Topic 2 Management Accounting: Cost Terms and Concepts: Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e

Topic 2
Management accounting:
cost terms and concepts
Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 2-1
Outline
• MA - Emphasis on costs
• Cost classifications
1. Controllable and uncontrollable
costs
2. Costs across the value chain
3. Costs behaviour
4. Costs for decision making
5. Direct and indirect costs
6. Manufacturing costs and cost flows
Management accounting systems
• Management accounting systems are
tailored to an organisation’s needs
• Components may include
– Costing systems
– Budgeting systems
– Performance measurement systems
– Cost management systems
• Traditional versus modern approaches

Traditional versus modern management

Emphasis on costs
• Why do management accountants pay
so much attention to costs?
– Historic focus on production costs
– Ready availability of cost data
– Importance of cost information
• Non-financial information is increasingly
important in modern management
accounting systems

What are costs?
• Resources given up to achieve a
particular objective
• Costs:
─Asset
─Expense
• Measured in monetary terms

Different cost classifications
for different purposes
• Before we classify costs, we need to
understand how managers intend to use
the information
• Different costs and classifications are
used for different purposes
• The same cost can be classified in a
number of ways depending on the
intended use of the cost information
Common cost classifications

Controllable and
uncontrollable costs
• Managers’ performance evaluation can be
enhanced by classifying responsibility centre
costs as either controllable by the manager or
uncontrollable
• Ideally, managers should be held responsible
only for costs they can control or significantly
influence
• Some costs are controllable in the long term
but not in the short term
(cont.)
Controllable and
uncontrollable costs (cont.)
A cost that can be significantly
influenced
by a manager is a controllable cost
Cost item Manager Classificaton

Cost of food used Restaurant Controllable
in a restaurant manager
Cost of national Restaurant Uncontrollable
advertising by a manager
restaurant chain
Costs across the value chain
• The value chain
– A set of linked processes or activities that
begins with acquiring resources and ends
with providing and supporting products and
services that customers value
• Various cost classifications can be used
within the upstream, downstream and
manufacturing areas
(cont.)

Costs across the value
chain (cont.)
• Upstream costs
– Research and development ,design and
supply costs
• Production costs
– The costs incurred to collect and assemble
the resources used to produce a product
• Downstream costs
– Marketing, distribution and customer service
costs (cont.)
Costs across the value
chain (cont.)

Classifying costs according
to their behaviour
• Managers need to understand how
costs change as the level of activity in
the business changes
• Level of activity
• Cost driver
• Variable costs
• Fixed costs
Cost Classifications
Cost behavior means
how a cost will react
to changes in the
level of business
activity.
– Total variable costs
change when
activity changes.
– Total fixed costs
remain unchanged
when activity
changes.
2-15
Total Variable Cost Example
Your total cable pay-per-view bill is based on
how many movies you watch.
Total Pay-Per-View
Bill
Pay-Per-View
Movies Watched 2-16
Variable Cost Per Unit Example
The cost per movie watched is constant. For
example, $4.00 per movie.
Per Movie Charge
Movies Watched
2-17
Total Fixed Cost Example
Your monthly cable bill probably does not change
when you watch movies on channels that you
have elected to be paid on a monthly basis (HBO).
Monthly Charge for
HBO Bill
Number of HBO Movies

Watched 2-18
Fixed Cost Per Unit Example
The average cost per HBO movie decreases
as more HBO movies are watched.
Monthly HBO Bill per Movie

Watched
Number of HBO
Movies Watched 2-19
Cost Classifications
Summary of Variable and Fixed Cost Behavior

Cost In Total Per Unit
Total variable cost changes Variable cost per unit

Variable as activity level changes. remains the same over
wide ranges of activity.
Total fixed cost remains Fixed cost per unit
Fixed the same even when the goes down as activity
activity level changes. level goes up.
2-20
Opportunity Cost
The potential benefit that is

given up when one
alternative is selected
over another.
– Example: If you were
not attending college,
you could be earning
$30,000 per year.
Your opportunity cost
of attending college for
one year is $30,000.
2-21
Sunk Costs
All costs incurred in the past that cannot be
changed by any decision made now or in the
future are sunk costs. Sunk costs should not be
considered in decisions.
– Example: You bought an automobile that cost
$22,000 two years ago. The $22,000 cost is
sunk because whether you drive it, park it, trade
it, or sell it, you cannot change the $22,000
cost.
2-22
Differential Costs
Costs that differ between alternatives.
Example: You can earn $1,500 per month in your

hometown or $2,000 per month in a nearby city.
Your commuting costs are $50 per month in your
hometown and $300 per month to the city.
What is your differential cost?

$300 - $50 = $250
2-23
Marginal Costs and Average Costs
The total cost to

The extra cost
produce a quantity
incurred to produce
divided by the
one additional unit.
quantity produced.
Marginal and average costs are

largely a function of cost behavior
-- variable and fixed costs.
2-24
Direct and indirect costs
• An important function of management
accounting is to measure the cost of
cost objects
– Cost objects are the items for which
management wants a separate measure of
costs
– Direct costs can be identified with or traced
to a particular cost object
– Indirect costs cannot be economically
identified or traced to a cost object (cont.)
Direct and indirect costs (cont.)
– Nature of the cost object
– Do we wish to know the cost of a
department, a product, a project, or an
entire company?
– A cost can be a direct cost of one cost
object and an indirect cost of another
cost object

Direct and Indirect Costs
Direct costs Indirect costs
• Costs that can be • Costs that must be
easily and allocated in order to
conveniently traced to be assigned to a
a product or product or
department. department.
• Example: cost of • Example: cost of
paint in the paint national advertising
department of an for an airline is
automobile assembly indirect to a particular
plant. flight.
2-27
Product Costs, Period Costs, and
Expenses
Product costs are costs associated with goods for
sale until the time period during which the products
are sold, at which time the costs become expenses.
Period costs are costs that are expensed during the

time period in which they are incurred.
Expenses are the consumption of assets for the

purpose of generating revenue.
2-28
Product costs
• Managers need estimates of product
costs for different purposes
• In financial accounting reports
– Product costs determine cost of goods sold
– Product costs help value inventory on hand
– Period costs
• For management decision making
– Definitions of product costs may include
non-manufacturing costs
Cost Classifications on Financial
Statements – Income Statement
Product Costs Period Costs
Cost of goods sold Operating expenses
2-30
Statements – Balance Sheet
Merchandiser Manufacturer
Current Assets Current Assets
– Cash
 Cash
 Receivables
– Receivables  Prepaid Expenses
– Prepaid Expenses  Inventories
– Merchandise Raw Materials
Inventory Work in Process
Finished Goods
2-31
– Cash
 Cash materials
Those
 waiting to be
Receivables
– Receivables processed.
 Prepaid Expenses
Finished Goods
2-32
PartiallyAssets
Current completed
Current Assets products – material to
 Cash
– Cash which some labor
 Receivables
and/or overhead has
– Receivables been added.
 Prepaid Expenses

Finished Goods
2-33
– Cash
 Cash
 Receivables
Completed products
– Receivables  awaiting sale.
Prepaid Expenses

Finished Goods
2-34
Manufacturing costs
• Manufacturing costs
• Non-manufacturing costs
• Classification of manufacturing costs
– Direct material, direct labour and
manufacturing overhead
– Direct or indirect cost classification assumes
that products are the relevant cost objects
• Traditional product costing
(cont.)
Manufacturing Costs
Direct Direct Manufacturing

Material Labor Overhead
The
Product
2-36
Direct Material
Cost of raw material that is used to
make, and can be conveniently
traced, to the finished product.
Example:
Example:
Steel
Steelused
usedto
to
manufacture
manufacture
the
theautomobile.
automobile.
2-37
Direct Labor
Cost of salaries, wages, and fringe
benefits for personnel who work
directly on manufactured products.
Example:
Example:
Wages
Wagespaid
paidto
toan
an
automobile
automobileassembly
assembly
worker.
worker.
2-38
Manufacturing Overhead
All other manufacturing costs
Indirect Indirect Other
Material Labor Costs
Materials used to support the

production process. Examples:
lubricants and cleaning
supplies used in an automobile
assembly plant.
2-39
Cost of personnel who do

not work directly on the
product. Examples:
maintenance workers,
janitors, and security
guards.
2-40
Examples: depreciation on
plant and equipment,
property taxes, insurance,
utilities, overtime premium,
and unavoidable idle time.
2-41
Classifications of Costs in
Manufacturing Companies
Manufacturing costs are often

combined as follows:
Direct Direct Manufacturing
Material Labor Overhead
Prime Conversion
Cost Cost
2-42
Product costs
• Managers need estimates of product
costs for different purposes
• In financial accounting reports
– Product costs determine cost of goods sold
– Product costs help value inventory on hand
– Period costs
• For management decision making
– Definitions of product costs may include
non-manufacturing costs
Cost flows in a manufacturing
business
• Material is purchased: the cost is added
to raw materials inventory
• Direct materials are consumed in
production: cost is removed from raw
materials inventory and added to work in
process inventory
Direct labour and manufacturing
overhead are accumulated in work in
process inventory (cont.)
Cost flows in a manufacturing
business (cont.)
• Products are completed: costs are
transferred from work in process
inventory and added to finished goods
inventory
• Products are sold: costs are transferred
from finished goods inventory to cost of
goods sold expense
• Cost of goods sold is deducted from
sales revenue to determine gross profit
(cont.)
Cost flows in manufacturing
business (cont.)
• Raw materials, work in process and
finished goods inventory balances are
reported in the balance sheet
• Cost of goods sold expense can be found
in the income statement
• The schedule of cost of goods
manufactured and schedule of cost of
goods sold summarise the flow of
manufacturing costs (cont.)

Manufacturing Cost Flows
Direct Material
Work in
Direct Labor Process
Inventory
Manufacturing
Overhead
2-47
Direct Material
Work in
Inventory
Manufacturing
Overhead
Finished
Goods
Inventory
2-48
Direct Material
Work in
Inventory
Manufacturing
Overhead
Finished Cost of
Goods Goods
Inventory Sold
2-49
Cost flows in
manufacturing
business (cont.)

Schedule of Cost of Goods
Manufactured
Comet Computer Corporation

Schedule of Cost of Goods Manufactured
Raw material used $ 134,980

Direct labor 50,000
Total manufacturing overhead 230,000
Total manufacturing costs $ 414,980
Add: Work-in-process inventory, January 1 120
Subtotal $ 415,100
Deduct: Work-in-process inventory, December 31 100
Cost of goods manufactured $ 415,000
2-51
ScheduleComputation
of Cost of Cost of Goods
of Raw Material Used
Manufactured
Raw-material inventory, January 1 $ 6,000
Add: Purchases of raw materials 134,000
Raw material available for use 140,000
Deduct: Raw material inventory, December 31 5,020

Direct labor 50,000
Subtotal $ 415,100
2-52
Manufactured
Include all direct labor costs
incurred during the current
period.Corporation
Comet Computer

Direct labor 50,000
Subtotal $ 415,100
2-53
Computation of Total Manufacturing Overhead
Indirect material $ 10,000

Indirect labor 40,000
Depreciation on factory 90,000
Depreciation on equipment 70,000
Utilities 15,000
Insuranceof Cost of Goods Manufactured
Schedule 5,000
Total manufacturing overhead $ 230,000
Direct labor 50,000
Subtotal $ 415,100
2-54
Manufactured
Beginning work-in-process
inventory is carried over
from the prior period.
Direct labor 50,000
Ending work-in-process
inventory contains theinventory,
Add: Work-in-process cost of January 1 120
unfinished
Subtotal goods, and is reported $ 415,100
in the current
Deduct: assets section
Work-in-process of
inventory, December 31 100
the
Costbalance
of goodssheet.
manufactured $ 415,000
2-55
Income Statement for a
Manufacturer

Income Statement
For the Year Ended December 31, 20X2
Sales revenue $ 700,000
Less: Cost of goods sold 415,010
Gross margin $ 284,990
Selling and administrative expenses 174,490
Income before taxes $ 110,500
Income tax expense 30,000
Net income $ 80,500
2-56
Schedule of Cost of Goods Sold
Finished-goods inventory, Jan. 1 $ 200
Add: Cost of goods manufactured 415,000
Cost of goods available for sale 415,200
Deduct Finished-goods inventory, Dec. 31 190
Cost of goods sold
Income Statement $ 415,010
Sales revenue $ 700,000
Less: Cost of goods sold 415,010
Gross margin $ 284,990
Selling and administrative expenses 174,490
Income before taxes $ 110,500
Income tax expense 30,000
Net income $ 80,500
2-57
Short Exercise 1
Consider the following items:
A. Tomatoes used in the manufacture of Hunts ketchup

B. Administrative salaries of executives employed by Jet Blue
Airlines
C. Wages of assembly-line workers at a Ford plant
D. Marketing expenditures of the Atlanta Braves baseball club
E. Commissions paid to Coca-Cola's salespeople
F. Straight-line depreciation on manufacturing equipment owned
by Dell Computer
G. Shipping charges incurred by Office Depot on out-going
orders
H. Speakers used in Sony home-theater systems
I. Insurance costs related to a Mary Kay Cosmetics'
manufacturing plant
Short Exercise 1
Required:
Complete the table that follows and classify each of the costs
listed as (1) a product or period cost and (2) DM/ DL or MOH
Product or DM/ DL/ MOH/

period cost NMOH
A
B
C
D
E
F
G
H
I
Short Exercise 2
The selected amounts that follow were taken from Kandace
Corporation's accounting records:

Required:
Compute the following:
A. Manufacturing overhead.
B. Work-in-process inventory, 12/31.
C. Finished-goods inventory, 1/1.
D. Cost of goods sold.
E. Gross margin.
F. Net income.
Summary
• Traditional and modern approaches to
management accounting can be distinguished
• Costing systems focus on the cost of products
and organisational units and are a component of
management accounting systems
• The classification of costs may vary depending on
the different intended uses of those costs
• Costs may be classified by behaviour, traceability,
controllability and function
• The value chain provides a framework to identify
where cost are incurred in an organisation (cont.)
Summary (cont.)
• In manufacturing businesses, production costs
typically consist of direct materials, direct labour
and manufacturing overhead, in line with external
reporting requirements
• The definition of product costs needed to support
management decision making may be broader
than that used for external reporting purposes
• Product costing systems track the manufacturing
costs from the beginning of production to finished
goods and link the product costing system to the
financial accounting reports


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Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Cost item Manager Classificaton

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Per Movie Charge

Number of HBO Movies

Monthly HBO Bill per Movie

Summary of Variable and Fixed Cost Behavior

Total variable cost changes Variable cost per unit

The potential benefit that is

Example: You can earn $1,500 per month in your

What is your differential cost?

The total cost to

Marginal and average costs are

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Period costs are costs that are expensed during the

Expenses are the consumption of assets for the

Product Costs Period Costs

Cost of goods sold Operating expenses

– Merchandise Raw Materials

– Merchandise Raw Materials

Direct Direct Manufacturing

Materials used to support the

Cost of personnel who do

Manufacturing costs are often

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

Comet Computer Corporation

Raw material used $ 134,980

Raw material used $ 134,980

Raw material used $ 134,980

Indirect material $ 10,000

Comet Computer Corporation

A. Tomatoes used in the manufacture of Hunts ketchup

Product or DM/ DL/ MOH/

Compute the following:

Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd

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