2

Introduction
To be effective, organisations should focus on managing their resources to create value for their customers and
shareholders (or owners). As we discuss in Chapter 17, while needing to create value in the current business
environment, many organisations are also under pressure to meet the expectations of a broader range of
stakeholders. Understanding and managing costs is vital to the creation of customer and shareholder value.
Managers need to plan future costs, monitor current costs and, most importantly, manage costs by focusing on
their underlying causes. Effective cost management is essential to businesses that pursue a cost leadership
strategy, but will enhance shareholder wealth in any organisation.
Some organisations do not have shareholders but are owned by government or not-for-profit bodies, such
as churches and charities. Consider, for example, the federal Department of Social Services or the Anglican
Church of Australia’s Anglicare services. These organisations focus on customer or client value rather than on
the creation of wealth. However, resource management, and in particular cost management, remains an
important consideration. In both profit and not-for-profit entities, costs are a vital source of information for
managers, and most of the material in this chapter therefore focuses on costs, particularly the common
accounting concepts used to accumulate, analyse and manage costs.1

MANAGEMENT ACCOUNTING INFORMATION

In Chapter 1 we described how organisations are managed and we considered the information needs of
managers. From this we can identify common components of management accounting systems. LO 2.1

COMPONENTS OF A MANAGEMENT ACCOUNTING SYSTEM

Management accounting systems are tailored to an organisation’s needs but they often include the
following:
■ costing system (or cost accounting system) that estimates the cost of goods or services, as well costing system (or
as the cost of organisational units, such as departments cost accounting
■ budgeting system that is used to prepare a detailed plan showing the financial consequences of system) a system
the organisation’s operating activities for a specific future period. The system estimates planned that estimates
revenues and costs the cost of goods
and services, as
■ performance measurement system that measures performance by comparing actual results with
well as the cost
some target
of organisational
■ cost management system that focuses on improving the organisation’s cost effectiveness through
units, such as
understanding and managing the real causes of costs. departments
Management accountants also provide information from a variety of other sources to help managers
with non-routine planning and decision making.

1. The economic concepts of relevant costs for decision making are described separately in the chapters in Part 4:
Information for creating value.
40 PART ONE INTRODUCTION TO MANAGEMENT ACCOUNTING

budgeting system TRADITIONAL VERSUS MODERN APPROACHES TO MANAGEMENT

a system used to ACCOUNTING
prepare a detailed We learned in Chapter 1 that major new approaches in management accounting have developed
plan, summarising since the 1980s, in response to dramatic changes in the business environment. Costing, budgeting
the financial and performance measurement systems are common to both traditional and these more modern
consequences of
management accounting systems, although there are substantial differences between the old and the
an organisation’s
new. Cost management systems tend to be identified with modern systems.
operating activities
for a specific Costing systems
future period Traditional costing systems estimate the costs of organisational units, such as departments, and of
products (i.e. goods or services). In analysing costs they assume that production volume is the only
performance
factor that can cause costs to change.
measurement Modern costing systems are much more detailed. They estimate the cost of the individual activities
system a system performed in the organisation and use this information to cost goods and services, customers,
that measures organisational units or other items. Modern costing recognises that production volume can cause costs
performance by to change, but so can a range of other factors. These systems are called activity-based costing systems.
comparing actual
results with some Budgeting systems ân sách theo ho

target Traditional budgeting systems estimate planned revenues and costs for organisational units such
as departments. Department budgets are aggregated to obtain a budget for the overall organisation.
Modern approaches to budgeting, called activity-based budgeting, are much more detailed and, as the
cost management name would suggest, are built around activities.
system a system
that focuses on Performance measurement systems
improving cost Traditional performance measurement systems provide measures of financial performance. They focus
effectiveness largely on controlling costs, by reporting differences between budgeted and actual costs. They monitor
through performance within the organisation. TT: so sánh chi phí ngân sách và thực tế
understanding and Modern performance measurement systems provide measures of performance across a whole range
managing the real
of critical success factors, such as quality, delivery, innovation and sustainability, as well as financial
causes of costs
performance. These factors derive from the business’ competitive strategy and are critical to its
survival. In addition to reporting on internal performance, modern performance management systems
critical success look at what is happening outside the organisation, for example, by monitoring the performance
factors factors of competitors and the satisfaction of customers and, perhaps, of other key stakeholders. Modern
that derive from approaches to performance measurement include strategically focused performance measurement
the competitive systems, such as the balanced scorecard, benchmarking and activity-based performance measures.
strategy, and are They focus on managing sources of customer value and shareholder wealth.
critical to the HĐ: đo lường hiệu suất trên toàn bộ các yếu tố quan trọng
survival of the Cost management systems
business Traditional performance measurement systems provide information to help managers control costs, by
focusing on differences between actual costs and planned (i.e. budgeted) costs. Modern approaches
are far more proactive in providing information to manage resources. Systems are developed not only
to control costs but to reduce them. Wasteful activities are identified and eliminated, and costs are
analysed to identify their real root causes. The causes rather than the costs are managed. Modern
approaches to cost management include activity-based management, customer profitability analysis,
supplier cost analysis, business process re-engineering, life cycle management and target costing.
Exhibit 2.1 summarises the differences between traditional and modern management accounting
systems. You need to have a knowledge of traditional management accounting systems, as they are still
used in many organisations. You also need a knowledge of the modern approaches, which are becoming
 CHAPTER TWO MANAGEMENT ACCOUNTING: COST TERMS AND CONCEPTS 41

Exhibit 2.1
Traditional versus modern management accounting systems
Components of management
accounting systems Traditional systems Modern systems
■ Costing systems ■ Focus on the costs of departments ■ Focus on the costs of activities,
and products* products, customers and suppliers
■ Assume production volume is the ■ Recognise that a range of factors
only factor that can cause costs to vary can cause costs to vary
■ Budgeting systems ■ Built around departments ■ Built around departments and
activities
■ Performance measurement ■ Monitor financial performance ■ Monitor performance across a
systems ■ Control what’s going on inside the range of critical success factors,
organisation such as quality, delivery and
sustainability, not just financial
performance
■ Also look at what’s happening
outside the organisation, for
example, at customers,
competitors and broader
stakeholders
■ Support the management of both
customer value and shareholder
wealth
■ Cost management ■ No separate system ■ Proactive approaches to managing
■ Costs mainly controlled through the resources and reducing costs,
financial performance measurement rather than just controlling them
system ■ Analyse real causes of costs and
eliminate wasteful activities
* Note that ‘products’ includes both goods and services.

more common, especially within organisations that are responding to the pressures of the current
business environment. These new approaches, as well as traditional costing, budgeting and performance
measurement systems, are described in more detail in later chapters.

EMPHASIS ON COSTS
An examination of the components of both traditional and modern management accounting systems
reveals that costs are an important source of information for managers. The systems include information LO 2.2
about product costs, the costs of departments and activities, as well as both budgeted costs and actual
costs. Modern management accounting systems also provide information about the causes of costs.
Let’s consider why management accountants pay so much attention to costs.

Historic focus on production costs

Historically, management accountants have given most consideration to manufacturing businesses,
in particular to their production costs. One reason for this is the need to value inventory (at cost)
and determine cost of goods sold for external reporting. Another reason is that many traditional
management accounting techniques evolved in manufacturing businesses by the mid-1920s. At that
42 PART ONE INTRODUCTION TO MANAGEMENT ACCOUNTING

time, focusing on manufacturing costs made sense, as manufacturing dominated business activity in
developed countries, and non-manufacturing costs in most businesses were relatively insignificant.
In the current business environment, non-manufacturing costs are much more significant. For
example, at a company like Microsoft, production costs can be relatively low, while research and
development, marketing and customer service costs can be relatively high. In addition, many developed
countries have experienced strong services sector growth. Consequently, management accountants
have become more interested in costs incurred across an organisation.

Ready availability of cost data

We learned in Chapter 1 that management accounting was once called cost accounting. The new name
recognises that managers need a broad range of information for managing resources to create customer
value and shareholder wealth. However, accounting systems are a prime source of data for management
accountants. When costs are incurred as a result of external transactions, they are recorded in the accounting
system. For example, when raw materials are purchased by a manufacturer, the costs of the raw material
are recorded in the general ledger as inventory. The additional costs of converting the raw material into
products are also recorded. Thus the accounting system provides a wealth of basic data about costs.

Importance of cost information

Costs have a vital role to play in helping managers to manage resources efficiently and effectively to
create customer value and shareholder wealth. For example, in planning the routes and flight schedules
of Qantas, managers must consider aircraft fuel costs, salaries of flight crews and airport landing
fees. To manage the costs of producing personal computers, Toshiba’s accountants must carefully
measure and keep track of the costs of research and development, production and customer service.
All organisations incur costs, and managers need information to understand and manage them. Many
short-term and long-term decisions require an understanding of costs.

THE ROLE OF NON-FINANCIAL INFORMATION

Traditional management accounting systems focus primarily on financial information, particularly
costs. However, throughout the business, non-financial and qualitative information is also needed to
help make decisions and to manage the various sources of customer value and shareholder wealth.
If you are managing a hospital, costs and revenues are important for decision making, but non-
financial information on the number of beds occupied, patient waiting lists, the number of patients
admitted for various medical and surgical procedures and the quality of patient care is also important.
If the strategy of your business is focused on improving customer service, you may need regular
non-financial information on the numbers of customer complaints, deliveries to customers on time
and defective products returned by customers, as well as the results of customer satisfaction surveys.
Modern management accounting places a much greater emphasis on non-financial information.2

COST CLASSIFICATIONS: DIFFERENT CLASSIFICATIONS

FOR DIFFERENT PURPOSES
LO 2.3 Given the emphasis on costs, an important first step in management accounting is to understand the
different ways that costs can be classified, analysed and reported.
Before management accountants can classify costs, they need to consider how managers will
use the information. Different cost concepts and classifications are used for different purposes.

2. See, for example, the performance measurement systems described in Chapter 14 and the information used for supply
chain management and for cost management described in Chapters 15 and 16.
 CHAPTER TWO MANAGEMENT ACCOUNTING: COST TERMS AND CONCEPTS 43

For example, some cost concepts are relevant to cost management, as managers need to understand
and manage the level of resources used to create customer value and shareholder wealth. Some
are relevant to product costing as managers need to determine product profitability and make
informed decisions about which products to produce. Some are relevant to planning, as managers
need to predict the costs of future operations, while some are relevant to reporting the results of
current activities.
The same cost can be classified in a number of ways, depending on the intended use of the cost
information. For example, to determine the profitability of producing cheese at a Mainland cheese
factory, it is useful to classify costs by whether or not they relate to the production of cheese. However,
to assess the performance of the production manager we need to be able to classify the same costs
according to whether or not they can be managed, or controlled, by the manager. Understanding the
different cost concepts and classifications enables the management accountant to provide relevant
cost information to the managers who need it. The ‘Real life’ below, about Insurance Australia Group
Limited (IAG), illustrates the importance of understanding and managing costs.
We introduce now some common ways in which costs can be classified. Exhibit 2.2 summarises
these cost classifications, the basis of classification and the way these various classifications are used by

Exhibit 2.2
Common cost classifications in management accounting
Basis of classification Cost classifications Used to:
■ Behaviour (see Chapter 3) ■ Variable ■ Plan (budget) costs
– Unit level ■ Control costs
– Engineered ■ Make decisions
■ Fixed
– Committed
– Discretionary
■ Traceability ■ Direct ■ Estimate the cost of goods and services
■ Indirect ■ Estimate the cost of organisational
units, such as departments or activities
■ Controllability (see Chapter 12) ■ Controllable ■ Measure managers’ performance
■ Uncontrollable ■ Control costs
■ Value chain ■ Upstream: ■ Analyse cost structures and identify
– Research and development strategies
– Design ■ Measure performance
– Supply ■ Control/manage costs
■ Manufacturing/production
■ Downstream:
– Marketing
– Distribution
– Customer service
■ Manufacturing/product costs ■ Direct material ■ Estimate the cost of products
■ Direct labour ■ Estimate the cost of goods sold for the
■ Manufacturing overhead income statement, and inventory for
the balance sheet
■ Timing of the expense ■ Product ■ Prepare income statement and balance
■ Period sheet
 44 PART ONE INTRODUCTION TO MANAGEMENT ACCOUNTING

REALLIFE

INSURANCE: THE IMPORTANCE OF MONITORING AND MANAGING COSTS

Insurance Australia Group Limited (IAG) is an international general insurance group, with operations in Australia, New Zealand and Asia.
Because the company’s operating costs are reflected in the price of their premiums, it is important to both their customers and their
shareholders that costs are managed efficiently. They are able to do this in a variety of ways, including keeping administrative costs
down, investing in technology and identifying ways to streamline their operations.
Managing the environment is also a key consideration for IAG, not simply because of the growing awareness of environmental
issues, but because of costs. As stated by IAG in their 2012 Sustainability Report:

Meeting our carbon neutral commitment

We also continued to reduce our own environmental footprint. In 2006, lAG committed to achieve voluntary carbon neutrality by
the end of 2012. This demonstrates our own efforts to curb carbon emissions which contribute to climate change. To reduce our
carbon emissions, we have focused on reducing electricity consumption, business travel, vehicle fuel and paper consumption.
This means that, not only are we contributing to a more sustainable environment, we are also reducing our costs by using fewer
resources. As a result, lAG reduced its CO2 equivalent emissions by 0.4 per cent during the past year. This included the addition
of new emission sources.
Removing these new sources saw a 6 per cent reduction in our emissions which is in line with our 5 per cent emission reduction
target for the year. The key contributors to this outcome were reduced electricity consumption through property consolidation in
Australia, significant hardware refreshes with more power efficient technology, and a continued focus on using alternative
communication options to reduce air travel. These reductions were slightly offset by increased print paper consumption in
Australia due mainly to the requirement to print additional insurance policy documents to reflect changes including the addition
of flood cover.

Source: Insurance Australia Group Limited 2012, Sustainability Report 2012. Reprinted with permission.

management accountants. This gives you an overview of the many different cost concepts used in this
book. In this chapter, we focus on traceability, the value chain and manufacturing cost classifications.
In Chapter 3 we describe cost behaviour in detail, and controllability is considered in Chapter 12.

costs the resources WHAT ARE COSTS?

given up to achieve
Costs are resources given up to achieve a particular objective. In accounting, they are usually measured
a particular
in monetary terms—which, in Australia, means in dollars. Although you may have studied accounting
objective
before, cost may be a new term. In financial accounting the focus is on assets and expenses, but not on
costs. Generally, costs are incurred to obtain future benefits. If the benefits extend beyond the current
asset a measure of accounting period, the costs are recorded as assets. As the benefits are used, the costs are no longer
the cost of future regarded as assets, but are expensed. Where benefits from a cost are confined to the current period, the
benefits cost is recorded as an expense rather than an asset. An expense is the cost that is used up in the
generation of revenue.3
For example, Penfolds Wines would regard all the costs of manufacturing its wine as an asset,
expense a cost
inventory. When the wine is sold, the cost of producing the wine is classified as cost of goods sold
used up in the
expense. This expense is deducted from the sales revenue of that wine to produce a profit (or loss).4 In
generation of
comparison, the salary of the winery’s sales manager does not generate any benefits that extend into
revenue
the future and is treated as an expense as it is incurred.

3. Statement of Accounting Concepts 4 (SAC 4), part of the conceptual framework developed by the Australian Accounting
Standards Board, provides further detail on the definition and recognition of assets and expenses for financial reporting purposes.
4. This recognition of expenses with a direct association to revenues is often referred to as matching of expenses and revenues.
 CHAPTER TWO MANAGEMENT ACCOUNTING: COST TERMS AND CONCEPTS 45

CLASSIFYING COSTS ACCORDING TO THEIR BEHAVIOUR

Management accountants can help managers to understand the way costs behave as the level of activity
in the business changes. The level of activity refers to the level of work performed in the organisation.
LO 2.4
The activity causes the cost and, for this reason, the level of activity is often referred to as the level of
cost driver. Activity can be expressed in many different ways, including units produced, kilometres
driven, pages printed and hours worked. Understanding cost behaviour is useful for planning and level of
activity the level
managing costs, particularly product costs. Two common cost behaviour classifications are variable
of work performed
and fixed costs. A variable cost changes in total, in direct proportion to a change in the level of
in the organisation
activity or cost driver. An example is the electricity used to manufacture a product, which may increase
in proportion to the number of units of the product manufactured. A fixed cost remains unchanged in
total despite changes in the level of activity. For example, the cost of rent of a manufacturing plant will
remain the same no matter what the level of production. These cost behaviour classifications, and the
assumptions behind them, are explained in greater detail in Chapter 3.

DIRECT AND INDIRECT COSTS

One of the important functions of management accounting is to measure the costs of cost objects.
LO 2.5
A cost object is simply an item for which management wants a separate measure of costs. Most
management accounting systems include some form of costing system to measure the costs of specific cost driver any
cost objects. Products, projects, contracts and departments are common cost objects in traditional activity or factor
costing systems. Cost objects of modern costing systems often include activities, suppliers and that causes costs to
customers, as well as products. be incurred
Costs can be classified as direct or indirect, depending on whether they can be traced to cost
objects. A direct cost is a cost that can be identified with, or traced to, a particular cost object in variable cost a
an economic manner. Generally, there is a physically observable relationship between the cost (or cost that changes,
the resource that it reflects) and the cost object. Consider, for example, this book as a cost object. in total, in direct
The cost of paper is a direct cost of this book. In contrast, an indirect cost is a cost that cannot be proportion to a
identified with, or traced to, the cost object in an economic manner. The salary of the managing editor change in the level
of McGraw-Hill Education Australia is an indirect cost of this book. She oversees the editing of all of activity
books and it is not easy to identify her time with any one book.
Indirect costs cause difficulties in estimating the costs of cost objects. Since we cannot trace fixed cost a cost
them to specific cost objects, we have to find some way to apportion (allocate) them. As your that remains
study of management accounting progresses, you will observe that cost allocation is a complex and unchanged in total
troublesome area! We discuss the classification of direct and indirect product costs in more detail despite changes in
later in this chapter. the level of activity

Direct and indirect costs of responsibility centres cost object an item

In most organisations the costing system is set up to measure the costs of individual managers’ areas assigned a separate
of responsibility, such as departments or activity centres. In management accounting, we call the areas measure of cost

of the business where managers are held accountable for activities and performance responsibility
centres. Assigning costs to units such as departments is part of responsibility accounting, which direct cost a
assigns responsibility to individual managers to run particular areas of the organisation and then holds cost that can be
each manager accountable for his or her area’s performance. This provides useful information for cost identified with,
control to department managers, as well as to their superiors, which helps to manage costs right across or traced to, a
particular cost
the business. (Responsibility accounting is discussed in Chapter 12.)
object in an
A cost that can be traced to a particular department, or responsibility centre, is called a direct cost
economic manner
of the department. The salary of a radiographer is a direct cost of the X-ray department at St John’s
46 PART ONE INTRODUCTION TO MANAGEMENT ACCOUNTING

Hospital in Hobart. The costs of national advertising for the Sovereign Hill tourist complex at Ballarat
indirect cost a
are direct costs of the marketing department.
cost that cannot
be identified with,
The salary of a plant manager at the pharmaceutical manufacturer AstraZenica Australia is an
or traced to, a indirect cost of each of the plant’s production departments. While the manager’s duties are important
cost object in an to the smooth functioning of each of the production departments, there is no precise way of tracing
economic manner part of his or her salary to each department.

Direct and indirect costs of products

responsibility
The direct and indirect cost classifications are also relevant to product costing. Manufacturing costs
centre a unit in an
that can be traced to products in an economic manner are direct product costs. These include direct
organisation (e.g.
a department or
material and direct labour. The cost of sugar used in the production of Pepsi is a direct material cost,
division) where and the wage paid to an operator on the bottling line is a direct labour cost.
the manager is Indirect product costs are the manufacturing costs that cannot be traced to products in an
held accountable economic manner. As discussed later in this chapter, these costs are called manufacturing overhead.
for activities and The wage paid to the forklift driver who moves the sugar around the Pepsi plant is an indirect cost and
performance part of manufacturing overhead. (We discuss the classification of product costs in more detail later in
this chapter.)
responsibility
accounting the
Direct or indirect, what is the cost object?
practice of What the above discussion indicates is that whether a cost is direct or indirect depends entirely on the
holding managers nature of the cost object—do we need to know the cost of a department? A product? A project? An
responsible for entire company? A given cost can be a direct cost of one cost object and an indirect cost of another
the activities and cost object. For example, the advertising costs that are a direct cost of the marketing department at
performance of Sovereign Hill are indirect costs of each of the departments that provide services to tourists, such as
their areas of the the motel, the Gold Museum and the Pioneer Village. The salary of the plant manager at AstraZenica
business Australia is an indirect cost of each of the plant’s production departments but is a direct cost of the
whole plant.

CONTROLLABLE AND UNCONTROLLABLE COSTS

Performance evaluation can be enhanced by classifying responsibility centre costs, such as department
LO 2.6 costs, as either controllable by the manager or uncontrollable. Ideally, when evaluating performance,
managers should be held responsible only for costs they can control. If a manager can control or
significantly influence the level of a cost, then that cost is classified as a controllable cost of that
manager. Costs that a manager cannot significantly influence are classified as uncontrollable costs.
direct product
Few costs are completely under the control of any individual. In classifying costs as controllable
costs manufacturing
or uncontrollable, management accountants generally focus on a manager’s ability to influence,
costs that can be
traced to products
rather than control, costs. Exhibit 2.3 lists several cost items, along with their typical classification
in an economic as controllable or uncontrollable. For example, a manager of a McDonald’s restaurant can probably
manner control (or influence) the quantity of food used in the restaurant but may not be able to influence the
price charged by suppliers. Also, some costs are controllable in the long term but not in the short
term. For example, the long-term costs associated with premises leased by the Country Fire Authority
indirect product in Victoria are controllable when a 10-year lease is initially negotiated. In the short term, during the
costs manufacturing lease period, the lease costs are not controllable.
costs that cannot be
The classification of costs as controllable or uncontrollable is relevant to both conventional and
traced to products
contemporary management accounting systems.
in an economic
The ‘Real life’ titled ‘Classifying costs in Australia’s hotel industry’ in the section ‘Costs across
manner
the value chain’ illustrates how classifying costs can help managers in the hotel industry.
 CHAPTER TWO MANAGEMENT ACCOUNTING: COST TERMS AND CONCEPTS 47

Exhibit 2.3 controllable

Controllable and uncontrollable costs cost a cost that a
specific manager
Cost item Manager Classification
can control or
■ Cost of raw material used to ■ Supervisor of the ■ Controllable (quantity is
significantly
produce circuit boards in an ASUS production department for controllable, but the price probably
influence
factory circuit boards is not)
■ Cost of food used in a McDonald’s ■ Restaurant manager ■ Controllable (quantity is controllable,
uncontrollable
restaurant but the price probably is not)
cost a cost
■ Cost of national advertising campaign ■ Manager of the Hertz rental ■ Uncontrollable (under the control of
that a manager
for the Hertz car rental company agency at Sydney Airport head office marketing manager)
cannot control
■ Cost of national accounting and ■ Manager of the NAB ■ Uncontrollable (under the control or significantly
data-processing operations for the branch in Katherine, of head office managers) influence
National Australia Bank (NAB) Northern Territory

COSTS ACROSS THE VALUE CHAIN

The value chain (see Exhibit 2.4) provides a useful framework for examining the areas where costs are
incurred within a business. The value chain is a set of linked processes or activities that begins with LO 2.7
acquiring resources and ends with providing (and supporting) goods and services that customers value.
value chain a set
Management accountants can use various cost classifications within the upstream, downstream
of linked processes
and manufacturing areas to help them assign costs to products, and to provide other information to
or activities
help manage resources efficiently and effectively in order to create value. For example, by focusing that begins
on the costs of each primary process, management can consider how to reduce costs and can make with acquiring
decisions about whether to outsource aspects of the organisation. resources and ends
with providing
UPSTREAM COSTS (and supporting)
Research and development (or R & D) costs include all the costs involved in developing new products that
products or processes. The costs of running laboratories, building prototypes of new products, and customers value

Exhibit 2.4 research and

The value chain development (or
R & D) costs all
Support services the costs incurred
in the development
• Human resources
• Finance of new products
• Legal and processes
• Information systems
• Telecommunications

Research Manufacturing Value of

Customer
and Design Supply or Marketing Distribution goods and
service
development production services

Upstream Downstream
Primary processes
 48 PART ONE INTRODUCTION TO MANAGEMENT ACCOUNTING

REALLIFE

CLASSIFYING COSTS IN AUSTRALIA’S HOTEL INDUSTRY

Most international hotels in Australia use a cost classification system based on the US
‘Uniform System of Accounts for the Lodging Industry (USALI)’. This system distinguishes
between direct and indirect costs, controllable and uncontrollable costs, and fixed and
variable costs, and provides an interesting example of the role these classifications
can play in the management process.
The two major production departments in most hotels are the rooms department
and the food and beverage department. In a typical mid-level hotel in Australia, direct
costs for the rooms department account for 30 to 40 per cent of rooms revenue. In
contrast, the direct costs of the food and beverage department average 70 to 95 per

DAL
cent of its revenue. The overall cost structure of a hotel depends on the ratio of rooms
revenue to food and beverage revenue. On average, hotels in Australia tend to have
direct expenses of 50 to 65 per cent of revenue, and indirect expenses of 20 to 25 per cent. An additional 5 to 10 per cent of revenue
is absorbed by property and owners’ costs.
One way to influence profit is to manage the yield on accommodation through careful pricing. There is a trade-off between room
rates and occupancy—as the room rate goes down, the occupancy level goes up. However, in setting room rates the hotel manager
must consider cost behaviour: which costs are variable costs of providing accommodation, such as room-cleaning costs, and which are
committed costs, such as council rates, premises costs and insurance costs. Room rates must be set so that they cover at least the
variable cost per room per day.
The only costs for which department managers are held responsible are direct costs. Other costs are not allocated to departments
as they are not controllable by these department managers. The average profit levels are around 60 to 70 per cent for room departments
and 5 to 30 per cent for food and beverage departments. A manager’s performance is compared with results in the previous period
and with industry averages. A food and beverage manager would not be expected to earn the same rate of profit as a rooms manager.
The system identifies the variable costs of the two major products: rooms, and food and beverages. The variable costs per room
tend to be low, whereas the variable costs per food and beverage service tend to be high. This means that the extra profit that can be
earned from each extra night of accommodation sold is high. The key to improving profitability is, therefore, maximising room sales.
The appropriate classification of costs helps the hotel industry to understand and manage its costs and profitability.

Source: Based on Mooney (1996); Hospitality Financial Technology and Professionals (2006)

testing new products and processes are all classified as research and development costs. These costs
design costs all
are becoming increasingly important as global competition increases, and product innovation is
costs associated
with the design of
one source of competitive advantage. Design costs include all the costs associated with designing a
a product and of product, as well as the costs of designing the processes that will be used to produce the new product.
the processes that Supplier costs refer to the costs of sourcing and managing incoming parts, assemblies and supplies.
will produce the (Supplier costs are discussed in more detail in Chapter 15.)
new product
PRODUCTION COSTS
Production costs include the costs incurred to collect and assemble the resources used to produce
supplier costs the
a product. In a manufacturing business these costs are often referred to as manufacturing costs
costs of sourcing
or factory costs. Manufacturing costs are discussed in more detail below, and we explore the cost
and managing
incoming parts,
concepts relevant to service organisations in Chapter 6.
assemblies and
supplies DOWNSTREAM COSTS
Marketing costs refer to the overall costs of selling products, such as salaries, commissions and
travel costs of sales personnel, and the costs of advertising and promotion. Distribution costs cover
 CHAPTER TWO MANAGEMENT ACCOUNTING: COST TERMS AND CONCEPTS 49

the costs of storing, handling and shipping finished products. Customer service costs include all the
production
costs of serving customers, such as the costs of answering customer enquiries, after-sales service and
costs the costs
warranty claims. incurred during the
production process
MANUFACTURING COSTS
In a manufacturing business, the production costs are often referred to as manufacturing costs. They
include all costs incurred within the factory area, whereas costs incurred outside the manufacturing
area (i.e. in upstream and downstream areas) are sometimes described as non-manufacturing costs.5
Manufacturing costs are usually divided into three categories: direct material, direct labour and LO 2.8
manufacturing overhead (or indirect manufacturing costs). This classification, as direct or indirect
costs, assumes that products are the relevant cost objects. Indeed, one of the major reasons for analysing
and classifying manufacturing costs is to determine the cost of products. In traditional product costing marketing
systems, which focus on estimating product costs for external financial reporting, only manufacturing costs the overall
costs are considered to be product costs. As we will see in a later section, broader definitions of costs of selling
product cost are used by many businesses for managerial decision making. goods and services

DIRECT MATERIAL distribution

costs the costs of
Raw material that:
storing, handling
■ is consumed in the manufacturing process and shipping
■ is physically incorporated into the finished product finished products
■ can be traced to products in an economic manner
is called direct material. Examples include the cost of hoses used in a Smeg dishwasher and the customer
cost of paper used in Cosmopolitan magazine. Materials that become an integral part of the finished service costs the
costs incurred
product but are insignificant in cost are often classified as indirect material (and also classified as
in servicing
manufacturing overhead). For example, materials such as glue or paint may be so inexpensive that
customers,
on cost–benefit grounds it may not be worthwhile setting up a system to trace their cost directly to
including after-
specific products. sales support and
warranty claims
DIRECT LABOUR
The cost of salaries, wages and labour on-costs for personnel who work directly on the manufactured manufacturing
product is usually classified as direct labour. Examples include the wages of personnel who assemble costs the cost of
Apple iPads and the wages of production workers who operate the sewing machines at a jeans factory. direct material,
These costs tend to be variable costs, as they vary with the level of production. direct labour and
Labour on-costs are the additional labour-related costs that businesses have to incur to employ manufacturing
personnel, such as payroll tax, workers’ compensation insurance and the employer’s superannuation overheads
contributions.6 Where labour on-costs relate to direct labour employees, they should be classified as part
of direct labour costs, as they are as much a part of the cost of labour as are employees’ regular wages. non-
Interestingly, this treatment of labour on-costs is not always observed in practice, as some manufacturing
companies classify these on-costs as manufacturing overhead. costs all costs
incurred outside of
5. In practice, some businesses call non-manufacturing costs overhead costs, but this can lead to confusion with the term manufacturing—
manufacturing overhead. This issue is discussed further in Chapter 7. that is, the cost
6. In Australia, labour on-costs can be distinguished from fringe benefits. The term fringe benefits is increasingly being used of upstream and
to describe benefits that employees receive in addition to their wages, and is often associated with managers’ salary downstream
packages. For example, a manager’s salary package may include the use of a company car, payment of private school fees
activities
for children and membership of the local golf club.
50 PART ONE INTRODUCTION TO MANAGEMENT ACCOUNTING

Sometimes, contractual arrangements and union agreements may mean that labour is a committed cost
direct material the
that does not vary with the level of production. In this situation, it may not always be possible to trace labour
cost of materials
consumed in the
costs directly to specific products, in which case these costs will be classified as indirect product costs.
manufacturing
process to produce a MANUFACTURING OVERHEAD
product, physically All other costs of manufacturing are classified as manufacturing overhead, sometimes called indirect
incorporated in manufacturing costs or factory burden costs. Manufacturing overhead covers all manufacturing
the product and costs other than direct material and direct labour costs. It includes the cost of indirect materials and
able to be traced to
indirect labour, which covers any material and labour, used in production, that is not classified as
the product in an
direct. Manufacturing overhead also includes the costs of depreciation and insurance of the factory and
economic manner
manufacturing equipment, utilities such as electricity, as well as the costs of manufacturing support
departments. Support departments (or service departments) are departments that do not work
direct labour the directly on producing products but are necessary for the manufacturing process to occur. Examples
cost of salary, include equipment maintenance departments and production scheduling departments.
wages and labour Manufacturing overhead costs also usually include overtime premiums and the cost of idle time. An
on-costs for overtime premium is the extra wages paid to an employee who works beyond normal working hours.
personnel who Suppose an electronics technician who assembles Blu-ray players earns $30 per hour. The technician works
work directly on 48 hours during a week instead of the normal working week of 40 hours. The overtime pay scale is time
the manufactured
and a half, or 150 per cent of the regular wage. The technician’s pay for the week is classified as follows:
product

Direct labour cost ($30 × 48 hours) $1440

labour on-
Overhead (overtime premium: 50% × $30 × 8 hours) 120
costs the
Total wages paid $1560
additional costs
that are incurred to
employ personnel, Only the extra wage of $15 per hour (50% × $30) is classified as overtime premium. The regular
including payroll
wage of $30 per hour is treated as direct labour, even for the eight hours worked during overtime. The
tax, workers’
overtime premium is classified as manufacturing overhead, rather than being treated as a direct labour
compensation
cost of the particular product that is produced during the overtime hours. This is because the overtime
insurance and
the employer’s
was caused by all the production scheduled during the day, not that particular product.
superannuation Idle time is time that is not spent productively by an employee due to such events as equipment
contributions breakdowns or new setups of production runs. The cost of an employee’s idle time is classified as
manufacturing overhead, relating to all the products produced rather than being associated with a
particular product.
manufacturing
overhead
CONVERSION AND PRIME COSTS
(or indirect
manufacturing Direct labour costs and manufacturing overhead are often combined and called conversion costs,
costs or factory since they are the costs of converting raw material into finished products. The costs of direct material
burden costs) all and direct labour are often combined and called prime costs, as they are the major costs that can be
manufacturing directly associated with the product.
costs other than
direct material and MODERN COSTING IN MANUFACTURING BUSINESSES
direct labour costs
Modern approaches to costing, such as activity-based costing, generally analyse costs in much more detail
than do traditional costing systems. Instead of being classified as direct or indirect product costs, labour
costs are often analysed as part of activity costs. Likewise, upstream and downstream costs may be classified
and analysed within an activity framework. Activity-based costing is described in Chapters 7 and 8.
 CHAPTER TWO MANAGEMENT ACCOUNTING: COST TERMS AND CONCEPTS 51

PRODUCT COSTS
One question managers often ask is: ‘How much does it cost to make this product?’ Managers need
estimates of product costs to assess product profitability and control costs, to decide whether to make
LO 2.9
the product in-house or to outsource it, and (sometimes) to set product prices, as well as to value
inventory and cost of goods sold in the balance sheet and income statement. The problem is that indirect materials
managers need different measures of product cost for different purposes. costs the costs
The ‘Real life’ below illustrates the importance of having an awareness of product costs, particularly of materials used
where price-based competition is intense. in production
that cannot be
directly assigned to
PRODUCT COSTS FOR FINANCIAL ACCOUNTING REPORTS
individual products
For financial accounting reports (i.e. the balance sheet and the income statement), a product cost is in an economic
a cost assigned to goods that were either manufactured or purchased for resale. The product cost is manner
regarded as part of the asset inventory until the goods are sold. When the goods are sold, the product
cost is transferred from the inventory account to cost of goods sold expense, an expense account.
indirect labour
Exhibit 2.5 illustrates the relationship between product costs and cost of goods sold expense. costs the costs of
The content of product costs used for financial reporting is defined in the Australian accounting any labour used
standard, AASB 102 Inventories.7 In brief, the product cost of inventory acquired for resale, by a in production that
retailer or wholesaler, consists of the purchase cost plus the cost of delivering the goods from the cannot be directly
supplier. The product cost of manufactured inventory consists of manufacturing costs only—that is, traced to individual
the direct material, direct labour and a portion of manufacturing overhead costs. For example, the products in an
labour cost of a production employee at a Campbell’s soup cannery is part of the product cost of economic manner
the cans of soup manufactured.
Another term used for product cost is inventoriable cost (or inventoried cost), since a product support
cost is stored as the cost of inventory until the goods are sold. Although the concept of product cost is department
(or service
department) a
Exhibit 2.5 manufacturing
Product costs and cost of goods sold department that
does not work
During the year, any inventory sold is transferred from directly on
the Inventory account to Cost of Goods Sold producing products
but is necessary for
Inventory Cost of Goods Sold
(asset) (expense) the manufacturing
process to occur
Retailer Inventory is acquired:
or product cost is the cost of Inventory is sold
wholesaler purchase plus the cost of overtime
transportation inwards premium the
extra wages paid
Goods are manufactured: to an employee
product cost consists of who works beyond
Manufacturer the manufacturing costs Inventory is sold
of direct material, direct normal working
labour and manufacturing hours
overhead

7. The appendix to Chapter 4 summarises the key requirements of the Australian accounting standards for inventory
valuation.
 52 PART ONE INTRODUCTION TO MANAGEMENT ACCOUNTING

REALLIFE

PIZZA WARS: BATTLING FOR A SLICE OF FAST FOOD ‘SUPREME-ACY’

Recent media reporting around the so-called ‘pizza war’ in the Australian fast food market highlights the importance of understanding
costs to remain viable, particularly in circumstances where competition is intense and price focused.
Australia’s pizza war began in earnest in mid-2014 when Domino’s Pizza cut the price of its value range pizzas to $4.95, something
a Domino’s spokesperson described as ‘never before seen on the pizza landscape’ (Cowie, 2014). In essence, Domino’s was positioning
itself to become a cost leader in the hotly contested pizza market. Don Meij, Domino’s chief executive, and himself a former pizza
delivery driver, explained the move as a response to customers asking for cheaper pizza deals across the week. Domino’s major
competitor, Pizza Hut, swiftly responded, matching Domino’s $4.95 offer and capping the cost of their most expensive pizza at $8.50.
Eagle Boys, Australia’s third big pizza chain at the time, did not immediately respond, as they felt the price drop was unsustainable.
Instead, they kept a close watch on price developments. Eventually, the price pressures and other factors took their toll on Eagle Boys,
and they were placed into voluntary administration in July 2016. It seems in the $3.5 billion fast food market for pizza, competition is
brutal, with value being king.
Sustaining this intense level of price-based competition requires careful consideration of costs to remain viable. As indicated in
Domino’s annual reports from 2010 to 2016, a range of initiatives had been introduced over time to make their business operations
more efficient. These included introducing in-store efficiencies and a global point-of-sale system, optimising their logistical activities,
reviewing arrangements with suppliers, and taking sustainability initiatives to reduce electricity, water and gas consumption. As the
largest player in the Australian market by a good margin, Domino’s are also able to leverage significant economies of scale in areas
such as procurement, marketing and head office administration.

Sources: Chung (2016); Cowie (2014); Domino’s Pizza Enterprises Limited Annual Reports (2010–2016); Ferguson (2016)

used by retailers, wholesalers and manufacturers to value their inventories, the accounting standards
idle time the cost
require alternative approaches for some non-manufacturing firms, such as agricultural and timber
of employees’ non-
productive time,
producers. Also, generally, service costs are not inventoried because services tend to be consumed as
arising from events they are produced.
such as equipment
breakdowns or Period costs
new setups of All costs that are not product costs are called period costs. These costs are expensed in the accounting
production runs period in which they are incurred rather than being attached to units of purchased or produced goods.
Examples of period costs are salaries of sales personnel, advertising expenditures, depreciation of office
equipment (but not depreciation of manufacturing equipment) and the salaries of top management. In
conversion
the income statement, period costs can be classified by line item or by function, for example as selling
costs the costs of
or administrative expenses. Selling expenses usually include the costs of selling goods or services and
direct labour and
the costs of distribution. Administrative expenses refer to the costs of running the business as a whole,
manufacturing
and include the costs of senior management as well as a range of (non-manufacturing) support services.
overhead incurred
to convert raw In most service firms there is no inventory so all costs are treated as period costs.
material to a
finished product PRODUCT COSTS FOR DECISION MAKING
While inventory valuations for financial accounting reports are limited to manufacturing costs,
managers often need a wider definition of product cost for decision making. For example, in setting a
prime costs the
product’s price, managers may need an estimate of all the costs associated with developing, producing
costs of direct
material and direct and selling the product. The different measures of product cost relevant to different decisions are
labour incurred to discussed in Chapter 4.
produce a product The mining industry is a particularly important source of products in Australia, and, as the
following ‘Real life’ shows, information about the costs of mineral products, such as gold, is essential
for effective management in this industry.
 CHAPTER TWO MANAGEMENT ACCOUNTING: COST TERMS AND CONCEPTS 53

REALLIFE

THERE’S PLENTY OF GOLD, BUT AT WHAT COST?

Australia has had a long and successful history of mining gold, and continuing discoveries suggest that there is still plenty of gold to mine.
However, gold mining is capital intensive, involving large-scale power generation and mining equipment. There are high energy costs in
extracting the ore from the ground and refining it. The importance of assigning costs to cost objects becomes apparent in assessing the
future of the gold industry. A key figure for gold miners and their investors is the estimated production cost per ounce of gold.
In June 1997, when the gold price fell to $450 per ounce, a number of Australian goldmines appeared unviable—only nine of the top
25 mines were comfortably covering costs, four were struggling and the others were in the red. The Tanami mine had the lowest cost,
at $232 per ounce, and Bullabulling had the highest, at $606 per ounce! Moreover, these figures were based on cash costs, with no
allowance made for depreciation and other expenses, which industry analysts suggested could add another $50 to $100 per ounce.
Since then, the cost of gold production has continued to rise, and so have prices. By the end of 2006, average global mine cash
costs had risen to approximately $400 per ounce, and the total production costs, including depreciation and other capital expenses,
were $508 per ounce. In April 2013, the global gold price was US$1325 per ounce. In comparison, a survey of 15 mid-tier Australian
mining firms indicated that the average cost per ounce was $1170 (Ker, 2013). Based on these figures, it was estimated that as many as
five out of the 15 companies surveyed may struggle to survive.
What has caused the price of gold to increase? There are many factors. Gold is viewed as a stable investment and is thus attractive
in times of economic uncertainty. Consequently investors and banks will purchase gold bullion in preference to shares and will even
invest in gold jewellery.
Australian mining companies are clearly at the mercy of global gold prices, so it is critical for those companies to closely monitor
their costs.

Source: Treadgold (1997); O’Connell (2007); Ker (2013); Reeves (2013)

COST FLOWS IN A MANUFACTURING BUSINESS

Direct material, direct labour and manufacturing overhead are the three types of production costs
incurred by manufacturers. Most manufacturers have costing systems to keep track of the flow of
LO 2.10
these costs from the time production begins until the finished products are sold. There are four steps
in the flow of costs in manufacturing.
product cost the
1. When raw material is purchased, its cost is added to raw material inventory, an account that cost assigned to
records the cost of all major materials purchased for manufacturing. goods that were
2. As direct material is consumed in production, its cost is removed from raw material and added to either manufactured
work in process inventory, an account that records the cost of manufactured products that are or purchased for
only partially completed at balance date. Similarly, the costs of direct labour and manufacturing resale
overhead are accumulated in work in process inventory.
3. When products are finished, their costs are transferred from work in process inventory to finished
cost of goods
goods inventory, an account that records the cost of manufactured goods that are complete and
sold expense the
ready for sale. The costs are then stored in finished goods until the products are sold. cost of products
4. When products are sold, the costs of those products are transferred from finished goods inventory transferred from
to the cost of goods sold account, which is an expense during the period when the sale is made. the inventory
Exhibit 2.6 details these cost flows and their impact on the financial statements of a manufacturing account when
sold, matched
business. You will notice that as production costs move through the raw material, work in process and
against revenue to
finished goods inventories, they are classified as assets and appear in the balance sheet. When finished
determine gross
goods are sold, the product costs move to the expense account cost of goods sold and are deducted
margin
from sales revenue to estimate the gross profit, which appears in the income statement. Period costs,
54 PART ONE INTRODUCTION TO MANAGEMENT ACCOUNTING

inventoriable cost Exhibit 2.6

(or inventoried Cost flows and financial statements: manufacturer
cost) another
term for product
Inventoriable Balance sheet Income statement
cost, derived from
costs
the process of
‘storing’ the cost
of inventory until Direct Raw materials Sales revenue
material inventory
the goods are sold

period costs costs Less

Direct
that are expensed
labour
in the accounting
period in which Work in process Finished
inventory Cost of goods sold
they are incurred goods
Manufacturing
overhead Equals
selling
Gross profit
expenses the costs
of selling and
distributing the Less
firm’s goods or
Selling and
services administrative
expenses
• Research and
administrative Period development
expenses the costs • Design
• Supplier costs
costs of running • Marketing
a business as a • Distribution
• Customer
whole, including service
the costs of senior
management and Equals
administrative
support Net profit
departments

raw material
inventory an relating to the expenses incurred in upstream and downstream areas of the value chain, are deducted
account that from the gross profit to estimate net profit. The detailed procedures and ledger accounts used to keep
records the cost of track of product costs are covered in Chapter 4.
the major materials
Costing systems are used to track direct material, direct labour and manufacturing overhead costs
that will be used in
through the various ledger accounts, to produce the financial statements. These same systems enable
production
the calculation of the costs of individual products, which may help managers to make decisions about
issues such as product prices and product mix.
Manufacturers often prepare a schedule of cost of goods manufactured and a schedule of cost of
goods sold to summarise the flow of manufacturing costs during an accounting period and link this
information to financial accounting statements. Unlike the financial statements, these schedules are
not reported externally. Exhibit 2.7 shows these two schedules, together with an income statement, for
 CHAPTER TWO MANAGEMENT ACCOUNTING: COST TERMS AND CONCEPTS 55

Exhibit 2.7 work in process

Manufacturing cost schedules inventory an
account that
Ringo Percussion Instruments records the cost
Schedule of cost of goods manufactured for the year ended 31 December of products that
are only partially
Direct material:
complete at
Raw material inventory, 1 January $ 10 000 balance date
Add Purchases of raw material 100 000
Raw material available for use 110 000
finished goods
Deduct Raw material inventory, 31 December 5 000 inventory an
Raw material used 105 000 account that
records the cost of
Direct labour 200 000
the manufactured
Manufacturing overhead: goods that are
Indirect material 8 000 complete and
Indirect labour 17 000 ready for sale

Depreciation on factory 50 000

Depreciation on equipment 20 000 schedule of
Electricity 15 000 cost of goods
manufactured
Insurance 5 000
schedule detailing
Total manufacturing overhead 115 000 the cost of direct
Total manufacturing costs 420 000 materials, direct
labour and
Work in process inventory, 1 January 25 000
manufacturing
Subtotal 445 000 overhead applied
Deduct Work in process inventory, 31 December 30 000 to work in process
Cost of goods manufactured $415 000 during the period,
and showing the
Schedule of cost of goods sold for the year ended 31 December changes to the
Finished goods inventory, 1 January $ 80 000 work in process
inventory
Add Cost of goods manufactured 415 000
Cost of goods available for sale 495 000
Deduct Finished goods inventory, 31 December 70 000 schedule of cost of
goods sold report
Cost of goods sold $425 000
showing the cost
of goods sold,
Income statement for the year ended 31 December
which is equal to
Sales revenue $700 000 the cost of goods
Less Cost of goods sold 425 000 manufactured
Gross profit 275 000 adjusted for
changes in finished
Selling and administrative expenses 175 000
goods inventory
Profit before taxes 100 000 and underapplied
Income tax expense 40 000 or overapplied
overhead
Net profit $ 60 000
 56 PART ONE INTRODUCTION TO MANAGEMENT ACCOUNTING

a manufacturer called Ringo Percussion Instruments. The arrows that link the three statements explain
the relationship between the cost of goods sold and the cost of goods manufactured. Notice that the
cost of goods manufactured is calculated using the following formula:

Cost of beginning total ending

goods = work in + manufacturing − work in
manufactured process costs process

This represents the cost of goods that are completed (and moved from work in process into finished
goods) during the period.
You will also note that cost of goods sold is calculated using this formula:

Cost of beginning cost of ending

goods = finished + goods − finished
sold goods manufactured goods

This represents the cost of goods that are removed from finished goods and sold during the period.
We return to these statements in Chapter 4.

Summary
In this chapter we introduced some of the concepts and ■ Costs may be classified according to their cost behaviour
terminology used in management accounting. Key points to provide management with useful information for
include: planning and managing costs.
■ Management accounting systems often include costing, ■ Direct and indirect costs refer to the ability to trace costs
budgeting and performance measurement systems. to various cost objects, such as activities, departments,
Modern management accounting systems also include products, projects or customers.
cost management systems, which focus on the ■ A cost may be classified as controllable or uncontrollable
identification and elimination of wasteful activities. to describe the extent to which a manager can influence
■ Management accounting systems focus on information it. This may be useful for evaluating the performance of
about costs partially for historical reasons, and partially a responsibility centre or a manager.
because of the ready availability of cost data in the ■ The value chain provides a useful framework for
accounting system, but primarily because under- describing the costs that occur in different areas of a
standing and managing costs is critical to managing business—namely, research and development, design,
resources to create value for customers and wealth for supply, production, marketing, distribution and custom-
shareholders. er service.
■ Management accounting provides regular reports on ■ Production costs in a manufacturing business are called
product costs, the costs of organisational units such as manufacturing costs and can be divided into direct
departments and divisions, planned costs and actual material, direct labour and manufacturing overhead
costs, as well as information for cost management. costs.
Costs are the resources that we give up to achieve a ■ The classification of costs as product costs is import-
particular objective. However, the word cost can have a ant. Product costs provide the basis for estimating
variety of meanings in different situations, and it is the value of inventory and cost of goods sold for
useful to classify costs in different ways for different external accounting reports. The accounting standards
purposes. confine these product costs to manufacturing costs.