introduces you to some of the basic managerial accounting concepts you will use
for the remainder of the course. The introduction to management accounting
begins with an overview of the design requirements of a managerial accounting
system. The system must allocate decision-making authority over a company's
resources. Second, it must furnish the information to support decision-making by
managers. Finally, the system must generate the information needed to evaluate
and reward performance.
Managers deal with the operations of the business, and with
information that is internal to the business. We call this operating
information. It involves things like product costing information, payroll
information and other sensitive or confidential information. For this reason,
operating information is not released to the public, but is used by managers to
improve business performance, and ensure the objectives of the company.
Manufacturing costs are first classified into direct material, direct labor
and manufacturing overhead. With these definitions established, we introduce the
critical distinction between product and period costs. This discussion in turn
lays the foundation for introducing the manufacturing inventory accounts: raw
materials, work-in-process, and finished goods.
The flow of costs through the inventory accounts is explained with the help
of an extended illustration. The example includes a detailed analysis of the
process of applying overhead using a predetermined rate. The text explains both
the mechanics and the rationale underlying overhead application at this point,
and calls attention to the potential weaknesses of volume based applications
that will be addressed in later chapters.
The chapter closes with the development of financial statements for a
manufacturing company. The schedule of cost of goods manufactured is introduced
as a supplement to the financial statements intended to assist managers in
evaluating the overall costs of manufactured products.
Management (or managerial) accounting is intended to fulfill a large number of
requirements. Financial accounting is intended to meet the needs of outside
users of financial information, and follows GAAP. Management accounting is
intended to satisfy the various needs of a large group of decision-makers inside
the business, and does not follow GAAP.
A single set of financial statements satisfies the requirements of GAAP, but
management accounting reports can be tailored for any situation and user. The
form and format can vary widely, depending on the type of decision being
You first need to learn to use a few basic concepts. After that, those
concepts can be modified in an almost infinite number of ways to analyze
business information, and make operating decisions.
A company's audited financial statements look backwards in to the prior year
or years. But managers have to make decisions today, that affect the present and
the future. Financial statements that are a year or more old are not very useful
for the daily decisions managers have to make. They are more interested in
current operating information, and projections about the future. They are also
concerned with setting goals, measuring progress and achievement, eliminating
waste, complying with government regulations, and a much, much more.
An accounting system is often organized into accounting cycles. These
cycles are connected and interrelated. Costs flow the product costing system as
illustrated in your text, and as described below.
||The Purchase/Payments cycle includes purchasing raw materials and
supplies as needed, and paying the bills when they come due.
||The Payroll cycle includes scheduling employees for production
and paying them on regular intervals.
||The Production cycle includes collecting materials, labor and
overhead costs into an inventory cost pool called Work in Process. Once
completed the product costs are transferred to Finished Goods inventory
until the goods are sold.
||Finally in the Sales/Receipts cycle sales are recorded when goods
are sold, and Finished Goods costs are transferred to Cost of Goods
Sold. Customers are billed and receipts are recorded when received.
Separating the accounting process lets us assign different people to
different tasks. Many companies have large Accounts Payable, Accounts Receivable
and Payroll departments, not to mention huge Production departments and many
sales people. Separating activities into accounting cycles helps us understand
and apply managerial controls to these activities.
Accounting Cycles are connected and interrelated.
We study manufacturing environments because they are some of the most complex
business environments. What we learn here can easily be transferred to other,
less complex, situations. Management accounting is really much easier than
financial accounting. We classify all costs as either manufacturing or
We separate manufacturing costs into three categories:
Manufacturing costs relate to making a product.
Direct Materials (DM) - raw materials and parts, directly traceable
to the product. Materials must attach themselves to, and become part of, the
finished product to be considered Direct Materials.
Direct Labor (DL) - wages and other payroll costs of the employees
that directly work to convert Direct Materials into finished products. These
costs are directly traceable to the product.
Manufacturing Overhead (OHD) - all the other costs related to
producing products that don't qualify as Direct Materials or Direct Labor.
Picture a manufacturing plant and all the costs of the plant. Now subtract DM
and DL. Everything that's left is Overhead. These costs are indirectly
traceable to the product.
Some costs are specifically not manufacturing costs, and therefore not DM, DL or
OHD. These are costs not related to the manufacturing plant or producing the
product. The include the following two categories:
The costs associated with selling the product are Selling Costs
include sales salaries and commissions, advertising, stores and their related
fixtures and equipment.
General and Administrative Costs
The costs associated with the central management and home office of a company,
and general costs of being incorporated, are classified as General and
Administrative (GA) costs. This includes buildings, offices, equipment,
salaries, etc. that are part of the administrative arm of the business, provided
these costs can't be traced directly or indirectly to the manufacturing
Some costs don't have any future value, and only relate to the current period.
These include Selling costs and GA costs. Other period costs include income
taxes and interest expense.
There are three classifications of inventory
- raw materials and parts used in producing goods
Work in process inventory
(WIP)- all partially completed goods, not
ready for sale
Finished goods inventory
- all completed goods ready for sale
We say that costs "flow" though a company. This means that we collect costs in
the books in certain accounts, and transfer those costs to other accounts, in a
way that resembles how those costs are actually incurred in the manufacturing
In general here is the way costs flow through an accounting system:
|Direct Materials >
Direct Labor ==>
Mfg Overhead =>
|Work in Process =>
||Cost of Goods Sold
These are the actual accounts that will be debited and credited in a
way that approximates the way costs are actually incurred in the production
process. These accounts are all debited to increase the account, and credited to
decrease the account.
To move costs along we debit the account the cost is moving into, and
credit the account the cost is moving from. Total cost increases as it
moves along, just like a snowball gets bigger as you roll it around in the snow.
As goods move through the manufacturing process they pick up all the related
costs along the way. Materials and labor are added as the goods are worked on,
and overhead is added along the way.
Let's look at how one unit of product picks up costs in its journey through
the production process. Amalgamated Widget, Inc. produces a variety of widgets
for home and commercial use. The production manager requisitions raw materials,
from the Materials inventory. Materials inventory account is credited and the
costs are transferred to the Work in Process inventory account.
Work is started in the shaping and forming department. Labor is added at this
point by crediting Direct Labor and debiting Work in Process inventory. After
the widgets are formed, they go to the finishing department. The appropriate
finish is applied and the finished widget is sent to the packing department,
where it is prepared for shipment. Additional Materials and Direct Labor costs
are added to Work in Process in the finishing and packing departments.
Overhead is added to the product cost at each stage of the operation by
debiting Work in Process inventory and crediting the Overhead account. We will
discuss Overhead allocation more in a moment.
At this point the product is complete and ready for sale. The final cost is
transferred to the Finished Goods inventory account. When the item is sold the
cost will then be transferred to the Cost of Goods Sold account.
The total cost of producing a widget accumulates as the widget moves along
though the production process.
Unit Product Costs
The word "unit" comes from the Latin unus, meaning one. The Spanish word
uno comes from the same Latin root, and also means one. A Unit Cost is
the cost of producing one unit of product. We might break that down into its
component parts - labor, materials & overhead - perhaps in great detail.
Manufacturing companies usually make a large quantity of products at a time.
Each batch of product may be thousands of units. In some cases production is
done on an assembly line, and there is little distinction between departments,
aside from those arbitrarily determined by management.
Ultimately the company must set a selling price for its goods. Since goods
are sold one at a time, the company must determine the total cost of
producing a single unit of goods. Unit costs are tracked throughout the
production cycle in some accounting systems. In other cases, unit costs are
determined at the end of production, after all costs of production have been
accumulated and the finished units have been counted.
It is important that you clearly distinguish between unit costs and total
costs, in your mind, at all times in this class.
Overhead consists of a large number of separate costs related to the
manufacturing process. They are collected in a single account and allocated to
the product cost using what is called an overhead application rate.
The overhead application rate is simply a way to divide the total overhead
costs for a year, across all the units of goods produced that year. Here's the
Total Annual Overhead Costs
Overhead Cost Driver
The overhead cost driver, is something related to production that can be used
to help spread the total cost evenly to individual units of product. Sometimes
that is simply the number of units of products produced in a given year. At
other times that's not the best measure to use. For instance, hot dogs are
produced by the tens-of-thousands per day, packed into boxes and sold by the
palette load. The overhead cost applied to one hot dog would be a very small
amount, and not very relevant to managers. They will apply overhead costs in a
way relevant to the decisions they need to make.
Allocating overhead using labor hours
Labor hours are often used as a cost driver, to apply overhead. Total overhead
costs are divided by total estimated labor hours to come up with a dollar rate
per labor hour. Each time labor is recorded, a corresponding amount of overhead
can also be allocated and recorded (transferred to WIP).
Advantages of using labor hours:
Tends to be a predictable & steady amount
Different pay rates among employees is irrelevant
Labor hours are closely related to production, so should be an accurate measure
Let's look at an example. The company estimates it will have 100,000 labor
hours and spend $200,000 in overhead costs. The company records 8,300 labor
hours this month. Their overhead allocation is:
$200,000 / 100,000 hours = $2 per labor hour x 8,300 hours = $16,600
The company would transfer $16,600 from the Overhead account to Work in
Process for the month's production.
Allocating overhead using labor dollars
Some very large companies allocate overhead using labor dollars, because they
have a large work force, and their total labor dollars tends to be a predictable
amount. They may be operating under a labor contract. They may have a large and
wide-spread work force.
Overhead costs are allocated in much the same manner as above, except that
labor dollars would be used, instead of labor hours.
Other Overhead Allocation Methods
Some companies use other allocation methods for overhead. Whatever method is
used should be a reliable and predictable method, where a cost driver or
reasonable cause and effect relationship can be found between costs and
Overhead costs are allocated using journal entries, which means that these
managerial accounting entries will also affect the audited financial statements
released to outsiders. The allocation method will come under the scrutiny of the
company's auditors, so it should be a reasonable method that complies with GAAP.