Management Accounting Consultancy Report

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Chapter 2

Management Accounting: Cost Terms and Concepts

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MONASH

BUSINESS

SCHOOL

Quizzes – Weeks 2 to11

Individual assessment

Topics Covered: subject materials of the previous week

On Moodle under tabs of Week 2 – Week 11

Available from 9:00am Monday to 23:59pm Saturday each week from Week 2 to Week 11

Attempts allowed – one time only for each week’s quiz

Good internet access required

Treat the quiz as an exam – you must finish it in 25 minutes

10 multiple choice questions - both calculative and non-calculative

Study relevant textbook chapters, lecture slides, in-class questions and homework questions before attempting the quiz

Results available on completion of the quiz.

Quiz review with right answers is available after a quiz is closed

www.buseco.monash.edu

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For this topic you should be able to:

Understand what cost is and why cost is important

Recognise the differences between conventional (traditional) and contemporary (modern) costing systems

Explain what is meant by different costs for different purposes

Classify costs according to their behaviour, traceability, controllability, position in the value chain and timing

Understand why cost classification is useful in practice

Prepare a schedule of cost of goods manufactured, cost of goods sold and an income statement.

Why is Cost Important?

What are costs?

Resources given up to achieve a particular objective.

Measured in monetary terms.

A cost is incurred to obtain a benefit.

In financial accounting:

if the benefit extends beyond the current accounting period the cost is classified as an asset.

If the benefit is used up in the generation of revenue, the cost is classified as an expense.

Importance of costs:

- Many short-term and long-term decisions require an understanding of costs

- Important source of information for decision-making, managing resources, and creating customer and shareholder value

Traditional Approaches to Costing

Monitors financial performance

Controls what’s going on inside the organisation

Provides information to help managers control cost

Looks at difference between actual & planned/budgeted costs

Estimates costs of organisational units (e.g. departments) and/or products (goods and services)

Assumes that production volume is the only factor that can cause costs to change

Information is mainly obtained from financial accounting system

Modern Approaches to Costing

Developed in 1990s in response to changes in the business environment

Pro-active and detailed in providing information to manage resources

Emphasises non-financial and qualitative information

for example, quality, delivery, innovation, sustainability etc.

Focuses on a broader range of costs

for example, costs of activities, products, customers, suppliers etc.

Examines what’s going on inside and outside the organisation

for example in relation to customers, competitors, suppliers etc.

Focus is not only to control costs but to reduce them

The real ‘root’ causes of costs are analysed, and wasteful activities are identified and eliminated

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Different Costs for Different Purposes

Before we classify costs, we need to understand how managers intend to use the information

Different costs and classifications are used for different purposes

The same cost can be classified in a number of ways depending on the intended use of the cost information

The total amount ($) of cost does not change; only the way we look at it!

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Different classification – exact same cost

Fixed

Indirect

Uncontrollable

Upstream

Period

Research Cost - $1.5 million – Pharmaceutical Company

1. Classifying Costs according to Behaviour

Costs change as the level of activity changes

The level of activity is the level of work performed in the organisation

Units produced, kilometres driven, hours worked

Variable costs

Change in total in direct proportion to a change in the level of activity

Fixed costs

Remain unchanged in total despite changes in the level of activity

Doesn’t mean the cost itself can’t change! But if it does change, this is usually unrelated to a change in the level of activity

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How to Classify a Cost according to Behaviour…

Determine the level of activity – usually this is what causes sales to go up or down

Question whether the cost is impacted significantly by the level of activity or not – is there a ‘direct proportion’ effect?

If yes – variable; If no –fixed

Different classification – exact same cost

Fixed – Does not change in direct proportion to the number of pharmaceutical products sold

Research Cost - $1.5 million – Pharmaceutical Company

Costs are direct or indirect depending on whether they can be traced to a cost object

Cost objects are the items for which management wants a separate measure of costs

Traditional costing systems - products, projects, contracts and departments

Modern costing systems - activities, customers and suppliers as cost objects

2. Classifying Costs according to Traceability

Direct and Indirect Costs

Direct cost - can be traced to a cost object in an economic manner

There is clear and observable relationship between the cost and the cost object

Easy to calculate the cost

Indirect cost – cannot be traced to the cost object in an economic manner

Because the cost has no direct relationship with the cost object, it has to be apportioned or allocated

Direct and Indirect Costs of Your Textbook

Direct Costs

Paper

Wages of factory workers

Indirect Costs

Glue

Salary of forklift driver

or production supervisor

How to Classify a Cost according to Traceability…

Identify the cost object – what do you want to know the cost of?

Is there a clear, observable and easily calculable relationship between the cost and this cost object? – do the benefits of tracing it outweigh the costs?

If yes – direct; If no - indirect

Therefore…..

Whether a cost is classified as direct or indirect depends on the nature of the cost object

Do we wish to know the cost of a department, a product, a project or an entire company?

A cost can be a direct cost of one cost object and an indirect cost of another cost object

Different classification – exact same cost

Depends on the cost object:

Research Department = direct cost

Production Department= indirect cost

Research Cost - $1.5 million – Pharmaceutical Company

Managers’ performance evaluation can be enhanced by classifying responsibility centre costs as either controllable by the manager or uncontrollable

Ideally, managers should be held responsible only for costs they can control or significantly influence

Some costs are controllable in the long term but not in the short term

3. Classifying Costs According to Controllability

Responsibility Centres

A responsibility centre is a unit of an organisation where the manager is held accountable for the unit’s activities and performance

The costing system may measure the costs of managers’ individual areas of responsibility

Responsibility accounting – holding managers accountable only for the costs that they are directly responsible for

Examples of Controllable and Uncontrollable costs

Different classification – exact same cost

Depends on the manager:

Research Manager = controllable

Maintenance manager = uncontrollable

Research Cost - $1.5 million – Pharmaceutical Company

The value chain:

A set of linked processes or activities that begins with acquiring resources and ends with providing and supporting products and services that customers value

Various cost classifications within the value chain:

Upstream, downstream and manufacturing costs

Allows managers to focus on each stage of the organisation’s activity separately and make decisions related to each stage, for example, whether to outsource.

4. Classifying Costs according to their Position

in the Value Chain

Costs across the Value Chain

Upstream Costs

Research and development costs include the costs involved in developing new products and processes

Design costs include the costs associated with designing a product or production process

Supply costs are the costs of sourcing and managing incoming parts, assemblies and supplies

Downstream Costs

Marketing costs are the costs of selling products and the costs of advertising and promotion

Distribution costs are the costs of storing, handling and shipping finished products

Customer service costs are the costs of serving customers, including after-sales service

Manufacturing Costs

Manufacturing costs are incurred within the factory area

Traditional product costing - only manufacturing costs are included in product costs

Modern costing systems - product costs include an allocation of upstream and downstream costs

Different classification – exact same cost

Upstream

Research Cost - $1.5 million – Pharmaceutical Company

Direct Manufacturing Costs

Direct material:

Physically incorporated into the finished products

Can be traced to products in an economic manner

A variable cost

Direct labour:

The cost of wages and labour on-costs for personnel who work directly on the manufacture of a product

On-costs include payroll tax, insurance, superannuation etc.

Indirect Manufacturing costs

Manufacturing overhead

....or indirect manufacturing costs or factory burden

indirect material

indirect labour

depreciation

insurance on factory equipment

utilities

manufacturing support department costs

overtime premium

idle time

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Conversion costs

The total of direct labour cost and manufacturing overhead cost

The cost of converting material into a product

Prime costs

The total of direct material cost and direct labour cost

The major cost associated with producing a product

Manufacturing Cost = DM + DL + MOH

Combining Manufacturing Costs

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Product costs:

A cost that is assigned to goods that were either manufactured or purchased for resale

Used to value inventory and cost of goods sold in the balance sheet and income statement

The product cost is regarded as an asset or inventoriable cost until the good is sold

Period costs

All costs that are not product costs

Selling and administrative expenses

Expensed in the period in which they are incurred rather than passing through various stages of inventory

In service firms, all costs are period costs

5. Classifying Costs according to Timing

Different classification – exact same cost

Period

Research Cost - $1.5 million – Pharmaceutical Company

Different classification – exact same cost

Fixed

Direct/Indirect

Controllable/ Uncontrollable

Upstream

Period

Research Cost - $1.5 million – Pharmaceutical Company

Illustration I: Cost Classifications

The cost data in the following page refers to 2017 and relates to Heartstrings Pty. Ltd., a greeting card manufacturer.

Required:

Calculate each of the following:

Total prime costs;

Total manufacturing overhead costs;

Total conversion-costs;

Total product costs;

Total period costs.

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Lecture Illustration 1: Cost Classifications

Prime costs MOH costs Conversion costs Product costs Period costs
Direct material used in production $550,000
Advertising expense $60,000
Depreciation on factory building $57,500
Direct labour: wages $242,500
Indirect labour: wages $70,000
Production supervisor’s salary $22,500
Service-department costs $50,000
Direct labour: fringe benefits $47,500
Indirect labour: fringe benefits $15,000
Fringe benefits for production supervisor $4,500
Total overtime premiums paid $27,500
Cost of idle time $20,000
Administrative costs $75,000
Rental of office space for sales personnel $7,500
Sales commissions $2,500
Promotion costs $5,000
Total costs

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Other production factors: Manufacturing overhead :

factory rent

depreciation

gas, electricity

etc

Direct Materials storage

Work in Progress

in the factory

Physical Flows in Manufacturing

Direct Materials

Direct Labour

Finished Goods Warehouse

Customers

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Material is purchased: the cost is added to raw materials inventory

Direct materials are consumed in production: cost is removed from raw materials inventory and added to work in process inventory

Direct labour and manufacturing overhead are accumulated in work in process inventory

Products are completed: costs are transferred from work in process inventory and added to finished goods inventory

Products are sold: costs are transferred from finished goods inventory to cost of goods sold expense

Cost of goods sold is deducted from sales revenue to determine gross profit

Timing of Product Costs in Manufacturing Business

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2

2

3

4

Cost Flows in a Manufacturing Business

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COGM

COGS

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Costing the Flow of Manufacturing

Raw materials, work in process and finished goods inventory balances are reported in the balance sheet

Cost of goods sold expense can be found in the income statement

The schedule of cost of goods manufactured and schedule of cost of goods sold summarise the flow of manufacturing costs

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Illustration 2: Cost Flows

The following accounting information is available for MedCo, Inc.. The information refers to January 2018.

Prepare the following information using the templates provided:

Schedule of Cost of Good Manufactured;

Schedule of Cost of Goods sold;

Statement of Financial Performance.

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Purchase of raw materials $90,000  
Raw materials inventory, January 1 10,000  
Raw materials inventory, January 31 17,000  
Depreciation, factory 42,000  
Insurance, factory 5,000  
Direct labour cost 60,000  
Maintenance, factory 30,000  
Administrative expenses 70,000  
Sales revenue 450,000  
Factory utilities, 27,000  
Factory supplies 1,000  
Selling expenses 80,000  
Indirect labour 65,000  
Work in process inventory, January 1 7,000  
Work in process inventory, January 31 30,000  
Finished goods inventory, January 1 10,000  
Finished goods inventory, January 31 40,000  

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Illustration 2: Cost Flows

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Schedule of Cost of Goods Manufactured
Direct material:    
Inventory, 1 January  
Add raw materials purchases
Material available for use  
Less Inventory, 31 January    
Raw material used  
Direct Labour  
Manufacturing overhead:  
Indirect labour  
Depreciation, factory  
Maintenance, factory  
Utilities, factory  
Insurance, factory  
Supplies, factory    
Total manufacturing overhead  
Total manufacturing costs  
Add WIP inventory, 1 January  
   
Less WIP inventory, 31 January  
Cost of Goods Manufactured (COGM)    

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Illustration 2: Cost Flows

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Schedule of Cost of Goods Sold
Finished Goods inventory, 1 January  
Add COGM  
   
Less Finished Goods inventory, 31 January  
Cost of Goods Sold (COGS)  
Statement of Financial Performance
Sales revenue  
Less COGS  
Gross profit  
Selling expenses  
Administrative expenses  
Net profit  

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Summary

Management accounting systems: tailored to the organisation’s needs

Costing systems focus on the cost of products and organisational units

We can distinguish between traditional and modern costing systems

There may be different costs for different purposes

Costs may be classified by behaviour, traceability, controllability, and function

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Summary

In manufacturing businesses, production costs typically consist of direct materials, direct labour and manufacturing overhead, in line with external reporting requirements

The definition of product costs needed to support management decision making may be broader than that used for external reporting purposes

Product costing systems track the manufacturing costs from the beginning of production to finished goods and link the product costing system to the financial accounting reports

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Acknowledgement

Some slides contained in this presentation were adapted from:

Management Accounting: Information for managing and creating value 8e, Langfield-Smith, Smith, Andon, Hilton and Thorne

Copyright © 2018 McGraw-Hill Education (Australia) Pty Ltd

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