CHAPTER FIVE

INTRODUCTION TO MANAGERIAL
ACCOUNTING

Contents
1. Introduction
2. Cost terms, concepts and terminologies
3. Cost classification
4. Costing systems

1
Introduction

Accounting in the modern times, has two

distinct functions to perform.

1. Historical functions

2. Managerial functions
 The historical function is concerned with recording,
classifying, summarizing and interpreting past
transactions for an accounting period of a business
enterprise.

 The objective of this function is to report at regular

interval to users through financial statements.

 In the early stages of the accounting development, the

historical functions were the primary tasks of
accountants.

 These days, the managerial functions have become the

prime tasks of accountants.
The objective of the managerial functions is to
maximize operational efficiency.

Managers carry out two major activities:

1. Planning: it is the formulation of basic

strategy by selecting a course of action
and specifying how this action is
implemented (budgeting) , and

2. Controlling: it is the assurance that the

plan is being implemented with appropriate
modifications as circumstances change.
Management accounting information plays a
vital role in these basic managerial
functions- but most particularly in the
planning and control ling functions.
Management Accounting functions

1. Provision of relevant information to support decisions

a. budgeting

b. make resource allocation, product mix and

process/department discontinuation decisions.

c. Determine selling prices,

d. Development and introduction of new products and

services, investment in new plant and equipment and
negotiations on long-term contracts with customers
and suppliers.

2. Provision of information for control (performance

evaluation)
7

1. Identify objectives
2. Search for alternative courses
Planning of action
Process 3. Gather data about alternatives
4. Select alternative courses of
action
5. Implement the decisions

6. Compare the actual outcome

Controlling with planned ones
process 7. Respond to divergences from
plans
 The first five stages represent decision-
making or planning process.

 Planning involves choosing among alternatives

and is primarily a practice of decision-making.

 The final two stages represent the control,

which is the process of measuring and
correcting deviations to ensure that the
chosen alternatives are properly implemented.
Cost and Management Accounting

 Cost Accounting provides information for both

management and financial accounting.

 Cost Accounting measures and reports

financial and non financial information relating
to costs of acquiring and/or utilizing
resources in an organization.

 Cost Accounting includes parts of both

management and financial accounting as it
collects and analyses cost information.
Cost Management: describes managers’ approaches
and activities in the short-run and long-run
planning and control decisions that increase value
for the customers and lower the costs of products
and services.

For example: managers make decision regarding

the amount and kind of materials being used,
changes of product design etc, to decrease costs
and increase value of product.
Cost terms, concepts and terminologies

Cost: is a resource sacrificed or forgone to achieve a

specific objective. A cost is usually measured as the
monetary amount that must be paid to acquire goods and
services.

A cost object: is anything for which a separate

measurement of costs is desired. Example are product,
department, customer, geographical area, process etc.

Cost pool: is a grouping of individual cost items possessing

identical nature. Cost pools can range from broad, such as
all costs within a manufacturing plant, to narrow, such as
the costs of operating a machine.
Cost accumulation: is the collection of costs in some
organized way by means of an accounting system, i.e., by
some natural or self descriptive classification.

E.g. material cost, labor cost, fuel,

advertisement cost etc.

Cost assignment: is a general term that includes:

a. Tracing direct costs

b. Allocating indirect costs

Cost driver: is a variable, such as an activity level or

volume, the change of which can affect costs over a
given time span.
An actual cost: is the cost incurred (a historical
cost) as distinguished from budgeted costs.

Relevant range: is the band of normal activity

level or volume in which there is a specific
relationship between the level or volume of
activity and cost in question.

Assume that fixed (leasing) costs are 72,000

Birr for a year and the costs remain the same
for a certain relevant range (1,000 - 6,000 units
of outputs).
Classification of Costs

Different cost classification bases:

1. Traceability
a. Direct costs: costs that have relationships with
the cost objects and can be traced to that cost
object in an economically feasible (cost effective)
way.
Example:
I. The cost of a bottle is a direct cost to
Pepsi-Cola because it can easily be traced to
or identified with the pepsi product ( the
soft drink).
II. Cost of paper is a direct cost for a sport
magazines because it can be conveniently
traced to a magazine.
b. Indirect costs: costs that have a
relationship with the cost object but
cannot be traced to that cost object in an
economically feasible way.

Example:

Salary of supervisors who oversee

production of different products.
Unlike the costs of materials, it is so
difficult to trace supervisor’s costs
to product line. Such costs are
allocated to products based on some
allocation base.
Thus, cost tracement is assigning direct costs to a
particular cost object and cost allocation is assigning
indirect costs to a particular cost object.

The distinction b/n a direct and indirect costs depends on

units of products, activities, departments, organization
etc.

So, a cost could be direct cost for one cost object and an
indirect to the other.

Example

A supervisors’ salary may be a direct cost to

the production department but an indirect
cost for the product being produced
2. Classification based on the pattern of cost behavior
Variable costs: are costs that change in the direct
proportion of changes in the level of activity but unit
variable costs remain constant.

Example: Cost of bottles for Pepsi-cola.

Fixed Costs: are costs that remain constant regardless of

the change in the level of activities up to a certain
relevant range but unit costs always vary with varying level
of activities.

Example: Monthly salary of employees of an organization.

Costs are defined as variable or fixed with respect
to a specific cost object and for a given time period.

Example

 Labor costs can be purely variable with respect to

units produced when workers are paid on a unit
basis.

 In contrast, labor costs may be classified as

fixed cost if the company agree with employees
to pay a certain amount of salary per month
regardless of volume of activity.
3. Classification based on function/operation/purpose

a. Manufacturing costs: are costs that are directly

involved in manufacturing of products and rendering of
services. Manufacturing cost is divided into three
broad categories.

 Direct materials

 Direct labor

 Manufacturing/factory overhead.
 Direct material costs: become an integral part of the
finished product and can be physically and
conveniently traced to it.

 Direct labor cost: those labor costs that can be

essentially traced to individual units of products.

 Manufacturing overhead costs: are all costs of

manufacturing except direct material and direct
labor.
b. Non-manufacturing costs
I. Administrative costs: include all executive,
organizational, and clerical costs associated with
general management of an organization

Example: Salary of managers, clerical staff, office

rents etc.

II. Marketing or selling costs: are costs related to selling

and distribution of goods and services.

Example: Transportation costs, advertising costs,

shipping costs, sales commission and sales salary.
Two terms used to describe costs classification in
manufacturing costing system.
1. Prime costs: are all direct manufacturing costs.
It includes direct materials and direct labor
costs.
Prime costs = DMC + DLC
2. Conversion costs: are all manufacturing costs
other than direct material costs. It includes
direct labor costs and MOH costs
Conversion cost = DLC + MOH
4. Classification based on timing recognition
a. Product costs: are necessary and integral part of
producing (acquiring) the finished product. They are
considered as an asset/inventory when they are
incurred. Under the matching principle, these costs
do not become expenses until the inventory is sold
out.
Example: Cost of direct material
b. Period Costs: are costs other than cost of goods
sold. They are treated as expenses of the period in
which they are incurred because they are expected
to benefit revenue of the current period.
Example: Office rent expense
 Financial Statements of Manufacturing
Organizations
24

Schedule of cost of goods manufactured

Beginning DM inventory…… ……XX

+ DM Purchased……………………. ..XX
DM Available for use ………….XXX
- Ending DM Inventory…………. XX
DM Used …………………………… .XXX
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DM Used ………………………………………. XXX

+ Direct Labor ………………………………. XX
+ Factory overhead cost (MOH)………..XX
Mfg Cost incurred during the year..XXX
+ Beginning WIP Inventory …………….. .XX
Total Mfg Cost to account for ………. XXX
-Ending WIP Inventory ………………….. …XX
Cost of Goods Manufactured ……… ....XXX
 Schedule of Cost of Goods Sold
26

Beginning FG Inventory XXX

+ Cost of FG Manufactured during the year XXX
Cost of FG available for sale XXX
- Ending FG Inventory XXX
Cost of goods sold XXX
I/S Format for a Manufacturing Company
ABC Company
Income Statement
For the Year ended Dec. 2010
Sales……………………………………………………..............XXX
Cost of goods sold …………………………………………...(XX)
Gross Profit on Sales …………………………………………XXX
Operating Expenses:
Selling Expenses………………………(XX)
Administrative Expense………......(XX)
Total Operating Expenses……………………………….(XXX)
Income from operations…………………………...........XXX
Less: Interest Expense………………………………..........(XX)
Income before income taxes……………………………..XXX
Income Tax expenses………………………………………...(XX)
Net Income…………………………………………................XXX
 5.4. Product Costing Systems
28

 Product Costing: is the process of assigning costs to the

products and services provided by a firm.

 Three main types of costing systems are commonly used

in manufacturing and in many service companies:

1. Job-order /Specific order costing

2. Process Costing
3. Activity Based Costing
29

1. Job-order Costing System

 In this system, the cost object is a unit or multiple
units of a distinct product or service called a job.
 Job is a task for which resources are extended in
bringing a distinct product or services to market. E.g.
Ship building
 Job costing system is used by organizations that make
special orders, customized products, or standard
products produced in batches.
 As a result, job-order costing system provides for a
separate record of the cost of each particular quantity
of product that passes through the factory.
30

 Thus, this system is best suited to industries that:

 Manufacture goods to fill special orders from
customers
 Produces different lines of products for stock
 Produces standard products in batch rather than on
a continuous basis
Examples
An auditing activity by an accounting firm,
Construction Companies, Automobile Assemblies,
Advertizing companies, Transportation companies,
Hospitals, Printing press etc.
 Job order costing system
31

Job cost sheet: in job order costing the costs incurred on

specific jobs are accumulated in a separate record called job
cost sheet.

A job cost sheet records all costs for a single cost unit or
job.

Job 11

Direct material cost ………… xx

Direct labor cost ………..........xx

Applied mfg. overhead….….xx

 General Approaches/Procedures to Job order
Costing
32

 There are seven steps to assigning costs to an

individual job.

 All steps/ procedures are applied equally to

assign costs to a job in a manufacturing,
merchandising and service sector.
1. Identify the job that is, the chosen cost object
Example, the job is the construction of the building or the annual
audit of the financial statement by an accounting firm.
2. Identify the direct cost of the job.
3. Select the cost-allocation base to use for allocating indirect costs
to the job
4. Identify the indirect costs associated with each cost allocation
base.
5. Compute the rate per unit of each cost allocation base used to
allocate indirect costs to the job.

Predetermined Estimated annual Expected annual

÷
=
Overhead rate Overhead costs Operating activity
34

6. Compute the indirect cost allocated to the job.

7. Compute the total cost of the job by adding all direct and
indirect costs assigned to the job.

FOH cost Allocation Predetermined

Allocated
= base × Overhead rate
 MOH
Applied to each
Direct job using a
material predetermined
OH rate

The Job

Direct
labor

35
36

Example: The following data is available for the

job numbered 11. Assume that a company uses
machine hours as the allocation base for
manufacturing overhead costs. The budgeted
indirect manufacturing cost of the year is Br
1,500,000 and the expected number of machine
hours to be used in a year is 15,000.

The direct material costs used amounts Br.18,000;

the direct labor cost amounts Br. 6,000 and the
machine hours used to finish job 11 is 80 hours.
Compute the total cost of Job 11.
37

Solution
Step 1. The cost object is Job 11.
Step 2. The direct costs of Job 11 are:
Direct Material ………Br. 18,000
Direct Labor ………….....Br. 6,000
Total ……………………..Br. 24,000
Step 3. The cost allocation base for MOH is Machine
hours
Step 4. FOH Cost pool
Step 5. Budgeted FOH rate = Br. 1,500,000/15,000
hrs
Br. 100/hr
 Cont’d
38

Step 6. Indirect Manufacturing cost of Job 11 is:

Br 100/hr × 80 hours = Br. 8,000

Step 7. Total manufacturing cost of Job 11:

Direct Material Cost …..Br 18,000

Direct Labor Cost ………….Br 6,000

FOH Cost ……………….........Br 8,000

Total mfg Cost ……….……Br 32,000

 2. Process Costing System
39

 In this costing system, the cost object is mass of

identical or similar units of a product or service, not
a specific product.

 A process costing system is a costing system in

which the cost of a product or service is obtained by
assigning costs to masses of like or similar units.

 In a process costing setting, each unit is assumed to

receive the same or similar amounts of direct
material, labor costs and other factory overhead
costs.

 Unit costs are then calculated by dividing total costs

incurred by the total number of units of output from
the production process on average basis.
40

 The cost of a product/service is obtained by using

broad average to assign costs to masses of similar
units.
 This system is used in industries that produces like
or similar units which are often mass produced.
 In these industries, products are manufactured in a
very similar way.

Examples,
 Banks provide same services for all customers who
are going there for deposit.
 Beverage companies (bottles of beer)
 Oil refinery companies (gallons of gasoline)
 Kilowatt hours of electricity
Cost Flows Chart

1. Job-Order Cost System

1. Direct Material WIP Inventory

Finished Goods Cost of Goods
2. Direct Labor Job No 111
Inventory Sold
3. FOH Job No 112

2. Process Cost System

1. DM
WIP WIP Finished Cost of
2. DL
Inventory Inventory Goods Goods
3. FOH
Department A Department B Inventory Sold
 Similarities and differences b/n the two
systems
42

Similarities
The two costing systems are similar in three ways:
1. The manufacturing cost element: DM, DL & FOH
2. The accumulation of the three manufacturing costs: Raw
material is debited to raw material control account, DL is
debited to WIP control account.
3. The flow of costs: RM WIP FG CGS
43
44

The Steps of Cost Allocation

1. Determine the Cost Objective (Cost Object).
2. Form Cost Pools: Accumulate indirect costs for a period
of time.
3. Select an allocation base for each cost pool to relate the
Cost Pools to Cost Objects, preferably a cost driver,
that is, a measure that causes the costs in the cost pool.
4. Measure the units of the cost-allocation base used for
each cost object and compute the total units used for
all cost objects.
5. Determine the percentage of total cost-allocation base
units used for each cost object.
6. Multiply the percentage by the total costs in the cost
pool to determine the cost allocated to each cost object.
Traditional Costing System (Job order costing and
Process Costing)

é Direct materials and direct labor costs are easy to

trace

é Overhead cannot be traced easily and must be

assigned with estimates

Need for the new system (ABC Costing)

é Amount of direct labor used in many industries has

decreased

é Total overhead from depreciation on equipment,

utilities, repairs, maintenance has increased
The ABC Approach

ABC is an overhead cost allocation system that

allocates overhead to multiple activity cost pools and
assigns the activity cost pools to products or services
by means of cost drivers that represent the activities
used.

Activity Any event, action, transaction, or work

sequence that causes a cost to be incurred in
producing a product or providing a service.

Activity Cost Pool The overhead cost allocated to a

distinct type of activity or related activities.
Indirect Costs

 Not easily and conveniently traceable to cost objects

• Cost element is shared among cost objects

• Physically impossible to trace

• Not cost effective to trace

 Need for allocation

 Estimate product or activity cost

 What does it really cost?

 Increase awareness on indirect costs

 Activities are cost not free

 Plan more cost efficient operations
Criticisms on Traditional Overhead Cost
Allocation

 Assumes all overhead is volume-related (machine

hours or direct labor costs etc are main
DRIVERS)

 Factory-wide or departmental rates

All related to single activity measure

 Departmental focus, not process focus

 Focus on costs incurred, not cause of costs

Steps Of ABC

1. Identify the major activities that cause overhead

costs to be incurred.

2. Group costs of activities into cost pools.

3. Identify measures (allocation bases) of activities

(the cost driver) for the activities identified.

4. Relate (trace) costs to products using cost drivers

as per the products demand for or consumption of
these activities.
Activity Based Costing

 Purpose
 Allocation of indirect costs based on causal
activities
 Attempts to identify “direct” link between cost
and cost object
 Results in better allocation
 Does not provide “true” cost
Pros and Cons of ABC

 ABC is less likely than traditional costing to

under-cost or over-cost products

 ABC may lead to improvements in cost control

 ABC can be expensive since data regarding

numerous allocation bases must be collected.
Activities and Related Cost Drivers
Cost Driver

 Any factor or activity that has a direct cause-

effect relationship with the resources
consumed.

 In ABC cost drivers are used to assign

activity cost pools to products or services.
Illustration 4-3
A Traditional Overhead Calculation

Gardenrite Co. manufactures 85,000 units of a Spade and

800 units of a Mower. The company currently uses direct-
labor cost to assign overhead costs to products. The
company estimates that it will incur $40,000,000 in
manufacturing overhead and estimates that labor cost will
be $8,000,000. Compute the predetermined overhead
rate.
$40,000,000
= 5 per labor dollar
$8,000,000
 A Spade uses $1.08 direct-labor cost per unit while a Mower
uses $15.00 direct-labor cost per unit. Use the following
information to compute each product’s total unit cost:

Spade Mower
Direct materials $1.80
Direct materials $60.00
Direct labor 1.08
Direct labor 15.00
Mfg. Overhead 1.08 DL$ x $5 = 5.40
Mfg. Overhead
$8.28
15 DL$ x $5 = 75.00
$150.00
Expand the number of indirect-cost pools until
each of these pools is homogeneous.
Identify the preferred cost-allocation base
(cost driver) for each indirect cost pool.

Number of Number of Number of Number of

Setups Material Machine Hours Workstations Used
Requisitions
 The First Stage Allocation

Overall Overhead
Cost Pool
$40,000,000

Setup Material Equipment

Costs Handling Deprec. Other
$4,000,000 $2,000,000 $10,000,000 $24,000,000
Manufacturing Activities

Annual Per 85,000 Per 800

Activity Center Total Spades Mowers
Number of setups 1,000 2 5
Number of requisitions 2,000 3 50
Number of machine hrs. 20,000 40 100
Number of workstations 3,000 1 15
The Second Stage Allocation - Spades

Machine Material Machine Work-

Setups Req. Hours stations
$4,000,000/ $2,000,000/ $10,000,000/ $24,000,000/
1,000 = 2,000 = 20,000 = 3,000 =
$4,000 $1,000 $500 $8,000

$4,000 $1,000 $500 $8,000

x2 x3 x 40 x1
$8,000 $3,000 $20,000 $8,000

$39,000 / 85,000 units = 0.46 per unit

The Second Stage Allocation - Mowers

Machine Material Machine Work-

Setups Req. Hours stations
$4,000,000/ $2,000,000/ $10,000,000/ $24,000,000/
1,000 = 2,000 = 20,000 = 3,000 =
$4,000 $1,000 $500 $8,000

$4,000 $1,000 $500 $8,000

x5 x 50 x 100 x 15
$20,000 $50,000 $50,000 $120,000

$240,000 / 800 units = $300 per unit

Product Unit Cost Comparison

Traditional Costing Activity-Based Costing

Spade (85,000 units) Spade (85,000 units)
Direct materials $1.80 Direct materials $1.80
Direct labor 1.08 Direct labor 1.08
Mfg overhead 5.40 Mfg overhead .46
Unit cost $3.34
Unit cost $8.28

Mower (800 units)

Mower (800 units)
Direct materials $ 60.00
Direct materials $ 60.00 Direct labor 15.00
Direct labor 15.00 Mfg overhead 300.00
Mfg overhead 75.00 Unit cost $375.00
Unit cost $150.00
64

Five purposes of cost allocation

1. Predict the economic effects of strategic and
operational control decisions, i.e. to provide
information for decision making.
2. Provide desired motivation and to give feedback
for performance evaluation.
3. Compute income and asset valuations for financial
reporting.
4. Justify costs or obtain reimbursement.
5. Setting sales prices for products and services
65