1 Managerial Accounting Fundamentals

Managerial Accounting

Managerial accounting is the branch of accounting that provides financial information to managers for their use in making decisions. When managerial accountants provide this information for internal use only and it is not included in external financial reports, they do not need to follow generally accepted accounting principles (GAAP). However, external financial reports do contain some information that managerial accountants, such as the value of inventories and cost of goods sold. If the information is used externally, it should be GAAP-compliant.

Managerial accounting is used in planning, implementing, and controlling operations. Managerial accountants prepare budgets, calculate costs, provide information for both short- and long-term decisions, evaluate the performance of the firm and its employees, and analyze data.

This book focuses on planning, costing, and operations. Students using this book should have previously completed an introductory managerial accounting course. This book will review topics from the introductory level that need little expansion, elaborate on other topics from the introductory level, and introduce new topics as well. The book is not intended to be a comprehensive study of every function performed by managerial accountants; rather, it is intended to teach concepts and tools used by managerial accountants so students can learn how managerial accountants think and operate.

In this chapter, we will review vocabulary you may have learned in your introductory-level course and cover some basic concepts that we’ll use again and again throughout this book.

Vocabulary Review

You should have learned the meaning of the following terms in an introductory accounting course. To review, and to ensure you are using these terms in the same way that they are used in this book, make sure you know the following definitions:

• Actual cost: A cost actually incurred, as opposed to a budgeted or standard cost
• Average cost: Total cost divided by number of units
• Budgeted cost: Predicted cost
• Conversion costs: Direct labor cost plus manufacturing overhead cost
• Cost: Something of value given up to achieve an objective
• Cost allocation: Spreading a common cost among cost objects in a systematic way
• Cost allocation base: A measure that is used to allocate costs to cost objects; the cost is allocated in proportion to the amount of cost allocation base used by each cost object
• Cost object: Something one is trying to find the cost of
• Cost of goods manufactured: The cost of goods completed during a period
• Cost of goods sold: The cost of goods sold during a period
• Direct cost: A cost that can be easily traced to a cost object
• Direct labor: Manufacturing labor costs that can be easily traced to the product
• Direct materials: Materials costs that can be easily traced to the product
• Expense: A cost that is recognized on the income statement during a period
• Finished goods inventory: Inventory of goods that are completed but not yet sold
• Fixed cost: A cost that does not change, in total, when production changes
• Indirect cost: A cost that cannot be easily traced to a cost object
• Indirect labor: Manufacturing labor costs that cannot be easily traced to the product
• Indirect materials: Materials costs that cannot be easily traced to the product
• Manufacturing overhead: All indirect manufacturing costs
• Net income: All revenues minus all expenses, including tax (after-tax income)
• Operating income: Operating revenues minus operating expenses (before tax)
• Period cost: A cost that is expensed in the period incurred, usually non-manufacturing
• Product cost: A cost associated with manufacturing the product
• Profit: Revenues minus expenses (income)
• Raw materials inventory: Inventory of materials used to produce the company’s goods
• Revenues: Inflows of assets received from customers in exchange for products or services
• Unit cost: Total cost divided by number of units
• Variable cost: A cost that changes, in total, when production changes
• Work-in-process inventory: Inventory of goods for which production is incomplete

Costing Systems: Theory

One of the most important jobs of a managerial accountant is to determine the cost of a firm’s products. In a merchandising firm, the cost of products is not difficult to determine—it is just the purchase price of those goods. In a manufacturing firm, however, goods are made, not purchased. So a manufacturing firm needs to use a product costing system to attach costs to goods. In this book, we will cover three kinds of product costing systems: job costing, process costing, and activity-based costing.

Under generally accepted accounting principles (GAAP), the matching principle requires that the cost of the firm’s products should not be expensed until the goods are sold. Until that time, the goods are held in inventory—first work-in-process inventory until the goods are completed, then finished goods inventory after the goods are completed and until they are sold. While the goods are held in inventory, the firm reports the costs attached to those goods on the balance sheet as the value of the inventories they are held in. When the goods are sold, the firm reports the costs attached to them as an expense on the income statement as cost of goods sold.

What costs should be attached to the firm’s products and go through this inventory cycle? GAAP requires that all the costs involved in manufacturing the products should be attached to them. Manufacturing costs can be divided into three categories: direct labor, direct materials, and manufacturing overhead. Direct labor and direct materials are costs that can be traced to the products, while manufacturing overhead consists of all other manufacturing costs that cannot be directly traced to the products, such as indirect labor, indirect materials, manufacturing supervisors’ salaries, factory equipment depreciation, and the cost of rent, insurance, and utilities for the space used to manufacture the goods.

Period costs, which are all costs other than manufacturing costs, are not part of the product costing system and do not go through the inventory cycle. Instead, they are expensed immediately, in the period in which they are incurred. Any costs that are part product and part period, such as the cost of a building containing both manufacturing and office space, should be split between the two categories, so that the manufacturing portion of the cost goes through the inventory cycle and the non-manufacturing portion is expensed immediately.

Costing Systems: Method

To attach costs to goods in a product costing system, we must identify the costs that go through the product costing system and separate them from the period costs that do not go through the product costing system.

First, classify the firm’s costs as indirect product costs (manufacturing overhead), direct product costs (direct labor and direct materials), or period costs (non-manufacturing costs).

Next, calculate total manufacturing overhead costs, total costs that should go through the product costing system, and total period costs. Remember that the total costs that should go through the product costing system should include both direct and indirect manufacturing costs; in other words, include manufacturing overhead, direct labor, and direct materials.

Illustrative Example: Costing Systems

Montana, Inc. spent $80,000 on direct labor and $74,000 on direct materials this month. In addition, they spent $18,000 on manufacturing supervisory salaries and $1,000 on indirect materials. Depreciation on the building totaled $15,000, and utilities and insurance costs for the building totaled $5,000. The building houses both manufacturing space and office space; the office takes up 20% of the total space in the building, and the rest is used for manufacturing. Depreciation on factory equipment was $7,000, and depreciation on office furniture and equipment was $1,500. Miscellaneous factory overhead totaled $11,000. Montana also spent $12,000 on selling expenses and $30,000 on administration.

Find total manufacturing overhead costs, total costs that should go through the product costing system, and total period costs.

Manufacturing overhead consists of all indirect costs related to manufacturing the product. While direct labor and direct materials are manufacturing costs, they are direct, so they should not be included. The indirect manufacturing costs are as follows:

Direct manufacturing costs consist of direct labor and direct materials:

All manufacturing costs consist of all costs that go through the product costing system, so that includes both direct manufacturing costs and manufacturing overhead:

Finally, period costs consist of all non-manufacturing costs: