Strathmore Introduction to Management Accounting.pdf

Accounting notes

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FINANCIAL AND
MANAGERIAL
ACCOUNTING
Modular MBA 2014
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Introduction to Management Acc and
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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.
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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

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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.
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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.
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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

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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.

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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

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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.
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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

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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
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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.
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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.
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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 .
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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
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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.
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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)
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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
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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.

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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.

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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.
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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.

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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.
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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.
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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.
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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.
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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
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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:
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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
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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)

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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.


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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.


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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.
•


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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.



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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.


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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)



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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.




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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.



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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.

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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.
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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.



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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).
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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.


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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.

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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.
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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