self reading notes 3 management accounting

7/25/2019 Self Reading Notes 3 Management Accounting

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Unit 3: Management Accounting

3.1 What is management accounting ?

Management accounting is involved with the provision of information (not raw data) to

managers and employees to help them to make decisions about the company. In thisregard it is internally focused and involves providing information on activities to helpthem to plan, direct, control and make decisions. This also means that, unlike financialaccounting, it is not subjected to legal reuirements or accounting standardsand may provide information that helps make decisions relevant to individual or parts ofthe business rather than the organi!ation as a whole. Management accountants provideinformation from a range of sources including the core accounting system, physical andoperational data from production systems, market, customer and economic data frominformation sources that may be e"ternal to the organi!ation.

The key uestions to think about as a management accountant are#

What information is required ? This information should be future oriented and

should be limited to that which is likely to be relevant to a business decision.$urthermore, this information should not reuire any further processing by those forwhom it is being provided. It should also include a range of financial and non%financial information to help the decision maker to understand the both the financialand social and conte"tual implications of decisions.

What skills does the user have ? &ome users may be less numerately skilled.

In what form should this information e !resented ? 'raphs, pie charts, tables,trend analysis.

management accounting system is used to record and collect information. This system

should be tailored to the organi!ations reuirements but commonly contains the followingcomponents#

A costing and cost management s"stem* this is used to record the cost of goods

and services and the costs of departments, locations etc. It also provides informationfor the improvement of an organi!ations costs.

A udgeting s"stem* this provides a detailed plan of the organi!ations operatingactivities and associated costs and revenues for a specified period of time such as ayear.

A !erformance measurement s"stem* this is used to compare the actualperformance with the planned targets for performance.

In this unit, we will be learning only about costing. If you are interested in advanced topics onbudgeting and performance measurement, please refer to the source textbook (Atkinson etal., Management Accounting, 5 th edition, earson publishing!.

3.# $osting

+ne common decision that a management accountant faces is to figure out which costs arerelevant for a decision. The term cost refers to a monetary measure of resources sacrificedto achieve a particular objective. There are different costs for different decisions. Tounderstand how costs are used in management accounting we refer to some of the morecommonly employed terms such as cost object, direct and indirect costs, manufacturingoverhead etc..


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3.#.1 $ost %&ect

cost o&ect refers to any activity or product for which the measurement of cost isreuired. ost objects may therefore range from the cost of operating a location, the costof a customer, the cost of operating a division or more obviously a product.

3.#.# 'irect and indirect costs

D i rect c o s t s: Those costs that can be specifically and e"clusively identified with a particularcost object. s an e"ample we can mention the wood for manufacturing a particular type of adesk in an organi!ation.

I n d ire c t c o s t s: Those costs that can -+T be identified specifically and e"clusively with agiven cost object. s an e"ample we can mention the salaries of factory supervisors or therent of the factory.

It is considerable that sometimes direct costs are treated as indirect because tracing costs

directly to the cost object is not cost effective. s an e"ample of this part we can mention thenails used to manufacture a particular desk. ecause the e"pense of nails is insignificant,their cost is not that much considerable for justifying the profit.

nother point that should be considered is that a cost can be treated as direct for one costobject but indirect in respect of another. $or e"ample if the cost object is the cost of usingdifferent distribution channels, then the rental of warehouses will be regarded as direct cost./owever, if the cost object is the product, that cost will be considered as indirect one.

3.#.3 $ategories of manufacturing costs

Traditional cost accounting systems accumulate product costs as follows#

0irect materials1111.11 """0irect labor1.11111.1. " ""2rime cost11111.11.1 """Manufacturing overhead1.1. """Total manufacturing cost...1..."""

D i rect m a t e r i als : consist of all those materials that can be identified with a specific product.s an e"ample wood that is used to manufacture a desk can easily be identified as part ofthe product and can thus be classified as direct materials.

I n d ire c t m a t e r i als : These items of materials can -+T be identified with any one product,because they are used for the benefit of all products rather than for any one specific product.s an e"ample the materials that used for the repair of a machine that is used for themanufacture of many different desks are classified in this group. Indirect materials are part ofmanufacturing overhead cost.

D i rect l a b or c o s t s: consists of those labor costs that can be specifically traced to oridentified with a particular product. s an e"ample of this category we can mention wages ofoperatives who assemble parts into the finished product.

I n d ire c t la b or c o st s : consists of those labor costs that can -+T be specifically traced to oridentified with a particular product. s an e"ample of this part we can mention the wages of

all employees who do not work on the product itself but who assist in the manufacturingoperation.


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P r i me c o s t: refers to the direct costs of the product and consists of direct labor costs plusdirect material costs.

M a n ufa c t ur ing o v e rhe a d: consists of all manufacturing costs other than direct labor, directmaterials and direct costs. Therefore it includes all indirect manufacturing labor andmaterials costs plus indirect manufacturing costs. 3ent of the factory and depreciation ofmachinery in a multi%product company are classified in this category.

In order to determine the total of the direct costs or the prime cost for a product, the totalresources used should be multiplied by the price paid per unit of resources used.

C o s t all o c a ti o n s : It is the process of estimating the cost of resources consumed byproducts that involves the use of surrogate, rather than direct measures.

3.#.( )lements of a !roduct

%ther manufacturing

Materials costs *aor

'irect Indirect Indirect 'irect

'irect materials +actor" overhead 'irect laor

3.#., -eriod and !roduct costs

P rod u ct c o st s : Those costs that are identified with goods purchased or produced for resale.4sually, accountants consider the cost of finished goods or partly completed goods until theyare sold.

P er i od c o sts: those costs that are -+T included in the inventory valuation and as a resultare treated as e"penses in the period in which they are incurred.

In manufacturing organi!ation all manufacturing costs are regarded as product costs andnon *manufacturing costs are regarded as period costs. The cost of the goods purchased bycompanies that are operating in merchandising is regarded as a product cost and all othercosts such as administration and selling and distribution e"penses are considered to beperiod costs.


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3.#. $ost ehavior

V ar i a b l e c o s t s: &hort term variable costs are those in which the total cost changes in directproportion to changes in volume, or output, within the relevant range, while the unit costremains constant. 5ariable costs are controlled by the department head responsible for

incurring them. In simple words it means if we double the level of activity the total variablecost will be doubled. &o it is clear that total variable costs are linear and unit variable cost isconstant.

Total 4nitvariable variablecost cost

6777

87

8777

977877 677 877 :77 677

ctivity level ctivity level4nits of output 4nits of output

Fixed c o st s : $i"ed costs are those in which total fi"ed cost remains constant over a relevant

range of output, while the fi"ed cost per unit varies with output ($or a specified period oftime) and the unit fi"ed costs decreases. s e"ample of fi"ed cost we can mentiondepreciation of the factory building, supervisors salaries and leasing charges for cars usedby the sales force.

Total 4nit$i"ed $i"edost cost

ctivity level ctivity level


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)/am!le 3.1

&uper'lass ompany manufactures several interior architecture glass products. 4nit costsassociated with a super strong glass product for stairs &&';777 is

0irect materials < :770irect labor 975ariable support costs =7$i"ed manufacturing support costs 877&ales commissions (:> of sales) 87dministrative salaries ;7Total < 9=7

Total product costs:77 ? 97 ? =7 ? 877 @ 977

Total period costs

87 ? ;7 @ =7

Total variable costs#:77 ? 97 ? =7 ? 87 @ 6;7

Total fi"ed costs#877 ? ;7 @ 8;7

Total nonmanufacturing costs#87 ? ;7 @ =7

Total manufacturing costs#

:77 ? 97? =7 ? 877 @ 977

0irect manufacturing costs#

:77 ? 97@ :97

"ote# $ecause %uper&lass is a manufacturing company, the total period andnonmanufacturing costs are the same.


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3.3 $ost0olume0-rofit 2$- Anal"sis

This analysis is important for providing answer to uestions such as#

A /ow many units must be sold for a company to break even (!ero profit) BA Chat would be the effect on profits if we reduce our selling price and sell more units B

reakeven can be computed by using either#

(8) Duation method or the(:) The graph method.

Cith the euation approach, breakeven sales in units is calculated using the followingrelationship#

(4nit sales price " 4nits sold) * (5ariable unit cost " 4nits sold) * $i"ed e"penses@ +perating profit

Breakevenunits Fixed expenses

Unit sales price -Variable

unit cost

4sing the graph method, we plot a line for total revenues and total costs. This means thatthe breakeven point is the point at which the total revenue line intersects the total costline. The area between the two lines to the right of the breakeven point is the operatingprofit area.


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3.( $ost Allocation

ost allocation involves the allocation of indirect costs to a cost object. These costs cannotbe traced to it in an economically feasible (cost effective) way. There are at least fourreasons why organi!ations allocate these costs#

To provide8. information for economic decisions (e.g. To decide whether to add a new product or todecide whether to manufacture a component part or to purchase it from anothermanufacturer, or to decide on the selling price for a product).:. To motivate managers and other employees.6. To justify costs or compute reimbursement.9. To measure income and assets for reporting to e"ternal parties

Management ccountants traditionally used relatively unsophisticated methods to allocateindirect costs to cost objects. The result of this is cost smoothing where some products areunder%costed and others over%costed. In response, activit" ased costing 2A4$ systems

were developed. In this section we focus first on developing your understanding of thetraditional systems and then we e"plain the activity based system in the ne"t section Ce willillustrate both traditional and methods with e"amples.

)/am!le 3.# 5 6raditional $ost Allocation.

osts are normally allocated using (a) 0irect method (b) &euential method and (c)3eciprocal method. Eets Illustrate this with an e"ample.

/iTec Dlectronics (fictional company) manufactures E0 2anels on the outskirts of Eeeds.The following information is available about the manufacturing site#

A Total suare feet @ 677,777A Total number of employees @ 877A Maintenance is allocated to different departments using suare feet.

A /uman 3esources are allocated using number of employees in each department.

udgeted costsMaintenance 7uman 8esources

before allocations#


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A The allocation ratio for allocating /uman 3esources toAssembly is;7FG; " ) "


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8eci!rocal Method:llocates costs by including the mutual services provided among allsupport departments.

MaintenanceM /3 $% 8H.;> 99.9> 6G.7>

/uman 3esources 88.H> % ;H.H> :.9>

A Maintenance cost (M8) @


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te! 1: $alculate activit" cost driver rates

Activit" Activit" $ost 'river

/andle 2roduction 3uns < ;77 per run&et up machines =7 per setup hour &upport products ;7,777 per product3un Machines 97 per machine hour

te! #: $alculate activit" e/!ense for each !roduct

Activit" A$'9 A) A$'9 A)71;1 71;1 A6#;1 A6#;1

/andle 2roduction 3uns =77

self reading notes 3 management accounting

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