managerial accounting handouts

Cost classifications► For external reporting ► For decision making cost behavior Product Costs raw materials through the use of labor and indirect manufacturing resources, such as the

MANAGERIAL ACCOUNTING

Lecturer

Nguyen Phong NguyenAuditor - PricewaterhouseCoopersLecturer in Accounting -

University of Economics HCMC

MA Monash University (Australia)DBA Candidate University of Western Sydney (Australia)

3 Explain the differences between managerial

accounting and financial accounting.

The Meaning of Managerial Accounting

►Managerial Accounting is the provision of

accounting information for a company’s internal

users

►Managerial accounting has three broad objectives:

Comparison of Financial and Managerial Accounting

Comparison of Financial and

Managerial Accounting (continued)

The key point is flexibility—

the accounting system should be able to supply

different information for different purposes

Managerial Accounting

and Ethical Conduct

► The objective of profit maximization should

be constrained by the requirement that

profits be achieved through legal and ethical

means.

► Ethical behavior involves choosing actions

that are right, proper, and just.

IMA Ethical Principles

►Competence – maintain an appropriate level of

professional expertise by continually developing

knowledge and skills;

►Confidentiality – refrain using confidential

information for unethical or illegal advantage;

►Integrity – abstain from engaging in or supporting

any activity that might discredit the profession; and

►Credibility – communicate information fairly and

objectively

Study questions – Q1

► How do managerial accounting and financial accounting

differ?

► Managerial accounting is internally focused, does not follow

mandatory rules, keeps track of both financial and nonfinancial

information, emphasizes the future, and provides detailed

information about various aspects of company management

Financial accounting, on the other hand, is externally focused,

follows externally imposed rules (such as GAAP), keeps track of

financial information, has a historical orientation, and provides

information about the company as a whole.

Study questions – Q2

managerial accounting?

►The three broad objectives of managerial

accounting are planning, controlling, and decision

making

Study questions – Q3

► What is ethical behavior? Explain the

underlying code of ethics of the IMA.

►Ethical behavior is choosing actions that are

right, proper, and just The code of ethics of IMA

includes four principles: competence,

confidentiality, integrity, and credibility [See the

slide with title “IMA ethical principles”]

Study questions – Q4

non-financial information?

►A managerial accounting information system

typically provides both financial and nonfi-nancial

information For example, financial information

on cost of production is tracked Other

information, such as the number of warranty

returns, may also be tracked by the management

information system

Section 2:

Basic Cost Concepts and

Classifications

Learning Objectives

1 Explain the meaning of cost and how costs

are assigned to products and services

2 Define how costs are classified (cost

classification).

3 Apply cost estimation methods to separate

mixed costs into fixed and variable

elements.

What is cost?

► Cost is the amount of cash or cash equivalent

sacrificed for goods and/or services that are

expected to bring a current or future benefit to

the organization.

Cost Objects

► A cost object is any item such as a product,

customer, department, project, geographic

region, plant, and so on, for which costs are

measured and assigned

Assigning costs is the way that a cost is linked to

some cost object.

To support Manufacturing?

To support Selling the Product?

?????

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Direct Costs

► Direct costs are those costs that can be easily

and accurately traced to a cost object

we often mean that the relationship between

the cost and the object can be physically

observed and is easy to track

object, the more accurate are the cost

assignments.

Indirect Costs

EASILY AND ACCURATELY TRACED to a cost

object.

assigned to a cost object by using a

reasonable and convenient method.

Exercise 2.30

a Salary of cell supervisor

b Power to heat and cool the plant in which the cell is located

c Materials used to produce the motors

d Maintenance for the cell’s equipment

e Labor used to produce motors

f Cafeteria that services the plant’s employees

g Depreciation on the plant

h Depreciation on equipment used to produce the motors

i Ordering costs for materials used in production

j Engineering support

k Cost of maintaining the plant and grounds

l Cost of the plant’s personnel office

m Property tax on the plant and land

Object Costing

► Direct and indirect costs occur in service businesses as well

► Some businesses refer to indirect costs as overhead costs or support

costs

Cost classifications

► For external reporting

► For decision making (cost behavior)

Product Costs

raw materials through the use of labor and

indirect manufacturing resources, such as the

manufacturing plant, land, and machinery

►Televisions, hamburgers, automobiles,

computers, clothes, and furniture are examples of

Determining Product Cost

costs, both direct and indirect, of producing a

product in a manufacturing firm or of

acquiring a product in a merchandising firm

and preparing it for sale

Determining Product Cost

(continued)

►Product costs initially are added to an inventory

account and remain in inventory until they are sold,

at which time they are transferred to cost of goods

►Product costs can be further classified as direct

materials, direct labor, and manufacturing

overhead

Direct Materials

materials that are a part of

the final product and can be

directly traced to the goods

being produced.

Direct Labor

►Direct labor is the labor that can be directly traced to

the goods being produced

► Physical observation can be used to measure the amount of

labor used to produce a product

► Those employees who convert direct materials into a product

are classified as direct labor.

►A company can also have indirect labor costs

Manufacturing Overhead

► All product costs other than direct materials and direct labor

are put into a category called manufacturing overhead

► In a manufacturing firm, manufacturing overhead also is known

as factory burden or indirect manufacturing costs.

► Costs are included as manufacturing overhead if they cannot

be traced to the cost object of interest (e.g., unit of product)

► The manufacturing overhead cost category contains a wide

variety of items

► Examples of manufacturing overhead costs include depreciation

on plant buildings and equipment, janitorial and maintenance

labor, plant supervision, materials handling, power for plant

utilities, and plant property taxes.

Exercise 2.31

Exercise 2.31 (cont’d)

Calculating Total Product Cost

materials, direct labor, and manufacturing

overhead:

► Total product post = Direct materials cost + Direct labor

cost + Manufacturing overhead cost

divided by the number of units produced:

Exercise 2.29

1 Direct materials—Product cost

Direct labor—Product cost

Manufacturing overhead—Product cost

Selling expense—Period cost

3 Unit product cost = $12,000/6.000 = $2.00

Period Costs

►The costs of production are assets that are carried in

inventories until the goods are sold

►There are other costs of running a company, referred to

as period costs, that are not carried in inventory

►Thus, period costs are all costs that are not product

costs

►The cost of office supplies, research and

development activities, the CEO’s salary, and

advertising are examples of period costs

►Period costs typically are expensed in the period in

which they are incurred

Selling Costs

► Those costs necessary to market, distribute, and service a

product or service are selling costs.

Commissions Advertising

Administrative Costs

►All costs associated with research, development, and

general administration of the organization that cannot

reasonably be assigned to either selling or production

are administrative costs

► Examples of general administrative costs are executive

salaries, legal fees, printing the annual report, and general

accounting.

► Research and development costs are the costs associated with

Cornerstone 2-3 Calculating Direct Materials Used in

Production

Work-in-Process

► Once the direct materials are calculated, the direct labor and

manufacturing overhead for the time period can be added to get

the total manufacturing cost for the period.

► The second type of inventory—work in process (WIP) is the cost

of the partially completed goods that are still on the factory floor

at the end of a time period.

► WIP units have been started, but not finished; they have some value, but

not as much as they will when they are completed; and there are

beginning and ending inventories of WIP

► We must adjust the total manufacturing cost for the time period for the

inventories of WIP

► When that is done, we will have the total cost of the goods that were

completed and transferred from work-in-process inventory to finished

Cornerstone 2-4 Calculating Cost of Goods Manufactured

Cornerstone 2-4 Calculating Cost of Goods Manufactured

(continued)

Cost of Goods Sold

► To meet external reporting requirements, costs must be

classified into three categories:

► Production

► Selling

► Administration

► Cost of goods sold represents the cost of goods that were

sold during the period and, therefore, transferred from

finished goods inventory on the balance sheet to cost of

goods sold on the income statement (i.e., as an inventory

expense) Cost of goods sold is calculated as:

Cost of goods sold = Beginning finished goods inventory + Cost

of goods manufactured - Ending finished goods inventory

Cornerstone 2-5 Calculating Cost of Goods Sold

Basics of Cost Behavior

► Cost behavior is the general term for describing whether a

cost changes when the level of output changes.

► Costs can be variable, fixed, or mixed

► A cost that does not change in total as output changes is a

fixed cost.

► A variable cost, on the other hand, increases in total with an

increase in output and decreases in total with a decrease in

output.

► Knowing how costs change as output changes is essential to

planning, controlling, and decision making.

Relevant Range and Cost

Relationships

► The relevant range is the range of output over which the

assumed cost relationship is valid for the normal operations

of a firm

Fixed Costs

► Fixed costs are costs that in total are constant within the relevant range as

the level of output increases or decreases.

► In this example of Colley Computers, notice while the total fixed cost of

supervision remains the same, the unit cost decreases as more computers

are produced.

Discretionary Fixed Costs and

Committed Fixed Costs

► Discretionary fixed costs are fixed costs that can be changed

or avoided relatively easily at management discretion.

► Committed fixed costs, on the other hand, are fixed costs

that cannot be easily changed.

Variable Costs

► Variable costs are costs that in total vary in direct proportion to changes

in output within the relevant range.

► Variable costs can also be represented by a linear equation

► Total variable costs depend on the level of output

► This relationship can be described by the following equation or graphs:

Total variable costs = Variable rate x Amount of output

Mixed Costs

► Mixed costs are costs that have both a fixed and a variable

component For example, overhead for a company may consist of a

fixed supervisor salary plus the cost of supplies that vary with the

quantity of output produced The formula and graph depiction for a

mixed cost is as follows:

Total cost = Total fixed cost + Total variable cost

Step Costs: Narrow Steps

► Some cost functions may be

discontinuous.

► These costs are known as step

costs (or semi-fixed).

► A step cost displays a constant

level of cost for a range of output

and then jumps to a higher level

(or step) of cost at some point,

where it remains for a similar

range of output.

► If a step cost has relatively narrow

steps, it means that the cost changes

in response to fairly small changes in

output and we can approximate it as a

variable cost (i.e., the red line).

Step Costs: Wide Steps

► Step cost with relatively wide steps

are more characteristic of fixed

costs

► For example, a company may have

to lease production machinery If

the machine can only produce

1,000 units and the company

grows, they will have to lease

additional machines for each 1,000

units of production needed

(resulting in the wide steps shown

in the graph)

Accounting Records and

Need for Cost Separation

► Only through a formal effort to separate costs can all costs be

classified into the appropriate cost behavior categories.

► If mixed costs are a very small percentage of total costs,

formal cost separation may be more trouble than it’s worth.

► In this case, mixed costs could be assigned to either the fixed

or variable cost category without much concern for the

classification error or its effect on decision making.

► Alternatively, the total mixed cost could be arbitrarily divided

between the two cost categories (This is rarely done and not

a good option.)

► Typically, mixed costs for many firms are large enough to call

for separation.

Methods for Separating Mixed Costs

into Fixed and Variable Components

►Three methods of separating a mixed cost into its

fixed and variable components are commonly used:

►the high-low method

►the scattergraph method

►the method of least squares

►Each method requires the simplifying assumption of

The High-Low Method

► Given two points, the slope and the intercept can be determined.

► The high-low method is method of separating mixed costs into fixed and

variable components by using just the high and low data points

► To demonstrate, we will use data from materials handling costs at

Anderson Company:

The High-Low Method

► Four steps must be taken in the high-low method:

► Step 1: Find the high point and the low point for a given data

set.

► Step 2: Using the high and low point, calculate the variable rate.

► Variable rate = (High point cost - Low point cost) ÷ (High

point output - Low point output)

► Step 3: Calculate the fixed cost using the variable rate (from

Step 2) and either the high point or low point.

► Fixed cost = Total cost at high point - (Variable rate x

Output at high point)

► Step 4: Form the cost formula for materials handling based on

the high-low method.

Cornerstone 3-2Using The High-Low Method to Calculate

Fixed Cost and the Variable Rate and to

Construct a Cost Formula

Solution:

Step 1—Find the high and low points: The high number of machine hours is in March, and the low number of

machine hours is in June (Hint: Did you notice that the high cost of $4,200 was for August? Yet August is not the high point because its

number of machine hours is not the highest activity level Remember, the high point is associated with the highest activity

level; the low point is associated with the lowest activity level.)

Cornerstone 3-2 Using The High-Low Method to Calculate Fixed Cost and the Variable

Rate and to Construct a Cost Formula

(continued)

Scattergraph Method

► The scattergraph method is a way to see the cost relationship

by plotting the data points on a graph

► The first step in applying the scattergraph method is to plot

the data points so that the relationship between materials

handling costs and activity output can be seen.

Scattergraph Method (continued)

► Then we inspect the scattergraph to see if it reveals one or

more points (outliers) that do not seem to fit the general

pattern of behavior.

► This knowledge might justify their elimination and perhaps

lead to a better estimate of the underlying cost function.

Scattergraph Method (continued)

► Next, we should question whether the line determined by the high and low points

is representative of the overall relationship.

► Notice that three points lie above the high-low line, but five points lie below it.

► This does not give us confidence in the high-low results for fixed and variable

costs

► In particular, we might wonder if the variable cost (slope) is somewhat higher than

it should be and the fixed cost is somewhat lower than it should be.

Scattergraph Method (continued)

► Finally, we can use the scattergraph to visually fit a line to the data points on the

graph

► Of course, the manager or cost analyst will choose the line that appears to fit the

points the best, and perhaps that choice will take into account past experience

with the behavior of the cost item.

► An infinite number of lines might go through the data, but this one goes through

the point for January (100, $2,000) and intersects the y-axis at $800

Scattergraph Method (continued)

► First, remember that our two points are (100,

$2,000) and (0, $800) Next, use these two

points to compute the variable rate (the slope):

Variable rate = ($2,000 - $800)

$100 - 0

= $1,200/100

= $12

► Thus the variable rate is $12 per material move.

► The fixed cost and variable rate for materials

handling cost have now been identified.

► The cost formula for the materials handling

activity can be expressed as:

Total cost = $800 + ($12 x Number of moves)

Using the Formula from the

Scattergraph Method

► Using this formula, the total cost of materials handling for between

100 and 500 moves can be predicted and then broken down into

fixed and variable components

► For example, assume that 350 moves are planned for November

► Using the cost formula, the predicted cost is:

$5,000 = $800 + ($12 x 350)

► Of this total cost, $800 is fixed, and $4,200 is variable.

► Unfortunately, the scattergraph method suffers from the lack

of any objective criterion for choosing the best-fitting line

► The quality of the cost formula depends on the quality of the

subjective judgment of the analyst.

The Method of Least Squares

►The method of least squares (regression) is a

statistical way to find the best-fitting line through a

set of data points

►One advantage of the method of least squares is that

for a given set of data, it will always produce the

same cost formula

►Basically, the best-fitting line is the one in which the

data points are closer to the line than to any other

line

Line Deviations

► The regression line better describes

the pattern of the data than other

possible lines

► This best description results because

the squared deviations between the

regression line and each data point

are, in total, smaller than the sum of

the squared deviations of the data

points and any other line

► The least squares statistical formulas

can find the one line with the smallest

Cornerstone 3-5Using The Regression Method to Calculate Fixed

Cost and the Variable Rate and to Construct a

Cost Formula and to Determine Budgeted Cost

Cornerstone 3-5Using The Regression Method to Calculate Fixed

Cost and the Variable Rate and to Construct a

Cost Formula and to Determine Budgeted Cost

(continued)

Comparison of Methods

changes in output is essential to planning,

controlling, and decision making

costs into fixed and variable components help

managers understand cost behavior and

consequently make good business decisions.

Comparison of Methods for Separating Fixed Costs

into Fixed and Variable Components

Managerial Judgment

► Managerial judgment is critically important in determining

cost behavior and is by far the most widely used method in

practice

► Many managers simply use their experience and past

observation of cost relationships to determine fixed and

variable costs

► This method, however, may take a number of forms

► Some managers simply assign some costs to the fixed

category and others to the variable category and ignore

the possibility of mixed costs.

► Other managers may identify mixed costs and divide these

into fixed and variable components.

Managerial Judgment

(continued)

► Finally, management may use experience and judgment to

refine statistical estimation results

► Perhaps the experienced manager might ‘‘eyeball’’ the data

and throw out several points as being highly unusual or revise

the results of estimation account for projected changes in

cost structure or technology.

► The advantage of using managerial judgment to separate

fixed and variable costs is its simplicity

► In situations in which the manager has a deep understanding

of the firm and its cost patterns, this method can give good

results

► However, if the manager does not have good judgment,

errors will occur.

Section 3:

Cost-Volume-Profit (CVP)

Analysis

Learning Objectives

1 Determine the break-even point in sales

units and sales value, the amount of revenue

required for a target profit, the margin of

safety, and the degree of operating leverage

2 Understand the underlying assumptions and

limitations of the CVP analysis tool.

Break-Even Point

in Units and Sales Dollars

►Cost-volume-profit (CVP) analysis estimates how

changes in the following three factors affect a

If the contribution margin income statement is

recast as an equation, it becomes more

useful for solving CVP problems

Basic CVP Equation

► Recall in Cornerstone 4-1 that Whittaker sells

mowers for $400 each and variable cost per

mower is $325 Total fixed cost equals $45,000

Required:

1 Calculate the number of mowers that Whittier

must sell to break even

2 Check your answer by preparing a contribution

margin income statement based on the break-even

point

Cornerstone 4-2 Calculating the Break-Even Point in Units

Cornerstone 4-2 Calculating the Break-Even Point in Units

(continued)

Break-Even Point in

Units

To recap, the break-even units are equal to the

fixed cost divided by the contribution margin

per unit

Break-Even Point

in Sales Dollars

Sometimes, managers using CVP analysis may prefer to use sales

revenue as the measure of sales activity instead of units sold A

units sold measure can be converted to a sales revenue measure

by multiplying the unit selling price by the units sold:

For example, the break-even point for Whittier is 600 mowers;

the selling cost is $400 per mower.

So , Breakeven in Sales $’s = 600 x $400 = $240,000

Variable Cost Ratio and

Contribution Margin Ratio

Any answer expressed in units sold can be easily

converted to one expressed in sales revenues.

Alternatively:

Cornerstone 4-3 Calculating the Variable Cost Ratio and

the Contribution Margin Ratio