ACCT 3121 Final Exam Study Tool

CH 12 — Absorption vs. Variable Costing & Capacity Analysis

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Core Distinction

Absorption Costing: A costing method in which fixed manufacturing overhead (fixed-MOH) costs are included ("absorbed") in a unit's inventoriable cost, along with DM, DL, and variable-MOH costs, whether the unit is in inventory or Cost of Goods Sold. Required by GAAP for external reporting.

Variable Costing: A costing method wherein DM, DL, and variable-MOH comprise inventoriable unit costs. Fixed-MOH is treated as a period cost, excluded from inventory entirely. Used for internal decision-making; not permitted by GAAP for external reporting.

Feature	Absorption Costing	Variable Costing
FMOH treatment	Product cost (capitalized in inventory)	Period cost (expensed immediately)
Inventory includes	DM + DL + VMOH + FMOH	DM + DL + VMOH only
Income statement format	Traditional (by function)	Contribution margin (by behavior)
Required for external reporting?	Yes — GAAP required	No — internal use only
FMOH volume variance?	Yes	No
OI affected by production level?	Yes	No — only sales drive OI

Operating Income Relationship

Units Produced > Units Sold → Absorption OI > Variable OI (FMOH deferred into ending inventory)
Units Produced < Units Sold → Absorption OI < Variable OI (prior FMOH released from beginning inventory)
Units Produced = Units Sold → Absorption OI = Variable OI

Reconciliation Statement

Variable Costing OI + FMOH in Ending Inventory (deferred to future) − FMOH in Beginning Inventory (released from prior period) = Absorption Costing OI Shortcut: Absorption OI = Variable OI + FMOH Rate × (Units Produced − Units Sold)

Trap: Absorption OI can be increased simply by producing MORE units (even if not sold) — this inflates inventory and defers FMOH. Variable costing prevents this manipulation.

Tip: Variable costing is better for internal decisions because it clearly separates fixed vs. variable costs, supporting CVP analysis and relevant cost analysis.

Denominator Volume Choices (Capacity Levels)

Capacity Level	Definition	FMOH Rate	Fixed-MOH Volume Variance
Theoretical	Production capacity calling for a facility's highest and best use, which assumes no downtime. It is unrealistic.	Lowest (highest denominator)	Usually large unfavorable
Practical	Production capacity that allows for unavoidable interruptions for things like maintenance, holiday shutdowns, and employee training. Challenging but plausible.	Medium — moderate, stable	Moderate unfavorable
Normal	The production capacity needed to satisfy average customer demand over a period of time. Because it aligns with demand (often lower than factory capacity), it results in the highest fixed-MOH rate and unit product costs.	Highest (lowest denominator)	Fluctuates with demand

Mnemonic: "The Practical Norm" — Theoretical (top/lowest rate) → Practical (middle) → Normal (lowest/highest rate)

Death Spiral: Normal capacity → highest FMOH rate → higher product costs → higher prices → demand drops → lower normal capacity → even higher FMOH rate → cycle repeats.

Practical capacity is preferred for product costing and capacity management — it reveals the cost of unused capacity explicitly.

Fixed-MOH Volume Variance (Absorption Only)

Fixed-MOH Volume Variance = (Actual Production − Budgeted Production) × Budgeted FMOH Rate Favorable = Actual > Budgeted (used more capacity than planned) Unfavorable = Actual < Budgeted (unused capacity)

CH 14 — Support Department Cost Allocation & Common Costs

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Types of Departments

Feature	Operating/Production Dept	Support/Service Dept
Definition	Operating Unit (Production Dept): The part of a business that makes products and services available for sale to external customers; it generates revenues and incurs expenses.	Support Dept (Service Dept): Departments that exist to support operating units. They are cost centers that do not earn any revenues on their own.
Revenue?	Yes — sells to external customers	No — cost center only
Examples	Mixing, Assembly, Canning, Juices, Teas	HR, IT, Maintenance, Accounting, Legal, Janitorial
Cost treatment	Forms product cost directly	Allocated to operating depts, then to products

4 Reasons to Allocate Support Costs

FDMC: Financial Reporting, Decision-Making, Motivate Managers, Cost Reimbursement (gov't contracts)

Three Allocation Methods

DSR = Direct → Step-Down → Reciprocal = Least to Most Accurate
"Dumb Students Rarely get full credit on cost exams"

Method	SD-to-SD Services?	Accuracy	Tool
Direct	Ignored completely	Least accurate	Simple ratios
Step-Down	One direction only	More accurate	Sequential allocation
Reciprocal	Full mutual exchange	Most accurate	Simultaneous equations

Direct Method

Direct Method: The simplest method. Costs of support departments are allocated straight to operating units based on proportional usage. Costs are not allocated to other support departments.

Denominator = Operating depts ONLY (never include other SDs) Budgeted Rate = SD Cost ÷ Sum of operating dept driver units Allocation to each operating dept = Rate × that dept's driver units

Trap: NEVER include other support departments in the denominator for the Direct Method.

Step-Down Method

Step Method (Step-Down): Allocates some support costs to other support departments, as well as to operating units. You must first rank the support departments (usually by highest cost or most services provided). You allocate the highest-ranked department's costs forward to the remaining support and operating departments. You then "step down" to the next support department and allocate its original costs plus the costs it just received. You never allocate backwards to a higher-ranked department.

1. Rank SDs: highest % (or $) of services provided to other SDs goes first 2. Allocate ranked SD to ALL remaining departments (other SDs + operating depts) 3. Close that SD — it receives NO further allocations 4. Next SD's cost = original cost + allocation received in prior steps 5. Repeat until all SDs are closed

Trap: Once a SD is stepped down (closed), it NEVER receives further allocations.
Trap: The newly allocated SD's cost for its step = original cost + amounts received from higher-ranked SDs.

Reciprocal Method

Reciprocal Method: The most detailed method. It captures the full exchange of services between all support departments and operating units simultaneously, requiring simultaneous equations to solve.

Set up simultaneous equations: J = Direct_J + (J's % of P) × P P = Direct_P + (P's % of J) × J Solve for J and P, then allocate each SD's total cost to ALL departments (including other SDs) using proportional driver units. Key: Denominator for each SD INCLUDES all other departments (both SDs and operating).

Trap: In reciprocal method, proportions are based on the OTHER department's driver perspective. J receives from P based on P's employee ratio, not J's sq ft ratio.

Total SD Cost Distributed — All Methods Equal

The total dollar amount of SD costs allocated to operating departments is IDENTICAL across all three methods. The distribution between operating departments differs.

Common Costs

Common Costs: Costs that are shared among two or more parties (e.g., two roommates sharing rent, or two product lines sharing factory insurance). Cannot be traced solely to one user.

Method	How It Works	Notes
Stand-Alone Method	Identifies the cost each entity would have to pay if it bore the cost alone. The total common cost is allocated based on the percentage each party would have paid had the costs not been shared (proportional sharing). Each user's % = their stand-alone cost ÷ total of all stand-alone costs.	Most equitable. No ranking needed.
Incremental Cost Method	Ranks the users of the cost. The primary (first-ranked) user is assigned the cost up to their stand-alone amount. Any additional (incremental) cost generated by sharing is assigned to the secondary user.	Primary bears heavier burden. FASB ASC 606 residual approach is similar.

FASB ASC 606 governs external reporting of bundled revenue (stand-alone selling price method or residual approach). Internal management can use any method.

CH 17 — Management Control Systems, Responsibility Centers & Transfer Pricing

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Management Control System (MCS)

A convergence of systems to gather and use information to aid and coordinate planning and control decisions. Can be formal or informal. Designed to ensure decisions throughout the organization support overall company objectives.

Three key properties: MGE — Motivation, Goal Congruence, Effort

Four Pillars: Budgeting | Responsibility Centers | Transfer Pricing | Performance Measurement

Centralized vs. Decentralized

Feature	Centralized	Decentralized
Definition	Centralization: A structure where decision-making authority resides within a narrow scope, at the highest levels of the firm.	Decentralization: The freedom for managers at all levels to make binding decisions without continuous interference by top management.
Pros	Stronger goal congruence; decisions made from a top-down, company-wide perspective; uniformity and control.	Better responsiveness to local needs; faster decision-making; increased motivation for lower-level managers; more specialization; frees up top executives to think strategically.
Cons	Slower decision-making; high risk of becoming overwhelmed; less responsiveness to local needs.	Suboptimal decision-making (managers benefit their unit at the expense of the company); duplication of activities or effort.
Ways to achieve	N/A	Delegation — moving decision-making authority from the top of the organization out to business unit managers (purchasing, accounting, shipping, customer service, sales).

Responsibility Centers

CRPI (ascending scope): Cost Center → Revenue Center → Profit Center → Investment Center

Type	Controls	Examples
Cost Center	Charged solely with managing costs. Managers are evaluated on their ability to operate within the budget.	A factory for a sporting goods company; a university payroll processing department.
Revenue Center	Charged strictly with generating revenues for the company. Evaluated on their ability to meet sales forecasts.	The marketing and fan engagement group for a sports team; a global sales team.
Profit Center	Charged with simultaneously generating revenues and maintaining expenses. Evaluated on their ability to meet a target profit.	The pharmacy inside a Walgreens; the garden center at Lowe's.
Investment Center	Charged with selecting which assets to use to generate a target return and then wisely reinvesting subsequent returns. Evaluated on ROI or RI.	The CEO running an entire corporation (like Amazon); a highly autonomous division where the manager controls asset acquisition.

Each responsibility center must have: Authority (power to decide), Responsibility (owning the task), Accountability (answering for results). Mnemonic: ARA

Investment Center Performance Measures

Return on Investment (ROI)

ROI = Operating Income ÷ Average Operating Assets DuPont breakdown: ROI = Return on Sales × Investment Turnover ROI = (OI ÷ Sales) × (Sales ÷ Avg Assets)

Interpretation: ROI yields the percentage of return for each dollar invested. It shows how efficiently a division uses its assets to generate profit. While popular, evaluating managers strictly on ROI can lead to suboptimal decisions (e.g., a manager might reject a good project if it slightly lowers their currently high ROI average).

Goal-Congruence Problem: If a division's ROI = 20% and a new project returns 15% (still above WACC), the manager REJECTS it to protect their ROI — bad for the firm. ROI discourages profitable new investment.

Residual Income (RI)

RI = Operating Income − (Required Rate of Return × Average Operating Assets) Accept if RI > $0 (earns above the required rate)

Interpretation: RI calculates the excess of actual income earned above a firm's required rate of return. It is expressed as a dollar amount rather than a percentage. Any positive residual income means the investment is generating more than the company's minimum hurdle rate. Using RI helps achieve better goal congruence, as managers are motivated to accept any project that provides a positive RI.

RI solves ROI's goal-congruence problem: managers accept any project with RI > $0, aligning division goals with firm goals.

Economic Value Added (EVA)

EVA = After-Tax Operating Income − (After-Tax WACC × Invested Capital) Invested Capital = Total Assets − Current Liabilities (For a specific project: use purchase price of asset) Accept if EVA > $0

Trap: Invested Capital for EVA = Total Assets MINUS Current Liabilities — NOT total assets alone.

Measure	Formula	Goal-Congruent?	Key Use
ROI	OI ÷ Avg Assets	No — discourages profitable projects	Comparison across divisions/firms
RI	OI − (RRR × Assets)	Yes — accept any RI > 0	Internal performance; overcomes ROI problem
EVA	After-tax OI − (WACC × Invested Capital)	Yes — accept any EVA > 0	Accounts for taxes and equity financing

Firms use all three together: ROI for comparisons; RI/EVA to overcome ROI's goal-congruence failures.

Transfer Pricing

Transfer Pricing: The internal transaction price at which two business units within the same company exchange a good or service. This situation typically arises due to vertical integration. A well-designed transfer pricing system ensures goal congruence — when managers make decisions that maximize their individual unit's profit, those decisions naturally align with and maximize the profit of the organization as a whole.

General Guideline (Minimum Transfer Price for Seller): TP_min = Variable Cost per unit + Opportunity Cost per unit If seller has NO idle capacity: TP_min = VC + Contribution Margin lost on foregone external sales If seller HAS idle capacity: TP_min = VC + $0 (no opportunity cost) Maximum Transfer Price for Buyer = External market price (what buyer would pay outside)

Method	How Set	Notes
Cost-Based	Variable cost or full cost (often cost-plus)	Simple; may not motivate seller
Market-Based	External market price	Objective; best when competitive market exists
Negotiated	Between TP_min (seller floor) and TP_max (buyer ceiling)	Most flexible; promotes goal congruence

Vertical Integration: A growth strategy where a company expands to include activities that either precede or follow the existing firm in its value chain. Upstream (Backward) Integration: Buying a company further from the final consumer (e.g., a supplier — IKEA buying forests for lumber). Downstream (Forward) Integration: Buying a company one step closer to the final consumer (e.g., Apple opening its own retail stores).

CH 18 — Strategy, Performance Measurement & Balanced Scorecard

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Key Definitions

Mission: An organization's purpose — its reason for existing and what drives it forward.
Strategy: The means by which an organization intends to achieve its mission and vision. It specifies how an organization matches its own capabilities with the opportunities in the marketplace to accomplish its objectives, create value for customers, and differentiate itself from competitors.
Strategic Plan: A comprehensive, potentially multi-year plan for an organization; helps an organization turn its purpose into action by establishing its direction, including specification of its mission and vision, goals and objectives, strategies and initiatives, and measures and targets.
Operating Plan: A plan, found within a strategic plan, that is more attuned to this year's expected outcomes and approaches for achieving them.
Strategy Map: A graphic showing a company's chosen objectives for the balanced scorecard perspectives, further specifying how the objectives affect other objectives (showing causal links).

Porter's Five Forces ⚠️ ON EXAM — Know All Five

Force	What It Means
Competitive Rivalry	The existing companies within an industry and the intensity of the competition among them — intense competition lowers profitability.
Power of Customers (Buyers)	Customers create demand and have the power to influence prices and quality expectations.
Threat of Substitutes	The threat of customers going elsewhere to satisfy their needs and wants (e.g., meal kits vs. restaurants) — limits pricing power.
Threat of New Entrants	New companies can enter the industry, potentially diluting existing profits by adding capacity and reducing market share.
Bargaining Power of Suppliers	If suppliers "hold the cards," they can influence an industry's profits by altering the amount/quality of goods supplied or by setting trade terms favorable to them.

Mnemonic: "Can't Survive Neglecting Suppliers" — Competition, Customers, Substitutes, New Entrants, Suppliers

SWOT Analysis ⚠️ ON EXAM

Internal	External
Strengths — advantages the company already has	Opportunities — favorable external conditions to exploit
Weaknesses — internal areas where the company falls short	Threats — external conditions that could harm the company

SWOT is used in strategic planning to match internal capabilities (S/W) with the external environment (O/T) identified through tools like Porter's Five Forces.

Two Basic Strategies ⚠️ ON EXAM

Strategy	Focus	Performance Measures Used	Example
Cost Leadership	A business strategy where a company focuses on achieving economies of scale, incorporating learning curve effects, disposing of redundant assets, eliminating non-value-added activities, and/or implementing other cost efficiencies to reduce the costs of offering its products and services. Competitive advantage: lower selling prices. Focus: eliminating waste, improving productivity, just-in-time inventory.	DM variances, DL variances, cost efficiency metrics, cycle time	Walmart, Ryanair
Product Differentiation	A business strategy wherein the uniqueness, customization, and/or quality of a company's products and/or services sets it apart. Competitive advantage: brand loyalty and the ability to command a price premium. Focus: research and development, patents, new product ideas, and superior perceived value.	Number of new products/patents, customer satisfaction, R&D spending	Apple, BMW

Customer Value Proposition — the company's unique mix of products, prices, services, relationships, and image. Three types:

Operational Excellence — best total cost; reliable, convenient, no-hassle (Cost Leadership)
Product Leadership — best product; continuous innovation (Differentiation)
Customer Solutions (Intimacy) — best total solution; deep relationships, customization

Compensation Types

Type	Who / When
Hourly wages	Best for positions requiring fewer skills, or for temporary, part-time, or contract positions. Overtime pay kicks in after a threshold.
Salary	Best for positions requiring a larger skillset and longer-term positions, where an employee is paid for outcomes, rather than hours.
Commission	Used to motivate those in sales to increase company revenues; compensation is based on total revenues or a percentage of sales.
Piece rate	A rate paid per unit of outcome (e.g., number of cars serviced or components assembled).
Bonuses	Often given as year-end awards; a percentage or sum based on the overall performance of the business for the year just ended.
Stock options	Equity compensation plans offered to incentivize employees over the long term. Often used by start-ups seeking to reward employees for taking a risk; options are canceled if not vested before the employee leaves.
Incentive pay	Used to encourage employees to work harder to meet a short-term target (more forward-looking than bonuses).

Short-term incentives (annual bonuses) can cause managers to cut R&D, training, or maintenance to boost this year's numbers — harming long-run value. Long-term incentives (stock options) combat this.

Balanced Scorecard (BSC) ⚠️ ON EXAM — Know Each Perspective

Balanced Scorecard: A framework for measuring organizational performance using both financial and nonfinancial performance measures. Created by Robert Kaplan and David Norton, it balances these measures while considering performance from multiple perspectives to ensure goal congruence.

Financial Measures (Lagging Indicators): Measure the results from decisions that happened in the past. Objective: evaluate profitability and past actions. Examples: gross margin, operating income, ROI, RI, standard cost variances, operating cash flows.

Nonfinancial Measures (Leading Indicators): Measure the actions the company is taking right now to drive future financial results. Objective: provide context to financial motives and observe metrics daily to make timely adjustments. Examples: average time to hire, employee turnover, defect rate, customer retention rate, net promoter score.

Perspective	Question Asked	Objectives (from textbook)	Example Metrics
Financial	How do we look to shareholders?	Increase revenues, increase operating margins, increase cash flow.	Operating income growth, revenue growth, cost reduction %, ROI, EPS
Customer	How do customers see us?	Increase customer satisfaction, increase market share, increase number of new customers.	Market share, customer satisfaction scores, retention rate, on-time delivery
Internal Business Process	What must we excel at internally?	Decrease time from order placed to delivery, reduce rework/defects, improve efficiency.	Cycle time, defect rate (% defect-free), process efficiency, throughput, # of patents
Learning & Growth	Can we innovate and improve?	Increase employee training, increase employee satisfaction, cross-train employees, empower employees to make decisions. (This is the foundational perspective.)	Training hours, employee satisfaction, turnover rate, R&D spending

FCIL: Financial → Customer → Internal Process → Learning & Growth
"Firms Can Improve Learning"
Strategy Map flows BOTTOM-UP: Learning & Growth → Internal Process → Customer → Financial

Features of a Good Balanced Scorecard ⚠️ ON EXAM

Tells the story of the company's strategy through cause-and-effect relationships
Communicates strategy to all members of the organization
Motivates managers to take actions that result in financial performance improvements
Limits the number of measures — focuses on the most critical ones; prevents information overload
Highlights less-than-optimal trade-offs so managers can weigh competing objectives

Pitfalls to Avoid with the Balanced Scorecard ⚠️ ON EXAM

Don't assume cause-and-effect linkages are precise — they are hypotheses, not certainties
Don't seek improvements in ALL measures simultaneously at all times — some trade-offs are necessary
Don't use only objective (financial) measures — nonfinancial measures are essential
Don't ignore nonfinancial measures when evaluating managers and employees — they are leading indicators

The BSC uses a Strategy Map to show how Learning & Growth enables better Internal Processes → which improves Customer satisfaction → which drives Financial results (bottom-up cause-and-effect).

Exam 1 Review (CH 2, 3, 4, 5) — Conceptual Only

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CH 2 — Cost Terms

Direct Cost: Obvious components that can be easily traced to the product or service.
Indirect Cost: Product costs incurred in the factory that are less obvious and not easily traced to the final product.
Variable Cost: Costs that are constant on a per-unit basis but change in total with the volume of activity.
Fixed Cost: A constant cost that does not change as more units are made within the available capacity.
Product Cost: The costs incurred to make a product and ready it for sale, including direct materials (DM), direct labor (DL), and manufacturing overhead (MOH). Flows through WIP → FG → COGS.
Period Cost: Costs that are not product costs and that are expensed on the income statement in the period they are incurred; includes selling, general, and administrative expenses.
Relevant Range: A band of activity that identifies a specific relationship between activity level and the cost being measured, where fixed costs remain fixed and unit variable costs are constant.

CH 3 — Cost Estimation Methods

Account Analysis: An estimation method that uses actual costs within a general ledger account to predict future costs. It requires insight and experience to identify whether a cost is fixed, variable, or mixed.
High-Low Method: A cost estimation method that uses actual cost relationships to make predictions of future mixed costs; this method uses two actual data points (the highest and lowest activity levels).
Regression Analysis: A cost estimation method, also known as least squares regression or linear regression, that uses every point in a data set in a mathematical computation designed to minimize the vertical distance among the given data points to generate a line of best fit.

CH 4 — CVP Analysis

Break-Even Units = Fixed Costs ÷ Contribution Margin per Unit Break-Even Sales $ = Fixed Costs ÷ CM Ratio CM per Unit = Selling Price − Variable Cost per Unit CM Ratio = CM per Unit ÷ Selling Price

Underlying assumptions: Selling price, variable cost, and fixed cost are constant; all units produced are sold; single product or constant sales mix.

CH 5 — Relevant Costs

Relevant Costs: Costs that relate to the specific decision being made. They differ between options, occur in the future, and are avoidable. Sunk costs are never relevant. Fixed costs are relevant only if they differ between alternatives.

Exam 2 Review (CH 8, 9, 10, 11) — Conceptual Only

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CH 8 — Job Costing

Used when products are distinct and customizable (hospitals, custom manufacturing, law firms)
Costs tracked per job on a job cost sheet
Normal costing: actual DM + actual DL + applied MOH (budgeted rate × actual driver)
Journal entries: DM issued → WIP; DL incurred → WIP; MOH applied → WIP; job complete → FG; sold → COGS

CH 9 — Activity-Based Costing (ABC)

Traditional Costing: Accumulates all manufacturing overhead (MOH) into a single, plant-wide cost pool (or a few departmental pools) and allocates it using a single volume-based cost driver (like direct labor hours or machine hours). This can inaccurately smooth out costs, often overcosting high-volume products and undercosting low-volume, customized products.
Activity-Based Costing (ABC): Divides large overhead cost pools into smaller, highly specific activity cost pools (e.g., machine setup, quality inspections, materials handling). It then uses relevant, activity-specific cost drivers to allocate those costs to products, resulting in a much more precise and accurate unit cost for management decision-making.
Benefits: better pricing, product mix, and process improvement decisions
Limitations: costly to implement and maintain; subjective driver selection

CH 10 — Variance Analysis

Variance / Variance Analysis: A process that identifies and calculates the difference between actual and budgeted outcomes to help organizations evaluate performance, troubleshoot issues, and take corrective action.

Flexible Budget: A "right-sized" master budget that flexes to use actual sales volumes when actual sales volumes differ from master budget sales volumes. It holds the budgeted selling prices and input costs constant to evaluate actual performance.

Price Variance: A variance that compares the actual cost incurred for a specific input (DM, DL, or variable-MOH) to the standard cost allowed for the actual input quantity used. Formula: (Actual Price − Standard Price) × Actual Quantity.
Efficiency Variance: A variance that compares the actual quantity used of each input to the standard quantity allowed for actual production, valued at its standard cost. Formula: (Actual Qty − Standard Qty) × Standard Price.
Favorable (F) Variance: Indicates an outcome that causes an increase in operating income compared to the budget (e.g., paying less for materials than planned, or using less labor time than expected).
Unfavorable (U) Variance: Indicates an outcome that causes a decrease in operating income compared to the budget (e.g., spending more on overhead than budgeted).

CH 11 — Process Costing

Weighted-Average Method: Blends and averages the actual work and costs incurred last period with the work and costs incurred this period. It ignores the degree of completion of beginning inventory and treats all units completed as if they were 100% produced in the current period. Can mask the immediate effects of input cost changes from one period to the next.

FIFO Method: Assumes the first units started in a process are the first to finish. It strictly keeps last period's work and costs separate from this period's work and costs. Equivalent units are calculated based only on the percentage of work added in the current period — more accurate for cost control.

Key difference: FIFO keeps prior-period costs separate; WA blends them together.