Chapter 2
Management accounting: cost terms
and concepts
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Outline
• Management accounting systems
• Emphasis on costs
• Cost classifications: different classifications for
different purposes
• Classifying costs according to their behaviour
• Direct and indirect costs
• Controllable and uncontrollable costs
• Costs across the value chain
• Manufacturing costs
• Cost flows in a manufacturing business
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Management accounting systems
• Management accounting systems are tailored to
an organisation’s needs
• Components may include systems for
–
–
–
–
Costing
Budgeting
Performance measurement
Cost management
• Conventional versus contemporary approaches
– Contemporary approaches developed in the 1990s in
response to changes in the business environment
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Emphasis on costs
• Why do management accountants pay so much
attention to costs?
– Historic focus on production costs—to value inventory
and cost of goods sold for external reporting
– Ready availability of cost data within the transactionbased accounting system
– Importance of cost information in managers’ decisions
• Non-financial information assumes increased
importance in contemporary management
accounting systems
– Used to make decisions and manage various sources of
customer value and shareholder wealth
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Cost classifications: different
classifications for different
purposes
• Before we classify costs, we need to consider how
managers intend to use the information
• Different costs and classifications are used for
different purposes
• The same cost can be classified in a number of
ways depending on the intended use of the cost
information
(cont.)
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Cost classifications: different
classifications for different
purposes (cont.)
• What are costs?
– Resources given up to achieve a particular objective
– In financial accounting
 if the benefit extends beyond the current accounting period
these costs are classified as assets
 If the benefit is used up in the generation of revenue, the
costs are classified as expense
– Measured in monetary terms
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Classifying costs according to
their behaviour
• Managers must understand how costs change as
the level of activity in the business changes
– The level of activity is the level of work performed in the
organisation
 Units produced, kilometres driven, hours worked
• Variable costs
– Change in total in direct proportion to a change in the
level of activity
• Fixed costs
– Remain unchanged in total despite changes in the level
of activity
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Direct and indirect costs
• An important function of management accounting
is to measure the cost of cost objects
– Cost objects are the items for which management wants
a separate measure of costs
– Products, projects, contracts and departments are
common cost objects in conventional costing systems
– Contemporary costing systems may also include
activities and customers as cost objects
(cont.)
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Direct and indirect costs (cont.)
• Responsibility centres
– A responsibility centre is a unit of an organisation where
the manager is held accountable for the unit’s activities
and performance
– The costing system may measure the costs of managers’
individual areas of responsibility
– Costs that can be traced to a particular responsibility
centre are direct costs of that centre
– Costs that relate to responsibility centres but cannot be
traced precisely to specific responsibility centres are
indirect costs of those centres
(cont.)
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Direct and indirect costs (cont.)
• Product costs
– Manufacturing costs that can be traced to products in an
economic manner are direct product costs
– Indirect costs are manufacturing costs that cannot be
traced to products in an economic manner
• Whether a cost is classified as direct or indirect
depends on the nature of the cost object
– Do we wish to know the cost of a department, a product,
a project, or an entire company?
– A cost can be a direct cost of one cost object and an
indirect cost of another cost object
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Controllable and uncontrollable
costs
• Managers’ performance evaluation can be
enhanced by classifying responsibility centre costs
as either controllable by the manager or
uncontrollable
• Ideally, managers should be held responsible only
for costs they can control or significantly influence
• Some costs are controllable in the long term but
not in the short term
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Costs across the value chain
• The value chain
– A set of linked processes or activities that begins with
acquiring resources and ends with providing and
supporting products and services that customers value
• Various cost classifications can be used within the
upstream, downstream and manufacturing areas
– To assign cost to products and to provide other
information to help manage resources efficiently and
effectively and to create value
(cont.)
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Costs across the value chain
(cont.)
• Upstream costs
– Research and development costs include the costs
involved in developing new products and processes
– Design costs include the costs associated with designing
a product or production process
– Supply costs are the costs of sourcing and managing
incoming parts, assemblies and supplies
(cont.)
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Costs across the value chain
(cont.)
• Production costs
– The costs incurred to collect and assemble the resources
used to produce a product (i.e. goods or services)
• Downstream costs
– Marketing costs are the costs of selling products and the
costs of advertising and promotion
– Distribution costs are the costs of storing, handling and
shipping finished products
– Customer service costs are the costs of serving
customers, including after-sales service
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Manufacturing costs
• Manufacturing costs are incurred within the factory
area
• Upstream and downstream costs are nonmanufacturing costs
• Manufacturing costs include three categories:
direct material, direct labour and manufacturing
overhead
– This classification as direct or indirect cost assumes that
products are the relevant cost objects
• Under conventional product costing, only
manufacturing costs are included in product costs
(cont.)
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Manufacturing costs (cont.)
• Direct material is –
–
–
–
Consumed in the manufacturing process
Physically incorporated into the finished products
Can be traced to products conveniently
Considered a variable cost
• Direct labour
– The cost of wages and labour on-costs for personnel
who work directly on the manufacture of a product
– Usually treated as variable costs, however contractual
arrangements sometimes mean that such labour is a
committed cost and so does not vary with the level of
production
(cont.)
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Manufacturing costs (cont.)
• Manufacturing overhead
– All manufacturing costs other than direct material and
direct labour
– Also called indirect manufacturing costs or factory
burden
– Includes the cost of indirect material and indirect labour,
depreciation and insurance on factory equipment, utilities
and the costs of support departments for manufacturing
– Includes cost of overtime premium and idle time
– Manufacturing support departments do not work directly
on producing products but are necessary for the
manufacturing process to occur
(cont.)
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Manufacturing costs (cont.)
• Conversion costs
– The total of direct labour cost and manufacturing
overhead cost
– The cost of converting material into a product
• Prime costs
– The total of direct material cost and direct labour cost
– The major cost associated with producing a product
(cont.)
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Manufacturing costs (cont.)
• Contemporary costing systems analyse costs in
greater detail than conventional costing systems
– Only direct material may be classified as direct product
costs
– Labour costs may be analysed as part of activity costs,
as may some upstream and downstream costs
• In many industries, direct material is the largest
proportion of the manufacturing cost and direct
labour costs are the smallest
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Product costs
• Managers need estimates of product costs for
different purposes
• In financial accounting reports
– Product costs determine cost of goods sold
– Product costs help value inventory on hand
– All costs that are not product costs are called period
costs
• For management decision making
– Definitions of product costs may include nonmanufacturing costs associated with developing,
producing and selling the product
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Cost flows in a manufacturing
business
1. Material is purchased: the cost is added to raw
materials inventory
2. Direct materials are consumed in production: cost
is removed from raw materials inventory and
added to work in process inventory
Direct labour and manufacturing overhead are
accumulated in work in process inventory
(cont.)
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Cost flows in a manufacturing
business (cont.)
3. Products are completed: costs are transferred from
work in process inventory and added to finished
goods inventory
4. Products are sold: costs are transferred from
finished goods inventory to cost of goods sold
expense
Cost of goods sold is deducted from sales revenue
to determine gross profit
(cont.)
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Cost flows in manufacturing
business (cont.)
• Raw materials, work in process and finished goods
inventory balances are reported in the Balance
Sheet
• Cost of goods sold expense can be found in the
income statement
• The schedule of cost of goods manufactured and
schedule of cost of goods sold summarise the flow
of manufacturing costs
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Summary
• Management accounting systems are tailored to
an organisation’s needs
• Costing systems focus on the cost of products and
organisational units and are a component of
management accounting systems
• We can distinguish between conventional and
contemporary management accounting systems
• There may be different costs for different purposes
• Costs may be classified by behaviour, traceability,
controllability and function
(cont.)
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Summary (cont.)
• In manufacturing businesses, production costs
typically consist of direct materials, direct labour
and manufacturing overhead, in line with external
reporting requirements
• The definition of product costs needed to support
management decision making may be broader
than that used for external reporting purposes
• Product costing systems track the manufacturing
costs from the beginning of production to finished
goods and link the product costing system to the
financial accounting reports
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