Scope and Concept of Management Accounting

1. Chapter 2

2. TABLE OF CONTENTS
• Summary
• Distinguish among service, merchandising, and manufacturing
companies.
• Describe the value chain and its elements.
• Distinguish between direct and indirect costs.
• Identify the inventoriable product costs and period costs of
merchandising and manufacturing firms.
• Prepare the financial statements for service, merchandising,
and manufacturing companies.
• Describe costs that are relevant and irrelevant for decision
making.
• Classify costs as fixed or variable and calculate total and
average costs at different volumes

3. SUMMARY

4. SUMMARY
• Difference between merchandising, manufacturing & service rendering business.
Service Business. This type of business provides services to its customers, it
could be defined as selling your time, or also known as labor business. These
type of businesses provide services to private and commercial clients. A few
examples of service businesses are: accounting firms, physical therapy offices,
handyman companies, a mechanic shop, etc.
• Merchandise Business. This type of business sells physical goods or products to
its customers, and the most common types of merchandise businesses are
department stores, grocery stores, dealerships, etc. There are also two
subcategories under this classification, because a merchandise business can be
either a wholesale business or a retail business. The difference between
wholesale and retail is that wholesalers buy directly from manufacturers and
then they sell the merchandise to retailers, and the retailers buy from
wholesalers (sometimes directly from the manufacturing company) and sell to
their customers.
• Manufacturing Business. A manufacturing business is in charge of producing the
physical goods that they sell to wholesalers or retailers, and sometimes directly
to the consumer. Manufacturing companies could be makers of clothing,
automobile manufacturers, and other types of factories that involve production.

5. SUMMARY
• Typically, when we think of a company we think of the product or
service that the company sells. With a company like Dell, we think of
the computers the company sells. In order for Dell to sell computers,
the company has to do a lot of other things right if it wants to stay in
business. These steps are called the value chain, or the activities
that a company engages in that add value to its products or services.
These steps are critically important to business success, but
companies must weight the costs and benefits to determine the
most efficient way to allocate resources to various aspects of the
value chain in order to maximize sales and profit.
• Managerial accounting is the art of planning, decision making and
controlling in business. In order to do that, we must identify what
we want to track. Are we looking at a product, a store, a department
within the company, or even a customer? Since managerial
accounting gives us so much flexibility, we need to make sure we
understand to what we want to assign costs. Cost object is anything
for which a company wants to assign costs

6. SUMMARY
• Most companies use products as the main basis for their cost objects.
Looking at the cost of products is extremely important to pricing of
those products. As we classify costs, one of the most useful
classifications is product and period costs. All costs can be classified as
product or period costs. These costs can also be broken down further.
Let’s look at which costs are considered product costs and which are
period costs and what defines each of these costs.
• Even though both merchandising companies and service companies
conform to generally accepted accounting principles or GAAP, there are
differences in the ways each type of firm prepares its financial
statements, especially income statements, where most differences
center around the existence of inventory.
• A merchandising company engages in the sale of tangible goods to
consumers. These businesses incur costs, such as labor and materials, to
present and ultimately sell products. Service companies do not sell
tangible goods to produce income; rather, they provide services to
customers or clients who value their innovation and expertise. Examples
of service companies include consultants, accountants, financial
planners, and insurance providers.

7. SUMMARY
• The classification of costs between relevant costs and irrelevant
costs is important in the context of managerial decision-making.
• In any managerial decision involving two or more alternatives, the
prime focus of analysis is to find out which alternative is more
profitable. The profitability of alternatives is determined by
considering the revenues generated by and costs incurred under
each alternative. Some costs may stay the same regardless of which
alternative is chosen while some costs may vary between the
alternatives. The classification between relevant and irrelevant costs
is useful in such situations.
• Cost is something that can be classified in several ways depending
on its nature. One of the most popular methods is classifying them
into fixed costs and variable costs. Fixed costs do not change with
increases/decreases in units of production volume, while variable
costs are solely dependent on the volume of units of production.
Fixed and variable costs are key terms relevant in managerial
accounting that are used in various forms of analysis of financial
statements

8. DISTINGUISH AMONG SERVICE, MERCHANDISING, AND MANUFACTURINGCOMPANIES
Section 1

9. THREE TYPES OF COMPANIES
• It is important to identify the
type of company you are
working with in managerial
accounting. Depending on the
type of company, you will
identify different costs and
set up reports differently.
Service
Company
Merchandisers
Manufacturers

10. THREE TYPES OF COMPANIES
• Service companies are in business to sell
intangible services such as health care,
insurance, and consulting rather than
tangible products.
• Service firms now make up the largest
sector of the US economy, providing jobs
to over 55% of the workforce. Because
these companies sell services, they
generally don’t have Inventory or Cost of
Goods Sold accounts (which makes it fairly
easy to calculate net income.) In addition
to labor costs, service companies incur
costs to develop new services, advertise,
and provide customer service.
• Examples of service companies include
accountants, banks, doctors, and lawyers.
Service
Company
Merchandisers
Manufacturers

11. THREE TYPES OF COMPANIES
• Merchandising companies such as
WalMart, resell tangible products they buy
from suppliers. For example, Wal-Mart
buys clothing, toys, and electronics and
resells them to customers at higher prices
than what it pays its own suppliers for
these goods. Merchandising companies
include retailers (such as WalMart) and
wholesalers.
• Wholesalers, often referred to as
“middlemen,” buy products in bulk from
manufacturers, mark up the prices, and
then sell those products to retailers.
Because merchandising companies sell
tangible products, they have inventory.
Service
Company
Merchandisers
Manufacturers

12. THREE TYPES OF COMPANIES
• The cost of merchandise inventory is the
cost merchandisers pay for the goods plus
all costs necessary to get the merchandise
in place and ready to sell. Because the
entire inventory is ready for sale, a
merchandiser’s balance sheet usually
reports just one inventory account called
Inventory or Merchandise Inventory.
Merchandisers also incur other costs to
identify new products and locations for
new stores, to advertise and sell their
products, and to provide customer service.
Costs to be included in inventory include
freight, taxes, etc.
Service
Company
Merchandisers
Manufacturers

13. THREE TYPES OF COMPANIES
Manufacturers- Three inventory accounts
• Raw materials -includes all raw materials
used in manufacturing or building a
product.
• Work in process - includes all goods that
are partway through the manufacturing
process but not yet complete (raw
materials plus some labor).
• Finished goods - includes completed goods
that have not yet been sold. While most
manufacturers sell their finished goods
inventory to merchandisers, some
manufacturers sell their products directly
to consumers (includes all costs associated
with the product).
Service
Company
Merchandisers
Manufacturers

14. DISTINGUISHAMONGSERVICE,MERCHANDISING,AND
MANUFACTURINGCOMPANIES
VideoTime–Thenextmanufacturingrevolutionishere
 “Economic growth has been slowing for
the past 50 years, but relief might come
from an unexpected place — a new form
of manufacturing that is neither what
you thought it was nor where you
thought it was”.
 Olivier Scalabre heads BCG's Operations
Practice for Western Europe, North
Africa and South America. In the last
three years, he launched BCG Ops
Centers serving regions out of Paris,
London, and Sao Paolo via 100 experts
dedicated to manufacturing, supply
chain, procurement and services
operations across industries
 https://www.youtube.com/watch?v=Ay
WtIwwEgS0

15. DESCRIBE THE VALUE CHAIN AND ITS ELEMENTS
Section 2

17. VALUE CHAIN
• Research and Development – i.e.,
research costs associated with
developing a fuel-efficient and safe car
(researching and developing new or
improved products or services and the
processes for producing them)
• Design – i.e., the specifications for the
dimensions and engine characteristics
for the car (detailed engineering of
products and services and the processes
for producing them)
• Production (manufacturer) or
Purchases (merchandiser) – i.e., sheet
metal used to build the car and the
assembly-line worker wages to build the
car (resources used to produce a
product or service or to purchase
finished merchandise intended for
resale)
Research and
Development
Design
Production/Purchases Marketing
Distribution Customer Service

18. VALUE CHAIN
• Marketing – i.e., advertising and
promotion costs (promotion and
advertising of products or services. The
goal of marketing is to create consumer
demand for products and services.)
• Distribution – i.e., costs of delivering
the car to the customer (delivery of
products or services to customers)
• Customer Service – i.e., costs of
providing warranty service to the
purchaser of the car (support provided
for customers after the sale)
• Many of the value-chain activities occur
in the order discussed here. However,
cross-functional teams also work on
R&D, design, production, marketing,
distribution, and customer service
simultaneously.
Research and
Development
Design
Production/Purchases Marketing
Distribution Customer Service

19. DISTINGUISH BETWEEN DIRECT AND INDIRECT COSTS
Section 3

20. COST OBJECT
First, a cost object must be defined.
A cost object is anything for which
managers want a separate
measurement of cost.
• Individual units (a specific,
custom-ordered Prius)
• Different models (the Prius,
Rav4, and Corolla)
• Alternative marketing strategies
(sales through dealers versus
built-to-order Web sales)
• Geographic segments of the
business (United States, Europe,
Japan)
• Departments (human resources,
R&D, legal)
Cost object
Individual units
Alternative
marketing
strategies
Geographic
segment
Different
models
Department

21. COST OBJECT
Direct cost: is a cost that can be
traced directly to a cost object, for
example a steering wheel used in
the production of a car would be a
direct cost.
Indirect cost: is a cost that cannot
be directly traced to the cost object,
for example, a plant manager’s
wages. These wages would not be
traceable to a single product.
Direct cost
Indirect
cost

22. IDENTIFY THE INVENTORIABLE PRODUCT COSTS AND PERIOD COSTS OF
MERCHANDISING AND MANUFACTURING FIRMS
Section 4

23. TWO DEFINITIONS OF PRODUCT COST
• To determine a product’s
profitability, subtract the cost of
the product from its selling price.
• Most companies use two
different definitions of costs:
• 1) total costs for internal
decision making and
• 2) inventoriable product costs
for external reporting.
Product profit =
selling price – cost
of product
Cost – total cost
for internal
decision making
Cost- inventoriable
product costs for
external reporting

24. TWO DEFINITIONS OF PRODUCT COST
• Total costs –include the costs of all
resources used throughout the
value chain.
• The total cost to research, design,
manufacture, market, distribute
and service that model. launching a
new model, managers predict the
total costs of the model to set a
selling price that will cover all costs
plus return a profit.
• Inventoriable product costs –
include only the costs incurred
during the “production or
purchases” stage of the value
chain.
• Inventoriable product costs are
treated as an asset (inventory)
until the product is sold.
Total cost – the cost for
all resources
Managers predict the
total cost
Inventoriable product
costs- cost during
production or
purchases

25. INVENTORIABLEPRODUCTCOSTS

26. PERIOD COSTS: ALL COSTS INCURRED IN THE OTHER
STAGES OF THE VALUE CHAIN
R&D,
Design
Marketing,
Distribution,
Customer Service
All Period
Costs

27. INVENTORIABLE PRODUCT COSTS: MERCHANDISER
• Inventoriable cost definition.
Cost that is considered to be part
of the cost of merchandise.
• For a retailer, the inventoriable
cost is the cost from the supplier
plus all costs necessary to get the
item into inventory and ready for
sale, e.g. freight-in
• + Purchase price from suppliers
• + Cost to get ready for sale
• + Freight-in
• + Import duties or tariffs

28. INVENTORIABLE PRODUCT COSTS: MANUFACTURER
Direct Costs
Direct materials
Direct labor
Indirect Costs
Manufacturing
overhead

29. MANUFACTURING OVERHEAD
• Indirect costs related to
manufacturing that are not direct
materials or direct labor.
• Indirect materials: includes materials
used in the plant that are not easily
traced to individual units (for
example, janitorial supplies).
• While it may be possible to trace the
indirect materials such as glue used in
a product, it would not be
economically feasible

30. PRIME AND CONVERSION COSTS
Direct
Materials
Prime Cost
Direct Labor
Prime Cost
Conversion
Cost
Manufacturing
Overhead
Conversion
Cost
Prime costs are defined as the expenditures directly related to creating
finished products, while conversion costs are the expenses incurred when
turning raw materials into a product.

31. DIRECT AND INDIRECT LABORCOSTS
• The cost of labor, in all areas of
the value chain, includes more
than the salaries and wages paid
to employees.
• The cost also includes company-
paid fringe benefits such as
health insurance, retirement plan
contributions, payroll taxes, and
paid vacations.
• These costs are very expensive.
Health insurance premiums,
which have seen double-digit
increases for many years, often
amount to $500 to $1,500 per
month for each employee
electing family coverage.

32. IDENTIFY THE INVENTORIABLE PRODUCT COSTS AND PERIOD COSTS OF
MERCHANDISING AND MANUFACTURING FIRMS
VideoTime–“Lettheinventorywalkandtalk”
 “Mick Mountz revolutionized the way
warehouses pack and ship their
inventory by using robots, mobile
shelving, and algorithms based on
complexity theory. What used to take
hours of tedious tasks is transformed
into fun, 15-minute, click-to-ship order
processing”.
 Mick Mountz is the founder and CEO of
Kiva Systems, making high-tech products
for fast, cheap and efficient inventory
fulfillment. In March 2012, Kiva was
acquired by Amazon.
 https://www.youtube.com/watch?v=szU
2-1infqc

33. THE FINANCIAL STATEMENTS FOR SERVICE, MERCHANDISING AND
MANUFACTURING COMPANIES
Section 5

34. INCOMESTATEMENT:SERVICECOMPANY
• Service companies have the most
basic income statement of all the
types of companies.
• Since service based companies do not
sell a product, the income statement
will not contain cost of goods sold.
• The difference between income and
operating expenses is operating
income. In this case, all expenses are
period costs.

35. INCOME STATEMENT: MERCHANDISER
• Expenses for a merchandising
company must be broken down
into product costs (cost of goods
sold) and period costs (selling
and administrative).
• Just like all income statements, the
first line is revenue. In the case of a
business that sells a product, we
refer to revenue as Sales or Sales
Revenue.
Sales
- Cost of goods sold
= Gross profit
- Operating expenses
= Operating income

36. COST OF GOODS SOLD CALCULATION: MERCHANDISER
• Cost of goods sold, often
abbreviated COGS, is a
managerial calculation that
measures the direct costs
incurred in producing products
that were sold during a period.
• In other words, this is the
amount of money the company
spent on labor, materials, and
overhead to manufacture or
purchase products that were
sold to customers during the
year.
• Beginning inventory
• + Purchases of new
inventory
• + Import duties or
tariffs must pay
• + Freight-in must pay
• = Cost of goods
available for sale
• - Cost of Ending
inventory
• = Cost of goods sold

38. INCOME STATEMENT: MANUFACTURER
Sales
- Cost of goods sold
= Gross profit
- Operating expenses
= Operating income

39. COST OF GOODS SOLD CALCULATION: MANUFACTURER
Beginning finished goods inventory
+ Cost of goods manufactured
= Cost of goods available for sale
- Ending finished goods inventory
= Cost of goods sold

40. COST OF GOODS MANUFACTURED CALCULATION: MANUFACTURER
Beginning work in process inventory
+ Direct materials added this year
+ Direct labor added this year
+ Manufacturing overhead allocated this year
= Total manufacturing costs to account for
- Ending work in process inventory
= Cost of goods manufactured this year

41. PRODUCT AND PERIOD COSTS
Type of Company
Inventoriable Product
Costs
Period
Costs
Service Company None
All costs along the value
chain
Merchandiser
Purchases plus cost of
freight, import duties, etc.
All costs except total
purchases
Manufacturer DM, DL, MOH
All costs except DM,
DL, MOH
Accounting Treatment
Inventory on balance
sheet until sold
Expensed on I/S in
period incurred
41
DM (Direct Material) DL (Direct Labour) MOH ( Manufacturing Overhead) I/S
(Income statement)

42. MANUFACTURING COMPANIES’ INVENTORY ACCOUNTS
Raw Materials Inventory
Beginning inventory
+ Purchases & freight
Less: Ending inventory →
Materials used
In work in
process

43. Work in Process
Inventory
Beginning inventory
+ Materials used from
raw materials
+ Direct labor added
+ Manufacturing O/H
added
Less: Ending inventory
Cost of goods
Manufactured
and sent to
finished goods
MANUFACTURING COMPANIES’ INVENTORY ACCOUNTS

44. Finished Goods Inventory
Beginning inventory
+ Cost of goods
manufactured
Less: Ending inventory
Cost of goods
sold
Income
Statement
MANUFACTURING COMPANIES’ INVENTORY ACCOUNTS

45. BALANCE SHEET DIFFERENCES
Type of Company Inventory Accounts
Service Company None
Merchandiser Merchandise Inventory
Manufacturer
Raw materials, work in process,
and finished goods inventory

46. DESCRIBE COSTS THAT ARE RELEVANT AND IRRELEVANT FOR
DECISION MAKING
Section 6

47. CONTROLLABLE AND UNCONTROLLABLE
COSTS
• Controllable – management can
influence or change cost
• Uncontrollable – management cannot
change or influence cost in the short-
run
• For example, let’s look at a Blockbuster
Video store. The controllable costs at
this location might include the wages of
the workers and the cost of videos.
• The manager would be able to
determine how much the employees
would be paid as well as how much to
spend on number and type of videos.
• would be a national advertising caAn
uncontrollable cost mpaign. The
manager at the location would have no
control over these costs.
• These costs are helpful in examining
manager performance. A manager
should be judged on the costs that
he/she can control rather than costs
that are beyond his/her control.

48. RELEVANTANDIRRELEVANTCOSTS
• Relevant – costs that differ between
alternatives
• Irrelevant – costs that do not differ
• For example, let’s say you are trying to
decide whether to sell your old car or
buy a new one.
• The relevant costs in this decision
would be the cost of repairs to your old
car, trade-in value of your old car, the
cost of the new car, and any other cost
that would differ between the two
alternatives.
• The amount you paid for your old car is
irrelevant and considered a sunk cost.
This is a hard mental barrier to
overcome and is commonly seen in
practice when managers do not want to
get rid of old equipment because “they
paid a lot for it.”
• When making decisions, management
must also consider qualitative factors
(such as effect on employee morale) in
addition to differential costs.

49. CLASSIFY COSTS AS FIXED OR VARIABLE AND CALCULATE TOTAL AND
AVERAGE COSTS AT DIFFERENT VOLUMES
Section 7

50. COST BEHAVIOR
• Variable costs – change in total cost in
direct proportion to changes in volume
• Fixed costs – stay constant in total cost
over a wide range of activity levels
• An example could be a car
manufacturer. A variable cost would be
the cost of the engines; as more cars are
manufactured, more engines are used,
so the engine cost will go up.
Manufacture 1 car, engine cost is
$1,000. Two cars, engine cost $2,000,
and so on.
• A fixed cost in this example would be
the rent on the factory. It doesn’t
matter if the company makes 1 car or
1000, the rent will stay the same.

51. TOTAL VARIABLE COSTS
$0
$500
$1,000
$1,500
$2,000
$2,500
$0 $10,000 $20,000 $30,000 $40,000
Total Sales
TotalSales
Commissions
Assume we pay 5% sales commissions on all sales. The total cost of
sales commissions increase proportionately with increases in sales.
x axis

52. TOTAL FIXED COSTS: STAY CONSTANT IN TOTAL OVER A
WIDE RANGE OF ACTIVITY LEVELS
$0
$500
$1,000
$1,500
$2,000
$2,500
$0 $10,000 $20,000 $30,000 $40,000
Total Sales
TotalSalesSalaries

53. TOTAL COST
• Total cost = Fixed costs + (Variable cost per unit x number of units)
• Example
Fixed costs = $20,000
Variable cost per unit = $50 per unit
Estimated Number of units = 100 units
Estimated Total Cost = $20,000 + ($50 x 100) = $25,000

54. AVERAGE COST
• Total cost ÷ number of units = Average cost
• Example
$25,000 = $250 average cost per unit
100 units
Note: The average cost per unit is NOT appropriate for predicting
total costs at different levels of output in future.
• For example, if the number of units goes up, the fixed
manufacturing costs are spread over more units, so the average
cost per unit declines.

55. MARGINAL COST
• Marginal cost is the cost of
making one additional unit.
• Since total fixed costs will not
change, the marginal cost is the
same as the variable cost. If we
make 9,000 units and then
manufacture 9,001, the cost to
go from 9,000 to 9,001 units is
the marginal cost.
• The difference is going to be the
variable cost per unit.