Module 1: The Role of Management Accounting
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Bottom of Form
Content
Mod 1: For Your Success
Learning Outcomes
1. Differentiate between management accounting and financial accounting.
2. Identify cost classifications, cost allocations, cost objects, cost pools and cost drivers.
3. Illustrate the value chain.
Mod 1: Readings
Required
o Chapters 1 in Managerial Accounting
o Miller, P. B.W., & Bahnson, P. R. (2009, July 20)..blackboard.com/bbcswebdav/pid-1577258-dt-content-rid-16513_5/xid-16513_5″>Implementing fair values: Overcoming ghosts and zombies. Accounting Today, 23(11), 18-19.
Mod 1: Content
I. Management Accounting and the Management Process
Management accounting provides managers and employees with the information they need to make informed decisions, to perform their jobs effectively, and to achieve their organizational goals. Because management accounting reports are for internal use, their format can be flexible and driven by each users need. They may report either historical information or future projections without any guidelines or restrictions. As you will recall, financial accounting reports focus on past performance and are strictly prepared in accordance with generally accepted accounting principles, or GAAP. Management accounting reports may be based on estimates and may be reported in monetary terms or in other measurements such as time or units. Management reports may also be prepared as often as needed and do not necessarily report monthly or quarterly information.
Primary Users
Management Accounting
Financial Accounting
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Managers and employees
People inside the organization
Owners or stockholders
Lenders
Customers
Governmental agencies
Parties outside the firm
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Managers need internal accounting reports because in todays competitive business environment, analysis of the value chain is critical to most companies survival. The value chain illustrates the process that businesses use to fulfill their mission and objectives. Each step in the value chain should add value to the products or services in which the business engages. Management accounting reports provide the information to managers to help them determine if value is being met in every phase of the value chain.
Each primary activity in the manufacture of a product or delivery of a service can be thought of as a link in a chain that adds value to the product or service.
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As a supporting activity, or a function that is not within the value chain, management accounting must be efficient and provide value to managers by developing information that is useful for their decision making. Analyzing the value chain through the reports that management accounting provides can help managers determine whether or not primary activities are building the value needed to remain competitive. A common result of analyzing the value chain is outsourcing the non value adding activities. When a company outsources functions that are not adding value to their product or service, they are able to provide more resources toward the activities that are their core competencies, or the activities for which the company is best at providing value.
Another use of management accounting reports is for decision making in continuous improvement efforts. You may have heard of the more popular types of continuous improvement management philosophies. The Just-in-Time operating philosophy, the Six Sigma philosophy, total quality management (TQM), and activity based management are all examples of continuous improvement management philosophies that rely heavily on management accounting reporting for successful implementation and maintenance.
Information for measuring performance is also provided through management accounting reporting. One of the more recent and popular forms of measuring performance in organizations is the balanced scorecard. The balanced scorecard is a framework that links the perspectives of an organizations four stakeholder groups to the organizations mission, objectives, resources, and performance measures. The four stakeholder groups in the balanced scorecard performance measurement system are financial, customers, learning and growth, and internal processes. Illustrated below are the possible objectives and performance measurements a health food grocery store might build into their balanced scorecard.
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As you can see the financial perspective performance measures would require management accounting information as well as the internal processes perspective.
II. Cost Classifications
Since a companys primary goal includes the ability to remain profitable, analyzing costs related to the operating activities is an essential task of every manager. Ultimately a company is profitable only when its revenues exceed its costs. Managers use information about operating costs to plan, perform, evaluate and communicate the results of the operating activities. A single cost can be classified and used in several ways depending on the purpose of the cost or the purpose of the analysis. Every cost incurred will contain at least one or more of the attributes in the following illustration. Lets look at some examples.
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Direct and indirect costs (the blue boxes on the left side of the illustration) relate to cost information gathered in a manufacturing firm. The direct costs are costs that are directly traceable to the product being manufactured. For example, in a furniture manufacturing firm, upholstery would be a direct cost as the exact amount used can be traced to a unit such as a chair. Indirect costs in our furniture manufacturer might include the cost of glue as it is most likely an immaterial amount that is used in each unit and not cost effective to trace each ounce used on an individual chair.
Variable and fixed costs relate to information used in cash flow projections. Variable costs are costs that are only incurred when a service is performed or a unit is manufactured. Fixed costs are the expenses that do not go away even if the plant is idle or services are not performed. Examples of fixed costs include mortgage payments and salaries of administrative personnel. Examples of variable costs are the cost of materials and labor in a manufacturing firm.
Value adding costs are the costs incurred as the product or service moves through the value chain. The value adding costs increase the market value of the product or service. In value chain analysis, the non-value adding costs are sought out in order to be minimized or eliminated.
Product costs and period costs are also usually associated with manufacturing firms producing a product. The product costs are those associated with manufacturing the product. Both direct and indirect costs, described above are also product costs. The product costs all end up in the Cost of Goods Sold section of the formal income statement. The period costs are the administrative costs in a manufacturing firm. They are the costs necessary to provide the infrastructure of the company, but are not directly associated with the manufacturing process. Period costs can contain fixed and variable costs, value adding and non value adding costs, but will not contain direct or indirect costs.
Since manufacturing firms were the first traditional users of cost data, we use manufacturing as examples when we study cost concepts. As the manufacturing process occurs, costs are incurred along the way. The costs are collected in inventory accounts during the manufacturing process. When materials are purchased, the costs are collected in the materials inventory account. As the manufacturing process occurs, and labor and overhead costs are added to the materials, the costs are collected in the Work In Process Inventory account. When the product has completed the manufacturing process, the costs are transferred to the finished goods inventory account. All of these accounts are reported on the formal balance sheet of the company as current assets.
The Manufacturing
Cost Flow (contd)
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In the illustration above, starting at the left top side, we see $250,000 coming out of materials inventory and being put into the manufacturing process by transferring the $250,000 to the work in process inventory account. We also see $120,000 of labor being added into the work in process inventory and $60,000 of overhead allocated to the product as well. Therefore, the product as it is being manufactured has incurred $250,000 + $120,000 + $60,000 of costs (the $20,000 shown in the work in process inventory account was left over from the prior period). Finally, we see $300,000 leaving the work in process inventory account and going into the finished good category.
When the product is sold, the cost to manufacture the product is taken out of the finished goods inventory asset account and transferred to the cost of goods sold account, an expense type account that is reported on the formal income statement of the company.
In the illustration below we see $240,000 leaving the finished goods inventory account and becoming an expense in the cost of goods sold account.
The Manufacturing
Cost Flow (contd)
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It is important for all managers to understand cost attributes and cost flows to make decisions and plan effectively for the success of the department in which they are responsible.
III. Allocating Overhead Costs
All products contain three types of costs: materials, labor, and overhead. I am sure you are familiar with the term overhead. The concept is used in many different settings. For the purposes of management accounting and in the manufacturing process that we use for illustrating cost concepts, overhead costs are the production related costs that cannot be conveniently or economically traced to specific units of the product. Our definition of indirect costs above describes overhead costs.
Overhead Costs
Production-related costs that cannot be conveniently and economically traced to specific units of the product
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Also called service overhead, factory overhead, factory burden, manufacturing overhead, or indirect manufacturing costs
As we saw illustrated above using the T-accounts, overhead costs are allocated to the product by applying an amount ($60,000 in our example above) into the work in process inventory account as the product is being manufactured. The two most popular methods for allocating overhead costs are the activity based costing (ABC) method and the traditional approach. The traditional approach is much easier to apply, but the ABC approach results in a more accurate product cost, especially when different types of products are sharing the same manufacturing system.
The traditional approach to applying overhead costs involves calculating a predetermined overhead application rate. The predetermined overhead rate is calculated using estimates based on prior years costs. All indirect costs from the prior year are considered, and an estimated amount in which indirect costs will increase during the coming year is included. The total amount estimated for indirect costs is called the cost pool. The cost pool is the amount that total overhead is estimated to be in the coming year.
Next, the important decision to determine what drives the costs of the overhead is made. Usually, an activity such as labor or machine hours is determined to be the factor that drives overhead costs into the product. For example, if a company is heavily automated with manufacturing equipment and does not employ very many factory workers, then machine hours would most likely be the cost driver for overhead. On the other hand, if a manufacturing process requires more labor than machine hours, then labor would be the cost driver.
Traditional overhead application rates then are easily calculated by dividing the dollar amount in the estimated cost pool by the number of hours (either machine hours or direct labor hours) estimated to be used in the manufacturing process in the coming year. Suppose that $20,000 was estimated to be the total amount for the coming years indirect costs pool, and 400,000 direct labor hours, the cost driver, is estimated to be used in the manufacturing process for the coming year.
$20,000
=
$.05 overhead cost applied per direct labor hour
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400,000 Direct Labor Hours
As labor is added into the work in process inventory account, overhead will also be added into the work in process inventory account at five cents per direct labor hour. So, for example, say 3,000 hours of labor at $10 per hour was incurred during the manufacturing process in July. As $30,000 of labor ($10 x 3,000 hours) was moved into the work in process inventory account, then $150 of overhead (3000 hours x .05) would also be moved into the work in process inventory account.
ABC overhead allocation is more complicated as it uses more than one cost pool and cost driver. To use an ABC method of allocating overhead, the company must first determine the specific activities that are performed that drive overhead. For example, inspection of the final product is an indirect activity that may require many resources such as labor and equipment. Other examples of activities that may be used in an ABC system are packaging, and machine set ups.
When implementing and maintaining an ABC system, careful analysis is involved to determine accurate estimates for each activity cost pool and each activity cost driver.
Allocating Overhead
Using ABC
Companies using ABC identify production-related activities and the events and circumstances that cause (drive) those activities
Production-related activities
Setup, inspections, building, etc.
Events and circumstances that cause (drive) those activities
Number of setups, number of inspections, machine hours, etc.
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Many smaller activity pools are created from the single overhead cost pool used in the traditional approach
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A predetermined rate must be calculated for each cost pool and then applied with each cost driver. Using our example of pools and drivers above, lets assume that the set up activity cost pool is $7000 and the cost driver is estimated at 700 set ups. Dividing the pool by the driver, just as we do for calculating traditional overhead, we determine that our activity cost rate is $10 ($7000/700) per set up. Therefore, $10 of overhead will be applied to the product for each set up performed. If 40 set ups are performed, the $400 ($10 x 40) overhead is applied. Moving on to the inspections activity, we would perform the same calculations, finding the rate by dividing the pool by the driver, then applying that activity cost rate to the actual number of inspections that were performed during the period. Using ABC, then, we must calculate overhead rates for every cost pool and driver, and then apply overhead for each activity. Usually, managers find that the accuracy in the calculation of the final cost of the product (materials + labor + overhead) using ABC is worth the extra effort when the company manufactures more than one type of product.