Introduction to management accounting, cost concepts and classification
- 1. Introduction to Management Accounting and Cost Concepts and Classification 1 UNIT FOUR Compiled & Prepared by: Shewit kinfe, University of Gondar, Ethiopia
- 2. Definition of Management Accounting Management accounting involves preparing and providing timely financial and statistical information to business managers so that they can make day-to- day and short-term managerial decisions. Management accounting can be viewed as Management-oriented Accounting. Basically it is the study of managerial aspect of financial accounting, "accounting in relation to management
- 3. FUNCTIONS OF MANAGEMENT ACCOUNTING The basic function of management accounting is to assist the management in performing its functions effectively. The functions of the management are planning, organizing, directing and controlling. Management accounting helps in the performance of each of these functions in the following ways:
- 4. Cont…Provides data: Management accounting serves as a vital source of data for management planning. The accounts and documents are a repository of a vast quantity of data about the past progress of the enterprise, which are a must for making forecasts for the future. Modifies data: The accounting data required for managerial decisions is properly compiled and classified. For example, purchase figures for different months may be classified to know total purchases made during each period product- wise, supplier-wise and territory-wise.
- 5. Cont…Analyses and interprets data: The accounting data is analysed meaningfully for effective planning and decision-making. For this purpose the data is presented in a comparative form. Ratios are calculated and likely trends are projected. Serves as a means of communicating: Management accounting provides a means of communicating management plans upward, downward and outward through the organization. Initially, it means identifying the feasibility and consistency of the various segments of the plan. At later stages it keeps all parties informed about the plans that have
- 6. Facilitates control: Management accounting helps in translating given objectives and strategy into specified goals for attainment by a specified time and secures effective accomplishment of these goals in an efficient manner. All this is made possible through budgetary control and standard costing which is an integral part of management accounting. Cont…
- 7. MANAGEMENT ACCOUNTING AND FINANCIAL ACCOUNTING Financial accounting and management accounting are closely interrelated since management accounting is to a large extent rearrangement of the data provided by financial accounting. In spite of such a close relationship between the two, there are certain fundamental differences. These differences can be laid down as follows:
- 8. Comparison of Financial Accounting and Managerial Accounting Financial Accounting Managerial Accounting Objective It is designed to supply information in the form of profit and loss account and balance sheet accounts. It is primarily an external reporting process It is designed principally for providing accounting information for internal use of the management. It is primarily an internal reporting process. Time focus Financial accounting is concerned with the monetary record of past events. Historical perspective Management accounting is accounting for future and, therefore, it supplies data both for present and future duly analysed in detail . Future emphasis Precision versus timeliness Emphasis on precision Emphasis on timeliness
- 9. Financial Accounting Managerial Accounting Monetary measurement In financial accounting only such economic events find place, which can be described in money. In management accounting, management is equally interested in non monetary economic events, viz., technical innovations, personnel in the organization, changes in the value of money, etc and these events affect management's decision Analyzing performance Financial accounting portrays the position of business as a whole. The financial statements like income statement and balance sheet report on overall performance or statues of the business. Financial accounting deals with the aggregates and, therefore, cannot reveal what part of the management action is going wrong and why. Primary focus is on the whole Management accounting directs its attention to the various divisions, departments of the business and reports about the profitability, performance, etc., of each of them. Management accounting provides detailed analytical data for the problems. Focuses on segments of an organization
- 10. Financial Accounting Managerial Accounting Periodicity of reporting The period of reporting is much longer in financial accounting as compared to management accounting. The Income Statement and the Balance Sheet are usually prepared on a yearly bases or in some cases half-yearly. Management requires information at frequent intervals and. In management accounting there is more emphasis on furnishing information quickly and at comparatively short intervals as per the requirements or needs of the management. Accounting principles It must follow GAAP and prescribed format Need not follow GAAP and any prescribed format
- 11. Financial Accounting Managerial Accounting Nature Financial accounting is more objective. It emphasis on verifiability Management accounting is more subjective. This is because management accounting is fundamentally based on judgement rather than on measurement. Emphasis on relevance for planning and control Legal compulsion/ requirement Mandatory for external report Not mandatory
- 12. Cont…. The above points of difference between Financial Accounting and Management Accounting prove that Management Accounting has flexible approach as compared to rigid approach in the case of Financial Accounting. In brief, financial accounting simply shows how the business has moved in the past while management accounting shows how the business has to move in the future.
- 13. COST ACCOUNTING AND MANAGEMENT ACCOUNTING Cost accounting is generally indistinguishable from management accounting. However, management accounting can be distinguished from cost accounting in one important respect. Management accounting has a wider scope as compared to cost accounting. Cost accounting deals primarily with cost data(determination and the control of costs) while management accounting involves the considerations of both cost and revenue. Management accounting is an all inclusive accounting information system, which covers financial accounting, cost accounting, and all aspects of financial management.
- 14. Cost concepts and classification Definition of Cost: An amount that has to be paid or given up in order to get something. In business, cost is usually a monetary valuation of effort, material, resources, time and utilities consumed, risks incurred, and opportunity forgone in production and delivery of a good or service. All expenses are costs, but not all costs (such as those incurred in acquisition of an income- generating asset) are expenses. Simply, accountants define cost as a resource sacrificed or forgone to achieve a specific objective.
- 15. Cost classification Recall that one of the purposes of managerial accounting is to provide management with information about the costs of products or services. Companies incur different types of costs that can be classified based on certain characteristics. Each cost classification provides management with a different type of information to be applied in analysing different business situations and these costs are classified differently according to the immediate need of management and other users. Costs can be classified commonly based on the following attributes:
- 16. Based on cost assignment (by Traceability): 1. Direct cost: Direct costs of a cost object are related to the particular cost object and can be traced to it in an economically feasible (cost-effective) way. For example, the cost of steel or tires is a direct cost of a car and salary of a workers who directly attached with the specific car/product.
- 17. Cont…. 2. Indirect cost: Indirect costs of a cost object are related to the particular cost object but cannot be traced to it in an economically feasible (cost-effective) way. For example, the salaries of plant administrators (including the plant manager) who oversee production of the many different types of cars produced at the plant are an indirect
- 18. Based on Cost-Behavior Cost behavior refers to how a cost will react to changes in the level of activity. The most common classifications are: Variable costs Fixed costs Mixed costs Variable Costs: Are costs that change proportionately (in total) with the activity level within a relevant range of activity.
- 19. Cont…. Fixed Costs: Are costs that do not change in total as activity level changes within a relevant range of activity. Mixed Costs: A mixed cost is one that contains both variable and fixed cost elements together. Mixed cost is also known as semi variable cost. Examples of mixed costs include electricity and telephone bills. A portion of these expenses are usually consists line rent. Line rent normally is fixed for each month.
- 20. Total Variable and Fixed Costs $ Number of units Number of units $ Total Fixed Cost
- 21. $ Number of units Number of units $ Variable and Fixed Costs Per Unit Per Unit Variable Cost
- 22. A) Based on the function of cost: Manufacturing costs: are those costs that are directly involved in manufacturing of products and services. Manufacturing cost is divided into three broad categories by most companies. a) Direct materials cost b) Direct labor cost c) Manufacturing overhead cost. a) Direct Material: it refers to those materials which become an integral part of the final product and can be easily traceable to specific physical units. Example: Steel, tire parts of a car
- 23. Cont…. b) Direct Labour: It is defined as the wages paid to workers who are engaged in the production process and whose time can be conveniently and economically traceable to specific physical units. Direct labor is sometime called touch labor, since direct labor workers typically touch the product while it is being made. c) Manufacturing Overhead Cost: is the third element of manufacturing cost, that is not directly associated with a product, that is , all costs other than direct materials cost and direct labour cost. It includes the cost of indirect material and indirect labour along with other expenses like electric power, depreciation etc
- 24. Cont…. Indirect Labour: Labour employed for the purpose of carrying out tasks incidental to goods produced or services provided is called indirect labour or indirect wages. In short, wages which cannot be directly identified with a job, process or operation, are generally treated as indirect wages. Indirect Material: all materials which are used for purpose ancillary to the business and which cannot conveniently be assigned to specific physical units are known as `indirect materials’. Oil, grease, consumable stores, printing and stationery material etc.
- 25. Cont…. Non-manufacturing Costs: Non-manufacturing costs are those costs that are not incurred to manufacture a product. Generally non-manufacturing costs are further classified into two categories. a) Marketing and Selling Costs b) Administrative Costs a) Marketing and Selling Costs: Marketing or selling costs include all costs necessary to secure customer orders and get the finished product into the hands of the customers. These costs are often called order getting or order filling costs. Examples of marketing or selling costs include advertising costs, shipping costs,
- 26. Cont…. b) Administrative costs: include all executive, organizational, and clerical costs associated with general management of an organization rather than with manufacturing, marketing, or selling. Examples of administrative costs include executive compensation, general accounting, secretarial, public relations, and similar costs involved in the overall, general administration of the organization as a whole.
- 27. Summary of manufacturing and non-manufacturing costs Manufacturing Costs Direct Materials: Materials that can be physically and conveniently traced to a product, such as wood in a table. Direct Labor: Labor costs that can be physically and conveniently traced to a product such as assembly line workers in a plant. Direct labor is also called touch labor cost. Manufacturing Overhead: All costs of manufacturing a product other than direct materials and direct labor, such as indirect materials, indirect labor, factory utilities, and depreciation of factory equipment. Non-manufacturing Costs Marketing or selling costs: All costs necessary to secure customer orders and get the finished product or service into the hands of the customer, such as sales commission, advertising, and depreciation of delivery equipment and finished goods warehouse. Administrative Costs: All costs associated with the general management of the company as a whole, such as executive compensation, executive travel costs, secretarial salaries, and depreciation of office building and equipment.
- 28. Prime and Conversion Costs Another way of classifying manufacturing cost as: Prime costs combine direct costs of direct materials and direct labor. Conversion costs are the costs to convert raw materials into finished goods: direct labor plus manufacturing overhead. Prime cost = DM + DL Conversion cost = DL + MOH
- 29. Based on their association with the product: Product Costs: product costs are traceable to the product and include direct material, direct labour and manufacturing overheads. In other words, product cost is equivalent to manufacturing cost. When products are sold, product costs are recognized as an expense (cost of goods sold). The costs of unsold products remain in inventory and are not expensed (i.e. not deducted from revenue in calculating net income).
- 30. Cont…. Period Costs: period costs are charged to the period in which they are incurred and are treated as expenses. They are incurred on the basis of time, e.g., rent, salaries, insurance etc. They cannot be directly assigned to a product, as they are incurred for several products at a time (generally). Period costs such as selling and administrative costs are expensed (i.e. deducted from revenue in calculating net income) in the period they are incurred
- 31. Product Costs Versus Period Costs Expense Income Statement Inventory Cost of Goods Sold Balance Sheet Income Statement Sale Product costs include direct materials, direct labor, and manufacturing overhead. Period costs are not included in product costs. They are expensed on the income statement.
- 32. Cost Classifications on Financial Statements: Merchandising and manufacturing firms, both prepare financial statement reports for creditors, stockholders, and others to show the financial condition of the firm and the firm's earnings performance over some specified intervals. Merchandising companies simply purchase goods and resale them to customers. Financial statement reports are therefore simple in case of merchandising companies. The financial statements prepared by manufacturing companies are more complex than the statements prepared by a
- 33. Balance Sheet The balance sheet or statement of financial position of a manufacturing company is similar to that of a merchandising company. However, the inventory accounts differ between two types of companies. A merchandising company has only one type of inventory called merchandise inventory, are goods purchased from suppliers that are awaiting for resale to customers. Merchandising company Inventory Accounts Beginning Balance Ending Balance Merchandising Inventory $100,000 $150,000
- 34. Cont…. In contrast manufacturing companies have three types of inventories:- 1. Direct materials inventory: are raw materials in stock and awaiting for use in the manufacturing process 2.Work-in-process inventory: are goods partially worked on but not yet completed 3.Finished goods inventory: are goods completed but not yet sold. A Manufacturing Corporation Inventory Accounts Beginning Balance Ending Balance Raw materials Work in process Finished goods $60,000 $90,000 $125,000 $50,000 $60,000 $175,000
- 35. Income Statement Following are comparative income statements of merchandising and manufacturing companies:Merchandising Company Income statement Sales Cost of goods sold: Beginning merchandising inventory Add: Purchases Cost Goods available for sale Less: Ending merchandising inventory Cost of goods sold Gross margin Less operating expenses: Selling expenses $xxxxx xxxx xxxxxx xxxxxx $xxxxx xxxxxx $xxxxx $xxxxxx $xxxxxx xxxxxx $xxxxxx
- 36. Manufacturing Company Income statement . Sales Cost of goods sold: Beginning finished goods inventory Add: Cost of goods manufactured* Goods available for sale Less: Ending finished goods inventory Cost of goods sold Gross margin Less: Operating expenses: Selling expenses Administrative expenses Total operating expense Net operating income $xxxxx xxxxx xxxxx xxxxx xxxxx xxxxx $xxxxxx xxxxxxx $xxxxxx xxxxxx $xxxxxx
- 37. *Schedule of Cost of Goods Manufactured Direct Materials: Beginning raw materials inventory Add: Purchases of raw materials Raw materials available for use Less: Ending raw materials inventory Raw materials used in production Direct Labor Manufacturing overhead: Insurance factory Indirect labor Machine rental Utilities factory Supplies Depreciation, factory Property taxes, factory Total overhead costs Total manufacturing cost Add: Beginning work in process Total manufacturing costs to account for Less: Ending work-in-process Cost of goods manufactured $xxxxxx xxxxxx xxxxxx xxxxxx xxxxxx xxxxxx xxxxxx xxxxxx xxxxxx xxxxxx xxxxxx $xxxxx xxxxx xxxxxx $xxxxxx xxxxxx $xxxxxx xxxxxx $xxxxxx
- 38. Illustration Fox wood Company is a metal- and wood cutting manufacturer, selling products to the home construction market. Consider the following data for 2011: Sandpaper………………………………………... $ 2,000 Materials-handling costs…………………………... 70,000 Lubricants and coolants……………………………. 5,000 Miscellaneous indirect manufacturing labor............... 40,000 Direct manufacturing labor……………………… 300,000
- 39. Cont…. Work-in-process inventory Jan. 1, 2011.............. 10,000 Work-in-process inventory Dec. 31, 2011......... 14,000 Plant-leasing costs…………………………….. 54,000 Depreciation—plant equipment……………..... 36,000 Property taxes on plant equipment........................ 4,000 Fire insurance on plant equipment.......................... 3,000 Direct materials purchased…………………... 460,000 Revenues……………………………………
- 40. Fox wood Company Schedule of Cost of Goods Manufactured For the Year Ended December 31, 2011 Direct materials: Beginning inventory, January 1, 2011 $ 40,000 Add: Purchases of direct materials 460,000 Cost of direct materials available for use 500,000 Less: Ending inventory, December 31, 2011 50,000 Direct materials used 450,000 Direct manufacturing labor 300,000 Indirect manufacturing costs(MOH): Sandpaper $ 2,000 Materials-handling costs 70,000 Lubricants and coolants 5,000 Miscellaneous indirect manufacturing labor 40,000 Plant-leasing costs 54,000 Depreciation—plant equipment 36,000 Property taxes on plant equipment 4,000 Fire insurance on plant equipment 3,000 Total MOH costs 214,000 Total Manufacturing costs incurred during 2011 964,000 Add: Beginning work-in-process inventory, January 1, 2011 10,000 Total manufacturing costs to account for 974,000 Less: Ending work-in-process inventory, December 31, 2011 14,000 = Cost of goods manufactured (to income statement) $ 960,000
- 41. Fox wood Company Income Statement For the Year Ended December 31, 2011 Revenues $1,360,000 Cost of goods sold: Beginning finished goods inventory January 1, 2011 $ 100,000 Add: Cost of goods manufactured (see the above schedule) 960,000 Cost of goods available for sale 1,060,000 Less: ending finished goods inventory December 31, 2011 150,000 CGS 910,000 Gross margin (or gross profit) 450,000 Operating costs: Marketing promotions 60,000 Marketing salaries 100,000 Distribution costs 70,000 Customer-service costs 100,000 Total operating costs 330,000 Operating income