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MANAGERIAL ACCOUNTING
Contents
1. Introduction
2. Cost terms, conce pts and terminologies
3. Cost cla s s ifica tion
4. Cos ting s ys te ms

1
Introduction

Accounting in the modern times, has two

distinct functions to perform.

1. Historical functions

2. Managerial functions
 The his torica l function is concerned with re cording,
classifying, summarizing and interpreting past
transactions for an accounting period of a business
enterprise.
 The obje ctive of this function is to report at re gula r
inte rva l
to users through financial statements.
 In the e a rly stag es of the a ccounting de ve lopme nt, the
historical functions were the primary tasks of accountants.

 These days, the ma na ge ria l functions have be come

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
controlling functions.
Management Accounting functions

1. Provision of relevant information to support decisions

a. budge ting

b. make resource a lloca tion, product mix a nd

process/department discontinuation decisions.

c. De te rmine s e lling price s ,

d. De ve lopme nt and introduction of new products a nd

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 a lte rna tive courses
Planning of a ction
Process 3. Gather data about alternatives
4. Select alternative courses of
5. action Implement the decisions

6. Compare the actual outcome

Controlling with planned ones
process
7. Respond to divergences from
plans
 The firs t five stages represent de cis ion-ma king
or
planning process.
 P la nning involve s choos ing a mong
a lte rna tive s
and is primarily a practice of decision-making.
 The fina l 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 provide s informa tion for

both
management and financial accounting.
 Cost Accounting m easures and re ports
fina ncia l
and non financial information relating to costs of
acquiring and/or utilizing resources in an
organization.
 Cost Accounting include s parts of both
management and financial accounting as it
collects and analyses cost information.
Cost Management: describes managers’ approaches
and a ctivitie s in the short-run and long-run
pla nning and control de cis ions that incre a s e va lue
for the custom ers and lowe r the costs of products
a nd s e rvice s .

For example: managers make decision regarding the

amount and kind of ma te ria ls be ing used, changes of
product de s ign etc, to decrease costs and incre a s e
va lue of product.
Cost terms, concepts and terminologies

Cost: is a resource sacrificed or forgone to achieve a specific

obje ctive . A cost is us ua lly m easured as the monetary
a mount that must be pa id to a cquire goods and s e rvice s .

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 a ffe ct costs over a
give n time s pa n.
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 s pe cific
re la tions hip between the le ve l or volume of
a ctivity and cost in que s tion.

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
obje ct in an e conomica lly fe a s ible
(cos t e ffe ctive ) wa y.
Example:
i. The cost of a bottle is a dire ct cost to P e ps i-Cola
because it can e a s ily be traced to or ide ntifie d
with the pe ps i product ( the s oft drink).
ii. Cost of paper is a dire ct cost for a bus ine s s
ma ga zine s b ecause it can be conve nie ntly traced
to a ma ga zine .
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

diffe re nt products. Unlike the costs of ma te ria ls , it is
s o difficult to trace s upe rvis or’s costs to product line .
Such costs are a lloca te d to products based on s ome
a lloca tion ba s e .
Thus, cost tracement is assigning direct costs to a particular
cost obje ct and cost a lloca tion is a s s igning indire ct costs to
a pa rticula r cost obje ct.

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 indire ct cost for
the product be ing produce d
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 pure ly va ria ble with re s pe ct

to
units produced when workers are paid on a unit
basis.
 In contrast, la bor costs may be cla ss ifie d a s fixe d
cost if the company agrees 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 costs are divided into three broad
categories.

a. Dire ct ma te ria ls

b. Dire ct la bor

c. Ma nufa cturing/fa ctory

ove rhe a d.
 Dire ct ma te ria l costs: becom e an inte gra l part of
the
finished product and can be physically and
conveniently traceable to it.
 Dire ct la bor costs: those la bor costs that ca n
be
essentially traced to individual units of products.
 Ma nufa cturing overhead costs: are a ll 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: Salaries 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.
i. Prime costs: are all direct manufacturing costs. It
includes direct materials and direct labor costs.
Prime costs = DMC + DLC
ii. 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
i. 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

ii. Period Costs: are costs other than cost of goods sold. They are
treated as expenses of the period in which they are incurred
b ecau se they are expected to be ne fit revenue of the
curre nt pe riod.
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
25

DM Used …………………………………… XXX

+ Direct Labor ………………… XX
+ Factory overhead cost(MOH)… X
X
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 XX
Cost of FG available for sale X
- Ending FG Inventory XXX
Cost of goods sold XX
X
XXX
I/S Format for a Ma nufa cturing Compa ny
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 (XXX)
Expenses…………………………
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 /S pe cific order

cos ting
2. Process Cos ting
3. Activity Based Cos ting
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 cos ting system is used by orga niza tions that make
s pe cia l orders, cus tomize d products, or standard products
produced in ba tche s .
 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:

 Ma nufa cture goods to fill s pe cia l orders from cus tome rs
 Produces diffe re nt line s of products for s tock
Produces standard products in batch rather than on a
continuous basis
Examples
An auditing activity by an accounting firm, Construction
Companies, Automobile Assemblies, Advertising
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

 J o b 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.
Job order Costing

1. Identify the job which is the 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. S e le ct the cos t-a lloca tion ba se to u se for a lloca ting indire ct 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
 Job order Costing
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 Predetermined

Allocated
= Allocatio
n base × Overhead rate
J o b order Costing

MOH Applie d
to each job
Direct us ing a
material pre de te rmine d
OH ra te

The Job

Direct
labor
 Job order Costing
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
ma nufa cturing cost of the year is Br 1,500,000 and the
e xpe cte d number of ma chine hours to be used in a year is
Br.15,000.
The direct material costs used amounts Br.18,000; the direct labor
cost amounts Br. 6,000 and the ma chine hours used to finis h job
11 is 80 hours. Compute the tota l cost of Job 11.
 J o b order Costing
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
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

sam e or s imila r amounts of dire ct ma te ria l, la bor costs and
othe r fa ctory overhead cos ts .

 Unit costs may then be calculated by dividing total costs incurred

by the tota l number of units of output from the production
proce s s on average ba s is .
2. Process Costing System
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 indus trie s that produces like or
s imila r units which are ofte n m ass produce d.
 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

Direct Material WIP Inventory

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

2. Process Cost Syst em

1. DM
WIP Inventory WIP Finished Cost of
2. DL
Department A Inventory Goods Goods
3. FOH
Department B Inventor Sold
y
 Similarities and differences
42

Similarities

The two costing systems are similar in three ways:

1. The manufacturing cost element: DM, DL & FOH
2. The a ccumula tion of the three ma nufa cturing
costs: Ra w ma te ria l is de bite d to raw ma te ria l
control account, DL is de bite d to WIP control
3. aThe
ccount.
flow of costs: RM WIP FG CGS
44

The Steps of Cost Allocation

1. Determine the Cost Objective (Cost Object).
2. Form Cost P ools : Accumula te indire ct costs for a pe riod of
3. time . S e le ct an a lloca tion b ase for each cost pool to re la te the
Cos t
Pools to Cost Objects, preferably a cost driver, that is, a
4. measure that causes the costs in the cost pool.
Measure the units of the cost-allocation base used for each cost
5. object and compute the total units used for all cost objects.
Determine the percentage of total cost-allocation base units
6. used for each cost object.
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)

 Dire ct ma te ria ls and dire ct la bor costs are easy to

tra ce
 Overhead cannot be traced e a s ily and must be with
a s s igne d
estimates
Need for the new system (ABC Costing)

 Amount of dire ct la bor used in many indus trie s ha s

de cre a s e d
 Tota l overhead from de pre cia tion on e quipme nt, utilitie s ,
re pa irs ,
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 ca us e s a cost to be incurred in producing a product
or a service.
providing
Activity Cost Pool The overhead cost allocated to a
distinct type of activity or related activities.
Indirect Costs

 Not e a s ily and conve nie ntly tra ce a ble to cost obje cts
• Cost e le me nt is shared among cost obje cts

• P hys ica lly impos s ible to tra ce

• Not cost e ffe ctive to tra ce
 Need for a lloca tion
 Es tima te product or a ctivity cos t

• What does it re a lly cos t?

 Incre a s e aw areness on indire ct cos ts

 Activities are cost not free

 P la n more cost e fficie nt ope ra tions

Criticisms on Traditional Overhead Cost Allocation

 As s ume s all overhead is volume-related (machine hours or

direct labor costs etc are main DRIVERS)

 Fa ctory-wide or de pa rtme nta l ra te s

All related to single activity measure

 De pa rtme nta l focus , not process focus

 Focus on costs incurre d, not cau se of cos ts

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

 P urpos e
 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 le s s like ly than tra ditiona l cos ting to under-cost

or
over-cost products
 ABC may le a d to improve me nts in cost control

 ABC can be expensive since data regarding numerous

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

 Any fa ctor or a ctivity that h as a dire ct ca us e -

effect relationship with the resources consumed.

 In ABC cost drive rs are used to a s s ign

a ctivity
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 Workstations
Requisitio Hours Used
ns
 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 - Mower
s

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 0.46
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 $375.0
Unit cost $150.00 0
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 a s s e t va lua tions for
fina ncia l re porting.
4. Justify costs or obtain reimbursement.
5. Setting sales prices for products and services
65

The End !!!