Cost and Management Accounting Chapter 2

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Chapter 1

Overview of Cost and


Management Accounting
Cost accounting

 Cost accounting is defined as "a systematic set of procedures for


recording and reporting measurements of the cost of manufacturing
goods and performing services in the aggregate and in detail. It in-
cludes methods for recognizing, classifying, allocating, aggregating
and reporting such costs and comparing them with standard costs.
 Cost accounting is the process of recording, classifying, summariz-
ing, and analyzing costs with the objective of cost control, cost calcu-
lations and projections, and cost reduction, thereby helping manage-
ment make prudent business decisions.
Management accounting

Management accounting refers to accounting information developed


for managers within an organization. In other words, management ac-
counting is the process of identifying, measuring, accumulating, analyz-
ing, preparing, interpreting and communicating information that helps
managers to fulfill organizational objectives. It reports financial and
non-financial information that enables manager makes decision to fulfill
the goals of the organization.
Managerial accounting (management accounting) is a field of ac-
counting that provides economic and financial information for managers
and other internal users.
Financial accounting

 Financial accounting refers to accounting information de-


veloped for the use of external parties such as stock hold-
ers, suppliers, banks, and governmental agencies.
 Financial accounting measures and records business trans-
actions and provides financial statements that are based on
generally accepted accounting principles/IFRS.
Management Accounting Ba-
sics
The activities that are part of managerial accounting are
as follows:
1 .Explaining manufacturing and nonmanufacturing costs and how they
are reported in the financial statements.
2 .Computing the cost of rendering a service or manufacturing a prod-
uct.
3 .Determining the behavior of costs and expenses as activity levels
change and analyzing cost-volume-profit relationships within a com-
pany.
Management Accounting Ba-
sics
The activities that are part of managerial accounting are as follows:
4. Assisting management in profit planning and formalizing the plans
in the form of budgets.
5. Providing a basis for controlling costs and expenses by comparing
actual results with planned objectives and standard costs.
6. Accumulating and using relevant data for management decision mak-
ing.
Differences Between Financial
and Managerial Accounting
FINANCIAL MANAGERIAL
ACCOUNTING ACCOUNTING
Primary Users of Reports
External users, who are Internal users, who are officers,
stockholders, creditors, and department heads, managers,
regulatory agencies. and supervisors in the
company.
Types and Frequency of Reports
Classified financial statements. Internal reports
Issued quarterly and annually. Issued as frequently as needed.
Purpose of Reports
To provide general-purpose To provide special-purpose
information for all users. information for a particular
user for a specific decision.
Differences Between Financial
and Managerial Accounting
FINANCIAL MANAGERIAL
ACCOUNTING ACCOUNTING
Content of Reports
Pertains to entity as a whole Pertains to subunits of the
and is highly aggregated entity and may be very
(condensed). detailed.
Limited to double-entry May extend beyond double-
accounting system and cost entry accounting system to
data. any type of relevant data.
Reporting standard is generally Reporting standard is relevance
accepted accounting to the decision to be made.
principles.
Verification Process
Annual independent audit by No independent audits.
certified public accountant.
The role of management accountants in
an organization

•Managerial accountants supply accounting informa-


tion to assists managers in the basic functions of
planning, Directing and motivating and control. A
common ingredient of both planning, Directing and
motivating and control is decision-making and man-
agerial accountant provide information useful to
management in making decisions.
Planning
Planning is the detailed formulation of action to
achieve a particular end.

Example
Increase market share
Setting objec- year-over-year by at least
five percent
tives

Identifying methods to • Consider diversification


• Sell More to Current Customers
achieve those objec- • Try Different Types of Channels
tives • Target a New Market Segment
Directing and motivating

 Directing and motivating involves coordinating diverse


activities and human resources to produce a smooth-run-
ning operation.
 This function relates to the implementation of planned
objectives.
 Most companies prepare organization charts to show
– the interrelationship of activities, and the delegation of author-
ity and responsibility within the company.
Controlling

Controlling is the managerial activity of moni-


toring a plan’s implementation and taking correc-
tive action as needed.
Compare

Actual Per- Expected


formance Performance
Controlling
 Controlling is the process of keeping the firm’s
activities on track.
 In controlling operations, management determines
– whether planned goals are being met, and
– what changes are necessary when there are de-
viations from targeted objectives.
Decision Making
Decision making is the process of choosing among competing al-
ternatives.
 This managerial function is intertwined with planning and control
 manager cannot successfully plan or control the organization’s ac-
tions without making decisions regarding competing alternatives

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Management Functions Review

Pl a &
nn ct i ng
ing Di re ng
it o ri
Decision M on
Making
Controlling
Management Functions Review

– While managers are planning future operations, accountants will help


them by preparing budgets (financial plan) and special reports.
– While managers are executing what is planned, accountants will help
them in measuring, recording and properly classifying the transactions
completed by the management for the preparation of financial reports.
– While managers are assessing whether the planned activities are imple-
mented as intended the evaluation phase, accountants will help managers
in supplying performance evaluation reports which show the planned tar-
get, the actual results, the variance (deviation of actual results from the
planned targets) and the possible causes for the variance.
Cost terminologies and
classification
To perform the three management functions effectively, man-
agement needs information. One very important type of in-
formation is related to costs. For example, questions such as
the following need answering:
– What costs are involved in making the product?
– If production volume is decreased, will costs decrease?
– What impact will automation have on total costs?
– How can costs best be controlled in the organization?
Cost terminologies and
classification
 Accountants define cost as a resource sacrificed or for-
gone to achieve a specific objective. It is usually measured
as the monetary that must be paid to acquire goods and
services. In the above definition there are two important
ideas included:-
a. Cost measures the use of resources in terms monetary
units. Cost measures the use of labor hours, materials, ma-
chine hours and other inputs in terms of monetary units
Cost terminologies and
classification
b. Cost measurement is related to a particular purpose or ac-
tivity. This purpose is referred to as a cost object. Cost ob-
ject is defined as anything for which a separate measure-
ment of costs is desired. To quite their decisions, managers
want to know how much a particular thing (such as a prod-
uct, services, machine or process) costs, we call this thing
cost object.
Manufacturing costs and Non-manufac-
turing

Manufacturing consists of activities and processes


that convert raw materials into finished goods. Man-
ufacturing costs are usually classified as follows:
– Direct Materials
– Direct Labor
– Manufacturing Overhead
Manufacturing Costs:
Direct Materials
 Raw materials represent the basic materials and
parts that are to be used in the manufacturing
process.
 Raw materials that can be physically and conve-
niently associated with the finished product during
the manufacturing process are termed direct ma-
terials.
Manufacturing Costs:
Indirect Materials
 Some raw materials cannot be easily associated with the
finished product. These are considered indirect mate-
rials.
 Indirect materials
– do not physically become part of the finished prod-
uct, or
– cannot be traced because their physical association
with the finished product is too small in terms of
cost.
 Indirect materials are accounted for as part of manufac-
turing overhead.
Manufacturing Costs:
Direct Labor
 Direct labor is the work of factory employees
that can be physically and conveniently associ-
ated with converting raw materials into finished
goods.

DIRECT LABOR
Manufacturing Costs:
Indirect Labor
 The wages of maintenance people, timekeepers,
and supervisors are normally categorized as indi-
rect labor because their efforts have no physical
association with the finished product or it is im-
practical to trace the costs to the goods provided.
Like indirect materials, indirect labor is part of
manufacturing overhead.
Manufacturing Costs: Man-
ufacturing Overhead
 Manufacturing overhead consists of costs that are indirectly asso-
ciated with the manufacture of the finished product. These costs may
also be defined as manufacturing costs that cannot be classified as ei-
ther direct materials or direct labor.
 Manufacturing overhead includes
– indirect materials;
– indirect labor;
– depreciation on factory buildings and machinery; and
– insurance, taxes, and maintenance on factory facilities.
Non-manufacturing Costs

 Marketing and selling costs . . .


– Costs necessary to get the order and deliver the
product.

 Administrative costs . . .
– All executive, organizational, and clerical costs.
Product Costs and Period
Costs
 Product costs (also called inventoriable costs) include
each of the manufacturing cost elements (direct materials,
direct labor, and manufacturing overhead). They are the
costs that are a necessary and integral part of producing
the finished product.
 These costs are not expensed (as cost of goods sold) under
the matching principle until the finished goods inventory
is sold.
Product Costs:
Prime and Conversion
 Direct materials and direct labor are often referred
to as prime costs due to their direct association
with the manufacturing of the finished product.
 Direct labor and manufacturing overhead are often
referred to as conversion costs since they are in-
curred in converting raw materials into finished
goods.
Product Costs and Period
Costs
 Period costs are identifiable with a specific time
period rather than a salable product.
 Period costs are deducted from revenues in the pe-
riod in which they are incurred.
 Period costs relate to nonmanufacturing, (thus, non-
inventoriable) costs, and include selling and admin-
istrative expenses.
Product Versus Period Costs
All
Costs
Product Costs Period Costs
Manufacturing Costs
(Go to Balance Sheet before
Nonmanufacturing Costs
Income Statement) (Go straight to Income Statement)

Direct Materials Prime Selling


Costs
Expenses
Direct Labor
Conversion Administrative
Costs Expenses
Manufacturing
Overhead
Product Costs Versus Period
Costs
Product costs include Period costs are not in-
direct materials, direct cluded in product
labor, and manufactur- costs. They are ex-
ing overhead. pensed on the income
statement.
Inventory Cost of Good Sold Expense

Sale

Balance Income Income


Sheet Statement Statement
Manufacturing Cost Flows
Balance Sheet Income State-
Costs Inventories ment
Material Purchases Raw Materials Expenses

Direct Labor Work in


Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold

Selling and Period Costs Selling and


Administrative Administrative
1-33

Schedule of Cost of Goods Manufac-


tured
Manufacturing Work
Raw Materials Costs In Process

Beginning raw Direct materials Beginning work in


materials inventory + Direct labor process inventory
+ Raw materials + Mfg. overhead + Total manufacturing
purchased = Total manufacturing costs
= Raw materials costs = Total work in
available for use process for the
in production period
– Ending raw materials – Ending work in
inventory process inventory
= Raw materials used = Cost of goods
in production manufactured.
1-34

Cost of Goods Sold


Work
In Process Finished Goods

Beginning work in Beginning finished


process inventory goods inventory
+ Manufacturing costs + Cost of goods
for the period manufactured
= Total work in process = Cost of goods
for the period available for sale
– Ending work in - Ending finished
process inventory goods inventory
= Cost of goods Cost of goods
manufactured sold
Variable and Fixed costs

How
How aa cost
cost will
will react
react to
to changes
changes in
in the
the level
level of
of busi-
busi-
ness
ness activity.
activity.

Total
Totalvariable
variablecosts
costschange
changewhen
whenactivity
activitychanges.
changes.


Total
Total fixed
fixed costs
costs remain
remain unchanged
unchanged when
when activity
activity
changes.
changes.
Variable and Fixed costs

Behavior of Cost (within the relevant range)


Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.
Direct Costs and Indirect Costs
Direct costs Indirect costs

 Costs that can be  Costs cannot be easily


easily and conveniently and conveniently traced
traced to a unit of product to a unit of product or
or other cost objective. other cost object.

 Examples: direct material  Example: manufacturing


and direct labor overhead
Opportunity Costs

 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 Br.150,000 per year.
Your opportunity cost of attending college for one
year is Br.150,000.
Sunk Costs

 Sunk costs cannot be changed by any decision.


They are not differential costs and should be ig-
nored when making decisions.
• Example: You bought an automobile that cost
$10,000 two years ago. The $10,000 cost is sunk
because whether you drive it, park it, trade it, or
sell it, you cannot change the $10,000 cost.
Avoidable and Unavoidable Costs

 Avoidable costs are costs that will not continue


if an ongoing operation is changed or deleted.
 Unavoidable costs are costs that continue even
if an operation is halted.
Standard cost, Budgeted cost
Actual Cost
 Standard cost refers to the pre-established or pre-determined cost
required to manufacture one product unit. It consists of an estimate
of the costs that are expected when producing a particular product.
 The term standard cost refers to a specific cost per unit.
 Budgeted cost refers to costs in total given a certain level of activ-
ity.
 Actual Costs, on the other hand, are those realized during the period
and compared at the end of the period. This difference between the
standard cost vs actual cost is termed as Variance.
Cost Unit
 Cost Unit is defined as Unit of quantity of product, service or time in
relation to which costs may be ascertained or expressed. A cost unit
refers to the unit of quantity of product, service or time (or combina-
tion of these) in relation to which costs may be ascertained or ex-
pressed. A cost unit may be expressed in terms of number, length,
area, weight, volume, time, or value. The following are examples of
cost units applied in different industries:
 Electric Company-Cost unit per unit
 Transport Companies-Cost unit per kilometer
 Steel Companies-Cost unit per ton
 Water Supply-Cost unit per 1,000 liters
Cost center and profit center
 A cost center is a reporting unit of a business that is responsible for
costs incurred. An example of a cost center is the maintenance de-
partment of a business, where its manager is only rated on the
amount of costs incurred to maintain facilities and equipment at a
predetermined level. Similarly, the accounting, finance, information
technology, and human resources departments are all treated as cost
centers.
 A profit center is a reporting unit of a business that is responsible for
profits generated. An example of a profit center is a subsidiary,
which is responsible for the amount of sales generated, as well as all
costs incurred. Profit center is responsible for both its revenues and
costs.
Linear, curvilinear and step
functions
 A linear cost function is a mathematical method used by businesses
to determine the total costs associated with a specific amount of pro-
duction. This method of cost estimation can be done whenever the
cost for each unit produced remains the same no matter how many
units are produced.
 When that is the case, the linear cost function can be calculated by
adding the variable cost, which is the cost per unit multiplied by the
units produced, to the fixed costs. Performing this equation will give
the total cost for a production order, thus enabling businesses to
budget accordingly and make decisions on production amounts.
Con,t
 This is the function where the cost curve of a particular product will
be a straight line. Mostly this function is used to find the total cost of
"x" units of the products produced. For any product, if the cost curve
is linear, the linear cost function of the product will be in the form of
y = Ax + B
y = total cost
x = number of units produced
A = cost per unit
B = total fixed costs
 The total cost of producing two dresses is Br.130 , and the production
cost of 5 similar dresses is Br.190 . By assuming a linear cost func-
tion, what is the cost of producing 8 such dresses?
Con,t

 Curvilinear costs increase at a non-constant rate as volume in-


creases. When volume and costs are graphed, curvilinear costs ap-
pear as a curved line that starts at the graph origin (total cost is zero
when volume is zero) and increases at different rates.
 There exists a linear correlation if the ratio of change in the two vari-
ables is constant. If we plot these coordinates on a graph, we will get
a straight line. There exists a curvilinear correlation if the change in
the variables is not constant. If we plot these coordinates on a graph,
we will get a curve.
Con,t
 Step costs are costs that do not change in direct proportion to in-
creasing levels of activity. In other words, step costs are constant at
a certain activity level but increase or decrease when an activity
threshold is met.
 Example. John operates a company that produces pens. A machine
costing Br.15,000 is capable of producing up to 1,000 pens. Assume
that there are no additional costs related to producing pens (no raw
materials, labor, etc.). As such, the cost of machinery is an example
of a step cost.
Con,t
 As shown in the above illustration, the cost of machinery closely re-
sembles steps. At a production of 500 or 750 pens, only one machine
is required. The total cost is, therefore, Br.15,000. However, at the
production of 1,500, the company must purchase an additional ma-
chine to expand its production capacity.
 At a production of 1,500 pens, the total cost is Br.30,000 (Br.15,000 x
2 machines). Therefore, it is an example of a step cost: costs that are
constant at a certain level of activity and rise or decrease when a cer-
tain activity threshold is met.

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