Previous chapters focused on the financial accounting system, whose main purpose is to prepare general-purpose financial statements. However, this information is incomplete for internal decision makers who manage organizations. This chapter discusses the purpose of managerial accounting, cost concepts, and reporting of manufacturing activities. We also look at how these concepts help managers gather, organize, and use this information.
The purpose of both managerial and financial accounting is providing useful information to decision makers. Both areas of accounting report monetary information, although managerial accounting includes the practice of reporting non-monetary information. The focus of managerial and financial accounting are different, however.
Planning is the process of setting goals and making plans to achieve them. Strategic plans usually set a firm’s long-term direction by developing a road map based on opportunities such as new products, new markets, and capital investments. Medium- and short-term plans are more operational in nature. They translate the strategic plans into actions. A short-term plan often covers a one-year period that, then translated into monetary terms is knows as a budget.
Control is the process of monitoring planning decisions and evaluating an organization’s activities and employees. It includes the measurement and evaluation of actions, processes, and outcomes. Feedback provided by the control system allows managers to revise their plans and take corrective actions to avoid undesirable outcomes.
Here we see a detailed comparison of financial accounting and managerial accounting. In addition to the focus on internal decisions, note particularly that managerial accounting information may follow a flexible format, involves frequent, timely reports, and may contain more estimates and projections than financial accounting.
By meeting customer needs in an efficient manner, a lean business model provides a positive return to its owners. Today’s customers have many choices, both domestic and foreign. To be successful, a business must deliver quality products and services to customers in a cost efficient manner.
Lean business practices include total quality management and just-in-time manufacturing. The central focus is always on the customer.
Continuous improvement rejects the notion of “good enough” or “acceptable” and challenges employees and managers to continuously experiment with new and improved business practices. This has led to adopting practices such as total quality management and just-in-time manufacturing.
Total quality management focuses on quality improvement and applies this standard to all aspects of business activities. Awards such as the Malcolm Baldrige National Quality Awards encourage an emphasis on quality.
A just-in-time manufacturer acquires inventories and produces goods only when needed. Companies manufacture products only after they receive an order (a demand-pull system) and then deliver the customer’s requirements on time.
Managerial accounting has an important role to play by providing accurate cost and performance information. Companies must understand the nature and sources of cost and develop systems that capture costs accurately. Developing such a system is important to measuring the “value” provided to customers. The price that customers pay is an important determinant of value. In turn, the costs a company incurs are key determinants of price. All else being equal, the better a company is at controlling its costs, the better its performance.
Managers often need different cost classifications for different decisions. We will discuss each of these types of cost classifications individually.
Classification of costs by behavior is helpful in cost-volume-profit analyses and short-term decision making. These are discussed in future chapters.
The upper chart shows that a fixed cost does not change when an activity changes. For example, rent for Rocky Mountain Bikes’ building is $22,000 and doesn’t change with the number of bikes produced.
The lower chart shows that variable costs increase as activity increases. For example, the cost of bicycle tires is variable with the number of bikes produced
Cost objects may be products, services, departments, or customers to which costs are assigned
Managers at higher levels in the organization have a greater degree of control over costs than do managers at lower levels in the organization. Classifying costs by controllability is an important part of assigning cost, responsibility, and evaluating a manager’s cost control performance.
Costs can be classified by relevance by identifying it as a sunk cost or an out-of-pocket cost
Opportunity costs are always relevant to a selection decision.
Product costs are incurred to manufacture a product. Product costs are not expensed as they are incurred. Instead, they are assigned to inventory and do not become expenses until the product is sold. Inventory is reported at cost as an asset on the balance sheet.
Period costs are expensed in the period incurred. They are non-manufacturing costs usually grouped into two broad categories: selling and administrative.
Starting on the left side of this flow chart of costs, we see that costs incurred are categorized as either period costs or product costs. Period costs flow directly to the current year’s income statement as they are expensed in the period incurred. Product costs are first assigned to the inventory account. Later, when the inventory is sold, product costs flow from the inventory account to cost of goods sold on the income statement for the year in which the products are sold.
Here we see examples of costs classified according to three of the means that we have discussed: behavior, traceability, and function.
While our primary focus has been on manufacturing companies, we should realize that the same cost concepts also apply to service companies such as airlines and hotels.
Merchandisers buy goods that are already completed and make them available to customers. Manufacturers buy raw materials and convert the raw materials into completed goods for their customers.
Manufacturers have three major inventory categories: raw materials, goods in process, and finished goods.
Raw materials can be direct or indirect. Direct materials are used directly in a product. Materials not clearly identified with a specific units or batches of product are indirect materials.
Inventory is a current asset on the balance sheet. Manufacturers have three major categories of inventory: raw materials, goods in process, and finished goods.
The finished goods inventory of a manufacturer is the equivalent of a merchandiser’s merchandise inventory account. Items in this inventory account are complete and awaiting sale. The major difference is that the manufacturer manufactures the items in the finished goods account, while the merchandiser buys the items in the merchandise inventory account. When items are sold from these inventory accounts, the cost of inventory, whether purchased or manufactured, becomes cost of goods sold on the income statement.
The inventory cost flows are similar for both merchandisers and manufacturers. Beginning inventory plus additions equals goods available for sale. Subtracting ending inventory from goods available for sale results in cost of goods sold.
Direct materials can be separately and readily traced to the individual units of product being manufactured. Direct materials are sufficiently significant in amount to justify the separate tracing.
Direct labor is the effort of employees who actually convert materials into a finished product. Direct labor costs are the wages of direct labor employees. Direct labor costs can be separately and readily traced to the individual units of product being manufactured.
Factory overhead is all manufacturing costs other than direct material and direct labor. Factory overhead costs are indirect manufacturing costs that support the major manufacturing activities. As indirect costs, they cannot be separately and readily traced to the individual units of product.
Direct labor and direct material are called the prime costs of manufacturing. Direct labor and manufacturing overhead are called conversion costs.
Take a minute and answer the next two questions before we proceed.
Goods in process is one of the three manufacturing inventory accounts. Inventory is a current asset on the balance sheet.
Here is your second question.
Product costs are assigned to inventory until the products are sold. Choice b is tempting, but remember that factory overhead is an indirect product cost.
Starting on the left side of this flow chart, we see that material purchases are combined with the materials beginning inventory. Materials are then either used or they remain in inventory. In the center portion of the flow chart, we see the materials being used are combined with labor, overhead, and the goods in process beginning balance. As goods are finished, they are transferred out of the goods in process inventory account into the finished goods inventory account. The cost of the goods finished in the period is called cost of goods manufactured. Finished goods are either sold, called cost of goods sold, or they remain in the finished goods inventory account.
The production activities in the center portion of the preceding flow chart can be summarized in a manufacturing statement. The three product costs are totaled and added to the beginning balance of the goods in process inventory account. Subtracting the ending balance of the goods in process account from this total results in the cost of goods manufactured for the period.
The information for Rocky Mountain Bikes is taken from your textbook.
Here you see the manufacturing statement for Rocky Mountain bikes in a highly summarized form. We will build each of the major parts of the statement starting with materials.
Material purchases for the current year are added to the beginning balance of materials inventory. The beginning balance of materials inventory for the current year is the ending balance of materials inventory from last year. Materials are either used or they remain in inventory. Subtracting the amount of materials on hand in inventory at the end of the year results in the cost of materials used for the current year.
Direct labor costs are the wages of direct labor employees who actually convert materials into a finished bike.
Factory overhead costs are indirect manufacturing costs that support the manufacturing activities. The eight factory overhead items in this example, totaling thirty thousand dollars, are commonly encountered in many manufacturing companies.
Total manufacturing costs for the current period are added to the beginning balance of goods in process. The beginning balance of goods in process for the current year is the ending balance of goods in process from last year.
Subtracting the ending balance of the goods in process account from the total cost of goods in process results in the cost of goods manufactured for the current year. Cost of goods manufactured is cost of goods completed and transferred to finished goods for the current year.
Now that we have mastered some of the basic concepts and principles of managerial accounting, we are ready to put this knowledge to work.