Part –IIManagement Accounting

MANAGEMENT ACCOUNTING

• Management Accounting is the process within an organization that provides information used by managers in planning, implementing, & controlling the organization’s activities.

• The process includes the identification, measurement, accumulation, analysis, preparation, interpretation & communication of the information needed by management to perform its functions.

Managerial Accounting and Financial Managerial Accounting and Financial AccountingAccounting

Little Insight to Management Accounting

• M.A. provides historical & estimated information on full costs & components of full costs structured by responsibility centers to support the measurement & control purpose of management accounting information;

• In Management Accounting, ‘COST’ is defined differently depending on the purpose;

• that accounting numbers are approximations; • that rarely they provide exactly the information needed;• that much more than accounting information is needed in

solution of a problem; &• that people, & not numbers, get things done.

COST ESTIMATION & MANAGEMENT

• COST: Resources sacrificed or forgone to achieve a specific objective. Usually measured as the monetary amount that must be paid to acquire goods & service.

• COST OBJECT: Any activity or item for which a separate measurement of cost is desired. Any change made in any of the cost drivers will cause a change in the total cost.

• Expl.: No of units produced, No. of set-ups, No.of items distributed etc.

Flow of Manufacturing Activities

Raw Materials

Beginning Inventory

Raw Materials

Purchases

Goods in Process

Beginning Inventory Finished Goods

Beginning Inventory

Raw Materials Used

Direct Labour Used

Materials ActivityMaterials Activity

(raw materials)(raw materials)

Financial Reports Raw MaterialsEnding Inv.

(balance sheet)

Production ActivityProduction Activity

(goods in process)(goods in process)

Goods in ProcessEnding Inv.

(balance sheet)

Finished GoodsFinished GoodsEnding Inv. Inv.

(balance sheet)(balance sheet)

Cost of Goods Cost of Goods Sold (income Sold (income

statement)statement)

Marketing ActivityMarketing Activity

(finished goods)(finished goods)

Goods

Manufactured

Factory Overhead

Used

COST SYSTEM

• A costing system accounts for costs in two basic stages – Accumulation & then assignment/ allocation.

1. Cost Accumulation: Collection of cost data in an organized way by means of an accounting system – eg. Raw materials used, fuel consumed, labour payment etc.

2. Cost Allocation: After accumulation, cost system allocates or traces the cost to cost objects.

Cost AllocationDirect vs. Indirect Costs

• Direct Costs of a cost object are related to the particular cost object & can be traced to it in an economically feasible (cost effective) way.

• Eg.: Cost of can or bottle is a direct cost of a soft drink producer.

• ‘Cost Tracing’ is used to describe the assignment of direct cost to particular cost object.

Indirect Cost

• Indirect costs of a cost object are related to the particular cost object but can not be traced to it in a cost effective way.

• Eg.: Cost of Quality – Control personnel conducting tests on multiple soft-drink products.

• ‘Cost Allocation’ is used to describe the assignment of indirect costs to particular cost object.

Cost Allocation

Maintenance FactoryAccounting

Electricity

MachiningDepartment

Assembly Department

Stage 1

Service Departments

Stage 2

Job 236 Job 237 Job 238

Elements of Cost

Materials Labour Other Expenses

Direct Indirect Direct Indirect

Indirect

OVERHEADS

Production orWorks Overhead

Office & AdministrativeOverhead

Selling & Distribution Overhead

COST

Statement of Cost Direct Material (+) Direct Labour

PRIME COST (+) Factory Overheads

WORKS/FACTORY/MANUFACTURING COST

(+) Office & Administrative OverheadsCOST OF PRODUCTION

(+) Selling & Distribution OverheadsCOST OF SALES

“Factory overheads’ are not expenses – they are part of Inventoriable cost & will funnel into the expense stream only when the inventoriable costs are released as ‘COGS’.

Inventoriable Costs/Unexpired Costs/Manufacturing Cost

Period Costs/Expired Costs/ Non- Manufacturing Expenses

Cost Classifications

• Costs can be classified by:–Relevance

–Behaviour

Costs Classification by Relevance

• Relevant– If costs influence a decision

• Costs that are applicable to a particular decision.Costs that are applicable to a particular decision.• Costs that should have a bearing on which Costs that should have a bearing on which

alternative a manager selects.alternative a manager selects.• Costs that are avoidable.Costs that are avoidable.• Future costs that differ between alternatives.Future costs that differ between alternatives.

• Irrelevant– If costs do not influence a decision

Costs Classification by Relevance

• Sunk Costs– All costs incurred in the past that cannot be

changed by any decision made now or in the future.– should not be considered in decisions.– Irrelevant– Example: You bought an automobile that cost

Rs.30,000 two years ago. The Rs.30,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the Rs.30,000 cost.

Costs Classification by Relevance

• Out-of-pocket costs– require future outlays of cash– associated with a particular decision– relevant for future decisions– Example: Considering the decision to take a

vacation or stay at home, if you choose a vacation, you will only have travel costs (out-of-pocket costs).

Costs Classification by Relevance

• Opportunity Costs– The potential benefit that is given up when one

alternative is selected over another.– Example: If you were not attending college or

university, you could be earning Rs.25,000 per year. Your opportunity cost of attending college or university for one year is Rs.25,000..

Costs Classification by Behavior

• Cost behavior refers to– how a cost will react to changes in the level of business activity.

• Fixed costs – Do not change when activity changes. Remains fixed in total for

a given period of time despite wide changes in the related level of total activity or volume (within the relevant range).

These are period costs i.e. Lease rental, Insurance of factory buildings etc.

• Variable costs – Change in proportion to changes in the volume of activity. These

are basically product costs i.e. Direct Material Cost, Direct Labour Costs, power, repair etc.

Total variable costs change when activity changes.

Variable costs per unit do not change as activity increases.

Variable Costs

Volume of activity

Tot

al v

aria

ble

cost

s

Volume of activityVar

iabl

e co

sts

per

unit

Variable Cost Example

• Consider the case of Manufacturing plant of Maruti at Gurgaon.

• Assume that Maruti buys a steering wheel at Rs.3,000 for each of its Swift lxi model Vehicle

• If Maruti produces 2,000 Swift-Lxi, total cost of steering wheels would be Rs.60,00,000.

Variable Costs Example

0 1 2 3 4 5

Rs240 –

Rs180 –

Rs120 –

Rs60 –

– – ––

Volume(Thousands Swift cars)

Tot

al V

aria

ble

Cos

ts(0

0’00

0)

Volume of ActivityVolume of Activity

Fix

ed c

osts

per

uni

tF

ixed

cos

ts p

er u

nit

Volume of ActivityVolume of Activity

Tot

al fi

xed

cost

sT

otal

fixe

d co

sts

• Total fixed costs remain unchangedTotal fixed costs remain unchangedwhen activity changes within a relevant range.when activity changes within a relevant range.

• Fixed costs per unit decline as activity increases.Fixed costs per unit decline as activity increases.

Fixed CostFixed CostFixed CostFixed Cost

Fixed Costs ExamplePlant leasing cost is Rs.200,00,000 for its Gurgaon plant for a designated

range of number of vehicles assembled during a month.

0 1 2 3 4 5

Rs400 –

Rs300 –

Rs200 –

Rs100 –

– – ––Volume

(Thousands of vehicles)

Tot

al F

ixed

Cos

ts(0

0’00

0)

Relevant Range...

– is a band of volume in which a specific relationship exists between cost and volume.

• Outside the relevant range, the cost either increases or decreases.

• A fixed cost is fixed only within a given relevant range and a given time span.

Relevant RangeF

ixed

Cos

ts (

Rs.

)

Volume in Units

160,000 –

120,000 –

80,000 –

40,000

0 5,000 10,000 15,000 20,000 25,000

– – –

Relevant Range

Relevant Range – Step Cost

• Step-Wise Costs– remain fixed over limited ranges of volumes but remain fixed over limited ranges of volumes but

increase by a lump sum when volume increases beyond increase by a lump sum when volume increases beyond maximum amounts.maximum amounts.

– Example:Example: additional production supervisors must be additional production supervisors must be added when another shift is added.added when another shift is added.

Su

perv

iso

ry S

ala

ries

Su

perv

iso

ry S

ala

ries

Production VolumeProduction Volume

Mixed Cost

• Semi- fixed/ Semi-variable costs– contain a combination of fixed and variable costs.contain a combination of fixed and variable costs.

Variable Variable

Sales CommissionsSales Commissions

Sales Sales

To

tal

Co

mp

ensa

tio

n

Total mixed cost

Total mixed cost

Fixed Fixed

Monthly salaryMonthly salary

Mixed Costs Example

• A mixed cost is part variable and part fixed (as most of the costs are neither perfectly fixed, nor perfectly variable).

• Assume a department of a company has fixed costs of Rs.50 per month (Rs.600 per year).

• There are also variable costs of Rs.3 per hour.

Mixed Costs Example

0 125 250 375 500 625

Rs2,475 –

Rs2,100 –

Rs1,350 –

Rs600 –

– – ––Volume (hours)

Tot

al

Cos

ts VariableCost

FixedCost

Estimating Cost – Volume Relationship

• Several methods are used to estimate the cost volume relationship, i.e. to arrive at the total fixed cost & the unit variable cost in the equation –

• TC = TFC + (UVC * X)

1. Judgment Method

• Using judgment in deciding how much of cost of each item or category will vary with volume & what will be the amount of fixed cost.

• Appropriate where;• Cost estimation for a situation where historical data are

irrelevant viz, a proposal to introduce a new product with a new process.

• The reliability of the results depends on the experience & skill of the estimator.

• Also known as ‘Account-by-Account Method’ as the analyst considers each account in the cost structure & judges whether the costs in that account are variable, fixed or semi-variable.

2. High – Low Method

1. Estimate total costs at each two volume levels, which identifies two points on the line – the upper & lower limits of the relevant range are selected for the purpose.

2. Subtract total cost at lower volume from the higher one & also subtract the corresponding lower volume from the higher.

3. Divide the difference in cost by difference in volume to arrive at the Unit Variable Cost (UVC).

4. Multiply either of the volumes by UVC & subtract the result from the total cost at that volume to arrive at the Fixed Cost.

3. Scatter Diagram

• Make a diagram in which actual costs recorded in past periods are plotted (on the vertical axis) against the volume of levels in those periods ( on the horizontal axis).

• Data on costs & volumes for each of the preceding several months may be used for the purpose.

• Draw a line that best fits the observation by visual inspection of the plotted points.

• The FC & TVC values are then determined by reading the values for any two points on the line and using the High-Low Method discussed previously.

Scatter diagram with High-Low Method of Cost Estimation

Indirect 1,456

Labour

Costs 710

Rs.

46 96Machine Hours

xx x

x xx x

x

Variable cost = Change in cost / Change in volume= (Rs1,456 – Rs.710) / (96 - 46) = Rs.14.92

per MH

Fixed cost = Mixed cost at high point - variable cost= Rs1,456 - (96 x Rs.14.92)= Rs.23.68 per week

Cost function =

Rs(23.68 + 14.92) per machine hour

Regression Analysis Method• Regression analysis is a statistical method that measures

the average amount of change in the dependent variable (x) that is associated with a unit change in one or more independent variable (s)

• Simple linear regression - one independent variable• Multiple regression - more than one independent variable• Allows for the evaluation of the quality of the cost function

– Coefficient of determination (R-Squared) measures the goodness of fit of the line to the underlying data

– t-value measures the potential error of the estimated variables

4. Linear Regression Method of Least Square

• This approach provides two mathematical properties that are missing in all previous methods.

• Σy = na + b Σx…………..(1)• Σxy = a Σx + b Σx2 ……..(2)

• Where Σy = Total cost; Σx = Total Volume• a= Total Fixed cost;• b= Variable cost per unit;• n= No. of time period• Σxy = Cost, time, volume summed

Nonlinearity Cost Function

Nonlinear cost function• a cost function in which the graph of total costs versus a

single cost driver does not form a straight line within the relevant range

Time

Cumulative Total Volume

NonlinearCost Function

(Learning Curve)

Nonlinear Cost Functions

1. Economies of Scale2. Quantity Discounts3. Step Cost Functions – resources increase in

“lot-sizes,” not individual units4. Learning Curves – labor hours consumed

decrease as workers learn their jobs and become better at them

5. Experience Curve – broader application of learning curve that includes downstream activities including marketing and distribution

Types of Learning Curves

• Cumulative Average-Time Learning Model – cumulative average time per unit declines by a constant percentage each time the cumulative quantity of units produced doubles

• Incremental Unit-Time Learning Model – incremental time needed to produce the last unit declines by a constant percentage each time the cumulative quantity of units produced doubles

Data “Problems”1. Some “variable” costs are actually allocated

fixed costs

2. Missing data points

3. Errors in recording data points

4. Lack of a homogeneous relationship between the dependent variable pool and cost driver

5. Collection periods for variables differ

6. Relationship between cost and cost driver is unstable

7. Impact of inflation on data points over time