Chapter 1

Introduction to management accounting

Learning Objectives

Identify the features of managerial accounting and the

(1)
functions of management.

Describe the classes of manufacturing costs and the

(2)
differences between product and period costs.

Explain and illustrate the concept of cost objects, cost

(3)
units and cost centers.

Distinguish between cost, profit, investment and

(4)
revenue centers.

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 MANAGERS
Require regular management information
For:

Planning

Control

Decision making

Decision Making Process

• Identify goals, objectives or problems.

Step 1

• Identify alternative solutions.

Step 2
Planning
• Collect and analyze relevant data.
Step 3

• Make the choice/decision. State the expected outcome.

Step 4

• Implement the decision.

Step 5

• Obtain data about actual results.

Step 6
Control • Compare actual results with the expected outcome.
Step 7 Evaluate achievements.

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 Managerial Accounting & Financial Accounting

Managerial accounting Financial accounting

provides information provides information
for managers inside an to stockholders,
organization who creditors and others
direct and control who are outside
its operations. the organization.

Management accounting Financial Accounting

Nature of the Tend to be general
Tend to be specific purpose
reports produced purpose

Level of detail Often very detailed Usually broad overview

Usually subject to
Regulations Unregulated
accounting regulation

As short as required by Usually annual or bi-

Reporting interval
managers annual

Often based on projected

Time orientation future information as well as Almost always historical
past information

Tend to contain financial and Focus on financial

Range and quality non-financial information, information, great
of information often use information that emphasis on objective,
cannot be verified verifiable evidence

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 Financial
information

Management
accounting
information

Non-
financial
information

Management activity and management information

Forward-looking,
Senior management
Strategic
planning external focus, non-financial

Tactical
planning Medium-term, linked to budgets, Middle management
(management
control) forecasts and resources

Operational planning
(operational control) Day-to-day, internal, detailed Front-line managers
often transactional level

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 Quality of good information

Relevant

Communi
Complete
cated

Timely Cost Accurate

Volume Clear

Confident

Data vs. Information

Data Information
 Raw material for  Processed Data
processing  Should be meaningful
 Relate to facts, events,
transactions etc.

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 Quick check 01

The following assertions relate to financial accounting and

to cost accounting:
 (i) The main users of financial accounting information are
external to an organisation.
 (ii) Cost accounting is that part of financial accounting
which records the cash received and payments made by
an organisation.
Which of the following statements are true?
A Assertions (i) and (ii) are both correct.
B Only assertion (i) is correct.
C Only assertion (ii) is correct

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Quick check 02

The following statements refer to strategic planning:

 (i) It is concerned with quantifiable and qualitative
matters.
 (ii) It is mainly undertaken by middle management in an
organisation.
 (iii) It is concerned predominantly with the long term.
Which of the statements are correct?
A (i) and (ii) only
B (i) and (iii) only
C (ii) and (iii) only
D (i), (ii) and (iii)

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 Basic Cost Terminology

 Cost – sacrificed resource to achieve a specific objective

 Actual cost – a cost that has occurred
 Budgeted cost – a predicted cost
 Cost object – anything of interest for which a cost is desired
 Cost unit - is a unit of product or service to which costs may
be ascertained.
 Cost centre - is a location, function or item of equipment in
respect of which costs may be ascertained and related to
cost units for control purposes.

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Cost unit

Costs unit - is a unit of product or service in relation to which

costs are ascertained - a basic control unit for costing purposes

Industry sector/ Activity Cost unit

 Brick-making  1,000 bricks
 Electricity  Megawatt-hour (MwH)
 Professional service  Chargeable hour
 Education  Enrolled student
 Hotel  Bed night
 Bus company  Passenger mile
 Hospital  In-patient day
 Credit control  Account maintained
 Selling  Customer call14

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 Production and non-production costs

Costs associated with the

Production production of goods and services,
from the supply of raw materials
costs up to the end of the production
process
Total costs
Non-production All other costs incurred in the
costs business

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Production and non-production costs

Cost of materials used in the

Materials making of the product/services

Production Labour
Cost of the workforce used in
costs making the product

Cost of any overheads required

Overheads to support the production
process

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 Production and non-production costs

All other costs incurred in

Administration managing the organisation

All costs incurred in

Selling promoting retaining
Non- customers
Production
All costs incurred in making
costs the packed product ready
Distribution for the despatch and
delivery to the customer

All costs incurred

Finance to finance the business

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Direct Costs vs. Indirect Costs

Direct costs Indirect (production) costs

 Costs that can be traced  Costs are incurred in the
in full to the product, course of making a
service or department that product/service but which
is being costed. cannot be identified with a
 E.g. direct materials, particular cost unit.
direct labour, direct  E.g. production overhead
expenses

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 Direct materials

 Materials that are incorporated into the finished product

or used in providing a service.
 Example: seats installed in a car made by Toyota.

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Direct labour

Wages paid to those workers who make

products in a manufacturing business or perform
the service in a service business.
Example: wages paid to automobile assembly
workers at Toyota.

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 Direct expenses

Expenses that have been incurred as a direct

consequence of making a product, or providing a
service.
E.g. patent royalties payable to the inventor of a
new product or process.
.

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Direct Direct
Prime cost Direct labour
materials expenses

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 Indirect costs

 Indirect materials
 Materials that are used in the production process but not
incorporated into the product.
 Insignificant costs that are attributable to each unit are sometimes
included in indirect materials for convenience.
 Indirect labour
 Wages and salaries of the other staff, such as supervisors,
storekeepers and maintenance workers.
 Indirect expenses
 Expenses that are not spent on individual units of production (e.g.
rent and rates, electricity and telephone).

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Quick check 3
Which of the following should be classifed as
indirect labour?
A Machine operators in a factory producing furniture
B Lawyers in a legal firm
C Maintenance workers in a power generation organization
D Lorry drivers in a road haulage company

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 Quick check 4

A manufacturing organization incurs costs relating to the following:

(i) Commission payable to salespersons
(ii) Inspecting all products
(iii) Packing the products at the end of manufacturing process prior to
moving them to the warehouse

Which of these costs are classified as production costs?

A (i) and (ii) only

B (i) and (Iii) only
C (ii) and (iii) only
D (i), (ii) and (iii) only

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Cost Classifications by Behaviors

Behavior of Cost (within the relevant range)

Cost In Total Per Unit

Variable Total variable cost changes Variable cost per unit remains
as activity level changes. the same over wide ranges
of activity.
Fixed Total fixed cost remains Fixed cost per unit goes
the same even when the down as activity level goes up.
activity level changes.

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 Cost Behavior (cont’d)

Variable costs
 Costs that vary in total directly and
proportionately with changes in the activity level.
Total variable cost

Volume of output (level of activity)

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Cost Behavior (cont’d)

Fixed costs
 Costs that remain the same in total regardless of
changes in the activity level within a relevant
range.
Total fixed cost

Volume of output

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 Cost Behavior (cont’d)

Stepped fixed costs: is a cost which is fixed in

nature but only within certain levels of activity.
90
Rent Cost in Thousands of

Relevant
60
Range
Dollars

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0
0 1,000 2,000 3,000
Rented Area (Square Feet)

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Cost Behavior (cont’d)

 Mixed costs (Semi-variable/Semi-fixed costs)

 Costs that have both a variable element and a fixed element.
Y = a + bX
Y: Total cost
Y
X: Activity level
a: Fixed cost
b: Variable cost per unit
Total Utility Cost

slope b Variable Cost

a
X Fixed Cost
Activity (Kilowatt Hours)

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 Quick check 5
When total purchases of raw material exceed 30,000 units in any one period
then all units purchased, including the initial 30,000, are invoiced at a lower
cost per unit.
Which of the following graphs is consistent with the behavior of the total
materials cost in a period?

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Cost Estimation

Y = a + bX
Y: Total cost
X: Activity level
a: Fixed cost
Y b: Variable cost per unit
Total Utility Cost

slope b Variable Cost

a
X Fixed Cost
Activity (Kilowatt Hours)

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 The High-Low Method

The high-low method uses the total costs incurred at the

high and the low levels of activity to classify mixed costs
into fixed and variable components.

 Step 1: Determine variable cost per unit

 Step 2: Determine Total fixed cost = Total cost – Variable cost

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The High-Low Method Illustration

Metro Transit Company has the following maintenance costs and

mileage data for its fleet of buses over a 6-month period.
Month Miles Driven Total Cost
January 20,000 $30,000
February 40,000 48,000
March 21,000 29,000
April 50,000 63,000
May 30,000 42,000
June 43,000 61,000

(63,000 - 30,000)
Variable costs per unit = = $1.10
(50,000 - 20,000)

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17
 The High-Low Method (cont’d)
 STEP 2: Determine the fixed cost by subtracting the total variable
cost at either the high or the low activity level from the total cost at
that activity level.

• Example:

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Quick check 6

 Byrnes Company accumulates the following data

concerning a mixed cost, using units produced as the
activity level.

a) Compute the variable- and fixed-cost elements using

the high-low method.
b) Estimate the total cost if the company produces 8,000
units.
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 Quick check 7

The following information for advertising and sales has been established over the past
six months:
Month Sales revenue Advertising exp.
$’000 $’000
1 155 3
2 125 2.5
3 200 6
4 175 5.5
5 150 4.5
6 225 6.5
Using the High – Low method which of the following is correct equation for linking
advertising and sales from the above data?

A. Sale revenue = 62,500 + (25 x advertising expenditure)

B. advertising expenditure = -2,500 + (0.04 x Sale revenue)
C. Sale revenue = 95,000 + (20 x advertising expenditure)
D. advertising expenditure = -4,750 + (0.05 x Sale revenue)

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Scatterplot Method

X
X X X
Material Handling Cost

X X X
X
X X
X X
X X
X
X
X

Number of Moves

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 Method of Least Squares
 The best-fitting line is the line with the smallest sum of
squared deviations
 Regression analysis determines the linear function with
the minimum sum of squared deviations
X
X X X
Material Handling Cost

X X X
X
X X
X X
X X
X
X
X

Number of Moves
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Method of Least Squares

n∑XY -∑X∑Y
Y b = -----------------
n∑X2 – (∑X)2
Total Mixed Cost

Y1 = a + bx1
slope b ---
Yn = a +bxn
a
X
Volume of output

a = (∑y - b∑x)/n

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 Quick check 8

If ∑x = 100, ∑Y = 400, ∑X2 = 2,040, ∑Y2 = 32,278, ∑XY

= 8,104 and n = 5 which of the following values for a and
b are correct in the formula Y = a + bX?
a b
A 28 -2.6
B 28 +2.6
C -28 -2.6 n∑XY -∑X∑Y
D -28 +2.6 b = -----------------
n∑X2 – (∑X)2

a = (∑y - b∑x)/n

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Reliability of regression line

Goodness of fit

 R is the Correlation Coefficient

 Measure the degree of correlation between two variables.
 Must always fall between +1 and –1.
 Two variables are said to be correlated if a change in the value of
one variable is accompanied by a change in the value of another
variable.

n∑XY -∑X∑Y
R= ----------------------------------
[n∑X2 – (∑X)2] [n ∑Y2 – (∑Y)2]

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 Quick check 9

The following four data pairs have been

obtained: (1,5), (2,6), (4,9), (5,11). Without
carrying out any calculation, which of the
following correlation coefficients best describes
the relationship between x and y?
A -0.98
B -0.25
C 0.98
D 0.25

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Perfect correlations

Positive correlation Negative correlation

x
x
x x
x
x
x
x
x
x

r=+1 r=-1

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 Partial correlations

Positive correlation Negative correlation

x
x
x x x x
x
x x x x
x
x x x x
x x
x x x
x

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No correlations

x
x
x x x
x x x
x x x
x
x
x x
x x
x

r=0

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 Reliability of regression line

Goodness of fit

 R2 is the coefficient of determination

 Measures the proportion of the total variation in the value of one
variable that can explained by variations in the value of the other
variable
 The closer to 100%, the better; no benchmark
 86.29% of the total variation in the value of (Y) material
handling costs could be explained by variance in value of
(X) number of moves.

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Quick check 10
Using data from 12 European countries, it has been calculated that the
correlation between the level of car ownership and the number of road
deaths is 0.73. Which of the statements shown follow from this?
 (i) High level of car ownership cause high levels of road deaths
 (ii) There is a strong relationship between the level of car ownership
and the number of road deaths
 (iii) 53% of the variation in the levels of road deaths from one country
to the next can be explained by the corresponding variation in the
level of car ownership
 (iv) 73% of the variation in the levels of road deaths from one country
to the next can be explained by the corresponding variation in the
level of car ownership
A (i) and (ii) only
B (i) and (iii) only
C (ii) and (iii) only
D (ii) and (iv) only

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 Quick check 18

A regression equation Y = 3 + 2X has been calculated from 6 pairs of

values, with X ranging from 1 to 10. The correlation coefficient is 0.8. It is
estimated that Y = 43 when X = 20. Which of the following are true?
(i) The estimate is not reliable because X is outside the range of the data
(ii) The estimate is not reliable because the correlation coefficient is low
(iii)The estimate is reliable
(iv)The estimate is not reliable because the sample is small
A (i) and (ii) only
B (i) and (iii) only
C (ii) and (iv) only
D (i) and (iv) only

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Time Series Analysis

 Evaluates data over time to

identify the trend and variations.

 Variations may be computed as

an additive or multiplicative
model.

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 Trend (T)

Methods to find trend:

 Regression analysis
 Moving averages

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Moving Average - Illustration

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 Time Series Model

Additive model: TS = T + SV
or
Multiplicative model: TS = T × SV
 The difference is how the variation is expressed (absolute or
relative to trend).

TS = time series value

T = trend
SV = Seasonal variation

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Seasonal variation illustration

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 Quick check 19

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Quick check 20

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 Index numbers

 An index measures the average changes in the values,

prices or quantities of a group of items.

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Price indices

Laspeyres price index Paasche price index

 Base weighted index  Current weighted index
 Tends to overstate  Tends to understate
inflation inflation

Fisher’s ideal index = Laspeyres x Paasche

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 Quick check 21

A country measures the rate of inflation using a base weighted index, with 20X1being
the base year. Three different products are used in the index. The unit prices of these
and the quantities purchased (units of each product) are shown below.
What is the weighted average price rise between 20X1and 20X2, using the country’s
base weighted index?

A. 20.0%
B. 24.0%
C. 24.3%
D. 77.2%

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Quick check 22

The following information is available for the price of materials used at P Co.
Laspeyre index for price in 20X5 (with base year of 20X0) 150.0
Corresponding Paasche index 138.24

What is Fisher’s ideal index?

A. 12.00
B. 16.98
C. 144.00
D. 288.24

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 Quick check 23

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End of chapter 1

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