Strathmore Introduction to Management Accounting.pdf
- 1. 1 FINANCIAL AND MANAGERIAL ACCOUNTING Modular MBA 2014 1 Introduction to Management Acc and Costing products
- 2. 2 Introduction In the previous session we covered Financial Accounting. This section will cover Management Accounting. Note that Management accounting first starts with issues regarding the costs in a business and thereafter making decisions using the revenues and costs. Therefore we shall talk about cost and management accounting to be more specific. 2 Introduction to Management Acc and Costing products
- 3. 3 Contents 1. Nature and purpose of Cost accounting and Management accounting. 2. Role of Cost and Management accounting 3. Cost classification 4. Establishing the cost of making a unit or providing a service 3 Introduction to Management Acc and Costing products
- 4. 4 1. Nature and purpose Cost accounting is a field of accounting that records, measures and reports information about costs of products (goods and services). Costs are resources that have been sacrificed or forgone to achieve a specific objective. Generally costs can either be tangible or intangible. 4 Introduction to Management Acc and Costing products
- 5. 5 1. Nature and purpose Generally costs can either be tangible or intangible. Tangible are those that can be measured while intangible are those that are not measurable. Cost and management accounting is mainly concerned with those costs that can be measured although intangible costs are also important for decision making. 5 Introduction to Management Acc and Costing products
- 6. 6 1. Nature and purpose Management accounting is involved with not only providing the information required by the management but also assisting in planning and controlling the business. The basic relationship between cost accounting and management accounting is that cost accounting helps in obtaining the information while management accounting uses the information in making important decisions i.e. closing down certain departments /divisions/product lines, choosing among products/jobs, deciding whether to buy or make, pricing etc 6 Introduction to Management Acc and Costing products
- 7. 7 2. Role of Cost and Management accounting 1. Formulation of long term plans e.g. budgeting. 2. Resource allocation e.g. how much will be generated or spent in a particular department 3. Cost planning and control of the business operations and activities e.g. how much should be incurred in wages and what actions are needed to ensure the wages costs do not increase. Introduction to Management Acc and Costing products
- 8. 8 2. Role of Cost and Management Accounting 4. Measuring performance and evaluating managers e.g. comparing the actual and budgeted results. 5. Aid in decision making in areas such as closing down certain departments /divisions/product lines, choosing among products/jobs, deciding whether to buy or make, pricing/ break even levels etc Introduction to Management Acc and Costing products
- 9. 9 3. Cost classification Classification is the arrangement of items in a logical sequence having regard to the nature and purpose. Cost Classification attempts to categorize the cost of goods or services that have similar characteristics. Introduction to Management Acc and Costing products
- 10. 10 3. Cost classification The main objective of classifying costs in healthcare organizations: • Enable the valuation of products (goods and services) • Enable decision making • Control costs Introduction to Management Acc and Costing products
- 11. 11 3.Cost classification There is no recommended method of classifying costs but main consideration is the nature of the entity. General methods of classifying costs include: – Product and Period Cost – Manufacturing and non manufacturing costs – According to cost behavior – According to relevance – According to Controllability – According to avoidance Introduction to Management Acc and Costing products
- 12. 12 3. Cost classification • Product and Period Cost Product costs are those costs that are identifiable with goods purchased or produced. These costs are included in the valuation of inventory e.g. in a manufacturing business all production costs are normally included as part of product costs and any units that are sold will include production costs as part of the cost of sales while unsold at the end of a financial period will also have their share of the production costs. Introduction to Management Acc and Costing products
- 13. 13 3. Cost classification Period costs are the costs that are excluded from inventory valuation and they are expensed in the period in which they are incurred e.g. in a manufacturing business other expenses like administration , selling and distribution are expensed when incurred and do not form part of the closing inventory or cost of sales. Introduction to Management Acc and Costing products
- 14. 14 3. Cost classification • Manufacturing and Non Manufacturing Cost Manufacturing costs: These are all the costs incurred in the production of goods: In the production process the total cost of manufacturing is made up of Direct Materials + Direct Labor + Other direct expenses + Production/ Factory overheads When the inventory is sold these components of cost are included in the cost of sales and if inventory is unsold then they will form part of the cost of inventory . Introduction to Management Acc and Costing products
- 15. 15 3. Cost classification • Direct Material is the material that can be physically identified with a specific product or service e.g. making a table the direct material would be the timber used. Direct Labor that can be specifically traced or identified with a particular product e.g. wages paid to personnel who are involved in the direct production of a product i.e. (Wages of machine operators). Direct expenses are other costs that can be directly traced to the manufacturing of a product e.g. royalties paid for every unit made Introduction to Management Acc and Costing products
- 16. 16 3. Cost classification • Factory overheads include indirect materials, indirect labor and other indirect expenses that cannot be traced to a specific unit. Examples of indirect materials include general packing materials, indirect labor includes salaries paid to factory supervisors and other indirect expenses comprise of Factory rent, power, electricity, insurance and depreciation of factory buildings and plant. Introduction to Management Acc and Costing products
- 17. 17 3. Cost classification Non Manufacturing Expenses: Include the costs that are incurred outside the production process. Main examples are: • Administration Expenses: Costs incurred in managing the firm. e.g. office salaries, office rent and rates. • Selling Expenses: Costs incurred in creating demand for the product and services of firm. e.g. advertising and sales commission • Distribution Expenses; Are Costs incurred in getting the finished product to customers (e.g. Transport costs and depreciation of motor vehicles used in delivery) • Finance Costs: Cost incurred in borrowing money (e.g. interest in loans and bank overdrafts) Introduction to Management Acc and Costing products
- 18. 18 3. Cost classification • According to cost behavior This category classifies costs based on how they relate with the level of activity - production or sales. Do they increase, decrease or remain fixed or are not affected by changes in activity. There are three general categories i.e. linear, non linear or no relationship. For the moment we only consider linear relationships as they are more common. Under Linear relationship: Cost can either be : • Variable Costs or • Fixed Costs or • Semi Variable Costs or • Semi Fixed Costs / Stepped fixed Costs Introduction to Management Acc and Costing products
- 19. 19 3. Cost classification Variable Costs : Costs that change in direct proportion with the change in the level of activity ( Units produced or Sold) e.g. Direct materials, Direct labor, direct expenses. Fixed Cost: They are costs that do not change in line with changes in level of activities but only within the relevant range. They are not affected by the change in the number of units produced or sold e.g. rent, salaries to factory supervisors. Introduction to Management Acc and Costing products
- 20. 20 3. Cost classification Semi Variable Costs : Costs that have a fixed component and then increase in direct proportion to the units e.g. electricity and water. They have a fixed charge and the cost increase with consumption. Semi fixed/stepped Cost: They are costs that remain fixed regardless of the change in units produced or sold but up to a certain level, after which they increase instantly with a change from one level or range to another. For example, factory rent remains fixed so long as production does not exceed a certain capacity. If it does then we rent more space. Introduction to Management Acc and Costing products
- 21. 21 3. Cost classification • According to relevance Under this category costs can be classified as either relevant or irrelevant • Relevant Costs; Are the future costs that would be affected or will change according to a certain cause of action like decision making. In most cases, expenses that will be incurred in the future are relevant. Another term that is closely associated with relevant cost is opportunity cost. Opportunity Cost is the cost measuring the benefit that has been lost or sacrificed when a certain cause of action is taken. For example to make product B a business may have to forgo making product A and if A is profitable, then the profit from Unit A is an opportunity cost. • Irrelevant costs : Are those costs that are not affected by a particular decision. Historical costs , sunk costs (Costs already incurred are normally classified as irrelevant) and Committed costs. Introduction to Management Acc and Costing products
- 22. 22 3. Cost classification • According to Controllability Under this category costs are classified based on whether they are controllable or uncontrollable. Controllable costs are the cost that can be reasonably regulated by a firm specifically the manager responsible. They can be influenced a management decision and can be adjusted from time to time in line with the management function, in most cases variable cost are controllable. Uncontrollable costs are costs that cannot be regulated by the management within a given period of time or relevant range. In most cases fixed costs are uncontrollable. Introduction to Management Acc and Costing products
- 23. 23 4. Establishing the costs of goods and services For the purpose of establishing costs of goods, we normally have two types of entities. The ones that buy and sell and the ones that actually make and sell. For those that buy and sell, the cost of a unit is simply the purchase price less trade discount plus all other expenses to get the unit ready for sale such as transport. Introduction to Management Acc and Costing products
- 24. 24 4. Establishing the costs of goods and services For those that make a unit, the cost of making a unit has been explained before. A quick reminder here: Direct materials + Direct labor + other direct expenses + production overheads. Introduction to Management Acc and Costing products
- 25. 25 4. Establishing the costs of goods and services Establishing the cost of direct materials, direct labor and direct expenses is straight forward, but the challenge is normally with production overheads. These cannot be ascertained in advance. Therefore the firm uses budgeted overheads and adds (absorbs them) on to the cost of making the unit. Introduction to Management Acc and Costing products
- 26. 26 4. Establishing the costs of goods and services A common term of including the overhead costs to products is overhead Absorption Rate. This rate enables the firm to add the production overhead costs to the cost of making the product. For example if the overhead absorption rate is $10 per direct labor hour and it takes two hours to make a unit, then total production overheads to be added to the cost of making the product would be $20. Introduction to Management Acc and Costing products
- 27. 27 4. Establishing the costs of goods and services At the end of the period the actual production overheads incurred will be different from those added to the cost of making goods (absorbed). The difference is referred to as under absorption or over absorption. This is normally adjusted to the total production costs at the end of the financial period. Example 1 Cost of making a unit Introduction to Management Acc and Costing products
- 28. 28 4. Establishing the costs of goods and services The cost of providing a service is somehow problematic because services cannot be separately identified. The first step in services is to identify a suitable basis of measuring costs called the cost unit. A cost unit is the basis upon which the cost of providing a service can be measured. Again services may have several cost units. General examples of cost units are as follows: Introduction to Management Acc and Costing products
- 29. 29 4. Establishing the costs of goods and services Service Cost Unit Transport (rail, air or road) Per passenger or per kilometer Hotels Occupied bed or room Restaurant/ Catering/ Canteen Meal served Education Per full time or part time student or per hour Hospitals In patient; Bed occupied. Out patient: per patient. Maintenance Per hour of maintenance Introduction to Management Acc and Costing products
- 30. 30 4. Establishing the costs of goods and services Another key feature of costing services is that direct materials are normally not expected to be a major cost of services unlike in making units. Once the cost unit has been established then the cost of providing a service per unit can be estimated as follows: Cost per unit= Total costs of providing service Number of service units Example two and three (Costing services) Introduction to Management Acc and Costing products
- 31. 31 4. Establishing the costs of goods and services Activity Based Costing Activity based costing is an alternative method of dealing with overheads. It involves the identification of factors (Cost drivers) that cause overheads, then the overheads are charged to products depending on their usage of that activity. For costs that vary with production levels then traditional methods of dealing with overheads such as absorption costing will be more appropriate but where the total costs are based on other activities then activity based costing is more appropriate. Introduction to Management Acc and Costing products
- 32. 32 4. Establishing the costs of goods and services • Activity based costing was developed due to the limitation of the traditional methods i.e. absorption costing. – There is arbitrary selection of a cost allocation and apportionment basis. – Where costs are allocated based on physical units then the physical units may not be very good basis because some overheads do not vary in direct proportion with number of units. Introduction to Management Acc and Costing products
- 33. 33 4. Establishing the costs of goods and services • Due to the above limitations activity based costing was designed so as to identify those activities that really contribute to the total cost and may not be highlighted by such methods, e.g. absorption costing. These activities include ordering, materials, handling, assembly, production run, setups and dispatching. • Introduction to Management Acc and Costing products
- 34. 34 4. Establishing the costs of goods and services • Under ABC the production of units demands or creates demand for these activities therefore it is more appropriate to allocate the costs ot a product or department on the basis of the consumption of the activities. Introduction to Management Acc and Costing products
- 35. 35 4. Establishing the costs of goods and services The following steps should be followed in using ABC Step 1. Identify the main activities of the organization which means that related tasks are grouped together as a major activity these activities are also known as activity cost centers. Introduction to Management Acc and Costing products
- 36. 36 4. Establishing the costs of goods and services Step 2: Identify the cost pool for each activity by allocating and apportioning overheads so as to determine the size of the cost of an activity, this will also be known as the cost driver Examples of cost drivers include (Number of orders = Total ordering costs, Production runs = production set up costs) Introduction to Management Acc and Costing products
- 37. 37 4. Establishing the costs of goods and services Step 3 Computed the absorption rate for each activity e.g. the total ordering costs can be divided with the number of orders to get the cost per order. Introduction to Management Acc and Costing products
- 38. 38 4. Establishing the costs of goods and services Step 4 Apply the overhead absorption rate based on step 3 to a product or department to determine the overheads allocated to the specific. Introduction to Management Acc and Costing products
- 39. 39 4. Establishing the costs of goods and services Activity based costing has the following benefits. 1. It tends to provide accurate and objective information for the purpose of making strategic decision 2. ABC ensures that the management is aware about critical activities in the business that consume resources for the purpose of controlling such activities. 3. ABC also provides timely and objective in formation in the various production processes and work done. Introduction to Management Acc and Costing products
- 40. 40 4. Establishing the costs of goods and services However ABC has the following limitations. 1. It may not be possible to identify all the activities in the business that leads to an increase in cost this is mainly due to some production systems being sophisticated. 2. It is normally argued that if the data on activity of the firm is not correct then ABC can be totally misleading as compared to the traditional method. Introduction to Management Acc and Costing products
- 41. 41 4. Establishing the costs of goods and services 3. In practice the cost of implementing and maintaining an ABC system normally exceeds the benefit his is because ABC requires very accurate information. 4. There still remains some elements of arbitrariness in accumulating costs in the various activities, this is because certain buildings cannot be trace directly to a particular activity. Introduction to Management Acc and Costing products
- 42. 42 4. Establishing the costs of goods and services Target Costing Under traditional approaches to pricing, businesses calculate the cost of manufacturing and selling a product, and then add mark up, to give the profit element. These methods are known as "cost plus pricing". A major criticism of cost plus pricing techniques is that they do not consider any external factors (e.g. demand for product; no. of competitors, etc). Introduction to Management Acc and Costing products
- 43. 43 4. Establishing the costs of goods and services Target costing involves setting a selling price for your product by reference to the market. From this your desired profit margin is deducted leaving you with a target cost. Introduction to Management Acc and Costing products
- 44. 44 4. Establishing the costs of goods and services Implementing target costing (a) Define product specification and estimate anticipated sales volume. (b) Set a target selling price at which the company will be able to achieve the desired market share. (c) Required profit is estimated based on profit margins or return on investment. Introduction to Management Acc and Costing products
- 45. 45 4. Establishing the costs of goods and services Target cost is calculated as: Target selling price X Less: target profit (X) Target cost X (e) The estimated cost of the product is calculated based on the product specification and current cost levels. Introduction to Management Acc and Costing products
- 46. 46 4. Establishing the costs of goods and services (f) Estimated Product Cost – Target Cost = Cost Gap (g) Efforts are made to close the cost gap. Aim to "design out" costs before production starts. (h) Negotiate with customer on price before deciding whether the project will go ahead Introduction to Management Acc and Costing products