Managerial Accounting: Key Concepts and Applications
Managerial Accounting
Identifying Features of Managerial Accounting and Functions of Management
The primary users of managerial accounting reports, issued as frequently as needed, are internal users, who are officers, department heads, managers, and supervisors in the company. The purpose of these reports is to provide special-purpose information for a particular user for a specific decision. The content of managerial accounting reports pertains to subunits of the business. It may be very detailed and may extend beyond the accrual accounting system. The reporting standard is relevance to the decision being made. No independent audits are required in managerial accounting.
The functions of management are planning, directing, and controlling. Planning requires management to look ahead and to establish objectives. Directing involves coordinating the diverse activities and human resources of a company to produce a smooth-running operation. Controlling is the process of keeping the activities on track.
Classes of Manufacturing Costs and Product vs. Period Costs
Manufacturing costs are typically classified as either (1) direct materials, (2) direct labor, or (3) manufacturing overhead. Raw materials that can be physically and directly associated with the finished product during the manufacturing process are called direct materials. The work of factory employees that can be physically and directly associated with converting raw materials into finished goods is considered direct labor. Manufacturing overhead consists of costs that are indirectly associated with the manufacture of the finished product. Manufacturing costs are typically incurred at the manufacturing facility.
Product costs are costs that are a necessary and integral part of producing the finished product (manufacturing costs). Product costs are also called inventoriable costs. These costs do not become expenses until the company sells the finished goods inventory.
Period costs are costs that are identified with a specific time period rather than with a salable product. These costs relate to nonmanufacturing costs and therefore are not inventoriable costs. They are expensed as incurred.
Computing Cost of Goods Manufactured and Financial Statements
Companies add the cost of the beginning work in process to the total manufacturing costs for the current year to arrive at the total cost of work in process for the year. They then subtract the ending work in process from the total cost of work in process to arrive at the cost of goods manufactured.
The difference between a merchandising and a manufacturing balance sheet is in the current assets section. The current assets section of a manufacturing company’s balance sheet presents three inventory accounts: finished goods inventory, work in process inventory, and raw materials inventory.
The difference between a merchandising and a manufacturing income statement is in the cost of goods sold section. A manufacturing cost of goods sold section shows beginning and ending finished goods inventories and the cost of goods manufactured.
Trends in Managerial Accounting
Managerial accounting has experienced many changes in recent years, including a shift toward service companies as well as an emphasis on ethical behavior. Improved practices include a focus on managing the value chain through techniques such as just-in-time inventory, total quality management, activity-based costing, and the theory of constraints.
The balanced scorecard is now used by many companies in order to attain a more comprehensive view of the company’s operations, and companies are now evaluating their performance with regard to their corporate social responsibility.
Finally, data analytics and data visualizations are important tools that help businesses identify problems and opportunities, and then make informed decisions.
Cost-Volume-Profit (CVP) Analysis
Variable, Fixed, and Mixed Costs and the Relevant Range
Variable costs are costs that vary in total directly and proportionately with changes in the activity index. Fixed costs are costs that remain the same in total regardless of changes in the activity index.
The relevant range is the range of activity in which a company expects to operate during a year. It is important in CVP analysis because the behavior of costs is assumed to be linear throughout the relevant range.
Mixed costs change in total but not proportionately with changes in the activity level. For purposes of CVP analysis, mixed costs must be classified into their fixed and variable components.
Applying the High-Low Method to Determine Mixed Cost Components
Determine the unit variable costs by dividing the change in total costs at the highest and lowest levels of activity by the difference in activity at those levels. Then, determine fixed costs by subtracting total variable costs from the amount of total costs at either the highest or lowest level of activity.
Preparing a CVP Income Statement to Determine Contribution Margin
The five components of CVP analysis are (1) volume or level of activity (quantity), (2) unit selling price, (3) unit variable costs, (4) total fixed costs, and (5) sales mix. Contribution margin is the amount of revenue remaining after deducting variable costs. It is identified in a CVP income statement, which classifies costs as variable or fixed. It can be expressed as a total amount, as a per unit amount, or as a ratio.
Computing the Break-Even Point Using Three Approaches
At the break-even point, sales revenue equals total costs, resulting in a net income of zero. The break-even point can be (a) computed from a mathematical equation, (b) computed by using a contribution margin technique, and (c) derived from a CVP graph.
Determining Sales for Target Net Income and Margin of Safety
The general equation for required sales is Sales − Variable costs − Fixed costs = Target net income. Two other equations are (1) Sales in units = (Fixed costs + Target net income) ÷ Unit contribution margin, and (2) Sales dollars = (Fixed costs + Target net income) ÷ Contribution margin ratio.
Margin of safety is the difference between actual or expected sales and sales at the break-even point. The equations for margin of safety metrics are (1) Actual (or expected) sales − Break-even sales = Margin of safety in dollars, and (2) Margin of safety in dollars ÷ Actual (expected) sales = Margin of safety ratio.
Regression Analysis
The high-low method provides a quick estimate of the cost equation for a mixed cost. However, the high-low method is based on only the highest and lowest data points. Regression analysis provides an estimate of the cost equation based on all data points. The cost equation line that results from regression analysis minimizes the sum of the (squared) distances of all of the data points from the cost equation line. Computer programs such as Excel enable easy estimation of the cost equation with regression.
Job Order Costing
Cost Systems and the Flow of Costs in a Job Order System
Cost accounting involves the procedures for measuring, recording, and reporting product and service costs. From the data accumulated, companies determine the total cost and the unit cost of each product. The two basic types of cost accounting systems are process cost and job order cost.
In job order costing, companies first accumulate manufacturing costs in three accounts: Raw Materials Inventory, Factory Labor, and Manufacturing Overhead. They then assign the accumulated costs to Work in Process Inventory and eventually to Finished Goods Inventory and Cost of Goods Sold.
Using a Job Cost Sheet to Assign Costs to Work in Process
A job cost sheet is a form used to record the costs chargeable to a specific job and to determine the total and unit costs of the completed job. Job cost sheets constitute the subsidiary ledger for the Work in Process Inventory control account.
Determining and Using the Predetermined Overhead Rate
The predetermined overhead rate is based on the relationship between estimated annual overhead costs and estimated annual operating activity. This is expressed in terms of a common activity base, such as direct labor cost. Companies use this rate to assign overhead costs to work in process and to specific jobs.
Recording Manufacturing and Service Jobs Completed and Sold
When jobs are completed, companies add the cost to Finished Goods Inventory and remove it from Work in Process Inventory. When a job is sold, a company increases Cost of Goods Sold and decreases Finished Goods Inventory for the cost of the goods.
Under- and Overapplied Manufacturing Overhead
Underapplied manufacturing overhead indicates that the overhead assigned to work in process is less than the overhead incurred. Overapplied overhead indicates that the overhead assigned to work in process is greater than the overhead incurred.
Budgetary Planning
Essentials of Effective Budgeting and Master Budget Components
The primary benefits of budgeting are that it (a) requires management to plan ahead, (b) provides definite objectives for evaluating performance, (c) creates an early warning system for potential problems, (d) facilitates coordination of activities, (e) results in greater management awareness, and (f) motivates personnel to meet planned objectives. The essentials of effective budgeting are (a) sound organizational structure, (b) research and analysis, and (c) acceptance by all levels of management.
The master budget consists of the following budgets: (a) sales, (b) production, (c) direct materials, (d) direct labor, (e) manufacturing overhead, (f) selling and administrative expense, (g) budgeted income statement, (h) capital expenditure budget, (i) cash budget, and (j) budgeted balance sheet.
Preparing Budgets for Sales, Production, and Direct Materials
The sales budget is derived from sales forecasts. The production budget starts with budgeted sales units, adds desired ending finished goods inventory, and subtracts beginning finished goods inventory to arrive at the required number of units to be produced. The direct materials budget starts with the direct materials units (e.g., pounds) required for budgeted production, adds desired ending direct materials units, and subtracts beginning direct materials units to arrive at required direct materials units to be purchased. This amount is multiplied by the direct materials cost (e.g., cost per pound) to arrive at the total cost of direct materials purchases.
Preparing Budgets for Direct Labor, Overhead, and Expenses
The direct labor budget starts with the units to be produced as determined in the production budget. This amount is multiplied by the direct labor hours per unit and the direct labor cost per hour to arrive at the total direct labor cost. The manufacturing overhead budget lists all of the individual types of overhead costs, distinguishing between fixed and variable costs. The selling and administrative expense budget lists all of the individual types of selling and administrative expense items, distinguishing between fixed and variable costs.
The budgeted income statement is prepared from the various operating budgets. Cost of goods sold is determined by calculating the budgeted cost to produce one unit, then multiplying this amount by the number of units sold.
Preparing a Cash Budget and a Budgeted Balance Sheet
The cash budget has three sections (receipts, disbursements, and financing) and the beginning and ending cash balances. Receipts and payments sections are determined after preparing separate schedules for collections from customers and payments to suppliers. The budgeted balance sheet is developed from the budgeted balance sheet from the preceding year and the various budgets for the current year.
Applying Budgeting Principles to Nonmanufacturing Companies
Budgeting may be used by merchandisers for the development of a merchandise purchases budget. In service companies, budgeting is a critical factor in coordinating staff needs with anticipated services. In not-for-profit organizations, the starting point in budgeting is usually expenditures, not receipts.
Budgetary Control and Responsibility Accounting
Static Budget Reports
Budgetary control consists of (a) preparing periodic budget reports that compare actual results with planned objectives, (b) analyzing the differences to determine their causes, (c) taking appropriate corrective action, and (d) modifying future plans, if necessary.
Static budget reports are useful in evaluating the progress toward planned sales and profit goals. They are also appropriate in assessing a manager’s effectiveness in controlling costs when (a) actual activity closely approximates the master budget activity level, and/or (b) the behavior of the costs in response to changes in activity is fixed.
Flexible Budget Reports
To develop the flexible budget, it is necessary to do the following. (a) Identify the activity index and the relevant range of activity. (b) Identify the variable costs, and determine the budgeted variable cost per unit of activity for each cost. (c) Identify the fixed costs, and determine the budgeted amount for each cost. (d) Prepare the budget for selected increments of activity within the relevant range. Flexible budget reports permit an evaluation of a manager’s performance in controlling production and costs.
Responsibility Accounting for Cost and Profit Centers
Responsibility accounting involves accumulating and reporting revenues and costs on the basis of the individual manager who has the authority to make the day-to-day decisions about the items. The evaluation of a manager’s performance is based on the matters directly under the manager’s control. In responsibility accounting, it is necessary to distinguish between controllable and noncontrollable fixed costs and to identify three types of responsibility centers: cost, profit, and investment.
Responsibility reports for cost centers compare actual costs with flexible budget data. The reports show only controllable costs, and no distinction is made between variable and fixed costs. Responsibility reports show contribution margin, controllable fixed costs, and controllable margin for each profit center.
Performance Evaluation in Investment Centers
The primary basis for evaluating performance in investment centers is return on investment (ROI). The equation for computing ROI for investment centers is Controllable margin ÷ Average operating assets.
Comparing ROI and Residual Income
ROI is controllable margin divided by average operating assets. Residual income is the income that remains after subtracting the minimum rate of return on a company’s average operating assets. ROI sometimes provides misleading results because profitable investments are often rejected when the investment reduces ROI but increases overall profitability.
Incremental Analysis in Decision-Making
Management’s Decision-Making Process and Incremental Analysis
Management’s decision-making process consists of (a) identifying the problem and assigning responsibility for the decision, (b) determining and evaluating possible courses of action, (c) making the decision, and (d) reviewing the results of the decision. Incremental analysis identifies financial data that change under alternative courses of action. These data are relevant to the decision because they vary across the possible alternatives.
Analyzing Relevant Costs in Accepting a Special Order
The relevant costs are those that change if the order is accepted. The relevant information in accepting an order at a special price is the difference between the variable manufacturing costs to produce the special order and expected revenues. Any changes in fixed costs, opportunity cost, or other incremental costs or savings (such as additional shipping) should be considered.
Analyzing Relevant Costs in a Make-or-Buy Decision
In a make-or-buy decision, the relevant costs are (a) the variable manufacturing costs that will be saved as well as changes to fixed manufacturing costs, (b) the purchase price, and (c) opportunity cost.
Analyzing Relevant Costs and Revenues in Sell or Process Further
The decision rule for whether to sell or process materials further is: Process further as long as the incremental revenue from processing exceeds the incremental processing costs.
Analyzing Relevant Costs in Repairing, Retaining, or Replacing
The relevant costs to be considered in determining whether equipment should be repaired, retained, or replaced are the effects on variable costs and the cost of the new equipment. Also, any disposal value of the existing asset must be considered.
Analyzing Relevant Costs in Eliminating an Unprofitable Segment
In deciding whether to eliminate an unprofitable segment or product, the relevant costs are the variable costs that drive the contribution margin, if any, produced by the segment or product. Opportunity cost and reduction of fixed expenses must also be considered.
Standard Costs and the Balanced Scorecard
Standard Costs
Both standards and budgets are predetermined costs. The primary difference is that a standard is a unit amount, whereas a budget is a total amount. A standard may be regarded as the budgeted cost per unit of product.
Standard costs offer a number of advantages. They (a) facilitate management planning, (b) promote greater economy, (c) are useful in setting selling prices, (d) contribute to management control, (e) permit “management by exception,” and (f) simplify the costing of inventories and reduce clerical costs.
The direct materials price standard should be based on the delivered cost of raw materials plus an allowance for receiving and handling. The direct materials quantity standard should establish the required quantity plus an allowance for waste and spoilage.
The direct labor price standard should be based on current wage rates and anticipated adjustments such as COLAs. It also generally includes payroll taxes and fringe benefits. Direct labor quantity standards should be based on required production time plus an allowance for rest periods, cleanup, machine setup, and machine downtime.
For manufacturing overhead, a standard predetermined overhead rate is used. It is based on an expected standard activity index such as standard direct labor hours or standard machine hours.
Determining Direct Materials Variances
The equations for the direct materials variances are as follows.
Determining Direct Labor and Total Manufacturing Overhead Variances
The equations for the direct labor variances are as follows.
The equation for the total manufacturing overhead variance is as follows.
Variance Reports and Balanced Scorecards
Variances are reported to management in variance reports. The reports facilitate management by exception by highlighting significant differences. Under a standard costing system, an income statement prepared for management will report cost of goods sold at standard cost and then disclose each variance separately.
The balanced scorecard incorporates financial and nonfinancial measures in an integrated system that links performance measurement and a company’s strategic goals. It employs four perspectives: financial, customer, internal process, and learning and growth. Objectives are set within each of these perspectives that link to objectives within the other perspectives.
*Computing Overhead Controllable and Volume Variances
The total overhead variance is generally analyzed through a price variance and a quantity variance. The name usually given to the price variance is the overhead controllable variance. The quantity variance is referred to as the overhead volume variance.