Cma p1 Text v2 Jan17 A4

CMA Part 1
Volume 2: Sections D E
Financial Reporting, Planning,

Performance and, Control
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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
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means without prior written permission from HOCK international, LLC.
ISBN: 978-1-934494-71-4
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CMA Part 1 Table of Contents
Table of Contents
Section D Cost Management ......................................................................................... 1

Why Cost Management? ................................................................................................... 2
Classifications of Costs .................................................................................................... 3
The Difference Between Costs and Expenses 3
Direct Versus Indirect Costs 3
Costs Based on Level of Production (Fixed, Variable and Mixed Costs) 4
Production vs. Period Costs 7
Cost of Goods Sold (COGS) and Cost of Goods Manufactured (COGM) 13
The Flow of Manufacturing Costs .................................................................................. 15
1. Materials Inventory 15
2. Payroll 15
3. Factory Overhead Control 16
4. Work-in-Process Inventory 16
5. Finished Goods Inventory 17
6. 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 .............................. 28
Overhead Allocation ........................................................................................................ 31
Manufacturing Overhead Allocation 31
Traditional (Standard) Allocation Method 32
Process 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 ........................................................................................................... 72
Operation Costing ........................................................................................................... 74
Activity-Based Costing ................................................................................................... 75
Life-Cycle Costing ........................................................................................................... 84
Customer Life-Cycle Costing.......................................................................................... 86
Joint Products and Byproducts ..................................................................................... 87
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Table of Contents CMA Part 1
Methods of Allocating Costs to Joint Products 87

Accounting for Byproducts 95
Variable and Absorption Costing ................................................................................. 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 ................................................................................. 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 ........................................................................................... 134
What is Supply Chain Management? 134
Lean Manufacturing 134
Just-in-Time (JIT) Inventory Management Systems 137
Kanban 138
Introduction to MRP, MRPII, and ERP 139
Outsourcing 141
Theory of Constraints (TOC) 142
Capacity Level and Management Decisions 152
Business Process Improvement .................................................................................. 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 ....................................................................................... 186
Governance, Risk, and Compliance............................................................................. 187
Corporate Governance 187
Responsibilities of the Board of Directors 192
Audit Committee Requirements, Responsibilities and Authority 193
Responsibilities of the Chief Executive Officer (CEO) 197
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CMA Part 1 Table of Contents
Election of Directors 197

Internal Control .............................................................................................................. 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 .............................................................. 223
Foreign Corrupt Practices Act (FCPA) 223
Sarbanes-Oxley Act and the PCAOB 224
External Auditors Responsibilities and Reports ........................................................ 230
Financial Statement Opinion 230
Internal Control Opinion 231
Internal Auditing ............................................................................................................ 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, Control Risk and Detection Risk 239
Systems Controls and Security Measures .................................................................. 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, Detective and Corrective 262
Controls Classified as Feedback, Feedforward and Preventive 262
Computerized Audit Techniques .................................................................................. 264
Internet Security ............................................................................................................ 266
Viruses, Trojan Horses and Worms 267
Cybercrime 268
Business Continuity Planning ...................................................................................... 272
Disaster Recovery 273
Answers to Questions ................................................................................................... 275
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Table of Contents CMA Part 1
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Section D Section D Cost Management
Section D Cost Management

Section D represents 20% of the Part 1 Exam. Section D focuses on the process of determining how much it
costs to produce a product. Topics covered include several types of cost accumulation, cost measurement and
cost allocation systems as well as sources of operational efficiency and business process performance for a
firm. An important concept in the business process performance portion is the concept of competitive
advantage and how a firm can attain it. 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, but simply that these three are
where you will need to spend more time to ensure that you fully understand them for the Exam.
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Why Cost Management? CMA Part 1
Why Cost Management?

Cost management systems are used as basic transaction reporting systems and for external financial
reporting. Cost management systems not only provide reliable financial reporting, but they also track costs in
order to provide information for management decision-making.
The most important function of cost management is to help management focus on factors that make the firm
successful. The management accountant is an integral part of management, identifying, summarizing, and
reporting on the critical success factors that are necessary for the firms success. Critical success factors
are a limited number of characteristics, conditions, or variables that have a direct and important impact on
the efficiency, effectiveness and viability of an organization. They are the aspects of the companys
performance that are essential to its competitive advantage 1 and therefore to its success. Activities related to
the critical success factors must be performed at the highest possible level of excellence.
For example, the management accountant can provide information about the sources of the firms competitive
advantage, such as the cost, 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. Strategic cost management is cost management that specifically
focuses on strategic issues such as these. Thus cost management contributes to the companys achieving its
strategic goals and objectives.
Evaluating Operating Performance

In determining whether a firm is achieving its goals and objectives, two aspects of operations are important:
effectiveness and efficiency.
As we said in the section on Strategic Planning in Section B, a publicly-owned for-profit company must have
maximizing shareholder value as its ultimate goal. The shareholders are the owners. They have provided risk
capital with the expectation that the managers will pursue strategies that will give them a good return on
their investment. Thus, managers have an obligation to invest company profits in such a way that shareholder
value will be maximized. Effectiveness and efficiency are important aspects of fulfilling that obligation.
An effective operation is one that achieves or exceeds the goals set for the operation. The ultimate goal is
to maximize shareholder value. Effectiveness in reaching its goals can be measured by analyzing the firms
critical success factors. Critical success factors may be a desired level of operating income, an increase in
market share, new products introduced, or a specified return on investment. 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.
An efficient operation is one that makes effective use of its resources in carrying out the operation. If the
firm attained its goal of increasing sales but it spent more of its resources than necessary in attaining that
goal, the firm may be effective but it is not efficient. Alternatively, a firm may be efficient in its use of
resources, spending less than planned per unit sold, but if the firms goals for profitability and growth are not
achieved because sales are too low, the firm was not effective.
Therefore, assessments of efficiency are independent from assessments of effectiveness. Cost management
aids in assessing both effectiveness and efficiency.
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. Competitive advantage is discussed in detail later in this book.
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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. It is important from the very beginning to understand the different types,
classifications and treatments of costs.
The Difference Between Costs and Expenses

Costs and expenses are two different things.
1) Costs are resources given up to achieve an objective.
2) Expenses are costs that have been charged against revenue in a specific accounting period.
Cost is an economic concept, while expense is an accounting concept. A cost need not be an expense, but
every expense was a cost before it became an expense. Most costs eventually do become expenses, such as
manufacturing costs that reach the income statement as Cost of Goods Sold when the units they are attached
to are sold, 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.
However, some costs do not reach the income statement. Implicit costs2 such as opportunity costs3 never
become expenses in the accounting records, but they are costs nonetheless because they represent resources
given up to achieve an objective.
Direct Versus Indirect Costs

Direct costs are costs that can be traced directly to a specific cost object. A cost object is anything for
which a separate cost measurement is recorded. It can be a function, an organizational subdivision, 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, products, jobs, capitalized projects, and so forth. 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.
Indirect costs are costs that cannot be identified with a specific cost object. In manufacturing, overhead is
an indirect cost. Other indirect costs include support functions such as IT, maintenance and security and
managerial functions such as executive management and other supervisory functions.
2
Implicit costs are costs that do not involve any specific cash payment and are not recorded in the accounting records.
3
An opportunity cost is the contribution to income that is lost by not using a limited resource in its best alternative use. An
opportunity cost is a type of implicit cost. Both implicit costs and opportunity costs are discussed in more detail later.
Classifications of Costs CMA Part 1
Costs Based on Level of Production (Fixed, Variable and Mixed Costs)

In the following table are the main groups of costs based on their behavior as the level of production
changes. 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.
Fixed costs Fixed costs do not change within the relevant range of production. As long as the
production volume remains within the relevant range, the total amount of
these costs does not change with a change in production volume.
However, the cost per unit decreases as production increases and
increases as production decreases.
Variable costs Variable costs are costs such as material and labor that are incurred only when a
product is made. 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.
Note: Because discounts are received when more units are purchased, it may
appear that variable costs per unit decrease as production increases. However,
companies do not order units one at a time. As part of the budgeting process a
company determines how many of a particular item it will need to purchase
during the year, and the cost per unit for that particular quantity of units is used
in the budget for each unit purchased. This means that budgeted variable costs
per unit do not change as the production levels change for the company.
Mixed costs Mixed costs have both a fixed and a variable component. An example is a data
plan on a smartphone. 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.
If you go over that allowance, you pay a specified amount per megabyte used.
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.
Having looked at the above table and the basics of these classifications, 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. It is important that you know how total costs and costs per unit change as production changes. 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. Although this is not inherently difficult, we will look in more detail at this subject
because it is such an underlying element of the process.
Variable Costs
Variable costs are those costs that are incurred only if the company actually produces something. If a
company produces no units (sits idle for the entire period), the company will incur no variable costs. Direct
material and direct labor are usually variable costs. (In some situations direct labor may be a fixed cost as in
the calculation of throughput contribution margin, covered later under Theory of Constraints, but we do not
need to worry about those situations for this purpose.)
As the production level increases, the total amount of variable costs will increase, but the variable cost
per unit will remain unchanged.
Note: Variable costs are covered in many other areas of the Exams, and they are presented here only for
awareness purposes. The selling price per unit minus all unit variable costs is equal to the unit contribu-
tion. 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. Contribution margin is a measure of
contribution as a percentage of the sales price.
Fixed Costs
Fixed costs are costs that do not change in total as the level of production changes, as long as production
remains within the relevant range. The relevant range is the range of production in which the fixed
cost is unchanged. As long as production activity remains within the relevant range, an increase in the
number of units produced will not cause an increase in the total fixed costs.
Fixed costs are best described by looking at a factory as an example. A factory has the capacity to produce a
certain maximum number of units. As long as production is between 0 and that maximum number of units,
the fixed cost for the factory will remain unchanged. However, once the level of production exceeds the
capacity of the factory, the company will need to build (or otherwise acquire) a second factory. Building the
second factory will increase the fixed costs as the company moves to another relevant range.
Within the relevant range of production the total fixed costs will remain unchanged, but the fixed costs
per unit will decrease as the level of production increases.
Note: Over a large enough time period, all costs will behave like variable costs. In the short term,
some costs may be fixed (such as a factory), but over a longer period of time, the company may be able to
change its factory situation so that the factory cost also becomes variable.
Mixed Costs
In reality, many costs are mixed costs, which are a combination of fixed and variable elements. Mixed costs
may be semi-variable costs or semi-fixed costs.
A semi-variable cost has both a fixed component and a variable component. There is a basic fixed amount
that must be paid regardless of activity, even if there is no activity, and added to that fixed amount is an
amount that varies with activity. Utilities provide an example. Some basic utility expenses are required just to
maintain a factory building, even if no production is taking place. Electric service, water service, and other
utilities usually must be continued, so that basic amount is the fixed component of utilities. If production
begins (or resumes), the cost for utilities increases by a variable amount, depending upon the production
level, because machines are running and using electricity and people are using the water. The fixed
component does not change, but the total cost increases incrementally by the amount of the variable
component when production activity increases. Another example of a semi-variable cost is a salesperson
receiving a base salary plus a commission for each sale made. The base salary is the fixed component of the
salespersons salary, and the commission is the variable component.
A semi-fixed cost is fixed over a given, small range of activity, and above that level of activity, the cost
suddenly jumps. It stays fixed again for a while at the higher range of activity, and when the activity moves
out of that range, it jumps again. A semi-fixed cost moves upward in a step fashion, staying at a certain level
over a small range and then moving to the next level quickly. All fixed costs behave this way, and a wholly
fixed cost is also fixed only as long as activity remains within the relevant range. However, a semi-fixed cost
is fixed over a smaller range than the relevant range of a wholly fixed cost. An example of a semi-fixed cost is
the nursing staff in a hospital. If the hospital needs one nurse for every 25 patients, then each time the
patient load increases by 25 patients, one additional nurse will be hired and total nurses salaries will jump by
the additional nurses salary. That is in contrast to administrative staff salaries at the same hospital, which
might remain fixed until the patient load increases by 250 patients, at which point an additional admitting
clerk would be needed. The administrative staff salaries are wholly fixed costs (over the relevant range),
whereas the nursing staff salaries are semi-fixed costs.
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. A semi-fixed cost moves
upward in steps.
Total Costs
Total costs consist of total fixed costs plus total variable costs. The lowest possible total cost occurs when
nothing is produced or sold, because at an activity level4 of zero, the only cost will be fixed costs. 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. In theory at least, 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.
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. The order of the two terms on the right side of
the equals sign is not important.
To illustrate, following is a graph of total manufacturing costs for a company with fixed manufacturing costs of
$700,000 and variable manufacturing costs of $20 per unit produced. Total cost is on the Y-axis, while total
production is on the X-axis. The cost function for this companys total manufacturing costs is
Y = $700,000 + $20X
The total cost line on the graph is a straight line beginning at $700,000 on the Y axis where X is zero and
increasing by $200,000 for each production increase of 10,000 units (because 10,000 units multiplied by $20
equals $200,000). The graph of the above cost function appears on the next page.
The graph should look familiar to you, because this is another use for linear regression analysis, which we
talked about in the Forecasting topic under Trend Projection and Regression Analysis in relation to using
simple regression analysis to make forecasts. You will see this same concept again later in this section, under
the topic of Estimating Fixed and Variable Costs.
4
Activity level or level of activity can be used to refer to various types of activity. It can refer to production volume in
number of units of output, the number of units of inputs to the production process, sales volume, or to any other activity
being performed.
Y
$2,100,000
$1,900,000
$1,700,000
Total Manufacturing Costs
$1,500,000
Y = $700,000 + $20X
$1,300,000
$1,100,000
$900,000
$700,000
$500,000
X
0 10K 20K 30K 40K 50K 60K 70K
Number of Units Produced
Production vs. Period Costs

In addition to the classification of costs based on their behavior as production changes, costs can also be
classified according to their purpose. The main distinction of costs that are based on purpose is that of
Production (or Product) Cost vs. Period Cost. It is important to know this.
Note: Period costs can be fixed or variable, and production costs can be fixed or variable. So these
different classifications are not mutually exclusive from each other.
Product Costs (also called Inventoriable Costs)

Product costs, or inventoriable costs, are those costs that go directly into the production process, without
which the product could not be made. Product costs are attached to each unit and will be carried on the
balance sheet as inventory when production is completed. When the item is sold, the cost will be transferred
from the balance sheet to the income statement where it is classified as cost of goods sold, which is an
expense.
The main types of product costs are: 1) direct materials, 2) direct labor, and 3) manufacturing
overhead (both fixed and variable). These different product costs can be combined and given different
names as outlined in the tables below. You need to know what types of costs are included in the different
classifications.
Note: This definition of product cost is in accordance with financial reporting purposes. However, there are
also other types of product costs for pricing and other purposes, and we will take a look at those later in
this section.
Types of Product Costs

This table includes the main costs that are incurred in the production process.
Direct labor Direct labor costs are the costs of labor that can be directly traced to the production
of a product. Assembly line workers are direct labor costs for a manufacturing
company.
Direct material Direct materials are the materials that are directly put into the finished product. The
costs included in the direct material cost are all of the costs associated with
acquiring it: the item itself, shipping-in, insurance and taxes, among others.
Common examples of direct materials are plastic and components.
Manufacturing Manufacturing overhead costs are the companys costs related to the production
overhead process that are not direct material or direct labor, but are necessary costs of
production. Examples are indirect labor, indirect materials, rework costs, electricity
and other utilities, depreciation of plant equipment, and factory rent.
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. The maintenance department is a
common example. Indirect labor is a manufacturing overhead cost.
Indirect material Similar to indirect labor, indirect materials are materials that are not the main
components of the finished goods. Examples are glue, screws and nails and other
materials that may not even be physically incorporated into the finished good
(machine oils, lubricants, and miscellaneous supplies). Indirect materials are a
manufacturing overhead cost.
Groupings of Product Costs

The five main types of product costs in the previous table can be further combined to create different cost
classifications. 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. These are the direct
inputs, or the direct costs of manufacturing.
Manufacturing Manufacturing costs include the prime costs and manufacturing overhead
costs applied. These are all of the costs that need to be incurred in order to actually
produce the product. Manufacturing costs do not include selling or administrative
costs, which are period costs.
Conversion costs Conversion costs include manufacturing overhead (both fixed and variable)
and direct labor. These are the costs that are required to convert the direct
materials into the final product.
Note: Direct labor is both a prime cost and a conversion cost.
Period Costs, or Nonmanufacturing Overheads

Period costs, as compared to product costs, are costs for activities other than production of the product. Even
if these costs were not incurred the product could still be manufactured. Period costs are usually expensed as
they are incurred.
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). The more commonly used
examples of period costs include selling, administration, and accounting, but period costs are all the costs of
any department that is not involved in production.
Period costs can be variable, 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). As stated above, for financial reporting
purposes, period costs are expensed to the income statement as they are incurred.
However, for internal decision-making, some period costs may be allocated to the production
departments and then to the individual units. This allocation is done so that the company can set a price
for each product that covers all of the costs the company incurs. We will discuss this type of allocation in the
topic of Shared Services Cost Allocation.
Note: Overhead allocation of period costs to production will not be reflected as such in the external
financial statements issued by the company, because it is not proper to do so according to U.S. GAAP, nor
is it proper under IFRS. According to both U.S. GAAP and IFRS, period costs should be expensed in the
period when they are incurred. This type of overhead allocation would be used for internal decision making
only.
The number of classifications of period costs that a company can use on its income statement will depend
upon that company. Examples include general and administrative, selling, accounting, depreciation (of
nonproduction facilities), and so on.
Other Costs and Cost Classifications

In addition to all of the costs and classifications listed above, there are other types of costs with which a
candidate must be familiar.
Explicit costs Explicit costs are also called out-of-pocket costs. Explicit costs involve payment of cash
and include wages and salaries, office supplies, interest paid on loans, payments to
vendors for raw materials, and so forth. Explicit costs are the opposite of implicit costs.
Most explicit costs eventually become expenses, though the timing of their recognition as
expenses may be delayed, as when inventory is purchased and its cost becomes an
expense when it is sold.
Implicit costs An implicit cost, also called an imputed cost, is a cost that does not involve any specific
cash payment and is not recorded in the accounting records. Implicit costs are also called
economic costs. They cannot be specifically segregated in financial reports, but they are
needed for use in a decision-making process. 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. The lost interest is an opportunity
cost of investing in the machine. The lost interest does not actually show up as an
expense on the income statement, but it is necessary in making the decision to invest in
the machine, because it will be different if the machine is not purchased. Implicit costs do
not become expenses.
Opportunity An opportunity cost is a type of implicit cost. Opportunity cost is an economics term, and
costs opportunity cost is considered an economic cost. It is the contribution to income that is
lost by not using a limited resource in its best alternative use. When calculating the
opportunity cost, 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.
Any time that money is invested or used to purchase something, there is lost return from
the next best use of that money. Often times, that lost return is interest, as mentioned
above. If money were not used to purchase inventory, for example, it could have been
deposited in a bank and earned interest. The lost interest can be calculated only for the
time period during which the cash flows are different between the two options.
Carrying Carrying costs are the costs the company incurs when it holds inventory. Carrying costs
costs include: rent and utilities related to storage; insurance and taxes on the inventory; costs
of employees who manage and protect the inventory; damaged or stolen inventory; the
lost opportunity cost of having money invested in inventory (called cost of capital); and
other storage costs.
Because storage of inventory does not add value to the items themselves, carrying costs
are expensed on the income statement as incurred. They are not included in inventory (in
other words, they are not included on the balance sheet).
Sunk costs Sunk costs are costs that have already been incurred and cannot be recovered. 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.
Committed Committed costs are costs for the companys infrastructure. They are costs required to
costs establish and maintain the readiness to do business. Examples of committed costs are
intangible assets such as the purchase of a franchise and the purchase of fixed assets
such as property, plant and equipment. They are fixed costs that are usually on the
balance sheet as assets and become expenses in the form of amortization and
depreciation.
Discretionary Discretionary costs are costs that may or may not be spent, at the decision of a manager.
costs In the short term, discretionary costs will not cause an adverse effect on the business if
they are not incurred, but in the long run they do need to be spent. These are cost
decisions that are made periodically and are not closely related to input or output
decisions. Furthermore, the value added and the benefits obtained from spending the
money cannot be precisely defined. Advertising, research and development (R&D) and
employee training are usually given as examples of discretionary costs. Discretionary
costs may be fixed costs, variable costs, or mixed costs.
Marginal Marginal costs are the additional costs necessary to produce one more unit.
costs
Engineered Engineered costs are costs that have a definite physical relationship to the activity base or
costs measure. They result from activities that have well defined cause and effect relationships
between inputs and outputs and between costs and benefits. They are called engineered
costs because engineers specify precisely how many inputs are required to generate a
specific output. The value added by activities associated with engineered costs is fairly
clear and easy to measure. Engineered costs are variable costs in their cost behavior.
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.
Indirect resources that vary with product specifications and production volume are also
engineered costs, though the cause and effect relationships are not as precise for indirect
resources as they are for direct labor and direct materials. Relationships for indirect
resources can be established using statistical techniques such as regression analysis and
correlation analysis.
Note: When overtime must be worked, the overtime premium that is paid to the workers is considered to
be factory overhead. The overtime premium is the amount that the hourly wage increases for overtime
work.
For example, direct labor is paid $20 per hour for regular hours and is paid and time and-a-half, or $30 per
hour, for overtime hours worked in excess of 40 hours per week. Ten hours of overtime are worked. The
regular rate of $20 per hour multiplied by 10 hours, or $200, is classified as a direct labor cost, even
though it is worked in excess of regular hours. The half-time premium of $10 additional paid per hour
multiplied by 10 hours, or $100, is classified as factory overhead.
The half-time premium of $100 is not charged to the particular units worked on during the overtime hours,
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, the overtime premium paid is
allocated equally among all units produced during the period.
However, if the need to work overtime is the result of a specific job or customer request, 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 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 12,000 units per month are
as follows.
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 and a sales level of 8,000 units are:
a) $692,000
b) $960,000
c) $948,000
d) $932,000
(CMA Adapted)
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, we will
turn our attention to using these different costs in accounting calculations. We will examine the calculation of
the cost of goods sold (COGS) and the cost of goods manufactured (COGM). Though these two items are
somewhat similar, they are very different in one key respect. COGS is an external reporting figure and it will
be reported on the income statement. It is the cost of producing the units that were actually sold during the
period. COGM, on the other hand, is an internal number and is not reported on either the balance sheet or the
income statement. It represents the cost of producing the units that were completed during the period. COGM
is, however, used in the calculation of the cost of goods sold for a company that produces its own inventory.
The calculation of both numbers is looked at in more detail below.
The process of calculating the cost of producing an item is a very important one for any company. It is critical
that the calculated cost represents the complete cost of production. If the company does not calculate the
cost of production correctly, it may charge a price for the product that will be incorrect. The result will be
either low sales volume if the price is too high or low profits if the price is too low.
Additionally, as we have already covered, it is this production cost that will be included on the balance sheet
as the value of inventory when the item is completed. When the item is sold, these costs will be transferred to
the income statement as cost of goods sold.
Due to this need to determine the cost of production accurately, the information that accountants provide to
management regarding the costs of the company is crucial. Furthermore, it is beneficial to provide this
information quickly and often, so that management can make any necessary adjustments such as changes in
pricing as soon as possible.
Note: Costs that are not production costs are period costs, and they are generally expensed as incurred
(for example: inventory carrying costs, general and administrative costs, and so on).
Calculating Cost of Goods Sold

COGS represents the cost to produce or purchase the units that were sold during the period. It is perhaps the
largest individual expense item on the income statement. As such, it is important that this amount is
calculated accurately.
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. This does not always happen in reality
because units may be damaged, stolen or lost. However, for the Part 1 Exam, the above formula is sufficient.
Calculating Cost of Goods Manufactured

The COGM represents the cost of the units completed and transferred out of work-in-process during the
period. For a manufacturing company this amount will be part of the cost of goods sold calculation. COGM
does not include the cost of work that was done on units that were not finished during the period.
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, this formula simplifies reality because it assumes that all
items of inventory are either used or are in ending inventory. In reality some of the inventory may have been
lost, damaged or otherwise not used, and therefore it is not in ending inventory. However, for the purposes of
the Exams, this formula is sufficient.
Note: Total manufacturing costs is a component of cost of goods manufactured; and cost of goods
manufactured is a component of cost of goods sold. Each one flows into the next one.
Total manufacturing costs consists of direct materials used, direct labor used, and manufacturing
overhead applied.
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.
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.
Beginning FG + Cost of goods manufactured Ending FG = Cost of goods sold.
Question 5: The Profit and Loss Statement of Madengrad Mining Inc. includes the following information for
the current fiscal year.
Sales $160,000
Gross profit 48,000
Year-end finished goods inventory 58,300
Opening finished goods inventory 60,190
The cost of goods manufactured by Madengrad for the current fiscal year is
a) $46,110
b) $49,890
c) $110,110
d) $113,890
(ICMA 2010)
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.
As we have seen, product costs include direct materials, direct labor, and manufacturing overhead.
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, direct labor and overhead costs are attached to each unit as it is in
production. These costs flow from raw materials to work-in-process to finished goods and, when the unit is
sold, to cost of goods sold. 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.
Following is a very broad outline of how production costs flow. Different costing systems introduce variations,
and we will talk about those later. Thus this explanation should be considered an introduction only, because it
is not specific enough to permit numerical examples at this point.
1. Materials Inventory
Materials inventory is an inventory account in the asset section of the balance sheet. It contains the cost
of raw materials purchased for use in manufacturing.
When raw materials are purchased on account and received, their cost is a debit to Materials Inven-
tory and a credit to Accounts Payable. Raw materials may include direct materials as well as indirect
materials. When the invoices for the raw materials are paid, Accounts Payable is debited and Cash is
credited.
When direct and/or indirect materials are placed into production, the cost of the direct materials
placed in production is debited to Work-in-Process Inventory, the cost of the indirect materials is
debited to Factory Overhead Control, and their total cost is credited to Materials Inventory.
Thus, the cost of materials put into production is moved from Materials Inventory to Work-In-Process
Inventory and Factory Overhead Control.
2. Payroll
The Payroll account is a control account. When manufacturing salaries and wages are earned, the total
amount of the salaries and wages is debited to Payroll and credited to Accrued Payroll.
Direct labor includes the wages of the workers who are directly involved in the manufacturing pro-
cess, such as those who operate machinery. Indirect labor includes salaries of plant supervisors and
other plant employees not directly engaged in manufacturing, such as the janitor who keeps the
plant clean.
After being debited to Payroll, the manufacturing portion of the payroll costs is distributed in the
accounting system according to whether it is for direct labor or indirect labor. Work-in-Process In-
ventory is debited for the amount of direct labor used, Factory Overhead Control is debited for the
amount of indirect labor used, and Payroll is credited for the total.
When the payroll is paid, the total amount paid is debited to Accrued Payroll and credited to Cash.
The Flow of Manufacturing Costs CMA Part 1
Note: The above is an extremely simplified version of what takes place. Recording the payroll in the
accounting system involves accounting for taxes withheld as well as for employers payroll taxes. For our
purposes here, we are ignoring those details.
Payroll will also include selling and administrative payroll. Selling and administrative costs are period costs
that are expensed as incurred and so are not discussed here because they are not manufacturing costs.
3. Factory Overhead Control

Manufacturing overhead includes costs for the physical manufacturing facilities as well as indirect materials
used, indirect labor used, and overtime premiums paid if not the result of a specific job or customer request.
When depreciation on factory facilities is recorded, the amount of the depreciation is debited to
Factory Overhead Control and credited to Accumulated Depreciation. Note that the depreciation is
not expensed as Depreciation Expense at this point.
When other factory overhead costs such as utilities are recorded, the amount is debited to Factory
Overhead Control and credited to Accounts Payable. When payment is made, Accounts Payable is
debited and Cash is credited. If any factory overhead costs are paid in cash, the amount is debited to
Factory Overhead Control and credited to Cash.
As production takes place, accumulated costs in the Factory Overhead Control account are applied to
production by debiting Work-in-Process Inventory and crediting Factory Overhead Control.
Usually, a separate account called Factory Overhead Applied is used for the credits. Factory Over-
head Applied should follow Factory Overhead Control in the chart of accounts and will carry a credit
balance. 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 difference is over-applied or under-
applied factory overhead, which is closed out at the end of the period. (The way in which the over-
applied or under-applied factory overhead is closed out will be covered later.)
4. Work-in-Process Inventory
Costs are accumulated in the Work-in-Process Inventory account as work progresses on the units being
manufactured.
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. The
costs remain in the Work-in-Process Inventory account until the units they are attached to are completed.
When job-order costing is being used, the company will have a work-in-process inventory account for each
individual job.
When process costing is being used, a company with several processing departments that the units move
through will have a departmental work-in-process inventory account for each department. 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. 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. Process costing will be discussed
in detail later.
Section D The Flow of Manufacturing Costs
5. Finished Goods Inventory

As units are completed, 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. The costs moved are the total accumulated costs per unit multiplied by the total number of
units completed. Again, when many identical units are being manufactured, this amount is determined by the
use of process costing.
6. Cost of Goods Sold

As units are sold, their cost is debited to Cost of Goods Sold and credited to Finished Goods Inventory.
If a perpetual inventory system is being used, 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 periodic inventory system is being used, 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.
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.
On the next page is a diagram of these cost flows.
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
Section D Costing Systems
Costing Systems
Product costing involves accumulating, classifying and assigning direct materials, direct labor, and factory
overhead costs to products, jobs, or services. In developing a costing system, 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, normal,
extended normal, or actual costing).
2) The cost accumulation method to use (job costing or process costing).
3) The method to be used to allocate overhead (volume-based or activity-based).
Introduction to Cost Measurement Systems

There are three main ways (plus one variation) in which costs are allocated to units manufactured. 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.
1) Standard Costing
A standard cost system assigns standard, or planned, costs to units produced. 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, with each input multiplied by the number of units of that input allowed for one unit of output.
The inputs include direct materials, direct labor and allocated overhead. The standard cost is what the cost
should be for that unit of output.
In a standard cost system, 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. For example, if 3 direct labor hours are allowed to produce
one unit and 100 units are actually produced, the standard number of direct labor hours for those 100 units is
300 hours (3 hours per unit 100 units). 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. This can be a difficult concept to grasp, because you are mixing standard
cost with actual output to find the total standard cost allowed for the actual output.
In a standard cost system, overhead is generally allocated to units produced by calculating a predeter-
mined, or standard, manufacturing overhead rate (a volume-based method). This standard manufacturing
overhead rate is budgeted overhead cost divided by the budgeted activity level of the allocation base. The
best cost driver to use as the allocation base is the measure that best represents what causes overhead. The
most frequently used allocation bases are direct labor hours, direct labor costs, or machine hours. For a labor-
intensive manufacturing process, the proper base is probably direct labor hours or direct labor costs. For an
equipment-oriented manufacturing process, number of machine hours is the better allocation base.
The predetermined overhead rate is then multiplied by the standard amount of the allocation base that is
allowed for producing one unit of product, 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.
Costing Systems CMA Part 1
Of course, the actual costs incurred will probably be different from the standard costs. The difference is called
a variance. The difference is also called an under-applied or over-applied cost. At the end of each
accounting period, 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, or they are prorated among Cost of Goods Sold and
the relevant Inventory accounts on the balance sheet. If the variances are closed out 100% to Cost of Goods
Sold, the cost of the goods in Inventories will be equal to their standard cost only.
Standard costing enables management to compare actual costs with what the costs should have been for
the actual amount produced. Moreover, it permits production to be accounted for as it occurs. Using actual
costs incurred for manufacturing inputs would cause an unacceptable delay in reporting, because those costs
are not known until well after the end of each reporting period, when all the invoices have been received.
The emphasis in standard costing is on flexible budgeting, where the flexible budget for the actual production
is equal to the standard cost per unit multiplied by the actual production volume.
Standard costing can be used in either a process costing or a job-order costing environment.
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, not multiplied by the actual amount of inputs used
per completed unit.
Standard costing is applicable to a wide variety of companies. Manufacturing companies use standard costing
with flexible budgeting to control direct materials and direct labor costs. Service companies such as fast-food
restaurants use standard costs, too, mainly to control their labor costs since they are labor-intensive.
Increasingly, firms are using Enterprise Resource Planning (ERP) systems to help them track standard and
actual costs and to assess variances in real time. Enterprise Resource Planning is covered in this book in the
topic Supply Chain Management in Section D.
2) Normal Costing
In a normal cost system, direct materials and direct labor costs are applied to production differently from
the way they are applied in standard costing. In normal costing, direct materials and direct labor costs are
applied at their actual rates multiplied by the actual amount of the direct inputs used for production.
To allocate overhead, a normal cost system uses a predetermined annual manufacturing overhead rate,
called a normal or normalized rate. The predetermined rate is calculated the same way the predetermined
rate is calculated under standard costing. However, under normal costing, that predetermined rate is
multiplied by the actual amount of the allocation base that was used in producing the product, whereas
under standard costing, the predetermined rate is multiplied by the amount of the allocation base allowed
for producing the product.
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. Process costing
is used when many identical or similar units of a product or service are being manufactured, such as on an
assembly line. Costs are accumulated by department or by process. In contrast, job costing accumulates
costs and assigns them to specific jobs, customers, projects, or contracts. Job costing is used when units of a
product or service are distinct and separately identifiable. Normal costing is used mainly in job costing.
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. It also makes current costs available. If
actual manufacturing overhead costs were used, those costs would not be known until well after the end of
each reporting period, when all the invoices had been received.
3) Extended Normal Costing

In extended normal costing (a variation on normal costing), 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. The estimated or normal rates are not
called standard costs, though, 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, not by the standard
amount allowed as in standard costing.
In extended normal costing, 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.
Extended normal costing would be most likely to be used in a job order environment and/or a service
business. In a professional service business such as an accounting practice, 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. A company needing timely information would use estimated rates to apply direct labor
costs to individual clients jobs.
4) Actual Costing
In an actual costing system, no predetermined or estimated or standard costs are used. Instead, the actual
direct labor and materials costs and the actual manufacturing overhead costs are allocated to the units
produced. 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.
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. In addition, actual costing is seldom used because it can
produce costs per unit that fluctuate significantly. This fluctuation can lead to errors in management decisions
such as pricing of the product, decisions about adding or dropping product lines, and performance
evaluations.
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, 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).
2) Direct labor and direct materials are treated the same under normal and actual costing.
3) Standard, normal and extended normal costing all use predetermined overhead rates. However, in
standard costing, the emphasis is on the standard rates allowed, and those standard rates do not
necessarily need to be the same all year. In normal and extended normal costing, the emphasis is on
normalized annual rates that do not fluctuate throughout the year due to period-to-period fluctuations
in activity levels.
4) Standard costing is typically used with a flexible budget system. Standard costing is based entirely on
the inputs (i.e., direct materials, direct labor and factory overhead) that should have been used for
the actual output produced.
It is important in answering a question to identify what type of costing the company uses.
If the company uses standard costing, 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.
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, extended normal, or actual costing.
Example of standard costing, normal costing, extended normal costing, and actual costing used for the
same product under the same set of assumptions:
Log Homes for Dogs, Inc. (LHD) manufactures doghouses made from logs. It offers only one size and style
of doghouse. For the year 20X4, the company planned to manufacture 20,000 doghouses. Overhead is
applied on the basis of direct labor hours. The companys 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, or $13 per doghouse (2 DLH/doghouse @ $6.50 per DLH)
LHD actually produced and sold 21,000 doghouses during 20X4.
LHDs actual costs incurred were:

Direct materials $882,000: 5.25 units of DM used per doghouse @ $8/unit of DM
Direct labor $617,400: 2.1 DLH used per doghouse @ $14/DLH
Variable overhead $224,910
Fixed overhead $264,600
Total Costs Applied Under Standard Costing:

Direct materials cost applied: $9 std. cost/unit of DM 5 units allowed/house 21,000 = $945,000
Direct labor applied: $15 std. rate/DLH 2 DLH allowed/house 21,000 = $630,000
Variable overhead applied: $5 std. rate/DLH 2 DLH. allowed/house 21,000 = $210,000
Fixed overhead applied: $6.50 std. rate/DLH 2 DLH. allowed/house 21,000 = $273,000
Total Costs Applied Under Normal Costing:

Direct materials cost applied: $8 actual rate/DM unit 5.25 units used/house 21,000 = $882,000
Direct labor cost applied: $14 actual rate/DLH. 2.1 DLH. used/house 21,000 = $617,400
Variable overhead applied: $5 est. rate/DLH 2.1 DLH used/house 21,000 = $220,500
Fixed overhead applied: $6.50 est. rate/DLH 2.1 DLH used/house 21,000 = $286,650
Total Costs Applied Under Extended Normal Costing:

Direct materials cost applied: $9 est. rate/DM unit 5.25 units used/house 21,000 = $992,250
Direct labor cost applied: $15 est. rate/DLH 2.1 DLH used/house 21,000 = $661,500
Variable overhead applied: $5 est. rate/DLH 2.1 DLH used/house 21,000 = $220,500
Fixed overhead applied: $6.50 est. rate/DLH 2.1 DLH used/house 21,000 = $286,650
Total Costs Applied Under Actual Costing:

Direct materials cost applied: $8 actual rate/DM unit 5.25 units used/house 21,000 = $882,000
Direct labor cost applied: $14 actual rate/DLH 2.1 DLH used/house 21,000 = $617,400
Variable overhead applied: $5.101 actual rate/DLH 2.1 DLH used/house 21,000 = $224,910
Fixed overhead applied: $6.002 actual rate/DLH 2.1 DLH used/house 21,000 = $264,600
1
Actual rate calculated as $224,910 21,000 = $10.71/house. $10.71 2.1 DLH/house = $5.10/DLH
2
Actual rate calculated as $264,600 21,000 = $12.60/house. $12.60 2.1 DLH/house = $6.00/DLH
(Continued)
The costs applied per unit under each of the cost measurement methods was:
Cost Applied per Unit Under Standard Costing:

Direct materials ($9 std. cost/unit of DM 5 units of DM allowed) $45.00
Direct labor ($15 std. rate/DLH 2 DLH allowed) 30.00
Variable overhead ($5/DLH allowed 2 DLH allowed) 10.00
Fixed overhead ($6.50/DLH allowed 2 DLH allowed) 13.00
Total cost per unit $98.00
Cost Applied per Unit Under Normal Costing:

Direct materials ($8 actual cost/DM unit 5.25 units used) $42.00
Direct labor ($14 actual rate/DLH 2.1 DLH used) 29.40
Variable overhead ($5 est. rate/DLH 2.1 DLH used) 10.50
Fixed overhead ($6.50 est. rate/DLH 2.1 DLH used) 13.65
Cost Applied per Unit Under Extended Normal Costing:

Direct materials ($9 est. cost/DM unit 5.25 units used) $47.25
Direct labor ($15 est. rate/DLH 2.1 DLH used) 31.50
Variable overhead ($5 est. rate/DLH 2.1 DLH used) 10.50
Fixed overhead ($6.50 est. rate/DLH 2.1 DLH used) 13.65
Cost Applied per Unit Under Actual Costing:

Direct materials ($8 actual cost/DM unit 5.25 units) $42.00
Direct labor ($14 actual rate/DLH 2.1 DLH used) 29.40
Variable overhead ($5.10 actual rate/DLH 2.1 DLH used) 10.71
Fixed overhead ($6.00 actual rate/DLH 2.1 DLH used) 12.60
Benefits and Limitations of Each Cost Measurement System
Standard Costing
Benefits Standard costing prescribes expected performance and provides control. The
standards establish what the costs should be, who should be responsible for them,
and what actual costs are under control.
If costs remain within the standards, managers can focus on other issues. When
costs vary significantly from the standards, managers are alerted that there may be
problems requiring attention. This approach helps managers to focus on important
issues.
Standard costing can be used in either a job costing or a process costing environ-
ment.
It simplifies the determination of equivalent-unit costs, because the standard costs

serve as the cost per equivalent unit for direct materials, direct labor, and manufac-
turing overhead.
It makes recordkeeping easier in either a job order or a process costing system,

because subsidiary ledgers need to be maintained for quantities on hand, and their
associated cost is the standard cost for the period.
Standards can provide benchmarks for employees to use to judge their own
performance.
Limitations If the variances from the standards are used in a negative manner, for instance to
assign blame, 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. An example of this is increasing output at the end of a
period to avoid an unfavorable direct labor efficiency variance, which can lead to poor
output quality because of the rush.
Output in many companies is not determined by how fast the employees work but
rather by how fast the machines work. Therefore, direct labor quantity standards
may not be meaningful.
The use of standard costing could lead to overemphasis on quantitative measures.

There is more to consider than just whether a variance is favorable or unfavora-
ble and the amount. A favorable materials quantity variance could result from using
less materials than should be used, which will result in substandard output. So
variances must be interpreted carefully.
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, on-time delivery, and customer satisfaction.
In environments that are constantly changing, it may be difficult to determine an

accurate standard cost.
The usefulness of standard costs is limited to standardized processes. The less

standardized the process is, the less useful standard costs are.
Meeting standards may not be enough. Continual improvement is necessary to

survive in a competitive environment.
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.
Manufacturing costs of a job are available earlier under a normal costing system than
under an actual costing system.
Normal costing allows management to keep product costs current, because actual
materials and labor costs incurred are readily available, while the actual incurred
overhead costs would not be available until much later and so are applied based on a
predetermined rate.
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; and overhead applied
may be less than the amount incurred if actual production is lower than expected.
Applied overhead may also be smaller than the amount incurred if the actual amount
of incurred overhead was greater than expected.
Normal costing requires the use of subsidiary ledgers to maintain the details of actual
costs for direct materials and direct labor.
Normal costing is not appropriate for process costing because the actual costs would
be too difficult to trace to individual units produced, so it is used primarily for job
costing.
Extended Normal Costing
Benefits In addition to the benefits of normal costing, extended normal costing utilizes
estimated labor rates, which may not be known until after the end of a reporting
period. This makes it most appropriate for a professional service business.
Limitations The limitations of extended normal costing are the same as the limitations of normal
costing.
Actual Costing
Benefits The primary benefit of using actual costing is that the costs used are actual costs,
not estimated costs.
Limitations Because actual costs must be computed and applied, information is not available as
quickly after the end of a period as it is with standard costing.
Actual costing leads to fluctuations in job costs because the amount of actual
overhead incurred fluctuates throughout the year.
It requires the use of subsidiary ledgers to maintain the details of actual costs for
direct materials and direct labor.
Like normal costing, actual costing is not appropriate for process costing because the
actual costs would be too difficult to trace to individual units produced. Therefore, it
is used primarily in a job costing environment.
Note: The focus of the remainder of this section will be on standard costing, because that is the
most commonly used system in manufacturing.
Introduction to Cost Accumulation Methods

Job order costing (also called job costing), process costing and operation costing are different types of
cost accumulation systems used in manufacturing. Cost accumulation systems are used to assign costs to
products or services.
Process costing is used when many identical or similar units of a product or service are being
manufactured, such as on an assembly line. Costs are accumulated by department or by process.
Job order costing (also called job costing) is used when units of a product or service are distinct
and separately identifiable. Costs are accumulated by job.
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.
In a process costing system, costs are accumulated according to processing department or area. Process
costing is appropriate when all of the units are produced in the same way, using the same resources, usually
in an assembly-line fashion. The accumulated costs for all the units move from process to process. As more
work is done on the units, the total accumulated cost increases with each added process. 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. This works because each unit produced uses the same
quantity of production resources. Mass-produced consumer goods are accounted for using process costing.
In a job order costing system, costs are accumulated according to assigned job numbers or some other
means of identification. The work is done according to the customers specifications, and those are generally
different for each job. Thus, each job uses a different quantity of resources. The actual quantity of resources
used on each specific job is used to calculate the costs to be allocated to that job.
Job costing is used widely in service industries such as printing companies, advertising agencies, hospitals,
repair shops, consulting firms, accounting firms, and law firms. The term job may not be used in a service
firm but instead it might be called client accounting or project accounting. Whatever name is used, the
costs of the services are accumulated according to job. Construction companies and manufacturers of
custom-built furniture where each project is separate make use of job costing, as well.
Job order costing is advantageous in these applications because it accurately tracks the cost of each unique
job. If average costs were allocated to jobs in the way process costing allocates average costs, the cost of
each job would be distorted.
Operation costing is a hybrid costing system with elements of job costing and elements of process costing.
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.
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. Direct materials costs are
accumulated by jobs or by batches and assigned to the products in each job or batch.
Industries suitable for operation costing are apparel manufacturing, food processing, furniture manufacturing,
and electronic equipment manufacturing.
Note: Process costing and job order costing are two ends of a continuum (with operation costing in the
middle). 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.
Process costing, job order costing and operation costing will be discussed in more detail later.
Introduction to Methods of Allocating Overhead

Overhead can be allocated in two primary ways:
1) Volume-based.
2) Activity-based.
Volume-based methods of allocating manufacturing overhead to products or jobs are also called traditional
methods. Volume-based methods allocate overhead on the basis of a cost driver 5 that is volume-based, such
as number of units produced, number of direct labor hours, or number of machine hours. Assigning overhead
according to number of units assumes that every unit or job uses the same amount of overhead. 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. In many companies, neither of these
assumptions is adequate to produce accurate overhead allocation.
Activity-based methods allocate manufacturing overhead to units or jobs using multiple cost drivers based
on cause-and-effect criteria. 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.
Volume-based and activity-based methods of allocating overhead will be covered in detail later.
5
A cost driver is anything (it can be an activity, an event or a volume of something) that causes costs to be incurred each
time the driver occurs. Examples of cost drivers in a volume-based overhead allocation system are machine hours and
direct labor hours. Examples of cost drivers in an activity-based overhead allocation system are set-ups, moving, number of
parts, casting, packaging or handling.
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. However, that is not the way it is done when standard costing is
being used.
In a standard cost system, the costs that are applied to the products as they are being manufactured are the
standard costs allowed for the actual amount produced. Those standard costs are based on the amount
of each direct manufacturing input allowed for the amount produced, at the per-unit cost allowed for each
input.
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.
This topic discusses direct inputs, and accounting for manufacturing overhead is treated separately.
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, and
The number of units of inputs actually used is usually not exactly the same as the standard
amounts allowed.
In a standard cost system, differences between actual costs and standard costs for direct materials and direct
labor are accounted for using variance accounts in the general ledger. The differences are accumulated in
these variance accounts throughout the reporting period, and at the end of the period, they are transferred
out in the closing entries.
Here is an example, using raw materials:
Raw materials are debited to the Raw Materials Inventory account when they are purchased. In a standard
cost system, 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.
1) Materials Price Variances Recognized When Materials Are Purchased

If the materials price variances are recognized as soon as the materials are purchased, the amount debited to
the Raw Materials Inventory account will be the extended standard cost of the purchased materials,
regardless of whether or not that was the actual cost at which the company purchased the materials.
For example, if the standard cost for Material A is $0.55 per unit but the price when 10,000 units of Material A
are purchased is $0.60 per unit, when those materials are received Raw Materials Inventory will be debited
for $0.55 10,000, or $5,500 because that is the standard cost for 10,000 units. The total due to the vendor
is $0.60 10,000, or $6,000. The difference, $500, will be debited to the Materials Price Variance account,
and it will remain there until it is resolved at the end of the period in the closing entries.
Dr Raw Materials Inventory.........5,500 $0.55 10,000
Dr Materials Price Variance ........... 500 ($0.60 $0.55) 10,000
Cr Accounts Payable ...................... 6,000 $0.60 10,000
At this point, the balance in the Raw Materials Inventory account consists of the 10,000 units of Material A, at
its standard cost of $0.55 per unit.
As production takes place and the materials are put into production, the standard cost of the raw materials
allowed for the actual production is moved to the Work-In-Process Inventory account. The standard cost per
unit for the amount of materials allowed for the actual number of units produced is debited to WIP Inventory.
However, 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. The Raw Materials
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.
The difference in cost due to the difference between the amount used and the amount allowed is a 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, at the
standard cost per unit.
For our example, lets say that 4,000 units of product are produced, and each unit is allowed two units of
Material A. Thus, 8,000 units of Material A at $0.55 per unit were allowed for the 4,000 units of product
actually produced. The cost of the raw materials in Raw Materials Inventory is $0.55 per unit (because
remember, the $0.05 per unit price variance was put into the Materials Price Variance account when the
materials were received).
The company actually uses 8,500 units of Material A to produce 4,000 units of product. The WIP Inventory
account will be debited for only 8,000 units of materials (the standard amount allowed for 4,000 units) at
$0.55 per unit (the standard cost allowed per unit), so the debit to WIP Inventory will be for $4,400. The
credit to Raw Materials Inventory, though, will be for 8,500 units of Material A at $0.55 per unit, or $4,675.
The difference, or $275, will be debited to the Materials Usage Variance account.
Dr Work-In-Process Inventory .... 4,400 $0.55 8,000
Dr Materials Usage Variance .......... 275 $0.55 500
Cr Raw Materials Inventory ............. 4,675 $0.55 8,500
So the company will end up with the following net changes in its trial balance related to Material A:
Raw Materials Inventory ................................ 825 $5,500 $4,675, or $0.55 1,500 units
Materials Price Variance ................................. 500 ($0.60 $0.55) 10,000
Work-In-Process Inventory ......................... 4,400 $0.55 8,000
Materials Usage Variance ............................... 275 (8,500 8,000) $0.55
Accounts Payable (if vendor is still unpaid) ................. 6,000 $0.60 10,000
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, Raw Materials Inventory will be debited and Accounts Payable will be credited for
$6,000 when the materials are received (their actual cost of $0.60 10,000 units).
Dr Raw Materials Inventory ........ 6,000 $0.60 10,000
Cr Accounts Payable ....................... 6,000 $0.60 10,000
As production takes place, the amount of raw materials used in production is accounted for. 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.
When Material A is used to produce 4,000 units, WIP Inventory will be debited for $0.55 8,000, or $4,400,
the standard amount allowed for 4,000 units at the standard per-unit cost of $0.55. However, the actual
usage of Material A was 8,500 units, and the actual cost of Material A was $0.60 per unit. So Raw Materials
Inventory will be credited for 8,500 units of Material A at $0.60, or $5,100, since the full cost of Material A
was debited to Raw Materials Inventory when it was received. The difference, $700, is partly a materials price
variance and partly a materials usage variance. The price variance is $0.05 8,500, or $425. The usage
variance is $0.55 500, or $275. Therefore, the Materials Price Variance account will be debited for $425,
and the Materials Usage Variance account will be debited for $275.
Dr Work-In-Process Inventory .... 4,400 $0.55 8,000
Dr Materials Price Variance............ 425 ($0.60 $0.55) 8,500
Dr Materials Usage Variance .......... 275 $0.55 500
Cr Raw Materials Inventory ............. 5,100 $0.60 8,500
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 ................................ 900 $6,000 $5,100, or $0.60 1,500 units
Materials Price Variance ................................ 425 ($0.60 $0.55) 8,500
Work-In-Process Inventory ..........................4,400 $0.55 8,000
Materials Usage Variance............................... 275 (8,500 8,000) $0.55
Accounts Payable (if vendor is still unpaid) ................. 6,000 $0.60 10,000
Because the materials price variance is not being recognized until the materials are put into production, the
materials price variance for the remaining, unused 1,500 units of Material A ($0.05 1,500 units, or $75)
remains in the Raw Materials Inventory account instead of being in the Materials Price Variance account, as it
was in the preceding example. When those remaining 1,500 units of Material A are used in production, the
price variance will be recognized at that time along with any usage variance.
Direct materials variances and their calculation are covered in detail in Performance Management in Section
C.
Direct Labor
Direct labor is accounted for similarly to direct materials, with one difference. There is no inventory account
specifically for direct labor costs; so direct labor is accounted for as it is used. Since there is no inventory
account for direct labor, unlike raw materials, there is only one way of accounting for differences between the
actual hourly rate (price) paid and the standard hourly rate (price). The variances are accounted for when the
direct labor is used.
A company may use a payroll clearing account for the initial debits for salaries and wages earned, with the
credits going to accrued payroll. The amount for direct labor used is then moved out of the payroll clearing
account. Work-In-Process Inventory is debited for the standard direct labor cost for the actual amount
produced, calculated as the standard wage rate the standard number of direct labor hours allowed for the
actual production. However, the actual cost of the direct labor used is credited to the payroll clearing
account.
The difference between the actual cost incurred and the standard cost allowed is the total variance, and it is
broken down between the Direct Labor Rate Variance and the Direct Labor Usage Variance. Those variances
are accumulated in their respective variance accounts.
Of course, this is a simplified explanation of payroll, because it does not include deductions from employees
paychecks for taxes and other things such as employees contributions to their employee benefits, nor does it
include the employers cost for payroll taxes.
Direct labor variances and their calculation are covered in detail in Section C, Performance Management.
Resolving the Direct Input Variances

At the end of the period, 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.
Variances in the cost of materials caused by price variances and usage variances may be 100% debited or
credited to Cost of Goods Sold, if the variances are immaterial (small) in relation to the total cost). If the
variances are significant in relation to the total cost, they should be distributed among Materials Inventory,
Work-in-Process Inventory, Finished Goods Inventory and Cost of Goods Sold.
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, if the variances are immaterial in relation to the total cost. If the variances are
significant in relation to the total cost, they should be distributed among Work-in-Process Inventory, Finished
Goods Inventory and 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.
Section D Overhead Allocation
According to ASC 330-10-30-12, 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. Thus, the standard costs should be reviewed regularly and, if the
variances between actual costs and the standard costs are too great, the standards should be revised to
minimize the size of future variances.
Overhead Allocation
Introductory Note on Overheads
In general, overheads are costs that cannot be traced directly to a specific product or unit. There are actually
two main types of overheads: manufacturing (or factory) overheads and nonmanufacturing overheads.
Manufacturing overheads are overheads that are related to the production process (factory rent and
electricity, for example), whereas nonmanufacturing overheads are not related to the production process.
Examples of nonmanufacturing overheads are accounting, advertising, sales, legal counsel and general
corporate administration.
In these materials, we will first look at the allocation of manufacturing overheads. This is covered in a variety
of methods that include traditional allocation, process costing, job order costing, operation costing, activity-
based costing, and life-cycle costing. 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, because in principle, activity-based costing does not conform to
generally accepted accounting principles. Methods that cannot be used for external financial reporting can be
used internally for decision-making.
The allocation of nonmanufacturing overheads is covered in the topic Shared Services Cost Allocation.
However, some of the concepts and ideas covered in manufacturing overhead are also applicable in the
allocation of nonmanufacturing overheads.
Note: In order to help these study materials flow more easily, we will use the term overhead in the
majority of situations, even when the term manufacturing overhead would be more technically accurate.
If we use the term manufacturing overhead in every situation, the language becomes very cumbersome
and more difficult to read. Also, the term factory overhead can be used in place of manufacturing
overhead because the two are interchangeable terms.
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. As such, there is little emphasis put on
the determination of DM and DL on the CMA Exam. Rather, the emphasis is on the allocation of overhead.
Overheads are production and operation costs that a company cannot trace to any specific product or unit of
a product. Because these costs are incurred and paid for by the company and are necessary for the
production process, it is essential that the company know what these costs are and allocate them to the
different products that are produced. 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. If a company does not take overhead costs
into account when it determines the selling price for a product, 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.
Overhead Allocation CMA Part 1
Furthermore, generally accepted accounting principles require the use of absorption costing for external
financial reporting. In absorption costing, all overhead costs associated with manufacturing a product become
a part of the products inventoriable cost along with the direct costs. Therefore, all manufacturing overhead
costs must be allocated to the units produced.
In this topic we will talk about the allocation of manufacturing overheads in detail.
The categories of costs included in factory overhead (OH) are:
1) Indirect materials materials not identifiable with a specific product or job, such as cleaning
supplies, small or disposable tools, machine lubricant and other supplies.
2) Indirect labor salaries and wages not directly attributable to a specific product or job, such as
those of the plant superintendent, janitorial services and quality control.
3) General manufacturing overheads, such as facilities costs (factory rent, electricity and utilities)
and equipment costs, including depreciation and amortization on plant facilities and equipment.
Note: Remember that factory overhead and manufacturing overhead are interchangeable terms that
mean the same thing. Either may be used in a question.
Overheads may be either fixed or variable (or mixed). A fixed overhead, like any fixed cost, is one that does
not change over the relevant range of activity or production. Examples of fixed manufacturing overhead are
factory rent and production equipment depreciation.
Variable overheads are costs that change as the level of production changes. Examples are plant electricity,
equipment maintenance, and utilities.
The number of ways in which a company can allocate overhead are numerous and limited only by the
imagination of the accountant, and now, the computer programmer. However, for the CMA Exam, there are
only a few methods of allocation with which you need to be familiar. But, no matter the manner of allocation,
it is simply a mathematical exercise of distributing the overhead costs to the products that were
produced using some sort of basis and formula.
Traditional (Standard) Allocation Method

Traditionally, manufacturing overhead costs have been allocated to the individual products based on
either the direct labor hours, machine hours, materials cost, units of production, weight of production or some
similar measure that is easy to measure and calculate. The measure used is called the activity base.
If a company allocates factory overhead based on direct labor hours, for example, for every hour of direct
labor that goes into a specific unit, a certain amount of factory overhead (the determination of how much is
covered below) would be allocated to, or applied to, that product. By adding together the direct materials,
direct labor and allocated manufacturing overhead costs, a company determines the total cost of producing
that specific product.
Determining the Basis of Allocation

When choosing the basis of allocation (for example, direct labor hours or machine hours), the basis used
should closely reflect the reality of the way in which the costs are actually incurred. For example, in a
company that is highly automated, 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. The allocation basis does not
need to be direct labor hours or machine hours, though those are the most common bases used. For
example, in a company that produces very large, heavy items (such as an appliance manufacturer), the best
basis on which to allocate overhead may be the weight of each product.
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, usually machine hours or labor hours. That is plant-wide
overhead allocation.
Or, it can choose to have a cost pool for each department that the products pass through in production. This
second method is called departmental overhead allocation. Each departments overhead costs are put into
a separate cost pool, and then the overhead is allocated according to the cost basis that managers believe is
best for that department.
In both of these methods, fixed overhead may be segregated in a separate cost pool from variable overhead
and the fixed and variable overheads allocated separately. The fixed and variable overheads can be allocated
using the same cost basis, or they can be allocated using different cost bases. For planning purposes and in
order to calculate fixed and variable overhead variances, it is virtually essential that fixed and variable
overhead costs be segregated.
Note: A cost basis, or basis of cost allocation, is a measure of activity such as direct labor-hours or
machine-hours that is used to assign costs to cost objects. A cost object is a function, organizational
subdivision, contract, or other work unit for which cost information is desired and for which provision is
made to accumulate and measure the cost of processes, products, jobs, capitalized projects, and so forth.
For example, if Department A uses very little direct labor but a lot of machine time, Department As overhead
costs would probably be allocated to products on the basis of machine hours. If Department B uses a lot of
direct labor and very little machine time, Department Bs overhead costs would probably be allocated to
products on the basis of direct labor hours. Or a department that paints might allocate overhead costs based
on square footage or meterage of the painted products, while a department that assembles products may
allocate costs based on the number of parts in each product.
To best reflect the way that manufacturing overhead is incurred, departmental overhead allocation is
preferable to plant-wide overhead allocation. The greater the number of manufacturing overhead allocation
rates used, the more accurate or more meaningful the overhead allocation will be. However, departmental
overhead allocation requires a lot more administrative and accounting time and thus is more costly. The more
bases that are used to allocate overhead, the more costs will be incurred to obtain the needed information for
the allocation. Therefore, 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.
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. For example, the additional
information could be used to develop more accurate product costs for use in setting prices and making other
decisions.
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.
Calculating the Manufacturing Overhead Allocation Rate

Once the method, or basis, of manufacturing overhead allocation is determined, the predetermined
manufacturing overhead allocation rate is calculated. 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, machine hours, and so on) used by that product during production.
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. Cost pools can range from very broad, such as all plant overhead costs, to very narrow, such as the cost of operating
a specific machine.
The predetermined overhead rate may be a combined rate including both variable and fixed overheads; or it
may be calculated separately for variable overhead and fixed overhead and applied separately. Whichever
way it is done, the total overhead allocated to production will be the same if the same allocation base is used
for both fixed and variable overhead.
It is important to note that fixed overhead is applied to units produced as if it were variable
overhead, even though fixed costs do not behave the same way variable costs behave. Actual variable costs
increase in total as production increases and decrease in total as production decreases. But as long as the
production level remains within the relevant range, actual fixed manufacturing costs do not change in total as
production increases and decreases. Therefore, 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.
Although actual fixed manufacturing overhead may not vary much in total from budgeted fixed manufacturing
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, on a per-unit basis, but it is not
incurred that way. Therefore, the fixed manufacturing overhead component of total overhead costs creates a
large part of the reported variances.
The rate that is used to allocate overhead is usually calculated at the beginning of the year, based upon
budgeted overhead for the coming year and the budgeted level of activity for the coming year.
Unless there are material changes in overhead costs during the year that necessitate a change to the
predetermined rate, that rate (or those rates, if fixed and variable overheads are allocated separately) will be
used to allocate manufacturing overheads throughout the year. 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. Because it is done at the beginning of the year, it must use
budgeted, or expected, amounts. This rate is called the predetermined rate because it is calculated at the
beginning of the period.
This predetermined rate, used throughout the period, is calculated as follows:
Budgeted Dollar Amount of Manufacturing Overhead
Budgeted Activity Level7
However, as noted above, 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, if you know the predetermined rate and the budgeted activity level, you can
easily reverse the process and calculate the budgeted overhead amount that was used to calculate the
predetermined rate. You will find this will be required in quite a few questions, particularly for fixed
overhead.
Predetermined rate Budgeted Activity (Production) Level = Budgeted Manufacturing Overhead
This is particularly important to remember when you are working with fixed manufacturing overhead, 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.
Only the amount of fixed overhead applied is affected by the actual production activity level.
7
The budgeted activity level is the number of budgeted direct labor hours, direct labor cost, material cost, or machine
hourswhatever is being used as the allocation basis. This will be discussed in greater detail as we proceed through this
explanation.
It is critical to use the budgeted (expected) amounts for both the numerator and the denominator in
calculating the predetermined overhead allocation rate. Do not use budgeted for one and actual for the other.
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. Again, 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,
unless something changes that requires the allocation rate to be adjusted.
Note: The calculation of the allocation rate that we will look at can also be done on a weekly or monthly
basis. In such a situation, 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, the budgeted rate is not going to be the actual rate that occurs during the year. However, 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, an estimated rate must be used. A company cannot wait
until the end of the year to determine what its cost of production was. As long as the rate is reviewed
periodically and adjusted when necessary, however, variances can be minimized.
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. The level of
activity used is the number of machine hours, direct labor hours, or whatever other activity base the company
plans to use during the year. The activity level is estimated in advance. As the activity level is one of the two
figures used in the determination of the manufacturing overhead rate, it will greatly impact the allocation
rate.
A company has several choices for the activity level to use in calculating a predetermined allocation rate for
overhead. U.S. GAAP, in ASC 330, specifically prescribes that normal capacity should be used for external
financial reporting. The other activity levels can be used for internal reporting and decision-making, however.
The choices are:
Theoretical, or ideal, capacity the level of activity that will occur if the company produces at its
absolute most efficient level at all times. A company will not be able to achieve this level, and manu-
facturing overhead will be under-applied if it is used because the resulting application rate will be
too low. (We will take a more detailed look at under- and over-applied manufacturing overhead lat-
er.)
Practical (or currently attainable) capacity the theoretical level reduced by allowances for
unavoidable interruptions such as shutdowns for holidays or scheduled maintenance, though not de-
creased for any expected decrease in sales demand. Though this basis is more realistic than
theoretical capacity, it is still greater than the level that will be achieved and will also result in an
under-application of manufacturing overhead.
Master budget capacity utilization (expected actual capacity utilization) the amount of
output actually expected during the next budget period based on expected demand. 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.
Normal capacity utilization the level of activity that will be achieved in the long run, taking into
account seasonal changes in the business as well as cyclical changes. Seasonal changes in business
result from changes in demand during the seasons of the year, and cyclical changes are connected
to the larger business cycle. 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.
The activity level a company should use depends on the given situation and upon the companys purpose in
using the activity level. Which one should be used in which circumstance is a management decision. In
addition to using normal capacity for external financial reporting, 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.
The primary use of the projected activity level is in developing the master budget for the coming year. The
master budget capacity utilization (expected actual capacity utilization) is the most appropriate activity level
to use for developing the master budget.
However, there can be other uses of a projected activity level in making management decisions; and other
activity levels may be better suited to these other uses. 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.
Master budget capacity is also best for current performance measurement. Since normal capacity is a
long-run average, it has no particular meaning for judging current performance. Using normal capacity to
evaluate current performance is misusing a long-run measure for a short-run purpose. The master budget
capacity is more meaningful for current period planning and control. Managers should be evaluated on their
achievement of the levels set in the master budget.
2) Practical Capacity
Practical capacity is best for pricing decisions. If demand decreases and thus production decreases and
normal capacity is being used, overhead costs will be spread over a smaller number of output units, causing
the per-unit costs to increase. Use of normal capacity for pricing decisions can thus result in high, noncompet-
itive selling prices that cause further decreases in demand and lead to a downward demand spiral. A
downward demand spiral is 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.
For example, 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. This can cause the
company to lose the business, which would cause the production level to be used in the next bid to be even
lower and the price even higher.
In this case, the use of practical capacity would avoid increasing unit costs if expected demand levels
decrease. The fixed cost allocation rate would be based on capacity available, not capacity used to meet
customer demand, and capacity available would not change because of a decrease in demand. For this
reason, practical capacity is a more stable capacity to use for pricing decisions.
Practical capacity directs managements attention to the cost of unused capacity because the cost of
the unused capacity is not spread over the units produced. This encourages managers to do something
about the unused capacity. Doing something about it could entail developing new products that will make use
of the unused facilities, leasing the unused capacity, or selling unused assets.
Practical capacity is required for tax reporting purposes in the U.S.; and year-end proration of variances
among inventories and cost of goods sold is also required unless a variance is not material.
3) Normal Capacity
Normal capacity is best for long-term planning. Normal capacity is often used as a basis for long-term
(multi-year) plans. For long-term planning purposes, 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. In other words, 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. 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. If the production level decreases in one of the
periods, the fixed costs will be spread over fewer units and each unit will bear more fixed cost. The cost per
unit may be projected to change over the long-term planning period for other reasons, but it should not be
projected to change only because of changing demand levels during the planning period.
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, then probably production will be lower in years 3, 4 and 5 than it is
in years 1 and 2 of the plan. If management uses different levels of production in their plan, then during
years 3, 4 and 5, each unit produced will bear more fixed overhead cost than it will during years 1 and 2.
That will cause the cost of one unit to be higher in years 3, 4 and 5 than in years 1 and 2.
To avoid this, management should use normal capacity utilization in determining the cost per unit for
long-term planning purposes. The normal capacity utilization activity level would be the average of
projected production levels during years 1, 2, 3, 4 and 5. Therefore, the activity level used would be the
same for each year of the long-term plan, and the cost per unit would not change each year due to
changes in the projected activity levels. 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, materials, and/or overhead. But it would
not change due to changes in the planned production level.
4) Theoretical Capacity
Theoretical, or ideal, capacity is just that: theoretical and ideal. It has very little use in practical
situations, because it will not be attained.
Example of a pricing decision: RedHawks Co. produces bookshelves for shipment to distributors. The
fixed manufacturing overheads of RedHawks for the coming year are expected to be $250,000. In a
perfect situation, RedHawks has the capacity to produce 40,000 bookshelves. During the current year,
RedHawks produced 38,000 bookshelves, which was the most in company history. Management thinks that
this was attributable to a performance bonus that was in place for management this year, but that will not
be given next year. For the 7 years prior to the current year, RedHawks produced an average of 34,000
bookshelves, with production always between 32,500 and 35,500. For next year, the company expects to
produce 36,000 bookshelves.
The CFO of RedHawks is trying to determine how much it will cost to produce each bookshelf. The CFO
knows to that a portion of the fixed manufacturing overhead must be allocated to each of the units. Below
are the calculations for the fixed overhead allocation rate using the four different levels of production.
Calculating the Predetermined Rate

1) If RedHawks uses theoretical capacity, the allocation rate for next year will be $6.25 per unit
($250,000 40,000 units).
2) If the fixed manufacturing overhead allocation rate is determined using the current years performance
as the practical capacity, the allocation rate will be $6.58 per unit ($250,000 38,000 units).
3) If the master budget capacity is used in calculating the predetermined rate, the allocation rate will
be $6.94 per unit ($250,000 36,000 units).
4) Finally, if they use what had been the normal capacity prior to the current year, the allocation rate
would be $7.35 ($250,000 34,000 units).
Allocation of Fixed Manufacturing Overhead Under the Traditional Method

Now lets move one year into the future. The year is now complete. RedHawks actually produced 35,750
units during the year. (Given the fact that there was no information about any other part of the process,
fixed overhead must be allocated per unit.) Under each of the four levels of capacity, a different amount of
fixed manufacturing overhead would have been allocated to the products. The allocation is made by
multiplying the actual number of units produced by the predetermined rate per unit.
1) Using theoretical capacity, RedHawks would have allocated $223,438 ($6.25 35,750 units) to the
units produced.
2) Using practical capacity, it would have allocated $235,235 ($6.58 35,750 units).
3) Using master budget capacity, it would have allocated $248,105 ($6.94 35,750 units).
4) Using normal capacity, it would have allocated $262,763 ($7.35 35,750 units).
Summary Analysis
As you can see, because the actual production was different from any of the bases that could be used, the
amount of fixed overhead allocated would not have been exactly correct no matter which capacity level
was chosen. However, the amount of overhead allocated under master budget capacity would be the
closest to the expected amount of $250,000.
If RedHawks had used the theoretical base at the beginning of the year in its calculation of cost per unit,
the company would have run the risk of underpricing the bookshelves. This is because the amount of fixed
overhead would have been allocated to too many bookshelves. Overhead would have been allocated to
bookshelves that would never be made, and not enough overhead would have been allocated to the
bookshelves that were made. If they had used normal capacity, they would have allocated too much
overhead to each bookshelf, and they might have overpriced the bookshelves.
If they used master budget capacity, the price they charged would fluctuate from one year to the next, as
the expected production level fluctuated from budget period to budget period based on anticipated
demand.
For pricing decisions, practical capacity is the best capacity level to use. We will discuss this more and the
reasons for it later under the topic Capacity Level and Management Decisions.
Allocating Manufacturing Overhead to the Units

As we have seen in the preceding example, once the overhead allocation rate is determined, the company can
allocate overhead to the individual units that are produced. 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.
This is a very simple mathematical operation, but it becomes a little more involved because the company
must make a decision about which cost allocation method to use: standard, normal, extended normal, or
actual. The four methods were discussed in the topic of Costing Systems, so we will just review them quickly
here as they apply to overhead application.
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
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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 $250,000 $288,000
Production volume (units) 100,000 125,000
Total machine hours 200,000 240,000
How much overhead would have been allocated to the production under standard, normal, extended
normal and actual costing?
Extended
Standard Normal Normal Actual
Predetermined OH Rate: $250,000 200,000 $1.25 $1.25 $1.25
Actual OH Rate: $288,000 240,000 $1.20
Allocation Base:
Standard number of machine hours 250,0001

Actual number of Machine hours 240,000 240,000 240,000
OH applied to production $312,500 $300,000 $300,000 $288,000

1
Two hours are allowed for each unit, calculated as 200,000 total machine hours budgeted divided by
budgeted production volume of 100,000 units. The standard number of machine hours is the actual
production volume of 125,000 multiplied by 2 machine hours allowed per unit.
Why would the company not want to use actual costing, 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. In most cases, overhead needs to be
applied to production as the production takes place. It cannot wait until the year has been closed out and
the total actual costs are known. Therefore, an estimated rate is used throughout the year. 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. See the following section for further information.
The Process of Accounting for Factory Overhead

Factory overhead includes all costs, both fixed and variable, that cannot be traced to the production of a
specific unit or group of units. Factory overhead includes supervisory and other indirect salaries and wages,
depreciation on production facilities, indirect materials used such as cleaning rags, indirect facility costs such
as utilities, and an almost limitless list of other costs.
As factory overhead costs are actually incurred, the actual incurred costs are debited to a factory
overhead (OH) control account with the following journal entry:
Dr Factory Overhead Control................................................ X
Cr Cash (or Accounts Payable) ................................................... X
This account accumulates (collects) all the actual factory overhead costs that the company incurs during the
year. It is from this account that overhead will be allocated to work-in-process and then to finished goods.
As each unit is produced, 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, using the calculated,
predetermined overhead rate and the amount of the allocation base that is allowed for the actual output:
Dr WIP Inventory ................................................................... X
Cr Factory Overhead Control ................................................. X
The credit may instead be to an account called Factory Overhead Applied, simply to keep the debits in one
account and the credits in a different account. The Factory Overhead Applied account follows the Factory
Overhead Control account in the chart of accounts. The net of the balances in the two accounts at any point in
time represents under-applied or over-applied overheads.
The work-in-process inventory account is one of the inventory accounts for the company (the others are
finished goods and raw materials). This process is called applying the overhead to production, and when
the overheads are transferred into the WIP account, they become what we call applied.
What is happening in the accounting process is that the Factory OH Control account is receiving the actual
costs that the company incurs, and then the costs are allocated out from the Factory OH Control Account to
the WIP account and applied to goods that are produced, using some sort of budgeted rate. Graphically it
looks like this:
Factory Account: Costs Applied to
Actual Costs Overhead Production @ Predetermined
Control Account Manufacturing OH Rate
Quantity of Allocation Base
If a separate account, Factory Overhead Applied, is used to apply the costs to production, it would look like
this:
Factory
Overhead
Control Account
Actual Costs
(Debit Balance)
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. 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, the
overhead is under-applied. This means that each unit received a lower amount of overhead than it should
have. If the amounts that come out during a period are greater than the incurred amounts, overhead is
over-applied. This means that each unit received a greater amount of overhead than it should have. The
amount of the difference is a variance, and it remains in the Factory OH Control Account until the period is
closed. This will be explained in more detail in the pages that follow.
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. 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. 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.
2) In Finished Goods Inventory on the balance sheet if the item has been completed but not sold.
3) As an expense in Cost of Goods Sold on the income statement if the item has been sold.
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. 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.
If the actual costs or usage are different from the budgeted, this allocation will be, in essence, incorrect. As
a result, the factory overhead control account will have a balance in it at the end of the year. This balance
may be a positive (debit) or negative (credit) balance, but in any case it needs to be eliminated from this
account.
If the balance is a debit balance (a balance still remains in the Factory OH Control account), it means
that we under-applied factory overhead to the products. If two accounts are being used, the net
of the two accounts will be a debit balance. In other words, 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.
If the Factory OH Control account has a credit balance (negative balance), it means we over-
applied factory overhead to the products. If two accounts are being used, the net of the two ac-
counts will be a credit balance. In other words, 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.
The amount of over- 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, the company needs to correct this imbalance, 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. Therefore, this
remaining balance (the amount over- or under-applied) in the factory overhead control account must be
removed from the account(s) as part of the period end closing entries.
If the company is using only one account (Factory Overhead Control), the amounts credited to
Factory Overhead Control to apply the overhead to production will decrease the balance in the ac-
count, and only the over- or under-applied amount will remain in the account at the end of the
period.
If the company is using two accounts (Factory Overhead Control and Factory Overhead Applied), the
Factory Overhead Applied account is closed to the Factory Overhead Control account in the closing
entries. That will leave the net amount of over- or under-applied overhead in the Factory Overhead
Control account, the same as if the company had been using just one account all during the period.
The way we transfer out this remaining over- or under-applied balance depends on whether the balance is
immaterial or material.
Immaterial Amount
If an under-applied amount is immaterial it will simply be charged (debited) to COGS in that period. This will
increase the COGS amount and decrease the profit for the period.
If an over-applied amount is immaterial, it will be taken out of (credited to) COGS, reducing COGS and
increasing the profit for the period.
In both cases, the other side of the entry goes to close out the balance in Factory Overhead Control by
reducing it to zero.
Material Amount
If the amount of overhead that was over- or under-applied is material, it must be distributed among the
WIP Inventory, Finished Goods Inventory and Cost of Goods Sold accounts. The variances are pro-
rated according to the amount of overhead included in each that was allocated to the current periods
production.
Note: The pro-ration of under- or over-applied overhead should be done on the basis of the
overhead allocated to production during the current period only, not on the basis of the balances in
the inventories and cost of goods sold accounts at year end. Information on the amount of overhead
allocated to production during the current year should be available in the accounting system.
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. 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.
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, 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.
Proportional allocation of under-applied overhead adds to the value (or cost) of each of the goods
produced during the period, regardless of where each unit was in the accounting system at the end
of the period.
Proportional allocation of over-applied overhead reduces the value (or cost) of each item produced
during the period, wherever it appears in the accounting system.
Note: ASC 330 prescribes a slightly different treatment of under- and over-applied manufacturing
overhead for external financial reporting purposes. Variable manufacturing overhead variances are to be
allocated proportionately among inventories and cost of goods sold. However, 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. The CMA exams do not test
the treatment prescribed by ASC 330, so you do not need to be concerned about it for the CMA exam.
However, you may need to be aware of these different requirements if you are doing external financial
reporting for a manufacturer. For more information, see ASC 330-10-30-1 through 330-10-30-8.
Accumulating Overhead Variances

Instead of immediately charging over- or under-applied overhead amounts to COGS or to inventories and
COGS each month, companies may accumulate the over- or under-applied overhead (also called the variance)
in variance accounts throughout the year by closing out the over- or under-applied monthly amount to the
variance accounts.
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. That is particularly true if, based on year-to-date variances, the standard overhead
application rates are adjusted mid-year.
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.
1) When the company makes up its budget for the coming year, it determines what its budgeted fixed
manufacturing overhead will be. For this example, budgeted fixed manufacturing overhead for the
coming year is $10,000,000.
2) The company determines the capacity level it will base its forecast on for the volume to be produced.
Since U.S. GAAP requires normal capacity to be used for external financial reporting, that is the ca-
pacity level this company will use. For simplicitys sake, we will assume the company has only one
product. We will say that the companys normal capacity is 1,000,000 units.
3) The company sets the standard for the quantity of the application base to be used for each unit to be
produced. This company is allocating fixed overhead on the basis of machine hours, and each unit is
expected to require 5 machine hours. Therefore, 5,000,000 machine hours will be required to
produce 1,000,000 units.
4) The company divides its total budgeted fixed manufacturing overhead for the coming year
($10,000,000) by the 5,000,000 machine hours it plans to use in the coming year. This gives it the
budgeted, or standard, fixed overhead cost per unit of the cost allocation base used. This per unit
amount is also called the predetermined rate. The standard (predetermined) fixed overhead rate for
the coming year is $2 per machine hour and, since 5 machine hours are required per unit, it is $10
per unit.
5) The next year begins. Fixed overhead costs such as rent, plant supervisor and janitorial salaries are
paid, depreciation on the plant property and equipment is recorded (see Note following this example),
and manufacturing production progresses. As each fixed cost is incurred, the accounting department
debits Fixed Factory Overhead Control for the cost and credits Accounts Payable or whatever other
account is appropriate. The actual costs will almost certainly not be exactly equal to the budgeted
cost of $10,000,000. In this case, the actual total fixed overhead costs for the year turn out to be
$11,000,000 when the year is over.
6) At the same time as the actual costs are being paid, the cost accountants are getting reports from the
factory floor about the number of units being manufactured. For each unit that is manufactured, the
cost accountants apply 5 machine hours $2 per machine hour, or $10 of fixed overhead to that
unit. They do not worry about what the actual costs are at this point. When the accountants apply the
fixed overhead, they debit Work-In-Process Inventory and credit Fixed Factory Overhead Control for
$10 of fixed overhead for each unit manufactured. (The same thing is done for variable overhead
costs using the predetermined variable overhead rate, as well.) This is done because as the year
progresses, no one knows what the actual fixed costs incurred will be at the end of the year. But by
applying this predetermined rate to production, the company can have a close estimate of what its
total production costs are as the year goes on. During the year, 1,200,000 units are manufac-
tured. Therefore, 1,200,000 $10, or $12,000,000 of fixed overhead will be applied to the
units produced. This applied overhead flows along with the rest of the applied costs first to Work-In-
Process inventory, then to Finished Goods Inventory as the units are completed, and finally, when the
units are sold, to Cost of Goods Sold.
(Continued)
7) By the end of the year, the company has three amounts: Budgeted fixed overhead of $10,000,000;
Actual fixed overhead of $11,000,000; and Applied fixed overhead of $12,000,000. The Total
Fixed Overhead Variance is the Actual Fixed Overhead of $11,000,000 minus the Applied Fixed Over-
head of $12,000,000, or $(1,000,000). Because $1,000,000 more overhead was applied than was
actually incurred, the fixed overhead is over-applied by $1,000,000.
8) This Total Fixed Overhead Variance of $(1,000,000) right now is a credit balance in the
Fixed Factory Overhead Control account. Remember we said that as actual costs are paid, they
are debited to the Fixed Factory OH Control account, and as the overhead is applied to production,
the amount applied is credited to the Fixed Factory OH Control account. (For this example, we are
assuming only a Fixed Factory Overhead Control account is being used, and a separate account for
Fixed Factory Overhead Applied is not being used.) Therefore, the Fixed Factory OH Control account
has been debited for $11,000,000 and credited for $12,000,000. Thus it has a credit balance of
$(1,000,000), which is also the Total Fixed Overhead Variance. 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.
9) The Total Fixed Overhead Variance can be split into two different sub-variances, to permit manage-
ment to better analyze it and understand what caused it. 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. The two sub-variances are:
10) Fixed Overhead Budget (or Fixed Overhead Spending) Variance, which is Actual Fixed
Overhead Incurred minus Budgeted Fixed Overhead. Here, that is $11,000,000 $10,000,000, which
is $1,000,000. This is a positive number, because Actual Fixed Overhead Incurred was greater than
Budgeted Fixed Overhead. This might be considered an Unfavorable variance, because actual costs
were higher than planned. However, remember that actual production was 1,200,000 units, which
was 200,000 greater than the 1,000,000 units that were planned. So actually, the fixed overhead
cost per unit was less than planned, because the fixed overhead cost per unit actually produced
was $11,000,000 1,200,000 units, or $9.16 per unit. So this is not an unfavorable variance.
11) Fixed Overhead Production-Volume Variance. This variance is Budgeted Fixed Overhead minus
Applied Fixed Overhead. Here, that will be $10,000,000 $12,000,000, which is $(2,000,000), a
negative number. This variance tells management that more fixed overhead was applied than had
been budgeted for. The reason more fixed overhead was applied than was budgeted for is, of course,
because production was higher than planned. And that is a good thing.
12) These two variances $1,000,000 Fixed Overhead Budget/Spending Variance plus $(2,000,000)
Fixed Overhead Production-Volume Variance total to $(1,000,000), which is the favorable Total
Fixed Overhead Variance.
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. The Fixed Overhead Budget/Spending Variance will be
closed out by distributing it proportionately among Work-In-Process Inventory, Finished Goods Inven-
tory and Cost of Goods Sold. The Fixed Overhead Production-Volume Variance will also be distributed
proportionately among those three accounts, because the production was greater than the normal
capacity, which led to over-application of fixed overhead. (Note that if the fixed overhead had been
under-applied because production was below normal capacity, the Fixed Overhead Production-Volume
Variance would have been closed out by debiting it to Cost of Goods Sold only.)
14) Distributing the Budget/Spending variance of $1,000,000 will cause an increase in the three accounts
it is distributed to (WIP Inventory, FG Inventory and COGS), because the Fixed Factory Overhead
Control account will be credited for $1,000,000 and the three accounts will be debited for a total of
$1,000,000.
(Continued)
15) Distributing the Production-Volume variance of ($2,000,000) will cause a decrease in the three
accounts, because the Fixed Factory Overhead Control account will be debited for $2,000,000 and the
three accounts will be credited for a total of $2,000,000.
16) The net effect will be a $1,000,000 decrease in the three accounts to which the variances
are distributed.
17) This allocation of the variances will take the balance in the Fixed Factory OH Control account to zero.
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. Because the fixed overhead was over-applied, this
allocation reduces the cost of each item produced during the period.
Note: Depreciation on factory facilities and equipment is a part of fixed manufacturing overhead. When
depreciation on manufacturing facilities is recorded in the accounting system, the debit goes to the Fixed
Factory Overhead Control account for application to production as part of overhead and not to Depreciation
Expense. Thus, when fixed overhead is applied to units produced, a portion of the amount applied to each
unit will be depreciation. Some of this depreciation will be in Finished Goods and Work-in-Process
Inventories at the end of the period, and some of it will have flowed to Cost of Goods Sold with units that
have been sold.
Recording of depreciation is a non-cash transaction. Therefore, the notes to the financial statements must
always show where all the recorded depreciation is classified in the financial statements, so that wherever
it is, it can be properly segregated as a non-cash item when the Statement of Cash Flows is prepared.
Note: In questions about overhead allocation on the exam, you need to make certain that you identify the
allocation base. It may be machine hours, direct labor hours, direct labor costs, weight, size, or something
similar. It is also possible that in a question there will be more than one overhead allocation base. If
there is more than one overhead allocation base, you simply need to perform the mathematics of overhead
allocation more than once and then add the numbers together. Doing this does not make the question any
more difficult; it just takes longer to do since you need to perform the same operation more than once.
This is seen in the following question.
Question 6: A company allocates overhead to jobs in process using direct labor costs, raw material costs
and machine hours. The overhead application rates for the current year are:
100% of direct labor.

20% of raw materials.
$117 per machine hour.
A particular production run incurred the following costs:
Direct labor, $8,000

Raw materials, $2,000
A total of 140 machine hours were required for the production run.
What is the total cost that would be charged to the production run?
a) $18,000
b) $18,400
c) $24,780
d) $34,780
(CIA Adapted)
Question 7: On January 1, 2005, the first year of operations, Medina Co. had the following annual budget.
Units produced 20,000
Sales $120,000
Minus:
Total variable expenses 70,000
Total fixed expenses 25,000
Net income $ 25,000
Factory overhead:
Variable $40,000
Fixed 20,000
At the end of the first year, there were no units in progress and the actual total factory overhead incurred
was $45,000. There was also $3,000 of over-applied factory overhead. Factory overhead was allocated on
a basis of budgeted units of production. How many units did Medina produce this year?
a) 14,000
b) 16,000
c) 20,000
d) 23,333
(HOCK)
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, and it means identical to
each other). Process costing is basically applicable to assembly lines and anything that shares a similar
production process. 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, or worked on,
during that period within that process (or department).
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. It is largely a mathematical operation
and as we will see, there are some basic formulas that we can use to make certain that everything is
accounted for.
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. We will conclude the coverage of process costing by reviewing the steps
and studying a comprehensive example.
As already briefly mentioned, 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 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).
2) They are transferred in from the previous department.
3) They were in the department on the first day of the period in the form of beginning work-in-
process (BWIP).
In reality the categories of costs can be numerous. There may be direct materials, direct labor, indirect
materials, indirect labor or other overheads. However, on the CMA Exam, there are generally only two
classifications of costs direct materials and conversion costs. Conversion costs include everything other
than direct materials and are the costs necessary for converting the raw materials into the finished product.
Note: Conversion costs is a term that is used in process costing questions to refer to direct labor and
factory overhead. It encompasses everything except raw materials. Conversion costs are the costs
necessary to convert the raw materials into the finished product. Placing these different costs into one
category simply reduces the number of individual allocations that you need to make on a question.
Note: Transferred-in costs are the total costs that come with the new product from the previous
department. They are similar to Raw Materials but in reality will include all of the costs (material and
conversion costs) from the previous department. The previous departments completed units are this
departments transferred-in costs and the costs for both of these items should be the same.
As we have said, 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, or they will remain in Ending WIP if they are not complete (we will look at this allocation process
later). The Ending WIP from this period will be the Beginning WIP for the next period. If the goods are then
sold before the end of the period, the costs associated with the units that were sold will end up in COGS. 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.
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. This
simply means that the unit has been completed in this process and transferred to the next department or
finished goods. Whether it has been sold (and is in COGS), still being worked on (ending WIP for the
company), or finished but not sold (ending finished goods inventory for the company) is irrelevant to what we
are looking at here. 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.
Note: The basic accounting for this type of system is as follows: all of the costs incurred are put into a
WIP account. These costs include direct material (though direct materials are usually allocated
differently from the conversion costs and may be accounted for separately), direct labor, indirect
materials, indirect labor and factory overhead. 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.
Costs for units completed during the period are transferred to either finished goods or to the next
department. This allocation will be done based on a per unit allocation basis, in a manner similar to the
standard allocation of overhead. However, you do not need to be familiar with the accounting steps in this
process, just the allocation process. This information is presented because it may help you see what is
happening in this process.
Steps in Process Costing

We will now examine the steps in process costing in more detail. It is important that you are very comfortable
with equivalent units of production (covered in much more detail later) and how they are calculated. This
is an important part of process costing and one that is likely to be tested. 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.
1. Determine the Physical Flow of Goods
Note: This formula is not going to be tested on the exam. We show it as a first step in Process costing
simply to help you understand how many units there are to account for.
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. In a problem you will be given enough information to solve this type of situation if you
understand the way the goods move. 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, water bottles in the
filling department at the end of the period that are partially full). In this formula, we are interested only in the
number of physical units, no matter how complete they are (for example, the number of actual water bottles
in the filling department). 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 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.
Note: When doing a problem like this about physical flow, 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). Here, we are looking simply at the number of physical units.
Question 8: Ben Company had 4,000 units in its work-in-process (WIP) on January 1. Each unit was 50%
complete in respect to conversion costs. During the first quarter, 15,000 units were completed. On March
31, there were 5,000 units in ending WIP that were 70% complete in respect to conversion cost. For this
product, all of the direct materials are added when the unit enters the facility. How many units did Ben
start during the first quarter?
a) 13,000
b) 15,000
c) 16,000
d) 16,500
(HOCK)
2. Calculate the Number of Units Started and Completed
Note: This formula by itself is not going to be tested on the exam. However, 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.
Next, we calculate how many units were started and completed during the period. This means that all of the
work on these units was done during the period. (For example, if the product is bottled water, how many
water bottles were transferred into the filling department during the period and were completely filled during
the period.) 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. If we subtract the number of
physical units in beginning WIP from the total number of units completed, the result will be the number of
units started and completed during the period.
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.
3. 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 actually a very simple thing to do, because this information will be provided
in the question. However, 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, conversion costs are added evenly throughout the process, but if conversion costs are added at a
specific point in the process, then those conversion costs would need to be treated like materials.
4. Calculate the Equivalent Units of Production (EUP)

To allocate costs to the individual units produced, we need to know how many units the costs should be
allocated to. In a system where there is no beginning or ending WIP in the department, this allocation of costs
would be a simple matter of dividing the costs by the number of units that were produced during the period.
However, since we have beginning and ending WIP, the process is more complicated. 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, and then started another
unit. Completely produced means completed from start to finish with all direct materials added and all
conversion activities completed. This number of complete units that could have been completed during the
period is called the number of equivalent units of production.
By way of illustration, because the units in beginning WIP are already completed to some extent, we do not
need to do one full units worth of work in order to finish each unit that is in BWIP. (For example, if a 1-liter
water bottle is 60% full on January 1, we would need to add only 40% of a liter to fill that bottle.) Similarly,
because each unit that is in ending WIP is not entirely complete, we have done less work on each of these
items than on the complete units. We must determine how many equivalent units were produced (EUP)
during the period.
Essentially, 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.
2) Started and Completed (calculated above), meaning that the unit was started on or transferred in
during the period and was completely finished during this period.
3) Started (but not completed), meaning that these are units that were started on or transferred in
during the period, but were not finished at the end of the period and thus have not yet been trans-
ferred out of the process.
We need to determine how many equivalent units were needed for each of these three categories of work
done on units. In the second example is a formula that we will use for this calculation.
The idea of EUP is probably best explained with a couple of examples.
Example: If there are 100 units in beginning WIP and each unit is 25% complete, if there are no other
units added to the system this period, and at the end of the period there are 100 complete units, the
number of EU produced this period is 75. This was calculated as 100 0.75, 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. If there are 100 bottles
that are each 25% full, we will need to add 75 liters of water to all of the bottles to make them all
complete. This means that we added 75 equivalent units of water during the period.
Example: Let us assume that in addition to the 100 units in beginning WIP (still 25% complete), there
were also 100 units (empty bottles to be filled) transferred in during the period, and at the end of the
period there are 10 units in ending WIP that are 40% complete. Calculate
1) The number of units completed,
2) The number of units started and completed, and
3) The number of EUP during the period.
Solutions:
1) The number of units completed is 190. This is calculated using the formula: Units in BWIP (100) +
Units transferred in (100) = Units in EWIP (10) + Units Completed (must be 190).
2) Having calculated the number of units completed, we can now determine that there were 90 units
started and completed (190 units completed 100 units in BWIP). This is used to calculate the number
of equivalent units produced.
3) To calculate the EUP we need to use the three steps of what could be done to a unit during the period.
The calculation of equivalent units of production is:
To Complete BWIP (100 0.75) = 75

Started and Completed (90 1.00) = 90
To Start EWIP (10 0.40) = 4
Total EUP 169
Though this concept of EUP is mathematically simple, people sometimes initially have trouble with it. So
please make certain that you spend the necessary time and are comfortable with how it works. We will look at
it in the following pages.
Question 9: Ben Company operates a production facility that has three departments. 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 1,300
Number of units completed 1,100
Number of units in EWIP 400
% complete for EWIP 80%
The equivalent units of production for Ben Company for May was:
a) 900
b) 1,260
c) 1,380
d) 1,620
(HOCK)
EUP for Materials and Conversion Costs Separately

There is, unfortunately, a minor complication to this 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. Usually, conversion costs are added proportionately throughout the
process, whereas direct materials are added at a specific point in the process. This does not make the
problem any more difficult; it simply means that we have twice as many calculations to complete.
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.
When the materials are added when the unit is 50% complete as to conversion costs, and the ending WIP is
only 40% completed as to conversion costs, 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. However, if the units in ending WIP
were 60% complete for conversion costs, this would mean that the entire unit of material has been added. In
this case, the unit would be 100% complete for materials, but only 60% complete for conversion costs.
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, as follows:
If the materials are added at the beginning of the process, beginning WIP Inventory will have
had 100% of the needed materials added, and no materials will need to be added to complete be-
ginning WIP Inventory during the current period.
If the materials are added at the end of the process, no materials will have been added to begin-
ning WIP Inventory, and all of the direct materials (100%) will need to be added to complete the
beginning WIP Inventory during the current period. Ending WIP Inventory will also have had no ma-
terials added.
If the materials are added at some point in the middle of the process (such as when the process
is 40% complete), compare that percentage with the percentage complete as to conversion costs for
the units in beginning WIP and ending WIP Inventories. If the units are completed beyond that point,
they will have had 100% of the needed materials added, and no materials will need to be added to
complete the beginning WIP Inventory during the current period. If the units are not completed be-
yond that point, they will have had no materials added, and beginning WIP Inventory will need to
have 100% of its materials added during the current period to complete production.
If the materials are added evenly throughout the process, the percentage of materials already
added to beginning WIP will be equal to the percentage of conversion costs added to beginning WIP
Inventory. The remaining amount (100% minus the percentage already added) will need to be add-
ed to complete beginning WIP Inventory during the current period.
How and when materials are added is something that you will need to pay attention to, and it is included in
some of the questions in these materials.
Question 10: Hoeppner Corp. uses process costing to allocate costs. In the Pressing Department all of the
materials are added at the very beginning of the process. After this first addition, no additional materials
are added during the process. At the end of January, Hoeppner was presented with the following
information:
Beginning Work-in-Progress (60% complete for conversion costs) 2,000

Units started in January 5,000
Transferred out from Pressing during January 6,000
Ending Work-in-Progress, (40% complete for conversion costs) 1,000
Under the EUP method already discussed, what are the equivalent units of production for the month of
January?
Materials Conversion
a) 5,000 5,200
b) 5,000 5,600
c) 5,200 5,400
d) 5,200 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. As with regular inventory, 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. In process costing,
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).
2) Weighted Average (WAVG) In WAVG we do not assume that the units in BWIP are finished first
and as a result, all of the units (both those from BWIP and those transferred in or started this peri-
od) will be treated the same. The costs of beginning WIP and the work done during the current
period will be combined and averaged (this is the weighted averaging).
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. Very briefly (this is covered in much more detail later),
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 departments costs of the current period to calculate a weighted average.
You need to be able to make the calculations for EUP under both of these methods. They are discussed in
more detail individually below. There is a simple formula for each method for calculating EUP. If you
memorize this formula, you should be able to answer EUP questions.
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. 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.
Because we know that the units that were in BWIP have been transferred out of the department, the costs
that were already associated with those units in BWIP are kept separate from the costs that are incurred
during the current period. 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. They are not allocated between units
transferred out and units remaining in ending WIP.
This means that the calculation of EUP and the allocation of the current periods 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. In other words, 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, 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).
Note: When the units are transferred out, the costs incurred this period, as well as the costs that were
with BWIP, are combined as the transferred-in costs for the next department they are not kept separate
in future departments. 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.
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. We draw no distinction between the units that were in BWIP and the units that were
transferred in or started on during the period. 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.
The costs that are associated with BWIP are combined with the costs that were incurred during the current
period. 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. This will enable us to reassign the total combined cost to all units
worked and determine their average cost.
Again, in WAVG, 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. Therefore, we are calculating an
average cost for the work done last period that is still in the department as well as for the costs incurred this
period.
Because we are assuming that all of the work done on BWIP was done during this period, the calculation of
EUP for the weighted average method is simpler than for FIFO. For WAVG there are only two categories of
units for which we need to calculate EUP. These two categories are Units Completed and the starting of EWIP.
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
This method essentially creates a weighted average cost of the production costs of the two periods by putting
them together (and hence, the name).
Note: The EUP under the weighted average method can never be lower than the EUP under
FIFO. They will be equal if there was no BWIP, but FIFO can never be higher than the weighted average
method. 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.
Question 11: The following data pertain to a company's cracking-department operations in December.
Units Completion
Work-in-process, December 1 20,000 50%
Units started 170,000
Units completed and transferred
to the distilling department 180,000
Work-in-process, December 31 10,000 50%
Materials are added at the beginning of the process and conversion costs are incurred uniformly
throughout the process. Assuming use of the FIFO method of process costing, the equivalent units of
conversion performed during December were:
a) 170,000 equivalent units.
b) 175,000 equivalent units.
c) 180,000 equivalent units.
d) 185,000 equivalent units.
(CIA Adapted)
9
Units completed is calculated as: Units in BWIP + Units Started/Transferred In Units in EWIP = Units Completed
The following information is for the next four questions: Levittown Company employs a process
cost system for its manufacturing operations. All direct materials are added at the beginning of the
process, 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 5,000
Total units to account for 6,000
Units completed and transferred out from BI 1,000

Units started and completed during November 3,000
Work-in-process on November 30 (20% complete as to conversion costs) 2,000
Total units accounted for 6,000
Question 12: Using FIFO, the EUP for direct materials for November are:
a) 5,000 units
b) 6,000 units
c) 4,400 units
d) 3,800 units
Question 13: Using FIFO, the EUP of conversion costs for November are:
a) 3,400 units
b) 3,800 units
c) 4,000 units
d) 4,400 units
Question 14: Using weighted-average, the EUP for materials for November are:
a) 3,400 units
b) 4,400 units
c) 5,000 units
d) 6,000 units
Question 15: Using weighted-average, the EUP for conversion costs for November are:
a) 3,400 units
b) 3,800 units
c) 4,000 units
d) 4,400 units
(CMA Adapted)
5. 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.
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. These costs that are in BWIP do not go into the process during the period. This is because
under FIFO, we assume that the units in BWIP are all finished before other units are started. Therefore, all of
the costs in BWIP will end up as costs for units completed and transferred out this period. 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. 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.
2) An allocated portion of costs incurred by this department during the current period.
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. This is the same as we did with the
calculation of EUP under the weighted average method. 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).
Because we are mixing the costs of the current and previous periods, we get a weighted average.
Selecting an Inventory Cost Flow Method

The weighted average method is simpler to use since there is only one calculation. However, this method
mixes together costs, so any change in the cost of an input is in a sense covered up by the weighted average.
The weighted average method is best used when prices are stable.
Because the FIFO method keeps the costs of the two periods separate, it is better to use FIFO when there
is a change in the price of the inputs between the two periods.
6. Calculation of the Cost per EUP

Once the EUP have been determined (under either FIFO or WAVG), and the costs to be allocated have been
identified, we must determine a rate (or unit cost) per EUP for both raw materials and conversion costs. 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). These rates for materials and conversion costs must be calculated
separately because the EUP for materials and conversion costs may be different.
Note: Remember that if using the FIFO cost flow assumption, all of the costs associated with the BWIP are
automatically transferred to FG or the next department, and they do not need to be allocated according to
the EUP.
7. Allocation of the Costs to the Products

After the rates per EUP for materials and conversion costs have been determined, 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 simply a mathematical exercise that requires multiplying the EUP by the rate (or cost) per
EUP.
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, however, it is critical that you do not forget to allocate the costs in BWIP to units
transferred out.
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. Under FIFO, the costs of BWIP go
directly to completed 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. Similarly, 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.
Following the diagrams, 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.
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.
on them and have been materials into the finished
allocated costs from the product.
previous period.
Costs associated with BWIP Cost of Conversion Costs Costs of Materials
The Process
In the process, we calculate

the EUP of materials and
conversion costs.
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. Costs
Cost/EUP of Conv. Costs
1
Under FIFO these units are considered to have been completed during the period, so the costs associated
with BWIP are all transferred out. The EUP that are in BWIP are ignored and not used in the allocation of costs
incurred during the current period.
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.
on them and have been materials into the finished
allocated costs from the product.
previous period.
Costs associated with BWIP Cost of Conversion Costs Costs of Materials

AND EUP associated with
BWIP
The Process
In the process, we calculate

the EUP of materials and
conversion costs. 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. Costs
Cost/EUP of Conv. Costs
2
Under WAVG these units are considered to have been done completely during this current period. 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.
Process Costing Summary

The seven steps in a process costing question are shown again below in an abbreviated form.
1) Determine the physical flow of units of goods. 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. The formula is:
Started and Completed = Units Completed/Transferred Out Units in BWIP
3) Determine when the materials are added to the process.
4) Calculate the equivalent units of production during the period. This calculation will most likely
need to be done twice once for materials and once for conversion costs. 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. However, if the materials are also added evenly in the process, only one cal-
culation for EUP for both materials and conversion costs must be made.
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
For Weighted Average:
1) Units Completed Units completed during the period 1

5) Calculate the costs incurred during the period.
For FIFO, 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. (Costs in BWIP are allocated 100% to
units completed.)
For WAVG, the costs allocated between units completed and units in Ending WIP will include those
actually incurred during the period, plus the costs that were in BWIP at the start of the period.
The costs for materials and conversion costs need to be calculated separately.
6) Calculate the cost per equivalent unit for materials and conversion costs. We accomplish this
by simply dividing the costs from Step 5 by the EUP calculated in Step 4. This calculation is done
separately for materials and conversion costs.
7) Allocate the costs between completed units and EWIP. This allocation is done by multiplying
the EUP calculated in Step 4 by the cost per EUP that was calculated in Step 6. It is usually easiest to
do this by calculating the ending inventory value since there is only one calculation. On the other
hand, two calculations are needed to calculate the amount to be allocated to completed units.
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. We will look at the same situation and calculate the dollar value of EWIP and FG
using both the FIFO and Weighted Average methods. If you are able to understand the entire process, the
Exam questions will be easier as they generally ask about only one part of the process.
FIFO Example: Beginning WIP inventory is 150 units (60% complete as to conversion costs). Beginning
WIP inventory material costs are $250 and conversion costs are $500. All material for the product is added
at the beginning of the production process. Conversion takes place continuously throughout the process.
During the period 550 units were started. Material costs for the period are $800 and conversion costs for
the period are $6,000. Ending WIP is 80 units at 20% completion as to conversion costs.
Calculate the amounts to be in EWIP and FG using the FIFO method.
1) Determine the physical flow.

BWIP + Started = EWIP + Units Completed
150 + 550 = 80 + 620
2) Calculate the Units Started and Completed.

S&C = Units Completed BWIP
470 = 620 150
3) Materials are added at the beginning of the process. Therefore, 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. Thus the number of
equivalent units of direct material in each is equal to the number of physical units in each.
4) Calculate equivalent units of production. Under FIFO, the costs in BWIP are allocated 100% to
units completed and transferred out. Therefore, only costs incurred during the current period are
allocated between completed units and units in EWIP on the basis of equivalent units.
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. Under FIFO, only costs actually incurred during the period are allocated
between units completed and units in EWIP.
Materials $ 800
Conversion Costs $6,000
6) Costs per equivalent unit.

Materials $ 800 550 = $ 1.46
Conversion Costs $ 6,000 546 = $10.99
7) Allocate costs to EWIP.

Materials $ 1.46 80 = $116.80
Conversion Costs $10.99 16 = 175.84
Total $292.64
Allocate costs to finished goods.

Costs of BWIP $250 +$ 500 = $ 750.00
Materials $1.46 470 = 686.20
Conversion Costs $10.99 530 = 5,824.70
Total $7,260.90
WAVG Example: Beginning WIP inventory is 150 units (60% complete as to conversion costs). Beginning
WIP inventory material costs are $250 and conversion costs are $500. All material for the product is added
at the beginning of the production process. Conversion takes place continuously throughout the process.
During the period 550 units were started. Material costs for the period are $800 and conversion costs for
the period are $6,000. Ending WIP is 80 units at 20% completion as to conversion costs.
Calculate the amounts to be in EWIP and FG using the Weighted Average method.
1) Determine the physical flow.

BWIP + Started = EWIP + Units Completed
150 + 550 = 80 + 620
2) Calculate the Units Started and Completed.

S&C = Transferred Out BWIP
470 = 620 150
3) Materials are added at the beginning of the process. Therefore, 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. Thus the number of
equivalent units of direct material in each is equal to the number of physical units in each.
4) Calculate equivalent units of production.

Materials Conversion Cost
Units COMPLETED 620 620
EWIP 80 16 = 80 20%
TOTAL 700 636
5) Calculate costs to allocate using EUP. Under WAVG the costs that are associated with BWIP are
added to the costs incurred during the period.
Materials $250 in BWIP + $ 800 incurred = $1,050
Conversion Costs $ 500 in BWIP + $ 6,000 incurred = $6,500
6) Costs per equivalent unit (including costs in BWIP).

Materials ($250 + $800) 700 = $ 1.50
Conversion Costs ($ 500 + $ 6,000) 636 = $10.22
7) Allocate costs to EWIP.

Materials $ 1.50 80 = $120.00
Conversion Costs $10.22 16 = 163.52
Total $283.52
Allocate costs to finished goods.

Materials $1.50 620 = $ 930.00
Conversion Costs $10.22 620 = 6,336.40
Total $7,266.40
Note: If the company is in its first month of operation, there will be no BWIP. 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.
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, which are
then transferred to the Finishing Department where a sealant is applied. The Forming Department began
manufacturing 10,000 "Casey Sluggers" during the month of May. There was no beginning inventory.
Costs for the Forming Department for the month of May were as follows:
Direct materials $33,000

Conversion costs 17,000
Total $50,000
A total of 8,000 bats were completed and transferred to the Finishing Department; the remaining 2,000
bats were still in the forming process at the end of the month. All of the Forming Department's direct
materials were placed in process, but, on average, only 25% of the conversion cost was applied to the
ending work-in-process inventory.
Question 16: The cost of the units transferred to the Finishing Department is:
a) $50,000
b) $40,000
c) $53,000
d) $42,400
Question 17: The cost of the work-in-process inventory in the Forming Department at the end of May is:
a) $10,000
b) $2,500
c) $20,000
d) $7,600
(CMA Adapted)
Question 18: Nance Co. began operations in January 2005 and uses the FIFO Process Costing method in
its accounting system. After reviewing the first quarter results, Nance is interested in how the equivalent
units produced would have been different if the weighted average method had been used instead. Assume
that the number of units in ending work-in-progress was the same at the end of January, February and
March and that at the end of each month they were the same percentage complete. If Nance had used
the weighted average method, 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)
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. The following information pertains
to operations for the month of May.
Units
Beginning work-in-process inventory, May 1 16,000
Started in production during May 100,000
Completed production during May 92,000
Ending work-in-process inventory, May 31 24,000
The beginning inventory was 60% complete for materials and 20% complete for conversion costs. The
ending inventory was 90% complete for materials and 40% complete for conversion costs.
Costs pertaining to the month of May are as follows:
Beginning inventory costs are materials, $54,560; direct labor, $20,320; and factory overhead,
$15,240.
Costs incurred during May are materials used, $468,000; direct labor, $182,880; and factory
overhead, $391,160.
Question 19: Using the weighted-average method, the equivalent unit cost of materials for May is
a) $4.12
b) $4.50
c) $4.60
d) $5.02
Question 20: Using the weighted-average method, the equivalent unit conversion cost for May is
a) $5.65
b) $5.83
c) $6.00
d) $6.20
(CMA Adapted)
Question 21: At the end of the first month of operations, Larkin had 2,000 units in ending WIP that were
25% complete as to conversion costs. All materials are added at the end of the process. The number of
equivalent units of conversion costs would be:
a) Equal to the number of units completed during the period.
b) Less than the number of equivalent units of materials.
c) Less than the number of units completed during the period.
d) Less than the number of units placed into the process during the period.
(HOCK)
Spoilage in Process Costing

Spoilage is the term used for defective units that are not transferred to the next process. Whenever there is
spoilage there are some issues that need to be addressed. 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, 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, some of the costs of production will be allocated to the spoiled units. Material has
been added to the spoiled units and some of the conversion work done has been done on them. Both the
materials used and the conversion costs expended for the spoiled units need to be allocated to the spoiled
units.
The treatment of spoilage is similar to the treatment of ending WIP the units were started but never
finished. 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.
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. However, now that
we add spoilage to the situation, we must add spoiled units as another possible destination for the costs that
are in the department.
If there are spoiled units in the process, we must allocate the material costs and conversion costs to these
spoiled units. The amount that will be allocated is done through the EUP and will depend on when the unit is
identified as spoiled.
1. How Many Units Were Spoiled

This information is usually given in the question. There may be a small calculation required, but nothing
difficult. Though this is usually given in the question, it is important that you identify this amount and know
exactly how many units were spoiled.
2. How are the spoiled units classified as normal or abnormal?

All spoiled units are classified as either normal or abnormal. Normal spoilage is the amount that is expected
from the production process.
For whatever process is being looked at, the company will have established standards about how many
defective (spoiled) units there should be (or are expected to occur). 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.
The number of spoiled units up to and including, but not exceeding, this expected number are classified as
Normal Spoilage. Any spoiled units in excess of the expected spoilage are classified as Abnormal Spoilage.
This distinction is important because the treatment of the costs associated with normal and abnormal spoilage
is different.
3. Calculating the Costs Allocated to Each Spoiled Unit

If the spoiled units are identified as spoiled after they start being processed in this department, they will have
some conversion costs allocated to them and possibly materials, depending on when the materials are added.
We need to allocate the conversion costs and material costs to the spoiled units based on their EUP. In order
to calculate the EUP of Spoiled Units, we do the same thing with them as we did with EWIP. We can simply
add another line into the formulas.
In a problem with spoilage, 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
4) + Starting Spoiled Units Units Spoiled % work done this period
In a problem with spoilage, the formula for WAVG now looks like this:
1) Units Completed Units completed during the period 1

3) + Starting Spoiled Units Units Spoiled % work done this period
Allocation of Costs to the Spoiled Units

After the cost per EUP of materials and conversion costs are calculated as discussed above, the company will
allocate costs to each unit, including the spoiled units. 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. Again, this will probably be done
separately for materials and conversion costs.
4. 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, those costs must
be transferred somewhere at the end of the period. (These costs will be some amount of materials and
conversion costs.) It is obvious that these units are neither finished goods nor work-in-process, but the costs
have been incurred in the department and must be moved out of the department.
The treatment of spoilage costs will depend on the type of spoilage.
Normal Spoilage
If the spoilage is normal 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). 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.
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.
It is generally considered that production management can control abnormal spoilage. Normal spoilage is
expected to occur and generally cannot be prevented. However, abnormal spoilage, by definition, should not
occur and should therefore be preventable.
Note: To simplify the allocation of costs to spoiled units under FIFO, the spoiled units are accounted for as
though they were all started in the current period. 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.
Additional Classifications of Spoilage

Below are some additional terms that are similar to spoilage that you need to be aware of.
Shrinkage
Shrinkage occurs when a product simply evaporates or losses some of its quantity through time. 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.
Rework
When spoiled goods are fixed and prepared for sale, this is called rework. 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. Costs incurred in rework of abnormally spoiled units should be expensed.
Waste
Waste is the material that is left over after production is complete. It is simply unused and is now unusable
materials.
Question 22: A company that manufactures baseballs begins operations on January 1. Finished baseballs
are inspected and defective ones are pulled out. Defective baseballs cannot be economically salvaged and
are destroyed. Normal spoilage is 3% of the number of baseballs that pass inspection. Cost and produc-
tion reports for the first week of operations are: Raw materials cost - $840 and Conversion cost - $315.
During the week 2,100 baseballs were completed and 2,000 passed inspection. There was no ending WIP.
Calculate abnormal spoilage.
a) $33
b) $20.35
c) $22
d) $1,100
(CIA Adapted)
Question 23: A company employs a process cost system using the FIFO method. The product passes
through both Department 1 and Department 2 in order to be completed. Units enter Department 2 upon
completion in Department 1. Additional direct materials are added in Department 2 when the units have
reached the 25% stage of completion with respect to conversion costs. Conversion costs are added
proportionally in Department 2. 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 transferred in from Department 1 80,000
Units to account for 95,000
Units completed and transferred to finished goods 85,000

Ending work-in-process inventory (20%
complete with respect to conversion costs) 10,000
Units accounted for 95,000
How many equivalent units for direct materials were added in Department 2 for the current month?
a) 70,000 units.
b) 80,000 units.
c) 85,000 units.
d) 90,000 units.
(CMA Adapted)
Question 24: Assume 5,500 units were worked on during a period when a total of 5,000 good units were
completed. Normal spoilage consisted of 300 units; abnormal spoilage, 200 units. Total production costs
were $2,200. The company accounts for abnormal spoilage separately on the income statement as loss
due to abnormal spoilage. Normal spoilage is not accounted for separately. What is the cost of the good
units produced?
a) $2,080
b) $2,120
c) $2,200
d) $2,332
(CIA Adapted)
Question 25: During May 20X5, Mercer Company completed 50,000 units costing $600,000, exclusive of
spoilage allocation. Of these completed units, 25,000 were sold during the month. An additional 10,000
units, costing $80,000, were 50% complete at May 31. All units are inspected between the completion of
manufacturing and transfer to finished goods inventory. Normal spoilage for the month was $20,000, and
abnormal spoilage of $50,000 was also incurred during the month. The portion of total spoilage that
should be charged against revenue in May is
a) $50,000
b) $20,000
c) $70,000
d) $60,000
(CMA Adapted)
Process Costing
Benefits Process costing is the easiest, most practical costing system to use to allocate costs
for homogeneous items. It is a simple and direct method that reduces the volume of
data that must be collected.
Process costing can aid in establishing effective control over the production process.
Process costing can be used with standard costing by using standard costs as the
incurred costs that are allocated. Use of standard costing with process costing makes
it possible to track variances and to recognize inefficiency in a specific process.
It is flexible. If the company adds or removes a process, it can adapt its process
costing system easily. Removal of a process might occur if the company identifies a
redundant (duplicative) process, and cost savings may result. Addition of a process
could occur if the company decides to produce a slightly different product or improve
the quality of an existing product.
Management accountants can review the amounts of materials and labor used in
each process to look for possible cost savings.
Process costing enables tracking of inventory.
Process costing enables obtaining and predicting the average cost of a product, an
aid in providing estimates to customers.
Limitations Process costing can introduce large variances into the costing system if standard
costs allocated to the units are not up to date. Depending upon how the variances
are resolved, these variances could cause the product to be over- or under-costed,
which could lead to pricing errors.
Process costing can be time-consuming for management accountants.
Calculating the equivalent units for beginning and ending work-in-process inventory
can lead to inaccuracies, since the percentage of completion of those inventories may
be subjective (an estimate or even a guess).
Process costing cannot provide an accurate cost estimate when a single process is
used to produce different (joint) products.
Process costing is not suitable for custom orders or diverse products.
Since the work of an entire department is combined in the process costing system,
process costing makes it difficult to evaluate the productivity of an individual worker.
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). The costs are accumulated on what is called a job-cost sheet.
All of the job sheets that are still being worked on equal the work-in-process at that time. In this system,
costs are recorded on the job-cost sheets, and not necessarily in an inventory account.
This method can be used when all of the products or production runs are unique and identifiable from each
other. A good example of this is an audit or legal firm. As employees work on a particular client or case, they
charge their time and any other costs to that specific job. At the end of the project, the company simply
needs to add up all of the costs assigned to it to determine the cost. Performance measurement can be done
by comparing each individual job to its budgeted amounts or by using a standard cost system.
While direct materials and direct labor are accumulated on an actual basis, manufacturing overhead must be
allocated to each individual job. This is done in much the same manner as has already been explained. 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. For example,
machine hours for each job may be used to allocate overhead costs such as depreciation and machine
maintenance, whereas direct labor hours for each job may be used to allocate plant supervision and
production support costs to jobs. If normal costing is being used, actual machine hours and actual direct labor
hours will be used. If standard costing is being used, the standard machine hours allowed and the standard
direct labor hours allowed for the actual output on each job will be used.
Note: Under job-order costing, selling and administrative costs are not allocated to the products in
order to determine the COGS per unit. They are expensed as period costs.
Question 26: Lucy Sportswear manufactures a line of T-shirts using a job-order cost system. During
March, the following costs were incurred completing Job ICU2: direct materials, $13,700; direct labor,
$4,800; administrative, $1,400; and selling, $5,600. Factory overhead was applied at the rate of $25 per
machine hour, and Job ICU2 required 800 machine hours. If Job ICU2 resulted in 7,000 good shirts, the
cost of goods sold per unit would be:
a) $6.50
b) $6.30
c) $5.70
d) $5.50
(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.
Section D Job-Order Costing
Job Order Costing
Benefits Job order costing is best for businesses that do custom work or service work.
Job order costing enables the calculation of profit on individual jobs, which can help
management determine in the future which kinds of jobs are desirable.
Managers are able to keep track of the performance of individuals for cost control,
efficiency, and productivity.
The records kept result in accurate costs for items produced.
Management can see and analyze each cost incurred on a job in order to determine
how it can be better controlled in the future.
Costs can be seen as they are added, rather than waiting until the job is complete.
This can enable accounting staff to detect costs recorded to the wrong job and
correct them immediately. For long jobs, the costs can be monitored on an ongoing
basis and if the costs get out of control, management can have time to make
changes before the job is finished. Or, with cost-plus10 customers, increased costs
can allow management to make customers aware in advance of cost overruns, which
can lead to negotiations.
Limitations Employees are required to keep track of all the direct labor hours used and all the
materials used.
The focus is on direct costs of products produced. The focus on direct costs can allow
for inefficiencies and increasing overhead costs.
Depending on the type of costing being used, overhead may be applied to jobs on
the basis of predetermined rates. If the overhead application rates are out of date,
the costing can be inaccurate. Charging the variances to individual jobs may not be
possible if jobs have been closed out by the time the variances are recognized.
Furthermore, if the customer is a cost-plus customer, it may not be possible to
charge the customer for a cost overrun that is not detected until the job has been
closed out.
If overhead is applied on the basis of predetermined rates and the rates are not
calculated on any meaningful basis, the cost of each job will not be meaningful. This
can occur most easily when overhead is allocated on the basis of machine hours or
direct labor hours. Allocation of overhead using activity-based costing is more
accurate but is also more time-consuming. (Activity-based costing will be covered
shortly.)
To produce meaningful results, job order costing requires a lot of accurate data
entry. There are many opportunities for mistakes because of the massive amount of
data recording required, and if not corrected, the errors can lead to poor manage-
ment decisions.
The use of job order costing is limited to businesses that do customer or service
work. It is not appropriate for high volume manufacturing or for retailing.
10
A cost-plus customer is a customer for whom the company uses cost-plus pricing to determine the price to charge the
customer. In cost-plus pricing, the company determines its costs and then adds a standard monetary amount of profit to
the cost to determine the price.
Operation Costing CMA Part 1
Operation Costing
Operation costing is a hybrid, or combination, of job-order costing and process costing. In this method
of costing, a company applies the basic operation of process costing to a production process that produces
batches of items. These different batches all follow a similar process, but the direct materials that are input to
each batch are different.
Examples of a system where this would be appropriate are clothing, furniture, shoes and similar items. As you
can see, for each of these items, the general product is the same (for example, a shirt), but the materials
that are used in each shirt may be different.
In operation costing the direct materials are charged to the specific batch where they are used, but
conversion costs are accumulated and distributed using a predetermined conversion cost per unit. These
conversion costs are allocated by batch.
An operation costing worksheet would look very much like a process costing worksheet, except it would
require a separate column for each products direct materials, while there would be one conversion costs
column that would pertain to the conversion of all the products.
Section D Activity-Based Costing
Activity-Based Costing
Activity-based costing (ABC) is another way of allocating overhead costs to products, and in ABC the method
of allocation is based on cost drivers. As with the other methods, ABC is a mathematical process of allocation
and requires identification of the costs to be allocated, followed by some manner of allocating them to the
produced products. We can use ABC in a variety of situations and apply it to both manufacturing and
nonmanufacturing overheads. It can also be used in service businesses.
By definition, according to the Statement of Management Accounting, activity-based costing:
identifies the causal relationship between the incurrence of cost and activities, determines
the underlying driver of activities, establishes cost pools11 related to individual drivers, devel-
ops costing rates, and applies cost to product on the basis of resources consumed (drivers).
Activity-based Costing is a costing system that focuses on individual activities as the fundamental cost
objects.
An activity is an event, task or unit of work with a specified purpose. Examples of activities are
designing products, setting up machines, operating machines, making orders or distributing prod-
ucts.
A cost object is anything for which costs are accumulated for managerial purposes. Examples of
cost objects are a specific job, a product line, a market or certain customers.
A cost driver is anything (it can be an activity, an event or a volume of something) that causes
costs to be incurred each time the driver occurs. Cost drivers can be structural or executional.
o Structural cost drivers relate to the actual structure of the companys operations and the
complexity of the technologies the company uses. A more complex working environment leads to
higher structural costs.
o Executional cost drivers relate to the actual processes performed. The cost of executing activ-
ities is determined by the companys effective use of staff and processes used. Examples of
executional cost drivers are set-ups, moving, number of parts, casting, packaging or handling.
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, such as usage of
machine hours or direct labor used. These resources used may or may not have a connection with the costs
being allocated.
With ABC, the cost allocations are not based on usage of resources. Instead, they are based on activities
performed and what those activities cost. ABC is much more detailed than traditional costing, because it
uses many more cost pools and each cost pool has its own cost driver.
Classification of Costs
Traditional costing methods classify costs as product costs or period costs. Product costs are direct materials,
direct labor, and factory overhead and are allocated to products according to some cost driver such as
machine hours used or direct labor used. Product costs are attached to units of inventory, and they are put
into Inventory on the balance sheet and charged as expense when the units they are attached to are sold.
Period costs include selling and general and administrative costs, and period costs are charged against income
in the period they are incurred and are not allocated to products at all.
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.
Activity-Based Costing CMA Part 1
In ABC, the premise is that the cost of a finished product should include the cost of direct materials, direct
labor and overhead manufacturing costs directly attributable to that product, but it should also include a
portion of the administrative costs necessary to produce the product.
For example, the cost of a product under ABC also includes the administrative costs to buy the raw materials,
including writing specifications, obtaining bids, issuing purchase orders, and so forth. Therefore, these costs,
which are period costs under traditional costing, are analyzed and allocated to products under ABC. This
means that products will be charged with the costs of both manufacturing and nonmanufacturing activities.
It also means that some costs that are considered product costs under traditional costing will not be attached
to products at all, if they have no direct relationship to the production of the products. For example, 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. But in ABC, that plant guard's salary would not be directly related to the cost of producing any of the
products, so it would be excluded from the product costs.
Note: Because of this difference from traditional costing methods in what is considered a product cost and
what is considered a period cost, ABC cannot be used for external financial reporting or for tax
reporting unless it is modified. If it is modified to conform to U.S. GAAP and to U.S. tax regulations so
that all product costs and only product costs are allocated to production, ABC can be used for external
financial reporting and tax reporting. The same total amount would be considered product costs under ABC
as under traditional costing. However, if more than one product is produced, the product costs would be
allocated differently among the products. This is discussed further below.
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.
If a product is produced in low volume, it will require fewer resources in total than a product that is produced
in high volume. Therefore, under traditional costing, that low-volume product would be allocated a small
amount of total overhead costs. However, a low-volume product may require just as much time and cost per
production run as a high-volume product.
One example is product setups. 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. If the cost of product setups is included in total
overhead and is allocated according to traditional costing, 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. If the cost of product setups is segregated from other overhead costs, as in
ABC, and is allocated according to how many product setups are done for each product instead of how many
units of each product are produced, then a more realistic cost for product setups will be allocated to the low-
volume product. And that will probably be higher than it would be under traditional costing, so cost per unit
allocated to the low-volume product will probably be higher under ABC than under traditional costing.
Note: ABC is becoming more of a necessity for many companies, since traditional systems may use direct
labor to allocate overheads and direct labor is becoming a smaller part of the overall production process.
Essentially, activity-based costing is very similar to the standard method of overhead allocation,
except for the fact that we have many cost drivers, and these cost drivers should have a direct relationship
to the incurrence of costs by an individual product. Therefore, in the application of ABC, you simply need to
perform many different overhead allocations. The main difference is the determination of what the
allocation bases are going to be. On the exam, in an ABC question that is numerical, you should be
prepared to make three or four allocations of different cost pools to the final product. You may also need to
determine what an appropriate allocation base would be for each of the cost pools.
ABC and External Financial and Tax Reporting

As we said above, the premise of ABC is that the cost of a finished product should include not only the cost of
the direct materials, direct labor and overhead costs directly attributable to that product, but it should also
include a portion of the administrative costs necessary to produce the product. U.S. GAAP and U.S. tax
regulations require the use of absorption costing, which means that manufacturing overhead not
administrative overhead must be accounted for as a product cost. Furthermore, product cost for external
reporting must include all of the manufacturing costs, whereas an ABC system may exclude some of the
manufacturing costs that actually belong there under absorption costing.
So technically, ABC can be used for external financial reporting, if it is used in accordance with U.S. GAAP. If
ABC is to be used for external financial reporting, the product cost data needs to conform to U.S. GAAP, so
that it includes all manufacturing overheads that need to be included for absorption costing and it excludes all
administrative overheads. This can be time-consuming and expensive if different costs are being used for
internal decision-making.
In addition, many of the overhead allocations in ABC are based upon subjective data for example,
interviews with personnel that may not be verifiable using concrete facts and figures. Auditors are
uncomfortable with the use of subjective data, because it has the potential to be manipulated by manage-
ment in order to make earnings and key ratios appear more favorable.
For all the above reasons, ABC is seldom used for external financial reporting. ABC is generally used only
internally for decision-making, while traditional absorption costing is used for external reporting.
The ABC Process

Setting up an ABC system is more difficult, time consuming and costly than setting up a traditional system,
because a company must first analyze the production process and decide what activities cause costs to be
incurred. Companies may identify a number of different cost drivers and use each of them to allocate
overhead. Each cost driver requires the company to keep records and increases the complexity of the ABC
system.
Identification of Activities
As part of the process of analyzing the production process, the company may identify some non-value-
adding activities. These are activities that do not add any value for the end consumer and the company
should try to reduce or eliminate them. 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. In turn, this will either enable the company to reduce the sales price or to recognize more profit
from the sale of each unit.
Value-adding activities are the opposite of non-value-adding activities. As the name suggests, these are
activities (costs) that add value to the customer. This means that these activities add something to the
product that customers are willing to pay for. Even though these activities are value-adding activities, they
must be monitored to make certain that the costs are not excessive. The different categories of costs are
listed a little further on in this topic.
Note: Fortunately, 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. You will simply need to use the provided
information to determine the amount of overhead that will need to be allocated to any product. In a
smaller question it is possible that you will need to determine the appropriate driver for each cost pool
from among those given. These are usually fairly direct, however, and if you simply think about what
would cause costs to be incurred, you will see what cost driver should be used for each cost pool.
Calculation of Allocation Rate and Allocation

An allocation rate is then calculated for each of the cost drivers. This process is like that done under the
traditional method (expected costs allocated to the cost driver the expected usage of the cost driver). The
costs are then allocated to the products based upon the usage of the cost driver of each product.
The manufacturing overhead costs that the company incurs are accumulated in cost pools. Each cost pool is
associated with one of the cost drivers (activities). A cost pool is similar to the traditional overhead account
for each activity, or cost driver. These cost pools collect the costs associated with the various activities
(drivers) that incur the costs, and then the costs are allocated as the drivers are used or consumed in the
production of the product.
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. The difference is that in ABC there are many cost
pools and drivers, so the allocation calculations will need to be performed many times.
Because of the increased number of allocation bases, ABC provides a more accurate costing of the
products. As we covered in the traditional method, a company should use only one allocation base if it
produces only one product. ABC is meaningful only if a company produces more than one product, because it
affects how much overhead in total is allocated to each product. ABC uses many allocation bases to try to
reflect the different consumptions of overhead activities between and among products.
Categories of Activities
There are four categories of activities, based upon where the activity occurs in relation to the final product
and the facility as a whole. These four categories are:
1) Unit-level activities These activities are performed for each unit that is produced. Some exam-
ples are hours of work, inspecting each item, operating a machine and performing a specific
assembly task.
2) Batch-level activities These activities occur each time a batch is produced. Some examples are
machine setup, purchasing, scheduling, materials handling and batch inspection.
3) Product-sustaining activities These activities are incurred in order to support the production
of a different product from what is currently produced. Examples include product design and engi-
neering changes.
4) Facility-sustaining activities These activities are incurred to support production in general,

such as security, maintenance, plant management, depreciation of the factory and property taxes.
Facility-sustaining activities and associated costs present a small issue that requires a company deci-
sion. Given the broad nature of these costs, it is very difficult to allocate them in any reasonable
manner to the final goods. However, a company may either try to allocate these costs, or the com-
pany may simply expense them in the period incurred. For external purposes they must be allocated
in order to maintain an absorption costing that is acceptable for GAAP.
Facility-sustaining activities allocated under ABC can also include selling and administrative expenses
that would be expensed for external purposes. For internal analysis, they can be included in the ABC
cost allocations to products, even though for external reporting, they are period costs and are ex-
pensed as they are incurred.
Note: You need to know these different categories of activities more for word questions than for numerical
questions. The allocation methods are the same for all of the activities, but what they relate to is different.
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.
By identifying the activities that cause costs to be incurred, ABC enables manage-
ment to identify activities that do not add value to the final product.
Limitations Not everything can be allocated strictly on a cost driver basis. This is particularly
true in respect to facility-sustaining costs.
ABC is expensive and time consuming to implement and maintain. Inclusion of

administrative overhead in product costs is not in compliance with any generally
accepted accounting principles or with U.S. tax reporting regulations. 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.
ABC will provide the most benefits to companies that produce very diverse products or have complex
activities. For companies that produce relatively similar products or have fairly straightforward processes that
are consumed equally by all products, the costs of ABC would probably outweigh the benefits.
The elements of Activity-Based Costing that you need to be familiar with are:
A cost driver (discussed above) is an event, factor or activity that causes cost to arise and be incurred. It
can be the level of activity or volume (for example, production volume or the number of purchases). The
main idea is a cause-and-effect relationship between an activity and the incurrence of costs. For example,
as an activity such as purchasing increases, all of the costs associated with purchases also increase costs
of shipping, insurance, telephone, and so forth. If there are no purchases, there will not be any purchasing
costs. So, a purchase is a cost driver.
A resource driver is a measure of the quantity of resources consumed by an activity. In the above
example, the resource driver measures how much of the total costs incurred by the company are
consumed by the purchasing activity. This is the determination of the total costs of the cost driver.
An activity driver measures how much of the activity (purchasing) is used by the cost object (Product A,
for example). We have to assign all costs associated with Product A using ABC to Product A. Using the
purchasing example, we need to assign purchasing costs to product A. An activity driver is the measure of
the demand for the purchasing activity by the cost object (in this case, Product A). In this case it could be
number of purchase orders that are required to purchase the parts for Product A.
Value-adding activities are activities that add customer value to the product. Value-adding activities
depend upon the industry and what the company does (manufacturing, resale, service). In a manufactur-
ing company, the manufacturing process converting raw materials to a finished product is a value-
adding activity. In a resale or service company, offering exceptional customer service is a value-adding
activity. The increase in value to the customer makes the company more competitive. Once value-adding
areas are identified, the organization can increase the related benefits from the value-adding activities. On
the other hand, unnecessary and inefficient activities are non-value-adding activities, and the cost
drivers of those activities need to be reduced or eliminated. For example, activity to rework defective
products is a non-value-adding activity and thus needs to be reduced or eliminated. At the same time, the
company needs to carry out the value-adding activities as efficiently as possible.
Question 27: Cost drivers are:
a) Accounting techniques used to control costs.
b) Accounting measurements used to evaluate whether performance is proceeding according to plan.
c) A mechanical basis, such as machine hours, computer time, size of equipment or square footage of
factory used to assign costs to activities.
d) Activities that cause costs to increase as the activity increases.
(CMA Adapted)
Here are three examples of how activity-based costing might be used in a real situation:
Example #1: A manufacturing firm. In a manufacturing environment, machine setup is required every
time the production line changes from producing one product to producing another product.
The cost driver is machine setups. An engineer might be required to supervise the setup of the machine
for the product change. Suppose the engineer spends 20% of his or her time supervising setups (the
resource driver). 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 not only is the engineer required. Production supervisors are also required to supervise machine
setup, and they spend 40% of their time doing that (the resource driver again).
All of the costs of machine setup are collected in a "machine setups" cost pool. Setup time spent on each
product as a percentage of setup time spent on all products is the activity driver. 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.
Example #2: A service firm. Bank tellers process all kinds of transactions. The transactions relate to
many different banking services that the bank offers. Transactions processed are the cost driver. How
should the tellers' time, the teller machines used by the tellers, 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, savings accounts, 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, savings account transactions, and so forth). Then,
information on how many of each type of transactions processed by tellers is captured. The average time
for each type of transaction is multiplied by the number of transactions processed. 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.
If the tellers spend 90% of their time performing teller transactions and 10% of their time doing
something else like answering telephones, then that 90% is the resource driver for the tellers' salaries.
90% of the tellers' salaries will be put into the "tellers" cost pool along with 100% of the costs of their
teller machines, their supplies, and the square footage occupied by their teller stations. 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.
Example #3: A manufacturing, sales or service firm. 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. The
invoicing is a necessary activity, because without it, the company would not receive payment. It does not
take an invoicing clerk any longer to create a line on an invoice for a quantity of 1,000 units of a product
or 1,000 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. So even though the revenue for 1,000 units will be 1,000 times as
much as the revenue for 1 unit, it would not be right to charge the 1,000-unit product or service for 1,000
times more of the invoicing clerk's expenses when 1,000 units are invoiced than when just 1 unit is
invoiced. But if the invoicing clerks costs were being allocated to products and services on the basis of
revenue invoiced, that is exactly what would happen. ABC can make the allocation of the clerks costs
more equitable.
In this example, 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, the more of
the clerk's time will be required. And if the volume grows so much that the one invoicing clerk cannot do it
all, then a second invoicing clerk will have to be hired. That is how lines on invoices drive costs.
Besides the clerk's salary, the invoicing clerk needs a desk and a computer and a file cabinet and office
space and a telephone. A resource driver is a measure of the consumption of a resource, and it is used
to determine the portion of total resource cost assigned to each activity. In this example, the resource
driver is the percentage of the invoicing clerk's time spent on invoicing. For example, the volume of
invoicing may require only 50% of the invoicing clerk's time, and the other 50% of the clerk's time is spent
assisting the marketing department, a totally unrelated activity. In this case, 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.
All of the costs related to invoicing make up one cost pool. In a good accounting system, 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. 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. Then, the total cost is allocated to products and/or
services according to usage.
The company may want to allocate the invoicing clerks costs in any of a number of ways, depending on
how management wants to see them. Geographical area, department, and product are just a few of the
possible ways. If the company wants to see the costs allocated by product or service, for example, the
number of invoice lines created for each product/service during the period will be retrieved from the
accounting system. The number of invoice lines used by each product as a percentage of the total invoice
lines used by all products will be calculated, and that is the activity driver. To find the amount of the
invoicing clerks costs to allocate to each product, the company will simply multiply the total costs in the
pool by the percentage of total usage by each product or service.
In an ABC system, all indirect and overhead costs are analyzed in this way. The analyst groups costs into cost
pools and looks for what the cost driver is for that cost pool. The cost driver activity is analyzed to determine
what percentage of the activity is being used by each product/service (the activity driver). 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. This enables the company to see which products or services are more profitable than others. 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.
In ABC, the cost driver for a cost pool can be anything at all that causes indirect or overhead costs to arise,
as long as those costs can be allocated to individual products or services (or organizational units, if
management wishes) in some meaningful way.
The following information is for the next two questions: Zeta Company is preparing its annual profit
plan. As part of its analysis of the profitability of individual products, 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 - $50,000 in total
Question 28: Under a costing system that allocates manufacturing overhead on the basis of direct labor
hours, the materials handling costs allocated to one unit of wall mirrors would be:
a) $1,000
b) $500
c) $2,000
d) $5,000
Question 29: Under activity-based costing (ABC), the materials handling costs allocated to one unit of wall
mirrors would be:
a) $1,000
b) $500
c) $1,500
d) $2,500
(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. Make certain that you are able to do this.
The following information is for the next two questions: Believing that its traditional cost system
may be providing misleading information, an organization is considering an activity-based costing
approach. It now employs a full cost system and has been applying its manufacturing overhead on the
basis of machine hours.
The organization plans on using 50,000 direct labor hours and 30,000 machine hours in the coming year.
The following data shows the budgeted manufacturing overhead.
Budgeted Budgeted
Activity Cost Driver Activity Cost
Material handling No. of parts handled 6,000,000 $ 720,000
Setup costs No. of setups 750 315,000
Machining costs Machine hours 30,000 540,000
Quality control No. of batches 500 225,000
Total Manufacturing Overhead Cost $1,800,000
Cost, sales and production for one of the organizations products for the coming year are as follows:
Prime Costs
Direct material cost per unit $4.40
Direct labor cost per unit = 0.05 DLH @ $15/DLH 0.75
Total Prime Cost $5.15
Sales and Production Data

Expected sales 2,000,000 units
Batch size 5,000 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, the cost per unit for this product for
the coming year will be:
a) $5.39
b) $5.44
c) $6.11
d) $6.95
Question 31: If the organization employs an activity-based costing system, the cost per unit for the
product described for the coming year will be:
a) $6.00
b) $6.08
c) $6.21
d) $6.30
(CIA Adapted)
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.
In life-cycle costing a company does not determine the production cost in the short-term sense of the
production of one unit. Rather, the company takes a much longer view to the cost of production and attempts
to allocate all of the research and development, marketing, development, after-sale service and support costs
and any other cost that is associated with this product during its life cycle. The life cycle of the product
may be called its value chain.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). For
the product to be profitable over its life, these costs also need to be covered by the sales price. If the
company fails to take into account the large costs of R&D, it runs the risk of the sales price covering the costs
of the actual production of that particular unit, but not the costs of R&D, marketing, after-sales and other
costs.
The process of a company looking at all of the costs hopefully enables it to determine the ultimate value of
developing a better product. In addition to R&D costs there are also after-sale costs such as warranties and
repair work and product support expense. It may be that a larger investment in the design or development of
the product will be recovered through smaller after-sale costs. Or alternatively, 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, whereas other methods treat these costs as period expenses that
are expensed as incurred. Therefore, under other methods, these pre-production and after-sale costs are
not directly taken into account when determining the profitability of a product or product line.
All of the costs in the life cycle of the company can be broken down into three categories. 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), testing, engineering, quality development
Manufacturing Costs
Purchasing
Direct and indirect manufacturing costs (labor, materials and overhead)
Downstream Costs (after production)
Marketing and distribution
Services and warranties
Under GAAP financial reporting, the R&D and design costs are expensed as they are incurred. However, for
internal decision-making purposes, it is important that the company treat these as product costs that will
need to be recovered.
Life-cycle costing plays a role in strategic planning and decision-making about products. After making the life-
cycle cost calculations, the company can make an assessment as to whether or not the product should be
manufactured. If they believe that they will not be able to charge the required price for the product, then it
should not be produced.
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, and finally to sell the finished products to
customers. The goal of value chain analysis is to provide maximum value to the customer for the minimum possible cost.
Section D Life-Cycle Costing
Also, by looking at all of the costs that are going to be incurred in the process of developing, producing and
selling the product, the company can identify any non-value-adding costs, which can then be reduced or
eliminated without reducing the value of the product to the customer.
Life-Cycle Costing
Benefits Life-cycle costing provides a long-term, more complete perspective on the costs and
profitability of a product or service when compared to other costing methods, which
typically report costs for a short period such as a month or a year.
When long-term costs are recognized in advance, life-cycle costing can be used to
lower those long-term costs.
Life-cycle costing includes research and development costs as well as future costs
such as warranty work, enabling better pricing for profitability over a products
lifetime.
Life-cycle costing can be used to assess future resource requirements such as

needed operational support for the product during its life.
Life-cycle costing can help in determining when a product will reach the end of its
economic life.
Limitations When life-cycle costing is used to spread the cost of fixed assets over the life of a
product, the assumption may be made that the fixed assets will be as productive in
later years as when they were new. That may not be an accurate assumption,
because a piece of equipment may gradually slow down, resulting in lower output
and lower profitability toward the end of its life.
Accurate estimation of the operational and maintenance costs for a product during its
whole lifetime can be difficult.
Cost increases over the life of the product need to be considered.
Life-cycle costing can require considerable time and resources, and the costs may
outweigh the benefits.
Customer Life-Cycle Costing CMA Part 1
Customer Life-Cycle Costing

Customer life-cycle costing looks at the cost of the product from the customers (the buyers) standpoint. It
focuses on the total costs that will be paid by the customer during the whole time the customer owns the
product: the customers purchase costs plus costs to use, maintain, and dispose of the product or service. For
example, the life-cycle cost of laundry equipment includes the purchase cost plus the cost for energy to
operate it over its lifetime, the cost of repairs, and the cost to dispose of it at the end of its life.
Customer life-cycle costing is important to a company because it is part of the pricing decision. If a product is
expected to require minimal maintenance when compared with its competition, the company can charge a
price for the product that is higher than what the competition is charging for their products, and the total cost
to the customer may still be lower than the cost for the competitors product.
Example: BusinessSoft Co. is about to launch a new product. 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.
However, it also expects to provide after-sale services as part of the contract within and beyond this
period.
The companys cost estimates are:
R&D $750,000
Design 500,000
Manufacturing costs 300,000
Marketing 200,000
Distribution 100,000
Customer service 250,000
After-sale support 60,000
The company plans to produce and sell 1,500 installations of the product and would like to earn a 40%
mark-up over its life-cycle costs relating to this product. Also, the company envisions that an average
client would incur around $500 of installation, training, operating, maintaining and disposal costs relating
to usage of this product per installation. 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, manufacturing and downstream
costs related to this product. The upstream costs are the research and development ($750,000) and the
design ($500,000) costs. Manufacturing costs are $300,000. Downstream costs include all of the other
costs listed above, from marketing to after-purchase support, totaling $610,000. In total, these manufac-
turing and downstream costs are $910,000. In total, the life-cycle costs are $2,160,000.
With a required 40% mark-up over the life-cycle cost, this will require a mark-up of $864,000 ($2,160,000
0.40). This means that the total amount that BusinessSoft needs to charge for the 1,500 installations is
$3,024,000, or $2,016 per installation.
If the company charges $2,016 per installation, 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.
The customers life-cycle cost will be the customers purchase price of $2,016 per installation plus the
$500 per installation for the cost of installation, training, operating, maintaining and disposal costs, for a
total of $2,516. The additional $500 cost to the customer is relevant information to the company in
making its final pricing decision, but the customers additional $500 costs are not included with the
companys costs when calculating the companys total life-cycle cost for the product.
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.
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.
These products are not identical, but they share the same production process up to what is called the splitoff
point. This is the point at which the two products stop sharing the same process and become different,
identifiable products.
An example of joint products would be the processing of pineapple. As a pineapple goes through processing at
the factory it becomes juice and pineapple slices that will be canned. 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.
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. Accurate allocation is needed primarily
for financial reporting purposes and pricing decisions. We need to accurately determine the inventory cost of
each unit of each joint product so that the balance sheet will be accurate. And since the inventory cost of
each unit becomes its cost of goods sold when it is sold, we need to know the amount of cost to be expensed
to COGS for each unit sold.
Joint costs may include direct materials, direct labor and overhead. Costs incurred after the splitoff point are
separable costs and they are allocated to each product as they are incurred by that product.
Byproducts are the low-value products that occur naturally in the process of producing higher value
products. They are, in a sense, accidental results of the production process.
Methods of Allocating Costs to Joint Products

There are a number of different allocation measures to use, but all of these different methods use some sort
of ratio between the two or more products to allocate the joint costs. This is largely a mathematical exercise,
but you need to remember how the different allocation bases are calculated. The different methods and how
to calculate the bases follow.
1. 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, relative to the
total sales value of all the joint products.
This method can also be called the Sales Value at Splitoff method or, more simply, just the Sales Value
method.
The formula to allocate the costs between or among the products is as follows, 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.e., with no
further processing). Management may decide it would be more profitable to the company to process some of
the joint products further; but the Sales Value at Splitoff method can still be used to allocate joint costs up to
the splitoff point, as long as sales prices at the splitoff point do exist for all of the joint products.
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. Part
of the manufacturing process is the production of the coffee basket assembly, which includes a basket and
a spreader. The 8-cup electric model and the 8-cup stovetop model use the same basket assembly, though
the pump stems are different. The basket assembly is also sold separately as a replacement part for both
percolators at a price of $10.00. Separate prices for the basket assemblies that go on to be incorporated
into the two percolators do not exist, since they become integral parts of the percolators. However, the
whole production run could be sold as replacement baskets, since a market does exist for them at that
stage of production.
One batch consists of 500 basket assemblies, of which 300 are destined to become part of electric
percolators, 150 are destined to become part of stovetop percolators, and 50 are sold separately as
replacement parts. The joint costs of one batch total $2,500, or $5.00 per unit.
Using the Sales Value at Splitoff method, how much of the joint cost is allocated to electric percolators,
how much to stovetop percolators, and how much to the replacement parts?
The sales value of the electric percolator basket assemblies is 300 $10.00, or $3,000. The sales value of
the stovetop percolator basket assemblies is 150 $10.00, or $1,500. The sales value of the replacement
baskets is 50 $10.00, or $500. The total sales value of all 500 basket assemblies is therefore $3,000 +
$1,500 + $500, or $5,000.
The portion of the joint cost allocated to the electric percolators is $3,000 $5,000 $2,500, or $1,500.
The portion of the joint cost allocated to the stovetop percolators is $1,500 $5,000 $2,500, or $750.
The portion of the joint cost allocated to the replacement basket assemblies is $500 $5,000 $2,500, or
$250.
We can confirm that the full $2,500 of joint cost has been allocated, because $1,500 + $750 + $250 =
$2,500.
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, which is in
proportion to the individual products ability to absorb costs.
The method is easy to calculate and is simple, straightforward, and intuitive.
The cost allocation base is expressed in terms of a common basis amount of

revenue that is recorded in the accounting system.
This is the best measure of the benefits received from the joint processing. It is
meaningful because generating revenues is the reason why the company would incur
the joint costs.
It can be used even if further processing is to be done, as long as selling prices do

exist for all the joint products. Thus, it does not require information on processing
after the splitoff, even if further processing is to be done.
Limitations To use this method, selling prices at the splitoff point must exist for all of the
products. If they do not, this method cannot be used.
Market prices of joint products may vary frequently, but the Sales Value at Splitoff
method uses a single set of selling prices throughout an accounting period. This can
introduce inaccuracies into the allocations.
2. 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. 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.
This method is essentially the same as the Relative Sales Value method, and the allocation is done in the
same way, except an estimated Net Realizable Value (NRV) is used for the product or products that must
be or will be processed further.
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,
instead of using NRV for those products, 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, while using the NRV(s) for the product(s) that
must be processed further to be marketable.
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, for example because a product is not marketable at the splitoff point. If a market price at the
splitoff point is available because the product can be sold at that point, that price is used instead of the
NRV, even if the product will be processed further.
If a sales value at splitoff is not available for one or more of the joint products, 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. For
instance, 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), while the other product can be sold at the splitoff
point. In a case such as this, the NRV of the product that must be processed further is its estimated NRV
(sales price after further processing less cost to process further), while the NRV of the product that can be
sold at the splitoff point is its sales value at the splitoff point.
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. However,
sometimes when sales prices at the splitoff do exist for all of the joint products but one or more products
can be processed further, an exam problem will say to use the Net Realizable Value method to allocate the
joint costs. If the problem says to use the Net Realizable Value method, use the net realizable value(s) for
the product(s) that can be processed further even though sales prices at splitoff do exist, but only if the
cost to process further is less than the additional revenue to be gained from the further
processing.
If the problem does not say to use the Net Realizable Value method and sales values at the splitoff exist
for all products, then use the sales values of all of the joint products for the allocation, even if one or
more of the products can be or will be processed further.
Note: The joint costs of production are not relevant costs in the decision to process further or sell
immediately. This is because they are sunk costs. In order to determine if a product should be processed
further, 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).
Costs that are incurred by each of the products after the splitoff point are simply allocated directly to those
products.
Example of the Net Realizable Value method:
Simpli Chili Company produces three flavors of its chili in a joint process: mild, original and extra spicy.
500,000 gallons of unspiced chili are produced per batch, and then varying amounts and types of spices
are added to produce the mild, original and extra spicy flavors. The three types of chili are packaged in 16-
ounce cans. The total joint cost of the unspiced chili is $1,850,000.
One batch results in 500,000 gallons of unspiced chili. The unspiced chili is, of course, not marketable at
that point. It needs spices.
After the spices have been added, Simpli has 800,000 cans of mild chili, 2,000,000 cans of original chili,
and 1,200,000 cans of extra spicy chili. The cost per can of adding the spices and blending them into the
unspiced chili are as follows:
Mild 0.065
Original 0.075
Extra spicy 0.080
The mild chili sells for $0.98 per can. The original chili sells for $1.05 per can. The extra spicy chili sells for
$1.09 per can.
Using the Net Realizable Value method of allocating the joint costs, how much of the joint costs will be
allocated to each type of chili?
Price/ Extended Cost to Pro- Percentage
Product # Cans Can Sales Value cess Further NRV of Total NRV
Mild 800,000 0.98 $ 784,000 $ 52,000 $ 732,000 18.8%

Original 2,000,000 1.05 2,100,000 150,000 1,950,000 50.1%
Extra spicy 1,200,000 1.09 1,308,000 96,000 1,212,000 31.1%
Total 4,000,000 $3,894,000
The joint cost of $1,850,000 will be allocated as follows:
Mild $1,850,000 0.188 = $ 347,800

Original $1,850,000 0.501 = 926,850
Extra Spicy $1,850,000 0.311 = 575,350
Total allocated $1,850,000
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,
because it provides a better measure of the benefits received than the other meth-
ods that could be used in this situation.
The allocation results in comparable profitability among the joint products.
Limitations This method is complex. It requires information on the specific sequence of further
processing and the separable costs of further processing, as well as the point at
which individual products will be sold.
The NRV method is often implemented with simplified assumptions. Companies

assume a specific set of processing steps beyond the splitoff point, but they may
actually do something else and in fact may change the steps frequently.
Selling prices of joint products may vary frequently, but the Net Realizable Value
method uses a single set of selling prices throughout an accounting period. This can
introduce inaccuracies into the allocations.
3. Physical Measure and Average Cost Methods

These two methods are essentially the same. In the Physical Measure method, the joint cost allocation is
done based on the weight, volume, or other physical measure of the joint products, such as pounds, tons, or
gallons. In the Average Cost method, the joint cost allocation is done based on the physical units of output.
In both methods, joint costs are allocated proportionately among the joint products, so that each product is
allocated the same amount of joint cost per unit of measure, whether that unit is a unit of physical measure
or a unit of output.
Physical Measure Method

Joint cost allocation may be done based on the weight, volume or other physical measure of the joint
products. In this method, joint costs are allocated based on some common unit of measurement of output at
the splitoff point, such as pounds, tons, gallons, or board feet (for lumber). This method may also be called
the Quantitative Unit method.
The total joint cost up to the splitoff point is prorated between or among the joint products based on the
physical measure being used. It stands to reason that it must be possible to measure all of the joint products
in the same unit of measurement. If all of the output that results from a joint process cannot be measured in
the same terms, this method cannot be used.
Example of the Physical Measure method:
We will use the Simpli Chili Company example again. The company produces three flavors of its chili in a
joint process: mild, original, and extra spicy. 500,000 gallons of unspiced chili are produced per batch, and
then varying amounts and types of spices are added to produce the mild, original and extra spicy flavors.
However, in this example we will say that each of the three types of chili is packaged in a choice of can
sizes: 12-ounce, 16-ounce and 20-ounce cans. 100,000 gallons are used to produce the mild chili, 250,000
gallons are used for the original chili, and 150,000 gallons are used for the extra spicy chili. The total joint
cost of the unspiced chili (including direct materials, direct labor and overhead) is $1,850,000. The joint
cost is allocated as follows:
Cost Per
Product Physical Measure Proportion Allocation of Joint Cost Gallon
Mild 100,000 gal. 0.20 $1,850,000 0.20 = $ 370,000 $3.70

Original 250,000 gal. 0.50 $1,850,000 0.50 = 925,000 $3.70
Extra spicy 150,000 gal. 0.30 $1,850,000 0.30 = 555,000 $3.70
Total 500,000 gal. $1,850,000
Average Cost Method

This method may also be called the Physical Unit method. It is used when the joint costs are to be allocated
on the basis of physical units of output in completed form. It is basically the same as the Physical Measure
method, but because physical units of completed product are used, it is called by the name Average Cost, or
sometimes Average Unit Cost method.
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. 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.
Example of the Average Cost/Physical Unit Method:
In our Simpli Chili example, now we will go back to packaging all three flavors of chili in 16-ounce cans
only. Since the size of the cans is all the same, we can now use units of output for the allocation, with the
can as the unit of output. The 500,000 gallons of output have now become 4,000,000 16-ounce cans. The
average cost per can is the total cost of $1,850,000 divided by 4,000,000, or $0.4625 per can.
Now, the output and the allocations from the joint process are as follows:
Product Units of Output Avg. Cost/Unit Allocation of Joint Cost
Mild 800,000 cans $0.4625 $ 370,000

Original 2,000,000 cans $0.4625 925,000
Extra spicy 1,200,000 cans $0.4625 555,000
Total 4,000,000 cans $1,850,000
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.
Physical Measure and Average Cost Methods of Allocating Costs to Joint Products
Benefits The physical measure and average cost methods are easy to use.
The allocation is objective.
The methods are useful when rates or prices are regulated. In a regulated
environment when rates are regulated and the seller is limited to a certain amount of
markup over and above its costs, using selling prices or net realizable values to
allocate the costs on which the prices are based leads to circular reasoning. If the
seller tries to allocate joint costs according to selling prices or net realizable values of
the products, it cannot be done. The seller does not know what the selling prices of
the products will be until they know what their costs are, because the selling price is
the cost plus a regulated amount of profit. But since the seller does not know what
the selling price of each product is, they cannot know how much joint cost to allocate
to each product. So using either the Relative Sales Value method or the Net Realiza-
ble Value method in a regulated environment just does not work. In that case, the
Physical Measure method and the Average Cost method can be used to avoid the
problem.
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. The physical
measures of the individual products may have no relationship to their respective
abilities to generate revenue. If weight or size is used, the heaviest or largest
product will be allocated the greatest amount of the joint cost; but that product may
have the lowest sales value. Products with a high sales value per weight or size
would show large profits, while products with a low sales value per weight or size
would show large losses.
Physical measures are not always comparable for products. For example, some
products might be in liquid form (i.e., petroleum), whereas some might be in
gaseous form (i.e., natural gas). Or some might be measured by weight whereas
others might be measured by size. In this situation, the Physical Measure method
cannot be used.
4. 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. It is done by backing into the amount of joint cost to be allocated to each of the joint products.
Step 1: Calculate the gross margin percentage for the total of both (or all, 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. This is done for all of the joint
products produced during the period, not for all of the joint products sold during the period. This is the total
gross margin percentage.
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 products final sales value.
Step 3: Subtract the gross profit calculated in Step 2 and any separable costs from each individual products
final sales value. The result of this subtraction process will be the amount of joint costs to allocate to each
product.
We will look at this with an example.
Example of the Constant Gross Profit (Gross Margin) Percentage method:

Pineapple Co. produces pineapple juice and canned slices at its Pineapple Processing Plant in Hawaii. The
information about the process and the two joint products is as follows:
10,000 pineapples are processed.
The process results in 2,500 kg of juice and 7,500 kg of slices.
The juice can be sold for $10 per kg and the slices can be sold for $15 per kg.
The joint costs of production are $120,000.
The juice can be processed further into a premium juice. This will cost an additional $8,000, but the
sales price per kg will be $15.
The slices can be further processed into chunks. This will cost $4,000 and the chunks can be sold for
$2 per kg more than the slices.
First we will calculate the overall gross margin for all products produced:
Premium Juice Chunks Total Gross Margin

Final sales value $37,500 1 $127,500 2 $ 165,000
Separable costs 12,000
Joint costs 120,000
Total Gross profit $ 33,000 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 $37,500 $127,500 $165,000
Separable costs (given to us) 8,000 4,000 12,000
Joint costs J C 120,000
Required gross profit $ 7,500 4 $ 25,500 5 $ 33,000 20%
We can now solve for J and C using these formulas to determine the amount of joint costs to allocate to
each product:
$37,500 $8,000 J = $7,500 J = $22,000
$127,500 $4,000 C = $25,500 C = $98,000
The $120,000 of joint costs is allocated $22,000 to juice and $98,000 to chunks.
Calculations:
1 2,500 $15
2 7,500 ($15 + $2)
3 $33,000 $165,000
4 $37,500 0.20
5 $127,500 0.20
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. This may be necessary in order to bring the gross
margin percentages of relatively unprofitable products up to the overall average, if
that is desired.
This method allocates both joint costs and profits. 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.
This method is relatively easy to implement, so it avoids the complexities of the NRV
method.
Limitations This method assumes that all products have the same ratio of cost to sales value,
which is probably not the case.
Accounting for Byproducts

As we said, byproducts are the low-value products that occur naturally in the process of producing higher
value products. They are, in a sense, accidental results of the production process. The main issue for
accounting for byproducts relates to the treatment of the associated costs and revenues.
There are two methods of accounting for byproducts that you need to be familiar with.
The Production Method: Inventory the Byproduct Costs

(Byproduct Recognized at Production)
In the Production Method, the costs that are allocated to the byproducts are inventoried, 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.
Byproducts are inventoried in a separate inventory account at their estimated net realizable value.
Inventoried costs allocated to the main product or joint products are reduced by the NRV allocated to the
byproduct. When the byproduct is sold, the company recognizes no revenue or cost of goods sold but simply
debits cash or accounts receivable and credits Byproduct Inventory.
And when the main product or joint products are sold, the COGS for the main product or joint products is
lower because their inventory cost has been decreased by the NRV of the byproduct.
The reason it is done this way is because the NRV of the byproduct was used to determine its cost in
inventory. Therefore, its cost will be the same as the revenue received for it, and there will be no gross profit
on the sale. There would be no reason to record the sale of the byproduct by increasing revenue and COGS by
the same amount, since the transactions would have no effect on net income. So the journal entry is simply
the debit to cash or accounts receivable and the credit to byproduct inventory.
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 some of the byproduct cannot be sold, the amount that cannot be
sold is not included in the amount debited to inventory for the byproduct, nor is it included in the reduction
of costs of the main product(s).
The Sales Method: Revenue from the Byproduct

(Byproduct Recognized at Time of Sale)
In the Sales Method, the byproduct costs are not put into inventory separately from the main product or joint
products. Instead, all of the costs of production are allocated to the main product or joint products in
inventory. When the main product or joint products are sold, their COGS will be higher than it would have
been under the Production Method. Since the byproduct is not put into inventory at all, when it is sold the
sale is recorded the way service revenue would be recorded, with no associated COGS. So the company
debits cash or accounts receivable and credits revenue for the amount of the sale.
Which Method is Better?

Both methods are acceptable. The Production Method, where the byproduct is inventoried at the time of
production is conceptually correct because it is consistent with the matching principle. Byproduct inventory is
recognized as an asset in the accounting period in which it is produced, and it reduces the inventory cost
assigned to the main product or joint products.
However, the Sales Method, where the byproduct is recognized at the time of sale, is simpler and is used
more frequently in practice if the dollar amounts of the byproduct(s) are immaterial. There is a disadvantage
to the sales method, though. The sales method makes it possible for managers to time when they sell the
byproduct(s) and thus permits them to manage their earnings. 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.
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.
Inventory cost assigned to the main product or joint products is reduced.
Limitations The Production Method is more complex than the Sales Method.
Sales Method of Accounting for Byproduct Costs
Benefits It is simpler to implement than the Production Method.
It is more practical when the dollar amounts of the byproducts are immaterial.
Limitations It is possible for managers to manage their earnings by timing the sale of the
byproducts.
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. If the question states that the
company inventories the byproduct, this means that it treats the revenue as a reduction of the
costs of production; this is the first method above.
Comprehensive Example of Joint and Byproduct Costing
Note: The journal entries are not expected to be tested on the exam. We have included them here to help
some people see how the journal entries work because that helps them understand what is happening.
Juice Unlimited Company manufactures orange juice. It has two versions: one with no pulp and one with
extra pulp. 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.
In each batch, the joint process produces 190,000 ounces of juice that is bottled into 20-ounce bottles: 5,000
bottles of No Pulp juice and 4,500 bottles of Extra Pulp juice. Three thousand pounds of rinds, the byproduct,
are also produced.
The joint process squeezes the juice out of the oranges. The standard costs of that process are $14,000,
broken down as follows:
Direct materials: $4,000
Direct labor: $7,000
Overhead: $3,000
Following the squeezing, 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 per bottle. The removed pulp is added to the juice that will become the
Extra Pulp juice, and the cost to add the pulp to the Extra Pulp juice is $0.10 per bottle.
The No Pulp juice sells for $2.00 per bottle. The Extra Pulp juice sells for $2.25 per bottle. The orange rinds
are sold at the splitoff point for $0.30 per pound.
The company uses the Net Realizable Value method to allocate the joint costs.
Scenario #1 The Production Method:

Under the Production Method, the byproduct, orange rinds, is recognized when production is
complete. The rinds are inventoried and a portion of the joint cost is allocated to them.
The amount allocated to the rinds is equal to their sales value, which is $900 ($0.30 3,000 pounds). They
are put into inventory at this allocated cost.
The remaining $13,100 ($14,000 $900 allocated to the rinds) in joint costs is allocated to the two joint
products according to their NRVs.
Calculation of NRVs and each products proportion of the total NRV:

No Pulp juice NRV: $2.00 sales price per bottle $0.25 per bottle separable costs = NRV of $1.75
per bottle. For a batch of 5,000 bottles, the total No Pulp NRV is $8,750 ($1.75 5,000).
Extra Pulp juice NRV: $2.25 sales price per bottle $0.10 per bottle separable costs = NRV of $2.15
per bottle. For a batch of 4,500 bottles, the total Extra Pulp NRV is $9,675 ($2.15 4,500).
The total NRV is $8,750 + $9,675 = $18,425.
No Pulp juice NRV $ 8,750 = 47.5% of total NRV ($8,750 $18,425)

Extra Pulp juice NRV 9,675 = 52.5% of total NRV ($9,675 $18,425)
Total NRV $18,425
Joint costs of $13,100 allocated:

No Pulp joint cost: 0.475 $13,100 = $ 6,223
Extra Pulp joint cost: 0.525 $13,100 = 6,877
Total joint cost allocated $13,100
Journal entries to transfer the No Pulp Juice, the Extra Pulp Juice, and the Byproduct from Work-in-
Process Inventory to Finished Goods Inventories:
Joint Cost:
Dr FG Inventory No Pulp Juice 6,223
Dr FG Inventory Extra Pulp Juice 6,877
Dr FG Inventory Byproduct (rinds) 900
Cr WIP Inventory direct materials used 4,000
Cr WIP Inventory direct labor used 7,000
Cr WIP Inventory overhead applied 3,000
Separable costs:
Dr FG Inventory No Pulp Juice ($0.25 5,000) 1,250
Dr FG Inventory Extra Pulp Juice ($0.10 4,500) 450
Cr WIP Inventory separable costs for both 1,700
Total costs inventoried:

No Pulp: $6,223 joint cost + separable costs of $1,250 = $ 7,473
Extra Pulp: $6,877 joint cost + separable costs of $450 = 7,327
Rinds: $900 joint cost (no separable costs) 900
Total costs inventoried $15,700
Inventory costs per unit for main products:

No Pulp: $7,473 5,000 = $1.4946 per bottle
Extra Pulp: $7,327 4,500 = $1.6282 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 10,000
Cr Sales Revenue 10,000
Dr Cost of Goods Sold 7,473
Cr FG Inventory No Pulp Juice 7,473
Sale of Extra Pulp Juice:

Cr FG Inventory Extra Pulp Juice 7,327
Sale of Byproduct (Rinds)13:

Dr Accounts Receivable 900
Cr FG inventory Byproduct (Rinds) 900
13
Note that under the Production Method, when the byproduct is sold, no credit is booked to Sales Revenue and no debit is
booked to Cost of Goods Sold, as long as it is sold for the anticipated amount, which is the inventoried amount. The sale is
recorded by simply debiting Accounts Receivable (or Cash, if cash is received for the sale) and crediting Inventory for the
inventoried amount, which here is $900. If the byproduct is actually sold for an amount that is different from the expected
amount of $900, then there could be either a gain or a loss on the sale. If either of those occurs, 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). The debit to Accounts
Receivable would be for the actual amount of the sale, the credit to Inventory would be for the inventoried amount, and the
credit to Sales Revenue or the debit to COGS would be the balancing entry.
Gross profit for each product:

When the No Pulp juice is sold, its gross profit is:
$2.00 5,000 = $10,000
Less: COGS 7,473
Gross Profit $ 2,527
When the Extra Pulp juice is sold, its gross profit is:
$2.25 4,500 = $10,125
Less: COGS 7,327
If the rinds are sold at their inventory cost, no gross profit results from their sale.
Total gross profit from the sale of the batch = $2,527 + $2,798 = $5,325.
Scenario #2 The Sales Method

Under the Sales Method, the byproduct is recognized at the time of sale. The rinds are not
inventoried.
The total joint costs of $14,000 are allocated between the No Pulp and the Extra Pulp juices only, using the same NRVs as we
used for Scenario #1, the Production Method. No Pulp juice constitutes 47.5% of the total NRV, while Extra Pulp juice
constitutes 52.5% of total NRV.
Joint costs of $14,000 allocated:

No Pulp joint cost: 0.475 $14,000 = $ 6,650
Extra Pulp joint cost: 0.525 $14,000 = 7,350
Total joint cost allocated $14,000
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 6,650
Dr FG Inventory Extra Pulp Juice 7,350
Cr WIP Inventory direct materials used 4,000
Cr WIP Inventory direct labor used 7,000
Cr WIP Inventory overhead applied 3,000
Separable costs:
Dr FG Inventory No Pulp Juice ($0.25 5,000) 1,250
Dr FG Inventory Extra Pulp Juice ($0.10 4,500) 450
Cr WIP Inventory separable costs for both 1,700
Total costs inventoried:

No Pulp: $6,650 joint cost + separable costs of ($0.25 5,000) = $ 7,900
Extra Pulp: $7,350 joint cost + separable costs of ($0.10 4,500) = 7,800
Total costs $15,700
Inventory costs per unit:

No Pulp: $7,900 5,000 = $1.58 per bottle
Extra Pulp: $7,800 4,500 = $1.7333 per bottle
Journal entries when the juice and rinds are sold (assuming a perpetual inventory system is being used):
Sale of No Pulp Juice:
Cr FG Inventory No Pulp Juice 7,900
Sale of Extra Pulp Juice:

Cr FG Inventory Extra Pulp Juice 7,800
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, its gross profit is:
$2.00 5,000 = $10,000
Less: COGS 7,900
When the Extra Pulp juice is sold, its gross profit is:
$2.25 4,500 = $10,125
Less: COGS 7,800
When the rinds are sold, their cost of goods sold is zero because none of the costs have been allocated to the
rinds. Therefore, the amount received from their sale$0.30 per pound 3,000 pounds, or $900is all
profit.
Total gross profit from the sale of the batch = $2,100 + $2,325 + $900 = $5,325.
Summary:
The same total costs ($15,700) are inventoried under both methods, but the total cost is allocated to
the two main products and the byproduct under the Production method, whereas under the Sales
method, the total cost is allocated only to the main products.
When the whole batch has been sold, the same total gross profit ($5,325) is realized for the sale of
the two joint products and the one byproduct for both the Production method and the Sales method.
But the cost is allocated differently.
14
Note that under the Sales Method, when the byproduct is sold, no debit is booked to Cost of Goods Sold and no credit is
booked to Inventory. That is because the byproduct was never in Inventory. Its sale is being accounted for as if it were
service revenue.
Question 32: Lankin Corp. produces two main products and a byproduct out of a joint process. The ratio
of output quantities to input quantities of direct materials used in the joint process remains consistent
from month-to-month. 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. Data regarding Lankins
operations for the current month are presented in the chart below. During the month, Lankin incurred
joint production costs of $2,520,000. The main products are not marketable at the splitoff point and,
thus, have to be processed further.
1st Main Product 2nd Main Product Byproduct

Monthly input in pounds 90,000 150,000 60,000
Selling price per pound $30 $14 $2
Separable process costs $540,000 $660,000
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) $1,200,000
b) $1,260,000
c) $1,500,000
d) $1,575,000.
(CMA Adapted)
Question 33: Sonimad Sawmill manufactures two lumber products from a joint milling process. The two
products developed are mine support braces (MSB) and unseasoned commercial building lumber (CBL). A
standard production run incurs joint costs of $300,000 and results in 60,000 units of MSB and 90,000
units of CBL. Each MSB sells for $2 per unit, and each CBL sells for $4 per unit.
If there are no further processing costs incurred after the splitoff point, the amount of joint cost allocated
to the mine support braces (MSB) on a relative sales value basis would be:
a) $75,000
b) $180,000
c) $225,000
d) $120,000
(CMA Adapted)
Question 34: A company manufactures products X and Y using a joint process. The joint processing costs
are $10,000. Products X and Y can be sold at splitoff for $12,000 and $8,000, respectively. After splitoff,
product X is processed further at a cost of $5,000 and sold for $21,000, whereas product Y is sold without
further processing. If the company uses the relative sales value method for allocating joint costs, the joint
cost allocated to X is:
a) $5,000
b) $6,000
c) $6,667
d) $10,000
(CIA Adapted)
Variable and Absorption Costing CMA Part 1
Variable and Absorption Costing

Variable and absorption costing are two different methods of inventory costing. Under both variable and
absorption costing, all variable manufacturing costs (both direct and indirect) are inventoriable costs. 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, but they may be reported in a slightly different manner on the income statement.
We will first look at the difference in the treatment of fixed factory overheads under each of these two
methods, and then we will look at the income statement presentation under each method.
Fixed Factory Overheads Under Absorption Costing

As was explained in Overhead Allocation, under absorption costing fixed factory overhead costs are
allocated to the units produced during the period according to a predetermined rate. 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.
Fixed factory overheads are allocated to the units produced as if they were variable costs, even
though they are not variable costs.
Absorption costing is required by U.S. GAAP for external financial reporting and by the U.S. taxing authorities
for tax reporting. (Job-order costing, process costing and in some cases activity-based costing can all be used
with absorption costing for external purposes.)
Under the absorption costing method, the profit of a company is influenced by the difference between the
level of production and the level of sales. When the level of production is higher than the level of sales, some
of the fixed manufacturing overhead costs from this period are included on the balance sheet as inventory at
the year-end. As a result, these costs that are in inventory are not included on the income statement as an
expense. We will look at this in more detail on the following page.
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. This means that no matter what the level of sales, all of the
fixed factory overheads will be expensed in the period when incurred.
Variable costing is not GAAP. For external reporting purposes, GAAP requires the use of absorption
costing for fixed manufacturing cost allocation, and therefore variable costing cannot be used for external
financial reporting. However, many accountants feel that variable costing is a better tool to use for internal
analysis, and therefore variable costing is often used internally.
15
The budgeted activity level is the number of budgeted direct labor hours, direct labor cost, material cost, or machine
hourswhatever is being used as the allocation basis. This will be discussed in greater detail as we proceed through this
explanation.
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. Under absorption costing, fixed factory overhead
costs are included, or absorbed, into the product cost. Under variable costing, they are excluded from the
product cost and treated as a period cost, because they are not variable costs.
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.
b) Profits fluctuate with sales.
c) An idle facility variation is calculated.
d) Product costs include "direct" (variable) administrative costs.
(CMA Adapted)
Effects of Changing Inventory Levels

Because fixed factory overheads are treated differently in these two methods, 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.
Note: In addition to producing different amounts of profit, these two methods will always produce different
values for ending inventory because they include different costs in each unit of inventory. 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.
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 is because all of the fixed factory overheads were expensed as a period cost
under the variable method, and all of the fixed factory overheads were sold and included in cost of goods
sold under the absorption method.
Whenever inventory changes over a period of time, the two methods will give different levels of net income.
Production Greater than Sales (Inventory Increases)

If production is greater than sales, 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. When a unit that was produced but not sold during the
period goes to the balance sheet as inventory, it takes some of the fixed factory overheads with it. This
temporarily puts that amount of fixed factory overhead on the balance sheet. 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.
Under variable costing all of the fixed factory overheads for the period are on the income statement.
Sales Greater than Production (Inventory Decreases)

If production is lower than sales, 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. Because sales were greater than production, some of the products that were produced in previous years
were sold in the current period. This means that under the absorption method, some of the fixed factory
overhead costs that had been inventoried in previous years will now be expensed in the current period.
Note: You should recognize that over a long period of time, 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, because in the long term the company will not produce more than it can sell and
therefore sales will equal production. Rather, the difference between them will appear in the allocation of
income to the different periods within that longer time period.
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, because there are more costs in each unit under absorption costing, and the number of
units in ending inventory are the same under both methods. There will always be some fixed costs in
ending inventory under absorption costing that will not be in ending inventory under variable costing.
Income Statement Presentation

As mentioned earlier, there is also a difference in the presentation of the Income Statement with these two
methods.
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. All variable and fixed nonproduction costs are then
subtracted from the gross profit to calculate net income.
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. From this manufacturing contribution
margin, we subtract nonmanufacturing variable costs to arrive at the contribution margin. All fixed costs
(manufacturing and non-manufacturing) are then subtracted from the contribution margin to calculate net
income.
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. But, you need to know that the absorption
method determines a gross profit and the variable method calculates a contribution margin; and the
two are different.
This is demonstrated in the example (and the answer to the example) that follows this explanation.
Absorption Costing versus Variable Costing: Benefits and Limitations

While absorption costing is required for external reporting (the GAAP financial statements), it is
generally thought that variable costing is better for internal uses.
Absorption Costing
Benefits Absorption costing provides matching of costs and benefits.
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.
Limitations When a greater number of products are produced than are sold during a period, it
causes Inventory to increase. Since fixed overhead is charged to the units produced
in absorption costing, an increase in Inventory means that some of the current
period fixed costs remain in the ending inventories. 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. The fixed costs are
released into Cost of Goods Sold expense only when the inventory is sold in a
subsequent period. Thus the effect of this manipulation is to move net operating
income from a future period to the current period. It also creates a buildup of
inventories that is not consistent with a profitable operation.
When the number of units sold is greater than the number of units produced,
Inventory decreases. Net income under absorption costing will be lower than it would
be under variable costing, because some prior period fixed manufacturing costs will
be expensed under absorption costing along with the current periods fixed manufac-
turing costs.
Variable Costing
Benefits The impact on profits of changes in sales volume is more obvious with variable
costing.
By not including fixed costs in the calculation of cost to produce, companies are able
to make better and more informed decisions about profitability and product mix.
Operating income is directly related to sales levels and is not influenced by changes
in inventory levels due to production or sales variances. This prevents managers
from being able to hide costs on the balance sheet by increasing production, thus
moving more of the fixed factory overheads to the balance sheet as inventory. Under
absorption costing, a manager can increase profits simply by producing more units.
Variance analysis of fixed overhead costs is less confusing than it is with absorption
costing. With variable costing, the fixed overhead variance is simply actual fixed
overhead incurred minus budgeted fixed overhead. Under absorption costing,
variances include comparisons with fixed overhead applied to production, which is
more complex (see Fixed Overhead Variances in the Performance Management
section for more information).
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.
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.
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 easier to assign responsibility for cost control. Operating management can

control variable costs, but fixed costs are usually controlled at a higher level.
Advocates argue that variable costing is more consistent with economic reality,
because fixed costs do not vary with production in the short run.
Limitations Variable costing does not provide proper matching of costs and benefits.
Since only variable manufacturing costs are charged to the inventory in variable
costing, this method requires separating all manufacturing costs into their fixed and
variable components.
To prepare a complete income statement based on variable costing, it is also

necessary to separate the selling and administrative costs into their fixed and
variable components.
Variable/Absorption Costing Example

Hardy Corp. uses the FIFO method to track inventory. The records for Hardy include the following
information. For simplicity, assume that the amounts given are both the budgeted amounts and the actual
amounts and thus, there were no variances.
Inventory Year 1 Year 2
Beginning balance, in units -0- 4,200
Production 12,000 10,000
Available for sale 12,000 14,200
Less units sold ( 7,800) (12,000)
Ending balance, in units 4,200 2,200
Other information
Sales ($2.10 per unit) $16,380 $25,200
Variable mfg. costs ($0.90/unit) 10,800 9,000
Fixed mfg. costs 5,000 5,400
Variable selling and admin. costs 2,250 3,750
Fixed selling and admin. costs 2,250 3,750
Required: Prepare the income statements for Year 1 and Year 2 using both the absorption and the variable
methods of costing. (The solution follows.)
Year 1 Absorption Costing: Year 1 Variable Costing:

Sales revenue $ Sales revenue $
+_________
Manuf. Cont. Margin $
________ ________
Gross Margin $ Contribution Margin $
________ ________
Operating Income $ Operating Income $
Year 2 Absorption Costing: Year 2 Variable Costing:

Sales revenue $ Sales revenue $
________
Manuf. Cont. Margin $
________ ________
Gross Margin $ Contribution Margin $
________ ________
Operating Income $ Operating Income $
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 ($5,00012,0007,800) 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 1s production. That
means the remainder, or 12,000 4,200 = 7,800 units, came from Year 2s 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 2s production is $0.54 7,800 = $4,212.
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 years 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 periods 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 years
production. So we know that the cost of the units sold will include only fixed manufacturing costs that are
this years 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 years 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 years 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 years planned cost per unit, we do not have the problem of having sold
units with a cost per unit that is different from this years 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 years 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 periods
fixed overhead per unit.
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 customers
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 Desks 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)
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)
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.
The following information is for the next two questions:
Product sales: 1,000 units at $10 each

Variable manufacturing costs: $5.50 per unit
Fixed manufacturing overhead (planned and actual): $1,200
Variable selling and administrative costs: $0.50 per unit sold
Fixed selling and administrative costs: $1,000
Units produced (planned and actual): 1,200
Beginning inventory 0 units
Question 36: Operating income under variable (direct) costing is:
a) $600
b) $700
c) $1,800
d) $2,300
Question 37: Assuming operating income under variable costing is $1,800, operating income under
absorption costing is:
a) $1,800
b) $1,967
c) $2,000
d) $2,167
(CIA Adapted)
Question 38: When a firm prepares financial reports using absorption costing:
a) Profits will always increase with increases in sales.
b) Profits will always decrease with decreases in sales.
c) Profits may decrease with increased sales even if there is no change in selling prices and costs.
d) Decreased output and constant sales result in increased profits.
(CMA Adapted)
Question 39: Nance Corp began operations in January. The company produced 50,000 units and sold
45,000 units in its first year of operations. Costs for the year were as follows:
Fixed Manufacturing Costs $250,000

Variable Manufacturing Costs 180,000
Fixed General and Selling Costs 75,000
Variable General and Selling Costs 80,000
How would the net income of Nance compare between the variable method and full absorption costing
methods?
a) Variable would be $25,000 higher.
b) Absorption would be $25,000 higher.
c) Variable would be $32,500 higher.
d) Absorption would be $32,500 higher.
(HOCK)
Question 40: Jansen, Inc. pays bonuses to its managers based on operating income. The company uses
absorption costing, and overhead is applied on the basis of direct labor hours. To increase bonuses,
Jansen's managers may do all of the following except:
a) Produce those products requiring the most direct labor.
b) Defer expenses such as maintenance to a future period.
c) Increase production schedules independent of customer demands.
d) Decrease production of those items requiring the most direct labor.
(CMA Adapted)
The following information is for the next two questions: Osawa planned to produce and actually
manufactured 200,000 units of its single product in its first year of operations. Variable manufacturing
costs were $30 per unit of product. Planned and actual fixed manufacturing costs were $600,000, and the
selling and administrative costs totaled $400,000. Osawa sold 120,000 units of product at a selling price
of $40 per unit.
Question 41: Osawas operating income using absorption costing is:
a) $200,000
b) $440,000
c) $600,000
d) $840,000
Question 42: Osawas operating income using variable costing is:
a) $200,000
b) $440,000
c) $800,000
d) $600,000
(CMA Adapted)
The following information is for the next six questions: Valyn Corporation employs an absorption
costing system for internal reporting purposes; however, the company is considering using variable
costing. Data regarding Valyn's planned and actual operations for the calendar year is:
Planned Actual
Activity Activity
Beginning finished goods
inventory in units 35,000 35,000
Sales in units 140,000 125,000
Production in units 140,000 130,000
The planned per unit cost figures shown in the next schedule were based on the estimated production and
sale of 140,000 units for the year. Valyn uses a predetermined manufacturing overhead rate for applying
manufacturing overhead to its product; therefore, a combined manufacturing overhead rate of $9.00 per
unit was employed for absorption costing purposes. Any over- or under-applied manufacturing overhead
is closed to the cost of goods sold account at the end of the reporting year.
Planned Costs Planned Incurred

Per Unit Total Costs Costs
Direct materials $12.00 $1,680,000 $1,560,000
Direct labor 9.00 1,260,000 1,170,000
Variable manufacturing
overhead 4.00 560,000 520,000
Fixed manufacturing
overhead 5.00 700,000 715,000
Variable selling expenses 8.00 1,120,000 1,000,000
Fixed selling expenses 7.00 980,000 980,000
Variable administrative
expenses 2.00 280,000 250,000
Fixed administrative
expenses 3.00 420,000 425,000
Total $50.00 $7,000,000 $6,620,000
The beginning finished goods inventory for absorption costing purposes was valued at the previous year's
planned unit manufacturing cost, which was the same as the current year's planned unit manufacturing
cost. 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 $70.00 per unit.
Question 43: The value of Valyn Corporation's current year actual ending finished goods inventory under
the absorption-costing basis was:
a) $900,000
b) $1,200,000
c) $1,220,000
d) $1,350,000
Question 44: The value of Valyn Corporation's actual ending finished goods inventory on the variable
costing basis was:
a) $1,400,000
b) $1,125,000
c) $1,000,000
d) $750,000
Question 45: Valyn Corporation's total fixed costs expensed under the absorption costing basis were:
a) $2,095,000
b) $2,120,000
c) $2,055,000
d) $2,030,000
Question 46: Valyn Corporation's actual manufacturing contribution margin calculated under the variable
costing basis was:
a) $4,375,000
b) $4,935,000
c) $4,910,000
d) $5,625,000
Question 47: The total variable cost currently expensed by Valyn Corporation under the variable costing
basis was:
a) $4,375,000
b) $4,500,000
c) $4,325,000
d) $4,550,000
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) $65,000
b) $25,000
c) $40,000
d) $90,000
(CMA Adapted)
Section D Shared Services Cost Allocation
Shared Services Cost Allocation

Shared services are administrative services that are provided by a central department to the companys
operating units. Shared services are usually services such as human resources, information technology,
maintenance, legal, and many accounting services such as payroll processing, invoicing and accounts
payable. 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.
These shared service, or support, departments incur costs (salary, rent, utilities and so on). For internal
decision-making, the costs of shared service departments need to be allocated to the operating, or
production, departments that use their services in order to calculate the full cost of production. The methods
of allocating these costs we are about to discuss are different from the activity-based costing method covered
above. These shared service costs are being allocated as a cost pool containing all of each departments
costs, and the costs are being allocated to user departments on the basis of a single cost driver, such as
hours of service used.
In Section C in Allocation of Common Costs, we talked about stand-alone cost allocation versus incremental
cost allocation. The cost allocation methods that follow are all stand-alone cost allocation methods.
Note: Allocation of shared service costs to products or to production departments does not change the fact
that for external financial reporting purposes, the costs of service departments are period expenses and
are expensed as they are incurred. Allocation of shared service costs does not make them product costs.
The allocation of service costs to the production departments is strictly an internal function that is used for
decision-making, and it is not reflected in the companys external financial statements.
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, it will be looking at a cost of production that is less
than the actual total cost. As a result of this incorrect calculation, the companys pricing decisions will not
be correct, and in a worst-case scenario, the company may sell the product for less than it actually costs to
produce it.
Reasons for allocating shared services costs include:
It provides accurate departmental and product costs for use in making decisions, valuing inventory,
and evaluating the efficiency of departments and the profitability of individual products;
It motivates managers and other employees to make their best effort in their own areas of responsi-
bility to achieve the companys strategic;
It provides an incentive for managers to make decisions that are consistent with the goals of top
management;
It provides a fair evaluation of the performance of segments and segment managers;
It justifies costs, such as transfer prices; and
It can also be used to compute reimbursement when a contract provides for cost reimbursement.
Cost allocations may be done for just one shared service or support department whose costs are allocated to
multiple user departments; 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. But even
when costs of shared service departments are allocated to other service departments, ultimately all the
shared service costs are allocated only to operating departments.
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 departments 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.
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:
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 departments 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 departments actions have caused a variance in costs for the company as a whole of
$131,000 over the budgeted amount.
(Continued)
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:

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:
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.
The examples above use the demand to calculate the allocation rate for the Maintenance Departments costs.
The company could instead use the supply of service, i.e., the Maintenance departments 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 managements
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 departments 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.
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
departments 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 departments 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 departments costs will be allocated to the other shared service departments and the
production departments. The second shared service departments costs (which now include its share of the
first shared service departments 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
shared service departments costs have been allocated, no costs will be allocated to it from other shared
service departments.
The problem on the Exam will give the allocation order to use if it is not obvious.
Following is an example of the step-down method.

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. Again, we did not show
the allocation calculations. The step-down method gives a slightly different result from the direct method,
even though the Production Departments used the same amounts of services of the two shared service
departments.
Note: In the step-down method, the costs allocated from the cafeteria include its own incurred costs
(120), plus the cafeterias portion of the maintenance costs that were allocated to it from maintenance
(10). When this allocation of the maintenance department is made, we will use the number of hours that
the cafeteria utilized the services of the maintenance department. However, when the cafeteria costs
(including the cafeterias share of the maintenance costs) are allocated, we do not consider the number of
people in the maintenance department or their usage of the cafeteria.
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.
Because of this detailed allocation between and among the shared service departments, the reciprocal
method is the most theoretically correct method to use. However, a company will need to balance the
additional costs required in doing this against the benefits that are received. Graphically the reciprocal
method looks like this:

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. As a result, the total amount allocated by each shared service department
will be greater than its own overhead costs, since each shared service department must allocate all of its own
costs plus some of the other shared service departments costs. The math to do this is the most complicated
of the three methods, but even it is not too difficult.
To solve a problem using the reciprocal method, simultaneous or multiple equations must be used. In a
situation in which there are two shared service departments, 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, and after that
solve for the other number. These calculated amounts become the amounts that need to be allocated from
the maintenance department or cafeteria to all the other departments, including the other service depart-
ments.
The process of solving the two equations is shown in detail in the example on the following pages.
Comprehensive Example of the Three Methods of Shared Service Cost Allocation
Example: We will use the following information about Cubs Co. to demonstrate the different methods of
allocating service costs. Cubs Co. has two shared service departments (A and B) and three production
departments (X, Y and Z). 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. The following
information is in respect to the service and production departments:
Dept. A Dept. B Dept. X Dept. Y Dept. Z Total

Overhead $100,000 $50,000 $200,000 $300,000 $250,000 $900,000
Labor Hours -- 1,000 2,000 4,000 3,000 10,000
Machine Hours 2,000 -- 2,000 2,000 2,000 8,000
Direct Method
Under the direct method each shared service department will allocate costs only to the production
departments. For Department A, the production departments used a total of 9,000 (2,000 + 4,000 +
3,000) labor hours, so each department will be allocated $11.11111 ($100,000 9,000) for each direct
labor hour used. Department B provided 6,000 (2,000 + 2,000 + 2,000) machine hours of service to the
production departments, so they will allocate $8.33333 ($50,000 6,000) per machine hour to the
production departments. We ignore the services that were provided to the other service departments in
this calculation. The numbers that are ignored are shaded.

Overhead $100,000 $50,000 $200,000 $300,000 $250,000 $900,000
Labor Hours -- 1,000 2,000 4,000 3,000 10,000
Machine Hours 2,000 -- 2,000 2,000 2,000 8,000
Now we can determine how much of the costs of the shared service departments will be allocated to each
department. First, we will allocate costs of Department A. Of the total 9,000 direct labor hours used in the
allocation, Department X used 2,000 labor hours, Department Y used 4,000 labor hours, and Department
Z used 3,000 labor hours. Department X is allocated $11.11111 2,000 hours = $22,222.22 of costs
from Department A. Department Y is allocated $11.11111 4,000 hours = $44,444.45 (adjusted for
rounding difference), and Department Z is allocated $11.11111 3,000 hours = $33,333.33.
Department Bs costs are allocated next. Of the total 6,000 machine hours used in the allocation,
Departments X, Y and Z each used 2,000 machine hours. Therefore, each production department will be
allocated $8.33333 per hour 2,000 hours = $16,666.66. (Two of the amounts will be adjusted for
rounding differences.)
Below are the total overhead costs for each department after the allocation:
Dept. A Dept. B Dept. X Dept. Y Dept. Z

Own Overhead $100,000.00 $50,000.00 $200,000.00 $300,000.00 $250,000.00
Allocated from A (100,000.00) 0.00 22,222.22 44,444.45 33,333.33
Allocated from B 0.00 (50,000.00) 16,666.67 16,666.66 16,666.67
Total OH $ 0.00 $ 0.00 $238,888.89 $361,111.11 $300,000.00
(Continued)
Step-Down Method
Under the step-down method we must determine which shared service departments costs will be allocated
first. We can calculate that 25% of the service provided by Department B was to Department A. Since only
10% of Department As service was to Department B, we will allocate Department Bs costs first.
Department Bs cost of $50,000 is allocated on the basis of machine hours used by all the other depart-
ments. In total 8,000 machine hours were used, so the Department Bs cost per machine hour is $6.25.
Department Bs costs will be allocated among all the other departments, including Department A, based on
machine hours used by each. Department A will receive $6.25 2,000 hours, or $12,500. This $12,500
will be added to the $100,000 of As own overhead, giving a total $112,500 cost for Department A. This
$112,500 cost for Department A will then be allocated only to the production departments based on the
direct labor hours used by each. The allocation of Department As costs is done the same way as in the
direct method, except that there are now more costs to allocate from Department A because some
allocated costs of Department B are included in Department As costs.
First, we allocate Department Bs costs: As mentioned previously, Department A will be allocated $12,500
of Department Bs costs. Since Departments X, Y and Z each also used 2,000 machine hours, each of those
departments will also be allocated $12,500 from Department B ($6.25 2,000 machine hours).
Next, we will allocate the costs of Department A. The total costs to be allocated for Department A are
Department As own overhead of $100,000 plus the $12,500 allocated overhead from Department B, for a
total to allocate of $112,500. That $112,500 is allocated based on direct labor hours, excluding the direct
labor hours used by Department B. Therefore, a total of 9,000 direct labor hours (2,000 + 4,000 + 3,000)
are used in allocating Department As total overhead of $112,500. $112,500 9,000 = $12.50 per direct
labor hour. Department X will be allocated $12.50 2,000 = $25,000, Department Y will be allocated
$12.50 4,000 = $50,000, and Department Z will be allocated $12.50 3,000 = $37,500.
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 departments costs.
The ignored numbers are shaded below:
Overhead $100,000 $50,000 $200,000 $300,000 $250,000 $900,000
Labor Hours -- 1,000 2,000 4,000 3,000 10,000
Machine Hours 2,000 -- 2,000 2,000 2,000 8,000

Own Overhead $100,000.00 $50,000.00 $200,000.00 $300,000.00 $250,000.00
Allocated from A (112,500.00) 0.00 25,000.00 50,000.00 37,500.00
Allocated from B 12,500.00 (50,000.00) 12,500.00 12,500.00 12,500.00
Total OH $ 0.00 $ 0.00 $237,500.00 $362,500.00 $300,000.00
Reciprocal Method
Under the reciprocal method we will allocate some of Department As costs to Department B and some of
Department Bs costs to Department A using simultaneous equations. Since we have two shared service
departments, we need to use two equations. (If there were three shared service departments, we would
need three equations, and so forth.) The equations will express how much each shared service department
needs to allocate to all of the departments, including the other shared service departments.
The equations we need are:

A = $100,000 + 0.25B
B = $50,000 + 0.1A
(Continued)
We solve for A by substituting the right side of the second equation into the first equation in place of the
variable B.
A = $100,000 + 0.25 ($50,000 + 0.1A)
Now we have only one variable in the equation and we can solve for Dept. A.
A = $100,000 + $12,500 + 0.025A

0.975A = $112,500
A = $115,384.62
The result, $115,384.62, is the total cost for Department A to be allocated to all the other departments,
including the other shared service department.
Now that we have solved for A, we can put the value we found for A into the second equation in place of
the A and solve for B.
B = $50,000 + 0.1 ($115,384.62)
B = $61,538.46
The total cost for Department B to be allocated to all the other departments, including the other shared
service department, is $61,538.46.
The total overhead cost for Department A, $115,384.61, is allocated among all the other departments on
the basis of 10,000 total direct labor hours used, or $11.53846 per hour. Department B is allocated
$11.53846 1,000 = $11,538.46 of Department As costs, Department X is allocated $11.52846 2,000
= $23,076.92, Department Y is allocated $11.53846 4,000 = $46,153.85, and Department Z is allocated
$11.53846 3,000 = $34,615.38.
The total overhead cost for Department B, $61,538.46, is allocated among all the other departments on
the basis of 8,000 total machine hours, or $7.69231 per machine hour. Departments A, X, Y and Z each
used 2,000 machine hours, so each will be allocated $7.69231 2,000 = $15,384.62. (Two of the
departments amounts will be adjusted for rounding differences.)

Own Overhead $100,000.00 $50,000.00 $200,000.00 $300,000.00 $250,000.00
Allocated from A (115,384.61) 11,538.46 23,076.92 46,153.85 34,615.38
Allocated from B 15,384.61 (61,538.46) 15,384.61 15,384.62 15,384.62
Total OH $ 0.00 $ 0.00 $238,461.53 $361,538.47 $300,000.00
Notice that in all of the methods of overhead allocation, 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 departmentsincurred during the period ($900,000).
Question 49: A segment of an organization is referred to as a service center if it has:
a) Responsibility for combining the raw materials, direct labor, and other factors of production into a
final output.
b) Responsibility for developing markets and selling the output of the organization.
c) Authority to make decisions affecting the major determinants of profit, including the power to
choose its markets and sources of supply.
d) Authority to provide specialized support to other units within the organization.
(CMA Adapted)
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. To aid them, they were provided the following information:
Quality Control Maintenance Machining Assembly Total

Budgeted overhead costs
before allocation $350,000 $200,000 $400,000 $300,000 $1,250,000
Budgeted machine hours -- -- 50,000 -- 50,000
Budgeted direct labor hours -- -- -- 25,000 25,000
Budgeted hours of service:
Quality Control -- 7,000 21,000 7,000 35,000
Maintenance 10,000 -- 18,000 12,000 40,000
Question 50: If Rochester uses the direct method of allocating support department costs, the total
support costs allocated to the Assembly Department would be:
a) $80,000
b) $87,500
c) $120,000
d) $167,500
Question 51: If Rochester uses the direct method, the total amount of overhead allocated to each
machine hour at Rochester would be:
a) $2.40
b) $5.25
c) $8.00
d) $15.65
Question 52: If Rochester uses the step-down method of allocating support costs beginning with quality
control, the maintenance costs allocated to the Assembly Department would be:
a) $70,000
b) $108,000
c) $162,000
d) $200,000
Question 53: If Rochester uses the reciprocal method of allocating support costs, the total amount of
quality control costs to be allocated to the other departments would be:
a) $284,211
b) $336,842
c) $350,000
d) $421,053
Question 54: If Rochester decides not to allocate support costs to the production departments, the
overhead allocated to each direct labor hour in the Assembly Department would be:
a) $3.20
b) $3.50
c) $12.00
d) $16.00
(CMA Adapted)
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. When we need to separate fixed costs from variable costs for analysis,
budgeting or costing purposes, there are two methods that can be used: the High-Low Points Method and
Regression Analysis.
High-Low Points Method

For the High-Low Points Method, we use the highest and lowest observed values of the cost driver within the
relevant range and the costs that go along with them.
If, for example, we need to segregate fixed production costs from variable production costs and all we have is
a single total cost amount, we will take the month of the highest level of production or usage and the month
of the lowest level of production or usage. By comparing the differences in production with the differences in
total costs between these two months, we can determine approximately what amount of the costs are
variable and what amount are fixed. 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, since the activity is the cost driver. Divide the difference between the costs associated with
the highest and the lowest activity by the difference between the highest and lowest activity.
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 months activity and the costs for the lowest months activity divided
by the difference in the two months activity levels must be the Variable Cost per Unit.
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.
3) Subtract the total variable cost from the total cost at that level to get the fixed cost.
Another way of estimating the variable cost per unit using the High-Low Points method is to set up two
equations in two variables, with one equation representing the highest level of the activity, or cost driver, and
one equation representing the lowest level. The two variables are Fixed Costs and Variable Costs. Then,
subtract one equation from the other equation to eliminate the Fixed Cost as a variable and solve the
remainder for the Variable Cost.
The result of doing this will be what is called the cost function. The cost function can be written in two ways,
as follows:
y = a + bx
Where: y = the dependent variable and the predicted value of y, which here is total costs
a = the constant coefficient and the y intercept, which here is the fixed cost
b = the variable coefficient and the slope of the line, which here is the variable cost per unit (or
per hour, if hours are the activity being used)
x = the independent variable, which here represents the number of units (or hours)
OR
y = ax + b
Where: y = the dependent variable and the predicted value of y, or total costs
a = the variable coefficient and the slope of the line, or the variable cost per unit or per hour
x = the independent variable, or the number of units or hours
b = the constant coefficient and the y intercept, or fixed cost
Estimating Fixed and Variable Costs CMA Part 1
Note: the terms may be in any order. The variable representing fixed costs may come first, or it may
come at the end. Whichever way the cost function is written, the constant coefficient (the fixed costs) will
always be by itself, and the variable coefficient (the variable cost per unit) will always be next to the
independent variable (the x, or the number of units/hours).
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 6,257,000 $1,500,000
February 4,630,000 1,200,000
March 5,200,000 1,300,000
April 5,443,000 1,350,000
May 5,715,000 1,400,000
June 3,000,000 900,000
July 3,543,000 1,000,000
August 3,815,000 1,050,000
September 5,715,000 1,400,000
October 6,800,000 1,600,000
November 6,529,000 1,550,000
December 5,172,000 1,300,000
What is Ray Corporations 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 6,800,000 $1,600,000
June 3,000,000 900,000
Using the first method to estimate the variable cost per unit:
Difference in Costs = $700,000 $0.1842105 variable cost/unit
Difference in Units 3,800,000
Using the second method (two equations) to estimate the variable cost per unit:
FC + 6,800,000 VC = $1,600,000
FC + 3,000,000 VC = 900,000
0 + 3,800,000 VC = $ 700,000
VC = $0.1842105
The next step is to put the Variable Cost per Unit into an equation to calculate Fixed Cost. For this step, we
can use either the lowest or the highest volume-cost equation. Here we will use the highest.
FC = Total Cost Variable Cost

FC = $1,600,000 ($0.1842105 6,800,000) = $347,369
The cost function that expresses the relationship between fixed and variable costs is:
y = $347,369 + $0.1842105x
We can prove these fixed and variable cost amounts by putting them into the cost function using the
lowest activity level. The result is the total historical cost at that historical level.
$347,369 + ($0.1842105 3,000,000) = $900,000
So Fixed Cost is $347,369, and Variable Cost is $0.1842105 per unit.
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. 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. There, we were using simple regression analysis with a
time series, where time was the independent variable and sales volume was the dependent variable.
However, simple regression analysis can also be used to analyze a set of data where time is not the
independent variable but rather, something else is the independent variable. When we use regression analysis
to estimate fixed and variable costs as in this example, production in units is the independent variable and
total production costs is the dependent variable. Although we have several sets of X and Y data and each set
of data represents activity for a specific month, this regression analysis will not have the months on the X
axis. For the purpose of this analysis, it makes no difference which month each set of data occurred in. What
is important is the relationship of the dependent variable (production costs) to the independent variable
(production volume) for each month. As we will see, it is very consistent. And because it is consistent, 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.
Regression analysis can be done in Excel using the Data Analysis ToolPak Add-In. This add-in must be loaded
into Excel before it will be accessible. Loading it is done differently depending upon which version of Excel you
have. If it is not loaded, you can get directions for loading it by searching the Help directory in your Excel
program for Load or Unload Add-In Programs.
When the Data Analysis Toolpak Add-In has been loaded, enter the input into a blank spreadsheet. 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). The independent variable (production in units) is in Column A and the
dependent variable (total production costs) is in Column B. You can give headings to the data if you wish, but
if you do, do not include the cells containing the headings in the ranges to be analyzed.
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
Estimating Fixed and Variable Costs CMA Part 1
Then launch the Data Analysis ToolPak. In the analysis tools available, choose Regression. In the dialogue
box that comes up,
1) Enter the dependent variable range into the field Input Y Range. In our example, the dependent
variable is in column B, so the range is $B$1:$B$12.
2) Enter the independent variable range into the field Input X Range. In this example, the independ-
ent variable is in column A, so the range is $A$1:$A$12.
3) For Output Options, choose New Worksheet Ply:
4) Click OK.
Note: This example was created in the Windows version of Excel 2007; another version of Excel might be
slightly different.
A new sheet will be created in your workbook. The new worksheet will look like this:
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.999977007
R Square 0.999954015
Adjusted R Square 0.999949417
Standard Error 1571.852533
Observations 12
ANOVA
df SS MS F Significance F
Regression 1 5.37267E+11 5.37267E+11 217453.5664 5.0603E-23
Residual 10 24707203.85 2470720.385
Total 11 5.37292E+11
Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 346902.0628 2084.915328 166.3866432 1.51077E-18 342256.582 351547.5436 342256.582 351547.5436
X Variable 1 0.184201867 0.000395012 466.319168 5.0603E-23 0.183321725 0.18508201 0.183321725 0.18508201
The four pieces of information you need from this spreadsheet are highlighted in the sheet above.
The coefficient of correlation is called Multiple R on this spreadsheet, and it is 0.999977007.

This is about as close to 1 as you can get, and it indicates a very strong correlation between produc-
tion volume and production costs. The coefficient of correlation is explained in detail in this book in
the section on Forecasting.
The coefficient of determination, called R square on this spreadsheet, is the square of the
coefficient of correlation. It is 0.999954015. 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). The coefficient of determination is also explained in
the section on Forecasting. If necessary, 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.
(Hint: In this example, 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. But make sure you un-
derstand why that is true.)
The amount of the fixed cost is the constant coefficient, or the Y-intercept, which is
$346,902.0628.
The variable cost per unit is the variable coefficient, or X variable, which is $0.184201867 per
unit.
This cost function is:
y = $346,902.0628 + $0.184201867x
Note how similar this result is to the result we got when we analyzed the same data using the High-Low
Points Method. With the High-Low Points Method, the fixed cost was $347,369 and the variable cost was
$0.1842105 per unit.
Forecasting Total Costs

Whether using the High-Low Points Method or regression analysis, the cost function that results can be used
to forecast the total cost at any forecasted activity level. For example, if production is forecast to be
6,000,000 units, then the forecasted total cost using the High-Low Points Method is:
y = $347,369 + ($0.1842105 6,000,000)
y = $1,452,632
And total cost forecasted using regression analysis (rounded) is:
y = $346,902.0628 + ($0.184201867 6,000,000)
y = $1,452,113
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.
Suppliers provide components to manufacturers, who in turn convert them into finished products that they
ship to distributors for shipping to retailers for purchase by the consumer. All of the organizations involved in
moving a product or service from suppliers to the end-user, the customer, are referred to collectively as the
supply chain.
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
supply chain firms endeavor to develop and run their supply chains in the most effective and efficient ways
possible. Supply chain activities cover product development, sourcing, production, logistics, and the
information systems needed to coordinate these activities.
The organizations that make up the supply chain are linked together through physical flows of products and
through flows of information. Physical flows involve the movement, storage and transformation of raw
materials and finished goods. The physical flows are the most visible part of the supply chain. But the
information flows are just as important. 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.
By sharing information and by planning and coordinating their activities, all of the members of the supply
chain can be in a position to respond quickly to needs without having to maintain large inventories. Retailers
share daily sales information with distributors and the manufacturer, so that the manufacturer knows how
much production to schedule and how much raw materials to order and when, and the distributors know how
much to order. The trading partners share inventory information. The sharing of information reduces
uncertainty as to demand.
The result of effective supply chain management is fewer stockouts at the retail level, reduction of excess
manufacturing by the manufacturer and thus reduction of excess finished goods inventories, and fewer rush
and expedited orders. Each company in the supply chain is able to carry lower inventories, thus reducing the
amount of cash tied up in inventories for all.
Some supply chain management goes so far as the retailer allowing the distributor or manufacturer to
manage their inventories for them, shipping product to them automatically whenever their inventory of an
item gets low. Such a practice is called supplier-managed or vendor-managed inventory.
Along with the benefits of supply chain management, issues and problems can arise because of communica-
tions problems, trust issues, incompatible information systems, and the required increases in personnel
resources and financial resources.
Lean Manufacturing
Lean manufacturing is a philosophy and system of manufacturing that was developed originally by Toyota.
Toyota called the system the Toyota Production System (TPS). Manufacturers throughout the world have
adapted the system to meet their own manufacturing needs, and it has become a global standard that
virtually all manufacturing companies must adopt in order to remain competitive. The generic term for the
system is lean manufacturing.
The emphasis in lean manufacturing is on cutting out waste in the manufacturing process. Waste is
anything other than the minimum amount of equipment, materials, parts, and working time that is absolutely
essential to add value to the customer. Waste is anything that does not add value to the customer or
anything the customer is not willing to pay for. Identifying and eliminating waste is a primary focus of lean
manufacturing.
Section D Supply Chain Management
Adding value to the customer is not the same thing as adding value to the product. If extra options added
to a product are not things the customer wants or is willing to pay for, they may well add value to the
product, but they do not add value to the customer.
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. Lean manufacturing strives to produce products that are
On time.
Using a few resources as possible.
Better than those of competitors.
Produced faster and cheaper than the competition.
The 7 primary wasteful activities addressed by lean manufacturing are:
1) Overproduction, or making more items than you can sell.
2) Delay, or waiting for processing, parts sitting in storage.
3) Transporting parts and materials from process to process or to various storage locations.
4) Over-processing, or doing more work on a part or product than is necessary.
5) Inventory, or committing money and storage space to unsold parts or products.
6) Motion, or moving parts more than the minimum amount required to complete and ship them.
7) Making defective parts, creating parts or products that are not sellable due to defects and must be
discarded or reworked.
Waste inhibits throughput, the rate at which work proceeds through a manufacturing system. Machine
downtime, waiting for materials, out of stock supplies, operator errors, and poorly designed processes all
contribute to poor throughput in a manufacturing system. Eliminating waste increases throughput. Even small
reductions in waste can have a cumulative effect in increasing throughput.
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. Specify value
from the standpoint of the customer.
2) Value stream The value stream is the set of steps and activities performed to deliver the
product or service to the customer. Identify the value stream for each product or service.
3) Flow Make the steps occur so the product or service flows smoothly to the customer. Eliminate
steps that do not create value for the customer.
4) Pull Producing or servicing is done based on customer demand.
5) Continuous improvement Seek perfection by continuing to make improvements.
Lean Concepts
Minimal machine downtime when changing from manufacturing one item to manufacturing a different item
is an important component of lean manufacturing. The changeover process generally involves removing and
replacing dies from machine beds and removing and replacing direct materials used. The more the downtime
involved in the changeover process can be reduced, the less waste of resources takes place. SMED, or
Single Minute Exchange of Die is a primary method of speeding up the changeover process. The goal of
SMED is to change dies and other components in less than 10 minutes. The most powerful method of
attaining SMED is to convert all internal setup procedures (procedures that can only be completed while the
machine is down) to external setup procedures (procedures that can be completed while the machine is
running). For example, preparation for the next setup can be done while the machine or process is still
running, resulting in less downtime because the machine needs to be stopped only during the actual setup
activities.
Often large batches are assumed to be more economical than small batches due to excessively long or
difficult changeover procedures. But production of large batches results in large on-hand inventories.
Reducing setup time makes it practical to produce smaller batches. Smaller batches can reduce finished goods
inventory on hand, allow for more varieties of products that can be produced more quickly, and lead to
greater customer responsiveness.
Ideally, batching is not done at all in lean manufacturing. The goal of lean manufacturing is to maintain
continuous flow, meaning once you begin producing a product, you keep it moving through the value
stream without ever placing it into a holding area for later processing.
Under lean manufacturing, the plant layout is re-arranged by manufacturing cells or work cells. Each
work cell produces a specific product or product type. The work cells are generally laid out in a U-shape or
horseshoe shape, but the shape can be whatever works best. The configurations 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. 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. Each worker in each cell
knows how to operate all the machines in that cell and can perform supporting tasks within that cell, reducing
downtime resulting from breakdowns or employee absences. Furthermore, a properly laid-out work cell can
produce a product with a staff of just one person moving from station to station, or fully staffed with a worker
at each station, or staffed somewhere in between. Product demand determines the staffing needed in each
work cell. The rate of production is matched to the demand to avoid creating excess inventory or incurring
excess costs.
Kaizen is part of the lean manufacturing philosophy. The term kaizen is a Japanese word that means
improvement. As used in business, it implies continuous improvement, or slow but constant incremental
improvements being made in all areas of business operations. Standard costs used in manufacturing may be
either ideal standards, attainable only under the best possible conditions, or practical, expected
standards, which are challenging to attain, but attainable under normal conditions. Toyota would say that
standards in manufacturing are temporary and not absolutes. Improvement is always possible, and the goal is
to attain the ideal standard. Even though practical standards are being attained, the ultimate goal is still not
being achieved. The concept of kaizen has extended to other business operations outside the manufacturing
function, and it will be discussed later in this book in that context.
Kanban is also a component of lean manufacturing. Kanban refers to a signal that tells workers that there is
more work to be done. Kanban is covered in more detail in the next few pages.
Error and mistake-proofing means creating improvements on many different levels to make the products
correctly the first time. 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. Even the design of the product may
be changed to minimize errors in manufacturing.
Just-In-Time (JIT) production and inventory management are also used in lean manufacturing. JIT is a
process for synchronizing materials, operators, and equipment so that the people and the materials are where
they need to be, when they need to be there, and in the state they need to be in. Just-in-time processes are
discussed in more detail in the next topic.
Benefits of Lean Manufacturing

Benefits of lean manufacturing include:
Quality performance, fewer defects and rework.
Fewer machine and process breakdowns.
Lower levels of inventory.
Less space required for manufacturing and storage.
Greater efficiency and increased output per person-hour.
Improved delivery performance.
Greater customer satisfaction.
Improved employee morale and involvement.
Improved supplier relations.
Lower costs due to elimination of waste leading to higher profits.
Increased business because of increased customer responsiveness.
Just-in-Time (JIT) Inventory Management Systems

Just-In-Time inventory management systems are used in lean manufacturing. They are based on a
manufacturing philosophy that combines purchasing, production and inventory control into one function. The
goal of a JIT system is to minimize the level of inventories that are held in the plant at all stages of
production, including raw materials, work-in-process and finished goods inventories while meeting customer
demand in a timely manner with high-quality products at the lowest possible cost.
The advantage of a JIT system is reduction in the cost of carrying the inventory. The cost savings include
reduction in the risk of damage, theft, loss, or a lack of ability to sell the finished goods.
One of the main differences between JIT and traditional inventory systems is that JIT is a demand-pull
system rather than a push system. In a push system, a department produces and sends all that it can to
the next step for further processing, which means that the manufacturer is producing something without
understanding consumer demand. The result of a push system can be large, useless stocks of inventory. The
main idea of JIT is that nothing is produced until the next process in the assembly line needs it. Ultimately,
this means essentially that nothing will be produced until a customer orders it, and then it will be produced
very quickly. This demand-pull feature requires close coordination between workstations. Close coordination
between workstations can keep the flow of goods smooth in spite of the low levels of inventory.
In a pull system, essentially nothing is produced until a customer orders it. By contrast, in a push system, 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, a company is producing something without knowing if it is actually needed or
not, resulting in a possibly large, useless stock of inventory.
To implement the JIT approach and to minimize inventory storage, the factory must be reorganized to permit
lean manufacturing.
Elimination of defects is an important part of a JIT system. Because of the close coordination between and
among workstations and the minimum inventories held at each workstation, defects caused at one
workstation very quickly affect other workstations. JIT requires problems and defects to be solved by
eliminating their root causes as quickly as possible. Since inventories are low, workers are able to trace
problems to their source and resolve them at the point where they originated.
Supply chain management is also an important part of just-in-time inventory management, and just-in-time
inventory management is an important part of supply chain management. Because inventory levels are kept
low in a JIT system, 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. In a JIT system, inventory is
purchased so that it will be delivered just as needed for production (or just as needed for sales, if the
company is a reseller instead of a manufacturer). The inventory must be of the required quality because there
is no extra to use in place of any defective units that are delivered. Because very little inventory is held, 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. Therefore, a company
that uses JIT purchasing must choose its suppliers carefully and maintain long-term supplier relationships.
In addition to the advantage of lower carrying costs for inventory, other benefits of a JIT system include
greater emphasis on improving quality by eliminating the causes of rework, scrap and waste. A goal of JIT is
to reduce setup times because reduced setup times makes production of smaller batches more economical.
This in turn reduces inventory levels and enables the company to respond quickly to changes in customer
demand. The reduced setup time also leads to lower manufacturing lead times.
As mentioned above in the topic of Lean Manufacturing, separating batch setup activities into preparation
activities and actual setup activities can reduce setup times. The preparation for the next setup can be done
while the machine or process is still running, resulting in less downtime because the machine needs to be
stopped only during the actual setup activities. Material handling for setups can be improved by moving the
material closer to the machine. These are only two suggestions, and there could be many other things that
can be done to reduce setup times, depending on the actual process.
Furthermore, 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. Reductions in square footage can
reduce energy use for heating, air conditioning, and lighting. Even more importantly, reducing the needed
floor space can reduce the need to construct additional production facilities, reducing the need for capital
investment and the associated environmental impacts that result from construction material use, land use,
and construction waste.
Just-in-time production also has costs and shortcomings. 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. This can contribute to traffic congestion and environmental impacts associated with
additional fuel use and additional vehicle emissions. If the products produced have large and/or unpredictable
market fluctuations, a JIT system may not be able to reduce or eliminate overproduction and associated
waste. And JIT implementation is not appropriate for high-mix manufacturing environments, which often have
thousands of products and dozens of work centers.
Kanban
Kanban is a Japanese inventory system. The word kanban means card or sign or visual record in
Japanese. Kanban is an integral part of lean manufacturing and JIT systems. Kanban provides the physical
inventory control cues that signal the need to move raw materials from the previous process.
The core of the kanban concept is that components are delivered to the production line on an as needed
basis, the need signaled, for example, by receipt of a card and an empty container, thus eliminating storage
in the production area. Kanban is part of a chain process where orders flow from one process to another, so
production of components is pulled to the production line, rather than pushed (as is done in the traditional
forecast-oriented system).
A kanban can be a card, a labeled container, a computer order, or some other device that is used to signal
that more products or parts are needed from the previous production process. The kanban contains
information on the exact product or component specifications that are needed for the next process. Reusable
containers may serve as the kanban, assuring that only what is needed gets produced.
Kanban are used to control work-in-process (WIP), production, and inventory flow. In this way, kanban
contributes to eliminating overproduction.
However, if production is being controlled perfectly, there will be no need for kanban because the needed
parts will arrive where they are needed at just the right time. If the parts do not arrive where and when
needed, though, then the kanban is sent to request the needed parts so that the station can keep operating.
As production control is improved, fewer kanban will be needed because the parts will almost always be
where they are needed when they are needed.
The major kanban principles are:
Kanban works from upstream to downstream in the production process, starting with the
customers order. At each step, only as many parts are withdrawn as the kanban instructs, helping
ensure that only what is ordered is made. The necessary parts in a given step always accompany the
kanban to ensure visual control.
The upstream processes produce only what has been withdrawn. This includes producing
items only in the sequence in which the kanban are received and producing only the number indicat-
ed on the kanban.
Only products that are 100 percent defect-free continue on through the production line. In
this way, each step recognizes and corrects the defects that are found before any more can be pro-
duced.
The number of kanban should be decreased over time. As mentioned above, kanban are used
when the needed components do not show up on time. As areas of needed improvement are ad-
dressed, the total number of kanban is minimized. By constantly improving production control and
reducing the total number of kanban, continuous improvement is facilitated while concurrently re-
ducing the overall level of stock in production.
Different types of kanban include supplier kanban (orders given to outside parts suppliers when parts are
needed for assembly lines); in-factory kanban (used between processes in the factory); and production
kanban (indicating operating instructions for processes within a line).
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.
Introduction to MRP, MRPII, and ERP

MRP, MRPII, and ERP systems are all integrated information systems that have evolved from early database
management systems. MRP stands for Material Requirements Planning; MRPII refers to Manufacturing
Resource Planning, and ERP stands for Enterprise Resource Planning. MRP and MRPII systems are
predecessors of ERP systems, though MRP and MRPII are still used widely in manufacturing organizations.
Material Requirements Planning (MRP) systems help determine what raw materials to order for production,
when to order them, and how much to order. Manufacturing Resource Planning (MRPII) systems followed MRP
and added integration with finance and personnel resources.
Enterprise Resource Planning (ERP) takes integration further by including all the systems of the organization,
not just the manufacturing systems. 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. For example, a
salesperson takes an order and submits the order on paper to an order entry clerk, who prepares the invoice
and shipping documents. The shipping documents are delivered manually to the shipping department, and the
shipping department prepares the shipment and ships the order. The customers account is updated with the
receivable due. If the organization maintains customer relations management software, the order information
is entered separately into that database, so that if the customer calls about the order, the customer service
person will be able to discuss the order with knowledge, since the customer service person does not have
access to the accounting records.
The above is only a minor example, and it does not even include the communication needed with production
to make certain the product ordered will be available to ship. Entering the same information into multiple
systems causes duplication of effort and leaves the organization open to more input errors.
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, order fulfillment, and other purposes.
MRP, MRPII, and ERP all provide information for decision-making by means of a centralized database.
Material Requirements Planning (MRP)

Material requirements planning, or MRP, is an approach to inventory management that uses computer
software to help manage a manufacturing process. It is a system for ordering and scheduling of dependent
demand inventories.
Dependent demand is demand for items that are components, or subassemblies, used in the production of
a finished good. The demand for them is dependent upon the demand for the finished good.
MRP is a push-through inventory management system. In a push-through system, finished goods are
manufactured for inventory on the basis of demand forecasts. MRP makes it possible to have the needed
materials available when they are needed and where they are needed.
When demand forecasts are made by the sales group, 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, based upon information about inventory of each component
already on hand, vendor lead times and other parameters that are input into the software.
Once the quantities and the timing have been worked out, the required cash to pay for the parts can be
planned for. MRP can be used to reduce cash needed by the organization, which in turn improves profitability
and ROI. 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. Instead, MRP aims
to remedy this through careful planning and management.
Although MRP is a push inventory system, it can also be used in a demand-pull situation, if an unexpected
order is received, 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.
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.
A bill of materials for each finished product. The bill of materials gives all the materials, compo-
nents, and subassemblies required for each finished product.
The quantities of the materials, components, 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. Accurate records of inventory and its costs are necessary. Management accountants also need to
estimate setup costs and downtime costs for production runs. When setup cots are high, producing larger
batches and thus incurring larger inventory carrying costs actually saves cost because the number of setups
needed is reduced.
Manufacturing Resource Planning (MRPII)

Manufacturing Resource Planning (MRPII) is a successor to Material Requirements Planning. While MRP is
concerned mainly with raw materials for manufacturing, MRPIIs concerns are more extensive. MRPII
integrates information regarding the entire manufacturing process, including functions such as production
planning and scheduling, capacity requirement planning, job costing, financial management and forecasting,
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 firms 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.
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 companys 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 companys 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 products 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.
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.
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.
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
Cutting 3,000 3,003 (3)
Stitching 3,334 3,388 (54)
Hemming 5,000 4,543 457
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)
The long-term answer to the problem is to add capacity to the constraint (elevate the constraint).
However, in the short-term, the challenge is to exploit the constraint by maximizing the flow through the
constraintmaking sure that the hemming operation has no downtime during which they are waiting for
the prior processes to provide them with jackets to hem. To do that, the company needs to make sure
there is a small work-in-process inventory waiting to be hemmed at all times, without letting the inventory
stack up too much in front of the hemming process.
The Drum-Buffer-Rope system is one of the ways this can be achieved.
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, while at the same time, not allowing too much work to build up in the buffer.
In the long term, if the company wants to meet the full demand, it will need to either hire more hemming
employees and invest in equipment for them to use, or it will need to find some way to increase the speed
of the hemming process. 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. After analyzing
the costs of the two alternatives, management determines it will cost less to purchase the attachments for
the hemming machines in order to make better use of the 4,543 hours available with current employees
and equipment. With hemming requiring only 27 minutes per jacket, the time required for 10,000 jackets
will be 4,500 hours (10,000 jackets 27 minutes to hem one jacket 60 minutes per hour). Now, the
hours required for Hemming is decreased and we have:
Difference
Total Total Between
Cutting 3,000 3,003 (3)
Stitching 3,334 3,388 (54)
Hemming 4,500 4,543 (43)
The company now has the capability of manufacturing 10,000 jackets per month.
When the Theory of Constraints is applied to production, it is a technique that improves speed in manufactur-
ing by increasing throughput contribution margin while decreasing investments and decreasing
operating costs. Throughput (product produced and shipped) will be maximized, investments will be
minimized, and operating costs will be minimized. TOC helps reduce throughput time, or cycle time, and
therefore operating costs. And with TOC there is a lower overall level of inventory, so inventory investment is
decreased.
In TOC terms, investments equals the sum of costs in direct materials, work-in-process and finished goods
inventories; R&D; and costs of equipment and buildings. Inventory costs are limited to costs that are
strictly variable, called super-variable, and these are usually only direct materials. (Note: this does
not mean that absorption costing for external financial reporting purposes is done differently when TOC is
being used. It means only that inventory costs for internal TOC analysis purposes are different from inventory
costs for financial reporting purposes.)
Also for the purpose of using Theory of Constraints, operating costs are equal to all operating costs other
than direct materials or any other strictly variable costs incurred to earn throughput contribution margin. In
TOC, operating cost is defined as the cost of converting the inventory into throughput.
Thus, operating costs include salaries and wages, rent, utilities, depreciation, indirect materials and other
overhead costs. All of these operating costs are treated as period costs that are being expensed as incurred,
and they are not inventoried. Inventory for TOC includes only the direct material costs. (Again, this is not
reflected in absorption costing it is only for TOC management.) All employee costs are considered operating
costs, whether they are direct labor or indirect labor. Direct labor is not included in the calculation of
throughput contribution margin, and thus it is considered an operating cost.
When work is properly scheduled, the constraint will achieve its maximum performance without interruptions.
The material is released only as needed without building up unneeded material (inventory) at the non-
bottleneck resources. This enables the factory to achieve optimal performance.
Throughput is product produced and shipped.
Throughput time or manufacturing cycle time is the time that elapses between the receipt of a
customers order and the shipment of the order.
Throughput contribution margin is revenue minus direct materials cost for a given period of time.
Only strictly variable costs which are usually only direct materials are considered inventory
costs. All other costs, even direct labor, are considered operating, or fixed costs.
Theory of Constraints assumes that operating costs are fixed costs because they are difficult to
change in the short run.
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.
Some ways that operations at the constraint process can be relieved include:
Eliminate idle time at the constraint operation. For example, perhaps hiring an additional employee
to work at the constraint operation would increase throughput at the constraint by 2,000 units per
year at an annual cost of $40,000. If the throughput contribution margin (selling price minus direct
material cost per unit) is greater than $20 per unit ($40,000 2,000), this action would increase
profits.
Process only products that increase throughput contribution margin and do not produce products
that will simply remain in finished goods inventory. Making products that remain in inventory does
nothing to increase throughout contribution margin.
Move products that do not need to be processed on the constraint operation to other, non-
constrained machines or outsource them.
Reduce setup time and processing time at the constraint operation. If reducing setup time costs an
additional $10,000 per year but it enables the company to produce 500 additional units per year,
again, if the throughput contribution margin is greater than $20 per unit ($10,000 500), profits
will increase.
Improve the quality of processing at the constrained resource. Poor quality is more costly at a
constraint operation than at a non-constraint operation. A non-constraint operation has unused ca-
pacity, and no throughput contribution is forgone when it produces product that cannot be sold, so
the cost of the defective production is limited to the wasted materials. However, unsellable product
produced by the constraint operation costs more than just the cost of the materials that are wasted.
The cost of poor quality at a constraint also includes the opportunity cost of lost throughout contribu-
tion margin, because the constraint does not have any extra time to waste. 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. Units in production should
be inspected before they are passed on to the constraint operation for processing.
If these actions are successful in increasing the capacity of the constraint operation, its capacity will
eventually increase to the point where it exceeds the capacity of some other process; and so the other
process will become the constraint. The company then focuses its continuous improvement actions on
increasing the efficiency and capacity of the new constraint process, and so on.
Theory of Constraints Reports

A Theory of Constraints Report conveys throughput contribution margin and selected operating data.
It identifies each products throughput contribution margin per hour required for the constraint. It also
identifies the most profitable product(s) and enables monitoring to achieve maximum profitability given
existing constraints. By identifying the most profitable products, it can assist in making decisions about
product mix.
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. The contribution margin is the difference between total revenues
and total variable costs, and contribution margin per unit is simply the sale price for one unit minus the
total variable costs for one unit. The variable costs included in the calculation of the contribution margin
include direct materials, direct labor, variable overhead, and variable selling expenses.
However, in Theory of Constraints analysis, everything except for direct materials and any other totally
variable cost is considered an operating cost and thus a period cost. So the throughput contribution margin or
throughput contribution margin per unit in TOC analysis is the selling price minus only the totally
variable costs, as referred to in the above discussion of TOC analysis. The totally variable costs are usually
only the direct materials costs. This is called super-variable costing. As we said earlier, the assumption
is made that labor and overheads are fixed costs because they can usually not be changed in the short term.
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, you will need to calculate how many
units can be produced in that time. 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.
Example: Using the garment manufacturer again, lets say the manufacturer has two different styles of
jackets: a down-filled jacket for winter and a light jacket for spring. For both jackets, the constraint is the
hemming operation. The winter jacket sells for $125, and the direct materials cost is $75. The spring
jacket sells for $75, and the direct materials cost is $30. The hemming process takes 30 minutes for the
winter jacket and 25 minutes for the spring jacket. Demand for the winter jacket is 6,000 jackets per
month, whereas demand for the spring jacket is 8,000 jackets per month. The company has 4,543 hours
available for hemming. 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,
calculated using the time required in the constraint process.
Winter Jacket Spring Jacket

Price $125.00 $75.00
Direct Materials cost 75.00 30.00
Throughput contribution margin $ 50.00 $45.00
Constraint time for hemming 30.00 25.00
Throughput margin per minute $ 1.67 $ 1.80
The company should manufacture the 8,000 spring jackets needed before manufacturing any winter
jackets, because the spring jackets throughput margin per minute in the constrained resource is higher.
That will mean using 3,334 hemming hours for the 8,000 spring jackets (8,000 25 minutes per jacket
60 minutes per hour). That will leave 1,209 hemming hours available for the winter jackets (4,543 hours
available 3,334 hours used for the spring jackets). With those 1,209 hours, the company can manufac-
ture 2,418 winter jackets (1,209 hours 60 minutes per hour 30 minutes per jacket). That will
maximize the companys total contribution margin.
Example: Here is another use for the throughput contribution margin.
Our company has an opportunity to get a special order for 100,000 units. We have excess capacity
(unused direct labor and equipment), and we would really like to have this order. Because we have unused
capacity, we would not need to hire any additional employees to if we accept this order, and we would not
need to cut back on production of other orders for any reason. We are bidding against several other
companies, so we know in order to get this order, we must get the price down as low as possible. 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 $900,000 ($9 per unit), we will just cover our variable costs (direct materials
and direct labor). So we bid $900,000. To our amazement, however, we lose the bid to a company that bid
$750,000.
If we had bid $700,000, or $7 per unit, we would have gotten the job. We would have recovered our
materials costs and net operating income would have been $100,000 higher ($1 per unit 100,000 units).
We would not have covered our direct labor cost; but then, we were paying those people anyway. Even
though we did not have work for them without the special order, we had no plans to lay them off. So in
this situation, 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. Likewise, the fixed manufacturing costs are no
different whether we have the order or not.
To illustrate this incremental analysis, lets say our operating income looks like this without this special
order, assuming a selling price of $12 and a current volume of 1,000,000 units:
Sales revenue $12 1,000,000 $12,000,000

Variable costs:
Direct materials $6 1,000,000 6,000,000
Direct labor $3 1,000,000 3,000,000
Fixed overhead $2 1,000,000 2,000,000
Net operating income $ 1,000,000
If we had bid $700,000 and gotten the special order, operating income would have been as follows:
Sales revenue without special order $12 1,000,000 $12,000,000

Special order revenue $7 100,000 700,000
Total revenue $12,700,000
Variable costs:
Direct materials $6 1,100,000 6,600,000
Direct labor $3 1,000,000 3,000,000
Fixed overhead $2 1,000,000 2,000,000
Net operating income $ 1,100,000
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 would have gotten the job and
would have made $100,000 more in net operating income than we have without the job.
Next time, we will use the throughput contribution margin in preparing our bid.
The following information is for the next four questions: EEK Industries produces thingamajigs. The
thingamajigs sell for $200 per unit. The product goes through three processes. The processes, costs and
volumes are as follows:
Molding Heat Transfer Trimming

Direct labor required
per unit @ $25/hr. 0.5 hrs. (2 units/hr.) 0.25 hrs. (4 units/hr.) 0.5 hrs. (2 units/hr.)
Direct labor hours available
per day 225 hrs. 100 hrs. 200 hrs.
Direct materials $100 per unit $20 per unit $0 per unit
Annual fixed manu-
facturing overhead $1,000,000 $750,000 $250,000
Fixed selling and admin.
exp. (allocated according $428,571 $190,476 $380,953
to available DL hrs.)
Daily capacity in units based
on DL hrs. available 450 units 400 units 400 units
Annual capacity (260
working days per year) 117,000 units 104,000 units 104,000 units
Annual production & sales 104,000 units 104,000 units 104,000 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. The company can sell all it can produce.
Question 55: What is the throughput contribution per unit according to the theory of constraints?
a) $48.75
b) $80.00
c) $30.59
d) $29.52
Question 56: What is the throughput contribution per day?
a) $36,000
b) $19,500
c) $12,236
d) $32,000
Question 57: What are the annual operating costs?
a) $3,412,500
b) $1,000,000
c) $6,412,500
d) $5,412,500
(Continued)
Question 58: The Heat Transfer and Trimming processes are very labor-intensive. 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.
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.
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.
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.
(HOCK)
Question 59: Urban Blooms is a company that grows flowering plants and sells them in attractively
designed container arrangements to upscale hotels, restaurants and offices throughout the greater New
York City metropolitan area. When first established, the organization produced every aspect of its product
on site and handled all business functions from its facility, in either the greenhouses, production areas or
office. The only exception was importing expensive, large containers from Mexico. After five years in
business, Urban Blooms had become very profitable and increased its staff from 10 to 200 employees,
including horticulturalists, production/design workers, business managers and sales staff. However, the
owners found it increasingly difficult to keep up with the complexities and demands brought about by the
companys continuing growth. It became apparent that there were several areas that were not time- or
cost-effective for Urban Blooms, such as mixing its own potting soil for the plants and maintaining payroll
accounting. Urban Blooms contacted Hampshire Farms to create a special potting soil mix for their plants,
and hired Lindeman Associates to handle the companys payroll accounting requirements.
This process is referred to as:
a) Materials resource planning (MRP).
b) Activity-based costing (ABC).
c) Outsourcing.
d) Lean production.
(HOCK)
Capacity Level and Management Decisions

Estimates about plant production capacity, called denominator level capacity, are used for various purposes.
Earlier in this section under the topic of allocation of overhead cost to production, we discussed production
activity levels used in developing standards and the budget. We now need to talk about them in the context
of management decisions, particularly decisions about pricing, bidding, and product mix.
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. The capacity level used in making
decisions should meet the need for the purpose for which it will be used. Recall that the various choices of
capacity levels are:
1) Theoretical, or ideal capacity assumes the company will produce at its absolutely most efficient
level at all times, with no breaks and no downtime.
2) Practical capacity the most that a company can reasonably expect to produce in a years time.
This is the theoretical level reduced by allowances for idle time and downtime, but not for any possi-
ble decreases in sales demand.
3) Master budget capacity the amount of output actually expected during the budget period based
on expected demand.
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.
The level of plant capacity to use in decision-making is an important strategic decision that needs to be made
by management. In fact, that decision should really be made before any decisions are made about how much
plant capacity to provide. If the company needs to manufacture 15,000 units per year, then management
needs to determine how much it will cost per year to acquire the capacity to make those 15,000 units. Since
the capacity acquired will be the capacity needed for 15,000 units, 15,000 units is the companys practical
capacity (theoretical capacity is not attainable).
In the short run, the capacity and its cost are fixed. If the company does not use all of the capacity it has
available, the fixed costs of that capacity do not decrease the way variable costs do. If the cost to acquire and
maintain the capacity to make 15,000 units per year is $1,125,000 per year, then at a production level of
15,000 units, the fixed cost per unit is $75. However, if the company does not produce 15,000 units in a
given year but instead produces only 12,500 units, not all of the capacity supplied at $75 per unit will be
needed or used that year. The company will be paying for unused capacity. The fixed cost per unit produced
based on actual production would be $90 per unit ($1,125,000 12,500 units); but in reality, the fixed cost
per unit should not change just because the number of units manufactured changes. The real fixed cost per
unit manufactured is still $75 per unit; and the company has unused capacity cost of $187,500 for the
units not produced ($75 [15,000 12,500]) that it needs to absorb as an expense.
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, regardless of whether that volume is being
produced or not.
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, regardless of the companys usage of its available
capacity. Recall that practical capacity is the absolute most that the company can reasonably expect to
produce in a years time using the capacity it has. It is the theoretical capacity level reduced by allowances for
unavoidable interruptions such as shutdowns for holidays or scheduled maintenance, though not decreased
for any expected decrease in sales demand. Therefore, practical capacity is the best denominator level to use
in pricing and other management decisions.
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. Customers will not absorb it. They will take their business elsewhere.
That will result in even lower production and even greater fixed cost per unit, even higher prices, and even
lower sales. This is the dreaded downward demand spiral, and it can put a company out of business.
Customers expect a company to manage its unused capacity or else to bear the cost of it itself, not to pass it
along to them.
Since the use of practical capacity excludes the cost of the unused capacity from the per unit fixed cost, 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. If the
company does not need all of its capacity, management should make adjustments. It may be that the
companys unneeded capacity can be rented or sold. Or, 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. Highlighting the cost of the unused capacity enables
management to make strategic decisions for its use.
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). This means that the manufacturing overhead charged to the products was actually less than the
actual incurred manufacturing overhead. On the other hand, if the amount of manufacturing overhead applied
is greater than the amount actually incurred, the manufacturing overhead will be over-applied, meaning that
more manufacturing overhead was charged to the products than was incurred by the company.
At the end of the accounting period, variances that result from differences between the actual overhead
incurred and the overhead applied must be resolved as part of the closing activities. These variances may be
prorated among ending work-in-process inventory, ending finished goods inventory, and cost of goods sold
for the period according to the amount of overhead included in each that was allocated to the current periods
production. Or, the variances may be 100% closed out to cost of goods sold. A third approach (though not
often used) is to restate all amounts using actual cost allocation rates rather than the budgeted cost
application rates.
If a variance is closed out 100% to cost of goods sold, reported net income and inventory balances
will vary depending upon the activity level that was used to calculate the overhead application rate.
However, 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 periods production for each, reported net
income will be the same regardless of what activity level was used to calculate the fixed overhead
application rate. 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.
This will be demonstrated with an example.
Note: The pro-ration of under- or over-applied overhead should be done on the basis of the
overhead allocated to production during the current period only, not on the basis of the balances in
the inventories and cost of goods sold accounts at year end. Information on the amount of overhead
allocated to production during the current year should be available in the accounting system.
If variances are closed out 100% to cost of goods sold, the use of master budget capacity or normal capacity
will lead to higher net income than if theoretical or practical capacity is used. This will be true whether
actual overhead incurred is greater than overhead applied (i.e., overhead is under-applied) or whether
overhead incurred is less than overhead applied (i.e., overhead is over-applied).
The reason for this is that when master budget or normal capacity is used, 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. Therefore, more manufacturing overhead will be allocated to the products throughout the period than
it will be if theoretical or practical capacity is used. So, 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.
To explain: When a variance is closed out 100% to cost of goods sold, no adjustment is made to inventories
as part of the closing entries. So inventories under master budget or normal capacity will remain higher than
under the other methods. Since inventories are higher, cost of goods sold will be lower. 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.
However, 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, the choice of the denominator level for allocating manufacturing costs during the period will have no
effect on the end-of-period financial statements.
After the variances have been resolved and closed out for the period, 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. Under all of the capacity levels, net income and inventory balances will be same as if the actual
incurred overhead had been allocated to the years production.
But note that is will be true only when a variance is pro-rated among inventories and cost of goods sold. If a
variance is charged to cost of goods sold only, this is not true.
Comprehensive Example
In this example, 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.
Remember this example of RedHawks Co. from the topic of Overhead Allocation:
RedHawks Co. produces bookshelves for shipment to distributors. The fixed manufacturing overheads of
RedHawks for the coming year are expected to be $250,000. In a perfect situation, RedHawks has the
capacity to produce 40,000 bookshelves. During the current year, RedHawks produced 38,000 book-
shelves, which was the most in company history. Management thinks that this was attributable to a
performance bonus that was in place for management this year, but will not be given next year. For the 7
years prior to the current year, RedHawks produced an average of 34,000 bookshelves, with production
always between 32,500 and 35,500. For next year, the company expects to produce 36,000 bookshelves.
The CFO of RedHawks is trying to determine how much it will cost to produce each bookshelf. The CFO
knows to do this, the fixed manufacturing overhead must be included in each of the units.
Calculating the Predetermined Rate
If RedHawks uses theoretical capacity, the allocation rate for next year will be $6.25 per unit ($250,000
40,000 units).
If the fixed manufacturing overhead allocation rate is determined using the current years performance as
the practical capacity, the allocation rate will be $6.58 per unit ($250,000 38,000 units).
If the master budget capacity is used in calculating the predetermined rate, the allocation rate will be
$6.94 per unit ($250,000 36,000 units).
Finally, if they use what had been the normal capacity prior to the current year, the allocation rate would
be $7.35 ($250,000 34,000 units).
Allocation of Fixed Manufacturing Overhead Under the Traditional Method
Now lets move one year into the future. The year is now complete. RedHawks actually produced 35,750
units during the year. (Given the fact that we have no information about any other part of the process,
fixed overhead must be allocated per unit.) Under each of the four levels of capacity, a different amount of
fixed manufacturing overhead would have been allocated to the products. The allocation is made by
multiplying the actual number of units produced by the predetermined rate per unit.
Using theoretical capacity, RedHawks would have allocated $223,438 ($6.25 35,750 units) to the
units produced.
Using practical capacity, it would have allocated $235,235 ($6.58 35,750 units).
Using master budget capacity, it would have allocated $248,105 ($6.94 35,750 units).
Using normal capacity, it would have allocated $262,763 ($7.35 35,750 units).
Now, lets carry that same example further and show the effect of the use of each capacity level on fixed
overhead in the financial statements.
The price of each bookshelf unit is $125.
Variable costs, both planned and actually incurred, are $80 per unit.
Sales are 35,000 units.
Planned fixed overhead is $250,000.
Actual fixed overhead incurred is $255,000.
Actual production is 35,750 units.
Theoretical capacity is 40,000 units.
Practical capacity is 38,000 units.
Master budget capacity is 36,000 units.
Normal capacity is 34,000 units.
Beginning Inventories are zero, so we can do the pro-ration of the variance on the basis of the
ending balances in inventories.
Ending work-in-process inventory is zero, so the only Inventory account is Finished Goods Inventory.
Predetermined overhead rates under each of the capacities:

Master
Theoretical Practical Budget Normal
Planned Fixed OH $250,000 $250,000 $250,000 $250,000
Total units planned 40,000 38,000 36,000 34,000
FOH Application Rate $6.25/unit $6.58/unit $6.94/unit $7.35/unit
Amount of fixed overhead applied and variances for production of 35,750 units under each
capacity:
Master
FOH Application Rate (above) $6.25/unit $6.58/unit $6.94/unit $7.35/unit
Total units produced 35,750 35,750 35,750 35,750
Actual FOH Incurred $255,000 $255,000 $255,000 $255,000
Fixed Overhead Applied 223,438 235,235 248,105 262,763
FOH Variances $ 31,562 $ 19,765 $ 6,895 $ (7,763)
Notice that with all capacity levels except for Normal, the fixed overhead is under-applied. Using Normal
capacity, however, the fixed overhead is over-applied.
Here are the income statements for RedHawks Co. when Theoretical, Practical, 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
Sales: 35,000 units @ $125 $4,375,000 $4,375,000 $4,375,000 $4,375,000
Variable Cost: 35,000 @ $80 2,800,000 2,800,000 2,800,000 2,800,000
FOH applied to sold units:
35,000 @ FOH application rate 218,750 230,300 242,900 257,250
Total Preliminary COGS $3,018,750 $3,030,300 $3,042,900 $3,057,250
Preliminary Gross Profit $1,356,250 $1,344,700 $1,332,100 $1,317,750
G & A and Selling Costs 1,000,000 1,000,000 1,000,000 1,000,000
Preliminary Net
Operating Income $ 356,250 $ 344,700 $ 332,100 $ 317,750
Before the variances are resolved, net operating income is highest under Theoretical capacity and lowest
under Normal capacity. This will not be universally true. It is governed by the size of each capacity level,
because that affects the amount of overhead applied to each unit produced. However, in general, net
operating income will be higher under Theoretical and Practical capacities and lower under Master Budget and
Normal capacities.
Calculation of Fixed Overhead Variances:
Master
Actual FOH Costs Incurred $255,000 $255,000 $255,000 $255,000
FOH Application Rate $6.25/unit $6.58/unit $6.94/unit $7.35/unit
Applied Fixed Overhead:
In COGS:
35,000 FOH Application Rate $218,750 $230,300 $242,900 $257,250
In Inventory:
750 FOH Application Rate 4,688 4,935 5,205 5,513
Total Applied Fixed OH $223,438 $235,235 $248,105 $262,763
FOH Under (Over) Applied $ 31,562 $ 19,765 $ 6,895 $ (7,763)
Final Net Operating Income if the fixed overhead variance is closed out 100% to COGS:
Master
Sales: 35,000 units @ $125 $4,375,000 $4,375,000 $4,375,000 $4,375,000
Cost of Goods Sold:
Variable COGS: 35,000 @ $80 2,800,000 2,800,000 2,800,000 2,800,000
FOH applied during period to sold

units: 35,000 FOH application
rate 218,750 230,300 242,900 257,250
FOH Variance closed out to COGS 31,562 19,765 6,895 (7,763)
Total Final COGS $3,050,312 $3,050,065 $3,049,795 $3,049,487
Final Gross Profit $1,324,688 $1,324,935 $1,325,205 $1,325,513
Final Net Operating Income $ 324,688 $ 324,935 $ 325,205 $325,513
Note that the lowest final net operating income is reported when Theoretical capacity is used; and the highest
is reported when Normal capacity is used.
Final Net Operating Income if the fixed overhead variance is pro-rated between Inventory
and COGS:
Master
Sales: 35,000 units @ $125 $ 4,375,000 $ 4,375,000 $ 4,375,000 $ 4,375,000
Cost of Goods Sold:
Variable COGS: 35,000 units @ $80 2,800,000 2,800,000 2,800,000 2,800,000
FOH applied to sold units:
35,000 @ FOH application rate 218,750 230,300 242,900 257,250
FOH variance pro-rated to COGS

(see below for calculations) $ 30,900 $ 19,350 $ 6,750 $ (7,600)
Total COGS $3,049,650 $3,049,650 $3,049,650 $3,049,650
Gross Profit $1,325,350 $1,325,350 $1,325,350 $1,325,350
Final Net Operating Income $ 325,350 $ 325,350 $ 325,350 $ 325,350
Calculation of variance disposition when prorated between Inventory and COGS (see Total
Fixed Manufacturing Costs of Current Years Production in Cost of Goods Sold and in Inventory for fixed
overhead applied to Inventory and COGS and Total Fixed Overhead Applied):
Master
Variance to be prorated $31,562 $19,765 $ 6,895 $ (7,763)
Total FOH Applied $223,438 $235,235 $248,105 $262,763
Prorated to Inventory:
[31,562 223,438 [19,765 235,235 [6,895 248,105 [(7,763) 262,763
Variance Total FOH
4,688] 4,935] 5,205] 5,513]
Applied FOH Applied to
Inventory $ 662 $ 415 $ 145 $ (163)
Prorated to COGS:
[31,562 223,438 [19,765 235,235 [6,895 248,105 [(7,763) 262,763
Variance Total FOH
218,750] 230,300] 242,900] 257,250]
Applied FOH Applied to
COGS 30,900 19,350 6,750 (7,600)
Reconciliation:
Total Variance Prorated $ 31,562 $19,765 $ 6,895 $ (7,763)
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, net operating income is exactly the same under all
four capacities. Inventory balances have not been shown in this example, but they are exactly the same
under all four capacities, as well. That is because prorating the variances corrects for the differences in the
application rates used for each capacity.
When a firm prorates its overhead variances between inventories and cost of goods sold, it makes no
difference what capacity level the firm chooses to use to calculate the predetermined application rate for
manufacturing overhead. Net operating income under all capacity levels will be the same as if the actual rate
had been used.
However, when the variances are closed out 100% to cost of goods sold, distortions result. In this example,
net operating income is highest under Normal capacity and lowest under Theoretical capacity. If we had
shown Inventory balances, Inventory would also have been highest under Normal capacity and lowest under
Theoretical capacity. That is because in this example, the fixed overhead application rate is lowest under
Theoretical capacity and highest under Normal capacity. Because the variances are 100% closed out to cost
of goods sold only, no correction to Inventory balances takes place.
So, if the company closes out any of its variances at the end of the period to cost of goods sold only, its
choice of denominator level for standards and overhead allocation will make a difference in the net
income it will report.
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. It is also activities that result in higher quality or
lowered costs of a product or service.
The Value Chain and Competitive Advantage

Michael Porter, a leading authority on competitive advantage from Harvard Business School, introduced the
concept of the value chain in his 1985 book, Competitive Advantage.
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. The greater value may be in lower prices for
the same product or service; or it may be in offering greater benefits and service than its competitors do,
thereby justifying higher prices; or it may be offering greater benefits at the same or even at a lower price
than its competitors charge.
A company that has competitive advantage will be more profitable than the companies it competes with for
customers. The higher its profits are in comparison to its competitors, the greater its competitive advantage
will be. Competitive advantage leads to increased profitability; and greater profitability leads to increased
competitive advantage. Competitive advantage makes the difference between a company that succeeds and a
company that fails.
Competitive Increased
Advantage Profits
In order to have competitive advantage, a company must have or create two basic things:
1) Distinctive competencies and the superior efficiency, quality, innovation and customer responsive-
ness that result from them.
2) The profitability that is derived from the value customers place on its products, the price that it
charges for its products, and the costs of creating those products.
Note: A companys distinctive competencies are the things that it does better than the competition.
Remember the four things that result from a companys distinctive competencies and that give the
company competitive advantage:
Superior efficiency
Superior quality
Superior innovation
Superior customer responsiveness
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. Retailers create value by providing a range of products to customers in a way that is
convenient, sometimes supported by services such as fitting rooms or personal shopper advice. In service
businesses, value is created when people use inputs of time, knowledge, equipment and systems to create
services of value to their customers.
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. All of an organizations functions play a role in lowering the cost structure and increasing the
perceived value of products and services through differentiation. The creation of value involves functions from
R&D through production to marketing and sales, and on to customer service, and includes all the activities
that play supporting roles.
The value chain describes the companys chain of activities for transforming inputs into the outputs that
customers will value. This process of transformation includes all of the primary activities (business
functions) that add value to the product or service, as well as support activities as shown below.
It is the chronological sequence of these activities that adds value to the customer.
Primary Value Chain Activities

The primary value chain activities involve design, creation, marketing and delivery of the companys product
or service and support and service after the sale. Primary activities are Research & Development, Production,
Marketing and Sales, and Customer Service.
Research is the search for knowledge that can be used to create new or improved products, ser-
vices or processes. Development uses those research findings in the planning process to improve
these products, processes or services, which the company intends to sell or use internally. Design is
the detailed planning and engineering for these efforts.
Production is the acquisition of raw materials, coordination and assembly required to produce a
product or deliver a service. The costs of production include direct materials, direct labor and factory
overhead (inventoriable costs).
Marketing and sales includes advertising, promotion and sales activities. Distribution, or delivery
of products or services to customers, is also a part of marketing.
Customer service includes customer support and warranty services after a sale.
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. Some examples are given
below in the topic Value Chain Analysis.
The actual activities in a companys value chain will depend on the type of business the company is in. In a
service industry, the focus will be on marketing, sales and customer service rather than on manufacturing and
raw materials. The analysis should take place at a relatively detailed level of operations, at the level of
processes that are just large enough to be managed as separate business activities.
Support Value Chain Activities

The support activities provide inputs that make it possible for the primary activities to take place.
Infrastructure refers to the companys support systems that enable it to maintain its day-to-day
activities. Infrastructure includes functions such as accounting, legal, administrative, and general
management. The infrastructure also includes the organizational structure, the organizations control
systems, and its culture. Through strong leadership, top management can shape the companys in-
frastructure and thus the performance of all the other value creation activities that go on within the
company.
Information systems are the electronic systems for maintaining records of inventory, sales, prices,
and customer service. For example, 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. Staying current with technological advances and maintaining
technical systems excellence are other sources of value creation.
Materials management is logistics. The logistics function manages the movement of physical
materials through the value chain. Materials management controls procurement as well as move-
ment of the procured materials through production and distribution. Procurement includes finding
vendors and negotiating the best prices. Efficiency in the materials management can significantly
lower costs, thus creating value. For example, by controlling the flow of goods from suppliers into its
stores and ultimately to the consumer, a retailer can eliminate the need to carry large inventories of
goods. 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. The human resources func-
tion also ensures that the people are properly trained, motivated and compensated. An effective
human resources function leads to greater employee productivity, which lowers costs. A competent
staff performs excellent customer service, which increases value to the customer.
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, the more the people who are its customers will be willing to pay for the
product and service, and the more they will be likely to keep on buying.
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. Value chain analysis identifies the steps or activities that do
and do not increase the value to the customers. Once those areas are identified, the organization can
maximize the value by increasing the related benefits or reducing (even eliminating) non-value-adding
activities.
The resulting increase in value to the customer and/or decrease in production costs will make the company
more profitable and competitive.
The firm should analyze each step in its operations carefully to determine how each activity contributes to the
companys profits and its competitiveness. The goal of value chain analysis is to provide maximum value to
the customer for the minimum possible cost.
For internal decision-making to achieve the goal of providing maximum value at minimum cost, value chain
financial statements may be utilized. In value chain financial statements, 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, product design, marketing and sales, customer
service) would be inventoriable costs in value chain financial statements. Value chain financial statements do
not conform to any Generally Accepted Accounting Principles, so their use is limited to internal decision-
making.
Steps in Value Chain Analysis

There are three steps in value chain analysis:
1) Identify the activities that add value to the finished product. These activities depend upon the
industry and what the company does (manufacturing, resale, service). They will be whatever activi-
ties this firm and firms in its industry perform in the processes of designing a product or service,
manufacturing the product, marketing it and providing customer service after the sale.
2) Identify the cost driver or cost drivers for each activity, and
3) Develop a competitive advantage by adding value to the customer or reducing the costs of the
activity. For example:
R&D can add value to established products or services by finding ways to improve them, in addi-
tion to developing new ones.
Productions function is to acquire the necessary raw materials and assemble them into finished
goods. By doing this efficiently, high quality products can be manufactured while costs are low-
ered, leading to higher profits.
Marketing adds value by informing customers about the products or services, which may in-
crease the utility that customers attribute to the product or service and enable the company to
charge a higher price. 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.
Customer service after the sale adds value by delighting customers with the responsive service
received, thus creating superior value for them. Increased utility for customers because of excel-
lent customer service can also enable the company to charge more for its products.
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 main concept in this type of value chain analysis is that each firm
occupies a selected part or parts of the entire value chain. Which part or parts of the value chain to
occupy is determined by comparative advantage of the individual firm, or where the firm can best provide
value at the lowest possible cost. Some firms manufacture parts that they sell to other firms, who take those
parts and put them together to manufacture another product entirely. Then those products may be sold to a
wholesaler, who sells them to a retailer, who sells them to the ultimate consumer. Each of these manufactur-
ers, sellers and resellers occupies a place in the value chain.
Question 60: The primary activities or business functions that are considered in the value chain include:
a) Customer service, production, marketing and sales, and human resources.
b) Customer service, production, marketing and sales, and information systems.
c) Infrastructure, human resources, materials management, and R&D.
d) Customer service, production, marketing and sales, and R&D.
(HOCK)
Question 61: An outside consultant has been hired by a manufacturing firm to evaluate each of the firms
major products beginning with the design of the products and continuing through the manufacture,
warehousing, distribution, sale and service. The consultant has also been requested to compare the
manufacturers major products with firms that are manufacturing and marketing the same or similar
products. The consultant is to identify where customer value can be increased, where costs can be
reduced, and to provide a better understanding of the linkages with customers, suppliers, and other firms
in the industry. 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.
b) Benchmarking analysis.
c) SWOT (strengths, weaknesses, opportunities, threats) analysis.
d) Value-chain analysis.
(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 also
activities that result in higher quality or lowered costs of a product or service.
For an insurance company, settling a claim is a business process. For just about any company, fulfilling a
customers order is a business process. Though manufacturing is a process, it is really a sub-process of order
fulfillment something that must take place in order to fulfill an order. 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.
Any process has inputs and it has outputs. Inputs are materials, labor, energy, and capital equipment. The
process transforms the inputs into outputs that have value to the customer. In classic economics terms,
inputs are economic resources such as land, labor and capital. The output of a process may be a manufac-
tured product, or it may be a service provided.
The challenge to a business is to make its processes work effectively and efficiently, in order to accomplish
the most possible with the least waste. Process analysis is used to understand the activities included in a
process and how they are related to each other. A process analysis is a step-by-step breakdown of the phases
of the process that conveys the inputs, outputs, and operations that take place during each phase of the
process. A process analysis is used to improve understanding of how the process operates. The process
analysis usually involves developing a process flowchart, illustrating the various activities and their
interrelationships.
Once a process has been analyzed, the information gained from the analysis can be used to make operating
decisions. Sometimes a process needs improvement, such as eliminating waste or increasing operating
efficiency, but sometimes the process needs to be completely reengineered.
Business Process Reengineering

Reengineering originally referred to the practice of disassembling a product in order to redesign it, but it more
recently applies to restructuring of organizational processes that is brought about by rapidly changing
technology and todays competitive economy. For instance, instead of simply using computers to automate an
outdated process, technological advances bring opportunities to fundamentally change the process itself. In
applying the concept of business process reengineering, management starts with a clean sheet of paper
and redesigns processes to accomplish its objectives. Operations that have become obsolete are discarded.
The philosophy of reengineering business processes was set forth by Michael Hammer and James Champy in
their book, Reengineering the Corporation: A Manifesto for Business Revolution. 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. Specialization in work assignments and the concept of division of labor that was
introduced back then brought about major productivity gains. Productivity increased immensely because
workers doing the same things over and over again became very adept at doing those things, and their speed
increased tremendously. Furthermore, it saved the time that was required for a worker to move from one
task to the next task. The assembly line model worked very well in the 1900s.
However, the authors say that because the world has changed since then, companies operated on the same
model no longer perform well. The underlying problem, they say, is fragmented processes. This includes
not only manufacturing but other businesses processes as well, such as order fulfillment, purchasing and
customer service.
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. Although this is modeled on the
assembly line that worked so well in the past century, 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 fact, because it wastes time, it inhibits the corporations ability to respond to
customers needs in a timely manner.
Business process reengineering involves analyzing and radically redesigning the workflow. Radical redesign
means throwing out the old procedures and inventing new ways of getting the work done. Reengineering is
not about making incremental improvements but it is about making quantum leaps.
Hammer and Champy recommend that in reengineering, the work should be organized around outcomes, not
tasks. In other words, think about what you want to accomplish, then think of ways to accomplish it rather
than thinking of tasks to be done.
The processes in the organization should first be identified, then they should be prioritized for reengineering
according to three criteria: (1) which processes are the most dysfunctional, (2) which will have the greatest
impact on customers, and (3) for which ones reengineering is most feasible.
They emphasize the use of technology: not to make old processes work better, but to break the rules and
create new ways of working. One of the primary rules in the use of technology is that information should be
captured only once, and it should appear simultaneously every place it is needed. If someone is taking
information from one system and inputting it into another, that is a process that is broken and needs to be
reengineered.
People within the organization involved in reengineering typically include:
A reengineering leader who makes a particular reengineering project happen.
The process owner, or the manager with specific responsibility for the process being reengineered.
The reengineering team, a group of people who diagnose the current process and oversee its rede-
sign and implementation of the redesign.
A reengineering steering committee, a group of senior managers who determine the organizations
overall reengineering strategy and oversee it.
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 companys various
reengineering projects.
The reengineering process begins with the customer, not with the companys 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.
Frequently, the answer to the question is that there are more effective ways to organize the companys value-
chain activities. For example, several different people in different areas might be passing work from person to
person to perform a business process. Instead, the same process might be able to be performed by one
person or one group of people all working closely together, at lower cost. Individual job assignments might
become more complex and thus more challenging, and the grouping of people into cross-functional teams can
both reduce costs and increase quality.
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, quality management takes over and
focuses on continued improvement and refinement of the new process.
Furthermore, internal controls for the reengineered process must not be neglected. When a process is
reengineered, its internal controls must be reengineered, as well. If existing internal controls are disassem-
bled and not replaced with new ones, the process will be without any controls.
Benchmarking Process Performance

One of the best ways to develop the distinctive competencies that lead to superior efficiency, superior
quality, superior innovation, and superior responsiveness to customers, all of which confer
competitive advantage to a firm, is to identify and adopt best practices. Best practices can be
accomplished through benchmarking.
A benchmark is a standard of performance; and benchmarking is the process of measuring the organization
against the products, practices and services of some of its most efficient global competitors or against those
of other segments of the firm. The company can use these standards, also called best practices, as a target
or model for its own operations. Through the application of research and sophisticated software analysis tools,
companies undertake best practice analysis and then implement improvements in the firms processes
match or beat the benchmark. The improvements could include cutting costs, increasing output, improving
quality, and anything else that will aid the firm in achieving its strategic business goals and objectives.
Benchmarking continuously strives to emulate (imitate) the performance of the best companies in the world
or the best units in the firm, and through meeting these higher standards, the organization may be able to
create a competitive advantage over its marketplace competitors. The benchmarked company does not
need to be in the same industry as the company that is trying to improve its performance.
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. Critical success factors are the aspects of the companys performance
that are essential to its competitive advantage and therefore to its success. Each companys critical success
factors depend upon the type of competition it faces.
After identifying its critical success factors, a team is set up to do best practice analysis. Best practice
analysis involves investigating and documenting what the best practices are for the processes that are used
in performing the firms critical success factor activities. The team members should be from different areas of
the business and have different skills. The team will need to identify what areas need improvement and how
they will accomplish this by utilizing the experience of the benchmarked company.
Certain companies are generally recognized as leaders in specific areas. Some examples are Nordstrom for
retailing, Ritz-Carlton Hotels for service, and Apple Computer for innovation. The American Productivity and
Quality Center (www.apqc.org), a non-profit organization, is a resource for companies that want to do
benchmarking. APQC is one of the worlds leading proponents of business process and performance
improvement. It maintains a large benchmarking database and offers firms several ways to participate in
benchmarking and to access benchmarking information.
Activity-Based Management (ABM)

Activity-based management (ABM) is closely related to and draws upon data from activity-based costing.
As we saw in the previous section on costing, activity-based costing uses activity analysis to develop detailed
information about the specific activities the company uses to perform its operations. Activity-based costing
improves tracing of costs to products and can even be used to trace costs to individual customers.
However, activity-based costing data is not just useful for costing. Activity-based management, drawing on
activity-based costing data, is a means of performing value chain analysis and business process reengineer-
ing. Activity-based management uses activity analysis and activity-based costing data to improve the value
of the companys products and services and to increase the companys competitiveness.
Activity-based management is divided into operational ABM and strategic ABM.
Operational ABM uses ABC data to improve efficiency. The goal is for activities that add value to the
product to be identified and improved, while activities that do not add value are reduced in order to cut costs
without reducing the value of the product or service.
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. Because ABC costs can also be traced to
individual customers, 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.
The Concept of Kaizen

The term kaizen is a Japanese word that means improvement. As used in business, it implies continuous
improvement, or slow but constant incremental improvements being made in all areas of business
operations. Small-scale improvements are considered to be less risky than a major overhaul of a system or
process. The slow accumulation of small developments in quality and efficiency can, over time, lead to very
high quality and very low costs. Kaizen needs to be a part of the corporate culture. It requires conscious
effort to think about ways that tasks could be done better. This can be difficult to maintain and takes years to
show results, but if done properly, it confers a sustained competitive advantage.
Kaizen principles can also be used for a blitz, in which substantial resources are committed to a focused,
short-term project to improve a process. A blitz usually involves analysis, design, and reengineering of a
product line or area. The results can be immediate and dramatic.
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.
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. The
market determines the target price, and the company must attain the target cost in order to realize its
desired profit margin for the product. The ideal standard is thus defined as the target cost, or the standard
cost that will enable the company to attain its desired cost and desired profit margin. Using kaizen principles,
the company figures out how it can manufacture the product for the target cost. 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.
Implementing ideal standards and quality improvements is the heart of the kaizen concept. Kaizen challenges
people to imagine the ideal condition and strive to make the necessary improvements to achieve that ideal.
Organizations can also apply kaizen principles to the budgeting process. Because kaizen anticipates
continuous improvements in the production process, a budget developed on kaizen principles will incorporate
planned improvements, resulting in decreasing costs of production over the budget period.
Note: Kaizen is the Japanese term for improvement and it is used in business to mean continuous
improvement.
The Costs of Quality

Management will also be closely interested in the cost of quality. The cost of quality includes not only the
cost of producing quality products, but it is also the cost of not producing quality products. Over the long
term, not producing a quality product is more expensive because it means that the company will lose
customers.
There are four different costs of quality and they are classified into two larger categories, which are the costs
of conformance and the costs of nonconformance. There are two subcategories of costs within each of
these two larger categories.
The costs of conformance are the costs to produce a quality product, and they can be broken down into
prevention costs and appraisal costs. The costs of non-conformance are the costs of not producing a
quality product, and they can be broken down into internal failure costs and external failure costs.
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 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. Prevention costs include:
Engineering (design and process) costs, so the design of the product is not defective and the
process for manufacturing it produces a quality product;
Quality training, both internal programs and external training to teach employees proper manu-
facturing procedures, proper delivery procedures, and proper customer service procedures,
including salaries and wages for employee time spent in training;
Preventive maintenance on production equipment so an equipment failure does not cause a qual-
ity failure;
Supplier selection and evaluation costs to ensure that materials and services received meet es-
tablished quality standards, and costs to train suppliers to conform to the firms requirements;
Evaluation and testing of materials received from a new supplier to confirm their conformance to
the companys standards;
Information systems costs to develop systems for measuring, auditing and reporting of data on
quality; and
Planning and execution costs of quality improvement programs such as Six Sigma or Total Quali-
ty Management.
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. These are the costs of:
Costs to test and inspect manufacturing equipment, raw materials received, work-in-process and
finished goods inventories;
Cost for equipment and instruments to be used in testing and inspecting manufacturing equip-
ment, raw materials, work-in-process and finished goods inventories; and
Costs for quality audits.
Costs of Nonconformance
Nonconformance costs are those costs that are incurred after a defective product has already been produced.
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. The costs
associated with this are:
Cost of spoilage and scrap;
Costs (materials, labor and overhead) to rework and reinspect spoiled units;
Tooling changes and the downtime required to do the tooling changes to correct a defective
product;
Machine repairs due to breakdowns;
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;
Lost contribution margin due to reduction of output caused by spending time correcting defective
units; and
Expediting costs - The cost of rushing to re-perform and complete an order in time because of a
failure to complete it correctly the first time.
2) External failure occurs when we do not detect the defect until the product is already with the
consumer. The costs of this are:
Customer service costs of handling customer complaints and returns;
Warranty costs to repair or replace failed products that are returned;
Product recall and product liability costs, including settlements of legal actions;
Public relations costs to restore the companys reputation after a high-profile external failure;
Sales returns and allowances due to defects;
Lost contribution margin on sales lost because of the loss of customer goodwill; and
Environmental costs such as fines and unplanned cleanup fees caused by a failure to comply with
environmental regulations.
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.
Opportunity Costs of Quality

The nonconformance costs include opportunity costs associated with poor quality. An opportunity cost is
the benefit of the next best use of the resource that was lost.
There are several ways in which a company can generate opportunity costs because of defective products it
produces.
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. If the product is repaired, the company must spend
time and pay people to fix or replace the defective parts. 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, and the replacement parts used could have been used in new products in-
stead. If the whole product is replaced, the products used to replace the defective ones are products
that could have been sold, but instead they will not generate any revenue even though their produc-
tion creates costs.
It will need to provide more customer service after the sale, so it will need to pay more customer
service employees. 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 will lose future sales because it will gain a reputation of supplying poor quality products. The lost
future sales represent lost profits. Here, the lost resource is the cash profits that could have been
earned from the lost sales. If the company had that cash, it could invest it and earn more future
profits with it.
There is another opportunity cost associated with poor quality management, and it concerns design
quality failures. Costs of design quality are costs to prevent poor quality of design or costs that
arise as a result of poor quality of design. Design quality failure costs include the costs of designing,
producing, marketing and distributing a poorly designed product as well as costs to provide service
after the sale for it. In addition, design quality failures can cause lost sales because the product is
not what customers really want. Design quality failures can be a significant component of design
quality costs.
Note: It is interesting to note that in manufacturing, it is often said that the main causes for quality
problems are the Four Ms: machines, materials, methods and manpower.
Calculating the Costs of Quality

The costs of quality (conformance and nonconformance) can be quantified and documented on a cost of
quality (COQ) report. A cost of quality report shows the financial impact of implementing processes for
prevention and appraisal and for responding to internal and external failures.
Activity-based costing simplifies preparation of a COQ report, because an ABC system identifies costs with
activities. 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, because traditional costing
systems accumulate costs according to function (such as production or administration), rather than according
to activities. Additional analysis is required with traditional costing to locate and segregate the costs of
quality.
Various formats can be used to report the costs of quality. The format used should depend on how
management wants to see it reported. Usually such a report would be done separately for each product or
product line. Here is one example of a cost of quality report in a spreadsheet format:
A B C D E F
1 Cost of Quality Widgets - 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 $ 34,320
5 Process engineering $60 per hour 528 hours 31,680
6 Training $55 per hour 160 hours 8,800
7 Supplier selection/evaluation $40 per hour 88 hours 3,520
8 Testing of materials $25 per hour 352 hours 8,800
9 Total prevention costs $ 87,120
10
11 Appraisal costs:
12 Inspection of manufacturing equipment $35 per hour 352 hours $ 12,320
13 Inspection of raw materials $30 per hour 176 hours 5,280
14 Inspection of work-in-process $30 per hour 528 hours 15,840
15 Inspection of finished goods $30 per hour 176 hours 5,280
16 Total appraisal costs $ 38,720
17
18 Internal failure costs:
19 Cost of spoilage $75 per def. unit 50 def. units $ 3,750
20 Cost of rework $95 per rewkd. unit 80 rewkd. units 7,600
21 Est. lost contribution margin due to rework $60 per rewkd. unit 80 Rewkd. units 4,800
22 Total internal failure costs $ 16,150
23
24 External failure costs:
25 Customer service-complaints & returns $35 per hour 176 hours $ 6,160
26 Warranty costs $110 per def. unit 35 def. units 3,850
27 Estimated product liability costs $25 per unit mfd. 3,300 Units mfd. 82,500
28 Contribution margin on estimated lost sales $230 per unit lost 300 Est. lost sls. 69,000
29 Total external failure costs $161,510
30
31 Total costs of quality $303,500
Total Quality Management (TQM)

TQM describes an approach that is committed to customer satisfaction and continuous improvement of
products or services. The basic premise of TQM is that quality improvement is a way of increasing revenues
and decreasing costs. As such, a company should always strive for improvement in performing its job and
producing its product correctly the first time. Total Quality Management is a prevention technique. The
costs of implementing a TQM program are classified on a Cost of Quality Report as prevention costs.
At the heart of TQM is the definition of what quality is. Quality can mean different things to different people.
For a customer it is a product that meets expectations and performs as it is supposed to for a reasonable
price. For a production manager it is a product that is within the required specification. When a company is
considering quality, it must be certain to include all of these different perspectives of quality from all of the
involved parties.
Total quality management programs are often developed to implement an overall low-cost or a differentiation
business strategy, because TQMs goals are to both reduce costs and improve quality. Approximately 90% of
manufacturing companies and 70% of service businesses have put into practice some form of a TQM
program, but success or failure revolves around involvement and leadership of senior management. A TQM
program requires a change in corporate culture by eliminating faulty processes, empowering employees and
creating teamwork that focuses on quality.
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, which leads to lower costs
Quick adaptation and flexibility in response to the shifting requirements of customers
Certain core principles, or critical factors, 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. For it to be successful, the entire organization must strive to this end. This
leads to the continued pursuit of excellence throughout the organization.
Part of this pursuit of excellence is a focus on continuing education. 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. In a TQM system, it is important to remember
that people within the organization are also customers. Every department, process or person is at some
point a customer and at some point a supplier.
Another feature of TQM is quality circles. 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. This
form of communication is vital to a successful TQM program.
In TQM, the role of quality manager is not limited to a special department; instead, every person in the
organization is responsible for finding errors and correcting any problems as soon as possible.
To achieve total quality management, the company must identify the relevant quality problems when
and/or where they occur, and then use some of the following, or similar, methods to analyze them.
Statistical Quality Control (SQC)

Statistical quality control (SQC), or statistical process control (SPC), is a method of determining whether a
process is in control or out of control. Some variations in quality are expected, but if too many units are
tested and found to be outside the acceptable range, the process may not be in control. A control chart is
used to record observations of an operation taken at regular intervals. This sample is used to determine
whether all the observations fall within the specified range for the operation, and the intervals are measurable
in time, batches, production runs or any other method of delineating an operation.
When statistics are used in determining the acceptable range, the control chart is a statistical control chart.
For example, the acceptable range might be plus or minus two standard deviations from the mean. If no
sample falls outside the limit of two standard deviations, the process is in statistical control, as long as all
the samples are randomly distributed with no apparent patterns, and if the numbers of observations that are
above and below the center of the specified range are about equal. If there are trends, clusters, or many
measurements near the limits, the process may be out of control even though all of the observations are
within two standard deviations of the mean.
Below is an example of a statistical control chart showing that all observations are within two standard
deviations of the mean, with no trends, no clusters, nor many measurements near the limits. For a company
that considers two standard deviations to be acceptable, this process is in control.
+3
+2
+1
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, or if they indicated a trend going one way or another, or if several observations were clustered
together near the 2 standard deviations, the process might not be in control.
Histograms
A histogram is a bar graph that represents the frequency of events in a set of data. Patterns that may not be
apparent when just looking at a set of numbers become clear in a histogram, which can pinpoint most of the
problem areas. For instance, if a particular production line is experiencing most of the difficulty, a histogram
can help determine what types of problems are causing the problems most often. Here is an example of a
histogram for a manufacturer of wood bookcases. The company has evaluated the various types of problems
that occur in the manufacturing process, and the most frequent problems are:
Wood cracked, 15 out of 100 defective units
Trim not attached correctly, 19 out of 100 defective units
Uneven stain, 38 out of 100 defective units
Shelves out of alignment, 21 out of 100 defective units
Shelf/shelves missing, 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
0
Wood Trim not Uneven Shelves out Shelf or
cracked attached stain of shelves
corrrectly alignment missing
Pareto Diagrams
A Pareto diagram is a specific type of histogram. Vilfredo Pareto, a 19th-century Italian economist, came up
with the now well-known 80-20 observation, or Pareto principle. We know it as 20% of the population
causes 80% of the problems; or 20% of the population is doing 80% of all the good things. After
management pinpoints which 20% of the causes are accounting for 80% of the problems, it can focus efforts
on improving the areas that are likely to have the greatest overall impact.
In addition to showing the frequency of the causes for the quality problems with bookcases, a Pareto diagram
puts them in order from the most frequent to the least frequent. Furthermore, it adds a curve to the graph
showing the cumulative number of causes, going from the most frequent to the least frequent.
Here is an example of a Pareto diagram for the manufacturer of wood bookcases.
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.
The histogram and the Pareto chart show graphically that uneven stain is the most frequently occurring
manufacturing problem. 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, the next step is to identify the cause or causes
of each quality problem.
Cause-and-Effect (Ishikawa) Diagram

A cause-and-effect diagram, or Ishikawa, diagram, organizes causes and effects visually to sort out root
causes and identify relationships between causes. This idea was identified by Karou Ishikawa, who noted that
it is often difficult to trace the many causes leading to a single problem. Ishikawa developed a way of
diagramming the relationships to better trace them. An Ishikawa diagram consists of a spine, ribs and bones,
so it is also called a fishbone diagram. The end of the spine is the quality problem; the spine itself connects
the main causes, the ribs to the effect, the quality problem.
Ishikawa Diagram
Usually, causes of problems in manufacturing fall into the following categories, referred to as the 4Ms:
Machines
Materials
Methods
Manpower
Operating personnel and management hold a series of meetings, called brainstorming sessions, in which
they attempt to figure out what is causing the problems with uneven stain on bookcases, using the 4Ms. They
find the following:
Machines:
No equipment is used. The stain and protective coating are applied by hand.
Materials:
Wood: Maple, a hardwood, is used in bookcase construction. Although hardwoods should absorb stains
evenly, maple sometimes does not. A wood conditioner used before the stain would alleviate this problem,
but management has not wanted the additional cost.
The maple sometimes is received from the lumberyard with machine marks in it that cause the stain to be
absorbed differently.
Methods:
The stain is applied with a brush. The more pressure is put on the brush, the more stain is applied to the
wood. If the pressure is not kept consistent, the stain will have variations in color. After the stain has been
applied, it is wiped off. The longer the stain is left on, the darker the resulting color. If the employee does not
work quickly enough, the color on the bookcase will be lighter in the first areas wiped off and darker in the
last areas wiped off.
Manpower:
The maple is inspected before it is made into bookcases. If boards with machine marks are not caught in this
inspection and are not pulled from production, there is little that can be done at the staining point to prevent
a poor stain job. Recently, a lot of those boards have been missed in the inspection.
The employees do not always keep a consistent pressure while applying the stain, and they do not always get
the color wiped off quickly enough. Both of these things are causing variations in the color. Some of the
employees are inexperienced, and some are simply not following procedures.
Following the brainstorming sessions, 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. The company may decide to use a spray-on stain that is easier to apply; 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; may increase employee training programs in both the staining department and in the wood inspection
department; and may even look into automating portions of the process.
Total Quality Management and Activity-Based Management

Activity-based management principles are widely used to recommend process performance improve-
ments. They are applied to help companies make better strategic decisions, enhance operating performance,
reduce costs, and benchmark performance. 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.
A total quality management system is most compatible with an ABC system because the ABC system
makes the costs of quality more apparent. A firm with a good ABC system only needs to modify it to identify
costs and activities relating to costs of quality. A company that utilizes ABC will also be continuously
identifying activities that can be eliminated, as well as ensuring that necessary activities are carried out
efficiently.
Unnecessary and inefficient activities are non-value-adding activities, and the cost drivers of those
activities need to be reduced or eliminated. Activity to rework defective products is a non-value-adding
activity and thus needs to be reduced or eliminated. On the other hand, the company needs to carry out the
value-adding activities as efficiently as possible. A focus on TQM and its central tenet of continuous
improvement will lead to achieving both of these goals.
ISO 9000
The International Organization of Standardization introduced the ISO 9000 quality assurance standards.
These standards do not have the force of law, but have been adopted by the EU. This means that if a
company fails to obtain these standards, it runs the risk of losing business due to perceived lack of quality.
The standards are not set to assure the quality of an individual product, but to assure that the
quality is the same throughout all of the companys product of that type.
Note: Adherence to (following) design specifications is one of the most important components of quality
control. ISO standards do not address that.
Quality Management and Productivity

At first glance, it may seem that as a companys commitment to quality increases, the productivity of the
company will decrease. Since productivity is measured as the level of output given an amount of input, it
would seem that by allocating resources to quality and spending resources in the quality process, there would
be fewer outputs for the level of inputs.
This, however, is not the case. In fact, as a companys commitment to quality increases, productivity also
increases. There are a number of reasons for this, including:
A reduction in the number of defective units. This in turn reduces the amount of time, material
and effort wasted on unusable output as well as time spent fixing salvageable defective units. (There
is a term called the hidden factory that refers to the time and effort spent on rework and repair.)
A more efficient manufacturing process. By looking from a quality production standpoint, the
company may remove or change inefficient, unproductive or non-value-adding activities.
A commitment to doing it right the first time. This is related to the first item, but as the culture
in the company focuses on doing it right the first time, the employees of the company can take a
more conscientious approach to their work, and this may lead to greater productivity.
No matter the cause, the relationship between quality and productivity is a positive one the more attention
paid to quality, the higher the levels of production.
Other Quality Related Issues

With the development of a good TQM system, a company can also manage its time better and become more
productive. In todays environment, it is ever more important to become the first company to get a new
product or service to the marketplace. This is seen in the need to have shorter product development time
and shorter response times to changes in demand or the market.
Customer-response time, or cycle time, is the measurement of the length of time between the order by
the customer and the receipt of the product by the customer. The components of cycle time are order
receipt time (from receipt of order until we are ready to produce it), manufacturing cycle time (from
readiness to produce to completion of the product), and order delivery time.
Question 62: Of these statements, which is not relevant to the overall benchmarking process?
a) Management determines what processes the company uses to convert materials, capital and labor
into value-adding products.
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.
c) Target costing utilizes kaizen to reduce costs in order to attain a desired profit margin.
d) Management puts into place a program to measure the organization against the products, practices
and services of the most efficient competitors in its marketplace.
(HOCK)
Question 63: Which of the following is not an objective of a companys TQM program?
a) To examine issues relating to creating value for the companys customers.
b) To understand the companys capacity for innovation.
c) To evaluate environmental issues that may affect the companys profitability.
d) To utilize computers in product development, analysis and design modifications.
(HOCK)
Question 64: The cost of scrap, rework and tooling changes in a product quality cost system are
categorized as a(n):
a) External failure cost.
b) Training cost.
c) Prevention cost.
d) Internal failure cost.
(CMA Adapted)
Question 65: Listed below are selected line items from the Cost of Quality Report for Watson Products for
last month.
Category Amount
Rework $ 725
Equipment maintenance 1,154
Product testing 786
Product repair 695
What is Watson's total prevention and appraisal cost for last month?
a) $2,665
b) $1,154
c) $786
d) $1,940
(CMA Adapted)
Accounting Process Redesign

While accounting and finance professionals are recommending process improvements for other areas of the
organization, they need to look at their own processes, too, for ways to make accounting and financial
operations more efficient.
Businesses are under pressure to reduce the cost of business transactions. At the same time, 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. Therefore, accounting and finance need to be able to provide the
same or even higher levels of service in transaction processing while using fewer resources. The resources
freed by these improvements can be put to new uses, enabling the financial function to add value to the
organization.
In order to accomplish these changes, the role of finance needs to be re-thought, and financial processes
need to be redesigned to do things better, faster, and cheaper, in line with the philosophy of continuous
improvement. By redeploying its resources to decision support and other value-adding activities, the financial
function can do more for the organization, and possibly for less.
Creating a Future Vision for Finance

In developing a future vision for the financial function, benchmarking studies should be used to identify best
practices being used. Much can be learned from organizations using best practices. 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. Benchmarking enables the project team to develop standards
against which their vision for the finance function can be measured.
A current use assessment is another technique for creating a future vision. 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. Internal customers are the internal users of the financial outputs. The project
team needs to ask, 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.
A current use assessment determines what reports are being used and by whom, how often updates are
needed, and what information in the reports is most essential. Surveys can be utilized to find out what
reports users use, why they use them, and whether they are satisfied or dissatisfied with them. The surveys
can also be used to gather information for a wish list of information the users would like to receive.
In addition, 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. Interviews and surveys can
help in gaining that understanding.
Selecting and Prioritizing Areas for Improvement

Every process cannot be redesigned at the same time, so it is necessary to prioritize. Priority should be given
to the processes most central to the organizations strategy. 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. Processes that have a high probability of successful redesign should
also receive priority.
Process Walk-Throughs
Once the decision has been made to redesign a specific accounting or finance function and the future vision
has been created, the first step is to gather information about how things are currently being done. The
current processes, assumptions, 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.
A walk-through is a demonstration or explanation detailing each step of a process. To conduct a process

walk-through, 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. 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.
The existing processes need to be thoroughly documented before they can be streamlined. Documentation of
a process involves more than simply listing the sequence of events in the process. In addition to listing the
steps performed, the documentation should include
time required to complete each step and what may be slowing down each step, so that improvement
can be directed toward shrinking the tasks that require the greatest amount of time rather than
those that require little time;
wait time between processing steps in order to discover areas requiring improvement;
forms used as inputs in order to locate those with duplicate, unused, or missing information;
reports used as outputs to identify unneeded reports or where information on several reports can be
merged into fewer reports;
identification of who performs each step, 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;
informal communication paths being used, so they can be included in the new formal process;
controls currently in place, in order to know in advance what controls will be affected by changes
made in the system; and
where errors typically occur in the process, because correction of errors is time-consuming and
decreasing the number of errors can decrease the amount time required for the process.
Every step, every piece of paper, and every input and output should be challenged. For example, investigate
why each step is being done, whether it is necessary, and whether it adds value;
whether the step could be automated and whether the physical pieces of paper being used are
necessary;
whether there may be duplication of effort;
whether the same data is being keyed in more than once, such as into a database and also into a
spreadsheet; and
how accurate are the inputs and outputs.
Process mapping may be used to provide a visual map of the way information, documents, and work is
routed through a process. Process maps can pinpoint problem areas such as bottlenecks within the system,
places where reports are being prepared manually due to fragmentation of data, and rework.
Identification of Waste and Over-capacity

The process walk-throughs are a good starting point for identifying waste and over-capacity, such as
duplication of effort,
tasks being done that are not necessary or that do not add value, and
output that is not being used.
Determination of personnel under- or over-capacity can be done in various ways:
One way of determining personnel needs is through metrics. For example, if an accounts payable
clerk can process 100 invoices for payment per day, historical totals of invoices processed can be
used to determine how many payables clerks are needed.
Another way of determining personnel usage is changes in the size of work backlogs. If work back-
logs increase, personnel capacity may be too low. If work backlogs decrease, personnel capacity may
be too high.
Employees can be asked to review their own needs for more or fewer employees.
If overtime is regularly excessive, then more employees may be needed.
Identifying the Root Cause of Errors

Again, the walk-through can help to identify the root cause of errors.
If the same data is being keyed in multiple times, not only is the duplication of effort wasteful, but
there is inherent risk that it will be keyed in differently. 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.
Each error regularly made, such as an error on an invoice or an error in an inventory count, is an
indication of a control weakness. Controls should be devised to prevent or detect the errors.
Process Design
Once the current process is fully understood, process design can take place in line with the vision for the new
process. The design process builds on the process concept developed during the vision step.
Every process is different, and a creative project team is required in order to generate a range of alternative
solutions. The redesigned process needs to cover every aspect of the internal customers (users) needs.
Risk-Benefit Evaluation
After the new process has been designed, potential risks and benefits of the new process need to be
evaluated. The greater the changes being made, the less the organization can be sure of a successful
outcome. The process design options need to be weighed carefully in terms of their potential risk impact as
well as their potential merits. Risk can be the deciding factor in taking one approach to process redesign over
another one. If the risks are determined to be too great, a return to the process design step may be
necessary.
Planning and Implementing the Redesign

A complete redesign of a process or processes has the potential to be very disruptive, and it requires careful
planning. The initiative for finance redesign often comes from senior management, so it is a top-down
implementation. It requires engaging people in the change, providing leadership, supporting the change, and
planning the change.
If the changes are extensive, they will need to be phased in to allow the employees and the rest of the
organization time to adjust to their impact. The impact of the changes on the people, their jobs, their sense
of security, and their attitudes must be considered. All those involved in the change effort need to actively
seek to reduce the stresses put on the human resources of the company, or else the people will limit the
effectiveness of the project. 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.
Process Training
Redesigning processes requires finding new ways to use the skills of existing employees and to further
enhance those skills through training.
Training will be needed in the changes that have been made to the process. Everyone involved in the
revised process should be included in the training.
The need for skills enhancement training should be evaluated on an individual basis. Skills training
should be individualized to the needs of each employee to eliminate weaknesses in each employees
skills. For example, certain employees may need to attend a class on using spreadsheets whereas
others would not need that but would need something else.
Training may be needed in how to fully take advantage of the systems being used.
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, quarter, and fiscal year. 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.
Accuracy at the point of data entry needs to be heightened so that reconciliations can be done more
quickly.
Perpetual inventory records should be used, and inventories can be estimated for the soft closes.
Timing-related accruals, such as inventories in transit, can be eliminated in the soft closes.
The materiality level for consolidation and elimination entries can be raised.
Use of a standardized chart of accounts and general ledger application across all company locations
is important for speed in closing.
Review transactions and a preliminary set of financial statements for errors prior to the end of the
period.
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.
If recurring invoices are sent out on a regular schedule, they can be printed in advance by setting
the accounting software date forward so the revenue is recorded in the proper months.
If expenses incurred or employee hours worked are billable to customers, review them before the
end of the period so the billing can be done quickly and accurately at the appropriate time.
Interest expense can usually be accrued prior to the end of the month. Unless a large change in debt
principal takes place at the very end of the period, last-minute changes in debt will not make much
impact on the total interest expense accrued.
For accruing unpaid wages, a centralized timekeeping system can be used so the most current
information about hours worked is available.
Depreciation can be calculated a few days before the end of the period. 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. However, for month-end closings, the missing depreciation can be recorded during the following
month, so the total depreciation expense for the year will still be correct. For year-end closings, the
depreciation can be adjusted if necessary.
To speed up payables closing, require purchase orders for all larger purchases so the company has a
record of all outstanding orders of a material size. The accounting staff can access the information to
accrue for invoices not yet received as of month end.
By completing some of the closing work before the end of the period, the accounting staff is less rushed and
may make fewer errors, leading to more accurate financial statements.
In order to maintain consistency, there should be a standard checklist of journal entries that are needed in
the closing. The checklist should include a place to initial for each month when the entry has been done.
Journal entry templates19 should be stored in the accounting system so the entry is standardized and the only
thing needed is the amount. The checklist should give the name of the stored template to be used for each
set of closing entries.
When divisional accounting staffs send summarized information to the corporate accounting staff, it can
contain errors that the corporate accounting staff must investigate and correct, which can be very time-
consuming. Furthermore, different accounting procedures used throughout the company result in inconsistent
reporting that is difficult to reconcile. Mandating standardized accounting procedures can improve accuracy at
the source, resulting in less time spent by the corporate accounting staff in correcting errors.
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.
When the processing of transactions is centralized, specific types of transactions such as accounts payable,
accounts receivable, and general ledger can be organized along functional lines, utilizing a smaller number of
highly-trained people. The result is usually fewer errors. By reorganizing responsibilities along functional lines
instead of geographical lines, responsibility for various closing tasks can be assigned to a smaller number of
managers who are in closer proximity, resulting in greater efficiency.
In a centralized accounting system, accounting errors can be researched more easily because of having a
single database of accounting information. 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 time required to locate and
resolve errors is shortened as a result.
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, sales, service and fulfillment. All the essential data is in one place, and the result can be a
much faster close.
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. Users go to the journal entry checklist to find the name of the
stored template, enter the numbers into the template, and save the journal entry with the correct date.
Section E Internal Controls CMA Part 1
Section E Internal Controls

Section E comprises 15% of the CMA Part 1 Exam. Section E is composed of three parts: (1) Governance,
Risk and Compliance; (2) Internal Auditing; and (3) Systems Controls and Security Measures.
Internal control examines all of the controls the company has developed and implemented to help achieve its
objectives. We often think of internal controls as trying to prevent something from going wrong, but they are
really set up to assist the organization in the achievement of its objectives. 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, 203, 204, 302, 404, and 407 of the Act and the role of the PCAOB (Public Company Accounting
Oversight Board), which was established by the Sarbanes-Oxley Act.
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. It is important to know these topics,
and the other internal control topics, not only from an academic standpoint (definitions and lists, for example)
but also from a practical application standpoint. 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. However, when you face these questions, do not spend too much time
thinking about any particular one because each has the same value, and therefore there is no benefit to
figuring out a hard question versus answering a simple one. So answer the simple questions first and spend
extra time on the hard ones only if time allows.
There are also a lot of questions from past exams that have covered specific situations relating to internal
control, internal audit, and systems control. These items may not be specifically covered in this textbook
because of the vast scope of potential topics that would need to be covered. Rather, these types of questions
are included in ExamSuccess. You do not need to remember every specific detail from a question, but you will
want to be familiar with the concepts and issues covered in those questions. 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. You will find the actual exam questions to be different from the practice questions in
your study materials, since the practice questions are previous exam questions. The actual exam questions
are always being updated and changed, so it is not likely that past exam questions will be asked again. For
that reason, we have determined not to try to teach to the study questions in this section of the study
materials. In this textbook, we prefer to focus on the topics covered in the ICMAs current Learning Outcome
Statements, 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.
Most of the internal control concepts covered in Governance, Risk and Compliance are adapted from the
report Internal Control Integrated Framework developed by COSO, the Committee of Sponsoring
Organizations of the Treadway Commission. It is the guide for all internal control systems.
The second part of this section is Internal Auditing. Internal Auditing focuses on the audit function that the
company operates internally, apart from the external audit of the financial statements. The internal audit
function has duties that spread far beyond the financial statements and some of these responsibilities may
not relate directly to finances. For example, the internal audit function may be involved in time or quality
audits.
When studying internal auditing, you need to prepare for this topic mostly on the definitional and conceptual
level. You need to know the characteristics of a successful internal audit function, how internal auditors test
compliance with controls and evaluate the effectiveness of controls, and the broad categories of services that
may be provided by the internal audit function.
The third part within this section is Systems Controls and Security Measures. In this part you will need to
become familiar with the terminology that is involved. Some of this you may be familiar with from work or
experience with computer systems, but it is important that you know the terminology.
Section E Governance, Risk, and Compliance
Governance, Risk, and Compliance

The internal controls of a company are an important part of its overall operations. A strong internal control
system will provide many benefits to a company including:
Lower external audit costs.
Better control over the assets of the company.
Reliable information for use in decision-making.
A company with weak internal controls is putting itself at risk for employee theft, loss of control over the
information relating to operations, and other inefficiencies in operations and decision-making that can
damage its business.
Corporate Governance
Good corporate governance is basic to internal control. The term governance will be used frequently in this
section. What is corporate governance, why is it important, and how is it related to risk assessment, internal
control and risk management?
What is Corporate Governance?

Corporate governance includes all of the means by which businesses are directed and controlled, including the
rules, regulations, processes, customs, policies, procedures, institutions and laws that affect the way the
business is administered. Corporate governance spells out the rules and procedures to be followed in making
decisions for the corporation. Corporate governance is the joint responsibility of the board of directors and
management.
Corporate governance also involves the relationships among the various participants and stakeholders in the
corporation, such as the board of directors, the shareholders, the Chief Executive Officer (CEO), and the
managers.
Corporate governance is very concerned with what is known as the agency problem. 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. The priorities and concerns of the managers are different
from the priorities and concerns of the shareholders. The managers are concerned with what will benefit them
personally and lead to increased salary, bonuses, power and prestige. The shareholders priorities lie with
seeing the value of their investment in the corporation increase. The priorities of the shareholders and the
priorities of the managers can easily be in conflict with one another, because what benefits the managers may
not benefit the owners.
Therefore, 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. Incentives are needed
so the agents will take actions that are consistent with shareholder benefit. At the same time, however,
monitoring mechanisms are needed to control any activities of the agents that would benefit them while
hurting the shareholders.
For example, 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. However, if management tries to conceal poor financial performance in an effort to keep the
stock price going up so their own bonuses remain intact, those same incentives can lead to fraudulent
financial reporting. Prevention of unintended consequences such as fraudulent financial reporting is the
responsibility of the board of directors and should be implemented through internal controls.
Governance, Risk, and Compliance CMA Part 1
Why is Corporate Governance Important?

Corporate governance has always been an important topic for shareholders, management and the board of
directors. However, the topic took on greater importance following the dramatic downfalls of companies such
as Enron, WorldCom, Adelphia and others back in 2001-02. More recently, the world financial crisis that
began in 2008 raised again the issue of good corporate governance. AIG (American International Group) went
from being the 18th largest public company in the world in 2008 to needing an $85 billion U.S. government
bailout. The Lehman Bros. bankruptcy in September 2008 was the largest bankruptcy in U.S. history. The
lesson from this is that good governance is not just a U.S. issue but it is a global issue.
Good governance is not just a good idea for a companyit is an absolute must. Considering just Enron, more
than $60 billion of shareholder wealth was erased from investors books. Thus, 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 countrys economy as well.
Corporate governance does not exist as a set of distinct and separate processes and structures. It is
interconnected with the companys internal control and enterprise risk management.
How is Corporate Governance Related to Risk Assessment, Internal Control and Risk Management?
We said that corporate governance specifies the distribution of rights and responsibilities among the various
participants in the corporation.
The board of directors and executive management are responsible for developing and implementing
business strategies.
In setting business strategies, the board and executive management must consider risk.
In order to consider risk, the company must have an effective process for identifying, assessing and
managing risk.
In order to have an effective risk management process, the company must have an effective internal
control system, because an effective internal control system is necessary in order to communicate
and manage risk.
Therefore, governance, risk management and internal control all rely on each other.
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.
Internal audits primary role is assessing internal controls over the reliability of financial reporting, the
effectiveness and efficiency of operations, and the organizations compliance with applicable laws and
regulations. According to IIA (Institute of Internal Auditors) Internal Auditing Standard 2110, 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.
Ensuring effective organizational performance, management and accountability.
Communicating risk and control information to appropriate areas of the organization.
Coordinating the activities of and communicating information among the board, external and internal
auditors, and management.
Principles of Good Governance

A set of governance principles, called 21st Century Governance Principles for U.S. Public Companies, was
published in 2007 by a group of leading academic experts from four universities. The principles were
developed by Paul D. Lapides, Joseph V. Carcello, Dana R. Hermanson and James G. Tompkins of Kennesaw
State University; Mark S. Beasley of North Carolina State University, F. Todd DeZoort of The University of
Alabama; and Terry L. Neal of University of Tennessee. The authors stated that the purpose of the principles
was to advance the current dialogue and to continue to promote investor, stakeholder and financial
statement user interests.
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 corporations stockholders while considering the interests of other exter-
nal and internal stakeholders (e.g. creditors, employees, etc.).
2) Board Responsibilities The boards major areas of responsibility should be monitoring the CEO
and other senior executives, overseeing the corporations strategy and processes for managing the
enterprise, including succession planning; and monitoring the corporations risks and internal con-
trols, including the ethical tone.20 Directors should employ healthy skepticism21 in meeting these
responsibilities.
3) Interaction Sound governance requires effective interaction among the board, management, the
external auditor, the internal auditor, and legal counsel.
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. Independent directors must be
able and willing to be objective in their judgments. The vast majority of the directors should be inde-
pendent in both fact and appearance.
5) Expertise and Integrity The directors should possess relevant business, industry, company, and
governance expertise. The directors should reflect a mix of backgrounds and perspectives and have
unblemished records of integrity. All directors should receive detailed orientation and continuing ed-
ucation to assure they achieve and maintain the necessary level of expertise.
6) Leadership The roles of Board Chair and CEO should be separate.22 If the roles are not separate,
then the independent directors should appoint an independent lead director. The lead director and
committee chairs should provide leadership for agenda setting, meetings, and executive sessions.
7) Committees The audit, compensation and governance committees of the board should have
charters, authorized by the board, which outline how each will be organized, their duties and respon-
sibilities, and how they report to the board. Each of these committees should be composed of
independent directors only, and each committee should have access to independent outside advisors
who report directly to the committee.
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. The independent directors and each of the committees should meet in execu-
tive session on a regular basis.
9) Internal Audit All public companies should maintain an effective, full-time internal audit function
that reports directly to the audit committee. Companies also should consider providing an internal
20
Companies need to make sure that inappropriate and unethical behavior is not tolerated. A culture of integrity is
dependent upon the tone at the top, the overall ethical climate that originates at the top of the organization with the
board of directors, the audit committee, and the CEO.
21
Healthy skepticism means having an attitude of doubt but not carrying it so far as to suspect wrongdoing everywhere.
It means asking questions, gathering information, and making your own decision. In this context, 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, because management may have forgotten to include some of the facts. Directors are not present on a day-to-
day basis and that makes their job more difficult than if they were on site. However, they can talk to people within the
organization at all levels and ask questions, and they should do that. They should not just assume that what they are being
told is true or is the whole truth.
22
Not too long ago, the CEO frequently served also as Chairman of the Board, and the dual role was not questioned.
However, since the boards responsibilities include monitoring the CEO, the CEO should not serve as Chairman of the Board,
because that creates a conflict of interest. The CEO would be leading the body that would be monitoring the CEO.
audit report to external stakeholders to describe the internal audit function, including its composi-
tion, responsibilities, and activities.
10) Compensation The compensation committee and full board should carefully consider the compen-
sation amount and mix (e.g., short-term vs. long-term, cash vs. equity) for executives and directors.
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.
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.g., financial performance, mergers and acquisitions, executive compensation, director compensa-
tion, insider trades, related-party transactions). Companies with anti-takeover provisions should
disclose why such provisions are in the best interests of their shareholders.
12) Proxy Access The board should have a process for shareholders to nominate director candidates,
including access to the proxy statement for long-term shareholders with significant ownership
stakes.
13) Evaluation The board should have procedures in place to evaluate on an annual basis the CEO,
the board committees, the board as a whole, and individual directors. 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. It spells out
the rules and procedures to be followed in making decisions for the corporation.
Formation, Charter, and Bylaws

U.S. corporations are formed under authority of state statutes. Application for a charter must be made to
the proper authorities of a state in order to form a corporation. A business usually incorporates in the state
where it intends to transact business but it may be formed in one state, while at the same time have its
principal place of business or conduct its business operations in another state or states. 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, and it is known as a foreign corporation in that state.
The corporation will owe state income tax, state franchise tax, state sales taxes and any other state taxes
imposed on businesses not only to the state where it is incorporated, but also to every state where it is
licensed as a foreign corporation.
Although the means of organizing a corporation may vary from state to state to some extent, each state
usually requires that articles of incorporation (the charter) be filed with the secretary of state or another
designated official within that state.
The charter is also referred to as the Articles of Incorporation or Certificate of Incorporation, and it
details the following:
The name of the corporation. In many states, the corporate name must contain the word corpora-
tion, incorporated, company, limited, or an abbreviation thereof. A corporate name cannot be the
same as, or deceptively similar to, the name of any other domestic corporation or any other foreign
corporation authorized to do business within the state.
The length of the corporations life, which is usually perpetual (meaning forever).
Its purpose and the nature of its business.
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.
The authorized number of shares of capital stock that can be issued with a description of the
various classes of such stock.
Provision for amending the articles of incorporation.
Whether existing shareholders have the first right to buy new shares.
The names and addresses of the incorporators, whose powers terminate upon filing.
The names and addresses of the members of the initial board of directors, whose powers commence
(begin) upon filing.
The name and address of the corporations registered agent for receiving service of process and
other notices.
The persons who sign the articles of incorporation are called the incorporators. Incorporators services end
with the filing of the articles of incorporation, and the initial board of directors, named in the articles of
incorporation, takes over.
State laws typically require that incorporators be natural persons (citizens of the U.S.), and over the age
of 18. State laws vary as to the number of incorporators required, but in most states, only one incorporator
is required.
Note: A corporation, being itself a legal entity, may act as an incorporator.
Most states provide standardized forms for articles of incorporation. A corporation can use the standardized
form or file another form as long as it complies with state requirements. The articles of incorporation are filed
with the designated state official for such filings, ordinarily the secretary of state. 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. However, some states may also require additional
filings in some counties before the corporation is recognized as a legal entity.
After the articles of incorporation have been filed and the certificate of incorporation has been issued by the
state, 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,
3) The directors meet to complete the organizational structure. At this meeting they:
a. Adopt bylaws for internal management of the corporation. The bylaws specify:
o The requirements for annual meetings of shareholders;
o Specifications regarding what constitutes a quorum at a shareholders meeting and what con-
stitutes a majority vote on the part of shareholders;
o Methods of calling special shareholders meetings;
o How directors are to be elected by the shareholders, the number of directors and the length
of their terms, specifications for meetings of the board of directors and for what constitutes a
quorum at a board meeting;
o How officers are to be elected by the board of directors, officer positions and the responsibili-
ties of each officer position;
o How the shares of the corporation shall be represented (for example, by certificates) and how
shares shall be issued and transferred;
o Specifications for payments of dividends; and
o How the bylaws can be amended. The directors ordinarily have the power to enact, amend or
repeal bylaws, but this authority may be reserved to the shareholders. Bylaws must conform
to all state laws and specifications in the articles of incorporation.
Note: Employees are not legally bound by the bylaws unless they have reason to be familiar with
them.
b. Elect officers.
c. Authorize establishment of the corporate bank account, designate the bank, and designate by
name the persons who are authorized to sign checks on the account.
d. Consider for ratification any contracts entered into before incorporation.
e. Approve the form of certificate that will represent shares of the companys stock.
f. Accept or reject stock subscriptions.
g. Comply with any requirements for doing business in other states. For example, if a corporation
files with another state as a foreign corporation located in that state, it will need to have a reg-
istered agent in that state.
h. Adopt a corporate seal to be used for corporate documents for which a seal is required.
i. Consider any other business as necessary for carrying on the business purpose of the corpora-
tion.
Amending the Articles of Incorporation

Most state corporation laws permit amendment of the articles. An example of an amendment might be an
increase in the number of authorized common shares of stock.
Any amendment to the articles of incorporation must be something that could have been included in the
original articles of incorporation. This means that an amendment is not allowed for something that the
corporation could not legally do.
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. After shareholder approval, the articles of
amendment are filed with the state authorities. The amendments become are effective only upon the issuance
of a certificate of amendment.
Although the articles of incorporation specify the name and address of the corporations initial registered
agent, changing the registered agent can usually be done by the board of directors without the need for
shareholder approval.
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, who are the owners of the company.
Thus, the members of the board of directors represent the owners of the company. The boards responsibility
is to provide governance, guidance and oversight to the management of the company. The board has the
following specific responsibilities:
Selecting and overseeing management. 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.
Because it elects the companys management, the board determines what it expects from manage-
ment in terms of integrity and ethics and it confirms its expectations in its oversight activities.
The board has authority in key decisions and plays a role in top-level strategic objective-setting and
strategic planning.
Because of its oversight responsibility, the board is closely involved with the companys internal
control activities.
Board members need to be familiar with the companys activities and environment, and they need to
commit the time required to fulfill their board responsibilities, even though they may be outside, in-
dependent directors.
Board members should investigate any issues they consider important. They must be willing to ask
the tough questions and to question managements activities. 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 companys external auditors and its legal coun-
sel.
Because board members are responsible for questioning and scrutinizing managements activities, it
is important that the board have members who are independent of the company. An independent di-
rector has no material relationship with the company. In other words, 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. 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.
Most boards of directors carry out their duties through committees. Committees of the board of directors are
made up of selected board members and are smaller, working groups of directors that are tasked with specific
oversight responsibilities. One of the committees whose membership is prescribed by SEC regulations is the
audit committee. Other usual committees are compensation, finance, nominating and employee benefits. All
of the committees of the board of directors are important parts of the companys internal control system, as
their members can bring specific internal control guidance in their specific areas of responsibility.
Audit Committee Requirements, Responsibilities and Authority

The responsibilities of the audit committee are particularly critical. The requirements for serving on an audit
committee of a publicly-held company have been formalized in law and regulations, first by the Sarbanes-
Oxley Act of 2002 and then, as directed by Sarbanes-Oxley, in SEC regulations. Secondary securities markets
also include audit committee requirements in their listing regulations.
According to the New York Stock Exchange, the audit committee of the board of directors of a corporation
stands at the crucial intersection of management, independent auditors, internal auditors and the board of
directors. 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 audit committee members audit
committee responsibilities are in addition to their responsibilities as members of the larger board.
The SEC first recommended that boards of directors of corporations have audit committees in 1972. Within
short order, stock exchanges began requiring or at least recommending that listed companies have audit
committees. The responsibilities of audit committees have been increased over the years.
In 1987, 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.
In 1998, 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. The report of
the Blue Ribbon Committee, published in 1999, 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. The Blue Ribbon Committees recommendations were incorporated into the listing standards
of the New York Stock Exchange, the American Stock Exchange, and the NASDAQ, and the SEC adopted new
rules requiring disclosure about the functioning, governance, and independence of corporate audit
committees.
The Sarbanes-Oxley Act of 2002 increased audit committees responsibilities to a great degree. It also
increased the qualifications required for members of audit committees, and it increased the authority of audit
committees. In response to the Sarbanes-Oxley Act, the stock exchanges and the SEC developed new rules
and regulations for the purpose of strengthening audit committees.
Under Section 3(a)(58) of the Exchange Act, as added by Section 205 of the Sarbanes-Oxley Act, 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; and
If no such committee exists with respect to an issuer, the entire board of directors of the issuer.
Accordingly, the SECs 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, if it fails to form a
separate committee or if it chooses, the entire board of directors will constitute the audit committee.
Thus, the requirements for and responsibilities of members of audit committees of public companies boards
of directors are highly regulated. The requirements for, responsibilities of and authority of the audit
committee are as follows.
Requirements for Audit Committee and Audit Committee Members

1) The audit committee is to consist of at least three members. This is a listing requirement of the New
York Stock Exchange and other stock exchanges. 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 entire board of directors will be responsible for the audit
committee function.
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.S.C. 78f), as amended. The section defines independence this way: In
order to be considered to be independent . . . a member of an audit committee of an issuer may not,
other than in his or her capacity as a member of the audit committee, the board of directors, or any
other board committee-- (i) accept any consulting, advisory, or other compensatory fee from the
issuer; or (ii) be an affiliated person of the issuer or any subsidiary thereof. In other words, the
members of the audit committee may not be employed by the company in any capacity.
3) In addition, the New York Stock Exchange requires a five-year cooling-off period for former em-
ployees of the listed company, or of its independent auditor, before they can serve on the audit
committee of a listed company.
4) One member of the committee must have accounting or financial management expertise. This
is a requirement made by stock exchanges. The Sarbanes-Oxley Act requires that if the audit com-
mittee does not include a financial expert, this fact must be disclosed.
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. This is a listing requirement of the New York Stock Exchange and other stock ex-
changes.
Responsibilities of the Audit Committee

1) The audit committee is responsible for selecting and nominating the external auditor, approving
audit fees, supervising the external auditor, overseeing auditor qualifications and independence, dis-
cussing with the auditors matters required under generally accepted auditing standards, and
reviewing the audit scope, plan and results. Rule 10A 3(b)(2) of the Securities Exchange Act of 1934
(15 U.S.C. 78f) sets forth the following as responsibilities of the audit committee: The audit com-
mittee of each issuer, in its capacity as a committee of the board of directors, shall be directly
responsible for the appointment, compensation, 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 each such registered public accounting firm shall report directly to the
audit committee.
2) The New York Stock Exchanges Listing Manual requires that listed companies have an audit com-
mittee charter that addresses the committee's purposewhich, at minimum, must be to: (A)
assist board oversight of (1) the integrity of the listed company's financial statements, (2) the listed
company's compliance with legal and regulatory requirements, (3) the independent auditor's qualifi-
cations and independence, and (4) the performance of the listed company's internal audit function
and independent auditors; and (B) prepare an audit committee report as required by the SEC to be
included in the listed company's annual proxy statement.
3) Rule 10A 3(b)(4) of the Securities Exchange Act specifies that each audit committee shall establish
procedures for (A) the receipt, retention, and treatment of complaints received by the issuer regard-
ing accounting, internal accounting controls, or auditing matters; and (B) the confidential,
anonymous submission by employees of the issuer of concerns regarding questionable accounting or
auditing matters. This rule relates to the whistleblower 24 requirement in the Sarbanes-Oxley Act.
4) The New York Stock Exchange Listing Manual further specifies that at least annually, the Audit
Committee is to obtain and review a report by the independent auditor describing: the firm's inter-
nal quality-control procedures; any material issues raised by the most recent internal quality-control
review, or peer review, of the firm, or by any inquiry or investigation by governmental or profession-
al authorities, within the preceding five years, respecting one or more independent audits carried out
by the firm, and any steps taken to deal with any such issues; and (to assess the auditor's inde-
pendence) all relationships between the independent auditor and the listed company. After
reviewing the independent auditors report, the audit committee will be in a position to evaluate the
auditor's qualifications, performance and independence. This evaluation should include the review
and evaluation of the lead partner of the independent auditor. In making its evaluation, 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). In addition to assuring the
regular rotation of the lead audit partner as required by law, 25 the audit committee should further
consider whether, in order to assure continuing auditor independence, there should be regular rota-
tion of the audit firm itself. The audit committee should present its conclusions with respect to the
independent auditor to the full board.
24
A whistleblower is a person who informs on someone else or makes public disclosure of corruption or wrongdoing.
Section 301 of the Sarbanes-Oxley Act mandated that Audit Committees of public companies establish a system for
receiving, retaining, and treating whistleblower complaints regarding accounting, internal controls, or auditing matters.
Public companies are required to establish a means for confidential, anonymous submission by employees and others about
concerns they may have regarding questionable accounting and auditing matters. Furthermore, Section 806 of Sarbanes-
Oxley authorizes the U.S. Department of Labor to protect whistleblower complainants against employers who retaliate and
also authorizes the U.S. Department of Justice to criminally charge those responsible for any retaliation. 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.
25
Per Sarbanes-Oxley Act, Section 203, discussed in detail in this text in the discussion of the Sarbanes-Oxley Act in the
topic Legislative Initiatives About Internal Control.
5) In addition, 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.
o The audit committee is to review with the independent auditor any audit problems or difficulties,
including any restrictions on the scope of the independent auditor's activities or on access to re-
quested information, and any significant disagreements with management and management's
response.
o The audit committee is to set clear hiring policies for employees or former employees of the in-
dependent auditors, taking into account the pressures that may exist for auditors consciously or
subconsciously when seeking a job with the company they audit.
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, the
company's compliance with legal or regulatory requirements, the performance and independence
of the company's independent auditors, or the performance of the internal audit function.
o And finally, the audit committee is to review: (A) major issues regarding accounting principles
and financial statement presentations, including any significant changes in the company's selec-
tion or application of accounting principles, 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; (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, including analyses of the effects of alternative GAAP methods on the fi-
nancial statements; (C) the effect of regulatory and accounting initiatives, as well as off-balance
sheet structures, on the financial statements of the listed company; and (D) the type and
presentation of information to be included in earnings press releases (paying particular attention
to any use of "pro forma," or "adjusted" non-GAAP, information), as well as review any financial
information and earnings guidance provided to analysts and rating agencies.
6) The Blue Ribbon Committee report recommended that the audit committee monitor the companys
internal control processes, and most audit committees do this. They oversee the internal audit func-
tion and monitor internal control systems for compliance with legal and regulatory requirements.
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, as it determines necessary to carry out
its duties.
Rule 10A-3(b)(6) of the Securities Exchange Act provides that each issuer shall provide for appro-
priate funding, as determined by the audit committee, in its capacity as a committee of the board of
directors, 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; and (B) to any advisers employed by
the audit committee under paragraph (5).
The audit committee has the authority to investigate any matter.
Responsibilities of the Chief Executive Officer (CEO)

The responsibilities of the CEO are determined by the corporations board of directors. A CEOs responsibilities
and authority can be extensive, or they can be very limited, depending upon how much authority and
responsibility the board of directors delegates to the CEO.
A CEO should not serve as chairman of the board of directors. Since the boards responsibilities include
monitoring the CEO, the CEO should not serve as Chairman of the Board, because that creates a conflict of
interest. The CEO would be leading the body that would be monitoring the CEO.
Election of Directors
The shareholders elect the members of the board of directors. Usually, each share of stock is allowed one
vote, and usually directors are elected by a plurality (whoever gets the most votes is elected, even if it is not
a majority).
The length of the directors term of office is set in the corporate bylaws. The term is usually one year, but it
may be longer, such as three years in staggered terms, with one-third of the board members up for election
at each annual shareholders meeting. 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.
Internal Control CMA Part 1
Internal Control
Who Cares About Internal Control?
Ever since commercial organizations, nonprofit organizations and governments have existed, their leaders
have recognized the need to exercise control in order to ensure that their objectives were achieved. Today,
however, the leaders of an organization are not the only ones who care about its internal control policies and
procedures.
For a public company, information on the effectiveness of its internal control system is important to
investors to enable them to evaluate managements performance of its stewardship responsibilities
as well as the reliability of its financial statements.
The companys external auditors recognize that an audit of a company with effective internal
controls can be performed more efficiently.
The potential for U.S. 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.
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.
Even customers have an indirect interest in internal controls because a strong internal control
system may reduce the costs of production, and therefore also reduce products prices.
Internal Control Definition

According to the COSO publication, Internal Control Integrated Framework,26
Internal control is a process, effected by27 an entitys board of directors, management, and other
personnel, designed to provide reasonable assurance regarding the achievement of objectives
relating to operations, reporting, and compliance.
Thus internal control is a process that is carried out (effected) by an entitys board of directors, management
and other personnel that is designed to provide reasonable assurance that the companys objectives
relating to operations, reporting, and compliance will be achieved.
1) Operations objectives relate to the effectiveness and efficiency of operations, or the extent to
which the companys basic business objectives are being achieved and its resources are being used
effectively and efficiently. Operations objectives include operational and financial performance goals
and safeguarding of assets against loss.
2) Reporting objectives include internal and external financial and non-financial reporting.
Reporting objectives include reliability, timeliness, transparency, or other requirements as set forth
by regulators, recognized standard setters, or the entitys policies.
3) Compliance objectives relate to the organizations compliance with applicable laws and regula-
tions, encompassing all laws and regulations to which the company is subject.
These three categories of company objectives with which internal control is concerned are very
important to know.
26
Internal Control Integrated Framework, copyright 1992, 1994 and 2013 by the Committee of Sponsoring Organizations
of the Treadway Commission. Used by permission. The Committee of Sponsoring Organizations of the Treadway
Commission includes the following five organizations: American Institute of Certified Public Accountants (AICPA), American
Accounting Association (AAA), Institute of Internal Auditors (IIA), Institute of Management Accountants (IMA), and
Financial Executives International (FEI).
27
To effect something means to cause it to happen or to accomplish it. So effected by means accomplished by.
Section E Internal Control
The three categories address different needs and they may be the direct responsibilities of different
managers. 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 three categories of objectives are distinct, but they
do overlap. Therefore, a specific control objective for a specific company could fall under more than one
category.
Fundamental Concepts
The definition of internal control reflects several fundamental concepts, as follows:
1) The purpose of internal control is to help the company achieve its objectives. The focus is on
achieving objectives. The objectives that internal control applies to fall into the three categories
above: operations, reporting, and compliance.
2) Internal control is an ongoing process. It is not something that can be done once and be completed.
It is a journey, not a destination. It consists of ongoing tasks and activities. It is a means to an end,
not an end in itself.
3) Internal control is effected (accomplished) by people. It is something that must be put into effect by
peopleit is not policies and procedures. People are located throughout the organization at every
level, from the members of the board of directors to the staff. Simply writing policy manuals that call
for internal control procedures is not enough. To be effective, people must put the policies and pro-
cedures into effect.
4) Internal control procedures can provide reasonable assurance onlynot absolute assurance
and not a guaranteeto the entitys board of directors and senior management that the compa-
nys objectives will be achieved in the three named areas. This statement reflects the fundamental
concepts that (1) the cost of an internal control system should not exceed the expected benefits, and
(2) the overall impact of a control procedure should not hinder operating efficiency.
5) Internal control must be flexible in order to be adaptable to the entitys structure. Internal control
needs to be adaptable to apply to an entire entity or just to a particular subsidiary, division, operat-
ing unit, or business process.
The Importance of Objectives

Since internal controls purpose is to provide reasonable assurance regarding the achievement of objectives
relating to operations, reporting, and compliance, it stands to reason that internal control cannot operate
effectively unless objectives have been set. Setting objectives is part of the strategic planning process by
management and the board of directors. Objectives should be set with consideration given to laws,
regulations, and standards as well as managements choices. Internal control cannot establish the entitys
objectives.
Who Is Responsible for Internal Control?

Before we get into the details of internal controls, we should start by discussing who is responsible for internal
controls.
The board of directors is responsible for overseeing the internal control system. The boards
oversight responsibilities include providing advice and direction to management, constructively chal-
lenging management, approving policies and major transactions, and monitoring managements
activities. Consequently, the board of directors is an important element of internal control. 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
CEO should provide leadership and direction to the senior managers and review the way they are
controlling the business. This tone (part of the control environment) is discussed in more detail
below.
Senior managers delegate responsibility for establishment of specific internal control policies
and procedures to personnel responsible for each units functions.
Financial officers and their staffs are central to the exercise of control, as their activities cut
across as well as up and down the organization. However, all management personnel are involved,
especially in controlling their own units activities.
Internal auditors play a monitoring role. They evaluate the effectiveness of the internal controls
established by management, thereby contributing to their ongoing effectiveness.
Virtually all employees are involved in internal control, because all employees produce information
used in the internal control system or carry out other activities that put the internal control systems
into effect. Furthermore, all employees are responsible for letting their managers know if they be-
come aware of problems in operations or that rules, regulations or policies are being violated.
External parties provide information that is useful to effective internal control. For example, independent
auditors audit the financial statements and often provide other useful information as well to management
and the board. Other external parties that may provide useful information include legislators, regulators,
customers, financial analysts, bond raters and the news media. However, external parties are not part of the
companys internal control system, and they are not responsible for it.
Note: Internal auditors evaluate the effectiveness of the control systems and contribute to their ongoing
effectiveness, but they do NOT have the primary responsibility for establishing or maintaining the control
systems.
Note: Internal control should be an explicit or implicit part of everyones job description.
Components of Internal Control

According to the COSO report, Internal Control Integrated Framework (2013 update), five interrelated
components comprise internal control. If the five components are present and functioning effectively, their
effective functioning provides the reasonable assurance regarding achievement of the companys objectives.
Thus, these components are all necessary for effective internal control to be present. 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.
Component 1: Control Environment

The control environment includes the standards, processes, and structures that provide the foundation for
carrying out internal control. The board of directors and senior management are responsible for establishing
the tone at the top, including expected standards of conduct that apply to all employees. Management is
responsible for reinforcing the expectations at all levels of the organization.
The control environment provides the organizations ethical values. It influences the control consciousness of
all the people in the organization and sets the tone for the entire organization. If the control environment
does not include the necessary factors, none of the other components of internal control will be effective.
Organizations with effective control environments have the following characteristics, exemplified by these five
principles:
1) They demonstrate a commitment to integrity and ethical values. They set a positive tone at
the top by communicating, verbally and by example as well as formally, the organizations ethical
values and commitment to integrity.
Every company should establish standards of conduct and formal policies regarding acceptable busi-
ness practices, conflicts of interest, and expected standards of behavior. However, these official
statements only state what management wants to have happen. Corporate culture, or the tone
at the top, determines what actually does happen. Top management, especially the CEO, sets the
ethical tone by modeling the ethical and behavioral standards that are expected of everyone in the
organization. Leadership by example is the most effective means of communicating that ethical be-
havior is expected, because people imitate their leaders.
Management should foster a control consciousness by setting formal and clearly communicated
policies and procedures that are to be followed at all times, without exception, and which result in
shared values and teamwork.
Standards of integrity and ethical values extend to outsourced service providers and business part-
ners, as well. Management retains responsibility for the performance of processes it has delegated to
outsourced providers and business partners.
Processes should be in place to identify issues and evaluate the performance of individuals and
teams against the expected standards of conduct, and deviations need to be addressed in a timely
and consistent manner. The actions taken by management when violations occur send a message to
employees, and that message quickly becomes a part of the corporate culture.
2) The board of directors demonstrates independence from management and exercises over-
sight over development and performance of internal control. 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, the shareholders. The attention and direction provided by the directors are critical.
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. Independence of the board from management is
critical, so that if necessary, difficult and probing questions will be raised.
Board and audit committee members should hold regular meetings with chief financial and account-
ing officers and internal and external auditors. Sufficient and timely information should be provided
to board and audit committee members.
The board of directors has oversight responsibility for internal control, but the Chief Executive Officer
and senior management have direct responsibility for developing and implementing the organiza-
tions internal control system.
3) With the oversight of the board, management establishes structures, reporting lines, and
appropriate authorities and responsibilities to enable the corporation to pursue its objectives.
The companys organizational structure should define the key areas of authority and responsibility
and delineate lines for reporting. The organizational structure is key to the companys ability to
achieve its objectives, because the organizational structure provides the framework for planning, ex-
ecuting, controlling and monitoring the activities it pursues to achieve its objectives.
The structure should be organized to best carry out the strategies designed to achieve the organiza-
tions objectives and to provide the necessary information flow. The existing structure should be
periodically evaluated to enable its realignment with changing priorities such as new regulations.
Authority and responsibility should be delegated to the extent necessary to achieve the organiza-
tions objectives. The board of directors delegates authority and assigns responsibility to senior
management. Senior management delegates authority and assigns responsibility at the entity level
and to its subunits. 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.
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. Delegation of authority provides the organization with
greater agility, but it also introduces complexity in risks to be managed. Senior management with
guidance from the board of directors needs to determine what is and is not acceptable, in line with
the organizations regulatory or contractual obligations.
The challenge is to delegate only to the extent required to achieve the organizations objectives. The
delegation should be based on sound practices for identifying and minimizing risk and on weighing
potential losses against potential gains from delegation.
4) The organization demonstrates a commitment to attract, develop, and retain competent

individuals in alignment with objectives. In order for tasks to be accomplished in accordance
with the companys objectives and plans for achievement of those objectives, the company needs to
have competent personnel. In order to have competent personnel, management should specify the
knowledge and skills required for each position. There should be formal or informal job descriptions
that specify the competence level needed for each job, and the company should make every effort to
hire and retain competent people and to train them when necessary.
Background checks should be thorough when hiring new employees. At a minimum, the applicants
work history and education should be confirmed and references checked. Any embellishment or un-
disclosed history should be a red flag.
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. 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. Therefore, appropriate personnel policies and procedures are integral to an
efficient control environment.
The board of directors should evaluate the competence of the CEO, 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.
5) The organization holds individuals accountable for their internal control responsibilities in
pursuit of objectives.
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 organizations
objectives. The CEO and senior management are responsible for establishing accountability for inter-
nal control at all levels of the organization.
Increased delegation requires personnel with a higher level of competence and requires the company
to establish accountability. There should be effective monitoring by management of results, because
the number of undesirable or unanticipated decisions may increase with increased delegation. The
extent that individuals recognize that they will be held accountable for results greatly affects the
control environment. If a person does something that is in violation of the companys policies and
standards, some sort of disciplinary action should be taken against that person. If there is no penalty
for the violation of the internal controls of the company, then other individuals will not see the need
for compliance.
Management should regularly review the organizations performance evaluation methods and incen-
tives to ensure they do not encourage inappropriate conduct. If increases in the bottom line are the
sole focus of performance evaluations, the organization is more likely to experience unwanted be-
havior such as manipulation of accounting records and reports, offers of kickbacks, and high-
pressure sales tactics.
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.
Component 2: Risk Assessment

Risk is the possibility that something will occur that will adversely affect the organizations achievement of its
objectives. Risk assessment involves identifying and assessing risks to the achievement of objectives, relative
to the organizations established risk tolerance.
Within the control environment, management is responsible for the assessment of risk. 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, analyzing and managing the risks that have the potential to
prevent the organization from achieving its objectives. 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 must
determine how much risk it is willing to accept and then work to maintain the risk within that level.
The 17 principles are numbered consecutively, so the principles relating to the risk assessment component
will begin with no. 6:
6) The companys objectives must be specified clearly enough so that the risks to those objec-
tives can be assessed. Objective setting is therefore the first step in managements process of risk
assessment. Objectives may be explicitly stated or they may be implicit, such as to continue a previ-
ous level of performance. Setting the companys objectives is a strategic planning function of
management.
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 companys mission, the fundamental
reason for the companys existence. They include objectives for the effectiveness and efficiency
of the companys operations and performance and profitability goals. They also include the safe-
guarding of company resources against loss. A companys operations objectives will vary
depending on the choices management makes about structure and performance. As part of the
objective-setting process, management should specify its risk tolerance. For operations objec-
tives, risk tolerance might be expressed as an acceptable level of variance related to the
objective.
Reporting objectives address the preparation of reports, including external financial reports,
external non-financial reports, internal financial reports, and internal non-financial reports. Ex-
ternal reporting objectives are driven by rules, regulations, and standards that are external to
the organization. Internal reporting objectives are driven by the entitys strategic direction and
by reporting requirements established by management and the board of directors.
Compliance objectives include adhering to all laws and regulations that the company is subject
to. These laws and regulations establish minimum standards of behavior and may include mar-
keting, packaging, pricing, taxes, environmental protection, employee safety and welfare, and
international trade as well as many others. A companys record of compliance or noncompliance
with laws and regulations affects its reputation in its communities. It also, of course, affects the
companys risk of being the recipient of disciplinary procedures.
Objectives can overlap. For example, the operations objective of safeguarding resources includes
prevention of loss through theft. The goal of ensuring reliable financial reporting includes making
sure that any such losses that may occur through theft are properly reflected in the companys fi-
nancial statements, a reporting objective.
Establishing these objectives is a required first step to establishing effective internal control, because
it forms the basis for assessing risk, in other words determining what could go wrong that could pre-
vent the company from achieving its objectives. If the objectives are not known, then it is not
possible to determine what could prevent the company from achieving them.
7) The organization identifies risks to the achievement of its objectives and analyzes them to
determine how the risks should be managed. The responsibility for risk identification and analysis re-
sides with management at the overall entity level and at the subunit level.
Risks can come from both internal and external factors that can affect the companys ability to
achieve its objectives. Change in objectives creates risk, especially. The greater the difference in
the current objectives from objectives of the pastthe greater the amount of changethe more risk
there is. Even the objective of maintaining performance as it has been in the past carries both inter-
nal and external risks.
The risk assessment process should consider all risks that may occur. The risk assessment should be
comprehensive and consider all significant interactions between the company and external parties,
throughout the organization. External parties to include in the assessment are suppliers (current and
potential), investors, creditors, shareholders, employees, customers, buyers, intermediaries, com-
petitors, public bodies and the news media.
Once the risks have been identified, they should be analyzed in order to determine how best to
manage each one.
Risk identification
Risk identification includes identification of risks at all levels of the organizational structure, including
the overall entity and its subunits. 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. Risks originating in outsourced service providers,
key suppliers, and channel partners need to be included in the risk assessment, as they could direct-
ly or indirectly impact the organizations achievement of its objectives.
Entity-level risks arise from external or internal factors. Here are a few examples:
External factors include economic factors that impact financing availability, environmental fac-
tors such as climate change that can lead to changes in operations, reduced availability of raw
materials or loss of information systems, regulatory changes such as new reporting standards or
new laws, changing customer needs, and technological changes that affect the availability and
the use of data.
Internal factors can include decisions that affect operations and the availability of infrastruc-
ture, changes in management responsibilities that affect the way controls are implemented,
changes in personnel that can influence the control consciousness in the organization, employee
access to assets that could contribute to misappropriation of assets, and a disruption in infor-
mation systems processing that could adversely affect the organizations operations.
Transaction-level risks occur at the level of subsidiaries, divisions, operating units, or functions
such as sales, production, or marketing. The potential risks depend upon what the objectives are.
For example,
An operational objective of maintaining an adequate raw materials inventory could lead to identi-
fying risks such as raw materials not meeting specifications, the failure of a key supplier, supply
disruptions in needed raw materials caused by weather conditions, or price increases above ac-
ceptable levels.
An objective of complying with existing laws and regulations leads to identifying risks associated
with lack of compliance.
The objective of protecting assets leads to identifying the risk of employee embezzlement ac-
companied by falsification of records to conceal the theft.
The number of potential risks is limitless, and practical limitations are needed. Some risks, such as a
meteor falling out of the sky onto the companys manufacturing facility, are too minimal to be con-
sidered. But any situation that causes a change that could impact the system of internal control
should be included.
Risk analysis
Risk analysis forms the basis for determining how the risks will be managed. After the company has
identified its entity-level and transaction-level risks, it should perform a risk analysis to (1) assess
the likelihood or frequency of each risks occurring; (2) estimate the impact of each risk; and (3)
consider how each risk should be managed by assessing what actions need to be taken.
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. However, risks with a high likelihood of occurring and that
carry the possibility of significant impact usually require serious attention. Risks that are in between
these two extremes require judgment.
Once the likelihood and estimated impact of risks have been assessed, the following steps should be
taken to manage the identified risks. Risk responses fall into the following categories:
Acceptance No action is taken to affect the likelihood or impact of the risk.
Avoidance Exiting the activity or activities that give risk to the risk, such as exiting a product
line or selling a division.
Reduction Action is taken to reduce the likelihood or impact of the risk. The amount of the po-
tential loss from each identified risk should be estimated to the extent possible. Some risks are
indeterminate and can only be described as large, moderate or small.
Sharing Reducing the risk likelihood or impact by transferring or sharing the risk such as pur-
chasing insurance or forming a joint venture.
If the decision is to reduce or to share the risk, the organization determines what action to take and
develops appropriate control activities for the action. If the decision is to accept or avoid the risk,
typically no control activities are required.
8) The organization considers the potential for fraud in assessing the risks to the achievement
of its objectives. Fraud can include fraudulent reporting, possible loss of assets, and corruption.
Fraud can occur at any level and its possible impact needs to be considered as part of the risk identi-
fication and assessment. The potential for management fraud through override of controls needs to
be considered, and the directors oversight of internal control is necessary to reduce that risk. Fraud
can arise at the employee level, as well, for example if two employees collude 28 to defraud the or-
ganization. Furthermore, fraud can be perpetrated from the outside, from someone hacking into the
computer systems for example.
When management detects fraudulent reporting, inadequate safeguarding of assets, or corruption,

remediation may be necessary. In addition to dealing with the improper actions, 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.
28
To collude is to act together, often in secret, to achieve some illegal or improper purpose.
9) The organization identifies and assesses changes that could impact the organizations sys-
tem of internal controls.
Changes can occur in the external environment, such as in the regulatory, economic, and physical
environment in which the entity operates. Changes can also occur in the internal environment such
as new product lines, acquired or divested businesses and their impact on the internal control sys-
tem, rapid growth, changes in leadership and their attitudes toward internal control.
Note: There is a difference between risk assessment, which is a function of internal control, and the
actions taken by management to address the risks, which are a function of management and not of the
internal control system.
Component 3: Control Activities

Control activities are actions established by policies and procedures that help ensure that managements
instructions that are intended to limit risks to the achievement of the organizations objectives are carried out.
Control activities may be preventive or detective and can include a range of activities such as authorizations
and approvals, verifications, reconciliations, and business performance reviews. Segregation of duties is
typically built in to the selection and development of control activities.
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.
Control activities should be integrated with risk assessment in order to put into effect actions needed
to carry out risk responses. The risk responses decided upon dictate whether control activities are
needed or not. If management decides to accept or avoid a risk, control activities are generally not
required. The decision to reduce or share a risk generally makes control activities necessary. The
control activities include a variety of controls including both manual and automated and preventive
and detective controls.
Segregation of duties should be addressed wherever possible and if segregation of duties is not prac-
tical, management should develop alternate control activities.
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).
o Examples of preventive controls are segregation of duties, job rotation, enforced vacations,
training and competence of personnel, employee screening practices, physical control over as-
sets such as dual access controls, requirements for authorizations, and requirements for
approvals.
o Examples of detective controls are reconciliations, internal audits, periodic physical inventory
counts, variance analyses to detect ratios that might be out of line, random surprise cash
counts, supervisory review and approval of accounting work, management review and approval
of account write-offs, and exception reporting and review to identify unusual items.
11) The organization selects and develops general control activities over technology29 to support
the achievement of its objectives.
o Control activities are needed when technology is embedded in business processes, to mitigate
the risk of the technology operating improperly.
29
See General Controls in Systems Controls and Security Measures later in this section for more information about
technology general controls.
o Control activities may be partially or wholly automated using technology. Automated controls re-
quire technology general controls.
Control activities over technology designed to support the continued operation of technology and to
support automated control activities are called technology general controls. Technology general
controls include controls over the technology infrastructure, security management, and technology
acquisition, development and maintenance.
Activities designed and implemented to restrict technology access to authorized users to protect the
organizations assets from external threats are a particularly important aspect of technology general
controls. Guarding against external threats is particularly important for an entity that depends on
telecommunications networks and the Internet.
12) The organization deploys control activities by developing policies that establish what is ex-
pected and procedures that put the policies into action. The control activities should be built
into business processes and employees day-to-day activities.
Whether a policy is in writing or not, it should establish clear responsibility and accountability. The
responsibility and accountability ultimately reside with the management of the entity and the subunit
where the risk resides. Procedures should be clear on what the responsibilities are of the personnel
performing the control activity. The procedures should be timely and should be performed diligently
and consistently by competent personnel.
Responsible personnel should investigate and if necessary take corrective action on matters identi-
fied as a result of executing control activities. For example, if a discrepancy is identified in the
process of doing a reconciliation, the discrepancy should be investigated. If an error occurred, the
error should be corrected and the correction reflected in the reconciliation.
Management should periodically review and reassess policies and procedures and related control ac-
tivities for continued relevance and revise them when necessary.
Component 4: Information and Communication

Relevant information must be identified, captured and communicated (shared) in a manner that enables
people to carry out the internal control responsibilities that support achievement of the organizations
objectives. Information and communication are both internal and external.
Principles relating to the Information and Communication component include:
13) The organization should obtain or generate and use relevant, quality information to support
the functioning of other components of internal control.
Relevant information can be financial or non-financial. The information can be generated from inter-
nal or external sources. Regardless of whether it is from internal or external sources and whether it
is financial or non-financial information, timely and relevant information is needed to carry out inter-
nal control responsibilities supporting all three of the categories of objectives.
o Some examples of internal sources include emails, production reports regarding quality, minutes
of meetings discussing actions in response to reports, time reports, information on number of
units shipped during a period, and internal contacts made to a whistle-blower hotline. Other
types of operating information, such as measurements of emissions generated, are needed to
monitor compliance with emissions standards.
o Some examples of external sources include data from outsourced providers, research reports,
information from regulatory bodies regarding new requirements, social media and blog postings
containing comments or opinions about the organization, and external contacts made to a whis-
tle-blower hotline. External information about economic conditions and actions of competitors is
needed for internal decision-making, such as decisions about optimum inventory levels and in-
ventory valuation.
14) The organization should internally communicate information, including objectives and responsi-
bilities for internal control, necessary to support the functioning of other components of internal
control.
Information systems must provide accurate, timely reports to appropriate personnel so they can car-
ry out their responsibilities. The people who deal with the customers every day are often the first to
know about a problem, and they should have a way to communicate that information upward. Fur-
thermore, people in the organization need to receive a clear message from top management that
their internal control responsibilities must be taken seriously.
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
organizations objectives. 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.
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.
o Internal communication of information also takes place across the organization through, for ex-
ample, policies and procedures, individual authorities, responsibilities and standards of conduct,
specified objectives, and any matters of significance relating to internal control such as instances
of deterioration or non-adherence.
Internal communication can take many forms, such as dashboards, email messages, training (either
live or online), one-on-one discussions, written policies and procedures, website postings, or social
media postings. Actions also communicate. The way managers behave in the presence of their sub-
ordinates can communicate more powerfully than any words.
15) The organization should communicate with external parties regarding matters affecting the
functioning of other components of internal control.
Relevant and timely information needs to be communicated to external parties including sharehold-
ers, partners, owners, regulators, customers, financial analysts, and other external parties.
External communication also includes incoming communications from customers (customer feed-
back), consumers, suppliers, external auditors, regulators, financial analysts, and others. A whistle-
blower hotline should be available to external parties, as well.
o Communication from customers and suppliers can provide valuable input on the design and qual-
ity of the companys products and services.
o Communications from the external auditors inform management and the board about the organ-
izations operations and control systems.
o Regulators report results of examinations and compliance reviews that can inform management
of control weaknesses.
o If the company is a public company, communications to shareholders, regulators, financial ana-

lysts and others need to provide information relevant to them, so they can understand the
entitys condition and risks.
o Customer complaints often mean there are operating problems that need to be addressed.
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.
o Outgoing communication can take the form of press releases, blogs, social media, postings on
the company website, and emails.
Component 5: Monitoring Activities

Finally, management must monitor the entire internal control system. 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. Monitoring assesses the quality of the internal control systems performance over
time to determine whether the components of internal control are present and are functioning. Management
must also revisit previously identified problems to make sure they have been corrected.
Monitoring ensures that the internal control system continues to operate effectively. Systems and procedures
change over time, and the way controls are applied need to change in order to continue to be effective.
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.
Information received from monitoring activities is used in managements assessment of the effectiveness of
its internal control. Principles relating to the Monitoring Activities component are:
16) The organization selects, develops, and performs ongoing and/or separate evaluations to
ascertain whether the components of internal control are present and functioning.
Monitoring can be done in two ways:
o through ongoing evaluations that are built into business processes during normal operations
and provide timely information, and
o through separate evaluations conducted periodically by management with the assistance of

the internal audit function.
If monitoring is done regularly during normal operations, it lessens the need for separate evalua-
tions.
Note: Monitoring should be done on a regular basis. An advantage to ongoing monitoring is that
if operating reports are used to manage ongoing operations, exceptions to anticipated results will
be recognized quickly.
17) The organization evaluates and communicates internal control deficiencies in a timely manner
to those parties responsible for taking corrective action, including senior management and the board
of directors, as appropriate.
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, and the results of the remedial action should also be monitored to be certain that the situa-
tion has been corrected.
An example of evaluating a monitoring activity is reviewing a reconciliation to make sure it was done
properly and in a timely manner, that the sources of information used in the reconciliation were ap-
propriate, and to look for trends in the reconciling items. All the reconciling items should have been
investigated and resolved, and management should evaluate whether there are any new risks in the
operation caused by changes in the internal and/or external environment.
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.
2) The board of directors exercises oversight responsibility for

internal control.
3) Management establishes structures, authorities, and responsibili-

ties.
4) There is a commitment to competence.
5) Individuals are held accountable for their internal control

responsibilities.
Risk Assessment 6) Objectives are specified so risks to their achievement can be

identified and assessed.
7) Risks are identified and analyzed.
8) Potential for fraud is considered.
9) Changes that could impact internal control are identified and

assessed.
Control Activities 10) Control activities to mitigate risks are selected and developed.
11) General control activities over technology are selected and

developed.
12) Control activities are deployed through policies and procedures.
Information and
13) Relevant, quality information is obtained or generated and is used.
Communication
14) Information is communicated internally.
15) The organization communicates with external parties.
Monitoring Activities 16) Ongoing and separate evaluations are performed of the internal
control system.
17) Internal control deficiencies are evaluated and communicated for

corrective action.
What is Effective Internal Control?

An effective internal control system provides reasonable assurance regarding achievement of an entitys
objectives by reducing to an acceptable level the risk of not achieving an entity objective. 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.
When an internal control system is effective, 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, regulations, and standards or with the entitys
specified reporting objectives, and
complies with applicable laws and regulations.
However, the board of directors and management cannot have absolute assurance that the organizations
objectives will be achieved. Human judgment in decision-making can be faulty, errors do occur, management
may be able to override internal controls, and through collusion, management, other personnel and/or third
parties may be able to circumvent internal controls.
Transaction Control Objectives

Commonly accepted transaction control objectives are:
Authorization. All transactions are approved by someone with the authority to approve the specific
transactions.
Completeness. All valid transactions are included in the accounting records.
Accuracy. All valid transactions are accurate, are consistent with the originating transaction data,
are correctly classified, and the information is recorded in a timely manner.
Validity. All recorded transactions fairly represent the economic events that occurred, are lawful,
and have been executed in accordance with managements authorization.
Physical safeguards and security. Access to physical assets and information systems are con-
trolled and restricted to authorized personnel.
Error handling. Errors detected at any point in processing are promptly corrected and reported to
the appropriate level of management.
Segregation of duties. Duties are assigned in a manner that ensures that no one person is in a
position to both perpetrate and conceal an irregularity.
Types of Transaction Control Activities

Authorization and approvals. Authorization confirms that the transaction is valid, 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, such as an automatic comparison of
an invoice to the related purchase order receiving report. When automated authorization of payables
is utilized, invoices within the tolerance level are automatically approved for payment, while invoices
outside the tolerance level are flagged for investigation.
Verifications. Items are compared with one another or an item is compared with a policy, and if the
items do not match or the item is not consistent with policy, follow up occurs.
Physical controls. Equipment, inventories, securities, 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.
Controls over standing data. Standing data, such as a master file containing prices or inventory
items, is often used in the processing of transactions. Controls need to be put into place over the
process of populating, updating, and maintaining the accuracy, completeness and validity of the data
in the master files.
Reconciliations. Reconciliations compare two or more data elements and, if there are differences,
action is taken to make the data agree. For example, a bank reconciliation reconciles the balance in
the account according to internal records with the balance in the account according to the bank.
Reconciling items are items in transit and are to be expected. However, differences that cannot be
explained by items in transit must be investigated and corrective action taken. Reconciliations gen-
erally address the completeness and accuracy of processing transactions.
Supervisory controls. Supervisory controls determine whether other transaction control activities
are being performed completely, accurately, and according to policy and procedures. For example, 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.
Safeguarding Controls
Physical safeguarding of assets against loss is an important part of a companys operations objectives. Loss to
assets can occur through unauthorized acquisition, use, or disposition of assets or through destruction caused
by natural disasters or fire.
Prevention of loss through waste, inefficiency, or poor business decisions relate to broader operations
objectives and are not specifically considered part of asset safeguarding.
Physical protection of assets requires:
Segregation of duties.
Physical protection and controlled access to records and documents such as blank checks, purchase
orders, passwords, and so forth.
Physical protection measures to restrict access to assets, particularly cash and inventory.
Effective supervision and independent checks and verification.
Segregation of Duties
Duties need to be divided among various employees to reduce the risk of errors or inappropriate activities.
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.
Note: Different people must always perform the following four functions of related activities:
1) Authorizing a transaction.
2) Recordkeeping: Recording the transaction, preparing source documents, maintaining journals.
3) Keeping physical custody30 of the related asset: For example, receiving checks in the mail.
4) The periodic reconciliation of the physical assets to the recorded amounts for those assets.
In a question about an effective or ineffective internal control, keep in mind that these four things must be
done by different people.
30
In the context of internal control, custody involves keeping, guarding, caring for, watching over, inspecting, preserving,
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.
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, that person could receive a cash remittance on account from a customer, authorize a
fraudulent write-off of the receivable, and divert the cash collected to their own use.
If the same person who authorizes issuance of purchase orders is also responsible for recording
receipt of inventory and for performing physical inventory counts, that person could authorize the
issuance of a purchase order to a fictitious vendor using a post office box personally rented for the
purpose, then prepare a fictitious receiving record, 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, the receiving report, and the invoice, as they
are supposed to do. Since all the documentation would match, the accounts payable department
would send a payment to the fictitious vendor for something the company never ordered or received.
Furthermore, during physical inventory counting that same person could easily mark the item as be-
ing in inventory when it never was in inventory, thereby concealing the fraud.
If the same person prepares the bank deposit and also reconciles the checking account, that person
could divert cash receipts and cover the activity by creating reconciling items in the account recon-
ciliation report.
Be aware, however, that segregation of duties does not guarantee that fraud will not occur. Two or more
employees could collude with one another (work together to conspire) to commit fraud, covering for one
another and, presumably, sharing the proceeds.
Software tools are available to assist a business in identifying incompatible functions. An access management
application can help to assess segregation-of-duties and access risks and conflicts.
Note: Collusion occurs when two or more individuals work together to overcome the internal control
system and perpetrate a fraud. When two or more people work together, they are able to get around the
segregation of duties that may have been set out.
Responsibilities and Duties Needing Segregation for Financial and Accounting Positions
Following is a list of some financial and accounting positions, general information on their responsibilities, and
incompatible duties that need to be segregated. The following list is not exhaustive because more positions
and more duties can always be added. However, this will give you several good examples.
Furthermore, firms organize their accounting and financial areas in different ways, so the general duties listed
here for each position should not be considered absolute. In any particular firm, duties listed here may be the
responsibility of a different position than is indicated here and some may overlap. 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.
Title Responsibilities Examples of Incompatible Duties

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

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

Credit Manager The Credit Manager manages the credit departments Employees who authorize and maintain
and Credit activities to ensure accuracy and timeliness of work. credit limits for customers should not
Function Selects and trains department staff and supervises also be able to record adjustments to the
their performance. Answers employees questions and balances owed by customers on their
helps them resolve any complex issues that arise. accounts.
Develops, implements and maintains systems,
procedures and policies related to credit functions.
Controls bad debt exposure by setting credit policies.
Supervises credit checks on customers, reviews
applicants financial statements if appropriate, makes
decisions regarding individual customer credit limits
and credit terms, and obtains guarantees or collateral
when necessary. Monitors the accounts receivable
portfolio using accounts receivable aging reports and
number of days of sales in accounts receivable,
monitor collections, stops extending credit to
delinquent accounts and initiates recovery actions
against delinquent customers. Ensures that the
Allowance for Doubtful Accounts is maintained at an
appropriate level.
Accounts The Accounts Receivable Manager oversees the The person who prepares customer
Receivable accounts receivable departments activities to ensure invoices should not be able to modify the
Manager and accuracy and timeliness, including the order entry customer master file, the pricing, or
Order Entry and process and invoice preparation as well as collections customer contracts.
and posting payments to customers accounts. The person who opens customer remit-
Accounts
Selects and trains department staff and supervises tances should not also record payments,
Receivable
their performance. Answers employees questions and record or authorize adjustments to cus-
Functions helps them resolve any complex issues that arise with tomer accounts, prepare the bank
customers. Develops, implements and maintains deposit, or reconcile the checking
systems, procedures and policies related to accounts account(s).
receivable functions. 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), the tomer accounts, record or authorize
Accounts Receivable Manager controls bad debt adjustments to customer accounts, or
exposure by setting credit policies. Conducts credit reconcile the checking account(s).
checks on customers, reviews applicants financial The person who records payments
statements if appropriate, makes decisions regarding
received on customers accounts should
individual customer credit limits and credit terms, and not also open the remittances, prepare
obtains guarantees or collateral when necessary. the deposit, or initiate adjustments or
Monitors the accounts receivable portfolio using
credits to customers accounts.
accounts receivable aging reports and number of
Adjustments to customers accounts
days of sales in accounts receivable, monitors
should be reviewed and approved by a
collections, stops extending credit to delinquent
supervisor not involved in recording
accounts and initiates recovery actions against
accounts receivable transactions.
delinquent customers. Ensures that the Allowance for
Doubtful Accounts is maintained at an appropriate The person who records transactions in
level. the accounts receivable system should
not also reconcile the accounts receivable
Order entry staff: Performs data input to prepare
system to the general ledger.
invoices for presentation to customers. If items are to
be shipped, 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. someone other than the person who
prepares the reconciliation.
Accounts Receivable staff: Receives customer
payments on accounts and posts the receipts to the
proper account.

Accounts The Accounts Payable Manager oversees the accounts The person who matches the purchase
Payable Manager payable departments activities, ensuring accuracy order, the receiving document, and the
and Accounts and timeliness. May oversee the payroll process as vendor invoice should not be involved in
Payable Function well. Selects and trains department staff and the purchasing or receiving process,
supervises their performance. Answers employees should not be able to modify the vendor
questions and helps them resolve any complex issues master file, or have record-keeping
that arise with vendors. Develops, implements and responsibilities for inventory, purchases,
maintains systems, procedures and policies related to payables, or returns.
accounts payable functions. 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.
recording in the accounting system. The person who records vendor invoices
should not also be responsible for
printing checks.
The person responsible for printing
checks and/or with access to blank check
stock should not have responsibility for
signing checks, recording the disburse-
ments or preparing, reviewing or ap-
proving the checking account recon-
ciliations.
The person responsible for signing checks
should not be involved in any other cash
disbursement process. If a signature
stamp is used to sign checks, the
signature stamp should remain in the
custody of the person whose signature is
on the stamp.
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.
The person responsible for approving
wire transfers should not also prepare or
review and approve bank reconciliations,
record invoices, review and authorize
journal entries in the general ledger, or
modify the vendor master file.
The person responsible for setup of new
vendors or modification of vendor records
in the vendor master file should not also
record vendor invoices, approve vendor
invoices, print checks, sign checks, or
authorize or execute wire transfers.

Accounting Clerk Performs a variety of support tasks in the accounting The person responsible for preparing
department, as assigned. Under supervision, may bank reconciliations should not also
post transactions to accounting journals, ledgers, and receive cash receipts, prepare cash
other records detailing financial transactions, compile deposits, generate or print checks,
data and prepare reports, perform reconciliations, authorize or execute wire transfers, or
investigate questionable data, and perform other have access to blank check stock.
accounting projects as needed.
Personnel or Approves changes in pay rates and changes to The person responsible for initiating
Human deductions from employees paychecks. Approves employee additions and deletions and
Resources new employees to be added to the payroll. 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. record the changes. Modifications should
be initiated by one employee and
reviewed and approved by another
employee.
Employees responsible for modifying the
employee master file should not also
have access to the payroll system, be
involved in the payroll process, generate
payroll checks, distribute payroll checks,
or make hiring and firing decisions.
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 employees supervisor
verifies that hours worked by hourly employees have before the hours are transmitted to the
been approved by the employees supervisors. If the payroll department.
company bills clients by the hour (such as attorneys
or accountants), the timekeeper monitors billable
hours to ensure accuracy.

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

Shipping Clerk Monitors merchandise leaving the companys Shipping employees should not have the
premises. Pulls inventory from the shelves, packs and ability to initiate or authorize sales
prepares shipments, prints shipping labels, tracks orders.
outgoing shipments delivery status. 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.
Inventory Inventory clerk: Maintains custody over and controls An inventory clerk should not be able to
Function access to physical inventory. perform physical inventory counts,
Receiving clerk: Unloads and checks incoming modify perpetual inventory records,
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, or
of each item. reconcile the perpetual inventory records
to the general ledger.
A receiving clerk should not be involved
in authorizing or recording purchase
orders, modifying the vendor master file,
recording vendors invoices for payment,
or recording returned merchandise.
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.
Manual adjustments to the inventory
records should be approved by a super-
visor before being recorded.
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.
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.
A supervisor should review and approve
all disposals or sales of scrapped goods
and obsolete inventory. The employee
who initiates the disposal request should
not also physically dispose of the
inventory or do any recordkeeping for the
disposal.
The person responsible for the sale of
obsolete inventory or scrap should not
also invoice the buyer and collect
payment for the sales. All invoicing and
collections should be done by the
accounting department.
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.
b) The individual who records a transaction must maintain custody of the asset resulting from the
transaction.
c) The individual who authorizes a transaction also records it.
d) The individual who maintains custody of an asset must have access to the accounting records for
the asset.
(CMA Adapted)
Question 67: In a well-designed internal control system, 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.
b) Distribution of payroll checks and approval of sales returns for credit.
c) Approval of bad debt write-offs, and reconciliation of the accounts payable subsidiary ledger and
controlling account.
d) Reconciliation of bank account and recording of cash receipts.
(CMA Adapted)
Question 68: An auditor noted that the accounts receivable department is separate from other accounting
activities. A separate credit department approves credit. Control accounts and subsidiary ledgers are
balanced monthly. Similarly, 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.
Credit memoranda are pre-numbered and must correlate with receiving reports. Which of the following
areas could be viewed as an internal control weakness of the above organization?
a) Credit approvals.
b) Monthly aging of receivables.
c) Write-offs of delinquent accounts.
d) Handling of credit memos.
(CIA Adapted)
Question 69: One characteristic of an effective internal control structure is the proper segregation of
duties. The combination of responsibilities that could be performed by the same person is:
a) Preparation of paychecks and check distribution.
b) Timekeeping and preparation of payroll journal entries.
c) Signing of paychecks and custody of blank payroll checks.
d) Approval of time cards and preparation of paychecks.
(CMA Adapted)
Physical Protection Controlled Access to Records and Documents

Checks should be stored in a locked area, and access to them should be limited to personnel who have
responsibility for preparing checks, subject to authorization and approvals by other individuals. The checks
should be pre-numbered, and the check numbers should be recorded in a log as they are used. Any checks
discovered missing should be promptly reported to supervisory personnel.
Purchase orders should also be pre-numbered, numbers logged as used, and access to them similarly
restricted.
Corporate credit cards should be kept in a locked cabinet and access to them controlled.
Password access should be controlled by limiting the access granted by each employees password to just the
information needed by that employee to do his or her job. Employees should be instructed not to put their
passwords in an exposed area.
Physical Protection Restricted Access to Assets

When cash must be stored until it can be deposited, it should be kept in a locked, fireproof file cabinet or safe
under controlled access.
Inventory can be a major portion of a companys assets, and it is vulnerable to loss from theft, fire, and
natural disasters. The risk of loss can be at least partially transferred through purchase of insurance, but
internal controls are vital to protect as much as possible against loss.
Inventory should be kept in a physically locked area, and the locks should be technically advanced
(not just simple combination locks).
Requisitions for inventory should be approved by authorized personnel.
The inventory area should be monitored by a gatekeeper who verifies proper authorization for
requests to move goods.
Security cameras can be used to monitor activity in the inventory area and to help identify theft and
thieves. The very existence of cameras tends to discourage employee theft.
Security alarms on doors and windows can alert local police in case of a break-in.
A security guard may be employed during hours when employees are not present if the inventory
has high value.
Regular physical inventories should be taken and missing items should be investigated.
Effective Supervision and Independent Checks and Verifications

Supervision over the performance of clerical functions is necessary. For example:
Comparison of independent sets of records is necessary, such as comparing the report of the physi-
cal count of inventory to the internal inventory records; or comparing the information on a bank
reconciliation with the actual bank statement to confirm the bank balance used in the reconciliation
is correct.
Invoices should be prepared based on verified orders. The packing slip should be prepared at the
same time the invoice is prepared, and nothing should be shipped without a packing slip. Records of
actual shipments made should be compared with internal shipping documents, which should be com-
pared with invoices issued to verify that the procedures are being followed.
The process of receiving inventory should be supervised to make sure the inventory clerk is actually
counting the items received before affirming their receipt.
Section E Legislative Initiatives About Internal Control
Legislative Initiatives About Internal Control

In the United States, various federal legislative initiatives have been created to promote or require companies
to implement internal controls. 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, 203, 204,
302, 404, and 407).
Identify the role of the Public Company Accounting Oversight Board (PCAOB) in providing guidance
on the auditing of internal controls.
Identify the PCAOB-preferred approach to auditing internal controls as outlined in Auditing Standard
#5.
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, and in some cases they apply to all companies.
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, which is the primary regulatory agency
of these internal control statutes. For example, many provisions of the Sarbanes-Oxley Act apply only to
publicly-traded companies and companies that report to the SEC, whereas some provisions apply to all
companies, even companies that do not report to the SEC. The accounting and internal control provisions of
the Foreign Corrupt Practices Act apply to all U.S. companies that are registered with and report to the SEC,
not only those with foreign operations, whereas the anti-corruption and anti-bribery provisions apply to any
company, public or private, with significant operations in the United States, regardless of whether the corrupt
act takes place inside or outside the United States.
Foreign Corrupt Practices Act (FCPA)

The Foreign Corrupt Practices Act of 1977 (FCPA), substantially revised in 1988 and amended in 1998 by the
International Anti-Bribery and Fair Competition Act of 1998, was enacted in response to disclosures of
questionable payments that had been made by large companies. Investigations by the SEC had revealed that
over 400 U.S. companies had made questionable or illegal payments in excess of $300 million to foreign
government officials, politicians, and political parties. The payments were either illegal political contributions
or payments to foreign officials that bordered on bribery.
The FCPA has two main provisions: an anti-bribery provision, and an internal control provision.
Anti-Bribery Provision
The anti-bribery provisions of the FCPA apply to all companies, regardless of whether or not they are
publicly traded.
Under the FCPA, 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. In addition, a firm, or an individual acting on behalf
of a firm, 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.
Note: This prohibition is only against corrupt payments to a foreign official, a foreign political party or
party official, or any candidate for foreign political office.
The entire company, not any one individual or position in the company, is responsible for ensuring
that all payments are legal and lawful, although individuals are personally liable for their own actions.
Furthermore, the company must ensure that all transactions are made in accordance with managements
general or specific authorization and are recorded properly.
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, whether or not the payment leads to the
desired outcome.
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. Therefore, under the Foreign Corrupt Practices Act corporate
management is required to maintain books, records, and accounts that accurately and fairly reflect
transactions and to develop and maintain a system of internal accounting control.
Note: The internal control provision of the FCPA applies only to companies that are publicly traded.
Sarbanes-Oxley Act and the PCAOB

The Sarbanes-Oxley Act of 2002 (SOX or SarbOx) contains provisions impacting auditors, management, and
audit committees. Sarbanes-Oxley was enacted in response to several major incidents of financial reporting
fraud and audit failures, and it applies to all publicly-held companies in the U.S., all of their divisions, and all
of their wholly-owned subsidiaries. It also applies to any non-U.S. owned, publicly-held multinational
companies that operate in the U.S. In addition, some provisions apply also to privately-held companies; and a
privately-held company may comply with SOX in preparation for an initial public offering, in preparation for
raising private funding for a sale of the company, or on a voluntary basis (for example, using it as a best-
practices benchmark).
Title I: Public Company Accounting Oversight Board (PCAOB)

Title 1 of the Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (PCAOB),
whose mandate is to oversee the auditing of public companies that are subject to the securities laws, protect
the interests of investors, and enhance the publics confidence in independent audit reports. As an
independent, non-governmental board, the PCAOB is a non-profit corporation that operates under the
authority of the SEC, which oversees the approval of its Boards rules, standards, and budget.
According to the Act, public accounting firms (that is, external auditors) are required to register with the
PCAOB. Furthermore, the PCAOB is charged with developing auditing standards to be used by registered
public accounting firms in their preparation and issuance of audit reports. In addition, 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.
The formation of the PCAOB constitutes the first time that auditors of U.S. public companies became subject
to external and independent oversight. Previously, the profession had been self-regulated through a formal
peer review31 program administered by the American Institute of Certified Public Accountants (AICPA). That
peer review program continues, and accounting and audit firms that are required to be inspected by the
PCAOB are also subject to peer review.
The responsibilities of the PCAOB include:
1) Registering public accounting firms that audit public companies. The Sarbanes-Oxley Act requires all
accounting firms (both U.S and non-U.S. firms) that prepare or issue audit reports on or participate
in audits of U.S. public companies to register with the PCAOB.
2) Establishing auditing and related attestation, quality control, ethics, independence, and other stand-
ards relating to the preparation of audit reports for issuers.
31
Peer review is a process of self-regulation used in professions to evaluate the work performed by ones equals (that is,
peers) to ensure it meets certain criteria. Peer review is performed by qualified individuals within the same profession. A
peer review is performed for an accounting and audit firm by professionals from another accounting and audit firm.
3) Conducting inspections of registered public accounting firms, annually for firms that audit more than
100 issuers and every three years for others. In the inspections, the Board assesses the firms com-
pliance with the Sarbanes-Oxley Act, the rules of the Board, the rules of the Securities and Exchange
Commission (SEC), and its professional standards in connection with the firms performance of au-
dits, issuance of audit reports, and related matters involving issuers.
4) Enforcing compliance with the Act, the rules of the Board, professional standards, and securities laws
relating to audit reports and the obligations of accountants for them.
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, the provisions of the
securities laws relating to the preparation and issuance of audit reports, or professional standards.
6) Management of the operations and staff of the Board.
Title II: Auditor Independence
Section 201: Services Outside the Scope and Practice of Auditors

In order to maintain auditor independence, 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. These services include:
1) Bookkeeping services or other services relating to keeping the accounting records or preparing the
financial statements of the audit client.
2) Financial information systems design and implementation.
3) Appraisal or valuation services, fairness opinions, or contribution-in-kind reports.
4) Actuarial services.
5) Internal audit outsourcing services.
6) Management functions.
7) Human resource services.
8) Broker/dealer, investment adviser, or investment banking services.
9) Legal services.
10) Expert services unrelated to the audit.
11) Any other service that the Public Company Accounting Oversight Board (PCAOB) determines, by
regulation, is not permissible.
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. Therefore, the lead audit partner and the concurring review audit
partner must rotate off a particular clients audit after five years. They must then remain off that audit for
another five years. 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.
Specialty partners, (partners who consult with others on the audit engagement regarding technical or
industry-specific issues), do not need to rotate off. 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, accounting or reporting matter affecting the companys financial statements or who maintains regular
contact with management and the audit committee of the audit client.
specialists. 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.
The purpose of the audit partner rotation requirement is to ensure that a new look is taken periodically at
the financial statements.
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 issuers Audit Committee:
1) All critical accounting policies and practices to be used;
2) All alternative treatments of financial information within generally accepted accounting principles
that have been discussed with the issuers management, the ramifications of the use of such alterna-
tive disclosures and treatments, and the treatment preferred by the registered pubic accounting
firm; and
3) Other material written communication between the registered public accounting firm and the man-
agement of the issuer, such as any management letter or schedule of unadjusted differences.
If management of the company is using an alternative method of accounting for something, even though it is
within generally accepted accounting principles, the outside public accounting firm performing the audit must
report that fact to the companys Audit Committee. 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, SEC reports) must include certifications by the companys principal
executive officer or officers and its principal financial officer or officers. This certification must indicate the
following:
1) Each signing officer has reviewed the report.
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.
3) To the best of the officers or officers knowledge, 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.
For the CMA Exam, the most important certifications by the officers are connected to the internal controls of
the company, as shown in the following lists.
1) The signing officers certify that they:
o Are responsible for establishing and maintaining internal controls.
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.
o Have evaluated the effectiveness of the companys internal controls within the previous
ninety days.
o Have reported on their findings about the effectiveness of their internal controls.
2) The signing officers have disclosed to the companys auditors and its audit committee of the board of
directors:
o All deficiencies in the design or operation of the companys internal controls and have identi-
fied for the companys auditors any material weaknesses in its internal controls.
o Any fraud, regardless of how material it is, that involves management or other employees who
have a significant role in the companys internal controls.
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 companys internal controls after the date of their evaluation, including any corrective
actions that have been taken with regard to deficiencies or material weaknesses.
Note: Companies cannot avoid these requirements by reincorporating outside the United States or by
transferring their companys activities outside of the United States. If they do this, the Act will continue to
have full legal force over them.
Title IV: Enhanced Financial Disclosures

Section 404: Management Assessment of Internal Controls and the Independent Auditors Attestation to
Managements 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.
2) Contain an assessment by management of the adequacy of the companys internal control over
financial reporting (or ICFR).
Section 404(b) requires the companys independent auditor to report on and attest to managements
assessment of the effectiveness of the internal controls.
In other words, according to Section 404(a) management is required to document and test its internal
financial controls and to report on their effectiveness. In many firms, the internal audit activity is very
involved in the management review and testing of the internal controls. Furthermore, 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 external auditors report is
done in order to assert that managements report is an accurate description of the internal control
environment.
The first step in a Section 404 compliance review is to identify the key processes. Here, 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. The overall processes are generally organized in terms of the basic
accounting cycles, 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, such as periodic record-
ing of depreciation
General IT cycle: general IT controls that are applicable to all IT operations
The internal controls covering the key processes are reviewed and documented, and then these controls are
tested. The external auditor then reviews the work and attests to its adequacy.
The extent of internal audits involvement in the Section 404 testing of internal controls varies from firm to
firm. It can take three forms:
1) Internal auditors may act as internal consultants in identifying the key processes, documenting the
internal controls over these processes, and performing tests of the controls. Senior managements
approval of internal audits work is necessary.
2) The company might designate some other internal or external consulting resource to perform the
Section 404 reviews. In this case, internal auditors could act as a resource to support the work. They
may review and test internal control processes as assistants or contractors for the entity doing the
review.
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, allowing the internal audit activity to
concentrate its resources on other internal audit projects.
Management, in its assessment of internal controls, and the independent auditor, in its attestation to
managements assessment, can have different testing approaches because their roles are different and
therefore they are subject to different guidance.
Guidance for the management assessment of internal controls is provided by the SEC in Release
Nos. 33-8810; 34-55929; FR-77; File No. S7-24-06 (hereinafter simply called Release No. 33-8810).
This release, containing the interpretive guidance for management on Section 404, is intended to
enable companies to implement the requirements more effectively and efficiently.
Guidance for the independent auditors attestation to managements assessment is contained in the
Public Company Accounting Oversight Boards Auditing Standard No. 5.
Although the sources of guidance are different for management and the independent auditor, the PCAOB
intentionally aligned its guidance in Auditing Standard No. 5 with the SECs guidance for management in the
SECs Release 33-8810, particularly with regard to prescriptive requirements, definitions, and terms.
Therefore, the guidance to management and the guidance to independent auditors are not in conflict.
Both SEC Release 33-8810 (guidance for management) and the PCAOBs Auditing Standard No. 5 (guidance
for external auditors) have the effect of efficiently focusing Section 404 compliance on the most
important matters affecting investors.
Both SEC Release 33-8810 and PCAOB Auditing Standard No. 5 prescribe a top-down, risk-based
approach to evaluating internal control over financial reporting. 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. Beginning with risk assessment allows the auditor to focus on higher-risk areas while
spending less time and effort on areas of lower risk. 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.33
It is important for the auditor to use a top-down approach, not a bottom-up approach. 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, transaction, and application levels. When the auditor uses a bottom-up
process, he or she often spends more time and effort than is necessary to complete the audit. Furthermore,
33
An assertion is a claim made. A management assertion is a claim made by management. Financial statement assertions
are claims made by management in presenting financial information. Examples of broad financial statement assertions are
Total liabilities at December 31, 20XX were $150,000,000 or Net income for the year ended December 31, 20XX was
$5,000,000. Financial statement assertions can be much narrower also, as in Receivables due from Customer X on
December 31, 20XX totaled $50,000. The auditors role is to determine whether the assertions being made by
management are correct. Most of the work of a financial audit involves evaluating and forming opinions about management
assertions.
when an auditor takes a bottom-up approach, 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, transactions, and applications. 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.
A top-down approach ensures the proper testing of the controls for the assessed risk of misstate-
ment to each relevant assertion. If a bottom-up approach is used, those controls that address the risk of a
material misstatement may not be tested.
Section 407: Disclosure of Audit Committee Financial Expert

Section 407 of the Sarbanes-Oxley Act required, and the SEC has issued rules requiring, each issuer of
publicly-traded securities to disclose whether or not the companys Audit Committee consists of at least one
member who is a financial expert. If the Audit Committee does not have at least one member who is a
financial expert, the company must state the reasons why not.
The definition of a financial expert is a person who, through education and experience as a public accountant,
auditor or a principal accounting or financial officer of an issuer of publicly-traded securities, 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, accruals, and
reserves;
2) experience in the preparation, auditing, 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;
3) experience and an understanding of internal accounting controls and procedures for financial report-
ing; and
4) an understanding of Audit Committee functions.
If the company discloses that it has one financial expert on its Audit Committee, it must disclose the name of
the expert and whether that person is independent. If the company discloses that it has more than one
financial expert serving on its Audit Committee, it may, but is not required to, disclose the names of those
additional persons and indicate whether they are independent.
34
Issuers means issuers of securities, generally publicly-traded securities.
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.
For publicly traded companies, the auditor presents two reports in the Annual Report:
An opinion on whether the financial statements present fairly, in all material respects, the financial
position, results of operations, and cash flows of the company, in conformity with generally accepted
accounting principles
An opinion on how effectively the companys management has maintained effective internal
control over financial reporting. (This opinion is not required for companies that are not publicly
traded.)
In its capacity as auditor, the external auditor has no responsibility to make recommendations or suggestions
to the client. They have no responsibility to follow up any audit findings from the previous year. The auditors
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).
However, an external auditor that is registered with the PCAOB under the Sarbanes-Oxley Act is obligated
under Section 204 to make reports to the companys Audit Committee of the board of directors of a publicly-
traded company that include:
The accounting principles being used,
All alternative treatments being used,
The ramifications of the use of such alternative treatments,
The treatment preferred by the public accounting firm, and
All other material written communication between the registered public accounting firm and the
management of the company.
Financial Statement Opinion

For the opinion on the financial statements, the auditor conducts an independent examination of the
accounting data prepared and presented by management and expresses an opinion on them. Though the
auditor will not use the word correct, the opinion is in essence whether or not the financial statements are
correct. Instead, the auditor would assert that the financial statements present fairly, in all material
respects the financial position of the company.
The auditors 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 auditors opinion may be:
Unqualified: Most audit reports are unqualified, meaning that the results are clean. The auditor
expresses the opinion that the financial statements present fairly, in all material respects, the finan-
cial position, results of operations, and cash flows of the company, in conformity with generally
accepted accounting principles.
Qualified: A qualified opinion contains an exception, meaning that the financial statements do
not present a true and fair picture. However, 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. There-
fore, it does prevent the auditor from issuing an unqualified opinion. Usually, a qualified opinion is
issued under one of these conditions:
o the scope of the auditors examination (that is, the work that the auditor wanted to perform)
was limited or was affected by restrictions, or
Section E External Auditors Responsibilities and Reports
o the statements do not present fairly the companys financial position or results of operations be-
cause of a lack of conformity with generally accepted accounting principles or because of
inadequate disclosures.
A qualified opinion states that, except for this specific matter, the financial statements present
fairly in all material respects, the financial position, results of operations, and cash flows of the com-
pany in conformity with generally accepted accounting principles.
Adverse: An adverse opinion is issued when the exceptions are so material that, in the auditors
judgment, a qualified opinion is not appropriate. This means that the financial statements, taken as
a whole, are not presented in conformity with generally accepted accounting principles. Ad-
verse opinions are seldom issued because most companies change their accounting upon the
instructions of the auditor, in which case an adverse opinion is not warranted.
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.
Internal Control Opinion

The second report, required by the Sarbanes-Oxley Act, is the auditors opinion as to whether or not the
companys management has maintained effective internal control over financial reporting. The companys
annual report, filed with the SEC and incorporated into the annual report to shareholders, must be
accompanied by a statement that management is responsible for creating and maintaining adequate internal
controls. Managements statement must set forth their assessment of the effectiveness of these controls. The
companys auditor must report on and attest to managements assessment of the effectiveness of the internal
controls, which is considered to be the core responsibility of the auditor and an integral part of the audit
report.
The criteria used by the independent auditor in assessing the companys internal control over financial
reporting come from the document Internal ControlIntegrated Framework issued by the Committee of
Sponsoring Organizations (COSO) of the Treadway Commission. The auditors 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. Furthermore, the auditors responsibility is to
express an opinion on the companys internal control over financial reporting based upon its audit.
If the independent auditor is satisfied with the companys internal control over financial reporting, it includes
the following paragraph:
In our opinion, _____________________ maintained, in all material respects, effective internal control over
financial reporting as of _________________, based on the COSO criteria.
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. This growth of the role and expectations
of internal auditors has led to the development of internal auditing as a profession.
The Institute of Internal Auditors, the professional organization of internal auditors, has defined the
fundamental purpose, nature, and scope of internal auditing as follows:
Internal auditing is an independent, objective assurance and consulting activity designed to add value
and improve an organizations operations. It helps an organization accomplish its objectives by
bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk man-
agement, control and governance processes.
An effective internal audit function provides to management and the audit committee a means of
monitoring the reliability of financial reporting and the organizations control over operations. The monitoring
of control over operations includes the effectiveness and efficiency of operations and the organizations
compliance with applicable laws and regulations.
The functional areas of internal auditing are similar to the functional areas of internal control. Internal control
is a process designed to provide reasonable assurance that the companys objectives in the areas of
effectiveness and efficiency of operations, reliability of financial reporting, and compliance with
applicable laws and regulations will be achieved. Internal auditing services contribute to the achievement
of these internal control objectives by providing monitoring services for the respective controls.
The Internal Audit Charter: Establishing the Internal Audit Function

The internal audit function of a firm must have a charter. In general, a charter is a document that outlines
the principles, functions, and organization of a corporate body. In the case of the internal audit function, the
internal audit charter formally defines the internal audit activitys purpose, authority, and responsibility. It
defines the nature of the assurance services and consulting services that the internal audit activity is
expected to provide to the organization.
The charter should establish that the Chief Audit Executive (CAE) reports to the board of directors. It
should give the internal-audit activity authority to access all records, personnel, and physical property that
may be relevant to the performance of engagements. The board of directors must approve the internal audit
charter.
Organizational Independence
The internal audit activity must have organizational independence. According to the Standards (Standard
1110), in order to have organizational independence, the Chief Audit Executive must report to a level that
allows the internal audit activity to fulfill its responsibilities. Organizational independence is achieved when
the Chief Audit Executive reports functionally to the board of directors. Reporting to the board permits the
internal audit activity to be free from interference in determining the scope of its internal auditing, performing
its work, and communicating its results. To accomplish the necessary organizational independence, the Chief
Audit Executive must communicate and interact directly with the board (Standard 1110.A1).
In other words, if the Chief Audit Executive were to report to a member of senior management, and if that
member of senior management were involved in some kind of fraud or fraudulent reporting, 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 managers improper activities. Furthermore, the senior manager
would have the power to fire the Chief Audit Executive. When the Chief Audit Executive is hired by and
Section E Internal Auditing
reports directly to the board, no senior manager or anyone else in the organization is able to influence what
the Chief Audit Executive does. That is the definition of organizational independence.
Scope of Activities and Responsibilities

The internal audit function should cover every part of the organizations operations, and to this end it must
have unlimited access to the companys documents, records, personnel, and properties. While the internal
audits scope might appear broad, there is a very specific limit to its responsibilities.
The responsibility of the internal auditor is to review and appraise policies, procedures, plans, and
records for the purpose of informing and advising management.
However, internal auditors do not have any authority or responsibility over operating activities. If
they had this responsibility, 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.
The responsibility of internal audit ends with the making of recommendations. Auditors should have
no authority over or responsibility for the activities they audit or the implementation of their recommenda-
tions. It is the responsibility of the board or management to implement the recommendations brought to
them by the internal auditors.
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.
Roles and Responsibilities of the Chief Audit Executive

The Chief Audit Executives is responsible for effectively managing the internal audit activity in accordance
with the internal audit charter and the Definition of Internal Auditing, the Code of Ethics, and the Internation-
al Standards for the Professional Practice of Internal Auditing.
Managing the internal audit activity includes the following:
Ensuring that the results of the internal audit activitys work achieve the objectives in the internal
audit charter,
Ensuring that the internal audit activity conforms with the Definition of Internal Auditing and the
Standards, and
Ensuring that the internal audit activity staff members conform to the Code of Ethics and the Stand-
ards.
In addition to the above, other specific responsibilities of the Chief Audit Executive include:
Establishing a risk-based plan to determine the priorities of the internal audit activity, consistent with
the organizations goals,
Communicating the internal audit activitys plans and resource requirements as well as the impact of
resource limitations to senior management and the board,
Establishing policies and procedures to guide the internal audit activity,
Coordinating activities with other internal and external providers of assurance and consulting ser-
vices to ensure proper coverage and minimize duplication of efforts, and
Reporting periodically to senior management and the board on the internal audit activitys purpose,
authority, responsibility, and performance relative to its plan.
Scope of Services
Based on the recommendations of the IIA, the scope of internal auditing work encompasses:
a systematic, disciplined approach to evaluating and improving the adequacy and effectiveness of
risk management, control, and governance process and the quality of performance in carrying
out assigned responsibilities. The purpose of evaluating the adequacy of the organizations existing
risk management, control, and governance process is to provide reasonable assurance that these
processes are functioning as intended and will enable the organizations objectives and goals to be
met, and to provide recommendations for improving the organizations operations, in terms of both
efficient and effective performance. Senior management and the board might also provide general
direction as to the scope of work and the activities to be audited.
The adequacy of risk management, control, and governance processes is present if management has
planned and designed for these items in a manner that provides reasonable assurance that the organizations
objectives and goals will be achieved efficiently and economically.
Reasonable assurance recognizes the fact that there is no way to guarantee that the risk management,
control, and governance processes are working perfectly. There is always the potential for mistakes, human
error, collusion, failure to properly apply a control, or other events that will cause a control to fail. While it is
not possible to provide absolute guarantees, 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. It is also important to note that external auditors
also provide only reasonable assurance with their audit work.
Note: The size and scope of an internal audit function of a company will depend upon a number of factors,
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. 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. 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. 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.
According to Internal Auditing Standard 2130.A1, the internal auditor assists the organization in maintaining
effective controls by evaluating the adequacy and effectiveness of controls in responding to risks within the
organizations governance, operations, and information systems regarding the:
Achievement of the organizations strategic objectives,
Reliability and integrity of financial and operational information,
Effectiveness and efficiency of operations and programs,
Safeguarding of assets, and
Compliance with laws, regulations, policies, procedures, and contracts.
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.
b) Assurance that fraudulent activities will be detected quickly.
c) Assurance that there is reasonable control over day-to-day operations.
d) Assurance that external financial statements are correct.
(CMA Adapted)
Testing and Evaluating the Effectiveness of the Internal Control System

The companys management, including the board of directors, is responsible for the organizations internal
control. In order to assist management in the fulfillment of this responsibility, internal auditors are used to
monitor the performance of the organizations internal control systems.
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, when properly executed, will adequately address these
risks. In a sense, the evaluation of the effectiveness of controls looks at how the controls are de-
signed in theory.
2) Testing compliance with controls, or the process of testing to see if the controls are being fol-
lowed. For example, if the control requires two signatures on all purchase orders, the test of
compliance would confirm that all purchase orders are signed by the proper two individuals.
The specific nature of a given test of a control will depend on the control itself. However, the details of this
testing are outside the scope the exam.
Determining Which Engagements to Conduct

The Chief Audit Executive (CAE) decides which engagements will be performed, and there are many factors
that the CAE will consider in making this decision. Many CAEs find it useful to first update the internal audit
activitys audit universe, which is a list of all the possible audits that the internal audit activity can perform.
To understand the nature of the audit universe, the CAE should obtain input from senior management and the
board. However, even without the assistance of senior management and the board, the CAE should be able to
determine what the audit universe includes.
Usually, the audit universe includes many more potential engagements than the internal audit function has
the resources to perform. Therefore, the chief audit executive will need to prioritize which engagements
should be performed.
One of the most important elements when prioritizing engagements is the consideration of risk. 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, consistent with the organizations goals. For this purpose, risk is
defined as the likelihood that the goals and objectives of the organization will not be achieved. Priority should
be given to areas where risk is assessed the highest.
In considering risk, the CAE takes into account the organizations risk management framework, including
using the risk appetite levels set by management for the different activities or parts of the organization. If a
framework does not exist, the CAE should use his or her own judgment of risks, after consultation with senior
management and the board.
It is largely through this consideration of risk that the CAE is able to prioritize the necessary engagements.
However, risk is not the only criteria because there are other factors that will be considered, including:
The length of time since the last engagement was performed in this area
Requests from senior management, the audit committee, or other governing bodies
An engagements relation to the external audits of financial statements and management control
over financial reporting
Changing circumstances in the business, operations, programs, systems, or controls
Changes in the risk environment or control procedures in a given department
The potential benefit that could be achieved from the engagement
Changes in the skills of the available staff, because new skills may enable the internal audit activity
to conduct different types of engagements (for instance, a new employee may bring new skills, or
training may give an existing staff member new skills)
Of all of these considerations, risk assessment is generally the most important because there are both
quantitative (numerical) assessments and qualitative (characteristics) assessments of risk. Quantitative
assessments include the dollar value of the assets at risk or the potential loss, 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, probability) of the loss occurring. For example, a CAE might consider and
assess the risks associated with petty cash: petty cash is available to a large number of people, the dollar
amount is generally low, and records of transactions require simple documentation. After considering these
factors, 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.
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, control procedures (or, more accurately, lack of control procedures)
connected to the production processes of the company may also be an area of risk that would need
investigation.
Types of Engagements
Internal auditors perform two basic categories of services: assurance services and consulting services.
Assurance services involve performing an objective examination of evidence to provide an independent

opinion or conclusions regarding an entity, an operation, a function, a process, a system, or some other
subject. Examples of this type of work include financial audits, performance audits, audit of financial controls,
risk management audits, compliance audits, audits of system security, and due diligence35 engagements.
Assurance engagements provide an assessment of the reliability and/or relevance of data and operations in
specific areas.
Consulting services involve providing advice to management. Usually they are performed at the request of
the client, and their nature and scope are agreed upon with the client36 prior to the engagement. They are
intended to add value and improve an organizations governance, risk management, and control processes
without the internal auditor assuming management responsibility.
Note: For the CMA Exam, look only at operational and compliance audits because these are the only two
types of engagements listed in the LOS.
Operational (or Performance) Audit

The purpose of an operational or performance audit is to examine and evaluate systems of internal
control, overall company operations, and the quality of performance in carrying out assigned responsibilities.
In order to assess these items, a company must have a standard level of behavior or output or some other
objective. The internal auditors will then compare the results of the operations with these standards.
35
Due diligence is a thorough investigation that is done prior to signing a contract. The most common use of the term in
business applies to the acquisition of a target company. Due diligence is the process of evaluating the target company or its
assets prior to making an offer for the business.
36
For an internal auditor, a client is an area within the same company for which internal auditing services are performed.
Internal auditors do not have external clients.
The focus of an operational or performance audit is on the three Es:
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 main techniques for the auditor in an operational audit are analysis, the observation of departmental
activities, and questionnaires or interviews of employees.
In addition, as part of an operational audit the internal auditor will make recommendations to improve the
process or operation.
The scope of the operational or performance audit exceeds that of a financial audit. In addition to evaluating
the financial records and information (that is, the focus of a financial audit), internal auditors will also look at
areas that do not affect the financial statements or other financial reporting, including evaluating the
adequacy and effectiveness of controls related to policies, procedures, and decision-making.
Compliance Audit
A compliance audit determines the degree to which an organization is operating in an orderly way, conforming
effectively and visibly to certain specific requirements of its policies, procedures, standards, or laws, and
complying with governmental regulations. Compliance auditing is more objective than other internal auditing
applications. To perform a compliance audit, the auditor must first know the applicable policies, procedures,
standards, and laws.
In a compliance audit, the internal auditor focuses on issues of compliance (or lack of compliance). In the
case of noncompliance, the auditor will also determine the cause of the noncompliance, the cost of the
noncompliance, and appropriate actions that must be taken in order for a company to be in 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 teams activities and output.
b) Fact-finding, analysis, and documentation.
c) Reporting on the findings.
d) Recommendations for improvement.
(CMA Adapted)
Question 72: An example of the subject of an operational audit would be:
a) The income tax return information of a manufacturer.
b) The performance statistics on the delivery of a citys services.
c) The verification of the dollar amount of royalties due to the developer of a manufacturing process
from the user of that process.
d) The five-year revenue and expenses forecast by an entrepreneur seeking to raise venture capital
for his prospective operation.
(CMA Adapted)
Reporting to the Board

A control breakdown occurs when a control fails. Many control breakdowns are accidental and do not put the
company at significant risk. However, the internal auditor needs to identify significant control breakdowns
that could harm to the company. In addition, breakdowns and their associated risks need to be properly
reported. This reporting will be in the engagement report and may also be reported directly to the Board.
All material weaknesses37 that could cause a control breakdown should be included in the auditors report.
The auditor may choose to issue an interim report if the breakdown is significant. Generally, interim reports
should be issued whenever there is an issue that needs to be addressed immediately.
If an internal auditor identifies a weakness in controls, he or she should evaluate its severity to determine
whether or not the deficiency, either individually or in combination with other deficiencies, represents a
material weakness. The severity depends upon:
Whether or not there is a reasonable possibility that the companys 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. In order to have a mitigating effect, a compensating control should operate
at a level of precision that would prevent or detect any misstatement that would be material.
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. These risk factors include:
The nature of the financial statement accounts, disclosures, and assertions involved
The susceptibility of the related asset or liability to loss or fraud, or how likely it is that something
could go wrong
The subjectivity, complexity, or extent of judgment required to determine the amount involved
The interaction or relationship of the control with other controls, including whether or not they are
interdependent or redundant
The interaction of the deficiencies (that is, if there is more than one, 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, internal auditors should reveal all material facts known to
them which, if not revealed, could either distort reports of operations under review or conceal unlawful
practices. Any variance between what should be and what is should be reported. Examples of incidents
that should be reported include but are not limited to:
1) Fraud. If fraud is suspected, the internal auditor should notify the appropriate level within the
organization. This level is always at least one level above the point at which the fraud is suspected.
2) Violation of any law, such as environmental regulations.
3) For a quality audit, inconsistent product quality that may cause a loss of market share.
4) A situation in which no control failure has occurred, no illegal activity is going on, and no accounting
errors have occurred may also be a reportable situation in certain circumstances. For instance, if an
37
Material as used in this context means important or capable of causing great consequences. A material weakness
occurs when one or more of a companys internal control procedures that is intended to prevent significant financial
statement irregularities is found to be ineffective. Thus a material weakness is a an important weakness that could lead to a
material (important, capable of causing great consequences) misstatement in the companys financial statements.
auditor discovers that a major supplier is not offering the organization a discount for early payment,
when the auditor knows that the supplier is offering discounts to other companies on similar pur-
chases, the goal of efficiency would indicate that he or she report this information to management.
IIA Practice Advisory 2060-1, provides guidance on this issue as follows:
Significant risk exposures and control issues are those conditions that, according to the CAEs judg-
ment, could adversely affect the organization and its ability to achieve its strategic, financial
reporting, operational, and compliance objectives. Significant issues may carry unacceptable expo-
sure to internal and external risks, including conditions related to control weaknesses, fraud,
irregularities, illegal acts, errors, inefficiency, waste, ineffectiveness, conflicts of interest, and finan-
cial viability.
After the information is communicated to the Board, the Board decides the actions to be taken. The role of
the internal auditor is simply to report to the Board, not to make decisions.
Inherent Risk, Control Risk and Detection Risk

Note: This topic is listed in the LOS in the section Governance, Risk and Compliance. This information is
included in Internal Audit because it fits better with the topic of auditing.
Generally, audit risk and the specific risks of inherent, control and detection risk are discussed as part of a
financial statement audit, and they are applicable to any type of engagement performed by the internal
auditor. Audit risk is the risk that the auditor will come to the wrong conclusion. For example, 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, when it is not really working properly. 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.
Audit risk can be looked at in these three ways:
Inherent risk: The risk that is natural in the function being audited, assuming that there are no
controls. It is the susceptibility to a material mistake that exists just because. An example of an
inherent risk is the calculation of pension liabilities, which by nature are extremely complex.
Control risk: The risk that an internal control will not prevent or detect a material misstatement in
a timely manner. As seen in the section on Internal Control, internal control is not a guarantee that
an organization will achieve its financial reporting, operational, and compliance objectives. No matter
how well designed and operated it is, internal control can provide only reasonable assurance to man-
agement and the board of directors that the organizations objectives will be achieved. Major risks
are that controls may fail because of human error, or they can be circumvented by collusion, or
management may override internal control procedures.
Detection risk: For an internal auditor, 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.
Question 73: In assessing relative risks, internal auditors should be least concerned with:
a) Statistical sampling techniques.
b) Compliance with internal and external rules and regulations.
c) Reliability and integrity of information.
d) Safeguarding of assets.
(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.
b) The risk that the auditor will not detect a material misstatement that exists in an assertion.
c) The susceptibility of an assertion to a material misstatement, assuming that there are no related
internal control structure policies or procedures.
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 entitys internal control structure policies or procedures.
(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 clients internal control structure policies or procedures. The best control
procedure for preventing or detecting fictitious payroll transactions is:
a) Personnel department authorization for hiring, pay rate, job status and termination.
b) To use and account for prenumbered payroll checks.
c) Periodic independent bank reconciliations of the payroll bank account.
d) Storage of unclaimed wages in a vault with restricted access.
(CMA Adapted)
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 companys
exposure to inaccuracies and fraud.
Since computers apply the same steps to similar transactions, there should be no chance for clerical (human)
error in processing. However, if there is a mistake in the program itself, there will be an error in every
transaction that is processed using that defective program. Furthermore, if a clerical error is made in input, it
will of course result in an output error.
Potential for fraud is always present in organizations and is a serious problem, even without computer
processing of data. The automatic processing of 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. The concentration of data storage creates exposure, as
well. The potential for fraud is further increased because of the fact that programs are used for the
processing. There is potential for fraud to be committed within the program itself. Without proper controls,
this type of fraud may go undetected for a long period of time.
Further complicating the situation is the fact that because of the nature of the system, paper audit trails
may exist for only a short period of time, since support documents may be periodically deleted. 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. The audit trail must include all of the
documentary evidence for each transaction and the control techniques that the transaction was subjected to,
in order to provide assurance that the transaction was properly authorized and properly processed. When an
audit trail is absent, the reliability of an accounting information system is questionable.
On the positive side, computer systems can provide large amounts of information to management in a very
short period of time. This can enable management to maintain closer control over the activities of the
company and their results.
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 companys objectives.
Maintaining the reliability of financial reporting through checking the accuracy and reliability of
accounting data.
Assuring compliance with all laws and regulations that the company is subject to, as well as adher-
ence to managerial policies.
Safeguarding assets.
Information system internal control guidelines are based upon two documents:
1) The report of the Committee of Sponsoring Organizations, Internal Control Integrated Framework,
which is discussed in the section of this text titled Internal Control.
2) Control Objectives for Information and related Technology (COBIT), authored by the IT Governance
Institute and published by the Information Systems Audit and Control Foundation (ISACF).
In Internal Control Integrated Framework, internal control is defined as a process designed to provide
reasonable assurance that the companys objectives will be achieved in the areas of effectiveness and
efficiency of operations, reliability of financial reporting, and compliance with applicable laws and regulations.
The internal control system is the responsibility of the companys board of directors, management and other
personnel.
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, procedures,
practices, 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. 39 The COBIT
document was used as a major resource for this section on systems control.
Common exposures to loss that result from a failure to implement controls include competitive disadvantage,
deficient revenues, loss of assets, inaccurate accounting, business interruption, statutory sanctions, erroneous
management decisions, fraud and embezzlement, and excessive costs.
The ultimate responsibility for internal control lies with management and the board.
Further, controls should be subjected to cost/benefit analysis. This means that management should not
spend more on controls than the amount the company can expect to receive in benefits from the controls.
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.
Threats to Information Systems

Sources of threats to information systems and data are many. 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, including trade secrets, 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, either deliberately or accidentally
Data can be altered directly in the data file, without recording any transaction that can be detected
Viruses, Trojan Horses, and worms can infect a system, causing a system crash, stealing data, or
damaging data
Hardware can be stolen
Physical facilities as well as the data maintained in them can be damaged by natural disasters, illegal
activity or sabotage
38
Internal Control Integrated Framework, copyright 1992, 1994, and 2013 by the Committee of Sponsoring
Organizations of the Treadway Commission, two volume edition 1994, Vol. 1, pp. 3-5. Used by permission.
39
Control Objectives for Information and related Technology (COBIT), 3rd Edition, copyright 2000, IT Governance Institute,
www.itgi.org. Reprinted with permission; reproduction without permission is not permitted.
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.
The first line of defense against events of this nature and threats such as those above is effective systems
controls. 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, inaccurate accounting, business interruption, fraud, violations of the
law, asset loss, and damage to the businesss competitive position. The controls must not only exist, but they
must also function effectively.
The Classification of Controls

Controls within a computer system are broken down into two types. They are general controls, which relate
to the environment; and application controls, which are controls that are specific to individual applications
and are designed to prevent, detect and correct errors and irregularities in transactions during the input,
processing and output stages. Both general controls and application controls are essential.
General controls relate to the general environment within which transaction processing takes place. They
are designed to ensure that the companys control environment is stable and well managed. A stable and
well-managed control environment strengthens the effectiveness of the companys application controls.
General controls include controls over the development, modification and maintenance of computer programs,
segregation of duties, data security, administrative controls, and provision for disaster recovery. General
controls are broken down into the following categories (each is discussed in greater detail below):
The organization and operation of the computer facilities, including provision for segregation of
duties within the data processing function as well as segregation of the data processing function
from other operations. The IS activity should have a high enough level in the organization and ade-
quate authority to permit it to meet its objectives. There should be a systems control group to
monitor production, keep records, balance input and output, and see that work is completed on
schedule.
General operating procedures, including written procedures and manuals. Operating procedures
also specify the process to be followed in system development and system changes, in order to pro-
vide reasonable assurance that development of, and changes to, computer programs are authorized,
tested, and approved prior to the use of the program.
Equipment and hardware controls, including controls installed in computers that can identify
incorrect data handling or improper operation of the equipment.
Access controls to equipment and data, 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.
Application controls are controls that are specific to individual applications. They are designed to prevent,
detect, and correct errors in transactions as they flow through the input, processing, and output stages of
work. Thus, they are broken down into these three main categories (each of which is discussed in greater
detail below):
Input controls
Processing controls
Output controls
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.
b) Maintain the accuracy of the inputs, files and outputs for specific applications.
c) Ensure the separation of incompatible functions in the data processing departments.
d) Plan for the protection of the facilities and backup for the systems.
(CMA Adapted)
General Controls
Organization and operation of the computer facilities
An IT Planning or Steering Committee should oversee the IT function. Members should include senior
management, user management and representatives from the IT function. The committee should
have regular meetings and report to senior management.
The IT function should be positioned within the organization so as to ensure its authority as well as
its independence from user departments.
Staffing requirements should be evaluated whenever necessary to make sure that the IT function
has sufficient, competent staff. 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. Responsibilities should be delegated with appropriate seg-
regation of duties, and duties should be rotated periodically at irregularly scheduled times for key
processing functions.
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.
General Operating Procedures

Standard procedures for all IT operations, including network operations, should be documented.
These should include documentation of the start-up process, job scheduling, processing continuity
during operator shift changes, operations logs and procedures that ensure connection and disconnec-
tion of links to remote operations.
Task descriptions should be written for each job function; personnel should be trained in their jobs;
assigned duties should be rotated periodically for key processing functions.
Physical safeguards should be established over forms such as negotiable instruments and over
sensitive output devices such as signature cartridges. Sequential numbers on individual forms should
be printed in advance so missing forms can be detected.
The process to follow in system development and system changes should be documented in order to
provide reasonable assurance that development of, and changes to, computer programs are author-
ized, tested and approved prior to the use of the program.
Turnaround documents should be used whenever appropriate. A turnaround document is a docu-

ment created by a computer, has some additional information that has been added to it, and then is
returned to become an input document to the computer. 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. Some examples of turnaround documents
are invoices with a top section that the customer tears off and returns with payment (with the
amount paid filled in); or magazine subscription renewal notices that the subscriber returns with re-
newal instructions. The use of a turnaround document limits the chances of input errors occurring
and reduces the need for manual data entry.
Equipment Controls
A defined backup procedure should be in place, and the usability of the backups should be verified
regularly.
Transaction trails should be available for tracing the contents of any individual transaction record
backward or forward, and between output, processing, and source. Records of all changes to files
should be maintained.
Statistics on data input and other types of source errors should be accumulated and reviewed to
determine remedial efforts needed to reduce errors.
Equipment Access and Data Access Controls

The responsibility for logical security and physical security should be assigned to an information security
manager who reports to the organizations senior management.
Logical security consists of access and ability to use the equipment and data. It includes Internet
security (firewalls) and virus protection procedures; access controls for users to minimize actions
they can perform; authentication processes to verify the identity of users; and cryptographic tech-
niques such as encryption of messages and digital signatures.
Unauthorized personnel, online connections and other system entry ports should be prevented from
accessing computer resources. Passwords should be changed regularly for all those authorized to ac-
cess the data. Procedures should be established for issuing, suspending and closing user accounts,
and access rights should be reviewed periodically.
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. For example, a person who does invoic-
ing needs access to the invoicing module of the accounting program but does not need access to the
general ledger module. The person who does receiving needs access to the purchase order module,
but not to invoicing.
Only authorized software from known sources should be allowed to be used in the system. Author-
ized software should be free of viruses and other malware.40
Physical security involves things such as keeping servers and associated peripheral equipment in a
separated, secure room with bars on the windows and use of blinds or reflective film on the windows
for heat blocking as well as physical protection. It also includes password protection for servers;
monitoring of hardware components to prevent them from being removed from the premises; securi-
ty for offsite backup tapes; and biometrics such as fingerprints, voice verification, and so forth to
identify a person based on physical or behavioral characteristics.
Physical security also involves the locations of wiring that connects the system, backup media, and
maintenance of uninterruptible power supplies. An IT member should escort visitors when they enter
the computer facilities, and a visitors log should be kept and reviewed regularly.
Media library contents should be protected. Responsibilities for storage media library management
should be assigned to specific employees. Contents of the media library should be inventoried sys-
tematically, so any discrepancies can be remedied and the integrity of magnetic media is
maintained. Policies and procedures should be established for archiving.
Dual access and dual control should be established to require two independent, simultaneous actions
before processing is permitted.
Segregation of Duties
The most important organizational and operating control is the segregation of duties. Although the
traditional segregation practiced in accounting of separating the responsibilities of authorization, record
keeping and custody of assets may not be practiced in the same manner in Information Systems (since the
work is quite different), there are still specific duties in the IS environment that should be separate from one
another.
Separate Information Systems from Other Departments

IS department personnel should be separated from the departments and personnel that they support (called
users). This means:
Users initiate and authorize all systems changes, and a formal written authorization is required.
Asset custody remains with the user departments.
An error log is maintained and referred to the user for correction. The data control group follows up
on errors.
Separate Responsibilities within the Information Systems Department

Responsibilities within the Information Systems Department should be separated from one another. An
individual with unlimited access to a computer, its programs, and its data could execute a fraud and at the
same time conceal it. Therefore, effective segregation of duties should be instituted by separating the
authority for and the responsibility for the function.
Although designing and implementing segregation of duties controls makes it difficult for one employee to
commit fraud, remember that segregation of duties is not perfect insurance against fraud because two
employees could collude to override the controls.
40
Malware is short for malicious software. It is software that is intended to damage or disable computers and computer
systems.
We will look at the various positions within a computer system and the responsibilities of each.
Systems analysts are responsible for reviewing the current system to make sure that it is meeting
the needs of the organization, and when it is not, they will provide the design specifications to the
programmers of the new system. Systems analysts should not do programming, nor should they
have access to hardware, software or data files.
Programmers are the individuals who write, test and document the systems. They are able to
modify programs, data files and controls, but should not have access to the computers and programs
that are in actual use for processing. For instance, if a bank programmer were allowed access to ac-
tual live data and had borrowed money from the bank, he or she could delete their own loan balance
while conducting a test. When programmers must do testing, they should work with copies of rec-
ords only and should not have the authority, opportunity or ability to make any changes in master
records or files.
Computer operators perform the actual operation of the computers for processing the data. They
should not have programming functions and should not be able to modify any programs. Their job
responsibilities should be rotated so no one operator is always overseeing the running of the same
application. The most critical segregation of duties is between programmers and computer
operators.
The data control group receives user input, logs it, monitors the processing of the data, reconciles
input and output, distributes output to authorized users, and checks to see that errors are corrected.
They also maintain registers of computer access codes and coordinate security controls with other
computer personnel. They must keep the computer accounts and access authorizations current at all
times. They should be organizationally independent of computer operations. Systems control
personnel should be responsible for detecting and correcting errors, not computer operators.
Transaction authorization: Users should submit a signed form with each batch of input data to
verify that the data has been authorized and that the proper batch control totals have been pre-
pared. Data control group personnel should verify the signatures and batch control totals before
submitting the input for processing.41 This would prevent a payroll clerk, for instance, from submit-
ting an unauthorized pay increase. Furthermore, no personnel in the Information Systems group
should have authority to initiate or authorize any entries or transactions.
Data conversion operators perform tasks of converting and transmitting data. They should have
no access to the library or to program documentation, nor should they have any input/output control
responsibilities.
Librarians maintain the documentation, programs and data files. They should have no access to
equipment. The librarian should restrict access to the data files and programs to authorized person-
nel at scheduled times. Furthermore, the librarian maintains records of all usage, and those records
should be reviewed regularly by the data control group for evidence of unauthorized use.
Only authorized people should be able to call program vendor technical support departments. If
vendor-supplied systems are used, the vendors technical support area should have a means of iden-
tifying callers and should give technical instructions for fixing problems only to employees who are
authorized to receive such instructions.
41
Batch control totals are any type of control total or count applied to a specific group of transactions, such as total sales
dollars in a batch of billings. Batch control totals are used to ensure that all input is processed correctly by the computer. In
batch processing, items are batched in bundles of a preset number of transactions. If a batch consists of financial
transactions, a batch control document that goes with the batch includes the bundle number, the date and the total dollar
amount of the batch. As the computer processes the batch, it checks the batch control total (the total dollar amount) for
the batch and compares the processed total with the batch control total. If they match, the batch is posted. If they do not,
the posting is rejected, and the difference must be investigated. Batch control totals can also be calculated and used for
non-financial fields in transactions. For instance, a batch control total might be the total hours worked by employees.
The database administrator controls access to various files, making program changes, and making
source code details available only to those who need to know.
The location of any off-site storage facilities should be known by as few people as possible.
No IS personnel should have access to any assets that are accounted for in the computer system.
System and Program Development and Change Controls

Systems development controls during the development stage of an information system enhance the ultimate
accuracy, validity, safety, security and adaptability of the new systems input, processing, output and storage
functions.
Controls are instituted at this stage for multiple reasons.
1) To ensure that all changes are properly authorized and are not made by individuals who lack suffi-
cient understanding of control procedures, proper approvals and the need for adequate testing.
2) To prevent errors in the resulting system that could cause major processing errors in data.
3) To limit the potential for a myriad of other problems during the development process and after its
completion.
The following are only a few of the control considerations in systems development. This is not an exhaustive
list but presented to give you an idea of what is involved. These have been adapted from the recommenda-
tions in COBIT.
1) Statement of Objectives Stage

The authorized users should submit a written request, stating the business need. The request should
be reviewed by the steering committee.
The user department management should participate in the definition and authorization of the
development, implementation, or modification project.
There should be a clear written statement defining the nature and scope of the project.
A risk assessment should be done as part of the initial proposal to document security threats, poten-
tial vulnerabilities and impacts, and the feasible security and internal control safeguards necessary to
reduce or eliminate the identified risks.
If the request is approved, resources are allocated for the next stage, which will be the feasibility study.
A clear, written statement of objectives and a risk assessment at this stage can limit the number of changes
needed later on and shorten the time required to identify solutions and get approvals later on.
2) Investigation and Feasibility Study Stage

A cost-benefit analysis is done. Questions to be answered include whether the system will provide an
adequate payback; whether it will fit into the existing software environment; whether it will run on
existing hardware or whether a hardware upgrade will be needed; whether new storage media will
be required; whether the resources are available for the project; whether the application would re-
quire extensive user or programmer training; and what effect it would have on existing systems.
The feasibility study should include an analysis of needs, costs, implementation times, and potential
risks.
In evaluating possible solutions, criteria should be developed for consideration of in-house develop-
ment, purchased solutions and outsourcing options.
The technological feasibility of each alternative for satisfying the business requirements should be
examined; and the costs and benefits associated with each alternative under consideration should be
analyzed.
Key users should be identified to assist in the analysis and recommendations.
The development team should have a good knowledge of the solutions available and limit their
consideration to proven technology rather than experimenting with new technology, unless experi-
mentation is justified by the situation.
Senior management should review the reports of the feasibility studies and approve or disapprove
proceeding with the project.
For each approved project, a master plan should be created to maintain control over the project
throughout its life, which includes a method of monitoring the time and costs incurred.
The cost-benefit analysis done at this stage is extremely important as a control tool, as this can also reduce
changes later on that could be caused by the discovery of unexpected costs. Furthermore, if the project is
seriously flawed, it can be rejected at this stage before a major investment is made.
3) Systems Analysis Stage

Business requirements satisfied by the existing system and those that the proposed system expects
to attain should be clearly defined, including user requirements, specifications as to what the new
system is supposed to accomplish, and alternatives for achieving the specifications such as in-house
development versus a vendor package.
Inputs, processing requirements and output requirements should be defined and documented.
All security requirements should be identified at the requirements phase of the project and justified,
agreed and documented.
A structured analysis process should be used.
If the information required by the users is not clear, the new system cannot possibly support the business
process, leading again to delays in implementation and additional costs to redesign the system.
4) Systems Design and Development Stage

Systems analysts, working closely with system users, create the design specifications and verify
them against the user requirements.
System flowcharts, report layouts, data conversion procedures and test plans are developed.
Design specifications should be reviewed and approved by management, the user departments and
senior management.
Detailed program specifications should be prepared to ensure that program specifications agree with
system design specifications.
Mechanisms for the collection and entry of data should be specified for the development project.
Data elements are defined. Each field in each file is listed and defined.
The file format should be defined and documented for the project to ensure that data dictionary rules
are followed.
All external and internal interfaces should be properly specified, designed and documented.
An interface between the user and the machine that is easy to use and contains online help functions
should be developed.
Hardware and software selection should identify mandatory and optional requirements. The potential
impact of new hardware and software on the performance of the overall system should be assessed.
An up-to-date inventory of hardware and software infrastructure should be available.
Acquisition policies and practices should be clearly understood, and the selection process should
focus on using reusable components.
Performance and capacity requirements should be duly considered.
Key requirements should be prioritized in case of possible scope reductions.
Adequate mechanisms for audit trails should be developed for the selected solution that provides the
ability to protect sensitive data.
Contracts with suppliers should include a definition of acceptance criteria and procedures, and
dependency on single-source suppliers should be managed.
If a vendor package or packages are to be used, they should be evaluated rigorously. Factors to
consider include the stability of the vendor, how long the system has been on the market, whether it
has a base of users and the satisfaction level of current users of the system, the vendors quality
control standards, the adequacy of the documentation, the availability of vendor technical support,
and flexibility of the system such as whether it has a report writer that users can use to develop re-
ports themselves. Also, what the systems processing speed will be on the organizations systems is
a consideration.
As already mentioned, only authorized people should be able to call vendor technical support de-
partments. This is an important control, so it warrants mentioning again. The evaluation of a vendor
system should include inquiries as to the means the vendor has to identify callers to its technical
support area and determine whether the caller has authority to receive technical instructions for fix-
ing problems.
The benefits from these controls should be reduction in delays due to inadequate infrastructure, reduced
interoperability and integration problems, and reduced costs for modifications later.
5) Program Coding and Testing Stage

Programs are coded according to the specifications developed in the systems design and develop-
ment stage.
Procedures should provide for a formal evaluation and approval by management of the user depart-
ment(s) and management of the IT function of work accomplished and test results in each phase of
the cycle before work on the next phase begins.
There should be a separation between development and testing activities.
A formal process for handover from development to testing to operations should be defined.
Resources should be available for a separate testing environment, which reflects as closely as possi-
ble the live environment, and sufficient time should be allowed for the testing process.
Parallel or pilot testing should be performed, and criteria for ending the testing process should be
specified in advance.
Testing should be done both of the individual application and of the application within the system.
An independent group should do the testing and try to make the system fail.
Both in-house systems and vendor packages should be tested.
Testing is the final check to make sure the system performs as it should.
6) Systems Implementation Stage

An implementation plan should be prepared, reviewed and approved by relevant parties and also
used to measure progress. It should include site preparation, equipment acquisition and installation,
user training, installation of operating software changes and implementation of operating procedures
and conversion procedures.
Data conversion is done. Controls such as record counts, reviews of reports and other types of
reconciliations are required.
The degree and form of documentation required is agreed upon and followed in the implementation.
Documentation will include system documentation, which is narrative descriptions, flowcharts, in-
put and output forms, file and record layouts, controls, authorizations for any changes and backup
procedures. It will also include program documentation, or descriptions of the programs, program
flowcharts, program listings of source code, input and output forms, change requests, operator in-
structions and controls. Operating documentation is the information about the performance of the
program. Procedural documentation provides information about the master plan and the handling
of files, and user documentation includes all the information a user will need to be able to use the
program.
Documentation provides a basis for effective operation, use, audit and future system enhancements.
It communicates among people who are developing, implementing and maintaining a system. A de-
tailed record of the systems design is necessary in order to install, operate or modify an application.
It is also needed for diagnosing and correcting programming errors; and it provides a basis for re-
construction of the system in case of damage or destruction.
Standard operating procedures should be documented, distributed, and maintained using knowledge
management, workflow techniques and automated tools.
Staff of the user departments and the operations group of the IT function should be trained in
accordance with the training plan.
Formal evaluation and approval of the test results and the level of security for the system by man-
agement of the user department and the IT function should cover all components of the information
system.
Before the system is put into operation, the user should validate its operation as a complete product
under conditions similar to the application environment.
The decision should be made as to whether the new system will be implemented using a parallel
conversion (running both the old and the new systems together for a period of time), a phased con-
version (converting only parts of the application at a time or only a few locations at a time), pilot
conversion (the new system is tested in just one work site before full implementation), or a direct
conversion (changing over immediately from the old system to the new).
The benefits of these controls are more seamless integration of the new system into existing business
processes, adequate documentation at a reduced cost, and greater user proficiency and satisfaction with the
training process.
7) Systems Evaluation and Maintenance Stage

After implementation, the system moves into the maintenance phase.
A process should be in place to manage coordination between and among changes, recognizing
interdependencies.
There should be segregation of duties between development and production.
Maintenance personnel should have specific assignments, their work should be monitored, and their
system access rights should be controlled.
There should be a post-implementation review to assess whether the users needs are being met by
the system.
Any modifications to the system should be authorized by user management, made in accordance
with the same standards as are used for system development, and should be tested and approved
by the user and IS management. Senior management should approve major projects.
When changes are being tested, they should be tested not only by using correct information, but
also by using incorrect information to make sure that the program will detect any errors and has the
necessary controls.
Whenever system changes are implemented, associated documentation and procedures should be
updated accordingly.
For a vendor package, maintenance procedures are of concern from a systems control standpoint.
Updates released by the vendor should be installed on a timely basis. For an organization with inte-
grated software, releases must be kept compatible. If one portion of the system is upgraded and
another part is not, the two systems may no longer interface properly.
If vendor-supplied software has had custom changes made to the vendors source code and the
changes are not properly reinstalled on top of new releases, erroneous processing can result. The
organization should maintain change controls to verify that all custom changes are properly identi-
fied. A good audit trail of all program changes is necessary. Another concern with vendor update
releases when in-house changes have been made is that the changes may need to be not only rein-
stalled, but completely rewritten. The changes made to the prior release of the program might not
work properly with the vendors new release.
Heavy modification of vendor code with no intention of installing new vendor releases because of the
necessity to reinstall the modifications should be avoided, because the system becomes essentially
an in-house system without the benefit of vendor support.
The benefits of these control procedures are reduced errors and disruptions due to poorly managed changes,
reduced resources and time required for changes, and reduced number of emergency fixes.
Another thing to be aware of is that programs are written in source code, which is the language that the
programmer uses for coding the program, and they also exist in object code, which is the machine language
that the processor can understand. The source code file is converted to object code by means of a program
called a compiler, and the object code, not the source code, is what actually runs on the computer. This is
important because although in theory the source code and the object code should correspond, the
computer does not require them to correspond. It would be possible for a knowledgeable person to
make a copy of the source code, rewrite portions of the instructions, compile the modified source code into a
new object code file for use by the computer, and then destroy the modified source code file, leaving the
authorized source code file unchanged. The result is that the executable object code the actual instructions
used by the computer will not match the authorized source code. This is a weakness that can be used to
commit computer fraud, if controls over compiling and cataloging activities are not adequate. Despite the
strongest internal controls over day-to-day operations in user departments, a fraudulent change to a program
could divert company funds to an individual, and the fraud could continue for a time without being detected.
Question 77: Program documentation is a control designed primarily to ensure that:
a) Programmers have access to the tape library or information on disk files.
b) Programs are kept up-to-date and perform as intended.
c) Programs do not make mathematical errors.
d) Data has been entered and processed.
(CMA Adapted)
Question 78: The reporting of accounting information plays a central role in the regulation of business
operations. The importance of sound internal control practices is underscored by the Foreign Corrupt
Practices Act of 1977, which requires publicly-owned U.S. corporations to maintain systems of internal
control that meet certain minimum standards. Preventive controls are an integral part of virtually all
accounting processing systems, and much of the information generated by the accounting system is used
for preventive control purposes. Which one of the following is not an essential element of a sound
preventive control system?
a) Documentation of policies and procedures.
b) Implementation of state-of-the-art software and hardware.
c) Separation of responsibilities for the recording, custodial and authorization functions.
d) Sound personnel practices.
(CMA Adapted)
Question 79: The process of learning how the current system functions, determining the needs of users
and developing the logical requirements of a proposed system is referred to as:
a) Systems analysis.
b) Systems feasibility study.
c) Systems implementation.
d) Systems maintenance.
(CMA Adapted)
Question 80: The most critical aspect of separation of duties within information systems is between:
a) Programmers and computer operators.
b) Programmers and project leaders.
c) Programmers and systems analysts.
d) Systems analysts and users.
(CMA adapted)
Physical Access Controls

Computer facility controls should be in place to protect the physical assets of the computer center: the
hardware, peripherals, documentation, programs and data files in the library. The computer-processing center
should be in a locked area, and access to it should be restricted to authorized persons. Some means of
accomplishing this are:
Have company personnel wear color-coded ID badges with photos. People authorized to enter the
computer area are assigned an ID badge of a particular color.
With magnetic ID cards, each employees entry into and exit from the computer center can be
automatically logged.
The door can be kept locked, and a person can enter only if buzzed in by the control person, who
permits only authorized people to enter.
Keys may be issued to authorized personnel, or combination locks can be used to limit access. If
keys are used, they should be keys that cannot be easily duplicated, and locks need to be changed
periodically. If a combination lock is used, the combination should be changed periodically.
The location of the computer center should also be in a place where it is protected from natural
disasters as much as possible.
The computer center should be equipped with smoke and water detectors, fire suppression devices,
burglar alarms and surveillance cameras monitored by security personnel.
Insurance is the last resort, to be called upon only if all else fails, because it does not actually pro-
tect from loss but rather compensates for loss after it occurs. Insurance policies for computer
damages are usually restricted to actual monetary losses suffered, which is difficult to assess. For
example, computers may have a market value that is far less than the value of their services to the
company.
Hardware Controls for Networks

Computer networks require special controls due to the decentralized nature of the hardware.
Checkpoint processing should be used to enable recovery in case of a system failure. Checkpoint
control procedures are performed several times per hour, and during that time, the network system
will not accept posting. It stops and backs up all the data and other information needed to restart
the system. This checkpoint is recorded on separate media. Then, if a hardware failure occurs, the
company simply reverts to the last saved copy, and reprocesses only the transactions that were
posted after that checkpoint. The effect of this is similar to the rollback and recovery method.
Routing verification procedures protect against transactions routed to the wrong computer
network system address. Any transaction transmitted over the network must have a header label
identifying its destination. Before sending the transaction, the system verifies that the destination is
valid and authorized to receive data. After the transaction has been received, the system verifies
that the message went to the destination code in the header.
Message acknowledgment procedures can prevent the loss of part or all of a transaction or
message on a network. Messages are given a trailer label, which the receiving destination checks to
verify that the complete message was received.
File Security and Storage Controls

File Security Control procedures include:
Labeling the contents of discs (CDs, DVDs, external hard drives), tapes, flash drives or memory
cards, and any other removable media, both externally and internally as part of the data file.
The read-only file designation is used to prevent users from altering or writing over data.
Database Management Systems use lockout procedures to prevent two applications from
updating the same record or data item at the same time.
Note: A deadly embrace occurs when two different applications or transactions each have a
lock on data that is needed by the other application or transaction. Neither process is able to pro-
ceed, because each is waiting for the other to do something. In these cases the system must
have a method of determining which transaction goes first, and then it must let the second trans-
action be completed using the updated information after the first transaction.
The librarians function is particularly critical, because documentation, programs and data files are
assets of the organization and require protection the same as any other asset would. The data files
contain information that is critical to the enterprise, such as accounting records. Although backup
procedures could reconstruct lost or damaged data, it is less costly to prevent a data loss than to re-
pair it. Furthermore, confidential information is contained in the data files and must be protected
from misuse by unauthorized individuals.
Protection of program documentation is critical. Data can be changed within a file by someone who
knows how to do it, and technical manuals containing file descriptions are one way to get the neces-
sary information. Only authorized people who have the responsibility to repair data files that may
become corrupt should have access to technical manuals.
Application Controls
Application controls focus on preventing, detecting and correcting errors in transactions as they flow through
the input, processing and output stages of work in an information system. Here are some things that can
go wrong and that adequate controls can prevent, detect and correct:
Input loss can occur when transaction information is transmitted from one location to another.
Input duplication can occur if an input item is thought to be lost and is recreated, but the original
item is subsequently found or was never actually lost.
Inaccurate input in the form of typographical errors in numbers or in spelling.
Missing information makes the input incomplete.
Unrecorded transactions can occur as accidental failures or can be the result of theft or embezzle-
ment.
In a volume-processing environment, management authorization of every individual transaction may

not take place, allowing improper transactions to slip through.
Automated transactions may be set up for regular orders or payments to suppliers. However, unusu-
al situations can call for special transactions, and automated transactions can cause problems.
Output can be sent to the wrong people, or may be sent too late to be used.
Programming errors or clerical errors can result in incomplete processing.
Processing may be delayed.
Files can be lost during processing.
Poor documentation and a loss of knowledgeable people can result in errors and omissions.
Application controls are divided into input controls, processing controls and output controls.
Input Controls
Input controls are the controls designed to provide reasonable assurance that data entered into the system
has proper authorization, has been converted to machine-sensible form, and has been entered accurately.
Input controls can also provide some assurance that data (including data sent over communications lines) has
not been lost, suppressed, added or changed in some manner.
Input is the stage where there is the most human involvement and, as a result, the risk of errors is higher
than in the processing and output stages. Most errors in systems are the result of input errors. If
information is not entered correctly, there is no chance that the output will be correct. Processing might be
done perfectly, but if the input into the system is inaccurate or incomplete, the output will be useless.
Effective input controls are vital.
There are three classifications of input controls:
1) Data observation and recording
2) Data transcription
3) Edit tests
Data Observation and Recording

One or more observational control procedures may be practiced:
Feedback mechanisms are manual systems that attest to the accuracy of a document. For in-
stance, a sales person might ask a customer to confirm their order with a signature, attesting to the
accuracy of the data in the sales order. Feedback mechanisms include authorization, endorse-
ment and cancellation.
Dual observation means more than one employee sees the input documents. In some cases this
might mean a supervisor reviews and approves the work.
Point-of-sale devices used to encode data can decrease errors substantially. In addition, point-of-
sale devices eliminate the need to manually convert the data to machine-readable format.
Preprinted forms such as receipt and confirmation forms can ensure that all the data required for
processing has been captured. For example, if a form utilizes boxes for each character in an invento-
ry part number, it is more likely that the correct number of characters will be entered.
Batch control totals should be used in the input phase to track data as it travels from place to
place before it reaches the computer, to make sure no data is lost.
Batch control totals do not work well with real-time systems, because data is entered at remote ter-
minals sporadically and by different people. Transactions cannot be easily batched. However, entries
can and should be displayed on a screen for visual verification and checked against backup data.
Furthermore, information input can be checked against the database, and edit programs can be used
to make sure that each field has the proper format (see following topics).
Transaction trails should be created by the system that show the date, terminal ID, and individual
responsible for the input. This is particularly important in a real-time system. All inputs are logged to
a special file that contains these identifying tags to identify the transactions. Including this addition-
al, audit-oriented information along with original transaction data is called tagging.
Transaction logs also provide a source of control totals.
Data Transcription
Data transcription is the preparation of the data for processing. If data is entered from source documents,
the source documents should be organized in a way that eases the input process.
The actual data input usually takes place at a workstation with a display terminal. A preformatted input
screen can assist in the transcription process. For example, a date field to be filled in would be presented
onscreen as __/__/____.
Format checks are used to verify that data is entered in the proper mode: numeric data in a numeric field, a
date in a date field, and so forth.
Edit Tests
Edit programs or input validation routines are programs that check the validity and accuracy of input
data. They perform edit tests by examining specific fields of data and rejecting transactions if their data
fields do not meet data quality standards. Edit tests include:
Completeness, or field, checks, which ensure that data is input into all required fields and that
the data is in the proper format. For example, a field check would not permit numbers to be input
into a field for a persons name.
Limit checks, which ensure that only data within predefined limits will be accepted by the system.
For example, the number of days worked in a week cannot exceed 7.
Validity checks, which match the input data to an acceptable set of values or match the character-
istics of input data to an acceptable set of characteristics.
Overflow checks, which make sure that the number of digits entered in a field is not greater than
the capacity of the field.
Check digits, which determine whether a number has been transcribed properly. A check digit is a
number that is a part of an account or other type of number. The check digit is a function of the oth-
er digits within the number, determined by a mathematical algorithm. If a digit in the account
number is keyed in incorrectly, the check digit will be incorrect, and the system will generate an er-
ror message and refuse to accept the input. Check digits are commonly used in credit card account
and bank account numbers, and they are especially helpful in detecting transposition errors. If an
operator keys in a number incorrectly, the operator will get an error message such as invalid ac-
count number.
Key verification, or keystroke verification, is the process of inputting the information again and
comparing the two results. Key verification is often used when changing a password, to confirm that
the password has been typed correctly. Key verification can also be used to require input of the
same information twice by different people.
Hash totals are another type of control total. They are totals of nonmonetary information. For
example, if a batch contains data on receipts from accounts receivable customers, the sum of all the
customers account numbers might be computed to create a hash total. The sum is, of course, useful
only for control purposes. A hash total can be run on a group of records to be input before pro-
cessing or transmission and again after processing. If the hash total changes during processing, it
indicates something has changed or may be lost.
Format checks check whether the data has been entered in the proper mode and within the proper
fields.
Reasonableness checks compare input with other information in existing records and historical
information to detect data that is not reasonable.
Numerical checks assure that numeric fields are used only for numeric data.
Overflow checks can prevent input that would exceed the capacity of a memory or field length.
Reconciliations and balancing. Reconciliations are used to determine whether differences exist
between two amounts that should be equal. If there are differences, the differences are analyzed to
detect the reason, and corrections can be made if necessary.
Corrections of errors present additional problems. Often, attempts to correct an error result in
additional errors. Error reports need to be analyzed, the action required to make the correction needs to be
determined, the incorrect data needs to be reversed and correct data needs to be input. Often, corrections
are needed in multiple data files.
Inquiries of data or master files need to be designed so there is no possibility of the inquiry changing the
information in the file.
Question 81: The online data entry control called preformatting is:
a) A check to determine if all data items for a transaction have been entered by the terminal operator.
b) A program initiated prior to regular input to discover errors in data before entry so that the errors
can be corrected.
c) The display of a document with blanks for data items to be entered by the terminal operator.
d) A series of requests for required input data that requires an acceptable response to each request
before a subsequent request is made.
(CMA Adapted)
Question 82: Routines that use the computer to check the validity and accuracy of transaction data during
input are called:
a) Operating systems.
b) Compiler programs.
c) Edit programs.
d) Integrated test facilities.
(CMA Adapted)
Processing Controls
Processing controls are controls designed to provide reasonable assurance that processing has occurred
properly and that no transactions have been lost or incorrectly added. Processing controls prevent or
discourage the improper manipulation of data and ensure satisfactory operation of hardware and software.
Processing controls include the physical security of the equipment. At one time, processing controls were
limited to the computer room. But with more and more distributed processing taking place, these controls are
moving outside the room where the computer equipment is located.
Access to the computer should be permitted only to people who are authorized to operate the equipment, and
operators should be given access only to information they need to set up and operate the equipment.
Processing controls fall into two classifications:
1) Processing controls at the time of data access
2) Controls involving data manipulation later in the processing
Data Access Controls

Transmittal documents such as batch control tickets are used to control movement of data from the source
to the processing point or from one processing point to another. Batch sequence numbers are used to
number batches consecutively to make sure all batches are accounted for.
Batch control totals were mentioned as input controls, but they are also processing controls. Batch control
totals are any type of control total or count applied to a specific group of transactions, such as total sales
dollars in a batch of billings. Batch control totals are used to ensure that all input is processed correctly by the
computer. In batch processing, items are batched in bundles of a preset number of transactions. If a batch
consists of financial transactions, a batch control document that goes with the batch includes the bundle
number, the date and the total dollar amount of the batch. As the computer processes the batch, it checks
the batch control total (the total dollar amount) for the batch and compares the processed total with the
batch control total. If they match, the batch is posted. If they do not, the posting is rejected, and the
difference must be investigated. Batch control totals can also be calculated and used for non-financial fields
in transactions. For instance, a batch control total might be the total hours worked by employees.
A hash total is another control that is both an input and a processing control. For instance, if a batch
contains data on receipts from accounts receivable customers, the sum of all the customers account numbers
might be computed to create a hash total. This sum is useful only for control purposes, and it is compared
with the total computed during processing to make sure nothing was lost or altered during processing.
A record count utilizes the number of transaction items and counts them twice, once when preparing the
transactions in a batch and again when performing the processing.
Data Manipulation Controls

Standard procedures should be developed and used for all processing.
Examining software documentation, such as system flowcharts, program flowcharts, data flow
diagrams and decision tables, can also be a control, because it makes sure that the programs are complete
in their data manipulation.
Computer programs are error tested by using a compiler, which checks for programming language errors.
Test data can be used to test a computer program.
System testing can be used to test the interaction of several different computer programs. Output from one
program is often input to another, and system testing tests the linkages between the programs.
There are a number of other tests of processing, such as:
Batch balancing is comparing the items actually processed against a predetermined control total.
Cross-footing compares the sum of the individual components to a total.
A zero-balance check is used when a sum should be zero. All of the numbers are added together
and the total is compared with zero.
Run-to-run totals are output control totals from one process used as input control totals over
subsequent processing. Critical information is checked to ensure that it is correct. The run-to-run to-
tals tie one process to another.
Default option is the automatic use of a predefined value when a certain value is left blank in input.
However, a default option may be correct, or it may be an incorrect value for a particular transac-
tion, so the default should not be automatically accepted.
Question 83: In an automated payroll processing environment, a department manager substituted the
time card for a terminated employee with a time card for a fictitious employee. The fictitious employee
had the same pay rate and hours worked as the terminated employee. The best control technique to
detect this action using employee identification numbers would be a:
a) Hash total.
b) Batch total.
c) Subsequent check.
d) Record count.
(CMA Adapted)
Question 84: Data input validation routines include:
a) Passwords.
b) Terminal logs.
c) Backup controls.
d) Hash totals.
(CMA Adapted)
Output Controls
Output can consist of account listings, displays, reports, files, invoices, or disbursement checks, to name just
a few of the forms output can take. Output controls are used to provide reasonable assurance that input and
processing has resulted in valid output. Controls should be in place to make sure that the output is sent to the
right people, that it is accurate and complete, it is sent in a timely manner, and that the proper reports are
retained for the appropriate time period.
The output of the system is supervised by the data control group. Output controls consist of:
Validating processing results
Controls over printed output
Validating Processing Results

Activity, or proof, listings that document processing activity provide detailed information about all changes
to master files and create an audit trail. These proof listings should be compared with the batch control totals
that went along with the input and processing functions in order to confirm that all of the transactions were
processed correctly.
Reconciliations are the analysis of differences between values in two files that should be substantially the
same. The nature of the reconciling items is used to identify whether differences are caused by errors or
whether they are valid differences.
A suspense account is used as a control total for items awaiting further processing, such as a file of back-
ordered products awaiting receipt so they can be shipped to fulfill orders.
Output control also includes review of the error logs by the control group and review of the output by the
users. End-of-job markers are printed at the end of the report and enable the user to easily determine if the
entire report has been received. A discrepancy report is a listing of items that have violated some detective
control and need to be investigated, such as a list of all past-due accounts that is sent to the credit manager.
Upstream resubmission is the resubmission of corrected error transactions as if they were new transac-
tions, so that they pass through all the same detective controls as the original transactions.
Printed Output Controls

Forms control, such as physical control over company blank checks, is one type of printed output controls.
Checks should be kept under lock and key, and only authorized persons should be permitted access.
However, there is another control needed with checks, because they are pre-numbered. The preprinted
check number on each completed check must match the system-generated number for that check,
which may or may not be also printed on the check. The preprinted numbers on the checks are
sequential; the system-generated numbers also are sequential. The starting system-generated number must
match the pre-printed number on the first check in the stack, or the numbers in the whole check run will be
off. If there is any discrepancy, it must be investigated because the starting number in the system should be
one more than the last check printed. If it does not match the preprinted number on the first check in the
stack to be printed, one or more checks could be missing.
Any form should be pre-numbered and controlled in the same manner as checks.
Companies are increasingly creating their own checks, using blank check stock and printers that print all of
their information as well as the MICR (Magnetic Ink Character Recognition) line as the check itself is printed.
The physical equipment used to create checks as well as the blank check stock must be strictly controlled.
Output control also concerns report distribution. For example, a payroll register with all the employees social
security numbers and pay rates is confidential information and thus its distribution must be restricted. There
should be an authorized distribution list, and only enough copies of the report should be generated to
permit one report to be distributed to each person on the list. For a confidential report, it is preferable to have
a representative pick the report up personally and sign for it. If this is not possible, a bonded employee can
be used to hand deliver the reports. The employees supervisor should make random checks on this
distribution.
Confidential reports should be shredded when they are no longer needed.
Controls Classified as Preventive, Detective and Corrective

Just as financial controls can be classified as preventive, detective and corrective, information systems
controls can be classified in the same manner.
Preventive controls prevent errors and fraud before they occur. Examples of preventive controls
are segregation of duties, job rotation, training and competence of personnel, dual access controls,
authorization, approval, endorsement and cancellation, and preformatted input.
Detective controls uncover errors and fraud after they have occurred. Examples of detective
controls are transmittal documents, batch control totals and other batch transmittal documents,
completeness checks, hash totals, batch balancing, check digits, limit checks, and validity checks.
The use of a turnaround document is also a detective control, because it checks on completeness
of input. Completeness-of-processing detective controls include run-to-run totals, reconciliations, use
of suspense accounts, and error logs. Correctness of processing detective controls are redundant
processing, overflow checks and summary processing.
Corrective controls are used to correct errors. Examples of corrective controls are discrepancy
reports and upstream resubmissions.
Controls Classified as Feedback, Feedforward and Preventive

Another way of classifying information systems controls looks at them as feedback, feedforward, or
preventive controls.
Feedback controls produce feedback that can be monitored and evaluated to determine if the
system is functioning as it is supposed to. Feedback controls are required in order to produce usable
information for end users. With the addition of feedback controls, a system becomes a self-
monitoring, self-regulating system.
A feedback loop is a part of a control system. It uses feedback to measure differences between the
actual output and the desired output. It then adjusts the operation according to those differences.
Thus, it self-corrects. A self-monitoring system is sometimes called a cybernetic system.
In a manufacturing situation, for example, where ingredients are being combined, computers may
monitor and control the mixing process, making adjustments as necessary to maintain the correct
proportions of each ingredient in the mix. In an accounting system, data entry displays or edit
sheets provide control of data entry activities, and accounting procedures such as reconciliations
provide feedback.
Another example of a feedback control is a report that summarizes variances from budgeted
amounts.
A feedforward control system may be used in addition to the feedback loop to provide better
controls. A feedforward system attempts to predict when problems and deviations will occur before
they actually occur. It gives people guidance about what problems could occur, so they can plan the
necessary changes or actions to prevent the problem or deviation from occurring. Or, if it is not pos-
sible to prevent the problem, it will enable the company to minimize the effects of the problem. A
budget is a feedforward control. Policies, procedures and rules are also feedforward controls, be-
cause they establish the way things are supposed to be done. When people have detailed
instructions, there is less chance that something will go wrong.
A preventive control attempts to stop a variance or problem from ever occurring, because it is
more cost effective to prevent a problem than it is to fix the problem after it occurs. Maintenance is
often given as an example of a preventive control. A preventive control is slightly different from a
feedforward control, in that the feedforward control simply tries to identify the potential problem,
whereas the preventive control attempts to prevent the problem from occurring. Segregation of du-
ties is a preventive control.
Question 85: An advantage of having a computer maintain an automated error log in conjunction with
computer edit programs is that:
a) Less manual work is required to determine how to correct errors.
b) Better editing techniques will result.
c) The audit trail is maintained.
d) Reports can be developed that summarize the errors by type, cause and person responsible.
(CMA Adapted)
Question 86: An employee in the receiving department keyed in a shipment from a remote terminal and
inadvertently omitted the purchase order number. The best systems control to detect this error would be:
a) Completeness test.
b) Batch total.
c) Reasonableness test.
d) Sequence check.
(CMA Adapted)
Question 87: Preventive controls are:
a) Usually more cost beneficial than detective controls.
b) Usually more costly to use than detective controls.
c) Found only in accounting transaction controls.
d) Found only in general accounting controls.
(CMA Adapted)
Question 88: Edit checks in a computerized accounting system:
a) Are preventive controls.
b) Must be installed for the system to be operational.
c) Should be performed on transactions prior to updating a master file.
d) Should be performed immediately prior to output distribution.
(CMA Adapted)
Computerized Audit Techniques CMA Part 1
Computerized Audit Techniques

Internal auditors use the computer to evaluate the processing being done by the computer and the controls
that are in place. There are a variety of tools that auditors can use to audit information systems.
Generalized Audit Software

Generalized audit software (GAS) permits the computer to be used by auditors as an auditing tool. The
computer can select, extract, and process sample data from computer files. Generalized audit software can be
used on mainframe computers and also on PCs. Generalized audit software can check computations, search
files for unusual items, and perform statistical selection of sample data. It can also prepare confirmation
requests.
Test Data
Test data is input prepared by an auditor that contains both valid and invalid data. The input is processed
manually to determine what the output should look like. The auditor then processes the test data electronical-
ly and compares the manually-processed results with the electronically-processed results. Test data is used
not only by auditors but also by programmers to verify the processing accuracy of the programs they write
and the programming changes they make.
Data used as test data might be real data, or it might be fictitious transactions. Since test data is not data
that should actually be processed, it is important to ensure that the test data do not actually update any of
the real data files maintained by the system.
Test data can only evaluate programs. Other tests that verify the integrity of input and output are required as
well. And the test data usually cannot represent all possible conditions that a computer program might
encounter in use. Furthermore, test data can be run only on a specific program at a specific time. Because the
test data must be processed separately from other data, the auditor cannot be sure that the program being
tested is the same program that is used in actual processing.
Integrated Test Facility

An Integrated Test Facility (ITF) involves the use of test data and also creation of test entities that do not
really exist, such as vendors, employees, products, or customers. The fictitious entities are actually included
in the systems master files, and the test data are processed concurrently with real transactions. The
transactions are processed against live master files that contain the real records as well as the fictitious
records.
The major difference between test data and an ITF is that the test data in an ITF are processed
along with real data. No one knows that the data being processed includes these fictitious entries to
fictitious records. In this way, the auditor can be sure that the programs being checked are the same
programs as those that are being used to process the real data.
The difficulty with using the ITF approach is that the fictitious transactions have to be excluded from the
normal outputs of the system in some way. This may be done manually, or it may be done by designing or
modifying the application programs. Either way, the fictitious transactions must be identified by means of
special codes so they can be segregated from the real data. Careful planning is required to make sure that
the ITF data do not become mixed in with the real data, corrupting the real data.
If this careful planning is done, the costs of using an ITF are minimal, because there is no special processing
required and thus no interruption of normal computer activity. There are costs involved in developing an ITF,
both while the application is being developed and as later modifications are made to it. However, once the
initial costs are past, the ongoing operating costs are low.
ITF is normally used to audit large computer systems that use real-time processing.
Section E Computerized Audit Techniques
Parallel Simulation
Parallel simulation is an audit technique that uses real data rather than simulated data but processes it
through test or audit programs. The output from the parallel simulation is compared with the output from the
real processing. Parallel simulation is expensive and time-consuming and is usually limited to sections of an
audit that are of major concern and are important enough that they require an audit of 100% of the
transactions.
Since parallel simulation is done using test programs, the parallel simulation can be done on a computer other
than the one used for the real processing. However, the auditor should make sure that the system used for
the real processing of the output that is used for comparison is the same one that is used all the time.
Embedded Audit Routines

Embedded audit routines involve modifying a regular production program by building special auditing routines
into it so that transaction data can be analyzed. Embedded audit data collection is one type of embedded
audit routine, and it uses specially programmed modules embedded as inline-code within the regular program
code. The embedded routine selects and records data as it is processing the data for normal production
purposes, for later analysis and evaluation by an auditor.
Transactions are selected by the embedded audit routine according to auditor-determined parameters for
limits and reasonableness. Transactions that violate those parameters are written to a file as exceptions.
Alternatively, transactions might be selected randomly. If transactions are selected randomly, the objective is
to create a statistical sample of transactions for auditing.
The approach that selects transactions that violate established limits is called a system control audit
review file (SCARF). The approach that selects random transactions is called a sample audit review file
(SARF).
It is easier to develop embedded audit routines when a program is initially developed than to add them later.
Extended Records and Snapshot

Many different processing steps may be combined in a program, and therefore the audit trail for a single
transaction may exist in several different files. Extended records refers to modifying a program to tag
specific transactions and save all their processing steps in an extended record, permitting an audit trail to be
reconstructed from one file for those transactions. Transactions might be selected randomly, or they might be
selected as exceptions to edit tests.
The snapshot technique takes a picture of a transaction as it is processed. Program code is added to the
application to cause it to print out the contents of selected memory areas when the snapshot code is
executed. A snapshot is used commonly as a debugging technique. As an audit tool, snapshot code can be
used only for transactions that exceed predetermined limits.
Extended records and snapshot are very similar. The difference is that snapshot generates a printed audit
trail, while extended records incorporates snapshot data in the extended record file rather than on hard copy.
Tracing
Tracing provides a detailed audit trail of all the instructions executed by a program. A single trace can
produce thousands of output records, so the auditor must take care to limit the number of transactions that
are tagged for tracing. Tracing might be used to verify that internal controls in an application are being
executed as the program is processing data, either live data or test data.
A trace may also reveal sections of unexecuted program code, which can indicate incorrect or unauthorized
modifications made to the program.
Internet Security CMA Part 1
Mapping
Mapping involves using special software to monitor the execution of a program. The software counts the
number of times each program statement in the program is executed. This originally was a technique used for
program design and testing, but auditors use it to determine whether program statements are being
executed. Mapping can help determine whether program application control statements that appear in the
source language listing of the program are actually executed when the program runs and have not been
bypassed. It can also locate dead program codes and can flag codes that may be being used fraudulently.
Mapping can be used with a program running test data. The output of the mapping program can indicate
whether there is unused code in the program. All unused codes are investigated, and the purpose of the
unused code is evaluated to determine whether it should stay in the program or be removed.
Internet Security
Once a company is connected to an outside network (usually the Internet), there are a number of additional
security issues that must be properly addressed. The company must make sure that the policies that it puts in
place allow the intended and authorized users to have access to the network as needed. However,
accessibility also creates vulnerability.
Electronic eavesdropping can occur if computer users are able to observe transmissions intended for
someone else. Therefore, organizations must ensure that information sent over a network is properly
protected to maintain the confidentiality of company information. Furthermore, the company must ensure
that company files cannot be accessed or changed without authorization.
At a minimum, the system should include user account management, a firewall, anti-virus protection
and encryption.
User account management is the process of giving people accounts and passwords. In order for
this to be as effective as possible, the company must keep these up-to-date. Inactive accounts
should be eliminated and active passwords changed frequently.
A firewall serves as a barrier between the internal and the external networks and prevents unau-
thorized access to the internal network. A properly configured firewall makes a computers ports
invisible to port scans. In addition to protecting a computer from incoming probes, a firewall can also
prevent backdoor42 applications, Trojan horses and other unwanted applications from sending data
from the computer. Most firewalls will usually prepare a report of Internet usage, including any ab-
normal or excessive usage and attempts to gain unauthorized entry to the network. A firewall can be
in the form of software directly installed on a computer, or it can be a piece of hardware that is in-
stalled between the computer and its connection to the Internet.
Antivirus software, regularly updated with the latest virus definitions, is the best defense against
viruses, Trojan horses and worms. Antivirus software recognizes and incapacitates viruses before
they can do damage. You must keep your antivirus software up-to-date, however, because new vi-
ruses appear constantly. Programs that specifically defend against Trojan horses are also available.
Encryption is the best protection against traffic interception resulting in data leaks. Encryption
converts data into a code and then a key is required to convert the code back to data. Unauthorized
people can receive the coded information, but without the proper key, cannot read it. Thus, an at-
tacker may be able to see where the traffic came from and where it went, but not the content.
42
A backdoor is an undocumented means to gain access to a program, online service or an entire computer system by
bypassing the normal authentication process. A backdoor is a potential security risk.
Section E Internet Security
Viruses, Trojan Horses and Worms

A computer virus is a program that alters the way another computer operates. Viruses can damage
programs, delete files or reformat the hard disk. Other viruses do not do damage but replicate themselves
and present text, video and audio messages. Although these viruses may not cause damage directly, they
create problems by taking up computer memory and causing erratic behavior or system crashes that can lead
to data loss. To be considered a virus, a virus must meet two criteria:
1) It must execute itself. A virus often places its own code in the path of the execution of another
program.
2) It must replicate itself. A virus can replace other executable files with a copy of the virus-infected
file.
A virus can be received from an infected disk, a downloaded file, or an email attachment, among other places.
A Trojan horse is different from a virus. A very important distinction between Trojan horses and viruses is
that Trojan horses do not replicate themselves, whereas viruses do. The purpose of a Trojan horse is not
to spread like a virus, but to have a particular target a particular computer on which to run a program. A
strict definition of a Trojan horse is, any program that does something besides what a person believes it will
do. A Trojan horse can appear to be something desirable, but in fact it contains malicious code that, when
triggered, will cause loss or even theft of data. A typical example of a Trojan horse is a program hidden inside
of a humorous animation that opens a back door into the system. Another example of a Trojan horse is
commercial software that collects data on the person running the program and sends it back to the
originating company without warning the target.
You can get a Trojan horse only by inviting it into your computer. Two examples are by:
1) Opening an e-mail attachment.
2) Downloading and running a file from the Internet. Many mass-mailing worms are considered Trojan
horses because they must convince someone to open them. The SubSeven server, which is software
that lets an attacker remotely control any computer it is installed on, is an example of a program
typically embedded in a Trojan horse.
A worm is a program that replicates itself from system to system without the use of any host file. The
difference between a worm and a virus is that the worm does not require the use of an infected host file,
while the virus does require the spreading of an infected host file. Worms generally exist inside of other files,
often Word or Excel documents. However, worms use the host file differently from viruses. Usually the worm
releases a document that has the worm macro inside the document. The entire document spreads from
computer to computer, so the entire document is, in essence, the worm.
A virus hoax is an e-mail telling you that a file on your computer is a virus when the file is not a virus. These
e-mails tell you to look on your system for a file with a specific name and, if you see it, delete it because the
file contains a virus that is unrecognizable by your anti-virus program. Everyone will find that file, because it
is a system file that is needed for the computer to operate correctly. If you believe this e-mail and delete the
file, your computer may malfunction.
Note: The difference between a virus and a Trojan horse is that a virus replicates itself, but a Trojan horse
does not.
The difference between a virus and a worm is that the virus requires an infected host file in order to
replicate itself, while the worm can replicate itself without a host file.
Question 89: An organization installed antivirus software on all its personal computers. The software was
designed to prevent initial infections, stop replication attempts, detect infections after their occurrence,
mark affected system components and remove viruses from infected components. This major risk in
relying on antivirus software is that antivirus software may:
a) Not detect certain viruses.
b) Make software installation overly complex.
c) Interfere with system operations.
d) Consume too many system resources.
(CIA Adapted)
Cybercrime
The Internet, online communications and e-business are all subject to computer crime and this threat is
growing every day.
A very broad definition of computer crime according to the FBI National Computer Crime Squad (NCCS) is
crimes where the computer is a major factor in committing the criminal offense. The NCCS investigates
violations of the Federal Computer Fraud and Abuse Act (CFAA) and is concerned with all computer crimes
that cross multiple state or international boundaries. CFAA was intended to control interstate computer crime
and since the advent of the Internet, almost all computer use has become interstate and international in
scope.
The NCCS explicitly lists the following as the most serious computer crimes:
Intrusions of the Public Switched Network (the telephone company)

Major computer network intrusions
Network integrity violations
Privacy violations
Industrial espionage
Pirated computer software
The Association of Information Technology Professionals (AITP) defines computer crime as:
The unauthorized use, access, modification or destruction of hardware, software, data or network
The unauthorized release of information
The unauthorized copying of software
Denying an end user access to his or her own hardware, software, data or network resources
Using or conspiring to use computer or network resources to illegally obtain information or tangible
property
Some specific computer crimes include:
Copyright infringement such as the illegal copying of copyrighted material, whether intellectual
property, such as computer programs or this textbook, or entertainment property such as music and
movies.
Denial of Service (DOS) attacks in which a website is accessed repeatedly so that other, legitimate
users cannot connect to it.
Theft of credit card numbers from retailers files.
Phishing, a high-tech scam that uses spam e-mail to deceive consumers into disclosing their credit
card numbers, bank account information, Social Security numbers, passwords or other sensitive per-
sonal information.
Installation of malware on a computer without the users knowledge. An example of malware is a

keylogger that records every keystroke and sends it back to the hacker. Keylogging software has
been used to gather bank information, credit card information, and passwords. Other malware turns
a PC into a zombie, giving hackers full control over the machine. Hackers set up botnets net-
works consisting of millions of zombies that can be made to each send out tens of thousands of
spam emails or emails infected with viruses, and the computer users do not even know it is happen-
ing.
Using port scans, hackers can look for a particular make of computer or a particular software program,
because they know of weaknesses in those computers or programs that they can exploit. Once a hacker has
identified a vulnerable computer or software application, they can leave a back door open in the computer in
order to re-enter it at any time. If the original entry point is detected and closed, the back door functions as a
hidden, undetected way back in.
A sniffer is a piece of software that grabs all of the traffic flowing into and out of a computer attached to a
network. Sniffers have legitimate as well as illegitimate uses. Intrusion Detection Systems (IDS) use sniffers
to match packets against a rule set designed to flag things that appear malicious or strange. Network
utilization and monitoring programs often use sniffers to gather data necessary for metrics and analysis.
Most personal computers are on Local Area Networks (LANs), meaning they share a connection with several
other computers. If a network is not switched (a switch is a device that filters and forwards packets between
segments of the LAN), traffic intended for any machine on a segment of the network is broadcast to every
machine on that segment. This means that every computer actually sees the data traveling to and from each
of its neighbors, but normally ignores it. The sniffer program tells a computer to stop ignoring all the traffic
headed to other computers and instead pay attention to that traffic. The program then begins a constant read
of all information entering the computer.
Anything transmitted in plain text over the network is vulnerable to a sniffer passwords, web pages,
database queries and messaging, to name a few. Once traffic has been captured, hackers can quickly extract
the information they need. The users will never know their information has been compromised, because
sniffers cause no damage or disturbance to the network environment.
Other tools of hackers include:
Password crackers, which is software that creates different combinations of letters and numbers in
order to guess passwords.
War dialing or programs that automatically dial random telephone numbers in search of a modem
connection.
Logic bombs or errors in the logic of computer programs that result in the destruction of computer
data or a malicious attack when specific criteria are met.
Buffer overflow, which sends too much data to the buffer in a computers memory, crashing it or
enabling the hacker to gain control over it.
Some computer crime tactics involve efforts in person as well as computer activities. Tactics involving
personal effort include social engineering and dumpster diving. Social engineering involves calling up
company employees and deceiving them into divulging information such as passwords. Dumpster diving is
sifting through a companys trash for information that can be used either to break into its computers directly
or to assist in social engineering.
Another online scam is directed against companies that advertise on search engines on a pay-per-click
basis. Google is probably the best-known example of a search site that charges advertisers each time a visitor
clicks on the ad links. In one version of this scam, a competitor will write a software program that repeatedly
clicks on a businesss ads in order to run up its advertising charges. Ultimately, after too many clicks within a
24-hour period, the ad is pushed off the search engine site, resulting in lost business for the company along
with the inflated advertising fees.
However, it is not only outsiders who commit computer crimes against a company. Insiders or company
employees are a primary source of trouble. Employees who are planning to leave one employer and go to
work for a competitor can use their company e-mail to transmit confidential information from the current
employer to the future employer.
Insider crime can also include using the company computer for private consulting, personal financial business,
playing video games on company time or browsing pornography sites. A legitimate use of sniffers, described
earlier, is monitoring network usage to reveal evidence of improper use. Some businesses install software
that enables them not only to monitor their employees access to websites but also to block access to certain
websites. Improper use of the Internet and e-mail at work can get an employee fired immediately.
Defenses Against Cybercrime

As we said earlier, the best defense against port scans is a good firewall. A firewall serves as a barrier
between the internal and the external networks and prevents unauthorized access to the internal network. A
properly configured firewall makes a computers ports invisible to port scans. In addition to protecting a
computer from incoming probes, a firewall can also prevent backdoor applications, Trojan horses and other
unwanted applications from sending data from the computer. Most firewalls will usually prepare a report of
Internet usage, including any abnormal or excessive usage and attempts to gain unauthorized entry to the
network. A firewall can be in the form of software directly installed on a computer, or it can be a piece of
hardware that is installed between the computer and its connection to the Internet.
An organization may also use a proxy server, which is a computer and software that creates a gateway to
and from the Internet. The proxy server contains an access control list of approved web sites and handles all
web access requests, limiting access to only those sites contained in the access control list. This enables an
employer to deny its employees access to sites that are unlikely to have any productive benefits. The proxy
server also examines all incoming requests for information and tests them for authenticity. In this way, a
proxy server functions as a firewall. The proxy server can also limit the information that is stored on it to
information that the company can afford to lose. Thus, if this server is broken into, the organizations main
servers remain functional.
Tools called antisniffers are available to defend against sniffers. When a sniffer program is active on a
computer, the computers network interface card (NIC) is placed in a state called promiscuous mode. The
antisniffer scans networks to determine if any network interface cards are running in promiscuous mode.
Antisniffers can be run regularly to detect evidence of a sniffer on the network. A switched network is also
a deterrent, because it eliminates the broadcasting of traffic to every machine, although there are programs
that a hacker can use to get around the switched network.
The best defense against phishing is in the hands of the recipient. Recipients need to know not to respond to
any e-mail that requests personal or financial information and not to click on any link given in such an e-mail
that could take them to a spoofed website. Similarly, recipients of unexpected e-mail attachments need to
know not to open them, even if a virus scan has not identified any virus in the attachment. New viruses
appear every day and one could slip past an antivirus program, even one that is updated regularly. Thus,
employee education is a vital part of Internet security.
Encryption
Also as mentioned earlier, encryption is the best protection against traffic interception resulting in data leaks.
Encryption converts data into a code and then a key is required to convert the code back to data.
Unauthorized people can receive the coded information, but without the proper key, cannot read it. Thus, an
attacker may be able to see where the information came from and where it went, but not the content.
The encryption process can be either in the hardware or in the software. There are two methods of software
encryption: secret key and public key/private key.
In a secret key system, each sender and recipient pair has a single key that is used to encrypt and
decrypt the messages. The disadvantage to this method is that every pair of senders and receivers
must have a separate set of keys that match. If several pairs all used the same set, then anyone
having the key could decrypt anyone elses message and it would not be a secret. This is impractical
over the Internet, because any one company could have thousands of potential customers as well as
others from whom it would need to receive messages.
The public key/private key encryption system is a better system for companies to use. In a
public-key/private-key encryption system, each entity that needs to receive encrypted data publish-
es a public key for encrypting data while keeping a private key to itself as the only means for
decrypting that data. Anyone can encrypt and send data to the company using its published public
key, but only the companys private key can be used to decrypt the data and only the company that
published the public key has the private key.
A company obtains a public key and the private key to go with it by applying to a Certificate Authori-
ty, which validates the companys identity and then issues a certificate and unique public and private
keys. The certificate is used to identify a company, an employee or a server within a company. The
certificate includes the name of the entity it identifies, an expiration date, the name of the Certificate
Authority that issued the certificate, a serial number and other identification. The certificate always
includes the digital signature of the issuing Certificate Authority, which permits the certificate to
function as a letter of introduction from the Certificate Authority. One example of public/private
encryption keys is SSL (Secure Socket Layer), used on secure web sites.
Public key/private key encryption can be illustrated with an analogy. Imagine a door with two locks,
one keyed to the public key, and the other keyed to the private key. Both locks are unlocked, and a
pile of keys that fit the public key lock is available on a table nearby. When anyone wants to leave
something in the room, they take a public key and lock the door. Upon locking the door with the
public key, the private key lock is locked automatically. Only the person with the private key can
open the door and look at what is in the room. Therefore, you know the message is both safe from
being read by anyone else and that only the intended recipient can read it.
The most important point to remember here is that only someone with the private key (which should
be closely guarded) can open the door and have access to the contents of the room. While it is pos-
sible to "pick the lock," doing so requires a large amount of time, skill and determination, just like in
real life.
Businesses can use public key cryptography when sending information. If Ronnie Retailer needs to order from
Smith Supply, they can use Smith Supplys public key to encrypt the information that they want to send via
the Internet. Smith Supply can then use their private key to decrypt the message and process whatever
transaction was requested. Anyone else who happens to intercept Ronnie Retailers message will see only
gibberish. This same process is also how your credit card information is sent securely to online merchants.
Business Continuity Planning CMA Part 1
Business Continuity Planning

Business continuity planning involves defining the risks facing a company in the event of a disaster, assessing
those risks, creating procedures to mitigate those risks, regularly testing those procedures to ensure that
they work as expected, and periodically reviewing the procedures to make sure that they are up to date. In
the context of an information technology system, it is essential that the company have plans for the backup
of data and the recovery of data, especially in the context of disaster recovery.
Several different processes and backup plans function as part of the backup and recovery plan.
Program files, as well as data files, should be backed up regularly.
Copies of all transaction data are stored as a transaction log as they are entered into the system.
Should the master file be destroyed during processing, computer operations will roll back to the
most recent backup; recovery takes place by reprocessing the data transaction log against the
backup copy.
Backups should be stored at a secure, remote location, so that in the event data is destroyed due to
a physical disaster, it can be reconstructed. It would do very little good to have a backup tape in the
same room as the computer if that area were destroyed by fire. Backup data can be transmitted
electronically to the backup site through a process called electronic vaulting. The security of the
remote location needs to be evaluated periodically.
Grandparent-parent-child processing is used because of the risk of losing data before, during or
after processing work. Data files from previous periods are retained and if a file is damaged during
updating, the previous data files can be used to reconstruct a new current file. Like backup files,
these files should also be stored off-premises.
Computers should be on Uninterruptible Power Supplies (UPS) to provide some protection in the
event of a power failure. Software is available that works in tandem with the UPS to perform an or-
derly shutdown of the system during that short period of power maintenance that the UPS can give
the computer.
Fault-Tolerant Systems are systems designed to tolerate faults or errors. They often utilize re-
dundancy in hardware design, so that if one system fails, another one will take over. Computer
networks can be made redundant in several ways:
o With multiple processors, consensus-based protocols specify that if one processor disagrees
with the others, it should be ignored.
o With two processors, the second processor can serve as a watchdog processor. If something
happens to the primary processor, the watchdog processor takes over.
o A computer or server could have two disks and all data on the first disk is mirrored on the sec-
ond disk. This is called disk mirroring or disk shadowing. Should one disk fail, the processing
continues on the good disk.
o Rollback processing may be used to prevent any transactions being written to disk until they
are complete. If there is a power failure or another fault during processing, the program auto-
matically rolls itself back to its pre-fault state at its first opportunity.
o Duplicate circuitry is the double wiring of key hardware elements to ensure that if one circuit
malfunctions, the other will take over.
o A redundancy check is the process of sending repeated sets of data to confirm the original da-
ta sent. Summary processing is a redundant process using a sum, which is compared with the
control total from the processing of the detailed items.
o An echo check is the process of sending the received data back to the sending computer to
compare what was actually sent to make sure that it is the same.
o In a dual read check, data is read twice during input and compared.
Section E Business Continuity Planning
o Boundary protection is protection against unauthorized entry (read or write) to a tape, disk or
other storage device.
o Graceful degradation means that if a part of the system malfunctions, other components can
be programmed to continue the processing, although on a less efficient basis.
o Overflow check means that the data is checked and an error message activated if data is lost
through arithmetic operations that exceed the planned capacity of the receiving fields.
Question 90: Managements enthusiasm for computer security seems to vary with changes in the
environment, particularly with occurrence of the other computer disasters. Which of the following
concepts should be addressed when making a comprehensive recommendation regarding the costs and
benefits of computer security?
I. Potential loss if security is not implemented.
II. Probability of occurrences.
III. Cost and effectiveness of the implementation and operation of computer security.
a) I only.
b) I and II only.
c) III only.
d) I, II and III.
(CIA Adapted)
Disaster Recovery
Not many firms could survive for long without computing facilities. Therefore, an organization should have a
formal disaster recovery plan to fall back on in the event of a hurricane, fire, earthquake, flood or criminal or
terrorist act. A disaster recovery plan specifies:
1) Which employees will participate in disaster recovery and what their responsibilities will be. One
person should be designated in charge of disaster recovery and another should be second in com-
mand.
2) What hardware, software and facilities will be used.
3) The priority of applications that should be processed.
Arrangements for alternative facilities as a disaster recovery site and offsite storage of the companys
databases are also part of the disaster recovery plan. An alternative facility might be a different facility owned
by the company, or it might be a facility contracted by a different company. The different locations should be
a significant distance away from the original processing site.
A disaster recovery site may be a hot site, a cold site, a warm site, or a mobile site.
A hot site is a backup facility that has a computer system similar to the one used regularly. The hot site must
be fully operational and immediately available, with all necessary telecommunications hookups for online
processing. A hot site also has current, live data that is replicated to it from the live site, either by data
communications or by on-site storage of backup media.
A cold site is a facility where space, electric power, and heating and air conditioning are available and
processing equipment can be installed, though the equipment and the necessary telecommunications are not
immediately available. If an organization uses a cold site, its disaster recovery plan must include arrange-
ments to quickly get computer equipment installed and operational.
Business Continuity Planning CMA Part 1
A warm site is in between a hot site and a cold site. It has the computer equipment and necessary data and
communications links installed, just as a hot site does. However, it does not have live data. If use of the
warm site is required because of a disaster, current data will need to be restored to it.
A mobile site is a disaster recovery site on wheels. It can be a hot site, a warm site, or a cold site. It is
usually housed in a trailer and contains the necessary electric power, heat and air conditioning. If it is a warm
or a hot site, it also contains the computer equipment; and if it is a hot site, it also contains current data.
A mobile site may be company-owned or it may be available to the company on a contracted basis. Several
companies operate mobile recovery centers. In the event of a disaster that destroys operations facilities, they
arrive within hours in a tractor-trailer or van that is fully equipped with their clients platform requirements,
50 to 100 workstations, and staffed with technical personnel to assist in recovery.
Personnel should be trained in emergency procedures and re-training should be done regularly to keep their
knowledge fresh. The disaster recovery plan should be tested periodically by simulating a disaster in order to
reveal any weaknesses in the plan. This test should be conducted using typical volumes, and processing times
should be recorded. The disaster recovery plan should be reviewed regularly and revised when necessary
because organizational and operational changes made that have not been incorporated into the recovery plan
could make the recovery plan unusable.
All members of the disaster recovery team should each keep a current copy of the plan at home.
Question 91: A critical aspect of a disaster recovery plan is to be able to regain operational capability as
soon as possible. To accomplish this, an organization can have an arrangement with its computer
hardware vendor to have a fully operational facility available that is configured to the user's specific
needs. This is best known as a(n):
a) Uninterruptible power system.
b) Parallel system.
c) Cold site.
d) Hot site.
(CMA Adapted)
Question 92: Each day after all processing is finished, a bank performs a backup of its online deposit files
and retains it for 7 days. Copies of each days transaction files are not retained. This approach is:
a) Valid, in that having a weeks worth of backups permits recovery even if one backup is unreadable.
b) Risky, in that restoring from the most recent backup file would omit subsequent transactions.
c) Valid, in that it minimizes the complexity of backup/recovery procedures if the online file has to be
restored.
d) Risky, in that no checkpoint/restart information is kept with the backup files.
(CIA Adapted)
CMA Part 1 Answers to Questions
Answers to Questions
1 b Conversion costs include direct labor and manufacturing overheads. In this question the direct labor is
$20 per unit and the manufacturing overheads are $21 per unit giving a conversion cost of $41 per unit.
2 d Prime costs include direct materials and direct labor. In this question, these are $32 and $20,
respectively, giving a prime cost per unit of $52.
3 b Total variable costs will include all variable costs, including direct materials and direct labor. These are
$32 + $20 + $15 + $3 = $70.
4 c To calculate the total estimated costs, we need to include both production and nonproduction (here,
selling) costs and both variable and fixed costs. Total estimated manufacturing costs include manufacturing
costs for the total number of units planned to be produced, not sold. Total estimated costs also include the
fixed and variable selling costs that are expensed as they are incurred, but for selling costs, we use the total
number of units planned to be sold, not produced.
Total estimated fixed manufacturing overhead must be calculated by multiplying the estimated fixed
manufacturing overhead per unit by the number of units planned to be produced per month. The estimated
total fixed manufacturing overhead was determined before the estimated unit cost was determined in the
planning process, and it does not change with changes in production level. The fixed manufacturing overhead
per unit was then determined by dividing the total estimated fixed manufacturing overhead by the number of
units planned to be produced. So to find what the estimated total fixed manufacturing overhead was, we need
to multiply the estimated fixed manufacturing overhead per unit ($6) by the number of units planned to be
produced (12,000).
Estimated total costs are:
Variable manufacturing cost of $67 per unit in total 12,000 units planned to be produced: $804,000
Fixed manufacturing overhead of $6 per unit 12,000 units planned to be produced: 72,000
Variable selling expense of $3 per unit 8,000 units sold: 24,000
Fixed selling expense (12,000 planned sales the fixed selling estimated cost of $4/unit): 48,000
$948,000
Note that total fixed selling expense does not change if only 8,000 units are sold instead of 12,000.
5 c - Cost of goods sold consists of cost of goods manufactured adjusted for the change in finished goods
inventory, as follows:
Beginning FG inventory + Cost of goods manufactured Ending FG inventory = Cost of goods sold
From the information given in this question, we can calculate what cost of goods sold is (Sales $160,000
Gross Profit $48,000 = $112,000); and we know what beginning and ending finished goods inventory are
because those are given. Therefore, using the formula above and letting X stand for cost of goods
manufactured, we can calculate what cost of goods manufactured is.
$60,190 + X $58,300 = $112,000
Solving for X, we get X = $110,110.
6 d This question is actually fairly simple and just requires that we make 3 allocations of overhead.
Overhead is allocated based on direct labor, raw materials and machine hours. These calculations, in this
order, are: $8,000 100% = $8,000; $2,000 20% = $400; 140 $117 = $16,380. These total $24,780,
but this is not the correct answer. This is the amount of overhead, but the question asks for total costs. This
means that we need to include direct labor ($8,000) and raw materials ($2,000). The total costs are $34,780.
7 b We are told that the actual overhead was $45,000 and that there was $3,000 of over-applied overhead.
This means that a total of $48,000 of overhead was applied. Given that the overhead was applied at a rate of
$3 [(40,000+20,000) 20,000 units] per unit produced, there must have been 16,000 units produced in
order to have $48,000 applied ($48,000 $3).
8 c To solve this question, we need to use the following formula:
Units in Beginning WIP + Units Transferred In = Units in Ending WIP + Units Completed
In this formula, the units transferred in is the same as the number of units started during the period. This
gives us the following: 4,000 + X = 5,000 + 15,000. Solving for X we get X = 16,000. In this question, the
information about the percentage complete of BWIP and EWIP is unnecessary since the question is about
physical units and not equivalent units.
9 c In order to solve this, we need to use the three stages of work that can be done on a unit. To finish
BWIP, Ben had to do 80% of the work on 200 units, giving 160 EUP to finish BWIP. There were 900 units
(1,100 units completed 200 units in BWIP) that were started and completed during the period, giving 900
EUP. There were 400 units in EWIP that had 80% of the work done, or 320 EUP. Adding these three EUP
figures together gives us 1,380 EUP for May.
Answers to Questions CMA Part 1
10 a In this question we need to calculate EUP separately for materials and conversion costs. Materials are
much easier because we are told that all materials are added at the beginning of the process. This means that
the EUP for materials will be equal to the number of units started, which was 5,000.
For conversion costs we will need to calculate the EUP to finish BWIP, the number of units that were started
and completed and the number of EUP to start EWIP. To finish BWIP it required 800 EUP because the 2,000
units in BWIP were already 60% complete, leaving 40% of the work to be done this period. There were 4,000
units started and completed (6,000 units were completed and there were 2,000 units in BWIP) so these
required 4,000 EUP. To start the EWIP required 400 EUP because the 1,000 units were 40% complete. In
total there were 5,200 EUP of conversion costs.
If we calculate the three steps, it looks like this:
Materials Conversion Costs
Complete Beginning WIP Already have been added 2,000 0.4 = 800
Started and Completed 4,000 4,000 1 = 4,000
Start Ending WIP 1,000 1,000 0.4 = 400
Total 5,000 5,200
11 b Under the FIFO method, we need to make 3 calculations to determine the number of equivalent units
of conversion costs. We need to determine the number of units required to finish the beginning work-in-
process, the number of units needed to start the ending work-in-process and the number of units that were
started and completed during the period. There were 20,000 units in beginning work-in-process and they
were 50% complete. This means that 50% of the work, or 10,000 equivalent units, was performed this
period. There were 10,000 units in ending work-in-process that were also 50% complete. This means that
50% of the work, or 5,000 equivalent units, was done this period. 180,000 units were transferred out, but as
there were 20,000 units in beginning work-in-process, only 160,000 units were started and completed.
Adding together these 3 numbers, we get 175,000 equivalent units of conversion costs.
12 a As with the previous question, material EUP is very simple under FIFO when all materials are added at
the beginning of the process. The EUP is equal to the number of units started during the period, or 5,000.
13 b In order to finish BWIP, 400 EUP were required (40% of 1,000, because BWIP consisted of 1,000 units
that were already 60% complete). A total of 3,000 units were started and completed (this is given in the
question). There were 400 EUP to start EWIP (20% of 2,000 units). 400 + 3,000 + 400 = 3,800 EUP of
conversion costs under FIFO.
14 d Under weighted average we assume that the work that was in BWIP was done during the current
period. Therefore, EUP for materials will include not only units started this period, but also the number of
units in BWIP. This is 6,000 in total (5,000 started and 1,000 in BWIP).
15 d Again, under weighted average we need to include the work that was in BWIP as well as the work
actually done. As a result, the calculation of EUP has only two parts units completed and units started that
were in EWIP at the end of the period. The number of units completed was 4,000 (1,000 in BWIP and 3,000
started and completed) and the EUP to start EWIP was 400 (20% of 2,000). This gives a total of 4,400 EUP.
The EUP under the weighted average method will never be lower than the EUP for FIFO.
16 d In order to answer this question we need to determine the cost per EUP. Materials are easier since
they have all been placed in production. This means that there have been 10,000 EUP of materials and with a
materials cost of $33,000, this gives a cost per EUP of $3.30. Conversion costs (CC) are a little bit more
involved, but not much. The EUP of CC is 8,000 for the finished goods. There are 2,000 physical units in EWIP
that are 25% complete as to conversion costs so this means that there are 500 EUP of CC in EWIP. Since CC
costs were $17,000 and there were 8,500 EUP in conversion costs, this gives a cost per EUP of CC of $2.00.
So, in total a finished good costs $5.30 ($3.30 + $2.00). There were 8,000 finished units, for a total cost of
the units transferred out of $42,400 (8,000 units $5.30).
17 d The cost of the EWIP is calculated as follows for materials and CC: There were 2,000 EUP of materials
in EWIP at a cost of $3.30 per unit ($6,600) and there were 500 EUP of CC in EWIP at a cost of $2.00 per unit
($1,000). In total there were $7,600 of costs in EWIP.
18 d When there is no BWIP (as in January), FIFO and weighted average give the same EUP. However,
when there is BWIP (as in February), weighted average will always give a higher EUP.
19 c Under the weighted average method to calculate the equivalent units, we simply need to add together
the number of units completed and the number of EUP that were done in order to start the EWIP. In this
question 92,000 units were completed and the 24,000 units in EWIP are 90% complete for materials, giving
us 21,600 EUP in EWIP. This gives a total of 113,600 EUP of materials for the period. The total costs to
allocate for materials under the weighted average method will include the costs incurred during the period
($468,000) as well as the costs of the materials in BWIP ($54,560). The total material cost is $522,560 and
this is divided by the 113,600 EUP giving us a cost per equivalent unit for materials of $4.60.
20 c Under the weighted average method to calculate the equivalent units, we simply need to add together
the number of units completed and the number of EUP that were done in order to start the EWIP. In this
question 92,000 units were completed and the 24,000 units in EWIP are 40% complete for conversion costs,
giving us 9,600 EUP in EWIP. This gives a total of 101,600 EUP of conversion costs for the period. The total
costs for conversion costs under the weighted average method will include the costs incurred during the
period ($182,880 + $391,160) as well as the costs of the conversion costs in BWIP ($20,320 + $15,240). The
total cost for conversion costs is $609,600 and this is divided by the 101,600 EUP giving us a cost per unit for
conversion costs of $6.00.
21 d If there is no BWIP, but there is EWIP, the number of EUP will have to be less than the units placed
into the process since not all of the units placed into the process were completed.
22 c The first thing that we need to do is determine how many spoiled units are abnormal spoilage. Since
3% of the good units is considered normal, this comes to 60 baseballs (3% 2,000 units passing inspection).
Since there were 100 spoiled units and 60 is the normal spoilage, abnormal spoilage was 40 units. After this,
we need to determine the cost per unit. Remember that we allocate costs to the spoiled units. Because there
was no beginning or ending work-in-progress, we can treat all of the costs the same, giving a total cost of
$1,155. This is allocated to each of the 2,100 units produced, giving a rate of $0.55 per unit. This is the cost
that is allocated to the 40 abnormally spoiled units, giving a total cost of $22 for abnormal spoilage ($0.55
40).
23 a Because the beginning work-in-progress is 40% complete, the materials have already been added.
However, as the ending work-in-progress is 20% complete, the materials have not been added. As a result,
the materials were added this period only to the units that were started and completed. 85,000 units were
completed during the period, but because there were 15,000 units in beginning work-in-progress, only 70,000
units were started and completed during the period.
24 b When the cost of normal spoilage is not accounted for separately, it is simply transferred to the next
department as part of the cost of the good units. We need to calculate the cost per unit of all units produced
both good and spoiled units. In total, 5,500 units were produced at a cost of $2,200. This is a cost per unit
of $0.40. The cost for the 5,000 good units and the 300 normally spoiled units is transferred to the next
department. This is 5,300 units at $0.40 per unit, or $2,120. It can also be calculated as $2,200 minus the
cost of the abnormally spoiled units, which is 200 units at $0.40, or $80.
25 d The abnormal spoilage of $50,000 is charged directly to the income statement in this period. The
$20,000 of normal spoilage is allocated to the 50,000 good units produced. This normal spoilage will then be
on the income statement only when the units are sold. Since only half of the good units were sold, only half
of the normal spoilage, or $10,000, has been charged against revenue. So, the total spoilage costs on the
income statement in May are $60,000.
26 d The cost of goods sold includes direct materials ($13,700), direct labor ($4,800) and overhead
($20,000 = 800 hours $25 per hour). In total this is $38,500. Allocated to the 7,000 units, this is a cost per
unit of $5.50. Administrative and selling costs are not part of the cost of goods sold.
27 d Cost drivers are activities, events or factors that cause costs to be incurred. Whenever there is a
cause-and-effect relationship between the activity and the incurrence of a cost or costs, the activity is a cost
driver for the cost or costs.
28 a If the overhead costs are allocated based upon direct labor hours, the mirrors and the windows will
each receive an equal amount of overhead. This is because they both have 200 direct labor hours. This means
that the mirrors will receive 1/2 of the overhead, or $25,000. Since they made 25 mirrors, the overhead per
mirror is $1,000.
29 b Under ABC, the materials handling costs would be allocated based on the number of material moves.
Each mirror has 5 material moves and each window has 15. Given that the number of mirrors and windows is
the same, we know that the mirrors have 25% of the total material moves. This means that the mirrors
should get 25% of the overhead costs, or $12,500. This is allocated to each of the 25 mirrors at a rate of
$500 per mirror.
30 c The traditional system will include the costs for direct materials, direct labor and overhead. Direct
materials and labor are $5.15 per unit so all we need to calculate is the overhead per unit. Under the
traditional method, overhead is applied based on just one activity base. This problem tells us that the
company has been applying its manufacturing overhead on the basis of machine hours; so machine hours is
the one activity base the company has been using to apply overhead under the traditional method. The rate is
$60 per machine hour ($1,800,000 budgeted costs 30,000 hours). Each unit requires 0.016 machine hours
(80 machine hours required for a batch 5,000 units in a batch). This means that each unit will have $0.96
of overhead applied to it under the traditional method. This gives us a total cost of $6.11 per unit under the
traditional method.
31 d Under the ABC method we will still have $5.15 in direct materials and direct labor, but we will need to
calculate the overhead again. In ABC, there are 4 calculations we will need to make as part of the overhead
allocation. These are below per activity:
a) Material Handling - $0.12 per part ($720,000 6,000,000) and there are 5 parts per unit. This is
$0.60.
b) Setup Costs - $420 per setup ($315,000 750). There are 2 setups per batch, for a cost of $840 for
each batch of 5,000 units. This is $0.168 per unit ($840 5,000).
c) Machining Costs - $18 per machine hour ($540,000 30,000 MH). There are 80 machine hours per
batch, giving us $1,440 per batch of 5,000 units, or $0.288 per unit.
d) Quality Control - $450 per batch. This is $0.09 per unit ($450 5,000).
In total, these costs add up to $6.30.
32 c In this question the first thing we need to do is to reduce the costs to allocate by the sales value of the
byproduct. The sales value of the byproduct is $120,000 and this will reduce the costs to allocate to
$2,400,000. These costs are to be allocated based upon the physical volume of the two products. One has a
volume of 90,000 and the second product has a volume of 150,000. In total this is 240,000, and since the
second product is 150,000, the allocation is as follows: $2,400,000 150,000 240,000 = $1,500,000.
33 a In order to do this problem, we need to determine the total sales value of all of the produced units.
We will then calculate what percentage of this total sales value comes from the MSB and this is the
percentage of the $300,000 of joint costs that will be allocated to the MSB. The sales value of the MSB is
$120,000 ($2 per unit 60,000 units), and the sales value of the CBL is $360,000 ($4 per unit 90,000
units). In total, this is $480,000, and the MSB is 25% of this total. Therefore, 25% of the joint costs, or
$75,000, is allocated to the MSB.
34 b Using the relative sales value method, we will allocate the $10,000 of joint costs to each product.
Since product X has a sales value of $12,000 and Y has a sales value of $8,000, the total sales value is
$20,000. 60% of this is X, so X will receive 60%, or $6,000, of the joint costs.
35 b Under variable costing, the profits that the company reports will fluctuate with the level of sales.
When sales increase, reported profits will increase. When sales decrease, reported profits will decrease.
With variable costing, manufacturing fixed costs are treated as period costs and are expensed as incurred
instead of being capitalized in inventory. So cost of goods sold consists of variable costs only. Therefore,
profits will increase by the amount of the unit contribution margin multiplied by any increase in units sold,
and they will decrease by the amount of the unit contribution margin multiplied by any decrease in units sold.
36 c Under variable costing, the fixed manufacturing overhead is simply expensed. The manufacturing
contribution per unit is calculated as the sales price ($10 per unit) minus the variable cost of goods sold
($5.50) and is $4.50 per unit. Since they sold 1,000 units, this gave them $4,500 of manufacturing
contribution margin.
Variable selling and administrative costs are $0.50 per unit sold. Therefore, the contribution margin (sales
revenue minus all variable costs, including both manufacturing and non-manufacturing) is thus $4.50 per unit
minus $0.50 per unit, or $4.00 per unit, which equals $4,000 in total.
Fixed manufacturing ($1,200) and fixed selling ($1,000) costs are subtracted from the contribution margin,
giving us a net operating income of $1,800 ($4,000 $1,200 $1,000).
37 c This problem can be solved two ways. The first way is to use the differences between variable and
absorption costing to calculate the difference between the net operating incomes under the two methods. We
can do this with this question because beginning inventory was zero.
Since we are given the variable costing operating income and since the beginning inventory was zero, we can
back into the absorption costing operating income. The difference between variable and absorption costing
operating income is in the treatment of fixed manufacturing overhead. Under variable costing it is expensed,
but under absorption costing it is treated as a product cost and is inventoried. Since the fixed factory
overheads were $1,200 and they produced 1,200 units, the fixed factory overhead per unit was $1.00. Since
production was 1,200 units and sales were only 1,000 units, 200 units were left in inventory. This means that
the fixed factory overhead related to those 200 units is not on the income statement but is on the balance
sheet in inventory. Since beginning inventory was zero, we know that operating income under the absorption
costing method will be $200 higher than variable method income. Since variable costing operating income
was $1,800, absorption costing operating income is $2,000.
The second way to solve this problem is to calculate a full absorption costing operating income statement, as
follows:
Per Unit Units Sold Total
Sales revenue $10.00 1,000 $10,000
Cost of goods sold:

Variable COGS 5.50 1,000 5,500
Fixed COGS 1.00* 1,000 1,000
Gross profit $3.50 1,000 $ 3,500
Variable S & A expense .50 1,000 500
Fixed S & A expense 1,000
Net operating income $ 2,000
* $1,200 fixed cost 1,200 units produced = fixed cost per unit of $1.00.
38 c When absorption costing is being used and sales are greater than production, net income will be lower
than it would be under variable costing, because some of the fixed costs incurred in a previous period and
capitalized in inventory at that time will be expensed in Cost of Goods Sold along with the current periods
fixed costs. Under variable costing, only the current periods fixed costs would have been expensed. Because
in this circumstance Cost of Goods Sold will be greater under absorption costing than under variable costing,
net income will be lower under absorption costing.
39 b The difference between the two methods relates only to the fixed manufacturing overhead costs.
Because this was the companys first year of operations and thus beginning inventory was zero, the amount
of the difference can be calculated as follows:
Fixed manufacturing costs per Unit Change in the level of inventory
Fixed manufacturing costs divided by 50,000 units produced equals fixed manufacturing cost per unit of $5.
The company produced 50,000 units and sold 45,000 units, so inventory increased by 5,000 units. Thus the
increase of fixed manufacturing costs in inventory was $5 5,000 = $25,000. Because this $25,000 is put
into inventory under absorption costing but expensed under variable costing, net income under the absorption
method would be $25,000 higher because cost of goods sold would be lower than under variable costing.
40 d If the managers decrease production of any item, they will put fewer costs on the balance sheet since
there will not be an increase in inventory. By putting fewer costs on the balance sheet there will be more
costs on the income statement, reducing profit and bonus. All of the choices that include an increase in
production will cause profits to be higher since some of the costs of production will be held in the balance
sheet as part of finished goods inventory.
41 b Under absorption costing, the fixed manufacturing costs are allocated to the products produced. The
variable costs of production are $30 per unit and the fixed costs per unit are $3 per unit ($600,000
200,000 units produced). In total, the cost per unit is $33. Since the sales price was $40 per unit, this is a
gross profit of $7 per unit. With 120,000 units sold, that is $840,000 in total gross profit. Subtracting from
this the selling and administrative costs of $400,000, we get an operating income of $440,000.
42 a Under variable costing, the fixed manufacturing costs are expensed. With a selling price of $40 per
unit and a variable cost of $30 per unit, the manufacturing contribution margin is $10 per unit. With sales of
120,000 units, this is in total $1,200,000. Subtracting from this the fixed manufacturing costs of $600,000
and the selling and administrative costs of $400, we get an operating income of $200,000.
43 b This problem does not specify whether Valyn is using a standard cost system (in which standard, or
planned, costs are used to account for production) or an actual cost system (in which actual costs are used).
However, it does say that Valyn uses a predetermined manufacturing overhead rate for applying manufactur-
ing overhead to its product. And since the actual, incurred per unit costs for direct materials, direct labor and
variable manufacturing overhead are exactly the same as the planned per unit costs for those items, we do
not need to know whether standard costing or actual costing is being used in order to answer these
questions. (Standard versus actual costing has not yet been covered in this book. It will be explained later in
this section.)
Under absorption costing, the per unit cost of inventory includes all production costs, both fixed and variable.
The costs are expensed only when the units are sold. The differences between the actual incurred fixed
overhead cost and the applied fixed overhead cost is a variance, also called under-applied or over-applied
fixed manufacturing overhead. Variances can be closed out at the end of the period either by debiting or
crediting the whole amount to cost of goods sold or by prorating the debits or credits among inventories and
cost of goods sold. This question says that over- or under-applied manufacturing overhead is closed to cost
of goods sold.
Although the actual variable costs per unit are exactly the same as the planned variable costs per unit, they
are not the same for the fixed manufacturing overhead. The amount applied to each unit for fixed manufac-
turing overhead was $5.00, so the total applied was $5 130,000 units produced, which was only $650,000,
whereas the incurred cost was $715,000. Since Valyn closes over- or under-applied manufacturing overhead
to the cost of goods sold account, the variance was a debit to cost of goods sold and did not affect the
finished goods inventory balance.
Therefore, the per-unit cost in ending finished goods inventory for Valyn is $30. This is made up of the costs
per unit for direct materials of $12, direct labor of $9, variable overhead of $4 and fixed overhead of $5. At
the end of the period there were 40,000 units in ending inventory, since there were 35,000 at the start of the
period and they produced 5,000 more units than were sold during the period. This gives an ending finished
goods inventory of 40,000 units $30 per unit, or $1,200,000.
44 c Under variable costing, the cost per unit in ending inventory was $25 ($12 direct materials per unit +
$9 direct labor per unit + $4 variable manufacturing overhead per unit). Fixed manufacturing cost per unit is
not included, since under variable costing, fixed manufacturing cost is expensed as incurred. Given an ending
inventory of 40,000 units, the value of ending inventory was $1,000,000 (40,000 units $25 per unit).
45 a Under absorption costing, the per-unit cost of inventory includes all production costs, both fixed and
variable. These costs are applied to each unit as it is produced, and the costs go into inventory until the units
the costs are attached to are sold. When the units are sold, the costs attached to each sold unit are
expensed. The difference between the actual incurred costs and the applied costs for fixed manufacturing
overhead is a variance, also called under-applied or over-applied costs. The problem says that this variance is
closed out at the end of the period by debiting or crediting the whole amount to cost of goods sold.
Thus, for each unit that is sold, $5 of fixed manufacturing overhead is expensed as cost of goods sold.
125,000 units were sold, so this is $625,000 fixed manufacturing costs in cost of goods sold related to the
units sold.
Since under- or over-applied overhead is allocated to cost of goods sold, we need to calculate the amount of
the under- or over-applied overhead. A total of $650,000 of fixed overhead was applied during the period
(130,000 units produced at $5 fixed manufacturing cost per unit). The actual fixed overhead was $715,000,
so fixed overhead was under-applied by $65,000. This $65,000 of under-applied overhead will be added to
cost of goods sold expense.
Also, all of the fixed selling and fixed administrative costs were expensed during the period because these are
period costs. These costs total $1,405,000.
Under absorption costing, the total fixed costs expensed therefore equals $625,000 + $65,000 + $1,405,000,
or $2,095,000.
46 d The per-unit sales price was $70 and the per unit variable production costs were $25 (direct materials
$12, direct labor $9 and variable manufacturing overhead $4). The contribution margin per unit was therefore
$70 $25, or $45; and with 125,000 units sold, this gives a total manufacturing contribution margin under
the variable costing basis of $5,625,000.
47 a Under variable costing, all variable production costs are put into inventory and are expensed only
when the unit is sold. The variable production costs per unit that were applied to the units produced were the
costs for direct labor, direct materials and variable overhead, a total of $25 per unit. The number of units
sold was 125,000, so the total variable production costs expensed were $3,125,000 ($25 125,000).
Additionally, the variable selling and administrative costs need to be included in our answer. The variable
selling costs were $1,000,000. The variable administrative costs were $250,000. Adding these two amounts
to the total variable production costs expensed of $3,125,000, we get $4,375,000.
48 b The difference between the two methods is the treatment of fixed factory overheads. Under the
absorption method, fixed manufacturing overheads are applied to the units produced at the predetermined
rate, whereas under the variable method, they are expensed. The fixed factory overhead cost per unit is $5
and we can determine the difference between these two methods by multiplying this $5 per unit difference by
the number of units that were added to inventory during the period. Inventory increased by 5,000 units,
calculated as follows:
Beginning Inventory 35,000 Units + 130,000 Units Produced 125,000 Units Sold = Ending Inventory 40,000
units.
Thus, the predetermined fixed overhead rate of $5 per unit that was applied to each unit as it was
manufactured is attached to the 5,000 units that were added to inventory and was not expensed under
absorption costing. 5,000 $5 gives us a $25,000 difference in income between the two methods.
The difference in operating income can be calculated in this way because (1) The beginning finished goods
inventory is valued at the same per unit manufacturing cost as the current year's planned per unit
manufacturing cost (which implies that the fixed manufacturing cost in beginning inventory was the same as
the current year's predetermined application rate per unit for fixed manufacturing overhead); (2) Over- or
under-applied manufacturing overhead is closed to the cost of goods sold account at the end of the period;
and (3) There is no beginning work-in-process inventory.
49 d A service department or service center provides specialized support services to other units and
departments in the organization.
50 d Under the direct method the service department costs are not allocated to other service departments.
When we determine the ratio to allocate the costs to the production departments, we must not include the
usage by the other service departments. In order to allocate the costs of the quality control department to
assembly, we need to determine what percentage of the quality control time used by the production
departments was used by assembly. Assembly used QC 7,000 hours and machining used QC 21,000. Thus,
assembly will get 25% (or $87,500) of the QC costs. Assembly used the maintenance department a total of
12,000 hours and machining used maintenance for 18,000 hours. Thus, assembly will get 40% of the
maintenance costs (or $80,000). In total, therefore, the assembly department received $167,500 from the
service departments.
51 d Again using the direct method we need to determine how much is allocated to the machining
department. We can do this in one of two ways. The first way is the same as the previous question. The
second way is to subtract the costs that were allocated to assembly from the total service costs. Total service
costs were $550,000. Since $167,500 was allocated to assembly, then $382,500 was allocated to machining.
However, we also need to include the machining departments own costs of $400,000. So, $782,500 in total
costs needs to be allocated to the 50,000 machine hours. This gives a rate of $15.65 per machine hour
($782,500 50,000).
52 b In the step-down method we need to first allocate costs from QC, and in this process we will allocate
some of its costs to maintenance. In total, QC provided 35,000 hours of service and maintenance used 7,000
of them. So, maintenance will get 20% of the QC costs, or $70,000. Adding this to the $200,000 of its own
costs, the maintenance department has $270,000 to allocate. These will be allocated only to the production
departments. The assembly department used 40% of the maintenance hours that were used by production
departments, so $108,000 will be allocated to assembly ($270,000 0.4).
53 d The reciprocal method requires the usage of two formulas. The two formulas are based on the total
costs that each service department incurred and they are:
QC = $350,000 + 0.25M and M = $200,000 + 0.20QC
Now, we can solve this for either variable by substituting one equation into the other. We will solve for QC
(because this is what the question asks for), as follows:
QC = $350,000 + 0.25($200,000 + 0.20QC)
QC = $350,000 + $50,000 + 0.05QC
.95QC = $400,000 QC = $421,053
This is the amount of costs that the QC department must allocate, including allocation to the maintenance
department.
54 c This is a very simple question, but after the previous four, it seems too easy. We simply need to divide
the assembly overhead costs by the number of direct labor hours. $300,000 25,000 = $12.
55 b The throughput contribution per unit is the selling price minus the strictly variable costs. Since the
company does not lay off idle workers, labor is not a variable cost for this company. The only strictly variable
cost is direct materials. Thus, the throughput contribution per unit is the $200 selling price $100 direct
materials used in Molding $20 direct materials used in Heat Transfer = $80 per unit. All of the other
information given is irrelevant.
56 d The company can produce 400 units per day because that is the output of the two lowest-producing
departments. The throughput contribution per unit is the $200 selling price $100 direct materials used in
Molding $20 direct materials used in Heat Transfer = $80 per unit. Therefore, the throughout contribution
per day is $80 400 units, or $32,000.
57 c Since direct labor is not a variable cost because the company does not lay off its employees, the
annual operating costs are:
Direct labor: 525 hours /day (225 hours in Molding + 100 hours in Heat Transfer + 200 hours in Trimming) @
$25 /hour 260 working days/year = $3,412,500
Fixed manufacturing overhead: $2,000,000 ($1,000,000 in Molding + $750,000 in Heat Transfer + $250,000
in Trimming)
Fixed selling and administrative expense: $1,000,000 ($428,571 + $190,476 + $380,953)
Total: $3,412,500 + $2,000,000 + $1,000,000 = $6,412,500
58 b Production capacity is the capacity of the lowest-producing department or departments, since that
represents the maximum number of units that can be produced, even though other department(s) may be
able to produce more. When other department(s) can produce more than the lowest-producing depart-
ment(s), those departments that can produce more have excess unusable resources. Production capacity will
be maximized at the point where the production capacity of every department is the same number of units
and thus none of the departments have excess unusable resources. At that point, net income will be
maximized.
By reassigning an employee for 5 hours per day from Molding to Heat Transfer and by reassigning employees
for 10 hours per day from Molding to Trimming, the production capacities in each department will be the
same: 420 units per day and 109,200 units per year. Thus, the overall companys capacity would increase
from 104,000 units to 109,200 units per year.
This was calculated by trial and error. Since this is a multiple choice question, trial and error means trying
each possible combination to see which one results in the highest daily and annual production capacities,
signified by the fact that the capacities are the same in every department. On an essay question, trial and
error would mean trying different combinations until the production capacities of the various departments are
the same, or as close to being the same as possible.
Here are the calculations of what the direct labor hours available, the volumes and the costs would be after
the usage of the available labor has been optimized:
Molding Heat Transfer Trimming
Direct labor @ $25/hr. 0.5 hrs. (2 units/hr.) 0.25 hrs. (4 units/hr.) 0.5 hrs. (2 units/hr.)
Direct labor hours
210 hrs. 105 hrs. 210 hrs.
available/day
Direct materials $100 per unit $20 per unit $0 per unit
Annual fixed manufactur- $1,000,000 $750,000 $250,000
ing overhead
Fixed selling and admin.
exp. (allocated according $400,000 $200,000 $400,000
to available DL hrs.)
Daily capacity in units 420 units 420 units 420 units
Annual capacity (260 109,200 units 109,200 units 109,200 units
working days per year)
Annual production & sales 109,200 units 109,200 units 109,200 units
The company can now produce 420 units per day or 109,200 units per year, compared with 400 units per day
and 104,000 units per year previously. Since the Heat Transfer and Trimming processes are labor-intensive,
no new equipment would need to be purchased, so the increase in operating income is the contribution per
unit (under TOC) multiplied by the increase in number of units produced. And since the company can sell all it
produces, the increase in operating income would be (109,200 104,000) $80 per unit, which equals
$416,000 per year.
The other options do not result in equal capacities in each department. Thus, they do not increase capacity as
much (or at all) and do not increase net income as much (or at all).
59 c A company outsources a particular function or functions to an outside specialist to free up its own
resources. This allows the company to focus on its primary operations. It may be cheaper to outsource a
function, but the disadvantage can be that the company loses direct control over the function or situation.
60 d Customer service, production, marketing and sales, and R&D are the primary activities or business
functions that add value to a companys product or service. Information systems, infrastructure, human
resources, and materials management are activities that support these primary activities as defined in the
value chain.
61 d Because the analysis is to include identifying where customer value can be increased, the type of
analysis the consultant most likely has been asked to perform is a value-chain analysis.
62 a Determining what processes the company uses to convert materials, capital and labor into value-
adding products is not part of benchmarking. Rather, benchmarking measures its products, practices and
services against successful competitors, using the competitors standards as goals for its own operations. This
best practices process helps the company to cut costs, boost output and achieve competitive advantage.
Companies use target costing to set standard costs, which creates the desired profit margin for their products
so that that ideal standards can be set to attain desired costs. Target costing utilizes kaizen, or continuous
improvement, to reduce costs and attain desired profit margins.
63 d TQM focuses on enhancing the quality of the product or service with consistency, providing a high
level of customer service, eliminating non-value-adding work, and responding quickly and flexibly to the
shifting requirements of customers. Computer-aided design (CAD) utilizes computers in the product
development, analysis and design modification stages.
64 d Internal failure occurs when a problem is detected before the product is shipped to any customer.
Internal failure costs include rework, scrap, tooling changes, downtime required to do the tooling changes,
and costs associated with rushing to complete an order because of a failure to do the work properly the first
time.
65 d The equipment maintenance and product testing are classified as prevention and appraisal costs
($1,940 = $1,154 + $786).
66 a Segregation of duties requires that the following four functions be done by different people: (1)
authorizing a transaction; (2) recording the transaction; (3) keeping physical custody of the related asset;
and (4) periodic reconciliation of the physical asset with the recorded amount for the asset. If the individual
recording the transaction were to also compare the accounting record of the asset with the asset itself, that
person would be performing two of the above functions: recording the transaction and periodic reconciliation
of the physical asset with the recorded amount for the asset.
67 d If the same person is recording cash receipts and also reconciling the bank account, that person could
post a cash receipt to a customers account, divert the cash from the bank deposit, and cover it up by
reporting an outstanding deposit or a reconciling item on the bank reconciliation.
68 c The accounts receivable managers writing off delinquent accounts is a violation of segregation of
duties, because it combines under one person the functions of authorizing a transaction and recording the
transaction.
69 b Both timekeeping and preparation of payroll journal entries should take place outside of the payroll
department. As long as a person performing those two functions had no payroll department function, that
person could do both timekeeping and prepare journal entries without violating segregation of functional
responsibilities.
70 c The internal audit function provides a means to monitor the organizations control over operations.
71 d External, independent auditors perform financial audits. Their responsibility is to issue an opinion on
the accuracy and fairness of managements assertions regarding the financial statements, and they do not
normally evaluate operations and make recommendations to management for improvement. Internal auditors
performing an operational audit, on the other hand, are expected to compare what is with what should be
and report to management their findings, with suggestions and recommendations for improvement.
72 b An operational audit consists of examining and evaluating systems of internal control, overall
operations of an organization, and the quality of performance in carrying out assigned responsibilities. As
such, performance statistics on the quality of the delivery of a citys service would be an appropriate subject
for an operational audit.
73 a Internal auditors are responsible for monitoring the organizations internal controls that protect the
organizations assets and maintain the reliability of financial reporting; and the organizations compliance with
internal and external rules and regulations. Statistical sampling techniques are among the tools used by
auditors to quantify sampling risk in the process of carrying out their responsibilities, but they are not the
auditors main concern.
74 c The assessment of audit risk is the assessment of the overall probability that an assertion of
management will be materially misstated, and the auditor will miss it. Overall audit risk is the product of
three component risks: inherent risk, control risk and detection risk. Inherent risk is the probability that an
assertion will be materially misstated if there are no controls in place, and the auditor would miss the
misstatement.
75 a The Personnel Department, a department separate from the Payroll Department, should authorize all
payroll changes such as hires, terminations, pay rate changes or job status changes. This fulfills the internal
control requirement that one person should authorize a transaction, while a different person records the
transaction.
76 b Application controls are related to the inputs, files and outputs of an application program.
77 b Good documentation is essential for installation, operation, and modification of a system.
78 b State-of-the-art software and hardware are not part of a sound preventive control system.
79 a Systems analysis consists of organizational analysis to learn about the current systems strengths and
weaknesses; identification of users requirements for the new system; identifying the system requirements to
fulfill the information needs of the users; evaluating alternative designs using cost-benefit analysis; and
preparing a systems analysis report documenting the design of the proposed system and its specifications.
80 a The most important segregation in computer systems is between the programmers and the operators.
81 c Preformatted input screens present a blank field in the format the input should take.
82 c Edit programs check the validity and accuracy of input data.
83 a A hash total is a meaningless sum of numbers in a batch, such as the sum of all the employee I.D.
numbers. A hash total would detect a substituted employee time card, because the employee I.D. number of
the substituted employee would be different from the employee I.D. number of the original employee.
84 d Hash totals are a method of validating the input of data.

85 d Computer generated reports can be designed to provide more specific, and sorted, information about
the errors.
86 a A completeness test would not let the processing proceed if the item is not complete.
87 a Preventive controls are the most cost effective controls.
88 c Edit tests are an input control. They are used to check whether data has been input correctly. Thus,
they should be performed on transaction files before those files are used to update the master file in a posting
run, because it is much easier to correct errors before posting has taken place than it is afterwards.
89 a Not detecting certain viruses is a major risk in relying on antivirus software. This software will work
only for known viruses and may not be completely effective for variants of those viruses.
90 d All three should be addressed in an analysis of cost-benefit considerations.
91 d A hot site is a backup facility with a computer system similar to the one used regularly that is fully
operational and immediately available.
92 b This is a true statement about retention of backup files, but not each days transaction files. By not
retaining each days transaction files it is possible that the last backup file that was created will be lost.

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CMA Part 1

Financial Reporting, Planning,

Hard copy books purchased from HOCK international or from an authorized

Financial Reporting, Planning,

Brian Hock, CMA, CIA

(866) 807-HOCK or (866) 807-4625

Published January 2017

Acknowledgement is due to the Institute of Certified Management Accountants for

2017 HOCK international, LLC

Throughout these materials, we have chosen particular language, spellings, structures

This material is designed exclusively to assist people in their exam preparation. No

Brian Hock, CMA, CIA

Section D Cost Management ......................................................................................... 1

Methods of Allocating Costs to Joint Products 87

Election of Directors 197

(This page intentionally left blank)

Section D Cost Management

Overhead Cost Allocation

Job Order 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:

3) Variable and Absorption Costing

Why Cost Management?

Evaluating Operating Performance

The Difference Between Costs and Expenses

1) Costs are resources given up to achieve an objective.

Direct Versus Indirect Costs

Costs Based on Level of Production (Fixed, Variable and Mixed Costs)

The cost function for total manufacturing costs is

Where: Y = Total Costs

Number of Units Produced

Production vs. Period Costs

Product Costs (also called Inventoriable Costs)

Types of Product Costs

Groupings of Product Costs

Note: Direct labor is both a prime cost and a conversion cost.

Period Costs, or Nonmanufacturing Overheads

Other Costs and Cost Classifications

Cost Item Estimated Unit Cost

Question 1: Estimated conversion costs per unit are:

Question 2: Estimated prime costs per unit are:

Question 3: Estimated total variable costs per unit are:

Cost of Goods Sold (COGS) and Cost of Goods Manufactured (COGM)

Calculating Cost of Goods Sold

COGS is calculated using the following formula:

Beginning finished goods inventory

Calculating Cost of Goods Manufactured

COGM is calculated using the following formula:

DM used + DL used + Manufacturing overhead applied = Total manufacturing costs

Beginning FG + Cost of goods manufactured Ending FG = Cost of goods sold.

The Flow of Manufacturing Costs

Materials Inventory or Materials Control

3. Factory Overhead Control

The balance in the account is increased by debits for:

Direct labor costs from Payroll for direct labor used

5. Finished Goods Inventory

6. Cost of Goods Sold

On the next page is a diagram of these cost flows.