Managerial Accounting

Management accounting or managerial accounting is the process of identifying, analyzing, recording and presenting financial information that is used for internally by the management for planning, decision making and control. In contrast to financial accounting, managerial accounting is concerned with providing helpful information and reports to internal users such as managers and entrepreneurs etc. so that they can control and plan the business activities. Few of the main areas, in which managerial accounting is used are:

Planning and Budgeting: Managers use managerial accounting techniques to plan what to sell, how much to sell, what price is to be charged to reimburse the costs of production and also earn an optimal profit. Also they have to plan how to finance the operations and how to manage cash etc. This is very important to keep the business operations working smoothly. The capital budgeting and master budget are the two important topics in this area. Decision Making: When managers have to decide whether or not to start a particular project, they need managerial accounting information to estimate the benefits of various opportunities and decide which one to choose. Mangers often use relevant costing techniques. Measurement of Performance: Managers have to compare the actual results of operations to budgeted figures to evaluate the performance of the business. They use managerial accounting techniques such as standard costing to evaluate the performance of specific departments. They then make necessary adjustments in those departments which are not performing well.

Financial vs. Managerial Accounting Although financial accounting and managerial accounting are closely related and work side by side but they are different on following aspects:

Users: Users of financial accounting information are people outside the organization such as stockholders, government, investors, etc. The users of managerial accounting information are people inside the organization for example managers and entrepreneurs. Time: Financial accounting is mainly concerned with past business activities. Financial accounting is used to record the actual facts and figures of financial transactions. Although managerial accounting does involve the analysis of past business activities to evaluate departmental performance, it is also concerned with future planning and budgeting. Regulation: Financial accounting practices are governed by GAAP and IFRS etc. Since financial accountants have to report about the financial performance of the business to external users therefore it is very necessary to enforce such regulations to provide correct information to people outside the organization. Managerial accounting is not governed by such rules and regulations. Requirement by Law: Registered companies are required by law to produce and publish financial accounting information. But managerial accounting is not mandatory by law. It is only required internally.

Cost and Cost Classifications Cost is a sacrifice of resources to obtain a benefit or any other resource. For example in production of a car, we sacrifice material, electricity, the value of machine's life (depreciation), and labor wages etc. Thus these are our costs. Costs are usually classified as follows: Product Costs Vs. Period Costs Product costs are costs assigned to the manufacture of products and recognized for financial reporting when sold. They include direct materials, direct labor, factory wages, factory depreciation, etc. Period costs are on the other hand are all costs other than product costs. They include marketing costs and administrative costs, etc. Breakup of Product Costs The product costs are further classified into:

Direct materials: Represents the cost of the materials that can be identified directly with the product at reasonable cost. For example, cost of paper in newspaper printing, cost of Direct labor: Represents the cost of the labor time spent on that product, for example cost of the time spent by a petroleum engineer on an oil rig, etc. Manufacturing overhead: Represents all production costs except those for direct labor and direct materials, for example the cost of an accountant's time in an organization, depreciation on equipment, electricity, fuel, etc.

The product costs that can be specifically identified with each unit of a product are called direct product costs. Whereas those which cannot be traced to a specific unit are indirect product costs. Thus direct material cost and direct labor cost are direct product costs whereas manufacturing overhead cost is indirect product cost. Prime Costs Vs. Conversion Costs Prime costs are the sum of all direct costs such as direct materials, direct labor and any other direct costs. Conversion costs are all costs incurred to convert the raw materials to finished products and they equal the sum of direct labor, other direct costs (other than materials) and manufacturing overheads. Cost Classification Diagram

Fixed Costs Vs. Variable Costs Fixed costs are costs which remain constant within a certain level of output or sales. This certain limit where fixed costs remain constant regardless of the level of activity is called relevant range. For example, depreciation on fixed assets, etc. Variable costs are costs which change with a change in the level of activity. Examples include direct materials, direct labor, etc. Sunk Costs Vs. Opportunity Costs The costs discussed so far are historical costs which means they have been incurred in past and cannot be avoided by our current decisions. Relevant in this regard is another cost classification, called sunk costs. Sunk costs are those costs that have been irreversibly incurred or committed; they may also be termed unrecoverable costs. In contrast to sunk costs are opportunity costs which are costs of a potential benefit foregone. For example the opportunity cost of going on a picnic is the money that you would have earned in that time. Product Cost vs Period Cost Costs are classified into product costs and period costs on the basis of whether they are capitalized to the cost of products produced or not. Product Costs Costs that become part of the cost of goods manufactured are called product costs. Such costs are incurred on manufacturing process either directly as material and labor costs or indirectly as overheads. Since the matching principle of accounting requires expenses to be matched to the revenue they generate, therefore it is necessary to expense product costs only when the revenue from the sale of products is realized. This is achieved by debiting product costs to the cost of goods manufactured and thus expensed only at the time of sale of such goods.

Examples of products costs are raw material, labor, factory depreciation, fuel and packaging costs. Product costs are further classified into direct material, direct labor and factory overhead. Period Costs Period costs are basically all costs other than product costs. These are not incurred on the manufacturing process and therefore these cannot be assigned to cost goods manufactured. Period costs are thus expensed in the period in which they are incurred. Example of period costs are advertising, sales commissions, office supplies, office depreciation, legal and research and development costs. Period costs may be further classified into selling costs and administrative costs. Direct Costs and Indirect Costs Manufacturing costs may be classified as direct costs and indirect costs on the basis of whether they can be attributed to the production of specific goods, services, departments or not. Direct Costs Direct costs can be defined as costs which can be accurately traced to a cost object with little effort. Cost object may be a product, a department, a project, etc. Direct costs typically benefit a single cost object therefore the classification of any cost either as direct or indirect is done by taking the cost object into perspective. A particular cost may be direct cost for one cost object but indirect cost for another cost object. Most direct costs are variable but this may not always be the case. For example, the salary of a supervisor for a month who has only supervised the construction of a single building is a direct fixed cost incurred on the building. Examples: Cost of gravel, sand, cement and wages incurred on production of concrete. Indirect Costs Costs which cannot be accurately attributed to specific cost objects are called indirect costs. These typically benefit multiple cost objects and it is impracticable to accurately trace them to individual products, activities or departments etc. Examples: Cost of depreciation, insurance, power, salaries of supervisors incurred in a concrete plant. Example Following costs are incurred by a factory on the production of identical cupboards: 1. 3. 5. 7. 9. Laborers' wages Power consumption Nails and screws Handles, locks and hinges Supervisors' salaries 2. 4. 6. 8. 1 Synthetic wood Glass Factory insurance Wood Factory

1 1.

Varnish, glue, paints

0. 1 2.

depreciation Factory manager's salary

Classify the above costs as direct or indirect. Solution 1. 3. 5. 7. 9. 11. Direct Indirect Indirect Direct Indirect Indirect 2. 4. 6. 8. 10. 12. Direct Direct Indirect Direct Indirect Indirect

Types of Costs by Behavior Cost behavior refers to the way different types of production costs change when there is a change in level of production. There are three main types of costs according to their behavior: Fixed Costs: Fixed costs are those which do not change with the level of activity within the relevant range. These costs will incur even if no units are produced. For example rent expense, straight-line depreciation expense, etc. Fixed cost per unit decreases with increase in production. Following example explains this fact: Total Fixed Cost $30,00 $30,00 $30,00 0 0 0 Units Produced 5,000 10,000 15,000 Fixed Cost per $6.00 $3.00 $2.00 Unit

Variable Costs: Variable costs change in direct proportion to the level of production. This means that total variable cost increase when more units are produced and decreases when less units are produced. Although variable in total, these costs are constant per unit. For example Total Variable $10,0 $20,0 $30,0 Cost 00 00 00 Units Produced 5,000 10,00 15,00 0 0 Variable Cost per $2.00 $2.00 $2.00 Unit

Mixed Costs: Mixed costs or semi-variable costs have properties of both fixed and variable costs due to presence of both variable and fixed components in them. An example of mixed cost is telephone expense because it usually consists of a fixed component such as line rent and fixed subscription charges as well as variable cost charged per minute cost. Another example of mixed cost is delivery cost which has a fixed component of depreciation cost of trucks and a variable component of fuel expense. Since mixed cost figures are not useful in their raw form, therefore they are split into their fixed and variable components by using cost behavior analysis techniques such as High-Low Method, Scatter Diagram Method and Regression Analysis. CHAPTER 4: COST BEHAVIOR Introduction: The most important building block of both microeconomic analysis and cost accounting is the characterization of how costs change as output volume changes. Output volume can refer to production, sales, or any other principle activity that is appropriate for the organization under consideration (e.g.: for a school, number of students enrolled; for a health clinic, number of patient visits; for an airline, number of passenger miles). The following discussion examines the volume of production in a factory, but the same principles apply regardless of the type of organization and the appropriate measure of activity. Costs can be variable, fixed, or mixed. Variable Costs: Variable costs vary in a linear fashion with the production level. However, when stated on a per unit basis, variable costs remain constant across all production levels within the relevant range. The following two charts depict this relationship between variable costs and output volume.

A good example of a variable cost is materials. If one pair of pants requires $10 of fabric, then every pair of pants requires $10 of fabric, no matter how many pairs are made. The fabric cost is $10 per unit at every level of production. If one pair is made, the total fabric cost is $10; if two pairs are made, the total fabric cost is $20; and if 1,000 pairs are made, the total fabric cost is $10,000. Hence, the total cost is increasing and linear in the production level. Fixed Costs: Fixed costs do not vary with the production level. Total fixed costs remain the same, within the relevant range. However, the fixed cost per unit decreases as production increases, because the same fixed costs are spread over more units. The following two charts depict this relationship between fixed costs and output volume.

In this example, fixed costs are $50,000. The first chart shows that fixed costs remain $50,000 at all production levels from 100 units to 1,000 units. The second chart shows that the fixed cost per unit decreases as production increases. Hence, when 100 units are manufactured, the fixed cost per unit is $500 ($50,000 100). When 500 units are manufactured, the fixed cost per unit is $100 ($50,000 500). Cost Volume Formula

Cost volume formula is a cost accounting relation used to estimate production cost of a given number of units of a product. A linear cost volume formula is of the following form: y=a+ bx In the above equation, y stands for total production cost; a for total fixed cost; b for variable cost per unit; and x for number of units Total Fixed Cost is the sum of pure fixed cost, such as rent on factory building and property taxes; and the fixed component of mixed costs, such as total fixed cost on delivery trucks i.e. straight line depreciation expense. Variable Cost per Unit is the sum of pure variable cost per unit, such as material cost per unit; and the variable component of mixed cost, such as variable cost per unit on delivery trucks i.e. fuel expense. For this purpose, mixed costs are split into their fixed and variable components by using any of the following techniques:
1. High-Low Method 2. Scatter Graph Method 3. Regression Method

The cost volume formula we discussed here is in the form of linear equation. Cost volume formulas can also be quadratic or other complex forms which are more accurate and thus suitable for practical use. Example: Find total fixed cost, variable cost per unit, total cost of producing 30,000 units from the following cost volume formula: y = $43,000 + 6x Solution Total Fixed Cost = $43,000 Variable Cost per Unit = $6 Total Cost of Producing 30,000 Units = $43,000 + 6 30,000 = $223,000