CHAPTER 3

Introduction to
Managerial
Accounting
1. Explain the meaning of managerial accounting.
2. Explain the differences between managerial
accounting and financial accounting.
3. Explain the importance of ethical behavior for
managers and managerial accountants.
4. Identify three forms of certification available to
managerial accountants.
5. Understand Cost definition, Classification and flow of
cost.
6. Demonstrate financial statement preparation of
manufacturing company.
• Managerial Accounting is an accounting which
provide accounting information for a company’s
internal users.
• Unlike financial accounting, managerial accounting
is not bound by any formal criteria such as
generally accepted accounting principles (GAAP)
• Managerial accounting has three broad objectives:
• Planning:
Planning provide information for planning the
organization’s actions
• Controlling:
Controlling provide information for controlling the
organization’s actions
• Decisions:
Decisions provide information for making effective
decisions
 Planning
Planning is the detailed formulation of action to
achieve a particular end.

Example
Increase market share year-over-
Setting objectives year by at least five percent

Identifying methods to • Consider diversification

• Sell More to Current Customers
achieve those objectives • Try Different Types of Channels
• Target a New Market Segment
 Controlling
Controlling is the managerial activity of
monitoring a plan’s implementation and taking
corrective action as needed.

Compare

Actual Expected
Performance Performance
 Decision Making
Decision making is the process of choosing among competing
alternatives.
• This managerial function is intertwined with planning and control
• manager cannot successfully plan or control the organization’s
actions without making decisions regarding competing alternatives

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 Management Accounting System
Framework
Top Management

Budget Plans: Actual Results: Performance

Future Current Evaluation: Past

Assign Support Evaluate

Decision Making Decision Making Decision Making
• Financial Accounting is primarily concerned with producing
information for external users, including investors, creditors,
customers, suppliers, government agencies, and labor unions.
• Financial accounting’s orientation is historical and is used for
investment decisions, care evaluation, monitoring activity, and
regulatory measures.
• Financial accounting, Financial statements must conform to
certain rules and conventions defined by agencies like the
Securities and Exchange Commission (SEC), the Financial
Accounting Standards Board (FASB), and the International
Accounting Standards Board (IASB).
(continued)

• Managerial Accounting produces information for

internal users, such as managers, executives, and
workers.
• Thus, managerial accounting could be properly
called internal accounting, and financial
accounting could be called external accounting.
• Specifically, managerial accounting identifies,
collects, measures, classifies, and reports financial
and nonfinancial information that is useful to
internal users in planning, controlling, and
decision making.
Comparing Financial Accounting
and Management Accounting
 Current Focus of Managerial Accounting
• The business environment in which companies operate has
changed dramatically over the past several decades.
• As a result, effective managerial accounting systems also
have changed in order to provide information that helps
improve companies’ planning, control, and decision-
making activities.
• Several important uses of managerial accounting resulting
from these advances include:
1. New methods of estimating product and service cost
and profitability,
2. Understanding customer orientation,
orientation
3. Evaluating the business from a cross-functional
perspective,
perspective and
4. Providing information useful in improving total quality.
 New Methods of Costing Products and Services

• Today’s companies need focused, accurate information on the

cost of the products and services they produce.
• Activity-based costing (ABC) is a more detailed approach to
determining the cost of goods and services.
• ABC improves costing accuracy by emphasizing the cost of
the many activities or tasks that must be done to produce a
product or offer a service.
• Process-value analysis focuses on the way in which
companies create value for customers.
• The objective is to find ways to perform necessary activities
more efficiently and to eliminate those that do not create
customer value.
 Customer Orientation
• Customer value is a key focus because firms can
establish a competitive advantage by creating better
customer value for the same or lower cost than
competitors or creating equivalent value for lower cost
than that of competitors.
• Customer value is the difference between
what a customer receives and what the
customer gives up when buying a product or
service.
Strategic Positioning
• Effective cost information can help the company identify
strategies that increase customer value. This is typically done
through a couple of general strategies:
• Cost Leadership:
Leadership The objective of the cost leadership
strategy is to provide the same or better value to customers
at a lower cost than competitors.
• Superior products through differentiation:
differentiation A differentiation
strategy strives to increase customer value by providing
something to customers not provided by competitors.
 Value Chain
• Successful pursuit of cost leadership and/or differentiation
strategies requires an understanding of a firm’s value chain.
• The value chain is the set of activities required to design,
develop, produce, market, and deliver products and services,
services
as well as provide support services to customers.
Cross-Functional Perspective
• A cross-functional perspective focuses on a group of
people with different functional expertise working
toward a common goal.
• It may include people from finance, marketing,
operations, and human resources departments.
• Typically, ccontemporary approaches to costing may
include initial design and engineering costs, as well as
manufacturing costs, and the costs of distribution, sales,
and service. levels of an organization
• Thus, in managing the value chain, a managerial
accountant must understand and measure many
functions of the business.
Total Quality Management
• Continuous improvement is the continual search for
ways to increase the overall efficiency and productivity
of activities by reducing waste, increasing quality, and
managing costs.
• Continuous improvement is fundamental for
establishing excellence.
• A philosophy of total quality management,
management in which
manufacturers strive to create an environment that
will enable workers to manufacture perfect (zero-
defect) products, has created a demand for a
managerial accounting system that provides
information about quality.
 (continued)
• For example, many companies attempt to increase
organizational value by eliminating wasteful activities
that exist throughout the value chain.
• This has led to a change in accounting, referred to as
lean accounting,
accounting which organizes costs according to
the value chain and collects both financial and
nonfinancial information.
(continued)

• Recently managerial accountants is carry out the

company’s enterprise risk management (ERM)
approach.
• Enterprise risk management (ERM) is the process of
planning, organizing, leading, and controlling the
activities of an organization in order to minimize the
effects of risk on an organization's capital and
earnings
• It is a formal way for managerial accountants to
identify and respond to the most important
threats and business opportunities facing the
organization.
 Time as a Competitive Element
• Time is a crucial element in all phases of the value
chain. World-class firms reduce time to market by
compressing design, implementation, and
production cycles.
• These firms deliver products or services quickly by
eliminating non value-added time,
time which is time of
no value to the customer (e.g., the time a product
spends on the loading dock).
• Interestingly, decreasing non value-added time
appears to go hand in hand with increasing quality.
 Efficiency
• Improving efficiency is also a vital concern.
• Both financial and nonfinancial measures of efficiency
are needed.
• Cost is a critical measure of efficiency.
• For these efficiency measures to be of value, costs must
be properly defined, measured, and assigned;
furthermore, production of output must be related to
the inputs required, and the overall financial effect of
productivity changes should be calculated.
• The role of managerial accountants in an organization is one
of the support.
• They assist those individuals who are responsible for carrying
out an organization’s basic objectives.
• Positions that have direct responsibility for the basic
objectives of an organization are referred to as line positions.
positions
• Positions that are supportive in nature and have only indirect
responsibility for an organization’s basic objectives are called
staff positions.
positions
• The controller supervises all accounting functions and reports
directly to the general manager and chief operating officer.
• In larger companies, the controller is separate from the
treasury department. The treasurer is responsible for the
finance function.
• The objective of profit maximization should be
controlled by the requirement that profits be
achieved through legal and ethical means.
• Ethical behavior involves choosing actions that are
right, proper, and just.
• Behavior should be right, it should be proper; and
the decisions we make should be fair.
• Companies in business for the long term find that it
pays to treat all of their functions with honesty and
loyalty.
loyalty
• To promote ethical behavior by managers and
employees, organizations commonly establish
standards of conduct referred to as Company Codes of
Conduct.
• A quick review of various corporate codes of conduct
shows some common ground.
• Important parts of corporate codes of conduct are
integrity, performance of duties, and compliance with
the rule of law.
• They also uniformly prohibit the acceptance of
kickbacks and improper gifts, insider trading, and
misappropriation of corporate information and assets.
• In addition to organizations establishing standards of
conduct for their managers and employees, professional
associations also establish ethical standards.
• Both the American Institute of Certified Public
Accountants (AICPA) and the Institute of Management
Accountants (IMA) have established ethical standards for
accountants.
• Professional accountants are bound by these codes of conduct.
• Perhaps the biggest challenge with ethical problem is that
when it arise, employees frequently do not realize
• when such a problem/dilemma has arisen or
• When the ‘‘correct’’ action that should be taken to correct the
dilemma/problem.
 Certification

• The accounting profession offers three major

forms of certification to managerial accountants:
• Certificate in Management Accounting
• Certificate in Public Accounting
• Certificate in Internal Auditing
• Each certification offers particular advantages to a
managerial accountant.
• All three certifications offer evidence that the
holder has achieved a minimum level of
professional competence.
• The Certificate in Management Accounting is designed
to meet the specific needs of managerial accountants.
• Four areas are emphasized in the qualifying
examination for the CMA. They are:
• economics, finance, and management;
• financial accounting and reporting;
• management reporting, analysis, and behavioral
issues decision analysis and
• information systems
• The parts of the CMA examination reflect a more
interdisciplinary flavor.
• The Certificate in Public Accounting is the oldest
and most well-known certification in accounting.
• The purpose of the certificate is to provide minimal
professional qualification for external auditors.
• Only a Certified Public Accountant (CPA) is
permitted (by law) to serve as an external auditor.
• CPAs must pass a national examination and be
licensed by the state in which they practice.
• Although the Certificate in Public Accounting does
not have a managerial accounting orientation,
many managerial accountants also hold this
certificate.
• Internal auditing differs from external auditing and
managerial accounting, and many internal auditors felt
a need for a specialized certification.
• The Certified Internal Auditor (CIA) has passed a
comprehensive examination designed to ensure
technical competence and has two years’ experience.
• In financial accounting, the term cost is
defined as a measurement, in monetary
terms, of the amount of resources used for
some purposes.
• It is the cash amount (or the cash equivalent)
given up for an asset. 
• Cost includes all costs necessary to get an
asset in place and ready for use.
• For example, the cost of an item in inventory also
includes the item's freight-in cost.
• In managerial accounting, the term cost is used in
many different ways.
• Different types of costs are used for different
purposes
• Some costs are useful and required for
inventory valuation and income
determination.
• Some costs are useful for planning,
budgeting, and cost control.
• Still others are useful for making short-term
and long-term decisions
 Cont’d
 Definition of Cost; it could be defined
as
 a measure of the supply or use of a
scarce resource to achieve a specific
objective. Or a resource sacrificed or
forgone to achieve a specific
objective.
A cost is usually measured as the
monetary amount that must be paid
to acquire goods and services.
CLASSIFICATION OF COSTS
• Cost classification is the process of grouping costs
according to their common characteristics.
• Different cost classifications are used to develop cost
information for a given purpose.
• Different information helps to make decision.

• Managers use this information to support product

and service decisions, enables cost control, provide
historical data for cost management.
There are different basis to classified costs.
• Costs can be classified into various categories,
according to:
1. Their management function
2. Their traceability to a particular cost object:
3. Their behaviour in accordance with changes
in activity
4. The time they are charged against revenue
5. Their relevance to control and decision
making
1. By their management function
1. Manufacturing costs
2. Nonmanufacturing costs
 Manufacturing costs: direct materials,
direct labor and manufacturing
overhead, and
• Non manufacturing costs: selling,
distribution, administration, R&D
2. Based on their traceability to a particular cost object:

• Direct: costs that have a relationship with

the cost object and can be traced to that
cost object in an economically feasible
(cost effective) way.

• Indirect: costs that have a relationship

with the cost object but cannot be traced
to that cost object in an economically
feasible way.
 3. Based on their behaviour
• Variable costs
• Fixed costs
• Semi variable costs
• Fixed (are total costs that remain constant regardless
of the level of activity up to a certain relevant range
but unit costs vary according to the level of activity.),
variable (are total costs that changes in direct proportion to
changes in the level of activity but unit costs remain
constant).,
4. Based on timing they are charged against revenue
• Product costs: are costs that are necessary and integral
part of producing (acquiring) the finished product. They
are considered as an asset/inventory when they are
incurred. Under the matching principle, these costs do
not become expenses until the finished goods inventory
is sold.
Example: Cost of direct material
• Period Costs: are costs of income statement other than
cost of goods sold. They are treated as expense of the
period in which they are incurred because they are
expected to benefit revenue in the current period.
Example: Advertising costs
5. Based on their relevance to control and decision making
• Controllable : costs that can be influenced by
management action
example: the cost of materials involved in
production of goods
• Uncontrollable: cost beyond the control of
management.
example: depreciation
• Incremental costs is the overall change that a
company experiences by producing one additional
unit of good.
• It represents a change in the total costs
resulting from a decision. Such a change in
cost is not necessarily variable in nature
• Opportunity cost may be as defined as
prospective change in cost following the
adoption of an alternative machine, process,
raw materials, specification or operation.
• Relevant costs are expected future costs, that
can be used for decision making
• costs that are not relevant are said to be
irrelevant.
• It is important to recognize that to be relevant
costs they must:
• Occur in the future:- every decision deals with
selecting a course of action based on its
expected future results.
• Differ among the alternative courses of action:-
costs that do not differ will not matter and,
hence, will have no bearing on the decision
being made
 Accounting for Manufacturing
Operations

Steps in the Manufacturing Process:

Buy raw Convert raw materials Sell finished

materials. into finished goods. goods.

Direct Direct labor and

Cost of goods
materials manufacturing
sold.
costs. overhead costs.
 Direct Materials
Raw materials &
component parts Can be traced
that become an directly and
integral part of conveniently to
finished products. products.

If materials cannot be traced directly to products, the materials are

considered indirect and are part of manufacturing overhead.
 Direct Labor
Includes the payroll cost of direct workers.

Those employees
who work directly on
the goods being
manufactured.

The cost of employees who do not work

directly on the goods is considered indirect
labor and is part of manufacturing overhead.
 Manufacturing Overhead
All manufacturing costs other than direct
materials and direct labor.

Includes:
• Indirect materials.
• Indirect labor.
• Machinery and
equipment costs. Does not include
• Cost of regulatory selling or general and
compliance. administrative
expenses.
 Accounting for Manufacturing
Operations

The cost to produce

a unit of product
includes:
Direct material
Direct labor
Manufacturing
overhead
 Manufacturing Overhead

The cost to
produce a unit of
product includes: Manufacturing overhead
Direct material must be mathematically
allocated to each unit of
Direct labor
product using a
Manufacturing predetermined overhead
overhead application rate.
(This will be discussed
later in this chapter.)
 Accounting for
Manufacturing Operations

Manufacturing costs are often

combined as follows:

Direct Direct Manufacturing

Materials Labor Overhead

Prime Conversion
Cost Cost
 Product Costs Versus Period Costs

Balance Sheet
Product Costs
(manufacturing Current assets and
costs) inventory
as
incurred
When goods are
sold.
Income Statement

Revenue
Period Costs
COGS
(operating expenses
Gross profit
and income taxes.)
Expenses
Net income.
as
incurred
Ethics, Fraud, and Corporate
Governance

Product costs are capitalized as

part of inventory and only
charged to expense when the
inventory is sold.

Period costs are charged

to expense as incurred.

Income will be artificially

inflated if period costs are
capitalized.
Inventories of a Manufacturing Business

Raw materials - inventory on

hand and available for use.

Work in
Finished goods-
process -
completed
partially
goods awaiting
completed
sale.
goods.
 The Flow of Physical Goods
Materials
Direct Direct Factory
Warehouse
materials materials used
purchased

Direct labor &

Manufacturing overhead
Finished goods

Finished goods
Warehouse
Goods sold
 The Flow of Manufacturing
Costs
Direct Materials Direct Work in Process
materials Inventory materials used Inventory
purchased

$$$ $$$ $$$ $$$

Direct labor &

Manufacturing overhead
Cost of goods
manufactured
Cost of Goods Finished Goods
Sold Inventory

$$$ $$$ $$$

Financial Statements of Manufacturing
Organizations

Cost of Goods Manufactured Schedule

Beginning DM inventory……….XX
+ DM Purchased………………….XX
DM Available for use …………XXX
- Ending DM Inventory…………..XX
DM Used ………………………XXX

55
 Schedule of Cost of Goods
Manufactured
DM Used …………………………….XXX
+ Direct Labor ………………………….XX
+ Factory overhead cost(MOH)…………XX
Mfg Cost incurred during the year......XXX
+ Beginning WIP Inventory …………….XX
Total Mfg Cost to account for ………..XXX
-Ending WIP Inventory …………………XX
Cost of Goods Manufactured ………...XXX

56
Schedule of Cost of Goods Sold
Beginning FG Inventory
XXX
Add: Cost of FG Manufactured during the year XXX
Cost of FG available for sale
XXX
Less: Ending FG Inventory
(XXX)
Cost of goods sold $XXX

57
 Income Statement Format for a Manufacturing
Company
ABC Company
Income Statement
For the Year ended Dec. 2010
Sales……………………………………………………............XXX
Less: Cost of goods sold ………………………………… ...(XX)
Gross Profit on Sales …………………………………………XXX
Less: Operating Expenses:
Selling Expenses………………………XX
Administrative Expense……….........XX
Total Operating Expenses………………………………….(XXX)
Income from operations…………………………........ ….. XXX
Less: Interest Expense……………………………….......... (XX)
Income before income taxes………………………………. .XXX
Income Tax expenses……………………………………… (XX)
Net Income…………………………………………...............XXX

58
 The Flow of Manufacturing Costs
Example

Pure-Ice Inc. had $52,000 of inventory in

direct materials inventory on January 1,
2002. During the year, Pure-Ice
purchased $586,000 of additional direct
materials. At December 31, 2002, $78,000
of the direct materials were still on hand.
How much direct material was
placed into production during 2002?
The Flow of Manufacturing Costs
Example

?
The Flow of Manufacturing Costs
Example

!
 The Flow of Manufacturing Costs
Example

In addition to the direct materials, Pure-

Ice incurred $306,000 of direct labor cost
during 2002. Manufacturing overhead for
2002 was $724,000.
Pure-Ice started 2002 with $132,000 in
work in process. During 2002, units
costing $1,480,000 were transfered to
finished goods inventory.
What is the ending balance in work
in process at December 31, 2002?
The Flow of Manufacturing Costs
Example
The Flow of Manufacturing Costs
Example

!
 Direct Costs and Indirect
Costs
Direct costs Indirect costs
• Costs that can be • Costs cannot be easily
easily and conveniently and conveniently
traced to a unit of traced to a unit of
product or other cost product or other cost
objective. object.
• Examples: direct • Example:
material and direct manufacturing
labor overhead
Overhead Application Rates
The overhead application rate expresses an
expected relationship between
manufacturing overhead costs and some
activity base related to the production
process.
Overhead Application Rates
Overhead costs are estimated based
on budgets and using mathematical
estimation techniques.
Overhead Application Rates
The base is the activity that “drives” the
cost, called the cost driver.
Direct labor hours and machine hours are
commonly used cost drivers.
 Overhead Application Rates
Example

Big “T” Company produces engines

for big trucks. Total overhead for
2002 is estimated to be $2,600,000.
Big “T” applies overhead based on
machine hours. Big “T” estimates
machine hours for 2002 to be 162,500
hours.
Compute Big “T’s”
predetermined overhead rate for
2002.
Overhead Application Rates
Example
Overhead Application Rates
Example
Overhead Application Rates
Some companies use different cost drivers for
different manufacturing activities, a process
called ACTIVITY BASED COSTING.
Determining the Cost of Finished
Goods Manufactured

A schedule of the cost

of finished goods
manufactured is
prepared to assist
managers in
understanding and
evaluating the overall
cost of manufacturing
products.
 The cost of goods
completed during the
period is used to compute
COGS for the period.
The income
statement is
prepared
using
established
financial
accounting
procedures.
End of Chapter 3

This is a great job, but

the overhead is killing
my profit margin!