1 The Nature and Purpose of

Management Accounting
Overview
• The role of the management accounting function as an information
provider has developed with advances in technology. In order to
assess the effectiveness of the management accounting function, a
clear understanding is needed of its objectives and activities, so that
appropriate measures of performance can be determined.
• Information may be presented to management in the form of a
report. Where reports are prepared, they should be presented in a
suitable format.
Key concepts and definitions
• Financial accounting systems ensure that the assets and liabilities of a business are properly
accounted for, and provide information about profits and so on to shareholders and to other
interested parties.
• Management accounting systems provide information specifically for the use of managers
within the organisation.
• Cost accounting and management accounting are terms which are often incorrectly used
interchangeably. Cost accounting is part of management accounting. Cost accounting provides a
bank of data for the management accountant to use. Information provided by management
accountants is likely to be used for planning, control and decision making.
• A management control system is a system which measures performance against a target or
benchmark, and indicates where control action may be required to make sure that the objectives
of an organisation are being met and the plans devised to attain them are being carried out.
• A management accounting system comprises people with accounting knowledge, technology,
records, processes, mathematical techniques, reports and the users for whom those reports are
prepared. The key components of the system are: inputs, processes and outputs. It is used for
strategic decision making, performance measurement, operational control and costing.
2 Basic Concepts of Cost
Accounting
Key concepts and definitions
• Organisations need costing systems that will provide the basic information that
management requires for planning, control and decision-making.
• A cost unit is the basic unit of measurement selected for cost control purposes.
• A cost centre is used as a ‘collecting place’ for costs, which may then be further
analysed and related to individual cost units.
• A cost object is anything for which costs can be ascertained. Examples are a product,
service, a centre, an activity, a customer and a distribution channel.
• Costs may be classified in a number of different ways depending on the reason for
the classification exercise. The main classifications are according to:
their nature (material, labour, expenses),
according to their purpose (direct or indirect)
according to responsibility.
• The concept of cost needs to be qualified as direct, full, marginal, etc.
in order to be meaningful.
• Costs which are not affected by changes in the level of activity are
fixed costs or period costs.
• A stepped fixed cost is constant within the relevant range for each
activity level.
• A variable cost increases or decreases in line with changes in the level
of activity.
• A cost which is partly fixed and partly variable is a semi-variable,
semi-fixed or mixed cost.
3 Cost behaviour and CVP
Analysis
Key concepts and definitions
• Cost behaviour is the way in which costs are affected by changes in
the levels of activity.
• The basic principle of cost behaviour is that as the level of activity
rises, costs will usually rise. It will cost more to produce 2 000 units of
output than it will to produce 1 000 units.
• Cost-volume-profit (CVP)/break-even analysis is the study of the
interrelationships between costs, volume and profits at various levels
of activity.
• The C/S ratio (or P/V ratio) is a measure of how much contribution is
earned from each $1 of sales.
• The safety margin is the difference in units between the budgeted
sales volume and the breakeven sales volume.
• It is sometimes expressed as a percentage of the budgeted sales
volume.
• The safety margin may also be expressed as the difference between
the budgeted sales revenue and the break-even sales revenue
expressed as a percentage of the budgeted sales revenue.
• At the break-even point, sales revenue = total costs and there is no
profit. At the break-even point total contribution = fixed costs.
• The target profit is achieved when S = V + F + P. Therefore, the total
contribution required for a target profit = fixed costs + required profit.
• The break-even point can also be determined graphically using a break-
even graph or a contribution break-even graph.
• These graphs show approximate levels of profit or loss at different
sales volume levels within a limited range.
• Break-even analysis is a useful technique for managers as it can
provide simple and quick estimates. Break-even graphs provide a
graphical representation of break-even calculations.
• Break-even analysis does, however, have a number of limitations.
4 Analysis of Overheads
Overview
• In this topic you will learn about the analysis of indirect costs or
overheads. We will be looking at the three-stage process of
attributing overheads to individual cost units: allocation,
apportionment and absorption.
Key concepts and definitions
• The three stages in attributing overheads to cost units are allocation,
apportionment and absorption. Allocation involves allotting whole
items of cost to a single cost centre.
• Apportionment is necessary when it is not possible to allot the whole
cost to a single cost centre.
• The cost must then be apportioned between cost centres using a suitable
basis.
• The primary apportionment of production overheads involves
apportioning the overhead costs to all cost centres.
• The secondary apportionment is then necessary to reapportion the
service cost centre costs to the production cost centres.
• The final totals of the production cost centre overheads are absorbed into
product costs using a predetermined production overhead absorption
rate.
• The absorption basis should reflect the type of activity undertaken within
each production cost centre.
• The production overhead absorption rate is calculated by dividing
the budgeted cost centre overheads by the budgeted number of units
of the absorption base (machine hours, direct labour hours, etc.).
• Under- or over-absorption arises at the end of a period when the
amount of production overhead absorbed into cost units is lower
than or higher than the actual production overhead incurred during
the period.
5 Marginal Costing
Overview and key concepts
• Marginal costing as a cost accounting system is significantly different
from absorption costing. It is an alternative method of accounting for
costs and profit, which rejects the principles of absorbing fixed
overheads into unit costs.
• In marginal costing, fixed production costs are treated as period costs
and are written off as they are incurred. In absorption costing, fixed
production costs are absorbed into the cost of units and are partially
carried forward in inventory to be charged against sales for the next
period. Inventory values using absorption costing are therefore
greater than those calculated using marginal costing.
7 Activity Based Costing
Overview and key concepts
• Traditional costing systems, which assume that all products consume
all resources in proportion to their production volumes, tend to
allocate too great a proportion of overheads to high volume products,
which use fewer support services and too small a proportion of
overheads to low volume products, which use more support services.
• Activity-based costing (ABC) attempts to overcome this problem and
charge overheads on the basis of the use of support services.
• ABC involves the identification of the factors (cost drivers) which cause
the costs of an organisation's major activities. Support overheads are
charged to products on the basis of their usage of an activity.
• When using ABC, for costs that vary with production levels in the
short term, the cost driver will be volume related (labour or machine
hours).
• Overheads that vary with some other activity, and not volume of
production, should be traced to products using transaction-based
cost drivers such as production runs or number of orders received.
• The main criticism of marginal costing decision making information is
that marginal costing analyses cost behaviour patterns according to
the volume of production.
• However, although certain costs may be fixed in relation to the
volume of production, they may in fact be variable in relation to
some other cost driver.
• ABC should only be introduced if the additional information it
provides will result in action that will increase the organisation's
overall profitability.
• ABC identifies four levels of activities: product level, batch level,
product sustaining level and facility sustaining level.
• ABC has a range of uses and has many advantages over more
traditional costing methods. However, the system does have its critics
and it is not a panacea for all costing problems.
8 Process Costing
Overview
• The chapter begins by considering process costing. Process costing is applied
when output consists of a continuous stream of identical units.
• We will begin with the basics and look at how to account for the most simple of
processes. We will then move on to how to account for any losses which might
occur, as well as what to do with any scrapped units which are sold.
• Next we will consider how to deal with closing work in process before examining
situations involving closing work in process and losses. We will then go on to
have a look at situations involving opening work in process and how to deal with
situations where we have both opening and closing work in process and losses.
• This is followed with an outline discussion of joint products and by-products.
Key concepts
• Process costing is a costing method used where it is not possible to identify
separate units of production, or jobs, usually because of the continuous
nature of the production processes involved.
• Costs incurred in processes are recorded in what are known as process
accounts. A process account has two sides, and on each side there are two
columns – one for quantities (of raw materials, work in process and finished
goods) and one for costs.
• A suggested four-step approach when dealing with process costing
questions.
Step 1 Determine output and losses.
Step 2 Calculate cost per unit of output, losses and WIP.
Step 3 Calculate total cost of output, losses and WIP.
Step 4 Complete accounts.
• Losses may occur in a process. If a certain level of loss is expected, this
is known as normal loss.
• If losses are greater than expected, the extra loss is abnormal loss.
• If losses are less than expected, the difference is known as abnormal
gain.
• Joint products are two or more products separated in a process, each
of which has a significant value.
• A by-product is an incidental product from a process which has an
insignificant value compared to the main products(s).
9 Specific Order Costing: Job
and Batch Costing
Overview and key concepts
• Specific order costing methods are appropriate for organisations which produce cost units
which are separately identifiable from one another.
• Job costing and batch costing are types of specific order costing that you will learn about in
this topic.
• In organisations which use these costing methods, each cost unit is different from all others
and each has its own unique characteristics.
• Job costing applies where work is undertaken according to individual customer requirements.
• Each job is of relatively short duration and may be undertaken on the customer’s premises or
on the contractor’s premises.
• In a job costing system, each job is given a unique number and the costs of each job are
collected and analysed on a job cost sheet.
• Batch costing is a form of job costing where each batch of similar items is a separately
identifiable cost unit.
10 Standard Costing
Key concepts
• A standard cost is a carefully predetermined unit cost.
• It is established in advance to provide a basis for planning, a target for achievement
and a benchmark against which the actual costs and revenues can be compared.
• The difference between the standard cost and the actual result is called a variance.
• The analysis of variances facilitates action through management by exception,
whereby managers concentrate on those areas of the business that are performing
below or above expectations and ignore those that appear to be conforming to
expectations.
• A number of different performance levels can be used in setting standards.
• The most common are ideal, attainable and current.
11 Variance Analysis
Overview
• The actual results achieved by an organisation during a reporting
period (week, month, quarter, year) will, more than likely, be different
from the expected results, the expected results being the standard
costs and revenues which we looked at in the previous chapter.
• Such differences may occur between individual items, such as the cost
of labour and the volume of sales, and between the total expected
profit and the total actual profit.
• This topic examines variance analysis and sets out the method of
calculating the variances.
Key concepts
• A variance is the difference between a planned, budgeted, or standard cost and the actual
cost incurred. The same comparisons can be made for revenues. The process by which the
total difference between standard and actual results is analysed is known as the variance
analysis.
• The direct material total variance can be subdivided into the direct material price variance
and the direct material usage variance.
• Direct material price variances are usually extracted at the time of receipt of the
materials, rather than at the time of usage.
• The direct labour total variance can be subdivided into the direct labour rate variance and
the direct labour efficiency variance.
• If idle time arises, it is usual to calculate a separate idle time variance, and to base the
calculation of the efficiency variance on active hours, when labour actually worked, only. It
is always an unfavorable variance.
• The variable production overhead total variance can be subdivided into the variable
production overhead expenditure variance and the variable production overhead
efficiency variance, based on active hours.
• The fixed production overhead total variance can be subdivided into an expenditure
variance and a volume variance.
• There are many possible reasons for cost variances arising, including changes in the
price or use of material, the availability of labour and the efficiency of machinery.
• Materiality, controllability, the type of standard being used, the interdependence of
variances and the cost of an investigation should be taken into account when deciding
whether to investigate reported variances.
• The selling price variance is a measure of the effect on expected profit of a different
selling price to standard selling price.
• The sales volume profit variance is the difference between the actual units sold and
the budgeted (planned) quantity, valued at the standard profit per unit. In other words,
it measures the increase or decrease in standard profit as a result of the sales volume
being higher or lower than budgeted (planned).
• Operating statements show how the combination of variances reconcile budgeted
profit and actual profit.
12 Decision Making and
Relevant Costing
Overview
• Management at all levels within an organisation take decisions. The
overriding requirement of the information that should be supplied by
the cost/management accountant to aid decision making is that of
relevance. This topic therefore begins by looking at the costing
technique required in decision-making situations, that of relevant
costing, and explains how to decide which costs need taking into
account when a decision is being made and which costs do not.
• We then go on to see how to apply relevant costing to product mix
decisions, and make or buy decisions.
Key concepts and definitions
Relevant costs are future cash flows arising as a direct consequence of a decision:
• Relevant costs are future costs.
• Relevant costs are cash flows.
• Relevant costs are incremental costs.
Relevant costs are also differential costs and opportunity costs:
• Differential cost is the difference in total cost between alternatives.
• An opportunity cost is the value of the benefit sacrificed when one course of
action is chosen in preference to an alternative.
• A sunk cost is a past cost which is not directly relevant in decision
making.
• In general, variable costs will be relevant costs and fixed costs will be
irrelevant to a decision.
• The relevant cost of an asset represents the amount of money that a company would have to receive
if it were deprived of an asset in order to be no worse off than it already is. We can call this the
deprival value.
• A limiting factor is a factor which limits the organisation's activities. In a limiting factor situation,
contribution will be maximized by earning the biggest possible contribution per unit of limiting factor.
• If an organisation has the freedom of choice about whether to make internally or buy externally and
has no scarce resources that put a restriction on what it can do itself, the relevant costs for the
decision will be the differential costs between the two options.
• Some observers predict that in ten to 20 years, most organisations will have outsourced every part of
the value chain except for the few key components that are unique and sources of competitive
advantage.
• Any activity is a candidate for outsourcing unless the organisation must control it to maintain its
competitive position or if the organisation can deliver it on a level comparable with the best
organisations in the world.
• To minimize the risks associated with outsourcing, organisations generally enter into long-run
contracts with their suppliers that specify costs, quality and delivery schedules.
• They build close partnerships or alliances with a few key suppliers, collaborating with suppliers on
design and manufacturing decisions, and building a culture and commitment for quality and timely
delivery.
13 Inventory and Pricing
Decisions
Key concepts
• JIT aims for zero inventory and perfect quality and operates by
demand-pull.
• It consists of JIT purchasing and JIT production and results in lower
investment requirements, space savings, greater customer satisfaction
and increased flexibility. JIT aims to eliminate all non-value-added costs.
• Inventory costs include purchase costs, holding costs, ordering costs
and costs of running out inventory. Inventory control levels can be
calculated in order to maintain inventories at the optimum level. The
three critical control levels are reorder level, minimum level and
maximum level.
• The economic order quantity (EOQ) is the order quantity which
minimizes inventory costs. The EOQ can be calculated using a table,
graph or formula. Many firms base price on simple cost-plus rules.
Full cost-plus pricing is a method of determining the sales price by
calculating the full cost of the product and adding a percentage
mark-up for profit.
Marginal cost-plus pricing/mark-up pricing is a method of
determining the sales price by adding a profit margin on to either
marginal cost of production or marginal cost of sales.
• Many firms base price on what consumers’ demand rather than
simple cost-plus rules.
• Target costing requires managers to change the way they think about
the relationship between cost, price and profit. The traditional
approach is to develop a product, determine the expected standard
production cost of that product and then set a selling price (probably
based on cost), with a resulting profit or loss.
• The target costing approach is to develop a product concept and then
to determine the price customers would be willing to pay for that
concept. The desired profit margin is deducted from the price, leaving
a figure that represents total cost. This is the target cost.
• Transfer prices are a way of promoting divisional autonomy, ideally
without prejudicing the divisional performance measurement or
discouraging overall corporate profit maximization. Transfer prices
may be based on market price where there is a market.
14 Budgeting
Key concepts and definitions
• A budget is a quantitative statement, for a defined period of time, which
may include planned revenues, expenses, assets, liabilities and cash
flows.
• The main purpose and benefit of using a budget is to assist with the
achievement of the organisation's objectives.
• Towards the end of the strategy planning stage, the budget will be
prepared. While the mechanics of budget preparation is the focus of your
immediate study, it is important to appreciate how important budgets
are in co-ordination and control. The co-ordination and administration of
budgets is usually the responsibility of a budget committee.
• The budget manual is a collection of instructions governing the
responsibilities of persons and the procedures, forms and records
relating to the preparation and use of budgetary data. The principal
budget factor is the factor which limits the activities of an
organisation.
• A functional operating or departmental budget is a budget forecasting
income and expenditure for a particular department or process. It
could be a production budget, a sales budget or a purchasing budget
depending on the function and the nature of its activities.
• A cash budget is a statement in which estimated future cash receipts and payments are
tabulated in such a way as to show the forecast cash balance of a business at defined
intervals. It is one of the most important planning tools that an organisations can use. It
shows the cash effect of all plans made within the budgetary process.
• As well as wishing to forecast its cash position, a business may want to estimate its
profitability and its financial position for a coming period.
• Budgeted statements of comprehensive income and financial position form the master
budget.
• A fixed (static) budget is a budget which is set for a single activity level, whereas a
flexible budget is a budget which is designed to change as volume of activity changes.
Incremental budgeting is concerned mainly with the increments in costs and revenues
which will occur in a coming period.
• Zero-based budgeting involves preparing a budget for each cost centre from a zero base.
• Human behaviour effects the budgeting process, the resulting budgets and the
performance of managers and employees alike
15 Performance Management
Overview
• Variances provide one way of highlighting a possible problem area to
managers, and is therefore a type of performance indicator. We will
have a look at other performance indicators, which can be used to
monitor the performance of individual departments in the
organisation and the organisation as a whole.
• The topic then moves on to a discussion about the key characteristics
of the balanced scorecard and its advantages over traditional
performance measurement systems.
• Finally, we consider reward systems.
Key concepts
Responsibility accounting is a system of accounting that segregates
revenue and costs into areas of personal responsibility in order to
monitor and assess the performance of each part of an organisation.
A responsibility centre is a function or department of an organisation
that is headed by a manager who has direct responsibility for its
performance. There are a number of different bases for control:
A cost centre is any unit of an organisation to which costs can be separately
attributed.
A profit centre is any unit of an organisation to which both revenues and costs
are assigned, so that the profitability of the unit may be measured.
An investment centre is a profit centre whose performance is measured by its
return on capital employed.
• Controllable costs are items of expenditure which can be directly
influenced by a given manager within a given time span. Materiality,
controllability and variance trend should be considered before a
decision about whether or not to investigate a variance is taken.
• Control limits may be illustrated on a control chart.
• If the cause of a variance is controllable, action can be taken to bring
the system back under control in future. If the variance is
uncontrollable, but not simply due to chance, it will be necessary to
review forecasts of expected results, and perhaps to revise the
budget.
• Performance measurement aims to establish how well something or
somebody is doing in relation to a planned activity.
• Ratios and percentages are useful performance measurement
techniques.
The profit margin (profit to sales ratio) is calculated as (profit ÷
sales) × 100%.
The gross profit margin is calculated as gross profit ÷ sales ×
100%.
Return on investment (ROI) or return on capital employed (ROCE)
shows how much profit has been made in relation to the amount
of resources invested.
Residual income (RI) is an alternative way of measuring the
performance of an investment centre. It is a measure of the
center’s profits after deducting a notional or imputed interest
cost.
• The balanced scorecard approach to the provision of information
focuses on four different perspectives: customer, financial, internal, and
learning and growth.
• Employment is an economic relationship: labour is exchanged for reward.
• Extrinsic rewards derived from job context and include pay and benefits.
Intrinsic rewards derive from job content and satisfy higher level needs.
Reward interacts with many other aspects of the organisation.
• Reward policy must recognize these interactions, the economic
relationship and the psychological contract.