Chapter

16 Management Accounting:
A Business Partner

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 Learning Outcomes
• Explain the three principles guiding the design of
management accounting systems.
• Describe the three basic types of manufacturing costs.
• Distinguish between product costs and period costs.
• Describe how manufacturing costs flow through
perpetual inventory accounts.
• Distinguish between direct and indirect costs.
• Prepare a schedule of the cost of finished goods
manufactured.

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 Management Accounting:
Basic Framework
• The design and use of accounting information
systems inside the company to achieve the
company’s objectives
• Links decision-making authority
• Principles
– Help to identify who has decision making authority over
company assets by management accounting system
– Support planning and decision making by accounting
information
– Provide a means of monitoring, evaluating and rewarding
performance

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 Role in Assigning Decision Making
Authority
• Be responsible for decisions about the firm’s assets
• Plant manager
– Equipment
– Employees
– Plant layout
– Sources of raw materials
• Materials inventory manager
– Reordering materials
• Production supervisor
– Assigning employees to jobs on the production line

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 Support Planning and Decision Making
• Need reliable and timely information
– Plant manager
• Information to assess if equipment is inefficient or
which plant layouts are more productive
• Need historical and projected information
– Current equipment’s cost and productivity
– The productivity and cost of other available
equipment

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 Support Planning and Decision Making
• Need information oriented both toward the specific
operations and toward other parts of the
organization’s value chain
• Value chain
– The linked set of activities and resources necessary to create
and deliver the product or service to the customer
• Sharing information
• Need information from both internal operations and
external independent consulting companies
• Benchmark studies

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 Performance Evaluation and Rewards
• Monitor the outcomes of the decision made by the
managers by the corporation
• Design parallel monitoring system
– Plant-level financial statements
• Assign decision making authority
– Establish budget plan
• Provide information for DM
– Collect actual results
• Furnish information for evaluating and rewarding
performance
– Compare with the budget and the actual results
• Be constantly monitored and adjusted

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 Comparing Financial Accounting and
Management Accounting

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 Accounting for Manufacturing
Operations
Steps in the Manufacturing Process:
Convert raw Sell
Buy raw
materials into finished
materials.
finished goods. goods.

Direct Direct labor and Cost of

materials manufacturing goods
costs. overhead costs. sold.

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 Classifications of manufacturing costs
• Direct materials
• Direct labor
• Manufacturing overhead

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 Direct Materials
Raw materials
& component Can be traced
parts that directly and
become an conveniently
integral part to products.
of finished
products.

If materials cannot be traced directly to products,

the materials are considered indirect and are part
of manufacturing overhead.

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 Direct Materials

Raw materials that become an

integral part of the product and that
can be conveniently traced directly
to it.

Example: A radio installed in an automobile

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 Direct Labor

Includes the payroll cost of direct workers.

Those employees
who work directly
on the goods
being
manufactured.

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 Direct Labor

Those labor costs that can be easily

traced to individual units of product.

Example: Wages paid to automobile assembly workers

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 Direct Labor

Includes the payroll cost of direct workers.

The cost of
employees who do
not work directly on Those employees
the goods is who work directly
considered indirect on the goods
labor and is part of being
manufacturing manufactured.
overhead.
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 Manufacturing Overhead
All manufacturing costs other than direct
materials and direct labor.

Includes:
• Indirect materials.
• Indirect labor.
• Machinery and
equipment costs.
• Cost of regulatory
compliance.
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 Manufacturing Overhead
Manufacturing costs that cannot be traced
directly to specific units produced.
Examples: Indirect materials and indirect labor

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 Manufacturing Overhead
• Indirect material
– Factory supplies- oil used to lubricate the cutting
machine
– Nuts and bolts used to attach shift levers
• Indirect labor costs
– Supervisors’ salaries
– Salaries of factory maintenance workers, forklift
drivers, receiving clerks, factory security personnel

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 Manufacturing Overhead
• Plant occupancy costs
– Depreciation of the factory and warehouse
– Insurance and property taxes
– Maintenance and repairs on buildings
– Utilities and telephone costs
• Machinery and equipment costs
– Depreciation of machinery
– Maintenance of machinery
• Cost of regulatory compliance
– Meeting factory safety requirements
– Disposal of waste materials
– Control over factory emissions

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 Manufacturing Overhead
All manufacturing costs other than direct
materials and direct labor.

Includes:
● Indirect materials.
● Indirect labor. Does not include
selling or general
● Machinery and and administrative
equipment costs. expenses.
● Cost of regulatory
compliance.
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 Manufacturing Overhead

The cost to
produce a unit of
product includes:
●Direct material
●Direct labor
●Manufacturing
overhead

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 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.)

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 Nonmanufacturing Costs

Administrative
Costs

All executive,
organizational, and
clerical costs.

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 Elements of Costs
Direct material
+ Prime costs
Production
Direct labor +
costs Cost
Manufacturing
overhead + of
sales Selling
Selling & + price
administration
Profit
overhead

Direct labor
+ Conversion
Manufacturing costs
overhead
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 Product Costs Versus Period Costs
Balance Sheet
Product Costs
(manufacturing Current assets
costs) as and inventory
incurred
When goods
Income are sold.
Statement
Period Costs Revenue
(operating COGS
expenses and Gross profit
income taxes.) Expenses
as Net income.
incurred
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 Product Costs Versus Period
Costs

Product costs include direct Period costs include all

materials, direct labor, and selling costs and
manufacturing overhead.
administrative costs.

Inventory Cost of Good Expense

Sold

Sale

Balance Income Income

Sheet Statement Statement

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 Balance Sheet
Merchandiser Manufacturer
Current assets Current Assets
● Cash
◆Cash
● Receivables
◆Receivables ● Inventories
◆Merchandise Inventory • Raw Materials
• Work in Process
• Finished Goods

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 Balance Sheet
Merchandiser Manufacturer
Current assets Current Assets
◆ Cash ● Cash
◆ Receivables ● Receivables
◆ Merchandise Inventory ● Inventories

• Raw Materials
• Work in Process
• Finished Goods

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 Product costs and matching principle
Example
• A real estate developer who starts a tract of
10 homes in May of current year. During the
year , the developer incurs material, labor, and
overhead costs amounting to $ 1 million. By
the end of December, none of the houses has
been sold.
• How much of the $ 1 million in construction
costs should appear on the developer’s
income statement for the current year?

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 Inventories of a Manufacturing
Business

Raw materials - inventory on

hand and available for use.

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

Direct labor &

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

Direct labor &

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

$$$ $$$ $$$

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 Manufacturing Cost Flows
Balance Sheet Income
Costs Inventories Statement
Expenses
Material Purchases Raw Materials

Direct Labor Work in

Process
Manufacturing
Overhead Cost of
Finished
Goods
Goods
Sold

Selling and Period Costs Selling and

Administrative Administrative
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 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?

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 The Flow of Manufacturing Costs
Example

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 The Flow of Manufacturing Costs
Example

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 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 transferred to
finished goods inventory.
What is the ending balance in work
in process at December 31, 2002?
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 The Flow of Manufacturing Costs
Example

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 The Flow of Manufacturing Costs
Example

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 Overhead Application Rates
The overhead application rate expresses an
expected relationship between
manufacturing overhead costs and some
activity base related to the production
process.

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 Overhead Application Rates
Overhead costs are estimated based
on budgets and using mathematical
estimation techniques.

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 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.

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 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.
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 Overhead Application Rates Example

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 Overhead Application Rates Example

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 Overhead Application Rates

Some companies use different cost drivers

for different manufacturing activities, a
process called ACTIVITY BASED COSTING.

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 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.

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McGraw-Hill/ © The McGraw-Hill Companies, Inc., 2002
 The cost of goods
completed during
the period is used
to compute COGS
for the period.

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 The income
statement is
prepared
using
established
financial
accounting
procedures.

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 The Income Statement
Cost of goods sold for manufacturers differs only slightly
from cost of goods sold for merchandisers.

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 Cost classification
Purpose of cost classification Cost classification

Preparing external financial statements Product costs ( Inventoriable)

Direct material

Direct labor

Manufacturing overhead

Period costs (expensed)

Nonmanufacturing costs
Selling costs

Administrative costs
Cost of quality Prevention costs
Appraisal costs

Internal failure costs

External failure costs

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 Cost classification
Purpose of cost classification Cost classification

Predicting cost behavior in response to Variable cost ( proportional to activity)

changes in activity
Fixed cost (constant in total)

Assigning costs to cost objects such as Direct cost ( can be easily traced)
departments or products
Indirect cost (cannot be easily traced)

Making decisions Differential cost ( differs between alternatives)

Sunk cost (past cost not affected by a

decision)
Opportunity cost ( forgone benefit)

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 End of Chapter 16

This is a great job, but

the overhead is killing
my profit margin!

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