Chapter 2

Management accounting:
basic terms and concepts

Copyright

2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An

Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith

Management accounting
information
Components
Costing system
Budgeting system
Performance measurement system
Cost management system

Conventional versus contemporary

approaches

Copyright 2003 McGraw-Hill Australia Pty

Conventional vs. contemporary

management accounting systems

Copyright 2003 McGraw-Hill Australia Pty

Emphasis on cost
Why do management accountants pay
so much attention to costs?
Historic focus on production costs, to value
inventory and COGS for external reporting
Ready availability of cost data within the
transaction-based accounting system
Importance of cost information in
managers decisions

Non-financial information has assumed

increased importance in contemporary
management accounting systems
Copyright 2003 McGraw-Hill Australia Pty

Cost classifications
Before classifying costs, need to
consider how managers intend to use
the cost information in decision
making
Different cost 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
continued

Copyright 2003 McGraw-Hill Australia Pty

Cost classifications
What are costs?
Resources given up to achieve a particular
objective
If the benefit extends beyond the current
accounting period these costs are
classified as assets
If the benefit is used, the costs are
classified as expense
Measured in monetary terms

Copyright 2003 McGraw-Hill Australia Pty

Cost behaviour
Managers must understand how costs
change as the as the level of activity
in the business changes
The level of activity is the level of work
performed in the organisation

Variable costs
Change in total in direct proportion to a
change in the level of activity
Sometimes referred to as unit-level costs
in product costing as they incurred for
each unit of product/service produced

continued

Copyright 2003 McGraw-Hill Australia Pty

Cost behaviour
Fixed costs
Remain unchanged in total despite
changes in the level of activity
Can be described as committed costs
Result from an organisations ownership or use
of premises and its basic organisation structure,
and is difficult to change in the short-term

or as discretionary costs
Result from managements decision to spend a
particular amount of money for some purpose,
and can be easily changed
continued

Copyright 2003 McGraw-Hill Australia Pty

Cost behaviour
Cost drivers
Any activities or factors that drive (cause)
costs

Conventional approaches focus on

production volume as the level of activity
(or cost driver)
Costs are classified as variable or fixed with
respect to production volume

Contemporary approaches recognise that

other (non-volume) cost drivers exist
Copyright 2003 McGraw-Hill Australia Pty

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
Products, projects, contracts and
departments are common cost objects in
conventional costing systems
Contemporary costing systems may also
include activities and customers as cost
objects

Copyright 2003 McGraw-Hill Australia Pty

10

Direct and indirect costs

In responsibility centres
The costing system may measure the costs
of managers individual areas of
responsibility
Costs that can be traced to a particular
responsibility centre are direct costs of
that centre
Costs that relate to responsibility centres,
but cannot be traced precisely to specific
responsibility centres are indirect costs of
those centres

continued

Copyright 2003 McGraw-Hill Australia Pty

11

Direct and indirect costs

Product costs
Manufacturing costs that can be traced to
product in an economic manner are direct
product costs
Indirect costs are manufacturing costs
that cannot be traced to products in an
economic manner

Whether a cost is classified as direct

or indirect depends on the nature of
the cost object
Copyright 2003 McGraw-Hill Australia Pty

12

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
continued

Copyright 2003 McGraw-Hill Australia Pty

13

Controllable and
uncontrollable costs

Copyright 2003 McGraw-Hill Australia Pty

14

Costs across the value

chain

The value chaina set of linked

processes or activities that begins
with acquiring resources and ends
with providing and supporting product
or services that customers value
Provides a useful framework for
examining the areas where costs are
incurred within a business
continued

Copyright 2003 McGraw-Hill Australia Pty

15

Costs across the value

chain
Upstream costs

Research and development costs include

the costs involved in developing new
products and processes
Design costs include the costs associated
with designing a product or production
process
Supply costs are the cost of sourcing and
managing incoming parts, assemblies and
supplies
continued

Copyright 2003 McGraw-Hill Australia Pty

16

Costs across the value

chain
Production costs

The costs incurred to collect and assemble the

resources used to produce a product or service

Downstream costs
Marketing costs are the cost of selling products
and the cost of advertising and promotion
Distribution costs are the cost of storing,
handling and shipping finished products
Customer service costs are the costs of serving
customers, including after-sales service

Copyright 2003 McGraw-Hill Australia Pty

17

Copyright 2003 McGraw-Hill Australia Pty

18

Manufacturing costs
Manufacturing costs are incurred within
the factory area, whereas upstream
and downstream costs are sometimes
called non-manufacturing costs
Manufacturing costs include three
categories: direct material, direct
labour and manufacturing overhead
This classification assumes that products
are the relevant cost objects
continued

Copyright 2003 McGraw-Hill Australia Pty

19

Manufacturing costs
Direct material
Material that is consumed in the
manufacturing process
Physically incorporated into the finished
products; and
Can be traced to products conveniently

Direct labour
The cost of wages and labour on-costs of staff
who work directly on manufacturing a product
However, contractual arrangement sometimes
means that such labour is a committed cost
continued

Copyright 2003 McGraw-Hill Australia Pty

20

Manufacturing costs
Manufacturing overhead
All manufacturing costs other than direct
material and direct labour
Also called indirect manufacturing costs or
factory burden
Includes the cost of indirect material and
indirect labour, depreciation and insurance
on factory equipment, utilities and the
costs of manufacturing support
departments
Also includes cost of overtime premium and
idle time

continued

Copyright 2003 McGraw-Hill Australia Pty

21

Manufacturing costs
Conversion costs
The total of direct labour and
manufacturing overhead costs
The cost of converting material into
product

Prime costs
The total of direct material and direct
labour costs
The major cost associated with producing
a product

continued

Copyright 2003 McGraw-Hill Australia Pty

22

Manufacturing costs
Contemporary costing systems
analyse costs in greater detail than
under conventional costing systems
Labour costs, and upstream and
downstream costs may be classified within
an activity framework

In general, direct material tends to be

the largest proportion of
manufacturing cost, and direct labour
costs the smallest
Copyright 2003 McGraw-Hill Australia Pty

23

Product costs
Managers need estimates of product
costs for different purposes
In financial accounting reports
To determine cost of goods sold
To value inventory on hand

For decision making

Definitions of product costs that include
non-manufacturing costs may be used

Copyright 2003 McGraw-Hill Australia Pty

24

Copyright 2003 McGraw-Hill Australia Pty

25

Cost flows in a manufacturing

business
1. Material is purchased: cost is added
to raw materials inventory
2. Direct materials are consumed in
production: cost is removed from raw
materials inventory and added to
work in process inventory
3. Direct labour and manufacturing
overhead are accumulated in work in
process inventory
continued

Copyright 2003 McGraw-Hill Australia Pty

26

Cost flows in a manufacturing

business
4. Products are completed: costs are
transferred from work in process
inventory and added to finished goods
inventory
5. Products are sold: costs are transferred
from finished goods inventory to cost of
goods sold expense
6. Cost of goods sold is deducted from
sales revenue to determine gross profit
continued

Copyright 2003 McGraw-Hill Australia Pty

27

Cost flows in manufacturing

business

Raw materials, work in processes and

finished goods inventories balances are
found in the Statement of Financial
Position
Cost of goods sold expense can be
found in the Statement of Financial
Performance
The Schedule of Cost of Goods
Manufactured and Schedule of Cost of
Goods Sold summarise the flow of
manufacturing costs
Copyright 2003 McGraw-Hill Australia Pty

28

Copyright 2003 McGraw-Hill Australia Pty

29

Cost and benefits of

information
Must determine which cost concepts
are most appropriate in each situation
Benefits of measuring and classifying
costs can be realised through
improvements in the quality of
managers decisions
Information overload occurs when
managers receive more information
than they can use efficiently
Copyright 2003 McGraw-Hill Australia Pty

30