Unit 3: Management Accounting

3.1 What is management accounting ?

Management accounting is involved with the provision of information (not raw data) to
managers and employees to help them to make decisions about the company. In this
regard it is internally focused and involves providing information on activities to help
them to plan, direct, control and make decisions. This also means that, unlike financial
accounting, it is not subjected to legal requirements or accounting standards
and may provide information that helps make decisions relevant to individual or parts of
the business rather than the organization as a whole. Management accountants provide
information from a range of sources including the core accounting system, physical and
operational data from production systems, market, customer and economic data from
information sources that may be external to the organization.
The key questions to think about as a management accountant are:
What information is required ? This information should be future oriented and
should be limited to that which is likely to be relevant to a business decision.
Furthermore, this information should not require any further processing by those for
whom it is being provided. It should also include a range of financial and nonfinancial information to help the decision maker to understand the both the financial
and social and contextual implications of decisions.
What skills does the user have ? Some users may be less numerately skilled.
In what form should this information be presented ? Graphs, pie charts, tables,
trend analysis.
A management accounting system is used to record and collect information. This system
should be tailored to the organizations requirements but commonly contains the following
components:
A costing and cost management system this is used to record the cost of goods
and services and the costs of departments, locations etc. It also provides information
for the improvement of an organizations costs.
A budgeting system this provides a detailed plan of the organizations operating
activities and associated costs and revenues for a specified period of time such as a
year.
A performance measurement system this is used to compare the actual
performance with the planned targets for performance.
In this unit, we will be learning only about costing. If you are interested in advanced topics on
budgeting and performance measurement, please refer to the source textbook (Atkinson et
al., Management Accounting, 5 th edition, Pearson publishing).
3.2 Costing
One common decision that a management accountant faces is to figure out which costs are
relevant for a decision. The term cost refers to a monetary measure of resources sacrificed
to achieve a particular objective. There are different costs for different decisions. To
understand how costs are used in management accounting we refer to some of the more
commonly employed terms such as cost object, direct and indirect costs, manufacturing
overhead etc..

3.2.1 Cost Object

A cost object refers to any activity or product for which the measurement of cost is
required. Cost objects may therefore range from the cost of operating a location, the cost
of a customer, the cost of operating a division or more obviously a product.
3.2.2 Direct and indirect costs
Direct costs: Those costs that can be specifically and exclusively identified with a particular
cost object. As an example we can mention the wood for manufacturing a particular type of a
desk in an organization.
Indirect costs: Those costs that can NOT be identified specifically and exclusively with a
given cost object. As an example we can mention the salaries of factory supervisors or the
rent of the factory.
It is considerable that sometimes direct costs are treated as indirect because tracing costs
directly to the cost object is not cost effective. As an example of this part we can mention the
nails used to manufacture a particular desk. Because the expense of nails is insignificant,
their cost is not that much considerable for justifying the profit.
Another point that should be considered is that a cost can be treated as direct for one cost
object but indirect in respect of another. For example if the cost object is the cost of using
different distribution channels, then the rental of warehouses will be regarded as direct cost.
However, if the cost object is the product, that cost will be considered as indirect one.

3.2.3 Categories of manufacturing costs

Traditional cost accounting systems accumulate product costs as follows:
Direct materials. xxx
Direct labor... xxx
Prime cost.. xxx
Manufacturing overhead.. xxx
Total manufacturing cost......xxx
Direct materials: consist of all those materials that can be identified with a specific product.
As an example wood that is used to manufacture a desk can easily be identified as part of
the product and can thus be classified as direct materials.
Indirect materials: These items of materials can NOT be identified with any one product,
because they are used for the benefit of all products rather than for any one specific product.
As an example the materials that used for the repair of a machine that is used for the
manufacture of many different desks are classified in this group. Indirect materials are part of
manufacturing overhead cost.
Direct labor costs: consists of those labor costs that can be specifically traced to or
identified with a particular product. As an example of this category we can mention wages of
operatives who assemble parts into the finished product.
Indirect labor costs: consists of those labor costs that can NOT be specifically traced to or
identified with a particular product. As an example of this part we can mention the wages of
all employees who do not work on the product itself but who assist in the manufacturing
operation.

Prime cost: refers to the direct costs of the product and consists of direct labor costs plus
direct material costs.
Manufacturing overhead: consists of all manufacturing costs other than direct labor, direct
materials and direct costs. Therefore it includes all indirect manufacturing labor and
materials costs plus indirect manufacturing costs. Rent of the factory and depreciation of
machinery in a multi-product company are classified in this category.
In order to determine the total of the direct costs or the prime cost for a product, the total
resources used should be multiplied by the price paid per unit of resources used.
Cost allocations: It is the process of estimating the cost of resources consumed by
products that involves the use of surrogate, rather than direct measures.
3.2.4 Elements of a product

Other manufacturing
costs

Materials

Direct

Indirect

Direct materials

Labor

Indirect

Factory overhead

Direct

Direct labor

3.2.5 Period and product costs

Product costs: Those costs that are identified with goods purchased or produced for resale.
Usually, accountants consider the cost of finished goods or partly completed goods until they
are sold.
Period costs: those costs that are NOT included in the inventory valuation and as a result
are treated as expenses in the period in which they are incurred.
In manufacturing organization all manufacturing costs are regarded as product costs and
non manufacturing costs are regarded as period costs. The cost of the goods purchased by
companies that are operating in merchandising is regarded as a product cost and all other
costs such as administration and selling and distribution expenses are considered to be
period costs.

3.2.6 Cost behavior

Variable costs: Short term variable costs are those in which the total cost changes in direct
proportion to changes in volume, or output, within the relevant range, while the unit cost
remains constant. Variable costs are controlled by the department head responsible for
incurring them. In simple words it means if we double the level of activity the total variable
cost will be doubled. So it is clear that total variable costs are linear and unit variable cost is
constant.
Total
variable
cost

Unit
variable
cost

3000
10
1000
100

300

100

200

300

400
Activity level
Units of output

Activity level
Units of output

Fixed costs: Fixed costs are those in which total fixed cost remains constant over a relevant
range of output, while the fixed cost per unit varies with output (For a specified period of
time) and the unit fixed costs decreases. As example of fixed cost we can mention
depreciation of the factory building, supervisors salaries and leasing charges for cars used
by the sales force.

Total
Fixed
Cost

Unit
Fixed
cost

Activity level

Activity level

Example 3.1
SuperGlass Company manufactures several interior architecture glass products. Unit costs
associated with a super strong glass product for stairs SSG5000 is
Direct materials
Direct labor
Variable support costs
Fixed manufacturing support costs
Sales commissions (2% of sales)
Administrative salaries
Total

200
40
60
100
10
50
460

Total product costs

200 + 40 + 60 + 100 = 400
Total period costs
10 + 50 = 60
Total variable costs:
200 + 40 + 60 + 10 = 350
Total fixed costs:
100 + 50 = 150
Total nonmanufacturing costs:
10 + 50 = 60
Total manufacturing costs:
200 + 40+ 60 + 100 = 400
Direct manufacturing costs:
200 + 40= 240
Note: Because SuperGlass is a manufacturing company, the total period and
nonmanufacturing costs are the same.

3.3 Cost-Volume-Profit (CVP) Analysis

This analysis is important for providing answer to questions such as:
How many units must be sold for a company to break even (zero profit) ?
What would be the effect on profits if we reduce our selling price and sell more units ?
Breakeven can be computed by using either:
(1) Equation method or the
(2) The graph method.
With the equation approach, breakeven sales in units is calculated using the following
relationship:
(Unit sales price x Units sold) (Variable unit cost x Units sold) Fixed expenses
= Operating profit

Breakeven

units

Fixed expenses
Unit sales price Variable

unit cost

Using the graph method, we plot a line for total revenues and total costs. This means that
the breakeven point is the point at which the total revenue line intersects the total cost
line. The area between the two lines to the right of the breakeven point is the operating
profit area.

3.4 Cost Allocation

Cost allocation involves the allocation of indirect costs to a cost object. These costs cannot
be traced to it in an economically feasible (cost effective) way. There are at least four
reasons why organizations allocate these costs:
To provide
1. information for economic decisions (e.g. To decide whether to add a new product or to
decide whether to manufacture a component part or to purchase it from another
manufacturer, or to decide on the selling price for a product).
2. To motivate managers and other employees.
3. To justify costs or compute reimbursement.
4. To measure income and assets for reporting to external parties
Management Accountants traditionally used relatively unsophisticated methods to allocate
indirect costs to cost objects. The result of this is cost smoothing where some products are
under-costed and others over-costed. In response, activity based costing (ABC) systems
were developed. In this section we focus first on developing your understanding of the
traditional systems and then we explain the activity based system in the next section We will
illustrate both traditional and ABC methods with examples.
Example 3.2 Traditional Cost Allocation.
Costs are normally allocated using (a) Direct method (b) Sequential method and (c)
Reciprocal method. Lets Illustrate this with an example.
HiTec Electronics (fictional company) manufactures LCD Panels on the outskirts of Leeds.
The following information is available about the manufacturing site:
Total square feet = 300,000
Total number of employees = 100
Maintenance is allocated to different departments using square feet.
Human Resources are allocated using number of employees in each department.

Budgeted costs
before allocations:
Square feet:
Number of employees:
Budgeted costs
before allocations:
Square feet:
Number of employees:

Maintenance

Human Resources

500,000
30,000
10

2,00,000
50,000
15

Assembly

Finishing

2,000,000
120,000
50

1000,000
100,000
25

Direct Allocation Method: allocates support department costs (Maintenance and

Personnel) to operating departments (Assembly and Finishing) only.
The allocation ratio for allocating Maintenance to Assembly is
120,000/220,000 x 500,000 = 272,727.
The allocation ratio for allocating Maintenance to Finishing is
100,000/220,000 x 500,000 = 227,273.

 The allocation ratio for allocating Human Resources to Assembly is

50/75 x 2,000,000 = 1,333,333.
The allocation ratio for allocating Human Resources to Finishing is
25/75 x 2,250,000 = 666,667.
Original costs:
Maintenance Allocated:
Human Resources Allocated:
Total

Assembly
2,000,000
272,727
1,333,333
3,606,060

Finishing
1000,000
227,273
666,667
1,893,940

Sequential Method: Allocates support department costs to other support departments

and to operating departments.
Which support department should be allocated first ?
The support department providing the greatest percentage of support to other support
departments is allocated first.
-

Maintenance provides 18.5 % (50,000/270,000) of its services to Human Resources.

Human Resources provides 11.8% (10/85) of its services to Maintenance.

The ratio to allocate Maintenance to Human Resources is

50,000/270,000 (or 18.5%) x 500,000 = 92,593.
The ratio to allocate Maintenance to Assembly is
(120,000/270,000) = (44.4 %) x 500,000 = 222,222.
The ratio to allocate Maintenance to Finishing is
(100,000/270,000) = (37.0 %) x 500,000 = 185,185.

Maintenance
Human Resources
Assembly
Finishing

Costs before
allocating Maintenance
500,000
2,000,000
2,000,000
1,000,000

Allocated
costs
(400,000)
92,593
222,222
185,185

Total
2,092,593
2,222,222
1,185,185

The ratio to allocate the 2,092,593 Human Resources costs to:

-- Assembly is 50/75 x 2,092,593 = 1,395,062.
-- Finishing is 25/75 x 2,092,593 = 697,531.

Human Resources
Assembly
Finishing

Costs before
allocating HR
2,092,000
2,222,222
1,185,185

Allocated
costs
(2,092,593)
1,395,062
697,531

Total
3,617,284
1,882,716

Reciprocal Method: Allocates costs by including the mutual services provided among all
support departments.
M
11.8%

Maintenance
Human Resources

HR
18.5%
-

A
44.4%
58.8%

F
37.0%
29.4%

Maintenance cost (M1) = 500,000 + 0.118*HR

Human Resource cost (HR1) = 2,000,000 + 0.185*M1
Maintenance cost (M1) = 500,000 + 0.118*(2,000,000 + 0.185*M1)
M1 = 500,000 + 236,000 + 0.022*M1
0.97817*M1 = 736,000
M1 = 752,425
HR1 = 2,000,000 + 0.185*(752,425)
HR1 = 2,139,199
Before allocation:
Allocation of M1:
Allocation of HR1:
Total

M
500,000
(752,425)
252,425
-

HR
2,000,000
139,199
(2,139,199)
-

A
2,000,000
334,077
1,257,849
3,591,926

F
1,000,000
278,397
628,925
1,907,322

Note: The direct method and the sequential method are less accurate than the reciprocal
method when support departments provide services to one another reciprocally.
Traditional systems were appropriate when:
1. Direct costs were the dominant costs
2. Indirect costs were relatively small.
3. Global competition was not as intense as today.
4. Product variety was limited.

3.4 Activity Based Costing (ABC)

ABC allocates costs to activities rather than to departments as in traditional systems. The
term activity cost driver is used to refer to the quantity of activities that is used by individual
products. For example it could include number of repairs, number of receipts, building
square footage, minutes of telephone call time. A cost driver rate refers to the monetary cost
of each individual activity (unit). This is calculated by dividing the total activity expense by
the total quantity of activity cost drivers. Lets Illustrate this with an example.
Example 3.3
WonderAl Company (fictional) makes two different grades of Aluminium. Grade SH101 is for
construction and housing and grade AT201 is for Auto and Transport. The Company has
identified four activities for WonderAls indirect costs.
Activity
Handle Production Runs
Set up machines
Support products
Run Machines

Activity Expense
(AE)
500,000
300,000
100,000
400,000

Activity Cost Driver

(ACDQ)
1000 production runs
5000 set up hours
2 products
10,000 machine hours

Step 1: Calculate activity cost driver rates

Activity

Activity Cost Driver

Handle Production Runs

Set up machines
Support products
Run Machines

500 per run

60 per setup hour
50,000 per product
40 per machine hour

Step 2: Calculate activity expense for each product

Activity
Handle Production Runs
Set up machines
Support products
Run Machines

ACDQ
SH101
600
2,000
1
7,000

AE
SH101
300,000
120,000
50,000
280,000

ACDQ
AT201
400
3,000
1
3,000

AE
AT201
200,000
180,000
50,000
120,000

Note: I have only illustrated a very simple example. I have skipped how ACDQ (Activity cost
driver quantity) for each product is calculated individually and summed up to obtain the total
ACDQ.
Finally lets consider when should a firm consider introducing ABC. There are a number of
characteristics that should be considered of the firm and its environment including:
Intensive competition.
Non-volume related indirect costs that are a high proportion of total indirect costs.
A diverse range of products, all consuming organisational resources in significantly
different proportions.
Complex products appear to be very profitable and simple products appear to be losing
money.
Operations staff have significant disagreements with the accounting staff about the
costs of manufacturing and marketing products and services.

References:
th

1. Atkinson et al.; Management Accounting, 5 edition, Pearson.

2. Woodrow et al., Management accounting lecture notes, MBS Worldwide.
3. Ilhan Dalci, Lecture notes on cost terms, Eastern Mediterranean University.
4. The Management Accountants role; Baldvindottir et al.; Financial Management, July/Aug
2009.
5. Management accounting and control: Lessons from the worlds tiniest companies; Datar et al;
Strategic Finance, Nov 2009.