Introduction to Managerial Accounting

Managerial Accounting Basics

Up to this point in your accounting education, you have been studying financial accounting.  Financial accounting is oriented to producing financial statements--namely, the Income Statement, Owner's Equity (or Stockholders' Equity) Statement, Balance Sheet, and Cash Flow Statement.  The goals of managerial accounting are far different.  Managerial accounting is designed to provide managers with information for decision making.  Questions such as the following are typical:

1.  How much does it cost to produce our product?
2.  Should a different model of product be produced?
3.  How much should we charge for our product?

Such questions cannot be answered fully using financial accounting information.    Details regarding cost behavior, cost classification, and economic information such as price elasticity of demand may be necessary.

A manager performs various types of functions: planning, organizing, staffing, controlling and directing. Accounting provides quantitative techniques to assist managers in these functions, particularly when it comes to planning and controlling. As you progress through the chapters in ACCT 203, keep in mind that the focus is internal--the objective is to achieve efficiency in use of resources while simultaneously achieving company goals.

Managerial Cost Concepts

Managers have a well-defined set of definitions in classifying costs of a product.  These definitions must be clearly understood in order to properly manage product costs.  One of the problems, however, is that the definitions sometimes overlap.  I suggest that you study the definitions carefully, and allow the definitions to exist independently in your mind.  The homework problems for this chapter will help you to clarify the areas of overlap.

Cost Behavior:  Variable, Fixed, Mixed

A basic description of a cost can be made by observing how the cost responds to additional units of activity.  Here's an example:  a company hires an employee at the rate of $10 per hour.  If the employee works zero hours, the cost is zero.    At one hour, the cost is $10; at two hours, the cost is $20, and so on.   This is an example of a variable cost.  A variable cost can be graphed as follows:

wpe11.gif (3894 bytes)
Notice that the activity or "cost driver" is shown as the independent variable on the X-axis; the resulting cost is shown on the Y-axis.  A variable cost will begin at the origin (0,0) and will appear as a straight line.  A feature of a variable cost is that it will be directly proportional to changes in the cost driver.    In the example shown, if hours worked doubles, the total pay doubles as well.    You should verify this characteristic on the graph.

A second type of cost behavior is that of a fixed cost.    A fixed cost is unresponsive to changes in a particular cost driver.   Suppose you are the manager of a factory.  The rent on the factory is $1,000 per month.   Although the production level of the factory varies from month to month, the factory rent does not change.  Examine the following graph:

wpe13.gif (3851 bytes)
Notice that the rent cost stays constant at $1,000 per month, whether the factory produces 0, 100, 200, 300, or 400 units.  There is a curious aspect to this situation, however.  What is the rent cost per unit at 100 units?   (Answer:   $1,000/100 units = $10 per unit).  Now, what is the rent cost per unit at 400 units? (Answer:  $1,000/400 units =$2.50 per unit).  This illustrates a valuable lesson regarding fixed costs:  the fixed cost per unit declines as the number of units increases.

Sometimes, a cost will have both a variable and a fixed component.  For example, a telephone company charges $20 per month plus $.10 per phone call.  This type of cost is a mixed cost, because it contains both a fixed and variable cost component.  What would the graph for this type of cost look like?

wpe17.gif (3861 bytes)
Notice that, unlike a pure variable cost, a mixed cost begins at the fixed cost point on the Y-axis--namely, at $20.  The variable portion of the cost puts the cost function above the $20 level based on the number of calls made.  At 10 calls for example, the total phone cost is $20 + 10*.10 = $21.  At 20 calls, the total is $22, and so on.

Manufacturing Costs

When a company produces a product, the costs that go into that product are called manufacturing costs or inventoriable costs.  There are three types of manufacturing costs:

Direct Material:  the cost of material that is directly traceable to the final product.  An example would be the wood in a wooden table.  The cost of the wood is traceable and bears a significant cost to the final product.  Direct material is almost always considered a variable cost; as more tables are built, the total cost increases in a directly proportional way.

Direct Labor:  Analogous to direct material, direct labor cost is directly traceable to the cost of the final product.   Some people call direct labor "hands-on" labor, suggesting that the worker holds, saws, drills, or otherwise applies labor directly to the product. 

Note:  in previous accounting courses, labor was considered an expense.  That is not the case here.  The labor cost is not expensed immediately in manufacturing accounting.  Rather, the labor cost becomes part of an asset--Inventory.  When the Inventory gets sold, the Inventory cost is transferred to Cost of Goods Sold.  Most textbooks consider direct labor to be a variable cost, and this is how you should classify it.  With the changes in union contracts over the past few decades, however, many direct laborers have become salaried.   Thus, the trend is toward more of a fixed cost for labor.

Manufacturing Overhead:  All factory costs that are 1) factory costs but 2) are not direct costs.  That is, such costs are not directly traceable to the final product.  Here are some typical manufacturing overhead costs:

1.  Depreciation on factory machinery and buildings;
2.  Heating, lighting, and electricity costs in the factory;
3.  Costs of indirect laborers, such as the cleanup crew who sweep the factory--they do not work directly on the product, but incur factory costs nonetheless.  Another example is that of the night watchman for the factory--no hands on labor, but this is part of the manufacturing operation.
4.  Indirect materials:  lubricants, small parts, sandpaper, screws, or other items of insignificant cost that are necessary to the manufacturing operation, but are too small and insignificant to measure.
5.  Factory supervisory costs.  The cost of the factory or plant manager is considered manufacturing overhead.

Here's a clarifying point, in case you are having difficulty classifying a certain cost--manufacturing overhead costs are always factory costs. So depreciation on a factory machine would be considered manufacturing overhead, but depreciation on a salesman's car or the president's secretary's computer would be considered period costs because they are outside the factory and are not part of the cost of inventory.

A major issue in managerial accounting is:  how shall we allocate manufacturing overhead to each unit of product?  For example, if we build a wooden table and there is $100 of direct material and two hours of direct labor at $25 per hour, we can measure these direct costs quite accurately.   We could say that the direct costs total $150 for this unit of product, but how do we include the costs of factory supervision, indirect materials, and indirect labor?   Those costs are not obviously related to this one unit.  Thus, we must find a way to allocate manufacturing overhead in a logical way.  The problem is, how?  We will explore some methods that have been around for decades--and a new method of allocation (Activity Based Costing) that has been implemented within the last decade.

Prime Costs and Conversion Costs

The term Prime Cost refers to the sum of direct labor cost + direct material cost.
The term Conversion Cost refers to the sum of direct labor cost + manufacturing overhead cost.

Period Costs

Period costs are non-manufacturing costs.  Typically, period costs are of the following types:
1.  Marketing and selling costs;
2.  Administrative costs;
3.  Research and development costs.
Period costs are costs that are outside of the factory.  If a certain cost is factory-related, it cannot be a period cost; such a cost must be considered direct material, direct labor, or manufacturing overhead.  Period costs are expensed immediately; they cannot be added to the cost of inventory.

The Big Picture

The following diagram is useful in seeing how all of these seemingly contradictory definitions relate to one another.  You should return to this diagram frequently as you are working on this chapter.

wpe18.gif (4014 bytes)

The Basic Inventory Formula

The logic of an inventory account is quite simple.  For a merchandiser, the formula to calculate the Cost of Goods Sold is:  Beginning Inventory + Purchases - Ending Inventory = Cost of Goods Sold.  In T-account form, it would appear as follows:

wpeD.gif (2293 bytes)

In this example, the company had $10,000 of Inventory on hand at January 1.  During the year, an additional $8,000 was purchased.  A year end count revealed that $6,000 was on hand at 12/31.  What was the Cost of Goods Sold?  Answer:  10,000 + 8,000 - 6,000 = 12,000.  The Cost of Goods Sold must have been $12,000.  This $12,000 cost will appear on the Income Statement for the period, and will be matched with the Sales Revenue generated.

Manufacturing:  Three Inventories

Unlike a merchandiser, a manufacturer must account for three separate inventories.  They are:

Raw Materials Inventory:  Raw materials consist of the materials that will be made into the final product.  These raw materials wait in storage until they are requisitioned into production.

Work in Process Inventory:  The cost of partially finished goods.  The three major manufacturing costs come together in this account:    the cost of the raw materials requisitioned into production (called direct materials), direct labor costs, and manufacturing overhead costs.  The goods stay in Work in Process until the moment they are finished.

Finished Goods Inventory  The cost of goods that are complete and ready to sell.

At the end of the accounting period, these three inventories will be reported on the balance sheet.  Finished Goods will be listed first, followed by Work in Process, and then Raw Materials.

The Cost of Goods Manufactured Statement

A major objective of Chapter 18 is to understand how a Cost of Goods Manufactured (COGM) Statement is constructed. Examine the following Cost of Goods Manufactured Statement:


Using the basic inventory formula shown earlier, we can break down the statement shown above.  This analysis will provide a background to understanding how Cost of Goods Manufactured is calculated.

Looking at the Raw Materials Inventory items on the statement, we find:

wpe11.gif (2451 bytes)

Can you determine the cost of Direct Materials?  Direct Materials cost was 30,000 + 205,000 - 20,000 = 215,000.

Let us examine the Work in Process Inventory account:

wpe13.gif (3196 bytes)

Notice that all three manufacturing costs are debited to Work in Process.  The direct materials cost of $215,000 came from the Raw Materials Inventory account as derived above.    Can you determined the Cost of Goods Manufactured amount?  It would be:    80,000 + 215,000 + 350,000 + 289,000 - 50,000 = $884,000.

Reconciliation of the Finished Goods Inventory account will require that you examine the Income Statement shonw below. 


A T-account for Finished Goods would look like this:

wpe17.gif (2631 bytes)

To compute Cost of Goods Sold:  110,000 + 884,000 - 120,000 = $874,000.  This amount would be debited to Cost of Goods Sold, and credited to the Finished Goods Inventory account.  On the Income Statement, Cost of Goods Sold would be subtracted from Net Sales to derive Gross Profit.  The rest of the Income Statement is parallel to others you have seen in your earlier Accounting courses.

Keep in mind that, though we are studying managerial accounting, the accounts are maintained using financial accounting procedures.  In the next chapter, we will explore the debits and credits for manufacturing accounting.  You already have a head start if you understand the cost flows through the three inventory accounts explored here.