Chapter 2

Management accounting:
cost terms and concepts

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 Outline

Management accounting systems

Emphasis on costs
Cost classifications
Direct and indirect costs
Controllable and uncontrollable costs
Costs across the value chain
Manufacturing costs and cost flows

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Management accounting systems
Management accounting systems are
tailored to an organisations needs
Components may include
Costing systems
Budgeting systems
Performance measurement systems
Cost management systems
Traditional versus modern approaches

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Traditional versus modern management

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 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

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 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
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 What are costs?

Resources given up to achieve a

particular objective
In financial accounting
Asset
Expense
Measured in monetary terms

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 Common cost classifications

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 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
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 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.)
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Direct and indirect costs (cont.)
Responsibility centres
A responsibility centre is a unit of an
organisation where the manager is held
accountable for the units activities and
performance
The costing system may measure the
costs of managers individual areas of
responsibility
Assigning costs to units is part of
responsibility accounting (cont.)

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Direct and indirect costs (cont.)
Product costs
Direct product costs
Indirect product costs
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
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 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.)
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 Controllable and
uncontrollable costs (cont.)

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 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.)

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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 2-15
 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.)
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 Costs across the value
chain (cont.)

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 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.)
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 Manufacturing costs (cont.)
Direct material is
Consumed in the manufacturing process
Physically incorporated into the finished
products
Can be economically traced to products
A variable cost (with respect to products)
Direct labour is
directly traced to a product
Usually treated as a variable cost unless
contractual arrangements in place (cont.)
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 Manufacturing costs (cont.)
Manufacturing overheads include:
Indirect manufacturing costs or factory
burden
Indirect material and indirect labour,
depreciation and insurance on factory
equipment, utilities and the costs of support
departments for manufacturing
Overtime premium and idle time
Manufacturing support departments do not
work directly on producing products (cont.)
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 Manufacturing costs (cont.)
Conversion costs
The total of direct labour cost and
manufacturing overhead cost
The cost of converting material into a
product
Prime costs
The total of direct material cost and direct
labour cost
The major cost associated with producing a
product (cont.)
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 Manufacturing costs (cont.)
Modern costing systems analyse costs
in greater detail than traditional costing
systems
Classifying direct material
Analysing labour costs may be analysed as
part of activity costs
In many industries, direct material is the
largest proportion of the manufacturing
cost and direct labour costs are the
smallest
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 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
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 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.)
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 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.)
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 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.)

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Cost flows in
manufacturing
business (cont.)

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 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.)
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 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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