Cost and management accounting fundamentals a southern african approach

The content is aligned to the latest curriculum of the Chartered Institute of Management Accountants CIMA, and deals with the basic concepts and techniques for the identification and con

Fundamentals – A southern African approach

Cost and Management Accounting

Cost and Management Accounting is a comprehensive resource intended for courses which

cover the fundamentals of this subject The content is aligned to the latest curriculum of the

Chartered Institute of Management Accountants (CIMA), and deals with the basic concepts

and techniques for the identification and control of costs, as well as general cost management

Cost and Management Accounting has a strong southern African perspective and covers current

issues on each topic

The following key features are geared to encourage self-study in students:

• Case studies

• Theory review questions

• Test-yourself questions

• Detailed end-of-chapter exercises

Extensive support materials include:

• Solutions to exercises in the book

• PowerPoint® slides

• Additional questions and answers

Written by a group of expert subject specialists using accessible language and engaging formats,

this student-friendly text is a must-have resource for students at universities and universities

of technology, as well as for those following MBA courses and other management accounting

courses

Support material is available to lecturers at prescribing institutions via the website

www.juta academic.co.za

About the general editor

Ferina Marimuthu is a Management Accounting lecturer at the Durban University of Technology

She has extensive lecturing experience in Cost and Management Accounting from basic to

advanced levels which has included lecturing on the Unisa BCompt and CTA programmes Ferina

takes a keen interest in learning materials development and adding value to students’ learning

experience She has also been involved with the writing of a variety of accounting textbooks

and acted as reviewer on several books both locally and internationally

Cost and Management Accounting

Fundamentals – A southern African approach

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This textbook comes with the following lecturer resources:

• PowerPoint® slides

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• Additional questions and answers

Student Support

This book comes with the following online resources accessible from the resource page on the

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• Exam and study skills

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Cost and Management

A c c o u n t i n g

General editor: Ferina Marimuthu Contributing authors: Elda du Toit, Thembinkosi Jodwana,

Avika Mungal, Anél du Plessis and Manoj Panicker

Fundamentals – A southern African approach

Cost and Management Accounting

Fundamentals – A southern African approach

First published 2015

Print first published in 2015

Juta and Company (Pty) Ltd

PO Box 14373, Lansdowne 7779, Cape Town, South Africa

© 2015 Juta & Company (Pty) Ltd

ISBN 978 1 48511 190 0 (Print)

ISBN 978 1 48511 540 3 (WebPDF)

All rights reserved No part of this publication may be reproduced or transmitted in any form or

by any means, electronic or mechanical, including photocopying, recording, or any information storage or retrieval system, without prior permission in writing from the publisher Subject to any applicable licensing terms and conditions in the case of electronically supplied

publications, a person may engage in fair dealing with a copy of this publication for his or her personal or private use, or his or her research or private study See section 12(1)(a) of the Copyright Act 98 of 1978

Project manager: Seshni Kazadi

Editor: Michelle Savage

Proofreader: Robyn Hoepner

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Cover designer: Monique Cleghorn

The author and the publisher believe on the strength of due diligence exercised that this work does not contain any material that is the subject of copyright held by another person In the alternative, they believe that any protected pre-existing material that may be comprised in it has been used with appropriate authority or has been used in circumstances that make such use permissible under the law

About the authors xi

How to use this book xiii

Foreword xv

Acknowledgements xvi

1 The context of management accounting 1

Introduction 2

Definition of management accounting 2

The purpose of management accounting 2

Comparison of financial accounting and management accounting 3

The link between cost accounting, financial accounting and management accounting 4

Characteristics of good information 5

Non-financial information 5

Financial information requirements for different types of organisations 6

Commercial organisations 6

Public organisations 6

Societies or non-profit organisations 6

Environmental management accounting 6

The management accountant 7

The role of management accountants 7

The positioning of the management accountant within an organisation 8

The management accountant as a dedicated business partner 8

The management accountant as an advisor 9

Shared service centre 9

Business process outsourcing 9

Ethics and professional standards in management accounting 10

The background of the CIMA 10

The role of CIMA in developing the practice of management accounting 11

CIMA qualification 11

Chartered Global Management Accountants 11

Summary 12

Test yourself solutions 13

Additional resource 17

Reference list 17

2 Basic cost accounting, cost classification, behaviour and estimation 19

Introduction 19

Cost and related terms 20

Manufacturing and non-manufacturing costs 21

Product and period costs 22

Classification by cost behaviour 23

Classification for decision making 26

Cost estimation 29

High-low method 30

Scatter graph method 30

Least squares method (regression analysis) 31

Total cost statement 33

Summary 35

Test yourself solutions 36

Additional resource 44

Reference list 44

3 Inventory management and control 45

Introduction 46

Material recording process 46

Inventory valuation 47

Periodic inventory system 48

Perpetual inventory system 52

Inventory variances between financial and manual records 55

Inventory management systems 55

Economic order quantity 56

Re-order point 59

Maximum inventory holding 59

Minimum inventory holding 59

Stock ledger cards 60

Material Requirement Planning 60

Just-in-Time 61

Accounting entries in a manufacturing organisation 62

Purchasing of inventory items 62

Issuing of inventory items 63

Summary 63

Test yourself solutions 65

Additional resource 71

Reference list 71

4 Labour cost and control 73

Introduction 74

Labour cost control 74

Payroll accounting 74

Methods of remuneration 75

Wage incentive schemes 76

Rowan premium 76

Halsey premium 76

Halsey-Weir premium 76

Calculating the remuneration 78

Normal deductions 78

Organisation allowances 79

Overtime 79

Direct and indirect labour 81

Labour recovery rate 82

Accounting entries 84

Summary 85

Test yourself solutions 86

Additional resource 92

Reference list 92

5 Manufacturing overheads 93

Introduction 93

Overheads in a manufacturing organisation 94

Manufacturing overheads 94

Non-manufacturing overheads 94

Allocation and apportionment of manufacturing overheads .94

Primary allocation and apportionment 94

Secondary allocation and apportionment .98

Predetermined overhead rate 98

Absorption of manufacturing overheads 100

Under- or over-absorbed overheads 100

Accounting entries 103

Activity-based costing 105

Summary 110

Test yourself solutions 111

Additional resource 119

Reference list 119

6 Job costing and the flow of manufacturing cost 121

Introduction 121

Job costing and batch costing 122

Job costing procedures 122

Flow of documents 123

The flow of costs in a production facility 124

Total cost of a job 124

Accounting entries for job costing and manufacturing cost flow 127

Statement of cost of goods manufactured and sold 131

Summary 136

Test yourself solutions 137

Additional resources 143

Reference list 143

7 Construction contract costing 145

Introduction 145

What is a construction contract? 146

Accounting for construction contracts 146

Cost flows within a contract 147

Revenue flows within a contract 148

Profit recognition within an accounting period 150

Accounting entries 152

Construction contracts in practice 160

Summary 161

Test yourself solutions 164

Additional resources 170

Reference list 170

Cost flows and unit costs 172

Process cost report 176

Incomplete units and equivalent production 176

Incomplete units in opening inventory 177

Weighted average method 177

The FIFO method 179

Spoilage (normal and abnormal) 183

Treatment of normal loss 183

Abnormal loss and gain 187

The short-cut method in process costing 192

Conditions for using the short-cut method 193

The process account and related entries 195

Summary 197

Test yourself solutions 198

Additional resources 209

Reference list 209

9 Budgets 211

Introduction 211

The purpose and importance of budgeting 212

Strategic planning, budgetary planning and operational planning 212

What is a budget? 213

The budgeting process 213

The budget period 214

The budget committee 214

The budget manual 214

The preparation of budgets 214

The inter-relationships of budgets 215

Using computers to prepare budgets 215

The master budget 215

The sales budget 219

The production budget 220

The cost of goods manufactured budget 220

The selling and administrative expenses budget 223

The master budget (or budgeted statement of comprehensive income) 224

The cash budget 225

The budgeted statement of financial position 226

An alternative cash budget example 229

Approaches to budgeting 232

Participative budgeting 233

Rolling budgets 233

Incremental budgeting 233

Zero-based budgeting 233

Budgetary control information 234

Budget centres 234

Budgetary control reports 235

Fixed and flexible budgets 235

Preparing a flexible budget 235

The total budget variance 237

Using budgets as a basis for rewards 239

Summary 239

Test yourself solutions 241

Reference list 256

10 Standard costing 257

Introduction 257

What is a standard cost? 258

The operation of a standard costing system 258

Purposes of standard costing 258

Performance levels 259

Ideal standard 259

Attainable standard 259

Current standard 259

Setting standard costs 260

Material standards 260

Labour standards 260

Overhead standards 260

Standard costing in the modern business environment 261

Flexible budgets and the total budget variance 262

What is variance analysis? 262

Variable cost variances 264

Direct material variances 265

Direct labour variances 269

Variable overhead variances 271

Fixed overhead variances 273

Sales variances 275

Reconciliation of variances 277

Working backwards with variances 278

The inter-relationship of variances 281

Summary 281

Test yourself solutions 282

Reference list 290

11 Integrated and interlocking accounting systems 291

Introduction 291

An integrated accounting system 292

Accounting entries applicable to an integrated accounting system 292

Basic cost variances 298

An interlocking accounting system 299

Accounting entries applicable to an interlocking accounting system 299

Reconciliation between cost and financial accounts 302

Summary 307

Test yourself solutions 308

Additional resources 318

Reference list 318

12 Direct and absorption costing 319

Introduction 319

Comparing direct and absorption costing concepts 320

Direct and absorption costing statements of comprehensive income 321

Differences in profit 323

Direct and absorption costing methods and inventory valuation 324

Reconciliation of the difference in profit 328

Direct costing versus absorption costing 330

Disadvantages of direct costing 331

Advantages of absorption costing 331

Disadvantages of absorption costing 331

Summary 331

Test yourself solutions 332

Reference list 342

13 Cost-volume-profit analysis 343

Introduction 343

Assumptions of the CVP analysis 344

The contribution income statement 344

Contribution 345

Contribution per unit 345

Contribution margin ratio 345

Break-even point 347

Margin of safety 349

Target profit analysis 351

Algebraic approaches to the CVP analysis 352

The break-even graph 353

Profit/volume graph 355

The ‘what if’ analysis 357

Limitations of a CVP analysis 358

Summary 358

Test yourself solutions 359

Additional resource 368

Reference list 368

14 Decision making 369

Introduction 369

Relevant and irrelevant costs 369

Discretionary costs 370

Opportunity cost 371

Sunk cost 371

Avoidable and unavoidable costs 371

Joint products and by-products 371

Physical measures method 373

Sales value at the split-off point method 373

Net realisable value at split-off point method 374

Constant gross profit percentage method 375

Joint cost allocations for decision making 376

Accounting for by-products 378

Scrap and waste 380

Make-or-buy decisions 380

Limiting factors affecting production 383

Summary 386

Test yourself solutions 387

Additional resource 396

Reference list 396

15 Pricing decisions 397

Introduction 397

Demand and the product life cycle 398

Price elasticity of demand 398

Factors affecting price elasticity 400

The product life cycle 400

The introductory phase 401

Growth phase 402

Maturity phase 402

Decline phase 402

The profit maximisation model 402

Limitations of the profit maximising model 403

Pricing strategies based on cost 404

Establishing percentage mark-ups 404

Cost-plus pricing 404

Return on investment pricing 405

Market-based pricing strategies 406

Target costing and pricing 406

Other pricing strategies 407

Penetration pricing 407

Price skimming 408

Premium pricing 408

Price differentiation 408

Loss leader pricing 408

Product bundling 408

Discount pricing 408

Controlled pricing 409

Summary 409

Test yourself solutions 410

Additional resource 414

Reference list 414

16 Investment appraisal 415

Introduction 415

Some principles underlying investment appraisal 416

Assumptions underlying investment appraisal decisions 416

Investment appraisal process 416

Screening stage 416

Search stage 416

Information acquisition stage 417

Authorisation stage 417

Financing stage 417

Implementation stage 417

Investment appraisal techniques 418

Payback method 418

Discounted payback method 420

Accounting rate of return method 421

Net present value method 422

Compounding 422

Discounting 423

Internal rate of return 429

Sensitivity analysis and investment appraisal 431

Summary 431

Test yourself solutions 432

Additional resource 439

Reference list 439

17 Management information 441

Introduction 411

Management reports 411

Budgets and variance reports 442

Contribution format income statement 442

Projected financial statements 442

Balanced scorecard 442

Responsibility centres 442

Cost centre 442

Revenue centre 443

Profit centre 443

Investment centre 443

Financial statements that inform management 443

Gross revenue 443

Contribution 443

Gross margin 444

Value added 444

Expenses: Marketing, selling and administration 444

Return on capital employed 444

Management information in a service organisation 446

Management information in non-profit organisations 447

Summary 449

Test yourself solutions 450

Additional resources 455

Reference list 455

About the authors

Ferina Marimuthu is a Management Accounting lecturer at the Durban University of

Technology She has extensive lecturing experience in Cost and Management Accounting

from the basic up to the advanced level, which has also included lecturing on the Unisa

BCompt and CTA programmes Her qualifications include a Master’s in Business

Administration from the University of Durban Westville, where she was also awarded the

Outstanding Management Accounting Student award Ferina takes a keen interest in

learning materials development and adding value to students’ learning experience in the

classroom through the use of innovative teaching and learning methods She has also

co-authored on a book titled Basic Accounting for non-accountants, published by Van Schaik

Ferina was also the general editor on Cost and Management Accounting, published by Juta She

has been a reviewer on several books, both locally and internationally, including the fourth

edition of Management Accounting by Professor Will Seal, published by McGraw-Hill

Anél du Plessis has worked as a shaft accountant in the mining industry and as a project

accountant within the engineering field She has been teaching full time at the Vaal

University of Technology for five years with experience of Cost and Management Accounting

from first year up to B-Tech level Anél has completed her Master’s Degree in Management

Accounting at the North West University and has published research within the

Environmental Accounting field. 

Avika Mungal is a lecturer in the Department of Management Accounting at the Durban

University of Technology Her qualifications include a Bachelor’s Degree in Technology:

Cost and Management Accounting, as well as a Master’s Degree in Technology: Cost and

Management Accounting She has presented papers on Teaching, Learning and Assessment

at various symposiums She has also published research articles in both accredited and

non-accredited international journals Her future plans include engagement in research towards

pursuing her Doctorate

Elda du Toit is a senior lecturer in the Department of Financial Management at the

University of Pretoria She has been a lecturer for more than ten years and also presents a

short course on cost and management accounting She obtained her DCom degree in 2012

and is actively involved in research She is also an academic Professional Accountant

(PA[SA]) and Associate Chartered Management Accountant (ACMA/CGMA) She has

co-authored numerous undergraduate financial textbooks

Manoj Panicker is the Head of Department of Accounting at Walter Sisulu University

(WSU), Butterworth campus Before he became the Head of Department he was a Financial

Manager at the Enterprise Development Centre (EDC), a unit within WSU Prior to that, he

About the authors

Institute of Management Accountants (CIMA) (2013) He also holds a Master of Business

Leadership (MBL) degree (2002) from the University of South Africa He has served the

profession, academia and industry for a period covering 23 years He has developed

considerable first-hand experience in the challenges associated with the development and

implementation of budgetary processes and procedures for the Faculty of Business

Management Sciences and Law at WSU He managed finances of two multi-million rand

projects with EDC His research interests are in the areas of strategic management

accounting and financial performance of SMEs

Thembinkosi Jodwana is a Senior Lecturer in the Department of Applied Accounting at

the Nelson Mandela Metropolitan University (NMMU) He has occupied various positions

in commerce and industry, one of which was as Export Accountant for a famous FMCG

company He holds a BCom (Rhodes), HDE (Rhodes), MTech (NMMU) and Post Graduate

Diploma in Applied Ethics (Stellenbosch University) He lectures Cost and Management

Accounting to first and third year National Diploma Accounting students and Project

Management to BTech students He is a member of the South African Institute of

Professional Accountants (SAIPA)

Mind maps – Each chapter begins with a mind map which creates a mental image of the

chapter helping you to focus on the parts that are important

Learning objectives – These follow on from the mind maps introducing topics covered

and summarise what you should have learnt by the end of the chapter You can use these to

view the key issues that are covered in the chapter You can also test yourself at the end of

each chapter to see if these learning objectives have been realised

Illustrative case studies – Each chapter contains a South African-based case study with

questions These allow you to apply your understanding of the concepts, issues and

techni-ques within a broader organisational context

Illustrative examples – The key areas in management accounting have been clearly

explained using illustrative examples These examples are concise and focus on a particular

key concept within the chapter

Test yourself questions with solutions – Each learning outcome consists of a test yourself

question which enables you to check your understanding and identify the areas in which

you need to do further work The solutions to these questions appear at the end of the

chapter

Summaries – Pull together the key points addressed in the chapter to provide a useful

reminder of the topics covered The summary links with the learning outcomes of each

chapter

Key concepts – Each chapter concludes with a list of the main concepts defined, explained

and illustrated in the chapter

Review questions – Short questions which encourage you to review and critically discuss

your understanding of the main topics and issues covered in each chapter

Exercises – This section of the chapter consists of 12 exercises beginning with a crossword

puzzle leading on to a set of multiple-choice questions, thereafter on to a set of comprehensive

questions mostly adapted from CIMA examinations The inclusion of professional

questions will prepare students with the required level of competency necessary to sit some

of the professional examinations The ability to understand these questions will indicate a

high level of understanding of the topic Fully worked solutions to the exercises are available

on the website to institutions that prescribe this book

How to use this book

Lecturer supplements

● Complete, downloadable Instructor’s Manual with solutions to the end of the chapter

exercises

● Additional questions and solutions on each chapter consisting of Crossword puzzles,

Match the column, True or false, Fill in the blanks, Multiple-choice questions and Short

questions

● Suggested solutions to all illustrative case study problems

● Editable PowerPoint® slides organised by chapter, allowing you to provide a lecture or

seminar presentation and/or print handouts

So, you are now at the introductory level of your cost and management accounting studies

For a moment, let’s look into your future … after graduation, when you might be applying

for a job as a cost and management accountant

Most job descriptions in the profession call for a specific skills set aligned to the requirements

of the role and organisation These skills include analytical skills, discipline, planning and

strategy development, control of resources, interpreting financial and economic data and

decision-making Above all, the job will require an interest in working with numbers, as well

as technical accounting and finance skills

In addition, however, softer skills will be necessary: communication skills, presentation

skills, the ability to persuade or convince, interpersonal skills, leadership skills and people

management These skills are essential for cost accountants to perform their roles with

professionalism and integrity

All these skills enable a cost and management accountant to see the organisation’s big

picture and to help the company’s owner or its directors make decisions that will ensure the

organisation’s success It’s a big role to step into eventually

So it is for this very reason that when we were deciding on the make-up and structure of the

Cost and Management Accounting Fundamentals textbook we considered the profession and the

environment in which you will eventually operate We believe that as a cost and management

accounting student you need to grow into the role of an accountant by first learning the

fundamentals of the discipline and then applying that knowledge The key is how the

fundamentals are learnt This is where Cost and Management Accounting Fundamentals makes

the difference

The textbook covers the new CIMA syllabus (effective 2015) and lays a solid foundation for

the key concepts and most important areas of focus in cost and management accounting

today The topics are clearly presented and the text show the logical development of

concepts Concise explanations and related examples illustrate how the concepts are

applied, and mini case studies, and particularly scenarios that depict the unique southern

African perspective, are threaded throughout each chapter With our insight into how

students learn at an introductory level, we specifically included extensive self-study

opportunities throughout the textbook, such as review questions, test-yourself questions

and end-of-chapter exercises Our intention is to encourage self-study and more importantly

to harness an attitude of always learning, which the profession also requires

We have presented the content you require in your course, balanced with the competencies

you will need, which mirrors CIMA’s approach in their syllabus So, even though this is your

first step towards a career as a future cost and management accountant, we hope that it is a

firm foothold and one that ensures that you are future-enabled for the cost and management

Foreword

The authors and publisher gratefully acknowledge permission to reproduce copyright

material in this book Every effort has been made to trace copyright holders, but if any

copyright infringements have been made, the publisher would be grateful for information

that would enable any omissions or errors to be corrected in subsequent impressions

Brand names in case studies: used with permission of ABSA, Standard Bank SA and Nedbank

SA; Adapted content in case study: ‘Ace Fertilizer Company: Ethical Cost Allocations and

Price Determination.’ Jerry Kreuze, Western Michigan University, IMA Educational Case

Journal, ISSN 1940-204X, Volume 2, Issue 3 ©2014, CIMA All rights reserved; Used by

permission ‘Impala Platinum ’, CGMA case study from: Management Accounting principles drive

20% lower costs than peers Leon van Schalkwyk FCMA, CGMA, ©2014, CIMA All rights

reserved; Case study used by permission: Mastercraft http://www.mastercraft.com; Case study

used by permission: ’GM SA plant still closed as strike continues’ Jul 07 2014 12:02 © Fin24

iab South Africa July 14, 2014; Case study used by permission: ‘Carmakers hit by South

African metalworkers strike’, by Andrew England, © Financial Times; Case study adapted

from ‘Forget the ‘China price’ - what’s the ‘China cost’? October 6, 2008, by Glenn Cheney

Accounting Today © Source MediaSource All rights reserved http://www.accountingtoday

com/ato_issues/2008_18/29239-1.html; Unpublished MCom Dissertation by S.W Sabela

2012: ‘An evaluation of the most prevalent budgeting practice in the South African business

community’, © 2012 University of Pretoria All rights reserved; Case study using Project

Report: ‘Costing the South African Public Library and Information Services Bill’, Department

of Arts and Culture, Pretoria, SA, August 2013; Case study: ‘What is an Integrated Accounting

System?’ by Paul Cole-Ingait, Demand Media © Copyright 2015 Hearst Newspapers, LLC;

Case study: ‘Factors influencing effective cost management within South Africa’s retail

banking sector’ Mistry K.S Research project submitted to the Gordon Institute of Business

Science, University of Pretoria An MBA requirement 10 November 2010 http://repository

up.ac.za/bitstream/handle/2263/24703/dissertation.pdf?sequence=1 Kirtan Shirishkumar

Mistry 29686131; Case study: ‘kulula.com: Making you want to fly’, 2010 © and permission

of Professor Colin Diggines; Astrapak case study: ‘Strike action dents Astrapak H1 earnings,

Engineering News 19 September 2014, edited by Chanel de Bruyn, Creamer Media Senior

Deputy Editor Online; Mercedes Benz case study: © 1997–2015, Institute of Management

Accountants, Inc; Springwater case study: © 2012-15 Great Ideas for Teaching Marketing

Geoff Fripp; Fry Group Food case study from: © 2012 Business and Marketing Cases Juta.

The context of management accounting

1

Learning objectives

After studying this chapter, you should be able to:

● understand the concept of management accounting

● identify the differences between financial and management accounting

● explain the role of the management accountant in an organisation

● explain the financial information requirements for companies, public organisations

and societies

● understand the importance of ethics

● understand the role of CIMA as a professional body

Purpose of management accounting

Financial vs management accounting

The importance of information

Environmental management accounting

The management accountant

The role of CIMA Management accounting

Management accounting focuses on providing relevant information to managers, the

key personnel within an organisation who plan, organise, direct and control operations

Management accounting provides essential information in a variety of reports, which

managers analyse and interpret in order to make informed decisions

In contrast, financial accounting focuses on providing information to shareholders,

investors, creditors and others who are outside an organisation Financial accounting pro­

vides statements on an organisation’s past performance, which are then used by outsiders

to determine how well the organisation is performing

This chapter addresses the meaning and purpose of management accounting, the

role of management accountants and the role of the Chartered Institute of Management

Accountants (CIMA) as a professional body for management accountants

Definition of management accounting

Management accounting is the process of preparing management reports that provide

accurate and timely financial and statistical information required by management to make

decisions It is also used to plan and control an organisation’s activities CIMA defines

management accounting as: ‘the application of the principles of accounting and financial

management to create, protect, preserve and increase value for the stakeholders of for­profit

and not­for­profit enterprises in the public and private sectors’ (Source: CIMA)

The purpose of management accounting

The purpose of management accounting is to provide useful information to management,

which is used to assist them in planning, directing, motivating and controlling the

opera tions Management accounting is an integral part of management’s role and

contributes largely to the success of any organisation Management accounting requires

the identification, generation, presentation and interpretation of relevant information It

assists in making strategic decisions, planning operations, determining capital structure and

sourcing funding, and measuring and reporting financial and non­financial performance

to management Furthermore, the information provided by the management accounting

process is essential for operational control, ensuring that resources are used effectively,

and that corporate governance procedures, risk management and internal controls are

implemented correctly

Planning involves setting the objectives of an organisation and formulating strategies to

achieve those objectives Planning is done at different levels:

● Strategic, or long­term planning performed by top management

● Managerial, or short­ to medium­term planning done by middle management

● Operational, or short­term planning for daily operations

Decision making involves analysing the information provided and making informed

decisions, usually by choosing between two or more alternatives Managers rely on accurate

information to compare each alternative and assess its impact on the organisation The

management accountant is responsible for providing the information on which these

decisions are based

Control entails evaluating the organisation’s performance by comparing actual

results with targets The differences between actual results and targets can be reported

to management so that they can improve the control of their operations Some common

performance measures are:

● variances, which compare actual results against budgeted results

● profitability, which may be measured using gross profit, net profit or gross margin

percentage

● returns, which are measured by means of ratios such as return on capital

Management accounting provides information to assist with the following tasks:

● Planning: As part of the planning process, management considers the effects of revenue

and expenditure Management accounting information is important in estimating these

effects Budgeting is also part of the planning process Management accountants collect,

analyse and summarise data for management to use in the preparation of budgets

● Decision making: Management accountants collect, analyse and interpret data which

is submitted to management in the form of reports These reports enable management

to make informed decisions Management accounting data, such as daily sales reports,

are often used in day­to­day decision making

● Controlling and monitoring: Performance reports which compare budgeted and

actual results are prepared by management accountants If actual performance falls

below the target, management is alerted so that appropriate control actions can be

taken Providing this kind of feedback to management is one of the main purposes of

management accounting

● Motivating: Motivating involves mobilising staff to carry out plans and run day­to­

day activities Managers need to motivate and direct their staff effectively to keep the

organisation functioning efficiently Management accounting data, such as daily sales

reports, budgets and performance reports, are a measure of a division’s or organisation’s

performance in relation to its objectives, and can be used to motivate and encourage

staff to work smarter or more efficiently

Test yourself 1.1

Briefly discuss the different levels of planning

Comparison of financial accounting and management accounting

Stakeholders, such as shareholders, investors, creditors etc who are external to the

organisation, use financial accounting reports Managers within the organisation use

management accounting reports for internal use Even though both financial and

management accounting often depend on the same basic financial data, the contrast in basic

orientation results in a number of major differences between financial and management

accounting These differences are summarised in Table 1.1

Table 1.1 Comparison of financial accounting and management accounting

Financial accounting Management accounting

External focus: reports to those outside the

organisation such as shareholders, lenders, tax

Internal focus: reports to those inside the organisation for planning, decision making,

Emphasis is on historical data Emphasis is on future decisions

Objectivity of data is emphasised Relevance is emphasised

Precise information is required Timely information is required

Must follow GAAP Need not follow GAAP

Summarised data for the entire organisation

is prepared

Detailed reports about different departments and functions are prepared

Mandatory for external reports Not mandatory

Governed by many rules and regulations Not governed by rules and regulations

Test yourself 1.2

The following characteristics relate to either management or financial accounting

Indicate to which each characteristic relates:

(a) Externally focused

(b) Not a mandatory requirement

(c) Assists in planning and decision making

(d) Aimed at shareholders and investors

(e) Governed by rules and regulations

The link between cost accounting, financial accounting and

management accounting

Accounting is concerned with the accumulation of data for internal and external reporting

The three areas of accounting are financial accounting, cost accounting and management

accounting

Financial accounting is the process employed to communicate the financial information

of an organisation to various parties interested in its progress One of the main objectives

of financial accounting is to report on an organisation’s profitability and to provide

information about its financial position The information presented in financial accounting

statements is used primarily to ascertain the performance of an organisation and to make

important investment or divestment decisions

Cost accounting involves accounting for costs and is used for determining an organisa­

tion’s profitability and for decision making It includes the accounting for all income

and expenditure, and preparation of periodical statements and reports, with the aim of

determining and controlling costs Cost accounting helps management by directing their

attention towards inefficient operations and assisting with the day­to­day control of

business activities Cost accounting information is used in both financial and management

accounting

Management accounting is a systematic approach to assist in managerial decision

making It generates information for establishing plans and controls, while also providing a

system of setting standards and targets, and reporting variances between planned and actual

performances for corrective actions Management accounting is the process of identifying,

measuring, analysing, preparing, interpreting and communicating financial information to

management This information is used to plan, evaluate and control activities, enabling the

organisation to achieve its objectives Management accounting consists of cost accounting,

budgetary and inventory controls, statistical measures, internal appraisals and reporting

Characteristics of good information

Organisations generate enormous quantities of data just through carrying out their

normal daily activities This data consists of basic facts and figures The data is then

processed into a useful form which is known as information Good information is needed

to make good decisions Characteristics of good information can be easily remembered

using the acronym ACCURATE

A – Accurate: The degree of accuracy varies, depending on the reason for which the

information is needed For example, when calculating the cost of a unit of output, managers

may want the cost to be accurate to the nearest rand or cent

C – Complete: Managers require all relevant information before making decisions For

example, a variance report should include all relevant standard and actual costs to understand

the variance calculation

C – Cost beneficial: Management information becomes valuable when it assists in decision

making The cost of generating information should not exceed the value of it

U – Understandable: Limited use of jargon and technical language improves under stand­

ability of information Care should be taken in the way in which financial information is

presented to non–financial managers

R – Relevant: Only relevant information should be included in the report The information

should be relevant to its purpose

A – Authoritative: Information should be included from a reliable source so that the users

can have assurance in the decision­making process

T – Timely: Information should be readily available to a manager so that he or she can

make decisions based on that information

E – Easy to use: Information should be easy to use and accessible to the person using it

Source: CIMA (adapted)

Non-financial information

Management requires both financial and non­financial information for decision making

Although financial information – such as costs and profit – is important, non­financial

information is also needed – such as the number of orders processed and the number of

complaints received Management accounting systems are capable of obtaining both

financial and non­financial information

Test yourself 1.3

Identify the characteristics of good information Choose all that apply

(a) Cost beneficial

(b) Accurate

(c) Accountable

(d) Complete

(e) Regular

(f) Timely

(g) Detailed

(h) Understandable

Source: CIMA (adapted)

Financial information requirements for different types of

organisations

The financial information requirement may vary depending on the users and their needs

Let us look at different types of organisations and their information needs below

Commercial organisations

The prime objective of commercial organisations is usually to maximise shareholder

wealth The type of information required by this type of organisation includes costing of

departments and products, profit measurement and return on capital

Shareholders are interested in the growth of their investment and they use the financial

statements to evaluate the organisation’s performance Shareholders are also interested in

the level of dividend payments

Public organisations

The main objective of public organisations is to provide services to the public, in line

with government requirements The information requirement of public organisations

is different from commercial organisations, in that public organisations are non­profit

entities and their focus should be on cost management Accurate and detailed information

is required for these organisations to assess the efficiency and effectiveness of their

operations Their objective, which is evaluated by the government and public, is public

service delivery

Societies or non-profit organisations

Societies or non­profit organisations (NPOs) require financial information relating to

their activities They will also be interested in the impact that organisations have on local

communities These types of organisations also find environmental reporting of good use

to the public since it measures and reports on the impact that organisations have on the

environment

Environmental management accounting

Environmental management accounting (EMA) involves the production and study of

both financial and non­financial information, in order to support internal environmental

management processes Organisations are under growing pressure to reduce their environ­

mental impact and therefore, it is important for them to understand the costs associated

in dealing with this problem Management can often be unaware of the magnitude of

environmental costs and may not be able to identify opportunities for cost savings

EMA can be applied in the assessment of environmental costs, product pricing,

budgeting and investment appraisal, and the setting of quantified performance targets

Environmental costs may be incurred for a number of reasons – they may be regulatory

costs or compliance costs – and can result in expenditure to meet legal or regulatory

requirements

There are also voluntary costs, where an organisation undertakes environmental

spending on its own initiative, either for social or for business reasons For example, some

environmentally friendly operations may create goodwill or satisfy customer expectations

through investing in beneficial environmental initiatives

Environmental costs can be split into two categories: internal costs and external costs

Internal costs impact directly on the profit of an organisation There are many different

types, for example, improved systems and checks in order to avoid penalties, waste disposal

costs, product take­back costs and regulatory costs, such as taxes

External costs are imposed on society at large, but not borne by the organisation that

generates the costs, e.g the costs of carbon emissions, energy and water usage, health care

and social welfare However, some governments are becoming increasingly aware of these

external costs and are implementing measures to convert them to internal costs by means

of taxes and regulations

Test yourself 1.4

Identify internal costs and external costs from the following list:

(a) Water disposal costs

(b) Health care costs

(c) Carbon emissions costs

(d) Regulatory costs

(e) Social welfare costs

(f) Product take-back costs

The management accountant

Management accountants play a crucial role in any organisation, by providing a variety

of information to management, which assists them in planning, controlling and decision

making Management accountants often hold senior positions in an organisation

The role of management accountants

The role of management accountants is changing from that of reporting performance to

enhancing performance Traditionally, management accountants were mainly involved in

reporting business results to management; but today, management accountants are seen

as value­adding partners of an organisation They are expected to forecast the future of

the business, as well as identify opportunities for enhancing organisational performance

Nowadays, management accountants along with business managers, function as mentors,

advisors and drivers of performance

The work of the chartered management accountant

Chartered management accountants assist organisations in establishing feasible strategies which

translate into profit in a commercial organisation, or into value for money in an NPO To achieve

this, they work as an integral part of multi-skilled management teams in carrying out the following

functions:

● developing policy and setting corporate objectives

● formulating strategic plans derived from corporate objectives

● drafting short-term operational plans

● acquisition and use of finance

● systems design, recording of transactions and management of information systems

● generating, communicating and interpreting financial and operating information for

management

● providing specific information and analysis on which decisions are based

● monitoring outcomes against plans and other benchmarks, and initiating responsive action for

performance improvement

● developing performance measures and benchmarks – financial and non-financial, quantitative

and qualitative – for monitoring and control

● improving business systems and processes through risk management internal audit review.

Chartered management accountants help organisations improve on their performance, security,

growth and competitiveness through the application of their expert knowledge and skills

Source: CIMA (adapted)

The positioning of the management accountant within an

organisation

It is important to position management accountants strategically within an organisation

Usually, they work within the finance function The available options are discussed in the

next section

The management accountant as a dedicated business partner

In this approach, an important business relationship between the managers and management

accountants is key to the success of an organisation They have to work together to achieve the

organisation’s objectives and their relationship must be based on trust, honesty and respect

The management accountants must act professionally at all times and demonstrate

technical and business awareness, which means that they must have up­to­date technical

knowledge and must be aware of the nature of the business and the needs of managers

Furthermore, they should also act with integrity The work done by management

accountants should be in the best interests of the organisation and the public; they should

avoid a conflict of these interests with their personal interests

Respectively, the managers need to trust the accountants and information provided by

them, as well as respect their knowledge, experience and professionalism Management

should discuss relevant aspects of work confidentially with the accountant and state clearly

what their requirements are

The management accountant as an advisor

Management accountants are expected to advise management on financial and non­financial

analysis, costing and pricing, business process re­engineering and performance management

To excel in this advisory role, management accountants need, not only financial skills, but

also communication and presentation skills

This approach helps to build strong relationships between the accountants and the

business and results in management having a better knowledge of the business area and its

requirements

On the other hand, this approach can result in duplication of effort across the

business Lack of knowledge sharing can occur with larger, diversified teams Management

accountants may become secluded within the business and develop their own way of

working They may also overlook the overall objectives of the business

Shared service centre

Shared service centre (SSC) is an approach in which the whole finance function is brought

together as one centre and provides all the accounting needs of the organisation It is often

known as ‘internal sourcing’ The advantages of an SSC are:

● reduced cost because of reduction in staff, premises and other related costs For example,

SSC may be located in an area where labour and property rates are favourable

● an improved quality of service due to the experience of the team and adoption of best

practices

● improved consistency of management information throughout the organisation

Business process outsourcing

Business process outsourcing (BPO) involves contracting an external supplier to provide

all, or part of, the business process Procurement, ordering and reporting functions are

usually outsourced, but in some cases, decision support and corporate functions are also

outsourced

The advantages of BPO include the following:

● Costs are reduced because there is less of a need for staff, premises and other related

costs

● Specialist service providers bring new expertise into the organisation

● The available capacity as a result of outsourcing routine processes can be used on more

value­adding processes, with the aim of providing the best information for management

decision making

The disadvantages of BPO include the following:

● There is a loss of control since management is unable to supervise the function closely

● The business has no direct access to information and only has access to the information

provided by the outsourcing company This can result in the business being overly

dependent on the service provider

● Confidentiality can be at risk because important information could end up in the wrong

hands

● Quality may be compromised Organisations need to implement quality control to

Test yourself 1.5

Which of the following are advantages of setting up an SSC?

(a) Consistency of management information

(b) Release of capacity

(c) Cost savings

(d) Increased quality of service

Ethics and professional standards in management accounting

Ethical standards provide sound, practical advice for management accountants and

managers Management accountants and financial managers have an obligation to

the public, their profession, the organisation they serve and themselves, in order to

maintain the highest standard of ethical conduct Codes of ethics are developed by

professional bodies and the fundamental principles of the CIMA code of ethics require

that practitioners of management accounting and financial management should maintain

the following standards:

● Integrity: Be straightforward, honest and truthful in all professional and business

relationships

● Objectivity: Do not allow bias, conflict of interest or the influence of other people to

override one’s professional judgement

● Professional competence: Maintain an ongoing commitment to improve professional

knowledge and skill

● Confidentiality: Do not disclose professional information unless there is specific

permission, legal or professional duty to do so

● Professional behaviour: Comply with relevant laws and regulations and avoid any

action that could negatively affect the reputation of the profession

Source: CIMA (adapted)

(e) Professional behaviour

The background of the CIMA

CIMA was originally formed in 1919 as the Institute of Cost and Works Accountants

(ICWA) It received the Royal Charter in 1975 and became known as the Chartered Institute

of Management Accountants in 1986

CIMA is the world’s largest professional body of management accountants with 227 000

members and students in 179 countries A professional qualification with CIMA is the best

preparation for an international career in business CIMA offers a professional accounting

qualification with an emphasis on strategic management, which makes it suitable for people

with the desire to become accountants or managers in business Students may study for the

qualification after completing a degree, or after completing their school career, as there are

no minimum entry requirements

CIMA’s members are key players in helping businesses to maintain financial control and

stability at all stages of the business cycle They work in all sectors of the economy, which

includes private, public and NPOs

CIMA’s regulatory framework underpins the professional standing of its members and

students through regulation, monitoring and where necessary, disciplinary procedures

It ensures that its members are competent, trusted and work within the public interest

The role of CIMA in developing the practice of management

accounting

CIMA qualification

The CIMA qualification is highly regarded worldwide and its members hold many high­

level finance positions The syllabus is constantly updated to ensure that it remains

current and relevant in meeting business needs Students must complete their professional

experience record before admission to membership, which ensures that members have

both technical and practical business knowledge Members are required to undertake

continuing professional development (CPD) to ensure that they maintain and develop

their knowledge

Chartered Global Management Accountants

CIMA recently entered into a joint venture with AICPA (American Institute of Certified

Public Accountants), which resulted in the creation of a new designation for management

accountants, known as Chartered Global Management Accountants (CGMA)

All qualified CIMA members are entitled to use the CGMA designation, which has been

designed to elevate the profession of management accounting worldwide The CGMA

designation will be recognised internationally, providing businesses worldwide with the

confidence that members of CGMA can assist them in making critical business decisions

and contribute to driving strong business performance

The work of CIMA ensures that both the public and businesses are protected by requiring

members to be trained to the highest levels and maintaining strict ethical and professional

standards

Source: CIMA (adapted)

Case study: Ace Fertilizer Company: Ethical cost

allocations and price determination

This case illustrates how profit maximisation goals have the potential to influence

ethical decision making Abbey, the Assistant Director of manufacturing, has the

opportunity to enhance both company profitability and reduce the purchase costs

of a product for the brother of George Smilee, the Director of manufacturing

However, that decision would shift costs to another customer, Breezland Ltd

Being a chartered management accountant (CMA), Abbey is appropriately using

the Chartered Institute of Management Accountants (CIMA) Code of Ethics as a

guide to the proper course of action

Management accounting is a key function within an organisation It provides management

with relevant information for decision making and its importance within internal manage­

ment, is well recognised by many organisations Today, management accountants have a

vital role to play in the achievement of setting goals and objectives of any organisation

Professional bodies such as CIMA, play a very important part in the development of

management accounting

Key concepts

Business process outsourcing involves contracting an external supplier to provide all, or

part of, the business processes

Environmental management accounting (EMA) involves the production and study of

both financial and non-financial information, in order to support internal environmental

management processes

Financial accounting involves preparing reports for the use of shareholders, investors

and creditors who are external to an organisation

Management accounting involves identification, generation, presentation, interpretation

and use of relevant information for internal decision making

➤➤

Planning is the process of setting an organisation’s objectives and formulating strategies

to achieve those objectives

Shared service centre (SSC) is an approach in which the whole finance function is

brought together as one centre and provides all the accounting needs of an organisation

Test yourself solutions

Test yourself 1.1

● Strategic, or long-term planning performed by the top management

● Managerial, short- to medium-term planning done by middle management

● Operational, or short-term planning for daily operations

Test yourself 1.2

(a) Externally focused: Financial accounting

(b) Not a mandatory requirement: Management accounting

(c) Assist in planning and decision making: Management accounting

(d) Focused at shareholders and investors: Financial accounting

(e) Governed by rules and regulations: Financial accounting

(a) Water disposal cost: Internal

(b) Health care costs: External

(c) Carbon emissions cost: External

(d) Regulatory costs: Internal

(e) Social welfare costs: External

(f) Product take-back costs: Internal

Test yourself 1.5

All options are correct

Test yourself 1.6

(b) Responsibility

(Although responsibility is a good quality for a CIMA member to have, it is not a fundamental

principle of the CIMA Code of Ethics)

Review questions

1.1 What is the purpose of management accounting?

1.2 What is planning? Discuss the different levels of planning

1.3 Differentiate between financial accounting and management accounting

1.4 Why is non-financial information important in the decision-making process?

1.5 What is environmental management accounting?

1.6 Briefly explain the changing role of management accounting

1.7 List three types of organisations

1.8 What is business process outsourcing?

1.9 Why are ethical standards important for management accountants?

Exercises

1.1 Complete the crossword below

4 3

5

6 7

8

9

10

ACROSS

1 Management accounting is … focused

4 Being straightforward, honest and truthful in all professional and business relationships

5 The prime objective of commercial organisations is usually to maximise wealth

7 Reports intended to communicate the organisation’s performance to staff

8 Characteristics of good information

9 Involves the evaluation of performance by comparing actual results with targets

10 Long-term planning performed by top management

2 Costs can be split into two categories: internal costs and external costs

3 Chartered Global Management Accountants

6 Short-term planning for daily operations

1.2 The following statements relate to management accounting:

A The main purpose of management accounting is to provide a true and fair view of the financial position of an organisation at the end of an accounting period

B Financial information is presented in a format needed by management

Which of the above statements are true?

(c) A and B

(d) None of the above

1.3 Which of the following are disadvantages of positioning a management

accountant as an advisor?

(a) An increased knowledge of the business

(b) A strong relationship between the accountant and the organisation

(c) A duplication of effort across the organisation

(d) A lack of knowledge sharing

1.4 Which of the following is not a purpose of management accounting?

(a) Planning

(b) Controlling

(c) Decision making

(d) Production of financial statements

1.5 Which of the following are advantages of business process outsourcing?

(a) Loss of control

(b) Cost reduction

(c) Access to specialist providers

(d) Over-reliance on external providers

1.6 Which of the following statements are true about CIMA?

(a) CIMA was established over 90 years ago

(b) CIMA only covers organisations based in the United Kingdom (UK)

(c) The main focus of CIMA is financial accounting

(d) Members of CIMA are known as chartered management accountants

1.7 Planning, decision making and controlling are key responsibilities of management

in any organisation Management accounting plays a very important role by providing information for planning, decision making and controlling Explain

1.8 Quality of information is key to making good decisions Explain the characteristics

of good information

1.9 There are different types of organisations and financial information requirements

1.10 Management accountants are usually part of the finance function and their

strategic position within an organisation is important Discuss different options available in positioning management accountants within an organisation

explain them

1.12

Case study: Impala Platinum

Embedding sound management accountancy principles at Impala Platinum has helped this South African mining group to improve on its cost management and remain in a competitive position

With management accountants feeding information to every part of the mining operation, Impala Platinum has costs running at around 20% lower than other groups in the industry

Strategic Finance Executive, Leon van Schalkwyk FCMA, CGMA, says the company boasts a management information system that is closely integrated with all areas of the business including human resources, line management and the top management team Shared and relevant information has been the basis of Impala Platinum’s model over the last 20 years

‘Gaining credibility for the company’s management accountants and their approach has been key to the success of this model,’ says van Schalkwyk, who has been with Impala Platinum for 25 years According to him, there is

no point in having management accountants who understand the business, unless their understanding is appreciated and taken notice of by management

‘Having the right people with the right knowledge in place is essential Having the right people presenting and getting involved in the different activities and on behalf of the entire company has also been key to our success over the years.’

In-depth knowledge of the business and relevant management information make effective decisions possible He states that a precise understanding of the integration of management accounting and business functions is essential to determine what action to take, when to take it and what the outcome will be

‘It is important to know when to implement a revised incentive scheme for our employees to drive the revenue The correct drivers for our people on the ground must be in place and put into action at the right time,’ he explains The result is that the business regards its management accountants instrumental

in day-to-day operations and overall strategy

➤➤

‘The business doesn’t see the management accounting function as a cost

control role only, but rather as major contributors in all aspects: from HR to

production, optimisation and operations on the ground.’

Source: www.cgma.org

Required:

1 Evaluate the importance of management information in Impala Platinum

2 Describe the role of management accounting in Impala Platinum

3 Explain the importance of positioning management accountants within

CIMA official study text Fundamentals of Management Accounting Kaplan Publishing.

‘Impala Platinum.’ Adapted from: www.cgma.org

Basic cost accounting, cost classification,

behaviour and estimation

2

Learning objectives

After studying this chapter, you should be able to:

● explain cost object and cost centre

● calculate the total cost of a cost object

● describe the nature and behaviour of variable, fixed and semi-variable costs

● prepare a total cost statement

● apply different methods of estimating costs

● formulate the straight line equation based on results from high-low, least squares

and scatter graph calculations

Introduction

The management of an organisation needs to control its operations and function properly

and efficiently Costs need to be collected, classified and analysed to aid in this management

and control Accounting systems are used to measure costs and facilitate profit calculation,

inventory valuation, decision making, the control of expenditure and performance

measurement and control This chapter addresses the basic concepts, classifications and

● Manufacturing and non- manufacturing

● Decision making

whether the organisation produces a product or provides a service, it needs to keep track of

its costs so as to report accurate information

Cost and related terms

Cost is a loosely used and often misused term that defies a simple definition It is used in so

many ways that perhaps no single definition could be written that would satisfy everyone

In accounting, for example, costs usually arise from completed transactions In contrast, in

economics, costs may be values assigned to opportunities forgone For our purposes, cost can

be defined as a monetary measure of any resource that has been sacrificed or forgone to achieve

a particular objective The resources may have a tangible substance (materials or machinery),

or they may take the form of services (wages, rent and electricity) If accountants, managers or

other people who use accounting information want to measure the cost of resources used to

make or sell something, then this something is referred to as the cost object A cost object can

be defined as a unit of output, either as a product for an organisation, or a unit of service for

a service organisation Costs can be charged to a cost unit, for example:

● A unit of production that an organisation produces could comprise a computer, a dress

or a book

● A unit of service can include a student per course or a customer who occupies a room

in a hotel

It is very important that we charge costs to specific areas within an organisation These are

known as cost centres A cost centre is a responsibility centre in an organisation where the

manager is responsible for costs The performance of the cost centre is measured according

to cost control Examples of cost centres include academic departments in a university, the

factory in a furniture manufacturing organisation, the laundry in a hotel, etc

Cost classification

Cost classification is essential when summarising cost data and this can be achieved by

arranging the costs into logical groups Thereafter, an efficient system must be devised in

order to collect and analyse the costs There are a number of cost classification systems Most

common classifications include classification by their purpose, nature and behaviour Each

of these systems differs according to the purpose for which the cost data is to be used The

broadest classification, which is cost classification by purpose, divides costs into direct and

indirect costs Cost classification by nature, classifies costs according to what they are, namely

materials, labour and expenses that are incurred in making a product or offering a service

In a restaurant, for example, materials would be the food and beverages, labour would be

the staff wages and production facilities such as the kitchen equipment, would be used to

convert the materials (such as the ingredients) into a finished product (the meal or beverage)

to be sold The expenses that would be incurred to ensure that the product is sold, would

include electricity, the rent of premises, repairs and maintenance, as well as the depreciation of

equipment Cost classification by behaviour classifies costs according to the manner in which

they react to changes in activity levels Other types of cost classification will also be discussed

Direct and indirect costs

Direct costs are the costs that can be traced directly to a unit of the cost object They are

incurred during the production process and can be clearly and exclusively identified with

the cost object i.e products or services When direct costs are assigned to the cost object,

this is referred to as cost tracing Direct costs normally include direct materials, direct

labour and other direct expenses

Direct material costs are the costs of material used in the manufacturing process to

produce a cost object The cost can be traced to each cost object in an economic manner

For example, timber would be classified as a direct material when making a wooden table

Similarly, fabric, buttons and a zipper would be classified as the direct materials used in

making a dress

Direct labour costs are the costs of the employees who were actually involved in the

production of the cost unit In the example of the manufacturing of the wooden table, the

wages paid to the machine operator, the assembler or the carpenter would be classified as

direct labour In the case of a restaurant, the wages paid to the chef would be regarded as

direct labour

Other direct expenses are the other expenses that can be directly related to the cost

object Consider, for example, that a company develops software The company requires

specific pre-generated assets such as purchased frameworks or development applications

These would be classified as direct expenses

The total direct costs of a product are referred to as prime costs i.e.:

Direct material + Direct labour + Direct expenses = Prime cost

All material, labour and other costs that cannot be traced specifically to a particular cost

object are classified as indirect costs, even though they have been incurred in the production

process These indirect costs are known as overheads Overheads can be broken down into

manufacturing overheads (also known as production or factory overheads), selling and

distribution overheads, and administration overheads Manufacturing overheads include

indirect materials (the nails used in manufacturing a desk), indirect labour (salary of the

factory supervisor), and other indirect costs (rent of the factory, depreciation of equipment,

insurance etc.) Sometimes direct costs are treated as indirect costs because the cost of

tracing these costs directly to the cost object is not cost effective Classifying a cost as direct

or indirect also depends on the cost object, because the cost can be treated as a direct cost

for one object, but the same cost maybe treated as indirect for another cost object Assigning

indirect costs to a cost object is referred to as cost allocation and this will be discussed in the

chapter on overheads

In order to convert raw materials into a completed product, direct labour and

manufacturing overheads are required and these are referred to as conversion costs i.e.:

Direct labour + Manufacturing overheads = Conversion costs

Manufacturing and non-manufacturing costs

Costs can also be classified according to the different phases in an organisation’s operations

In a manufacturing organisation, total operating costs consist of manufacturing and

non-manufacturing costs

Manufacturing costs, also referred to as production costs, are usually defined as the

sum of the three cost elements namely, direct materials, direct labour and manufacturing

overheads, and are therefore the total costs incurred in the production process

Non-manufacturing costs include the selling and distribution costs (also referred to as

marketing costs) and administration costs Selling and distribution costs include all costs

incurred in securing a customer order and getting the finished product to the customer

costs, sales salaries etc Administration costs include all management, organisational and

clerical costs associated with the general management of an organisation Examples include

management and secretarial salaries, general accounting costs, human resource (HR) costs etc

Product and period costs

Of prime importance in external reporting, but of less significance internally, is the

classification between product and period costs Product costs are the costs incurred in

the manufacturing of a product and are matched with the revenue in the period in which

the product is sold These costs are deferred as inventories prior to a product being sold

and are treated as an expense when the product is ultimately sold Period costs are those

costs assigned to periods of time rather than units of product These costs are charged to

the revenue in the period in which the cost was incurred Expenditures that are associated

with the manufacturing function are usually classified as product costs and those that are

related to the functions of selling and administration, are classified as period costs

Closely related to product and period costs, for stock valuation and profit measurement,

we must distinguish between unexpired costs (assets) and expired costs (expenses)

Unexpired costs are resources which have been acquired for the purpose of contributing to

future revenue Initially, they are recorded as assets in the balance sheet Once they have been

consumed in the generation of revenue and have no further potential, they are considered

to be expired costs and are recorded in the income statement as an expense From this

explanation it can be seen that an expense is a cost which has been consumed in generating

revenue Figure 2.1 summarises some of the concepts covered thus far

Prime cost Conversion cost

Manufacturing cost (Product cost)

Non-manufacturing cost (Period cost)

Administration

Selling and distribution

Manufacturing overhead Direct labour

Direct material

Figure 2.1 Manufacturing and non-manufacturing costs

Test yourself 2.1

North Coast Boards manufactures various types of furniture During a particular month,

2 000 units were manufactured and sold The following cost details were provided:

➤➤