal, orange juice), paper mills, and cement plants. Because each unit is indistinguishable from the next, it makes no sense to track costs by individual unit as in job-order costing. Instead, costs are averaged across all units produced in the period.

5.2 Equivalent Units of Production

The central challenge in process costing is that at period-end, some units are only partially complete (work in process). We cannot simply average total costs over all units because partially complete units represent less than a full unit’s worth of cost.

5.3 Weighted-Average Method

The weighted-average method blends the cost of beginning WIP inventory (work done in the prior period) with current-period costs. It is simpler than the FIFO method and is most commonly examined in introductory courses.

Four steps of the production cost report:

Step 1: Physical Flow of Units

	Units
Beginning WIP	+
Units started in period	= Total to account for
Units completed and transferred out	+
Ending WIP	= Total accounted for

Step 2: Compute Equivalent Units

	Direct Materials	Conversion Costs
Units completed and transferred out	100% complete	100% complete
Ending WIP	% complete for DM	% complete for conversion
Total EUP

Step 3: Compute Cost per Equivalent Unit

\[ \text{Cost per EUP} = \frac{\text{Cost in Beginning WIP} + \text{Cost added during period}}{\text{Total EUP (Step 2)}} \]

Compute separately for DM and conversion costs.

Step 4: Assign Costs to Units

\[ \text{Cost of units transferred out} = \text{Total EUP (transferred)} \times \text{Cost per EUP} \]\[ \text{Cost of ending WIP} = \text{EUP (ending WIP)} \times \text{Cost per EUP} \]

5.4 Multiple Departments

In many process-costing environments, units flow through several departments sequentially (e.g., Mixing → Cooking → Packaging). Costs transferred from Department 1 are called transferred-in costs in Department 2 and are treated as a separate cost category alongside DM and conversion costs in the receiving department’s production cost report.

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Chapter 6: Variable Costing vs. Absorption Costing

6.1 The Two Methods Defined

6.2 Income Statement Format Comparison

Absorption Costing Income Statement:

Sales	$XXX
Cost of goods sold (variable + fixed MOH per unit × units sold)	($XXX)
Gross margin	$XXX
Selling and administrative expenses	($XXX)
Net operating income	$XXX

Variable Costing Income Statement (Contribution Format):

Sales	$XXX
Variable cost of goods sold (variable manufacturing cost per unit × units sold)	($XXX)
Variable selling and administrative	($XXX)
Contribution margin	$XXX
Fixed manufacturing overhead	($XXX)
Fixed selling and administrative	($XXX)
Net operating income	$XXX

6.3 When Income Differs: The Reconciliation

The key difference arises when units produced ≠ units sold:

• Production > Sales: Absorption NOI > Variable costing NOI. Under absorption costing, some fixed MOH is deferred in ending inventory; under variable costing, all fixed MOH is expensed.
• Production < Sales: Absorption NOI < Variable costing NOI. Fixed MOH from prior periods’ inventory is released to COGS under absorption costing.
• Production = Sales: Both methods yield identical NOI.

The exact difference is:

\[ \Delta \text{NOI} = \text{Fixed MOH rate} \times (\text{Units Produced} - \text{Units Sold}) \]

where the fixed MOH rate = Budgeted Fixed MOH / Budgeted Units Produced.

6.4 Management Implications

	Absorption Costing	Variable Costing
GAAP compliance	Yes (required for external reports)	No
Fixed MOH treatment	Product cost (deferred in inventory)	Period cost (expensed immediately)
Profit manipulation risk	Yes — produce more to increase profit	No
CVP analysis compatibility	Poor (mixes fixed and variable)	Excellent
Internal decision usefulness	Lower	Higher

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Chapter 7: Activity-Based Costing

7.1 Limitations of Traditional Volume-Based Costing

Traditional overhead allocation uses a single, volume-based allocation base (typically DLH or machine-hours) to assign all overhead costs to products. This approach is adequate when:

• Overhead is a small fraction of total cost.
• All products consume overhead resources in roughly the same proportions.
• Production volume is the primary driver of overhead costs.

These conditions no longer hold in most modern manufacturing and service environments. Product lines have proliferated; automation has increased the ratio of overhead to direct labour; and many overhead activities — machine setups, product design, quality inspections, customer order processing — are not driven by production volume. The result is product cost distortion: high-volume standard products are systematically overcosted and low-volume complex products are undercosted (Horngren, Datar & Rajan, 2015, Ch. 5).

7.2 The ABC Framework

ABC involves two stages:

• First stage: Overhead costs are traced to activity cost pools (e.g., machine setup, purchase order processing, quality inspection). This is done using resource drivers (e.g., the percentage of a supervisor’s time devoted to each activity).
• Second stage: Each activity cost pool is assigned to products using an activity rate and the actual quantity of the cost driver each product consumes.

\[ \text{Activity Rate} = \frac{\text{Total Cost in Activity Pool}}{\text{Total Cost Driver Quantity}} \]

7.3 Activity Hierarchy

Cooper and Kaplan (founders of ABC at Harvard) classified activities into four levels:

Level	Description	Example Activities	Example Cost Drivers
Unit-level	Performed each time a unit is produced	Machining, direct energy	Machine-hours, kWh
Batch-level	Performed each time a batch is processed	Machine setups, purchase orders, material moves	Number of setups, number of orders
Product-level (Product-sustaining)	Sustain a product line regardless of volume	Engineering design, product specs, testing	Engineering hours, number of parts
Facility-level (Facility-sustaining)	Sustain the facility overall	Plant management, property taxes, general insurance	Square footage, cannot be meaningfully allocated

7.4 ABC Implementation — Full Numerical Example

7.5 ABC and Pricing Decisions

7.6 ABC for Customer Profitability Analysis

The same methodology extends to customers. A customer who places many small orders, demands custom configurations, returns goods frequently, and requires extensive after-sale support consumes more resources than a customer who places large standard orders with few complications. ABC can reveal that some nominally “large” customers are actually unprofitable once all service costs are attributed to them.

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Chapter 8: Budgeting

8.1 The Purpose of Budgets

Budgets translate strategic goals into quantified operational plans. Their functions include:

1. Planning: Forcing managers to think ahead and anticipate problems before they arise.
2. Coordination: Ensuring that the plans of different departments are compatible (e.g., production can actually supply what sales expects to sell).
3. Communication: Conveying management’s expectations to all levels of the organization.
4. Control: Providing a benchmark against which actual results are measured (via variance analysis).
5. Motivation: Serving as performance targets that motivate managers and employees.

8.2 The Master Budget

The master budget is a comprehensive, integrated set of budgets for the upcoming period (typically one fiscal year, broken into monthly or quarterly sub-periods). It consists of two major sections:

Operating Budgets

The operating budgets flow sequentially from the sales forecast:

1. Sales Budget — The foundation of the entire master budget. Estimated unit sales × selling price per unit = budgeted sales revenue.

2. Production Budget — How many units must be produced?

\[ \text{Required Production} = \text{Budgeted Sales} + \text{Desired Ending FG Inventory} - \text{Beginning FG Inventory} \]

3. Direct Materials Budget — How much raw material must be purchased?

\[ \text{Raw Material Purchases} = (\text{Production Units} \times \text{DM per unit}) + \text{Desired Ending RM Inventory} - \text{Beginning RM Inventory} \]

4. Direct Labour Budget:

\[ \text{Total DL Cost} = \text{Production Units} \times \text{DLH per unit} \times \text{DL wage rate} \]

5. Manufacturing Overhead Budget — Separates variable and fixed overhead for the planned production level.

6. Selling and Administrative Expense Budget — Variable S&A (per unit sold or per sales dollar) + fixed S&A.

7. Budgeted Income Statement — Assembles the above budgets into a pro forma income statement.

Financial Budgets

8. Capital Expenditure Budget — Planned purchases of long-term assets (property, plant, equipment).

9. Cash Budget — Perhaps the most critical short-term planning tool.

\[ \text{Ending Cash Balance} = \text{Beginning Cash} + \text{Cash Receipts} - \text{Cash Disbursements} \]

Cash receipts typically lag behind sales (accounts receivable collection patterns). Cash disbursements include DM purchases (with payment lags), payroll, overhead, S&A, capital expenditures, debt repayments, and dividends.

10. Budgeted Balance Sheet — Projects assets, liabilities, and equity at the end of the budget period.

8.3 Full Master Budget Example — Summit Gear Ltd.

8.4 Flexible Budgets

A static budget is fixed at the planned activity level. When actual activity differs from the plan, comparing actual costs against the static budget conflates the volume effect (more/fewer units produced) with actual cost efficiency. A flexible budget adjusts the budget to the actual activity level achieved:

\[ \text{Flexible Budget Cost} = (\text{Variable rate} \times \text{Actual activity}) + \text{Budgeted fixed cost} \]

Cost Component	Static Budget (5,000 units)	Flexible Budget (5,400 units)	Actual (5,400 units)	Flexible Budget Variance
Variable MOH ($3/unit)	$15,000	$16,200	$16,800	$600 U
Fixed MOH	$40,000	$40,000	$41,200	$1,200 U
Total MOH	$55,000	$56,200	$58,000	$1,800 U

The $1,800 unfavourable flexible budget variance indicates that actual costs exceeded what they should have been at 5,400 units — a true efficiency signal.

8.5 Behavioural Aspects of Budgeting

Budgets are not merely technical documents; they shape human behaviour. Important behavioural considerations include:

• Participative budgeting (bottom-up): Involving lower-level managers in setting budget targets increases buy-in and taps local knowledge, but creates risk of budgetary slack (deliberately setting easy targets).
• Budgetary slack: The practice of understating revenues or overstating costs to make targets easier to achieve. It distorts resource allocation and reduces the control value of the budget.
• Budget pressure and ethics: Unrealistically tight budgets can create pressure to misreport results or cut corners on quality and safety.
• Zero-based budgeting (ZBB): Each budget period, managers must justify every expenditure from scratch rather than simply adjusting prior-year amounts. ZBB eliminates the inertia of “baseline plus a percentage” budgeting but is time-consuming.

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Chapter 9: Standard Costs and Variance Analysis

9.1 Standard Costs Defined

Standard costs are set for each component of manufacturing cost:

• Standard DM cost = Standard quantity of DM per unit × Standard price per unit of DM
• Standard DL cost = Standard hours per unit × Standard hourly rate
• Standard variable MOH cost = Standard hours per unit × Standard variable MOH rate

Standards are developed through engineering studies, time-and-motion analyses, supplier negotiations, and historical data adjusted for expected improvements.

Types of Standards

Type	Description	Effect on Behaviour
Ideal (theoretical)	Perfect efficiency, no waste, no downtime	Usually unachievable; can demoralize workers
Currently attainable (practical)	Achievable with reasonable efficiency; allows for normal waste and downtime	Most commonly used; motivates without demoralizing
Historical average	Based on past average performance	May entrench inefficiency

9.2 Direct Materials Variances

Let AQ = actual quantity purchased/used, AP = actual price, SP = standard price, SQ = standard quantity allowed for actual output.

\[ \text{Materials Price Variance (MPV)} = AQ \times (AP - SP) \]

A positive result is unfavourable (U); negative is favourable (F).

\[ \text{Materials Quantity Variance (MQV)} = SP \times (AQ - SQ) \]\[ \text{Total DM Variance} = \text{MPV} + \text{MQV} = (AQ \times AP) - (SQ \times SP) \]

9.3 Direct Labour Variances

Let AH = actual hours worked, AR = actual rate, SR = standard rate, SH = standard hours allowed for actual output.

\[ \text{Labour Rate Variance (LRV)} = AH \times (AR - SR) \]\[ \text{Labour Efficiency Variance (LEV)} = SR \times (AH - SH) \]\[ \text{Total DL Variance} = \text{LRV} + \text{LEV} \]

9.4 Variable Manufacturing Overhead Variances

Variable MOH variances use the same two-variance structure as DL, with hours as the allocation base:

\[ \text{Variable OH Spending Variance} = AH \times (AR_{\text{VOH}} - SR_{\text{VOH}}) \]\[ \text{Variable OH Efficiency Variance} = SR_{\text{VOH}} \times (AH - SH) \]

The efficiency variance for variable MOH mirrors the labour efficiency variance: if more hours are worked than standard, more variable overhead is consumed.

9.5 Fixed Manufacturing Overhead Variances

Fixed overhead analysis differs from variable overhead because fixed costs do not fluctuate with activity. The standard fixed MOH rate is:

\[ SR_{\text{FOH}} = \frac{\text{Budgeted Fixed MOH}}{\text{Budgeted (Denominator) Activity Level}} \]\[ \text{Fixed OH Spending (Budget) Variance} = \text{Actual Fixed MOH} - \text{Budgeted Fixed MOH} \]\[ \text{Fixed OH Volume Variance} = \text{Budgeted Fixed MOH} - \text{Applied Fixed MOH} \]

where Applied Fixed MOH = SR_FOH × Standard hours allowed for actual output.

The volume variance measures the cost of operating above or below the denominator activity level. If actual output was less than the denominator level, the volume variance is unfavourable (fixed costs were not fully “absorbed” by output). It is a capacity utilization measure, not an efficiency measure.

9.6 Performance Reports

Variance analysis is presented in a performance report that compares flexible budget amounts with actual results for each cost category. Managers use these reports to:

• Identify significant variances (those exceeding a threshold, e.g., 5% or $5,000).
• Determine root causes (e.g., MPV unfavourable → supplier raised prices; LEV unfavourable → untrained workers requiring more time).
• Assign responsibility to the appropriate manager.
• Take corrective action.

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Chapter 10: Segmented Reporting and Performance Evaluation

10.1 Segmented Income Statements

Organizations are commonly divided into segments — product lines, geographic regions, divisions, or departments — for performance evaluation purposes. A segmented income statement presents each segment’s revenues and costs separately, culminating in a segment margin.

Traceable vs. Common Fixed Costs

The segment margin = Sales − Variable costs − Traceable fixed costs. This is the best long-run measure of a segment’s contribution to overall firm profitability — it shows how much a segment contributes to covering common costs and generating profit.

Do not allocate common fixed costs to segments for decision-making purposes; doing so can make profitable segments appear unprofitable and lead to incorrect decisions.

10.2 Return on Investment (ROI)

Using the DuPont decomposition:

\[ \text{ROI} = \underbrace{\frac{\text{NOI}}{\text{Sales}}}_{\text{Profit Margin}} \times \underbrace{\frac{\text{Sales}}{\text{Average Operating Assets}}}_{\text{Asset Turnover}} \]

This decomposition reveals two levers for improving ROI: (1) increasing the profit margin on each sales dollar, or (2) generating more revenue from the same asset base (or reducing the asset base for the same revenue).

10.3 Residual Income

RI solves the suboptimization problem inherent in ROI. Under ROI, a division manager with a current ROI of 20% might reject a new project earning 15% ROI, even if the company’s required return is only 12%. The manager is “protecting” their ROI metric at the expense of firm value. Under RI, that same project would be accepted because it generates positive residual income (15% − 12% = positive spread), increasing the manager’s RI.

10.4 Balanced Scorecard

Perspective	Key Question	Example Measures
Financial	How do we look to shareholders?	ROI, RI, EVA, revenue growth, operating margin
Customer	How do customers see us?	Customer satisfaction scores, market share, defect rates, on-time delivery
Internal Business Processes	What must we excel at?	Cycle time, process yield, capacity utilization, defect rate
Learning & Growth	Can we continue to improve?	Employee training hours, employee satisfaction, R&D investment, innovation pipeline

The BSC prevents managers from focusing exclusively on short-term financial metrics at the expense of long-run value drivers. Lead indicators (customer, process, learning) predict future financial outcomes.

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Chapter 11: Relevant Costs for Short-Term Decisions

11.1 The Relevant Cost Principle

11.2 Make-or-Buy Decisions

A make-or-buy decision evaluates whether to produce a component internally or outsource it to an external supplier.

Relevant costs of making:

• Variable manufacturing costs (DM, DL, variable MOH)
• Avoidable fixed costs (those that would disappear if production ceased)
• Opportunity cost of capacity used (if capacity could be deployed elsewhere)

Relevant costs of buying:

• Purchase price per unit
• Any incremental costs of managing the supplier relationship

Fixed costs that will continue regardless (e.g., allocated general overhead) are not relevant.

11.3 Special Orders

A special order is a one-time order at a price below the regular selling price. The key questions are: Does idle capacity exist? What are the relevant incremental costs?

Decision rule: Accept the special order if the special order price exceeds the incremental cost of filling the order. Fixed costs are typically irrelevant if they are already committed and capacity is available.

11.4 Dropping a Segment

Decision rule: Drop the segment if the avoidable costs saved exceed the CM lost from the segment.

11.5 Sell or Process Further (Joint Products)

In industries that generate joint products from a common process (e.g., oil refining produces gasoline, diesel, and jet fuel simultaneously), managers must decide whether to sell joint products at the split-off point or process them further.

Decision rule: Process further only if the incremental revenue from further processing exceeds the incremental cost of further processing. Joint costs incurred before the split-off point are sunk and always irrelevant to this decision.

\[ \text{Process further if:} \quad \text{Revenue after further processing} - \text{Revenue at split-off} > \text{Additional processing cost} \]

11.6 Constrained Resource (Bottleneck) Decisions

When a single resource is scarce (a bottleneck), the firm cannot produce as many units of all products as it could sell. The optimal product mix maximizes total contribution margin given the constraint.

Ranking rule: Rank products by contribution margin per unit of the scarce resource (not by CM per unit):

\[ \text{Priority metric} = \frac{\text{CM per unit}}{\text{Scarce resource units required per unit of product}} \]

Produce as much of the highest-priority product as possible before allocating remaining capacity to lower-priority products.

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Chapter 12: Capital Budgeting

12.1 The Nature of Capital Budgeting Decisions

Capital budgeting involves decisions about long-term investments in assets that will generate benefits over multiple years: purchasing equipment, building facilities, acquiring technology, or launching new product lines. These decisions are particularly consequential because:

1. Large amounts of capital are typically at stake.
2. The decisions are often difficult or costly to reverse.
3. Cash flows are distributed over many years, making the time value of money critical.
4. Errors in forecasting cash flows or selecting the discount rate can be very costly.

Relevant Cash Flows in Capital Budgeting

Typical cash flow categories include:

• Initial investment (Year 0): Cost of equipment, installation, net working capital increase.
• Operating cash flows (Years 1–n): After-tax incremental revenues minus after-tax incremental cash costs. Often approximated as net operating income plus non-cash charges (depreciation add-back).
• Terminal cash flows (Year n): Salvage value of equipment, recovery of net working capital.

12.2 Time Value of Money

The time value of money holds that a dollar received today is worth more than a dollar received in the future, because today’s dollar can be invested now to earn a return.

Present value of a future cash flow received in \(n\) periods at discount rate \(r\):

\[ PV = \frac{FV}{(1 + r)^n} \]

Present value of an annuity (equal annual cash flows \(CF\) for \(n\) periods):

\[ PV_{\text{annuity}} = CF \times \frac{1 - (1 + r)^{-n}}{r} \]

The factor \(\frac{1 - (1 + r)^{-n}}{r}\) is the present value annuity factor (PVAF), tabulated in standard finance and accounting textbooks.

12.3 Net Present Value (NPV)

Decision rule:

• If NPV ≥ 0: Accept the project (it earns at least the required return and creates value).
• If NPV < 0: Reject the project (it destroys value).

12.4 Internal Rate of Return (IRR)

Decision rule:

• If IRR ≥ Required rate of return: Accept.
• If IRR < Required rate of return: Reject.

For uniform cash flows, the IRR can be estimated by finding the PVAF that satisfies:

\[ \text{PVAF} = \frac{C_0}{CF} \]

then interpolating from standard tables.

Limitations of IRR:

1. Multiple IRRs can exist when cash flows change sign more than once (non-conventional cash flows).
2. IRR assumes reinvestment of interim cash flows at the IRR itself — an often unrealistic assumption.
3. IRR can give conflicting rankings vs. NPV for mutually exclusive projects of different scales or timings.

NPV is generally preferred as the theoretically correct method because it measures the absolute increase in firm value.

12.5 Payback Period

Decision rule: Payback period ≤ management’s maximum acceptable payback period.

The payback method has two major weaknesses:

1. It ignores the time value of money.
2. It ignores all cash flows after the payback point — a project with a very large cash inflow in year 10 looks no better than one with a modest inflow, if both recover the initial investment in year 3.

The discounted payback period corrects for weakness 1 by using present values of cash flows, but still ignores post-payback flows.

12.6 Capital Budgeting Methods — Summary

Method	Considers TVM?	Uses All Cash Flows?	Measures Value Created?	Decision Criterion
Net Present Value	Yes	Yes	Yes — in dollar terms	NPV ≥ 0
Internal Rate of Return	Yes	Yes	Indirectly (as a rate)	IRR ≥ hurdle rate
Payback Period	No	No	No	Payback ≤ threshold
Discounted Payback	Yes	No	No	Payback ≤ threshold

12.7 Qualitative Factors in Capital Budgeting

Quantitative analysis is necessary but not sufficient for capital budgeting decisions. Qualitative considerations include:

• Strategic fit: Does the investment align with long-term competitive strategy?
• Risk: How uncertain are the projected cash flows? Sensitivity analysis (varying key assumptions) and scenario analysis (best case / worst case) help quantify risk.
• Regulatory and environmental compliance: Some investments are mandated by law regardless of NPV.
• Employee and community impact: Plant closures or major automation projects affect stakeholders beyond financial metrics.
• Opportunity cost of capital constraint: When capital is rationed, projects must be ranked by the profitability index (PI = NPV / Initial Investment) rather than selected independently.

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Integrative Review: Connecting the Frameworks

How the Chapters Fit Together

AFM 102 builds a coherent analytical framework for internal decision-making that operates at three time horizons:

Short-run (Chapters 1–3, 11): CVP analysis and relevant cost analysis address decisions that can be implemented quickly and whose effects are felt within a single period: pricing, product mix, accept/reject special orders, make-or-buy, dropping segments. These analyses use contribution margin thinking and require only incremental, avoidable costs.

Medium-run (Chapters 4–7, 8–10): Costing systems (job-order, process, ABC) and budgeting frameworks address recurring operational decisions: how to assign costs to products, how to plan and control departmental spending, and how to evaluate divisional performance. Variance analysis connects the planning function (budgets) to the control function (actual vs. standard) and feeds into performance evaluation (ROI, RI, balanced scorecard).

Long-run (Chapter 12): Capital budgeting addresses strategic, multi-year investment decisions where the time value of money is critical. The discount rate used in NPV analysis reflects the firm’s cost of capital — itself an output of financial accounting and corporate finance.

Key Formulas Reference Sheet

The following summarizes the principal formulas used throughout the course:

Formula	Expression
Break-even (units)	Fixed Costs ÷ CM per unit
Break-even (dollars)	Fixed Costs ÷ CM ratio
Target profit units	(Fixed Costs + Target Profit) ÷ CM per unit
DOL	Total CM ÷ NOI
Margin of safety ratio	Margin of Safety ÷ Actual Sales
POHR	Estimated MOH ÷ Estimated allocation base
Cost per EUP (weighted-avg)	(Beg WIP cost + Period cost) ÷ Total EUP
Absorption vs. Variable NOI difference	Fixed MOH rate × (Produced − Sold)
Activity rate (ABC)	Activity pool cost ÷ Cost driver quantity
DM Price Variance	AQ × (AP − SP)
DM Quantity Variance	SP × (AQ − SQ)
DL Rate Variance	AH × (AR − SR)
DL Efficiency Variance	SR × (AH − SH)
ROI	NOI ÷ Average operating assets
Residual Income	NOI − (Required return × Operating assets)
NPV	\(\sum CF_t / (1+r)^t\) − Initial investment
Payback (uniform flows)	Initial investment ÷ Annual cash inflow

A Note on Ethical Responsibilities

Management accountants operate at the intersection of information production and decision-making authority. The potential for bias, manipulation, and misrepresentation is real:

• Budgetary slack distorts resource allocation.
• Absorption costing creates incentives to overproduce.
• Allocated overhead can make segments appear unprofitable when they are not.
• Capital budgeting cash flow forecasts can be inflated to secure project approval.

CPA Canada’s ethical guidelines require management accountants to maintain competence (stay current with standards and techniques), confidentiality (protect proprietary information), integrity (avoid conflicts of interest and misrepresentation), and objectivity (present information fairly and without bias). Recognizing ethical dimensions — not just technical dimensions — of managerial accounting is essential for professional practice.

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These notes synthesize material from Garrison, Libby, Webb, Noreen & Brewer (2024), Managerial Accounting, 13th Canadian Edition (McGraw-Hill Ryerson) and Horngren, Datar & Rajan (2015), Cost Accounting: A Managerial Emphasis, 15th Edition (Pearson).