Fundamentals of Management

Accounting

Facilitator:
Dr Irfan Sahibzada
Contact Details:
Irfan.sahibzada@nbs.nust.edu.pk
Ph. Office: 051 90853154
Mob: 0342 5093739
Office: Room 311
 Introduction
• The purpose of Management Accounting is to assist
management in running the business in ways that will
improve the performance of the business.
• The aim of this syllabus is to develop a knowledge and
understanding of the principles and techniques used in
recording, analysing and reporting costs and revenues for
internal management purposes.
• It covers management information, cost recording,
costing techniques, budgeting and performance
measurement.
 Syllabus Scope
The nature, scope and purpose of management information (A)

Budgeting (c)

Standard costing (D) Cost accounting

techniques (B)

Performance measurement (E)

 Cost and Management Accounting
Purpose and Role
1. To provide financial information to managers that will help
them to plan the activities, control the activities for which
they are responsible and see the financial implications of
any decisions they may take.
2. It serves management by providing information for
planning, decision-making and control.
3. It collects, manages and reports information in demand by
managers, employees and decision makers internal to the
organisation.
4. Management information is generally supplied in the form
of reports.
• Reports may be routine (monthly management accounts) or
prepared for a specific purpose (e.g. one-off decisions)
Cost and Management Accounting
• Cost accounting and management accounting are terms
which are often used interchangeably. It is not correct to
do so.
• Cost accounting is part of management accounting.
 Cost Accounting is mainly
concerned with:
• The preparation of statements (e.g. budgets, costing).
• Cost data collection.
• Applying costs to inventory, products and services.

• Therefore, management accounting goes beyond cost

accounting.
• In general, cost accounting information is unsuitable for
decision-making.
 Financial Accounting
vs

Management Accounting
  Management Accounting Financial Accounting
External use
1. Users and Internal use management and
shareholders, banks,
decision-makers. employees
government
To record the financial
2. Purpose of To aid in planning, decision-
performance and position
Information making and control
of the business
limited companies must
3. Legal requirements none produce financial
statements
Management decide the best According to company
4. Formats way to present information. law
5. Nature of Most monetary; but also
Monitory information
information nonmonetary information
6. Time Period Historical and forward-looking mainly historical
 Functions of Management
• The main functions of management are:
• Planning
• Decision-Making
• Control
 Planning
• Planning involves establishing objectives and selecting
appropriate strategies to achieve these objectives. An
objective is the aim or goal of an organization.
• A strategy is a possible course of action that might
enable an organisation to achieve its objectives.
• Planning can be either short-term (tactical and
operational planning) or long-term (strategic planning).
 Strategic Planning
• Senior management formulate long-term (e.g. 5 to 10
years) objectives and plans for an organization.
• Such plans include overall profitability, the profitability of
different segments of the business, capital equipment
requirements and so on.
 Tactical Planning
• Senior management make medium-term, more detailed
plans for the next year.
• For example decide how the resources of the business
should be employed, and to monitor how they are
being and have been employed.
• Another example would be, how many people should
be employed next year?
 Operational Planning
• All managers are involved in making day-to-day decisions.
• Front-line managers such as foremen or senior clerks have to
ensure that specific tasks are planned and carried out properly
within a factory or office.
• Operational information is derived almost entirely from
internal sources.
• It is prepared frequently and is highly detailed. It is mainly
quantitative
Strategic, Tactical and Operational
Planning
Strategic Planning Long Term

Tactical Planning Short Term

Operational Planning Day-to-Day

 Decision Making
• Managers of all levels within an organisation take
decisions. Decision making always involves a choice
between alternatives;
• e.g. decide on the selling price to charge for a new
product introduced on the market.
• The first part of the decision-making process is planning.
The second part is control.
 Control
• Managers use the information relating to actual results
to take control measures and to re-assess and amend
their original budgets or plans.
• Actual performance of the organisation is compared
against detailed operational plans;
• e.g. check whether the company is over or under spending on
materials. Any deviations from the plans are identified and
corrective action is taken.
• A management control system measures and corrects
the performance of activities of subordinates in order to
make sure that the objectives of an organization are
being met and the plans devised to attain them are being
carried out.
 The Planning-Control Relationship
Planning Control
1 1
Establish Objectives Establish Standards
2 2 Measure and Compare
Determine Activities
3
Delegate 3 Evaluate Results
4 4
Schedule Tasks Feedback and Coach
5
Allocate Resources 5
Take Corrective Action
6
Communicate and Coordinate
7
Provide Incentives
 Data vs Information
• Data is the raw material for data processing. Data relate to
numbers, raw facts, events and transactions which have been
recorded but not yet processed into a form suitable for use.
Data on its own is meaningless.
• Information is data that has been processed in such a way as
to be meaningful to the person who receives it.
• The information can be provided in different ways, but is
usually in the form of reports. For example, a report analysing
costs of producing each of several products may assist
management in deciding which products to produce.
• It is the management accountant who will be expected to
provide the information, and in order to do so he/she needs to
collect data – Process it – into information.
 Why is Information Important?
• Consider the following problems and what management needs to
solve these problems.
1. A company wishes to launch a new product. The company's pricing
policy is to charge cost plus 20%. What should the price of the
product be?
2. An organisation's widget-making machine has a fault. The
organisation has to decide whether to repair the machine, buy a
new machine or hire a machine. What does the organisation do if
its aim is to control costs?
3. A firm is considering offering a discount of 2% to those customers
who pay an invoice within 7 days of the invoice date and a discount
of 1% to those customers who pay an invoice within 8 to 14 days of
the invoice date. How much will this discount offer cost the firm?
• In solving these and a wide variety of other problems,
management need information.
 Types of Information
• Most organizations require the following types of information
1. Financial e.g. costs of heat and light, capital costs, etc.
2. Non-financial, e.g. attendance records, details of the
number of meals served each day, etc.
3. A combination of financial and non-financial information.
• While management accounting is mainly concerned with the
provision of financial information to aid to planning, decision
making and control, the management accountant cannot
ignore non-financial influences and should qualify the
information provided with non-financial matters as
appropriate.
 What Makes a Good Information?
• Good quality information should:
• Be accurate
• Be complete (but not excessive)
• Be Cost effective (should cost less than the savings to be made)
• Be Understandable (to whoever is using it)
• Be Relevant (to the decision being made)
• Be Accessible ( i.e. communicated by an appropriate channel (for
example, be printed or be sent electronically)
• Be Timely
• Be Easy to use
 Cost Classification
• Cost classification is the arrangement of cost items into
logical groups.
• For example: by their nature (materials, wages etc.); or
function (administration, production etc.).
• The eventual aim of costing is to determine the cost of
producing a product/service; for profitability analysis,
selling price determination and/or stock valuation
purposes.
 Cost Classification
1. Production vs non-Production costs
2. Direct vs indirect costs
3. Classification by function
Production & Non-Production Costs
• For the preparation of financial statements, costs are often
classified as: Production and Non-production costs.
• Production Costs
• Production costs are costs identified with goods produced for
resale. Production costs are all the costs involved in the
manufacturing of goods, i.e. direct material, direct labour, direct
expenses, variable production overheads and fixed production
overheads.
• Non-production Costs
• Non-production costs are not directly associated with production
of manufactured goods. They are taken directly to the income
statement as expenses in the period in which they are incurred;
such costs consist of administrative costs, selling and distribution
expenses, and finance costs.
 Different Elements of Production
Cost
• Costs can be classified by element: materials, labour and
overheads (expenses).
• Materials
• This includes all costs of materials purchased for production or
non-production activities, e.g. raw materials and components.
• Labour
• This includes all staff costs relating to employees.
• Overheads
• Overheads include all other costs which are not materials or
labour. These include rent, telephone, and depreciation of
equipment.
 Different Elements of Non-
Production Costs
• Administrative Costs
• These include all the costs involved in running the general admin
department of an organization, for example:
• Depreciation of office buildings and equipment.
• Office salaries, including salaries of directors and accountants etc.
• Rent, rates, insurance, lighting, cleaning, telephone charges and
others.
• Selling Costs
• Selling costs include all costs incurred in promoting sales and
retaining customers, for example:
• Salaries and commission of salesmen and sales department staff.
• Advertising and sales promotion, market research.
• Rent, rates and insurance of sales offices and showroom.
 Different Elements of Non-
Production Costs Continued …
• Distribution Costs
• These include all costs incurred in making the packed product
ready for dispatch and delivering it to the customer, for example:
• Delivery costs
• Wages of packers, drivers and despatch clerks.
• Insurance charges, rent, rates and depreciation of warehouse.
• Finance Costs
• These include all the costs that are incurred in order to finance an
organization, for e.g. loan interest.
• Non-production costs are taken directly to the income
statement as expenses in the period in which they are
incurred.
 Total Product/Service Cost
• The total cost of making a product or providing a service
consists of the following.
1. Cost of materials
2. Cost of the wages and salaries (labour costs)
3. Cost of other expenses
i. Rent and rates
ii. Electricity and gas bills
iii. Depreciation
 Direct Costs
• It is a cost that can be traced in full to the product, service or
department that is being costed. It has three types:
• Direct materials: Materials used in making and selling a
product (or even providing a service); e.g. raw material,
packing material.
• Direct labour: The specific costs of the workforce used to
make a product or provide a service.
• Direct expenses: Any expenses which are incurred on a
specific product other than direct material cost and direct
wages, e.g. depreciation of machine used in the production
of the goods.

Direct materials + Direct labour + Direct expenses = Prime Cost

 Indirect Costs
• An indirect cost (or overhead) is a cost that is incurred in the course
of making a product, providing a service or running a department,
but which cannot be traced directly and in full to the product,
service or department.
• Indirect materials: Those costs which cannot be traced in the finished
product, e.g., oil for machine in a production line.
• Indirect labour: All wages not charged directly to a product. These
include wages of non-productive personnel in the production
department, e.g., supervisor.
• Indirect expenses: These are costs not directly charged to production,
e.g., rent, rates and insurance of a factory, depreciation, fuel, power,
maintenance of plant, machinery and buildings.

Indirect materials + Indirect labour + Indirect expenses = Overheads

 Classification of Cost by Function
• Classification by function involves classifying costs as
production/manufacturing costs, admin costs or marketing/selling
and distribution costs.
• In a 'traditional' costing system for a manufacturing organisation,
costs are classified as follows:
1. Production or manufacturing costs. These are costs associated with
the factory.
2. Administration costs. These are costs associated with general office
departments.
3. Marketing, or selling and distribution costs. These are costs associated
with sales, marketing, warehousing and transport departments.
• Classification in this way is known as classification by function.
• Expenses that do not fall fully into one of these classifications might
be categorised as general overheads or even listed as a classification
on their own (e.g. research and development costs).
 Full Cost of Sales
• In costing a small product made by a manufacturing
organisation, direct costs are usually restricted to some of the
production costs. A commonly found build-up of costs is
therefore as follows.
Production Costs $
Direct Materials A
Direct Wages B
Direct Expenses ___C_ _
Prime Cost A+B+C
Production Overheads ______D______
Full Factory Cost A+B+C+D
Administration Costs E
Selling and Distribution Costs ______F______
Full Cost of Sales A+B+C+D+E+F
 Different Types of Cost Behaviour
• Costs can be classified according to the way that they
behave within different levels of activity.
• Cost behaviour tends to classify costs as:
• Fixed cost
• Variable cost
• Stepped fixed cost
• Semi-variable cost
 Fixed and Variable Costs
• A fixed cost is a cost which is incurred for a particular period of
time and which, within certain activity levels, is unaffected by
changes in the level of activity.
• Examples of fixed costs include the salary of the managing
director, the rent of a building and straight line depreciation
of machinery.
• A variable cost is a cost which tends to vary with the level of
activity. As total costs increase with activity levels, the variable
cost per unit remains constant. By their nature, direct costs
will be variable costs.
• Examples of variable costs include raw materials and direct
labour.
 Fixed Costs

• The total cost remains constant over a given level of activity

but that the cost per unit falls as the level of activity increases.
 Variable Costs

• As total costs increase with activity levels, the cost per unit of
variable costs remains constant.
 Stepped Fixed Cost
• A stepped fixed cost is only fixed within certain levels of
activity.
• For example, the depreciation of a machine may be fixed if
production remains below 1,000 units per month. If
production exceeds 1,000 units, a second machine may be
required, and the cost of depreciation (on two machines)
would go up a step.
• Other stepped fixed costs include rent of warehouse (more
space required if activity increases) and supervisors’ wages
(more supervisors required if number of employees increase).
 Stepped Fixed Cost

• This is a type of fixed cost that is only fixed within certain

levels of activity.
 Semi-variable Costs
(Semi-fixed/Mixed)
• Semi-variable costs contain both fixed and variable components
and are therefore partly affected by changes in the level of
activity.
• Examples of semi-variable costs includes:
Electricity and gas bills
Fixed cost = standing charge Variable cost = Unit Charge
Salesman's salary
Fixed cost = basic salary Variable cost = commission on
sales made
Costs of running a car
Fixed cost = road tax, Variable costs = petrol, oil,
insurance repairs
 Semi-variable Costs

• Semi-variable costs contain both fixed and variable cost

elements and are therefore partly affected by fluctuations in
the level of activity.
 Example
Cost behaviour and activity level
• Hans Bratch has a fleet of company cars for sales reps. Running costs
have been estimated as follows:
a. Cars cost $12,000 when new, and have a guaranteed trade-in value of
$6,000 at the end of two years. Depreciation is charged on a straight-line
basis.
b. Petrol and oil cost 15 cents per mile.
c. Tyres cost $300 per set to replace; replacement occurs after 30,000 miles.
d. Routine maintenance costs $200 per car (on average) in the first year and
$450 in the second year.
e. Repairs average $400 per car over two years and are thought to vary with
mileage. The average car travels 25,000 miles per annum.
f. Tax, insurance, membership of motoring organisations and so on cost
$400 per annum per car.
• Calculate the average cost per annum of cars which travel 15,000
miles per annum and 30,000 miles per annum.
 Solution
• Annual costs may be analysed into fixed, variable and stepped-
fixed cost items as follows:
1. Fixed costs
a) Depreciation ($12,000 - $6,000)/2 = $3,000
b) Routine maintenance ($200 + $450)// = $325
c) Tax insurance etc. = $400
2. Variable costs
a) Petrol and Oil per mile = $0.15
b) Repairs per mile ($400/50,000) = $0.08
3. Stepped-fixed costs
a) If car travels exactly of less than 30,000 miles in 2 years, the cost is
zero.
b) If the car travels more than 30,000 miles in 2 years, the total cost is
$300 and the average cost per annum is $150.
 Solution Continued…
• The estimated cost per annum of cars traveling 15,000 miles
per annum and 30,000 miles per annum would be as follows:
15,000 miles per 30,000 miles per
annum annum
Fixed costs $3,725 $3,725
Variable costs ($0.158 per mile) $2,370 $4,740
Stepped-Fixed costs 0 $150
$6,095 $8,615
 Allocating Semi-Variable costs
• The fixed and variable elements of semi-variable costs can be
determined by the high-low method, using the following steps:
• Step 1: Select the highest and lowest activity levels, and their
associated costs. (Note: do not take the highest and lowest costs).
• Step 2: Calculate the variable cost per unit:

• Step 3: Calculate the fixed cost by substitution, using either the

high or low activity level.

• Step 4: Use the total fixed cost and the variable cost per unit
values (steps 2 and 3) to calculate the estimated cost at different
activity levels.
 Example: High Low Method
Output (Units) Total Cost ($)
200 7,000
300 8,000
400 9,000

1. Total fixed cost by substituting at high activity level:

Total Cost = $9,000

Total variable cost = 400 x $10 = $4,000
Therefore, Fixed cost = $5,000
2. If output is 350 units or 600 Units:

Variable cost = 350 x $10 = $3,500 = 600 x $10 = $6,000

Fixed Cost = $5,000 = $5,000
Therefore, Total cost = $8,500 = $11,000
 Another Example
• An organization has the following costs at two activity
levels:
Activity level (units) 20,000 25,000
Total Costs ($) 110,000 135,000

• What is the total cost at an activity level of 22,000 units?

 Example: Stepped Fixed Cost and
Change in Variable cost
• The following data relate to the overhead expenditure of
contract cleaners (for industrial cleaning) at two activity levels.
Square meters cleaned 12,750 15,100
Overheads $73,950 $83,585
• When more than 14,000 square metres are industrially
cleaned, there will be a step up in fixed costs of $4,700.

• Calculate the estimated total cost if 14,500 square metres are

to be industrially cleaned?
• Additionally, a round of wage negotiations have just taken
place which will cost an additional $1 per square metre.
 Another Example
• An organization has the following costs at two activity
levels:
Activity level (units) 16,000 22,000
Total Costs ($) 135,000 170,000

• The variable cost per unit is constant within this range of

activity but there is a step up of $5,000 in the total fixed
costs, when the activity exceeds 17,500 units.

• What is the total cost at an activity level of 20,000 units?

 Another Example
• An organization has the following costs at different
activity levels:

Activity level 4,000 6,000 8,000

(units)
Total Costs ($) 105,000 150,000 190,000

• There is a 20% step increase in fixed costs for each

increase in activity level of 5,000 units.
• What is the total cost at an activity level of 4,500 units?
 Linear Equations
• A linear equation is a straight line and has the general
form:

• where
• y is the dependent variable whose value depends on the
value of x.
• x is the independent variable whose value helps to
determine the corresponding value of y.
• a is a constant; that is, a fixed amount.
• b is also a constant, being the coefficient of x (that is, the
number by which the value of x should be multiplied to
derive the value of y).
 Example: Deriving a Linear
Equation
• A salesperson's weekly wage is made up of a basic weekly
wage of $100 and commission of $5 for every item they sell.
Derive an equation which describes this scenario.
• Solution:

• Note that the letters used in an equation do not have to be x

and y. It may be sensible to use other letters, for example we
could use p and q if we are describing the relationship
between the price of an item and the quantity demanded.
 Cost Codes
• Once costs have been classified, a coding system can be applied
to make it easier to manage the cost data, both in manual
systems and in computerised systems.
• Each individual cost should be identifiable by its code. This is
possible by building up the individual characteristics of the cost
into the code.
• The characteristics which are normally identified are as follows:
• The nature of the cost (materials, labour, overhead), which is
known as a subjective classification.
• The type of cost (direct, indirect and so on).
• The cost centre to which the cost should be allocated or cost unit
which should be charged, which is known as an objective
classification.
• The department which the particular cost centre is in.
 Features of a Good Coding System
1. Easy to use and communicate.
2. Unique code.
3. Allow for expansion.
4. Human interest should dominate in case of conflict.
5. Flexible.
6. Comprehensive.
7. Should be brief but long enough to allow for suitable coding.
8. The likelihood of error going undetected should be minimized.
9. Should be regularly reviewed.
10. Should be issued from a single central point.
11. Entirely numeric or entirely alphabetic.
12. Uniform.
13. Should be signalling about the item being coded.
14. Alphabetic characters should be derived from the item’s description.
15. Should have an index or reference book of codes.
 Types of Codes
• Composite Codes
• The CIMA Official Terminology definition of a code describes a
composite code in such a manner:
• For example, in costing, the first three digits in the composite code
211.392 might indicate the nature of the expenditure (subjective
classification) and the last three digits might indicate the cost
centre or cost unit to be charged (objective classification).
• Therefore, the digits 211 might refer to:
• 2 Materials 1 Raw materials 1 Timber. This would indicate to anyone
familiar with the coding system that the expenditure was incurred on
timber.
• The digits 392 might refer to:
• 3 Direct cost, 9 Factory alpha, 2 Assembly department. This would
indicate that the expenditure was to be charged as a direct material
cost to the assembly department in factory alpha.
 Other Types of Codes
• Sequence codes: Just follows ordinary numerical sequence.
• Group classification codes: A digit indicates the classification
of an item is added into a sequence code.
• Faceted codes: Further refinement of group classification
codes, where each digit of the code gives information about
an item.
• Significant codes: These incorporate some digits which are
part of the description of the item being coded.
• Hierarchical codes: This is a type of faceted code where each
digit represents a classification, and each digit further to the
right represents a smaller subset than those to the left.
 Cost Centres
• Cost centres are collecting places for costs before they are
further analysed. Costs are further analysed into cost units
once they have been traced to cost centres.
• Therefore, when costs are incurred, they are generally
allocated to a cost centre.
• Cost centres may include the following:
• A department.
• A machine, or group of machines.
• A project (e.g. the installation of a new computer system).
• Overhead costs e.g. rent, rates, electricity (which may then be
allocated to departments or projects).
 Cost Units
• Once costs have been traced to cost centres, they can be
further analysed in order to establish a cost per unit.
• Alternatively, some items of cost may be charged directly
to a cost unit, for example direct materials and direct
labour costs.
• Examples of cost units include the following:
• Patient episode (in a hospital).
• Room (in a hotel).
• Barrel (in the brewing industry).
 Cost Objects
• A cost object is any activity for which a separate
measurement of costs is desired.
• If the users of management information wish to know
the cost of something, this something is called a cost
object.
• Examples include the following:
• The cost of a product.
• The cost of operating a department.
• The cost of a service.
 Profit Centres
• Profit centres are similar to cost centres but are
accountable for both costs and revenues.
• Profit centre managers should normally have control
over how revenue is raised and how costs are incurred.
• Often, several cost centres will comprise one profit
centre.
• The profit centre manager will be able to make decisions
about both purchasing and selling and will be expected
to do both as profitably as possible.
 Revenue Centres
• Revenue centres are similar to cost centres and profit centres
but are accountable for revenues only. Revenue centre
managers should normally have control over how revenues
are raised.
• A revenue centre manager is not accountable for costs.
• They will be aiming purely to maximise sales revenue.
• They will want information on markets and new products and
they will look closely at pricing and the sales performance of
competitors – in addition to monitoring revenue figures.
 Investment Centres
• An investment centre is a profit centre with additional
responsibilities for capital investment and possibly for
financing, and whose performance is measured by its
return on investment.

• Cost centres, revenue centres, profit centres and

investment centres are also known as responsibility
centres.