Chapter 2
Management accounting:
basic terms and concepts
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
Management accounting
information
 Components
Costing system
Budgeting system
Performance measurement system
Cost management system
 Conventional versus contemporary
approaches
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
2
Conventional vs. contemporary
management accounting systems
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
3
Emphasis on cost
 Why do management accountants pay so
much attention to costs?
Historic focus on production costs, to value
inventory and COGS for external reporting
Ready availability of cost data within the
transaction-based accounting system
Importance of cost information in managers’
decisions
 Non-financial information has assumed
increased importance in contemporary
management accounting systems
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
4
Cost classifications
 Before classifying costs, need to consider
how managers intend to use the cost
information in decision making
 Different cost 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
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
5
Cost classifications
 What are costs?
Resources given up to achieve a particular
objective
If the benefit extends beyond the current
accounting period these costs are classified as
assets
If the benefit is used, the costs are classified as
expense
Measured in monetary terms
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
6
Cost behaviour
 Managers must understand how costs
change as the as the level of activity in the
business changes
The level of activity is the level of work
performed in the organisation
 Variable costs
Change in total in direct proportion to a change
in the level of activity
Sometimes referred to as unit-level costs in
product costing as they incurred for each unit of
product/service produced
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
7
Cost behaviour
 Fixed costs
Remain unchanged in total despite changes in
the level of activity
Can be described as committed costs
Result from an organisation’s ownership or use of
premises and its basic organisation structure, and is
difficult to change in the short-term
or as discretionary costs
Result from management’s decision to spend a
particular amount of money for some purpose, and
can be easily changed
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
8
Cost behaviour
 Cost drivers
Any activities or factors that drive (cause) costs
 Conventional approaches focus on
production volume as the level of activity
(or cost driver)
Costs are classified as variable or fixed with
respect to production volume
 Contemporary approaches recognise that
other (non-volume) cost drivers exist
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
9
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
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
10
Direct and indirect costs
 In responsibility centres
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
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
11
Direct and indirect costs
 Product costs
Manufacturing costs that can be traced to
product 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
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
12
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
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
13
Controllable and
uncontrollable costs
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
14
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 product or services that
customers value
 Provides a useful framework for examining
the areas where costs are incurred within a
business
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
15
Costs across the value
chain
 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 cost of sourcing and
managing incoming parts, assemblies and
supplies
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
16
Costs across the value
chain
 Production costs
The costs incurred to collect and assemble the
resources used to produce a product or service
 Downstream costs
 Marketing costs are the cost of selling products
and the cost of advertising and promotion
 Distribution costs are the cost of storing,
handling and shipping finished products
 Customer service costs are the costs of serving
customers, including after-sales service
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
17
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
18
Manufacturing costs
 Manufacturing costs are incurred within the
factory area, whereas upstream and
downstream costs are sometimes called
non-manufacturing costs
 Manufacturing costs include three
categories: direct material, direct labour
and manufacturing overhead
This classification assumes that products are the
relevant cost objects
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
19
Manufacturing costs
 Direct material
Material that is consumed in the manufacturing
process
Physically incorporated into the finished
products; and
Can be traced to products conveniently
 Direct labour
The cost of wages and labour on-costs of staff
who work directly on manufacturing a product
However, contractual arrangement sometimes
means that such labour is a committed cost
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
20
Manufacturing costs
 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
manufacturing support departments
Also includes cost of overtime premium and idle
time
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
21
Manufacturing costs
 Conversion costs
The total of direct labour and manufacturing
overhead costs
The cost of converting material into product
 Prime costs
The total of direct material and direct labour
costs
The major cost associated with producing a
product
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
22
Manufacturing costs
 Contemporary costing systems analyse
costs in greater detail than under
conventional costing systems
Labour costs, and upstream and downstream
costs may be classified within an activity
framework
 In general, direct material tends to be the
largest proportion of manufacturing cost,
and direct labour costs the smallest
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
23
Product costs
 Managers need estimates of product costs
for different purposes
 In financial accounting reports
To determine cost of goods sold
To value inventory on hand
 For decision making
Definitions of product costs that include nonmanufacturing costs may be used
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
24
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
25
Cost flows in a manufacturing
business
1. Material is purchased: 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
3. Direct labour and manufacturing overhead
are accumulated in work in process
inventory
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
26
Cost flows in a manufacturing
business
4. Products are completed: costs are
transferred from work in process inventory
and added to finished goods inventory
5. Products are sold: costs are transferred
from finished goods inventory to cost of
goods sold expense
6. Cost of goods sold is deducted from sales
revenue to determine gross profit
continued
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
27
Cost flows in manufacturing
business

Raw materials, work in processes and
finished goods inventories balances are
found in the Statement of Financial
Position


Cost of goods sold expense can be found
in the Statement of Financial Performance
The Schedule of Cost of Goods
Manufactured and Schedule of Cost of
Goods Sold summarise the flow of
manufacturing costs
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
28
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
29
Cost and benefits of
information
 Must determine which cost concepts are
most appropriate in each situation
 Benefits of measuring and classifying costs
can be realised through improvements in
the quality of managers’ decisions
 Information overload occurs when
managers receive more information than
they can use efficiently
Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An
Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton
Slides prepared by Kim Langfield-Smith
30