Chapter 5

INTRODUCTION TO MANAGEMENT ACCOUNTING

5.1. Introduction
5.2. Cost Concepts
5.3. Classification of Costs
5.4. Accounting for Manufacturing Operations
5.5. Statement of Cost of Goods Manufactured
5.1. Introduction

• Accounting in the modern times, has two distinct functions to

perform;

1. Historical Functions
2. Managerial Functions

2
• Historical functions: This function is concerned with recording,
classifying, summarizing and interpreting the past transactions for an
accounting period of a business enterprise.
• The objective of this function is to report at regular interval to users
by means of financial statement.
• In the early stages of the development of accounting, the
historical function was the primary function of accountants
but these days, the managerial function has become the prime
function of accountants.

3
• Managerial Functions: This function is concerned with planning the future
activities of the enterprise and controlling the operations of the business.
• The objective of this function is to promote maximum operational efficiency.
• Managers carry out two major activities:
1. Planning: Planning involves establishing a basic strategy selecting a course of
action and specifying how the action will be implemented (budgeting) and
2. Controlling: involves ensuring that the plan is actually carried out and is
appropriately modified as circumstances change.

4
• Management accounting information plays a vital role in these basic management
activities- but most particularly in the planning and control functions.
Management accounting involves
the development and interpretation
of accounting information
 intended specifically to assist managing in operating the business.
Management accounting information is for internal use & provides special
information for managers.

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Functions of management accounting
1. provide relevant information to help managers make better Planning decisions;
a. budgeting
b. To make resource allocation and product mix and discontinuation decisions.
c. To determine selling prices,
d. To develop and introduce new products and services, investment in new
plant and equipment and the negotiation of long-term contracts with customers
and suppliers.
3. Provide information for control(performance evaluation).
To evaluate profitability of various segments of the business
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Management Accounting:
Basic Framework
M a na g em en t accou ntin g a nd
a ss ig n ing decisio n-m aking auth ority.

Accounting system s help to identify

w ho has authority over assets.

Accounting inform ation supports

planning and decision-making.

Accounting reports provide a means of

m onitoring, evaluating, and rew arding performance.
Management Accounting
Systems Framework
Top Management

Budget: Actual Results: Performance

Future Plans Current Evaluation: Past

Assign Support Evaluate

Decision-Making Decision-Making Decision-Making
5.2. Cost Concepts
Cost: is a resource sacrificed or forgone to achieve a specific objective. A cost is usually
measured as the monetary amount that must be paid to acquire goods and services.
A Cost object: is anything for which a separate measurement of costs is desired.
Example; product, department, customer, geographical area, process etc.
Cost pool: A cost pool is a grouping of individual cost items possessing identical
nature. Cost pools can range from broad, such as all costs within a manufacturing plant,
to narrow, such as the costs of operating machine.

9
 Cost accumulation: is the collection of costs in some organized way by means of an accounting
system, i.e., by some natural or self descriptive classification.
Eg. material cost, labor cost, fuel, Advertisement cost etc.
 Cost assignment: is a general term that includes:
a. Tracing accumulated costs: For direct costs
b. Allocating accumulated costs: For indirect costs
 Cost driver is a variable, such as an activity level or volume, the change of which causally affect
costs over a given time span. That is, there is a specific cause-and-effect relationship between
change in level of activity or volume and change in level of cost.

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2.3. Classification of Costs

 Different cost classifications are used to develop cost information

for a given purpose(decision Making).

11
Classification Bases Types of costs included

Association with - Direct

cost object - Indirect

Reaction to
- Variable - Fixed
changes in
- Mixed - Step
activity

Classification - Unexpired - Expired

on the - Period - Product
- Prime
Financial - Conversion
Statements
 Costs are classified into different categories on the basis of different
reasons:
1. Based on their traceability to a particular cost object
[Association with cost object]
2. Based on their behavior pattern
[Reaction to changes in activity]
3. Based on timing they are charged against revenue[Classification on the
Financial Statements]
4. Based on function/operation/purpose
4. Based on purpose of Manufacturing costs
1. Based on their traceability to a particular cost object
[Association with cost object]

a. Direct Costs: costs that have a relationship with the cost object and
can be traced to that cost object in an economically feasible (cost
effective) way.
Example:
i. The cost of bottle is a direct cost to Pepsi-Cola because the cost of it
can be easily traced to or identified with the drink.
ii. Cost of paper is a direct cost for a sport magazines because it can be
conveniently traced to a magazine.
b. Indirect Costs: costs that have a relationship with the cost object but
cannot be traced to that cost object in an economically feasible way.

Example: Salary of supervisors who oversee production of different

soft drink products. Unlike the cost of bottles of Pepsi-cola, it is so
difficult to trace supervisors cost s to Pepsi-cola line. Such costs are
allocated to products based on some cost allocation base.

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Thus, the term cost tracing is used to describe the assignment of direct
costs to a particular cost object and the term cost allocation is used to
describe the assignment of indirect costs to a particular cost object.
The distinction between a direct cost and indirect cost depends on
units of products, activities, departments, organization etc.
So, a cost could be direct cost for one cost object and an indirect cost
to the other.
Example: A supervisors’ salary may be a direct cost to the production
department but an indirect cost for the product being produced

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 2. Based on their behavior pattern
a. Variable costs: are total costs that changes in direct proportion to
changes in the level of activity but unit costs remain constant.
Example: Cost of bottles for Pepsi-cola.

.
b Fixed Costs: are total costs that remain constant regardless of the
level of activity up to a certain relevant range but unit costs vary
according to the level of activity.
Example: Monthly salary of employees of an organization.

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Costs are defined as variable or fixed with respect to a specific cost object and for
a given time period.
Example:

Labor costs can be purely variable with respect to units produced when workers
are paid on a unit basis.


In contrast, labor costs may be classified as fixed cost if the company agree with
employees to pay a certain amount of salary per month regardless of volume of
activity.

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 3. Based on timing they are charged against revenue
a. Product costs: are costs that are necessary and integral part of producing
(acquiring) the finished product. They are considered as an asset/inventory
when they are incurred. Under the matching principle, these costs do not
become expenses until the finished goods inventory is sold.
Example: Cost of direct material
b. Period Costs: are costs of income statement other than cost of goods sold.
They are treated as expense of the period in which they are incurred
because they are expected to benefit revenue in the current period.
Example: Advertising costs
 4. Based on function/operation/purpose
a. Manufacturing costs are those costs that are directly involved in
manufacturing of products and services. Manufacturing cost is
divided into three broad categories by most companies.
• Direct materials cost
• Direct labor cost
• Manufacturing overhead cost.

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Direct Material costs: are those materials that become an integral part of the finished
product and that can be physically and conveniently traced to it. The cost incurred in
acquiring these direct materials are called direct material costs.
Direct Labor Cost: those labor costs that can be essentially traced to individual units of
products.
Manufacturing Overhead Costs: includes all costs of manufacturing except direct
material and direct labor. Examples include indirect material, indirect labor, maintenance
and repairs, heat and light, property taxes, depreciation, and insurance on manufacturing
facilities etc.

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b. Non-manufacturing Costs
i. Administrative costs: include all executive, organizational, and clerical
costs associated with general management of an organization rather
than with manufacturing, marketing, or selling.
Example: Salary of managers, clerical staffs, office rents etc.
ii. Marketing or selling costs: are costs related to selling and distribution
of goods and services. Includes all costs necessary to secure customer
orders and get the finished product into the hands of the customers.
Example: Transportation Costs, advertising costs, Shipping costs,
Sales commission and Sales salary.
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5. Based on purpose of manufacturing costs
Prime Costs and Conversion Costs

Two terms used to describe costs classification in manufacturing costing

system.
1. Prime Costs: are all direct manufacturing costs. It includes direct
materials cost and direct labor cost.
Prime cost =Direct material costs + Direct labor costs
2. Conversion Costs: are all manufacturing costs other than direct
material costs. It includes direct labor costs and FOH costs
Conversion Cost = Direct Labor Cost + MOH
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2.4. Accounting for Manufacturing Operations

Steps in the Manufacturing Process:

Buy raw Convert raw materials Sell finished

materials. into finished goods. goods.

Direct Direct labor and

Cost of goods
materials manufacturing
sold.
costs. overhead costs.
Direct Materials
Raw materials &
component parts Can be traced
that become an directly and
integral part of conveniently to
finished products. products.

If materials cannot be traced directly to products, the materials are

considered indirect and are part of manufacturing overhead.
Direct Labor
Includes the payroll cost of direct workers.

Those employees who

Direct labor Wage work directly on the
×
hours rate goods being
manufactured.

The cost of employees who do not work directly on the goods is

considered indirect labor and is part of manufacturing overhead.
Manufacturing Overhead

All manufacturing costs other than direct

materials and direct labor.

Includes:
 Indirect materials.
Does not include selling
 Indirect labor. or general and
 Machinery and administrative
equipment costs. expenses.
 Cost of regulatory
compliance.
Product Cost

The cost to produce a unit of

product includes:
 Direct material
 Direct labor
 Manufacturing overhead
Product Cost: Manufacturing Overhead

The cost to
produce a unit of
product includes: Manufacturing overhead
Direct material must be mathematically
allocated to each unit of
Direct labor product using a
predetermined overhead
Manufacturing application rate.
overhead
Product Costs Versus Period Costs

Balance Sheet
Product Costs
(manufacturing Current assets and
costs)
as inventory
incurred
When goods are
sold.
Income Statement

Period Costs Revenue

(operating expenses COGS
and income taxes.) Gross profit
Expenses
as Net income.
incurred
Inventories of a Manufacturing Business

Raw materials - inventory on Work in process -

hand and available for use. partially completed
goods.

Finished goods- completed goods

awaiting sale.
The Flow of Physical Goods
Direct Materials Direct Factory
materials Warehouse materials used
purchased

Direct labor &

Manufacturing overhead
Finished goods
Finished goods
Warehouse

Goods sold
The Flow of Manufacturing Costs

Direct Materials Direct Work in Process

materials Inventory materials used Inventory
purchased

Birr Birr Birr Birr

Direct labor &

Manufacturing overhead
Cost of goods
manufactured
Cost of Goods Finished Goods
Sold Inventory

Birr Birr Birr

5.5. STATEMENT OF COST OF GOODS MANUFACTURED
Flow of Costs Associated With Production

Pure-Ice Inc. had $52,000 of inventory in

direct materials inventory on January 1,
2005. During the year, Pure-Ice
purchased $586,000 of additional direct
materials. At December 31, 2005, $78,000
of the direct materials were still on hand.
How much direct material was
placed into production during 2005?
Flow of Costs Associated
With Production
Beginning materials
inventory $ 52,000
+ Materials purchased 586,000
Materials available to be
=
placed into production 638,000
Materials placed into
–
production ?
?
Ending materials
=
inventory $ 78,000
Flow of Costs Associated
With Production
Beginning materials
inventory $ 52,000
+ Materials purchased 586,000
Materials available to be
=
placed into production 638,000
Materials placed into
–
production 560,000
Ending materials
=
inventory $ 78,000
Flow of Costs Associated
With Production
In addition to the direct materials, Pure-
Ice incurred $306,000 of direct labor cost
during 2005. Manufacturing overhead for
2005 was $724,000.
Pure-Ice started 2005 with $132,000 in
work in process. During 2005, units
costing $1,480,000 were transferred to
finished goods inventory.
What is the ending balance in work
in process at December 31, 2005?
Flow of Costs Associated
With Production
Be ginning w ork in
proce ss inve ntory $ 132,000
+ Ma nufa cturing costs
a dde d 1,590, 000
= Tota l costs in proce ss
during the ye a r 1,722, 000
– Cost of goods
comple te d during the
ye a r (1,480,000)
= Ending w ork in
proce ss inve ntory ?

Direct Materials $ 560,000

Direct Labor 306,000
Manufacturing
Overhead 724,000
Total costs added
during the year $ 1,590,000
Flow of Costs Associated
With Production
Beginning work in
process inventory $ 132,000
+ Manufacturing costs
added 1,590,000
= Total costs in process
during the year 1,722,000
– Cost of goods
completed during the
year (1,480,000)
= Ending work in
process inventory $ 242,000
Determining the Cost of Finished Goods
Manufactured
A schedule of the cost of finished
goods manufactured is prepared to
provide managers with an overview of
manufacturing activities during a
period.
 CONQUEST, INC.
Schedule of the Cost of Finished Goods Manufactured
For the Year Ended December 31, 2005

Work in process inventory, beg. $ 30,000

Manufacturing cost assigned to
production:
Direct materials $ 150,000
Direct labor 300,000
Manufacturing overhead 360,000

Total manufacturing costs 810,000

Total cost of all work in process
during the year 840,000
Less: Work in process
inventory, end of year (40,000)
Cost of finished goods manufactured $ 800,000
 Beginning finished goods
inventory $ 150,000

Add: Cost of finished goods

manufactured
CONQUEST, INC. during the year 800,000
Schedule of the Cost of Finished Goods Manufactured
For the Year EndedCost of 31,
December finished
2005 goods
available for sale 950,000
Less:
Work in process inventory, beg.
Manufacturing cost assigned to
Ending $
finished
30,000
goods
production: inventory 168,000
Direct Materials $ 150,000
Direct Labor Cost of goods sold
300,000 $ 782,000
Manufacturing overhead 360,000

Total manufacturing costs 810,000

Total cost of all work in process
during the year 840,000 The cost of goods
Less: Work in process
inventory, end of year (40,000)
completed during the
Cost of finished goods manufactured $ 800,000 period is used to compute
COGS for the period.
 CONQUEST, INC.
Income Statement
The income For the Year Ended December 31, 2005
statement is
prepared Sales $ 1,300,000
using Cost of goods sold 782,000
established Gross profit on sales $ 518,000
financial Operating expenses 400,000
accounting Income from operations $ 118,000
procedures.
Less: Interest expense 18,000
Income before income
taxes $ 100,000
Income tax expense 30,000
Net income $ 70,000
 Exercise
Inventories January 1 December 31
Materials Br. 165,000 Br. 210,000
WIP Br. 306000 Br. 290,000
Finished Goods Br. 298,000 Br. 284,000
Additional Information:
Advertising ExpBr. 148,000
Depr. Expe-Office Equip. 41,900 (50% of which is factory dep)
Direct Labor 360,000
Heat, Light, and Power-Factory 8,500
Materials Purchased 325,000 (60% on credit)
Salaries Exp. 195,000 (24% of which is office exp)
Property Taxes 24,800 (70% of which is factory exp)
Sales 1,630,000
Miscellaneous Exp. 4,200 (20% of which is office exp)
• Required:
• Prepare the statement of cost of goods
manufactured
• Determine the cost of goods sold
• Compute Net income/net loss

• END OF THE CHAPTER