A Compilation of Materials for SCOMAN2

OVERVIEW: This provides materials that will aid students’ understanding about the concepts and application of
different management accounting techniques. Topics in this compilation include: Responsibility Accounting &
Transfer Pricing, Balanced Scorecard, Relevant Costing and Differential Analysis, Capital Budgeting, Quantitative
Techniques and Management Consultancy.

I. RESPONSIBILITY ACCOUNTING and TRANSFER PRICING

RESPONSIBILITY ACCOUNTING is the system that recognizes various decision centers throughout an
organization and traces costs (and revenues, assets and liabilities where pertinent) by areas of responsibility. This
system is also known as activity accounting and profitability accounting. It operates on the premise that managers
should be held responsible for their performance, the activities of their subordinates and all activities within their
responsibility center.

Therefore, this is implemented in an organization so that performance, in terms of costs and/or revenues are recorded
and reported by levels of responsibility within an organization.

STEPS IN IMPLEMENTING RESPONSIBILITY ACCOUNTING

1. Responsibility accounting requires that costs and/or revenues be classified according to responsibility
centers.

Types of responsibility centers:

Cost Center – where managers are held responsible for the costs incurred by the segment/responsibility
center.

Revenue Center – In here, managers are held responsible primarily for the revenues of the segment but
not the costs of generating revenues. The managers performance is measured in terms of the revenues
earned. Some of the basis include ROI, Profit Margin, ROA, among others.

Profit Center – where managers are held responsible for both revenues and costs of the segment

Investment Center – where managers are held responsible for revenues, costs and investments
Responsibility Center is a segment of organization that is engaged in the performance of a single function or a
group of closely related functions. This segment is usually governed by a manager, who is accountable and
responsible for the activities of the segment.

Performance Evaluation Tools:

Return on Investment (ROI) = Operating Income / Operating Assets
= Margin x Turnover
Where: Margin = Operating Income / Sales
Turnover = Sales / Operating Assets
ROI computation is based on the DuPont formula:

Return on Assets = Asset Turnover x Return on Sales

Net Income Sales Net Income

= x
Assets Assets Sales

Page 1 of 40
 Residual Income = Operating Income – Required Income
Where: Required Income = Operating Assets x Minimum RoI

Economic Value Added (EVA) – more specific version of residual income that measures the investment
center’s real economic gains. It uses the weighted-average cost of capital (WACC) to compute the required
income.
EVA = Operating Income after Tax – Required Income
Where: Required Income = (Total Assets – Current Liabilities) x WACC

2. Within each responsibility center, costs are classified either controllable or non-controllable.

Generally, all costs are controllable. The key difference lies in the level of management who can control costs:
CONTROLLABLE COSTS are those items of cost that may be directly regulated at lower levels of
management. NON-CONTROLLABLE COSTS are costs that cannot be regulated at a particular
management level other than the top level. Costs may also be classified into DIRECT (attributable to a
particular segment) or INDIRECT (common to a number of segments), the latter being subject to arbitrary
allocation.

3. Within the controllable classification, costs are further classified according to the nature of expense.

4. A performance report is furnished by each center and reported to the appropriate level of management.
A PERFORMANCE REPORT is the end product of responsibility accounting process. It is a report that shows
and compares actual results with the intended (budgets or standards) results of a responsibility center, thereby
highlighting deviations that need corrective actions.

Consider the following illustrative example:

Sales P 500,000
Variable manufacturing costs ( 150,000)
Manufacturing contribution margin P 350,000
Variable selling and administrative costs ( 50,000)
Contribution margin P 300,000
Controllable fixed costs:
Manufacturing P 100,000
Selling and administrative 75,000 ( 175,000)
Short-run performance margin P 125,000
Non-controllable fixed costs:
Depreciation P 40,000
Rent and leases, insurance 10,000 ( 50,000)
Segment margin P 75,000
Allocated common costs ( 30,000)
Income P 45,000

DECENTRALIZATION
Decentralization can be defined as a transfer of authority, responsibility, and decision making from top management to
subunit managers. There are many advantages to decentralization including:
 Managers with the best knowledge make the decisions.
 Leads to greater job satisfaction and job enrichment
 Makes accomplishment of organizational goals and objectives easier
 May reduce decision making time.

ALLOCATING SERVICE DEPARTMENT COSTS

Service department costs are allocated to operating departments for a variety of reasons including:
 Encourage operating departments to make wise use of service department resource
 Provide operating departments with more complete cost data for making decisions
 Help measure the profitability of operating departments
 Create an incentive for service departments to operate efficiently
 To value inventory for financial statement purposes

There are three principal methods of allocating service department costs:

Direct method 
- allocates all service costs directly to operating departments

Page 2 of 40
 - it ignores the services provided by one service department to another service department
- the advantage of this allocation method is that it is simple to calculate
- its disadvantage is that it may not be very accurate in that it ignores interdepartmental services

Step method 
- allocation of a service department's costs is made to other service departments and to operating
departments in a sequential order
- to apply the step method allocation, a benefit provided ranking must be specified in advance

Algebraic or reciprocal method 

- is the most accurate of the three methods in that it recognizes all interactions of service departments and no
ranking order decisions need be made
- a schedule is created to show the proportionate usage by each department of the other departments' services
- these proportions are then used to develop equations that, when solved simultaneously, give cost allocations
that fully recognize the reciprocal services provided

TRANSFER PRICING
- an internal charge established for the exchange of goods or services between responsibility
centers within a company. 
- these prices are eliminated for external reporting purposes.
- it is also known as intersegment price.

Some of the objectives of Transfer Pricing includes the following:

1. Primary objective
To evaluate performance by virtually transforming cost centers into profit centers so that performance of the
manager of mainly cost centers can be measured reliably in terms of both revenues and expense.

2. Secondary objective
To save on costs involved in producing or buying a product by in-sourcing rather than outsourcing.

Basis of Transfer Price:

1. Cost based
o Variable Cost
o Full Cost (Variable and fixed manufacturing and non-manufacturing costs)
o Full Absorption Cost (Variable and fixed manufacturing costs)
o Cost-plus (Variable costs/Full Costs/Full absorption costs plus mark-up)
2. Market based
- the price charged on the open market for the good or service
o Market Price (Regular Selling Price)
o Modified Market Price (Selling Price adjusted for any allowance for discounts, etc.)
3. Negotiated
- the transfer price is set through a process of bargaining between the selling and the buying segment

Maximum vs. Minimum Transfer Prices

To minimize the effect of sub-optimization, a range for transfer price must be set based on the following limits:
A. Upper Limit (Maximum Transfer Price)
- The maximum transfer price should be not higher than the lowest market price at which the good or
service can be acquired.
B. Lower Limit (Minimum Transfer Price)
- The minimum transfer price should not be less than the sum of the selling segment’s incremental costs for
the goods or services plus any opportunity costs.

ILLUSTRATIVE EXERCISES:
1. RESPONSIBILITY CENTERS
Indicate how each of the business situations below is most likely to be organized: cost center (CC), revenue center
(RC), profit center (PC), or investment center (IC)
A. The repairs and maintenance department of Skyliner van line
B. The Magnolia product division of San Miguel Corporation San Jose Tacloban
C. The Divine Word Hospital car park ticket outlets.
Page 3 of 40
 D. The Palo branch of Jollibee.
E. The accounting department of BPI Justice Romualdez.
F. The College of Business and Accountancy of St. Paul School of Professional Studies.
G. The parts department of Hyundai Motors Corporation Tacloban.
H. The convenience store that is owned by a chain organization. The head office supplies all the goods to be
sold and determines the selling prices.

2. SEGMENTED INCOME STATEMENT

The following data pertain to AR Group operations for the year 2010:
TOTAL NORTHWEST CENTRAL
Division Division
Amount % Amount % Amount %
Sales P 1,000,000 (100%) (100%) (100%)
Less: Variable Expenses ( ) ( ) ( )
Contribution margin ( ) P 360,000 ( 60% ) ( )
Less: Traceable fixed ( ) (P 150,000 ( ) (P ( )
expenses 200,000)
Division segment ( ) ( ) P 120,000 ( 30% )
margin
Less: Common fixed ( )
expenses
Income P 40,000 ( )
REQUIRED:
Fill-in the missing data.

3. TRANSFER PRICING
Alegro Company’s Division ‘A’ produces a small tool used by other companies as a key part in their products. Cost and
sales data relating to the small tool are given below:
Selling price per unit P 50
Variable costs per unit P 30
Fixed costs per unit* P 12

*Based on A division’s capacity of 40,000 tools per year.

The company’s Division ‘B’ is introducing a new product that will use a tool such as the one produced by Division A. An
outside supplier has quoted the Division B a price of P 48 per tool. Division B would like to purchase the tools from
Division A, if an acceptable transfer price can be worked out.

REQUIRED:
1. Determine the lower limit of the transfer price assuming that:
A) Division A has ample idle capacity to handle all the Division B’s needs
B) Division A is presently selling all the tools it can produce to outside customers

2. From the standpoint of the entire company, should the Division B purchase the tools from the Division A (operating
at capacity) or from outside supplier? Why?

3) Assume that the Division B requires 10,000 tools per year and the Division A is presently selling 36,000 tools per
year to outside customers:
A) Determine the lower limit of the transfer price.
B) What would be the overall effect on company profits if all 10,000 tools were acquired from the Division A rather
than from the outside suppliers?

4. PRICE-SETTING METHODS
The Rocabo Company is operating with two divisions. Division H is producing a product line that is required as a
component part of the product being manufactured by Division W.
For Division H, the costs of producing the component part per unit are:
Direct materials P 10
Direct labor P 8
Variable factory overhead P 5
Fixed factory overhead P 2
The product of Division H is being sold in a highly competitive market for P 30 per unit.

Page 4 of 40
Division W is currently buying 80% of the production output of Division H at a negotiated price of P28 per unit. It is
expected that 25,000 units of product will be produced by Division H.

With emphasis on divisional welfare rather than the company’s welfare, a new transfer price must be developed. It is
suggested that a 40% mark-up on cost will be added when transferring the product from Division H to Division W.
An additional processing cost for Division W is P 8 per unit. The selling price of the product of Division W is P 45 per
unit.

REQUIRED:
Determine the gross profit per unit of the product from Division W under each of the following independent
assumptions:
A) Transfer price is full-cost based.
B) Transfer price is cost-based plus mark-up.
C) Transfer price is based on a negotiated price.
D) Transfer price is market-based.

PRACTICE EXERCISES:
1. The basic purpose of a responsibility accounting system is
a. Budgeting c. Authority
b. Motivation d. Variance analysis

2. A successful responsibility accounting reporting system is dependent upon

a. The correct allocation of controllable variable costs
b. Identification of the management level at which all costs are controllable
c. The proper delegation of responsibility and authority
d. A responsible separation of costs to their fixed and variable components since fixed costs are not
controllable and must be eliminated from the performance report

3. The least complex segment or area of responsibility for which costs are allocated is a(n)
a. Profit center c. Contribution center
b. Investment center d. Cost center

4. Which of the following techniques would be best for evaluating the management performance of a department
that is operated as a cost center?
a. Return on assets ratio c. Payback method
b. Return on investment ratio d. Variance analysis

5. Comparing budgeted and actual amounts is important in evaluating the performance of

a. The manager of a cost center c. The manager of an investment center
b. The manager of a profit center d. Any manager

6. Decentralized firms can delegate authority and yet retain control and monitor manager’s performance by
structuring the organization into responsibility centers. Which one of the following organizational segments is
almost like an independent business?
a. Revenue center c. Cost center
b. Profit center d. Investment center

7. In responsibility accounting, a center’s performance is measured by controllable costs. Controllable costs are
best described as including
a. Direct material and direct labor only
b. Only those costs that the manager can influence in the current time period
c. Only discretionary costs
d. Those costs about which the manager is knowledge and informed
8. If a manufacturing company uses responsibility accounting, which one of the following items is least likely to
appear in a performance report for a manager of an assembly line?
a. Labor payroll c. Repairs and maintenance
b. Materials d. Depreciation on equipment

9. In evaluating an investment center, top management should concentrate on

a. Peso rates c. Profit percentages
b. Net income d. Return on investment

10. When using a contribution margin format for internal reporting purposes, the major distinction between
segment manager performance and segment performance is

Page 5 of 40
 a. Unallocated fixed cost
b. Direct variable costs of producing the product
c. Direct fixed cost controllable by the segment manager
d. Direct fixed cost controllable by others (non-controllable by the segment manager)

11. A firm earning a profit can increase its return on investment by

a. Increasing sales revenues and expenses by the same peso amount
b. Decreasing sales revenues and operating expenses by the same percentage
c. Decreasing sales revenues and operating expenses by the same percentage
d. Increasing sales revenues and operating expenses by the same percentage

12. Compared to a jewelry store, a supermarket has

a. Higher margin and higher turnoverc. Lower margin and higher turnover
b. Higher margin and lower turnover d. Lower margin and lower turnover

13. The segment margin of an investment center after deducting the imputed interest on the assets used by the
investment center is known as
a. Return on investment c. Operating income
b. Residual income d. Return on assets

14. Which equation is residual income? (I = investment, N = income, and K = minimum required ROI)
a. N – (K x I) c. N/I – K
b. (K x I) – N d. (K x I) – (N/I)

15. If a division’s ROI and the minimum required ROI are the same, the division’s residual income is
a. Positive c. Negative
b. Zero d. None of the above

16. The imputed interest rate used in the residual income approach to performance evaluation can best be
described as the
a. Average lending rate for the year being evaluated
b. Historical weighted-average cost of capital for the company
c. Target return on investment set by the company’s management
d. Average return on investment for the company over the last several years

17. Residual income is a performance evaluation that is used in conjunction with, or instead of, return on
investment (ROI). In many cases, residual income is preferred to ROI because
a. Residual income is a measure over time, while ROI represents the results for one period
b. Residual income concentrates on maximizing absolute amount of income rather than percentage return
like ROI
c. The imputed interest used in calculating residual income is more easily derived than the target rate that is
compared to the calculated ROI
d. Average investment is employed with residual income while year-end investment is employed with ROI

18. Residual income is a better measure for performance evaluation of an investment center manager that return
on investment because
a. The problems associated with measuring the asset base are eliminated
b. Desirable investment decisions will not be neglected by high-return investment
c. Only the gross book value of assets needs to be calculated
d. The arguments about the implicit cost of interest are eliminated

19. A segment of an organization is referred to as a service center if it has

a. Responsibility for developing markets and selling the output of the organization
b. Responsibility for combining the raw materials, direct labor, and other factors of production into a final
output
c. Authority to make decisions affecting the major determinants of profits including the power to choose its
markets and sources of supply
d. Authority to provide specialized support to other units within the organization

20. A management decision may be beneficial for a given profit center, but not for the entire company. From the
overall company viewpoint, this decision would lead to
a. goal congruence c. suboptimization
b. centralization d. maximization

Page 6 of 40
21. The following is the summarized income statement of Ruby Co.’s profit center No. 5254 for May:
Contribution Margin P 70,000
Period Expenses:
Manager’s salary P 20,000
Facility depreciation 8,000
Corporate expense allocated 5,000 (33,000)
Profit center income P 37,000

Which of the following amounts is most likely subject to the control of the profit center’s manager?
a. 70,000 c. 37,000
b. 50,000 d. 33,000

22. If Division C has a 10% return on sales, income of P 5,000, and an investment turnover of 4 times, divisional
investment is
a. 5,000 c. 20,000
b. 12,500 d. 50,000

Questions 23-24 are based on the following information:

Jade Co.’s industrial photo finishing division VVV incurred the following costs and expenses in 2010:
Variable Fixed
Direct materials P 200,000
Direct labor 150,000
Factory overhead 70,000 P 42,000
General, selling and administrative 30,000 48,000
TOTAL P 450,000 P 90,000

During 2010, VVV produced 300,000 units of industrial photo-prints, which were sold for P 2.00 each. Jade’s
investment in VVV was P 500,000 and P 700,000 at January 1, 2010 and December 31, 2010, respectively.
Jade normally imputes interest on investment at 15% of average invested capital.

23. For the year ended December 31, 2010, VVV’s return on investment was
a. 15.0% c. 8.6%
b. 10.0% d. (5.0%)

24. Assume that the net operating income was P 60,000 and that average invested capital was P 600,000. For the
year ended December 31, 2010, VVV’s residual income (loss) was
a. 150,000 c. (45,000)
b. 60,000 d. (30,000)

25. Myrrh Co. reported these data at year-end:

Pre-tax operating income P 4,000,000 Current liabilities P 2,000,000
Current assets 4,000,000 Long-term liabilities 5,000,000
Long-term assets 16,000,000
Assuming a tax rate of 25% and a weighted average cost of capital (WACC) of 9%, what is Myrrh
Company’s economic value-added (EVA)?

a. 1,380,000 c. 1,830,000
b.1,620,000 d. 3,000,000
NOTE: EVA = [income after tax] – [WACC x (total assets – current liabilities)]

Page 7 of 40
II. RELEVANT COSTING
COST CONCEPTS & TERMINOLIGIES CONSIDERED IN DECISION MAKING

 Relevant Cost In incremental analysis, the only factors to be considered are those costs and revenues that differ
across alternatives. Those factors are called relevant costs.
 Opportunity Cost Often in choosing one course of action, the company must give up the opportunity to benefit
from some other course of action. For example, if a machine is used to make one type of product, the benefit of
making another type of product with the machine is lost. The lost benefit is referred to as opportunity cost.
 Sunk Cost Costs that have already been incurred and will not be changed or avoided by any present or future
decision are referred to as sunk costs. For example, if you have already purchased a machine, and now a new, more
efficient machine is available, the book value of the original machine is a sunk cost. It should have no bearing on
your decision whether to buy the new machine. Sunk costs are not relevant costs.
 Differential Cost Increases (increments) or decreases (decrements) in total costs that result from selecting one
alternative instead of another.
 Avoidable Costs are costs that will be saved or those that will not be incurred if a certain decision is made. Also a
relevant cost.
 Out-of-pocket costs are costs that will require expenditure of cash or incurrence of a liability as a consequence
of a management decision. Also a relevant cost.
 Joint Costs are costs incurred in simultaneously manufacturing two or more (joint) products that are difficult to
identify individually as separate types of products until the products reach a certain processing stage known as the
split-off point.
 Split off point is the point in the manufacturing process where some or all of joint products can be recognized as
distinct and separate products.
 Further processing costs are costs incurred beyond split-off point as separated joint products are to be
processed further. Also a relevant cost.
 Bottleneck resources are any resources or operation where the capacity is less than the demand placed upon it.

TYPES OF INCREMENTAL ANALYSIS

1. Accept or reject a special order
2. Sell or process further a product line
3. Make or buy a part of a product line
4. Continue or shutdown a business segment
5. Choosing the best product combination
6. Selecting a change in profit factors

SHORT-TERM DECISION MAKING GUIDELINES

Decision objective: Decide in favor of the action that will give the organization the BEST PROFIT POSITION –
highest revenues and lowest costs.

MAKE OR BUY
Consideration: Should the part or product be manufactured (in-sourced) or bought (outsourced) from outside
supplier?
Decision guideline: Choose the option that involves the lower cost. In most cases, fixed costs are irrelevant.
Consider opportunity costs, if any.

ACCEPT OR REJECT
Consideration: Should a special order that usually requires a price lower than the regular selling price be accepted?
Decision guideline: Accept the order when the additional revenue from the special order exceeds additional costs,
provided the regular market will not be affected. In most cases, fixed production costs are irrelevant.

CONTINUE or SHUTDOWN
Consideration: Should a business segment, which may be a product line, a department or a branch be continued or
discontinued?
Decision guideline: Continue if avoidable revenue of the segment involved is greater than its avoidable costs;
otherwise, consider shutting down the segment. Since allocated fixed cost is usually unavoidable, it is considered
irrelevant.

Page 8 of 40
SELL or PROCESS FURTHER
Consideration: Should a product, after undergoing joint process, be sold at split-off point or be processed further?
Decision guideline: Process further if additional revenue from processing further is greater than further processing
costs. Joint costs, since already incurred, are considered as sunk costs and irrelevant.

BEST PRODUCT COMBINATION

Consideration: Which product(s) should be produced and sold when there is a limited resource or bottleneck
operation?
Decision guideline: Identify and measure the constraint on the limited resource(s). Rank the product(s) according
to highest contribution margin per unit of limited resources.

CHANGE IN PROFIT FACTORS

Consideration: Should any of the profit factors such as sales price, volume, variable cost, fixed cost and sales mix be
manipulated to increase profit?
Decision guideline: Identify the factor to be changed and the amount of contemplated change. Change the profit
factor if it will cause an improvement on the company’s over-all profit position.

ILLUSTRATIVE EXERCISES
1. TOTAL VERSUS DIFFERENTIAL ANALYSIS
Joel Company has a single product called Mojojo. The company normally produces and sells 80,000 units each year at
a selling price of P40 per unit. The company’s unit cost at this level of activity is given below:

Direct materials 10.00

Direct labor 8.00
Variable overhead 4.00
Fixed overhead 6.00
Variable selling expense 2.00
Fixed selling expense 3.00
Total (unit cost) 33.00
REQUIRED:
1. Compute Joel Company’s income.
2. Joel Company could increase sales by 25% if it were to increase the fixed selling expenses (ex. placement of
advertisements) by P120,000. Determine the effect on company profit using:
A. Total analysis
B. Differential analysis

2. MAKE OR BUY
Joan Company uses 30 units of part “jowan” per month in the production of its main product. The manufacturing costs
per unit of part “jowan” are as follows:
Materials 1,000
Handling cost * 100
Direct labor 5,000
Factory overhead (40% fixed) 10,000
Total 16,100

*Handling cost is applied at 10% of cost of direct materials and or any purchased parts.
Julie Ann Company, a well-known producer of part “jowan” has offered to supply the part for Joan Company at
P12,000 per unit. Should Joan Company accept Julie Ann’s offer, the resulting idle facility may be used to produce
another product, Product “Julin”, which is expected to contribute P40,000 per month.
REQUIRED:
Should Joan Company make or buy part “jowan” from Julie Ann Company?

3. MAKE OR BUY
The Joven Show Motors executive is trying to decide whether the company should continue to produce an engine
component or buy it from Saraw-Philippines at P100 each. Demand for the coming year is 200 units. Data for the
current year follow (based on 200 units):
Direct materials 10,000
Direct labor 4,000
Variable factory overhead 2,000
Fixed factory overhead 5,000
Total 21,000
If Joven Show makes the components, the unit costs of direct materials will increase by 20%.
Page 9 of 40
If Joven Show buys the components, 30% of the fixed cost will be avoided. Moreover, the production facility now used
to make the components can be rented out to another firm for P2,500.

REQUIRED:
Should Joven Show make or buy the components?
4. SPECIAL ORDER DECISION
Joey Company manufactures toasters. For the first 8 months of 2005, the company reported the following operating
results while operating at 75% of plant capacity:
Sales (350,000 units) 4,375,000
Cost of goods sold 2,500,000
Gross profit 1,875,000
Operating expenses 875,000
Net income 1,000,000

Cost of goods sold was 70% variable and 30% fixed; operating expenses were also 70% variable and 30% fixed. In
September, Joey Company receives a special order for 15,000 toasters at P7.50 each from Rocabo Company of Burauen
City. Acceptance of the order would result in P3,000 of shipping costs but no increase in fixed operating expenses.

Instructions:
1. Prepare an incremental analysis for the special order.
2. Should Joey Company accept the special order? Why or why not?

5. SPECIAL ORDER PRICING

Aireen Company sells Samsung Galaxy at a price of P27,000 per unit. Galaxy’s costs per unit are:
Direct materials 7,500
Direct labor 4,000
Variable overhead 4,500
Fixed overhead 6,500
Total 22,500

A special order for 1,000 units was received from Aileen Wholesalers, Inc., a well-known cell phone dealer based in
Catbalogan City. Additional shipping costs for this sale are P3,000 per unit.

REQUIRED:
What is the minimum selling price per unit if:
A. Aireen is operating at full capacity?
B. Aireen has excess capacity?

6. CONTINUE OR SHUTDOWN OPERATIONS

The most recent monthly income statement for Een’s Stores is given below:
Tacloban Catbalogan Total
Store Store
Sales 1,200,000 800,000 2,000,000
Less: variable expenses (840,000) (360,000) (1,200,000)
Contribution margin 360,000 440,000 800,000
Less: traceable fixed (210,000) (180,000) (390,000)
expenses
Segment margin 150,000 260,000 410,000
Less: common fixed (180,000) (120,000) (300,000)
expenses
Net operating income (loss) (30,000) 140,000 110,000

Management of Een’s Stores is considering the elimination of the Tacloban Store. If the Tacloban Store were
eliminated, then its traceable fixed expenses could be avoided. The total common fixed expenses are merely allocated
and would be unaffected.

Required:
1. The elimination of the Tacloban Store would result in an overall company net operating income (loss) of
2. Assume that if Tacloban Store is closed, one-fifth (20%) of its traceable fixed expense would continue
unchanged. Also, closing of North Store would result in a 20% decrease in sales of South Store. The overall
decrease in operating income will be

7. PRODUCT ELIMINATION (SHUTDOWN) POINT

Page 10 of 40
Eileen Company expects that the volume of sales will drop below the current level of 5,000 units per month. An
operating statement prepared for the monthly sales of 5,000 units show the following:

Sales (5,000 @ P3) 15,000

Less:
Variable costs (5,000 @ P2) 10,000
Non-variable costs 5,000 15,000
-Nil-

If plant operations are suspended, a shutdown cost (i.e., plant maintenance, taxes and insurance premiums) of P2,000
per month will remain as incurred. Since there is no immediate possibility of profit under present conditions, the
problem of the company is just how to minimize the loss.

REQUIRED:
1. Shutdown point in units and pesos.
2. Should the company continue or shutdown operations if the company expects to demand to be:
A) 4,000 units B) 2,000 units

8. SELL OR PROCESS FURTHER

James Company produces four products for a joint cost of P10,000. The products are currently processed beyond split-
off point, and the final products are sold as follows:

Products Sales Additional Processing Cost

M 36,000 22,000
I 26,500 12,000
L 10,500 8,000
O 2,500 3,000

The firm could sell the products at the split-off point for the amounts:
M 16,000
I 9,500
L 2,000
O

REQUIRED:
1. Which product(s) should the firm sell at split-off point?
2. If James Company takes the most profitable action, what will be its profit?

9. BEST PRODUCT COMBINATION

Arius Co. produces three products: A, B and C. One machine is used to produce the products. The contribution
margins, sales demands, and time on the machine (in hours) are as follows:
Market Limit Selling price Unit Variable Cost Hours on machine
A 100 units 30 10 10 per unit
B 80 units 25 7 5 per unit
C 150 units 40 15 10 per unit
There are 2,400 hours available on the machine during the week. Total fixed cost is P5,000.

REQUIRED:
1. How many units should be produced and sold to maximize the weekly contribution?
a. A, 100; B, 80; C, 150 c. A, 90; B, 0; C, 150
b. A, 50; B, 80; C, 150 d. A, 100; B, 80; C, 100

2. How much is the profit associated with the best product combination?

PRACTICE EXERCISES:
1. Which of the following is not part of the decision making process?
A. Identifying the problem

Page 11 of 40
 B. Quantifying the factors associated with the alternatives
C. Reaching a decision
D. Reversing the decision if not economically sound

2. An organization’s executive committee, meeting to solve an important problem, spent 30 minutes analyzing data
and debating the cause of the problem. Finally, they agreed and could move on to the next step. Possible steps in the
creative problem-solving process are listed below. Which step should the committee perform next?
A. Select a solution C. Identify the problem
B. Generate alternative solutions D. Consider the reaction of competitors to various courses of action

3. In the development of the accounting data for decision-making purchases, a relevant cost is defined as:
A. Future costs which will differ under each alternative course of action.
B. The change in prime cost under each alternative course of action.
C. Standard costs which are developed by time-and-motion-study techniques because of their relevance to
managerial control.
D. Historical costs which are the best available basis for estimating future costs.

4. As part of the data presented in support of a proposal to increase the production of clock-radios, the sales manager
of Arab Electronics reported the total additional cost required for the proposed increased production level. The
increase in total cost is known as
A. Controllable cost C. Opportunity cost
B. Differential cost D. Out-of-pocket cost

5. The relevance of a particular cost to a decision is determined by the

A. Size of the cost C. Potential effects on the decision
B. Risk level of the decision D. Accuracy and verifiability of the cost

6. In a decision analysis situation, which one of the following costs is generally not relevant to the decision?
A. Incremental cost C. Avoidable cost
B. Differential cost D. Historical cost

7. The kind of cost that can be ignored in short-term decision making is a(an):
A. Differential cost C. Sunk cost
B. Incremental cost D. Relevant cost

8. An item whose entire amount is usually a differential cost is

A. Factory overhead C. Conversion cost
B. Direct cost D. Period cost

9. A major accounting contribution to the managerial decision-making process in evaluating possible courses of action
is to
A. assign responsibility for the decision.
B. provide relevant revenue and cost data about each course of action.
C. determine the amount of money that should be spent on a project.
D. decide which actions that the management should consider.

10. One of the behavioral problems with relevant cost analysis is the overemphasis on short-term goals, which can lead
to neglect of:
A. sales promotion C. quarterly net income results
B. expense control D. long-term strategic goals

11. Incremental analysis is most useful

A. in evaluating the master budget.
B. in choosing between the net present value method and the internal rate of return method.
C. in developing relevant information for management decisions.
D. as a replacement technique for variance analysis.

12. Which of the following best describes relevant information?

A. Focused on the past and differs between the alternatives under consideration.
B. Focused on the past and not related to the decision under consideration.
C. Focused on the future and differs between the alternatives under consideration.
Page 12 of 40
 D. Focused on the future and not related to the decision under consideration.

13. Incremental analysis would not be appropriate for

A. a make or buy decision. C. elimination of an unprofitable segment.
B. an allocation of limited resource decision. D. analysis of manufacturing variances.

14. Which of the following is least likely to be a relevant item in deciding whether to replace an old machine?
A. acquisition cost of the old machine
B. outlay to be made for the new machine
C. annual savings to be enjoyed on the new machine
D. life of the new machine

16. An “opportunity cost” is

A. the difference in total costs that results from selecting one alternative instead of another
B. the profit forgone by selecting one alternative instead of another
C. a cost that may be saved by not adopting an alternative
D. a cost that may be shifted to the future with little or no effect on current operations

17. The best characterization of an opportunity cost is that it is

A. relevant to decision making but is not usually reflected in accounting records
B. not relevant to decision making and is not usually reflected in accounting records
C. relevant to decision making and is usually reflected in accounting records
D. not relevant to decision making and is usually reflected in accounting records

18. Which of the following is (are) a true statement(s) about cost behaviors in incremental analysis?
I. Fixed costs will not change between alternatives.
II. Fixed costs may change between alternatives.
III. Variable costs will always change between alternatives.
A. I C. III
B. II D. II and III

19. For the year ended April 30, 2007, Salmo Company incurred direct costs of P800,000 based on a particular course
of action. Had a different course of action been taken, direct costs would have been P650,000. In addition,
Salmo’s fixed costs during the fiscal year were P110,000.
The incremental (decremental) cost was:
A. P 40,000 C. P 150,000
B. P( 40,000) D. P(150,000)

20. Venus Company, a manufacturer of lamps, budgeted sales of 400,000 lamps at P20 per unit for the year. Variable
manufacturing costs were budgeted at P8 per unit, and fixed manufacturing costs at P 5 per unit. A special order
offering to buy 40,000 lamps for P11.50 each was received by Venus in April. Venus has sufficient plant capacity
to manufacture the additional quantity of lamps; however, the production would have to be done by the present
work force on an overtime-basis at an estimated additional cost of P1.50 per lamp. Venus will not incur any
selling expenses as a result of the special order. Venus Company would have a unit relevant cost of
A. P 8.00 C. P 9.50
B. P13.00 D. P14.50

21. Intellectual Co. recently received an order for a product that it does not normally produce. Since the company has
excess production capacity, management is considering accepting the order. In analyzing the decision, the
assistant controller is compiling the relevant costs of producing the order.
The special order requires 1,000 kilograms of powdered Nitrocide, a solid chemical regularly used in the
company’s products. The current stock of Nitrocide is 8,000 kilograms at a book value of P8.10 per kilogram. If
the special order is accepted, the firm will be forced to restock powdered Nitrocide earlier than expected, at a
predicted cost of P8.70 per kilogram. Without the special order, the purchasing manager predicts that the price
will be P8.30, when normal restocking takes place. Any order of the Nitrocide must be in 5,000 kilograms.
What is the relevant cost of powdered Nitrocide to be included in the special order?
A. P 8,700 C. P10,300
B. P 8,300 D. P43,500

22. Balagtas & Company expects to incur the following costs at the planned production level of 10,000 units:
Direct materials P100,000
Direct labor 120,000
Variable overhead 60,000
Page 13 of 40
 Fixed overhead 30,000
The selling price is P50 per unit. The company currently operates at full capacity of 10,000 units. Capacity can
be increased to 13,000 units by operating overtime. Variable costs increase by P14 per unit for overtime
production. Fixed overhead costs remain unchanged when overtime operations occur. Balagtas has received a
special order from Florante, Inc. who has offered to buy 2,000 units at P45 each.
What is the incremental cost associated with this special order?
A. P42,000 C. P31,000
B. P84,000 D. P62,000

23. You have been approached by a foreign customer who wants to place an order for 15,000 units of Product C at
P22.50 a unit. You currently sell this item for P39 a unit, and the item has a cost of P29 a unit. Further analysis
reveals that you will not be paying sales commission of P2.50 a unit on this sales and its packaging requirement
will save you an additional P1.50 per unit. However, the additional graphics required on this job will cost you
P30,000. Note also that fixed costs amounting to P400,000 for the production of 50,000 of such products by the
firm will not change. You decide to accept this order, but another customer who buys an average of 2,000 units for
the period wants to pay you P22.50 rather than the regular price of P39 a unit. Profit will
A. increase profit by P19,500 C. increase profit by P52,500
B. increase profit by P16,500 D. decrease profit by P52,500

24. KC Industries manufactures a product with the following costs per unit at the expected production of 30,000 units.
Direct materials P 4
Direct labor 12
Variable manufacturing overhead 6
Fixed manufacturing overhead 8
The company has the capacity to produce 40,000 units. The product regularly sells for P40. A wholesaler has
offered to pay P32 a unit for 2,000 units.
If the firm accepts the special order the effect on its operating income would be a
A. P20,000 increase C. P4,000 increase
B. P16,000 decrease D. P 0 effect

III. CAPITAL BUDGETING

Page 14 of 40
Capital budgeting is the process which enables the management to decide which, when and where to make long-
term investments.

 Following are the capital budgeting techniques: 

 Net Present Value
 Internal Rate of Return
 Profitability Index
 Payback Period
 Bail-out payback method
 Accounting rate of return
 Payback reciprocal method
 
A Capital Budgeting Decision rules likely to satisfy the following criteria:
 Must give consideration to all cash flows generated by the project.
 Must take into account Time Value of Money concept.
 Must always lead to the correct decision when choosing among mutually exclusive projects.

CAPITAL BUDGETING PROCESS

The capital budgeting process consists of five distinct but interrelated steps.

1. Proposal generation. Proposals are made at all levels within a business organization and are reviewed by finance
personnel. Proposals that require large outlays are more carefully scrutinized than less costly ones.
2. Review and analysis. Formal review and analysis is performed to assess the appropriateness of proposals and
evaluate their economic viability. Once the analysis is complete, a summary report is submitted to decision makers.
3. Decision making. Firms typically delegate capital expenditure decision making on the basis of dollar limits.
Generally, the board of directors must authorize expenditures beyond a certain amount. Often plant managers are
given authority to make decisions necessary to keep the production line moving.
4. Implementation. Following approval, expenditures are made and projects implemented. Expenditures for a large
project often occur in phases.
5. Follow-up. Results are monitored and actual costs and benefits are compared with those that are expected. Action
may be required if actual outcomes differ from projected ones.

INDEPENDENT AND MUTUALLY EXCLUSIVE PROJECTS

A Project whose cash flows have no impact on the acceptance or rejection of other projects is termed as Independent
Project. Thus, all such Projects which meet this criterion should be accepted.

A set of projects from which at most one will be accepted is termed as Mutually Exclusive Projects. In mutually
exclusive projects, cash flows of one project can be adversely affected by the acceptance of the other project.

FACTORS TO CONSIDER IN CAPITAL BUDGETING

1. Net Investments
- The company’s net investments refer to the following:
a. Costs less savings incidental to the acquisition of the capital investment projects.
b. Cash outflows less cash inflows incidental to the acquisition of the capital investment projects.

Costs or cash outflows

1. Purchase price of the asset, net of related discount
2. Incidental project-related expenses such as freight, insurance, handling, installation, test-runs,etc.
Consider also the following if any:
* Additional working capital needed to support the operation of the project at the desired level.
* Market value of existing idle assets to be used in the operation of the proposed capital project.
* Training cost, net of related tax.

Savings or cash inflows

1. Proceeds from sale of old asset disposed, net of related tax
Consider also the following if any:
* Trade in value of old asset.
* Avoidable cost of immediate repairs on the old asset to be replaced, net of related tax.

2. Net Returns
Net returns of the company will depend on whether it is accrual or cash basis.
 ACCRUAL BASIS: Accounting net income after tax
Page 15 of 40
  CASH BASIS: Net cash inflows
> Direct Method
Net cash inflows = cash inflows – cash outflows
> Indirect Method
Net cash inflows = Net income after tax + noncash expenses (ex. Depreciation expense)

3. Cost of capital
The cost of capital used in capital budgeting is the Weighted Average Cost of Capital (WACC). These are specific costs
of using long-term funds obtained from the different sources: borrowed (debt) and invested (equity) capital. This topic
will be discussed in full in the following chapter.

CAPITAL BUDGETING TECHNIQUES

Non-discounted methods include the following:
1. Payback period method
2. Bail-out payback method
3. Accounting rate of return
4. Payback reciprocal method

Discounted methods include the following:

1. Net present value method
2. Profitability index method
3. Internal rate of return method
4. Present value payback method

NON-DISCOUNTED TECHNIQUES: DO NOT CONSIDER TIME VALUE OF MONEY

PAYBACK PERIOD
It is defined as the time period required for the investment’s returns to cover its cost. Payback period is easy to apply
and easy to understand technique; therefore, widely used by investors.

The formula for payback period is computed as follows:

Net initial cost of investment
Payback Period =
Annual net after-tax cash inflows
Decision guideline: The shorter the payback period, the more attractive the investment.

Advantages of payback period:

1. Payback is simple to compute and easy to understand.
2. Payback gives information about the liquidity of the project.
3. It is a good surrogate for risk. A quick or short payback period indicates a less risky project.
Disadvantages of payback period:
1. Payback does not consider the time value of money. All cash received during the payback period is assumed to be of
equal value of in analyzing the project.
2. It gives more emphasis on liquidity rather than on profitability of the project. In other words, more emphasis is
given on return of investment rather than return on investment.
3. It does not consider the salvage value of the project.
4. It ignores cash flows that may occur after the payback period (short-sighted).
BAIL-OUT PAYBACK PERIOD
Bail-out payback period is a modified payback method wherein cash recoveries include the estimated salvage value at
the end of each year of the project life.

ACCOUNTING RATE OF RETURN

It indicates the profitability of a capital expenditure by dividing expected annual net income by the average investment.
Accounting rate of return is also called annual rate of return. The formula is computed as follows:

Annual rate of return = Expected annual net income ÷ Average investment

Decision guideline: A project is acceptable if its rate of return is greater than management’s required rate of return.

Advantages of ARR:
1. The ARR closely parallels accounting concepts of income measurement and investment return.
2. It facilitates re-evaluation of projects due to ready availability of data from the accounting records.
3. This method considers income over the entire life of the project.
Page 16 of 40
4. It indicates and emphasizes the project’s profitability.

Disadvantages of ARR:
1. Like traditional payback methods, the ARR does not consider the time value of money.
2. With the computation of income and book value based on historical cost accounting data, the effect of inflation is
ignored.

There are a lot of terms used to denote the ARR some of them are as follows:
* Book value rate of return
* Unadjusted rate of return
* Simple rate of return
* Approximate rate of return method
* Financial statement rate of return method
* Average return on investment

PAYBACK RECIPROCAL
Payback reciprocal is a reasonable estimate of the discounted cash flow rate of return (a.k.a. IRR) provided that the
following conditions are met:
1. The economic life of the project is at least twice the payback period.
2. The net cash inflows are constant (uniform) throughout the life of the project.

Payback reciprocal is computed as follows:

Net cash inflows 1
Payback Reciprocal = =
Investment Payback period

DISCOUNTED TECHNIQUES: CONSIDER TIME VALUE OF MONEY

NET PRESENT VALUE 
Net Present Value measures the difference between present value of future cash inflows generated by a project and
cash outflows during a specific period of time. With a help of net present value we can figure out an investment that is
expected to generate positive cash flows. 

NPV=Present Value of Future Cash Inflows – Cash Outflows (Investment Cost)

  
Advantages of NPV:
1. NPV emphasizes cash flows.
2. NPV recognizes the time value of money.
3. NPV assumes discount rate as reinvestment rate.

Disadvantages of NPV:
1. NPV requires determination of the costs of capital or the discount rate to be used.
2. The NPV of different values of different competing projects may not be comparable because of differences in
magnitude or sizes of the projects.

Decision Rule: 
A prospective investment should be accepted if its Net Present Value is positive and rejected if it is negative. 

PROFITABILITY INDEX
Profitability index (PI) is the ratio of investment to payoff of a suggested project. It is a useful capital budgeting
technique for grading projects because it measures the value created by per unit of investment made by the investor.
This technique is also known as profit investment ratio (PIR), benefit-cost ratio and value investment ratio (VIR).

The ratio is calculated as follows:

Present value of cash inflows
Profitability Index =
Present value of cash outflows

The profitability index method is designed to provide a common basis of ranking alternatives that require different
amounts of investment.
Decision Rule:
Rules for the selection or rejection of a proposed project:
If Profit Index is greater than 1, then project should be accepted.
If Profit Index is less than 1, then reject the project.

Page 17 of 40
INTERNAL RATE OF RETURN
IRR is “The Discount rate at which the costs of investment equal to the benefits of the investment. Or in other words
IRR is the Required Rate that equates the NPV of an investment zero.

In other words, IRR is the rate of return that equates the present value of cash inflows to present value of cash
outflows. It is also known as discounted cash flow rate of return, time-adjusted rate of return or sophisticated rate of
return.

Guidelines in determining IRR:

1. Determine the present value factor (PVF) for the internal rate of return (IRR) with the use of the following formula:
Net investment Cost
PVF for IRR =
Net cash inflows

2. Using the present value annuity table, find on line ‘n’ (economic life) the PVF obtained in No. 1. The corresponding
rate is the IRR. If the exact rate is not found on the PVF table, ‘interpolation’ process may be necessary.

Advantages of IRR:
1. IRR emphasizes cash flows.
2. IRR recognizes the time value of money.
3. IRR computes the true return of project.

Disadvantages of IRR:
1. Assumes that IRR is the re-investment rate.
2. When project includes negative earnings during its life, different rates of return may result.

Decision Rule:
If Internal Rate of Return exceeds the required rate of Return, the investment should be accepted or should be rejected
otherwise.

PRESENT VALUE PAYBACK METHOD/DISCOUNTED PAYBACK PERIOD

This technique is somewhat similar to payback period except that the expected future cash flows are discounted for
computing payback period.
Decision Rule of Discounted Payback:
If discounted payback period is smaller than some pre-determined number of years then an investment is worth
undertaking.

ILLUSTRATIVE EXERCISES:
1. NET RETURNS (INCREASE IN REVENUE)
The management of J29Eleven plans to install coffee vending machines costing P200,000 in its movie house. Annual
sales of coffee are estimated at 10,000 cups at a price of P15 per cup. Variable costs are estimated at P6 per cup, while
incremental fixed cash costs, excluding depreciation at P20,000 per year. The machines are expected to have a service
life of 5 years with no salvage value. Depreciation will be computed on a straight line basis. The company’s income tax
rate is 30%.

Required: Assuming that the vending machines are installed, determine:

a. The increase in annual net income
b. The annual cash inflows that will be generated by the project.

2. NET RETURNS (COST SAVINGS)

J29Eleven is planning to buy cleaning equipment that can reduce car wash service cost and other cash expenses by an
average of P70,000 per year. The new cleaning equipment will cost P100,000 and will be depreciated for 5 years on a
straight-line basis. No salvage value is expected at the end of the equipment’s life. Income tax is estimated at 32% of
income before tax.

Required: Determine the net cash inflows that will be generated by the project.

3. PAYBACK PERIOD
RDC is a medium sized metal fabricator that is currently contemplating two projects: Project A requires an initial
investment of P42,000; project B requires an initial investment of P45,000. The projected relevant cash flows for the
two projects are presented below:

Page 18 of 40
 Capital Expenditure for RDC

Project A Project B
Initial
P42,000 P45,000
Investment
Year Operating cash inflows
1 14,000 28,000
2 14,000 12,000
3 14,000 10,000
4 14,000 10,000
5 14,000 10,000

How much is AL Company’s payback period for projects A and B?

4. BAIL-OUT PAYBACK PERIOD

A project costing P180,000 will produce the following annual cash flows and salvage value:
Year Cash flows Salvage value
1 50,000 65,000
2 50,000 50,000
3 50,000 35,000
4 50,000 20,000
Required: Bail-out payback period.

5. ACCOUNTING RATE OF RETURN

Alegro Company is considering an investment of P130,000 in new equipment. the new equipment is expected to last
five years and have zero salvage value at the end of its useful life. The straight line method of depreciation is used for
accounting purposes. The following data are available.
Sales 200,000
Manufacturing costs (exclusive of depreciation) 132,000
Selling and administrative expenses 22,000
Income tax expense 7,000
Requirement: Compute for the annual rate of return.

6. PAYBACK PERIOD & ACCOUNTING RATE OF RETURN (WITH EVEN CASH FLOWS)
Rocabo Company considers the replacement of some old equipment. The cost of the new equipment is P90,000 with a
useful life estimate of 8 years and a salvage value of P10,000. The annual pre-tax cash savings from the use of the new
equipment is P40,000. The old equipment has zero market value and is fully depreciated. The company uses a cost of
capital of 25%.

Required: Assuming that the income tax rate is 40%, compute:

a. Payback period
b. Accounting rate of return on original investment.
c. Accounting rate of return on average investment.

7. PAYBACK PERIOD & ACCOUNTING RATE OF RETURN (UNEVEN CASH FLOWS)

AR Group has an investment opportunity costing P90,000 that is expected to yield the following cash flows over the
next five years: (assuming a cut-off rate of 30%)
Year Amount
1 40,000
2 35,000
3 30,000
4 20,000
5 10,000
135,000
Required:
a. Payback period in months
b. Book rate of return
8. PAYBACK RECIPROCAL
RF Farms is planning to buy an equipment costing P640,000 that has an estimated life of 30 years and is expected to
produce after-tax net cash inflows of P128,000 per year.
Required: Without using present value factors, estimate IRR.

9. NPV, PROFITABILITY INDEX & INTERNAL RATE OF RETURN (EVEN vs. UNEVEN
CASH FLOWS)
A Corporation gathered the following data on two capital investment opportunities.
Page 19 of 40
 Project No. 1 Project No.2
Cost of investment 195,200 150,000
Cost of capital 10% 10%
Expected useful life 3 years 3 years
Net cash flows P100,000 P100,000*
* this amount is to decline by P20,000 annually thereafter.

Required: Round-off factors to three decimal places in all cases.

Fill-in the blanks.

Project 1 Project 2
NPV: A) B)
P. Index: C) D)

Required:
 What is project 1’s internal rate of return?
 What is the project 2’s time-adjusted rate of return?

10. INTERNAL RATE OF RETURN

Walang Sabaw Soup Company is considering the purchase of a new front-end loader at a cost of P244,371. Net annual
cash flows from this loader are estimated to be P100,000 a year for three years. Compute for the company’s internal
rate of return.

11. PRESENT VALUE PAYBACK METHOD

A company purchased a machine for P10,000 which yields cash inflows of P8,000, P2,000, and P1,000 in year 1, 2 and
3 respectively. The cost of capital is 15%.

Required: Compute for the discounted payback period.

12. CAPITAL RATIONING-RANKING PROJECTS

AR Corporation is considering five different investment opportunities. The company’s cost of capital is 12%. Data on
these opportunities under consideration are given below.
Project Investment PV-cash NPV IRR(%) P. Index
flow
1 35,000 39,325 4,325 16 1.12
2 20,000 22,930 2,930 15 1.15
3 25,000 27,453 2,543 14 1.10
4 10,000 10,854 854 18 1.09
5 9,000 8,749 (251) 11 0.97

Required:
A) Rank the projects in descending order of preference according to NPV, IRR and benefit/cost ratio.
B) If only a budget of P55,000 is available, which projects should be chosen?

PRACTICE EXERCISES:
1. The long-term planning process for making and financing investments that affect a company’s financial results over
a number of years is referred to as
A. capital budgeting C. master budgeting
B. strategic planning D. long-range planning

2. The first step in the decision-making process is to

A. determine and evaluate possible courses of action.
B. identify the problem and assign responsibility.

Page 20 of 40
 C. make a decision.
D. review results of the decision.

3. Capital budgeting is the process

A. used in sell or process further decisions.
B. of determining how much capital stock to issue
C. of making capital expenditure decisions
D. of eliminating unprofitable product line

4. A capital investment decision is essentially a decision to:

A. exchange current assets for current liabilities.
B. exchange current cash outflows for the promise of receiving future cash inflows.
C. exchange current cash flow from operating activities for future cash inflows from investing activities.
D. exchange current cash inflows for future cash outflows.

5. Cost of capital is the

A. amount the company must pay for its plant assets.
B. dividends a company must pay on its equity securities.
C. cost the company must incur to obtain its capital resources.
D. cost the company is charged by investment bankers who handle the issuance of equity or long-term debt
securities.

6. A project that when accepted or rejected will not affect the cash flows of another project.
A. Independent projects C. Mutually exclusive projects
B. Dependent projects D. Both b and c

7. The primary advantages of the average rate of return method are its ease of computation and the fact that:
A. It is especially useful to managers whose primary concern is liquidity
B. There is less possibility of loss from changes in economic conditions and obsolescence when the commitment
is short-term
C. It emphasizes the amount of income earned over the life of the proposal
D. Rankings of proposals are necessary

8. The technique most concerned with liquidity is

A. Payback method.
B. Net present value technique.
C. Internal rate of return.
D. book rate of return.
9. The cash payback technique:
A. should be used as a final screening tool.
B. can be the only basis for the capital budgeting decision.
C. is relatively easy to compute and understand.
D. considers the expected profitability of a project.

10. Which of the following methods of evaluating capital investment projects incorporates the time value of money?
A. Payback period, accounting rate of return, and internal rate of return
B. Accounting rate of return, net present value, and internal rate of return
C. Payback period and accounting rate of return
D. Net present value and internal rate of return

11. Which is true of the net present value method of determining the acceptability of an investment?
A. The initial cost of the investment is subtracted from the present value of net cash flows
B. The net cash flows are not adjusted to present value
C. A negative net present value indicates the investment should be undertaken
D. The net present value method requires no subjective judgments

12. The profitability index

A. does not take into account the discounted cash flows.
B. Is calculated by dividing total cash flows by the initial investment.
Page 21 of 40
 C. allows comparison of the relative desirability of projects that require differing initial investments.
D. will never be greater than 1.0.

13. According to the reinvestment rate assumption, which method of capital budgeting assumes cash flows are
reinvested at the project’s rate of return?
A. payback period C. internal rate of return
B. net present value D. none of the above

14. If a company’s required rate of return is 12 percent and in using the profitability index method, a project’s index is
greater than 1.0, this indicates that the project’s rate of return is
A. equal to 12 percent. C. less than 12 percent.
B. greater than 12 percent. D. dependent on the size of the investment.

15. The relationship between payback period and IRR is that

A. a payback period of less than one-half the life of a project will yield an IRR lower than the target rate.
B. the payback period is the present value factor for the IRR.
C. a project whose payback period does not meet the company’s cutoff rate for payback will not meet the
company’s criterion for IRR.
D. none of the above.

16. NPV indicates a project is deemed desirable (acceptable) when the NPV is
A. greater than or equal to zero
B. less than zero
C. greater than or equal to the risk-adjusted cost of capital
D. less than or equal to the risk-adjusted cost of capital

17. If Arbitrary Company wants to use IRR to evaluate long-term decisions and to establish a cutoff rate of return, it
must be sure that the cutoff rate is
A. at least equal to its cost of capital.
B. at least equal to the rate used by similar companies.
C. greater than the IRR on projects accepted in the past.
D. greater than the current book rate of return.

18. In choosing from among mutually exclusive investments, the manager should normally select the one with
the highest
A. Net present value. C. Profitability index.
B. Internal rate return. D. Book rate of return.

19. Bruell Company is considering to replace its old equipment with a new one. The old equipment had a net book
value of P100,000, 4 remaining useful life with P25,000 depreciation each year. The old equipment can be sold at
P80,000. The new equipment costs P160,000, have a 4-year life. Cash savings on operating expenses before 40%
taxes amount to P50,000 per year. What is the amount of investment in the new equipment?
A. P160,000 C. P 80,000
B. P 72,000 D. P 68,000

20. A piece of labor saving equipment that Marubeni Electronics Company could use to reduce costs in one of its
plants in Angeles City has just come onto the market. Relevant data relating to the equipment follow:
Purchase cost of the equipment P432,000
Annual cost savings that will be provided by the equipment 90,000
Life of the equipment 12 years
What is the simple rate of return to be provided by the equipment?
A. Between 15% and 18%. C. 20.83%.
B. 25.00%. D. 12.50%.
21. If an asset costs P35,000 and is expected to have a P5,000 salvage value at the end of its ten-year life, and generates
annual net cash inflows of P5,000 each year, the cash payback period is
A. 8 years C. 6 years
B. 7 years D. 5 years

22. Consider a project that requires cash outflow of P50,000 with a life of eight years and a salvage value of P5,000.
Annual before-tax cash inflow amounts to P10,000 assuming a tax rate of 30% and a required rate of return of 8%.
Salvage value is ignored in computing depreciation. The project has a payback period of
A. 5.0 years C. 6.0 years
B. 5.6 years D. 6.6 years
Page 22 of 40
23. The Mejicano Company is planning to purchase a piece of equipment that will reduce annual cash expenses over its
5-year useful life by equal amounts. The company will depreciate the equipment using straight-line method of
depreciation based on estimated life of 5 years without any salvage value. The company is subject to 40 percent
tax. The marginal cost of capital for this acquisition is 11.055 percent. The management accountant calculated
that the internal rate of return based on the estimated after-tax cash flows is 12.386 percent and a net present
value of P10,000. The president, however, wants to know the profitability index before he finally decides. What is
the profitability index for this investment?
A. 1.011 C. 1.022
B. 1.034 D. 1.044

IV. QUANTITATIVE TECHNIQUES

QUANTITATIVE TECHNIQUES
Refers to the application of mathematics in actual business operations. It is also known as quantitative methods.
TYPICAL QUANTITATIVE METHODS APPLICATIONS
1. Corporate planning models
2. Forecasting mechanism
3. Productivity and efficiency measures
4. Inventory planning and control

Page 23 of 40
 5. Resource allocation

NETWORK MODELS
- Involve project scheduling techniques that are designed to aid the planning and control of large-scale projects that
have many interrelated activities. These models aid management in predicting and controlling costs that pertain to
certain projects or business activities.

COMMON PROJECT SCHEDULING TECHNIQUES

1. Gantt or bar chart
2. Program Evaluation and Review Technique (PERT)
3. Critical Path Method (CPM)

Sample Applications: building constructions, book publishing, new product planning, feasibility studies, research and
development projects, and audit planning and scheduling.

GANT CHARTS
This is a graphical illustration of a scheduling technique in the form of a horizontal chart. The project is divided into
different sub-projects called activities or tasks (also called milestones). The starting and completion time of activity is
estimated and a bar chart is prepared showing each activity as a horizontal bar along a time scale.

Queries: Which task is the longest in completion time?

All tasks are being performed in what month?

PROGRAM EVALUATION AND REVIEW TECHNIQUE (PERT)

PERT is based on what is called a Network Plan. A flow chart – the network – is used to show how the individual parts
of a project (the activities and the starting events) depend on one another and which tasks must be finished before
others can be started. PERT is developed to aid managers in controlling large-scale, complex problems.

PERT RELATED TERMINOLOGIES

 PERT diagram is a probabilistic diagram of the interrelationship of a complex series of activities; it is a free-
form network showing each activity as line between events.
 EVENTS –discrete moment in time representing the start or finish of an activity; they consume no resources.
 ACTIVITIES – tasks to be accomplished; they consume resources (including time).
 Series – an activity that cannot be done unless another activity is undertaken first.
 Parallel – an activity that can be performed simultaneously with another activity.
Estimates derived from PERT Analysis:
1. The earliest expected time for completion of each activity, or task.
2. The latest allowable time for each completion event.
3. The critical path of the network; that is, the path through the flow chart that has the least total amount of slack.
(Slack is the difference between the latest allowable time and the expected time of completion.)
4. The probabilities that events will occur on schedule.

CPM (Critical Path Method) or Project Management is closely related to PERT. Both PERT and CPM involve
determining expected times of completion of individual events for the entire project.

PERT goes further to include variance analysis while CPM does not. CPM, on the other hand, goes beyond PERT in
another direction. It uses cost data to assess the financial effects of setting up crash programs in the network’s critical
path segments to ensure completion on schedule.

CPM, like PERT, is a network technique; however, CPM uses deterministic time and cost estimate; among its
advantages include cost estimates plus the concept of crash efforts and costs.

CPM-RELATED TERMINOLOGIES
 CRITICAL PATH – is longest path through the PERT network.
 EXPECTED TIME – is the average time an activity would require if it were repeated several times.

te = (to + 4tm + tp)/6

Where: to – optimistic time; tm – most likely time; tp – pessimistic time

 SLACK TIME – the amount of time that can be added to an activity without increasing the total time
required on th critical path; the length of time an activity can be delayed without forcing a delay for the entire
project.

Page 24 of 40
  CRASH TIME – the amount of time to complete an activity assuming that, under rush or urgent condition,
all available resources were devoted to the task (e.g. overtime, extra labor, etc.) ;any crash time spent in an
activity normally would incur crash cost.

PROBABILITY ANALYSIS
Is important to decision making because of the unpredictability of future events.

Decision making involves:

 RISK – this occurs when the probability distribution of the possible future state of nature is known.
 UNCERTAINTY – this occurs when the probability distribution of possible future state of nature is not
known and must be subjectively determined.

The probability of an event varies from o to 1 (0 to 100%). 100% or probability of 1.0 means that event is certain to
occur while zero probability means the event cannot occur under any circumstances.

THE CONCEPT OF EXPECTED VALUE

The expected value of an action is found by multiplying the probability of each outcome by its pay-off and
summing up the products. A decision tree diagram is normally devised to show several possible decisions or acts
and the possible consequences (outcome or events) of each act.

PROBABILITY RELATED TERMINOLOGIES

 Objective probabilities – calculated from either logic or actual experience.
 Subjective probabilities – estimates, based on judgment, of the likelihood of future events.
 Two events are said to be mutually exclusive if they cannot occur simultaneously.
 Two events are said to be independent if occurrence of one has no effect on probability of another.
 The joint probability of two events is the probability that both will occur.
 The conditional probability of two events is the probability that one will occur given that the other has already
occurred.

REGRESSION AND CORRELATION ANALYSIS

REGRESSION ANALYSIS – tries to estimate the relationship between a dependent variable (cost) and one or more
independent variables (volume) from a set of actual observations on these variables.

SCATTERGRAM (Scatter Diagram) – is obtained by plotting the data set on an ordinary two axis graph, this
diagram gives a fair indication of the nature between the dependent and independent variables.

CORRELATION ANALYSIS – In contrast to simple regression analysis, the objective of simple linear correlation
analysis is to measure the degree of relationship between the two variables X and Y. Thus, the terms dependent
variable and independent variable have no meaning in correlation analysis.

a. The coefficient of correlation r is a measure of the degree of linearity in the relationship between X and Y. A perfectly
linear relationship means r = 1 (positive slope line) or r = -1 (negative slope line); r can only lie between +1 and -1.

b. The square of r is called the coefficient of determination. It is equal to the proportion of the total variation in Y that
can be explained by the regression of Y and X.

r² = Explained Variation ÷ Total Variation

LINEAR PROGRAMMING
Linear Programming is a mathematical technique for optimum allocation of scarce resources.

Linear Programming involves:

1. Constructing a set of simultaneous linear equations which represent the model of the problem and which include
many variables; and
2. Solving the equations with the help of a computer.

Steps applied in Linear Programming:

1. Formulate the objective function. This objective is usually to maximize profit or minimize cost.
2. Determine the basic relationships particularly the constraints.

Page 25 of 40
3. Determine the feasible alternatives.
4. Compute the optimum solution.

LEARNING CURVE
Learning Curve describes the efficiencies arising from experience, because with experience comes increased
productivity. This productivity increases with production size, but at a decreasing rate.

The time required to perform a given task becomes progressively shorter, but this is applicable only to the early stages
of production.
The curve is expressed as a percentage of reduced time (usually between 60% and 80%) to complete a task of each
doubling of cumulative production. Hence, the time required is reduced by 20% to 40% each time cumulative
production is doubled.

Important notes:
 The cumulative average time per unit is reduced by a certain percentage each time production doubles.
 Incremental unit time (time to produce the last unit) is reduced when production doubles.

ILLUSTRATIVE EXERCISES:
PROBABILITY
It has been observed by the Probe Company over the past 100 weeks that the weekly demand for Product A was 30
units during 25 of these 100 weeks, 35 units during 35 of the past 100 weeks, and 40 units during the remaining 40
weeks. The demand pattern can be expected to remain stable in the future.

The company buys the product from another source at a cost of P30 per unit and sells it for P50 each. The product is
perishable and unsold units become worthless at the end of the week.

REQUIRED:
1. Compute the probability of the demand for Product A weekly at 30 units, 35 units, and 40 units.
2. Compute the expected value of the weekly demand.
3. Prepare a Pay-off Table that will show the expected monetary value of each outcome.

LINEAR PROGRAMMING
Linear Company produces Product A and B which contributes to profit per unit at P20 and P15 respectively. Product A
is processed in Machine X requiring 4 hours per unit and Machine Y requiring 3 hours per unit. Product B is
processed only in Machine Y using 4 hours per unit. Machine X and Y could provide 4,000 hours and 4,800 hours
respectively each year.

Product A and B passes the Polishing Department requiring 2 hours per unit each product before it is considered a
finished product. The polishing department has 2,600 hours available each year.
Required:
1. Formulate the objective function.
2. Determine the basic relationships (Constraints or limitations).
3. Formulate the problem.

PERT and CPM

Alegro Construction Firm will soon begin to work on a hotel building in Catbalogan City named Alegro Hotel that was
initially started by another firm that has gone out of business. The construction firm’s schedule of activities and related
expected completion time are presented in the following table:

Activity Activity Description Estimated

Code Time (in
weeks)
A–B Obtain on-site work permits 2
B–E Repair damages done by vandals 8
B–C Inspect construction materials left on site 1

Page 26 of 40
 C–E Order and receive construction materials 2
C–D Apply for waiver to add new materials 3
D–E Obtain waiver to add new materials 2
E–F Perform electric work 6
F–G Complete interior partitions 4

Required:
1. Prepare the PERT network for Alegro Hotel.
2. What is the critical path and its expected time in weeks?
3. What is the shortest path and its slack time in weeks?

PERT and CPM

A construction company has contracted to complete a new building and has asked for assistance in analyzing the
project. Using the Program Evaluation Review Technique (PERT), the network has been developed. All paths from the
start point to the finish point, event 6, represent activities or processes that must be completed. The numbers above
the paths or line segments represent expected completion times for the activities or processes. The expected time is
based upon the commonly used, 1-4-1, three-estimate method. For example, the three-estimate method gives an
estimated time of 4.2 to complete event 1.

5.2

7.1

5.0
2 5 3.5
4.2

4.2
S 1 3.0 6
7.3

2.1
3 4
3.6 4.6

5.0
7 8

REQUIRED: Determine the following:

1. Critical path (the path requiring the greatest amount of time.)
2. The slack time on path 1-9-6.
3. The latest time for reaching event 6 via path 1-2-5-6.
4. The earliest time for reaching 6 via path 1-2-5-6.

LEARNING CURVE
A particular manufacturing job is subject to an estimated 80% experience (learning) curve. The first unit required 20
labor hours to complete.
Required:
1. What is the cumulative average time per unit after four (4) units are completed?
2. What is the total time in hours required to produce two (2) units?
3. How many hours are required to produce the second unit?

PRACTICE EXERCISES:
1. Which of the following is a useful technique in determining the fixed and variable elements of a semi- variable
expense?
A. Linear Programming C. PERT
B. Queing theory D. Simple regression analysis

2. Which of the following quantitative methods will separate a semi-variable costs into its fixed and variable
components with the highest degree of precision under all circumstances.
A. High-low method C. Least-squares method
B. Simplex method D. Scatter-graph method

Page 27 of 40
3. Simple regression analysis involves the use of
A. One variable C. Three variables
B. Two variables D. More than three variables

4. Probability (risk) analysis

A. Ignores probability weights under fifty percent
B. Is only for situations in which there are three or fewer possible outcomes
C. Does not enhance the usefulness of sensitivity analysis data
D. Is an extension of sensitivity analysis

5. Regression analysis is superior to other cost behavior analysis techniques because it

A. Produces measures of probable error. C. Proves a cause and effect relationship
B. Examines only one variable D. It is not a sampling technique

6. A formal diagram of the interrelationships of complex time series of activities is

A. PERT C. Linear programming
B. The method of least squares D. Correlation analysis

7. A quantitative technique used to discover and evaluate possible cause-and-effect relationship is

A. Linear programming C. Poisson distribution models
B. PERT D. Correlation analysis

8. The constraints in a linear programming problem usually model

A. Profits C. Dependent variables
B. Restrictions D. Goals

9. Linear programming is used most commonly to determine

A. That mix of variables which result in the largest quantity.
B. The best use of scarce resources.
C. The most advantageous prices
D. The fastest timing.

10. Simple regression analysis involves the use of

Dependent Variables Independent Variables
A. One None
B. One One
C. One Two
D. None Two

V. INTRODUCTION TO MANAGERIAL ACCOUNTING

MANAGERIAL ACCOUNTING
Managerial accounting is concerned with providing information to managers-that is, people inside an
organization who direct and control its operation.

MANAGEMENT – the process of planning, organizing, and controlling tasks to realize the objectives of the
organization.

BASIC MANAGEMENT FUNCTIONS

PLANNING

Page 28 of 40
  Involves selecting a course of action and specifying how the action will be implemented.
o (1) setting of goals and objectives,
o (2) identifying the alternative courses of action necessary to reach the desired goals and objectives.
The plans of management are often expressed formally in budgets, and the term budgeting is
applied to generally describe the planning process.

ORGANIZING
 involves
o (1) tackling of activities and
o (2) utilization of available resources necessary to reach the desired goals and objectives of the company. In
plain language, organizing refers to simply putting plans into action.

CONTROLLING
 Simply mean keeping the company’s activities on track.
 Can be done by making sure that the company’s activities are geared towards achieving those goals and
objectives set.
 If in case discrepancies arise, the company should be ready to make adjustments or redirection.
Decision-making is an inherent function of management; all management functions would require certain amount of
decision-making.

MANAGEMENT BY OBJECTIVES (MBO) vs. MANAGEMENT BY EXCEPTION (MBE)

Management by Objectives
 The procedure in which a subordinate and a supervisor agree on goals and the methods of achieving them and
develop a plan in accordance with that agreement.
 The subordinate is then evaluated with reference to the agreed plan at the end of the period.

Management by Exception
 Refers to the technique of highlighting those which vary significantly from plans and standards in line with the
management principle that executive time should be spent on items that are non-routine and are identified as
top priority.

MANAGERIAL VERSUS FINANCIAL ACCOUNTING

SIMILARITIES
1. Both deal with economic events.
2. Both require quantifying the results of economic activity.
3. Both are concerned with revenues and expenses, assets, liabilities and cash flows.
4. Both involve financial statements.

DIFFERENCES
1. User of information
2. Guiding principles
3. Optional/ Mandatory
4. Type of information
5. Emphasis of reports
6. Purpose/ End result
7. Source of data
8. Amount of detail
9. Focus of information
10. Frequency
11. Time orientation
12. Unifying model
Financial Accounting Managerial Accounting
Primarily for external users Exclusively for internal users
(management)
GAAP Management wants and needs
Mandatory (especially for public Discretionary or optional
entities)
Primarily monetary (financial in Monetary or non-monetary
nature)
Reliability (precision of data) Relevance (timeliness of data)
Financial reporting and compliance Decision making
From company’s internal info From internal and external sources
system
Compressed and simplified Extensive and detailed
Focus mainly on business as a wholeFocus on segments and business as
a whole
Periodic (annually, quarterly) As frequent as the need arises
Mainly historical (past) data Future-oriented using current and
past data
Assets = Liabilities + Equity No unifying model or equation

ORGANIZATIONAL STRUCTURE
Organizational structure refers to the way that an organization arranges people and jobs so that its work can be
performed and its goals can be met.
Page 29 of 40
An organizational structure tells:
1. Employees
a. What they do
b. Who they report to
2. Managers
a. What they do
b. Who reports to them

ORGANIZATIONAL LINES OF CONTROL

Line functions - are those management systems that have direct accountability for sales or production target
achievement. They have the authority to give command or orders to subordinates; it exercises direct downward
authority over line departments (ex. VP for Operations over operations manager).

Staff functions - are management structures that assist the line managers to achieve their targets by extending
support. They have the authority to advise but not to command others. It is exercised laterally or upward.

STAFF VERSUS LINE FUNCTION

Line Function Staff Function
Target Accountability Line managers are directly The staff function governs advisory
responsible for achievement of target services that impact the efficacy of the line
oriented jobs that form the core of the function but do not directly take part in the
business's existence, such as sales or production planning and marketing.
production.
Reporting Authority Line managers have the authority to The directions given by staff managers are
overrule the suggestions given by the expected to be followed by line managers.
staff manager.
Line function can give direct orders toStaff function cannot give direct orders to
subordinates. subordinates.

CONTROLLERSHIP – the practice of the established science of control, which is the process by which management
assures itself that company resources are obtained and utilized according to plans that are in line with the company’s
set objectives.

THE TREASURER
 responsible for managing corporate assets and liabilities, planning the finances, budgeting capital, financing
the business, formulating credit policy, and managing the investment portfolio.
 He serves as front liners because they are the ones who face customers, banks, suppliers, creditors and
investors.
 He reports to the vice president for finance.

THE CONTROLLER
 is in charge of the accounting department, generally known as the “chief accountant”.
 His authority is basically staff authority in that his office gives advice and service to other departments.
 at the same time, he has line authority over members of his or her department such as internal auditors,
bookkeepers, budget analysts, etc.
 He is basically concerned with internal matters, namely, financial and cost accounting, taxes, budgeting, and
control functions.
 He serves as processors because he is the one who processes information for the management, BIR, SEC,
government agencies and the like.
 He reports to the vice president for finance.

CONTROLLER VERSUS TREASURER

1. The Controller is primarily concerned with the accounting function.
2. The Treasurer is primarily concerned with custody of funds.
Controller (PREGPET) Treasurer (PIBISCI)
Planning and control Provision of Capital
Reporting and interpreting Investor relations
Evaluation and consulting Banking and custody
Government reporting Investments
Protection of assets Short-term financing
Economic appraisal Credit and collections

Page 30 of 40
 Tax administration Insurance

STANDARDS OF ETHICAL CONDUCT (CICO)

COMPETENCE
 Maintain an appropriate level of professional competence by ongoing development of their knowledge and
skills.
 Perform their professional duties in accordance with relevant laws, regulations and technical standards.
 Prepare complete and clear reports and recommendations after appropriate analysis of relevant and reliable
information

INTEGRITY
 Avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict.
 Refrain from engaging in any activity that would prejudice their ability to carry out their duties ethically.
 Refuse any gift, favor, or hospitality that would influence or would appear to influence their actions.
 Refrain from either activity or passively subverting the attainment of the organization's legitimate and ethical
objectives.
 Recognize and communicate professional limitations or other constraints that would preclude responsible
judgment or successful performance of an activity.
 Communicate unfavorable as well as favorable information and professional judgment or opinion.
 Refrain from engaging or supporting any activity that would discredit the profession.

CONFIDENTIALITY
 Refrain from disclosing confidential information acquired in the course of their work except when authorized,
unless legally obligated to do so.
 Inform subordinates as appropriate regarding the confidentiality of information acquired in the course of their
work and monitor their activities to assure the maintenance of that confidentiality
 Refrain from using or appearing to use confidential information acquired in the course of their work for
unethical or illegal advantage either personally or through third parties.

OBJECTIVITY
 Communicate information fairly and objectively
 Disclose fully all relevant information that could reasonably be expected to influence an intended user's
understanding of the reports, comments, and recommendations presented.

RESOLUTION OF ETHICAL CONFLICTS

 Discuss such problems with immediate superior except when it appears that superior is involved, in which case
the problem should be presented to the next higher managerial level. If a satisfactory resolution cannot be
achieved when the problem is initially presented, submit the issue to the next higher managerial level.
 If the immediate superior is the chief executive officer or equivalent, the acceptable reviewing authority may be
a group such as the audit committee, executive committee, board of directors, board of trustees, or owners.
Contact with a level above the immediate superior should be initiated only with the superior's knowledge.
Assuming the superior is not involved. Except where legally prescribed, communication of such problems to
authorities or individuals not employed or engaged by the organization is not considered appropriate.
 Clarify relevant ethical issues by confidential discussion with an objective adviser to obtain a better
understanding of possible course of action
 Consult your own attorney as to legal obligations and rights concerning the ethical conflict.
 If the ethical conflict still exists after exhausting all levels of internal review, there may be no other recourse on
significant matters than to resign from the organization and to submit an informative memorandum to an
appropriate representative of the organization. After resignation, depending on the nature of the ethical
conflict, it may also be appropriate to notify other parties.

PRACTICE EXERCISES:
1. The discipline of accounting concerned with providing information to management in making decisions about
business operations.
A. cost accounting C. government accounting
B. financial accounting D. management accounting

2. The primary purpose of management accounting is to provide information

A. to external users C. to both external and internal users
B. to internal users D. to management and government

Page 31 of 40
3. For decision-making purposes, managers are more concerned with receiving information that is:
A. Completely accurate and precise C. Relevant, completely accurate and precise
B. Completely objective and verifiable D. Relevant, flexible and immediately available

4. Management accounting
A. Is discretionary rather than mandatory
B. Is concerned only with monetary information
C. Is governed by GAAP
D. Is focused on business as a whole rather than on segments of the business

5. Which of these information characteristics is deemed most important to management accounting?

A. verifiability and accuracy C. relevance, flexibility and timeliness
B. comparability and full disclosure D. conservatism and substance over form

6. Managerial accounting is similar to financial accounting in that

A. both are governed by GAAP
B. both classify reported information in the same way
C. both concentrate with historical cost
D. both deal with economic events

7. The basic management process does not include

A. rationalizing C. subordinating
B. controlling D. planning

8. The function of management that compares planned results against actual results is known as
A. planning C. controlling
B. directing and motivating D. decision making

9. A practice in which a subordinate and a supervisor agree on goals and the methods of achieving them.
A. management by objectives C. management by exception
B. management by subjective D. management by example

10. The controller primarily

A. occupies a line position C. occupies a non-supervisory rank-and-file position
B. occupies a staff position D. has no or very little influence in the decision-making process

11. Which is a characteristic of a line function rather than a staff function?

A. it is a function that gives support, advice and service to line managers
B. it is the authority to command action or give orders to subordinates
C. it is exercised laterally upward
D. it is a support function by provision of services to a co-department

12. Which of the following statements is true?

A. the controller, as the title implies, exercises direct control over business operations
B. the controller performs primarily a line function
C. the treasurer performs primarily a line function
D. the primary functions of a controller are basically the same as those of a treasurer.
13. Management accounting is used by an organization’s management for a multitude of purposes that do not
include
A. marketing C. evaluation
B. control D. reporting

14. Controllers are ordinarily not concerned with

A. preparation of tax returns C. protection of assets
B. reporting to government D. investor relations

15. The treasurer is usually not concerned with

A. financial reporting C. cash custody and banking
B. short-term financing D. credit extension and collection of bad debts

16. The professional certification most relevant for managerial accountants is the
A. CPA C. CISA
Page 32 of 40
 B. CMA D. CFA

17. All of the following entities would have a need for managerial accounting information except:
A. Saint Paul School of Professional Studies.
B. XYZ Hotel.
C. RDC Professional Development Center.
D. None of the above responses is correct, as all of these entities would use managerial accounting
information.

18. Which of the following choices correctly depicts whether Bank of the Philippine Islands, Lazada, and
University of the Philippines would have a need for managerial accounting?

BPI Lazada UPVTC

A. Yes Yes No
B. Yes No Yes
C. Yes Yes Yes
D. No Yes No

19. Which of the following employees at American Airlines would not be considered as holding a line position?
A. Pilot.
B. Chief financial officer (CFO).
C. Flight attendant.
D. Ticket agent.
E. Baggage handler.

20. Which of the following employees would be considered as holding a line position?
A. The controller of Exxon Corporation.
B. The vice-president for government relations of Microsoft.
C. The manager of food and beverage services at Disney's Magic Kingdom.
D. A secretary employed by Hewlett-Packard.

21. The major functions of management is (are):

A. strategic management and long-range planning.
B. planning and decision making.
C. identifying threats and opportunities for the firm.
D. all of the above.

22. The process of identifying, measuring, analyzing, interpreting, and communicating information in
pursuit of an organization's goals is called
A. managerial accounting C. management
B. financial accounting D. promotional activities

23. The primary objective of management accounting is

A. to provide stockholders and potential investors with useful information for decision making.
B. to provide banks and other creditors with information useful in making credit decisions.
C. to provide management with information useful for planning and control of operations.
D. to provide supervising government agencies with information about the company’s management affairs.

24. Management accounting information

A. uses historical cost as the basis for reports to managers who are making decisions about future courses of
action.
B. should be developed and provided only if its benefits exceed its costs.
C. does not reflect the financial criteria of verifiability or consistency.
D. should serve the basic needs of investors and creditors.

25. Which of the following is included in the day-to-day work of the management team?
A. decision making C. controlling
B. planning D. all of the above

26. Paying rent, purchasing supplies, and purchasing inventory are which of the day-to-day work activities
of the management team?
A. decision making C. directing operational activities
B. planning D. only A and B

Page 33 of 40
 27. Which of the following statements are true regarding financial and managerial accounting?
I. Both are mandatory.
II. Both rely on the same underlying financial data.
III. Both emphasize the segments of an organization, rather than just looking at the organization as a whole.
IV. Both are geared to the future, rather than to the past.
A. I, II, III, and IV C. Only II and III
B. Only II, III and IV D. Only II

28. Managerial accounting activity adds value to an organization by pursuing five major objectives,
which include
A. providing information for decision making and planning.
B. measuring the performance of activities within an organization.
C. assisting managers in directing and controlling operational activities.
D. all of them

29. Managerial accounting places considerable weight on:

A. generally accepted accounting principles.
B. the financial history of the entity.
C. ensuring that all transactions are properly recorded.
D. detailed segment reports about departments, products, and customers.

30. Which of the following statement is FALSE?

A. Managerial accounting need not conform to GAAP.
B. Financial accounting reports focus on subunits of the organization.
C. Managerial accounting is not required
D. Managerial accounting focuses on the needs of internal users.

31. For internal uses, managers are more concerned with receiving information that is:
A. completely objective and verifiable.
B. completely accurate and precise.
C. relevant, flexible, and immediately available.
D. relevant, completely accurate, and precise.

32. Which of the following statements is correct?

A. A certified public accountant can readily render management advisory services to the public.
B. A CPA with MBA and DBM degrees is automatically qualified to render management advisory
services.
C. Competence as a standard in the rendition of management advisory services by a CPA may be
equated to having excellent scholarly preparation to include the usual baccalaureate degree, an
MBA and other post graduate studies.
D. Adequate training and experience in both the analytical approach and process in a particular
undertaking are requisites for the CPA to be involved in a management advisory service engagement.

34. The following characterize management advisory services except

A. It involves decision for the future
B. It broader in scope and varied in nature
C. It utilizes more junior staff than senior members of the firm
D. It relates to specific problems where expert help is required

35. Which of the following statements is incorrect?

A. CPAs provide management advisory services to go around the ethical constraints as mandated by the
Accountancy Law.
B. Businesses hire management consultants to help define specific problems and develop solutions.
C. CPAs who are performing management advisory services may be considered to be in the practice of
management consulting.
D. Included in the practice of consulting is the provision of confidential service in which the identity of the
client is concealed.

Page 34 of 40
 36. The primary purpose of management advisory services is
A. To conduct special studies, preparation of recommendations, development of plans and programs, and
provision of advice and assistance in their implementation.
B. To provide services or to fulfill some social needs.
C. To improve the client’s use of its capabilities and resources to achieve the objectives of the organization.
D. To earn the best rate of return on resources entrusted to its care with safety of investment being
taken into account and consistent with firm’s social and legal responsibilities.

37. Managerial accounting information:

A. pertains to the entity as a whole and is highly aggregated.
B. pertains to subunits of the entity and may be very detailed.
C. is prepared only once a year.
D. is constrained by the requirements of generally accepted accounting principles.

38. Managerial accounting is primarily concerned with:

A. segments of a company rather than the company as a whole.
B. the data needs of stockholders and creditors.
C. meeting the requirements of generally accepted accounting principles.
D. the company as a whole rather than a segment of the organization.

V. MANAGEMENT ADVISORY SERVICES

MAS – refers to the consulting services performed by CPAs and other financial advisors to improve client’s use of its
capabilities and resources, to achieve business objectives. Examples of MAS engagements: financial planning,
computer system installation and wealth management. NOTE: In most CPA firms, MAS departments are kept
independent from other departments like audit and tax.

CHARACTERISITICS OF MAS ENGAGEMNTS

 Broad in scope
 Involves in problem solving
 Involves varied assignments
 Engagements are usually non-recurring
 Relates to the future (i.e., forward looking)
Page 35 of 40
  Engagements usually require highly qualified staff Human relations play a vital role in each engagement
 Services are rendered for the management that is usually a third-party client

BROAD STAGES IN MAS ENGAGEMENTS

1.) ANALYSIS STAGE – involves determining facts and circumstances, identifying objects, and defining the
problem or opportunity for improvement
2.) DESIGN STAGE – involves evaluating possible solutions, communicating findings and presenting
recommendations.
3.) IMPLEMENTATION STAGE – involves scheduling actions and providing technical assistance in the
implementation of the recommendations. (NOTE: to maintain independence, the business advisor shall NOT
implement the recommendations but provide technical assistance only in the implementation.

SPECIFIC STAGES IN MAS ENGAGEMENT

1. Negotiating the engagement
2. Preparing for and starting the engagement
3. Conducting the engagement
4. Preparing and presenting the reports and recommendations
5. Implementing the recommendations
6. Evaluating the engagement
7. Post engagement follow-up

MANAGEMENT CONSULTANT – refers to a person who is qualified by education, experience, technical expertise
to advise and assist businessmen on a professional basis in identifying and solving specific management problems
regarding business operations.

REASONS FOR HIRING MANAGEMENT CONSULTANTS

 A consultant is considered independent, objective and detached to the problems of the organization.
 A consultant possesses special knowledge and skills that are not normally available from company personnel.
 A consultant serves as a catalyst for much needed changes that are not normally perceived by company
personnel.
 In certain business situations, hiring consultants are less expensive than hiring-full time managers.

FACTORS FOR THE EMERGENCE & GROWTH OF MANAGEMENT CONSULTANCY

 Lack of competent staff
 Trend towards industrialization
 Growth in size and complexities of business firm
 Complexities in managing and conducting a business
 Emergence of new management solutions and techniques
 Need for adequate and timely information for management decision-making

DOCUMENTS USED TO FORMALIZE MANAGEMENT CONSULTANCIES & MAS ENGAGEMENTS

 CONTRACT – a legal document often prepared by the client, incorporating a proposal letter or engagement
letter prepared by the business advisor.
 PROPOSAL LETETR – an offer of service which, if accepted and approved by the client, becomes a contractual
engagement
 ENGAGEMENT LETTER – a contractual agreement used when he client has already agreed that the business
advisor will conduct the engagement.
 CONFRIMATION LETTER – a brief and concise statement of agreement previously reached with a client.
MANAGEMENT ADVISORY SERVICES by CPAs
Management consultancy is not limited to CPAs. However, CPAs have distinct advantages over other business advisors
as they are already familiar with the client and its business, and they enjoy the client’s confidence; CPAs are members
of a profession with recognized standing and equipped with technical know-how in accounting and taxation.

ESSENTIAL ATTRIBUTES THAT MAKE A CPA QUALIFIED TO RENDER MAS

 Technical competence
 Professional independence, objectivity and integrity
 Analytical ability and experience in solving business problems
 Familiarity with client’s finance, control systems and business problems

SCOPE OF MAS BY CPAs

Page 36 of 40
Mas engagements are usually connected with the services rendered by CPAs in the areas of auditing, tax, and
accounting, and may involve activities such as:
 Introducing new ideas, concepts, and methods to management.
 Counseling management in its analysis, planning, organizing, operating and controlling functions.
 Reviewing and suggesting improvement of policies, procedures, systems, methods, and organizational
relationships.
 Conducting special studies, proposing plans and programs, and providing guidance and technical assistance in
their implementation.

TYPES OF CLIENTS SERVED BY CPAs IN MAS ENGAGEMENTS

 Private-owned business firms
 Professional associations or organizations
 Governmental agencies and organizations
 Not-for-profit governmental organizations
 Other organizations like labor unions and religious groups

VARIOUS TYPES OF MANAGEMENT ADVISORY SERVICES BY CPAs

 Management Accounting-Related Services
This involves providing assistance to management related to planning and controlling business operations as well
as decision-making. (Examples: cost reduction studies, cost accounting systems, financial statement analysis,
budgeting, variance analysis and responsibility accounting)
 Financial Management-Related Services
This involves the study of working capital and long-term capital requirements as well as analysis and study of
capital investment proposals. (Examples: capital budgeting, working capital management, study on cost of capital
and optimal capital structure)
 Design and Appraisal of Accounting System
This involves development of an accounting system for a newly organized firm or the revision, partial or complete,
of an existing accounting system. (Examples: systems engagement and accounting software selection and
implementation.
 Global-Risk Management Solutions
This involve managing the totality of risks – financial, operational and systems – and overall strategy to improve
financial and business performance. (Examples: financial risk management, strategic risk management, systems
risk management, compliance risk management and internal audit services)
 Transaction Services
This involves services related to mergers, acquisition, divestitures, joint ventures and strategic alliances.
(Examples: due diligence services to uncover potential financial and strategic risk and rewards)
 Other Services:
 Project feasibility studies
 Financial advisory services
 Operations research (quantitative methods)
 Industrial engineering
 Project finance and privatization
 Valuation services
 Business recovery services
 Dispute analysis and investigations
 Compute risk management
 Organization and personnel
 General management
 Marketing consultation

MAS PRACTICE STANDARDS

CPAs performing management consulting and other advisory services are considered in the practice of
accountancy and are bound by the Code of Ethics for Professional Accountants. Consider the following MAS
Practice Standards:
1. Personal Characteristics – in performing MAS, a practitioner must act with integrity and objectivity and be
independent in mental attitude.
2. Competence – engagements are to be performed by a practitioner having competence in the analytical
approach and process, and in the technical subject matter under consideration.
3. Client Benefit – a practitioner should notify the client, before accepting the engagement, of any
reservations he may have concerning the realization of the anticipated benefits.
4. Due Professional Care – the MAS practitioner shall exercise due professional care by observing rules and
regulations applicable to specific MAS engagements.
Page 37 of 40
 5. Understanding with Client – before undertaking the engagement, a practitioner is to inform his client of
all significant matters related to the engagement.
6. Planning and Supervision – the MAS practitioner shall adequately plan and supervise an engagement in a
manner that provides reasonable assurance that the work is conducted in accordance with the under
professional standards and rules of conduct.
7. Sufficient Relevant Data – sufficient relevant data are to be obtained, documented and evaluated in
developing conclusions and recommendations.
8. Communication of Results – all significant matters relating to the result of the engagement (e.g., principal
findings, major facts and assumptions used) are to be communicated to the client.

PRACTICE EXERCISES:
1. What is the primary purpose of Management Advisory Services?
a. To help clients identify their problems
b. To help clients maximize their resources
c. To reach and service more potential clients by the CPA firm
d. To improve the client’s use of its capabilities and resources to achieve business objective

2. Which of the following is NOT a characteristic of Management Advisory Services (MAS)?

a. MAS is broad in scope
b. Beneficiary of service in management
c. MAS is repetitive as far as the same client is concerned
d. MAS involves problem-solving affecting future operations of the client

3. Which of the following is NOT a qualification of a CPA in MAS practice?

a. Auditor of the client
b. Analytical experience in problem solving
c. Professional independence, objectivity and integrity
d. Familiarity with the client’s financial accounting and internal control systems

4. Which of the following statement is true?

a. Strict adherence to generally accepted accounting principles in MAS is required
b. In a management services engagement, the independent CPA renders technical advice
c. A non-CPA is prohibited under the revised accountancy law to engage in professional management
advisory services to practice
d. A CPA in management services engagement may take position that would impart its independence if the
client is not his audit client currently.

5. Which of the following is NOT an area in MAS practice?

a. Conducting special studies
b. Marketing and public relations work
c. Introducing new ideas, concepts and methods
d. Reviewing and suggesting improvement of policies, procedures, systems and methods
6. Management and Services of CPAs cover all the following, EXCEPT
a. Project feasibility study c. System design and implementation
b. Audit, tax and legal services d. Organizational development and planning

7. The MAS engagement that involves providing assistance to management in relation to planning, controlling
and decision making.
a. Financial management c. Taxation
b. Management accounting d. Financial Accounting

8. This engagement involves the review of compliance with regulatory requirement and ethical conduct
standards.
a. Strategic risk management c. Operational and systems risk management
b. Financial risk management d. Compliance risk management

9. These involves services related to mergers, acquisitions, divestitures, joint ventures, spin-off and strategic
alliance.
a. Strategic risk management c. Compliance risk management

Page 38 of 40
 b. Due diligence audit d. Financial risk management

10. Management consultancy

a. Is limited to CPAs c. Can be practiced by anybody
b. Is not limited to CPAs d. is exclusive to the CPA profession

11. Most definitions of `consultancy’ would include services related to the following, EXCEPT
a. Information technology c. Legal advisory
b. Corporate strategy d. Systems and operations management

12. Which of the following is NOT common reason for hiring a management consultant?
a. To render an independent opinion
b. To provide specialized skills and experience
c. To serve as a catalyst for needed changes in the workplace
d. To implement solutions and decide on business matters on behalf of the client

13. It is an offer of service which, if accepted and approved by the client, becomes a contractual agreement.
a. Contract c. Engagement letter
b. Confirmation letter d. Proposal letter

14. The engagement letter generally includes the following, EXCEPT

a. Objectives and benefits
b. Fees and billing arrangement
c. Scope of the work and the role of the consultant
d. Personnel who will be assigned to the engagement team

15. The MOST important factor in selecting an engagement team is to assign consultants
a. With prior experience in the client’s industry
b. With a combination of skills and experiences in various business functional areas as well as in different
industries
c. With the appropriate skills, experiences and types of thinking to deal effectively with the client’s problem
d. Who are likely to employ different approaches to problem solving, such as highly imaginative thinking, or
unusual skill in the interpretation and use of financial and statistical data

16. Factors that must be considered when defining the target level of competence of management consultants
include the following, EXCEPT
a. Scope of practice area c. Service variety
b. Client requirement d. Investment required

17. The following are considered in determining that scope of services that a CPA may perform, EXCEPT
a. Independence c. Requirement for specialization
b. Competence d. Range of fees that the CPA will earn

18. As a business consultant, the CPA practitioner should

a. Encourage dependence of client on the consultant’s staff so as to pinpoint clear responsibility in
implementing systems
b. Exercise administrative control over the client’s staff to avoid unnecessary delays in implementation.
c. Not take responsibility for making decisions and policy judgments in MAS engagements
d. Conduct his engagement as if he is a member of the client’s organization

19. Which of the following statements is NOT acceptable?

a. A CPA provides consulting services to an existing audit client
b. A CPA offers and provides consulting services to two major competing clients
c. A CPA shares with a new client substantial information regarding another client belonging to same
industry
d. A CPA represents three major players in rationalizing the industry’s incentives before the government
public hearings

20. A management advisory services engagement generally involves the following activities in what particular
order? (NOTE: this question was given/asked in the 1996 CPA Licensure Examinations)
I. Post engagement follow-up
II. Implementing the recommendation
III. Conducting the engagement
Page 39 of 40
IV. Negotiating the engagement
V. Preparing for and starting the engagement
VI. Evaluating the engagement
VII. Preparing and presenting the report and recommendation
a. VII,VI,V,IV,III,II and I
b. III,IV,V,VI,VII,I and II
c. IV,III,V,VI,II,VII and I
d. IV,V,III,VII,II,VI and I

Page 40 of 40