Part I

Foundations of
Management Accounting

Chapter 1 • Introduction to Management Accounting

Chapter 2 • Management Accounting and Decision-making

Chapter 3 • Financial Statements for Manufacturing Businesses

Chapter 4 • Classification of Manufacturing Costs and Expenses

Chapter 5 • Management Accounting Theory of Cost Behavior

Chapter 6 • Direct Costing Financial Statements

 Management Accounting |1

Introduction to Management Accounting

Introduction
Managerial accounting may be regarded as a body of knowledge that is
concerned with concepts and decision-making tools that enable management to
make better decisions and to evaluate results. As a body of technical knowledge,
management accounting primarily consists of certain decision‑making techniques or
tools drawn from financial and management theory and practice. A basic premise is
that the primary task of management is to make decisions and that this task is greatly
improved by the knowledge and skills of the management accountant. A corollary
premise is that the management accountant’s ability to serve management is greatly
enhanced by a knowledge of management and, in particular, a sound knowledge of
the fundamentals of marketing, production, and finance.
This book is based on the assumption that the accountant in the role of advisor
to management must understand basic management concepts, particularly those
concepts embedded in the function of decision‑making. Only if the accountant has
a proper understanding of management’s needs will he or she be able to furnish
the data and special analyzes that will enable management to make consistently
good decisions. Conversely, this book assumes that management must understand
accounting and the type of information that the accountant can provide. Without
an understanding of some accounting, the manager or decision‑maker may fail to
request information or seek help at a critical time. Therefore, this book is written for
two groups of individuals: accountants and managers. The accountants, of course,
are expected to acquire a higher degree of proficiency in the use of the planning and
control techniques presented.
2 | CHAPTER ONE • Introduction to Management Accounting

Definition of Management Accounting

What is accounting? A very old but frequently used definition states: “Accounting is
the art of recording, classifying, and summarizing in a significant manner and in terms
of money, transactions, and events, which are, in part at least of a financial character,
and interpreting the results thereof.” (AIA Bulletin No. 1 ‑ Review and Resume)
A more recent definition states: “Accounting is a service activity. Its function is to
provide quantitative information, primarily financial in nature, about economic entities
that is intended to be useful in making economic decisions–in making reasoned
choices among alternative courses of action.” (APB Statement No. 4) This latter
definition is more appropriate to managerial accounting because of its emphasis on
decision‑making.
Management accounting may be simply defined as a body of accounting knowledge
primarily consisting of concepts and techniques (tools) useful to management in
making better decisions and evaluating performance. Most managerial accounting
theorists and writers agree that the following concepts and tools represent the
foundation of management accounting:
Decision-making Tools Concepts
1. Cost‑volume‑profit analysis 1. Fixed and variable costs
2. Comprehensive budgeting 2. Escapable and inescapable costs
3. Flexible budgeting 3. Relevant costs
4. Incremental analysis 4. Incremental costs
5. Return on investment 5. Sunk costs
6. Direct costing 6. Opportunity costs
7. Capital budgeting 7. Common costs
8. Inventory models 8. Direct and indirect cost
9. Cost analysis for marketing 9. Contribution margin
production, and finance 10. Planning
10. Segmental income statements 11. Control
11. Financial statement ratio analysis 12. Standards
13. Organization
From the above listing, it is apparent that the subject matter of management
accounting has little to do with transactions analysis and the preparation of statements
from historical data. However, management accounting is not independent of financial
accounting. Financial accounting is a foundation requirement for management
accounting and a study of financial accounting must precede the study of management
accounting. The basic carryover from the study of financial accounting is a solid
understanding of financial statements. An understanding of how to analyze and
record the effects of individual transactions of assets, liabilities, capital, and revenue
is helpful but not essential.
Management: The Focal Point of Management Accounting
The term management accounting obviously consists of two words each of which
represents highly developed areas of study. The term management accounting
suggests an important relationship between management and accounting.
 Management Accounting |3

Furthermore, there is implied an area of common interests. Management accounting

is not merely the application of accounting to management; rather it is a study of
analytical techniques that result from the combining of accounting fundamentals with
the fundamental concepts of management.
The student that is planning a professional career in accounting must develop
an appreciation and understanding of management. It is management that guides
the business and makes the decisions which determine the success or failure of a
business. The accountant serves in a staff or advisory function under management.
On the other hand, those students planning a professional career as managers
need to understand and appreciate that a knowledge of accounting is critically
important. Although accountants use technical accounting expertise to prepare
financial statements, it is management that receives and uses financial statements.
Management, not accountants, has the need and responsibility to read and understand
financial statements. Financial statements, in one sense, are summary reports of
how well management has performed (made decisions) for a given period of time.
For management to have a negative attitude towards accounting is tantamount to
being negative towards their own responsibilities and accomplishments.
Certain concepts of management are essential to a study of management
accounting. The following concepts will be employed throughout this text as important
in understanding the technical aspects of management accounting.
Planning
Control (performance evaluation)
Organization
Standards
Decision‑making
Feedback
Goals and objective
Strategy
These terms will be explained in the chapters where they can be logically
associated to the management accounting tools that make them relevant.
Accounting as an Organizational Function
Management accounting techniques are useful in all types of businesses.
Managers of service, merchandising, manufacturing, banks, insurance companies,
etc. all can benefit from the use of management accounting. Management accounting
is frequently associated with fairly large corporate businesses; however, it is equally
useful to small businesses.
When a business reaches a certain size, then the accounting activity is of such a
volume that the accounting activity must be organized and managed. Consequently,
accounting in larger businesses can be thought of as a departmentalized function
appearing on the organization chart as a staff function. While the term management
accounting implies to individuals possessing specialized knowledge of management
and accounting, the term can also be applied to the accounting department as a whole.
A simple model of the accounting function is shown in Figure 1.1. The management
techniques presented in this book would primarily be used in the budgeting and
revenue and cost analysis section of the accounting department.
4 | CHAPTER ONE • Introduction to Management Accounting

From a departmental viewpoint, all accounting activities are management in nature.

The accounting department exists to serve the financial data needs of management.
The controller or head of the accounting department in many companies is considered
to be a part of the decision‑making team. Therefore, from an organizational viewpoint,
the distinction between financial accounting and managerial accounting is somewhat
artificial. The controller, the chief executive officer of the accounting department, is
always serving as an management accountant, regardless of what type of accounting
is being done. However, the majority of accounting activities he or she supervises
would from an academic viewpoint be classified as financial accounting as opposed
to management accounting.
Relationship of Financial and Managerial Accounting
The study of accounting is normally divided into two broad categories: financial
and managerial. This division is somewhat arbitrary in that the study of managerial
accounting requires a strong foundation in financial accounting. However, there is a
definite difference in orientation and methodology which needs to be understood.
Accounting exists in a network of complex business relationships both internal
and external. In management accounting, the focal point is the role of management
within the organizational structure. Both the financial accountant and the managerial
accountant need a knowledge of external factors and relationships as well as a
conceptual knowledge of accounting principles and procedures. Accounting as a
function within a business organization is service oriented. Accounting serves the
financial information needs of many different types of groups including investors,
governments, customers, employees, unions, and bankers. Most importantly, it serves
the internal information needs of management. Figure 1.2 illustrates the environment
in which management and the management accountant operate.

FIGURE 1.1 • Diagram of the Accounting Function

Board of
Directors

President

Marketing Production Finance

Department Department Department

Accounting
Department
 Management Accounting |5

In a broad sense, financial accounting, as a branch of accounting in general,

serves all types of users. Management accounting, on the other hand, is intended
to serve primarily management’s internal information needs; therefore, managerial
accounting is not governed by strictly defined and publicly promulgated principles
and standards. Financial accounting is concerned with the reporting of operations
to external parties; whereas, management accounting is internal in direction and is
primarily concerned with serving the decision‑making needs of management.
Management accounting as a body of technical knowledge is, in fact, a synthesis
of various disciplines. Many of the techniques such as capital budgeting models and
EOQ models have been borrowed from other disciplines. The conceptual framework
of management accounting, then, has building blocks in its foundation from:
1. Management theory ( planning, control, organization)
2. Financial accounting (financial statements)
3. Finance theory (capital budgeting, working capital)
4. Economic theory (pricing, forecasting, supply, demand, cost behavior)
5. Marketing theory (order getting, order processing, order delivery)
6. Mathematics (algebra, calculus)
Therefore, an understanding of management accounting is greatly enhanced, if
preceded by a knowledge of the fundamentals of management, finance, production,
marketing, economics, and mathematics.
Environmental Structure of Accounting
Accounting is a complex body of knowledge and procedures that has evolved
over the last few hundred years. The complexity of accounting in the last fifty years
has greatly accelerated as more complex financial transactions have been developed
and regulatory agencies, both private and non private, have come into existence.
Voluminous rules and regulations, (for example, Financial Accounting Standards)
have been written and put into practice. Also, the rapid development of personal
computers and very powerful accounting and systems software has had its impact
in accelerating the complexity of accounting. Within accounting, there are highly
developed specialized areas such as the following:
Tax accounting Accounting Information Systems
Financial auditing Internal auditing
Management accounting Financial accounting
Not-for-profit accounting Governmental accounting
Accounting as a profession employs hundreds of thousands of individuals who
serve both in public accounting and private accounting. As of 2006, there were
approximately 650,000 CPAs in the USA. Accounting is needed in every type of
business and organizations including state and federal governments, banks, not-for-
profit businesses, manufacturing and retail businesses of all types, and labor unions.
The professional accountant needs to have an awareness and knowledge of how
the financial and economic environment has an impact on business. Also, an acute
awareness of the many different types of organizations that a business interacts with
is crucial to being a successful management accountant.
6 | CHAPTER ONE • Introduction to Management Accounting

Comparison to Financial Accounting

The differences between financial and managerial accounting can be effectively
illustrated by using (1) an input and output approach and (2) a financial statement
approach. Both approaches will be illustrated.
Input/output Approach - Although narrower in scope of users, management
accounting, nevertheless, is broader in scope in the type of data used in the models
through which data is processed and analyzed. The input and output diagrams
illustrated in Figures 1.3 and 1.4 reveal the differences in the nature of inputs and the
mode of processing between financial and management accounting.
The input/output diagram shown in Figure 1.4 reveal that management accounting
deals with a wider range of inputs and outputs. Also, the methodology of processing
data involves numerous types of mathematical model. The inputting, processing, and
outputting of data in management accounting is not limited to a prescribed set of
rules dealing only with historical data as is the case in financial accounting.
Financial Statement Approach
Both financial accounting and management accounting are concerned with financial
statements. The financial accountant is concerned with analyzing and recording the
historical transactions (past decisions) of the business. A primary objective of the
financial accountant is to fairly present financial statements based on past events (see
Figure 1.3). The management accountant is primarily concerned with desired future

Figure 1.2 • Accounting Environment

ORGANIZATIONS

Governments Financial Business

Business Firms Labor Unions Consumers Investors
(States & Federal) Instiltutions Professions

President

Financial Accounting Accounting System

Marketing Production Finance

Balance Income Cash Flow General Ledger

Jourlnals
Sheet Statement Statement
Accounting
Special Journals

Auditing Systems Payroll General

Cost Accounting Budgeting
Accounting

Accounting Theory and Methodlogy

Theory Assumptions Standards and Recording Rules Statistical and Mathematical Techniques
 Management Accounting |7

events. Future events will be the results of decisions to be made by management.

The management accountant, then, is also concerned with financial statements
(e.g. budgeted financial statements) that reflect the anticipated consequences of
planned decisions (planned transactions). For example, the financial accountant is
concerned with questions such as: What is the amount of cash on hand? What is the
cost of inventory on hand? The management accountant, however, is concerned with
questions such as: What amount of cash should be on hand? What is the desired
level of inventory? Figure 1.5 summarizes the differences in viewpoint for each item
on the balance sheet and income statement.

Figure 1.3 • Financial Accounting

Inputs
Accounting Transactions
(Historical Data)

Accounting Department
Accounting transactions are processed by means
of journals, accounts and ledgers. Now done
primarily by use of accounting software and computers.

Outputs
Income Statement
Balance Sheet
Statement of Cash Flows
Other types of financial reports

Figure 1.4 • Managerial Accounting

Inputs
Planned data, Statistical data, Future costs.
Standards, Historical accounting data, if relevant

Accounting Department
Data for decision-making and performance
evaluation are processed by means of budget
models, forecasting models, cost analysis
techniques, etc.

Outputs
Operating budgets
Capital budgets
Flexible budgets
Special reports (graphic, tables)
Summaries and Schedules
Segmental income statement
8 | CHAPTER ONE • Introduction to Management Accounting

Figure 1.5

Summary of Financial And Managerial Accounting Points of View

Financial Accounting Viewpoint Managerial Accounting Viewpoint

1. CASH 1. CASH
What is the balance? How much cash should be on hand?
Emphasis is on: Emphasis is on:
General journal entries, Cash budgeting, cash flow, alternative
bank reconciliations, petty cash. uses of cash.

2. ACCOUNTS RECEIVABLE 3. ACCOUNTS RECEIVABLE

What is the amount that is collectible?
Emphasis is on:
Estimation of bad debts, factoring,
recording of collections.
What should the credit terms be?
Emphasis is on:
Effect of different credit terms, bad debt
factors, analysis of credit revenue and
expenses.

3. INVENTORY 3. INVENTORY
What is the historical dollar amount that What is the optimum level of inventory?
should be assigned to inventory? Emphasis is on:
Emphasis is on: EOQ models, safety stock, quantity
Inventory cost methods, methods of discounts.
estimating inventory.

4. FIXED ASSETS 4. FIXED ASSETS

What is the unamortized amount?
Emphasis is on:
Depreciation methods, journal entries or
trades and retirements.
How much plant and equipment is
needed?
Emphasis is on:
Capacity requirements, capital
budgeting, replacement of equipment.

5. SHORT-TERM DEBT 5. SHORT-TERM DEBT

What amount is owed? How much short-term debt is needed?
Emphasis is on? Emphasis is on:
Recording accrued liabilities and interest Cost of capital, debt/equity ratios, cash
expense. budgeting, and risk.

6. LONG-TERM DEBT 6. LONG-TERM DEBT

What amount is owed? How much long-term debt should be
Emphasis is on: issued?
Amortization of bond premium and Emphasis is on:
discount, accrued interest, and bond Cost of capital, debt/equity ratio, cash
refunding. budgeting, issuance of different types
of securities.
 Management Accounting |9

7. STOCKHOLDERS’ EQUITY 7. STOCKHOLDERS’ EQUITY

What is the amount of stock issued?
How should different types of stock
transactions be recorded?
Emphasis is on:
Recording different types of stock
transactions, recording of different types
of dividends.
How much stock should be issued?
What kind of stock security should be
issued?
Emphasis is on:
Cost of capital, debt/equity ratio, cash
flow, and amount of dividends.

8. SALES 8. SALES
How much were sales? What will the amount of sales be?
Emphasis is on: Emphasis is on:
Recording of sales and purchases Sales forecasting, pricing, cash
transactions. budgeting, methods of increasing
sales.

9. EXPENSES 9. EXPENSES
How much were expenses? What should the amount expenses be?
Emphasis is on: Emphasis is on:
Journal entries, accrued expenses, Budgeting, flexible budgeting cost-
depreciation, bad debts. volume-profit analysis.

The Management Accountant

The management accountant is a professional accountant just like the CPA. He
or she is likely to possess a degree in accounting. However, unlike the CPA, the
management accountant is more likely to work for an industrial firm rather than an
accounting firm. In a manner similar to the CPA, he or she may even be certified.
The Institute of Management Accountants which is the professional organization of
management accountants has over 70,000 members. The IMA gives twice a year a
comprehensive three day exam over the knowledge expected of the management
accountant. Individuals passing all parts of the exam are awarded a Certificate in
Management Accounting (CMA). CMA’s are governed by a set of ethical rules and
are also required to accumulate a certain number of CPE hours each year. The exam
is a difficult test with less than 20% of those taking the exam passing in one setting.
The exam is given in five parts covering the following subject areas: (1) managerial
economics and business finance, (2) organization and behavior, (3) public reporting
standards, auditing and taxes, (4) periodic reporting for internal and external purposes,
and (5) decision analysis, including modeling and information systems. If you are
interested in learning more about the IMA, visit their web site, IMA.COM.
Management Accounting Conceptual Framework
The real business world is extremely complex. The environment in which the
accountant and manager operates has myriads of components which are highly
10 | CHAPTER ONE • Introduction to Management Accounting

interrelated. A successful approach in dealing with complexity is to develop a model

which contains the components of reality that need to be studied and understood.
Most management accounting books have some underlying model; unfortunately,
these authors’ use of the model is seldom well‑defined or clearly presented. This
book is based on a well defined model, somewhat traditional in nature, but different
in approach in that it is explicitly defined and consistently used throughout the book.
Furthermore, a comprehensive management accounting simulation based on the
same model accompanies the book. This management accounting model will facilitate
the understanding of how accounting and management are interrelated and how they
have a mutual dependency upon each other. Furthermore, this model clarifies the
relationship of financial and managerial accounting. This conceptual management
accounting framework is presented in chapter 2.
Summary
Management accounting consists of a body of knowledge that consists of tools
capable of helping management make better decisions. The tools require special
types of information not normally found in the traditional records of the accounting
system. In management accounting, the accounting function is required to provide
a much broader range of information. Also, in management accounting, the role of
the accountant is perceived to be much broader. Consequently, the accountant is
expected to have a much better understanding of marketing, production, and finance
fundamentals. Management accounting is a subject that should be understood by
both management and accountants.

Q.1.1 List six examples of tools that the management accountant could use
to help management to make decisions.
Q.1.2 List several features of management accounting that make it different
from financial accounting.
Q.1.3 What types of activities both financial and managerial does the
accounting department within a business provide?
Q.1.4 In terms of financial statements and from a management accounting
point of view, what kinds of questions does the management accountant
ask?
Q.1.5 In the study of management accounting, what kind of concepts would
you be likely to encounter that are more important than in financial
accounting?

Exercise 1.1 • Financial and Management Accounting Compared

For each item or statement listed below, indicate (4) whether this item or statement
pertains more to financial accounting or to management accounting.
 Management Accounting | 11

Financial Management
Statement/item
Accounting Accounting

Information is made available to management to make a

1
purchase decision.

2 Use of the sales journal to record sales on credit.

“Accounting is the art of recording, classifying, and

3
summarizing transactions and event…”
Use of fixed and variable costs to develop standards for
4
evaluating performance.

5 “Accounting is a service activity…”

Preparation of a segmental contribution income

6
statement.

7 Installation of a payroll accounting system.

8 Installation of a profit planning system.

Installation of a cost system for material, labor, and

9
overhead.
A body of knowledge that uses concepts and techniques
10 from management, marketing, and financial theory and
also uses techniques from economics and mathematics.
More likely to ask the question, what is the correct cash
11
balance?
More likely to ask the question, what is correct cost
12
amount to assign to inventory?
More likely to ask the question, what amount of inventory
13
should be on hand?
More likely to ask the question, how much plant capacity
14
is needed?
Concerned with the procedures for recording issue of
15
stocks and bonds.
Concerned with determining whether to issue stocks or
16
bonds.
The body of knowledge that must be learned to become
17
a CPA.

The body of knowledge that must be learned to become

18
a CMA.

More likely to be concerned with future events and also

19
with the internal events of a company.

More likely to be concerned with historical external

20
events such as transactions already completed.
12 | CHAPTER ONE • Introduction to Management Accounting

Exercise 1.2 • Financial and Management Accounting Compared

For each item or statement listed below, indicate (4) whether this item or statement
pertains more to financial accounting or to management accounting.

Financial Management
Statement/item
Accounting Accounting

The IRS has requested certain invoices and documents

1
to support certain expenses deducted for tax purposes.

The vice president of marketing has requested certain

2
cost estimates concerning a new proposed product.

A customer returned a defective product purchased the

3
previous day. An entry to his account was made.

A significant increase in advertising has been made and

4 a request has been made concerning by how much sales
much increase to offset the increase in advertising.

An income statement showing segmental contribution

5
and segmental net income has been requested.

An analysis of operating expenses in terms of fixed and

6
variable expenses has been requested.

A physical inventory of raw materials has been made and

7
the count compared to perpetual inventory records.

A new sales people compensation plan has been

8 proposed and an analysis of the effect on sales and total
sales people compensation has been requested.

Two supplier have made a proposal concerning the sale

9 and installation of new production equipment. Only one
proposal will be accepted.

10 A new computerized accounting system was installed.

 Management Accounting | 13

Exercise 1.3 • Financial and Management Accounting Compared

For each item or statement listed below, indicate (4) whether this item or statement
pertains more to financial accounting or to management accounting.

Financial Management
Statement/item
Accounting Accounting

1 General Ledger

2 Cost-volume-profit tool

3 Accounts

4 Comprehensive business budgeting

5 Inventory costing using FIFO

6 Recordings sales in the sales journal
7 Making end-of-year adjusting entries
8 Preparing segmental income statements

9 Comparing actual results against standards

10 Preparing income tax forms

11 Preparing manufacturing overhead rates
12 Subsidiary ledgers

13 Use of ratios to evaluate performance

14 Recording materials issued in a materials used summary

Preparing financial statements from an adjusted trial

15
balance
Using incremental analysis to evaluate which equipment
16
to purchase

17 Recording labor incurred in a labor cost summary

Installing a perpetual inventory system to control raw

18
materials

19 Preparing a cost of goods manufactured statement

20 Sending the annual report to stockholders

14 | CHAPTER ONE • Introduction to Management Accounting