By Dennis Caplan, University at Albany (State University of New York)


Five-Page Summary of Key Concepts:


Cost Classifications:

Cost object: something we want to know the cost of.

All costs can be classified along each of the following three dimensions.

- direct costs versus overhead costs (also called indirect costs)

- variable costs versus fixed costs (many costs are mixed; also called semi-variable)

- manufacturing costs versus non-manufacturing costs


Steps in Cost Allocation:

Step 1: Identify the cost object (usually a product or service of the organization).

Step 2: Identify the direct costs. These costs can be traced directly to the cost object.

Step 3: Identify the overhead cost pools associated with the cost object.

Step 4: Select the cost allocation base for assigning each overhead pool to the cost object.

Step 5: Develop the overhead rate per unit of the allocation base:



Overhead Rate =

Total Costs in the Overhead Cost Pool

Total Quantity of the Cost Allocation Base


This rate is used to allocate overhead to the cost object based on the quantity of the allocation base incurred by the cost object. For example, to allocate utility expense at a factory using direct labor hours as the allocation base, the ratio in Step 5 is total utility expense incurred by the factory during the period divided by total hours of direct labor incurred for all products made at the factory. Utility expense is then allocated to each product using this ratio multiplied by the total direct labor hours incurred in the production of each product.

If overhead is allocated using budgeted rates (as in Normal Costing and Standard Costing), Step 5 becomes:


Step 5a: For the budget period, estimate the total quantity of the cost allocation base that will be incurred.

Step 5b: For the budget period, estimate the cost of items identified in Step 3 above.

Step 5c: Compute the budgeted overhead rate as: Step 5b Step 5a

Activity-Based Costing (ABC): A costing system characterized by the use of multiple overhead pools, each with its own allocation base, and characterized by the choice of cost drivers for the allocation bases.

Misapplied Overhead (O/H)

When overhead is allocated using budgeted rates, a difference can arise between actual overhead incurred, and overhead allocated to product. This difference is called Underapplied or Overapplied Overhead.


Misapplied overhead = actual overhead incurred overhead applied

If actual overhead incurred is greater than overhead applied, overhead is underapplied.

If actual overhead incurred is less than overhead applied, overhead is overapplied


Cost-Volume-Profit Analysis:

P = (SP VC) x Q - FC

Where: P = profits,

SP = sales price per unit,

VC = variable cost per unit (manufacturing and non-manufacturing),

Q = number of units made and sold

FC = total fixed costs (manufacturing and non-manufacturing).

SP VC is the unit contribution margin (UCM)

Q x (SP VC) is the total contribution margin. (TCM)

TCM sales is the contribution margin ratio. (CMR)

Breakeven Point: in units = FC UCM; in sales dollars = FC CMR


Flexible Budgeting:

Static budget variance = actual results static budget (i.e., the original budget)


Flexible budget for costs =

(static budget VC x actual units produced or sold) + static budget FC.


Flexible budget for revenues = static budget SP x actual units sold.


Flexible budget variance = actual results flexible budget


Variable Cost Variances:

The materials price (or labor rate) variance


= (AP - SP) x AQ = (AQ x AP) (AQ x SP)


The materials quantity or usage (or labor efficiency) variance


= (AQ - SQ) x SP = (AQ x SP) (SQ x SP)


Where AP = actual price per unit of input, SP = budgeted (i.e., standard) price per unit of input, AQ = actual quantity of inputs used (or purchased), and SQ = quantity of inputs that should have been used for the actual output achieved (actual units produced x standard quantity allowed per unit; a flexible budget concept)


Fixed Manufacturing Overhead (FMOH) Cost Variances

There are important issues related to how the denominator in the overhead rate (step 5) is calculated for the purpose of allocating fixed overhead. Two choices are:

1. Practical Capacity: The level of the allocation base that would be incurred if fixed assets run full-time, but allowing for routine maintenance and unavoidable interruptions.

2. Budgeted Utilization: The level of the allocation base that would be expected for budgeted production.


Budget variance (also called the fixed overhead spending variance)

= actual total FMOH - budgeted total FMOH


Volume variance = budgeted total FMOH - FMOH allocated to output using a standard costing system (i.e., budgeted FMOH per unit x actual units produced).


Budgeted FMOH per unit = FMOH the denominator concept in step 5 above.

The volume variance is favorable if actual production exceeds the denominator in the FMOH rate.


Absorption Costing and Variable Costing:

Under Absorption Costing (also called Full Costing), product costs (also called inventoriable costs) include all manufacturing costs: labor, materials, and manufacturing overhead (fixed and variable). Absorption Costing is required for external reporting under GAAP.


Variable Costing (also called Direct Costing) is an alternative method that treats direct manufacturing costs and variable manufacturing overhead as product costs, but treats fixed manufacturing overhead as a period expense (appears on the income statement when incurred). Variable costing assumes fixed costs are unrelated to production, since these costs are incurred in the short-run even if nothing is produced.


Absorption Costing and Variable Costing treat direct labor, direct materials, and variable manufacturing overhead in the same way (and they both honor the matching principle for these costs). Both methods also treat non-manufacturing costs in the same way (as a period expense). Only fixed manufacturing overhead is treated differently.

Each method is associated with its own income statement format:


Gross Margin Income Statement under Absorption Costing







COGS (cost of goods sold)

Gross margin

Fixed and variable non-manufacturing costs



Where COGS = (manufacturing VC + FMOH per unit) x units sold; and FMOH per unit = FMOH units produced (or other denominator-level concept).


Contribution Margin Income Statement under Variable Costing









Variable manufacturing costs

Variable non-manufacturing costs

Contribution margin

Fixed manufacturing costs

Fixed non-manufacturing costs



Where variable manufacturing costs = manufacturing VC x units sold (honoring the matching principle); and variable non-manufacturing costs = all variable non-manufacturing costs incurred during the period (not honoring the matching principle).


Calculation of Ending Inventory:

Absorption Costing: (manufacturing VC + FMOH per unit) x units in ending inventory


Variable Costing: manufacturing VC x units in ending inventory


Operational Budgeting:

Production budget (in units)

Beginning units + units produced = units sold + ending units


Cash budget (in dollars)

Beginning cash + receipts = ending cash + disbursements

Capital Budgeting:

Net Present Value (NPV) = the present value of current and future cash inflows minus the present value of current and future cash outflows.


Internal Rate of Return (IRR) = the interest rate computed such that the NPV of the project is zero.


Payback Period = net investment average annual cash flow


Accounting Rate of Return (ARR), also called the Book Rate of Return:





Average annual income average book investment



Where, for example, average annual income equals cash flow less depreciation expense, and average book investment is net of accumulated depreciation.


Divisional Performance Evaluation Tools:

Return on Investment (ROI) = divisional operating profit divisional investment.

Also, ROI = investment turnover x profit margin

Where: profit margin = operating profits revenues

And: investment turnover = revenues investment.


Residual Income = operating profit (hurdle rate x divisional investment) where operating profit does not reflect a deduction for interest expense.


Transfer pricing:

Transfer prices are used to value goods or services exchanged between divisions of a decentralized firm. The transfer price is the price one division charges another division for an intermediate product. The selling division is the upstream division and the buying division is the downstream division. Three methods for setting transfer prices are a market-based transfer price; a negotiated transfer price; and a cost-based transfer price.


Three Common Costing Systems:





Actual Costing System


Normal Costing System


Standard Costing System


Direct Costs:


(Actual prices or rates x actual quantity of inputs per output) x actual outputs


(Actual prices or rates x actual quantity of inputs per output) x actual outputs


(Budgeted prices or rates x standard inputs allowed for each output) x actual outputs


Overhead Costs:


Actual overhead rates x actual quantity of the allocation base incurred.


Budgeted overhead rates x actual quantity of the allocation base incurred.


Budgeted overhead rates x (standard inputs allowed for actual outputs achieved)






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Management Accounting Concepts and Techniques; copyright 2006; most recent update: November 2010


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