For MBA students

1. Introduction to Management Accounting
and
Cost Concepts and Classification
1
UNIT FOUR
Compiled & Prepared by:
Shewit kinfe, University of Gondar, Ethiopia

2. Definition of Management Accounting
 Management accounting involves
preparing and providing timely financial
and statistical information to business
managers so that they can make day-to-
day and short-term managerial
decisions.
 Management accounting can be viewed
as Management-oriented Accounting.
 Basically it is the study of managerial
aspect of financial accounting,
"accounting in relation to management

3. FUNCTIONS OF MANAGEMENT ACCOUNTING
 The basic function of management
accounting is to assist the
management in performing its
functions effectively.
 The functions of the management are
planning, organizing, directing and
controlling.
 Management accounting helps in the
performance of each of these functions
in the following ways:

4. Cont…Provides data:
 Management accounting serves as a vital
source of data for management planning. The
accounts and documents are a repository of a
vast quantity of data about the past progress
of the enterprise, which are a must for making
forecasts for the future.
Modifies data:
 The accounting data required for managerial
decisions is properly compiled and classified.
For example, purchase figures for different
months may be classified to know total
purchases made during each period product-
wise, supplier-wise and territory-wise.

5. Cont…Analyses and interprets data:
 The accounting data is analysed meaningfully
for effective planning and decision-making.
For this purpose the data is presented in a
comparative form. Ratios are calculated and
likely trends are projected.
Serves as a means of communicating:
 Management accounting provides a means of
communicating management plans upward,
downward and outward through the
organization. Initially, it means identifying the
feasibility and consistency of the various
segments of the plan. At later stages it keeps
all parties informed about the plans that have

6. Facilitates control:
 Management accounting helps in
translating given objectives and
strategy into specified goals for
attainment by a specified time and
secures effective accomplishment of
these goals in an efficient manner.
 All this is made possible through
budgetary control and standard
costing which is an integral part of
management accounting.
Cont…

7. MANAGEMENT ACCOUNTING AND
FINANCIAL ACCOUNTING
 Financial accounting and management
accounting are closely interrelated since
management accounting is to a large
extent rearrangement of the data
provided by financial accounting.
 In spite of such a close relationship
between the two, there are certain
fundamental differences. These
differences can be laid down as follows:

8. Comparison of Financial Accounting and Managerial Accounting
Financial Accounting Managerial Accounting
Objective  It is designed to supply
information in the form of
profit and loss account and
balance sheet accounts.
 It is primarily an external
reporting process
 It is designed principally for
providing accounting information for
internal use of the management.
 It is primarily an internal reporting
process.
Time focus  Financial accounting is
concerned with the
monetary record of past
events.
 Historical perspective
 Management accounting is
accounting for future and, therefore,
it supplies data both for present and
future duly analysed in detail .
 Future emphasis
Precision
versus
timeliness
 Emphasis on precision Emphasis on timeliness

9. Financial Accounting Managerial Accounting
Monetary
measurement
 In financial accounting only
such economic events find
place, which can be described
in money.
 In management accounting,
management is equally
interested in non monetary
economic events, viz., technical
innovations, personnel in the
organization, changes in the
value of money, etc and these
events affect management's
decision
Analyzing
performance
 Financial accounting portrays
the position of business as a
whole. The financial
statements like income
statement and balance sheet
report on overall performance
or statues of the business.
 Financial accounting deals
with the aggregates and,
therefore, cannot reveal what
part of the management action
is going wrong and why.
 Primary focus is on the whole
 Management accounting directs
its attention to the various
divisions, departments of the
business and reports about the
profitability, performance, etc.,
of each of them.
 Management accounting
provides detailed analytical data
for the problems.
 Focuses on segments of an
organization

10. Financial Accounting Managerial Accounting
Periodicity
of reporting
 The period of reporting is much
longer in financial accounting
as compared to management
accounting. The Income
Statement and the Balance
Sheet are usually prepared on
a yearly bases or in some
cases half-yearly.
 Management requires
information at frequent intervals
and. In management
accounting there is more
emphasis on furnishing
information quickly and at
comparatively short intervals as
per the requirements or needs
of the management.
Accounting
principles
 It must follow GAAP and
prescribed format
 Need not follow GAAP and any
prescribed format

11. Financial Accounting Managerial Accounting
Nature  Financial accounting is
more objective.
 It emphasis on
verifiability
 Management accounting is
more subjective. This is
because management
accounting is fundamentally
based on judgement rather
than on measurement.
 Emphasis on relevance for
planning and control
Legal
compulsion/
requirement
 Mandatory for external
report
 Not mandatory

12. Cont….
 The above points of difference between
Financial Accounting and Management
Accounting prove that Management
Accounting has flexible approach as
compared to rigid approach in the case
of Financial Accounting.
 In brief, financial accounting simply
shows how the business has moved in
the past while management accounting
shows how the business has to move in
the future.

13. COST ACCOUNTING AND MANAGEMENT ACCOUNTING
 Cost accounting is generally indistinguishable from
management accounting. However, management
accounting can be distinguished from cost accounting in
one important respect.
 Management accounting has a wider scope as compared
to cost accounting. Cost accounting deals primarily with
cost data(determination and the control of costs) while
management accounting involves the considerations of
both cost and revenue.
 Management accounting is an all inclusive accounting
information system, which covers financial accounting,
cost accounting, and all aspects of financial
management.

14. Cost concepts and classification
Definition of Cost:
 An amount that has to be paid or given up in order
to get something.
 In business, cost is usually a monetary valuation of
effort, material, resources, time and utilities
consumed, risks incurred, and opportunity forgone
in production and delivery of a good or service.
 All expenses are costs, but not all costs (such as
those incurred in acquisition of an income-
generating asset) are expenses.
 Simply, accountants define cost as a resource
sacrificed or forgone to achieve a specific
objective.

15. Cost classification
 Recall that one of the purposes of managerial
accounting is to provide management with
information about the costs of products or services.
Companies incur different types of costs that can be
classified based on certain characteristics.
 Each cost classification provides management with a
different type of information to be applied in
analysing different business situations and these
costs are classified differently according to the
immediate need of management and other users.
 Costs can be classified commonly based on the
following attributes:

16. Based on cost assignment (by Traceability):
1. Direct cost:
 Direct costs of a cost object are related
to the particular cost object and can be
traced to it in an economically feasible
(cost-effective) way.
 For example, the cost of steel or tires is a
direct cost of a car and salary of a
workers who directly attached with the
specific car/product.

17. Cont….
2. Indirect cost:
 Indirect costs of a cost object are
related to the particular cost object but
cannot be traced to it in an
economically feasible (cost-effective)
way.
 For example, the salaries of plant
administrators (including the plant
manager) who oversee production of
the many different types of cars
produced at the plant are an indirect

18. Based on Cost-Behavior
 Cost behavior refers to how a cost will
react to changes in the level of activity.
The most common classifications are:
Variable costs
Fixed costs
Mixed costs
Variable Costs:
Are costs that change proportionately
(in total) with the activity level within a
relevant range of activity.

19. Cont….
Fixed Costs:
Are costs that do not change in total as activity
level changes within a relevant range of
activity.
Mixed Costs:
 A mixed cost is one that contains both
variable and fixed cost elements together.
 Mixed cost is also known as semi variable
cost.
 Examples of mixed costs include electricity
and telephone bills. A portion of these
expenses are usually consists line rent.
 Line rent normally is fixed for each month.

20. Total Variable and Fixed
Costs
$
Number of units
Number of units
$
Total Fixed Cost

21. $
Number of units Number of units
$
Variable and Fixed Costs Per
Unit
Per Unit Variable Cost

22. A) Based on the function of cost:
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.
a) Direct materials cost
b) Direct labor cost
c) Manufacturing overhead cost.
a) Direct Material: it refers to those materials
which become an integral part of the final
product and can be easily traceable to specific
physical units. Example: Steel, tire parts of a
car

23. Cont….
b) Direct Labour: It is defined as the wages paid
to workers who are engaged in the production
process and whose time can be conveniently
and economically traceable to specific physical
units. Direct labor is sometime called touch
labor, since direct labor workers typically touch
the product while it is being made.
c) Manufacturing Overhead Cost: is the third
element of manufacturing cost, that is not
directly associated with a product, that is , all
costs other than direct materials cost and
direct labour cost. It includes the cost of indirect
material and indirect labour along with other
expenses like electric power, depreciation etc

24. Cont….
Indirect Labour: Labour employed for the
purpose of carrying out tasks incidental to
goods produced or services provided is called
indirect labour or indirect wages.
In short, wages which cannot be directly
identified with a job, process or operation, are
generally treated as indirect wages.
Indirect Material: all materials which are used
for purpose ancillary to the business and
which cannot conveniently be assigned to
specific physical units are known as `indirect
materials’. Oil, grease, consumable stores,
printing and stationery material etc.

25. Cont….
Non-manufacturing Costs:
 Non-manufacturing costs are those costs that
are not incurred to manufacture a product.
Generally non-manufacturing costs are further
classified into two categories.
a) Marketing and Selling Costs
b) Administrative Costs
a) Marketing and Selling Costs: Marketing or
selling costs include all costs necessary to
secure customer orders and get the finished
product into the hands of the customers. These
costs are often called order getting or order
filling costs. Examples of marketing or selling
costs include advertising costs, shipping costs,

26. Cont….
b) Administrative costs: include all
executive, organizational, and clerical costs
associated with general management of an
organization rather than with manufacturing,
marketing, or selling.
Examples of administrative costs include
executive compensation, general
accounting, secretarial, public relations, and
similar costs involved in the overall, general
administration of the organization as a
whole.

27. Summary of manufacturing and non-manufacturing costs
Manufacturing Costs
Direct Materials:
Materials that can be physically and conveniently traced to a product, such as wood in a table.
Direct Labor:
Labor costs that can be physically and conveniently traced to a product such as assembly line workers in a plant.
Direct labor is also called touch labor cost.
Manufacturing Overhead:
All costs of manufacturing a product other than direct materials and direct labor, such as indirect materials, indirect
labor, factory utilities, and depreciation of factory equipment.
Non-manufacturing Costs
Marketing or selling costs:
All costs necessary to secure customer orders and get the finished product or service into the hands of the
customer, such as sales commission, advertising, and depreciation of delivery equipment and finished goods
warehouse.
Administrative Costs:
All costs associated with the general management of the company as a whole, such as executive compensation,
executive travel costs, secretarial salaries, and depreciation of office building and equipment.

28. Prime and Conversion Costs
 Another way of classifying manufacturing
cost as:
 Prime costs combine direct costs of direct
materials and direct labor.
 Conversion costs are the costs to convert raw
materials into finished goods: direct labor plus
manufacturing overhead.
Prime cost = DM + DL
Conversion cost = DL + MOH

29. Based on their association with the
product:
Product Costs:
 product costs are traceable to the product
and include direct material, direct labour and
manufacturing overheads. In other words,
product cost is equivalent to manufacturing
cost.
 When products are sold, product costs are
recognized as an expense (cost of goods
sold). The costs of unsold products remain in
inventory and are not expensed (i.e. not
deducted from revenue in calculating net
income).

30. Cont….
Period Costs:
period costs are charged to the period in
which they are incurred and are treated as
expenses. They are incurred on the basis of
time, e.g., rent, salaries, insurance etc. They
cannot be directly assigned to a product, as
they are incurred for several products at a
time (generally).
 Period costs such as selling and
administrative costs are expensed (i.e.
deducted from revenue in calculating net
income) in the period they are incurred

31. Product Costs Versus Period
Costs
Expense
Income
Statement
Inventory
Cost of
Goods Sold
Balance
Sheet
Income
Statement
Sale
Product costs include
direct materials, direct
labor, and
manufacturing
overhead.
Period costs are not
included in product
costs. They are
expensed on the
income statement.

32. Cost Classifications on Financial
Statements:
 Merchandising and manufacturing firms, both
prepare financial statement reports for
creditors, stockholders, and others to show
the financial condition of the firm and the
firm's earnings performance over some
specified intervals.
 Merchandising companies simply purchase
goods and resale them to customers.
Financial statement reports are therefore
simple in case of merchandising companies.
 The financial statements prepared by
manufacturing companies are more complex
than the statements prepared by a

33. Balance Sheet
 The balance sheet or statement of financial
position of a manufacturing company is similar
to that of a merchandising company. However,
the inventory accounts differ between two
types of companies.
 A merchandising company has only one type
of inventory called merchandise inventory,
are goods purchased from suppliers that are
awaiting for resale to customers.
Merchandising company
Inventory Accounts
Beginning Balance Ending Balance
Merchandising Inventory $100,000 $150,000

34. Cont….
 In contrast manufacturing companies
have three types of inventories:-
1. Direct materials inventory: are raw
materials in stock and awaiting for use in the
manufacturing process
2.Work-in-process inventory: are goods
partially worked on but not yet completed
3.Finished goods inventory: are goods
completed but not yet sold.
A Manufacturing Corporation
Inventory Accounts
Beginning Balance Ending Balance
Raw materials
Work in process
Finished goods
$60,000
$90,000
$125,000
$50,000
$60,000
$175,000

35. Income Statement
 Following are comparative income statements
of merchandising and manufacturing
companies:Merchandising Company
Income statement
Sales
Cost of goods sold:
Beginning merchandising
inventory
Add: Purchases
Cost Goods available for sale
Less: Ending merchandising
inventory
Cost of goods sold
Gross margin
Less operating expenses:
Selling expenses
$xxxxx
xxxx
xxxxxx
xxxxxx
$xxxxx
xxxxxx
$xxxxx
$xxxxxx
$xxxxxx
xxxxxx
$xxxxxx

36. Manufacturing Company
Income statement .
Sales
Cost of goods sold:
Beginning finished goods
inventory
Add: Cost of goods
manufactured*
Goods available for sale
Less: Ending finished goods
inventory
Cost of goods sold
Gross margin
Less: Operating expenses:
Selling expenses
Administrative expenses
Total operating expense
Net operating income
$xxxxx
xxxxx
xxxxx
xxxxx
xxxxx
xxxxx
$xxxxxx
xxxxxxx
$xxxxxx
xxxxxx
$xxxxxx

37. *Schedule of Cost of Goods Manufactured
Direct Materials:
Beginning raw materials inventory
Add: Purchases of raw materials
Raw materials available for use
Less: Ending raw materials inventory
Raw materials used in production
Direct Labor
Manufacturing overhead:
Insurance factory
Indirect labor
Machine rental
Utilities factory
Supplies
Depreciation, factory
Property taxes, factory
Total overhead costs
Total manufacturing cost
Add: Beginning work in process
Total manufacturing costs to account for
Less: Ending work-in-process
Cost of goods manufactured
$xxxxxx
xxxxxx
xxxxxx
xxxxxx
xxxxxx
xxxxxx
xxxxxx
xxxxxx
xxxxxx
xxxxxx
xxxxxx
$xxxxx
xxxxx
xxxxxx
$xxxxxx
xxxxxx
$xxxxxx
xxxxxx
$xxxxxx

38. Illustration
 Fox wood Company is a metal- and wood
cutting manufacturer, selling products to
the home construction market. Consider
the following data for 2011:
 Sandpaper………………………………………... $
2,000
 Materials-handling costs…………………………...
70,000
 Lubricants and coolants…………………………….
5,000
 Miscellaneous indirect manufacturing labor...............
40,000
 Direct manufacturing labor………………………
300,000

39. Cont….
 Work-in-process inventory Jan. 1, 2011..............
10,000
 Work-in-process inventory Dec. 31, 2011.........
14,000
 Plant-leasing costs……………………………..
54,000
 Depreciation—plant equipment…………….....
36,000
 Property taxes on plant equipment........................
4,000
 Fire insurance on plant
equipment.......................... 3,000
 Direct materials purchased…………………...
460,000
 Revenues……………………………………

40. Fox wood Company
Schedule of Cost of Goods Manufactured
For the Year Ended December 31, 2011
Direct materials:
Beginning inventory, January 1, 2011 $ 40,000
Add: Purchases of direct materials 460,000
Cost of direct materials available for use 500,000
Less: Ending inventory, December 31, 2011 50,000
Direct materials used 450,000
Direct manufacturing labor 300,000
Indirect manufacturing costs(MOH):
Sandpaper $ 2,000
Materials-handling costs 70,000
Lubricants and coolants 5,000
Miscellaneous indirect manufacturing labor 40,000
Plant-leasing costs 54,000
Depreciation—plant equipment 36,000
Property taxes on plant equipment 4,000
Fire insurance on plant equipment 3,000
Total MOH costs 214,000
Total Manufacturing costs incurred during 2011 964,000
Add: Beginning work-in-process inventory, January 1, 2011 10,000
Total manufacturing costs to account for 974,000
Less: Ending work-in-process inventory, December 31, 2011 14,000
= Cost of goods manufactured (to income statement) $ 960,000

41. Fox wood Company
Income Statement
For the Year Ended December 31, 2011
Revenues
$1,360,000
Cost of goods sold:
Beginning finished goods inventory January 1, 2011 $ 100,000
Add: Cost of goods manufactured (see the above schedule) 960,000
Cost of goods available for sale 1,060,000
Less: ending finished goods inventory December 31, 2011 150,000
CGS 910,000
Gross margin (or gross profit) 450,000
Operating costs:
Marketing promotions 60,000
Marketing salaries 100,000
Distribution costs 70,000
Customer-service costs 100,000
Total operating costs
330,000
Operating income