Fundamental Management Accounting Concepts

Management accounting is the branch of accounting designed to meet the needs of internal users. It is concerned with an information process and system that measures and provides financial and non-financial information to assist managerial decision making, motivate behaviour and create a culture which will achieve the stated objectives of the organisation.

In directing the operations of an organisation, one of the basic functions of management is decision making. Managers are constantly faced with problems of deciding what mix of products to sell, what production methods to use, how to make the most productive use of facilities, how to optimise use of scarce resources, whether to accept orders at special prices, and so forth. Critical to these decisions is an understanding of the different types of costs the organisation is incurring and the ways in which these costs behave.

A manufacturing firm is more complex than most other organisations as it is broader in its activities, being involved in production, retailing and administration. Each of these activities involves costs. The manufacturing costs of a product are made up of three basic elements - materials, labour and production overhead (expense). We will examine these in
more detail later in this topic. The selling costs are all the costs necessary to obtain customer orders and to supply the finished product to the customer. The administrative costs are all the costs incurred in operating the business affairs of a firm.

We now need to supplement these simple and fairly intuitive cost classifications with an analysis of costs according to the way they behave and are dealt with in the accounting process. Horngren et al. (1996) use three main criteria for classifying costs.

1. Assignment of costs (ease of traceability) to cost object
a) direct costs
b) indirect costs.
2. Profit determination (timing of charges against revenue)
a) product costs
b) period costs.

3. Cost behaviour patterns
a) variable costs
b) fixed costs
c) other costs.

A cost object is anything within the organisation for which separate costs may need to be identified. Direct cost is a cost that can be obviously and physically traced to the particular cost object under consideration. Indirect cost is a cost that must be allocated in order to be assigned to the cost object under consideration.

In measuring profit, we need to be able to determine product and period costs. Product costs are viewed as 'attaching' to units of product as the goods are purchased or manufactured, and they remain attached until sale takes place. At the point of sale, the costs are released from stock as expenses and matched against sales revenue. Period (non-inventoriable) costs are costs treated as an expense in the period incurred and matched against revenue on a time basis. All selling and administrative expenses are considered to be period costs. However, product and period costs will include a mixture of direct and indirect costs and variable and fixed costs.

From a planning and control standpoint, perhaps the most useful way to classify costs is by behaviour. Cost behaviour means how a cost will react or respond to changes in the level of business activity. For planning purposes costs are classified into two categories - variable and fixed. Variable costs are costs that vary, in total, in direct proportion to changes in the level of activity (a good example of a variable cost is direct materials). Fixed costs are costs that remain constant in total, regardless of changes in the level of
activity (rent is a good example of a fixed cost).

Cost behaviour is focused the relevant range assumption, that is, that the identified cost behaviour patterns are correct only for a certain range of activity. Some costs do not exactly fit the variable cost or fixed cost classification because their behaviour pattern is not always the same. These are termed semi-variable costs and semi-fixed costs. Semi-variable costs increase with increasing levels of activity but not at a constant rate (e.g., labour cost learning curves). Semi-fixed costs increase with the level of activity, but do so intermittently rather than continuously.

Historical costs are identified at the time they are compute and form the basis of financial reporting relied on by accountants. However, since historical costs are related to costs already incurred through past decisions, they are unsatisfactory for managers who need future costs for making decisions; they are sometimes referred to as actual costs or sunk costs.

This basis of cost classification shifts from the product or service to the person who is responsible for the cost incurred. Controllable costs are those that occur due to activities or decisions by a manager for which they are responsible. Those costs for which a manager has no responsibility are viewed as non-controllable (although they might be in a different part of an organisation).

Materials are commodities that are used up or changed in form during the manufacturing process. Raw materials can be subdivided into two categories. Direct materials; that have an obvious relationship to the finished product. Indirect materials and manufacturing supplies: These are materials that do not have an obviously identifiable relationship to the finished product, or, if they do, it is not economically feasible to charge them as direct materials (e.g., glue in a joinery).

Labour costing is of primary interest to management, which wants to know what it is getting
for its labour dollar. From management's point of view the objectives of labour costing may

  • to identify direct labour with the costs of products, services or projects
  • to use, where desired, direct labour as a basis for overhead application through an overhead rate based on labour cost or labour time
  • to use data on direct and indirect labour as a basis for controlling the efficiency of operations.

For cost accounting and control purposes it is necessary to differentiate between direct and indirect labour. Direct labour is generally labour that is used in the actual production of the product, and is therefore identifiable with product costs. Indirect labour is work that is incidental to the product but is not identifiable with the cost of a specific product (aka 'reflexive labour' in sociology).

Production overhead includes all costs related to manufacturing other than direct materials and
direct labour. Total overhead costs must be allocated or apportioned across the products produced. It is necessary to use a predetermined overhead rate that can be applied to production. This rate is usually computed as follows:

Overhead rate = Budgeted overhead for period/Budgeted production units

Two methods - direct and step - are available for overhead cost allocation. Under the direct method, the service department costs are transferred to the production departments and added to the overhead already existing in the production departments. The step method, recognises the interdependence of service departments.