Está en la página 1de 294

CMA Part 1

Volume 2: Sections D – E

Financial Reporting, Planning,
Performance and, Control

HOCK international books are licensed only for individual use and may not be
lent, copied, sold or otherwise distributed without permission directly from
HOCK international.

If you did not download this book directly from HOCK international, it is not a
genuine HOCK book. Using genuine HOCK books assures that you have complete,
accurate and up-to-date materials. Books from unauthorized sources are likely outdated
and will not include access to our online study materials or access to HOCK teachers.

Hard copy books purchased from HOCK international or from an authorized
training center should have an individually numbered orange hologram with the
HOCK globe logo on a color cover. If your book does not have a color cover or does
not have this hologram, it is not a genuine HOCK book.

2017 Edition
CMA
Preparatory Program

Part 1
Volume 2: Sections D – E

Financial Reporting, Planning,
Performance and Control

Brian Hock, CMA, CIA
and
Lynn Roden, CMA
with
Kevin Hock

HOCK international, LLC
P.O. Box 6553
Columbus, Ohio 43206

(866) 807-HOCK or (866) 807-4625
(281) 652-5768

www.hockinternational.com
cma@hockinternational.com

Published January 2017

Acknowledgements

Acknowledgement is due to the Institute of Certified Management Accountants for
permission to use questions and problems from past CMA Exams. The questions and
unofficial answers are copyrighted by the Certified Institute of Management Accountants
and have been used here with their permission.

The authors would also like to thank the Institute of Internal Auditors for permission to
use copyrighted questions and problems from the Certified Internal Auditor Examinations
by The Institute of Internal Auditors, Inc., 247 Maitland Avenue, Altamonte Springs,
Florida 32701 USA. Reprinted with permission.

The authors also wish to thank the IT Governance Institute for permission to make use
of concepts from the publication Control Objectives for Information and related
Technology (COBIT) 3rd Edition, © 2000, IT Governance Institute, www.itgi.org.
Reproduction without permission is not permitted.

© 2017 HOCK international, LLC

No part of this work may be used, transmitted, reproduced or sold in any form or by any
means without prior written permission from HOCK international, LLC.

ISBN: 978-1-934494-71-4

Thanks

The authors would like to thank the following people for their assistance in the
production of this material:

§ All of the staff of HOCK Training and HOCK international for their patience in the
multiple revisions of the material,
§ The students of HOCK Training in all of our classrooms and the students of HOCK
international in our Distance Learning Program who have made suggestions,
comments and recommendations for the material,
§ Most importantly, to our families and spouses, for their patience in the long hours
and travel that have gone into these materials.

Editorial Notes

Throughout these materials, we have chosen particular language, spellings, structures
and grammar in order to be consistent and comprehensible for all readers. HOCK study
materials are used by candidates from countries throughout the world, and for many,
English is a second language. We are aware that our choices may not always adhere to
“formal” standards, but our efforts are focused on making the study process easy for all
of our candidates. Nonetheless, we continue to welcome your meaningful corrections and
ideas for creating better materials.

This material is designed exclusively to assist people in their exam preparation. No
information in the material should be construed as authoritative business, accounting or
consulting advice. Appropriate professionals should be consulted for such advice and
consulting.

and it is our goal to make this process as efficient as possible for you.com.hock@hockinternational. I wish you success in your studies. Ÿ Teacher Support via our online student forum. and commitment to your work. Your personalized plan can also be emailed to you at the beginning of each week. through the study process. Answer explanations for the correct and in- correct answers are also included for each question. You can use them to review whenever you have a few minutes. and we will match that commitment in our efforts to help you. Ÿ Videos using a multimedia learning platform that provide the same coverage as a live-taught course. we understand that your time is too valuable to study for an exam twice. Furthermore. and telephone through- out your studies to answer any questions that may arise. but don’t want to take your textbook along. CMA. Ÿ The Textbook that you are currently reading. To do so. We understand the commitment that you have made to the exams. teaching all of the main topics on the exam syllabus. This textbook follows the exam contents and provides all necessary background information so that you don’t need to purchase or read other books. The process of certification is an important one that demonstrates your skills. Ÿ ExamSuccess contains original questions and questions from past exams that are relevant to the current syllabus. Ÿ A Mock Exam enables you to make final preparations using questions that you have not seen before. key formulas and concepts. You can also create a personalized study plan online to adapt the plan to fit your schedule. Ÿ The Flash Cards include short summaries of main topics. Brian Hock. knowledge. We know that this is a great responsibility. Sincerely. This is your main study source and contains all of the information necessary to pass the exam. please contact me directly at brian. e-mail. so we will do everything possible to make sure that you pass the first time. CIA President and CEO . and if there is anything I can do to assist you. Ÿ Practice Essays taken from past CMA Exams that provide the opportunity to practice the essay-style questions on the Exam. HOCK has developed the following tools for your use: Ÿ A Study Plan that guides you. week by week.Dear Future CMA: Welcome to HOCK international! You have made a wonderful commitment to yourself and your profession by choosing to pursue this prestigious credential. We are honored that you have chosen HOCK as your partner in this process.

...................................... 1 Why Cost Management? .......................................................................................... Period Costs 7 Cost of Goods Sold (COGS) and Cost of Goods Manufactured (COGM) 13 The Flow of Manufacturing Costs ............................................................................................................ For personal use only by original purchaser................... LLC.............................. Resale prohibited............................................ 3 The Difference Between Costs and Expenses 3 Direct Versus Indirect Costs 3 Costs Based on Level of Production (Fixed. 87 © 2017 HOCK international............................................................................................... i ........CMA Part 1 Table of Contents Table of Contents Section D – Cost Management ........................................ 2 Classifications of Costs .......................................... 84 Customer Life-Cycle Costing................................ Cost of Goods Sold 17 Costing Systems................................................................................. 19 Introduction to Cost Measurement Systems 19 Benefits and Limitations of Each Cost Measurement System 24 Introduction to Cost Accumulation Methods 26 Introduction to Methods of Allocating Overhead 27 Accounting for Direct Manufacturing Inputs in Standard Costing ................................................................ 48 Steps in Process Costing 49 Process Costing Diagram – FIFO 60 Process Costing Diagram – Weighted Average 61 Process Costing Summary 62 Process Costing Examples 62 Spoilage in Process Costing 67 Job-Order Costing ................... 86 Joint Products and Byproducts ................... 72 Operation Costing ...................................................................................................................................... Work-in-Process Inventory 16 5.................................................... Materials Inventory 15 2............ Factory Overhead Control 16 4.. 74 Activity-Based Costing ....................................................... Payroll 15 3............ 31 Manufacturing Overhead Allocation 31 Traditional (Standard) Allocation Method 32 Process Costing ........................................... 15 1................................ 75 Life-Cycle Costing ................... Variable and Mixed Costs) 4 Production vs................................................................................... Finished Goods Inventory 17 6.............................................................................................................. 28 Overhead Allocation ................................................

.............................................. 102 Fixed Factory Overheads Under Absorption Costing 102 Fixed Factory Overheads Under Variable Costing 102 Effects of Changing Inventory Levels 103 Income Statement Presentation 104 Shared Services Cost Allocation ............. and ERP 139 Outsourcing 141 Theory of Constraints (TOC) 142 Capacity Level and Management Decisions 152 Business Process Improvement ................................ For personal use only by original purchaser....................... ..................... LLC............................................. 117 Allocating Costs of A Single (One) Service or Support Department to Multiple Users 118 Allocating Costs of Multiple Service or Support Departments 121 Estimating Fixed and Variable Costs................... 129 High-Low Points Method 129 Regression Analysis 131 Forecasting Total Costs 133 Supply Chain Management .................................................... 187 Corporate Governance 187 Responsibilities of the Board of Directors 192 Audit Committee Requirements... MRPII..................................................................... and Compliance.............................................. 186 Governance................................... Risk.............................Table of Contents CMA Part 1 Methods of Allocating Costs to Joint Products 87 Accounting for Byproducts 95 Variable and Absorption Costing .................. 134 What is Supply Chain Management? 134 Lean Manufacturing 134 Just-in-Time (JIT) Inventory Management Systems 137 Kanban 138 Introduction to MRP......... Responsibilities and Authority 193 Responsibilities of the Chief Executive Officer (CEO) 197 ii © 2017 HOCK international......................................................................... 161 The Value Chain and Competitive Advantage 161 Process Analysis 165 Business Process Reengineering 166 Benchmarking Process Performance 167 Activity-Based Management (ABM) 168 The Concept of Kaizen 168 The Costs of Quality 169 ISO 9000 179 Quality Management and Productivity 179 Other Quality Related Issues 179 Accounting Process Redesign 181 Section E – Internal Controls ................................ Resale prohibited...................

......................................... Resale prohibited.......................................................... 230 Financial Statement Opinion 230 Internal Control Opinion 231 Internal Auditing .....................................................................................CMA Part 1 Table of Contents Election of Directors 197 Internal Control ........................... iii ............. 198 Internal Control Definition 198 The Importance of Objectives 199 Who Is Responsible for Internal Control? 199 Components of Internal Control 200 What is Effective Internal Control? 211 Transaction Control Objectives 211 Types of Transaction Control Activities 211 Safeguarding Controls 212 Legislative Initiatives About Internal Control ........................................... 264 Internet Security ................. Detective and Corrective 262 Controls Classified as Feedback.................... 275 © 2017 HOCK international..................... 266 Viruses............ LLC............................................ 232 Definition of Internal Auditing 232 The Internal Audit Charter: Establishing the Internal Audit Function 232 Organizational Independence 232 Scope of Activities and Responsibilities 233 Testing and Evaluating the Effectiveness of the Internal Control System 235 Determining Which Engagements to Conduct 235 Types of Engagements 236 Reporting to the Board 238 Inherent Risk........................................ 223 Foreign Corrupt Practices Act (FCPA) 223 Sarbanes-Oxley Act and the PCAOB 224 External Auditors’ Responsibilities and Reports ........... 241 Introduction to Systems Controls 241 Threats to Information Systems 242 The Classification of Controls 243 General Controls 244 Application Controls 256 Controls Classified as Preventive........................................................................................................................................... Feedforward and Preventive 262 Computerized Audit Techniques ...................................................................................................................... Control Risk and Detection Risk 239 Systems Controls and Security Measures .................. Trojan Horses and Worms 267 Cybercrime 268 Business Continuity Planning ......................................... For personal use only by original purchaser................................. 272 Disaster Recovery 273 Answers to Questions .....

LLC. .Table of Contents CMA Part 1 (This page intentionally left blank) iv © 2017 HOCK international. Resale prohibited. For personal use only by original purchaser.

Major topics include:  Overhead Cost Allocation  Process Costing  Job Order Costing  Operation Costing  Activity-based Costing  Life-cycle Costing  Joint Product and Byproduct Costing  Variable and Absorption Costing  Shared Services Cost Allocation  Estimating Fixed and Variable Costs  Supply Chain Management  Business Process Improvement The three topics that will be the most challenging are: 1) Process Costing 2) Activity-based Costing 3) Variable and Absorption Costing This is not to say that the others are not important or will not be tested. Resale prohibited. but simply that these three are where you will need to spend more time to ensure that you fully understand them for the Exam. An important concept in the business process performance portion is the concept of competitive advantage and how a firm can attain it. 1 .Section D Section D – Cost Management Section D – Cost Management Section D represents 20% of the Part 1 Exam. cost measurement and cost allocation systems as well as sources of operational efficiency and business process performance for a firm. © 2017 HOCK international. Topics covered include several types of cost accumulation. For personal use only by original purchaser. Section D focuses on the process of determining how much it costs to produce a product. LLC.

a firm may be efficient in its use of resources. 1 Competitive advantage is an advantage that a company has over its competitors that it gains by offering consumers greater value than they can get from its competitors. such as the cost.” Effectiveness and efficiency are important aspects of fulfilling that obligation. two aspects of operations are important: effectiveness and efficiency. and reporting on the critical success factors that are necessary for the firm’s success. “a publicly-owned for-profit company must have maximizing shareholder value as its ultimate goal. or a specified return on investment. Alternatively. productivity or efficiency advantage the firm has relative to competitors or about the additional prices the company can charge for additional features that make its offering distinctive relative to the costs of adding those features.Why Cost Management? CMA Part 1 Why Cost Management? Cost management systems are used as basic transaction reporting systems and for external financial reporting. identifying. Activities related to the critical success factors must be performed at the highest possible level of excellence. For example. LLC. . effectiveness and viability of an organization. summarizing. Cost management aids in assessing both effectiveness and efficiency. an increase in market share. The shareholders are the owners. The most important function of cost management is to help management focus on factors that make the firm successful. Critical success factors may be a desired level of operating income. An efficient operation is one that makes effective use of its resources in carrying out the operation. Thus. Critical success factors are a limited number of characteristics. Thus cost management contributes to the company’s achieving its strategic goals and objectives. new products introduced. If the firm attained its goal of increasing sales but it spent more of its resources than necessary in attaining that goal. The master budget states the desired operating income for the period and is a basic starting point for evaluating the effectiveness of the firm in attaining its profitability goals by comparing actual results with the planned results. Competitive advantage is discussed in detail later in this book. Resale prohibited. Effectiveness in reaching its goals can be measured by analyzing the firm’s critical success factors. but if the firm’s goals for profitability and growth are not achieved because sales are too low. 2 © 2017 HOCK international. An effective operation is one that achieves or exceeds the goals set for the operation. They are the aspects of the company’s performance that are essential to its competitive advantage 1 and therefore to its success. managers have an obligation to invest company profits in such a way that shareholder value will be maximized. but they also track costs in order to provide information for management decision-making. assessments of efficiency are independent from assessments of effectiveness. Therefore. the management accountant can provide information about the sources of the firm’s competitive advantage. The management accountant is an integral part of management. the firm may be effective but it is not efficient. As we said in the section on Strategic Planning in Section B. They have provided risk capital with the expectation that the managers will pursue strategies that will give them a good return on their investment. Strategic cost management is cost management that specifically focuses on strategic issues such as these. Cost management systems not only provide reliable financial reporting. For personal use only by original purchaser. or variables that have a direct and important impact on the efficiency. conditions. The ultimate goal is to maximize shareholder value. Evaluating Operating Performance In determining whether a firm is achieving its goals and objectives. spending less than planned per unit sold. the firm was not effective.

but they are costs nonetheless because they represent resources given up to achieve an objective. while “expense” is an accounting concept. products. In manufacturing. and so forth. An opportunity cost is a type of implicit cost. Most costs eventually do become expenses. some costs do not reach the income statement. A cost need not be an expense. Indirect costs are costs that cannot be identified with a specific cost object. © 2017 HOCK international. overhead is an indirect cost. “Cost” is an economic concept. 2) Expenses are costs that have been charged against revenue in a specific accounting period. but every expense was a cost before it became an expense. such as manufacturing costs that reach the income statement as Cost of Goods Sold when the units they are attached to are sold. Examples of direct costs that we will spend a lot of time talking about are direct materials and direct labor used in the production of products. Both implicit costs and opportunity costs are discussed in more detail later. Implicit costs2 such as opportunity costs3 never become expenses in the accounting records. Direct Versus Indirect Costs Direct costs are costs that can be traced directly to a specific cost object.Section D Classifications of Costs Classifications of Costs The first thing that needs to be covered for this Section is a number of terms and concepts related to the different classifications of costs. an organizational subdivision. However. It is important from the very beginning to understand the different types. A cost object is anything for which a separate cost measurement is recorded. 1) Costs are resources given up to achieve an objective. a contract or other work unit for which cost data are desired and for which provision is made to accumulate and measure the cost of processes. Other indirect costs include support functions such as IT. classifications and treatments of costs. 2 Implicit costs are costs that do not involve any specific cash payment and are not recorded in the accounting records. Resale prohibited. LLC. 3 . It can be a function. 3 An opportunity cost is the contribution to income that is lost by not using a limited resource in its best alternative use. maintenance and security and managerial functions such as executive management and other supervisory functions. The Difference Between Costs and Expenses Costs and expenses are two different things. or the cost of administrative fixed assets that have been capitalized on the balance sheet and subsequently expensed over a period of years as depreciation. For personal use only by original purchaser. jobs. capitalized projects.

it may appear that variable costs per unit decrease as production increases. The per unit variable cost remains unchanged as production increases or decreases while total variable cost increases as production increases and decreases as production decreases. 4 © 2017 HOCK international. you pay a specified amount per megabyte used. However. Resale prohibited. the total amount of these costs does not change with a change in production volume. The selling price per unit minus all unit variable costs is equal to the unit contribu- tion. we will now examine in greater depth the different ways in which fixed and variable costs behave in the production process as the production level changes. Unless you have an unlimited usage plan. you pay a fixed amount each month that includes a usage allowance of a certain amount of data. the total amount of variable costs will increase. we will look in more detail at this subject because it is such an underlying element of the process. Contribution is the amount from the sale that the company is able to put toward the covering of fixed costs or profit after the variable costs have been covered. the cost per unit decreases as production increases and increases as production decreases. but we do not need to worry about those situations for this purpose. but the variable cost per unit will remain unchanged. . The overage charge is a variable cost based on the number of megabytes of data used over and above your data allowance for the month. Fixed costs Fixed costs do not change within the relevant range of production. LLC. Mixed costs Mixed costs have both a fixed and a variable component. However. and they are presented here only for awareness purposes. Variable and Mixed Costs) In the following table are the main groups of costs based on their behavior as the level of production changes. Direct material and direct labor are usually variable costs.Classifications of Costs CMA Part 1 Costs Based on Level of Production (Fixed.) As the production level increases. Note: Variable costs are covered in many other areas of the Exams. For these three types of costs you need to know both how the cost per unit changes and how the total cost changes as the level of production changes. the company will incur no variable costs. If you go over that allowance. and the cost per unit for that particular quantity of units is used in the budget for each unit purchased. Note: Because discounts are received when more units are purchased. Variable costs Variable costs are costs such as material and labor that are incurred only when a product is made. Variable Costs Variable costs are those costs that are incurred only if the company actually produces something. Although this is not inherently difficult. companies do not order units one at a time. (In some situations direct labor may be a fixed cost as in the calculation of throughput contribution margin. For personal use only by original purchaser. If a company produces no units (sits idle for the entire period). As long as the production volume remains within the relevant range. covered later under Theory of Constraints. An example is a data plan on a smartphone. It is important that you know how total costs and costs per unit change as production changes. As part of the budgeting process a company determines how many of a particular item it will need to purchase during the year. This means that budgeted variable costs per unit do not change as the production levels change for the company. This fundamental behavior of fixed and variable costs is used in other sections of the CMA Part 1 exam as well as in the CMA Part 2 exam. Contribution margin is a measure of contribution as a percentage of the sales price. Having looked at the above table and the basics of these classifications.

all costs will behave like variable costs. If production begins (or resumes). the company may be able to change its factory situation so that the factory cost also becomes variable. small range of activity. It stays fixed again for a while at the higher range of activity. If the hospital needs one nurse for every 25 patients. the cost suddenly jumps. Within the relevant range of production the total fixed costs will remain unchanged. at which point an additional admitting clerk would be needed. Resale prohibited. the company will need to build (or otherwise acquire) a second factory. some costs may be fixed (such as a factory). All fixed costs behave this way. Note: Over a large enough time period. depending upon the production level. © 2017 HOCK international. and added to that fixed amount is an amount that varies with activity. but the fixed costs per unit will decrease as the level of production increases. and other utilities usually must be continued. a semi-fixed cost is fixed over a smaller range than the relevant range of a wholly fixed cost. LLC. There is a basic fixed amount that must be paid regardless of activity. but the total cost increases incrementally by the amount of the variable component when production activity increases. as long as production remains within the relevant range. and the commission is the variable component. The administrative staff salaries are wholly fixed costs (over the relevant range). it jumps again. then each time the patient load increases by 25 patients. An example of a semi-fixed cost is the nursing staff in a hospital. However. The fixed component does not change. However. Building the second factory will increase the fixed costs as the company moves to another relevant range. Utilities provide an example. even if no production is taking place. the cost for utilities increases by a variable amount. Fixed costs are best described by looking at a factory as an example. the fixed cost for the factory will remain unchanged. As long as production is between 0 and that maximum number of units. A semi-fixed cost moves upward in a step fashion. which might remain fixed until the patient load increases by 250 patients. A semi-fixed cost is fixed over a given. and above that level of activity. and when the activity moves out of that range. and a wholly fixed cost is also fixed only as long as activity remains within the relevant range. 5 . many costs are mixed costs. A factory has the capacity to produce a certain maximum number of units. A semi-variable cost has both a fixed component and a variable component. Some basic utility expenses are required just to maintain a factory building. once the level of production exceeds the capacity of the factory. That is in contrast to administrative staff salaries at the same hospital. Mixed Costs In reality. but over a longer period of time. staying at a certain level over a small range and then moving to the next level quickly. Electric service. In the short term. The difference between a semi-variable and a semi-fixed cost is that the semi-variable cost starts out at a given base level and moves upward smoothly from there as activity increases. Mixed costs may be semi-variable costs or semi-fixed costs. which are a combination of fixed and variable elements. whereas the nursing staff salaries are semi-fixed costs. The base salary is the fixed component of the salesperson’s salary. The relevant range is the range of production in which the fixed cost is unchanged. an increase in the number of units produced will not cause an increase in the total fixed costs. one additional nurse will be hired and total nurses’ salaries will jump by the additional nurse’s salary. Another example of a semi-variable cost is a salesperson receiving a base salary plus a commission for each sale made.Section D Classifications of Costs Fixed Costs Fixed costs are costs that do not change in total as the level of production changes. even if there is no activity. because machines are running and using electricity and people are using the water. so that basic amount is the fixed component of utilities. For personal use only by original purchaser. A semi-fixed cost moves upward in steps. As long as production activity remains within the relevant range. water service.

Total costs begin at the fixed cost level and rise by the amount of variable cost per unit for each unit of increase in activity. It can refer to production volume in number of units of output. Resale prohibited. The cost function for this company’s total manufacturing costs is Y = $700.000 for each production increase of 10. total costs graph as a straight line that begins at the fixed cost level on the Y intercept and rises at the rate of the variable cost per unit for each unit of increase in activity. following is a graph of total manufacturing costs for a company with fixed manufacturing costs of $700. the only cost will be fixed costs. the number of units of inputs to the production process.000 and variable manufacturing costs of $20 per unit produced. sales volume. 6 © 2017 HOCK international.000 on the Y axis where X is zero and increasing by $200. You will see this same concept again later in this section. The cost function for total manufacturing costs is Y = F + VX Where: Y = Total Costs F = Fixed Costs V = Variable Costs X = Total Production Note: The cost function can also be written as Y = VX + F.000 units (because 10. For personal use only by original purchaser.000 + $20X The total cost line on the graph is a straight line beginning at $700. The lowest possible total cost occurs when nothing is produced or sold. or to any other activity being performed. . The graph of the above cost function appears on the next page.000). To illustrate. Total cost is on the Y-axis.Classifications of Costs CMA Part 1 Total Costs Total costs consist of total fixed costs plus total variable costs. because at an activity level4 of zero. LLC. because this is another use for linear regression analysis. under the topic of Estimating Fixed and Variable Costs. while total production is on the X-axis.000 units multiplied by $20 equals $200. The order of the two terms on the right side of the equals sign is not important. In theory at least. 4 “Activity level” or “level of activity” can be used to refer to various types of activity. which we talked about in the Forecasting topic under Trend Projection and Regression Analysis in relation to using simple regression analysis to make forecasts. The graph should look familiar to you.

000 X 0 10K 20K 30K 40K 50K 60K 70K Number of Units Produced Production vs. LLC.300. Product costs are “attached” to each unit and will be carried on the balance sheet as inventory when production is completed.900.000 Total Manufacturing Costs $1. Product Costs (also called Inventoriable Costs) Product costs. It is important to know this. 7 .000 $1.000 + $20X $1.000 Y = $700. without which the product could not be made. and production costs can be fixed or variable. are those costs that go directly into the production process. So these different classifications are not mutually exclusive from each other.000 $1.000 $500.000 $900. which is an expense. Note: Period costs can be fixed or variable. Resale prohibited.100. Period Cost. or inventoriable costs.100. Period Costs In addition to the classification of costs based on their behavior as production changes.000 $1. The main distinction of costs that are based on purpose is that of Production (or Product) Cost vs. the cost will be transferred from the balance sheet to the income statement where it is classified as cost of goods sold. © 2017 HOCK international. For personal use only by original purchaser.Section D Classifications of Costs Y $2. When the item is sold. costs can also be classified according to their purpose.000 $700.500.700.

Indirect material Similar to indirect labor. Manufacturing Manufacturing costs include the prime costs and manufacturing overhead costs applied. Indirect labor is a manufacturing overhead cost. Conversion costs Conversion costs include manufacturing overhead (both fixed and variable) and direct labor. rework costs. Examples are indirect labor. Indirect labor Indirect labor is the labor that is part of the overall production process but does not come into direct contact with the product. insurance and taxes. You need to know what types of costs are included in the different classifications. Direct labor Direct labor costs are the costs of labor that can be directly traced to the production of a product. but are necessary costs of production. and factory rent. there are also other types of “product costs” for pricing and other purposes. among others. Assembly line workers are direct labor costs for a manufacturing company. The costs included in the direct material cost are all of the costs associated with acquiring it: the item itself. These are the costs that are required to convert the direct materials into the final product. and 3) manufacturing overhead (both fixed and variable). electricity and other utilities. Direct material Direct materials are the materials that are directly put into the finished product. Groupings of Product Costs The five main types of product costs in the previous table can be further combined to create different cost classifications. and miscellaneous supplies). indirect materials. shipping-in. and we will take a look at those later in this section. which are period costs. Resale prohibited. LLC. Note: This definition of product cost is in accordance with financial reporting purposes. These different product costs can be combined and given different names as outlined in the tables below. . For personal use only by original purchaser. Manufacturing costs do not include selling or administrative costs. 8 © 2017 HOCK international. Common examples of direct materials are plastic and components. Types of Product Costs This table includes the main costs that are incurred in the production process. The three classifications that you need to be aware of are in the following table. Prime costs Prime costs are the costs of direct material and direct labor. The maintenance department is a common example. 2) direct labor. depreciation of plant equipment. screws and nails and other materials that may not even be physically incorporated into the finished good (machine oils. lubricants. or the direct costs of manufacturing. Indirect materials are a manufacturing overhead cost. However. Manufacturing Manufacturing overhead costs are the company’s costs related to the production overhead process that are not direct material or direct labor. These are the direct inputs.Classifications of Costs CMA Part 1 The main types of product costs are: 1) direct materials. These are all of the costs that need to be incurred in order to actually produce the product. Examples are glue. indirect materials are materials that are not the main components of the finished goods.

Period Costs. as when inventory is purchased and its cost becomes an expense when it is sold. there are other types of costs with which a candidate must be familiar. for internal decision-making. Implicit costs An implicit cost. We will discuss this type of allocation in the topic of Shared Services Cost Allocation. administration. Period costs can be variable. The number of classifications of period costs that a company can use on its income statement will depend upon that company. The lost interest does not actually show up as an expense on the income statement. This type of overhead allocation would be used for internal decision making only. As stated above. period costs should be expensed in the period when they are incurred. also called an imputed cost. though the timing of their recognition as expenses may be delayed. The “lost” interest is an opportunity cost of investing in the machine. This allocation is done so that the company can set a price for each product that covers all of the costs the company incurs. depreciation (of nonproduction facilities). For personal use only by original purchaser. but it is necessary in making the decision to invest in the machine. Implicit costs do not become expenses. Note: Overhead allocation of period costs to production will not be reflected as such in the external financial statements issued by the company. Explicit costs Explicit costs are also called out-of-pocket costs. but period costs are all the costs of any department that is not involved in production. Explicit costs are the opposite of implicit costs. period costs are expensed to the income statement as they are incurred. selling. GAAP. Other Costs and Cost Classifications In addition to all of the costs and classifications listed above. because it is not proper to do so according to U. is a cost that does not involve any specific cash payment and is not recorded in the accounting records. or Nonmanufacturing Overheads Period costs. are costs for activities other than production of the product. The more commonly used examples of period costs include selling. nor is it proper under IFRS. © 2017 HOCK international. accounting. Most explicit costs eventually become expenses. 9 . office supplies. GAAP and IFRS. Period costs are usually expensed as they are incurred.S. and so forth. Implicit costs are also called economic costs. They cannot be specifically segregated in financial reports. Examples include general and administrative. Explicit costs involve payment of cash and include wages and salaries. Resale prohibited.S. some period costs may be allocated to the production departments and then to the individual units. and so on. LLC. but they are needed for use in a decision-making process. because it will be different if the machine is not purchased. Even if these costs were not incurred the product could still be manufactured. fixed or mixed. but they are not included in the calculation of cost of goods sold or cost of goods manufactured (both of these are covered later). According to both U. The number of period costs is almost unlimited because period costs include essentially everything other than the product costs (all costs must be either a product cost or a period cost). as compared to product costs. payments to vendors for raw materials.Section D Classifications of Costs Note: Direct labor is both a prime cost and a conversion cost. for financial reporting purposes. and accounting. Interest not earned on money that could have been invested in an interest-paying security but instead was invested in manufactur- ing equipment is often an implicit or imputed cost. interest paid on loans. However.

Any time that money is invested or used to purchase something. If money were not used to purchase inventory. Direct materials and direct labor are engineered costs because the quantities required for production of a specific output are part of the engineering specifications for that output. They are costs required to costs establish and maintain the readiness to do business. or mixed costs. variable costs. Resale prohibited. Often times.Classifications of Costs CMA Part 1 Opportunity An opportunity cost is a type of implicit cost. They are not included in inventory (in other words. damaged or stolen inventory. Opportunity cost is an economics term. It is the contribution to income that is lost by not using a limited resource in its best alternative use. Committed Committed costs are costs for the company’s infrastructure. Examples of committed costs are intangible assets such as the purchase of a franchise and the purchase of fixed assets such as property. the value added and the benefits obtained from spending the money cannot be precisely defined. insurance and taxes on the inventory. costs In the short term. Sunk costs Sunk costs are costs that have already been incurred and cannot be recovered. though the cause and effect relationships are not as precise for indirect resources as they are for direct labor and direct materials. at the decision of a manager. Discretionary costs may be fixed costs. Because storage of inventory does not add value to the items themselves. carrying costs are expensed on the income statement as incurred. discretionary costs will not cause an adverse effect on the business if they are not incurred. For personal use only by original purchaser. for example. The value added by activities associated with engineered costs is fairly clear and easy to measure. They are called “engineered costs” because engineers specify precisely how many inputs are required to generate a specific output. 10 © 2017 HOCK international. Carrying Carrying costs are the costs the company incurs when it holds inventory. costs of employees who manage and protect the inventory. . When calculating the opportunity cost. Advertising. that lost return is interest. plant and equipment. it could have been deposited in a bank and earned interest. Engineered costs are variable costs in their cost behavior. but in the long run they do need to be spent. there is lost return from the next best use of that money. Marginal Marginal costs are the additional costs necessary to produce one more unit. Relationships for indirect resources can be established using statistical techniques such as regression analysis and correlation analysis. Furthermore. Sunk costs are irrelevant in any decision-making process because they have already been incurred and no present or future decision can change that fact. research and development (R&D) and employee training are usually given as examples of discretionary costs. They result from activities that have well defined cause and effect relationships between inputs and outputs and between costs and benefits. They are fixed costs that are usually on the balance sheet as assets and become expenses in the form of amortization and depreciation. it includes only the expenditures that would not be made in the other available alternatives and/or the contribution that would have been earned if an alternative decision had been made. and other storage costs. Indirect resources that vary with product specifications and production volume are also engineered costs. as mentioned above. LLC. The lost interest can be calculated only for the time period during which the cash flows are different between the two options. These are cost decisions that are made periodically and are not closely related to input or output decisions. the lost opportunity cost of having money invested in inventory (called cost of capital). costs Engineered Engineered costs are costs that have a definite physical relationship to the activity base or costs measure. Carrying costs costs include: rent and utilities related to storage. and costs opportunity cost is considered an economic cost. they are not included on the balance sheet). Discretionary Discretionary costs are costs that may or may not be spent.

Resale prohibited. or $30 per hour. For personal use only by original purchaser. or $200. The regular rate of $20 per hour multiplied by 10 hours.Section D Classifications of Costs Note: When overtime must be worked. because the units worked on during the overtime hours could just as easily have been different units if the jobs to be done had simply been scheduled differently. As overhead. For example. © 2017 HOCK international. or $100. the overtime premium should be charged to that specific job as part of the direct labor cost of that job and not included in the overall overhead amount to be allocated. The overtime premium is the amount that the hourly wage increases for overtime work. The half-time premium of $10 additional paid per hour multiplied by 10 hours. for overtime hours worked in excess of 40 hours per week. LLC. if the need to work overtime is the result of a specific job or customer request. 11 . is classified as factory overhead. Ten hours of overtime are worked. direct labor is paid $20 per hour for regular hours and is paid and time and-a-half. even though it is worked in excess of regular hours. the overtime premium that is paid to the workers is considered to be factory overhead. is classified as a direct labor cost. However. the overtime premium paid is allocated equally among all units produced during the period. The half-time premium of $100 is not charged to the particular units worked on during the overtime hours.

For personal use only by original purchaser.000 c) $948.000 (CMA Adapted) 12 © 2017 HOCK international. LLC.000 b) $960.000 units and a sales level of 8. Cost Item Estimated Unit Cost Direct materials $32 Direct labor 20 Variable manufacturing overhead 15 Fixed manufacturing overhead 6 Variable selling 3 Fixed selling 4 Question 1: Estimated conversion costs per unit are: a) $35 b) $41 c) $48 d) $67 Question 2: Estimated prime costs per unit are: a) $73 b) $32 c) $67 d) $52 Question 3: Estimated total variable costs per unit are: a) $38 b) $70 c) $52 d) $18 Question 4: Estimated total costs that would be incurred during a month with a production level of 12.000 units are: a) $692.000 d) $932.000 units per month are as follows.Classifications of Costs CMA Part 1 The following information is for the next four questions: The estimated unit costs for a company using absorption (full) costing and planning to produce and sell at a level of 12. Resale prohibited. .

It is perhaps the largest individual expense item on the income statement. We will examine the calculation of the cost of goods sold (COGS) and the cost of goods manufactured (COGM). COGS is an external reporting figure and it will be reported on the income statement. for the Part 1 Exam. It represents the cost of producing the units that were completed during the period. and so on). Note: Costs that are not production costs are period costs. For personal use only by original purchaser. The result will be either low sales volume if the price is too high or low profits if the price is too low. on the other hand. it is this production cost that will be included on the balance sheet as the value of inventory when the item is completed. COGM. used in the calculation of the cost of goods sold for a company that produces its own inventory. Resale prohibited. LLC. it may charge a price for the product that will be incorrect. © 2017 HOCK international. Calculating Cost of Goods Manufactured The COGM represents the cost of the units completed and transferred out of work-in-process during the period.Section D Classifications of Costs Cost of Goods Sold (COGS) and Cost of Goods Manufactured (COGM) Now that we have looked at all of the different classifications of costs and their different behaviors. Furthermore. stolen or lost. It is the cost of producing the units that were actually sold during the period. they are very different in one key respect. It is critical that the calculated cost represents the complete cost of production. When the item is sold. the above formula is sufficient. Calculating Cost of Goods Sold COGS represents the cost to produce or purchase the units that were sold during the period. COGS is calculated using the following formula: Beginning finished goods inventory + Purchases (for a reseller) or cost of goods manufactured (for a manufacturer) − Ending finished goods inventory = Cost of Goods Sold This written formula is a simplification of what is actually occurring in reality in that it assumes all of the units were either sold during the period or were still in ending inventory. and they are generally expensed as incurred (for example: inventory carrying costs. however. As such. However. Additionally. The process of calculating the cost of producing an item is a very important one for any company. so that management can make any necessary adjustments such as changes in pricing as soon as possible. general and administrative costs. COGM does not include the cost of work that was done on units that were not finished during the period. Due to this need to determine the cost of production accurately. This does not always happen in reality because units may be damaged. the information that accountants provide to management regarding the costs of the company is crucial. we will turn our attention to using these different costs in accounting calculations. Though these two items are somewhat similar. 13 . it is important that this amount is calculated accurately. COGM is. is an internal number and is not reported on either the balance sheet or the income statement. these costs will be transferred to the income statement as cost of goods sold. The calculation of both numbers is looked at in more detail below. it is beneficial to provide this information quickly and often. If the company does not calculate the cost of production correctly. For a manufacturing company this amount will be part of the cost of goods sold calculation. as we have already covered.

.110 d) $113.300 Opening finished goods inventory 60. for the purposes of the Exams. and therefore it is not in ending inventory.890 c) $110.  Total manufacturing costs consists of direct materials used. and manufacturing overhead applied.Classifications of Costs CMA Part 1 COGM is calculated using the following formula: Direct Materials Used* + Direct Labor Used + Manufacturing Overhead Applied = Total Manufacturing Costs + Beginning Work-in-Process Inventory − Ending Work-in-Process Inventory = Cost of Goods Manufactured * Direct Materials Used = Beginning Direct Materials Inventory + Purchases + Transportation-In – Net Returns – Ending Direct Materials Inventory As was the case with the COGS formula above.890 (ICMA 2010) 14 © 2017 HOCK international. this formula is sufficient. direct labor used. includes the following information for the current fiscal year. Beginning FG + Cost of goods manufactured – Ending FG = Cost of goods sold. LLC. For personal use only by original purchaser. Beginning WIP + Total manufacturing costs – Ending WIP = Cost of goods manufactured  Cost of goods sold consists of cost of goods manufactured adjusted for the change in finished goods inventory. However. and cost of goods manufactured is a component of cost of goods sold.000 Gross profit 48. In reality some of the inventory may have been lost. DM used + DL used + Manufacturing overhead applied = Total manufacturing costs  Cost of goods manufactured consists of total manufacturing costs adjusted for the change in work- in-process inventory. Note: Total manufacturing costs is a component of cost of goods manufactured. Sales $160.000 Year-end finished goods inventory 58.190 The cost of goods manufactured by Madengrad for the current fiscal year is a) $46. Question 5: The Profit and Loss Statement of Madengrad Mining Inc. this formula simplifies reality because it assumes that all items of inventory are either used or are in ending inventory. damaged or otherwise not used. Resale prohibited. Each one flows into the next one.110 b) $49.

2. This flow of costs is called sequential tracking of costs because the journal entries are recorded in sequence as the units progress through the production process and to final sale. the cost of the indirect materials is debited to Factory Overhead Control. Payroll The Payroll account is a control account. When manufacturing salaries and wages are earned. Thus. such as the janitor who keeps the plant clean.  When the payroll is paid. These costs flow from raw materials to work-in-process to finished goods and. Factory Overhead Control is debited for the amount of indirect labor used. Resale prohibited. and manufacturing overhead. LLC. the cost of materials put into production is moved from Materials Inventory to Work-In-Process Inventory and Factory Overhead Control. Indirect labor includes salaries of plant supervisors and other plant employees not directly engaged in manufacturing. such as those who operate machinery. the total amount of the salaries and wages is debited to Payroll and credited to Accrued Payroll. Typical general ledger accounts used for manufacturing costs are called:  Materials Inventory or Materials Control  Payroll  Factory Overhead Control  Work-in-Process Inventory  Finished Goods Inventory  Cost of Goods Sold A certain amount of direct materials. when the unit is sold.  Direct labor includes the wages of the workers who are directly involved in the manufacturing pro- cess. Work-in-Process In- ventory is debited for the amount of direct labor used. Following is a very broad outline of how production costs flow. and Payroll is credited for the total. direct labor and overhead costs are “attached” to each unit as it is in production. and their total cost is credited to Materials Inventory. and we will talk about those later. 15 . because it is not specific enough to permit numerical examples at this point. Different costing systems introduce variations. Accounts Payable is debited and Cash is credited. Thus this explanation should be considered an introduction only.  When raw materials are purchased on account and received. Raw materials may include direct materials as well as indirect materials.  After being debited to Payroll. © 2017 HOCK international. their cost is a debit to Materials Inven- tory and a credit to Accounts Payable. direct labor. When the invoices for the raw materials are paid. the total amount paid is debited to Accrued Payroll and credited to Cash. Materials Inventory Materials inventory is an inventory account in the asset section of the balance sheet. product costs include direct materials.Section D The Flow of Manufacturing Costs The Flow of Manufacturing Costs In order to understand the various concepts we will be covering in this section. it is necessary to understand how product costs are accumulated and accounted for in a manufacturing company. 1. For personal use only by original purchaser. the cost of the direct materials placed in production is debited to Work-in-Process Inventory. the manufacturing portion of the payroll costs is distributed in the accounting system according to whether it is for direct labor or indirect labor.  When direct and/or indirect materials are placed into production. to cost of goods sold. It contains the cost of raw materials purchased for use in manufacturing. As we have seen.

16 © 2017 HOCK international. The costs move from one departmental work-in-process account to the next departmental work-in-process account until the units they are attached to are complete. accumulated costs in the Factory Overhead Control account are applied to production by debiting Work-in-Process Inventory and crediting Factory Overhead Control. When process costing is being used. Recording the payroll in the accounting system involves accounting for taxes withheld as well as for employer’s payroll taxes. indirect labor used. and overtime premiums paid if not the result of a specific job or customer request. Resale prohibited. The two accounts netted together (the debit balance in Factory Overhead Control and the credit balance in Factory Overhead Applied) represent the difference between the amount of over- head costs incurred and the amount applied to production. the company will have a work-in-process inventory account for each individual job.  When depreciation on factory facilities is recorded. a company with several processing departments that the units move through will have a departmental work-in-process inventory account for each department. The difference is over-applied or under- applied factory overhead. the amount is debited to Factory Overhead Control and credited to Accounts Payable. The costs remain in the Work-in-Process Inventory account until the units they are attached to are completed. The balance in the account is increased by debits for:  Costs transferred from Materials Inventory when materials are put into production  Direct labor costs from Payroll for direct labor used  Overhead allocated to units produced from the Factory Overhead Control or Factory Overhead Applied account A portion of all of these costs is allocated to each individual unit in the process of being manufactured. Accounts Payable is debited and Cash is credited. Payroll will also include selling and administrative payroll. 3. a separate account called Factory Overhead Applied is used for the credits. we are ignoring those details.  When other factory overhead costs such as utilities are recorded. Usually. For personal use only by original purchaser. Note that the depreciation is not expensed as Depreciation Expense at this point. Work-in-Process Inventory Costs are accumulated in the Work-in-Process Inventory account as work progresses on the units being manufactured. (The way in which the over- applied or under-applied factory overhead is closed out will be covered later. the amount of the depreciation is debited to Factory Overhead Control and credited to Accumulated Depreciation. For our purposes here. Process costing will be discussed in detail later. When payment is made. . which is closed out at the end of the period. When job-order costing is being used. Process costing is used to determine the amount of costs to move on to the next department or to Finished Goods for units completed during the period and the amount of costs attached to units still in Work-in-Process Inventory at the end of the period.) 4. If any factory overhead costs are paid in cash. LLC.The Flow of Manufacturing Costs CMA Part 1 Note: The above is an extremely simplified version of what takes place. the amount is debited to Factory Overhead Control and credited to Cash. Factory Over- head Applied should follow Factory Overhead Control in the chart of accounts and will carry a credit balance. Factory Overhead Control Manufacturing overhead includes costs for the physical manufacturing facilities as well as indirect materials used.  As production takes place. Selling and administrative costs are period costs that are expensed as incurred and so are not discussed here because they are not manufacturing costs.

the total accumulated costs attached to the completed units are moved from Work-in- Process Inventory to Finished Goods Inventory by debiting Finished Goods Inventory and crediting Work-in- Process Inventory. as each unit is sold the total accumulated cost at- tached to it is debited to Cost of Goods Sold and credited to Finished Goods Inventory.  If a perpetual inventory system is being used. Resale prohibited. Cost of Goods Sold As units are sold. LLC. Finished Goods Inventory As units are completed. Again. The difference between a perpetual and a periodic inventory system is covered in Volume 1 of this textbook in Section A in the Inventory topic. 6. the amount to be debited to Cost of Goods Sold and credited to Finished Goods Inventory is calculated at the end of each accounting period and the amount for the whole period is moved in total from Finished Goods Inventory to Cost of Goods Sold as a period-end adjusting entry. 17 .Section D The Flow of Manufacturing Costs 5. this amount is determined by the use of process costing. their cost is debited to Cost of Goods Sold and credited to Finished Goods Inventory. For personal use only by original purchaser. The costs moved are the total accumulated costs per unit multiplied by the total number of units completed. © 2017 HOCK international.  If a periodic inventory system is being used. On the next page is a diagram of these cost flows. when many identical units are being manufactured.

The Flow of Manufacturing Costs CMA Part 1 The Flow of Manufacturing Costs Purchases Direct Materials Used Raw Materials Inventory Payroll Direct Labor Used Indirect Materials Indirect Used Labor Used Factory Work-in-Process Depreciation Recorded Overhead Inventory Control Overhead Incurred Goods Completed Finished Goods Inventory Goods Sold Cost of Goods Sold 18 © 2017 HOCK international. . LLC. Resale prohibited. For personal use only by original purchaser.

management accountants need to make choices in three categories of costing methods: 1) The cost measurement method to use in allocating costs to units manufactured (standard. LLC. manufacturing overhead rate (a volume-based method). because you are mixing standard cost with actual output to find the total standard cost allowed for the actual output. The best cost driver to use as the allocation base is the measure that best represents what causes overhead. or services. and factory overhead costs to products. In a standard cost system. For a labor- intensive manufacturing process. The most frequently used allocation bases are direct labor hours. extended normal. For example. direct materials and direct labor are applied to production by multiplying the standard price or rate per unit of direct materials/direct labor by the standard amount of direct materi- als/direct labor allowed for the actual output. the standard number of direct labor hours for those 100 units is 300 hours (3 hours per unit × 100 units). with each input multiplied by the number of units of that input allowed for one unit of output. direct labor and allocated overhead. In a standard cost system. For personal use only by original purchaser. The standard cost of producing one unit of output is based on the standard cost for one unit of each of the inputs required to produce that output unit. The four systems are: 1) Standard 2) Normal 3) Extended normal 4) Actual costing systems These costing systems are used for allocating both direct manufacturing costs (direct labor and direct materials) and indirect manufacturing (overhead) costs in order to value the products manufactured. 19 . The predetermined overhead rate is then multiplied by the standard amount of the allocation base that is allowed for producing one unit of product. The standard cost for direct labor for the 100 units is the standard hourly wage rate multiplied by the 300 hours allowed for the actual output regardless of how many direct labor hours were actually worked. In developing a costing system. Introduction to Cost Measurement Systems There are three main ways (plus one variation) in which costs are allocated to units manufactured. if 3 direct labor hours are allowed to produce one unit and 100 units are actually produced. © 2017 HOCK international. the proper base is probably direct labor hours or direct labor costs. or planned. For an equipment-oriented manufacturing process. 3) The method to be used to allocate overhead (volume-based or activity-based). direct labor. Resale prohibited. classifying and assigning direct materials. jobs. direct labor costs. and then that standard overhead amount for one unit is multiplied by the number of units actually produced to calculate the standard overhead cost to be applied to all the units produced. overhead is generally allocated to units produced by calculating a predeter- mined. number of machine hours is the better allocation base.Section D Costing Systems Costing Systems Product costing involves accumulating. The standard cost is what the cost should be for that unit of output. This can be a difficult concept to grasp. or actual costing). normal. costs to units produced. 2) The cost accumulation method to use (job costing or process costing). 1) Standard Costing A standard cost system assigns standard. or machine hours. This standard manufacturing overhead rate is budgeted overhead cost divided by the budgeted activity level of the allocation base. or standard. The inputs include direct materials.

under normal costing. The predetermined rate is calculated the same way the predetermined rate is calculated under standard costing. when all the invoices had been received. Enterprise Resource Planning is covered in this book in the topic Supply Chain Management in Section D. In contrast. Moreover. . In normal costing. where the flexible budget for the actual production is equal to the standard cost per unit multiplied by the actual production volume. when all the invoices have been received. customers. It also makes current costs available. job costing accumulates costs and assigns them to specific jobs. called a normal or normalized rate. Note: The standard cost for each input per completed unit is the standard rate per unit of input multiplied by the amount of inputs allowed per completed unit. those costs would not be known until well after the end of each reporting period. The emphasis in standard costing is on flexible budgeting. Normal costing is used mainly in job costing. Resale prohibited. The purpose of using a predetermined annual manufacturing overhead rate in normal costing is to normalize factory overhead costs and avoid month-to-month fluctuations in cost per unit that would be caused by variations in actual overhead costs and actual production volume. If actual manufacturing overhead costs were used. it permits production to be accounted for as it occurs. the actual costs incurred will probably be different from the standard costs. or contracts. For personal use only by original purchaser. because those costs are not known until well after the end of each reporting period. Manufacturing companies use standard costing with flexible budgeting to control direct materials and direct labor costs. projects. variances are accounted for in one of two basic ways: either they are closed out 100% to Cost of Goods Sold expense on the income statement. If the variances are closed out 100% to Cost of Goods Sold. The difference is also called an “under-applied” or “over-applied” cost. Standard costing enables management to compare actual costs with what the costs should have been for the actual amount produced. Standard costing can be used in either a process costing or a job-order costing environment. direct materials and direct labor costs are applied at their actual rates multiplied by the actual amount of the direct inputs used for production. Normal costing is not appropriate in a process costing environment because it is too difficult to determine the actual costs of the specific direct materials and direct labor used for a specific production run. a normal cost system uses a predetermined annual manufacturing overhead rate. the cost of the goods in Inventories will be equal to their standard cost only. Standard costing is applicable to a wide variety of companies. 2) Normal Costing In a normal cost system. or they are prorated among Cost of Goods Sold and the relevant Inventory accounts on the balance sheet. Costs are accumulated by department or by process. LLC. firms are using Enterprise Resource Planning (ERP) systems to help them track standard and actual costs and to assess variances in real time. Using actual costs incurred for manufacturing inputs would cause an unacceptable delay in reporting. that predetermined rate is multiplied by the actual amount of the allocation base that was used in producing the product. the predetermined rate is multiplied by the amount of the allocation base allowed for producing the product. whereas under standard costing. too. To allocate overhead. mainly to control their labor costs since they are labor-intensive. direct materials and direct labor costs are applied to production differently from the way they are applied in standard costing. Increasingly. such as on an assembly line. 20 © 2017 HOCK international. The difference is called a variance. However. Service companies such as fast-food restaurants use standard costs. Process costing is used when many identical or similar units of a product or service are being manufactured. At the end of each accounting period. Job costing is used when units of a product or service are distinct and separately identifiable.Costing Systems CMA Part 1 Of course. not multiplied by the actual amount of inputs used per completed unit.

actual direct professional labor can be hard to track until after the end of a reporting period due to bonuses that depend upon performance during the period. For personal use only by original purchaser. and performance evaluations. In a professional service business such as an accounting practice. the costs for direct materials and direct labor are applied to production by multiplying estimated or normal rates (not the actual rates that are used in normal costing) by the actual amount of the direct inputs used. In extended normal costing. though. A company needing timely information would use estimated rates to apply direct labor costs to individual clients’ jobs. Resale prohibited. overhead is applied the same way as in normal costing: the predetermined (normal or normalized) manufacturing overhead rate is multiplied by the actual amount of the allocation base that was used in producing the product. The cost of a unit is the actual direct cost rates multiplied by the actual quantities of the direct cost inputs used and the actual indirect (overhead) cost rates multiplied by the actual quantities used of the cost allocation bases. This fluctuation can lead to errors in management decisions such as pricing of the product. no predetermined or estimated or standard costs are used. actual costing is seldom used because it can produce costs per unit that fluctuate significantly. LLC. Instead. The estimated or normal rates are not called standard costs. 21 . 4) Actual Costing In an actual costing system. Actual costing is practical only for job order costing for the same reasons that normal and extended normal costing are practical only for job order costing. decisions about adding or dropping product lines. © 2017 HOCK international. Extended normal costing would be most likely to be used in a job order environment and/or a service business. the actual direct labor and materials costs and the actual manufacturing overhead costs are allocated to the units produced. not by the standard amount allowed as in standard costing. In addition. because this is not a standard cost system and because the costs are applied by multiplying the estimated/normal rate by the actual amount of the resource used.Section D Costing Systems 3) Extended Normal Costing In extended normal costing (a variation on normal costing).

Resale prohibited. .. 2) Direct labor and direct materials are treated the same under normal and actual costing.Costing Systems CMA Part 1 Below is a summary of the four cost measurement methods: Cost Direct Accumulation Direct Materials/ Cost Method Materials/ Direct Labor Overhead Measurement Usually Direct Labor Application Application Overhead Method Used With Application Rate Base Rate Allocation Base Standard Standard Process Amount of Amount Predetermined Standard Costing or Standard Allocation Base Allowed Standard Costing Job Order Rate Allowed for Actual Rate Costing for Actual Production Production Actual Amount Actual of Allocation Amount Estimated Normal Job Order Actual Base Used Normalized Costing Costing Rate Used for Actual Rate for Actual Production Production Actual Amount Actual of Allocation Extended Estimated Amount Estimated Job Order Base Normal Normalized Used Normalized Costing Used Costing Rate for Actual Rate for Actual Production Production Actual Amount Actual of Allocation Amount Actual Job Order Actual Actual Base Used Costing Costing Rate Rate Used for Actual for Actual Production Production Note: The following points should be noted when comparing standard. 4) Standard costing is typically used with a flexible budget system. normal and extended normal costing systems: 1) All of the costing systems record the cost of inventory based on actual output (note the use of the words “actual production” for every costing system in the Overhead Allocation Base column in the summary chart). In normal and extended normal costing. 22 © 2017 HOCK international. LLC. in standard costing. For personal use only by original purchaser. However. direct labor and factory overhead) that should have been used for the actual output produced. 3) Standard. direct materials. the emphasis is on normalized annual rates that do not fluctuate throughout the year due to period-to-period fluctuations in activity levels. the emphasis is on the standard rates allowed. and those standard rates do not necessarily need to be the same all year. normal and extended normal costing all use predetermined overhead rates. Standard costing is based entirely on the inputs (i.e.

rate/DLH × 2.000: 5.60 ÷ 2.60/house.000 = $617.000 = $630. The company’s planned costs were as follows: Direct materials $45 per doghouse (5 units of DM/doghouse @ $9/ unit) Direct labor $30 per doghouse (2 DLH/doghouse @ $15/ DLH) Variable overhead $10 per doghouse (2 DLH/doghouse @ $5/DLH Fixed overhead $260.000 = $210.000 = $617.1 DLH/house = $6.1 DLH/house = $5.000 = $882. extended normal.000 doghouses during 20X4. rate/DLH × 2. rate/DLH × 2. Example of standard costing.000 Direct labor cost applied: $14 actual rate/DLH × 2.1 DLH used/house × 21.000 = $10.500 Variable overhead applied: $5 est. For the year 20X4. Inc.25 units used/house × 21.1 DLH used/house × 21.101 actual rate/DLH × 2.10/DLH 2 Actual rate calculated as $264.600 Total Costs Applied Under Standard Costing: Direct materials cost applied: $9 std.50 per DLH) LHD actually produced and sold 21.500 Fixed overhead applied: $6.250 Direct labor cost applied: $15 est.400 Variable overhead applied: $5.Section D Costing Systems It is important in answering a question to identify what type of costing the company uses.1 DLH used/house × 21. rate/DLH × 2.000 = $12.910 Fixed overhead $264.1 DLH used/house × 21.  If the company uses standard costing.000 Fixed overhead applied: $6.650 Total Costs Applied Under Extended Normal Costing: Direct materials cost applied: $9 est.000 = $224. allowed/house × 21.000 = $273.000 doghouses.1 DLH used per doghouse @ $14/DLH Variable overhead $224.000 Variable overhead applied: $5 std.71/house.1 DLH. extended normal costing. It offers only one size and style of doghouse.600 ÷ 21.910 ÷ 21.000 Direct labor cost applied: $14 actual rate/DLH. For personal use only by original purchaser. LLC.1 DLH used/house × 21.1 DLH used/house × 21.  Actual amount of inputs used for the actual production are used in calculating the costs applied to each unit only when the company uses normal. rate/DLH × 2 DLH. Resale prohibited.000 Total Costs Applied Under Normal Costing: Direct materials cost applied: $8 actual rate/DM unit × 5.71 ÷ 2. Overhead is applied on the basis of direct labor hours.400: 2. × 2.000 = $264. rate/DLH × 2 DLH allowed/house × 21.25 units used/house × 21. rate/DLH × 2 DLH.650 Total Costs Applied Under Actual Costing: Direct materials cost applied: $8 actual rate/DM unit × 5. the company planned to manufacture 20.50 est. or $13 per doghouse (2 DLH/doghouse @ $6.002 actual rate/DLH × 2.400 Variable overhead applied: $5 est. $10. or actual costing. and actual costing used for the same product under the same set of assumptions: Log Homes for Dogs. $12.000 = $661. allowed/house × 21.1 DLH used/house × 21. LHD’s actual costs incurred were: Direct materials $882.000 = $286.000.000 = $286. cost/unit of DM × 5 units allowed/house × 21.000 = $220.00/DLH (Continued) © 2017 HOCK international.50 est.25 units used/house × 21.25 units of DM used per doghouse @ $8/unit of DM Direct labor $617. the costs applied to each unit will be the standard costs for the standard amount of inputs allowed for production of the actual number of units produced.000 = $945.000 = $882.1 DLH used/house × 21. normal costing.000 = $220. rate/DLH × 2.910 Fixed overhead applied: $6. 23 .50 std.600 1 Actual rate calculated as $224. used/house × 21. rate/DM unit × 5. (LHD) manufactures doghouses made from logs.000 Direct labor applied: $15 std.000 = $992.500 Fixed overhead applied: $6.

because the standard costs serve as the cost per equivalent unit for direct materials.1 DLH used) 13. LLC.50 Variable overhead ($5 est.00 actual rate/DLH × 2.50/DLH allowed × 2 DLH allowed) 13.00 Direct labor ($14 actual rate/DLH × 2.1 DLH used) 29.25 units) $42. and manufac- turing overhead.  It simplifies the determination of equivalent-unit costs. and what actual costs are under control.25 units used) $47.40 Variable overhead ($5 est. rate/DLH × 2.1 DLH used) 12.25 units used) $42.  It makes recordkeeping easier in either a job order or a process costing system. When costs vary significantly from the standards.55 Cost Applied per Unit Under Extended Normal Costing: Direct materials ($9 est.1 DLH used) 10. direct labor. .50 Fixed overhead ($6. managers are alerted that there may be problems requiring attention. because subsidiary ledgers need to be maintained for quantities on hand.1 DLH used) 29.1 DLH used) 10. For personal use only by original purchaser.65 Total cost per unit $95. 24 © 2017 HOCK international. The standards establish what the costs should be. Resale prohibited. rate/DLH × 2.1 DLH used) 13.00 Direct labor ($14 actual rate/DLH × 2.10 actual rate/DLH × 2. This approach helps managers to focus on important issues.00 Direct labor ($15 std.00 Cost Applied per Unit Under Normal Costing: Direct materials ($8 actual cost/DM unit × 5.  If costs remain within the standards. rate/DLH × 2.65 Total cost per unit $102.50 est. cost/unit of DM × 5 units of DM allowed) $45.Costing Systems CMA Part 1 The costs applied per unit under each of the cost measurement methods was: Cost Applied per Unit Under Standard Costing: Direct materials ($9 std. rate/DLH × 2.40 Variable overhead ($5.71 Fixed overhead ($6.1 DLH used) 10. rate/DLH × 2. and their associated cost is the standard cost for the period.60 Total cost per unit $94.00 Fixed overhead ($6. rate/DLH × 2 DLH allowed) 30.71 Benefits and Limitations of Each Cost Measurement System Standard Costing Benefits  Standard costing prescribes expected performance and provides control.00 Total cost per unit $98.  Standards can provide benchmarks for employees to use to judge their own performance. who should be responsible for them.50 est.90 Cost Applied per Unit Under Actual Costing: Direct materials ($8 actual cost/DM unit × 5.50 Fixed overhead ($6. managers can focus on other issues.25 Direct labor ($15 est.1 DLH used) 31.00 Variable overhead ($5/DLH allowed × 2 DLH allowed) 10. cost/DM unit × 5.  Standard costing can be used in either a job costing or a process costing environ- ment.

and overhead applied may be less than the amount incurred if actual production is lower than expected. LLC.  In environments that are constantly changing. Resale prohibited. direct labor quantity standards may not be meaningful.  Applied overhead may also be smaller than the amount incurred if the actual amount of incurred overhead was greater than expected.  Normal costing is not appropriate for process costing because the actual costs would be too difficult to trace to individual units produced. So variances must be interpreted carefully. because actual materials and labor costs incurred are readily available. For personal use only by original purchaser. it may be difficult to determine an accurate standard cost. so it is used primarily for job costing.  Manufacturing costs of a job are available earlier under a normal costing system than under an actual costing system. A favorable materials quantity variance could result from using less materials than should be used.Section D Costing Systems Limitations  If the variances from the standards are used in a negative manner. Normal Costing Benefits  The use of normal costing avoids the fluctuations in cost per unit that occur under actual costing because of changes in the month-to-month volume of units produced and in month-to-month fluctuations in overhead costs. on-time delivery. for instance to assign blame.  Meeting standards may not be enough. which can lead to poor output quality because of the rush. and customer satisfaction. The less standardized the process is. © 2017 HOCK international. An example of this is increasing output at the end of a period to avoid an unfavorable direct labor efficiency variance. employee morale suffers and employees are tempted to cover up unfavorable variances and to do things they should not do in order to make sure the variances will be favorable. 25 .  Normal costing requires the use of subsidiary ledgers to maintain the details of actual costs for direct materials and direct labor. Therefore.  Normal costing allows management to keep product costs current. There is more to consider than just whether a variance is “favorable” or “unfavora- ble” and the amount. Limitations  Using a predetermined factory overhead rate to apply overhead cost to products can cause total overhead applied to the units produced to be greater than the actual overhead incurred when production is higher than expected.  The use of standard costing could lead to overemphasis on quantitative measures. Continual improvement is necessary to survive in a competitive environment. which will result in substandard output.  The usefulness of standard costs is limited to standardized processes. the less useful standard costs are.  Output in many companies is not determined by how fast the employees work but rather by how fast the machines work.  There may be a temptation on the part of management to emphasize meeting the standards without considering other important things such as maintaining and improving quality. while the actual incurred overhead costs would not be available until much later and so are applied based on a predetermined rate.

LLC. Costs are accumulated by job. the total accumulated cost increases with each added process.  Like normal costing. using the same resources. As more work is done on the units. Note: The focus of the remainder of this section will be on standard costing. because that is the most commonly used system in manufacturing. The work is done according to the customer’s specifications. and those are generally 26 © 2017 HOCK international.  It requires the use of subsidiary ledgers to maintain the details of actual costs for direct materials and direct labor. Limitations  The limitations of extended normal costing are the same as the limitations of normal costing. The accumulated costs for all the units move from process to process.  Job order costing (also called job costing) is used when units of a product or service are distinct and separately identifiable. In a process costing system. extended normal costing utilizes estimated labor rates. Process costing is appropriate when all of the units are produced in the same way. The cost of one unit of finished goods is an average: it is the total accumulated manufacturing cost for all the units in the batch divided by the number of units of output in the batch. Costs are accumulated by department or by process. Actual Costing Benefits  The primary benefit of using actual costing is that the costs used are actual costs. Therefore. Introduction to Cost Accumulation Methods Job order costing (also called job costing). which may not be known until after the end of a reporting period. costs are accumulated according to assigned job numbers or some other means of identification. This works because each unit produced uses the same quantity of production resources. . Cost accumulation systems are used to assign costs to products or services. costs are accumulated according to processing department or area. not estimated costs. This makes it most appropriate for a professional service business.  Actual costing leads to fluctuations in job costs because the amount of actual overhead incurred fluctuates throughout the year. actual costing is not appropriate for process costing because the actual costs would be too difficult to trace to individual units produced.  Process costing is used when many identical or similar units of a product or service are being manufactured. For personal use only by original purchaser. In a job order costing system.Costing Systems CMA Part 1 Extended Normal Costing Benefits  In addition to the benefits of normal costing. it is used primarily in a job costing environment. usually in an assembly-line fashion.  Operation costing is a hybrid system in which job costing is used for direct materials costs while a departmental (process costing) approach is used to allocate conversion costs (direct labor and over- head) to products or services. process costing and operation costing are different types of cost accumulation systems used in manufacturing. such as on an assembly line. Limitations  Because actual costs must be computed and applied. Mass-produced consumer goods are accounted for using process costing. Resale prohibited. information is not available as quickly after the end of a period as it is with standard costing.

Examples of cost drivers in a volume-based overhead allocation system are machine hours and direct labor hours. Direct labor and factory overhead conversion costs are accumulated by process (called an operation in operation costing) or by department and then are allocated to products. packaging or handling. Thus. © 2017 HOCK international. number of parts. accounting firms. The actual quantity of resources used on each specific job is used to calculate the costs to be allocated to that job. or number of machine hours. The primary difference between process costing and job order costing is the extent of averag- ing used in computing unit costs of products or services.Section D Costing Systems different for each job. Activity-based methods allocate manufacturing overhead to units or jobs using multiple cost drivers based on cause-and-effect criteria. Industries suitable for operation costing are apparel manufacturing. Construction companies and manufacturers of custom-built furniture where each project is separate make use of job costing. neither of these assumptions is adequate to produce accurate overhead allocation. consulting firms. It is used when conversion activities (direct labor and overhead costs) are similar for several product lines but the direct materials used in the various products differ. Note: Process costing and job order costing are two ends of a continuum (with operation costing in the middle). repair shops. Assigning overhead according to number of units assumes that every unit or job uses the same amount of overhead. Introduction to Methods of Allocating Overhead Overhead can be allocated in two primary ways: 1) Volume-based. advertising agencies. For personal use only by original purchaser. each job uses a different quantity of resources. furniture manufacturing. and electronic equipment manufacturing. Volume-based methods allocate overhead on the basis of a cost driver 5 that is volume-based. an event or a volume of something) that causes costs to be incurred each time the driver occurs. Examples of cost drivers in an activity-based overhead allocation system are set-ups. In many companies. such as number of units produced. LLC.” Whatever name is used. 27 . 2) Activity-based. Volume-based and activity-based methods of allocating overhead will be covered in detail later. Direct materials costs are accumulated by jobs or by batches and assigned to the products in each job or batch. Assigning overhead according to number of direct labor hours or number of machine hours assumes that each product or job uses overhead based on its usage of a single cost driver. and law firms. Process costing. job order costing and operation costing will be discussed in more detail later. Activity-based costing uses some volume-based cost drivers and some non- volume-based cost drivers to allocate overhead more accurately by better reflecting resource consumption. Resale prohibited. the costs of the services are accumulated according to job. 5 A cost driver is anything (it can be an activity. casting. food processing. moving. Operation costing is a hybrid costing system with elements of job costing and elements of process costing. The term “job” may not be used in a service firm but instead it might be called “client accounting” or “project accounting. number of direct labor hours. Job costing is used widely in service industries such as printing companies. Job order costing is advantageous in these applications because it accurately tracks the cost of each unique job. as well. hospitals. If average costs were allocated to jobs in the way process costing allocates average costs. Volume-based methods of allocating manufacturing overhead to products or jobs are also called traditional methods. the cost of each job would be distorted.

.... LLC.. For example. 500 ($0. using raw materials: Raw materials are debited to the Raw Materials Inventory account when they are purchased..... the amount of raw materials actually used to produce those units will probably be either greater than or less than the standard amount allowed for the number of units produced. 6. All costs are applied to production on the basis of the amounts allowed for the actual production in standard costing: direct manufacturing inputs (direct materials and direct labor) as well as manufacturing overhead.. In a standard cost system. they are transferred out in the closing entries. or $5... and it will remain there until it is resolved at the end of the period in the closing entries.. the costs that are applied to the products as they are being manufactured are the standard costs allowed for the actual amount produced.000 Dr Materials Price Variance ....000 units of Material A are purchased is $0...55 × 10. The difference. An accounting problem arises because:  The actual costs per unit for the inputs used are usually not exactly the same as the standard costs per unit of input. at the per-unit cost allowed for each input. Those standard costs are based on the amount of each direct manufacturing input allowed for the amount produced. For personal use only by original purchaser.60 × 10. As production takes place and the materials are put into production. The standard cost per unit for the amount of materials allowed for the actual number of units produced is debited to WIP Inventory.. and accounting for manufacturing overhead is treated separately.. 1) Materials Price Variances Recognized When Materials Are Purchased If the materials price variances are recognized as soon as the materials are purchased.000 At this point.Accounting for Direct Manufacturing Inputs in Standard Costing CMA Part 1 Accounting for Direct Manufacturing Inputs in Standard Costing The description of the way product costs are accumulated and accounted for in a manufacturing company under the topic The Flow of Manufacturing Costs a few pages ago assumed that all costs were being accounted for at their actual cost amounts.. This topic discusses direct inputs. that is not the way it is done when standard costing is being used... the amount debited to the Raw Materials Inventory account will be the extended standard cost of the purchased materials.. the standard cost of the raw materials allowed for the actual production is moved to the Work-In-Process Inventory account..000 units. differences between actual costs and standard costs for direct materials and direct labor are accounted for using variance accounts in the general ledger.500 $0.000 units of Material A. when those materials are received Raw Materials Inventory will be debited for $0.55 per unit.000 Cr Accounts Payable .. The Raw Materials 28 © 2017 HOCK international. . However. or $6. In a standard cost system... Resale prohibited. However. Here is an example.500 because that is the standard cost for 10..000.. The differences are accumulated in these variance accounts throughout the reporting period...60 per unit. and at the end of the period.000.55 per unit but the price when 10..000. and  The number of units of inputs actually used is usually not exactly the same as the standard amounts allowed. Dr Raw Materials Inventory. will be debited to the Materials Price Variance account..55) × 10. if the standard cost for Material A is $0.60 − $0... $500.60 × 10. regardless of whether or not that was the actual cost at which the company purchased the materials... The total due to the vendor is $0. In a standard cost system.55 × 10.000 $0. the balance in the Raw Materials Inventory account consists of the 10.5. at its standard cost of $0.. the amount debited to the Raw Materials Inventory account depends upon whether price variances are recognized 1) at the time of purchase or 2) at the time when the materials are used in production.

55 × 8..........55 × 8.55 × 500 Cr Raw Materials Inventory .........000.. 4.... so the debit to WIP Inventory will be for $4. The company actually uses 8.... or $5...60 × 10....60 per unit.500 – 8... However...000 $0.000 units)..000 Work-In-Process Inventory ...400 $0.500 Dr Materials Usage Variance . The Materials Usage Variance account will be debited (if the amount used is greater than the amount allowed) or credited (if the amount used is less than the amount allowed) for the difference........000 units of product.. and the actual cost of Material A was $0...675....... For our example... is partly a materials price variance and partly a materials usage variance. 4......55 per unit were allowed for the 4.500......55) × 10. $700.55 Accounts Payable (if vendor is still unpaid) ...000 units) at $0....400.500 units. WIP Inventory will be debited for $0.... 6.... or $275... or $0.. The usage variance is $0.60 × 10. Therefore...000 units of product are produced.000 Dr Materials Price Variance..... 4..60 × 10.. the Materials Price Variance account will be debited for $425... though.. let’s say that 4....000) × $0.. Dr Raw Materials Inventory . Raw Materials Inventory will be debited and Accounts Payable will be credited for $6..500 − $4... 425 ($0..000 As production takes place.. The difference. Resale prohibited... the actual usage of Material A was 8...000 2) Materials Price Variances Recognized When Materials Are Used In Production If the materials price variances are recognized at the time when the materials are put into production instead of when they are purchased.. or $4.000 Materials Usage Variance ..000 $0... So Raw Materials Inventory will be credited for 8...675.55.... will be for 8.... 825 $5........ 500 ($0. or $275.55) × 8.100..100 $0.500 © 2017 HOCK international.500 units of Material A at $0..400.. 6..... and each unit is allowed two units of Material A.. will be debited to the Materials Usage Variance account.000 Dr Materials Usage Variance ..60 × 8.....60 − $0....55 × 500... The price variance is $0. The difference in cost due to the difference between the amount used and the amount allowed is a materials usage variance... The WIP Inventory account will be debited for only 8. the $0... and the Materials Usage Variance account will be debited for $275... The credit to Raw Materials Inventory. 4..... LLC.... 5.. or $425. 275 (8.55 × 500 Cr Raw Materials Inventory .....000 $0......500 units of Material A at $0.... 275 $0.55 × 8..000 units of product actually produced.55 per unit. The difference..05 per unit price variance was put into the Materials Price Variance account when the materials were received).000 units of Material A at $0..55 per unit (because remember......55 per unit (the standard cost allowed per unit)... at the standard cost per unit....400 $0.000 Cr Accounts Payable .000 when the materials are received (their actual cost of $0. For personal use only by original purchaser.675 $0..500 units of Material A to produce 4. since the full cost of Material A was debited to Raw Materials Inventory when it was received..... 6..500 units Materials Price Variance ...000 units of materials (the standard amount allowed for 4.... or $4..000 units......60 − $0.000 units at the standard per-unit cost of $0.. 29 ....60...05 × 8. 8. Dr Work-In-Process Inventory ...55 × 8.. When Material A is used to produce 4... the amount of raw materials used in production is accounted for..... Dr Work-In-Process Inventory ....55 × 1.. the standard amount allowed for 4..60 × 10. The cost of the raw materials in Raw Materials Inventory is $0..400 $0..Section D Accounting for Direct Manufacturing Inputs in Standard Costing Inventory account will be credited for the number of units of raw materials actually used at the standard cost per unit.55 × 8..500 So the company will end up with the following net changes in its trial balance related to Material A: Raw Materials Inventory . Thus.. The standard cost per unit for the amount of materials allowed for the actual number of units produced is moved from the Raw Materials Inventory account to Work-In-Process Inventory by debiting WIP.. 275 $0..

. Direct labor variances and their calculation are covered in detail in Section C....55 Accounts Payable (if vendor is still unpaid) . Direct materials variances and their calculation are covered in detail in Performance Management in Section C. if the variances are immaterial in relation to the total cost... or $75) remains in the Raw Materials Inventory account instead of being in the Materials Price Variance account. The amount for direct labor used is then moved out of the payroll clearing account.. If the variances are significant in relation to the total cost.. 425 ($0..Accounting for Direct Manufacturing Inputs in Standard Costing CMA Part 1 So the company will end up with the following net changes in its trial balance related to Material A: Raw Materials Inventory . 30 © 2017 HOCK international.... .....500 units of Material A ($0....... 6. LLC... Work-in-Process Inventory...000 Because the materials price variance is not being recognized until the materials are put into production.......... Work-In-Process Inventory is debited for the standard direct labor cost for the actual amount produced.. Performance Management.. However.55) × 8.. with the credits going to accrued payroll.......... calculated as the standard wage rate × the standard number of direct labor hours allowed for the actual production. When those remaining 1...500 Work-In-Process Inventory .. For personal use only by original purchaser...000) × $0.. Finished Goods Inventory and Cost of Goods Sold.. Resolving the Direct Input Variances At the end of the period. because it does not include deductions from employees’ paychecks for taxes and other things such as employees’ contributions to their employee benefits...500 units of Material A are used in production. with one difference.. the actual cost of the direct labor used is credited to the payroll clearing account. if the variances are immaterial (small) in relation to the total cost)..... they should be distributed among Work-in-Process Inventory.. Variances in the cost of direct labor caused by rate variances or usage variances may be 100% debited or credited to Cost of Goods Sold.400 $0. the price variance will be recognized at that time along with any usage variance... unlike raw materials... or $0......500 units.. There is no inventory account specifically for direct labor costs. nor does it include the employer’s cost for payroll taxes.05 × 1.. Those variances are accumulated in their respective variance accounts...500 – 8..... The difference between the actual cost incurred and the standard cost allowed is the total variance. If the variances are significant in relation to the total cost.. Variances in the cost of materials caused by price variances and usage variances may be 100% debited or credited to Cost of Goods Sold.... Note that the distribution of direct labor variances does not include Raw Materials Inventory. whereas the distribution of direct materials variances does include Raw Materials Inventory.. Finished Goods Inventory and Cost of Goods Sold.60 × 1...60 − $0...4. they should be distributed among Materials Inventory. the materials price variance for the remaining.............000 Materials Usage Variance. 275 (8...000 − $5........500 units Materials Price Variance . 900 $6.. there is only one way of accounting for differences between the actual hourly rate (price) paid and the standard hourly rate (price). unused 1.100.. Direct Labor Direct labor is accounted for similarly to direct materials.... this is a simplified explanation of payroll.55 × 8... Of course. Resale prohibited.000 $0. so direct labor is accounted for as it is used. A company may use a payroll clearing account for the initial debits for salaries and wages earned. The variances are accounted for when the direct labor is used... the variances in the variance accounts are closed out with adjusting entries that either transfer the full amounts of the variances to Cost of Goods Sold or that distribute the variances among the various accounts that are relevant....60 × 10.... and it is broken down between the Direct Labor Rate Variance and the Direct Labor Usage Variance........ Since there is no inventory account for direct labor... as it was in the preceding example.

Overheads are production and operation costs that a company cannot trace to any specific product or unit of a product. for example).Section D Overhead Allocation According to ASC 330-10-30-12. In these materials. because in principle. Methods that cannot be used for external financial reporting can be used internally for decision-making. Also. 31 . and life-cycle costing. some of the concepts and ideas covered in manufacturing overhead are also applicable in the allocation of nonmanufacturing overheads. All of these methods except for life-cycle costing can be used for external financial reporting. although some of the principles of activity-based costing must be adapted in order for it to be used for external reporting. it is essential that the company know what these costs are and allocate them to the different products that are produced. There are actually two main types of overheads: manufacturing (or factory) overheads and nonmanufacturing overheads. activity-based costing does not conform to generally accepted accounting principles. If we use the term “manufacturing overhead” in every situation. the language becomes very cumbersome and more difficult to read. “Standard costs are acceptable if adjusted at reasonable intervals to reflect current conditions so that at the balance-sheet date standard costs reasonably approximate costs computed under one of the recognized bases. © 2017 HOCK international. the emphasis is on the allocation of overhead. However. For personal use only by original purchaser.” Thus. As such. if the variances between actual costs and the standard costs are too great. activity- based costing. process costing. Manufacturing overheads are overheads that are related to the production process (factory rent and electricity. the standard costs should be reviewed regularly and. Because these costs are incurred and paid for by the company and are necessary for the production process. The allocation of nonmanufacturing overheads is covered in the topic Shared Services Cost Allocation. Resale prohibited. Manufacturing Overhead Allocation We have already covered the three main classifications of production costs: 1) Direct materials 2) Direct labor 3) Manufacturing (or factory) overhead Direct materials (DM) and direct labor (DL) are usually simple to trace to individual units or products because these costs are directly and obviously part of the production process. advertising. This must occur so that the full costs of production and operation are known in order to set the selling prices for the different products. whereas nonmanufacturing overheads are not related to the production process. operation costing. LLC. If a company does not take overhead costs into account when it determines the selling price for a product. Overhead Allocation Introductory Note on Overheads In general. there is little emphasis put on the determination of DM and DL on the CMA Exam. job order costing. sales. we will first look at the allocation of manufacturing overheads. Examples of nonmanufacturing overheads are accounting. the standards should be revised to minimize the size of future variances. even when the term “manufacturing overhead” would be more technically accurate. we will use the term “overhead” in the majority of situations. legal counsel and general corporate administration. Note: In order to help these study materials flow more easily. This is covered in a variety of methods that include traditional allocation. the term “factory overhead” can be used in place of “manufacturing overhead” because the two are interchangeable terms. Rather. there is significant risk that it will price the product so that it is actually selling at a loss if the price that a company charges covers the direct costs of production but not the indirect costs of production. overheads are costs that cannot be traced directly to a specific product or unit.

all manufacturing overhead costs must be allocated to the units produced. a company determines the total cost of producing that specific product. Examples are plant electricity. weight of production or some similar measure that is easy to measure and calculate. direct labor hours or machine hours). electricity and utilities) and equipment costs. and now. for the CMA Exam. there are only a few methods of allocation with which you need to be familiar. is one that does not change over the relevant range of activity or production. a certain amount of factory overhead (the determination of how much is covered below) would be allocated to. no matter the manner of allocation. 2) Indirect labor – salaries and wages not directly attributable to a specific product or job. that product. If a company allocates factory overhead based on direct labor hours. Determining the Basis of Allocation When choosing the basis of allocation (for example. the basis used should closely reflect the reality of the way in which the costs are actually incurred. The number of ways in which a company can allocate overhead are numerous and limited only by the imagination of the accountant. However. manufacturing overhead costs have been allocated to the individual products based on either the direct labor hours. Examples of fixed manufacturing overhead are factory rent and production equipment depreciation. In absorption costing. equipment maintenance. Either may be used in a question. generally accepted accounting principles require the use of absorption costing for external financial reporting. in a company that produces very large. units of production. Note: Remember that factory overhead and manufacturing overhead are interchangeable terms that mean the same thing. direct labor would most likely not be a good allocation basis for factory overhead because labor would not be a large part of the production process. 32 © 2017 HOCK international. such as facilities costs (factory rent. Variable overheads are costs that change as the level of production changes. materials cost.Overhead Allocation CMA Part 1 Furthermore. or applied to. though those are the most common bases used. janitorial services and quality control. the best basis on which to allocate overhead may be the weight of each product. small or disposable tools. For personal use only by original purchaser. direct labor and allocated manufacturing overhead costs. The categories of costs included in factory overhead (OH) are: 1) Indirect materials – materials not identifiable with a specific product or job. . But. like any fixed cost. Traditional (Standard) Allocation Method Traditionally. and utilities. for example. machine hours. heavy items (such as an appliance manufacturer). the computer programmer. The allocation basis does not need to be direct labor hours or machine hours. for every hour of direct labor that goes into a specific unit. Overheads may be either fixed or variable (or mixed). such as cleaning supplies. Therefore. The measure used is called the activity base. In this topic we will talk about the allocation of manufacturing overheads in detail. A fixed overhead. Resale prohibited. For example. all overhead costs associated with manufacturing a product become a part of the product’s inventoriable cost along with the direct costs. in a company that is highly automated. it is simply a mathematical exercise of distributing the overhead costs to the products that were produced using some sort of basis and formula. 3) General manufacturing overheads. LLC. machine lubricant and other supplies. such as those of the plant superintendent. By adding together the direct materials. including depreciation and amortization on plant facilities and equipment. For example.

Or a department that paints might allocate overhead costs based on square footage or meterage of the painted products. 33 . and then the overhead is allocated according to the cost basis that managers believe is best for that department. Departmental overhead allocation would be chosen by a company if it felt the benefit of the additional information produced would be greater than the cost to produce the information. of manufacturing overhead allocation is determined. is a measure of activity such as direct labor-hours or machine-hours that is used to assign costs to cost objects. If Department B uses a lot of direct labor and very little machine time. That is plant-wide overhead allocation.Section D Overhead Allocation Plant-Wide versus Departmental Overhead Allocation A company can choose to put all of its overhead costs into one cost pool6 and then allocate the costs in that cost pool to products using one allocation basis. departmental overhead allocation is preferable to plant-wide overhead allocation. Resale prohibited. For example. capitalized projects. fixed overhead may be segregated in a separate cost pool from variable overhead and the fixed and variable overheads allocated separately. jobs. The greater the number of manufacturing overhead allocation rates used. Department B’s overhead costs would probably be allocated to products on the basis of direct labor hours. Note: A cost basis. Therefore. or they can be allocated using different cost bases. Calculating the Manufacturing Overhead Allocation Rate Once the method. To best reflect the way that manufacturing overhead is incurred. the additional information could be used to develop more accurate product costs for use in setting prices and making other decisions. However. or basis. such as all plant overhead costs. The fixed and variable overheads can be allocated using the same cost basis. the more costs will be incurred to obtain the needed information for the allocation. For example. a company needs to find a balance between the usefulness of having more than one overhead allocation basis against the cost of making the needed calculations for the additional bases. it can choose to have a cost pool for each department that the products pass through in production. such as the cost of operating a specific machine. the predetermined manufacturing overhead allocation rate is calculated. or other work unit for which cost information is desired and for which provision is made to accumulate and measure the cost of processes. For personal use only by original purchaser. usually machine hours or labor hours. In both of these methods. © 2017 HOCK international. A cost object is a function. and so on) used by that product during production. if Department A uses very little direct labor but a lot of machine time. it is virtually essential that fixed and variable overhead costs be segregated. to very narrow. For planning purposes and in order to calculate fixed and variable overhead variances. Cost pools can range from very broad. Department A’s overhead costs would probably be allocated to products on the basis of machine hours. and so forth. while a department that assembles products may allocate costs based on the number of parts in each product. 6 A cost pool is a group of indirect costs that are being grouped together for allocation on the basis of some cost allocation base. Note: The only time that it may be applicable to use only one rate for the factory is when production is limited to a single product or to different but very similar products. products. the more accurate or more meaningful the overhead allocation will be. Or. The predetermined rate is the amount of manufacturing overhead that will be charged (allocated) to each unit of a product for each unit of the allocation basis (direct labor hours. This second method is called departmental overhead allocation. contract. LLC. machine hours. or basis of cost allocation. departmental overhead allocation requires a lot more administrative and accounting time and thus is more costly. organizational subdivision. The more bases that are used to allocate overhead. Each department’s overhead costs are put into a separate cost pool.

actual fixed manufacturing costs do not change in total as production increases and decreases. if fixed and variable overheads are allocated separately) will be used to allocate manufacturing overheads throughout the year. For personal use only by original purchaser. the total overhead allocated to production will be the same if the same allocation base is used for both fixed and variable overhead. Predetermined rate × Budgeted Activity (Production) Level = Budgeted Manufacturing Overhead This is particularly important to remember when you are working with fixed manufacturing overhead. direct labor cost. is calculated as follows: Budgeted Dollar Amount of Manufacturing Overhead Budgeted Activity Level7 However. You will find this will be required in quite a few questions. based upon budgeted overhead for the coming year and the budgeted level of activity for the coming year. it must use budgeted. Resale prohibited. Although actual fixed manufacturing overhead may not vary much in total from budgeted fixed manufacturing overhead. 34 © 2017 HOCK international. Because it is done at the beginning of the year. It is important to note that fixed overhead is applied to units produced as if it were variable overhead. the variance between the amount of actual fixed manufacturing overhead incurred and the amount of fixed manufacturing overhead applied to production can be significant because of the fact that fixed overhead is applied to production the same way variable overhead is. Therefore. 7 The budgeted activity level is the number of budgeted direct labor hours. It is important to remember that this manufacturing overhead allocation rate is calculated at the beginning of the year and then used throughout the year unless it is changed during the year. . if you know the predetermined rate and the budgeted activity level. since neither actual nor budgeted fixed overhead is affected in total by the number of units actually produced or the amount of the allocation base actually used as long as production remains within the relevant range. This rate is called the predetermined rate because it is calculated at the beginning of the period. actual fixed manufacturing cost per unit (total fixed manufacturing cost divided by the actual number of units produced) must change as the production level increases and decreases. This predetermined rate. LLC. material cost. but it is not incurred that way. This will be discussed in greater detail as we proceed through this explanation. used throughout the period. The rate that is used to allocate overhead is usually calculated at the beginning of the year. Unless there are material changes in overhead costs during the year that necessitate a change to the predetermined rate. even though fixed costs do not behave the same way variable costs behave. or it may be calculated separately for variable overhead and fixed overhead and applied separately. Whichever way it is done. Actual variable costs increase in total as production increases and decrease in total as production decreases. particularly for fixed overhead.Overhead Allocation CMA Part 1 The predetermined overhead rate may be a combined rate including both variable and fixed overheads. you can easily reverse the process and calculate the budgeted overhead amount that was used to calculate the predetermined rate. or expected. amounts. But as long as the production level remains within the relevant range. or machine hours—whatever is being used as the allocation basis. Only the amount of fixed overhead applied is affected by the actual production activity level. the application rate should be reviewed periodically and adjusted if necessary so that the amount applied is a reasonable approximation of the current overhead costs per unit. Note: Since the predetermined rate is a calculated rate using Budgeted Manufacturing Overhead divided by Budgeted Activity Level. on a per-unit basis. as noted above. Therefore. that rate (or those rates. the fixed manufacturing overhead component of total overhead costs creates a large part of the reported variances.

S. Do not use budgeted for one and actual for the other. As the activity level is one of the two figures used in the determination of the manufacturing overhead rate. it is still greater than the level that will be achieved and will also result in an under-application of manufacturing overhead. However. In such a situation.  Normal capacity utilization – the level of activity that will be achieved in the long run. it will greatly impact the allocation rate. (We will take a more detailed look at under. specifically prescribes that normal capacity should be used for external financial reporting. A company has several choices for the activity level to use in calculating a predetermined allocation rate for overhead. This level will result in a different overhead rate for each budget period because of increases or decreases in planned production due to expected increases or decreases in demand. or whatever other activity base the company plans to use during the year. Which one should be used in which circumstance is a management decision. and cyclical changes are connected to the larger business cycle. In © 2017 HOCK international. Though this basis is more realistic than theoretical capacity. The other activity levels can be used for internal reporting and decision-making. The level of activity used is the number of machine hours. The choices are:  Theoretical. though not de- creased for any expected decrease in sales demand. Normal capacity utilization is the level of activity that will satisfy aver- age customer demand over a long-term period such as 2-3 years. direct labor hours. the company determines the allocation rate at the start of the year and uses it for the entire year for the application of the manufacturing overhead costs. Determining the Level of Activity In relation to the allocation rate. the company must decide what level of activity to use for its budgeted amount of the activity level in the denominator of the overhead predetermined rate calculation.  Master budget capacity utilization (expected actual capacity utilization) – the amount of output actually expected during the next budget period based on expected demand. in order to determine the cost of goods produced throughout the year so their cost can flow to inventory when produced and then to cost of goods sold when they are sold. LLC. These are the costs that the company expects to incur and the number of units of the allocation base allowed for the expected production during the upcoming year. and manu- facturing overhead will be under-applied if it is used because the resulting application rate will be too low. however. Note: The calculation of the allocation rate that we will look at can also be done on a weekly or monthly basis. U. Resale prohibited. The activity level is estimated in advance. the process would be exactly the same except that the budgeted numbers would be for the upcoming week or month (or whatever time period is used). Clearly. Seasonal changes in business result from changes in demand during the seasons of the year. 35 .)  Practical (or currently attainable) capacity – the theoretical level reduced by allowances for unavoidable interruptions such as shutdowns for holidays or scheduled maintenance. A company will not be able to achieve this level. or ideal. Again.Section D Overhead Allocation It is critical to use the budgeted (expected) amounts for both the numerator and the denominator in calculating the predetermined overhead allocation rate. in ASC 330. variances can be minimized. the budgeted rate is not going to be the actual rate that occurs during the year. The activity level a company should use depends on the given situation and upon the company’s purpose in using the activity level.and over-applied manufacturing overhead lat- er. For personal use only by original purchaser. As long as the rate is reviewed periodically and adjusted when necessary. an estimated rate must be used. taking into account seasonal changes in the business as well as cyclical changes. unless something changes that requires the allocation rate to be adjusted. however. capacity – the level of activity that will occur if the company produces at its absolute most efficient level at all times. GAAP. A company cannot wait until the end of the year to determine what its cost of production was.

not capacity used to meet customer demand. Normal capacity is often used as a basis for long-term (multi-year) plans. The primary use of the projected activity level is in developing the master budget for the coming year. If the production level decreases in one of the 36 © 2017 HOCK international. For personal use only by original purchaser. For long-term planning purposes. and other activity levels may be better suited to these other uses.. LLC. In this case. which would cause the production level to be used in the next bid to be even lower and the price even higher.S. In other words. practical capacity is a more stable capacity to use for pricing decisions. . Since normal capacity is a long-run average. This encourages managers to do something about the unused capacity. and so forth. causing the per-unit costs to increase. Resale prohibited. it has no particular meaning for judging current performance. 2) Practical Capacity Practical capacity is best for pricing decisions. The master budget capacity utilization (expected actual capacity utilization) is the most appropriate activity level to use for developing the master budget. here are the best uses for the various capacity level options: 1) Master Budget Capacity Master budget capacity (expected actual capacity utilization) is best for developing the master budget.Overhead Allocation CMA Part 1 addition to using normal capacity for external financial reporting. 3) Normal Capacity Normal capacity is best for long-term planning. or selling unused assets. For example. Practical capacity directs management’s attention to the cost of unused capacity because the cost of the unused capacity is not spread over the units produced. Using normal capacity to evaluate current performance is misusing a long-run measure for a short-run purpose. Use of normal capacity for pricing decisions can thus result in high. Doing something about it could entail developing new products that will make use of the unused facilities. However. This can cause the company to lose the business. the cost per unit gets higher and higher. and capacity available would not change because of a decrease in demand. overhead costs will be spread over a smaller number of output units. there can be other uses of a projected activity level in making management decisions. the cost per unit should not increase and decrease in each of the planning years due to different planned production levels in each year caused by changing projected demand in each year. Practical capacity is required for tax reporting purposes in the U. As demand drops. It is perfectly all right for a company to use one activity level in developing its master budget while using other activity levels to calculate per-unit costs for other decision-making purposes. and year-end proration of variances among inventories and cost of goods sold is also required unless a variance is not material. which lead to more reduction in demand. noncompet- itive selling prices that cause further decreases in demand and lead to a downward demand spiral. the use of practical capacity would avoid increasing unit costs if expected demand levels decrease. Master budget capacity is also best for current performance measurement. A downward demand spiral is a continuing reduction in demand that occurs when costs are too high. leasing the unused capacity. the cost to produce one unit should not change over the period of the long-term plan due only to changes in projected production levels. Changing activity levels would cause the cost per unit to be higher in one accounting period than in another only because demand and thereby production levels are expected to be different in that period. The master budget capacity is more meaningful for current period planning and control. If demand decreases and thus production decreases and normal capacity is being used. The fixed cost allocation rate would be based on capacity available. For this reason. a total cost per unit when fixed cost per unit is based on a low production level may cause a bid to be higher than it would be if it were based on fixed costs with a higher production level. Managers should be evaluated on their achievement of the levels set in the master budget. leading to more price increases.

Section D Overhead Allocation periods. management should use normal capacity utilization in determining the cost per unit for long-term planning purposes. The cost per unit may be projected to change over the long-term planning period for other reasons. 4 and 5 than in years 1 and 2. 2. the activity level used would be the same for each year of the long-term plan. and/or overhead. 4 and 5 than it is in years 1 and 2 of the plan. 4 and 5. 4) Theoretical Capacity Theoretical. because it will not be attained. but it should not be projected to change only because of changing demand levels during the planning period. and the cost per unit would not change each year due to changes in the projected activity levels. For personal use only by original purchaser. © 2017 HOCK international. each unit produced will bear more fixed overhead cost than it will during years 1 and 2. If management uses different levels of production in their plan. the fixed costs will be spread over fewer units and each unit will bear more fixed cost. materials. But it would not change due to changes in the planned production level. It has very little use in practical situations. That will cause the cost of one unit to be higher in years 3. 3. 4 and 5. then probably production will be lower in years 3. To avoid this. Resale prohibited. capacity is just that: theoretical and ideal. then during years 3. Therefore. Example: If a five-year plan is being developed and management expects that at the beginning of year 3 a recession lasting 3 years will begin. The planned cost per unit might well change over that 5-year period due to other factors such as changes in the cost of labor. 37 . The normal capacity utilization activity level would be the average of projected production levels during years 1. LLC. or ideal.

750 units) to the units produced. This is because the amount of fixed overhead would have been allocated to too many bookshelves. We will discuss this more and the reasons for it later under the topic Capacity Level and Management Decisions. the amount of fixed overhead allocated would not have been exactly correct no matter which capacity level was chosen. For pricing decisions. as the expected production level fluctuated from budget period to budget period based on anticipated demand.000 bookshelves. and not enough overhead would have been allocated to the bookshelves that were made.) Under each of the four levels of capacity.94 × 35. but that will not be given next year. Overhead would have been allocated to bookshelves that would never be made. The year is now complete. If RedHawks had used the theoretical base at the beginning of the year in its calculation of cost per unit. RedHawks produced an average of 34. the allocation rate will be $6. Resale prohibited.Overhead Allocation CMA Part 1 Example of a pricing decision: RedHawks Co. the allocation rate would be $7. Below are the calculations for the fixed overhead allocation rate using the four different levels of production. 2) If the fixed manufacturing overhead allocation rate is determined using the current year’s performance as the practical capacity. 4) Finally.000 units). because the actual production was different from any of the bases that could be used.000.235 ($6. the company would have run the risk of underpricing the bookshelves. If they had used normal capacity.58 × 35. which was the most in company history.750 units). RedHawks would have allocated $223. For personal use only by original purchaser.750 units). 1) Using theoretical capacity. and they might have overpriced the bookshelves. a different amount of fixed manufacturing overhead would have been allocated to the products.000  40.000  34. they would have allocated too much overhead to each bookshelf. If they used master budget capacity. the allocation rate for next year will be $6.000 units). it would have allocated $262. The CFO knows to that a portion of the fixed manufacturing overhead must be allocated to each of the units. 2) Using practical capacity.500 and 35.58 per unit ($250.25 × 35. Calculating the Predetermined Rate 1) If RedHawks uses theoretical capacity. The CFO of RedHawks is trying to determine how much it will cost to produce each bookshelf. 38 © 2017 HOCK international. During the current year. In a perfect situation. 3) Using master budget capacity. RedHawks has the capacity to produce 40. practical capacity is the best capacity level to use.25 per unit ($250.000 units). fixed overhead must be allocated per unit.35 × 35. the company expects to produce 36. LLC. it would have allocated $235.000  38. if they use what had been the normal capacity prior to the current year. 3) If the master budget capacity is used in calculating the predetermined rate.763 ($7. However. 4) Using normal capacity.105 ($6. Summary Analysis As you can see.750 units). it would have allocated $248.35 ($250. The allocation is made by multiplying the actual number of units produced by the predetermined rate per unit.000 bookshelves. RedHawks actually produced 35.000 units).000 bookshelves. For the 7 years prior to the current year. the price they charged would fluctuate from one year to the next. (Given the fact that there was no information about any other part of the process. Allocation of Fixed Manufacturing Overhead Under the Traditional Method Now let’s move one year into the future. with production always between 32.750 units during the year.438 ($6.000. The fixed manufacturing overheads of RedHawks for the coming year are expected to be $250. RedHawks produced 38.94 per unit ($250. the amount of overhead allocated under master budget capacity would be the closest to the expected amount of $250. Management thinks that this was attributable to a performance bonus that was in place for management this year. . the allocation rate will be $6. For next year.000  36.000 bookshelves.500. produces bookshelves for shipment to distributors.

accurate. If you did not download this book directly from HOCK international. copied. LLC. and up-to-date materials. 39 . Resale prohibited. For personal use only by original purchaser. The four methods were discussed in the topic of Costing Systems. normal. so we will just review them quickly here as they apply to overhead application. If your book does not have a color cover or does not have this hologram. Hard copy books purchased from HOCK international or from an authorized training center should have an individually numbered orange hologram with the HOCK globe logo on a color cover. the company can allocate overhead to the individual units that are produced.Section D Overhead Allocation Allocating Manufacturing Overhead to the Units As we have seen in the preceding example. but it becomes a little more involved because the company must make a decision about which cost allocation method to use: standard. sold. Overhead Overhead Application Rate Allocation Base Predetermined Standard Amount of Standard Costing Standard Allocation Base Allowed Rate for Actual Production Estimated Amount of Allocation Base Normal Costing Normalized Actually Used for Rate Actual Production Estimated Amount of Allocation Base Extended Normal Normalized Actually Used for Costing Rate Actual Production Amount of Allocation Base Actual Actual Costing Actually Used for Rate Actual Production HOCK international books are licensed only for individual use and may not be lent. This is a very simple mathematical operation. Overhead is allocated by multiplying the predetermined rate by the number of units of the allocation basis that were either actually used or that were supposed to be used in the production of each unit. it is not a genuine HOCK book. or actual. or otherwise distributed without permission directly from HOCK international. once the overhead allocation rate is determined. © 2017 HOCK international. Books from unauthorized sources are likely outdated and will not include access to our online study materials or access to HOCK teachers. it is not a genuine HOCK book. Using genuine HOCK books assures that you have complete. extended normal.

..... calculated as 200....000 How much overhead would have been allocated to the production under standard.. depreciation on production facilities..25 $1... and an almost limitless list of other costs...000 units....000 240. Resale prohibited. The standard number of machine hours is the actual production volume of 125..000 240..... The difference between the actual amount of overhead incurred and the amount applied (called over-applied or under- applied overhead) is closed out after the total costs for the year are known by either debiting or crediting cost of goods sold for the total amount of the variance or by distributing the variance between cost of goods sold and inventories. X This account accumulates (collects) all the actual factory overhead costs that the company incurs during the year....000 1 Two hours are allowed for each unit..... Factory overhead includes supervisory and other indirect salaries and wages. the actual incurred costs are debited to a factory overhead (OH) control account with the following journal entry: Dr Factory Overhead Control.......25 Actual OH Rate: $288.000 multiplied by 2 machine hours allowed per unit..000 Total machine hours 200......0001 Actual number of Machine hours 240.. extended normal and actual costing? Extended Standard Normal Normal Actual Predetermined OH Rate: $250...... See the following section for further information.Overhead Allocation CMA Part 1 Example: A company that allocates overhead on the basis of machine hours has the following budgeted and actual results for 20XX: Budgeted Actual Overhead cost $250..20 Allocation Base: Standard number of machine hours 250........25 $1..000 total machine hours budgeted divided by budgeted production volume of 100. As factory overhead costs are actually incurred.... 40 © 2017 HOCK international..000 ÷ 240.000 240.. For personal use only by original purchaser.. that cannot be traced to the production of a specific unit or group of units..000 $1.000 $288. It cannot wait until the year has been closed out and the total actual costs are known.......500 $300.. overhead needs to be applied to production as the production takes place.. indirect materials used such as cleaning rags..000 Production volume (units) 100.000 $288..... an estimated rate is used throughout the year... X Cr Cash (or Accounts Payable) . normal..000 $300.. It is from this account that overhead will be allocated to work-in-process and then to finished goods. both fixed and variable..... LLC. Why would the company not want to use actual costing..000 ÷ 200....000 $1. Therefore.... indirect facility costs such as utilities...000 OH applied to production $312. . In most cases. since the amount of overhead applied under that system is correct whereas the amounts applied under the other systems are not accurate? The total actual costs for the year are not known until some time after the end of the reporting period because there is always a delay in receiving and recording invoices....000 125.. The Process of Accounting for Factory Overhead Factory overhead includes all costs.

.............. This process is called applying the overhead to production..... The net of the balances in the two accounts at any point in time represents under-applied or over-applied overheads.... This will be explained in more detail in the pages that follow.. This means that each unit received a greater amount of overhead than it should have. using some sort of budgeted rate............ 41 . Graphically it looks like this: Work-in-Process Inventory Factory Account: Costs Applied to Actual Costs Overhead Production @ Predetermined Control Account Manufacturing OH Rate × Quantity of Allocation Base If a separate account. The Factory Overhead Applied account follows the Factory Overhead Control account in the chart of accounts. X Cr Factory Overhead Control .... X The credit may instead be to an account called Factory Overhead Applied..... predetermined overhead rate and the amount of the allocation base that is allowed for the actual output: Dr WIP Inventory ... If the amounts that come out of the factory overhead control account (the amounts applied to units produced) during a period are less than the actual incurred amounts that went into the Factory OH Control account... and it remains in the Factory OH Control Account until the period is closed.... they become what we call applied. The amount of the difference is a variance.. What is happening in the accounting process is that the Factory OH Control account is receiving the actual costs that the company incurs... If the amounts that come out during a period are greater than the incurred amounts...... and when the overheads are transferred into the WIP account............... the overhead is under-applied.. overhead is over-applied....... using the calculated.. Factory Overhead Applied......... Resale prohibited.. and then the costs are allocated out from the Factory OH Control Account to the WIP account and applied to goods that are produced.. This means that each unit received a lower amount of overhead than it should have..... LLC.. The work-in-process inventory account is one of the inventory accounts for the company (the others are finished goods and raw materials).. For personal use only by original purchaser...... some of the cost that has accumulated in the Factory Overhead Control account is transferred to the Work-in-Process (WIP) account with the following journal entry...... is used to apply the costs to production....Section D Overhead Allocation As each unit is produced. © 2017 HOCK international.. it would look like this: Factory Overhead Control Account Actual Costs (Debit Balance) Work-in-Process Inventory Factory Account: Costs Applied to Overhead Production @ Predetermined Applied Account Manufacturing OH Rate × (Credit Balance) Quantity of Allocation Base The amount applied to production from the Factory OH Control Account will not be exactly the same amount as the actual costs that were debited to the Factory OH Control account when the costs were incurred.. simply to keep the debits in one account and the credits in a different account.......

and only the over. the net of the two ac- counts will be a credit balance. the amount of factory overhead that was applied (credited to Factory OH Control) during the period was less than the actual factory overhead incurred (debited to the account) during the period. the Factory Overhead Applied account is closed to the Factory Overhead Control account in the closing entries. This is problematic because of the fact that the actual costs are being allocated using the budgeted costs and budgeted usage of the allocation basis. The three possible locations in the financial statements are: 1) In ending WIP Inventory on the balance sheet if the item has not yet been completed at the end of the period. the amount of factory overhead that was applied (credited to Factory OH Control) during the period was greater than the actual factory overhead costs incurred (debited to the account) during the period. In other words. If two accounts are being used. The amount of over. That will leave the net amount of over. the factory overhead control account will have a balance in it at the end of the year.  If the company is using two accounts (Factory Overhead Control and Factory Overhead Applied). For personal use only by original purchaser.Overhead Allocation CMA Part 1 After the overhead costs are moved into the WIP account. they will be in one of three places in the financial statements at the end of the year.  If the company is using only one account (Factory Overhead Control). “incorrect. Therefore. 42 © 2017 HOCK international. This balance may be a positive (debit) or negative (credit) balance. LLC. In other words. it means that we under-applied factory overhead to the products. this remaining balance (the amount over. The way we transfer out this remaining over. this allocation will be. but in any case it needs to be eliminated from this account. If two accounts are being used. it means we over- applied factory overhead to the products. in essence. .or under-applied factory overhead is calculated as follows: Actual Costs Incurred − Factory Overhead Applied During the Period = Under (Over) Applied Factory Overhead In either of these situations. Resale prohibited. the same as if the company had been using just one account all during the period.or under-applied overhead in the Factory Overhead Control account. If the actual costs or usage are different from the budgeted.or under-applied balance depends on whether the balance is immaterial or material. because it is not reasonable to have any balance in this account (or the net of the two accounts) at the end of the period.or under-applied amount will remain in the account at the end of the period. 2) In Finished Goods Inventory on the balance sheet if the item has been completed but not sold.  If the Factory OH Control account has a credit balance (negative balance). Where the cost of a particular unit is in the financial statements depends on what happened to that unit by the end of the year. 3) As an expense in Cost of Goods Sold on the income statement if the item has been sold. the amounts credited to Factory Overhead Control to apply the overhead to production will decrease the balance in the ac- count. the net of the two accounts will be a debit balance. Over-Applied and Under-Applied Manufacturing Overhead Chances are very good that the actual costs incurred and/or the actual level of activity during the period will be different from the estimates made at the beginning of the year.or under-applied) in the factory overhead control account must be removed from the account(s) as part of the period end closing entries.” As a result.  If the balance is a debit balance (a balance still remains in the Factory OH Control account). the company needs to correct this imbalance.

or under-applied monthly amount to the variance accounts. Note: The pro-ration of under. An under-applied amount will be added (debited) to these accounts while an over-applied amount will be taken out of (credited to) these accounts. LLC. However.and over-applied manufacturing overhead for external financial reporting purposes.Section D Overhead Allocation Immaterial Amount If an under-applied amount is immaterial it will simply be charged (debited) to COGS in that period.  Proportional allocation of over-applied overhead reduces the value (or cost) of each item produced during the period. Resale prohibited. For personal use only by original purchaser. Whenever the variances (under-applied or over-applied amounts) are allocated proportionately among inventories and cost of goods sold on the basis of the costs applied during the period.or under-applied overhead (also called the variance) in variance accounts throughout the year by closing out the over. However.  Proportional allocation of under-applied overhead adds to the value (or cost) of each of the goods produced during the period. the cost per unit for those costs will be the same as if the actual costs per unit instead of the budgeted costs per unit had been allocated to production during the year. The variances are pro- rated according to the amount of overhead included in each that was allocated to the current period’s production.or under-applied overhead amounts to COGS or to inventories and COGS each month. wherever it appears in the accounting system. Note: ASC 330 prescribes a slightly different treatment of under. not on the basis of the balances in the inventories and cost of goods sold accounts at year end. see ASC 330-10-30-1 through 330-10-30-8. the standard overhead application rates are adjusted mid-year. The other side of the entries will bring the balance in the Factory Overhead Control account to zero as of the end of the period. regardless of where each unit was in the accounting system at the end of the period. If an over-applied amount is immaterial. Accumulating Overhead Variances Instead of immediately charging over. This will increase the COGS amount and decrease the profit for the period. Variable manufacturing overhead variances are to be allocated proportionately among inventories and cost of goods sold. reducing COGS and increasing the profit for the period.or under-applied is material. Material Amount If the amount of overhead that was over. the other side of the entry goes to close out the balance in Factory Overhead Control by reducing it to zero. Finished Goods Inventory and Cost of Goods Sold accounts. companies may accumulate the over. That is particularly true if. The CMA exams do not test the treatment prescribed by ASC 330. Information on the amount of overhead allocated to production during the current year should be available in the accounting system. it must be distributed among the WIP Inventory. based on year-to-date variances. it will be taken out of (credited to) COGS. so you do not need to be concerned about it for the CMA exam. An advantage of waiting until year-end to resolve the variances is that some of the variances may reverse by the end of the year.or over-applied overhead should be done on the basis of the overhead allocated to production during the current period only. For more information. © 2017 HOCK international. 43 . fixed manufacturing overhead variances are to be handled in several different ways. depending upon the cause(s) of the variance and whether the fixed overhead was over-applied or under-applied. In both cases. you may need to be aware of these different requirements if you are doing external financial reporting for a manufacturer.

1. But by applying this predetermined rate to production.000. it determines what its budgeted fixed manufacturing overhead will be. or $12.000 units are manufac- tured. 3) The company sets the standard for the quantity of the application base to be used for each unit to be produced. Fixed overhead costs such as rent. We will say that the company’s normal capacity is 1. (Continued) 44 © 2017 HOCK international. 1. The actual costs will almost certainly not be exactly equal to the budgeted cost of $10. For personal use only by original purchaser. to Cost of Goods Sold. Therefore. . and finally.000 of fixed overhead will be applied to the units produced.000 units.Overhead Allocation CMA Part 1 Comprehensive Example of Accounting for Fixed Overhead and FOH Variances The following example should help to clarify the way fixed manufacturing overhead is handled in a standard cost accounting environment. plant supervisor and janitorial salaries are paid. then to Finished Goods Inventory as the units are completed.000.000 machine hours it plans to use in the coming year. 2) The company determines the capacity level it will base its forecast on for the volume to be produced. when the units are sold. In this case. For each unit that is manufactured. or $10 of fixed overhead to that unit. the cost accountants apply 5 machine hours × $2 per machine hour. 5. For simplicity’s sake. 1) When the company makes up its budget for the coming year. This per unit amount is also called the predetermined rate. depreciation on the plant property and equipment is recorded (see Note following this example).000. 4) The company divides its total budgeted fixed manufacturing overhead for the coming year ($10. as well. Therefore. that is the ca- pacity level this company will use.000.000. They do not worry about what the actual costs are at this point. the accounting department debits Fixed Factory Overhead Control for the cost and credits Accounts Payable or whatever other account is appropriate. (The same thing is done for variable overhead costs using the predetermined variable overhead rate. and manufacturing production progresses. When the accountants apply the fixed overhead. since 5 machine hours are required per unit. fixed overhead cost per unit of the cost allocation base used.000 machine hours will be required to produce 1. This applied overhead flows along with the rest of the applied costs first to Work-In- Process inventory. LLC.) This is done because as the year progresses.200. budgeted fixed manufacturing overhead for the coming year is $10. Resale prohibited. The standard (predetermined) fixed overhead rate for the coming year is $2 per machine hour and. This gives it the budgeted. it is $10 per unit. 5) The next year begins. or standard. During the year.S.000 × $10. This company is allocating fixed overhead on the basis of machine hours. the actual total fixed overhead costs for the year turn out to be $11. For this example.000.000 units.200.000) by the 5.000. As each fixed cost is incurred. 6) At the same time as the actual costs are being paid. they debit Work-In-Process Inventory and credit Fixed Factory Overhead Control for $10 of fixed overhead for each unit manufactured.000. and each unit is expected to require 5 machine hours. Since U. no one knows what the actual fixed costs incurred will be at the end of the year.000.000.000 when the year is over. we will assume the company has only one product.000. the company can have a close estimate of what its total production costs are as the year goes on. GAAP requires normal capacity to be used for external financial reporting. the cost accountants are getting reports from the factory floor about the number of units being manufactured.

because the fixed overhead cost per unit actually produced was $11. (Note that if the fixed overhead had been under-applied because production was below normal capacity. because Actual Fixed Overhead Incurred was greater than Budgeted Fixed Overhead.Section D Overhead Allocation 7) By the end of the year. That variance will be moved out of the Fixed Factory OH Control account by the accountants in the period-end adjusting entries they will make.000) right now is a credit balance in the Fixed Factory Overhead Control account. the Fixed Factory OH Control account has been debited for $11.000.000 − $12.000.000. a negative number.000.200.000.000). The Fixed Overhead Budget/Spending Variance will be closed out by distributing it proportionately among Work-In-Process Inventory. FG Inventory and COGS).) Therefore. Resale prohibited.000) Fixed Overhead Production-Volume Variance – total to $(1.000.000. because actual costs were higher than planned. to permit manage- ment to better analyze it and understand what caused it. or $9.000. which is Actual Fixed Overhead Incurred minus Budgeted Fixed Overhead. the company has three amounts: Budgeted fixed overhead of $10.000. which led to over-application of fixed overhead. The Fixed Overhead Production-Volume Variance will also be distributed proportionately among those three accounts.000 units. 9) The Total Fixed Overhead Variance can be split into two different sub-variances.000.000. (Continued) © 2017 HOCK international.000. This might be considered an Unfavorable variance.000.000).000. Because $1.000.000. Remember we said that as actual costs are paid. the fixed overhead is over-applied by $1.000.000.000. (For this example.000.200.000 will cause an increase in the three accounts it is distributed to (WIP Inventory. of course.000. the Fixed Overhead Production-Volume Variance would have been closed out by debiting it to Cost of Goods Sold only.000. Here. because the Fixed Factory Overhead Control account will be credited for $1.000.000 minus the Applied Fixed Over- head of $12.) 14) Distributing the Budget/Spending variance of $1. the amount applied is credited to the Fixed Factory OH Control account. This variance tells management that more fixed overhead was applied than had been budgeted for. that is $11. 13) The cost accountants will need to clear this fixed overhead variance out of the Fixed Factory OH Control account at the end of the period. This is a positive number. because production was higher than planned.000. And that is a good thing. the fixed overhead cost per unit was less than planned.000.16 per unit.000.000.000 units that were planned.000 − $10.000. Actual fixed overhead of $11. and a separate account for Fixed Factory Overhead Applied is not being used. which was 200. LLC.000 ÷ 1.000 more overhead was applied than was actually incurred. This variance is Budgeted Fixed Overhead minus Applied Fixed Overhead. 8) This Total Fixed Overhead Variance of $(1.000).000 units. which is the favorable Total Fixed Overhead Variance. because the production was greater than the normal capacity. The two sub-variances are: 10) Fixed Overhead Budget (or Fixed Overhead Spending) Variance. This is covered in more detail in the Performance Management section of this book and will be discussed here only as it pertains to the accounting for fixed overhead variances. Finished Goods Inven- tory and Cost of Goods Sold. However. Here. and as the overhead is applied to production. The Total Fixed Overhead Variance is the Actual Fixed Overhead of $11. they are debited to the Fixed Factory OH Control account.000. So actually. remember that actual production was 1. The reason more fixed overhead was applied than was budgeted for is.000 and the three accounts will be debited for a total of $1.000).000.000 Fixed Overhead Budget/Spending Variance plus $(2. which is $1. Thus it has a credit balance of $(1. 12) These two variances – $1. that will be $10.000. So this is not an unfavorable variance.000 and credited for $12.000.000 greater than the 1. and Applied fixed overhead of $12.000. 45 . 11) Fixed Overhead Production-Volume Variance. which is $(2. we are assuming only a Fixed Factory Overhead Control account is being used. For personal use only by original purchaser.000.000. which is also the Total Fixed Overhead Variance. or $(1.000.

LLC. Note: Depreciation on factory facilities and equipment is a part of fixed manufacturing overhead. direct labor costs. so that wherever it is. Resale prohibited. For personal use only by original purchaser. because the Fixed Factory Overhead Control account will be debited for $2. the debit goes to the Fixed Factory Overhead Control account for application to production as part of overhead and not to Depreciation Expense.000) will cause a decrease in the three accounts.000 and the three accounts will be credited for a total of $2.000. Recording of depreciation is a non-cash transaction. it just takes longer to do since you need to perform the same operation more than once.000. It may be machine hours. this allocation reduces the cost of each item produced during the period. Note: In questions about overhead allocation on the exam. . and some of it will have flowed to Cost of Goods Sold with units that have been sold. When depreciation on manufacturing facilities is recorded in the accounting system.000. you simply need to perform the mathematics of overhead allocation more than once and then add the numbers together. 46 © 2017 HOCK international. Doing this does not make the question any more difficult.000. weight.Overhead Allocation CMA Part 1 15) Distributing the Production-Volume variance of ($2. Thus. direct labor hours. This is seen in the following question. Therefore. Some of this depreciation will be in Finished Goods and Work-in-Process Inventories at the end of the period. when fixed overhead is applied to units produced.000 decrease in the three accounts to which the variances are distributed.000. size. you need to make certain that you identify the allocation base. Because the fixed overhead was over-applied. the notes to the financial statements must always show where all the recorded depreciation is classified in the financial statements. it can be properly segregated as a non-cash item when the Statement of Cash Flows is prepared. If there is more than one overhead allocation base. 17) This allocation of the variances will take the balance in the Fixed Factory OH Control account to zero. a portion of the amount applied to each unit will be depreciation. 16) The net effect will be a $1. or something similar. 18) Allocating the variance amounts proportionately to the inventories and cost of goods sold accounts makes their balances essentially the same as if the actual costs instead of the standard costs had been allocated to production all during the year. It is also possible that in a question there will be more than one overhead allocation base.

333 (HOCK) © 2017 HOCK international. What is the total cost that would be charged to the production run? a) $18. raw material costs and machine hours.000 Net income $ 25.000 c) 20.Section D Overhead Allocation Question 6: A company allocates overhead to jobs in process using direct labor costs.000 Minus: Total variable expenses 70. For personal use only by original purchaser. The overhead application rates for the current year are: 100% of direct labor. Resale prohibited.000 Factory overhead: Variable $40.000 b) $18.000 At the end of the first year. LLC. $2.000 d) 23. There was also $3. there were no units in progress and the actual total factory overhead incurred was $45.000 b) 16. How many units did Medina produce this year? a) 14.000 Fixed 20. A particular production run incurred the following costs: Direct labor.780 d) $34. the first year of operations.000 Total fixed expenses 25. Units produced 20.400 c) $24. $117 per machine hour.000 Sales $120.000.780 (CIA Adapted) Question 7: On January 1.000 of over-applied factory overhead. had the following annual budget.000 A total of 140 machine hours were required for the production run. $8.000 Raw materials. Factory overhead was allocated on a basis of budgeted units of production. 47 . Medina Co. 2005. 20% of raw materials.

In reality the categories of costs can be numerous. 48 © 2017 HOCK international. There may be direct materials. LLC. It is largely a mathematical operation and as we will see. They are similar to Raw Materials but in reality will include all of the costs (material and conversion costs) from the previous department. or they will remain in Ending WIP if they are not complete (we will look at this allocation process later). Conversion costs include everything other than direct materials and are the costs necessary for converting the raw materials into the finished product. In process costing all of the costs incurred by a process (a process is often referred to as a department) are collected and then allocated to the individual goods that were produced. all of the costs for the units worked on incurred during the current period and during all previous periods must be allocated to either finished goods or EWIP at the end of the current period. The basic exercise is to allocate all of the incurred costs to either the finished goods that left the department or to the ending work-in-process (EWIP) that is still in the department.Process Costing CMA Part 1 Process Costing Process costing is used to allocate costs to individual products when the products are all relatively similar and are mass-produced (the term “homogeneous” is used to describe the products. However. . For personal use only by original purchaser. there are some basic formulas that we can use to make certain that everything is accounted for. Note: Conversion costs is a term that is used in process costing questions to refer to direct labor and factory overhead. We will conclude the coverage of process costing by reviewing the steps and studying a comprehensive example. on the CMA Exam. the costs associated with the units that were sold will end up in COGS. Placing these different costs into one category simply reduces the number of individual allocations that you need to make on a question. If the goods are then sold before the end of the period. Resale prohibited. The previous department’s “completed units” are this department’s transferred-in costs and the costs for both of these items should be the same. indirect labor or other overheads. indirect materials. or worked on. direct labor. Conversion costs are the costs necessary to convert the raw materials into the finished product. 2) They are transferred in from the previous department. As already briefly mentioned. The Ending WIP from this period will be the Beginning WIP for the next period. at the end of the period all of the costs within the department must either be moved to Finished Goods Inventory (or to the next department if further work is required) if the work on them was completed. We will start by looking at some general concepts and ideas of process costing and will then go through the steps of process costing one-by-one. As we have said. Note: Transferred-in costs are the total costs that come with the new product from the previous department. Process costing is basically applicable to assembly lines and anything that shares a similar production process. 3) They were in the department on the first day of the period in the form of beginning work-in- process (BWIP). during that period within that process (or department). and it means “identical to each other”). The costs of the units that have been completed but have not been sold will be in Ending Inventory – Finished Goods at the end of the period. The costs in the department that require allocation can come from one of three places: 1) They are incurred by the department during the period (we will usually have materials and con- version costs in a question). It encompasses everything except raw materials. there are generally only two classifications of costs – direct materials and conversion costs.

Resale prohibited. However. For personal use only by original purchaser. just the allocation process. in a manner similar to the standard allocation of overhead. or finished but not sold (ending finished goods inventory for the company) is irrelevant to what we are looking at here. These costs include direct material (though direct materials are usually allocated differently from the conversion costs and may be accounted for separately). It is important that you are very comfortable with equivalent units of production (covered in much more detail later) and how they are calculated. still being worked on (ending WIP for the company). This simply means that the unit has been completed in this process and transferred to the next department or finished goods. Note: The basic accounting for this type of system is as follows: all of the costs incurred are put into a WIP account. This information is presented because it may help you see what is happening in this process. Here we are looking at only the allocation between completed units and ending work-in- process inventory of costs incurred to date on products worked on in one department during one period. © 2017 HOCK international. 49 . This is an important part of process costing and one that is likely to be tested. Costs for units completed during the period are transferred to either finished goods or to the next department. indirect labor and factory overhead. indirect materials. Steps in Process Costing We will now examine the steps in process costing in more detail. direct labor. The steps in process costing are: 1) Determine the physical flow of goods 2) Calculate how many units were started and completed during the period 3) Determine when materials are added to the process 4) Calculate the equivalent units of production for materials and conversion costs 5) Calculate the costs incurred during the period for materials and conversion costs 6) Calculate the cost per equivalent unit for materials and conversion costs 7) Allocate the costs for materials and conversion costs separately between EWIP and Transferred Out according to the equivalent units in each Each step is looked at in more detail below. This allocation will be done based on a per unit allocation basis. you do not need to be familiar with the accounting steps in this process. These costs that are in WIP then need to be allocated between units completed during the period and units remaining in ending WIP at the end of the period. LLC. Whether it has been sold (and is in COGS).Section D Process Costing This means that the cost of every unit that goes through a particular process in a given period must be recorded in one of the four following places at the end of the period: 1) Ending WIP in the department or process 2) The next department in the assembly process 3) Ending finished goods inventory 4) Cost of goods sold Items 2 and 3 above are classified together as completed units transferred out of the department.

) All of the units that were completed during the period were either in beginning inventory at the beginning of the period or were started on (or transferred in) during the period. Note: When doing a problem like this about physical flow. the number of actual water bottles in the filling department). Question 8: Ben Company had 4. there were 5. water bottles in the filling department at the end of the period that are partially full). the result will be the number of units started and completed during the period. Resale prohibited. we are interested only in the number of physical units. How many units did Ben start during the first quarter? a) 13. the number of units started and completed is used later in and you may need to know how to calculate it for a later step. This means that all of the work on these units was done during the period. However.000 d) 16. On March 31. we calculate how many units were started and completed during the period. 15. we are looking simply at the number of physical units. In this formula. Here.000 units were completed. . During the first quarter. This formula enables us to keep track of how many physical units went into production and where they are at the end of the period. the completion percentages for any of the beginning or ending WIP units are not important (this is part of equivalent units of production that we will look at later).000 units in its work-in-process (WIP) on January 1.500 (HOCK) 2.000 b) 15.000 c) 16. For this product. 50 © 2017 HOCK international.000 units in ending WIP that were 70% complete in respect to conversion cost. Here is the formula that enables us to calculate the number of units that were both started and completed during the period (meaning that 100% of the work was performed this period): # Units Completed – # Units in Beginning WIP = Units Started and Completed This Period 8 This may also be the number of units started during the period if the process is the first in the assembly line. LLC. If we subtract the number of physical units in beginning WIP from the total number of units completed. We show it as a first step in Process costing simply to help you understand how many units there are to account for. Determine the Physical Flow of Goods Note: This formula is not going to be tested on the exam. Next. In a problem you will be given enough information to solve this type of situation if you understand the way the goods move. (For example. For personal use only by original purchaser. In a problem there are often units that are partially completed at the beginning of the period and partially completed at the end of the period (for example. if the product is bottled water. One of the most important things that you may need to do in a process costing problem is to track each of the physical units that go through the department and know where they came from and where they were at the end of the period. how many water bottles were transferred into the filling department during the period and were completely filled during the period. The formula is: Units in Beginning WIP + Units Transferred In8 = Units in Ending WIP + Units Completed/Transferred Out You must be able to use this formula to solve for any of the items within it.Process Costing CMA Part 1 1. Calculate the Number of Units Started and Completed Note: This formula by itself is not going to be tested on the exam. all of the direct materials are added when the unit enters the facility. Each unit was 50% complete in respect to conversion costs. no matter how complete they are (for example.

We accomplish this allocation by calculating the number of units that would have been “completely produced” (100% completed) during the period if the company had simply produced one unit from start to finish. the process is more complicated. we have done less work on each of these items than on the complete units. 3) Started (but not completed). but were not finished at the end of the period and thus have not yet been trans- ferred out of the process. we do not need to do one full unit’s worth of work in order to finish each unit that is in BWIP. because this information will be provided in the question. In a system where there is no beginning or ending WIP in the department. there are three different amounts of work that may apply to an individual unit during the period: 1) Completed (beginning work-in-process inventory that has been completed) meaning that some of the work was done in the previous period. Essentially. this allocation of costs would be a simple matter of dividing the costs by the number of units that were produced during the period. © 2017 HOCK international. because the units in beginning WIP are already completed to some extent. “Completely produced” means completed from start to finish with all direct materials added and all conversion activities completed. and then started another unit. We must determine how many equivalent units were produced (EUP) during the period. meaning that these are units that were started on or transferred in during the period. Calculate the Equivalent Units of Production (EUP) To allocate costs to the individual units produced.) Similarly. LLC. This number of complete units that could have been completed during the period is called the number of equivalent units of production. since we have beginning and ending WIP. meaning that the unit was started on or transferred in during the period and was completely finished during this period. 4. if a 1-liter water bottle is 60% full on January 1. In the second example is a formula that we will use for this calculation. (For example. conversion costs are added evenly throughout the process. then those conversion costs would need to be treated like materials. Determine When the Materials Are Added to the Process The point at which the materials are added is used to determine the amount of materials that were added to beginning work-in-process inventory during the previous period and to ending work-in-process inventory during the current period. this is an important item for later steps so it is important that you identify whether the materials are added:  At the beginning of the process  At the end of the process  At some point in the middle of the process  Evenly throughout the process (in which case they will behave like conversion costs) Usually. because each unit that is in ending WIP is not entirely complete. we need to know how many “units” the costs should be allocated to. we would need to add only 40% of a liter to fill that bottle. 51 . 2) Started and Completed (calculated above). Resale prohibited. We need to determine how many equivalent units were needed for each of these three categories of work done on units. However. but if conversion costs are added at a specific point in the process. This is actually a very simple thing to do.Section D Process Costing 3. For personal use only by original purchaser. By way of illustration. However.

75. This is calculated using the formula: Units in BWIP (100) + Units transferred in (100) = Units in EWIP (10) + Units Completed (must be 190). we can now determine that there were 90 units started and completed (190 units completed – 100 units in BWIP). Example: Let us assume that in addition to the 100 units in beginning WIP (still 25% complete). Example: If there are 100 units in beginning WIP and each unit is 25% complete. Resale prohibited. 2) The number of units started and completed. and at the end of the period there are 100 complete units. we will need to add 75 liters of water to all of the bottles to make them all complete. and at the end of the period there are 10 units in ending WIP that are 40% complete.40) = 4 Total EUP 169 Though this concept of EUP is mathematically simple. LLC. 2) Having calculated the number of units completed. if there are no other units added to the system this period. the number of EU produced this period is 75. people sometimes initially have trouble with it. 3) To calculate the EUP we need to use the three steps of what could be done to a unit during the period. This is used to calculate the number of equivalent units produced.Process Costing CMA Part 1 The idea of EUP is probably best explained with a couple of examples. This was calculated as 100 × 0. and 3) The number of EUP during the period. . This means that we added 75 “equivalent units” of water during the period. since 100 units needed 75% of the work in order to complete them. We can look at this from the standpoint of filling water bottles that are each 1-liter. Solutions: 1) The number of units completed is 190. So please make certain that you spend the necessary time and are comfortable with how it works. 52 © 2017 HOCK international. The calculation of equivalent units of production is: To Complete BWIP (100 × 0.75) = 75 Started and Completed (90 × 1. For personal use only by original purchaser. there were also 100 units (empty bottles to be filled) transferred in during the period. Calculate 1) The number of units completed. If there are 100 bottles that are each 25% full.00) = 90 To Start EWIP (10 × 0. We will look at it in the following pages.

260 c) 1. Ending WIP Inventory will also have had no ma- terials added. this would mean that the entire unit of material has been added. whereas direct materials are added at a specific point in the process. and beginning WIP Inventory will need to have 100% of its materials added during the current period to complete production. a minor complication to this process.100 Number of units in EWIP 400 % complete for EWIP 80% The equivalent units of production for Ben Company for May was: a) 900 b) 1. and no materials will need to be added to complete the beginning WIP Inventory during the current period. they will have had no materials added. the unit would be 100% complete for materials. For personal use only by original purchaser. Usually. and no materials will need to be added to complete be- ginning WIP Inventory during the current period. conversion costs are added proportionately throughout the process.380 d) 1. and the ending WIP is only 40% completed as to conversion costs. it simply means that we have twice as many calculations to complete. if the units in ending WIP were 60% complete for conversion costs. and all of the direct materials (100%) will need to be added to complete the beginning WIP Inventory during the current period. compare that percentage with the percentage complete as to conversion costs for the units in beginning WIP and ending WIP Inventories. no materials will have been added to begin- ning WIP Inventory. The following information is in respect to the second production department for the month of May: Number of units in BWIP 200 % complete for BWIP 20% Number of units started 1. unfortunately. but only 60% complete for conversion costs.620 (HOCK) EUP for Materials and Conversion Costs Separately There is.Section D Process Costing Question 9: Ben Company operates a production facility that has three departments. In this case. LLC. However. beginning WIP Inventory will have had 100% of the needed materials added. © 2017 HOCK international.  If the materials are added at some point in the middle of the process (such as when the process is 40% complete). The same calculations are necessary for beginning WIP in order to calculate the work that was done in the current period to complete those units in beginning WIP. This does not make the problem any more difficult.300 Number of units completed 1. When the materials are added when the unit is 50% complete as to conversion costs. Resale prohibited. they will have had 100% of the needed materials added.  If the materials are added at the end of the process. If the units are completed beyond that point. as follows:  If the materials are added at the beginning of the process. In most problems we will need to calculate EUP for materials and conversion costs separately because materials are not added to production in the same way conversion costs are added to production. 53 . When the Materials Are Added In EUP questions you must also pay attention to when materials are added to the process to calculate EUP for materials in both beginning WIP Inventory and ending WIP Inventory. If the units are not completed be- yond that point. the materials have not yet been added to the units in ending WIP and therefore are not included in the EUP of materials for ending WIP.

200 5. In the Pressing Department all of the materials are added at the very beginning of the process. There is a simple formula for each method for calculating EUP. Very briefly (this is covered in much more detail later). For personal use only by original purchaser. In process costing.000 5. The remaining amount (100% minus the percentage already added) will need to be add- ed to complete beginning WIP Inventory during the current period.600 c) 5. you should be able to answer EUP questions. Hoeppner was presented with the following information: Beginning Work-in-Progress (60% complete for conversion costs) 2. After this first addition. Question 10: Hoeppner Corp. under FIFO all of the costs and equivalent units that are in BWIP will automatically be transferred out to finished goods (or transferred out to the next department) and under WAVG the costs and equivalent units in BWIP will be combined with this department’s costs of the current period to calculate a weighted average. As with regular inventory. LLC.000 Under the EUP method already discussed.000 Transferred out from Pressing during January 6. The costs of beginning WIP and the work done during the current period will be combined and averaged (this is the weighted averaging).000 Ending Work-in-Progress.400 d) 5.Process Costing CMA Part 1  If the materials are added evenly throughout the process. there are two inventory flow systems that are used: 1) First-in-first-out (FIFO) – In FIFO we assume that in each period we finish what is in BWIP before starting any new units (the FIFO method is what has been used in the previous explanations and ex- amples). no additional materials are added during the process. If you memorize this formula. (40% complete for conversion costs) 1.200 b) 5. 54 © 2017 HOCK international. The main difference between FIFO and WAVG is the treatment of the costs that were assigned to the units already in BWIP at the start of the period. Resale prohibited.200 5.200 (HOCK) EUP and Inventory Tracking Methods Another complication in the EUP calculation and the allocation of costs (and a much more significant complication) is that the calculation of EUP is influenced by the inventory cost flow assumption that the company uses in its process costing. How and when materials are added is something that you will need to pay attention to. uses process costing to allocate costs. all of the units (both those from BWIP and those transferred in or started this peri- od) will be treated the same. At the end of January.000 Units started in January 5. 2) Weighted Average (WAVG) – In WAVG we do not assume that the units in BWIP are finished first and as a result. we need a system to determine whether or not each unit that was completed was an old unit taken from the units that were in BWIP. and it is included in some of the questions in these materials.000 5. what are the equivalent units of production for the month of January? Materials Conversion a) 5. . They are discussed in more detail individually below. You need to be able to make the calculations for EUP under both of these methods. the percentage of materials already added to beginning WIP will be equal to the percentage of conversion costs added to beginning WIP Inventory.

The costs that are associated with BWIP are combined with the costs that were incurred during the current period. This means that the next department will use a weighted average for the cost of the units transferred in and will not have similar units that have different costs.Section D Process Costing EUP Under FIFO Method Under the FIFO assumption we assume that all of the units that were in BWIP at the beginning of the period were completed before any other new units were started. Note: When the units are transferred out. This means that we will not make any distinction between the work done and costs incurred on the BWIP last period and the work done and costs incurred this period to finish the BWIP. Those costs that were in BWIP at the beginning of the period (costs incurred in this department during the previous period) are 100% transferred out. the cost per EUP calculation will include three elements: 1) The work required to complete the units in BWIP 2) The work for all of the units started and completed 3) The work done to start the EWIP Those costs and EUP that are already in BWIP will automatically be transferred to Finished Goods because under the FIFO assumption we assume that first the units in BWIP are finished. as well as the costs that were with BWIP. Because we know that the units that were in BWIP have been transferred out of the department. the costs and EUP of work that already were held in BWIP at the start of the period are considered to have been incurred and worked during this current period. We draw no distinction between the units that were in BWIP and the units that were transferred in or started on during the period. Again. This will enable us to reassign the total combined cost to all units worked and determine their average cost. This means that we will consider all of the units that were in BWIP to have been 100% worked on and completed during the current period. Therefore. In other words. LLC. Resale prohibited. the costs that were already associated with those units in BWIP are kept separate from the costs that are incurred during the current period. are combined as the transferred-in costs for the next department – they are not kept separate in future departments. The FIFO calculation of EUP during the period consists of three steps as follows (you must know this): How Calculated 1) Completion of BWIP Units in BWIP × % of work done this period 2) + Started & Completed # of S&C Units × 1 3) + Starting of EWIP # of units in EWIP × % of work done this period = EUP this period TOTAL EUP Under the Weighted Average Method In this method we assume that all of the costs and EUP that are in BWIP are simply added together with all of the work that is done this period and averaged together for allocation between units completed and units in EWIP. in WAVG. For personal use only by original purchaser. This means that under the FIFO method. we know for certain that all of the units that were in BWIP were completed and were transferred out at the end of the period. we are calculating an © 2017 HOCK international. This means that the calculation of EUP and the allocation of the current period’s costs between units transferred out and units in EWIP will include only the work actually done during the period and the costs incurred this period. 55 . the costs incurred this period. and then other new units are started. The costs incurred during this period will be allocated between units completed and transferred out (items numbered 1 and 2 above) and units in EWIP (item 3 above). They are not allocated between units transferred out and units remaining in ending WIP.

For WAVG there are only two categories of units for which we need to calculate EUP. . (CIA Adapted) 9 Units completed is calculated as: Units in BWIP + Units Started/Transferred In – Units in EWIP = Units Completed 56 © 2017 HOCK international. the name). Units Completion Work-in-process.000 Work-in-process. The difference in the EUP between the two methods will be equal to the EUP that were in BWIP at the start of the period.000 equivalent units.000 50% Materials are added at the beginning of the process and conversion costs are incurred uniformly throughout the process. The formula for EUP under the WAVG Method has two steps is as follows (you must know this): How Calculated 9 1) Units Completed # of Units completed during the period × 1 2) + Starting of EWIP # of units in EWIP × % of work done this period = EUP this period TOTAL This method essentially creates a weighted average cost of the production costs of the two periods by putting them together (and hence. b) 175. the equivalent units of conversion performed during December were: a) 170. For personal use only by original purchaser.000 equivalent units.000 Units completed and transferred to the distilling department 180. Note: The EUP under the weighted average method can never be lower than the EUP under FIFO. Resale prohibited. but FIFO can never be higher than the weighted average method. LLC. Because we are assuming that all of the work done on BWIP was done during this period.000 equivalent units.Process Costing CMA Part 1 average cost for the work done last period that is still in the department as well as for the costs incurred this period. December 31 10. the calculation of EUP for the weighted average method is simpler than for FIFO. They will be equal if there was no BWIP. Question 11: The following data pertain to a company's cracking-department operations in December. Assuming use of the FIFO method of process costing. December 1 20. These two categories are Units Completed and the starting of EWIP. d) 185. c) 180.000 equivalent units.000 50% Units started 170.

000 Work-in-process on November 30 (20% complete as to conversion costs) 2.400 units (CMA Adapted) © 2017 HOCK international.000 units d) 4.000 Units completed and transferred out from BI 1.000 units d) 6.000 units Question 15: Using weighted-average.400 units b) 3.400 units b) 3. the EUP for conversion costs for November are: a) 3.400 units d) 3.400 units c) 5. Resale prohibited. the EUP for direct materials for November are: a) 5.000 units c) 4. LLC.000 Total units accounted for 6.400 units b) 4.000 units d) 4.000 Total units to account for 6. For personal use only by original purchaser.000 units b) 6.800 units Question 13: Using FIFO.800 units c) 4.Section D Process Costing The following information is for the next four questions: Levittown Company employs a process cost system for its manufacturing operations. 57 . the EUP of conversion costs for November are: a) 3.400 units Question 14: Using weighted-average.000 Units started and completed during November 3.800 units c) 4. All direct materials are added at the beginning of the process.000 Question 12: Using FIFO. the EUP for materials for November are: a) 3. and conversion costs are added proportionately. The production schedule for November is: Units Work-in-process on November 1 (60% complete as to conversion costs) 1.000 Units started during November 5.

6. 2) An allocated portion of costs incurred by this department during the current period. Costs Incurred Under the FIFO Method Under the FIFO method all of the costs that are with the units in BWIP at the start of the period are transferred out. the last step is to allocate the costs to units transferred out and to EWIP based upon the number of EUP that were completed and that are in EWIP. This is because under FIFO. Calculation of Costs Incurred During the Period After calculating the EUP during the period the next step is to determine the costs that we will consider to have been incurred during the period under each inventory method. This is done by dividing each of the total costs to be allocated (step #5) by the EUP for both materials and conversion costs (step #4). Because we are mixing the costs of the current and previous periods. Note: Remember that if using the FIFO cost flow assumption. The costs in BWIP and the costs incurred during the period will be allocated to either completed units or to ending WIP according to the EUP in each during the period that were calculated under the WAVG method (which included the EUP that were in BWIP at the beginning of the period). and the costs to be allocated have been identified. so any change in the cost of an input is in a sense covered up by the weighted average. LLC. Thus the costs allocated to units completed and transferred out will consist of two components: 1) All of the costs incurred by this department during the previous period for the EUP in BWIP. This is the same as we did with the calculation of EUP under the weighted average method. Selecting an Inventory Cost Flow Method The weighted average method is simpler to use since there is only one calculation. These costs that are in BWIP do not go into the “process” during the period. However. This is simply a mathematical exercise that requires multiplying the EUP by the rate (or cost) per EUP. we must determine a rate (or unit cost) per EUP for both raw materials and conversion costs. this method mixes together costs. it is better to use FIFO when there is a change in the price of the inputs between the two periods. . Because the FIFO method keeps the costs of the two periods separate. Only the costs that were actually incurred during this period will be allocated between units completed and transferred out and ending WIP according to the EUP in each during the period. and they do not need to be allocated according to the EUP. These rates for materials and conversion costs must be calculated separately because the EUP for materials and conversion costs may be different. Costs Incurred Under the Weighted Average Method Under the weighted average method we will take all of the costs that are in BWIP and simply add them together with the costs that were actually incurred during this period. 58 © 2017 HOCK international. For personal use only by original purchaser. all of the costs in BWIP will end up as costs for units completed and transferred out this period. all of the costs associated with the BWIP are automatically transferred to FG or the next department. we get a weighted average.Process Costing CMA Part 1 5. Therefore. we assume that the units in BWIP are all finished before other units are started. 7. Allocation of the Costs to the Products After the rates per EUP for materials and conversion costs have been determined. The weighted average method is best used when prices are stable. Calculation of the Cost per EUP Once the EUP have been determined (under either FIFO or WAVG). Resale prohibited.

59 . © 2017 HOCK international. Under FIFO.Section D Process Costing Note: It is usually easiest to allocate the costs to EWIP first and then all remaining costs end up in units transferred out. In FIFO. Similarly. it is critical that you do not forget to allocate the costs in BWIP to units transferred out. while under the weighted average method the costs in BWIP are included with the costs added into the “process” for this period and are allocated. Following the diagrams. LLC. the costs of BWIP go directly to completed units transferred out. under the weighted average method the work that had been done in previous periods on the BWIP is also added to the “process” and is considered to have been done this period. however. Resale prohibited. On the following two pages are diagrams illustrating the FIFO and Weighted Average process costing systems. Note that the only difference between them is the treatment of BWIP. For personal use only by original purchaser. we will again go through the steps to process costing and this will be followed by an example that goes through all of these steps for both FIFO and WAVG.

previous period. A cost per EUP is calculated and used to allocate the costs incurred between units Transferred Out and EUP in Ending WIP. we calculate the EUP of materials and conversion costs. Transferred Out Ending WIP # of units completed that EUP of Materials × were NOT in BWIP × Cost/EUP of Materials cost/EUP for whole unit + (Materials and Conv. 60 © 2017 HOCK international. . The EUP that are in BWIP are ignored and not used in the allocation of costs incurred during the current period. Costs × Cost/EUP of Conv. LLC. Costs associated with BWIP Cost of Conversion Costs Costs of Materials The Process In the process. Resale prohibited. Costs) EUP of Conv. Costs 1 Under FIFO these units are considered to have been completed during the period. For personal use only by original purchaser. so the costs associated with BWIP are all transferred out. on them and have been materials into the finished allocated costs from the product.Process Costing CMA Part 1 Process Costing Diagram – FIFO 1 Beginning WIP Conversion Costs Added Materials Added During During Period Period In Beginning WIP there are a These are the costs paid for These are the costs paid for number of units that have labor and overhead during materials during the period had some work (EUP) done the period to convert the to produce the product.

We include the units that were in BWIP and assume that that work was done during this period A cost per EUP is calculated and used to allocate the costs incurred between units Transferred Out and EUP in Ending WIP Transferred Out Ending WIP # of units completed that EUP of Materials × were NOT in BWIP × Cost/EUP of materials cost/EUP for whole unit + (Materials and Conv. Costs) EUP of Conv. we calculate the EUP of materials and conversion costs. Resale prohibited. The costs and EUP in BWIP are added together with the costs incurred this period and the total cost is divided by the work done this period (total EUP) in calculating the cost/EUP. Costs × Cost/EUP of Conv. Costs associated with BWIP Cost of Conversion Costs Costs of Materials AND EUP associated with BWIP The Process In the process. LLC. © 2017 HOCK international. For personal use only by original purchaser. on them and have been materials into the finished allocated costs from the product. 61 . Costs 2 Under WAVG these units are considered to have been done completely during this current period. previous period.Section D Process Costing Process Costing Diagram – Weighted Average 2 Beginning WIP Conversion Costs Added Materials Added During During Period Period In Beginning WIP there are a These are the costs paid for These are the costs paid for number of units that have labor and overhead during materials during the period had some work (EUP) done the period to convert the to produce the product.

only costs that were actually incurred during the period are included in the amount to be allocated between units completed and units in Ending WIP. However. It is usually easiest to do this by calculating the ending inventory value since there is only one calculation. For personal use only by original purchaser. The formula is: Started and Completed = Units Completed/Transferred Out – Units in BWIP 3) Determine when the materials are added to the process. The costs for materials and conversion costs need to be calculated separately. We accomplish this by simply dividing the costs from Step 5 by the EUP calculated in Step 4. the Exam questions will be easier as they generally ask about only one part of the process. 4) Calculate the equivalent units of production during the period.Process Costing CMA Part 1 Process Costing Summary The seven steps in a process costing question are shown again below in an abbreviated form. This calculation will most likely need to be done twice – once for materials and once for conversion costs. 7) Allocate the costs between completed units and EWIP. only one cal- culation for EUP for both materials and conversion costs must be made. If you are able to understand the entire process. For FIFO. This allocation is done by multiplying the EUP calculated in Step 4 by the cost per EUP that was calculated in Step 6. If materials are added at the beginning of the process (or at any other point in the process) you will need to make the EUP calculation separately. The formula is: Units in BWIP + Started/Transferred In = Units in EWIP + Completed/Transferred Out 2) Calculate how many units were started and completed during the period. two calculations are needed to calculate the amount to be allocated to completed units. Resale prohibited.) For WAVG. . We will look at the same situation and calculate the dollar value of EWIP and FG using both the FIFO and Weighted Average methods. LLC. Process Costing Examples On the following two pages is an example of how this entire process works for both the FIFO and the Weighted Average methods. This calculation is done separately for materials and conversion costs. if the materials are also added evenly in the process. 62 © 2017 HOCK international. On the other hand. For FIFO: 1) Completion of BWIP Units in BWIP × % work done this period 2) + Started and Completed Number of S&C Units × 1 3) + Starting of EWIP Units in EWIP × % work done this period = EUP this period TOTAL For Weighted Average: 1) Units Completed Units completed during the period × 1 2) + Starting of EWIP Units in EWIP × % work done this period = EUP this period TOTAL 5) Calculate the costs incurred during the period. (Costs in BWIP are allocated 100% to units completed. plus the costs that were in BWIP at the start of the period. 1) Determine the physical flow of units of goods. the costs allocated between units completed and units in Ending WIP will include those actually incurred during the period. 6) Calculate the cost per equivalent unit for materials and conversion costs.

only costs actually incurred during the period are allocated between units completed and units in EWIP.99 7) Allocate costs to EWIP.99 × 530 = 5. Under FIFO. Materials Conversion Cost Complete BWIP 0 60 = 150 × 40% Started & Completed 470 470 Start EWIP 80 16 = 80 × 20% TOTAL EUP 550 546 5) Calculate costs incurred. All material for the product is added at the beginning of the production process. Ending WIP is 80 units at 20% completion as to conversion costs.90 © 2017 HOCK international. Therefore. Calculate the amounts to be in EWIP and FG using the FIFO method. For personal use only by original purchaser.00 Materials $1. Under FIFO. Materials $ 800 Conversion Costs $6.46 Conversion Costs $ 6. 1) Determine the physical flow. Materials $ 1. Material costs for the period are $800 and conversion costs for the period are $6. the costs in BWIP are allocated 100% to units completed and transferred out.84 Total $292. During the period 550 units were started.Section D Process Costing FIFO Example: Beginning WIP inventory is 150 units (60% complete as to conversion costs).000. Therefore.260.46 × 470 = 686.70 Total $7. BWIP + Started = EWIP + Units Completed 150 + 550 = 80 + 620 2) Calculate the Units Started and Completed. only costs incurred during the current period are allocated between completed units and units in EWIP on the basis of equivalent units.64 Allocate costs to finished goods. we know that 100% of the required materials were added to the units in BWIP during the previous period and 100% of the re- quired materials have been added to the units in EWIP during the current period.000 ÷ 546 = $10. 63 .80 Conversion Costs $10. Costs of BWIP $250 +$ 500 = $ 750.46 × 80 = $116.20 Conversion Costs $10.824.000 6) Costs per equivalent unit. Beginning WIP inventory material costs are $250 and conversion costs are $500. Materials $ 800 ÷ 550 = $ 1. Resale prohibited. Thus the number of equivalent units of direct material in each is equal to the number of physical units in each. Conversion takes place continuously throughout the process. S&C = Units Completed – BWIP 470 = 620 – 150 3) Materials are added at the beginning of the process. 4) Calculate equivalent units of production. LLC.99 × 16 = 175.

Material costs for the period are $800 and conversion costs for the period are $6. Thus the number of equivalent units of direct material in each is equal to the number of physical units in each. For personal use only by original purchaser.Process Costing CMA Part 1 WAVG Example: Beginning WIP inventory is 150 units (60% complete as to conversion costs). there will be no BWIP.52 Total $283. Beginning WIP inventory material costs are $250 and conversion costs are $500. During the period 550 units were started. LLC.00 Conversion Costs $10. Conversion takes place continuously throughout the process. 1) Determine the physical flow.000. All material for the product is added at the beginning of the production process.22 × 620 = 6.22 7) Allocate costs to EWIP.40 Note: If the company is in its first month of operation.50 × 620 = $ 930. Materials $250 in BWIP + $ 800 incurred = $1. S&C = Transferred Out – BWIP 470 = 620 – 150 3) Materials are added at the beginning of the process.22 × 16 = 163. Materials Conversion Cost Units COMPLETED 620 620 EWIP 80 16 = 80 × 20% TOTAL 700 636 5) Calculate costs to allocate using EUP.000 incurred = $6. Calculate the amounts to be in EWIP and FG using the Weighted Average method.050 Conversion Costs $ 500 in BWIP + $ 6. Therefore.40 Total $7.52 Allocate costs to finished goods. This means that there will be no difference between FIFO and WAVG because the treatment of BWIP is the only difference between the two methods.00 Conversion Costs $10. Under WAVG the costs that are associated with BWIP are added to the costs incurred during the period. Ending WIP is 80 units at 20% completion as to conversion costs. 4) Calculate equivalent units of production.000) ÷ 636 = $10.50 Conversion Costs ($ 500 + $ 6.266.50 ×80 = $120. Materials ($250 + $800) ÷ 700 = $ 1. we know that 100% of the required materials were added to the units in BWIP during the previous period and 100% of the re- quired materials have been added to the units in EWIP during the current period. Resale prohibited.500 6) Costs per equivalent unit (including costs in BWIP). BWIP + Started = EWIP + Units Completed 150 + 550 = 80 + 620 2) Calculate the Units Started and Completed.336. Materials $1. 64 © 2017 HOCK international. Materials $ 1. .

000 b) $40. LLC. February and March and that at the end of each month they were the same percentage complete.000 d) $7. The Forming Department began manufacturing 10.600 (CMA Adapted) Question 18: Nance Co. only 25% of the conversion cost was applied to the ending work-in-process inventory. There was no beginning inventory. Question 16: The cost of the units transferred to the Finishing Department is: a) $50. All of the Forming Department's direct materials were placed in process. If Nance had used the weighted average method.000 bats were still in the forming process at the end of the month.400 Question 17: The cost of the work-in-process inventory in the Forming Department at the end of May is: a) $10.500 c) $20. but. which are then transferred to the Finishing Department where a sealant is applied. 65 .000 b) $2.Section D Process Costing The following information is for the next two questions: A sporting goods manufacturer buys wood as a direct material for baseball bats. The Forming Department processes the baseball bats. For personal use only by original purchaser.000 bats were completed and transferred to the Finishing Department.000 c) $53. Resale prohibited.000 Total $50. After reviewing the first quarter results. the remaining 2. began operations in January 2005 and uses the FIFO Process Costing method in its accounting system.000 Conversion costs 17.000 A total of 8.000 "Casey Sluggers" during the month of May.000 d) $42. Costs for the Forming Department for the month of May were as follows: Direct materials $33. the EUP for conversion costs for each of the first two months would have compared to the FIFO method in what way? January February a) Same Same b) Greater number Greater number c) Greater number Same d) Same Greater number (HOCK) © 2017 HOCK international. on average. Assume that the number of units in ending work-in-progress was the same at the end of January. Nance is interested in how the equivalent units produced would have been different if the weighted average method had been used instead.

Costs pertaining to the month of May are as follows: • Beginning inventory costs are materials.00 d) $6.880. direct labor.320. May 1 16. May 31 24. The number of equivalent units of conversion costs would be: a) Equal to the number of units completed during the period. Question 19: Using the weighted-average method. Larkin had 2.50 c) $4. the equivalent unit conversion cost for May is a) $5. (HOCK) 66 © 2017 HOCK international.02 Question 20: Using the weighted-average method.20 (CMA Adapted) Question 21: At the end of the first month of operations.560.000 Ending work-in-process inventory. c) Less than the number of units completed during the period.65 b) $5. $468.83 c) $6.000 Completed production during May 92. LLC.12 b) $4. The following information pertains to operations for the month of May. and factory overhead. $54. Units Beginning work-in-process inventory.000 Started in production during May 100. direct labor. d) Less than the number of units placed into the process during the period. $182.000. and factory overhead. Resale prohibited.000 The beginning inventory was 60% complete for materials and 20% complete for conversion costs.240. $20.160.60 d) $5. All materials are added at the end of the process. • Costs incurred during May are materials used. $391. the equivalent unit cost of materials for May is a) $4. $15.000 units in ending WIP that were 25% complete as to conversion costs. . b) Less than the number of equivalent units of materials.Process Costing CMA Part 1 The following information is for the next two questions: Kimbeth Manufacturing uses a process cost system to manufacture Dust Density Sensors for the mining industry. For personal use only by original purchaser. The ending inventory was 90% complete for materials and 40% complete for conversion costs.

but nothing difficult. it is important that you identify this amount and know exactly how many units were spoiled. 67 . this expected number are classified as Normal Spoilage. How Many Units Were Spoiled This information is usually given in the question. The number of spoiled units up to and including. Both the materials used and the conversion costs expended for the spoiled units need to be allocated to the spoiled units. Resale prohibited. If there are spoiled units in the process. 1. Any spoiled units in excess of the expected spoilage are classified as Abnormal Spoilage.Section D Process Costing Spoilage in Process Costing Spoilage is the term used for defective units that are not transferred to the next process. For personal use only by original purchaser. the formula to calculate the physical flow of units of goods needs to be expanded to the following: Units in BWIP + Started/Transferred In = Units in EWIP + Completed/Transferred Out + Spoiled Units When there is spoilage. the company will have established standards about how many defective (spoiled) units there should be (or are expected to occur). but not exceeding. For whatever process is being looked at. Earlier we had established that all of the costs that are in the department (either as Beginning WIP or incurred during the period) must be allocated to either finished goods (FG) or Ending WIP. This expected amount of spoilage is usually presented in a question in one of three ways: 1) A percentage of the number of units started into production 2) A percentage of the units that complete production 3) A percentage of the good units that passed inspection This is helpful for us as it gives in the question the way to calculate the number of spoiled units. 2. we must add spoiled units as another possible destination for the costs that are in the department. The spoiled units have costs associated with them based on what has been done to them – just like EWIP. We will look at the treatment of the costs allocated to spoiled units later. © 2017 HOCK international. LLC. Though this is usually given in the question. This distinction is important because the treatment of the costs associated with normal and abnormal spoilage is different. now that we add spoilage to the situation. Whenever there is spoilage there are some issues that need to be addressed. Normal spoilage is the amount that is expected from the production process. Material has been added to the spoiled units and some of the conversion work done has been done on them. we must allocate the material costs and conversion costs to these spoiled units. There may be a small calculation required. some of the costs of production will be allocated to the spoiled units. However. The treatment of spoilage is similar to the treatment of ending WIP – the units were started but never finished. The amount that will be allocated is done through the EUP and will depend on when the unit is identified as spoiled. How are the spoiled units classified – as normal or abnormal? All spoiled units are classified as either normal or abnormal. These are:  How many units were spoiled?  How are the spoiled units classified – as normal or abnormal?  What is the cost that is allocated to each spoiled unit?  What is done with the costs associated with each soiled unit? In a situation in which there is spoilage.

but the costs have been incurred in the department and must be moved out of the department. What is Done with the Costs Allocated to the Spoiled Units? After determining the costs that are allocated to the normally and abnormally spoiled units. . 68 © 2017 HOCK international. It is generally considered that production management can control abnormal spoilage. depending on when the materials are added. Again. In a problem with spoilage. LLC.) It is obvious that these units are neither finished goods nor work-in-process. we do the same thing with them as we did with EWIP. the company will allocate costs to each unit. those costs must be transferred somewhere at the end of the period. However. abnormal spoilage. the costs that have been allocated to the normally spoiled units are added to the costs of the good units that are transferred out to finished goods (or the next department). Resale prohibited. the formula for FIFO now looks like this: 1) Completion of BWIP Units in BWIP × % work done this period 2) + Started and Completed Number of S&C Units × 1 3) + Starting of EWIP Units in EWIP × % work done this period 4) + Starting Spoiled Units Units Spoiled × % work done this period = EUP this period TOTAL In a problem with spoilage. For personal use only by original purchaser. this will probably be done separately for materials and conversion costs. This will cause the cost per unit transferred in to the next department to be higher than the cost of producing a good unit in the current department. We can simply add another line into the formulas. (These costs will be some amount of materials and conversion costs. the formula for WAVG now looks like this: 1) Units Completed Units completed during the period × 1 2) + Starting of EWIP Units in EWIP × % work done this period 3) + Starting Spoiled Units Units Spoiled × % work done this period = EUP this period TOTAL Allocation of Costs to the Spoiled Units After the cost per EUP of materials and conversion costs are calculated as discussed above. We need to allocate the conversion costs and material costs to the spoiled units based on their EUP. Normal Spoilage If the spoilage is normal spoilage. they will have some conversion costs allocated to them and possibly materials. This is done in the same manner as the allocation to EWIP – the number of EUP for spoiled units is multiplied by the cost per EUP. Calculating the Costs Allocated to Each Spoiled Unit If the spoiled units are identified as spoiled after they start being processed in this department. The treatment of spoilage costs will depend on the type of spoilage. should not occur and should therefore be preventable. by definition. Abnormal Spoilage The costs that have been allocated to the abnormally spoiled units will be expensed on the income statement in that period as a loss from abnormal spoilage. 4.Process Costing CMA Part 1 3. Normal spoilage is expected to occur and generally cannot be prevented. In order to calculate the EUP of Spoiled Units. including the spoiled units.

100 baseballs were completed and 2.100 (CIA Adapted) © 2017 HOCK international. Cost and produc- tion reports for the first week of operations are: Raw materials cost . Calculate abnormal spoilage. Rework When spoiled goods are fixed and prepared for sale. During the week 2. It is simply unused and is now unusable materials. this is called rework. Normal spoilage is 3% of the number of baseballs that pass inspection. the spoiled units are accounted for as though they were all started in the current period. Defective baseballs cannot be economically salvaged and are destroyed. Additional Classifications of Spoilage Below are some additional terms that are similar to spoilage that you need to be aware of. 69 . There was no ending WIP. The costs incurred in rework of normally spoiled goods should be charged to the factory overhead account and allocated to all good units as part of factory overhead.$315. Resale prohibited. Waste Waste is the material that is left over after production is complete. Finished baseballs are inspected and defective ones are pulled out.35 c) $22 d) $1. We account for it in the same manner as spoilage – if it is normal it is charged to good units produced and if it is abnormal it is charged to the income statement.Section D Process Costing Note: To simplify the allocation of costs to spoiled units under FIFO. LLC.$840 and Conversion cost . Although some of the beginning work in process probably was included in the spoiled units. all spoilage is treated as if it came from current production and thus only the current production costs incurred are used to allocate cost to the spoiled units. Question 22: A company that manufactures baseballs begins operations on January 1. Costs incurred in rework of abnormally spoiled units should be expensed. a) $33 b) $20. For personal use only by original purchaser.000 passed inspection. Shrinkage Shrinkage occurs when a product simply evaporates or losses some of its quantity through time.

080 b) $2. The portion of total spoilage that should be charged against revenue in May is a) $50.000 Units accounted for 95.000 Units transferred in from Department 1 80.000 Ending work-in-process inventory (20% complete with respect to conversion costs) 10.000 good units were completed. Of these completed units. The product passes through both Department 1 and Department 2 in order to be completed. Additional direct materials are added in Department 2 when the units have reached the 25% stage of completion with respect to conversion costs. The production activity in Department 2 for the current month was: Beginning work-in-process inventory (40% complete with respect to conversion costs) 15.000 units. costing $80.000.000 Units completed and transferred to finished goods 85. 25. 200 units.000 units. Normal spoilage consisted of 300 units. Resale prohibited.000 was also incurred during the month.000 Units to account for 95.200 d) $2.000 (CMA Adapted) 70 © 2017 HOCK international.000. exclusive of spoilage allocation. (CMA Adapted) Question 24: Assume 5. The company accounts for abnormal spoilage separately on the income statement as loss due to abnormal spoilage. Normal spoilage is not accounted for separately.200. Conversion costs are added proportionally in Department 2. c) 85.000 units. Normal spoilage for the month was $20. Units enter Department 2 upon completion in Department 1. were 50% complete at May 31. For personal use only by original purchaser.000. What is the cost of the good units produced? a) $2. All units are inspected between the completion of manufacturing and transfer to finished goods inventory. . b) 80. abnormal spoilage. LLC.000 units.000 b) $20.000 units costing $600.120 c) $2. An additional 10.000 c) $70.500 units were worked on during a period when a total of 5.Process Costing CMA Part 1 Question 23: A company employs a process cost system using the FIFO method. and abnormal spoilage of $50.000 How many equivalent units for direct materials were added in Department 2 for the current month? a) 70.000 were sold during the month. Mercer Company completed 50.000 units. d) 90. Total production costs were $2.000 d) $60.332 (CIA Adapted) Question 25: During May 20X5.

 Management accountants can review the amounts of materials and labor used in each process to look for possible cost savings. Limitations  Process costing can introduce large variances into the costing system if standard costs allocated to the units are not up to date. It is a simple and direct method that reduces the volume of data that must be collected.  Since the work of an entire department is combined in the process costing system.  It is flexible. Addition of a process could occur if the company decides to produce a slightly different product or improve the quality of an existing product. If the company adds or removes a process.  Process costing can aid in establishing effective control over the production process. most practical costing system to use to allocate costs for homogeneous items. © 2017 HOCK international. an aid in providing estimates to customers. and cost savings may result.  Process costing enables tracking of inventory. Depending upon how the variances are resolved.  Calculating the equivalent units for beginning and ending work-in-process inventory can lead to inaccuracies. it can adapt its process costing system easily. process costing makes it difficult to evaluate the productivity of an individual worker.  Process costing can be time-consuming for management accountants. Removal of a process might occur if the company identifies a redundant (duplicative) process.or under-costed. which could lead to pricing errors. Resale prohibited. LLC.  Process costing is not suitable for custom orders or diverse products. For personal use only by original purchaser. 71 .  Process costing cannot provide an accurate cost estimate when a single process is used to produce different (joint) products. these variances could cause the product to be over. Use of standard costing with process costing makes it possible to track variances and to recognize inefficiency in a specific process.  Process costing enables obtaining and predicting the average cost of a product. since the percentage of completion of those inventories may be subjective (an estimate or even a guess). Process costing can be used with standard costing by using standard costs as the incurred costs that are allocated.Section D Process Costing Process Costing Benefits  Process costing is the easiest.

administrative. and not necessarily in an inventory account. they charge their time and any other costs to that specific job. the following costs were incurred completing Job ICU2: direct materials. Note: Under job-order costing. Performance measurement can be done by comparing each individual job to its budgeted amounts or by using a standard cost system. 72 © 2017 HOCK international. manufacturing overhead must be allocated to each individual job. the cost of goods sold per unit would be: a) $6. During March. If standard costing is being used. LLC. machine hours for each job may be used to allocate overhead costs such as depreciation and machine maintenance. Factory overhead was applied at the rate of $25 per machine hour. whereas direct labor hours for each job may be used to allocate plant supervision and production support costs to jobs. At the end of the project. Question 26: Lucy Sportswear manufactures a line of T-shirts using a job-order cost system. A predetermined rate is calculated and applied to each product based either on:  Actual usage of the allocation base (normal costing)  Standard usage of the allocation base (standard costing) Multiple cost allocation bases may be used if different overheads have different cost drivers. selling and administrative costs are not allocated to the products in order to determine the COGS per unit. direct labor.700. If normal costing is being used.400. The costs are accumulated on what is called a job-cost sheet. While direct materials and direct labor are accumulated on an actual basis. the company simply needs to add up all of the costs assigned to it to determine the cost. This method can be used when all of the products or production runs are unique and identifiable from each other. For personal use only by original purchaser.50 b) $6.Job-Order Costing CMA Part 1 Job-Order Costing Job-order costing is a cost system in which all of the costs associated with a specific job (or client) are accumulated and charged to that job (or client). actual machine hours and actual direct labor hours will be used. Resale prohibited. $13. $5. $4.30 c) $5.000 good shirts.70 d) $5. $1. All of the job sheets that are still being worked on equal the work-in-process at that time.600. As employees work on a particular client or case. and selling. A good example of this is an audit or legal firm. This is done in much the same manner as has already been explained. In this system. . If Job ICU2 resulted in 7.50 (CMA Adapted) Note: On the Exam a numerical question about job-order costing is most likely to be nothing more than a question where you need to use a standard overhead application rate to apply overhead to specific jobs. They are expensed as period costs.800. the standard machine hours allowed and the standard direct labor hours allowed for the actual output on each job will be used. For example. costs are recorded on the job-cost sheets. and Job ICU2 required 800 machine hours.

 The focus is on direct costs of products produced. management can have time to make changes before the job is finished. If the overhead application rates are out of date. There are many opportunities for mistakes because of the massive amount of data recording required. Resale prohibited. rather than waiting until the job is complete. the costs can be monitored on an ongoing basis and if the costs get out of control. For personal use only by original purchaser. and productivity. It is not appropriate for high volume manufacturing or for retailing.Section D Job-Order Costing Job Order Costing Benefits  Job order costing is best for businesses that do custom work or service work. Charging the variances to individual jobs may not be possible if jobs have been closed out by the time the variances are recognized. 10 A “cost-plus customer” is a customer for whom the company uses cost-plus pricing to determine the price to charge the customer. The focus on direct costs can allow for inefficiencies and increasing overhead costs.)  To produce meaningful results. Limitations  Employees are required to keep track of all the direct labor hours used and all the materials used. which can lead to negotiations. Furthermore.  If overhead is applied on the basis of predetermined rates and the rates are not calculated on any meaningful basis. overhead may be applied to jobs on the basis of predetermined rates. In cost-plus pricing. with cost-plus10 customers. it may not be possible to charge the customer for a cost overrun that is not detected until the job has been closed out.  The use of job order costing is limited to businesses that do customer or service work.  Depending on the type of costing being used. and if not corrected. LLC. job order costing requires a lot of accurate data entry. © 2017 HOCK international. which can help management determine in the future which kinds of jobs are desirable. the cost of each job will not be meaningful. increased costs can allow management to make customers aware in advance of cost overruns.  Managers are able to keep track of the performance of individuals for cost control. For long jobs. Allocation of overhead using activity-based costing is more accurate but is also more time-consuming.  Management can see and analyze each cost incurred on a job in order to determine how it can be better controlled in the future. (Activity-based costing will be covered shortly.  Job order costing enables the calculation of profit on individual jobs.  Costs can be seen as they are added. if the customer is a cost-plus customer. efficiency. This can occur most easily when overhead is allocated on the basis of machine hours or direct labor hours. Or. This can enable accounting staff to detect costs recorded to the wrong job and correct them immediately. the costing can be inaccurate. the errors can lead to poor manage- ment decisions.  The records kept result in accurate costs for items produced. the company determines its costs and then adds a standard monetary amount of profit to the cost to determine the price. 73 .

These conversion costs are allocated by batch. . but conversion costs are accumulated and distributed using a predetermined conversion cost per unit. LLC. a company applies the basic operation of process costing to a production process that produces batches of items. or combination.Operation Costing CMA Part 1 Operation Costing Operation costing is a hybrid. of job-order costing and process costing. the general product is the same (for example. As you can see. Resale prohibited. but the materials that are used in each shirt may be different. For personal use only by original purchaser. shoes and similar items. In operation costing the direct materials are charged to the specific batch where they are used. except it would require a separate column for each product’s direct materials. while there would be one conversion costs column that would pertain to the conversion of all the products. An operation costing worksheet would look very much like a process costing worksheet. Examples of a system where this would be appropriate are clothing. 74 © 2017 HOCK international. for each of these items. These different batches all follow a similar process. a shirt). furniture. but the direct materials that are input to each batch are different. In this method of costing.

Product costs are direct materials. followed by some manner of allocating them to the produced products. such as usage of machine hours or direct labor used.  A cost object is anything for which costs are accumulated for managerial purposes. These resources used may or may not have a connection with the costs being allocated. Examples of cost objects are a specific job. It can also be used in service businesses. Instead. Examples of activities are designing products.” Activity-based Costing is a costing system that focuses on individual activities as the fundamental cost objects. according to the Statement of Management Accounting. activity-based costing: “identifies the causal relationship between the incurrence of cost and activities. 11 A cost pool is a group of indirect costs that are being grouped together for allocation on the basis of some cost allocation base. establishes cost pools11 related to individual drivers. an event or a volume of something) that causes costs to be incurred each time the driver occurs. With ABC. determines the underlying driver of activities. operating machines. Examples of executional cost drivers are set-ups. task or unit of work with a specified purpose. the cost allocations are not based on usage of resources. o Executional cost drivers relate to the actual processes performed. a market or certain customers. A more complex working environment leads to higher structural costs.Section D Activity-Based Costing Activity-Based Costing Activity-based costing (ABC) is another way of allocating overhead costs to products. Cost drivers can be structural or executional. and period costs are charged against income in the period they are incurred and are not allocated to products at all. a product line. setting up machines. 75 . ABC is much more detailed than traditional costing. and applies cost to product on the basis of resources consumed (drivers). For personal use only by original purchaser. and in ABC the method of allocation is based on cost drivers. making orders or distributing prod- ucts. We can use ABC in a variety of situations and apply it to both manufacturing and nonmanufacturing overheads. casting. number of parts. Product costs are attached to units of inventory.  An activity is an event. they are based on activities performed and what those activities cost. devel- ops costing rates. As with the other methods. LLC. Traditional Costing versus ABC Differences between traditional costing and activity-based costing include: Allocations Based On Different Things Traditional costing systems allocate costs according to general usage of resources. Resale prohibited.  A cost driver is anything (it can be an activity. o Structural cost drivers relate to the actual structure of the company’s operations and the complexity of the technologies the company uses. Period costs include selling and general and administrative costs. By definition. direct labor. moving. ABC is a mathematical process of allocation and requires identification of the costs to be allocated. because it uses many more cost pools and each cost pool has its own cost driver. and factory overhead and are allocated to products according to some cost driver such as machine hours used or direct labor used. The cost of executing activ- ities is determined by the company’s effective use of staff and processes used. packaging or handling. Classification of Costs Traditional costing methods classify costs as product costs or period costs. © 2017 HOCK international. and they are put into Inventory on the balance sheet and charged as expense when the units they are attached to are sold.

these costs. However.S. but it should also include a portion of the administrative costs necessary to produce the product. If it is modified to conform to U. Note: Because of this difference from traditional costing methods in what is considered a product cost and what is considered a period cost. And that will probably be higher than it would be under traditional costing. in an ABC question that is numerical. not much product setup cost will be allocated to the low-volume product because the volume of products produced and the total resources used to produce them is low relative to other products. ABC cannot be used for external financial reporting or for tax reporting unless it is modified. But in ABC. so it would be excluded from the product costs. and so forth. in the application of ABC. . that low-volume product would be allocated a small amount of total overhead costs. If the cost of product setups is segregated from other overhead costs. GAAP and to U. under traditional costing. This is discussed further below. direct labor and overhead manufacturing costs directly attributable to that product. and these cost drivers should have a direct relationship to the incurrence of costs by an individual product. if they have no direct relationship to the production of the products. activity-based costing is very similar to the standard method of overhead allocation. The same total amount would be considered product costs under ABC as under traditional costing. that plant guard's salary would not be directly related to the cost of producing any of the products. the cost of a product under ABC also includes the administrative costs to buy the raw materials. if more than one product is produced. On the exam. Costs Attached to Low-Volume Products The use of activity-based costing can result in greater per-unit costs for products produced in low volume relative to other products than would be reported under traditional costing. Resale prohibited. The main difference is the determination of what the allocation bases are going to be. ABC can be used for external financial reporting and tax reporting. It also means that some costs that are considered product costs under traditional costing will not be attached to products at all.S. are analyzed and allocated to products under ABC.Activity-Based Costing CMA Part 1 In ABC. then a more realistic cost for product setups will be allocated to the low- volume product. since traditional systems may use direct labor to allocate overheads and direct labor is becoming a smaller part of the overall production process. LLC. the premise is that the cost of a finished product should include the cost of direct materials. This means that products will be charged with the costs of both manufacturing and nonmanufacturing activities. You may also need to determine what an appropriate allocation base would be for each of the cost pools. you simply need to perform many different overhead allocations. so cost per unit allocated to the low-volume product will probably be higher under ABC than under traditional costing. If the cost of product setups is included in total overhead and is allocated according to traditional costing. the product costs would be allocated differently among the products. If a product is produced in low volume. Essentially. 76 © 2017 HOCK international. except for the fact that we have many cost drivers. For example. For personal use only by original purchaser. Therefore. Therefore. One example is product setups. including writing specifications. It would take just as much time to set up the production process for a low- volume product as it would for a high-volume product. it will require fewer resources in total than a product that is produced in high volume. the salary paid to the security guard at the plant entrance is an overhead cost in a traditional cost system and is included in the fixed overhead that is allocated to products on the basis of machine hours or direct labor hours. For example. which are period costs under traditional costing. as in ABC. issuing purchase orders. However. and is allocated according to how many product setups are done for each product instead of how many units of each product are produced. Therefore. obtaining bids. you should be prepared to make three or four allocations of different cost pools to the final product. Note: ABC is becoming more of a necessity for many companies. a low-volume product may require just as much time and cost per production run as a high-volume product. tax regulations so that all product costs and only product costs are allocated to production.

tax regulations require the use of absorption costing. If ABC is to be used for external financial reporting. This can be time-consuming and expensive if different costs are being used for internal decision-making. the product cost data needs to conform to U. the premise of ABC is that the cost of a finished product should include not only the cost of the direct materials. if it is used in accordance with U.S. because a company must first analyze the production process and decide what activities cause costs to be incurred.Section D Activity-Based Costing ABC and External Financial and Tax Reporting As we said above. © 2017 HOCK international. these are activities (costs) that add value to the customer. while traditional absorption costing is used for external reporting. Identification of Activities As part of the process of analyzing the production process. many of the overhead allocations in ABC are based upon subjective data − for example.S. The different categories of costs are listed a little further on in this topic. whereas an ABC system may exclude some of the manufacturing costs that actually belong there under absorption costing. GAAP. time consuming and costly than setting up a traditional system. the company may identify some non-value- adding activities.S. on the CMA Exam you will generally not need to identify the cost drivers or cost pools in a large question because they will be provided for you. The ABC Process Setting up an ABC system is more difficult. this will either enable the company to reduce the sales price or to recognize more profit from the sale of each unit. In a smaller question it is possible that you will need to determine the appropriate driver for each cost pool from among those given. This means that these activities add something to the product that customers are willing to pay for. Companies may identify a number of different cost drivers and use each of them to allocate overhead. GAAP. For personal use only by original purchaser. because it has the potential to be manipulated by manage- ment in order to make earnings and key ratios appear more favorable. In turn. ABC is seldom used for external financial reporting. In addition. ABC is generally used only internally for decision-making. Furthermore. This reduction of non-value-adding costs is an additional benefit to the company (in addition to more accurate costing of products) and can lead to a reduction in the cost of production. you will see what cost driver should be used for each cost pool. These are activities that do not add any value for the end consumer and the company should try to reduce or eliminate them. For all the above reasons. 77 . ABC can be used for external financial reporting. Value-adding activities are the opposite of non-value-adding activities. however. U. and if you simply think about what would cause costs to be incurred. You will simply need to use the provided information to determine the amount of overhead that will need to be allocated to any product. So technically. These are usually fairly direct. which means that manufacturing overhead – not administrative overhead – must be accounted for as a product cost. but it should also include a portion of the administrative costs necessary to produce the product. Auditors are uncomfortable with the use of subjective data. Resale prohibited. Even though these activities are value-adding activities. LLC. GAAP and U. so that it includes all manufacturing overheads that need to be included for absorption costing and it excludes all administrative overheads.S. direct labor and overhead costs directly attributable to that product. interviews with personnel − that may not be verifiable using concrete facts and figures. Each cost driver requires the company to keep records and increases the complexity of the ABC system. Note: Fortunately. As the name suggests. they must be monitored to make certain that the costs are not excessive. product cost for external reporting must include all of the manufacturing costs.

78 © 2017 HOCK international. or the com- pany may simply expense them in the period incurred. Some exam- ples are hours of work. or cost driver.Activity-Based Costing CMA Part 1 Calculation of Allocation Rate and Allocation An allocation rate is then calculated for each of the cost drivers. This process of cost allocation is similar to the accumulation of actual manufacturing overhead costs that we discussed in the traditional method of overhead allocation. As we covered in the traditional method. Note: You need to know these different categories of activities more for word questions than for numerical questions. However. they can be included in the ABC cost allocations to products. it is very difficult to allocate them in any reasonable manner to the final goods. scheduling. Some examples are machine setup. such as security. Each cost pool is associated with one of the cost drivers (activities). maintenance. because it affects how much overhead in total is allocated to each product. so the allocation calculations will need to be performed many times. 2) Batch-level activities – These activities occur each time a batch is produced. Because of the increased number of allocation bases. Categories of Activities There are four categories of activities. The difference is that in ABC there are many cost pools and drivers. materials handling and batch inspection. These four categories are: 1) Unit-level activities – These activities are performed for each unit that is produced. Resale prohibited. LLC. plant management. . Given the broad nature of these costs. This process is like that done under the traditional method (expected costs allocated to the cost driver ÷ the expected usage of the cost driver). For external purposes they must be allocated in order to maintain an absorption costing that is acceptable for GAAP. ABC provides a more accurate costing of the products. inspecting each item. based upon where the activity occurs in relation to the final product and the facility as a whole. operating a machine and performing a specific assembly task. ABC uses many allocation bases to try to reflect the different consumptions of overhead activities between and among products. Facility-sustaining activities and associated costs present a small issue that requires a company deci- sion. Examples include product design and engi- neering changes. For personal use only by original purchaser. a company should use only one allocation base if it produces only one product. purchasing. 3) Product-sustaining activities – These activities are incurred in order to support the production of a different product from what is currently produced. they are period costs and are ex- pensed as they are incurred. These cost pools collect the costs associated with the various activities (drivers) that incur the costs. ABC is meaningful only if a company produces more than one product. A cost pool is similar to the traditional overhead account for each activity. even though for external reporting. The manufacturing overhead costs that the company incurs are accumulated in cost pools. Facility-sustaining activities allocated under ABC can also include selling and administrative expenses that would be expensed for external purposes. For internal analysis. and then the costs are allocated as the drivers are used or consumed in the production of the product. The allocation methods are the same for all of the activities. depreciation of the factory and property taxes. but what they relate to is different. a company may either try to allocate these costs. The costs are then allocated to the products based upon the usage of the cost driver of each product. 4) Facility-sustaining activities – These activities are incurred to support production in general.

production volume or the number of purchases). Limitations  Not everything can be allocated strictly on a cost driver basis. LLC. the resource driver measures how much of the total costs incurred by the company are consumed by the “purchasing” activity. there will not be any purchasing costs. At the same time. tax reporting regulations. In this case it could be number of purchase orders that are required to purchase the parts for Product A. Value-adding activities depend upon the industry and what the company does (manufacturing. Inclusion of administrative overhead in product costs is not in compliance with any generally accepted accounting principles or with U.S. Thus a company using ABC to allocate administrative overhead to production will need to keep two sets of records: one for external reporting with administrative overhead costs expensed as incurred and one for internal decision-making utilizing administra- tive overhead costs included in product costs.  By identifying the activities that cause costs to be incurred.Section D Activity-Based Costing Benefits and Limitations of Activity-Based Costing Activity-Based Costing Benefits  ABC provides a more accurate product cost for use in pricing and strategic decisions. 79 .  ABC is expensive and time consuming to implement and maintain. resale. ABC will provide the most benefits to companies that produce very diverse products or have complex activities. as an activity such as purchasing increases. For example. all of the costs associated with purchases also increase – costs of shipping. A resource driver is a measure of the quantity of resources consumed by an activity. telephone. It can be the level of activity or volume (for example. We have to assign all costs associated with Product A using ABC to Product A. ABC enables manage- ment to identify activities that do not add value to the final product. For example. and the cost drivers of those activities need to be reduced or eliminated. If there are no purchases. © 2017 HOCK international. the company needs to carry out the value-adding activities as efficiently as possible. factor or activity that causes cost to arise and be incurred. An activity driver measures how much of the activity (purchasing) is used by the cost object (Product A. The elements of Activity-Based Costing that you need to be familiar with are: A cost driver (discussed above) is an event. This is the determination of the total costs of the cost driver. In the above example. In a manufactur- ing company. Once value-adding areas are identified. the manufacturing process – converting raw materials to a finished product – is a value- adding activity. The increase in value to the customer makes the company more competitive. This is particularly true in respect to facility-sustaining costs. Value-adding activities are activities that add customer value to the product. An activity driver is the measure of the demand for the purchasing activity by the cost object (in this case. unnecessary and inefficient activities are non-value-adding activities. Product A). insurance. the costs of ABC would probably outweigh the benefits. For companies that produce relatively similar products or have fairly straightforward processes that are consumed equally by all products. Using the purchasing example. So. a purchase is a cost driver. the organization can increase the related benefits from the value-adding activities. Resale prohibited. The main idea is a cause-and-effect relationship between an activity and the incurrence of costs. In a resale or service company. service). On the other hand. and so forth. offering exceptional customer service is a value-adding activity. activity to rework defective products is a non-value-adding activity and thus needs to be reduced or eliminated. For personal use only by original purchaser. we need to assign purchasing costs to product A. for example).

then that 90% is the resource driver for the tellers' salaries. And not only is the engineer required.Activity-Based Costing CMA Part 1 Question 27: Cost drivers are: a) Accounting techniques used to control costs. and they spend 40% of their time doing that (the resource driver again). computer time. The transactions relate to many different banking services that the bank offers. (CMA Adapted) Here are three examples of how activity-based costing might be used in a real situation: Example #1: A manufacturing firm. Resale prohibited. c) A mechanical basis. b) Accounting measurements used to evaluate whether performance is proceeding according to plan. information on how many of each type of transactions processed by tellers is captured. Suppose the engineer spends 20% of his or her time supervising setups (the resource driver). . d) Activities that cause costs to increase as the activity increases. The average time for each type of transaction is multiplied by the number of transactions processed. 90% of the tellers' salaries will be put into the "tellers" cost pool along with 100% of the costs of their teller machines. Production supervisors are also required to supervise machine setup. their supplies. such as machine hours. savings account transactions. 80 © 2017 HOCK international. LLC. and the square footage occupied by their teller stations. size of equipment or square footage of factory used to assign costs to activities. Then the percentage of tellers' time spent on each type of transaction in relation to their total time spent on all teller transactions (the activity driver) is used to allocate the teller costs in the cost pool proportionately among the bank's various services. If the tellers spend 90% of their time performing teller transactions and 10% of their time doing something else like answering telephones. The cost driver is machine setups. Then. machine setup is required every time the production line changes from producing one product to producing another product. How should the tellers' time. Transactions processed are the cost driver. the teller machines used by the tellers. In a manufacturing environment. The total costs in the pool are allocated to the different products being produced based on what percentage of total setup time is used for each product. For personal use only by original purchaser. Setup time spent on each product as a percentage of setup time spent on all products is the activity driver. savings accounts. All of the costs of machine setup are collected in a "machine setups" cost pool. So 20% of the engineer's salary and other expenses will be costs to be allocated according to the amount of time the engineer spends supervising each product's machine setup as a percentage of the amount of time spent supervising all product setups (the resource driver). and so forth). Bank tellers process all kinds of transactions. the supplies used by the tellers and the space occupied by the tellers be allocated among the various services offered by the bank (checking accounts. An engineer might be required to supervise the setup of the machine for the product change. The percentage of teller time spent on each type of transaction as a percentage of the amount of teller time spent on all types of transactions is the activity driver. and so forth) in order to determine which services are most profitable? The bank would do time and motion studies to determine the average time that it takes tellers to process each type of transaction (checking account transactions. Example #2: A service firm.

department. sales or service firm. because without it. In an ABC system.000 hours of service than it does to create a line on an invoice for a quantity of 1 unit of the same product or 1 hour of the same service. it would not be right to charge the 1. So even though the revenue for 1. In this example. It does not take an invoicing clerk any longer to create a line on an invoice for a quantity of 1. if management wishes) in some meaningful way. Besides the clerk's salary. only 50% of the invoicing clerk's salary and 50% of the costs for the other resources used by the invoicing clerk should go into the "invoicing" cost pool.Section D Activity-Based Costing Example #3: A manufacturing. That is how lines on invoices drive costs. 81 . the volume of invoicing may require only 50% of the invoicing clerk's time. the company will simply multiply the total costs in the pool by the percentage of total usage by each product or service. Then. the resource driver is the percentage of the invoicing clerk's time spent on invoicing. So the total costs in the cost pool are divided by the total number of lines of invoicing done by the clerk to calculate a cost per line. the more of the clerk's time will be required. the company would not receive payment. that is exactly what would happen. all indirect and overhead costs are analyzed in this way. then a second invoicing clerk will have to be hired. For example. This enables the company to see which products or services are more profitable than others. it should be possible to capture information on how many lines are invoiced for each of the company's products during a given period of time. An invoicing clerk who prepares invoices for the whole company is creating invoices for all of the products and/or services that the company provides. and that is the activity driver.000 times more of the invoicing clerk's expenses when 1. A resource driver is a measure of the consumption of a resource. But if the invoicing clerk’s costs were being allocated to products and services on the basis of revenue invoiced. The number of invoice lines used by each product as a percentage of the total invoice lines used by all products will be calculated. To find the amount of the invoicing clerk’s costs to allocate to each product. The costs in the cost pool are then allocated to products/services proportionately to the amount of the activity that was used by each one. as long as those costs can be allocated to individual products or services (or organizational units. © 2017 HOCK international. The cost driver activity is analyzed to determine what percentage of the activity is being used by each product/service (the activity driver).000-unit product or service for 1. the cost driver for a cost pool can be anything at all that causes indirect or overhead costs to arise.000 times as much as the revenue for 1 unit. and product are just a few of the possible ways. a totally unrelated activity. The company may want to allocate the invoicing clerk’s costs in any of a number of ways. LLC.000 units of a product or 1. depending on how management wants to see them. In ABC. For personal use only by original purchaser. All of the costs related to invoicing make up one cost pool. and the other 50% of the clerk's time is spent assisting the marketing department. In a good accounting system.000 units will be 1. The analyst groups costs into cost pools and looks for what the cost driver is for that cost pool. for example. the total cost is allocated to products and/or services according to usage. And if the volume grows so much that the one invoicing clerk cannot do it all. and it is used to determine the portion of total resource cost assigned to each activity. In this case. If the company wants to see the costs allocated by product or service. the invoicing clerk needs a desk and a computer and a file cabinet and office space and a telephone.000 units are invoiced than when just 1 unit is invoiced. ABC can make the allocation of the clerk’s costs more equitable. Geographical area. the number of invoice lines created for each product/service during the period will be retrieved from the accounting system. the cost driver is the number of lines on invoices (not sales dollars invoiced). The number of lines on invoices is the cost driver because the more lines that need to be invoiced. In this example. Resale prohibited. The invoicing is a necessary activity. It also enables the company to set prices to cover the full cost of providing each product or service so that very profitable products are not subsidizing unprofitable products.

000 Question 29: Under activity-based costing (ABC).Activity-Based Costing CMA Part 1 The following information is for the next two questions: Zeta Company is preparing its annual profit plan. the materials handling costs allocated to one unit of wall mirrors would be: a) $1.500 (CMA Adapted) Note: This is a very good example of a question where you may need to determine the cost under both ABC and the traditional method. As part of its analysis of the profitability of individual products. .500 d) $2.000 b) $500 c) $1. the materials handling costs allocated to one unit of wall mirrors would be: a) $1.$50. 82 © 2017 HOCK international.000 b) $500 c) $2. Resale prohibited.000 in total Question 28: Under a costing system that allocates manufacturing overhead on the basis of direct labor hours. LLC.000 d) $5. the controller estimates the amount of manufacturing overhead that should be allocated to the individual product lines from the information given as follows: Wall Mirrors Specialty Windows Units produced 25 25 Material moves per product line 5 15 Direct labor hours per unit 200 200 Budgeted materials handling costs . For personal use only by original purchaser. Make certain that you are able to do this.

44 c) $6.30 (CIA Adapted) © 2017 HOCK international.39 b) $5.000 direct labor hours and 30. of setups 750 315. of parts handled 6.000 Machining costs Machine hours 30.00 b) $6. Budgeted Budgeted Activity Cost Driver Activity Cost Material handling No. 83 . of batches 500 225.75 Total Prime Cost $5. The organization plans on using 50.000 machine hours in the coming year.000 Total Manufacturing Overhead Cost $1. For personal use only by original purchaser.000 units Setups 2 per batch Total parts per finished unit 5 parts Machine hours required 80 MH per batch Question 30: If the organization uses the traditional full cost system. Resale prohibited.Section D Activity-Based Costing The following information is for the next two questions: Believing that its traditional cost system may be providing misleading information.08 c) $6. It now employs a full cost system and has been applying its manufacturing overhead on the basis of machine hours.000 units Batch size 5.000 Cost.11 d) $6.21 d) $6.40 Direct labor cost per unit = 0.000 540.000.000.000 Setup costs No.95 Question 31: If the organization employs an activity-based costing system.05 DLH @ $15/DLH 0.000 $ 720. an organization is considering an activity-based costing approach. the cost per unit for this product for the coming year will be: a) $5.15 Sales and Production Data Expected sales 2. the cost per unit for the product described for the coming year will be: a) $6. LLC. sales and production for one of the organization’s products for the coming year are as follows: Prime Costs Direct material cost per unit $4.000 Quality control No.800. The following data shows the budgeted manufacturing overhead.

LLC. testing. the R&D and design costs are expensed as they are incurred. under other methods. whereas other methods treat these costs as period expenses that are expensed as incurred. it is important that the company treat these as product costs that will need to be recovered. it runs the risk of the sales price covering the costs of the actual production of that particular unit. quality development Manufacturing Costs  Purchasing  Direct and indirect manufacturing costs (labor. Resale prohibited. but not the costs of R&D. for internal decision-making purposes. Or alternatively. After making the life- cycle cost calculations. 12 The term “value chain” refers to the steps a business goes through to transform inputs such as raw materials into finished products by adding value to the inputs by means of various processes. For personal use only by original purchaser. However. the company can make an assessment as to whether or not the product should be manufactured. after-sales and other costs. . These three categories and the types of costs that are included in them are: Upstream Costs (before production)  Research and Development  Design – prototyping (the first model). For the product to be profitable over its life. It may be that a larger investment in the design or development of the product will be recovered through smaller after-sale costs. after-sale service and support costs and any other cost that is associated with this product during its life cycle. Rather. then it should not be produced. development. 84 © 2017 HOCK international. the company takes a much longer view to the cost of production and attempts to allocate all of the research and development. these pre-production and after-sale costs are not directly taken into account when determining the profitability of a product or product line. In life-cycle costing a company does not determine the production cost in the short-term sense of the production of one unit. The life cycle of the product may be called its value chain. engineering. If the company fails to take into account the large costs of R&D. materials and overhead) Downstream Costs (after production)  Marketing and distribution  Services and warranties Under GAAP financial reporting. The process of a company looking at all of the costs hopefully enables it to determine the ultimate value of developing a better product. The goal of value chain analysis is to provide maximum value to the customer for the minimum possible cost. Life-cycle costing plays a role in strategic planning and decision-making about products. marketing.12 This longer-term view is of particular importance when the product has significant research and development (R&D) costs associated with it (or other nonproduction costs such as after sale service and support costs). the company may realize that additional design costs will not provide sufficient benefit later to make the additional investment in design and development feasible. Note: Life-cycle costing is different from other costing methods because it treats pre-production and after- sale costs as part of the product costs. these costs also need to be covered by the sales price. Therefore. All of the costs in the life cycle of the company can be broken down into three categories.Life-Cycle Costing CMA Part 1 Life-Cycle Costing Life-cycle costing is another type of costing that is useful only for internal decision-making. marketing. If they believe that they will not be able to charge the required price for the product. In addition to R&D costs there are also after-sale costs such as warranties and repair work and product support expense. and finally to sell the finished products to customers.

resulting in lower output and lower profitability toward the end of its life.  Life-cycle costing includes research and development costs as well as future costs such as warranty work. which typically report costs for a short period such as a month or a year. enabling better pricing for profitability over a product’s lifetime. 85 . Life-Cycle Costing Benefits  Life-cycle costing provides a long-term.  Accurate estimation of the operational and maintenance costs for a product during its whole lifetime can be difficult. more complete perspective on the costs and profitability of a product or service when compared to other costing methods. life-cycle costing can be used to lower those long-term costs. the company can identify any non-value-adding costs.  Cost increases over the life of the product need to be considered. LLC. © 2017 HOCK international. That may not be an accurate assumption. producing and selling the product.  Life-cycle costing can require considerable time and resources. the assumption may be made that the fixed assets will be as productive in later years as when they were new. by looking at all of the costs that are going to be incurred in the process of developing. Limitations  When life-cycle costing is used to spread the cost of fixed assets over the life of a product. Resale prohibited. because a piece of equipment may gradually slow down.  When long-term costs are recognized in advance.  Life-cycle costing can help in determining when a product will reach the end of its economic life.  Life-cycle costing can be used to assess future resource requirements such as needed operational support for the product during its life. which can then be reduced or eliminated without reducing the value of the product to the customer.Section D Life-Cycle Costing Also. and the costs may outweigh the benefits. For personal use only by original purchaser.

For personal use only by original purchaser.000 × 0. the life-cycle cost of laundry equipment includes the purchase cost plus the cost for energy to operate it over its lifetime. and the cost to dispose of it at the end of its life. maintaining and disposal costs relating to usage of this product per installation. the cost of repairs. For example. maintaining and disposal costs. Note: The costs incurred by the customer are relevant only for customer life-cycle costing and as input into pricing decisions made by the company. Customer life-cycle costing is important to a company because it is part of the pricing decision. totaling $610. it will be able to recover all of the life-cycle costs associated with this product and have a 40% mark-up on those costs.000 Design 500.016 per installation. from marketing to after-purchase support.000 After-sale support 60.016 per installation.000 Distribution 100. manufacturing and downstream costs related to this product. If the company charges $2. operating. these manufac- turing and downstream costs are $910. the life-cycle costs are $2.000.160.Customer Life-Cycle Costing CMA Part 1 Customer Life-Cycle Costing Customer life-cycle costing looks at the cost of the product from the customer’s (the buyer’s) standpoint. LLC.000. maintain.000) and the design ($500. Manufacturing costs are $300. operating. Also. and dispose of the product or service. training. but the customer’s additional $500 costs are not included with the company’s costs when calculating the company’s total life-cycle cost for the product. This means that the total amount that BusinessSoft needs to charge for the 1. training.500 installations is $3. Resale prohibited.516.000. 86 © 2017 HOCK international.000 Customer service 250. The customer’s life-cycle cost will be the customer’s purchase price of $2. or $2.000 ($2. If a product is expected to require minimal maintenance when compared with its competition. Example: BusinessSoft Co.000) costs. the company can charge a price for the product that is higher than what the competition is charging for their products. In total. for a total of $2. The company expects a 6-year life cycle from the moment it starts developing this product through its last sale and installation of the product. Downstream costs include all of the other costs listed above. The upstream costs are the research and development ($750.000 Marketing 200. In total. The company’s cost estimates are: R&D $750. the company envisions that an average client would incur around $500 of installation.024. is about to launch a new product. The additional $500 cost to the customer is relevant information to the company in making its final pricing decision. this will require a mark-up of $864.40).000 The company plans to produce and sell 1.000. However.500 installations of the product and would like to earn a 40% mark-up over its life-cycle costs relating to this product.016 per installation plus the $500 per installation for the cost of installation.000 Manufacturing costs 300.000. What is the expected total life-cycle cost per installation for BusinessSoft? And how much do they need to charge per installation? Solution: The life-cycle costs to BusinessSoft include all of the upstream. It focuses on the total costs that will be paid by the customer during the whole time the customer owns the product: the customer’s purchase costs plus costs to use.160. With a required 40% mark-up over the life-cycle cost. . it also expects to provide after-sale services as part of the contract within and beyond this period. and the total cost to the customer may still be lower than the cost for the competitor’s product.

just the Sales Value method. more simply. This is the point at which the two products stop sharing the same process and become different. © 2017 HOCK international. Management may decide it would be more profitable to the company to process some of the joint products further.Section D Joint Products and Byproducts Joint Products and Byproducts Joint products occur when one production process leads to the production of two or more finished products.e. This method can also be called the Sales Value at Splitoff method or. in a sense. Methods of Allocating Costs to Joint Products There are a number of different allocation measures to use. 87 . but all of these different methods use some sort of ratio between the two or more products to allocate the joint costs. for each of the joint products: Sales Value of Product X Amount allocated to the × Joint Costs = Total Sales Value of all Joint Products individual Joint Product This method can be used only if all of the joint products can be sold at the splitoff point (i. The different methods and how to calculate the bases follow. Costs incurred after the splitoff point are separable costs and they are allocated to each product as they are incurred by that product. we need to know the amount of cost to be expensed to COGS for each unit sold. direct labor and overhead. And since the inventory cost of each unit becomes its cost of goods sold when it is sold. Relative Sales Value at Splitoff Method (or Gross Market Value Method) Joint costs are allocated on the basis of the sales values of each product at the splitoff point. 1. LLC. For personal use only by original purchaser. This is largely a mathematical exercise. with no further processing). identifiable products. We need to accurately determine the inventory cost of each unit of each joint product so that the balance sheet will be accurate. They are. relative to the total sales value of all the joint products. As a pineapple goes through processing at the factory it becomes juice and pineapple slices that will be canned. An example of joint products would be the processing of pineapple. Accurate allocation is needed primarily for financial reporting purposes and pricing decisions. Joint costs may include direct materials. These products are not identical.. These are two products that arise from the same process and as such the joint costs of processing the pineapple need to be allocated to the juice and to the slices. but you need to remember how the different allocation bases are calculated. accidental results of the production process. Resale prohibited. but the Sales Value at Splitoff method can still be used to allocate joint costs up to the splitoff point. Byproducts are the low-value products that occur naturally in the process of producing higher value products. but they share the same production process up to what is called the splitoff point. The formula to allocate the costs between or among the products is as follows. The main issue with joint products is how to account for the joint costs (those costs incurred prior to the splitoff point) and how to allocate these costs to the different products. as long as sales prices at the splitoff point do exist for all of the joint products.

00.500 + $750 + $250 = $2. though the pump stems are different.500.  It can be used even if further processing is to be done. how much of the joint cost is allocated to electric percolators. One batch consists of 500 basket assemblies.000. of which 300 are destined to become part of electric percolators. If they do not. The basket assembly is also sold separately as a replacement part for both percolators at a price of $10.000. For personal use only by original purchaser.  The cost allocation base is expressed in terms of a common basis – amount of revenue – that is recorded in the accounting system. 88 © 2017 HOCK international.500 ÷ $5. Separate prices for the basket assemblies that go on to be incorporated into the two percolators do not exist. The portion of the joint cost allocated to the replacement basket assemblies is $500 ÷ $5. or $500. The portion of the joint cost allocated to the stovetop percolators is $1. since they become integral parts of the percolators. even if further processing is to be done.00 per unit. since a market does exist for them at that stage of production.  This is the best measure of the benefits received from the joint processing. how much to stovetop percolators. straightforward. The 8-cup electric model and the 8-cup stovetop model use the same basket assembly.000 × $2. the whole production run could be sold as replacement baskets.500 + $500.  Market prices of joint products may vary frequently. Thus. We can confirm that the full $2.000 × $2. because $1. Part of the manufacturing process is the production of the coffee basket assembly. which includes a basket and a spreader. Relative Sales Value at Splitoff (Gross Market Value) Method of Allocating Costs to Joint Products Benefits  Costs are allocated to products in proportion to their expected revenues.500. 150 are destined to become part of stovetop percolators. The sales value of the replacement baskets is 50 × $10.00. and intuitive. Limitations  To use this method. LLC. selling prices at the splitoff point must exist for all of the products. it does not require information on processing after the splitoff.500. Using the Sales Value at Splitoff method.00.000 + $1. and 50 are sold separately as replacement parts. The joint costs of one batch total $2. The total sales value of all 500 basket assemblies is therefore $3. or $5. Resale prohibited. or $1. This can introduce inaccuracies into the allocations.500.500. The portion of the joint cost allocated to the electric percolators is $3. this method cannot be used. as long as selling prices do exist for all the joint products. but the Sales Value at Splitoff method uses a single set of selling prices throughout an accounting period. or $5. or $250. which is in proportion to the individual products’ ability to absorb costs. It is meaningful because generating revenues is the reason why the company would incur the joint costs. and how much to the replacement parts? The sales value of the electric percolator basket assemblies is 300 × $10.500.Joint Products and Byproducts CMA Part 1 Example of the Relative Sales Value at Splitoff method: Cafe Industries manufactures two kinds of coffee percolators: an electric model and a stovetop model. or $3. or $750.  The method is easy to calculate and is simple.000 × $2. The sales value of the stovetop percolator basket assemblies is 150 × $10. or $1. However.500. .500 of joint cost has been allocated.000 ÷ $5.00.

© 2017 HOCK international. while the NRV of the product that can be sold at the splitoff point is its sales value at the splitoff point. The estimated NRV for a product to be processed further is calculated as: Sales price of items produced that will be sold in the future − Separable costs that are incurred after the splitoff point = Estimated Net Realizable Value Note: If one (or more) of the joint products is not processed further but is sold at the splitoff point. even if the product will be processed further. it is acceptable to use within the same allocation the net realizable value(s) of the product(s) that must be processed further in order to be sellable while using the sales value(s) at splitoff for the product(s) that can be sold at the splitoff point. If a sales value at splitoff is not available for one or more of the joint products. For personal use only by original purchaser.Section D Joint Products and Byproducts 2. If a market price at the splitoff point is available because the product can be sold at that point. The estimated NRV method would generally be used instead of the Relative Sales Value at Splitoff Point method only when a market price at the splitoff point is not available for one or more of the joint products. even if one or more of the products can be or will be processed further. This is because they are sunk costs. LLC. sometimes when sales prices at the splitoff do exist for all of the joint products but one or more products can be processed further. then use the sales values of all of the joint products for the allocation. If the problem says to use the Net Realizable Value method. an exam problem will say to use the Net Realizable Value method to allocate the joint costs. the company should compare the incremental revenues (the increase in the sales price that results from further processing) with the incremental cost (the increase in costs related to the additional processing). However. Note: The joint costs of production are not relevant costs in the decision to process further or sell immediately. In a case such as this. you may have one product that cannot be sold at the splitoff point and must be processed further (thus there is no sales value at splitoff available for it). If the problem does not say to use the Net Realizable Value method and sales values at the splitoff exist for all products. This method is essentially the same as the Relative Sales Value method. It may also be used under certain circumstances if one or more of the joint products may be processed beyond the splitoff point in order to increase its value above the selling price at the splitoff point. the company will simply use the Sales Value(s) at the splitoff point for the product(s) that can be sold at the splitoff point. for example because a product is not marketable at the splitoff point. For instance. while using the NRV(s) for the product(s) that must be processed further to be marketable. use the net realizable value(s) for the product(s) that can be processed further even though sales prices at splitoff do exist. Resale prohibited. Estimated Net Realizable Value (NRV) Method This method can be used if one or more of the joint products must be processed beyond the splitoff point in order to be sold. 89 . In order to determine if a product should be processed further. except an estimated Net Realizable Value (NRV) is used for the product or products that must be or will be processed further. the NRV of the product that must be processed further is its estimated NRV (sales price after further processing less cost to process further). that price is used instead of the NRV. and the allocation is done in the same way. Note: The Net Realizable Value method is generally used in preference to the Relative Sales Value at Splitoff method only when selling prices for one or more products at splitoff do not exist. while the other product can be sold at the splitoff point. instead of using NRV for those products. but only if the cost to process further is less than the additional revenue to be gained from the further processing.

05 2.000.000 cans of extra spicy chili.000 90 © 2017 HOCK international.308. how much of the joint costs will be allocated to each type of chili? Price/ Extended Cost to Pro.000 1.05 per can. One batch results in 500.200.000 will be allocated as follows: Mild $1.000 1. original and extra spicy. and 1. 2. The three types of chili are packaged in 16- ounce cans. Using the Net Realizable Value method of allocating the joint costs.075 Extra spicy 0.000.188 = $ 347.98 per can.1% Extra spicy 1.350 Total allocated $1.000 1.000 18. The unspiced chili is. For personal use only by original purchaser.850.8% Original 2. After the spices have been added.850 Extra Spicy $1.000 cans of original chili. It needs spices.000 gallons of unspiced chili are produced per batch.000 cans of mild chili. The extra spicy chili sells for $1. The total joint cost of the unspiced chili is $1.311 = 575.850. of course.000 150.000. The cost per can of adding the spices and blending them into the unspiced chili are as follows: Mild 0. .080 The mild chili sells for $0.850.000 0. Example of the Net Realizable Value method: Simpli Chili Company produces three flavors of its chili in a joint process: mild.000 × 0.212.850.100.501 = 926.950. original and extra spicy flavors.98 $ 784.850.000. Resale prohibited.000 $ 732.000 50.000 gallons of unspiced chili.850.000 × 0.200.894. and then varying amounts and types of spices are added to produce the mild.000 $3.Joint Products and Byproducts CMA Part 1 Costs that are incurred by each of the products after the splitoff point are simply allocated directly to those products.000 The joint cost of $1. not marketable at that point.000 96. 500.800 Original $1. Percentage Product # Cans Can Sales Value cess Further NRV of Total NRV Mild 800. The original chili sells for $1.09 1.09 per can.000 $ 52. LLC. Simpli has 800.1% Total 4.000 31.000 1.000 × 0.065 Original 0.

joint costs are allocated proportionately among the joint products. such as pounds. the joint cost allocation is done based on the physical units of output. such as pounds. 91 .  The NRV method is often implemented with simplified assumptions. In the Physical Measure method. For personal use only by original purchaser. because it provides a better measure of the benefits received than the other meth- ods that could be used in this situation. The total joint cost up to the splitoff point is prorated between or among the joint products based on the physical measure being used. LLC. Physical Measure Method Joint cost allocation may be done based on the weight.  The allocation results in comparable profitability among the joint products. volume. In this method. This method may also be called the Quantitative Unit method. This can introduce inaccuracies into the allocations. the joint cost allocation is done based on the weight. whether that unit is a unit of physical measure or a unit of output. volume or other physical measure of the joint products. If all of the output that results from a joint process cannot be measured in the same terms. or other physical measure of the joint products. Companies assume a specific set of processing steps beyond the splitoff point.Section D Joint Products and Byproducts Net Realizable Value Method of Allocating Costs to Joint Products Benefits  The Net Realizable Value method can be used instead of the Sales Value at Splitoff method when selling prices for one or more products at the splitoff do not exist. joint costs are allocated based on some common unit of measurement of output at the splitoff point. It requires information on the specific sequence of further processing and the separable costs of further processing. tons. Limitations  This method is complex. or gallons. Resale prohibited. or board feet (for lumber). this method cannot be used. © 2017 HOCK international. In the Average Cost method. as well as the point at which individual products will be sold. but the Net Realizable Value method uses a single set of selling prices throughout an accounting period. so that each product is allocated the same amount of joint cost per unit of measure. In both methods. 3.  Selling prices of joint products may vary frequently. Physical Measure and Average Cost Methods These two methods are essentially the same. tons. gallons. but they may actually do something else and in fact may change the steps frequently. It stands to reason that it must be possible to measure all of the joint products in the same unit of measurement.

4625 $ 370.000 gallons are used for the original chili.70 Total 500. original and extra spicy flavors. direct labor and overhead) is $1.000. 100.000 $3. Example of the Average Cost/Physical Unit Method: In our Simpli Chili example. 0. It is basically the same as the Physical Measure method.000 Total 4.850.000 cans $0.50 = 925. 16-ounce and 20-ounce cans. The total joint cost is divided by the total number of units of all of the joint products produced to calculate the average cost per unit.4625 925. Then that average cost per unit is multiplied by the number of units of each product produced to find the amount of cost to be allocated to each product.30 $1.000. and 150.000 gal.000 $3. Resale prohibited. now we will go back to packaging all three flavors of chili in 16-ounce cans only.850. with the can as the unit of output.000 cans $1. or sometimes Average Unit Cost method. 500.000.Joint Products and Byproducts CMA Part 1 Example of the Physical Measure method: We will use the Simpli Chili Company example again.000 cans $0.70 Original 250. . Now.000 Extra spicy 1. the output and the allocations from the joint process are as follows: Product Units of Output × Avg. in this example we will say that each of the three types of chili is packaged in a choice of can sizes: 12-ounce.000 Note that the allocation of the cost by product using the Average Cost/Physical Unit method is exactly the same as it was using the Physical Measure method.000 × 0.000 $3.850. it is called by the name Average Cost. The total joint cost of the unspiced chili (including direct materials.850. Since the size of the cans is all the same.000.000 × 0.000 gal.850.20 = $ 370. and extra spicy. 92 © 2017 HOCK international.30 = 555.000 Original 2.000 Average Cost Method This method may also be called the Physical Unit method. LLC. The company produces three flavors of its chili in a joint process: mild.000.000 gallons of output have now become 4. 0. The 500. 250.200.000 gallons are used to produce the mild chili.000 gallons of unspiced chili are produced per batch.000 divided by 4.20 $1. The average cost per can is the total cost of $1.000 gal.000 gallons are used for the extra spicy chili.850.70 Extra spicy 150. and then varying amounts and types of spices are added to produce the mild. The joint cost is allocated as follows: Cost Per Product Physical Measure Proportion Allocation of Joint Cost Gallon Mild 100. $1. For personal use only by original purchaser.000. 0. However. but because physical units of completed product are used. or $0.000 16-ounce cans. Cost/Unit Allocation of Joint Cost Mild 800.000 cans $0.000 gal.4625 per can. we can now use units of output for the allocation. It is used when the joint costs are to be allocated on the basis of physical units of output in completed form.000 × 0. original.50 $1.4625 555.850.

the heaviest or largest product will be allocated the greatest amount of the joint cost. For personal use only by original purchaser. If weight or size is used. the Physical Measure method and the Average Cost method can be used to avoid the problem. In a regulated environment when rates are regulated and the seller is limited to a certain amount of markup over and above its costs. If the seller tries to allocate joint costs according to selling prices or net realizable values of the products. while products with a low sales value per weight or size would show large losses. using selling prices or net realizable values to allocate the costs on which the prices are based leads to circular reasoning. Step 1: Calculate the gross margin percentage for the total of both (or all. Products with a high sales value per weight or size would show large profits.  The allocation is objective. petroleum).. © 2017 HOCK international. But since the seller does not know what the selling price of each product is. It is done by “backing into” the amount of joint cost to be allocated to each of the joint products. For example. The physical measures of the individual products may have no relationship to their respective abilities to generate revenue.Section D Joint Products and Byproducts Physical Measure and Average Cost Methods of Allocating Costs to Joint Products Benefits  The physical measure and average cost methods are easy to use.e. Resale prohibited. Or some might be measured by weight whereas others might be measured by size. it cannot be done.. because the selling price is the cost plus a regulated amount of profit. The result of this subtraction process will be the amount of joint costs to allocate to each product. Step 3: Subtract the gross profit calculated in Step 2 and any separable costs from each individual product’s final sales value. 93 . Limitations  The Physical Measure and Average Cost methods can result in a product cost that is greater than their market value for some of the joint products. In this situation. whereas some might be in gaseous form (i. We will look at this with an example. Constant Gross Profit (Gross-Margin) Percentage Method This method allocates the joint costs so that all of the joint products will have the same gross margin percentage. 4. LLC. The seller does not know what the selling prices of the products will be until they know what their costs are. if more than two) of the joint products to be included in the allocation by subtracting the total joint and total separable costs from the total final sales value and dividing the remainder by the total final sales value. they cannot know how much joint cost to allocate to each product. but that product may have the lowest sales value. the Physical Measure method cannot be used. some products might be in liquid form (i. In that case. This is the total gross margin percentage.  The methods are useful when rates or prices are regulated. Step 2: Calculate the gross profit for each of the individual products by multiplying the total gross margin percentage calculated in Step 1 by each individual product’s final sales value. not for all of the joint products sold during the period.e. So using either the Relative Sales Value method or the Net Realiza- ble Value method in a regulated environment just does not work.  Physical measures are not always comparable for products. natural gas). This is done for all of the joint products produced during the period.

500 × 0.000.Joint Products and Byproducts CMA Part 1 Example of the Constant Gross Profit (Gross Margin) Percentage method: Pineapple Co.20 5 $127.500 $127.000 ÷ $165.000 20% We can now solve for J and C using these formulas to determine the amount of joint costs to allocate to each product: $37.000 Separable costs (given to us) 8.500 kg of juice and 7. For personal use only by original purchaser.500 × $15 2 7. Calculations: 1 2.000 Separable costs 12. The information about the process and the two joint products is as follows: • 10. • The juice can be processed further into a premium juice.000 12.000 $127.000 − C = $25. This will cost an additional $8.000 Joint costs 120.500 kg of slices.500 − $8.000 4.000 and the chunks can be sold for $2 per kg more than the slices. • The joint costs of production are $120.000 to chunks.500 2 $ 165. • The slices can be further processed into chunks.500 − $4.000 pineapples are processed.000 4 $37.500 1 $127.500 4 $ 25.000 to juice and $98.000 Required gross profit $ 7.000 20%3 We will now do the calculations to allocate enough of the joint costs so that each product has a 20% gross margin by working a bit more with the table started above: Premium Juice Chunks Total Gross Margin Final sales value $37.000 Total Gross profit $ 33.000 The $120.000.500 × ($15 + $2) 3 $33.500 C = $98. • The juice can be sold for $10 per kg and the slices can be sold for $15 per kg. LLC. but the sales price per kg will be $15.000 − J = $7. .000 Joint costs J C 120.20 94 © 2017 HOCK international.000 of joint costs is allocated $22. produces pineapple juice and canned slices at its Pineapple Processing Plant in Hawaii.500 J = $22. • The process results in 2. First we will calculate the overall gross margin for all products produced: Premium Juice Chunks Total Gross Margin Final sales value $37. This will cost $4. Resale prohibited.500 5 $ 33.500 $165.500 × 0.

 This method allocates both joint costs and profits. Inventoried costs allocated to the main product or joint products are reduced by the NRV allocated to the byproduct. since the transactions would have no effect on net income.Section D Joint Products and Byproducts Constant Gross Profit (Gross Margin) Percentage Method of Allocating Costs to Joint Products Benefits  This method is the only method for allocating joint costs under which products may receive negative allocations. accidental results of the production process. For personal use only by original purchaser. the COGS for the main product or joint products is lower because their inventory cost has been decreased by the NRV of the byproduct. Resale prohibited. 95 . nor is it included in the reduction of costs of the main product(s). The reason it is done this way is because the NRV of the byproduct was used to determine its cost in inventory. So the journal entry is simply the debit to cash or accounts receivable and the credit to byproduct inventory. The Production Method: Inventory the Byproduct Costs (Byproduct Recognized at Production) In the Production Method.  This method is relatively easy to implement. Therefore. They are. which is probably not the case. Gross margin is allocated to the joint products in order to determine the joint cost allocations so that the resulting gross margin percentage for each product is the same. the company recognizes no revenue or cost of goods sold but simply debits cash or accounts receivable and credits Byproduct Inventory. When the byproduct is sold. Limitations  This method assumes that all products have the same ratio of cost to sales value. in a sense. so it avoids the complexities of the NRV method. And when the main product or joint products are sold. the costs that are allocated to the byproducts are inventoried. Accounting for Byproducts As we said. If some of the byproduct cannot be sold. Byproducts are inventoried in a separate inventory account at their estimated net realizable value. There are two methods of accounting for byproducts that you need to be familiar with. The main issue for accounting for byproducts relates to the treatment of the associated costs and revenues. and the sales revenue received from the sale of the byproduct is treated as a reduction of the costs of production of the main product. There would be no reason to record the sale of the byproduct by increasing revenue and COGS by the same amount. and there will be no gross profit on the sale. © 2017 HOCK international. its cost will be the same as the revenue received for it. the amount that cannot be sold is not included in the amount debited to inventory for the byproduct. This may be necessary in order to bring the gross margin percentages of relatively unprofitable products up to the overall average. byproducts are the low-value products that occur naturally in the process of producing higher value products. Note: Only the sales proceeds from what can actually be sold are used to reduce the costs of production of the main product(s). if that is desired. LLC.

and it reduces the inventory cost assigned to the main product or joint products. For personal use only by original purchaser. all of the costs of production are allocated to the main product or joint products in inventory. Instead. though. the byproduct costs are not put into inventory separately from the main product or joint products. where the byproduct is inventoried at the time of production is conceptually correct because it is consistent with the matching principle. their COGS will be higher than it would have been under the Production Method. Since the byproduct is not put into inventory at all. Production Method of Accounting for Byproduct Costs Benefits  It is conceptually correct because byproduct inventory is recognized as an asset in the accounting period in which it is produced. . However. Which Method is Better? Both methods are acceptable. is simpler and is used more frequently in practice if the dollar amounts of the byproduct(s) are immaterial. When the main product or joint products are sold. Sales Method of Accounting for Byproduct Costs Benefits  It is simpler to implement than the Production Method. LLC. So the company debits cash or accounts receivable and credits revenue for the amount of the sale. Note: A question on the Exam will outline the treatment of the costs or revenue associated with the byproduct and you just need to follow the math that is required.  Inventory cost assigned to the main product or joint products is reduced. this means that it treats the revenue as a reduction of the costs of production.Joint Products and Byproducts CMA Part 1 The Sales Method: Revenue from the Byproduct (Byproduct Recognized at Time of Sale) In the Sales Method. Limitations  It is possible for managers to manage their earnings by timing the sale of the byproducts. The sales method makes it possible for managers to time when they sell the byproduct(s) and thus permits them to manage their earnings. where the byproduct is recognized at the time of sale. Byproduct inventory is recognized as an asset in the accounting period in which it is produced. this is the first method above. the Sales Method.  It is more practical when the dollar amounts of the byproducts are immaterial. with no associated COGS. The Production Method. Resale prohibited. If the question states that the company inventories the byproduct. when it is sold the sale is recorded the way service revenue would be recorded. Limitations  The Production Method is more complex than the Sales Method. There is a disadvantage to the sales method. 96 © 2017 HOCK international. A manager could store the byproducts for a period of time and sell them to increase revenues and profits during a time when sales and/or profits from the main product or joint products are low.

100 = 6. They are put into inventory at this allocated cost. 97 .75 × 5. The joint process squeezes the juice out of the oranges.500 bottles. No Pulp juice NRV $ 8.750 = 47. In each batch.675 ($2. the total Extra Pulp NRV is $9.100 allocated: No Pulp joint cost: 0.5% of total NRV ($8.25 per bottle separable costs = NRV of $1.000 Following the squeezing.15 × 4.Section D Joint Products and Byproducts Comprehensive Example of Joint and Byproduct Costing Note: The journal entries are not expected to be tested on the exam.10 per bottle separable costs = NRV of $2.425. the byproduct.30 per pound.500 bottles of Extra Pulp juice.675 = 52. For a batch of 4.75 per bottle.00 sales price per bottle − $0.000 pounds).25 per bottle.25 per bottle. the byproduct. The rinds are inventoried and a portion of the joint cost is allocated to them.000 ounces of juice that is bottled into 20-ounce bottles: 5. broken down as follows:  Direct materials: $4.  The total NRV is $8.000  Overhead: $3.100 © 2017 HOCK international. The company uses the Net Realizable Value method to allocate the joint costs. The standard costs of that process are $14. For a batch of 5. are also produced.750 + $9.000.525 × $13. the total No Pulp NRV is $8. Juice Unlimited Company manufactures orange juice. The Extra Pulp juice sells for $2.425) Total NRV $18. the joint process produces 190. LLC. Resale prohibited.877 Total joint cost allocated $13.30 × 3.223 Extra Pulp joint cost: 0.000 bottles of No Pulp juice and 4. which is $900 ($0.  Extra Pulp juice NRV: $2.00 per bottle. For personal use only by original purchaser.475 × $13.000 bottles.100 = $ 6. The orange rinds are sold at the splitoff point for $0.425) Extra Pulp juice NRV 9.675 = $18. Three thousand pounds of rinds.750 ($1. Scenario #1 – The Production Method: Under the Production Method. Orange rinds are produced as a byproduct of the juicing process and they are sold to a company that processes them into flavorings and scents.675 ÷ $18. We have included them here to help some people see how the journal entries work because that helps them understand what is happening.425 Joint costs of $13. and the cost to add the pulp to the Extra Pulp juice is $0.000 − $900 allocated to the rinds) in joint costs is allocated to the two joint products according to their NRVs. The No Pulp juice sells for $2. is recognized when production is complete.000  Direct labor: $7.000).750 ÷ $18. The amount allocated to the rinds is equal to their sales value. The removed pulp is added to the juice that will become the Extra Pulp juice.10 per bottle.5% of total NRV ($9. the juice that will become No Pulp juice goes to a process where it is strained to remove its pulp at a cost of $0.25 sales price per bottle − $0. Calculation of NRVs and each product’s proportion of the total NRV:  No Pulp juice NRV: $2. The remaining $13. It has two versions: one with no pulp and one with extra pulp.500).100 ($14.15 per bottle. orange rinds.

125 Dr Cost of Goods Sold 7.327 Rinds: $900 joint cost (no separable costs) 900 Total costs inventoried $15.10 × 4.700 Inventory costs per unit for main products: No Pulp: $7.877 Dr FG Inventory – Byproduct (rinds) 900 Cr WIP Inventory – direct materials used 4. the Extra Pulp Juice. LLC. no credit is booked to Sales Revenue and no debit is booked to Cost of Goods Sold.223 Dr FG Inventory – Extra Pulp Juice 6. If either of those occurs. as long as it is sold for the anticipated amount. The debit to Accounts Receivable would be for the actual amount of the sale. If the byproduct is actually sold for an amount that is different from the expected amount of $900.700 Total costs inventoried: No Pulp: $6.250 = $ 7.000 Separable costs: Dr FG Inventory – No Pulp Juice ($0. when the byproduct is sold. which is the inventoried amount. if cash is received for the sale) and crediting Inventory for the inventoried amount.000 Cr WIP Inventory – overhead applied 3.000 Cr Sales Revenue 10. then there could be either a gain or a loss on the sale.250 Dr FG Inventory – Extra Pulp Juice ($0. and the Byproduct from Work-in- Process Inventory to Finished Goods Inventories: Joint Cost: Dr FG Inventory – No Pulp Juice 6.327 Cr FG Inventory – Extra Pulp Juice 7. The sale is recorded by simply debiting Accounts Receivable (or Cash.25 × 5. the difference would be recorded as either a credit to Sales Revenue (if a gain) or a debit to Cost of Goods sold (if a loss).000 Dr Cost of Goods Sold 7. For personal use only by original purchaser.000) 1.500 = $1. .473 Extra Pulp: $6. the credit to Inventory would be for the inventoried amount.473 Sale of Extra Pulp Juice: Dr Accounts Receivable 10.473 ÷ 5.327 ÷ 4.000 Cr WIP Inventory – direct labor used 7.223 joint cost + separable costs of $1. Resale prohibited.500) 450 Cr WIP Inventory – separable costs for both 1. 98 © 2017 HOCK international.877 joint cost + separable costs of $450 = 7.327 Sale of Byproduct (Rinds)13: Dr Accounts Receivable 900 Cr FG inventory – Byproduct (Rinds) 900 13 Note that under the Production Method.473 Cr FG Inventory – No Pulp Juice 7.6282 per bottle Journal entries when the juice and rinds are sold (assuming a perpetual inventory system is being used): Sale of No Pulp Juice: Dr Accounts Receivable 10.4946 per bottle Extra Pulp: $7. and the credit to Sales Revenue or the debit to COGS would be the balancing entry.125 Cr Sales Revenue 10.000 = $1.Joint Products and Byproducts CMA Part 1 Journal entries to transfer the No Pulp Juice. which here is $900.

000 Journal entries to transfer the No Pulp Juice and the Extra Pulp Juice from Work-in-Process Inventory to Finished Goods Inventories: Joint Cost: Dr FG Inventory – No Pulp Juice 6.798 If the rinds are sold at their inventory cost. Resale prohibited.650 Dr FG Inventory – Extra Pulp Juice 7.000) 1.473 Gross Profit $ 2.00 × 5. The total joint costs of $14. Total gross profit from the sale of the batch = $2.125 Less: COGS 7. the Production Method.25 × 5.58 per bottle Extra Pulp: $7.500 = $10.000 Cr WIP Inventory – direct labor used 7.900 Extra Pulp: $7.350 Total joint cost allocated $14.350 joint cost + separable costs of ($0.000 = $10.000 = 7.527 When the Extra Pulp juice is sold. the byproduct is recognized at the time of sale. while Extra Pulp juice constitutes 52. its gross profit is: $2.000 allocated: No Pulp joint cost: 0.000 = $1.700 Total costs inventoried: No Pulp: $6.Section D Joint Products and Byproducts Gross profit for each product: When the No Pulp juice is sold.500 = $1.325. Joint costs of $14. Scenario #2 – The Sales Method Under the Sales Method.000 Separable costs: Dr FG Inventory – No Pulp Juice ($0.10 × 4.800 ÷ 4.500) = 7.25 × 5.000 Less: COGS 7.900 ÷ 5. using the same NRVs as we used for Scenario #1.327 Gross Profit $ 2.5% of the total NRV.25 × 4. The rinds are not inventoried.650 joint cost + separable costs of ($0.700 Inventory costs per unit: No Pulp: $7. no gross profit results from their sale.000 = $ 6.250 Dr FG Inventory – Extra Pulp Juice ($0.650 Extra Pulp joint cost: 0.000) = $ 7.798 = $5. No Pulp juice constitutes 47.000 are allocated between the No Pulp and the Extra Pulp juices only. LLC.500) 450 Cr WIP Inventory – separable costs for both 1.350 Cr WIP Inventory – direct materials used 4.527 + $2.000 Cr WIP Inventory – overhead applied 3.525 × $14. its gross profit is: $2.475 × $14.10 × 4. For personal use only by original purchaser. 99 .800 Total costs $15.7333 per bottle © 2017 HOCK international.5% of total NRV.

LLC. Its sale is being accounted for as if it were service revenue. That is because the byproduct was never in Inventory. the amount received from their sale—$0.800 Sale of Byproduct (Rinds)14: Dr Accounts Receivable 900 Cr Sales Revenue 900 Gross profit for each product: When the No Pulp juice is sold.125 Cr Sales Revenue 10. 100 © 2017 HOCK international.125 Dr Cost of Goods Sold 7. Summary:  The same total costs ($15.000 pounds.700) are inventoried under both methods.000 Cr Sales Revenue 10. Total gross profit from the sale of the batch = $2. or $900—is all profit.000 Less: COGS 7. For personal use only by original purchaser.900 Cr FG Inventory – No Pulp Juice 7.000 Dr Cost of Goods Sold 7. Therefore. its gross profit is: $2. the total cost is allocated only to the main products.000 = $10.325) is realized for the sale of the two joint products and the one byproduct for both the Production method and the Sales method.500 = $10.100 + $2. But the cost is allocated differently.Joint Products and Byproducts CMA Part 1 Journal entries when the juice and rinds are sold (assuming a perpetual inventory system is being used): Sale of No Pulp Juice: Dr Accounts Receivable 10.30 per pound × 3.25 × 4.  When the whole batch has been sold. when the byproduct is sold. the same total gross profit ($5.900 Gross Profit $ 2.325.800 Cr FG Inventory – Extra Pulp Juice 7. whereas under the Sales method. . its gross profit is: $2. 14 Note that under the Sales Method. but the total cost is allocated to the two main products and the byproduct under the Production method.00 × 5. no debit is booked to Cost of Goods Sold and no credit is booked to Inventory.125 Less: COGS 7.900 Sale of Extra Pulp Juice: Dr Accounts Receivable 10.100 When the Extra Pulp juice is sold. their cost of goods sold is zero because none of the costs have been allocated to the rinds. Resale prohibited.325 When the rinds are sold.325 + $900 = $5.800 Gross Profit $ 2.

product X is processed further at a cost of $5. thus. A standard production run incurs joint costs of $300. Products X and Y can be sold at splitoff for $12. The joint processing costs are $10.500.000 and sold for $21.000 $660.000 c) $1. If there are no further processing costs incurred after the splitoff point. 1st Main Product 2nd Main Product Byproduct Monthly input in pounds 90. If the company uses the relative sales value method for allocating joint costs.000. After splitoff.575.000.000 60. the joint cost allocated to X is: a) $5. During the month.000 d) $120. The main products are not marketable at the splitoff point and. Lankin has employed the physical-volume method to allocate joint production costs to the two main products. The net realizable value of the byproduct is used to reduce the joint production costs before the joint costs are allocated to the two main products.000 (CIA Adapted) © 2017 HOCK international.000 d) $1.000 b) $1.000 (CMA Adapted) Question 34: A company manufactures products X and Y using a joint process.000 and results in 60.000.000 The amount of joint production cost that Lankin would allocate to the Second Main Product by using the physical-volume method to allocate joint production costs would be: a) $1.000 150.520. respectively.000 and $8.000 units of MSB and 90. Each MSB sells for $2 per unit.000. whereas product Y is sold without further processing. The two products developed are mine support braces (MSB) and unseasoned commercial building lumber (CBL). (CMA Adapted) Question 33: Sonimad Sawmill manufactures two lumber products from a joint milling process. 101 . produces two main products and a byproduct out of a joint process. Lankin incurred joint production costs of $2.000.260.000 units of CBL. have to be processed further.000 c) $225. LLC. For personal use only by original purchaser. Data regarding Lankin’s operations for the current month are presented in the chart below.000 b) $6. and each CBL sells for $4 per unit. Resale prohibited.000 c) $6.000 b) $180. the amount of joint cost allocated to the mine support braces (MSB) on a relative sales value basis would be: a) $75.200.667 d) $10.000 Selling price per pound $30 $14 $2 Separable process costs $540.Section D Joint Products and Byproducts Question 32: Lankin Corp. The ratio of output quantities to input quantities of direct materials used in the joint process remains consistent from month-to-month.

Resale prohibited. For external reporting purposes. even though they are not variable costs. Under both variable and absorption costing. the profit of a company is influenced by the difference between the level of production and the level of sales. and then we will look at the income statement presentation under each method. As a result. For personal use only by original purchaser.S. We will look at this in more detail on the following page. taxing authorities for tax reporting. GAAP requires the use of absorption costing for fixed manufacturing cost allocation. 15 The budgeted activity level is the number of budgeted direct labor hours. 102 © 2017 HOCK international. all variable manufacturing costs (both direct and indirect) are inventoriable costs. GAAP for external financial reporting and by the U. This will be discussed in greater detail as we proceed through this explanation. and therefore variable costing is often used internally. all of the fixed factory overheads will be expensed in the period when incurred. Fixed factory overheads are allocated to the units produced as if they were variable costs. process costing and in some cases activity-based costing can all be used with absorption costing for external purposes. some of the fixed manufacturing overhead costs from this period are included on the balance sheet as inventory at the year-end.S. material cost. these costs that are in inventory are not included on the income statement as an expense. LLC. Absorption costing is required by U. Variable costing is not GAAP. We will first look at the difference in the treatment of fixed factory overheads under each of these two methods. and therefore variable costing cannot be used for external financial reporting.” under absorption costing fixed factory overhead costs are allocated to the units produced during the period according to a predetermined rate.) Under the absorption costing method. Fixed Factory Overheads Under Variable Costing Under variable costing (also called direct costing). fixed factory overheads are a period cost that are expensed in the period when they are incurred. or machine hours—whatever is being used as the allocation basis. The only two differences between the two methods are in: 1) Their treatment of fixed manufacturing overhead 2) The income statement presentation of the different costs Note: All other costs except for fixed factory overheads are treated in the same manner under both of these methods. This means that no matter what the level of sales. When the level of production is higher than the level of sales. direct labor cost. but they may be reported in a slightly different manner on the income statement. (Job-order costing. many accountants feel that variable costing is a better tool to use for internal analysis.Variable and Absorption Costing CMA Part 1 Variable and Absorption Costing Variable and absorption costing are two different methods of inventory costing. Fixed Factory Overheads Under Absorption Costing As was explained in “Overhead Allocation. . However. The predetermined fixed overhead allocation rate is Budgeted Dollar Amount of Manufacturing Overhead Budgeted Activity Level15 Fixed manufacturing overhead is therefore a product cost under absorption costing.

Sales Greater than Production (Inventory Decreases) If production is lower than sales. and all of the fixed factory overheads were “sold” and included in cost of goods sold under the absorption method. it is most certain that these two methods (variable and absorption) will result in different amounts of net income or net loss for the same period of time. Only when production and sales are equal in a period (meaning that there is no change in inventory levels and everything that was produced was sold) will there not be a difference between the incomes reported under these two methods. This means that under the absorption method. into the product cost. When a unit that was produced but not sold during the period goes to the balance sheet as inventory. This temporarily puts that amount of fixed factory overhead on the balance sheet. Because sales were greater than production.Section D Variable and Absorption Costing Note: It is important to remember that the only difference in the profit between these two methods relates to the treatment of fixed factory overheads. they are excluded from the product cost and treated as a period cost. because they are not variable costs. the two methods will give different levels of net income. (CMA Adapted) Effects of Changing Inventory Levels Because fixed factory overheads are treated differently in these two methods. Ending inventory under absorption costing will be higher because each unit of inventory will include some fixed factory overhead costs and under variable costing this is not included in the inventory. c) An idle facility variation is calculated. the variable method will result in a greater net income because the only fixed factory overheads included as an expense in this period were those that were incurred during the year. Note: In addition to producing different amounts of profit. the net income calculated under the absorption method is greater because some of the fixed factory overheads were inventoried under this method. Under absorption costing fixed factory overheads are allocated to each unit. Question 35: Which of the following statements is true for a firm that uses variable costing? a) The cost of a unit of product changes because of changes in the number of manufactured units. Production Greater than Sales (Inventory Increases) If production is greater than sales. © 2017 HOCK international. some of the products that were produced in previous years were sold in the current period. 103 . Under variable costing. b) Profits fluctuate with sales. LLC. it takes some of the fixed factory overheads with it. some of the fixed factory overhead costs that had been inventoried in previous years will now be expensed in the current period. Under absorption costing. Resale prohibited. For personal use only by original purchaser. This is because all of the fixed factory overheads were expensed as a period cost under the variable method. or absorbed. Whenever inventory changes over a period of time. these two methods will always produce different values for ending inventory because they include different costs in each unit of inventory. Under variable costing all of the fixed factory overheads for the period are on the income statement. When the unit is sold the next period that amount of fixed factory overhead will go to the income statement as cost of goods sold. fixed factory overhead costs are included. d) Product costs include "direct" (variable) administrative costs.

the difference between them will appear in the allocation of income to the different periods within that longer time period. LLC. because in the long term the company will not produce more than it can sell and therefore sales will equal production. From this manufacturing contribution margin. because there are more costs in each unit under absorption costing. there is also a difference in the presentation of the Income Statement with these two methods. The income statement under absorption costing is as follows: Sales revenue − Cost of goods sold – variable and fixed manufacturing costs of items sold = Gross profit − Variable nonmanufacturing costs (expensed) − Fixed nonmanufacturing costs (expensed) = Operating Income The Income Statement under Variable (Direct) Costing Under variable costing we calculate a manufacturing contribution margin by subtracting all variable manufacturing costs for goods that were sold from revenue. The following table summarizes the effect of changing inventory levels (production compared to sales) under the two methods: Production & Sales Profit Production = Sales Absorption = Variable Production > Sales Absorption > Variable Production < Sales Absorption < Variable Note: Ending inventory under absorption costing will always be higher than ending inventory under variable costing.Variable and Absorption Costing CMA Part 1 Note: You should recognize that over a long period of time. The Income Statement under Absorption Costing Under absorption costing we calculate a gross profit by subtracting all variable and fixed manufacturing costs for goods sold (this being COGS) from revenue. . For personal use only by original purchaser. the total income that will be presented under both methods will be essentially the same. In the long term these two methods do not differ in total income. Rather. we subtract nonmanufacturing variable costs to arrive at the contribution margin. Resale prohibited. 104 © 2017 HOCK international. There will always be some fixed costs in ending inventory under absorption costing that will not be in ending inventory under variable costing. All fixed costs (manufacturing and non-manufacturing) are then subtracted from the contribution margin to calculate net income. All variable and fixed nonproduction costs are then subtracted from the gross profit to calculate net income. and the number of units in ending inventory are the same under both methods. Income Statement Presentation As mentioned earlier.

Absorption Costing versus Variable Costing: Benefits and Limitations While absorption costing is required for external reporting (the GAAP financial statements).  When the number of units sold is greater than the number of units produced. This is demonstrated in the example (and the answer to the example) that follows this explanation. and the two are different. it is generally thought that variable costing is better for internal uses. But. Limitations  When a greater number of products are produced than are sold during a period. 105 . Inventory decreases. Net income under absorption costing will be lower than it would be under variable costing. Absorption Costing Benefits  Absorption costing provides matching of costs and benefits. The fixed costs are released into Cost of Goods Sold expense only when the inventory is sold in a subsequent period. This creates an opportunity for plant managers to manipulate reported net income by overproducing in order to keep some of the fixed costs on the balance sheet in Inventory. For personal use only by original purchaser. It also creates a buildup of inventories that is not consistent with a profitable operation. Thus the effect of this manipulation is to move net operating income from a future period to the current period. Since fixed overhead is charged to the units produced in absorption costing.Section D Variable and Absorption Costing The income statement under variable costing is as follows: Sales revenue − Variable manufacturing costs of items sold = Manufacturing contribution margin − Variable nonmanufacturing costs (expensed) = Contribution Margin − All fixed manufacturing costs (expensed) − All fixed nonmanufacturing costs (expensed) = Operating Income Note: This cosmetic difference between the two methods does not change the effect of the treatment of fixed manufacturing overheads under the different methods. LLC. Resale prohibited. because some prior period fixed manufacturing costs will be expensed under absorption costing along with the current period’s fixed manufac- turing costs. © 2017 HOCK international. it causes Inventory to increase. you need to know that the absorption method determines a gross profit and the variable method calculates a contribution margin. an increase in Inventory means that some of the current period fixed costs remain in the ending inventories.  Absorption costing is consistent not only with Generally Accepted Accounting Principles but also with Internal Revenue Service requirements for the report- ing of income on income tax returns.

106 © 2017 HOCK international.  Advocates argue that variable costing is more consistent with economic reality.  The impact of fixed costs on profit is obvious and visible under variable costing because they are on the income statement and shown as costs. thus moving more of the fixed factory overheads to the balance sheet as inventory. With variable costing. Operating management can control variable costs. Resale prohibited.  To prepare a complete income statement based on variable costing.  Operating income is directly related to sales levels and is not influenced by changes in inventory levels due to production or sales variances.Variable and Absorption Costing CMA Part 1 Variable Costing Benefits  The impact on profits of changes in sales volume is more obvious with variable costing. . Under absorption costing. but fixed costs are usually controlled at a higher level. Limitations  Variable costing does not provide proper matching of costs and benefits.  It is easier to assign responsibility for cost control. which is more complex (see “Fixed Overhead Variances” in the Performance Management section for more information). companies are able to make better and more informed decisions about profitability and product mix. LLC.  By not including fixed costs in the calculation of cost to produce.  It is easier to determine the “contribution” to fixed costs made by a division or product – and thereby helps determine if the product or division should be discontin- ued. the fixed overhead variance is simply actual fixed overhead incurred minus budgeted fixed overhead.  Variance analysis of fixed overhead costs is less confusing than it is with absorption costing. variances include comparisons with fixed overhead applied to production. This prevents managers from being able to “hide costs” on the balance sheet by increasing production. Under absorption costing. a manager can increase profits simply by producing more units. because fixed costs do not vary with production in the short run.  Variable costing tends to be less confusing than absorption costing because it presents costs in the same way they are incurred: variable costs on a per-unit basis and fixed costs in total. it is also necessary to separate the selling and administrative costs into their fixed and variable components. For personal use only by original purchaser. this method requires separating all manufacturing costs into their fixed and variable components.  Since only variable manufacturing costs are charged to the inventory in variable costing.

costs 5. Cont. costs ($0.200 2. Resale prohibited. 4. LLC. there were no variances.10 per unit) $16. costs 2. Margin $ ________ ________ Gross Margin $ Contribution Margin $ ________ ________ Operating Income $ Operating Income $ © 2017 HOCK international.380 $25.Section D Variable and Absorption Costing Variable/Absorption Costing Example Hardy Corp.200 Other information Sales ($2. costs 2. assume that the amounts given are both the budgeted amounts and the actual amounts and thus. in units 4. Inventory Year 1 Year 2 Beginning balance. uses the FIFO method to track inventory. Margin $ ________ ________ Gross Margin $ Contribution Margin $ ________ ________ Operating Income $ Operating Income $ Year 2 Absorption Costing: Year 2 Variable Costing: Sales revenue $ Sales revenue $ ________ Manuf.750 Required: Prepare the income statements for Year 1 and Year 2 using both the absorption and the variable methods of costing. (The solution follows.90/unit) 10.250 3.000 10.400 Variable selling and admin.200 Variable mfg. Cont.000 Available for sale 12.000 14.750 Fixed selling and admin. in units -0.000 Fixed mfg.800) (12. 107 . For personal use only by original purchaser. For simplicity.250 3.000 5. The records for Hardy include the following information.800 9.200 Production 12.200 Less units sold ( 7.000) Ending balance.) Year 1 Absorption Costing: Year 1 Variable Costing: Sales revenue $ Sales revenue $ +_________ Manuf.

Variable and Absorption Costing CMA Part 1

Answer to the Variable/Absorption Costing Example
Year 1 Income Statements

Absorption Costing Variable (Direct) Costing

Sales (7,800 × $2.10) $ 16,380 Sales (7,800 × $2.10) $ 16,380

Variable Mfg. COGS (7,800 × $0.90) 7,020 Variable Mfg. COGS (7,800 × $0.90) (7,020)

Fixed Mfg. COGS ($5,000÷12,000×7,800) 3,250 Manufacturing Contribution Margin $ 9,360

COGS (10,270) Less: Variable S&A (2,250)

Contribution margin $ 7,110

Gross margin $ 6,110

S&A exp. ($2,250 var. + $2,250 fixed) (4,500) Less: Fixed mfg. costs (5,000)

Fixed S&A (2,250)

Operating income $ 1,610 Operating income $ (140)

Year 2 Income Statements

Absorption Costing Variable (Direct) Costing

Sales (12,000 × $2.10) $ 25,200 Sales (12,000 × $2.10) $ 25,200

Variable Mfg. Cost (12,000 × $0.90) 10,800 Variable Mfg.COGS (12,000×$0.90) (10,800)
16
Fixed Mfg. COGS-Year 1 production 1,750 Manufacturing Contribution margin 14,400
17
Fixed Mfg. COGS-Year 2 production 4,212 Variable S&A (3,750)

COGS (16,762) Contribution margin 10,650

Gross margin 8,438 Less: Fixed mfg. costs (5,400)

S&A expenses (7,500) Fixed S&A (3,750)

Operating income $ 938 Operating income $ 1,500

16
Beginning inventory for Year 2 was 4,200 units, and those units were produced during Year 1 at Year 1 costs. Each unit
had $0.4167 of fixed manufacturing cost attached to it ($5,000 fixed manufacturing costs in Year 1 ÷ 12,000 units
produced in Year 1). Since the company uses FIFO, those units were the first units sold in Year 2. 4,200 units × $0.4167 of
fixed manufacturing cost per unit = $1,750 of fixed manufacturing cost from Year 1 production that was sold in Year 2.
17
A total of 12,000 units were sold in Year 2. As noted above, 4,200 of those units came from Year 1’s production. That
means the remainder, or 12,000 – 4,200 = 7,800 units, came from Year 2’s production. Fixed manufacturing cost per unit
during Year 2 was $5,400 fixed manufacturing costs ÷ 10,000 units produced, or $0.54 per unit. So the fixed manufactur-
ing cost included in the units that were sold from Year 2’s production is $0.54 × 7,800 = $4,212.

108 © 2017 HOCK international, LLC. For personal use only by original purchaser. Resale prohibited.

Section D Variable and Absorption Costing

Note: In a situation in which there is no beginning inventory, or the LIFO inventory assumption is used
and ending inventory is higher than beginning inventory (i.e., none of the beginning inventory is sold), it is
very easy to calculate the difference between the variable and absorption methods using the method
following. This method can also be used under other inventory cost flow assumptions if (1) the beginning
inventories are valued at the same per-unit fixed manufacturing cost as the current year’s planned per-unit
fixed manufacturing cost and (2) if under- or over-applied fixed manufacturing overhead is closed out to
cost of goods sold only.

Given that the only difference between the absorption and variable methods is the treatment of fixed
factory overheads, when the question asks for the difference in income between the two methods, if one
of the three situations above applies, you simply need to make the following calculation:

Fixed overhead cost per unit applied to production18
× Number of units of change in inventory
= Difference in income between the two methods

Remember that this works only if any one of the following applies:

(1) There is no beginning inventory (which is often the case in an Exam question). If there is
some beginning inventory, that beginning inventory would have been produced during the previous period,
and the fixed manufacturing cost per unit during the previous period is almost certainly different from the
fixed manufacturing cost this period. Therefore, a part of the amount of cost expensed for sold units under
absorption costing may be the costs from the previous period that were in inventory at the beginning of
the period. This is most likely to occur if FIFO is being used, because under FIFO, the first units sold are
the earliest units produced. The earliest units produced will be the units that are in inventory at the
beginning of the period. But if we limit the use of this formula to situations where there is no beginning
inventory, we avoid that problem and can be confident that all of the cost of goods sold expensed this
period was cost of production that was produced during this period, at this period’s cost per unit.

(2) The LIFO inventory assumption is used if ending inventory is higher than beginning
inventory. Under LIFO, we assume that the last units produced are the first units sold. Therefore, if the
ending inventory is higher than the beginning inventory, we must have sold only units from this year’s
production. So we know that the cost of the units sold will include only fixed manufacturing costs that are
this year’s costs, and we do not have the problem of having sold units that were manufactured during a
previous period and that would have a per unit cost that is different from this year’s costs.

(3) Under other inventory cost flow assumptions if the beginning inventories are valued at the
same per-unit fixed manufacturing cost as the current year’s planned per-unit fixed manufac-
turing cost and if under- or over-applied fixed manufacturing overhead is closed out to cost of
goods sold only. If the cost per unit of the beginning inventory (including fixed manufacturing costs) is
exactly the same as the current year’s planned cost per unit, we do not have the problem of having sold
units with a cost per unit that is different from this year’s costs. We may have sold some units that were
manufactured in a previous year and some units that were manufactured this year. If the costs during the
two years were different, we would have a problem. But since they are not different, we can use the fixed
cost per unit in the formula, since it is the same for both years, to calculate the difference in income
between the two methods.

What if the Number of Units is Not Known or is Not Meaningful?
If a company sells more than one product or sells similar products but charges different prices, the number of
units cannot be used to find the difference between operating income under absorption and under variable
costing. In that case, the way to find the difference is to calculate the variable cost of goods sold and variable
other expenses using the absorption costing income statement.

18
If the inventory level has fallen, you will need to use the previous year’s fixed overhead per unit figure as the “extra
inventory” sold that was produced during the previous year. If inventory has risen, you need to use the current period’s
fixed overhead per unit.

© 2017 HOCK international, LLC. For personal use only by original purchaser. Resale prohibited. 109

Variable and Absorption Costing CMA Part 1

Example: Adjustable Desks Unlimited manufactures motorized sit-stand desks that quickly adjust in
height so the user can either sit or stand to work. The desks are manufactured to each customer’s
specifications as to size, finish, and minimum and maximum height; and the prices per desk vary
accordingly. Adjustable Desks uses job order costing as its cost accumulation method and normal costing
as its cost measurement system. Adjustable Desks has been using absorption costing for both external and
internal reporting but wants to start using variable costing for internal reporting. Factory overhead is
applied to custom jobs on the basis of direct labor hours. Over-applied or under-applied overhead is closed
out to cost of goods sold.
Adjustable Desks used the same predetermined overhead rates in applying overhead to job orders in both
Year 1 and Year 2. The rates were based on the following budgeted amounts:
Fixed factory overhead $ 90,000
Variable factory overhead 315,000
Direct labor cost 405,000
Direct labor hours 45,000
Actual direct labor hours incurred were 43,000 in Year 1 and 48,000 in Year 2. Actual fixed factory
overhead incurred was $95,000 in Year 1 and $115,000 in Year 2. Actual variable factory overhead
incurred was $301,000 in Year 1 and $336,000 in Year 2. The planned direct labor cost per hour was
achieved in both years. Raw materials purchased were $1,000,000 in Year 1 and $1,100,000 in Year 2.
Inventory balances at year-end were as follows:
Year 1 Year 2
Raw materials inventory $ 43,000 $ 42,000
Work in process inventory:
Costs $120,000 $135,000
Direct labor hours of OH in inventory 2,000 3,000
Finished goods inventory:
Costs $ 50,000 $ 45,000
Direct labor hours of OH in inventory 1,500 1,350
Administrative expenses in both years were 100% fixed. Selling expenses were partly fixed and partly
variable. The variable portion of the selling expense consisted of a 10% sales commission based on sales
revenue.
Adjustable Desk’s income statements under the absorption method for Years 1 and 2 are below. Prepare a
revised income statement for Year 2 using the variable costing method.
Year 1 Year 2
Sales $3,500,000 $4,000,000
Cost of Goods Sold:
Beginning Finished Goods Inventory $ 48,000 $ 50,000
Cost of Goods Manufactured 1,700,000 1,950,000
Goods Available for Sale $1,748,000 $2,000,000
Ending Finished Goods Inventory 50,000 45,000
Cost of Goods Sold before adjustment for
under- or over-applied overhead 1,698,000 1,955,000
Under-applied Fixed Overhead 9,000 19,000
Cost of Goods Sold (adjusted) 1,707,000 1,974,000
Gross Profit $1,793,000 $2,026,000
Selling expense 500,000 550,000
Administrative expense 250,000 275,000
Total operating expense $ 750,000 $ 825,000
Operating income $1,043,000 $1,201,000

(Solution begins on next page)

110 © 2017 HOCK international, LLC. For personal use only by original purchaser. Resale prohibited.

Section D Variable and Absorption Costing

Solution:

Step 1: Adjust work-in-process and finished goods absorption cost beginning and ending
inventory balances to variable cost inventory balances by removing the fixed overhead
capitalized in the balances.

The fixed overhead application rate is $90,000 budgeted overhead ÷ 45,000 budgeted direct labor hours =
$2 per direct labor hour. The overhead was applied on the basis of actual direct labor hours worked, since
normal costing was used. We remove the amount of fixed overhead included in the beginning and ending
inventories by multiplying $2 by the number of direct labor hours’ overhead cost in inventory, as follows:

Work-in process, Year 2:
Beginning inventory: $120,000 – ($2 × 2,000 DLH) = $116,000 under variable costing
Ending inventory: $135,000 – ($2 × 3,000 DLH) = $129,000 under variable costing

Finished goods, Year 2:
Beginning inventory: $50,000 – ($2 × 1,500 DLH) = $47,000 under variable costing
Ending inventory: $45,000 – ($2 × 1,350 DLH) = $42,300 under variable costing

Step 2: Calculate cost of goods manufactured on the variable costing basis (without fixed
overhead costs).

Since normal costing is being used, the direct materials and direct labor were applied on the basis of actual
costs. Overhead was applied by multiplying the predetermined overhead rate by the actual number of
direct labor hours worked.

Raw materials used:

$43,000 beginning raw materials inventory + $1,100,000 purchases − $42,000 ending raw materials
inventory = $1,101,000 raw materials used.

Direct labor used:
The predetermined direct labor rate was $405,000 budgeted direct labor cost ÷ 45,000 budgeted direct
labor hours = $9 per DLH. The planned direct labor cost per hour was achieved, so the actual direct labor
cost per hour was also $9. 48,000 direct labor hours were used during Year 2.
48,000 actual direct labor hours used × $9 actual direct labor cost/hour = $432,000 direct labor used.

Variable overhead applied:
The predetermined variable factory overhead application rate was $315,000 budgeted variable factory
overhead ÷ 45,000 budgeted direct labor hours, or $7 per direct labor hour.
Variable overhead applied was $7 × 48,000 actual direct labor hours worked = $336,000. (Note that
actual variable overhead incurred was also $336,000 and therefore there was no under- or over-
application of variable overhead.)

Cost of goods manufactured on the variable costing basis:
Direct materials used $ 1,101,000
Direct labor used 432,000
Variable overhead applied 336,000
= Total manufacturing costs $ 1,869,000
+ Beginning WIP inventory (variable) 116,000 (calculated in Step 1)
− Ending WIP inventory (variable) ( 129,000) (calculated in Step 1)
= Cost of goods manufactured (variable) $ 1,856,000

(Continued)

© 2017 HOCK international, LLC. For personal use only by original purchaser. Resale prohibited. 111

Variable and Absorption Costing CMA Part 1

Step 3: Calculate cost of goods sold on the variable costing basis, using the beginning and
ending finished goods inventories under the variable costing method calculated in Step 1 and
cost of goods manufactured under the variable costing method calculated in Step 2:

Beginning FG inventory (variable) $ 47,000
+ Cost of goods manufactured (variable) 1,856,000
− Ending FG inventory (variable) ( 42,300)
= Cost of goods sold (variable) $1,860,700

Step 4: Prepare the income statement on the basis of the variable costing method.

Income Statement for Year 2, Variable Costing:

Sales $ 4,000,000
Cost of goods sold (variable) from Step 3 1,860,700
Manufacturing contribution margin $ 2,139,300
Variable selling expenses ($4,000,000 × 0.10 commission) 400,000
Contribution margin $ 1,739,300

Operating expenses:
Actual fixed manufacturing overhead incurred $ 115,000
Fixed selling expenses ($550,000 − $400,000 variable) 150,000
Fixed administrative expenses 275,000
Total fixed expenses $ 540,000
Operating income $ 1,199,300

The difference between operating income under absorption costing and operating income under variable
costing is $1,201,000 − $1,199,300, or $1,700. Operating income under absorption costing was $1,700
higher than operating income under variable costing.

This difference arises because of the way fixed manufacturing overhead is treated. Under absorption
costing, fixed manufacturing overhead is capitalized in inventory and expensed only when the units it is
attached to are sold. Under variable costing, fixed manufacturing overhead is expensed as it is incurred.

Because the fixed overhead application rate was the same for both years, the difference between the two
operating incomes can be reconciled to check the accuracy of our work. We multiply the amount of change
in the number of direct labor hours included in work-in-process and finished goods inventories from the
beginning of the year to the end of the year by the $2 application rate used for fixed manufacturing
overhead under absorption costing to calculate the amount of fixed costs in inventory under absorption
costing and sum the results, as follows:
End of End of Amount of × $2 =
Year 1 Year 2 Change FC in Inv.
Work in process inventory:
Direct labor hours of fixed costs in inv. 2,000 3,000 +1,000 +$2,000
Finished goods inventory:
Direct labor hours of fixed costs in inv. 1,500 1,350 − 150 − 300

Difference between absorption and variable operating income +$1,700

The calculated difference matches the difference between the two operating incomes on the income
statements.

The $1,700 difference is the amount of change during the year in fixed manufacturing overhead that
remained on the balance sheet in inventory under absorption costing but was expensed under variable
costing. Because of these fixed costs on the balance sheet instead of on the income statement, operating
income under variable costing was $1,700 lower than operating income under absorption costing.

112 © 2017 HOCK international, LLC. For personal use only by original purchaser. Resale prohibited.

967 c) $2.800. c) Profits may decrease with increased sales even if there is no change in selling prices and costs.800 d) $2. LLC. For personal use only by original purchaser.Section D Variable and Absorption Costing The following information is for the next two questions: Product sales: 1. 113 .000 units at $10 each Variable manufacturing costs: $5. b) Profits will always decrease with decreases in sales. d) Decreased output and constant sales result in increased profits.800 b) $1. (CMA Adapted) © 2017 HOCK international. Resale prohibited. operating income under absorption costing is: a) $1.50 per unit sold Fixed selling and administrative costs: $1.300 Question 37: Assuming operating income under variable costing is $1.167 (CIA Adapted) Question 38: When a firm prepares financial reports using absorption costing: a) Profits will always increase with increases in sales.000 Units produced (planned and actual): 1.200 Variable selling and administrative costs: $0.200 Beginning inventory 0 units Question 36: Operating income under variable (direct) costing is: a) $600 b) $700 c) $1.50 per unit Fixed manufacturing overhead (planned and actual): $1.000 d) $2.

(CMA Adapted) The following information is for the next two questions: Osawa planned to produce and actually manufactured 200. c) Increase production schedules independent of customer demands.000 (CMA Adapted) 114 © 2017 HOCK international.000 How would the net income of Nance compare between the variable method and full absorption costing methods? a) Variable would be $25. Costs for the year were as follows: Fixed Manufacturing Costs $250. LLC. pays bonuses to its managers based on operating income.000 higher.500 higher.000 units and sold 45.000 units of product at a selling price of $40 per unit. Osawa sold 120. (HOCK) Question 40: Jansen.000 higher.000 c) $600.000 units of its single product in its first year of operations. Jansen's managers may do all of the following except: a) Produce those products requiring the most direct labor. The company produced 50. Resale prohibited.000 Fixed General and Selling Costs 75.000 c) $800.000 Variable General and Selling Costs 80.000 Variable Manufacturing Costs 180.000 units in its first year of operations. For personal use only by original purchaser.000. Planned and actual fixed manufacturing costs were $600. c) Variable would be $32.000 d) $600.000 Question 42: Osawa’s operating income using variable costing is: a) $200. d) Decrease production of those items requiring the most direct labor. To increase bonuses.000 d) $840. d) Absorption would be $32.000. Inc. b) Absorption would be $25. Variable manufacturing costs were $30 per unit of product. and overhead is applied on the basis of direct labor hours. b) Defer expenses such as maintenance to a future period.500 higher.Variable and Absorption Costing CMA Part 1 Question 39: Nance Corp began operations in January.000 b) $440.000 b) $440. Question 41: Osawa’s operating income using absorption costing is: a) $200. . The company uses absorption costing. and the selling and administrative costs totaled $400.

400.350.00 per unit was employed for absorption costing purposes. 115 .000 Total $50. Planned Costs Planned Incurred Per Unit Total Costs Costs Direct materials $12.000 Direct labor 9.000.000 125.or under-applied manufacturing overhead is closed to the cost of goods sold account at the end of the reporting year.Section D Variable and Absorption Costing The following information is for the next six questions: Valyn Corporation employs an absorption costing system for internal reporting purposes.00 700.00 $1.00 per unit.000 520. LLC.220.00 1. Valyn uses a predetermined manufacturing overhead rate for applying manufacturing overhead to its product.000 250.000 © 2017 HOCK international.000 1.000 Variable administrative expenses 2.000 Fixed manufacturing overhead 5.00 280.000 1.000 Fixed administrative expenses 3.000 b) $1.620.000 c) $1.560.000 c) $1. Resale prohibited.00 $7.00 420. the company is considering using variable costing.000 35.000 Question 44: The value of Valyn Corporation's actual ending finished goods inventory on the variable costing basis was: a) $1.170.00 560.000 b) $1. therefore.000 715.000. which was the same as the current year's planned unit manufacturing cost.00 980.000.000 $1.125.000 Sales in units 140.000 130.000 Production in units 140.000 d) $750. a combined manufacturing overhead rate of $9. Question 43: The value of Valyn Corporation's current year actual ending finished goods inventory under the absorption-costing basis was: a) $900.000 Variable manufacturing overhead 4. For personal use only by original purchaser.000 The beginning finished goods inventory for absorption costing purposes was valued at the previous year's planned unit manufacturing cost.000 $6.000 The planned per unit cost figures shown in the next schedule were based on the estimated production and sale of 140.00 1.260.000 d) $1.000 Fixed selling expenses 7.000 Variable selling expenses 8.680. Any over. There are no work-in-process inventories at either the beginning or the end of the year. The planned and actual selling price per unit for the current year was $70.000 980.000 425. however.200.000 units for the year. Data regarding Valyn's planned and actual operations for the calendar year is: Planned Actual Activity Activity Beginning finished goods inventory in units 35.120.

000 Question 46: Valyn Corporation's actual manufacturing contribution margin calculated under the variable costing basis was: a) $4.000 d) $4. LLC. Resale prohibited. For personal use only by original purchaser.000 b) $2. .030.120.625.Variable and Absorption Costing CMA Part 1 Question 45: Valyn Corporation's total fixed costs expensed under the absorption costing basis were: a) $2.055.000 b) $4.000 c) $4.000 c) $4.000 c) $40.000 c) $2.000 b) $25.000 Question 48: The difference between Valyn Corporation's operating income calculated on the absorption costing basis and calculated on the variable costing basis was: a) $65.375.325.000 Question 47: The total variable cost currently expensed by Valyn Corporation under the variable costing basis was: a) $4.000 b) $4.000 d) $90.095.935.550.000 d) $5.375.500.000 d) $2.910.000 (CMA Adapted) 116 © 2017 HOCK international.

 It justifies costs. Allocation of shared services is done internally because if a company calculates its cost of production but does not include the costs of its service departments. As a result of this incorrect calculation. ultimately all the shared service costs are allocated only to operating departments. Shared services are usually services such as human resources. departments incur costs (salary. or support. For internal decision-making. and evaluating the efficiency of departments and the profitability of individual products. and it is not reflected in the company’s external financial statements. Resale prohibited. The cost allocation methods that follow are all stand-alone cost allocation methods. Cost allocations may be done for just one shared service or support department whose costs are allocated to multiple user departments.  It provides an incentive for managers to make decisions that are consistent with the goals of top management. the company may sell the product for less than it actually costs to produce it. and  It can also be used to compute reimbursement when a contract provides for cost reimbursement. © 2017 HOCK international. Note: Allocation of shared service costs to products or to production departments does not change the fact that for external financial reporting purposes. The allocation of service costs to the production departments is strictly an internal function that is used for decision-making. departments that use their services in order to calculate the full cost of production. and in a worst-case scenario. Allocation of shared service costs does not make them product costs. Usage of the services by the individual departments (cost objects) can be traced in a meaningful way based upon a cost driver that fairly represents their usage of the service. Reasons for allocating shared services costs include:  It provides accurate departmental and product costs for use in making decisions. the company’s pricing decisions will not be correct. LLC. and many accounting services such as payroll processing. For personal use only by original purchaser. information technology. These shared service costs are being allocated as a cost pool containing all of each department’s costs. rent. or production. it will be looking at a cost of production that is less than the actual total cost. the costs of shared service departments need to be allocated to the operating. such as transfer prices. such as hours of service used. and the costs are being allocated to user departments on the basis of a single cost driver. 117 . But even when costs of shared service departments are allocated to other service departments. maintenance. In Section C in Allocation of Common Costs.  It provides a fair evaluation of the performance of segments and segment managers. utilities and so on). we talked about stand-alone cost allocation versus incremental cost allocation. The methods of allocating these costs we are about to discuss are different from the activity-based costing method covered above.  It motivates managers and other employees to make their best effort in their own areas of responsi- bility to achieve the company’s strategic. These shared service.Section D Shared Services Cost Allocation Shared Services Cost Allocation Shared services are administrative services that are provided by a central department to the company’s operating units. valuing inventory. or they may be done for multiple shared service or support departments whose costs are being allocated both to other service/support departments and to other user departments. invoicing and accounts payable. legal. the costs of service departments are period expenses and are expensed as they are incurred.

Shared Services Cost Allocation CMA Part 1

Allocating Costs of A Single (One) Service or Support Department to Multiple Users
Before allocating the costs of a shared service department to operating departments, management must
decide whether the shared service department’s fixed costs and its variable costs should be allocated as one
amount or whether the fixed and variable costs should be allocated separately, which would enable the fixed
costs to be allocated in a different manner from the variable costs. Allocating the costs as one amount is
called the single-rate method. Allocating them as two separate cost pools, one consisting of variable costs
and one consisting of fixed costs, is called the dual-rate method.

 Single-Rate Method – The single-rate method does not separate fixed costs of service departments
from their variable costs. It puts all of the service department costs into one cost pool and allocates
the costs using one allocation base.

 Dual-Rate Method – The dual-rate method breaks the cost of each service department into two
pools, a variable-cost pool and a fixed-cost pool, and allocates each cost pool using a different cost-
allocation base.

Allocation bases for either the single-rate method or the dual-rate method can be:

 Budgeted rate and budgeted hours to be used by the operating divisions.

 Budgeted rate and actual hours used by operating divisions.

Following are examples of the single-rate method and the dual-rate method, using the same data for both.

118 © 2017 HOCK international, LLC. For personal use only by original purchaser. Resale prohibited.

Section D Shared Services Cost Allocation

Example #1: Single-rate method of allocation:

The following information is from the 20X0 budget for EZYBREEZY Co. EZYBREEZY has one service
department, its Maintenance Department, that serves its Manufacturing and Sales departments. The
Maintenance Department has a practical capacity of 5,000 hours of maintenance service available each
year. The fixed costs of operating the Maintenance Department (physical facilities, tools) are budgeted at
$247,500 per year. The wages for the maintenance people and the supplies they require are the variable
costs, and those are budgeted at $25 per hour.

Budgeted Maintenance usage by the Manufacturing and Sales departments is as follows:
Manufacturing 3,500 hours
Sales 1,000 hours
Total budgeted usage 4,500 hours

Using a single-rate method, the budgeted total cost pool will be:

$247,500 fixed cost + (4,500 hours × $25) variable cost = $360,000

The allocation rate for the total maintenance cost is $360,000 ÷ 4,500 hours, which is $80 per hour.

The single-rate method is usually used with the second allocation base option: budgeted rate and actual
hours used. The actual maintenance hours used by the Manufacturing and Sales departments are as
follows:
Manufacturing 3,600 hours
Sales 1,100 hours
Total actual usage 4,700 hours

Therefore, the amounts of Maintenance department costs that will be allocated to the Manufacturing and
Sales departments are:
Manufacturing 3,600 × $80 $288,000
Sales 1,100 × $80 88,000
Total cost allocated $376,000

The problem with the single-rate method is that, from the perspective of the user departments, the
amount they are charged is a variable cost, even though it includes costs that are fixed. The manager of
the Manufacturing department could be tempted to cut his department’s costs and outsource the
maintenance function if he could find a company to supply maintenance for less than $80 per hour.

Suppose that an outside maintenance company offers to do the maintenance for the Manufacturing
department for $60 per hour. The amount paid to the outside company will be 3,600 hours @ $60 per
hour, or $216,000. The Manufacturing department manager is happy, because he has saved $72,000
($288,000 − $216,000).

However, the fixed costs of the in-house Maintenance department do not go away just because Manufac-
turing is not using their services any longer. The total cost of the Maintenance department (now being
used only by the Sales department) will be $247,500 fixed cost + (1,100 hours for the sales department ×
$25) variable cost = $275,000, assuming the actual costs incurred are equal to the budgeted amounts.
This is $85,000 less than was budgeted ($360,000 − $275,000). However, the company has an additional
cost of $216,000 being paid to the outside maintenance company. So for the company as a whole, total
maintenance cost is now $491,000 ($275,000 for the maintenance department + $216,000 for the outside
company), which is $131,000 greater than the budgeted amount of $360,000 for maintenance. The
Manufacturing department’s actions have caused a variance in costs for the company as a whole of
$131,000 over the budgeted amount.

(Continued)

© 2017 HOCK international, LLC. For personal use only by original purchaser. Resale prohibited. 119

Shared Services Cost Allocation CMA Part 1

Example #2: Dual-rate method of allocation:

The following information is from the 20X0 budget for EZYBREEZY Co. EZYBREEZY has one service
department, its Maintenance Department, that serves its Manufacturing and Sales departments. The
Maintenance Department has a practical capacity of 5,000 hours of maintenance service available each
year. The fixed costs of operating the Maintenance Department (physical facilities, tools) are budgeted at
$247,500 per year. The wages for the maintenance people and the supplies they require are the variable
costs, and those are budgeted at $25 per hour.

Budgeted Maintenance usage by the Manufacturing and Sales departments is as follows:
Manufacturing 3,500 hours
Sales 1,000 hours
Total budgeted usage 4,500 hours

Because a dual-rate method is being used, EZYBREEZY selects an allocation base for the variable costs and
an allocation base for the fixed costs. The company allocates the variable costs based on the budgeted
variable cost per hour ($25) and the actual hours used. They allocate fixed costs based on budgeted
fixed costs per hour and the budgeted number of hours for each department (option #1).

The actual maintenance hours used by the Manufacturing and Sales departments are as follows:
Manufacturing 3,600 hours
Sales 1,100 hours
Total actual usage 4,700 hours

The allocation rate for the fixed cost is $247,500 ÷ 4,500 hours, or $55 per hour. The allocation rate for
the variable cost is $25 per hour.

The amounts allocated to each user department are now:

Manufacturing:
Fixed Costs: $55 × 3,500 hours $192,500
Variable Costs: $25 × 3,600 hours 90,000
Total allocated to Manufacturing $282,500

Sales:
Fixed Costs $55 × 1,000 hours $ 55,000
Variable Costs: $25 × 1,100 hours 27,500
Total allocated to Sales $ 82,500

Total cost allocated $365,000

The total amounts allocated to each user department are different under the dual-rate method and the
single-rate method because the fixed costs are allocated based on the budgeted usage under the dual-
rate method and based on the actual usage under the single-rate method.

Under the dual-rate method, the Manufacturing and Sales departments would each be charged for their
budgeted fixed allocation even if they do not use the internal Maintenance department. That should
discourage the manager of the Manufacturing department from contracting with an outside maintenance
service.

120 © 2017 HOCK international, LLC. For personal use only by original purchaser. Resale prohibited.

Section D Shared Services Cost Allocation

The examples above use the demand to calculate the allocation rate for the Maintenance Department’s costs.
The company could instead use the supply of service, i.e., the Maintenance department’s practical capacity of
5,000 hours to calculate the allocation rate per hour. When the supply is used to calculate the allocation rate
and if 100% of the supply is not budgeted for use by user departments, there will be some unused capacity
that will not be allocated. However, if unused capacity is caused by one of the user departments having
budgeted for time that it later did not use, the unused resources would still be allocated to that user
department.

Using practical capacity to allocate service department costs has the advantage of focusing management’s
attention on the unused capacity. It also avoids charging user departments with the cost of the unused
capacity. When demand is the basis for the allocation, all of the costs of the service department – including
the unused capacity – get allocated to the user departments. Charging user departments for unused capacity
could cause a downward demand spiral. Recall that we defined a downward demand spiral as a continuing
reduction in demand that occurs when costs are too high. As demand drops, the cost per unit gets higher and
higher, leading to more price increases, which lead to more reduction in demand, and so forth.

Single-Rate Method

Benefits  The cost to implement it is low because it avoids the analysis needed to classify
all of the service department’s cost into fixed and variable costs.

Limitations  The single-rate method makes fixed costs of the service department appear to
be variable costs to the user departments, possibly leading to outsourcing that
hurts the organization as a whole.

Dual-Rate Method

Benefits  It helps user department managers see the difference in the ways that fixed
costs and variable costs behave. And it guides user department managers to
make decisions that are in the best interest of the organization as a whole, as
well as each individual department.

Limitations  The cost is higher than the cost of the single-rate method because of the need
to classify all of the costs of the service department into fixed and variable
costs.

Allocating Costs of Multiple Service or Support Departments
Special cost allocation problems arise when there are several shared service departments within an
organization and the shared service departments provide support not only to the production departments but
to the other shared service departments as well. The factor that complicates the process is service
departments using the services of other service departments. For example, people in the maintenance
department use the services of the IT department and eat in the cafeteria.

There are three different methods of allocating costs of multiple shared service departments in a situation like
the one above. All three methods are simply mathematical allocations, much like the way manufacturing
overhead is allocated to the products. The different methods of multiple shared service cost allocation treat
these reciprocal services differently.

The three methods of allocation are:

1) The direct method
2) The step (or step-down) method
3) The reciprocal method

We will look at each of these in turn.

© 2017 HOCK international, LLC. For personal use only by original purchaser. Resale prohibited. 121

Shared Services Cost Allocation CMA Part 1

Note: In a question, you should treat the service departments as shared service departments even if you
feel that they should be treated in a different manner. This may be the case with accounting, for example.
In some companies accounting (or other departments) may be expensed and not allocated, but in a
question, if accounting is given as a service department, you should treat it as such.

The Direct Method
Under the direct method the reciprocal services that are provided by the different shared service departments
to each other are ignored. The company will simply allocate all of the shared service departments’ costs
directly to the production departments. The allocation is made on a basis that is reasonable and hopefully
equitable to the production departments. For example, the costs of a subsidized employee cafeteria should be
allocated to the production departments based on the number of employees, while the maintenance
department’s costs may be allocated based on the number of maintenance hours used by each production
department.

When calculating the usage ratios for the different production departments, we count only the usage made
of the shared service departments by the production departments. We do not count the usage made
of shared service departments that takes place in the other service departments, because service depart-
ments will not be allocated any costs from other service departments.

This is the simplest and most common method and a very short example follows (the calculations of the
allocations are not shown).

Maintenance Cafeteria Production 1 Production 2 Production 3
Departmental 100 120 300 400 800
Costs

Allocation of
Maintenance (100) 20 30 50
Costs

Allocation of
Cafeteria (120) 30 30 60
Costs
TOTAL COSTS 0 0 350 460 910

The Step-Down or Sequential Method
The step-down method is also called the step method or the sequential method. In the step-down
method we attempt to recognize the services that the shared service departments provide to each other, but
we only make one allocation of the costs of each service department. After a particular service department
has had its costs allocated, it will not receive any costs from other service departments. This leads to a stair
step-like diagram of cost allocations as below. All costs ultimately end up allocated to the production
departments.

In order to use the step-down method, there must be an order in which we allocate the costs of the service
departments. This order can be any order management chooses. A popular method is to determine the
order according to the percentage of each department’s services that are provided to other shared service
departments, but that is not the only way it can be done. If, for example, the department that provides the
highest percentage of its services to other shared service departments is allocated first, then the department
that provides the next highest percentage of its services to other shared service departments comes next,
and so forth.

The first shared service department’s costs will be allocated to the other shared service departments and the
production departments. The second shared service department’s costs (which now include its share of the
first shared service department’s costs) will be allocated to the other shared service departments (but not to
the first shared service department that has already been allocated) and the production departments. Once a

122 © 2017 HOCK international, LLC. For personal use only by original purchaser. Resale prohibited.

the total amount allocated by each shared service department will be greater than its own overhead costs. Maintenance Cafeteria Production 1 Production 2 Production 3 Departmental 100 120 300 400 800 Costs Allocation of Maintenance (100) 10 16 28 46 Costs Allocation of Cafeteria (130) 36 32 62 Costs TOTAL COSTS 0 0 352 460 908 You will notice that this is a little bit different from the example for the direct method. when the cafeteria costs (including the cafeteria’s share of the maintenance costs) are allocated. even though the Production Departments used the same amounts of services of the two shared service departments. a company will need to balance the additional costs required in doing this against the benefits that are received. Because of this detailed allocation between and among the shared service departments. the costs allocated from the cafeteria include its own incurred costs (120). Following is an example of the step-down method. As a result. we do not consider the number of people in the maintenance department or their usage of the cafeteria. 123 . since each shared service department must allocate all of its own © 2017 HOCK international. Resale prohibited. Section D Shared Services Cost Allocation shared service department’s costs have been allocated. However. The Reciprocal Method The reciprocal method is the most complicated and advanced of these methods because it recognizes all of the services that are provided by the shared service departments to the other shared service departments. plus the cafeteria’s portion of the maintenance costs that were allocated to it from maintenance (10). The problem on the Exam will give the allocation order to use if it is not obvious. Again. When this allocation of the maintenance department is made. we did not show the allocation calculations. LLC. Graphically the reciprocal method looks like this: Maintenance Cafeteria Production 1 Production 2 Production 3 Departmental 100 120 300 400 800 Costs Allocation of Maintenance (108) 10 20 29 49 Costs Allocation of Cafeteria 8 (130) 33 30 59 Costs TOTAL COSTS 0 0 353 459 908 Notice that in this method. the shared service departments are each allocating some of their costs to the other shared service department. we will use the number of hours that the cafeteria utilized the services of the maintenance department. no costs will be allocated to it from other shared service departments. However. The step-down method gives a slightly different result from the direct method. For personal use only by original purchaser. Note: In the step-down method. the reciprocal method is the most theoretically correct method to use.

LLC. Resale prohibited. For personal use only by original purchaser. The process of solving the two equations is shown in detail in the example on the following pages.” and after that solve for the other number.Shared Services Cost Allocation CMA Part 1 costs plus some of the other shared service department’s costs. but even it is not too difficult. These calculated amounts become the amounts that need to be allocated from the maintenance department or cafeteria to all the other departments. 124 © 2017 HOCK international. The math to do this is the most complicated of the three methods. To solve a problem using the reciprocal method. . “simultaneous” or multiple equations must be used. the multiple equations will be set up this way: Maintenance Costs (M) to Allocate = $ amount M + their % of C Cafeteria Costs (C) to Allocate = $ amount of C + their % of M We can then solve for either “Maintenance Costs to Allocate” or “Cafeteria Costs to Allocate. In a situation in which there are two shared service departments. including the other service depart- ments.

000 $200. X Dept. we will allocate costs of Department A. The following information is in respect to the service and production departments: Dept.000.000) labor hours.67 Total OH $ 0.11111 × 3.00 22. has two shared service departments (A and B) and three production departments (X. X Dept. Y Dept.11111 × 4.000 10. Y and Z). each production department will be allocated $8.000 -.11 $300. LLC.00 $50.89 $361. Department X used 2.000 2.000 machine hours. Y Dept.33333 ($50. First. (Two of the amounts will be adjusted for rounding differences.000 + 3.000) per machine hour to the production departments.888.000 hours = $16. 1.000 4.000 + 2.000) machine hours of service to the production departments. Shared Service Department A will allocate its overhead based on direct labor hours and Shared Service Department B will allocate its overhead based on machine hours. For personal use only by original purchaser.000 2.000 Labor Hours -.000 + 2.22 of costs from Department A.000 (2. so they will allocate $8. so each department will be allocated $11.000 3.000 $250.666. B Dept.000 $900. A Dept.000 8.45 (adjusted for rounding difference).000 hours = $33. B Dept.000 2.000 (2.45 33.Section D Shared Services Cost Allocation Comprehensive Example of the Three Methods of Shared Service Cost Allocation Example: We will use the following information about Cubs Co. For Department A.00) 16.000.000 direct labor hours used in the allocation. Y and Z each used 2.000.000 Machine Hours 2.000.66 16.666.000 hours = $44.11111 ($100. Z Total Overhead $100. A Dept. Z Total Overhead $100. Department X is allocated $11.000 2.000.000 Now we can determine how much of the costs of the shared service departments will be allocated to each department.000 4.66.00 $ 0.000 $250. The numbers that are ignored are shaded.000 ÷ 6.00) 0.000.00 Allocated from A (100. A Dept.000 $900.00 (Continued) © 2017 HOCK international.000 Machine Hours 2. Departments X.000. We ignore the services that were provided to the other service departments in this calculation.000 Direct Method Under the direct method each shared service department will allocate costs only to the production departments.000 labor hours. Department B provided 6. Dept.22 44.222. Y Dept.333.00 $200. Resale prohibited.000 Labor Hours -. Department Y used 4.33. Department B’s costs are allocated next. Of the total 6.000 2.000 2.000 -.666.000 8. Z Own Overhead $100. Of the total 9.000 $200.000 $300. Cubs Co. 125 . Department Y is allocated $11. 2.33333 per hour × 2. the production departments used a total of 9.000 labor hours.000.000 labor hours.111.333.000 3.) Below are the total overhead costs for each department after the allocation: Dept.00 $250.666.67 16.00 (50.222. to demonstrate the different methods of allocating service costs.00 $300.33 Allocated from B 0.000 10. X Dept.000 + 4. Therefore.000 machine hours used in the allocation. B Dept. 2.000 $50.000) for each direct labor hour used. and Department Z used 3.000 $300.444.000 hours = $22. 1.000 $50.11111 × 2. and Department Z is allocated $11.00 $238.000 ÷ 9.444.

we will allocate Department B’s costs first.000 10. In total 8.500.000.25B B = $50. X Dept. Department Y will be allocated $12.000 hours. A Dept.500 allocated overhead from Department B.00 Allocated from A (112. The equations we need are: A = $100.00 50.000 2.500. Department X will be allocated $12.00 (50. and Department Z will be allocated $12.000 $200.000 2.500 from Department B ($6.000 Labor Hours -.000.000 is allocated on the basis of machine hours used by all the other depart- ments.000 4.Shared Services Cost Allocation CMA Part 1 Step-Down Method Under the step-down method we must determine which shared service department’s costs will be allocated first. The total costs to be allocated for Department A are Department A’s own overhead of $100.000.500 of Department B’s costs. B Dept. Z Own Overhead $100. Department B’s costs will be allocated among all the other departments.000.000.000 Machine Hours 2.000) are used in allocating Department A’s total overhead of $112. so the Department B’s cost per machine hour is $6.500. Department A will be allocated $12.00 $200. excluding the direct labor hours used by Department B.000 direct labor hours (2. X Dept. Since only 10% of Department A’s service was to Department B. For personal use only by original purchaser.000 machine hours). Since Departments X.000 plus the $12.000 + 4. we need to use two equations. The ignored numbers are shaded below: Dept.000.500 cost for Department A. This $112.500.000 + 0. each of those departments will also be allocated $12. including Department A.000.00 $50. Y and Z each also used 2.000 $900.500.000 machine hours.00 $300. Resale prohibited.500. The allocation of Department A’s costs is done the same way as in the direct method. Y Dept.00 Total OH $ 0.000 = $50. We can calculate that 25% of the service provided by Department B was to Department A. we would need three equations.000 $300.000.50 × 4.000 Below are the total overhead costs for each department after the allocation: Dept. 2. Next. we allocate Department B’s costs: As mentioned previously. and so forth.500 will be added to the $100.000 $250. That $112.500.000 8. Z Total Overhead $100.500 ÷ 9. It is important to remember in the step-down method that the hours that the second shared service department provides to the first are ignored when allocating the second shared service department’s costs. A Dept.00 $ 0.00 Reciprocal Method Under the reciprocal method we will allocate some of Department A’s costs to Department B and some of Department B’s costs to Department A using simultaneous equations.00 25.00 $300.25 × 2. based on machine hours used by each.50 × 2.000 + 0.00 Allocated from B 12. Department B’s cost of $50. we will allocate the costs of Department A.000. First.000 3. Y Dept.00) 12. LLC.50 per direct labor hour. B Dept.00 37.000 machine hours were used.000. Department A will receive $6. This $12. .00 $362.1A (Continued) 126 © 2017 HOCK international.000 = $25.25. (If there were three shared service departments.000 + 3.500 cost for Department A will then be allocated only to the production departments based on the direct labor hours used by each. including the other shared service departments. Since we have two shared service departments. a total of 9.00 12.00 12.000 of A’s own overhead. except that there are now more costs to allocate from Department A because some allocated costs of Department B are included in Department A’s costs.00 $250.500 is allocated based on direct labor hours.000 = $37. for a total to allocate of $112.00 $237.25 × 2. or $12.500. 1. Therefore.500.00) 0.50 × 3.500.000 2.000 -.500.000.500. $112.) The equations will express how much each shared service department needs to allocate to all of the departments.000 = $12. giving a total $112.000 $50.

the total amount of overhead in the production departments after the allocation is equal to the total amount of overhead that the company as a whole— including the shared service departments—incurred during the period ($900.92 46.538.53846 × 3.00 Notice that in all of the methods of overhead allocation. B Dept. d) Authority to provide specialized support to other units within the organization.00 $200.076.62.000 + 0. The total overhead cost for Department B. we can put the value we found for A into the second equation in place of the A and solve for B.000 = $11.69231 per machine hour. X Dept. including the power to choose its markets and sources of supply.61 15. A Dept.000 + 0. is the total cost for Department A to be allocated to all the other departments.384.461.46. is $61.384.00 $ 0. Z Own Overhead $100. Now that we have solved for A.000 = $23. A = $100.000. including the other shared service department.53 $361.000.62 Total OH $ 0. direct labor.000.153. 127 .000. X.00 Allocated from A (115.000 = $46.Section D Shared Services Cost Allocation We solve for A by substituting the right side of the second equation into the first equation in place of the variable B. LLC. c) Authority to make decisions affecting the major determinants of profit. and other factors of production into a final output. (CMA Adapted) © 2017 HOCK international.000. Question 49: A segment of an organization is referred to as a service center if it has: a) Responsibility for combining the raw materials. Y and Z each used 2.000 + $12.62) B = $61.538.000).384.384. or $11.61 (61. The total overhead cost for Department A. B = $50.53846 × 1.384.62 The result.46) 15.46 The total cost for Department B to be allocated to all the other departments.53846 per hour.38 Allocated from B 15. Y Dept.46 23.52846 × 2. is allocated among all the other departments on the basis of 8.384.500 + 0.000 machine hours.538.62 15.00 $238.69231 × 2.53846 × 4.000. Department X is allocated $11.000 = $34.61) 11. Department B is allocated $11.46 of Department A’s costs. $115. is allocated among all the other departments on the basis of 10.500 A = $115.62.38.538. $115.153. A = $100.85 34.1A) Now we have only one variable in the equation and we can solve for Dept. and Department Z is allocated $11.025A 0.25 ($50.384.000 = $15.92.00 $300. Department Y is allocated $11. or $7.975A = $112.47 $300.00 $250.61.538.384.384.46.) Below are the total overhead costs for each department after the allocation: Dept. b) Responsibility for developing markets and selling the output of the organization.076. Departments A.1 ($115. including the other shared service department. Resale prohibited.384. so each will be allocated $7.000 total direct labor hours used. $61.00 $50.000 total machine hours. For personal use only by original purchaser.000 + 0.538.85. A. (Two of the departments’ amounts will be adjusted for rounding differences.538.615.615.

00 (CMA Adapted) 128 © 2017 HOCK international.000 c) $162.000 d) $167. the total amount of quality control costs to be allocated to the other departments would be: a) $284.000 $400.250. 7.20 b) $3.Shared Services Cost Allocation CMA Part 1 The following information is for the next five questions: The managers of Rochester Manufacturing are discussing ways to allocate the cost of support departments such as Quality Control and Maintenance to the production departments. 18.211 b) $336. the overhead allocated to each direct labor hour in the Assembly Department would be: a) $3.000 $1.000 35.500 c) $120.053 Question 54: If Rochester decides not to allocate support costs to the production departments.500 Question 51: If Rochester uses the direct method.65 Question 52: If Rochester uses the step-down method of allocating support costs beginning with quality control.000 21.000 Budgeted hours of service: Quality Control -.842 c) $350.25 c) $8.000 $300. . the total amount of overhead allocated to each machine hour at Rochester would be: a) $2.000 25.000 Budgeted direct labor hours -. -.000 Question 53: If Rochester uses the reciprocal method of allocating support costs. the total support costs allocated to the Assembly Department would be: a) $80.50 c) $12.000 d) $421.000 b) $87. LLC. 25.000 40.000 Budgeted machine hours -. Resale prohibited.00 d) $15. To aid them. -. For personal use only by original purchaser. 50.000 b) $108. they were provided the following information: Quality Control Maintenance Machining Assembly Total Budgeted overhead costs before allocation $350. -. the maintenance costs allocated to the Assembly Department would be: a) $70.000 -.000 d) $200.00 d) $16.000 12.000 Maintenance 10.000 $200. 50.000 Question 50: If Rochester uses the direct method of allocating support department costs.40 b) $5.000 -.000 7.

there are two methods that can be used: the High-Low Points Method and Regression Analysis. budgeting or costing purposes. Another way of estimating the variable cost per unit using the High-Low Points method is to set up two equations in two variables. or the number of units or hours b = the constant coefficient and the y intercept. if hours are the activity being used) x = the independent variable. When we need to separate fixed costs from variable costs for analysis. Resale prohibited. which here is the variable cost per unit (or per hour. for example. The two variables are Fixed Costs and Variable Costs. 3) Subtract the total variable cost from the total cost at that level to get the fixed cost. Then. which here is the fixed cost b = the variable coefficient and the slope of the line. which here is total costs a = the constant coefficient and the y intercept. or the variable cost per unit or per hour x = the independent variable. High-Low Points Method For the High-Low Points Method. or cost driver. subtract one equation from the other equation to eliminate the Fixed Cost as a variable and solve the remainder for the Variable Cost. we will take the month of the highest level of production or usage and the month of the lowest level of production or usage. 2) Multiply the Variable Cost per Unit by the unit volume at either the highest or the lowest production volume to get the total variable cost at that level. Difference in Costs = Variable Cost per Unit Difference in Activity (Units) Since we are assuming that fixed costs do not change with changes in activity. the difference be- tween the costs for the highest month’s activity and the costs for the lowest month’s activity divided by the difference in the two months’ activity levels must be the Variable Cost per Unit. For personal use only by original purchaser. we need to segregate fixed production costs from variable production costs and all we have is a single total cost amount. or total costs a = the variable coefficient and the slope of the line. we use the highest and lowest observed values of the cost driver within the relevant range and the costs that go along with them. which here represents the number of units (or hours) OR y = ax + b Where: y = the dependent variable and the predicted value of y.Section D Estimating Fixed and Variable Costs Estimating Fixed and Variable Costs Sometimes costs are mixed costs or the fixed costs are not segregated from the variable costs in the historical information available. we can determine approximately what amount of the costs are variable and what amount are fixed. since the activity is the cost driver. By comparing the differences in production with the differences in total costs between these two months. and one equation representing the lowest level. Divide the difference between the costs associated with the highest and the lowest activity by the difference between the highest and lowest activity. The result of doing this will be what is called the cost function. LLC. as follows: y = a + bx Where: y = the dependent variable and the predicted value of y. The steps to calculate this are the following: 1) Estimate the variable portion of the total cost using the highest and lowest production or activity values. 129 . or fixed cost © 2017 HOCK international. with one equation representing the highest level of the activity. The cost function can be written in two ways. If.

000 1.369 The cost function that expresses the relationship between fixed and variable costs is: y = $347.257.715.800.500.000 Using the first method to estimate the variable cost per unit: Difference in Costs = $700.000 March 5.000 1.1842105 × 6.000 1.000 1.715.000 1.369 + ($0.1842105 per unit. the constant coefficient (the fixed costs) will always be by itself.000 February 4.1842105x We can prove these fixed and variable cost amounts by putting them into the cost function using the lowest activity level.443.400.1842105 variable cost/unit Difference in Units 3. Whichever way the cost function is written. .000 − FC + 3.369.550.000 Using the second method (two equations) to estimate the variable cost per unit: FC + 6. and the variable coefficient (the variable cost per unit) will always be next to the independent variable (the x.000 900. For personal use only by original purchaser.800.000 October 6. or it may come at the end. 130 © 2017 HOCK international.000 $1.000 What is Ray Corporation’s Fixed Cost and what is its Variable Cost per Unit? The highest and the lowest production volumes and their associated production costs are: Production in Units Total Production Costs October 6.000 VC = $1.000 $0.000 0 + 3.1842105 The next step is to put the Variable Cost per Unit into an equation to calculate Fixed Cost.000 May 5.1842105 × 3.800.000 April 5.000) = $347.600.600.800. Here we will use the highest.369 + $0.000 June 3.200.000 November 6.000 December 5. The variable representing fixed costs may come first.000.000 June 3.000 September 5.800. FC = Total Cost − Variable Cost FC = $1.050.000 1.000 $1. Example: Ray Corporation experienced the following total production costs during the past year: Ray Corporation Production Volumes and Costs Production in Units Total Production Costs January 6. or the number of units/hours).000.000 1.000) = $900. Resale prohibited.529.000 VC = $0. and Variable Cost is $0.000. The result is the total historical cost at that historical level.815.000 900.000 1. we can use either the lowest or the highest volume-cost equation.350.000 VC = 900.800.000 1.400.600.300.172.000. $347.000 August 3.Estimating Fixed and Variable Costs CMA Part 1 Note: the terms may be in any order.543.000 1.200.300.000. For this step.000 VC = $ 700.630. LLC.000 − ($0.000 July 3.000 So Fixed Cost is $347.600.

LLC. Loading it is done differently depending upon which version of Excel you have. We used it in the section on Forecasting to graph a trend line and extend that trend line out to create a forecasted sales amount based on the previous trend. do not include the cells containing the headings in the ranges to be analyzed. enter the input into a blank spreadsheet. When we use regression analysis to estimate fixed and variable costs as in this example. As we will see. There. Regression analysis can be done in Excel using the Data Analysis ToolPak Add-In. you can get directions for loading it by searching the Help directory in your Excel program for “Load or Unload Add-In Programs. This add-in must be loaded into Excel before it will be accessible. something else is the independent variable. Although we have several sets of X and Y data and each set of data represents activity for a specific month. Resale prohibited. For personal use only by original purchaser. but if you do. production in units is the independent variable and total production costs is the dependent variable. A B 1 6257000 1500000 2 4630000 1200000 3 5200000 1300000 4 5443000 1350000 5 5715000 1400000 6 3000000 900000 7 3543000 1000000 8 3815000 1050000 9 5715000 1400000 10 6800000 1600000 11 6529000 1550000 12 5172000 1300000 © 2017 HOCK international.” When the Data Analysis Toolpak Add-In has been loaded. we were using simple regression analysis with a time series. What is important is the relationship of the dependent variable (production costs) to the independent variable (production volume) for each month. where time was the independent variable and sales volume was the dependent variable. it can be used to predict what fixed costs and variable costs will be in any future month based on what we predict production volume will be in that month. 131 . You can give headings to the data if you wish. If it is not loaded.Section D Estimating Fixed and Variable Costs Regression Analysis Simple regression analysis can also be used to find the fixed cost and the variable cost per unit when you have an independent variable such as production in units and a dependent variable such as total production costs. The independent variable (production in units) is in Column A and the dependent variable (total production costs) is in Column B. However. simple regression analysis can also be used to analyze a set of data where time is not the independent variable but rather. Here is the data from the Ray Corporation example on the preceding page as it would appear in an Excel spreadsheet (formatting is not important). it makes no difference which month each set of data occurred in. it is very consistent. And because it is consistent. For the purpose of this analysis. this regression analysis will not have the months on the X axis.

The coefficient of determination is also explained in the section on Forecasting.0% Upper 95. (Hint: In this example.  The coefficient of correlation is called “Multiple R” on this spreadsheet. Note: This example was created in the Windows version of Excel 2007. 3) For “Output Options. is the square of the coefficient of correlation.385 Total 11 5.000395012 466. .18508201 0. The coefficient of correlation is explained in detail in this book in the section on Forecasting.5436 342256.37267E+11 217453.183321725 0.0603E-23 0.319168 5.51077E-18 342256. and it indicates a very strong correlation between produc- tion volume and production costs. In the analysis tools available. choose “Regression. 2) Enter the independent variable range into the field “Input X Range. they tell us that any estimate of fixed and variable costs that we make for any given production level based on this regression should be quite accurate.” In the dialogue box that comes up.Estimating Fixed and Variable Costs CMA Part 1 Then launch the Data Analysis ToolPak. the independ- ent variable is in column A.999954015. you should go back and reread about both the coefficient of correlation and the coefficient of determination so that you understand what these coefficients mean.184201867 0. and it is 0. 1) Enter the dependent variable range into the field “Input Y Range.” In our example. It is 0. so the range is $B$1:$B$12.5664 5.582 351547. called “R square” on this spreadsheet.3866432 1. This is about as close to 1 as you can get.999954015 Adjusted R Square 0.0603E-23 Residual 10 24707203.999977007 R Square 0. For personal use only by original purchaser.  The coefficient of determination.18508201 The four pieces of information you need from this spreadsheet are highlighted in the sheet above.915328 166.852533 Observations 12 ANOVA df SS MS F Significance F Regression 1 5.” choose “New Worksheet Ply:” 4) Click OK.0% Intercept 346902.999949417 Standard Error 1571. A new sheet will be created in your workbook.5436 X Variable 1 0. The coefficient of determination indicates the proportion of the total variation in the dependent variable (production costs) that can be explained by variations in the independent variable (production volume).85 2470720.) 132 © 2017 HOCK international.999977007. the dependent variable is in column B. Resale prohibited. If necessary.37267E+11 5. The new worksheet will look like this: SUMMARY OUTPUT Regression Statistics Multiple R 0. so the range is $A$1:$A$12.0628 2084. But make sure you un- derstand why that is true.582 351547. another version of Excel might be slightly different.” In this example.183321725 0. LLC.37292E+11 Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.

 The variable cost per unit is the variable coefficient.0628 + $0. 133 .452.369 and the variable cost was $0. With the High-Low Points Method.452. the fixed cost was $347. Resale prohibited.Section D Estimating Fixed and Variable Costs  The amount of the fixed cost is the constant coefficient. This cost function is: y = $346. which is $346.369 + ($0.000) y = $1.184201867 × 6.000. or X variable. then the forecasted total cost using the High-Low Points Method is: y = $347.000) y = $1.632 And total cost forecasted using regression analysis (rounded) is: y = $346.113 © 2017 HOCK international. Forecasting Total Costs Whether using the High-Low Points Method or regression analysis.000. For personal use only by original purchaser.000 units.000. For example.902.184201867 per unit. LLC.902.1842105 per unit.1842105 × 6.0628. if production is forecast to be 6. which is $0.0628 + ($0.902.184201867x Note how similar this result is to the result we got when we analyzed the same data using the High-Low Points Method. or the Y-intercept. the cost function that results can be used to forecast the total cost at any forecasted activity level.

logistics. so that the manufacturer knows how much production to schedule and how much raw materials to order and when. The generic term for the system is lean manufacturing. and fewer rush and expedited orders. All of the organizations involved in moving a product or service from suppliers to the end-user. Physical flows involve the movement. thus reducing the amount of cash tied up in inventories for all. trust issues. “Waste” is anything other than the minimum amount of equipment. Waste is anything that does not add value to the customer or anything the customer is not willing to pay for. The result of effective supply chain management is fewer stockouts at the retail level. LLC. Identifying and eliminating waste is a primary focus of lean manufacturing. By sharing information and by planning and coordinating their activities. the customer. . Such a practice is called supplier-managed or vendor-managed inventory. issues and problems can arise because of communica- tions problems. who in turn convert them into finished products that they ship to distributors for shipping to retailers for purchase by the consumer.Supply Chain Management CMA Part 1 Supply Chain Management What is Supply Chain Management? Nearly every product that reaches an end user represents the coordinated efforts of several organizations. The supply chain firms endeavor to develop and run their supply chains in the most effective and efficient ways possible. Each company in the supply chain is able to carry lower inventories. materials. The physical flows are the most visible part of the supply chain. and working time that is absolutely essential to add value to the customer. Manufacturers throughout the world have adapted the system to meet their own manufacturing needs. sourcing. Along with the benefits of supply chain management. incompatible information systems. all of the members of the supply chain can be in a position to respond quickly to needs without having to maintain large inventories. and the distributors know how much to order. The trading partners share inventory information. Resale prohibited. Information flows allow the various supply chain partners to coordinate their long-term plans and to control the day-to-day flow of goods and material up and down the supply chain. Some supply chain management goes so far as the retailer allowing the distributor or manufacturer to manage their inventories for them. reduction of excess manufacturing by the manufacturer and thus reduction of excess finished goods inventories. Supply chain management is the active management of supply chain activities by the members of a supply chain with the goals of maximizing customer value and achieving a sustainable competitive advantage. The sharing of information reduces uncertainty as to demand. The emphasis in lean manufacturing is on cutting out waste in the manufacturing process. Lean Manufacturing Lean manufacturing is a philosophy and system of manufacturing that was developed originally by Toyota. But the information flows are just as important. production. are referred to collectively as the supply chain. storage and transformation of raw materials and finished goods. and it has become a global standard that virtually all manufacturing companies must adopt in order to remain competitive. The organizations that make up the supply chain are linked together through physical flows of products and through flows of information. Supply chain activities cover product development. Toyota called the system the Toyota Production System (TPS). parts. shipping product to them automatically whenever their inventory of an item gets low. Retailers share daily sales information with distributors and the manufacturer. and the required increases in personnel resources and financial resources. and the information systems needed to coordinate these activities. 134 © 2017 HOCK international. For personal use only by original purchaser. Suppliers provide components to manufacturers.

Waste inhibits throughput. 3) Transporting parts and materials from process to process or to various storage locations. and poorly designed processes all contribute to poor throughput in a manufacturing system. For personal use only by original purchaser. The more the downtime involved in the changeover process can be reduced.” or “Single Minute Exchange of Die” is a primary method of speeding up the changeover process. or committing money and storage space to unsold parts or products. they may well add value to the product. 5) Inventory. The goal of SMED is to change dies and other components in less than 10 minutes. “SMED. 4) Over-processing. or doing more work on a part or product than is necessary. the less waste of resources takes place. 4) Pull – Producing or servicing is done based on customer demand. 2) Value stream – The value stream is the set of steps and activities performed to deliver the product or service to the customer. out of stock supplies. 3) Flow – Make the steps occur so the product or service flows smoothly to the customer.  Produced faster and cheaper than the competition. 6) Motion. 5) Continuous improvement – Seek perfection by continuing to make improvements. Machine downtime. Lean Principles The five key principles that guide the lean manufacturing philosophy and manufacturing approach are: 1) Customers – Understand your customers and identify what is important to them. parts sitting in storage. or making more items than you can sell. Identify the value stream for each product or service. the rate at which work proceeds through a manufacturing system. but they do not add value to the customer. or waiting for processing. Lean Concepts Minimal machine downtime when changing from manufacturing one item to manufacturing a different item is an important component of lean manufacturing. creating parts or products that are not sellable due to defects and must be discarded or reworked. Operations are streamlined to give the customers what they want when they want it at the lowest possible cost within the least amount of time. waiting for materials. 135 . 7) Making defective parts. Eliminate steps that do not create value for the customer.Section D Supply Chain Management “Adding value to the customer” is not the same thing as adding value to the product. The 7 primary wasteful activities addressed by lean manufacturing are: 1) Overproduction.  Better than those of competitors. or moving parts more than the minimum amount required to complete and ship them. If extra options added to a product are not things the customer wants or is willing to pay for. The changeover process generally involves removing and replacing dies from machine beds and removing and replacing direct materials used. LLC. Lean manufacturing strives to produce products that are  On time. Even small reductions in waste can have a cumulative effect in increasing throughput. The most powerful method of attaining SMED is to convert all “internal setup” procedures (procedures that can only be completed while the © 2017 HOCK international. operator errors.  Using a few resources as possible. Resale prohibited. Eliminating waste increases throughput. Specify value from the standpoint of the customer. 2) Delay.

Improvement is always possible. a properly laid-out work cell can produce a product with a staff of just one person moving from station to station. The term kaizen is a Japanese word that means “improvement. and it will be discussed later in this book in that context. . Tooling and processes are often reworked to produce error-free products or to catch errors before they become products that become scrap or require rework. The concept of kaizen has extended to other business operations outside the manufacturing function. Even the design of the product may be changed to minimize errors in manufacturing. preparation for the next setup can be done while the machine or process is still running. and lead to greater customer responsiveness. JIT is a process for synchronizing materials. or practical. Smaller batches can reduce finished goods inventory on hand. expected standards. the ultimate goal is still not being achieved. but the shape can be whatever works best. Even though practical standards are being attained. Just-in-time processes are discussed in more detail in the next topic. and the goal is to attain the ideal standard. when they need to be there. Reducing setup time makes it practical to produce smaller batches. Kanban is also a component of lean manufacturing. The configuration’s purpose is to enable workers to easily move from one process to another and to pass parts from one worker to another with little effort.Supply Chain Management CMA Part 1 machine is down) to “external setup” procedures (procedures that can be completed while the machine is running). The goal of lean manufacturing is to maintain continuous flow. attainable only under the best possible conditions. the plant layout is re-arranged by manufacturing cells or work cells. Error and mistake-proofing means creating improvements on many different levels to make the products correctly the first time. meaning once you begin producing a product. For personal use only by original purchaser. or staffed somewhere in between. reducing downtime resulting from breakdowns or employee absences. Kaizen is part of the lean manufacturing philosophy. it implies “continuous improvement. Ideally. 136 © 2017 HOCK international. The work cells are generally laid out in a U-shape or horseshoe shape. Kanban is covered in more detail in the next few pages. Toyota would say that standards in manufacturing are temporary and not absolutes. But production of large batches results in large on-hand inventories. and equipment so that the people and the materials are where they need to be. batching is not done at all in lean manufacturing. The rate of production is matched to the demand to avoid creating excess inventory or incurring excess costs. Furthermore. and in the state they need to be in. Standard costs used in manufacturing may be either ideal standards. Product demand determines the staffing needed in each work cell. Each worker in each cell knows how to operate all the machines in that cell and can perform supporting tasks within that cell. allow for more varieties of products that can be produced more quickly. The goal in the layout of the work cell is for the workers to be able to pass a part or product through every needed process with a minimum amount of wasted motion and distance. Kanban refers to a signal that tells workers that there is more work to be done. Under lean manufacturing. resulting in less downtime because the machine needs to be stopped only during the actual setup activities. LLC. Just-In-Time (JIT) production and inventory management are also used in lean manufacturing.” or slow but constant incremental improvements being made in all areas of business operations.” As used in business. operators. Often large batches are assumed to be more economical than small batches due to excessively long or difficult changeover procedures. For example. Each work cell produces a specific product or product type. or fully staffed with a worker at each station. Resale prohibited. but attainable under normal conditions. which are challenging to attain. you keep it moving through the value stream without ever placing it into a holding area for later processing.

this means essentially that nothing will be produced until a customer orders it.  Increased business because of increased customer responsiveness. the factory must be reorganized to permit lean manufacturing. in a push system. To implement the JIT approach and to minimize inventory storage.Section D Supply Chain Management Benefits of Lean Manufacturing Benefits of lean manufacturing include:  Quality performance. The main idea of JIT is that nothing is produced until the next process in the assembly line needs it. theft. defects caused at one workstation very quickly affect other workstations. resulting in a possibly large. a department produces all that it can and sends those units to the next step in the process for further processing.” In a push system.  Improved supplier relations. Because inventory levels are kept © 2017 HOCK international. a department produces and sends all that it can to the next step for further processing.  Improved delivery performance. They are based on a manufacturing philosophy that combines purchasing. production and inventory control into one function. In a push system. Close coordination between workstations can keep the flow of goods smooth in spite of the low levels of inventory.  Greater customer satisfaction. The goal of a JIT system is to minimize the level of inventories that are held in the plant at all stages of production. fewer defects and rework. Ultimately. workers are able to trace problems to their source and resolve them at the point where they originated. By contrast. Because of the close coordination between and among workstations and the minimum inventories held at each workstation. useless stocks of inventory. Just-in-Time (JIT) Inventory Management Systems Just-In-Time inventory management systems are used in lean manufacturing. Supply chain management is also an important part of just-in-time inventory management.  Lower levels of inventory. which means that the manufacturer is producing something without understanding consumer demand. loss. This demand-pull feature requires close coordination between workstations. The cost savings include reduction in the risk of damage. essentially nothing is produced until a customer orders it. JIT requires problems and defects to be solved by eliminating their root causes as quickly as possible.  Greater efficiency and increased output per person-hour.  Fewer machine and process breakdowns. In a pull system. and just-in-time inventory management is an important part of supply chain management.  Less space required for manufacturing and storage. including raw materials. For personal use only by original purchaser. or a lack of ability to sell the finished goods. Resale prohibited.  Improved employee morale and involvement. One of the main differences between JIT and traditional inventory systems is that JIT is a “demand-pull system” rather than a “push system. The result of a push system can be large. and then it will be produced very quickly. Elimination of defects is an important part of a JIT system. Since inventories are low. LLC. useless stock of inventory. 137 .  Lower costs due to elimination of waste leading to higher profits. The advantage of a JIT system is reduction in the cost of carrying the inventory. a company is producing something without knowing if it is actually needed or not. work-in-process and finished goods inventories while meeting customer demand in a timely manner with high-quality products at the lowest possible cost.

thus eliminating storage in the production area. This can contribute to traffic congestion and environmental impacts associated with additional fuel use and additional vehicle emissions. As mentioned above in the topic of Lean Manufacturing. The reduced level of inventory carries with it an increased risk of stockout costs and can lead to more frequent trips for parts and material inputs from sister facilities or suppliers. so production of components is pulled to the production line. and inventory flow. if the company is a reseller instead of a manufacturer). Even more importantly. Material handling for setups can be improved by moving the material closer to the machine. scrap and waste. JIT systems typically require less floor space than traditional factories do for equal levels of production because they do not need to store large amounts of inventories. The preparation for the next setup can be done while the machine or process is still running. Kanban Kanban is a Japanese inventory system. The inventory must be of the required quality because there is no extra to use in place of any defective units that are delivered. Furthermore. reducing the need for capital investment and the associated environmental impacts that result from construction material use. Therefore. The core of the kanban concept is that components are delivered to the production line on an “as needed” basis. and construction waste. For personal use only by original purchaser. A kanban can be a card. Kanban are used to control work-in-process (WIP). land use. a supplier that does not deliver direct materials on time or delivers direct materials that do not meet quality standards can cause the company to not be able to meet its own scheduled deliveries. reducing the needed floor space can reduce the need to construct additional production facilities. Reductions in square footage can reduce energy use for heating. by receipt of a card and an empty container. This in turn reduces inventory levels and enables the company to respond quickly to changes in customer demand. and there could be many other things that can be done to reduce setup times. If the products produced have large and/or unpredictable market fluctuations. Because very little inventory is held. In a JIT system. a labeled container.Supply Chain Management CMA Part 1 low in a JIT system. other benefits of a JIT system include greater emphasis on improving quality by eliminating the causes of rework. . Kanban is part of a chain process where orders flow from one process to another. Kanban is an integral part of lean manufacturing and JIT systems. a computer order. 138 © 2017 HOCK international. The reduced setup time also leads to lower manufacturing lead times. The kanban contains information on the exact product or component specifications that are needed for the next process. assuring that only what is needed gets produced. production. or some other device that is used to signal that more products or parts are needed from the previous production process. These are only two suggestions. In this way. Resale prohibited. separating batch setup activities into preparation activities and actual setup activities can reduce setup times. depending on the actual process. kanban contributes to eliminating overproduction. Kanban provides the physical inventory control cues that signal the need to move raw materials from the previous process. air conditioning. Just-in-time production also has costs and shortcomings. In addition to the advantage of lower carrying costs for inventory. the need signaled. A goal of JIT is to reduce setup times because reduced setup times makes production of smaller batches more economical. a JIT system may not be able to reduce or eliminate overproduction and associated waste. and lighting. And JIT implementation is not appropriate for high-mix manufacturing environments. inventory is purchased so that it will be delivered just as needed for production (or just as needed for sales. for example. rather than pushed (as is done in the traditional forecast-oriented system). The word “kanban” means “card” or “sign” or “visual record” in Japanese. resulting in less downtime because the machine needs to be stopped only during the actual setup activities. a company that uses JIT purchasing must choose its suppliers carefully and maintain long-term supplier relationships. the company must have a very close relationship with its suppliers to make certain that the supplier makes frequent deliveries of smaller amounts of inventory. Reusable containers may serve as the kanban. LLC. which often have thousands of products and dozens of work centers.

As mentioned above. fewer kanban will be needed because the parts will almost always be where they are needed when they are needed. and how much to order. The shipping documents are delivered manually to the shipping department. It should be mentioned that kanban can be extended beyond being a lean manufacturing and JIT technique because it can also support industrial reengineering and HR management. As production control is improved. in-factory kanban (used between processes in the factory). MRPII refers to Manufacturing Resource Planning. © 2017 HOCK international. the total number of kanban is minimized. If the organization maintains customer relations management software. though MRP and MRPII are still used widely in manufacturing organizations. MRPII. a salesperson takes an order and submits the order on paper to an order entry clerk. and it does not even include the communication needed with production to make certain the product ordered will be available to ship. MRP and MRPII systems are predecessors of ERP systems. Entering the same information into multiple systems causes duplication of effort and leaves the organization open to more input errors. In this way. The necessary parts in a given step always accompany the kanban to ensure visual control. Different types of kanban include supplier kanban (orders given to outside parts suppliers when parts are needed for assembly lines). if production is being controlled perfectly. Resale prohibited. The above is only a minor example. then the kanban is sent to request the needed parts so that the station can keep operating. Material Requirements Planning (MRP) systems help determine what raw materials to order for production. LLC. the customer service person will be able to discuss the order with knowledge. continuous improvement is facilitated while concurrently re- ducing the overall level of stock in production. only as many parts are withdrawn as the kanban instructs. though. MRP stands for Material Requirements Planning. and ERP stands for Enterprise Resource Planning. For example. MRPII. there will be no need for kanban because the needed parts will arrive where they are needed at just the right time. Enterprise Resource Planning (ERP) takes integration further by including all the systems of the organization. At each step. The major kanban principles are:  Kanban works from upstream to downstream in the production process. starting with the customer’s order. For personal use only by original purchaser. not just the manufacturing systems. This includes producing items only in the sequence in which the kanban are received and producing only the number indicat- ed on the kanban. each step recognizes and corrects the defects that are found before any more can be pro- duced. The customer’s account is updated with the receivable due. and ERP systems are all integrated information systems that have evolved from early database management systems. As areas of needed improvement are ad- dressed.Section D Supply Chain Management However. and production kanban (indicating operating instructions for processes within a line). Manufacturing Resource Planning (MRPII) systems followed MRP and added integration with finance and personnel resources. and ERP MRP. since the customer service person does not have access to the accounting records. 139 . and the shipping department prepares the shipment and ships the order.  Only products that are 100 percent defect-free continue on through the production line. the order information is entered separately into that database. when to order them. so that if the customer calls about the order. ERP systems address the problem in organizations of paper-based tasks that cause information to be entered into systems that do not “talk” to one another. kanban are used when the needed components do not show up on time. Introduction to MRP. helping ensure that only what is ordered is made.  The upstream processes produce only what has been withdrawn. By constantly improving production control and reducing the total number of kanban.  The number of kanban should be decreased over time. If the parts do not arrive where and when needed. who prepares the invoice and shipping documents.

Material Requirements Planning (MRP) Material requirements planning. The demand for them is dependent upon the demand for the finished good. . While MRP is concerned mainly with raw materials for manufacturing. MRP is a “push-through” inventory management system. including functions such as production planning and scheduling. the required cash to pay for the parts can be planned for. In a push-through system. and ERP all provide information for decision-making by means of a centralized database. the MRP software breaks out the finished products to be produced into the required components and determines total quantities to be ordered of each component and when each component should be ordered. The bill of materials gives all the materials. Accurate records of inventory and its costs are necessary. vendor lead times and other parameters that are input into the software. MRP creates the antithesis of the situation often found in old manufacturing organizations where large amounts of cash are tied up in inventory before products can be assembled and sold.  A bill of materials for each finished product. For personal use only by original purchaser.Supply Chain Management CMA Part 1 Enterprise Resource Planning integrates all departments and functions across a company onto a single computer system with a single database so that the information needed by everyone will be available to the people who need it for planning. to determine the components to be purchased and when each should be purchased in order to produce the special order as efficiently and quickly as possible using Just-In-Time (JIT) inventory management techniques. Management accountants also need to estimate setup costs and downtime costs for production runs. producing larger batches and thus incurring larger inventory carrying costs actually saves cost because the number of setups needed is reduced. MRP can be used to reduce cash needed by the organization. components. Resale prohibited. MRP.  The quantities of the materials. used in the production of a finished good. MRPII’s concerns are more extensive. When demand forecasts are made by the sales group. or MRP. and subassemblies required for each finished product. if an unexpected order is received. and other purposes. It is a system for ordering and scheduling of dependent demand inventories. Dependent demand is demand for items that are components. Once the quantities and the timing have been worked out. MRPII integrates information regarding the entire manufacturing process. Although MRP is a push inventory system. MRPII. compo- nents. based upon information about inventory of each component already on hand. Instead. Manufacturing Resource Planning (MRPII) Manufacturing Resource Planning (MRPII) is a successor to Material Requirements Planning. MRP makes it possible to have the needed materials available when they are needed and where they are needed. MRP aims to remedy this through careful planning and management. financial management and forecasting. and product inventories to determine the necessary outputs at each stage of production A challenge in using MRP is the need for management accountants to collect and maintain updated inventory records. is an approach to inventory management that uses computer software to help manage a manufacturing process. When setup cots are high. which in turn improves profitability and ROI. finished goods are manufactured for inventory on the basis of demand forecasts. MRP uses the following information in order to determine what outputs will be necessary at each stage of production and when to place orders for each needed input component:  Demand forecasts for finished goods. LLC. it can also be used in a “demand-pull” situation. or subassemblies. job costing. capacity requirement planning. order fulfillment. 140 © 2017 HOCK international.

Section D Supply Chain Management

order processing, shop floor control, time and attendance, performance measurement, and sales and
operations planning.

An MRPII system is designed to centralize, integrate and process information for effective decision making in
scheduling, design engineering, inventory management and cost control in manufacturing.

If a firm wants to integrate information on its non-manufacturing functions with the information on its
manufacturing functions, it needs an ERP system.

Enterprise Resource Planning (ERP)
Enterprise Resource Planning (ERP) is a successor to Manufacturing Resource Planning. It is usually a suite of
integrated applications that is used to collect, store, manage and interpret data across the organization. Often
the information is available in real-time. The applications share data, facilitating information flow among
business functions.

ERP systems integrate not only production information but also the sales, marketing, customer service and all
accounting functions. ERP systems track all of a firm’s resources (cash, raw materials, and fixed assets, for
example) as well as the status of its commitments (orders, purchase orders, and payroll, for example).

Early ERP systems ran on mainframe computers and could take several years and several million dollars to
implement, so their use was limited to the largest companies. As the systems evolved, vendors created a new
generation of ERP systems targeted to small and mid-sized businesses that were easier to install, easier to
manage, required less implementation time and less startup cost. Many ERP systems are now available in the
cloud, where the software is not purchased and is not installed at the user company but is accessed over the
Internet. Use of cloud-based ERP systems allows smaller and mid-sized businesses to access only what they
need and to reduce their investment in hardware and IT personnel.

Increasingly, ERP systems are being extended outside the organization as well, for example enabling supply
chain management solutions in which vendors can access production schedules and materials inventory levels
so they know when to ship more raw materials. Interconnected ERP systems are known as extended
enterprise solutions. ERP has also been adapted to support e-commerce applications.

Benefits of ERP include

 Reduction in operational costs. Communication is improved across departments, leading to greater
efficiencies in production, planning, and decision-making that can lead to lower production costs,
lower marketing expenses, and other efficiencies.

 Inventory management facilitated. Detailed inventory records are available, simplifying inventory
transactions. Inventories can be managed more effectively to keep them at optimal levels.

 Day-to-day operations are facilitated. All employees can easily gain access to real-time information
that they need to do their jobs. Ready access by managers facilitates their decision-making and con-
trol over the factors of production.

 Resource planning as a part of strategic planning is simplified. Senior management has access to the
information it needs in order to do strategic planning.

Outsourcing
When a company outsources, an external company performs one or more of its internal functions. By
outsourcing certain functions to a specialist, management can free up resources within the company in order
to focus on the primary operations of the company. It may also be cheaper to outsource a function to a
company that specializes in an area than it is to run and support that function internally. The disadvantage of
outsourcing is that the company loses direct control over these functions.

© 2017 HOCK international, LLC. For personal use only by original purchaser. Resale prohibited. 141

Supply Chain Management CMA Part 1

Theory of Constraints (TOC)
Theory of Constraints (TOC) was developed by Eliyahu M. Goldratt in the 1980s as a means of making
decisions at the operational level that will impact a company’s profitability positively. For a company to be
competitive, it needs to be able to respond quickly to customer orders. Theory of Constraints is an important
way for a company to speed up its manufacturing time so it can improve its customer response time and thus
its competitiveness and its profitability.

Manufacturing cycle time, also called manufacturing lead time or throughput time, is usually defined
as the amount of time between the receipt of a customer order and the shipment of the order. However,
different firms may define the beginning of the cycle differently. For some, it begins when a customer places
an order. For others, it can begin when a production batch is scheduled, when the raw materials for the order
are ordered, or when actual production on the order begins.

In addition to the actual production time, manufacturing cycle time includes activities (and non-activities)
such as waiting time (the time before the order is received by the manufacturing department or time spent
waiting for parts for the next process); time spent inspecting products and correcting defects; and time spent
moving the parts, the work-in-process, and the finished goods from one place to another.

Manufacturing cycle efficiency, or MCE, is the ratio of the actual time spent on production to the total
cycle time.

Manufacturing Cycle Efficiency (MCE) = Value-Adding Manufacturing Time
Total Manufacturing Cycle Time

Notice that only actual manufacturing time, time when value is being added to the product, is included in
the numerator. Waiting time, time spent on equipment maintenance and other non-value-adding time is
not included in the numerator. For example, if the actual time spent on manufacturing is 3 days while the
total manufacturing cycle time is 10 days, the MCE is 30%. Companies would like their MCE to be as close
to 1 as possible, because that means very little time is being spent on non-value-adding activities.

Theory of Constraints can be used to decrease a company’s manufacturing cycle time and its costs. If a
company is not using TOC, management might be devoting its time to improving efficiency and speed in all
areas of the manufacturing process equally. But TOC stresses that managers should focus their attention only
on areas that are constraints or bottlenecks.

Constraints are the activities that slow down the product’s total cycle time while areas and people
performing other activities have slack time. If managers spend their time and effort speeding up activities
that are not constraints, they are wasting resources. Unnecessary efficiency just results in the buildup of work
waiting to be done at the constraint, while activities following the constraint do not have enough work to do
because work is held up in the constraint process. If activities that are not constraints are speeded up, total
production speed is not improved despite the extra cost incurred to improve efficiency. Managers’ time and
effort and the associated cost should be spent on speeding up the activities that cause production to slow
down.

Theory of Constraints says that constraint processes are the only areas where improvements in
their performance will bring about a meaningful change in overall profitability. If you want to
improve profitability, you need to identify the constraints and focus on them. Theory of Constraints
focuses on measurements that are linked directly to performance measures such as net profit, return on
investment, and cash flow. It gives managers a method of making decisions on a day-to-day basis that will
truly affect the overall performance of the organization.

As we have already mentioned, throughput time, or manufacturing cycle time, is the time that elapses
between the receipt of a customer order and the shipment of the order. Throughput time is a rate. It is the
rate at which units can be produced and shipped. For example, if it takes 2 days to produce and ship 100
units, then the rate per day is 50 units per day.

142 © 2017 HOCK international, LLC. For personal use only by original purchaser. Resale prohibited.

Section D Supply Chain Management

Throughput contribution margin is the rate at which contribution margin dollars are being earned.
Throughput contribution margin is the revenue earned from the sale of units minus the totally variable costs
only (usually only direct materials) for those units sold during a given period of time. If the sale price for one
unit is $500, the direct materials cost is $300 per unit, and throughput rate per day is 50 units per day, then
the throughput contribution margin per day is $200 × 50 = $10,000. Or, calculated another way, if 50
units can be produced and shipped in one 8-hour day, then it takes 8 hours ÷ 50, or 0.16 of one hour, to
produce and ship one unit. $200 ÷ 0.16 = $1,250 per hour. In an 8-hour day, throughput contribution
margin is $1,250 × 8, or $10,000. Throughput contribution margin is the amount earned for product
produced and shipped during a period such as one hour, one day, or one month, calculated using revenue for
the period minus only the strictly variable costs.

Following are the steps in managing constraint operations through the use of TOC analysis:

1) Identify the constraint. Recognize that the constraint or bottleneck operation determines the
throughput contribution margin of the system as a whole, and identify the constraint by determining
where total required hours exceed available hours. To identify where slack hours exist and where
they are negative because total required hours exceed available hours, analysis of the production
process is prepared. The management accountant works with manufacturing managers and engi-
neers to develop a flow diagram that shows the sequence of processes, the amount of time each
process requires given current demand levels, and the amount of time available in terms of labor
hours and machine hours. The flow diagram enables them to identify the constraint.

2) Determine the most profitable product mix given the constraint. The most profitable product
mix is the combination of products that maximizes total profits. Product profitability is measured us-
ing the throughput contribution margin. The throughput contribution margin is the product price
less materials cost, including the cost of all materials used, all purchased components, and all mate-
rials-handling costs. Direct labor and other manufacturing costs such as overhead are excluded,
because it is assumed they will not change in the short term. The throughput contribution margin of
each product is divided by the number of minutes required for one unit at the constraint to calculate
the throughput contribution margin per minute per unit in the constraint activity for each
product. The product with the highest throughput contribution margin per minute in the constraint
will be the most profitable, even though it may have a lower throughput contribution margin for the
manufacturing process as a whole.

3) Maximize the flow through the constraint. The management accountant looks for ways to
simplify the constraint process, reduce setup time, or reduce other delays due to non-value-adding
activities such as machine breakdowns, in order to speed the flow through the constraint.

4) Add capacity to the constraint. Increase the production capabilities of the constraint by adding
capacity such as additional equipment and/or labor, which is a longer-term measure to consider if it
is possible and profitable to do so.

5) Redesign the manufacturing process for flexibility and fast cycle time. Analyze the system to
see if improvements can be made by redesigning the manufacturing process, introducing new tech-
nology, or revising the product line by eliminating hard-to-manufacture products or by redesigning
products so they can be manufactured more easily. This is the most strategic response to the con-
straint.

© 2017 HOCK international, LLC. For personal use only by original purchaser. Resale prohibited. 143

Supply Chain Management CMA Part 1

TOC Terms
Exploiting the constraint means taking advantage of the existing capacity at the constraint, because that
capacity can be wasted by producing the wrong products or by improper policies and procedures for
scheduling and controlling the constraint. Exploiting the constraint means using it to its best advantage to
produce the product that will be most profitable to sell and by scheduling work so that the constraint is kept
busy all the time.

Elevating the constraint means adding capacity to the constrained activity or otherwise adjusting the
resources to increase the output possible from the constrained activity. Adding capacity means purchasing an
additional machine or using a new technology that makes better use of the existing machine.

Drum-Buffer-Rope
Drum-Buffer-Rope is the production planning methodology portion of Theory of Constraints. It is a tool that
can be used to balance the flow of production through the constraint. It minimizes the buildup of excess
inventory at the constraint, while at the same time keeping it producing at all times.

 Drum: The drum is the process that takes the longest time. It is the constraint. The constraint is
called the drum because it provides the beat that sets the pace for the whole production process. All
production flows must be synchronized to the drum.

 Rope: The rope consists of all of the processes that lead up to the drum, or the constraint. Activities
preceding the drum must be carefully scheduled so that they do not produce more output than can
be processed by the constraint, because this creates excess inventory and its associated costs with-
out increasing throughput contribution margin. But at the same time, the constraint must be kept
working with no down time.

 Buffer: The buffer is a minimum amount of work-in-process inventory (a “buffer” inventory) of jobs
waiting for the constraint that is maintained to make sure the constraint process is kept busy at all
times. Production schedules are planned so that workers in the non-constrained processes will not
produce any more output than can be processed by the drum, the constraint process; but at the
same time, they will produce enough to keep the buffer full.

144 © 2017 HOCK international, LLC. For personal use only by original purchaser. Resale prohibited.

Section D Supply Chain Management

Example: A company manufactures garments. The manufacture of a jacket involves four separate
processes:
1) Cutting the fabric pieces
2) Stitching the fabric pieces together
3) Hemming the sleeves and the bottom of the jacket
4) Finishing the jacket, folding it and packaging it in clear plastic.
The process that takes the most time is the hemming of the sleeves and the bottom of the jacket.

The garment manufacturer sells only to wholesalers, who in turn sell to retailers. The time required for
each process for one jacket and the available time is as follows. The total hours available per month is
calculated by assuming 22 work days per person per month and 7 hours work per person per day.
Minutes Total Hours
Required Number of Available
per unit Employees Per Month
Cutting 18 20 3,080
Stitching 20 23 3,542
Hemming 30 28 4,312
Finishing, folding and packaging 10 11 1,694

The demand per month averages 10,000 jackets per month. The constraint process is the process for
which the demand exceeds the hours available. Here are the total hours required to produce 10,000
jackets per month using the current number of employees and the current equipment. The total hours
required is 10,000 × minutes required per unit ÷ 60.
Difference
Total Total Between
Hours Hours Hrs. Required &
Required Available Hrs. Available
Cutting 3,000 3,080 (80)
Stitching 3,334 3,542 (208)
Hemming 5,000 4,312 688
Finishing, folding and packaging 1,667 1,694 (27)

Since the work the employees is doing is not specialized to their jobs, this shows that some of the
employees currently doing other jobs could be shifted to the hemming process, since they have some extra
time and the hemming process requires more time than is currently available. One employee currently
doing cutting could spend half time doing hemming instead. And 1 employee could be shifted from
stitching to hemming. The company has enough equipment to accommodate those changes. The number
of employees per process will change to 19.5 for Cutting, 22 for Stitching, and 29.5 for Hemming. That
would create the following changes in total hours available and the differences:
Difference
Total Total Between
Hours Hours Hrs. Required &
Required Available Hrs. Available
Cutting 3,000 3,003 (3)
Stitching 3,334 3,388 (54)
Hemming 5,000 4,543 457
Finishing, folding and packaging 1,667 1,694 (27)

The production capability of the whole department is dependent upon the production capability of the
constraint, which is the hemming process. The production line cannot move any faster than its slowest
process. After making these duty reassignments, the company still does not have the capacity to produce
10,000 units per month. With 4,543 hours available, the company can produce only 9,086 jackets per
month (4,543 hours available × 60 minutes per hour ÷ 30 minutes to hem one jacket).

(Continued)

© 2017 HOCK international, LLC. For personal use only by original purchaser. Resale prohibited. 145

For personal use only by original purchaser.500 hours (10. CONSTRAINT BUFFER Small amount of work-in-process Input inventory Cutting Stitching Hemming Finishing ROPE Output DRUM The work in cutting and stitching must be carefully controlled so that just the right amount of work-in- process is in the buffer at any one time so that the hemming process is always busy and always working at its maximum. not allowing too much work to build up in the buffer. the company needs to make sure there is a small work-in-process inventory waiting to be hemmed at all times. The Drum-Buffer-Rope system is one of the ways this can be achieved. In the long term. The company finds it can invest in attachments for the hemming machines that will reduce the time for the hemming from 30 minutes per jacket to 27 minutes per jacket.000 jackets per month. Available Cutting 3.Supply Chain Management CMA Part 1 The long-term answer to the problem is to add capacity to the constraint (elevate the constraint). management determines it will cost less to purchase the attachments for the hemming machines in order to make better use of the 4. 146 © 2017 HOCK international. Required & Required Available Hrs. Now. folding and packaging 1. in the short-term. it will need to either hire more hemming employees and invest in equipment for them to use. if the company wants to meet the full demand.500 4. Resale prohibited.003 (3) Stitching 3. After analyzing the costs of the two alternatives.000 jackets will be 4.694 (27) The company now has the capability of manufacturing 10.388 (54) Hemming 4. or it will need to find some way to increase the speed of the hemming process. .334 3.543 hours available with current employees and equipment. the time required for 10. the challenge is to exploit the constraint by maximizing the flow through the constraint—making sure that the hemming operation has no downtime during which they are waiting for the prior processes to provide them with jackets to hem.543 (43) Finishing. LLC. However. With hemming requiring only 27 minutes per jacket.000 3.667 1. To do that. the hours required for Hemming is decreased and we have: Difference Total Total Between Hours Hours Hrs. while at the same time. without letting the inventory stack up too much in front of the hemming process.000 jackets × 27 minutes to hem one jacket ÷ 60 minutes per hour).

utilities. In TOC. called “super-variable. investments will be minimized. In TOC terms. perhaps hiring an additional employee to work at the constraint operation would increase throughput at the constraint by 2.) All employee costs are considered operating costs. and therefore operating costs. All other costs. operating costs include salaries and wages. All of these operating costs are treated as period costs that are being expensed as incurred. © 2017 HOCK international. non- constrained machines or outsource them.  Process only products that increase throughput contribution margin and do not produce products that will simply remain in finished goods inventory. or fixed costs.) Also for the purpose of using Theory of Constraints. For example. investments equals the sum of costs in direct materials. Inventory costs are limited to costs that are strictly variable. so inventory investment is decreased. and costs of equipment and buildings. the constraint will achieve its maximum performance without interruptions. Some ways that operations at the constraint process can be relieved include:  Eliminate idle time at the constraint operation. When work is properly scheduled.000. indirect materials and other overhead costs. The material is released only as needed without building up unneeded material (inventory) at the non- bottleneck resources. it is a technique that improves speed in manufactur- ing by increasing throughput contribution margin while decreasing investments and decreasing operating costs. It means only that inventory costs for internal TOC analysis purposes are different from inventory costs for financial reporting purposes.” and these are usually only direct materials. are considered operating. rent. • Only strictly variable costs – which are usually only direct materials – are considered inventory costs. This enables the factory to achieve optimal performance. And with TOC there is a lower overall level of inventory. (Note: this does not mean that absorption costing for external financial reporting purposes is done differently when TOC is being used. and they are not inventoried. If the throughput contribution margin (selling price minus direct material cost per unit) is greater than $20 per unit ($40. • Throughput is product produced and shipped. TOC helps reduce throughput time. “operating cost” is defined as the cost of converting the inventory into throughput. Throughput (product produced and shipped) will be maximized. R&D. (Again.000 ÷ 2.  Move products that do not need to be processed on the constraint operation to other. depreciation. Direct labor is not included in the calculation of throughput contribution margin. • Theory of Constraints focuses on short-run maximization of throughput contribution margin by managing operations at the constraint in order to improve the performance of production as a whole. operating costs are equal to all operating costs other than direct materials or any other strictly variable costs incurred to earn throughput contribution margin. this action would increase profits. Thus. and thus it is considered an operating cost. • Theory of Constraints assumes that operating costs are fixed costs because they are difficult to change in the short run. 147 . • Throughput time or manufacturing cycle time is the time that elapses between the receipt of a customer’s order and the shipment of the order. this is not reflected in absorption costing – it is only for TOC management. LLC. Inventory for TOC includes only the direct material costs.000). Resale prohibited. work-in-process and finished goods inventories. whether they are direct labor or indirect labor. Making products that remain in inventory does nothing to increase throughout contribution margin. For personal use only by original purchaser. or cycle time. even direct labor.Section D Supply Chain Management When the Theory of Constraints is applied to production. and operating costs will be minimized. • Throughput contribution margin is revenue minus direct materials cost for a given period of time.000 units per year at an annual cost of $40.

because the constraint does not have any extra time to waste. This is called super-variable costing. The throughput contribution margin will be the throughput contribution margin per unit multiplied by the number of units that can be produced in the given time. For personal use only by original purchaser. The company then focuses its continuous improvement actions on increasing the efficiency and capacity of the new constraint process. unsellable product produced by the constraint operation costs more than just the cost of the materials that are wasted. profits will increase. it can assist in making decisions about product mix. Units in production should be inspected before they are passed on to the constraint operation for processing. The contribution margin is the difference between total revenues and total variable costs. again. . If you are asked on an exam to calculate throughput contribution margin (or throughput contribution or throughput margin – they all mean the same thing) for a period of time. its capacity will eventually increase to the point where it exceeds the capacity of some other process. as referred to in the above discussion of TOC analysis. Theory of Constraints Reports A Theory of Constraints Report conveys throughput contribution margin and selected operating data. Calculating Throughput Contribution Margin The concept of throughput contribution margin as it is used in Theory of Constraints analysis is a variation on the concept of contribution margin.000 per year but it enables the company to produce 500 additional units per year. and no throughput contribution is forgone when it produces product that cannot be sold. in Theory of Constraints analysis. Poor quality is more costly at a constraint operation than at a non-constraint operation. the assumption is made that labor and overheads are fixed costs because they can usually not be changed in the short term. variable overhead. Resale prohibited. and contribution margin per unit is simply the sale price for one unit minus the total variable costs for one unit. and so the other process will become the constraint. and so on. direct labor. If reducing setup time costs an additional $10. you will need to calculate how many units can be produced in that time. The totally variable costs are usually only the direct materials costs. LLC. and variable selling expenses.  Improve the quality of processing at the constrained resource.Supply Chain Management CMA Part 1  Reduce setup time and processing time at the constraint operation. However. By identifying the most profitable products. However. A non-constraint operation has unused ca- pacity. so the cost of the defective production is limited to the wasted materials. So the throughput contribution margin or throughput contribution margin per unit in TOC analysis is the selling price minus only the totally variable costs. The cost of poor quality at a constraint also includes the opportunity cost of lost throughout contribu- tion margin. If these actions are successful in increasing the capacity of the constraint operation. 148 © 2017 HOCK international. everything except for direct materials and any other totally variable cost is considered an operating cost and thus a period cost. if the throughput contribution margin is greater than $20 per unit ($10. As we said earlier. It identifies each product’s throughput contribution margin per hour required for the constraint. The variable costs included in the calculation of the contribution margin include direct materials. Lost time at the constraint is lost throughput contribution margin. So the constraint operation should not waste time processing units it receives from the previous process that are defective. It also identifies the most profitable product(s) and enables monitoring to achieve maximum profitability given existing constraints.000 ÷ 500).

000 jackets per month. Which jacket should the company give priority to in scheduling production? The company should give priority to the product with the higher throughput margin per minute. Resale prohibited. With those 1. let’s say the manufacturer has two different styles of jackets: a down-filled jacket for winter and a light jacket for spring.334 hemming hours for the 8. the company can manufac- ture 2. The company has 4.00 Constraint time for hemming 30. The spring jacket sells for $75.00 Throughput contribution margin $ 50. That will leave 1.543 hours available – 3. whereas demand for the spring jacket is 8. The winter jacket sells for $125.00 $45. © 2017 HOCK international.209 hours.00 25.543 hours available for hemming. LLC.67 $ 1.00 $75. Demand for the winter jacket is 6.000 spring jackets (8. That will maximize the company’s total contribution margin.000 × 25 minutes per jacket ÷ 60 minutes per hour).209 hemming hours available for the winter jackets (4.00 Throughput margin per minute $ 1.334 hours used for the spring jackets).80 The company should manufacture the 8. and the direct materials cost is $30.418 winter jackets (1. Winter Jacket Spring Jacket Price $125. because the spring jacket’s throughput margin per minute in the constrained resource is higher. The hemming process takes 30 minutes for the winter jacket and 25 minutes for the spring jacket.00 Direct Materials cost 75. For personal use only by original purchaser. For both jackets. and the direct materials cost is $75.00 30. calculated using the time required in the constraint process.000 spring jackets needed before manufacturing any winter jackets.000 jackets per month. 149 .209 hours × 60 minutes per hour ÷ 30 minutes per jacket). the constraint is the hemming operation. That will mean using 3.Section D Supply Chain Management Example: Using the garment manufacturer again.

000 If we had bid $700.000.000.100.000.000.000 700.000 If we had calculated a throughput contribution margin using a price of $7 ($7 − $6 direct materials = throughput contribution margin of $1) in preparing our bid instead. We have excess capacity (unused direct labor and equipment).000 units. we must get the price down as low as possible.000 Direct labor $3 × 1.000.000. We calculate our costs per unit as follows: Direct materials $ 6 Direct labor 3 Fixed Overhead 2 Total $11 We determine that if we bid $900. We are bidding against several other companies. Our company has an opportunity to get a special order for 100. Next time. let’s say our operating income looks like this without this special order. we would have gotten the job. We would not have covered our direct labor cost.000 Net operating income $ 1. We would have recovered our materials costs and net operating income would have been $100.000 3. To our amazement. but then. we will use the throughput contribution margin in preparing our bid.000.000.000 Fixed overhead $2 × 1.000 $12.000 Total revenue $12.600. we had no plans to lay them off.100.000 Variable costs: Direct materials $6 × 1.700.000 units: Sales revenue $12 × 1.000 Variable costs: Direct materials $6 × 1.100. Likewise. we would not need to hire any additional employees to if we accept this order.000. so we know in order to get this order.000 Fixed overhead $2 × 1. If we had bid $700.000 higher ($1 per unit × 100.000 6.000 Contribution margin $ 3.000 and gotten the special order. So in this situation.000 3. and we would not need to cut back on production of other orders for any reason.000.000 Contribution margin $ 3.000 Special order revenue $7 × 100. Because we have unused capacity. Resale prohibited.000. our direct labor cost is like a fixed cost because it will be the same whether we have the special order or whether we do not have the special order. however.000. assuming a selling price of $12 and a current volume of 1.000 units). we lose the bid to a company that bid $750. and we would really like to have this order. operating income would have been as follows: Sales revenue without special order $12 × 1. we will just cover our variable costs (direct materials and direct labor).Supply Chain Management CMA Part 1 Example: Here is another use for the throughput contribution margin. 150 © 2017 HOCK international. we would have gotten the job and would have made $100. So we bid $900.000.000 6. To illustrate this incremental analysis.000. For personal use only by original purchaser. Even though we did not have work for them without the special order.000.000. or $7 per unit.000.000 $12. . the fixed manufacturing costs are no different whether we have the order or not. LLC.000 2.000 ($9 per unit).000.000 more in net operating income than we have without the job. we were paying those people anyway.000 Net operating income $ 1.000 2.000 Direct labor $3 × 1.000.000.

52 Question 56: What is the throughput contribution per day? a) $36.000.5 hrs.75 b) $80.000 units 104.412.953 to available DL hrs. 151 .000 $250. 100 hrs.412.000 b) $19. 0.476 $380.25 hrs. LLC.000 c) $6. 200 hrs. For personal use only by original purchaser.Section D Supply Chain Management The following information is for the next four questions: EEK Industries produces thingamajigs.412. exp.00 c) $30.) 0. (4 units/hr.000 units EEK has a policy of not laying off idle workers but instead finds other work for them to do such as maintenance on equipment.500 (Continued) © 2017 HOCK international. (2 units/hr.59 d) $29. (2 units/hr. The processes. The thingamajigs sell for $200 per unit.000 units 104.) Daily capacity in units based on DL hrs.) 0.000 units Annual production & sales 104.000 Question 57: What are the annual operating costs? a) $3. Question 55: What is the throughput contribution per unit according to the theory of constraints? a) $48.500 b) $1. (allocated according $428. available 450 units 400 units 400 units Annual capacity (260 working days per year) 117.) Direct labor hours available per day 225 hrs. The product goes through three processes.5 hrs. Resale prohibited.571 $190. The company can sell all it can produce.500 c) $12.236 d) $32.000 units 104.000 $750.500 d) $5.000.000 units 104. costs and volumes are as follows: Molding Heat Transfer Trimming Direct labor required per unit @ $25/hr.000 Fixed selling and admin. Direct materials $100 per unit $20 per unit $0 per unit Annual fixed manu- facturing overhead $1.

restaurants and offices throughout the greater New York City metropolitan area. such as mixing its own potting soil for the plants and maintaining payroll accounting. d) By reassigning an employee for 5 hours per day from Molding to Heat Transfer and reassigning an employee for 5 hours per day from Molding to Trimming. or ideal capacity – assumes the company will produce at its absolutely most efficient level at all times. A company does not need to use the same denominator level capacity for management decisions as it uses to set standards and allocate overhead for its external financial statements. Earlier in this section under the topic of allocation of overhead cost to production.or cost-effective for Urban Blooms. the organization produced every aspect of its product on site and handled all business functions from its facility. including horticulturalists. called denominator level capacity. the owners found it increasingly difficult to keep up with the complexities and demands brought about by the company’s continuing growth. The only exception was importing expensive. are used for various purposes. c) By reassigning employees for 10 hours per day from Molding to Heat Transfer and reassigning an employee for 5 hours per day from Molding to Trimming. For personal use only by original purchaser. particularly decisions about pricing. After five years in business. and product mix. Urban Blooms contacted Hampshire Farms to create a special potting soil mix for their plants. 2) Practical capacity – the most that a company can reasonably expect to produce in a year’s time. in either the greenhouses. The capacity level used in making decisions should meet the need for the purpose for which it will be used. and hired Lindeman Associates to handle the company’s payroll accounting requirements. d) Lean production. we discussed production activity levels used in developing standards and the budget. business managers and sales staff. b) Activity-based costing (ABC). Resale prohibited. This is the theoretical level reduced by allowances for idle time and downtime. 152 © 2017 HOCK international. . How could EEK better assign its existing workers to increase its net income? a) By reassigning an employee for 5 hours per day from Molding to Heat Transfer. LLC. However. with no breaks and no downtime. This process is referred to as: a) Materials resource planning (MRP). bidding. c) Outsourcing. Recall that the various choices of capacity levels are: 1) Theoretical. large containers from Mexico. production/design workers. It became apparent that there were several areas that were not time. We now need to talk about them in the context of management decisions. Urban Blooms had become very profitable and increased its staff from 10 to 200 employees. (HOCK) Capacity Level and Management Decisions Estimates about plant production capacity.Supply Chain Management CMA Part 1 Question 58: The Heat Transfer and Trimming processes are very labor-intensive. When first established. b) By reassigning an employee for 5 hours per day from Molding to Heat Transfer and reassigning employees for 10 hours per day from Molding to Trimming. but not for any possi- ble decreases in sales demand. production areas or office. (HOCK) Question 59: Urban Blooms is a company that grows flowering plants and sells them in attractively designed container arrangements to upscale hotels.

Section D Supply Chain Management 3) Master budget capacity – the amount of output actually expected during the budget period based on expected demand. and it can put a company out of business. not all of the capacity supplied at $75 per unit will be needed or used that year. It may be that the company’s unneeded capacity can be rented or sold. For personal use only by original purchaser.000 units per year. LLC. and the company has unused capacity cost of $187.000 units. The “real” fixed cost per unit manufactured is still $75 per unit. Customers cannot be expected to absorb the unused capacity cost by paying higher prices that the company charges per unit in order to cover the higher fixed cost it is allocating to each unit produced because production is below the expected level. not to pass it along to them. practical capacity is the best denominator level to use in pricing and other management decisions. If the company does not use all of the capacity it has available. It is the theoretical capacity level reduced by allowances for unavoidable interruptions such as shutdowns for holidays or scheduled maintenance.500 for the units not produced ($75 × [15.500 units. Or. © 2017 HOCK international. In fact.000 ÷ 12. Since the capacity acquired will be the capacity needed for 15.000 units in a given year but instead produces only 12. The fixed cost per unit produced based on actual production would be $90 per unit ($1. though not decreased for any expected decrease in sales demand. management might be able to make use of that unused capacity by developing a new product or by making arrangements to produce a product for another company that is outsourcing some of its manufacturing.000 per year. If the company does not need all of its capacity. Since the use of practical capacity excludes the cost of the unused capacity from the per unit fixed cost. then management needs to determine how much it will cost per year to acquire the capacity to make those 15. the fixed cost per unit is $75.000 units per year is $1. Resale prohibited. They will take their business elsewhere. Recall that practical capacity is the absolute most that the company can reasonably expect to produce in a year’s time using the capacity it has. management should make adjustments. That will result in even lower production and even greater fixed cost per unit.500]) that it needs to absorb as an expense. Highlighting the cost of the unused capacity enables management to make strategic decisions for its use. If the company needs to manufacture 15. the capacity and its cost are fixed. 4) Normal capacity – the level of annual activity that will be achieved in the long run that will satisfy average customer demand over a period of 2-3 years. that decision should really be made before any decisions are made about how much plant capacity to provide. Therefore.125. even higher prices. If the cost to acquire and maintain the capacity to make 15. Use of practical capacity as the denominator level for pricing and bidding decisions best expresses what the true cost per unit of supplying the capacity should be. In the short run.125.000 units. This is the dreaded downward demand spiral.000 units. then at a production level of 15. but in reality. However. if the company does not produce 15.000 units is the company’s practical capacity (theoretical capacity is not attainable). The company will be paying for unused capacity. Pricing decisions and bidding decisions should be made using the $75 per unit fixed cost that results from using practical capacity to calculate the fixed cost per unit.500 units). 153 . the fixed cost per unit should not change just because the number of units manufactured changes. the fixed costs of that capacity do not decrease the way variable costs do. The level of plant capacity to use in decision-making is an important strategic decision that needs to be made by management. Customers expect a company to manage its unused capacity or else to bear the cost of it itself. and even lower sales. it gives management a more accurate idea of the resources that are needed in order to produce one unit of product and thus the resources needed to produce the volume the company is actually producing. 15. regardless of whether that volume is being produced or not. regardless of the company’s usage of its available capacity.000 – 12. Customers will not absorb it.

For personal use only by original purchaser. Or. meaning that more manufacturing overhead was charged to the products than was incurred by the company. no adjustment is made to inventories as part of the closing entries. Note: The pro-ration of under. more manufacturing overhead will be allocated to the products throughout the period than it will be if theoretical or practical capacity is used. On the other hand. However. ending finished goods inventory..or over-applied overhead should be done on the basis of the overhead allocated to production during the current period only. If variances are closed out 100% to cost of goods sold.. The reason for this is that when master budget or normal capacity is used. the variances may be 100% closed out to cost of goods sold.Supply Chain Management CMA Part 1 Capacity Level and its Effect on Financial Statements The company will have an under-application of manufacturing overhead any time the actual overhead incurred is greater than the amount of manufacturing overhead applied to production (the level of production achieved).  If a variance is closed out 100% to cost of goods sold. more manufacturing overhead will be included in the finished goods and work-in-process inventories on the balance sheet at the end of the period than would be the case with usage of the other denominator levels. if variances caused by differences between the actual manufacturing overhead incurred and the overhead applied during the period are pro-rated among finished goods inventory. work in process inventory and cost of goods sold on the basis of the amount of overhead allocated during the current period to the units in each. At the end of the accounting period. reported net income will be the same regardless of what activity level was used to calculate the fixed overhead application rate. That is the reason why net income will be higher when master budget or normal capacity is used and 100% of the variances are closed out to COGS. . reported net income and inventory balances will vary depending upon the activity level that was used to calculate the overhead application rate. the use of master budget capacity or normal capacity will lead to higher net income than if theoretical or practical capacity is used.  However. The combination of the amount allocated to production and the pro-ration of the variance will cause inventories and cost of goods sold expense to be equal to the actual rate under all activity levels.e. the denominator level used will be lower than if theoretical or practical capacity is used. That means the resulting application rate will be the higher. LLC. Since inventories are higher. Information on the amount of overhead allocated to production during the current year should be available in the accounting system. 154 © 2017 HOCK international. This will be true whether actual overhead incurred is greater than overhead applied (i. Therefore. To explain: When a variance is closed out 100% to cost of goods sold. the manufacturing overhead will be over-applied. not on the basis of the balances in the inventories and cost of goods sold accounts at year end. This will be demonstrated with an example. variances that result from differences between the actual overhead incurred and the overhead applied must be resolved as part of the closing activities. overhead is under-applied) or whether overhead incurred is less than overhead applied (i. if a variance is pro-rated between inventories and cost of goods sold according to the amount of that type of overhead allocated to the current period’s production for each. if the amount of manufacturing overhead applied is greater than the amount actually incurred. So. the choice of the denominator level for allocating manufacturing costs during the period will have no effect on the end-of-period financial statements. and cost of goods sold for the period according to the amount of overhead included in each that was allocated to the current period’s production. overhead is over-applied). This means that the manufacturing overhead charged to the products was actually less than the actual incurred manufacturing overhead. So inventories under master budget or normal capacity will remain higher than under the other methods.e. Resale prohibited. These variances may be prorated among ending work-in-process inventory. cost of goods sold will be lower. A third approach (though not often used) is to restate all amounts using actual cost allocation rates rather than the budgeted cost application rates.

the company expects to produce 36.25 × 35. a different amount of fixed manufacturing overhead would have been allocated to the products. The year is now complete.000 units). Resale prohibited.  Using theoretical capacity. Allocation of Fixed Manufacturing Overhead Under the Traditional Method Now let’s move one year into the future. with production always between 32.000 bookshelves. Comprehensive Example In this example.25 per unit ($250. The allocation is made by multiplying the actual number of units produced by the predetermined rate per unit. The CFO knows to do this. RedHawks produced 38. (Given the fact that we have no information about any other part of the process. RedHawks actually produced 35. If a variance is charged to cost of goods sold only.Section D Supply Chain Management After the variances have been resolved and closed out for the period.000 units). from the topic of Overhead Allocation: RedHawks Co. produces bookshelves for shipment to distributors.438 ($6.000 ÷ 36. it would have allocated $262. The CFO of RedHawks is trying to determine how much it will cost to produce each bookshelf.500 and 35. 155 .35 × 35. For next year. In a perfect situation. the allocation rate will be $6. During the current year. Finally. the fixed manufacturing overhead must be included in each of the units. For personal use only by original purchaser. LLC.000 bookshelves.35 ($250.750 units during the year. this is not true. the allocation rate will be $6.94 × 35. Calculating the Predetermined Rate If RedHawks uses theoretical capacity. Management thinks that this was attributable to a performance bonus that was in place for management this year. If the master budget capacity is used in calculating the predetermined rate. RedHawks produced an average of 34.500. RedHawks has the capacity to produce 40. The fixed manufacturing overheads of RedHawks for the coming year are expected to be $250. If the fixed manufacturing overhead allocation rate is determined using the current year’s performance as the practical capacity. net income and inventory balances will be same as if the actual incurred overhead had been allocated to the year’s production.000 units).105 ($6. the allocation rate would be $7.000  34. it would have allocated $248.235 ($6.750 units). the allocation rate for next year will be $6.763 ($7.  Using master budget capacity. but will not be given next year.750 units).58 per unit ($250.750 units) to the units produced.94 per unit ($250.000 units). Under all of the capacity levels. fixed overhead must be allocated per unit. Remember this example of RedHawks Co.  Using practical capacity. if they use what had been the normal capacity prior to the current year.000 bookshelves. But note that is will be true only when a variance is pro-rated among inventories and cost of goods sold. © 2017 HOCK international. it would have allocated $235. final net income and inventory balances will be the same no matter which capacity level was used to determine the overhead allocation rate during the period.000.750 units). RedHawks would have allocated $223. we will construct four income statements showing the net income under each of the four capacity levels when the variances are closed out to cost of goods sold and when they are prorated between inventories and cost of goods sold. which was the most in company history.000 book- shelves. For the 7 years prior to the current year.000  38.  Using normal capacity.58 × 35.000  40.) Under each of the four levels of capacity.

so the only Inventory account is Finished Goods Inventory. .000.  Normal capacity is 34.000 units.  Practical capacity is 38.750 units.  Ending work-in-process inventory is zero.  Variable costs. are $80 per unit.  Actual fixed overhead incurred is $255.  The price of each bookshelf unit is $125.  Master budget capacity is 36.  Beginning Inventories are zero. so we can do the pro-ration of the variance on the basis of the ending balances in inventories.  Sales are 35. both planned and actually incurred.Supply Chain Management CMA Part 1 Now.000 units. 156 © 2017 HOCK international. For personal use only by original purchaser.000 units.000.  Theoretical capacity is 40.000 units. let’s carry that same example further and show the effect of the use of each capacity level on fixed overhead in the financial statements.000 units.  Planned fixed overhead is $250. Resale prohibited.  Actual production is 35. LLC.

765 $ 6.000 $4.000 FOH Application Rate $6.895 $ (7. the fixed overhead is over-applied.332.000.750 G & A and Selling Costs 1.94/unit $7. Using Normal capacity.000 Fixed Overhead Applied 223. Practical.000 38.800. 157 . Master Budget and Normal capacity levels are used to determine the fixed overhead application rate: Preliminary income statements under each capacity (before variances are resolved): Master Theoretical Practical Budget Normal Sales: 35.750 35.Section D Supply Chain Management Predetermined overhead rates under each of the capacities: Master Theoretical Practical Budget Normal Planned Fixed OH $250.800. Here are the income statements for RedHawks Co.000 Preliminary Net Operating Income $ 356.100 $ 317.750 units under each capacity: Master Theoretical Practical Budget Normal FOH Application Rate (above) $6.000 1.94/unit $7.750 Actual FOH Incurred $255.35/unit Total units produced 35.000 @ $80 2.105 262. LLC.700 $1.763) Notice that with all capacity levels except for Normal.000 $255.018.58/unit $6.562 $ 19.000 $250.800.000 36.344.000 1.000.800.000.763 FOH Variances $ 31.250 $ 344.375.900 $3.25/unit $6.057.300 $3.750 $3.250 Total Preliminary COGS $3. Resale prohibited.317.030. For personal use only by original purchaser.000 $255.000 $250.042. however.356.300 242.250 Preliminary Gross Profit $1.000 Total units planned 40.000 34.000 1.000 Variable Cost: 35.000.000 2.235 248.000 FOH applied to sold units: 35.000 $255.000 2.000 $250.750 35.58/unit $6.750 230.100 $1.375.750 35.700 $ 332.000 $4.250 $1.900 257. the fixed overhead is under-applied.000 2. when Theoretical.25/unit $6.750 © 2017 HOCK international.375.35/unit Amount of fixed overhead applied and variances for production of 35.000 $4.000 units @ $125 $4.375.438 235.000 @ FOH application rate 218.

765 6.375.765 $ 6.000 1.000 $255.000 2.487 Final Gross Profit $1.795 $3.250 In Inventory: 750 × FOH Application Rate 4.800.205 $1.324. Calculation of Fixed Overhead Variances: Master Theoretical Practical Budget Normal Actual FOH Costs Incurred $255.58/unit $6.000 Cost of Goods Sold: Variable COGS: 35.Supply Chain Management CMA Part 1 Before the variances are resolved.000 units @ $125 $4.049.000 2.000 $4.000 $4.205 $325.050.235 $248.94/unit $7.000 2.763 FOH Under (Over) Applied $ 31. net operating income is highest under Theoretical capacity and lowest under Normal capacity.000 Final Net Operating Income $ 324.562 19.562 $ 19.000 $255.750 $230.000 × FOH application rate 218.800.935 $ 325.935 5.000 FOH applied during period to sold units: 35.763) Final Net Operating Income if the fixed overhead variance is closed out 100% to COGS: Master Theoretical Practical Budget Normal Sales: 35. .000.312 $3.375.895 $ (7.35/unit Applied Fixed Overhead: In COGS: 35.688 4.513 Note that the lowest final net operating income is reported when Theoretical capacity is used.688 $1. It is governed by the size of each capacity level.000.513 G & A and Selling Costs 1.000 $255.000.513 Total Applied Fixed OH $223. For personal use only by original purchaser.000 @ $80 2.25/unit $6.325.300 242.250 FOH Variance closed out to COGS 31.900 257.000 $4. 158 © 2017 HOCK international.000 1. This will not be universally true.205 5.935 $1.065 $3.895 (7.750 230. However.688 $ 324.800.325.000 × FOH Application Rate $218.375.900 $257.438 $235. LLC.375.000 1.000 FOH Application Rate $6.105 $262.000.049.324.800. and the highest is reported when Normal capacity is used. because that affects the amount of overhead applied to each unit produced. in general. Resale prohibited.050.300 $242.763) Total Final COGS $3. net operating income will be higher under Theoretical and Practical capacities and lower under Master Budget and Normal capacities.

000 2.000 FOH applied to sold units: 35.800.650 Gross Profit $1.235 [6.Section D Supply Chain Management Final Net Operating Income if the fixed overhead variance is pro-rated between Inventory and COGS: Master Theoretical Practical Budget Normal Sales: 35.763 Prorated to Inventory: [31.325.000 units @ $80 2.750 $ (7.763 Variance ÷ Total FOH × 4.438 [19. For personal use only by original purchaser.763) ÷ 262.105 [(7.235 $248.765 $ 6.000. Resale prohibited.000.049.763) ÷ 262.688] × 4.800.000.900 $ 19.205] × 5.438 [19.562 $19.325. 159 .235 [6.000 1.900 19.375.800.763) © 2017 HOCK international.375.000 1.000.350 $ 325.750 230.105 $262.765 $ 6.350 G & A and Selling Costs 1.763 Variance ÷ Total FOH × 218.325.562 $19.895 ÷ 248.049.049.438 $235.600) Reconciliation: Total Variance Prorated $ 31.325.513] Applied × FOH Applied to Inventory $ 662 $ 415 $ 145 $ (163) Prorated to COGS: [31.750 (7.300] × 242.763) Total FOH Applied $223.000 Cost of Goods Sold: Variable COGS: 35.800.350 $1.350 $ 325.650 $3.000 $ 4.765 ÷ 235.000 2.935] × 5.300 242.000 units @ $125 $ 4.650 $3.650 $3.250 FOH variance pro-rated to COGS (see below for calculations) $ 30.000 $ 4.105 [(7.900 257.000 1.350 $1.600) Total COGS $3.562 ÷ 223.000 Final Net Operating Income $ 325.000 2.350 $ 325.765 ÷ 235.895 $ (7.350 $ 6.000 $ 4. LLC.350 Calculation of variance disposition when prorated between Inventory and COGS (see “Total Fixed Manufacturing Costs of Current Year’s Production in Cost of Goods Sold and in Inventory” for fixed overhead applied to Inventory and COGS and Total Fixed Overhead Applied): Master Theoretical Practical Budget Normal Variance to be prorated $31.049.000 @ FOH application rate 218.375.895 ÷ 248.375.900] × 257.350 6.750] × 230.350 $1.895 $ (7.250] Applied × FOH Applied to COGS 30.562 ÷ 223.

Resale prohibited. but they are exactly the same under all four capacities. as well. its choice of denominator level for standards and overhead allocation will make a difference in the net income it will report. Net operating income under all capacity levels will be the same as if the actual rate had been used. That is because in this example. Inventory balances have not been shown in this example. distortions result. LLC. So. In this example. However. 160 © 2017 HOCK international. net operating income is exactly the same under all four capacities. For personal use only by original purchaser. if the company closes out any of its variances at the end of the period to cost of goods sold only. When a firm prorates its overhead variances between inventories and cost of goods sold.Supply Chain Management CMA Part 1 Note that when the variances are prorated between inventory and cost of goods sold on the basis of the amount of overhead applied to each during the period. when the variances are closed out 100% to cost of goods sold. the fixed overhead application rate is lowest under Theoretical capacity and highest under Normal capacity. That is because prorating the variances corrects for the differences in the application rates used for each capacity. net operating income is highest under Normal capacity and lowest under Theoretical capacity. it makes no difference what capacity level the firm chooses to use to calculate the predetermined application rate for manufacturing overhead. Because the variances are 100% closed out to cost of goods sold only. Inventory would also have been highest under Normal capacity and lowest under Theoretical capacity. no correction to Inventory balances takes place. . If we had shown Inventory balances.

It is also activities that result in higher quality or lowered costs of a product or service. Resale prohibited. 161 . Competitive advantage makes the difference between a company that succeeds and a company that fails. quality. Note: A company’s distinctive competencies are the things that it does better than the competition. LLC. a leading authority on competitive advantage from Harvard Business School. Remember the four things that result from a company’s distinctive competencies and that give the company competitive advantage: • Superior efficiency • Superior quality • Superior innovation • Superior customer responsiveness © 2017 HOCK international. Competitive advantage leads to increased profitability. A company that has competitive advantage will be more profitable than the companies it competes with for customers. Competitive Advantage Competitive advantage is an advantage that a company has over its competitors that it gains by offering consumers greater value than they can get from its competitors. For personal use only by original purchaser. innovation and customer responsive- ness that result from them. The Value Chain and Competitive Advantage Michael Porter. The greater value may be in lower prices for the same product or service. the price that it charges for its products. and the costs of creating those products.Section D Business Process Improvement Business Process Improvement A business process is a related group of activities encompassing several functions that produces a specific product or service of value to a customer or customers. or it may be offering greater benefits at the same or even at a lower price than its competitors charge. Competitive Increased Advantage Profits In order to have competitive advantage. introduced the concept of the value chain in his 1985 book. Competitive Advantage. a company must have or create two basic things: 1) Distinctive competencies and the superior efficiency. the greater its competitive advantage will be. and greater profitability leads to increased competitive advantage. The higher its profits are in comparison to its competitors. 2) The profitability that is derived from the value customers place on its products. or it may be in offering greater benefits and service than its competitors do. thereby justifying higher prices.

It is the chronological sequence of these activities that adds value to the customer. direct labor and factory overhead (inventoriable costs). Development uses those research findings in the planning process to improve these products. All of an organization’s functions play a role in lowering the cost structure and increasing the perceived value of products and services through differentiation. processes or services. as well as support activities as shown below.  Production is the acquisition of raw materials. and Customer Service. value is created when people use inputs of time. . ser- vices or processes. or delivery of products or services to customers. marketing and delivery of the company’s product or service and support and service after the sale. sometimes supported by services such as fitting rooms or personal shopper advice. Production. In a service industry. the focus will be on marketing. The value that is created and captured by a company is called the profit margin: Value Created and Captured – Cost of Creating that Value = Profit Margin Anything that increases the value to the customer or decreases the cost of creating that value adds to the profit margin. Distribution. The analysis should take place at a relatively detailed level of operations. coordination and assembly required to produce a product or deliver a service. The value chain describes the company’s chain of activities for transforming inputs into the outputs that customers will value.  Marketing and sales includes advertising. creation. sales and customer service rather than on manufacturing and raw materials.Business Process Improvement CMA Part 1 The Value Chain Manufacturing companies create value for customers by transforming raw materials into something of value to customers. Some examples are given below in the topic Value Chain Analysis. The creation of value involves functions from R&D through production to marketing and sales. All of these activities contain opportunities to increase the value to the customer or to decrease costs without decreasing the value to the customer by reducing non-value-adding activities. Marketing and Sales. In service businesses.  Research is the search for knowledge that can be used to create new or improved products. For personal use only by original purchaser. Resale prohibited. is also a part of marketing. at the level of processes that are just large enough to be managed as separate business activities.  Customer service includes customer support and warranty services after a sale. promotion and sales activities. LLC. which the company intends to sell or use internally. knowledge. Primary activities are Research & Development. and includes all the activities that play supporting roles. 162 © 2017 HOCK international. Primary Value Chain Activities The primary value chain activities involve design. The actual activities in a company’s value chain will depend on the type of business the company is in. and on to customer service. The costs of production include direct materials. Design is the detailed planning and engineering for these efforts. This process of transformation includes all of the primary activities (business functions) that add value to the product or service. Retailers create value by providing a range of products to customers in a way that is convenient. equipment and systems to create services of value to their customers.

 Information systems are the electronic systems for maintaining records of inventory. and the more they will be likely to keep on buying. 163 . the more the people who are its customers will be willing to pay for the product and service. the organization’s control systems. LLC.  Infrastructure refers to the company’s support systems that enable it to maintain its day-to-day activities. For example. For personal use only by original purchaser. Infrastructure includes functions such as accounting. “Procurement” includes finding vendors and negotiating the best prices. An effective human resources function leads to greater employee productivity. The infrastructure also includes the organizational structure. administrative. and general management. motivated and compensated. Efficiency in the materials management can significantly lower costs. a retailer can eliminate the need to carry large inventories of goods. thus creating value.Section D Business Process Improvement Support Value Chain Activities The support activities provide inputs that make it possible for the primary activities to take place. which increases value to the customer. For example. The human resources func- tion also ensures that the people are properly trained. top management can shape the company’s in- frastructure and thus the performance of all the other value creation activities that go on within the company. Materials management controls procurement as well as move- ment of the procured materials through production and distribution. Primary Activities R&D Product Production Marketing Customer INPUTS Design and Sales Service OUTPUTS Infrastructure Information Materials Human Systems Management Resources Support Activities The more value a company creates.  Materials management is logistics. Resale prohibited. © 2017 HOCK international. sales. A competent staff performs excellent customer service. Through strong leadership. and customer service. legal. Lower inventories lead to lower inventory costs and greater value creation.  The human resources function aids the organization in obtaining and keeping the right mix of skilled people needed to perform its value creation activities effectively. information systems can add value to the customer by tracking inventory and sales so that the company can provide the proper mix of goods to customers while eliminating items that do not sell well. The logistics function manages the movement of physical materials through the value chain. prices. Staying current with technological advances and maintaining technical systems excellence are other sources of value creation. which lowers costs. by controlling the flow of goods from suppliers into its stores and ultimately to the consumer. and its culture.

Increased utility for customers because of excel- lent customer service can also enable the company to charge more for its products. In value chain financial statements. For example:  R&D can add value to established products or services by finding ways to improve them.  Production’s function is to acquire the necessary raw materials and assemble them into finished goods. The goal of value chain analysis is to provide maximum value to the customer for the minimum possible cost. and 3) Develop a competitive advantage by adding value to the customer or reducing the costs of the activity. For internal decision-making to achieve the goal of providing maximum value at minimum cost. The main concept in this type of value chain analysis is that each firm occupies a selected part or parts of the entire value chain. thus creating superior value for them. Which part or parts of the value chain to occupy is determined by comparative advantage of the individual firm. customer service) would be inventoriable costs in value chain financial statements. manufacturing the product. the organization can maximize the value by increasing the related benefits or reducing (even eliminating) non-value-adding activities. These activities depend upon the industry and what the company does (manufacturing. high quality products can be manufactured while costs are low- ered. which may in- crease the utility that customers attribute to the product or service and enable the company to charge a higher price. marketing it and providing customer service after the sale. marketing and sales. They will be whatever activi- ties this firm and firms in its industry perform in the processes of designing a product or service. The resulting increase in value to the customer and/or decrease in production costs will make the company more profitable and competitive. in addi- tion to developing new ones.  Customer service after the sale adds value by delighting customers with the responsive service received. Marketing can also discover what customers want and need through mar- keting research and communicate that to the R&D group so the R&D group can design products that match the customers’ needs. service). Resale prohibited. leading to higher profits. For personal use only by original purchaser. Value chain financial statements do not conform to any Generally Accepted Accounting Principles. By doing this efficiently. Steps in Value Chain Analysis There are three steps in value chain analysis: 1) Identify the activities that add value to the finished product. value chain financial statements may be utilized.Business Process Improvement CMA Part 1 Value Chain Analysis Value chain analysis can help an organization gain competitive advantage by identifying the ways in which the organization creates value for its customers.  Marketing adds value by informing customers about the products or services. so their use is limited to internal decision- making. Once those areas are identified. 2) Identify the cost driver or cost drivers for each activity. or where the firm can best provide 164 © 2017 HOCK international. product design. . LLC. all the costs for primary activities are considered product costs that are allocated to products and inventoried whereas all the costs for support activities are considered period costs that are expensed as incurred. Value chain financial statements are significantly different from conventional financial statements because many costs that are period costs in conventional financial statements (research and development. resale. Value chain analysis identifies the steps or activities that do and do not increase the value to the customers. Value chain analysis can also be used to determine what place a firm should occupy in a complete value chain that consists of multiple businesses. The firm should analyze each step in its operations carefully to determine how each activity contributes to the company’s profits and its competitiveness.

production. The challenge to a business is to make its processes work effectively and efficiently. marketing and sales. outputs. and operations that take place during each phase of the process. labor. energy. Any process has inputs and it has outputs. Though manufacturing is a process. and other firms in the industry. materials management. A process analysis is a step-by-step breakdown of the phases of the process that conveys the inputs. A process analysis is used to improve understanding of how the process operates. (HOCK) Question 61: An outside consultant has been hired by a manufacturing firm to evaluate each of the firm’s major products beginning with the design of the products and continuing through the manufacture. sale and service. Each of these manufactur- ers. 165 . production. labor and capital. threats) analysis. The output of a process may be a manufac- tured product. c) SWOT (strengths. In classic economics terms. Some firms manufacture parts that they sell to other firms. Then those products may be sold to a wholesaler. marketing and sales. The consultant is to identify where customer value can be increased. It is also activities that result in higher quality or lowered costs of a product or service. where costs can be reduced. The process transforms the inputs into outputs that have value to the customer. settling a claim is a business process. For an insurance company. human resources. b) Customer service. and to provide a better understanding of the linkages with customers. who sells them to a retailer. and capital equipment. in order to accomplish the most possible with the least waste.Section D Business Process Improvement value at the lowest possible cost. Question 60: The primary activities or business functions that are considered in the value chain include: a) Customer service. inputs are economic resources such as land. who sells them to the ultimate consumer. distribution. sellers and resellers occupies a place in the value chain. b) Benchmarking analysis. c) Infrastructure. and R&D. The process © 2017 HOCK international. and R&D. Resale prohibited. Process analysis is used to understand the activities included in a process and how they are related to each other. or it may be a service provided. LLC. The type of analysis that the consultant most likely has been asked to perform for the manufacturing firm is called a a) Balanced scorecard study. and human resources. and information systems. warehousing. fulfilling a customer’s order is a business process. For just about any company. Inputs are materials. opportunities. d) Customer service. weaknesses. For personal use only by original purchaser. production. The sales function is also a sub- process of order fulfillment. because it is also something that must take place before any order is fulfilled. The consultant has also been requested to compare the manufacturer’s major products with firms that are manufacturing and marketing the same or similar products. d) Value-chain analysis. marketing and sales. who take those parts and put them together to manufacture another product entirely. (ICMA 2013) Process Analysis We said at the beginning of this topic that a business process is a related group of activities encompassing several functions that produces a specific product or service of value to a customer or customers. it is really a sub-process of order fulfillment – something that must take place in order to fulfill an order. suppliers.

Business process reengineering involves analyzing and radically redesigning the workflow. instead of simply using computers to automate an outdated process. such as order fulfillment. Specialization in work assignments and the concept of division of labor that was introduced back then brought about major productivity gains. technological advances bring opportunities to fundamentally change the process itself. Although this is modeled on the assembly line that worked so well in the past century. Reengineering is not about making incremental improvements but it is about making quantum leaps. The assembly line model worked very well in the 1900s. Hammer and Champy maintained that businesses are still being operated on the assembly line model that led to the industrial revolution in the 20th century. Resale prohibited. the authors say that because the world has changed since then. However. The underlying problem. They emphasize the use of technology: not to make old processes work better. the information gained from the analysis can be used to make operating decisions. purchasing and customer service. LLC. is fragmented processes. passing work around an organization today slows down the completion of the process and creates additional costs without adding any value to the product or service that the customer receives. In other words. If someone is taking information from one system and inputting it into another. Sometimes a process needs improvement. it inhibits the corporation’s ability to respond to customers’ needs in a timely manner. and it should appear simultaneously every place it is needed. One of the primary “rules” in the use of technology is that information should be captured only once. Reengineering the Corporation: A Manifesto for Business Revolution. 166 © 2017 HOCK international. think about what you want to accomplish. (2) which will have the greatest impact on customers. management starts with a clean sheet of paper and redesigns processes to accomplish its objectives. This includes not only manufacturing but other businesses processes as well. such as eliminating waste or increasing operating efficiency. Business Process Reengineering Reengineering originally referred to the practice of disassembling a product in order to redesign it. then think of ways to accomplish it rather than thinking of tasks to be done. Once a process has been analyzed. but to break the rules and create new ways of working. Operations that have become obsolete are discarded. because it wastes time. Hammer and Champy recommend that in reengineering. The processes in the organization should first be identified. but sometimes the process needs to be completely reengineered. illustrating the various activities and their interrelationships. then they should be prioritized for reengineering according to three criteria: (1) which processes are the most dysfunctional. it saved the time that was required for a worker to move from one task to the next task. For instance. Radical redesign means throwing out the old procedures and inventing new ways of getting the work done. . they say. companies operated on the same model no longer perform well. The philosophy of “reengineering” business processes was set forth by Michael Hammer and James Champy in their book. For personal use only by original purchaser. and (3) for which ones reengineering is most feasible. Furthermore. Productivity increased immensely because workers doing the same things over and over again became very adept at doing those things. The division of labor model has led to fragmented processes where one department performs a part of the process and then hands the work off to the next department to do their part. that is a process that is broken and needs to be reengineered.Business Process Improvement CMA Part 1 analysis usually involves developing a process flowchart. not tasks. the work should be organized around outcomes. In applying the concept of business process reengineering. In fact. and their speed increased tremendously. but it more recently applies to restructuring of organizational processes that is brought about by rapidly changing technology and today’s competitive economy.

For personal use only by original purchaser. the process will be without any controls. and superior responsiveness to customers.Section D Business Process Improvement People within the organization involved in reengineering typically include:  A reengineering leader who makes a particular reengineering project happen. Furthermore. the organization may be able to create a competitive advantage over its marketplace competitors. Instead. Resale prohibited. The company can use these standards. Benchmarking Process Performance One of the best ways to develop the distinctive competencies that lead to superior efficiency. its internal controls must be reengineered. Critical success factors are the aspects of the company’s performance that are essential to its competitive advantage and therefore to its success. and anything else that will aid the firm in achieving its strategic business goals and objectives. When a process is reengineered. or the manager with specific responsibility for the process being reengineered. a group of senior managers who determine the organization’s overall reengineering strategy and oversee it. several different people in different areas might be passing work from person to person to perform a business process. The improvements could include cutting costs. A benchmark is a standard of performance. as well. the answer to the question is that there are more effective ways to organize the company’s value- chain activities.  The reengineering team. Individual job assignments might become more complex and thus more challenging. For example. Best practices can be accomplished through benchmarking. increasing output. © 2017 HOCK international. and the grouping of people into cross-functional teams can both reduce costs and increase quality. also called best practices. LLC. 167 . The reengineering process begins with the customer. improving quality. practices and services of some of its most efficient global competitors or against those of other segments of the firm. The benchmarked company does not need to be in the same industry as the company that is trying to improve its performance. superior quality. at lower cost. and through meeting these higher standards. all of which confer competitive advantage to a firm.  The process owner. Benchmarking continuously strives to emulate (imitate) the performance of the best companies in the world or the best units in the firm.  A reengineering czar. a person with overall responsibility for developing reengineering techniques to be used throughout the organization and for coordinating the activities of the company’s various reengineering projects. Frequently.  A reengineering steering committee. and benchmarking is the process of measuring the organization against the products. not with the company’s product or service. The reengineering team asks itself how it can reorganize the way work is done to provide the best quality and the lowest-cost goods and services to the customer. a group of people who diagnose the current process and oversee its rede- sign and implementation of the redesign. quality management takes over and focuses on continued improvement and refinement of the new process. as a target or model for its own operations. Each company’s critical success factors depend upon the type of competition it faces. the same process might be able to be performed by one person or one group of people all working closely together. internal controls for the reengineered process must not be neglected. If existing internal controls are disassem- bled and not replaced with new ones. superior innovation. companies undertake best practice analysis and then implement improvements in the firm’s processes match or beat the benchmark. After the business process reengineering has been completed and the value-chain activities have been reorganized to get the product to the final customer more efficiently. is to identify and adopt best practices. The first thing that a company must do is to identify the critical success factors for its business and the processes it needs to benchmark. Through the application of research and sophisticated software analysis tools.

Activity-based management uses activity analysis and activity-based costing data to improve the value of the company’s products and services and to increase the company’s competitiveness. Strategic ABM uses ABC data to make strategic decisions about what products or services to offer and what activities to use to provide those products and services. The goal is for activities that add value to the product to be identified and improved. The Concept of Kaizen The term kaizen is a Japanese word that means “improvement.” or slow but constant incremental improvements being made in all areas of business operations. Certain companies are generally recognized as leaders in specific areas.” in which substantial resources are committed to a focused. The results can be immediate and dramatic. short-term project to improve a process. Activity-based costing improves tracing of costs to products and can even be used to trace costs to individual customers. while activities that do not add value are reduced in order to cut costs without reducing the value of the product or service. and reengineering of a product line or area. a non-profit organization. Kaizen needs to be a part of the corporate culture. Kaizen can be used along with activity-based management and activity-based costing in a business process reengineering project to improve the quality and/or reduce the cost of a business process. As we saw in the previous section on costing. over time. A blitz usually involves analysis. Activity-Based Management (ABM) Activity-based management (ABM) is closely related to and draws upon data from activity-based costing. but if done properly. The American Productivity and Quality Center (www. A company may use target costing along with kaizen principles to determine what its ideal standard costs are. This puts the focus on the market because it starts with a target price based on the market price. it implies “continuous improvement. The team members should be from different areas of the business and have different skills. a team is set up to do best practice analysis. Activity-based management is divided into operational ABM and strategic ABM. Best practice analysis involves investigating and documenting what the best practices are for the processes that are used in performing the firm’s critical success factor activities. activity-based costing uses activity analysis to develop detailed information about the specific activities the company uses to perform its operations.” As used in business. The ideal standard is thus defined as the target cost. The market determines the target price.apqc. lead to very high quality and very low costs. Small-scale improvements are considered to be less risky than a major overhaul of a system or process. The team will need to identify what areas need improvement and how they will accomplish this by utilizing the experience of the benchmarked company. Ritz-Carlton Hotels for service. . Activity-based management. or the standard 168 © 2017 HOCK international. LLC.org).Business Process Improvement CMA Part 1 After identifying its critical success factors. Resale prohibited. drawing on activity-based costing data. and Apple Computer for innovation. It maintains a large benchmarking database and offers firms several ways to participate in benchmarking and to access benchmarking information. it confers a sustained competitive advantage. and the company must attain the target cost in order to realize its desired profit margin for the product. Operational ABM uses ABC data to improve efficiency. Because ABC costs can also be traced to individual customers. Some examples are Nordstrom for retailing. It requires conscious effort to think about ways that tasks could be done better. Kaizen principles can also be used for a “blitz. APQC is one of the world’s leading proponents of business process and performance improvement. The slow accumulation of small developments in quality and efficiency can. strategic ABM can also be used to do customer profitability analysis in order to identify which customers are the most profitable so the company can focus more on them and on serving their needs. For personal use only by original purchaser. design. This can be difficult to maintain and takes years to show results. activity-based costing data is not just useful for costing. is a resource for companies that want to do benchmarking. is a means of performing value chain analysis and business process reengineer- ing. However.

There are four different costs of quality and they are classified into two larger categories. There are two subcategories of costs within each of these two larger categories. For personal use only by original purchaser. Resale prohibited. The two types of costs of conformance are: 1) Prevention costs are the costs that are incurred in order to prevent a defect from occurring in the first place. The Costs of Quality Management will also be closely interested in the cost of quality. resulting in decreasing costs of production over the budget period. 169 . LLC. Organizations can also apply kaizen principles to the budgeting process. © 2017 HOCK international.  Quality training. not producing a quality product is more expensive because it means that the company will lose customers. auditing and reporting of data on quality. the company figures out how it can manufacture the product for the target cost. so the design of the product is not defective and the process for manufacturing it produces a quality product. which are the costs of conformance and the costs of nonconformance.  Preventive maintenance on production equipment so an equipment failure does not cause a qual- ity failure. and they can be broken down into internal failure costs and external failure costs. and  Planning and execution costs of quality improvement programs such as Six Sigma or Total Quali- ty Management. but it is also the cost of not producing quality products. The cost of quality includes not only the cost of producing quality products. Over the long term. The costs of non-conformance are the costs of not producing a quality product.  Supplier selection and evaluation costs to ensure that materials and services received meet es- tablished quality standards. both internal programs and external training to teach employees proper manu- facturing procedures.Section D Business Process Improvement cost that will enable the company to attain its desired cost and desired profit margin.  Evaluation and testing of materials received from a new supplier to confirm their conformance to the company’s standards. Because kaizen anticipates continuous improvements in the production process. proper delivery procedures. and they can be broken down into prevention costs and appraisal costs. Note: Kaizen is the Japanese term for improvement and it is used in business to mean continuous improvement. including salaries and wages for employee time spent in training.  Information systems costs to develop systems for measuring. a budget developed on kaizen principles will incorporate planned improvements. Prevention costs include:  Engineering (design and process) costs. The standard is achieved through development of new manufacturing methods and techniques that entail continuous improvement or the ongoing search for new ways to reduce costs. and proper customer service procedures. and costs to train suppliers to conform to the firm’s requirements. Implementing ideal standards and quality improvements is the heart of the kaizen concept. Using kaizen principles. Cost of Conformance The costs of conformance are the costs that the company incurs to assess internal quality with the purpose of insuring that no defective products reach the consumer. The costs of conformance are the costs to produce a quality product. Kaizen challenges people to imagine the ideal condition and strive to make the necessary improvements to achieve that ideal.

170 © 2017 HOCK international. For personal use only by original purchaser. work-in-process and finished goods inventories.  Product recall and product liability costs.  Sales returns and allowances due to defects.  Costs (materials.The cost of rushing to re-perform and complete an order in time because of a failure to complete it correctly the first time.  Lost contribution margin on sales lost because of the loss of customer goodwill.  Lost contribution margin due to reduction of output caused by spending time correcting defective units. 2) External failure occurs when we do not detect the defect until the product is already with the consumer. The costs of nonconformance can be broken down into two types: 1) Internal failure occurs when we detect the problem before shipment to the customer.  Machine repairs due to breakdowns. labor and overhead) to rework and reinspect spoiled units. .  Warranty costs to repair or replace failed products that are returned. The costs of this are:  Customer service costs of handling customer complaints and returns.  Cost for equipment and instruments to be used in testing and inspecting manufacturing equip- ment. and  Environmental costs such as fines and unplanned cleanup fees caused by a failure to comply with environmental regulations.  Engineering costs to redesign the product or process to correct quality problems and improve manufacturing processes if the problem is detected before the product is in the customers’ pos- session.Business Process Improvement CMA Part 1 2) Appraisal costs are the costs that are incurred in order to monitor production processes and indi- vidual products and services before delivery in order to determine whether all units of the product or service meet customer requirements. and  Costs for quality audits. Resale prohibited.  Tooling changes and the downtime required to do the tooling changes to correct a defective product. raw materials. Note: You need to make certain that you know what the four subcategories of the costs of quality are and what individual items go into these four types of costs. LLC. Costs of Nonconformance Nonconformance costs are those costs that are incurred after a defective product has already been produced. work-in-process and finished goods inventories. These are the costs of:  Costs to test and inspect manufacturing equipment. including settlements of legal actions. The costs associated with this are:  Cost of spoilage and scrap.  Public relations costs to restore the company’s reputation after a high-profile external failure. and  Expediting costs . raw materials received.

because an ABC system identifies costs with activities. An opportunity cost is the benefit of the next best use of the resource that was lost. Costs of design quality are costs to prevent poor quality of design or costs that arise as a result of poor quality of design.  It will lose future sales because it will gain a reputation of supplying poor quality products. For personal use only by original purchaser. A cost of quality report shows the financial impact of implementing processes for prevention and appraisal and for responding to internal and external failures. There are several ways in which a company can generate opportunity costs because of defective products it produces. If the company had that cash. The people the company pays to do this could have been producing more parts for sale instead of spending their time on something that will not produce any revenue. Calculating the Costs of Quality The costs of quality (conformance and nonconformance) can be quantified and documented on a cost of quality (COQ) report. marketing and distributing a poorly designed product as well as costs to provide service after the sale for it. In addition. The costs of activities that are required to prevent or to respond to poor quality can be much more easily identified when ABC is used than when a traditional costing system is used. the company must spend time and pay people to fix or replace the defective parts. The extra people spending their time on customer service for the defective prod- ucts could have been doing something else for the company that would be more productive. it is often said that the main causes for quality problems are the “Four Ms”: machines. the products used to replace the defective ones are products that could have been sold. Here. The lost future sales represent lost profits. the lost resource is the cash profits that could have been earned from the lost sales. producing. and it concerns design quality failures. because traditional costing systems accumulate costs according to function (such as production or administration). Activity-based costing simplifies preparation of a COQ report. it could invest it and earn more future profits with it. materials. methods and manpower. If the whole product is replaced. rather than according to activities. Additional analysis is required with traditional costing to locate and segregate the costs of quality. so it will need to pay more customer service employees. design quality failures can cause lost sales because the product is not what customers really want. Various formats can be used to report the costs of quality. Usually such a report would be done separately for each product or product line. If the product is repaired.Section D Business Process Improvement Opportunity Costs of Quality The nonconformance costs include opportunity costs associated with poor quality. LLC. but instead they will not generate any revenue even though their produc- tion creates costs. Design quality failure costs include the costs of designing. 171 . and the replacement parts used could have been used in new products in- stead. Resale prohibited. Here is one example of a cost of quality report in a spreadsheet format: © 2017 HOCK international.  It will need to provide more customer service after the sale. Note: It is interesting to note that in manufacturing. The format used should depend on how management wants to see it reported.  There is another opportunity cost associated with poor quality management.  It must either repair or replace defective products that fail within the warranty period and/or prod- ucts that may be recalled if the defect is serious. Design quality failures can be a significant component of design quality costs.

unit 80 Rewkd.520 8 Testing of materials $25 per hour 352 hours 8.Month of May 20X2 Cost Allocation Base Total 2 Cost Allocation Rate Quantity Costs 3 Prevention costs: 4 Design engineering $65 per hour 528 hours $ 34. lost contribution margin due to rework $60 per rewkd. Resale prohibited.500 28 Contribution margin on estimated lost sales $230 per unit lost 300 Est. unit 50 def.300 Units mfd.800 22 Total internal failure costs $ 16. units $ 3.800 7 Supplier selection/evaluation $40 per hour 88 hours 3. lost sls.280 14 Inspection of work-in-process $30 per hour 528 hours 15.000 29 Total external failure costs $161.720 17 18 Internal failure costs: 19 Cost of spoilage $75 per def. 3.840 15 Inspection of finished goods $30 per hour 176 hours 5.320 5 Process engineering $60 per hour 528 hours 31. units 4. . units 7. 69. LLC.280 16 Total appraisal costs $ 38.510 30 31 Total costs of quality $303.500 172 © 2017 HOCK international.120 10 11 Appraisal costs: 12 Inspection of manufacturing equipment $35 per hour 352 hours $ 12.850 27 Estimated product liability costs $25 per unit mfd. unit 35 def. For personal use only by original purchaser. units 3.320 13 Inspection of raw materials $30 per hour 176 hours 5.160 26 Warranty costs $110 per def. 82.150 23 24 External failure costs: 25 Customer service-complaints & returns $35 per hour 176 hours $ 6.750 20 Cost of rework $95 per rewkd. unit 80 rewkd.Business Process Improvement CMA Part 1 A B C D E F 1 Cost of Quality – Widgets .800 9 Total prevention costs $ 87.600 21 Est.680 6 Training $55 per hour 160 hours 8.

LLC. This leads to the continued pursuit of excellence throughout the organization.Section D Business Process Improvement Total Quality Management (TQM) TQM describes an approach that is committed to customer satisfaction and continuous improvement of products or services. but success or failure revolves around involvement and leadership of senior management. A quality circle is a small group of employees who work together and meet regularly to discuss and resolve work-related problems and monitor solutions to the problems. At the heart of TQM is the definition of what quality is. process or person is at some point a customer and at some point a supplier. the role of quality manager is not limited to a special department. 173 . Quality can mean different things to different people. For a production manager it is a product that is within the required specification. Approximately 90% of manufacturing companies and 70% of service businesses have put into practice some form of a TQM program. Employees at all levels participate regularly in continuing education and training in order to promote and maintain a culture of quality. One of the unique perspectives of TQM relates to customers. Another feature of TQM is quality circles. This form of communication is vital to a successful TQM program. the entire organization must strive to this end. For personal use only by original purchaser. For a customer it is a product that meets expectations and performs as it is supposed to for a reasonable price. The objectives of TQM include:  Enhanced and consistent quality of the product or service  Timely and consistent responses to customer needs  Elimination of non-value-adding work or processes. Total quality management programs are often developed to implement an overall low-cost or a differentiation business strategy. because TQM’s goals are to both reduce costs and improve quality. Part of this pursuit of excellence is a focus on continuing education. empowering employees and creating teamwork that focuses on quality. it is important to remember that people within the organization are also customers. In TQM. A TQM program requires a change in corporate culture by eliminating faulty processes. Resale prohibited. every person in the organization is responsible for finding errors and correcting any problems as soon as possible. When a company is considering quality. As such. which leads to lower costs  Quick adaptation and flexibility in response to the shifting requirements of customers Certain core principles. instead. The basic premise of TQM is that quality improvement is a way of increasing revenues and decreasing costs. a company should always strive for improvement in performing its job and producing its product correctly the first time. are common to all TQM systems:  They have the support and active involvement of top management  They have clear and measurable objectives  They recognize quality achievements in a timely manner  They continuously provide training in TQM  They strive for continuous improvement (kaizen)  They focus on satisfying their customers’ expectations and requirements  They involve all employees TQM is an organizational action. Every department. The costs of implementing a TQM program are classified on a Cost of Quality Report as prevention costs. Total Quality Management is a prevention technique. it must be certain to include all of these different perspectives of quality from all of the involved parties. © 2017 HOCK international. or critical factors. For it to be successful. In a TQM system.

methods to analyze them. LLC. 174 © 2017 HOCK international. . the company must identify the relevant quality problems when and/or where they occur. this process is in control. clusters. or similar. If no sample falls outside the limit of two standard deviations. the process may be out of control even though all of the observations are within two standard deviations of the mean. If there are trends. production runs or any other method of delineating an operation. For a company that considers two standard deviations to be acceptable. This sample is used to determine whether all the observations fall within the specified range for the operation. For personal use only by original purchaser. and then use some of the following. the process is in statistical control. Statistical Quality Control (SQC) Statistical quality control (SQC). Below is an example of a statistical control chart showing that all observations are within two standard deviations of the mean. and if the numbers of observations that are above and below the center of the specified range are about equal. Some variations in quality are expected. nor many measurements near the limits. the process might not be in control. is a method of determining whether a process is in control or out of control. but if too many units are tested and found to be outside the acceptable range. the acceptable range might be plus or minus two standard deviations from the mean. or if they indicated a trend going one way or another. the control chart is a statistical control chart. or many measurements near the limits. the process may not be in control. no clusters. or if several observations were clustered together near the ±2 standard deviations. and the intervals are measurable in time. batches. or statistical process control (SPC). For example. with no trends. When statistics are used in determining the acceptable range. +3σ +2σ +1σ μ −1σ −2σ −3σ JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC If any of the observations were above +2 standard deviations or below −2 standard deviations from the mean. A control chart is used to record observations of an operation taken at regular intervals. as long as all the samples are randomly distributed with no apparent patterns. Resale prohibited.Business Process Improvement CMA Part 1 To achieve total quality management.

Here is an example of a histogram for a manufacturer of wood bookcases. 7 out of 100 defective units The company develops the following histogram to illustrate its findings: Defective Bookcases 40 35 30 25 20 15 10 5 0 Wood Trim not Uneven Shelves out Shelf or cracked attached stain of shelves corrrectly alignment missing © 2017 HOCK international. 19 out of 100 defective units  Uneven stain. which can pinpoint most of the problem areas. a histogram can help determine what types of problems are causing the problems most often.Section D Business Process Improvement Histograms A histogram is a bar graph that represents the frequency of events in a set of data. 15 out of 100 defective units  Trim not attached correctly. if a particular production line is experiencing most of the difficulty. and the most frequent problems are:  Wood cracked. For personal use only by original purchaser. For instance. The company has evaluated the various types of problems that occur in the manufacturing process. 21 out of 100 defective units  Shelf/shelves missing. 175 . Patterns that may not be apparent when just looking at a set of numbers become clear in a histogram. 38 out of 100 defective units  Shelves out of alignment. LLC. Resale prohibited.

going from the most frequent to the least frequent. the next step is to identify the cause or causes of each quality problem. or “20% of the population is doing 80% of all the good things. came up with the now well-known 80-20 observation. it adds a curve to the graph showing the cumulative number of causes. Resale prohibited.” After management pinpoints which 20% of the causes are accounting for 80% of the problems. Vilfredo Pareto. Here is an example of a Pareto diagram for the manufacturer of wood bookcases. The histogram and the Pareto chart show graphically that uneven stain is the most frequently occurring manufacturing problem. or Pareto principle. We know it as “20% of the population causes 80% of the problems”. a Pareto diagram puts them in order from the most frequent to the least frequent. it can focus efforts on improving the areas that are likely to have the greatest overall impact. Defective Bookcases 100 90 80 70 60 50 40 30 20 10 0 Uneven Shelves out Trim not Wood Shelf or stain of attached cracked shelves alignment corrrectly missing The curve on the graph illustrates the incremental addition to total defective bookcases contributed by each cause. In addition to showing the frequency of the causes for the quality problems with bookcases. a 19th-century Italian economist. 176 © 2017 HOCK international. For personal use only by original purchaser. Furthermore.Business Process Improvement CMA Part 1 Pareto Diagrams A Pareto diagram is a specific type of histogram. The company will be able to maximize its quality control efforts by giving first priority to finding ways to prevent the uneven stain problem. . Once the most frequent quality problems have been identified. LLC.

Materials: Wood: Maple. The end of the spine is the quality problem. The more pressure is put on the brush. the stain will have variations in color. the ribs — to the effect. The longer the stain is left on. organizes causes and effects visually to sort out root causes and identify relationships between causes. causes of problems in manufacturing fall into the following categories. using the 4Ms. For personal use only by original purchaser. the quality problem. a lot of those boards have been missed in the inspection. a hardwood. the color on the bookcase will be lighter in the first areas wiped off and darker in the last areas wiped off. If boards with machine marks are not caught in this inspection and are not pulled from production. The stain and protective coating are applied by hand. 177 . © 2017 HOCK international. the spine itself connects the main causes.Section D Business Process Improvement Cause-and-Effect (Ishikawa) Diagram A cause-and-effect diagram. Recently. is used in bookcase construction. it is wiped off. Ishikawa developed a way of diagramming the relationships to better trace them. the more stain is applied to the wood. there is little that can be done at the staining point to prevent a poor stain job. This idea was identified by Karou Ishikawa. A wood conditioner used before the stain would alleviate this problem. The maple sometimes is received from the lumberyard with machine marks in it that cause the stain to be absorbed differently. so it is also called a fishbone diagram. referred to as the “4M”s:  Machines  Materials  Methods  Manpower Operating personnel and management hold a series of meetings. or Ishikawa. Methods: The stain is applied with a brush. After the stain has been applied. maple sometimes does not. Manpower: The maple is inspected before it is made into bookcases. If the employee does not work quickly enough. Ishikawa Diagram Usually. the darker the resulting color. but management has not wanted the additional cost. LLC.” in which they attempt to figure out what is causing the problems with uneven stain on bookcases. They find the following: Machines: No equipment is used. diagram. who noted that it is often difficult to trace the many causes leading to a single problem. called “brainstorming sessions. If the pressure is not kept consistent. ribs and bones. Although hardwoods should absorb stains evenly. Resale prohibited. An Ishikawa diagram consists of a spine.

and the cost drivers of those activities need to be reduced or eliminated. and benchmark performance. as well as ensuring that necessary activities are carried out efficiently. Unnecessary and inefficient activities are non-value-adding activities. The company may decide to use a spray-on stain that is easier to apply. Resale prohibited. 178 © 2017 HOCK international. and may even look into automating portions of the process. A company that utilizes ABC will also be continuously identifying activities that can be eliminated. Both of these things are causing variations in the color. a cause-and-effect diagram is prepared: Machines Materials Wood conditioner not being used Not applicable-no machines used for staining Machine marks in wood Problem: Uneven Machine marks in wood Stain High level of skill required missed in inspections Highly labor-intensive Inexperienced employees Employees not following instructions Methods Manpower The above cause-and-effect diagram can lead to changes made that may mitigate the problem of uneven stain. Total Quality Management and Activity-Based Management Activity-based management principles are widely used to recommend process performance improve- ments. enhance operating performance. A firm with a good ABC system only needs to modify it to identify costs and activities relating to costs of quality. Some of the employees are inexperienced. A total quality management system is most compatible with an ABC system because the ABC system makes the costs of quality more apparent. reduce costs. and some are simply not following procedures. .Business Process Improvement CMA Part 1 The employees do not always keep a consistent pressure while applying the stain. may decide to begin using a wood conditioner on the maple or may change to using a different hardwood that will take the stain more evenly. On the other hand. They are applied to help companies make better strategic decisions. A focus on TQM and its central tenet of continuous improvement will lead to achieving both of these goals. For personal use only by original purchaser. LLC. the company needs to carry out the value-adding activities as efficiently as possible. may increase employee training programs in both the staining department and in the wood inspection department. Following the brainstorming sessions. Activity to rework defective products is a non-value-adding activity and thus needs to be reduced or eliminated. and they do not always get the color wiped off quickly enough. Activity-based management uses activity-based costing data to trace costs to products and/or individual customers for the purpose of analyzing business process perfor- mance.

The standards are not set to assure the quality of an individual product.)  A more efficient manufacturing process. the relationship between quality and productivity is a positive one – the more attention paid to quality. There are a number of reasons for this. productivity also increases. LLC. however. as a company’s commitment to quality increases. unproductive or non-value-adding activities. In fact. These standards do not have the force of law. This is related to the first item. the company may remove or change inefficient. it runs the risk of losing business due to perceived lack of quality. the employees of the company can take a more conscientious approach to their work. the higher the levels of production. Resale prohibited. This is seen in the need to have shorter product development time and shorter response times to changes in demand or the market. it is ever more important to become the first company to get a new product or service to the marketplace. and order delivery time.  A commitment to doing it right the first time. This in turn reduces the amount of time. Customer-response time. The components of cycle time are order receipt time (from receipt of order until we are ready to produce it). No matter the cause. or cycle time. and this may lead to greater productivity. there would be fewer outputs for the level of inputs. but as the culture in the company focuses on doing it right the first time. the productivity of the company will decrease. By looking from a quality production standpoint. This. 179 . including:  A reduction in the number of defective units. it would seem that by allocating resources to quality and spending resources in the quality process. it may seem that as a company’s commitment to quality increases. In today’s environment. Since productivity is measured as the level of output given an amount of input. Note: Adherence to (following) design specifications is one of the most important components of quality control. Other Quality Related Issues With the development of a good TQM system. This means that if a company fails to obtain these standards. (There is a term called the hidden factory that refers to the time and effort spent on rework and repair. manufacturing cycle time (from readiness to produce to completion of the product). is the measurement of the length of time between the order by the customer and the receipt of the product by the customer. © 2017 HOCK international.Section D Business Process Improvement ISO 9000 The International Organization of Standardization introduced the ISO 9000 quality assurance standards. a company can also manage its time better and become more productive. is not the case. Quality Management and Productivity At first glance. but to assure that the quality is the same throughout all of the company’s product of that type. For personal use only by original purchaser. but have been adopted by the EU. ISO standards do not address that. material and effort wasted on unusable output as well as time spent fixing salvageable defective units.

. c) To evaluate environmental issues that may affect the company’s profitability. analysis and design modifications. c) Prevention cost. d) Internal failure cost. capital and labor into value-adding products. b) Training cost.154 Product testing 786 Product repair 695 What is Watson's total prevention and appraisal cost for last month? a) $2. For personal use only by original purchaser. b) Management uses target costing to set standard costs in order to put the focus on the market as well as on what target price to sell the product because the company must attain the target cost to realize its desired profit margin for the product.Business Process Improvement CMA Part 1 Question 62: Of these statements. (HOCK) Question 63: Which of the following is not an objective of a company’s TQM program? a) To examine issues relating to creating value for the company’s customers. LLC. d) Management puts into place a program to measure the organization against the products. which is not relevant to the overall benchmarking process? a) Management determines what processes the company uses to convert materials. practices and services of the most efficient competitors in its marketplace. c) Target costing utilizes kaizen to reduce costs in order to attain a desired profit margin. (CMA Adapted) Question 65: Listed below are selected line items from the Cost of Quality Report for Watson Products for last month.940 (CMA Adapted) 180 © 2017 HOCK international. (HOCK) Question 64: The cost of scrap. b) To understand the company’s capacity for innovation.154 c) $786 d) $1. rework and tooling changes in a product quality cost system are categorized as a(n): a) External failure cost. Resale prohibited. d) To utilize computers in product development.665 b) $1. Category Amount Rework $ 725 Equipment maintenance 1.

© 2017 HOCK international. the financial function needs to focus more of its resources on activities that add greater value to the organization such as decision support and strategic analysis. The project team can make best-practice visits to organizations that are functioning at high levels of efficiency and effectiveness in the processes being considered for redesigning. and whether they are satisfied or dissatisfied with them. Selecting and Prioritizing Areas for Improvement Every process cannot be redesigned at the same time. the financial function can do more for the organization. and financial processes need to be redesigned to do things better. and the structures of the function need to be examined in order to identify improvements that can be made in efficiency and effectiveness. Process walk-throughs are used to gather the necessary information. why they use them. assumptions. Interviews and surveys can help in gaining that understanding. and possibly for less. in line with the philosophy of continuous improvement. In order to accomplish these changes. Surveys can be utilized to find out what reports users use. The current processes. Priority should be given to the processes most central to the organization’s strategy. Creating a Future Vision for Finance In developing a future vision for the financial function. Any area that has a significant impact on the effectiveness of the business drives total performance and should receive top priority because those areas are critical to the success of the organization. At the same time. accounting and finance need to be able to provide the same or even higher levels of service in transaction processing while using fewer resources. Process Walk-Throughs Once the decision has been made to redesign a specific accounting or finance function and the future vision has been created. benchmarking studies should be used to identify best practices being used. For personal use only by original purchaser. faster. Resale prohibited.Section D Business Process Improvement Accounting Process Redesign While accounting and finance professionals are recommending process improvements for other areas of the organization. Benchmarking enables the project team to develop standards against which their vision for the finance function can be measured. enabling the financial function to add value to the organization. Processes that have a high probability of successful redesign should also receive priority. Businesses are under pressure to reduce the cost of business transactions. the first step is to gather information about how things are currently being done. how often updates are needed. LLC. In addition. so it is necessary to prioritize. 181 . A current use assessment is another technique for creating a future vision. they need to look at their own processes. moving toward a decision-support model for finance requires an understanding of what type of decisions are being made and how the finance function can support the efforts. Internal customers are the internal users of the financial outputs. The surveys can also be used to gather information for a “wish list” of information the users would like to receive. “What value do we currently provide to users?” Current use assessment identifies the outputs and activities that are depended on by users and that must remain a part of the redesigned processes. By redeploying its resources to decision support and other value-adding activities. The project team needs to ask. too. A current use assessment is a customer-centered approach based on the idea that every aspect of the financial function should be traceable to internal customer needs. for ways to make accounting and financial operations more efficient. the role of finance needs to be re-thought. and what information in the reports is most essential. Much can be learned from organizations using best practices. The resources freed by these improvements can be put to new uses. and cheaper. Therefore. A current use assessment determines what reports are being used and by whom.

so they can be included in the new formal process. For example.  whether the step could be automated and whether the physical pieces of paper being used are necessary. investigate  why each step is being done. The existing processes need to be thoroughly documented before they can be streamlined.  reports used as outputs to identify unneeded reports or where information on several reports can be merged into fewer reports. whether it is necessary. documents.  identification of who performs each step. and whether it adds value. and  output that is not being used. . For personal use only by original purchaser. LLC. and work is routed through a process. every piece of paper.  controls currently in place. A process owner is a person who has the ultimate responsibility for the performance of a process and who has the necessary authority and ability to make changes in the process. unused. To conduct a process walk-through. Documentation of a process involves more than simply listing the sequence of events in the process.  whether there may be duplication of effort. and every input and output should be challenged.  wait time between processing steps in order to discover areas requiring improvement. such as  duplication of effort.  tasks being done that are not necessary or that do not add value.Business Process Improvement CMA Part 1 A walk-through is a demonstration or explanation detailing each step of a process.  whether the same data is being keyed in more than once. a member of the process redesign team meets with the process owner and each participant in the process in order to gain a thorough understanding of how the work gets done from beginning to end for the purpose of uncovering opportunities for improvement.  informal communication paths being used. the documentation should include  time required to complete each step and what may be slowing down each step.  forms used as inputs in order to locate those with duplicate. 182 © 2017 HOCK international. and  how accurate are the inputs and outputs. such as into a database and also into a spreadsheet. In addition to listing the steps performed. Identification of Waste and Over-capacity The process walk-throughs are a good starting point for identifying waste and over-capacity. or missing information. so that improvement can be directed toward shrinking the tasks that require the greatest amount of time rather than those that require little time. places where reports are being prepared manually due to fragmentation of data. and  where errors typically occur in the process. Process mapping may be used to provide a visual map of the way information. in order to know in advance what controls will be affected by changes made in the system. Every step. Process maps can pinpoint problem areas such as bottlenecks within the system. Resale prohibited. because correction of errors is time-consuming and decreasing the number of errors can decrease the amount time required for the process. because handing off the process from employee to employ- ee can cause waiting times that could be eliminated by assigning the task steps to fewer employees to reduce the number of work queues. and rework.

they will need to be phased in to allow the employees and the rest of the organization time to adjust to their impact. the walk-through can help to identify the root cause of errors. and their attitudes must be considered.  Employees can be asked to review their own needs for more or fewer employees. not only is the duplication of effort wasteful. process design can take place in line with the vision for the new process. such as an error on an invoice or an error in an inventory count. Risk-Benefit Evaluation After the new process has been designed. Process Design Once the current process is fully understood.  Another way of determining personnel usage is changes in the size of work backlogs. their jobs. Risk can be the deciding factor in taking one approach to process redesign over another one. or else the people will limit the effectiveness of the project. if an accounts payable clerk can process 100 invoices for payment per day. All those involved in the change effort need to actively seek to reduce the stresses put on the human resources of the company. If work back- logs increase. then more employees may be needed. and it requires careful planning. The project team needs to move the people involved from denial and resistance to the change to acceptance and commitment to the new way of doing things.Section D Business Process Improvement Determination of personnel under. but there is inherent risk that it will be keyed in differently. For example. LLC. © 2017 HOCK international. personnel capacity may be too high. a return to the process design step may be necessary. Every process is different. providing leadership. and a creative project team is required in order to generate a range of alternative solutions. If the changes are extensive. supporting the change. 183 . personnel capacity may be too low. If work backlogs decrease. Changing the process so that the data is keyed in just once and establishing controls such as reconciliations of data can eliminate the cause of errors. The design process builds on the process concept developed during the vision step. potential risks and benefits of the new process need to be evaluated.  Each error regularly made. so it is a top-down implementation. Planning and Implementing the Redesign A complete redesign of a process or processes has the potential to be very disruptive. their sense of security. The redesigned process needs to cover every aspect of the internal customers’ (users’) needs. For personal use only by original purchaser.  If the same data is being keyed in multiple times. The initiative for finance redesign often comes from senior management. is an indication of a control weakness. the less the organization can be sure of a successful outcome. The greater the changes being made. The process design options need to be weighed carefully in terms of their potential risk impact as well as their potential merits. Controls should be devised to prevent or detect the errors. and planning the change. The impact of the changes on the people.or over-capacity can be done in various ways:  One way of determining personnel needs is through metrics. Resale prohibited. Identifying the Root Cause of Errors Again. historical totals of invoices processed can be used to determine how many payables clerks are needed.  If overtime is regularly excessive. If the risks are determined to be too great. It requires engaging people in the change.

 The materiality level for consolidation and elimination entries can be raised. require purchase orders for all larger purchases so the company has a record of all outstanding orders of a material size. For example. There is the risk that a fixed asset would be acquired or disposed of after the calculations are done and before the end of the pe- riod. 184 © 2017 HOCK international.Business Process Improvement CMA Part 1 Process Training Redesigning processes requires finding new ways to use the skills of existing employees and to further enhance those skills through training.  Bank reconciliations can be done daily without waiting for the month-end statement by accessing transactions online.  Valuation accounts for obsolete inventory and bad debts should be reviewed for updating in advance of the period end.  Depreciation can be calculated a few days before the end of the period. so the total depreciation expense for the year will still be correct. last-minute changes in debt will not make much impact on the total interest expense accrued.  Review transactions and a preliminary set of financial statements for errors prior to the end of the period. can be eliminated in the soft closes.  To speed up payables closing.  Perpetual inventory records should be used. “Soft closes” can be used for month-end closes while reserving the more detailed closing activities and allocations for quarter-end and year-end closes.  Timing-related accruals. a centralized timekeeping system can be used so the most current information about hours worked is available.  For accruing unpaid wages. certain employees may need to attend a class on using spreadsheets whereas others would not need that but would need something else. LLC. .  The need for skills enhancement training should be evaluated on an individual basis. For year-end closings. and fiscal year.  Accuracy at the point of data entry needs to be heightened so that reconciliations can be done more quickly.  If expenses incurred or employee hours worked are billable to customers. Unless a large change in debt principal takes place at the very end of the period.  Interest expense can usually be accrued prior to the end of the month.  If recurring invoices are sent out on a regular schedule. Resale prohibited.  Training will be needed in the changes that have been made to the process. the depreciation can be adjusted if necessary. For personal use only by original purchaser.  Use of a standardized chart of accounts and general ledger application across all company locations is important for speed in closing.  Training may be needed in how to fully take advantage of the systems being used. such as inventories in transit. and inventories can be estimated for the soft closes. The accounting staff can access the information to accrue for invoices not yet received as of month end. review them before the end of the period so the billing can be done quickly and accurately at the appropriate time. Reducing the Accounting Close Cycle Significant improvements can be made in the time required to close the general ledger at the end of each month. they can be printed in advance by setting the accounting software date forward so the revenue is recorded in the proper months. Skills training should be individualized to the needs of each employee to eliminate weaknesses in each employee’s skills. quarter. the missing depreciation can be recorded during the following month. However. for month-end closings. Everyone involved in the revised process should be included in the training.

Section D Business Process Improvement By completing some of the closing work before the end of the period. 19 A journal entry template is a blank journal entry stored in the accounting software for which the same account numbers are used repetitively but the amounts of the entries vary. In order to maintain consistency. the accounting staff is less rushed and may make fewer errors. When the processing of transactions is centralized. Journal entry templates19 should be stored in the accounting system so the entry is standardized and the only thing needed is the amount. Mandating standardized accounting procedures can improve accuracy at the source. 185 . sales. Analysts can more easily drill down through the data to locate problem areas when the numbers do not look right instead of having to contact the divisional accounting office and asking them to research it and then waiting for them to respond. The checklist should give the name of the stored template to be used for each set of closing entries. which can be very time- consuming. it can contain errors that the corporate accounting staff must investigate and correct. different accounting procedures used throughout the company result in inconsistent reporting that is difficult to reconcile. Use of Cloud-Based Services Smaller companies that may not be able to justify the cost of an ERP system can turn to the cloud to integrate finance. there should be a standard checklist of journal entries that are needed in the closing. specific types of transactions such as accounts payable. enter the numbers into the template. accounts receivable. resulting in less time spent by the corporate accounting staff in correcting errors. responsibility for various closing tasks can be assigned to a smaller number of managers who are in closer proximity. service and fulfillment. resulting in greater efficiency. By reorganizing responsibilities along functional lines instead of geographical lines. Users go to the journal entry checklist to find the name of the stored template. Furthermore. The checklist should include a place to initial for each month when the entry has been done. In a centralized accounting system. The time required to locate and resolve errors is shortened as a result. and general ledger can be organized along functional lines. and save the journal entry with the correct date. accounting errors can be researched more easily because of having a single database of accounting information. leading to more accurate financial statements. All the essential data is in one place. The result is usually fewer errors. LLC. © 2017 HOCK international. Resale prohibited. Centralization of Accounting as a Shared Service Centralization of all accounting processes using a single consolidated accounting system is the best way to resolve closing problems created by accounting decentralization. For personal use only by original purchaser. When divisional accounting staffs send summarized information to the corporate accounting staff. utilizing a smaller number of highly-trained people. and the result can be a much faster close.

but it is important that you know the terminology. not only from an academic standpoint (definitions and lists. For example. so it is not likely that past exam questions will be asked again. The third part within this section is Systems Controls and Security Measures. For that reason. the internal audit function may be involved in time or quality audits. how internal auditors test compliance with controls and evaluate the effectiveness of controls. for example) but also from a practical application standpoint. You will find the actual exam questions to be different from the practice questions in your study materials. The second part of this section is Internal Auditing. the Committee of Sponsoring Organizations of the Treadway Commission. but you will want to be familiar with the concepts and issues covered in those questions. and (3) Systems Controls and Security Measures. In this textbook. Internal control examines all of the controls the company has developed and implemented to help achieve its objectives. 203. and the broad categories of services that may be provided by the internal audit function. 404. The best we can advise you to do is to learn the overall concepts and issues and then apply your best professional judgment to answering questions about them. (2) Internal Auditing. So answer the simple questions first and spend extra time on the hard ones only if time allows. Some of this you may be familiar with from work or experience with computer systems. We often think of internal controls as trying to prevent something from going wrong. these types of questions are included in ExamSuccess. we prefer to focus on the topics covered in the ICMA’s current Learning Outcome Statements. you need to prepare for this topic mostly on the definitional and conceptual level. Resale prohibited. as we believe questions asked on an exam today are more likely to be from the current Learning Outcome Statements than they are likely to duplicate past exam questions. Risk and Compliance are adapted from the report Internal Control – Integrated Framework developed by COSO. Most of the internal control concepts covered in Governance. For personal use only by original purchaser. Section E is composed of three parts: (1) Governance. It is important to be very familiar with the objectives of internal control. Other important topics are the major internal control provisions of the Sarbanes-Oxley Act of 2002 in Sections 201. Rather. internal audit. and systems control. 302. The internal audit function has duties that spread far beyond the financial statements and some of these responsibilities may not relate directly to finances. Two of the main elements of internal control that you need to understand are the segregation of duties and the elements that make up the components of internal control. The answers to the application-related questions can be very difficult because it may seem that all of the choices are good controls or none of the duties are ones that can be performed by the same person. It is important to know these topics.Section E – Internal Controls CMA Part 1 Section E – Internal Controls Section E comprises 15% of the CMA Part 1 Exam. Internal Auditing focuses on the audit function that the company operates internally. In this part you will need to become familiar with the terminology that is involved. You need to know the characteristics of a successful internal audit function. There are also a lot of questions from past exams that have covered specific situations relating to internal control. and therefore there is no benefit to figuring out a hard question versus answering a simple one. LLC. and the other internal control topics. . However. which was established by the Sarbanes-Oxley Act. It is the guide for all internal control systems. do not spend too much time thinking about any particular one because each has the same value. 204. 186 © 2017 HOCK international. The actual exam questions are always being updated and changed. Risk and Compliance. we have determined not to try to “teach to the study questions” in this section of the study materials. when you face these questions. since the practice questions are previous exam questions. and 407 of the Act and the role of the PCAOB (Public Company Accounting Oversight Board). apart from the external audit of the financial statements. but they are really set up to assist the organization in the achievement of its objectives. When studying internal auditing. You do not need to remember every specific detail from a question. These items may not be specifically covered in this textbook because of the vast scope of potential topics that would need to be covered.

” Agency issues arise from the fact that the owners of the corporation (the shareholders) and the managers of the corporation (the agents of the shareholders) are different people. and Compliance The internal controls of a company are an important part of its overall operations. The managers are concerned with what will benefit them personally and lead to increased salary. Resale prohibited. The priorities and concerns of the managers are different from the priorities and concerns of the shareholders. Incentives are needed so the agents will take actions that are consistent with shareholder benefit. 187 . At the same time.  Better control over the assets of the company. However. Risk. if management tries to conceal poor financial performance in an effort to keep the stock price going up so their own bonuses remain intact. processes. The shareholders’ priorities lie with seeing the value of their investment in the corporation increase. corporate governance specifies the distribution of rights and responsibilities among the various parties with conflicting priorities and concerns in an effort to mitigate the agency problem and bring about congruence between the goals of the shareholders and the goals of the agents. customs. monitoring mechanisms are needed to control any activities of the agents that would benefit them while hurting the shareholders. policies.Section E Governance. internal control and risk management? What is Corporate Governance? Corporate governance includes all of the means by which businesses are directed and controlled. the shareholders. Corporate governance also involves the relationships among the various participants and stakeholders in the corporation. and other inefficiencies in operations and decision-making that can damage its business. Corporate governance is very concerned with what is known as the “agency problem. Corporate governance spells out the rules and procedures to be followed in making decisions for the corporation. because what benefits the managers may not benefit the owners. The priorities of the shareholders and the priorities of the managers can easily be in conflict with one another. Corporate Governance Good corporate governance is basic to internal control. loss of control over the information relating to operations. institutions and laws that affect the way the business is administered. The term “governance” will be used frequently in this section. however. and Compliance Governance. A strong internal control system will provide many benefits to a company including:  Lower external audit costs. LLC. What is corporate governance. the Chief Executive Officer (CEO). Risk. © 2017 HOCK international. bonuses. Therefore. why is it important. those same incentives can lead to fraudulent financial reporting. management compensation policies that tie managers’ bonuses to stock price increases can lead to actions on the part of management that will cause the stock price to increase and will thus be good for all shareholders.  Reliable information for use in decision-making. and the managers. Corporate governance is the joint responsibility of the board of directors and management. such as the board of directors. regulations. For personal use only by original purchaser. and how is it related to risk assessment. A company with weak internal controls is putting itself at risk for employee theft. Prevention of unintended consequences such as fraudulent financial reporting is the responsibility of the board of directors and should be implemented through internal controls. including the rules. procedures. power and prestige. For example.

Public Companies. The principles were developed by Paul D. LLC. the topic took on greater importance following the dramatic downfalls of companies such as Enron. we can see that good corporate governance is not only important for company shareholders but it is vital for the general health and well being of a country’s economy as well. the board and executive management must consider risk. the world financial crisis that began in 2008 raised again the issue of good corporate governance. Risk.S.  The board of directors and executive management are responsible for developing and implementing business strategies. bankruptcy in September 2008 was the largest bankruptcy in U. Considering just Enron. The lesson from this is that good governance is not just a U. Joseph V. How is Corporate Governance Related to Risk Assessment. Carcello. assessing and managing risk. risk management and internal control all rely on each other. According to IIA (Institute of Internal Auditors) Internal Auditing Standard 2110. the effectiveness and efficiency of operations. this includes assessing and making appropriate recommendations for improving the governance process in its accomplish- ment of the following objectives:  Promoting appropriate ethics and values within the organization. Good governance is not just a good idea for a company—it is an absolute must. Principles of Good Governance A set of governance principles. Thus. Todd DeZoort of The University of 188 © 2017 HOCK international. Beasley of North Carolina State University. Corporate governance does not exist as a set of distinct and separate processes and structures. . and management. called 21st Century Governance Principles for U. F. governance.S.  In order to consider risk.  Coordinating the activities of and communicating information among the board. Resale prohibited. WorldCom. Adelphia and others back in 2001-02. Tompkins of Kennesaw State University. more than $60 billion of shareholder wealth was erased from investors’ books. Internal Control and Risk Management? We said that corporate governance specifies the distribution of rights and responsibilities among the various participants in the corporation.S. history. government bailout. Lapides. was published in 2007 by a group of leading academic experts from four universities. management and the board of directors. and the organization’s compliance with applicable laws and regulations. because an effective internal control system is necessary in order to communicate and manage risk. Mark S. For personal use only by original purchaser. management and accountability. and Compliance CMA Part 1 Why is Corporate Governance Important? Corporate governance has always been an important topic for shareholders. Dana R. However. More recently.Governance.S. Internal audit’s primary role is assessing internal controls over the reliability of financial reporting. issue but it is a global issue. external and internal auditors. the company must have an effective internal control system.  In order to have an effective risk management process. It is interconnected with the company’s internal control and enterprise risk management. AIG (American International Group) went from being the 18th largest public company in the world in 2008 to needing an $85 billion U. Hermanson and James G.  Ensuring effective organizational performance.  In setting business strategies. The internal audit activity serves as the “eyes and ears” of management and the audit committee and thus has an important role in the governance function of the organization. the company must have an effective process for identifying. Therefore.  Communicating risk and control information to appropriate areas of the organization. The Lehman Bros.

© 2017 HOCK international. because management may have “forgotten” to include some of the facts. because that creates a conflict of interest. the external auditor. 189 . overseeing the corporation’s strategy and processes for managing the enterprise. and executive sessions. 21 “Healthy skepticism” means having an attitude of doubt but not carrying it so far as to suspect wrongdoing everywhere. The lead director and committee chairs should provide leadership for agenda setting. stakeholder and financial statement user interests. since the board’s responsibilities include monitoring the CEO. Resale prohibited. and how they report to the board. management. 8) Meetings and Information – The board and its committees should meet frequently for extended periods of time and should have unrestricted access to the information and personnel they need to perform their duties. They should not just assume that what they are being told is true or is the whole truth. In this context. the audit committee. and making your own decision. 6) Leadership – The roles of Board Chair and CEO should be separate. which outline how each will be organized. the CEO should not serve as Chairman of the Board. 7) Committees – The audit.” The principles are (some explanatory footnotes have been added by HOCK): 1) Board Purpose – The board of directors should understand that its purpose is to promote and protect the interests of the corporation’s stockholders while considering the interests of other exter- nal and internal stakeholders (e. 5) Expertise and Integrity – The directors should possess relevant business. 3) Interaction – Sound governance requires effective interaction among the board. employees. Directors are not present on a day-to- day basis and that makes their job more difficult than if they were on site. including succession planning. gathering information. The vast majority of the directors should be inde- pendent in both fact and appearance. and Compliance Alabama.g. and the CEO. The independent directors and each of the committees should meet in execu- tive session on a regular basis. All directors should receive detailed orientation and continuing ed- ucation to assure they achieve and maintain the necessary level of expertise. 9) Internal Audit – All public companies should maintain an effective. Risk. The CEO would be leading the body that would be monitoring the CEO.20 Directors should employ healthy skepticism21 in meeting these responsibilities. and governance expertise. and legal counsel. they can talk to people within the organization at all levels and ask questions. For personal use only by original purchaser. authorized by the board. Each of these committees should be composed of independent directors only. LLC. and monitoring the corporation’s risks and internal con- trols. and the dual role was not questioned.Section E Governance.). etc. and they should do that. The directors should reflect a mix of backgrounds and perspectives and have unblemished records of integrity. full-time internal audit function that reports directly to the audit committee. it means directors should not just accept without question the information they are given by management but should “dig a little deeper” and find out the facts.” the overall ethical climate that originates at the top of the organization with the board of directors. Independent directors must be able and willing to be objective in their judgments. Neal of University of Tennessee. then the independent directors should appoint an independent lead director. A culture of integrity is dependent upon the “tone at the top.22 If the roles are not separate. meetings. 22 Not too long ago. and Terry L. including the ethical tone. industry. company. It means asking questions. their duties and respon- sibilities. However. The authors stated that the purpose of the principles was “to advance the current dialogue and to continue to promote investor. compensation and governance committees of the board should have charters. the internal auditor. 4) Independence – An “independent” director has no current or prior professional or personal ties to the corporation or its management other than service as a director. However. Companies also should consider providing an internal 20 Companies need to make sure that inappropriate and unethical behavior is not tolerated. creditors. and each committee should have access to independent outside advisors who report directly to the committee. the CEO frequently served also as Chairman of the Board. 2) Board Responsibilities – The board’s major areas of responsibility should be monitoring the CEO and other senior executives.

or an abbreviation thereof. including its composi- tion. which is usually perpetual (meaning forever). 23 A proxy statement is a document containing the information that a company is required by the SEC to provide to shareholders so they can make informed decisions about matters that will be brought up at an annual stockholder meeting. and Compliance CMA Part 1 audit report to external stakeholders to describe the internal audit function. The compensation committee should evaluate the incentives and risks associated with a heavy em- phasis on short-term performance-based incentive compensation for executives and directors. the corporate name must contain the word corpora- tion. the board committees. the name of any other domestic corporation or any other foreign corporation authorized to do business within the state. For personal use only by original purchaser. short-term vs. A business usually incorporates in the state where it intends to transact business but it may be formed in one state. A company that wants to have its principal place of business located in a different state from its incorporation files with the other state for a license to do business in that state. state sales taxes and any other state taxes imposed on businesses not only to the state where it is incorporated. company. 12) Proxy Access – The board should have a process for shareholders to nominate director candidates. Although the means of organizing a corporation may vary from state to state to some extent. Application for a charter must be made to the proper authorities of a state in order to form a corporation. executive compensation. incorporated. and individual directors. equity) for executives and directors. 11) Disclosure – Proxy statements23 and other communications (required filings and press releases) should reflect board and corporate activities and transactions in a transparent and timely manner (e. Charter. and Bylaws U. Risk. but also to every state where it is licensed as a foreign corporation.g.  Its purpose and the nature of its business.” and it details the following:  The name of the corporation. LLC. corporations are formed under authority of state statutes. The evaluation process should be a catalyst for change in the best interests of the shareholders. Hierarchy of Corporate Governance Corporate governance includes all of the means by which businesses are directed and controlled. or deceptively similar to.S. state franchise tax.Governance. long-term. The charter is also referred to as the “Articles of Incorporation” or “Certificate of Incorporation.  The length of the corporation’s life. mergers and acquisitions.g. The corporation will owe state income tax. and it is known as a “foreign” corporation in that state. director compensa- tion. while at the same time have its principal place of business or conduct its business operations in another state or states. 190 © 2017 HOCK international.. insider trades. and activities. cash vs. 13) Evaluation – The board should have procedures in place to evaluate on an annual basis the CEO. the board as a whole. financial performance. It spells out the rules and procedures to be followed in making decisions for the corporation. each state usually requires that articles of incorporation (the charter) be filed with the secretary of state or another designated official within that state. limited. 10) Compensation – The compensation committee and full board should carefully consider the compen- sation amount and mix (e. Formation. In many states. . Companies with anti-takeover provisions should disclose why such provisions are in the best interests of their shareholders. Resale prohibited. responsibilities. A corporate name cannot be the same as. including access to the proxy statement for long-term shareholders with significant ownership stakes.. related-party transactions).

A corporation is usually recognized as a legal entity as soon as the articles of incorporation are filed or when the certificate of incorporation is issued by the state. ordinarily the secretary of state. may act as an incorporator. and over the age of 18. the following steps must be carried out by the new corporation: 1) The incorporators elect the directors if they are not named in the articles. 2) The incorporators resign.). Incorporators’ services end with the filing of the articles of incorporation. some states may also require additional filings in some counties before the corporation is recognized as a legal entity. being itself a legal entity. LLC.  Whether existing shareholders have the first right to buy new shares. State laws vary as to the number of incorporators required.  The names and addresses of the members of the initial board of directors. o How officers are to be elected by the board of directors. named in the articles of incorporation. After the articles of incorporation have been filed and the certificate of incorporation has been issued by the state.Section E Governance. officer positions and the responsibili- ties of each officer position. specifications for meetings of the board of directors and for what constitutes a quorum at a board meeting. o How the shares of the corporation shall be represented (for example. and © 2017 HOCK international. At this meeting they: a. o Specifications regarding what constitutes a quorum at a shareholders’ meeting and what con- stitutes a majority vote on the part of shareholders. 3) The directors meet to complete the organizational structure. o Methods of calling special shareholders’ meetings. Most states provide standardized forms for articles of incorporation.S. Adopt bylaws for internal management of the corporation. Resale prohibited. For personal use only by original purchaser. The articles of incorporation are filed with the designated state official for such filings. A corporation can use the standardized form or file another form as long as it complies with state requirements. Note: A corporation. takes over. State laws typically require that incorporators be natural persons (citizens of the U. and Compliance  The authorized number of shares of capital stock that can be issued with a description of the various classes of such stock.  The names and addresses of the incorporators. but in most states. whose powers terminate upon filing. o How directors are to be elected by the shareholders.  Provision for amending the articles of incorporation. and the initial board of directors. the number of directors and the length of their terms.  The name and address of the corporation’s registered agent for receiving service of process and other notices. However. whose powers commence (begin) upon filing. only one incorporator is required. The persons who sign the articles of incorporation are called the incorporators. o Specifications for payments of dividends. by certificates) and how shares shall be issued and transferred. 191 . Risk. The bylaws specify: o The requirements for annual meetings of shareholders.

amend or repeal bylaws. the articles of amendment are filed with the state authorities. guidance and oversight to the management of the company. Thus. g. This means that an amendment is not allowed for something that the corporation could not legally do. Comply with any requirements for doing business in other states. h. Elect officers. Note: Employees are not legally bound by the bylaws unless they have reason to be familiar with them. designate the bank. Risk. Bylaws must conform to all state laws and specifications in the articles of incorporation. Consider any other business as necessary for carrying on the business purpose of the corpora- tion. The board of directors usually adopts a resolution containing the proposed amendment and then this resolution must be approved by a majority of the voting shares. c. i. Amending the Articles of Incorporation Most state corporation laws permit amendment of the articles. f. Responsibilities of the Board of Directors The board of directors of a company is responsible for ensuring that the company is operated in the best interest of the shareholders. Authorize establishment of the corporate bank account. and Compliance CMA Part 1 o How the bylaws can be amended. 192 © 2017 HOCK international. it will need to have a reg- istered agent in that state. d. e. The board has the following specific responsibilities:  Selecting and overseeing management. Although the articles of incorporation specify the name and address of the corporation’s initial registered agent. An example of an amendment might be an increase in the number of authorized common shares of stock. b. changing the registered agent can usually be done by the board of directors without the need for shareholder approval. Consider for ratification any contracts entered into before incorporation. The amendments become are effective only upon the issuance of a certificate of amendment. Approve the form of certificate that will represent shares of the company’s stock. Adopt a corporate seal to be used for corporate documents for which a seal is required. Any amendment to the articles of incorporation must be something that could have been included in the original articles of incorporation. For personal use only by original purchaser. After shareholder approval. the board determines what it expects from manage- ment in terms of integrity and ethics and it confirms its expectations in its oversight activities. who are the owners of the company. . and designate by name the persons who are authorized to sign checks on the account.  Because it elects the company’s management. the members of the board of directors represent the owners of the company.Governance. if a corporation files with another state as a foreign corporation located in that state. but this authority may be reserved to the shareholders. LLC. The directors ordinarily have the power to enact. Resale prohibited. The board of directors elects the officers of the company and the board of directors is responsible for overseeing the activities of the officers they elect. Accept or reject stock subscriptions. The board’s responsibility is to provide governance. For example.

The Blue Ribbon Committee’s recommendations were incorporated into the listing standards of the New York Stock Exchange. even though they may be outside. One of the committees whose membership is prescribed by SEC regulations is the audit committee. the American Stock Exchange. and Compliance  The board has authority in key decisions and plays a role in top-level strategic objective-setting and strategic planning. The SEC first recommended that boards of directors of corporations have audit committees in 1972. Other usual committees are compensation. For personal use only by original purchaser. Audit Committee Requirements. The report of the Blue Ribbon Committee. as directed by Sarbanes-Oxley.  Board members should investigate any issues they consider important.” The audit committee of the board of directors is made up of members of the board of directors who are charged with overseeing the audit function of the corporation. the New York Stock Exchange and the National Association of Securities Dealers sponsored a committee called the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees that was tasked with making recommendations for improving audit committees’ effectiveness.  Because board members are responsible for questioning and scrutinizing management’s activities. In 1987. Secondary securities markets also include audit committee requirements in their listing regulations. the board is closely involved with the company’s internal control activities. In 1998. Committees of the board of directors are made up of selected board members and are smaller. the audit committee of the board of directors of a corporation “stands at the crucial intersection of management. Within short order. The responsibilities of audit committees have been increased over the years.Section E Governance. it is important that the board have members who are independent of the company. 193 . finance. They must be willing to ask the tough questions and to question management’s activities. in SEC regulations. working groups of directors that are tasked with specific oversight responsibilities. in- dependent directors. Risk. as their members can bring specific internal control guidance in their specific areas of responsibility. In other words. the Treadway Commission made six recommendations for audit committees in their study aimed at identifying the causes of fraudulent financial reporting and making recommendations to reduce its incidence. and the NASDAQ. nominating and employee benefits. Resale prohibited. LLC. According to the New York Stock Exchange. Boards of companies that are listed on secondary securities markets such as the New York Stock Exchange are required to consist of a majority of independent directors.  Because of its oversight responsibility. All of the committees of the board of directors are important parts of the company’s internal control system. published in 1999. and they need to commit the time required to fulfill their board responsibilities. and the SEC adopted new © 2017 HOCK international. The audit committee members’ audit committee responsibilities are in addition to their responsibilities as members of the larger board. first by the Sarbanes- Oxley Act of 2002 and then. stock exchanges began requiring or at least recommending that listed companies have audit committees. independent auditors. made ten recommendations for improving the effectiveness of audit committees and provided five guiding principles for audit committees to follow in developing policies for their companies. Most boards of directors carry out their duties through committees. They must have access to the neces- sary resources to do this and must have unrestricted communications with all company personnel – including the internal auditors – as well as with the company’s external auditors and its legal coun- sel. internal auditors and the board of directors.  Board members need to be familiar with the company’s activities and environment. an independent director is not an officer or employee of the company and thus is not active in the day-to-day management of the company. Responsibilities and Authority The responsibilities of the audit committee are particularly critical. An independent di- rector has no material relationship with the company. The requirements for serving on an audit committee of a publicly-held company have been formalized in law and regulations.

or any other board committee-. .” In other words. the board of directors. LLC. or other compensatory fee from the issuer. or “(ii) be an affiliated person of the issuer or any subsidiary thereof. the entire board of directors will constitute the audit committee. Under Section 3(a)(58) of the Exchange Act. advisory. Risk. The requirements for. the entire board of directors will be responsible for the audit committee function. 5) All members of the audit committee must be financially literate at the time of their appointment or must become financially literate within a reasonable period of time after their appointment to the audit committee. 78f). the entire board of directors of the issuer. before they can serve on the audit committee of a listed company. Resale prohibited. and independence of corporate audit committees. or of its independent auditor. a member of an audit committee of an issuer may not. the members of the audit committee may not be employed by the company in any capacity. . other than in his or her capacity as a member of the audit committee. 194 © 2017 HOCK international. the requirements for and responsibilities of members of audit committees of public companies’ boards of directors are highly regulated. the SEC’s final rule on audit committees for issuers of securities states that an issuer either may have a separately designated audit committee composed of members of its board or. . the audit committee is defined as:  A committee (or equivalent body) established by and amongst the board of directors of an issuer for the purpose of overseeing the accounting and financial reporting processes of the issuer and audits of the financial statements of the issuer. This is a listing requirement of the New York Stock Exchange and other stock ex- changes. For personal use only by original purchaser. the stock exchanges and the SEC developed new rules and regulations for the purpose of strengthening audit committees.Governance. 3) In addition. 4) One member of the committee must have accounting or financial management expertise.S. and it increased the authority of audit committees. The Sarbanes-Oxley Act of 2002 increased audit committees’ responsibilities to a great degree. This is a requirement made by stock exchanges. Requirements for Audit Committee and Audit Committee Members 1) The audit committee is to consist of at least three members. as added by Section 205 of the Sarbanes-Oxley Act. the New York Stock Exchange requires a five-year “cooling-off” period for former em- ployees of the listed company. This is a listing requirement of the New York Stock Exchange and other stock exchanges.“(i) accept any consulting. It also increased the qualifications required for members of audit committees. this fact must be disclosed.C. as amended. responsibilities of and authority of the audit committee are as follows. In response to the Sarbanes-Oxley Act. governance. and Compliance CMA Part 1 rules requiring disclosure about the functioning. Thus. Accordingly. if it fails to form a separate committee or if it chooses. 2) All members of the audit committee must be independent per Section 10A 3(b)(3) of the Securities Exchange Act of 1934 (15 U. and  If no such committee exists with respect to an issuer. The Sarbanes-Oxley Act requires that if the audit com- mittee does not include a financial expert. The Sarbanes-Oxley Act and the SEC do not pre- scribe a minimum number of members for the audit committee but do state that if the corporation does not form an audit committee. The section defines independence this way: “In order to be considered to be independent .

The audit committee should present its conclusions with respect to the independent auditor to the full board. discussed in detail in this text in the discussion of the Sarbanes-Oxley Act in the topic Legislative Initiatives About Internal Control.” This rule relates to the “whistleblower” 24 requirement in the Sarbanes-Oxley Act. there should be regular rota- tion of the audit firm itself. 78f) sets forth the following as responsibilities of the audit committee: “The audit com- mittee of each issuer. Department of Justice to criminally charge those responsible for any retaliation. This evaluation should include the review and evaluation of the lead partner of the independent auditor. and any steps taken to deal with any such issues. and (4) the performance of the listed company's internal audit function and independent auditors. (3) the independent auditor's qualifi- cations and independence. or auditing matters. 4) The New York Stock Exchange Listing Manual further specifies that at least annually. of the firm. Section 1107 of the Act makes it a crime for a person to knowingly retaliate against a whistleblower for disclosing truthful information to a law enforcement officer regarding an alleged federal offense. the audit committee should take into account the opinions of management and the listed company's internal auditors (or other personnel responsible for the internal audit function). “the audit committee will be in a position to evaluate the auditor's qualifications. within the preceding five years. anonymous submission by employees and others about concerns they may have regarding questionable accounting and auditing matters. the Audit Committee is to “obtain and review a report by the independent auditor describing: the firm's inter- nal quality-control procedures. and each such registered public accounting firm shall report directly to the audit committee. internal controls.” 2) The New York Stock Exchange’s Listing Manual requires that listed companies have an audit com- mittee charter that “addresses the committee's purpose—which. 195 . or auditing matters.S. at minimum. Section 203. 25 Per Sarbanes-Oxley Act.S. and Compliance Responsibilities of the Audit Committee 1) The audit committee is responsible for selecting and nominating the external auditor. and treatment of complaints received by the issuer regard- ing accounting. anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters. Department of Labor to protect whistleblower complainants against employers who retaliate and also authorizes the U. © 2017 HOCK international. and (B) the confidential. or by any inquiry or investigation by governmental or profession- al authorities.” 3) Rule 10A 3(b)(4) of the Securities Exchange Act specifies that “each audit committee shall establish procedures for (A) the receipt. supervising the external auditor. and reviewing the audit scope. In making its evaluation. compensation. respecting one or more independent audits carried out by the firm. dis- cussing with the auditors matters required under generally accepted auditing standards. 25 the audit committee should further consider whether. Rule 10A 3(b)(2) of the Securities Exchange Act of 1934 (15 U. in order to assure continuing auditor independence.” 24 A “whistleblower” is a person who informs on someone else or makes public disclosure of corruption or wrongdoing. any material issues raised by the most recent internal quality-control review. shall be directly responsible for the appointment. and treating whistleblower complaints regarding accounting. retaining. retention. and oversight of the work of any registered public accounting firm employed by that issuer (including resolution of disagreements between manage- ment and the auditor regarding financial reporting) for the purpose of preparing or issuing an audit report or related work. and (B) prepare an audit committee report as required by the SEC to be included in the listed company's annual proxy statement. (2) the listed company's compliance with legal and regulatory requirements. Risk. in its capacity as a committee of the board of directors. Section 806 of Sarbanes- Oxley authorizes the U. internal accounting controls. overseeing auditor qualifications and independence.C. Section 301 of the Sarbanes-Oxley Act mandated that Audit Committees of public companies establish a system for receiving. performance and independence. or peer review. For personal use only by original purchaser. must be to: (A) assist board oversight of (1) the integrity of the listed company's financial statements. Resale prohibited. and (to assess the auditor's inde- pendence) all relationships between the independent auditor and the listed company. Public companies are required to establish a means for confidential. plan and results.S. LLC.” After reviewing the independent auditor’s report. approving audit fees. In addition to assuring the regular rotation of the lead audit partner as required by law.Section E Governance. Furthermore.

and Compliance CMA Part 1 5) In addition. or the performance of the internal audit function. o The audit committee is to report regularly to the full board of directors to review any issues that arise with respect to the quality or integrity of the listed company's financial statements. . on the financial statements of the listed company. as well as review any financial information and earnings guidance provided to analysts and rating agencies. taking into account the pressures that may exist for auditors consciously or subconsciously when seeking a job with the company they audit. including any significant changes in the company's selec- tion or application of accounting principles. (B) analyses prepared by management and/or the independent auditor setting forth significant financial reporting issues and judgments made in connection with the preparation of the financial statements. For personal use only by original purchaser. and any significant disagreements with management and management's response.Governance. Risk. as determined by the audit committee." or "adjusted" non-GAAP. the company's compliance with legal or regulatory requirements. and (D) the type and presentation of information to be included in earnings press releases (paying particular attention to any use of "pro forma.” 6) The Blue Ribbon Committee report recommended that the audit committee monitor the company’s internal control processes.”  Rule 10A-3(b)(6) of the Securities Exchange Act provides that “each issuer shall provide for appro- priate funding. as well as off-balance sheet structures. They oversee the internal audit func- tion and monitor internal control systems for compliance with legal and regulatory requirements. in its capacity as a committee of the board of directors. and major issues as to the adequacy of the company's internal controls and any special audit steps adopted in light of material control defi- ciencies. and (B) to any advisers employed by the audit committee under paragraph (5). the performance and independence of the company's independent auditors. the New York Stock Exchange specifically requires the following for listed companies: o The audit committee is to review the annual and quarterly financial statements and the MD&A (Management Discussion and Analysis) of the company and discuss them with management and the independent auditors and review earnings press releases and earnings guidance provided to analysts and rating agencies and discuss with management guidelines and policies to govern the process of risk assessment and risk management. o The audit committee is to meet periodically and separately with management and with internal auditors and independent auditors in order to uncover issues warranting committee attention. for payment of compensation (A) to the registered public accounting firm employed by the issuer for the purpose of rendering or issuing an audit report. including analyses of the effects of alternative GAAP methods on the fi- nancial statements. Resale prohibited. and most audit committees do this. including any restrictions on the scope of the independent auditor's activities or on access to re- quested information. LLC. 196 © 2017 HOCK international. (C) the effect of regulatory and accounting initiatives. Authority and Funding of the Audit Committee  Rule 10A 3(b)(5) of the Securities Exchange Act provides that “each audit committee shall have the authority to engage independent counsel and other advisers. information). as it determines necessary to carry out its duties. o And finally. o The audit committee is to review with the independent auditor any audit problems or difficulties. the audit committee is to “review: (A) major issues regarding accounting principles and financial statement presentations.”  The audit committee has the authority to investigate any matter. o The audit committee is to set clear hiring policies for employees or former employees of the in- dependent auditors.

or they can be very limited. Holding staggered elections provides for continuity on the board as there are always some returning board members. Note: Power for the board to increase its size without shareholder approval can be reserved in the articles of incorporation or the bylaws of the corporation. For personal use only by original purchaser. Risk. with one-third of the board members up for election at each annual shareholders’ meeting. depending upon how much authority and responsibility the board of directors delegates to the CEO. Usually. A CEO’s responsibilities and authority can be extensive. © 2017 HOCK international. and Compliance Responsibilities of the Chief Executive Officer (CEO) The responsibilities of the CEO are determined by the corporation’s board of directors. The length of the directors’ term of office is set in the corporate bylaws. Resale prohibited. and usually directors are elected by a plurality (whoever gets the most votes is elected. A CEO should not serve as chairman of the board of directors. each share of stock is allowed one vote.Section E Governance. Since the board’s responsibilities include monitoring the CEO. such as three years in staggered terms. LLC. The CEO would be leading the body that would be monitoring the CEO. 197 . the CEO should not serve as Chairman of the Board. but it may be longer. because that creates a conflict of interest. Election of Directors The shareholders elect the members of the board of directors. The term is usually one year. even if it is not a majority).

2) Reporting objectives include internal and external financial and non-financial reporting.  The company’s external auditors recognize that an audit of a company with effective internal controls can be performed more efficiently. or the extent to which the company’s basic business objectives are being achieved and its resources are being used effectively and efficiently. So “effected by” means “accomplished by. the leaders of an organization are not the only ones who care about its internal control policies and procedures. reporting. information on the effectiveness of its internal control system is important to investors to enable them to evaluate management’s performance of its stewardship responsibilities as well as the reliability of its financial statements.  The development of larger organizations with increased numbers of employees has made it neces- sary for management to limit and direct employees’ authority and discretion. These three categories of company objectives with which internal control is concerned are very important to know. transparency. and therefore also reduce products’ prices. corporations to make illegal payments to foreign governments is of concern to legislative and regulatory bodies and is addressed through internal control policies and proce- dures. copyright 1992. Reporting objectives include reliability. recognized standard setters. their leaders have recognized the need to exercise control in order to ensure that their objectives were achieved. management. 3) Compliance objectives relate to the organization’s compliance with applicable laws and regula- tions. Internal Control – Integrated Framework. Resale prohibited. and compliance. or the entity’s policies. For personal use only by original purchaser.” 198 © 2017 HOCK international. however. Today.Internal Control CMA Part 1 Internal Control Who Cares About Internal Control? Ever since commercial organizations. 1994 and 2013 by the Committee of Sponsoring Organizations of the Treadway Commission. American Accounting Association (AAA).  Even customers have an indirect interest in internal controls because a strong internal control system may reduce the costs of production. Thus internal control is a process that is carried out (effected) by an entity’s board of directors. designed to provide reasonable assurance regarding the achievement of objectives relating to operations. management and other personnel that is designed to provide reasonable assurance that the company’s objectives relating to operations. or other requirements as set forth by regulators. and Financial Executives International (FEI).S. 27 To “effect” something means to cause it to happen or to accomplish it. encompassing all laws and regulations to which the company is subject. . Used by permission. and other personnel.  The potential for U. LLC. Operations objectives include operational and financial performance goals and safeguarding of assets against loss.26 Internal control is a process. 1) Operations objectives relate to the effectiveness and efficiency of operations. Institute of Internal Auditors (IIA). 26 Internal Control – Integrated Framework. Internal Control Definition According to the COSO publication.  For a public company. The Committee of Sponsoring Organizations of the Treadway Commission includes the following five organizations: American Institute of Certified Public Accountants (AICPA). effected by27 an entity’s board of directors. timeliness. nonprofit organizations and governments have existed. and compliance will be achieved. Institute of Management Accountants (IMA). reporting.

division. constructively chal- lenging management. people must put the policies and pro- cedures into effect. Consequently. not an end in itself. but they do overlap. Internal control needs to be adaptable to apply to an entire entity or just to a particular subsidiary. The three categories of objectives are distinct. But every internal control should be directed toward the achievement of objectives in at least one and possibly more than one of the three categories.  The board of directors is responsible for overseeing the internal control system. It is something that must be put into effect by people—it is not policies and procedures. The board and senior management establish the tone for the organization concerning the importance of internal control and the expected standards of conduct across the entity.  The CEO is ultimately responsible for the internal control system and the “tone at the top. The board’s oversight responsibilities include providing advice and direction to management. The Importance of Objectives Since internal control’s purpose is to provide reasonable assurance regarding the achievement of objectives relating to operations. from the members of the board of directors to the staff. For personal use only by original purchaser. approving policies and major transactions. Internal control cannot establish the entity’s objectives. Setting objectives is part of the strategic planning process by management and the board of directors. and compliance. LLC.Section E Internal Control The three categories address different needs and they may be the direct responsibilities of different managers. This statement reflects the fundamental concepts that (1) the cost of an internal control system should not exceed the expected benefits. 4) Internal control procedures can provide reasonable assurance only—not absolute assurance and not a guarantee—to the entity’s board of directors and senior management that the compa- ny’s objectives will be achieved in the three named areas. not a destination. The focus is on achieving objectives. Therefore. It is a journey. 199 . or business process.” The CEO should provide leadership and direction to the senior managers and review the way they are © 2017 HOCK international. People are located throughout the organization at every level. The objectives that internal control applies to fall into the three categories above: operations. 5) Internal control must be flexible in order to be adaptable to the entity’s structure. 2) Internal control is an ongoing process. and monitoring management’s activities. it stands to reason that internal control cannot operate effectively unless objectives have been set. and compliance. Fundamental Concepts The definition of internal control reflects several fundamental concepts. Resale prohibited. the board of directors is an important element of internal control. regulations. and (2) the overall impact of a control procedure should not hinder operating efficiency. as follows: 1) The purpose of internal control is to help the company achieve its objectives. It consists of ongoing tasks and activities. It is not something that can be done once and be completed. Simply writing policy manuals that call for internal control procedures is not enough. 3) Internal control is effected (accomplished) by people. Objectives should be set with consideration given to laws. It is a means to an end. Who Is Responsible for Internal Control? Before we get into the details of internal controls. reporting. operat- ing unit. we should start by discussing who is responsible for internal controls. To be effective. reporting. a specific control objective for a specific company could fall under more than one category. and standards as well as management’s choices.

Thus. Internal Control – Integrated Framework (2013 update). 200 © 2017 HOCK international. If the five components are present and functioning effectively. independent auditors audit the financial statements and often provide other useful information as well to management and the board. . Component 1: Control Environment The control environment includes the standards. For personal use only by original purchaser.” including expected standards of conduct that apply to all employees.  Senior managers delegate responsibility for establishment of specific internal control policies and procedures to personnel responsible for each unit’s functions. all employees are responsible for letting their managers know if they be- come aware of problems in operations or that rules. especially in controlling their own units’ activities. because all employees produce information used in the internal control system or carry out other activities that put the internal control systems into effect. external parties are not part of the company’s internal control system.  Financial officers and their staffs are central to the exercise of control.Internal Control CMA Part 1 controlling the business. Furthermore. Components of Internal Control According to the COSO report. Management is responsible for reinforcing the expectations at all levels of the organization. However. Note: Internal auditors evaluate the effectiveness of the control systems and contribute to their ongoing effectiveness. processes. but they do NOT have the primary responsibility for establishing or maintaining the control systems. customers. Note: Internal control should be an explicit or implicit part of everyone’s job description. LLC. However. these components are all necessary for effective internal control to be present.  Internal auditors play a monitoring role. five interrelated components comprise internal control. For example. all management personnel are involved. financial analysts. thereby contributing to their ongoing effectiveness. their effective functioning provides the reasonable assurance regarding achievement of the company’s objectives. as their activities cut across as well as up and down the organization. regulations or policies are being violated. and they are not responsible for it. This tone (part of the control environment) is discussed in more detail below. and structures that provide the foundation for carrying out internal control. External parties provide information that is useful to effective internal control. bond raters and the news media. regulators.  Virtually all employees are involved in internal control. Other external parties that may provide useful information include legislators. They evaluate the effectiveness of the internal controls established by management. Resale prohibited. The board of directors and senior management are responsible for establishing the “tone at the top. They are: 1) Control Environment 2) Risk Assessment 3) Control Activities 4) Information and Communication 5) Monitoring Activities Embedded within these five components are 17 principles.

because the organizational structure provides the framework for planning.Section E Internal Control The control environment provides the organization’s ethical values. and expected standards of behavior. 201 . and which result in shared values and teamwork. and deviations need to be addressed in a timely and consistent manner. Leadership by example is the most effective means of communicating that ethical be- havior is expected. difficult and probing questions will be raised. conflicts of interest. sets the ethical tone by modeling the ethical and behavioral standards that are expected of everyone in the organization. It influences the control consciousness of all the people in the organization and sets the tone for the entire organization. Corporate culture. Board and audit committee members should hold regular meetings with chief financial and account- ing officers and internal and external auditors. Management retains responsibility for the performance of processes it has delegated to outsourced providers and business partners. For personal use only by original purchaser. Processes should be in place to identify issues and evaluate the performance of individuals and teams against the expected standards of conduct. and appropriate authorities and responsibilities to enable the corporation to pursue its objectives. exemplified by these five principles: 1) They demonstrate a commitment to integrity and ethical values. and that message quickly becomes a part of the corporate culture. They set a positive “tone at the top” by communicating. Independence of the board from management is critical. The company’s organizational structure should define the key areas of authority and responsibility and delineate lines for reporting. verbally and by example as well as formally. the shareholders. The attention and direction provided by the directors are critical. Top management. or the “tone at the top. Organizations with effective control environments have the following characteristics. the organization’s ethical values and commitment to integrity. without exception. The board of directors should have a sufficient number of members who are independent from man- agement (not employed full-time by the company in management positions) to be independent and objective in its evaluations and decision-making. The board of directors has oversight responsibility for internal control. Management should foster a “control consciousness” by setting formal and clearly communicated policies and procedures that are to be followed at all times. Standards of integrity and ethical values extend to outsourced service providers and business part- ners. ex- ecuting. reporting lines. none of the other components of internal control will be effective.” determines what actually does happen. these official statements only state what management wants to have happen. Resale prohibited. 2) The board of directors demonstrates independence from management and exercises over- sight over development and performance of internal control. However. so that if necessary. The actions taken by management when violations occur send a message to employees. Sufficient and timely information should be provided to board and audit committee members. 3) With the oversight of the board. Every company should establish standards of conduct and formal policies regarding acceptable busi- ness practices. controlling and monitoring the activities it pursues to achieve its objectives. The board of directors is responsible for setting corporate policy and for seeing that the company is operated in the best interest of its owners. especially the CEO. but the Chief Executive Officer and senior management have direct responsibility for developing and implementing the organiza- tion’s internal control system. If the control environment does not include the necessary factors. The organizational structure is key to the company’s ability to achieve its objectives. © 2017 HOCK international. LLC. as well. because people imitate their leaders. management establishes structures.

The board of directors holds the CEO accountable for understanding the risks faced by the organiza- tion and for establishing internal controls to support the achievement of the organization’s objectives. management should specify the knowledge and skills required for each position. The challenge is to delegate only to the extent required to achieve the organization’s objectives. Increased delegation requires personnel with a higher level of competence and requires the company to establish accountability. and the company should make every effort to hire and retain competent people and to train them when necessary. Resale prohibited. The CEO and senior management are responsible for establishing accountability for inter- nal control at all levels of the organization. appropriate personnel policies and procedures are integral to an efficient control environment. In order to have competent personnel. Their lack of capa- bility provides an opportunity for someone else to take advantage of their lack of knowledge or skills and perpetrate a fraud. some sort of disciplinary action should be taken against that person. The extent that individuals recognize that they will be held accountable for results greatly affects the control environment. In order for tasks to be accomplished in accordance with the company’s objectives and plans for achievement of those objectives. The board of directors should evaluate the competence of the CEO. For personal use only by original purchaser. because the number of undesirable or unanticipated decisions may increase with increased delegation. develop. Delegation of authority means giving up centralized control of some of the business decisions and allowing those decisions to be made at lower levels in the organization by the people who are closest to the day-to-day operations of the business. 4) The organization demonstrates a commitment to attract. Background checks should be thorough when hiring new employees. The existing structure should be periodically evaluated to enable its realignment with changing priorities such as new regulations. Delegation of authority provides the organization with greater agility. and retain competent individuals in alignment with objectives. Individuals who are working in positions for which they are unqualified create a risk simply because they are not capable of adequately performing the work they are supposed to do. The delegation should be based on sound practices for identifying and minimizing risk and on weighing potential losses against potential gains from delegation. If a person does something that is in violation of the company’s policies and standards. Authority and responsibility should be delegated to the extent necessary to achieve the organiza- tion’s objectives. Senior management with guidance from the board of directors needs to determine what is and is not acceptable. The board of directors delegates authority and assigns responsibility to senior management. in line with the organization’s regulatory or contractual obligations. but it also introduces complexity in risks to be managed. . There should be effective monitoring by management of results. Any embellishment or un- disclosed history should be a red flag. Therefore. If there is no penalty 202 © 2017 HOCK international. At a minimum. There should be formal or informal job descriptions that specify the competence level needed for each job. the company needs to have competent personnel. 5) The organization holds individuals accountable for their internal control responsibilities in pursuit of objectives.Internal Control CMA Part 1 The structure should be organized to best carry out the strategies designed to achieve the organiza- tion’s objectives and to provide the necessary information flow. the applicant’s work history and education should be confirmed and references checked. and management should evalu- ate the competence across the organization and within outsourced providers in relation to established policies and procedures and then act as necessary to address any shortcomings. The way management assigns authority and responsibility for operating activities affects the control environment because it determines how much initiative individuals are encour- aged to use in solving problems as well as the limits of their authority. LLC. Senior management delegates authority and assigns responsibility at the entity level and to its subunits.

They also include the safe- guarding of company resources against loss. Risk assessment involves identifying and assessing risks to the achievement of objectives.Section E Internal Control for the violation of the internal controls of the company. and standards that are external to the organization. Assessment of risk involves determining the dollar value of assets that are exposed to loss as well as the probability that a loss will occur. management is responsible for the assessment of risk. Management should regularly review the organization’s performance evaluation methods and incen- tives to ensure they do not encourage inappropriate conduct. offers of kickbacks. analyzing and managing the risks that have the potential to prevent the organization from achieving its objectives. Resale prohibited. Internal controls are more likely to function well if management believes that the controls are important and communicates that support to employees at all levels. 203 . Objective setting is therefore the first step in management’s process of risk assessment. risk tolerance might be expressed as an acceptable level of variance related to the objective. The 17 principles are numbered consecutively. the fundamental reason for the company’s existence. internal financial reports. Management must determine how much risk it is willing to accept and then work to maintain the risk within that level. and internal non-financial reports. so the principles relating to the risk assessment component will begin with no.  Compliance objectives include adhering to all laws and regulations that the company is subject to. For operations objec- tives. and international trade as well as many others. affects the company’s risk of being the recipient of disciplinary procedures. They include objectives for the effectiveness and efficiency of the company’s operations and performance and profitability goals. and high- pressure sales tactics. environmental protection. the organization is more likely to experience unwanted be- havior such as manipulation of accounting records and reports. Ex- ternal reporting objectives are driven by rules. external non-financial reports. of course.  Reporting objectives address the preparation of reports. If increases in the bottom line are the sole focus of performance evaluations. For personal use only by original purchaser. Objectives may be explicitly stated or they may be implicit. It also. relative to the organization’s established risk tolerance. Component 2: Risk Assessment Risk is the possibility that something will occur that will adversely affect the organization’s achievement of its objectives. then other individuals will not see the need for compliance. such as to continue a previ- ous level of performance. As part of the objective-setting process. 6: 6) The company’s objectives must be specified clearly enough so that the risks to those objec- tives can be assessed. A company’s record of compliance or noncompliance with laws and regulations affects its reputation in its communities. taxes. These laws and regulations establish minimum standards of behavior and may include mar- keting. Setting the company’s objectives is a strategic planning function of management. regulations. including external financial reports. LLC. pricing. packaging. employee safety and welfare. Internal reporting objectives are driven by the entity’s strategic direction and by reporting requirements established by management and the board of directors. © 2017 HOCK international. A company’s operations objectives will vary depending on the choices management makes about structure and performance. Broad categories of objectives that need to be specified so that the risks to them can be assessed are:  Operations objectives relate to the achievement of the company’s mission. The questions should always be asked: What could go wrong here? What assets do we need to protect? Risk assessment is the process of identifying. Within the control environment. management should specify its risk tolerance.

the operations objective of safeguarding resources includes prevention of loss through theft. environmental fac- tors such as climate change that can lead to changes in operations. com- petitors. For example. The greater the difference in the current objectives from objectives of the past—the greater the amount of change—the more risk there is. supply 204 © 2017 HOCK international. reduced availability of raw materials or loss of information systems. Entity-level risks arise from external or internal factors. The goal of ensuring reliable financial reporting includes making sure that any such losses that may occur through theft are properly reflected in the company’s fi- nancial statements. regulatory changes such as new reporting standards or new laws. External parties to include in the assessment are suppliers (current and potential). as they could direct- ly or indirectly impact the organization’s achievement of its objectives. employees. The risk assessment should be comprehensive and consider all significant interactions between the company and external parties. For example. and a disruption in infor- mation systems processing that could adversely affect the organization’s operations. a reporting objective. in other words determining what could go wrong that could pre- vent the company from achieving its objectives. public bodies and the news media. the failure of a key supplier. LLC. changes in management responsibilities that affect the way controls are implemented. and channel partners need to be included in the risk assessment. changes in personnel that can influence the control consciousness in the organization.  Internal factors can include decisions that affect operations and the availability of infrastruc- ture. employee access to assets that could contribute to misappropriation of assets. Once the risks have been identified. Even the objective of maintaining performance as it has been in the past carries both inter- nal and external risks. production. changing customer needs. Resale prohibited. Transaction-level risks occur at the level of subsidiaries.Internal Control CMA Part 1 Objectives can overlap. especially. creditors. The potential risks depend upon what the objectives are. The risk assessment process should consider all risks that may occur. Risk identification Risk identification includes identification of risks at all levels of the organizational structure. divisions. Change in objectives creates risk. key suppliers. and technological changes that affect the availability and the use of data. Entity level risk identification is conducted at a high level and does not include assessing transaction-level risks. The identification of risks at the process level is more detailed and includes transaction-level risks. they should be analyzed in order to determine how best to manage each one. 7) The organization identifies risks to the achievement of its objectives and analyzes them to determine how the risks should be managed. Risks originating in outsourced service providers. The responsibility for risk identification and analysis re- sides with management at the overall entity level and at the subunit level. . then it is not possible to determine what could prevent the company from achieving them. including the overall entity and its subunits. investors. intermediaries. shareholders.  An operational objective of maintaining an adequate raw materials inventory could lead to identi- fying risks such as raw materials not meeting specifications. Risks can come from both internal and external factors that can affect the company’s ability to achieve its objectives. operating units. or marketing. For personal use only by original purchaser. If the objectives are not known. or functions such as sales. customers. Establishing these objectives is a required first step to establishing effective internal control. throughout the organization. because it forms the basis for assessing risk. Here are a few examples:  External factors include economic factors that impact financing availability. buyers.

LLC. or corruption. Resale prohibited. and the directors’ oversight of internal control is necessary to reduce that risk. Fraud can arise at the employee level.  Reduction – Action is taken to reduce the likelihood or impact of the risk. 28 To “collude” is to act together. (2) estimate the impact of each risk. The potential for management fraud through override of controls needs to be considered.  Avoidance – Exiting the activity or activities that give risk to the risk. The number of potential risks is limitless. possible loss of assets. inadequate safeguarding of assets. Risk analysis Risk analysis forms the basis for determining how the risks will be managed. Risks that do not have a significant impact on the company and that have a low likelihood of occur- ring would not warrant serious concern. such as exiting a product line or selling a division. risks with a high likelihood of occurring and that carry the possibility of significant impact usually require serious attention. Fraud can include fraudulent reporting. steps may need to be taken to make changes in the risk assessment process and in other components of the internal control system such as control activities. In addition to dealing with the improper actions. The amount of the po- tential loss from each identified risk should be estimated to the extent possible. and practical limitations are needed. If the decision is to accept or avoid the risk. or price increases above ac- ceptable levels. as well. Once the likelihood and estimated impact of risks have been assessed. typically no control activities are required. the following steps should be taken to manage the identified risks. remediation may be necessary. it should perform a risk analysis to (1) assess the likelihood or frequency of each risk’s occurring. Fraud can occur at any level and its possible impact needs to be considered as part of the risk identi- fication and assessment. often in secret. such as a meteor falling out of the sky onto the company’s manufacturing facility. the organization determines what action to take and develops appropriate control activities for the action. 205 . to achieve some illegal or improper purpose.  Sharing – Reducing the risk likelihood or impact by transferring or sharing the risk such as pur- chasing insurance or forming a joint venture. from someone hacking into the computer systems for example. After the company has identified its entity-level and transaction-level risks. for example if two employees collude 28 to defraud the or- ganization. When management detects fraudulent reporting. However. Some risks are indeterminate and can only be described as large. © 2017 HOCK international. are too minimal to be con- sidered. and corruption. Risk responses fall into the following categories:  Acceptance – No action is taken to affect the likelihood or impact of the risk. 8) The organization considers the potential for fraud in assessing the risks to the achievement of its objectives. and (3) consider how each risk should be managed by assessing what actions need to be taken. moderate or small.Section E Internal Control disruptions in needed raw materials caused by weather conditions. Furthermore. Risks that are in between these two extremes require judgment. For personal use only by original purchaser. fraud can be perpetrated from the outside. If the decision is to reduce or to share the risk.  The objective of protecting assets leads to identifying the risk of employee embezzlement ac- companied by falsification of records to conceal the theft.  An objective of complying with existing laws and regulations leads to identifying risks associated with lack of compliance. But any situation that causes a change that could impact the system of internal control should be included. Some risks.

and exception reporting and review to identify unusual items. The risk responses decided upon dictate whether control activities are needed or not. changes in leadership and their attitudes toward internal control. and the actions taken by management to address the risks. o Control activities are needed when technology is embedded in business processes. The decision to reduce or share a risk generally makes control activities necessary. variance analyses to detect ratios that might be out of line. . If management decides to accept or avoid a risk. o Examples of detective controls are reconciliations. o Examples of preventive controls are segregation of duties. requirements for authorizations. and requirements for approvals. Segregation of duties should be addressed wherever possible and if segregation of duties is not prac- tical. The control activities include a variety of controls including both manual and automated and preventive and detective controls. periodic physical inventory counts. which are a function of management and not of the internal control system. Principles relating to Control Activities include: 10) The organization selects and develops control activities that contribute to mitigating (reduc- ing) risks to the achievement of objectives to acceptable levels. verifications. Control activities should be integrated with risk assessment in order to put into effect actions needed to carry out risk responses. random surprise cash counts. 206 © 2017 HOCK international. management review and approval of account write-offs. and business performance reviews. supervisory review and approval of accounting work. physical control over as- sets such as dual access controls. acquired or divested businesses and their impact on the internal control sys- tem. Resale prohibited. LLC.Internal Control CMA Part 1 9) The organization identifies and assesses changes that could impact the organization’s sys- tem of internal controls. Control activities may be preventive or detective and can include a range of activities such as authorizations and approvals. reconciliations. employee screening practices. 29 See General Controls in Systems Controls and Security Measures later in this section for more information about technology general controls. Component 3: Control Activities Control activities are actions established by policies and procedures that help ensure that management’s instructions that are intended to limit risks to the achievement of the organization’s objectives are carried out. rapid growth. For personal use only by original purchaser. A preventive control is designed to avoid an unintended event while a detective control is de- signed to discover an unintended event before the ultimate objective has occurred (for example. before financial statements are issued or before a manufacturing process is completed). 11) The organization selects and develops general control activities over technology29 to support the achievement of its objectives. management should develop alternate control activities. control activities are generally not required. Changes can occur in the external environment. Note: There is a difference between risk assessment. economic. which is a function of internal control. and physical environment in which the entity operates. training and competence of personnel. internal audits. enforced vacations. such as in the regulatory. to mitigate the risk of the technology operating improperly. Changes can also occur in the internal environment such as new product lines. Segregation of duties is typically built in to the selection and development of control activities. job rotation.

the error should be corrected and the correction reflected in the reconciliation. Other types of operating information.Section E Internal Control o Control activities may be partially or wholly automated using technology. Control activities over technology designed to support the continued operation of technology and to support automated control activities are called “technology general controls. Automated controls re- quire technology general controls.” Technology general controls include controls over the technology infrastructure. © 2017 HOCK international. Guarding against external threats is particularly important for an entity that depends on telecommunications networks and the Internet. minutes of meetings discussing actions in response to reports. External information about economic conditions and actions of competitors is needed for internal decision-making. information from regulatory bodies regarding new requirements. Procedures should be clear on what the responsibilities are of the personnel performing the control activity. security management. time reports. timely and relevant information is needed to carry out inter- nal control responsibilities supporting all three of the categories of objectives. development and maintenance. and technology acquisition. Information and communication are both internal and external. and internal contacts made to a whistle-blower hotline. Principles relating to the Information and Communication component include: 13) The organization should obtain or generate and use relevant. Regardless of whether it is from internal or external sources and whether it is financial or non-financial information. For example. are needed to monitor compliance with emissions standards. such as decisions about optimum inventory levels and in- ventory valuation. If an error occurred. Relevant information can be financial or non-financial. production reports regarding quality. the discrepancy should be investigated. information on number of units shipped during a period. 12) The organization deploys control activities by developing policies that establish what is ex- pected and procedures that put the policies into action. such as measurements of emissions generated. For personal use only by original purchaser. Whether a policy is in writing or not. Component 4: Information and Communication Relevant information must be identified. The procedures should be timely and should be performed diligently and consistently by competent personnel. The responsibility and accountability ultimately reside with the management of the entity and the subunit where the risk resides. The control activities should be built into business processes and employees’ day-to-day activities. 207 . and external contacts made to a whis- tle-blower hotline. o Some examples of external sources include data from outsourced providers. o Some examples of internal sources include emails. Resale prohibited. captured and communicated (shared) in a manner that enables people to carry out the internal control responsibilities that support achievement of the organization’s objectives. quality information to support the functioning of other components of internal control. Responsible personnel should investigate and if necessary take corrective action on matters identi- fied as a result of executing control activities. Activities designed and implemented to restrict technology access to authorized users to protect the organization’s assets from external threats are a particularly important aspect of technology general controls. Management should periodically review and reassess policies and procedures and related control ac- tivities for continued relevance and revise them when necessary. LLC. if a discrepancy is identified in the process of doing a reconciliation. social media and blog postings containing comments or opinions about the organization. it should establish clear responsibility and accountability. The information can be generated from inter- nal or external sources. research reports.

or social media postings. Internal communication also includes separate communication channels such as whistleblower hotlines that enable confidential and anonymous communication when normal channels of com- munication are not effective.Internal Control CMA Part 1 14) The organization should internally communicate information. LLC. so they can understand the entity’s condition and risks. customers. necessary to support the functioning of other components of internal control. email messages. financial analysts. policies and procedures. owners. Members of the board of directors should also have direct access to employees without senior management present to give board members an opportunity to ask questions and assess matters that employees might not feel comfortable discussing in the pres- ence of management such as management override of controls that may be taking place. regulators. 15) The organization should communicate with external parties regarding matters affecting the functioning of other components of internal control. training (either live or online). blogs. such as dashboards. o Outgoing communication can take the form of press releases. and they should have a way to communicate that information upward. o Regulators report results of examinations and compliance reviews that can inform management of control weaknesses. For personal use only by original purchaser. external auditors. financial ana- lysts and others need to provide information relevant to them. Relevant and timely information needs to be communicated to external parties including sharehold- ers. Information systems must provide accurate. people in the organization need to receive a clear message from top management that their internal control responsibilities must be taken seriously. External communication also includes incoming communications from customers (customer feed- back). timely reports to appropriate personnel so they can car- ry out their responsibilities. and other external parties. Internal communication can take many forms. o If the company is a public company. . Fur- thermore. o Communications from the external auditors inform management and the board about the organ- ization’s operations and control systems. written policies and procedures. A whistle- blower hotline should be available to external parties. and any matters of significance relating to internal control such as instances of deterioration or non-adherence. o Internal communication of information also takes place across the organization through. o Any outsider dealing with the company must be informed that improper actions such as kick- backs or other improper dealings will not be tolerated. regulators. responsibilities and standards of conduct. o Communication from customers and suppliers can provide valuable input on the design and qual- ity of the company’s products and services. The way managers behave in the presence of their sub- ordinates can communicate more powerfully than any words. social media. postings on the company website. o Customer complaints often mean there are operating problems that need to be addressed. specified objectives. consumers. and others. communications to shareholders. and emails. suppliers. financial analysts. 208 © 2017 HOCK international. Resale prohibited. as well. website postings. partners. including objectives and responsi- bilities for internal control. regulators. individual authorities. o Internal communication includes communications between the board of directors and manage- ment so that both have the information they need to fulfill their roles in achieving the organization’s objectives. for ex- ample. Actions also communicate. one-on-one discussions. The people who deal with the customers every day are often the first to know about a problem.

and performs ongoing and/or separate evaluations to ascertain whether the components of internal control are present and functioning. management must monitor the entire internal control system. Resale prohibited. An advantage to ongoing monitoring is that if operating reports are used to manage ongoing operations. All the reconciling items should have been investigated and resolved. including senior management and the board of directors. Management must also revisit previously identified problems to make sure they have been corrected. and o through separate evaluations conducted periodically by management with the assistance of the internal audit function. 209 . © 2017 HOCK international. Monitoring can be done in two ways: o through ongoing evaluations that are built into business processes during normal operations and provide timely information. Monitoring is an activity overseen and/or performed at the management level for the purpose of assessing the operation and effectiveness of existing internal controls. that the sources of information used in the reconciliation were ap- propriate. develops. exceptions to anticipated results will be recognized quickly. as appropriate. 17) The organization evaluates and communicates internal control deficiencies in a timely manner to those parties responsible for taking corrective action. An example of evaluating a monitoring activity is reviewing a reconciliation to make sure it was done properly and in a timely manner. and to look for trends in the reconciling items. Monitoring assesses the quality of the internal control system’s performance over time to determine whether the components of internal control are present and are functioning. Systems and procedures change over time. it lessens the need for separate evalua- tions. Principles relating to the Monitoring Activities component are: 16) The organization selects. LLC. Management needs to determine whether the internal control system is still relevant and whether it is still able to address new risks that may have developed. and management should evaluate whether there are any new risks in the operation caused by changes in the internal and/or external environment. Information received from monitoring activities is used in management’s assessment of the effectiveness of its internal control. For personal use only by original purchaser. Findings from monitoring activities are evaluated against established criteria and deficiencies are communicated to management and the board of directors as appropriate. Remedial action should be taken. Monitoring ensures that the internal control system continues to operate effectively. Note: Monitoring should be done on a regular basis. and the results of the remedial action should also be monitored to be certain that the situa- tion has been corrected. If monitoring is done regularly during normal operations.Section E Internal Control Component 5: Monitoring Activities Finally. and the way controls are applied need to change in order to continue to be effective.

authorities. 12) Control activities are deployed through policies and procedures. Risk Assessment 6) Objectives are specified so risks to their achievement can be identified and assessed. 210 © 2017 HOCK international. 8) Potential for fraud is considered.Internal Control CMA Part 1 Summary: The 5 Components and the 17 Principles of Internal Control Components Principles Control Environment 1) There is a commitment to integrity and ethical values. LLC. 17) Internal control deficiencies are evaluated and communicated for corrective action. 3) Management establishes structures. 2) The board of directors exercises oversight responsibility for internal control. Communication 14) Information is communicated internally. . quality information is obtained or generated and is used. 5) Individuals are held accountable for their internal control responsibilities. Monitoring Activities 16) Ongoing and separate evaluations are performed of the internal control system. 4) There is a commitment to competence. and responsibili- ties. 9) Changes that could impact internal control are identified and assessed. Resale prohibited. 11) General control activities over technology are selected and developed. 7) Risks are identified and analyzed. Information and 13) Relevant. 15) The organization communicates with external parties. Control Activities 10) Control activities to mitigate risks are selected and developed. For personal use only by original purchaser.

 Error handling. Duties are assigned in a manner that ensures that no one person is in a position to both perpetrate and conceal an irregularity. © 2017 HOCK international. Types of Transaction Control Activities  Authorization and approvals. while invoices outside the tolerance level are flagged for investigation. 211 . in other words that it represents an actual economic event. Authorization generally is in the form of an approval by a higher level of management or of another form of verification. and the information is recorded in a timely manner.  Accuracy. and have been executed in accordance with management’s authorization. When automated authorization of payables is utilized. inventories. However.  Physical safeguards and security. Errors detected at any point in processing are promptly corrected and reported to the appropriate level of management. management.  Physical controls. errors do occur. regulations. Equipment. securities.  Segregation of duties. All valid transactions are accurate. invoices within the tolerance level are automatically approved for payment.  Completeness. Authorization confirms that the transaction is valid. Transaction Control Objectives Commonly accepted transaction control objectives are:  Authorization. other personnel and/or third parties may be able to circumvent internal controls. are consistent with the originating transaction data. are lawful. and if the items do not match or the item is not consistent with policy. When an internal control system is effective. and  complies with applicable laws and regulations.Section E Internal Control What is Effective Internal Control? An effective internal control system provides reasonable assurance regarding achievement of an entity’s objectives by reducing to an acceptable level the risk of not achieving an entity objective.  Validity. All transactions are approved by someone with the authority to approve the specific transactions. All recorded transactions fairly represent the economic events that occurred. the board of directors and management cannot have absolute assurance that the organization’s objectives will be achieved.  Verifications. All valid transactions are included in the accounting records. cash and other assets are secured physically in locked or guarded areas with physical access restricted to authorized personnel and are periodical- ly counted and compared with amounts in control records. and through collusion. Items are compared with one another or an item is compared with a policy. such as an automatic comparison of an invoice to the related purchase order receiving report. senior management and the board of directors have reasonable assurance that the organization:  achieves effective and efficient operations or understands the extent to which operations are man- aged effectively and efficiently.  prepares reports in conformity with applicable rules. Human judgment in decision-making can be faulty. It requires that each of the five components and relevant principles be present and functioning. and that the five components are operating together in an integrated manner. LLC. Access to physical assets and information systems are con- trolled and restricted to authorized personnel. and standards or with the entity’s specified reporting objectives. are correctly classified. management may be able to override internal controls. follow up occurs. For personal use only by original purchaser. Resale prohibited.

guarding. Prevention of loss through waste. such as a master file containing prices or inventory items. or poor business decisions relate to broader operations objectives and are not specifically considered part of asset safeguarding. Separating functions ensures that no single individual is given too much responsibility so that no employee is in a position to both perpetrate and conceal irregularities. is often used in the processing of transactions. and maintaining the accuracy. Reconciliations gen- erally address the completeness and accuracy of processing transactions.  Effective supervision and independent checks and verification. and so forth. inefficiency. if there are differences.  Physical protection measures to restrict access to assets. or disposition of assets or through destruction caused by natural disasters or fire. Segregation of Duties Duties need to be divided among various employees to reduce the risk of errors or inappropriate activities.  Supervisory controls. 30 In the context of internal control. particularly cash and inventory. receiving checks in the mail. purchase orders. 212 © 2017 HOCK international. and according to policy and procedures.Internal Control CMA Part 1  Controls over standing data. 4) The periodic reconciliation of the physical assets to the recorded amounts for those assets. a supervisor may review a bank reconciliation performed by an accounting clerk to check whether the bank balance as given on the reconciliation report matches the balance on the statement and wheth- er reconciling items have been followed up and corrected or an appropriate explanation is provided. Standing data. differences that cannot be explained by items in transit must be investigated and corrective action taken. Supervisory controls determine whether other transaction control activities are being performed completely. a bank reconciliation reconciles the balance in the account according to internal records with the balance in the account according to the bank. 2) Recordkeeping: Recording the transaction. Reconciliations compare two or more data elements and. Reconciling items are items in transit and are to be expected. For example. use. . caring for. accurately. and/or maintaining the security of an item that is within the immediate personal care and control of the person to whose custody it is entrusted. custody involves keeping. 3) Keeping physical custody30 of the related asset: For example. Loss to assets can occur through unauthorized acquisition.  Physical protection and controlled access to records and documents such as blank checks. In a question about an effective or ineffective internal control. action is taken to make the data agree. Resale prohibited. Physical protection of assets requires:  Segregation of duties. completeness and validity of the data in the master files. Note: Different people must always perform the following four functions of related activities: 1) Authorizing a transaction. Controls need to be put into place over the process of populating. Safeguarding Controls Physical safeguarding of assets against loss is an important part of a company’s operations objectives. However. preserving. passwords. maintaining journals. LLC. watching over. inspecting. updating.  Reconciliations. preparing source documents. For example. For personal use only by original purchaser. keep in mind that these four things must be done by different people.

Software tools are available to assist a business in identifying incompatible functions. as they are supposed to do. however. and divert the cash collected to their own use. For personal use only by original purchaser. Furthermore. duties listed here may be the responsibility of a different position than is indicated here and some may overlap. However. covering for one another and. and the invoice. that person could authorize the issuance of a purchase order to a fictitious vendor using a post office box personally rented for the purpose. In any particular firm. that person could receive a cash remittance on account from a customer. during physical inventory counting that same person could easily mark the item as be- ing in inventory when it never was in inventory. The following list is not exhaustive because more positions and more duties can always be added. An access management application can help to assess segregation-of-duties and access risks and conflicts. then prepare a fictitious receiving record. Two or more employees could collude with one another (work together to conspire) to commit fraud. Note: Collusion occurs when two or more individuals work together to overcome the internal control system and perpetrate a fraud.Section E Internal Control Examples of potential internal control failures that can result from inadequate segregation of duties:  If the same person has custody of cash received and also has the authority to authorize account write-offs.  If the same person who authorizes issuance of purchase orders is also responsible for recording receipt of inventory and for performing physical inventory counts. Since all the documentation would match. Be aware. When two or more people work together. this will give you several good examples. authorize a fraudulent write-off of the receivable. and personally mail an invoice to the company in the name of the fictitious vendor using the personal post office box. The accounts payable depart- ment of the company would match the purchase order. Furthermore. the accounts payable department would send a payment to the fictitious vendor for something the company never ordered or received. that segregation of duties does not guarantee that fraud will not occur. sharing the proceeds. the receiving report. presumably.  If the same person prepares the bank deposit and also reconciles the checking account. they are able to get around the segregation of duties that may have been set out. so the general duties listed here for each position should not be considered absolute. Resale prohibited. Responsibilities and Duties Needing Segregation for Financial and Accounting Positions Following is a list of some financial and accounting positions. and incompatible duties that need to be segregated. They are presented simply to provide assistance to those who may not be familiar with all of the general functions of the financial area of a business. general information on their responsibilities. firms organize their accounting and financial areas in different ways. thereby concealing the fraud. that person could divert cash receipts and cover the activity by creating “reconciling items” in the account recon- ciliation report. LLC. 213 . © 2017 HOCK international.

overseeing risk All investments should be authorized by a management. Custodial responsibilities establishing bank accounts should not Treasury include opening bank accounts. maintaining stockholder records and paying prepare bank reconciliations. For personal use only by original purchaser. Represents the company to investment bankers and in quarterly earnings calls with outside analysts and investors. overseeing into the general ledger or to receive disbursements (payables and payroll). and serve as business advisors to CEOs and Boards of Directors. Oversees budgeting manager could be covering up a and preparation of periodic financial forecasts of misappropriation of assets. Participates in Board of Directors meetings and presents as necessary. managing cash. Develops and maintains the capital budget and analyzes new capital budgeting proposals. The member of senior management. forecasting cash needs. . generate disbursements. override occurs when a manager including developing formal internal control policies authorizes staff to not perform an and procedures. supervising collection also be able to enter the new account Function and recording of cash receipts. There could regulations and for certifying the accuracy of the be a good reason for the omission. profit and loss and cash flow. direct integration of key business processes. Directs override of controls. Corporate Responsible for the custody and use of a business’s The treasury employee responsible for Treasurer and funds and other assets. people who authorize and initiate investment transactions should not also record investment transactions or reconcile investment account statements to the general ledger. Management and has overall responsibility for internal control. or financing. Resale prohibited. and directing tax accounting. 214 © 2017 HOCK international. Persons involved in obtaining loans should not also record the loan in the general ledger. securing transactions in the general ledger. stimulate change and business transformation. The greatest potential for fraud at the Officer (CFO) maintenance of its fiscal records. establishing credit policies. The Treasurer generally reports to the CFO.Internal Control CMA Part 1 Title Responsibilities Examples of Incompatible Duties Chief Financial Directs the organization’s accounting practices. Serves as a member of senior management and takes part in the strategic planning process. or the company’s financial statements. All loans obtained in the name of the corporation should be authorized by senior management. dividends. Responsible for compliance with internal control procedure. LLC. and preparation and senior management level is not in lack of interpretation of its financial reports for internal segregation of duties but in management purposes and for external financial reporting. CFOs are expected to work in collaboration with others throughout the organization. record investments.

services. including but not limited to periodic people who have no record-keeping or physical counts of inventory and fixed assets. © 2017 HOCK international. CFO. Monitors receipts of orders to ensure Employees authorizing purchase orders they are received on time. and prepares purchase orders. preparing journal entries should not also authorize the entries. compliance with all applicable laws. which reports to the perform physical inventory counts. quality and delivery capabilities. reviews requisitions for goods and initiating the purchase requisition. The Accounting Manager answers transactions in the general ledger. record or authorize their performance. and machinery. accounts payable. items purchased and inventories on hand. receive COO (Chief Operating Officer). Accounting The Accounting Manager is responsible for financial The person responsible for adding. payroll. tools. the CFO. Vendor invoices should be approved by the employee who initiated and authorized the purchase requisition or another person independent of the purchasing function. LLC. maintenance of authorize purchases or disposals of fixed fixed asset records. or to the file.Section E Internal Control Title Responsibilities Examples of Incompatible Duties Controller and Responsible for the integrity of the balance sheet. not also perform general ledger account Selects and trains department staff and supervises reconciliations. accounting practices and procedures to accounts to financial statements should Function ensure accurate and timely financial statements. Employees involved in purchasing should not be responsible for approving vendor invoices. The Accounting Manager The person responsible for initiating and generally reports to the Controller. Negotiates contracts authority to generate or approve with suppliers and monitors their contract purchase requisitions. traces lost shipments and should not be able to also generate the follows up on undelivered items. rules. Maintains records of purchase orders. or maintain physical custody of of information required for the annual financial fixed assets. inventory or fixed assets following preparation of financial statements. or employees’ questions and helps them resolve any approve changes to the GL chart of complex issues that arise such as non-routine accounts or the account mapping. For personal use only by original purchaser. cash projections. Ensures authorization responsibilities. Purchasing The Purchasing Manager/Agent purchases raw All purchase requisitions (internal re- Function materials for manufacturing. record the entries. and employees in the pur- Analyzes price proposals and other information to chasing department should not have determine a reasonable price. finished goods for quests for purchases or for purchase resale. from indirect purchasing. their reputation. their only by employees in the purchasing products. prices. Researches Purchase orders should be generated and evaluates suppliers. tax preparation and preparation assets. equipment. system should not also reconcile the fixed asset system to the general ledger. and The person who records adjustments to regulations. which reports to the operating areas it inventory. and mapping general ledger Accounting systems. statement audit. performance. have custody of inventory. implements and maintains deleting. reconcile inventory or write off materials). accounts physical counts should not reconcile the receivable. The Controller generally reports to The person who maintains the fixed asset the CFO. or serves. by someone other than the person Requests bids. parts and orders to be issued) should be approved supplies as needed for the operation of a business. Supervises the monthly closing process. department. 215 . Resale prohibited. the Purchasing not be able to modify the vendor master Manager may report to the CEO. record vendor invoices. reporting transactions. Manager and reporting. Periodic physical counts of inventory and Controller’s Implements and documents adequate and effective fixed assets should be performed by Function internal controls. variance reporting. Employees involved in purchasing should Depending on the organization. or reconcile accounts. Some manufacturing goods and record their receipt in organizations separate direct purchasing (raw inventory. budgeting and fixed asset system to the physical count. Develops.

accounts. someone other than the person who prepares the reconciliation. accounts receivable aging reports and number of Adjustments to customers’ accounts days of sales in accounts receivable. Answers employees’ questions and record or authorize adjustments to cus- Functions helps them resolve any complex issues that arise with tomer accounts. procedures and policies related to accounts account(s). Ensures that the Allowance for Doubtful Accounts is maintained at an appropriate level. reviews applicants’ financial statements if appropriate. the accounts receivable system should not also reconcile the accounts receivable Order entry staff: Performs data input to prepare system to the general ledger. and not also open the remittances. Controls bad debt exposure by setting credit policies. delinquent customers. procedures and policies related to credit functions. Answers employees’ questions and balances owed by customers on their helps them resolve any complex issues that arise. Develops. Develops. prepare the bank customers. or Order Entry and process and invoice preparation as well as collections customer contracts. the deposit. or reconcile the checking systems. 216 © 2017 HOCK international. monitors should be reviewed and approved by a collections. and obtains guarantees or collateral when necessary. For personal use only by original purchaser. the tomer accounts. record or authorize Accounts Receivable Manager controls bad debt adjustments to customer accounts. credit limits for customers should not Function Selects and trains department staff and supervises also be able to record adjustments to the their performance. prepare obtains guarantees or collateral when necessary. Ensures that the Allowance for Doubtful Accounts is maintained at an appropriate The person who records transactions in level. The person who prepares the deposit Along with the credit manager (or instead of the should not also record payments to cus- credit manager if there is no credit manager). implements and maintains systems. Conducts credit reconcile the checking account(s). the packing list should be prepared by The reconciliation of the accounts the order entry clerk at the same time as the invoice receivable system to the general ledger is prepared and serve as authorization to ship the should be reviewed and approved by goods. or exposure by setting credit policies. If items are to be shipped. invoices for presentation to customers. and posting payments to customers’ accounts. reviews applicants’ financial The person who records payments statements if appropriate. makes decisions regarding individual customer credit limits and credit terms. stops extending credit to delinquent supervisor not involved in recording accounts and initiates recovery actions against accounts receivable transactions. receivable functions. the pricing. . stops extending credit to delinquent accounts and initiates recovery actions against delinquent customers. Accounts The Accounts Receivable Manager oversees the The person who prepares customer Receivable accounts receivable department’s activities to ensure invoices should not be able to modify the Manager and accuracy and timeliness. Supervises credit checks on customers. Monitors the accounts receivable portfolio using accounts receivable aging reports and number of days of sales in accounts receivable. or initiate adjustments or Monitors the accounts receivable portfolio using credits to customers’ accounts. implements and maintains deposit. Accounts Receivable staff: Receives customer payments on accounts and posts the receipts to the proper account.Internal Control CMA Part 1 Title Responsibilities Examples of Incompatible Duties Credit Manager The Credit Manager manages the credit department’s Employees who authorize and maintain and Credit activities to ensure accuracy and timeliness of work. including the order entry customer master file. LLC. The person who opens customer remit- Accounts Selects and trains department staff and supervises tances should not also record payments. Resale prohibited. monitor collections. Receivable their performance. checks on customers. makes decisions regarding received on customers’ accounts should individual customer credit limits and credit terms.

The person responsible for signing checks should not be involved in any other cash disbursement process. ensuring accuracy order. the signature stamp should remain in the custody of the person whose signature is on the stamp. The person who records accounts payable Accounts payable staff: Pays approved expenditures transactions (vendor invoices and pay- in a timely manner (approval of invoices should be ments) should not also be responsible for limited to the employee who initiated and authorized reconciling the disbursement sub-ledger the purchase requisition). Codes expenditures for to the general ledger. or authorize or execute wire transfers. and the and Accounts and timeliness. or have record-keeping that arise with vendors. LLC. sign checks. recording the disburse- ments or preparing. Selects and trains department staff and the purchasing or receiving process. reviewing or ap- proving the checking account recon- ciliations. © 2017 HOCK international. the receiving document. Resale prohibited. approve vendor invoices. print checks. 217 . accounts payable functions. supervises their performance. procedures and policies related to payables. The person who records vendor invoices should not also be responsible for printing checks. The person responsible for approving wire transfers should not also prepare or review and approve bank reconciliations. or returns. For personal use only by original purchaser. Answers employees’ should not be able to modify the vendor questions and helps them resolve any complex issues master file. maintains systems. No one person should be able to both authorize and initiate a wire transfer. Wire transfers above a set amount should be reviewed. approved and released by additional authorizers who have been granted authority to release payments over that set amount. If a signature stamp is used to sign checks. The person responsible for printing checks and/or with access to blank check stock should not have responsibility for signing checks. or modify the vendor master file. Develops. implements and responsibilities for inventory.Section E Internal Control Title Responsibilities Examples of Incompatible Duties Accounts The Accounts Payable Manager oversees the accounts The person who matches the purchase Payable Manager payable department’s activities. The person responsible for setup of new vendors or modification of vendor records in the vendor master file should not also record vendor invoices. record invoices. review and authorize journal entries in the general ledger. recording in the accounting system. purchases. May oversee the payroll process as vendor invoice should not be involved in Payable Function well.

distribute payroll checks. If the payroll department. and receive cash receipts. For personal use only by original purchaser. may bank reconciliations should not also post transactions to accounting journals. the timekeeper monitors billable hours to ensure accuracy. LLC. record the changes. be involved in the payroll process. generate payroll checks. company bills clients by the hour (such as attorneys or accountants). as assigned. Notifies changes to employee information should Function the payroll department of terminated employees so not also have the ability to approve or they are removed from the payroll. ledgers. . data and prepare reports. Under supervision. Personnel or Approves changes in pay rates and changes to The person responsible for initiating Human deductions from employees’ paychecks. generate or print checks. Modifications should be initiated by one employee and reviewed and approved by another employee. Timekeeping The timekeeper reviews timesheet/timecard infor. Hours worked should be reviewed and Function mation on hours worked by hourly employees and approved by the employee’s supervisor verifies that hours worked by hourly employees have before the hours are transmitted to the been approved by the employees’ supervisors. accounting projects as needed. Approves employee additions and deletions and Resources new employees to be added to the payroll. authorize or execute wire transfers. compile deposits. Employees responsible for modifying the employee master file should not also have access to the payroll system. or investigate questionable data. Resale prohibited.Internal Control CMA Part 1 Title Responsibilities Examples of Incompatible Duties Accounting Clerk Performs a variety of support tasks in the accounting The person responsible for preparing department. 218 © 2017 HOCK international. or make hiring and firing decisions. perform reconciliations. prepare cash other records detailing financial transactions. and perform other have access to blank check stock.

Section E Internal Control Title Responsibilities Examples of Incompatible Duties Payroll Clerk Calculates wages payable by multiplying the number The person who calculates the wages of hours worked by each employee by the employee’s should not also be able to modify the hourly rate. The person who reconciles the payroll system to the general ledger should not be able to modify the payroll system in any way. payroll. or authorize adjustments to customers’ The cashier’s department is a treasury function and accounts. For personal use only by original purchaser. approve the taxes. or reconcile checking accounts. As with accounts payable. 219 . The person responsible for signing payroll checks should not be involved in any other cash disbursement process. record cashier’s department is the head cashier. LLC. and other withholdings. The person responsible for recording the payroll in the general ledger should not be able to modify the employee master file. © 2017 HOCK international. the journal entry to record the payroll. The supervisor of a should not also record payments. generate payroll checks. generally reports to the Treasurer. prepare or authorize payroll. the person responsible for printing payroll checks and/or with access to blank check stock should not have responsibility for signing checks. should be delivered to a supervisory-level person who is separate from the payroll processing area. Prepares payroll register summarizing wages and distribute payroll checks. and for general research purposes. generate the payroll checks. If a signature stamp is used to sign checks. recording the disbursements. The person who prepares the bank deposit should not also receive cash. or preparing. Resale prohibited. or distribute payroll checks. record payments. The supervisor should review the payroll reports and distribute the payroll checks. reviewing or approving the checking account reconciliations. the signature stamp should remain in the custody of the person whose signature is on the stamp. or reconcile checking accounts. or receive deductions for each employee to be used in compiling payroll reports. Cashier A cashier in a business is a person who is responsible The person responsible for receiving cash for receiving and disbursing cash. Calculates paycheck deductions such as employee master file. health insurance. record or authorize adjustments to customers’ accounts. Payroll checks that are undistributed or rejected should be investigated and reconciled by a supervisory-level person. to prepare tax The payroll reports and payroll checks reports.

Pulls inventory from the shelves. reconcile the perpetual inventory records to the general ledger. recording vendors’ invoices for payment. The employee who initiates the disposal request should not also physically dispose of the inventory or do any recordkeeping for the disposal. All invoicing and collections should be done by the accounting department. tracks orders. modifying the vendor master file. Returned merchandise should be received by the shipping clerk and forwarded to the accounting department so the return can be recorded in the sales and accounts receivable records. or recording returned merchandise. A receiving clerk should not be involved in authorizing or recording purchase orders. Inventory Inventory clerk: Maintains custody over and controls An inventory clerk should not be able to Function access to physical inventory. packs and ability to initiate or authorize sales prepares shipments. outgoing shipments’ delivery status. Physical inventory counts should be performed by someone who does not have day-to-day responsibility for the physical inventory or inventory record- keeping and reconciliation responsibili- ties.Internal Control CMA Part 1 Title Responsibilities Examples of Incompatible Duties Shipping Clerk Monitors merchandise leaving the company’s Shipping employees should not have the premises. Reconciliation of the physical inventory counts to the perpetual inventory system and the general ledger should be reviewed and approved by a supervisor who does not have daily responsibilities in the inventory process. For personal use only by original purchaser. The person responsible for making adjustments to the inventory records should not also be able to record entries in the general ledger or reconcile the perpetual inventory system to the physical inventory counts. Receiving clerk: Unloads and checks incoming modify perpetual inventory records. 220 © 2017 HOCK international. A supervisor should review and approve all disposals or sales of scrapped goods and obsolete inventory. . LLC. Resale prohibited. prints shipping labels. shipments and verifies that the merchandise received reconcile the physical inventory counts to is the correct type and notes the quantities received the perpetual inventory records. perform physical inventory counts. Manual adjustments to the inventory records should be approved by a super- visor before being recorded. The person responsible for the sale of obsolete inventory or scrap should not also invoice the buyer and collect payment for the sales. or of each item.

accounts are aged monthly. The accounts receivable manager writes off delinquent accounts after 1 year. or sooner if a bankruptcy or other unusual circumstances are involved. Similarly. c) Approval of bad debt write-offs. (CIA Adapted) Question 69: One characteristic of an effective internal control structure is the proper segregation of duties. (CMA Adapted) Question 68: An auditor noted that the accounts receivable department is separate from other accounting activities. and reconciliation of the accounts payable subsidiary ledger and controlling account. d) The individual who maintains custody of an asset must have access to the accounting records for the asset. LLC. A separate credit department approves credit. c) Signing of paychecks and custody of blank payroll checks. The combination of responsibilities that could be performed by the same person is: a) Preparation of paychecks and check distribution.Section E Internal Control Question 66: The proper segregation of duties requires that: a) The individual who records a transaction does not compare the accounting record of the asset with the asset itself. d) Approval of time cards and preparation of paychecks. (CMA Adapted) Question 67: In a well-designed internal control system. 221 . Resale prohibited. b) Distribution of payroll checks and approval of sales returns for credit. c) The individual who authorizes a transaction also records it. Control accounts and subsidiary ledgers are balanced monthly. two tasks that should be performed by different people are: a) Posting of amounts from both the cash receipts journal and cash payments journal to the general ledger. (CMA Adapted) © 2017 HOCK international. d) Handling of credit memos. Which of the following areas could be viewed as an internal control weakness of the above organization? a) Credit approvals. b) The individual who records a transaction must maintain custody of the asset resulting from the transaction. c) Write-offs of delinquent accounts. For personal use only by original purchaser. b) Timekeeping and preparation of payroll journal entries. Credit memoranda are pre-numbered and must correlate with receiving reports. b) Monthly aging of receivables. d) Reconciliation of bank account and recording of cash receipts.

and access to them should be limited to personnel who have responsibility for preparing checks.  Security alarms on doors and windows can alert local police in case of a break-in.  Regular physical inventories should be taken and missing items should be investigated. Employees should be instructed not to put their passwords in an exposed area. and access to them similarly restricted. such as comparing the report of the physi- cal count of inventory to the internal inventory records.  Invoices should be prepared based on verified orders. 222 © 2017 HOCK international. and the check numbers should be recorded in a log as they are used. Inventory can be a major portion of a company’s assets. The packing slip should be prepared at the same time the invoice is prepared. fire. Resale prohibited. Purchase orders should also be pre-numbered.  Inventory should be kept in a physically locked area.Internal Control CMA Part 1 Physical Protection – Controlled Access to Records and Documents Checks should be stored in a locked area. LLC. but internal controls are vital to protect as much as possible against loss. and nothing should be shipped without a packing slip. Any checks discovered missing should be promptly reported to supervisory personnel. Password access should be controlled by limiting the access granted by each employee’s password to just the information needed by that employee to do his or her job. For personal use only by original purchaser.  A security guard may be employed during hours when employees are not present if the inventory has high value. The checks should be pre-numbered. The very existence of cameras tends to discourage employee theft. The risk of loss can be at least partially transferred through purchase of insurance. For example:  Comparison of independent sets of records is necessary. subject to authorization and approvals by other individuals.  Security cameras can be used to monitor activity in the inventory area and to help identify theft and thieves.  The inventory area should be monitored by a gatekeeper who verifies proper authorization for requests to move goods. fireproof file cabinet or safe under controlled access. Records of actual shipments made should be compared with internal shipping documents. Corporate credit cards should be kept in a locked cabinet and access to them controlled. or comparing the information on a bank reconciliation with the actual bank statement to confirm the bank balance used in the reconciliation is correct. numbers logged as used.  The process of receiving inventory should be supervised to make sure the inventory clerk is actually counting the items received before affirming their receipt. and it is vulnerable to loss from theft. Physical Protection – Restricted Access to Assets When cash must be stored until it can be deposited. . Effective Supervision and Independent Checks and Verifications Supervision over the performance of clerical functions is necessary. it should be kept in a locked. and natural disasters. which should be com- pared with invoices issued to verify that the procedures are being followed.  Requisitions for inventory should be approved by authorized personnel. and the locks should be technically advanced (not just simple combination locks).

and an internal control provision. Under the FCPA. various federal legislative initiatives have been created to promote or require companies to implement internal controls. and in some cases they apply to all companies. whereas the anti-corruption and anti-bribery provisions apply to any company. 302. the company must ensure that all transactions are made in accordance with management’s general or specific authorization and are recorded properly. 204. substantially revised in 1988 and amended in 1998 by the International Anti-Bribery and Fair Competition Act of 1998. a foreign political party or party official. many provisions of the Sarbanes-Oxley Act apply only to publicly-traded companies and companies that report to the SEC. politicians. In addition. or an individual acting on behalf of a firm. Anti-Bribery Provision The anti-bribery provisions of the FCPA apply to all companies.  Identify the role of the Public Company Accounting Oversight Board (PCAOB) in providing guidance on the auditing of internal controls. The entire company. which is the primary regulatory agency of these internal control statutes. although individuals are personally liable for their own actions. For example. it is illegal for any company or anyone acting on behalf of a company to bribe any foreign official in order to obtain or retain business. 203. companies that are registered with and report to the SEC. not any one individual or position in the company. regardless of whether the corrupt act takes place inside or outside the United States. The payments were either illegal political contributions or payments to foreign officials that bordered on bribery. regardless of whether or not they are publicly traded. © 2017 HOCK international. Investigations by the SEC had revealed that over 400 U. Companies that are not publicly traded and do not report to the SEC do not need to comply with many of these laws because they do not fall under the jurisdiction of the SEC. or any candidate for foreign political office. is responsible for ensuring that all payments are legal and lawful. will be held criminally liable if it makes payments to a third party with the knowledge that those payments will be used by the third party as bribes.S. public or private. Furthermore. and political parties. Resale prohibited. Note: This prohibition is only against corrupt payments to a foreign official.Section E Legislative Initiatives About Internal Control Legislative Initiatives About Internal Control In the United States. and 407). One significant issue with these federal laws is that in some cases these statutes apply only to publicly traded companies or only to companies that report to the SEC. The FCPA has two main provisions: an anti-bribery provision. a firm.  Identify the PCAOB-preferred approach to auditing internal controls as outlined in Auditing Standard #5. was enacted in response to disclosures of questionable payments that had been made by large companies. even companies that do not report to the SEC. For personal use only by original purchaser. 404. CMA candidates should be able to do the following:  Identify and describe the major internal control provisions of the Foreign Corrupt Practices Act.  Describe the major internal control provisions of the Sarbanes-Oxley Act (Sections 201. The accounting and internal control provisions of the Foreign Corrupt Practices Act apply to all U. whereas some provisions apply to all companies. with significant operations in the United States. companies had made questionable or illegal payments in excess of $300 million to foreign government officials.S. Foreign Corrupt Practices Act (FCPA) The Foreign Corrupt Practices Act of 1977 (FCPA). 223 . LLC. not only those with foreign operations.

That peer review program continues.S. or on a voluntary basis (for example. and accounts that accurately and fairly reflect transactions and to develop and maintain a system of internal accounting control. external auditors) are required to register with the PCAOB. For personal use only by original purchaser. The Sarbanes-Oxley Act requires all accounting firms (both U. peers) to ensure it meets certain criteria.S. non-governmental board. A peer review is performed for an accounting and audit firm by professionals from another accounting and audit firm. Resale prohibited. standards. the PCAOB conducts regular inspections of the registered public accounting firms to assess their degree of compliance with the Act and it has procedures to investigate and discipline firms that commit violations. Note: The internal control provision of the FCPA applies only to companies that are publicly traded. and enhance the public’s confidence in independent audit reports.S and non-U. which oversees the approval of its Board’s rules. the PCAOB is a non-profit corporation that operates under the authority of the SEC. In addition. Furthermore. using it as a best- practices benchmark). Therefore. Sarbanes-Oxley was enacted in response to several major incidents of financial reporting fraud and audit failures. whether or not the payment leads to the desired outcome. owned. public companies became subject to external and independent oversight. Sarbanes-Oxley Act and the PCAOB The Sarbanes-Oxley Act of 2002 (SOX or SarbOx) contains provisions impacting auditors. independence.S.S. and a privately-held company may comply with SOX in preparation for an initial public offering. and budget. the profession had been self-regulated through a formal peer review31 program administered by the American Institute of Certified Public Accountants (AICPA).Legislative Initiatives About Internal Control CMA Part 1 Note: A corrupt payment is one that is intended to cause the recipient to misuse his or her official position in order to wrongfully direct business to the payer. 2) Establishing auditing and related attestation. all of their divisions. and accounting and audit firms that are required to be inspected by the PCAOB are also subject to peer review. and all of their wholly-owned subsidiaries.S. the PCAOB is charged with developing auditing standards to be used by registered public accounting firms in their preparation and issuance of audit reports. Previously. and it applies to all publicly-held companies in the U. ethics. under the Foreign Corrupt Practices Act corporate management is required to maintain books. It also applies to any non-U. publicly-held multinational companies that operate in the U. quality control. 31 “Peer review” is a process of self-regulation used in professions to evaluate the work performed by one’s equals (that is. public accounting firms (that is. LLC. The formation of the PCAOB constitutes the first time that auditors of U. protect the interests of investors. and audit committees. in preparation for raising private funding for a sale of the company. The responsibilities of the PCAOB include: 1) Registering public accounting firms that audit public companies.. records. In addition. whose mandate is to oversee the auditing of public companies that are subject to the securities laws. management. Peer review is performed by qualified individuals within the same profession.S. Title I: Public Company Accounting Oversight Board (PCAOB) Title 1 of the Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (PCAOB). As an independent. . and other stand- ards relating to the preparation of audit reports for issuers. firms) that prepare or issue audit reports on or participate in audits of U. 224 © 2017 HOCK international. some provisions apply also to privately-held companies. Internal Control Provision The fundamental premise of the internal control requirements of the FCPA is that effective internal control acts as a deterrent to illegal payments. According to the Act. public companies to register with the PCAOB.

professional standards. 225 . the Board assesses the firm’s com- pliance with the Sarbanes-Oxley Act. LLC. 5) Internal audit outsourcing services. investment adviser. In the inspections. 6) Management of the operations and staff of the Board. They must then remain off that audit for another five years. accounting or reporting matter affecting the company’s financial statements or who maintains regular contact with management and the audit committee of the audit client. Section 201 lists specific non-audit services that may not be provided by an external auditor to an audit client because their provision creates a fundamental conflict of interest for the accounting firms. Title II: Auditor Independence Section 201: Services Outside the Scope and Practice of Auditors In order to maintain auditor independence. Examples of specialty partners are tax or valuation 32 An “audit partner” is defined as any partner on the audit engagement team with responsibility for decision-making on any significant audit. Resale prohibited. or professional standards. do not need to rotate off. (partners who consult with others on the audit engagement regarding technical or industry-specific issues). and its professional standards in connection with the firm’s performance of au- dits. Other audit partners32 who are part of the engagement team must rotate off after seven years and remain off for two years if they meet certain criteria. 7) Human resource services. the lead audit partner and the concurring review audit partner must rotate off a particular client’s audit after five years. 3) Appraisal or valuation services. the rules of the Board. © 2017 HOCK international. the provisions of the securities laws relating to the preparation and issuance of audit reports. by regulation. Section 203: Audit Partner Rotation A public accounting firm that is registered with the PCAOB may not provide audit services to a client if the lead audit partner or the concurring review audit partner has performed audit services for that client in each of the five previous fiscal years of the client. the rules of the Board. 2) Financial information systems design and implementation. 6) Management functions. Therefore. 4) Enforcing compliance with the Act. 8) Broker/dealer. These services include: 1) Bookkeeping services or other services relating to keeping the accounting records or preparing the financial statements of the audit client. 4) Actuarial services. or contribution-in-kind reports. and related matters involving issuers. 5) Conducting investigations and disciplinary proceedings and imposing appropriate sanctions for violations of any provision of the Sarbanes-Oxley Act. the rules of the Board. fairness opinions. issuance of audit reports. Specialty partners. annually for firms that audit more than 100 issuers and every three years for others. or investment banking services. 9) Legal services. and securities laws relating to audit reports and the obligations of accountants for them. For personal use only by original purchaser. is not permissible. 11) Any other service that the Public Company Accounting Oversight Board (PCAOB) determines. the rules of the Securities and Exchange Commission (SEC). 10) Expert services unrelated to the audit.Section E Legislative Initiatives About Internal Control 3) Conducting inspections of registered public accounting firms.

even though it is within generally accepted accounting principles. o Have evaluated the effectiveness of the company’s internal controls within the previous ninety days. the ramifications of the use of such alterna- tive disclosures and treatments. as shown in the following lists. the outside public accounting firm performing the audit must report that fact to the company’s Audit Committee. the financial statements and all the other related information in the report fairly present in all material respects the financial condition and results of operations of the company for all of the periods presented in the report. Resale prohibited. Section 204: Auditor Reports to Audit Committees Section 204 requires each public accounting that is registered with the PCAOB and performs an audit for an issuer of publicly-traded securities to report the following in a timely manner to the issuer’s Audit Committee: 1) All critical accounting policies and practices to be used. LLC. 226 © 2017 HOCK international. If management of the company is using an alternative method of accounting for something. For the CMA Exam. and the treatment preferred by the registered pubic accounting firm. The independent auditor must report all critical accounting principles being used and any other material written communications between them and management. Title III: Corporate Responsibility Section 302: Corporate Responsibility for Financial Reports Sarbanes-Oxley requires that each annual or quarterly report that is filed or submitted in accordance with the Securities Exchange Act of 1934 (that is. 1) The signing officers certify that they: o Are responsible for establishing and maintaining internal controls. the most important certifications by the officers are connected to the internal controls of the company. SEC reports) must include certifications by the company’s principal executive officer or officers and its principal financial officer or officers. such as any management letter or schedule of unadjusted differences. 3) To the best of the officer’s or officers’ knowledge. This certification must indicate the following: 1) Each signing officer has reviewed the report. Other partners who serve as technical resources for the audit team and are not involved in the audit per se are also not required to rotate off the audit. 2) The report does not contain any untrue material statement or omit to state any material fact that could cause the report to be misleading. and 3) Other material written communication between the registered public accounting firm and the man- agement of the issuer. For personal use only by original purchaser. o Have designed the internal controls to ensure that they are made aware of all material in- formation relating to the company and all subsidiaries.Legislative Initiatives About Internal Control CMA Part 1 specialists. . o Have reported on their findings about the effectiveness of their internal controls. 2) All alternative treatments of financial information within generally accepted accounting principles that have been discussed with the issuer’s management. The purpose of the audit partner rotation requirement is to ensure that a “new look” is taken periodically at the financial statements.

In many firms. Section 404(b) requires the company’s independent auditor to report on and attest to management’s assessment of the effectiveness of the internal controls. as shown here:  Revenue cycle: processing of sales and/or service revenue  Direct expenditures cycle: expenditures for material and direct production costs  Indirect expenditures cycle: operating costs other than for production activities  Payroll cycle: compensation of personnel  Inventory cycle: processes for the management of direct materials inventory until it is applied to production  Fixed assets cycle: processes for accounting for property and equipment. For personal use only by original purchaser. regardless of how material it is. o That the signing officers have stated in their report whether or not there were any significant changes in internal controls or in any other factors that could have a negative impact on the company’s internal controls after the date of their evaluation. the Act will continue to have full legal force over them. In other words. the internal audit activity is very involved in the management review and testing of the internal controls. 2) Contain an assessment by management of the adequacy of the company’s internal control over financial reporting (or ICFR). Here. If they do this. Resale prohibited.Section E Legislative Initiatives About Internal Control 2) The signing officers have disclosed to the company’s auditors and its audit committee of the board of directors: o All deficiencies in the design or operation of the company’s internal controls and have identi- fied for the company’s auditors any material weaknesses in its internal controls. Furthermore. LLC. according to Section 404(a) management is required to document and test its internal financial controls and to report on their effectiveness. o Any fraud. the internal audit activity can be of major assistance because it may already have defined the key processes during its annual audit planning and documentation. that involves management or other employees who have a significant role in the company’s internal controls. Note: Companies cannot avoid these requirements by reincorporating outside the United States or by transferring their company’s activities outside of the United States. including any corrective actions that have been taken with regard to deficiencies or material weaknesses. such as periodic record- ing of depreciation  General IT cycle: general IT controls that are applicable to all IT operations © 2017 HOCK international. according to Section 404(b) the external auditors are then required to review the supporting materials used by management and/or internal auditing in developing their internal financial controls report. The overall processes are generally organized in terms of the basic accounting cycles. Title IV: Enhanced Financial Disclosures Section 404: Management Assessment of Internal Controls and the Independent Auditor’s Attestation to Management’s Assessment of Internal Controls Section 404(a) requires each annual report required by the SEC to: 1) State the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting. 227 . The first step in a Section 404 compliance review is to identify the key processes. The external auditor’s report is done in order to assert that management’s report is an accurate description of the internal control environment.

A top-down approach begins by identifying the risks that a material misstatement of the financial statements would not be prevented or detected in a timely manner. 5 (guidance for external auditors) have the effect of efficiently focusing Section 404 compliance on the most important matters affecting investors. The external auditor then reviews the work and attests to its adequacy. In this case. An auditor who approaches the audit of internal controls from the bottom up would focus first on performing detailed tests of controls at the process. For personal use only by original purchaser. Most of the work of a financial audit involves evaluating and forming opinions about management assertions. 20XX totaled $50. FR-77.Legislative Initiatives About Internal Control CMA Part 1 The internal controls covering the key processes are reviewed and documented. 33-8810). 5 with the SEC’s guidance for management in the SEC’s Release 33-8810. 33-8810. Senior management’s approval of internal audit’s work is necessary. Although the sources of guidance are different for management and the independent auditor. and then these controls are tested. he or she often spends more time and effort than is necessary to complete the audit.” The auditor’s role is to determine whether the assertions being made by management are correct. Both SEC Release 33-8810 and PCAOB Auditing Standard No. and performing tests of the controls. Therefore. and terms. and the independent auditor. in its attestation to management’s assessment. the PCAOB intentionally aligned its guidance in Auditing Standard No. as in “Receivables due from Customer X on December 31. the guidance to management and the guidance to independent auditors are not in conflict.000. can have different testing approaches because their roles are different and therefore they are subject to different guidance. Resale prohibited.000. allowing the internal audit activity to concentrate its resources on other internal audit projects. 5 prescribe a top-down. 5. The auditor should test those controls that are important to the auditor's conclusion about whether the company's controls sufficiently address the assessed risk of misstatement to each relevant assertion. Examples of broad financial statement assertions are “Total liabilities at December 31. Beginning with risk assessment allows the auditor to focus on higher-risk areas while spending less time and effort on areas of lower risk. and application levels. S7-24-06 (hereinafter simply called Release No. 34-55929. When the auditor uses a bottom-up process.000. Both SEC Release 33-8810 (guidance for management) and the PCAOB’s Auditing Standard No. documenting the internal controls over these processes.  Guidance for the independent auditor’s attestation to management’s assessment is contained in the Public Company Accounting Oversight Board’s Auditing Standard No. 2) The company might designate some other internal or external consulting resource to perform the Section 404 reviews. 20XX was $5. Management.33 It is important for the auditor to use a top-down approach. Financial statement assertions are claims made by management in presenting financial information. 3) Internal audit may work with and assist other corporate resources that are performing the Section 404 reviews without being directly involved with those reviews. This release. It can take three forms: 1) Internal auditors may act as internal consultants in identifying the key processes. LLC. risk-based approach to evaluating internal control over financial reporting. A management assertion is a claim made by management.  Guidance for the management assessment of internal controls is provided by the SEC in Release Nos. transaction. particularly with regard to prescriptive requirements. in its assessment of internal controls. definitions. .” Financial statement assertions can be much narrower also. is intended to enable companies to implement the requirements more effectively and efficiently.000” or “Net income for the year ended December 31. internal auditors could act as a resource to support the work. 228 © 2017 HOCK international. 33 An assertion is a claim made. The extent of internal audit’s involvement in the Section 404 testing of internal controls varies from firm to firm. They may review and test internal control processes as assistants or contractors for the entity doing the review. 20XX were $150.000. not a bottom-up approach. containing the interpretive guidance for management on Section 404. File No. Furthermore.

has 1) an understanding of generally accepted accounting principles and financial statements and the ability to assess the general application of GAAP in connection with accounting for estimates. the company must state the reasons why not. and 4) an understanding of Audit Committee functions. it must disclose the name of the expert and whether that person is independent.Section E Legislative Initiatives About Internal Control when an auditor takes a bottom-up approach. If the company discloses that it has more than one financial expert serving on its Audit Committee. and the SEC has issued rules requiring. 3) experience and an understanding of internal accounting controls and procedures for financial report- ing. and applications. or active supervision of the preparation or auditing of finan- cial statements of generally comparable issuers34 in terms of the breadth and level of complexity of accounting issues. © 2017 HOCK international. accruals. Resale prohibited. transactions. auditing. 229 . but is not required to. 34 “Issuers” means issuers of securities. Spending more effort than is necessary in lower-risk areas can diminish the effectiveness of the audit because it may prevent a higher-risk area from receiving the audit attention that it should. auditor or a principal accounting or financial officer of an issuer of publicly-traded securities. disclose the names of those additional persons and indicate whether they are independent. LLC. the auditor may spend relatively little time testing and evaluating entity-level controls but instead may rely almost exclusively on detailed tests of controls over individual processes. and reserves. generally publicly-traded securities. A top-down approach ensures the proper testing of the controls for the assessed risk of misstate- ment to each relevant assertion. Section 407: Disclosure of Audit Committee Financial Expert Section 407 of the Sarbanes-Oxley Act required. those controls that address the risk of a material misstatement may not be tested. through education and experience as a public accountant. For personal use only by original purchaser. If the Audit Committee does not have at least one member who is a financial expert. it may. If a bottom-up approach is used. If the company discloses that it has one financial expert on its Audit Committee. each issuer of publicly-traded securities to disclose whether or not the company’s Audit Committee consists of at least one member who is a financial expert. The definition of a financial expert is a person who. 2) experience in the preparation.

The auditor’s opinion may be:  Unqualified: Most audit reports are unqualified. The auditor’s only responsibilities are to express an opinion about the financial statements and to express an opinion about internal controls of the company (in the case of a publicly-traded company). the financial position. and  All other material written communication between the registered public accounting firm and the management of the company. However. Usually. For personal use only by original purchaser.  The ramifications of the use of such alternative treatments. (This opinion is not required for companies that are not publicly traded.  All alternative treatments being used. They have no responsibility to follow up any audit findings from the previous year.) In its capacity as auditor. or 230 © 2017 HOCK international.  The treatment preferred by the public accounting firm.” The auditor expresses the opinion that the financial statements present fairly. in all material respects” the financial position of the company. the auditor presents two reports in the Annual Report:  An opinion on whether the financial statements present fairly. and cash flows of the company. However. LLC. the finan- cial position. results of operations. an external auditor that is registered with the PCAOB under the Sarbanes-Oxley Act is obligated under Section 204 to make reports to the company’s Audit Committee of the board of directors of a publicly- traded company that include:  The accounting principles being used.External Auditors’ Responsibilities and Reports CMA Part 1 External Auditors’ Responsibilities and Reports The Audit Committee nominates the independent auditor and the shareholders ratify this appointment at the annual meeting of shareholders. the external auditor has no responsibility to make recommendations or suggestions to the client. the auditor conducts an independent examination of the accounting data prepared and presented by management and expresses an opinion on them. Financial Statement Opinion For the opinion on the financial statements. The auditor’s report on the financial statements contains either an opinion on the financial statements as a whole or an assertion that an opinion cannot be expressed and the reasons why an opinion cannot be expressed. the work that the auditor wanted to perform) was limited or was affected by restrictions. in conformity with generally accepted accounting principles  An opinion on how effectively the company’s management has maintained effective internal control over financial reporting. the auditor would assert that the financial statements “present fairly.  Qualified: A qualified opinion contains an exception.” the opinion is in essence whether or not the financial statements are “correct. meaning that the results are “clean. and cash flows of the company. in all material respects. it does prevent the auditor from issuing an unqualified opinion. There- fore. Resale prohibited. Though the auditor will not use the word “correct. . For publicly traded companies. meaning that the financial statements do not present a true and fair picture.” Instead. in conformity with generally accepted accounting principles. the exception is usually not significant enough to cause the statements as a whole to be misleading to the point that they should not be used. in all material respects. a qualified opinion is issued under one of these conditions: o the scope of the auditor’s examination (that is. results of operations.

are not presented in conformity with generally accepted accounting principles. is the auditor’s opinion as to whether or not the company’s management has maintained effective internal control over financial reporting. The company’s annual report. A qualified opinion states that. Ad- verse opinions are seldom issued because most companies change their accounting upon the instructions of the auditor. the financial position. For personal use only by original purchaser. The criteria used by the independent auditor in assessing the company’s internal control over financial reporting come from the document Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission.Section E External Auditors’ Responsibilities and Reports o the statements do not present fairly the company’s financial position or results of operations be- cause of a lack of conformity with generally accepted accounting principles or because of inadequate disclosures. © 2017 HOCK international. required by the Sarbanes-Oxley Act. the auditor’s responsibility is to express an opinion on the company’s internal control over financial reporting based upon its audit. Resale prohibited. except for this specific matter. the financial statements present fairly in all material respects. effective internal control over financial reporting as of _________________. Management’s statement must set forth their assessment of the effectiveness of these controls.  Disclaimer: A disclaimer of opinion is used when the auditor has not been able to gather enough information on the financial statements to express an opinion. filed with the SEC and incorporated into the annual report to shareholders. The auditor’s opinion states that manage- ment is responsible for maintaining effective internal control over financial reporting and for assessing the effectiveness of its internal control over financial reporting. LLC. in the auditor’s judgment. must be accompanied by a statement that management is responsible for creating and maintaining adequate internal controls. The company’s auditor must report on and attest to management’s assessment of the effectiveness of the internal controls. taken as a whole. Internal Control Opinion The second report. in which case an adverse opinion is not warranted. it includes the following paragraph: In our opinion. This means that the financial statements. _____________________ maintained. based on the COSO criteria. If the independent auditor is satisfied with the company’s internal control over financial reporting. Furthermore. a qualified opinion is not appropriate. and cash flows of the com- pany in conformity with generally accepted accounting principles. in all material respects. results of operations. 231 . which is considered to be the core responsibility of the auditor and an integral part of the audit report.  Adverse: An adverse opinion is issued when the exceptions are so material that.

Furthermore. . The Institute of Internal Auditors. the senior manager would have the power to fire the Chief Audit Executive. and communicating its results. Organizational independence is achieved when the Chief Audit Executive reports functionally to the board of directors. It helps an organization accomplish its objectives by bringing a systematic. This growth of the role and expectations of internal auditors has led to the development of internal auditing as a profession. The board of directors must approve the internal audit charter. It should give the internal-audit activity authority to access all records. the Chief Audit Executive must communicate and interact directly with the board (Standard 1110. performing its work. Resale prohibited. in order to have organizational independence. and if that member of senior management were involved in some kind of fraud or fraudulent reporting. The Internal Audit Charter: Establishing the Internal Audit Function The internal audit function of a firm must have a charter. Internal auditing services contribute to the achievement of these internal control objectives by providing monitoring services for the respective controls. nature. Organizational Independence The internal audit activity must have organizational independence. objective assurance and consulting activity designed to add value and improve an organization’s operations. For personal use only by original purchaser.Internal Auditing CMA Part 1 Internal Auditing Definition of Internal Auditing Internal auditing has undergone major changes in the past few decades and has come to include areas of expertise and usage beyond strictly financial and accounting matters. functions. In general. LLC. disciplined approach to evaluate and improve the effectiveness of risk man- agement. the professional organization of internal auditors. and responsibility. In the case of the internal audit function. and compliance with applicable laws and regulations will be achieved. The monitoring of control over operations includes the effectiveness and efficiency of operations and the organization’s compliance with applicable laws and regulations. According to the Standards (Standard 1110). To accomplish the necessary organizational independence. that senior manager could instruct the Chief Audit Executive in how to do the auditing so that the internal audit activity would not be able to discover the senior manager’s improper activities. When the Chief Audit Executive is hired by and 232 © 2017 HOCK international. The charter should establish that the Chief Audit Executive (CAE) reports to the board of directors.A1). authority. The functional areas of internal auditing are similar to the functional areas of internal control. and physical property that may be relevant to the performance of engagements. An effective internal audit function provides to management and the audit committee a means of monitoring the reliability of financial reporting and the organization’s control over operations. In other words. and scope of internal auditing as follows: Internal auditing is an independent. reliability of financial reporting. It defines the nature of the assurance services and consulting services that the internal audit activity is expected to provide to the organization. control and governance processes. personnel. if the Chief Audit Executive were to report to a member of senior management. Internal control is a process designed to provide reasonable assurance that the company’s objectives in the areas of effectiveness and efficiency of operations. and organization of a corporate body. a charter is a document that outlines the principles. the internal audit charter formally defines the internal audit activity’s purpose. Reporting to the board permits the internal audit activity to be free from interference in determining the scope of its internal auditing. the Chief Audit Executive must report to a level that allows the internal audit activity to fulfill its responsibilities. has defined the fundamental purpose.

and records for the purpose of informing and advising management. other specific responsibilities of the Chief Audit Executive include:  Establishing a risk-based plan to determine the priorities of the internal audit activity. That is the definition of organizational independence. the Code of Ethics. If they had this responsibility. responsibility. Managing the internal audit activity includes the following:  Ensuring that the results of the internal audit activity’s work achieve the objectives in the internal audit charter. internal auditors do not have any authority or responsibility over operating activities. Roles and Responsibilities of the Chief Audit Executive The Chief Audit Executive’s is responsible for effectively managing the internal audit activity in accordance with the internal audit charter and the Definition of Internal Auditing.  Coordinating activities with other internal and external providers of assurance and consulting ser- vices to ensure proper coverage and minimize duplication of efforts. and  Ensuring that the internal audit activity staff members conform to the Code of Ethics and the Stand- ards. Auditors should have no authority over or responsibility for the activities they audit or the implementation of their recommenda- tions. and to this end it must have unlimited access to the company’s documents. It is the responsibility of the board or management to implement the recommendations brought to them by the internal auditors.  Establishing policies and procedures to guide the internal audit activity. authority. 233 . LLC. While the internal audit’s scope might appear broad. Note: The practice of internal auditing is governed by the International Standards for the Professional Practice of Internal Auditing issued by the Institute of Internal Auditors. In addition to the above. Scope of Activities and Responsibilities The internal audit function should cover every part of the organization’s operations.Section E Internal Auditing reports directly to the board. it would impair any independence and objectivity the internal auditors may have in working in these areas because they would in essence be auditing themselves. no senior manager or anyone else in the organization is able to influence what the Chief Audit Executive does. and properties.  Communicating the internal audit activity’s plans and resource requirements as well as the impact of resource limitations to senior management and the board. consistent with the organization’s goals. For personal use only by original purchaser. The responsibility of the internal auditor is to review and appraise policies. plans. and performance relative to its plan. personnel. there is a very specific limit to its responsibilities. The responsibility of internal audit ends with the making of recommendations. procedures. Resale prohibited. and  Reporting periodically to senior management and the board on the internal audit activity’s purpose. © 2017 HOCK international. and the Internation- al Standards for the Professional Practice of Internal Auditing. However.  Ensuring that the internal audit activity conforms with the Definition of Internal Auditing and the Standards. records.

 Safeguarding of assets. and  Compliance with laws. The adequacy of risk management. b) Assurance that fraudulent activities will be detected quickly. and governance processes are working perfectly. collusion. Note: The size and scope of an internal audit function of a company will depend upon a number of factors. policies. and contracts. It is also important to note that external auditors also provide only “reasonable assurance” with their audit work. According to Internal Auditing Standard 2130. Senior management and the board might also provide general direction as to the scope of work and the activities to be audited. and governance process and the quality of performance in carrying out assigned responsibilities. control. (CMA Adapted) 234 © 2017 HOCK international. operations. procedures. and governance process is to provide reasonable assurance that these processes are functioning as intended and will enable the organization’s objectives and goals to be met. control.  Reliability and integrity of financial and operational information. control. disciplined approach to evaluating and improving the adequacy and effectiveness of risk management. the internal auditor assists the organization in maintaining effective controls by evaluating the adequacy and effectiveness of controls in responding to risks within the organization’s governance. “Reasonable assurance” recognizes the fact that there is no way to guarantee that the risk management. The purpose of evaluating the adequacy of the organization’s existing risk management. and to provide recommendations for improving the organization’s operations. the scope of internal auditing work encompasses: a systematic. the internal audit function can provide reasonable assurance that these areas of the business are operating as they should by properly designing tests and testing controls and by properly analyzing the control activities in a company. or other events that will cause a control to fail. LLC. . Question 70: Which of the following statements represents the most important benefit that the internal audit department provides to management? a) Assurance that the organization is in compliance with legal requirements. regulations. There is always the potential for mistakes. and governance processes is present if management has planned and designed for these items in a manner that provides reasonable assurance that the organization’s objectives and goals will be achieved efficiently and economically. A small company may not have an internal audit function and will outsource to consultants or external auditors any work that would be done by an internal auditor. Resale prohibited. d) Assurance that external financial statements are correct. and among these are the size and complexity of the operations of the company and the amount of risk that the owners are willing to bear. The main thing to bear in mind is that the benefit of the internal audit function must be greater than the cost of the internal audit function. c) Assurance that there is reasonable control over day-to-day operations.Internal Auditing CMA Part 1 Scope of Services Based on the recommendations of the IIA. control. failure to properly apply a control. While it is not possible to provide absolute guarantees. in terms of both efficient and effective performance. For personal use only by original purchaser.  Effectiveness and efficiency of operations and programs.A1. human error. Large companies will have their own internal audit function that will be led by the Chief Audit Executive (CAE) and may have hundreds of staff members. and information systems regarding the:  Achievement of the organization’s strategic objectives.

the CAE takes into account the organization’s risk management framework. the CAE should obtain input from senior management and the board. It is largely through this consideration of risk that the CAE is able to prioritize the necessary engagements. Usually. However. the CAE should be able to determine what the audit universe includes. when properly executed. The specific nature of a given test of a control will depend on the control itself. will adequately address these risks. including using the risk appetite levels set by management for the different activities or parts of the organization. the audit committee. For personal use only by original purchaser. 235 . after consultation with senior management and the board. the test of compliance would confirm that all purchase orders are signed by the proper two individuals. even without the assistance of senior management and the board. However. the chief audit executive will need to prioritize which engagements should be performed. In order to assist management in the fulfillment of this responsibility. According to Internal Auditing Standard 2010: “The chief audit executive must establish a risk-based plan to determine the priorities of the internal audit activity. is responsible for the organization’s internal control. which is a list of all the possible audits that the internal audit activity can perform. or controls  Changes in the risk environment or control procedures in a given department  The potential benefit that could be achieved from the engagement © 2017 HOCK international. Determining Which Engagements to Conduct The Chief Audit Executive (CAE) decides which engagements will be performed. programs. risk is not the only criteria because there are other factors that will be considered. consistent with the organization’s goals. if the control requires two signatures on all purchase orders. This monitoring of the control system essentially has two parts: 1) Evaluating the effectiveness of controls by identifying risks and then assessing existing controls to determine whether or not these controls. To understand the nature of the audit universe. the audit universe includes many more potential engagements than the internal audit function has the resources to perform. including:  The length of time since the last engagement was performed in this area  Requests from senior management. operations. Resale prohibited. or the process of testing to see if the controls are being fol- lowed. systems. One of the most important elements when prioritizing engagements is the consideration of risk. the details of this testing are outside the scope the exam. In a sense.” For this purpose. the CAE should use his or her own judgment of risks. the evaluation of the effectiveness of controls looks at how the controls are de- signed in theory. In considering risk. Therefore. and there are many factors that the CAE will consider in making this decision. or other governing bodies  An engagement’s relation to the external audits of financial statements and management control over financial reporting  Changing circumstances in the business. Many CAEs find it useful to first update the internal audit activity’s audit universe. including the board of directors.Section E Internal Auditing Testing and Evaluating the Effectiveness of the Internal Control System The company’s management. risk is defined as the likelihood that the goals and objectives of the organization will not be achieved. LLC. 2) Testing compliance with controls. If a framework does not exist. internal auditors are used to monitor the performance of the organization’s internal control systems. Priority should be given to areas where risk is assessed the highest. However. For example.

a CAE might consider and assess the risks associated with petty cash: petty cash is available to a large number of people. and records of transactions require simple documentation. audits of system security. and their nature and scope are agreed upon with the client36 prior to the engagement. probability) of the loss occurring. the dollar amount is generally low.Internal Auditing CMA Part 1  Changes in the skills of the available staff. The internal auditors will then compare the results of the operations with these standards. They are intended to add value and improve an organization’s governance. 236 © 2017 HOCK international. look only at operational and compliance audits because these are the only two types of engagements listed in the LOS. and control processes without the internal auditor assuming management responsibility. more accurately. Internal auditors do not have external clients. Resale prohibited. After considering these factors. and the quality of performance in carrying out assigned responsibilities. For personal use only by original purchaser. Assurance services involve performing an objective examination of evidence to provide an independent opinion or conclusions regarding an entity. a new employee may bring new skills. Operational (or Performance) Audit The purpose of an operational or performance audit is to examine and evaluate systems of internal control. a system. and due diligence35 engagements. risk management audits. control procedures (or. a process. the CAE may determine that petty cash has a lower priority when compared to an area where there is a lower risk of loss but the potential amount of the loss is much greater. In order to assess these items. a function. Usually they are performed at the request of the client. while qualitative assessments include things such as risk in the area of fraudulent behavior or the importance of the section to the operations of the business as a whole. One way to measure the extent of risk in different areas is to multiply the dollar amount that is at risk of loss by the percentage chance (that is. or some other subject. a “client” is an area within the same company for which internal auditing services are performed. 36 For an internal auditor. lack of control procedures) connected to the production processes of the company may also be an area of risk that would need investigation. . Examples of this type of work include financial audits. LLC. Consulting services involve providing advice to management. Quantitative assessments include the dollar value of the assets at risk or the potential loss. risk assessment is generally the most important because there are both quantitative (numerical) assessments and qualitative (characteristics) assessments of risk. a company must have a standard level of behavior or output or some other objective. There are also risks that are not related to the assets of the company or to a specific monetary amount that also need to be assessed. For example. because new skills may enable the internal audit activity to conduct different types of engagements (for instance. risk management. audit of financial controls. Due diligence is the process of evaluating the target company or its assets prior to making an offer for the business. 35 “Due diligence” is a thorough investigation that is done prior to signing a contract. Note: For the CMA Exam. an operation. compliance audits. or training may give an existing staff member new skills) Of all of these considerations. Types of Engagements Internal auditors perform two basic categories of services: assurance services and consulting services. overall company operations. For example. performance audits. Assurance engagements provide an assessment of the reliability and/or relevance of data and operations in specific areas. The most common use of the term in business applies to the acquisition of a target company.

237 . procedures. To perform a compliance audit. and complying with governmental regulations. as part of an operational audit the internal auditor will make recommendations to improve the process or operation. Compliance auditing is more objective than other internal auditing applications. procedures. the auditor will also determine the cause of the noncompliance. (CMA Adapted) © 2017 HOCK international. In a compliance audit.Section E Internal Auditing The focus of an operational or performance audit is on the three “E”s:  Efficiency  Effectiveness  Economy The overall goal of these engagements is to help the company perform better by utilizing assets more efficiently and effectively and to make certain that the activities within the company are helping the company achieve its goals. the auditor must first know the applicable policies. (CMA Adapted) Question 72: An example of the subject of an operational audit would be: a) The income tax return information of a manufacturer. or laws. and documentation. standards. Compliance Audit A compliance audit determines the degree to which an organization is operating in an orderly way. the internal auditor focuses on issues of compliance (or lack of compliance). Question 71: Which one of the following items is included in an operational audit but is not required in a financial audit conducted by an external auditor? a) Supervision of the audit team’s activities and output. standards. procedures. For personal use only by original purchaser. Resale prohibited. analysis. conforming effectively and visibly to certain specific requirements of its policies. c) The verification of the dollar amount of royalties due to the developer of a manufacturing process from the user of that process. d) Recommendations for improvement. internal auditors will also look at areas that do not affect the financial statements or other financial reporting. and decision-making. and questionnaires or interviews of employees. and laws. b) The performance statistics on the delivery of a city’s services. In addition to evaluating the financial records and information (that is. In the case of noncompliance. c) Reporting on the findings. the focus of a financial audit). b) Fact-finding. LLC. The scope of the operational or performance audit exceeds that of a financial audit. the cost of the noncompliance. and appropriate actions that must be taken in order for a company to be in compliance. The main techniques for the auditor in an operational audit are analysis. including evaluating the adequacy and effectiveness of controls related to policies. In addition. the observation of departmental activities. d) The five-year revenue and expenses forecast by an entrepreneur seeking to raise venture capital for his prospective operation.

All material weaknesses37 that could cause a control breakdown should be included in the auditor’s report. if not revealed. Many control breakdowns are accidental and do not put the company at significant risk. or extent of judgment required to determine the amount involved  The interaction or relationship of the control with other controls. whether or not they collectively could cause a material misstatement)  The possible future consequences of the deficiency Types of Incidents That Should Be Reported to the Board When reporting on the results of their work. a compensating control should operate at a level of precision that would prevent or detect any misstatement that would be material. represents a material weakness. complexity. capable of causing great consequences) misstatement in the company’s financial statements. Resale prohibited. In addition. no illegal activity is going on. 3) For a quality audit. internal auditors should reveal all material facts known to them which. Any variance between “what should be” and “what is” should be reported. 4) A situation in which no control failure has occurred. including whether or not they are interdependent or redundant  The interaction of the deficiencies (that is. interim reports should be issued whenever there is an issue that needs to be addressed immediately. and assertions involved  The susceptibility of the related asset or liability to loss or fraud. inconsistent product quality that may cause a loss of market share. This level is always at least one level above the point at which the fraud is suspected. If fraud is suspected. 2) Violation of any law. if an 37 “Material” as used in this context means important or capable of causing great consequences. LLC. 238 © 2017 HOCK international. This reporting will be in the engagement report and may also be reported directly to the Board.Internal Auditing CMA Part 1 Reporting to the Board A control breakdown occurs when a control fails. In order to have a mitigating effect. either individually or in combination with other deficiencies. he or she should evaluate its severity to determine whether or not the deficiency. Risk factors affect whether or not there is a reasonable possibility that a deficiency or a combination of deficiencies will result in a misstatement of an account balance or disclosure. For personal use only by original purchaser. the internal auditor should notify the appropriate level within the organization. The severity depends upon:  Whether or not there is a reasonable possibility that the company’s controls will fail to prevent or detect a misstatement of an account balance or disclosure  The magnitude of the potential loss resulting from the deficiency or deficiencies The auditor should evaluate the effect of compensating controls when determining whether or not a control deficiency is a material weakness. such as environmental regulations. For instance. breakdowns and their associated risks need to be properly reported. Examples of incidents that should be reported include but are not limited to: 1) Fraud. or how likely it is that something could go wrong  The subjectivity. However. Generally. If an internal auditor identifies a weakness in controls. The auditor may choose to issue an interim report if the breakdown is significant. could either distort reports of operations under review or conceal unlawful practices. if there is more than one. . the internal auditor needs to identify significant control breakdowns that could harm to the company. These risk factors include:  The nature of the financial statement accounts. Thus a material weakness is a an important weakness that could lead to a material (important. A material weakness occurs when one or more of a company’s internal control procedures that is intended to prevent significant financial statement irregularities is found to be ineffective. and no accounting errors have occurred may also be a reportable situation in certain circumstances. disclosures.

according to the CAE’s judg- ment. internal control is not a guarantee that an organization will achieve its financial reporting. and compliance objectives. or they can be circumvented by collusion. As seen in the section on Internal Control. Audit risk is the risk that the auditor will come to the wrong conclusion. and they are applicable to any type of engagement performed by the internal auditor. operational. fraud. Audit risk can be looked at in these three ways:  Inherent risk: The risk that is natural in the function being audited. This information is included in Internal Audit because it fits better with the topic of auditing. including conditions related to control weaknesses. or management may override internal control procedures. LLC. could adversely affect the organization and its ability to achieve its strategic. Major risks are that controls may fail because of human error. It also is the risk that they will conclude that the internal control system is not working properly when it is in fact working properly. ineffectiveness. errors.  Detection risk: For an internal auditor. conflicts of interest. For personal use only by original purchaser. irregularities. the goal of efficiency would indicate that he or she report this information to management. not to make decisions. The role of the internal auditor is simply to report to the Board. After the information is communicated to the Board. No matter how well designed and operated it is. and finan- cial viability. waste. this is the risk that the auditor through audit testing will not detect a material misstatement in an account balance or class of transactions that could result in a material weakness for the company. inefficiency. when it is not really working properly. Inherent Risk. and compliance objectives. financial reporting. assuming that there are no controls. 239 . © 2017 HOCK international. for an internal auditor there is a risk that after they do all of their testing and analysis they will conclude that the internal control system is working properly. For example. operational. IIA Practice Advisory 2060-1. Control Risk and Detection Risk Note: This topic is listed in the LOS in the section Governance. which by nature are extremely complex. Risk and Compliance. Generally.  Control risk: The risk that an internal control will not prevent or detect a material misstatement in a timely manner. provides guidance on this issue as follows: Significant risk exposures and control issues are those conditions that. It is the susceptibility to a material mistake that exists “just because. internal control can provide only reasonable assurance to man- agement and the board of directors that the organization’s objectives will be achieved.” An example of an inherent risk is the calculation of pension liabilities. illegal acts. Resale prohibited. the Board decides the actions to be taken. Significant issues may carry unacceptable expo- sure to internal and external risks. when the auditor knows that the supplier is offering discounts to other companies on similar pur- chases. audit risk and the specific risks of inherent. control and detection risk are discussed as part of a financial statement audit.Section E Internal Auditing auditor discovers that a major supplier is not offering the organization a discount for early payment.

c) Reliability and integrity of information. (CMA Adapted) Question 74: Inherent risk is: a) The risk that the auditor may unknowingly fail to appropriately modify his opinion on financial statements that are materially misstated. LLC. (CMA Adapted) Question 75: Control risk is the risk that a material misstatement in an account will not be prevented or detected in a timely basis by the client’s internal control structure policies or procedures. (CMA Adapted) 240 © 2017 HOCK international. The best control procedure for preventing or detecting fictitious payroll transactions is: a) Personnel department authorization for hiring. b) The risk that the auditor will not detect a material misstatement that exists in an assertion. Resale prohibited. assuming that there are no related internal control structure policies or procedures. For personal use only by original purchaser. job status and termination. d) Storage of unclaimed wages in a vault with restricted access. d) The risk that a material misstatement that could occur in an assertion will not be prevented or detected on a timely basis by the entity’s internal control structure policies or procedures. d) Safeguarding of assets.Internal Auditing CMA Part 1 Question 73: In assessing relative risks. c) Periodic independent bank reconciliations of the payroll bank account. internal auditors should be least concerned with: a) Statistical sampling techniques. b) Compliance with internal and external rules and regulations. b) To use and account for prenumbered payroll checks. c) The susceptibility of an assertion to a material misstatement. . pay rate.

there should be no chance for clerical (human) error in processing. 2) Control Objectives for Information and related Technology (COBIT). LLC. The audit trail must include all of the documentary evidence for each transaction and the control techniques that the transaction was subjected to. which is discussed in the section of this text titled Internal Control. as well. © 2017 HOCK international. However. On the positive side. this type of fraud may go undetected for a long period of time. since support documents may be periodically deleted. if there is a mistake in the program itself. the reliability of an accounting information system is questionable. there will be an error in every transaction that is processed using that defective program. Information system internal control guidelines are based upon two documents: 1) The report of the Committee of Sponsoring Organizations. Without proper controls. In Internal Control – Integrated Framework. Furthermore. internal control is defined as a process designed to provide reasonable assurance that the company’s objectives will be achieved in the areas of effectiveness and efficiency of operations. and compliance with applicable laws and regulations. The existence of an audit trail means that an amount appearing in a general ledger account can be verified by evidence supporting all the individual transactions that go into the total. paper audit trails may exist for only a short period of time. reliability of financial reporting. The concentration of data storage creates exposure. Further complicating the situation is the fact that because of the nature of the system. The objectives of controls for an information system are similar to the objectives of overall organizational internal controls:  Promoting effectiveness and efficiency of operations in order to achieve the company’s objectives. if a clerical error is made in input. it will of course result in an output error. This can enable management to maintain closer control over the activities of the company and their results. Potential for fraud is always present in organizations and is a serious problem.  Safeguarding assets. as well as adher- ence to managerial policies. management and other personnel. in order to provide assurance that the transaction was properly authorized and properly processed. Resale prohibited. even without computer processing of data. The automatic processing of data. computer systems can provide large amounts of information to management in a very short period of time. Since computers apply the same steps to similar transactions. The internal control system is the responsibility of the company’s board of directors. The potential for fraud is further increased because of the fact that programs are used for the processing. Internal Control – Integrated Framework.  Assuring compliance with all laws and regulations that the company is subject to.  Maintaining the reliability of financial reporting through checking the accuracy and reliability of accounting data. the volume of the data processed and the complexity of the processing are aspects of computer processing that can increase both the risk of loss and the potential dollar loss from exposures that would exist anyway. When an audit trail is absent.Section E Systems Controls and Security Measures Systems Controls and Security Measures Introduction to Systems Controls Extensive use of computers in operations and accounting systems can tend to increase the company’s exposure to inaccuracies and fraud. There is potential for fraud to be committed within the program itself. authored by the IT Governance Institute and published by the Information Systems Audit and Control Foundation (ISACF). 241 . For personal use only by original purchaser.

This is a matter of judgment by management to determine what is required to attain reasonable assurance that the control objectives are being met without spending more than can possibly be gained. This means that management should not spend more on controls than the amount the company can expect to receive in benefits from the controls. inaccurate accounting. Reprinted with permission. erroneous management decisions. controls should be subjected to cost/benefit analysis. 1994. or damaging data  Hardware can be stolen  Physical facilities as well as the data maintained in them can be damaged by natural disasters. without recording any transaction that can be detected  Viruses. and worms can infect a system. and 2013 by the Committee of Sponsoring Organizations of the Treadway Commission. Trojan Horses.Systems Controls and Security Measures CMA Part 1 The internal control system consists of five interrelated components: 1) The control environment 2) Risk assessment 3) Control activities 4) Information and communication 5) Monitoring38 Control Objectives for Information and related Technology defines control as “the policies. LLC. practices. Vol. deficient revenues. Resale prohibited. 1. pp. Common exposures to loss that result from a failure to implement controls include competitive disadvantage. statutory sanctions. and excessive costs. Used by permission. For personal use only by original purchaser. copyright 2000. illegal activity or sabotage 38 Internal Control – Integrated Framework.” 39 The COBIT document was used as a major resource for this section on systems control. causing a system crash.org. copyright 1992.itgi. A few of them are:  Errors can occur in system design  Errors can occur in input or input manipulation may occur  Data can be stolen over the Internet  Data and intellectual property. and organizational structures designed to provide reasonable assurance that business objectives will be achieved and that undesired events will be prevented or detected and corrected. including trade secrets. either deliberately or accidentally  Data can be altered directly in the data file. Threats to Information Systems Sources of threats to information systems and data are many. . two volume edition 1994. fraud and embezzlement. reproduction without permission is not permitted. 242 © 2017 HOCK international. 39 Control Objectives for Information and related Technology (COBIT). Further. stealing data. IT Governance Institute. 3rd Edition. can be stolen by employees who carry it out on very small storage media or just email it out  Unauthorized alterations can be made to programs by programmers adding instructions that divert assets to their own use  Data and programs can be damaged and/or become corrupted. The ultimate responsibility for internal control lies with management and the board. 3-5. loss of assets. procedures. www. business interruption.

Controls must be a part of every system and application to preserve the integrity of the data and reduce the risk of loss from poor records. Application controls are controls that are specific to individual applications. They are designed to ensure that the company’s control environment is stable and well managed. General controls relate to the general environment within which transaction processing takes place. They are general controls. asset loss.  General operating procedures. Both general controls and application controls are essential. but they must also function effectively.  Equipment and hardware controls. fraud. The first line of defense against events of this nature and threats such as those above is effective systems controls. business interruption. Thus. processing and output stages. which relate to the environment. processing. 243 . There should be a systems control group to monitor production. General controls are broken down into the following categories (each is discussed in greater detail below):  The organization and operation of the computer facilities. violations of the law. detect and correct errors and irregularities in transactions during the input. detect. and application controls. modification and maintenance of computer programs. For personal use only by original purchaser. data security. tested.Section E Systems Controls and Security Measures High profile incidents such as the theft of millions of peoples’ names and social security numbers from databases have underscored the importance of protecting information systems and data. and approved prior to the use of the program. They are designed to prevent. including controls installed in computers that can identify incorrect data handling or improper operation of the equipment. The controls must not only exist. The Classification of Controls Controls within a computer system are broken down into two types. and output stages of work. computer programs are authorized. and correct errors in transactions as they flow through the input. Operating procedures also specify the process to be followed in system development and system changes. including provision for segregation of duties within the data processing function as well as segregation of the data processing function from other operations. and see that work is completed on schedule. A stable and well-managed control environment strengthens the effectiveness of the company’s application controls. they are broken down into these three main categories (each of which is discussed in greater detail below):  Input controls  Processing controls  Output controls © 2017 HOCK international. Resale prohibited. balance input and output. which are controls that are specific to individual applications and are designed to prevent. and damage to the business’s competitive position. inaccurate accounting. keep records.  Access controls to equipment and data. LLC. General controls include controls over the development. The IS activity should have a high enough level in the organization and ade- quate authority to permit it to meet its objectives. including written procedures and manuals. such as controls over physical access to the computer system and the data that are adequate to protect the equipment and data files from damage or theft. and changes to. administrative controls. in order to pro- vide reasonable assurance that development of. and provision for disaster recovery. segregation of duties.

c) Ensure the separation of incompatible functions in the data processing departments.Systems Controls and Security Measures CMA Part 1 Question 76: EDP accounting control procedures are referred to as general controls or application controls. The primary objective of application controls in a computer environment is to: a) Provide controls over the electronic functioning of the hardware. files and outputs for specific applications. . LLC. The committee should have regular meetings and report to senior management. Members should include senior management. Responsibilities should be delegated with appropriate seg- regation of duties. Management should make certain that all personnel in the organiza- tion know their responsibilities with respect to information systems and that they have sufficient authority to exercise their responsibilities. 244 © 2017 HOCK international. user management and representatives from the IT function.  Staffing requirements should be evaluated whenever necessary to make sure that the IT function has sufficient. and duties should be rotated periodically at irregularly scheduled times for key processing functions. Resale prohibited.  Segregation of duties should be maintained between and among the following functions: o Systems analysts o Information systems use o Data entry o Data control clerks o Programmers o Computer operation o Network management o System administration o Librarian o Systems development and maintenance o Change management o Security administration o Security audit Segregation of duties will be discussed in more detail later. d) Plan for the protection of the facilities and backup for the systems. For personal use only by original purchaser. b) Maintain the accuracy of the inputs.  The IT function should be positioned within the organization so as to ensure its authority as well as its independence from user departments. (CMA Adapted) General Controls Organization and operation of the computer facilities  An IT Planning or Steering Committee should oversee the IT function. competent staff.

The documents are printed with Optical Character Recognition (OCR) fonts so that they can be read by the computer when they are scanned and thus the information does not need to be keyed in.  Logical security consists of access and ability to use the equipment and data. For personal use only by original purchaser. Unauthorized personnel. has some additional information that has been added to it. including network operations. Resale prohibited. online connections and other system entry ports should be prevented from accessing computer resources. processing continuity during operator shift changes. assigned duties should be rotated periodically for key processing functions. and changes to. and cryptographic tech- niques such as encryption of messages and digital signatures. personnel should be trained in their jobs. and source. and then is returned to become an input document to the computer. 245 . and between output. Equipment Controls  A defined backup procedure should be in place. a person who does invoic- ing needs access to the invoicing module of the accounting program but does not need access to the © 2017 HOCK international. It includes Internet security (firewalls) and virus protection procedures.  Turnaround documents should be used whenever appropriate. computer programs are author- ized. The use of a turnaround document limits the chances of input errors occurring and reduces the need for manual data entry. job scheduling. Sequential numbers on individual forms should be printed in advance so missing forms can be detected. All passwords should be issued with levels of authority that permit the users to access only the data that they need to be able to access in order to do their jobs. These should include documentation of the start-up process.