Cost and management accounting

The nature of good information

‘Data’ means facts. Data consists of numbers, letters, symbols, raw facts, events and
transactions which have been recorded but not yet processed into a form suitable for
use. Information is data which has been processed in such a way that it is meaningful to
the person who receives it (for making decisions).

Attributes of good information

Information is provided to management to assist them with planning, controlling
operations and making decisions. Management decisions are improved when they are
provided with better quality information.

Accurate
• The degree of accuracy depends on the reason why the information is
needed.

Complete.
• Managers should be given all the information they need, but information
should not be excessive.
• For example, a complete control report on variances should include all
standard and actual costs necessary to aid understanding of the
variance calculations.

Costeffective
• The value of information should exceed the cost of producing it.
• Management information is valuable, because it assists decision making.

Understandable
• Use of technical language or jargon must be limited. Accountants must always be
careful about the way in which they present financial information to nonfinancial
managers.

Relevant
• Use of technical language or jargon must be limited. Accountants must always be
careful about the way in which they present financial information to nonfinancial
managers.
The managerial processes of planning, decision making and
Control

The main functions that management are involved with are planning,
decision making and control

Planning
Planning involves establishing the objectives of an organisation and
formulating relevant strategies that can be used to achieve those objectives. In order to
make plans, it helps to know what has happened in the past so that decisions about
what is achievable in the future can be made.
Planning can be either short term tactical planning) or long term (strategic planning).

Decision making
Decision making involves considering information that has been provided
and making an informed decision.
In most situations, decision making involves making a choice between two or more
alternatives. Managers need reliable information to compare the different courses of
action available and understand what the consequences might be of choosing each of
them. The first part of the decision making process is planning, the second part is
control.

Control
Information relating to the actual results of an organisation is reported to
managers. Managers use the information relating to actual results to take control
measures and to reassess and amend their original budgets or plans.
Internally sourced information, produced largely for control purposes, is
called feedback.

Levels of planning
During the planning process the mission statement of a business is used to
produce effective aims and objectives for employees and the company as a
whole. Aims and objectives should be SMART.

By following the SMART hierarchy a business should be able to produce

plans that lead to goal congruence throughout the departments, centres
and/or regional offices (the whole business).
There are three different levels of planning (known as ‘planning
horizons’).These three levels differ according to their time span and the
seniority of the manager responsible for the tasks involved.
Strategic planning
'Strategic planning' can also be known as 'longterm planning' or 'corporate
planning'. It considers: Senior managers formulate longterm objectives (goals) and
plans (strategies) for an organisation as a whole. These objectives and plans
should all be aiming to achieving the company's mission.

Tactical planning
Tactical planning takes the strategic plan and breaks it down into
manageable chunks i.e. shorter term plans for individual areas of the
business to enable the strategic plan to be achieved.

Senior and middle managers make short to medium term plans for the next
year.
Specific – are the objectives well defined and understandable?

Measurable – can achievement of the objectives be measured so that

completion can be confirmed?

Attainable – sometime referred to as achievable. Can the objectives

set be achieved with the resources and skills available?

Relevant – are the objectives relevant for the people involved and to
the mission of the business?

Timed – are deadlines being set for the objectives that are achievable?
Are there any stage reviews planned to monitor progress towards the
objective?

Operational planning
Operational planning involves making day today decisions about what to do next
and how to deal with problems as they arise. All managers are involved in day to
day decisions.

Financial, cost and management accounting

Financial accounting involves recording the financial transactions of an

organisation and summarising them in periodic financial statements for
external users who wish to analyse and interpret the financial position of the
organization
Cost accounting
Managers usually want to know about the costs and the profits of individual
products and services. In order to obtain this information, details are needed for each
cost, revenue, profit and investment centre. Such information is provided by cost
accounting and management accounting systems.
Cost accounting is a system for recording data and producing information about costs
for the products produced by an organisation and/or the services it provides. It is also
used to establish costs for particular activities or responsibility centres.

The role of management accounting within an organisation’s management information

system.

Management information is generally supplied to management in the form of

reports. Reports may be routine reports prepared on a regular basis (e.g.
monthly) or they may be prepared for a special purpose (e.g. ad hoc report).
• annual statutory accounts
• budgets and forecasts
• product profitability reports
• cash flow reports
• capital investment appraisal reports
• standard cost and variance analysis reports
• returns to government departments, e.g. Sales Tax returns.

The limitations of management information

There are a number of respects in which management accounting information may fail
to meet its objective of assisting management in the decision making process.
These can be summarised as follows:
• failure to meet the requirements of useful information
• the problem of relevant costs and revenues
• nonfinancial information
• external information.

Relevant costs and revenues

Not all information produced by an accounting system is relevant to the decisions made
by management. In particular, information produced mainly for financial reporting
purposes and then taken as the basis for management decisions will often need
significant modification to be useful to management.
The principle here is that the figures presented to assist in management decision
making are those that will be affected by the decision, i.e. they should be:

• Accuracy – overestimating costs may result in a decision not to

produce a product which in fact is profitable; on the other hand,
overestimating the price at which the output can be sold may result in
the organisation producing output which cannot be sold in sufficient
volume to be profitable.

• Timeliness – in connection with a decision to close a division or department if the

information is presented to management after a decision had been made to lay off staff
that could have been profitably employed in other divisions or activities, the company
has incurred unnecessary redundancy costs, lost possible future revenues and
demotivated the remaining employees when they learn of the redundancies.

• Understandable – excessive focus by management accountants on more complex

techniques of which general management have little or no knowledge or understanding
may mean that the accountant’s advice will be ignored. There is significant attention
being given to the role of the management accountant as an educator within the
organisation – explaining the information and training general management to help
them to understand the information better.

• Future – costs and revenues that are going to be incurred some time in the future.
Costs and revenues that have already been incurred are known as sunk costs and are
not relevant to the decision to be made.

• Incremental – the extra cost or revenue that is created as a result of a decision taken.
• Cash flows – actual cash being spent or received not monetary items that are
produced via accounting convention e.g. book or carrying values, depreciation charges.

Non-financial information

Managers will not always be guided by the sort of financial and other (hard)
information supplied by the management accounting system. They will also
look at qualitative, behavioral, motivational, even environmental factors.
These nonfinancial factors can be just as important in relation to a decision
as financial information – but they are often more difficult to estimate and
quantify.
Cost classification
A cost object is any activity for which a separate measurement of cost is
undertaken.

Examples of cost objects:

• cost of a product
• cost of a service
• cost of running a department
• cost of running a regional office.

Cost units
A cost unit is a unit of product or service in relation to which costs are
ascertained. Examples of cost units:
Cost centres
• a room (in a hotel)
• a litre of paint (paint manufacturers)
• inpatient (in a hospital).

A cost centre is a production or service location, function, activity or item of

equipment for which costs can be ascertained.
Examples of cost centres:
• a department
• a machine
• a project
• a ward (in a hospital).

Classifying costs
Costs can be classified in a number of different ways.
• Element – classify costs as to whether they relate to material, labour or
expenses. This is useful for cost control.
• Nature – classify costs as to how they relate to production. Are they directly
involved in the production of the product/service or indirectly involved in
production? This is useful for cost accounting.
• Function – classify costs based on whether they are production costs or
nonproduction costs. This is useful for the financial accounts.
• Behaviour – classify costs based on how they change in relation to levels of
output or activity. This is useful for budgeting and decision making.

Classification by element
The cost elements that you need to know about are materials, labour and
expenses. To classify by element you need to decide if a cost is a material
cost, a labour cost or a cost relating to something else – an expense.
• Materials – all costs of materials purchased for production or nonproduction
activities. For example, raw materials, components, cleaning
materials, maintenance materials and stationery.

Classification by nature
Direct costs
Direct costs are costs which can be directly identified with a specific cost
unit or cost centre.
There are three main types of direct cost – direct material, direct labour and
direct expenses. The direct costs associated with a shirt (cost unit)
manufactured by a clothing company would be:
• direct materials – cloth for making shirts
• direct labour – the wages of the workers stitching the cloth to make the
shirts
• direct expenses – the royalties paid to a designer.
The total of direct costs is known as the prime cost.
Indirect costs
Indirect costs are costs which cannot be directly identified with a specific
cost unit or cost centre.
The indirect costs associated with a shirt (cost unit) manufactured by a
clothing company would be:

clothing company would be:

The total of indirect costs is known as overheads.
• indirect materials – these include materials that cannot be traced to an
individual item for example cleaning fluids for cleaning the machinery
• indirect labour – the cost of a supervisor who supervises the shirt
makers
• indirect expenses – the cost of renting the factory where the shirts are
Manufactured
The total of indirect costs is known as overheads

5 Classification by function
Production costs
Production costs are costs that relate to the manufacture of a product or provision of a
service. These cost as are found in the cost of sales section of the statement of profit or
loss.Production costs, such as direct materials, direct labour, direct expenses
and production overheads, are included in the valuation of inventory

Non production costs

These are costs that are not directly associated with the production of the businesses
output,costs, such as administrative costs, selling costs and finance costs, are charged
to the statement of profit or loss as expenses for the period in which they are incurred.
Non-production costs are not included in the valuation of inventory.

Classification by behaviour
Costs may be classified according to the way that they behave in relation to changes in
levels of activity. Cost behaviour classifies costs as one of the following:
Variable costs
• variable cost
• fixed cost
• stepped fixed cost
• semivariable cost.
Variable costs are costs that vary in direction proportion with the level of
activity. As activity levels increase then total variable costs will also increase.

• Note that as total costs increase with activity levels, the cost per unit of
variable costs remains constant.
• Examples of variable costs include direct costs such as raw materials
and direct labour.

Fixed costs
A fixed cost is a cost which is incurred for an accounting period, and which,
within certain activity levels remains constant.

Note that the total cost remains constant over a given level of activity but
that the cost per unit falls as the level of activity increases.
• Examples of fixed costs:
– rent
– business rates
– executive salaries.

Stepped fixed costs

This is a type of fixed cost that is only fixed within certain levels of activity.
Once the upper limit of an activity level is reached then a new higher level of
fixed cost becomes relevant.

Examples of stepped fixed costs:

– warehousing costs (as more space is required, more warehouses
must be purchased or rented)
– supervisors’ wages (as the number of employees increases, more
supervisors are required).

Semi-variable costs

These are costs contain both fixed and variable cost elements and are
therefore partly affected by changes in the level of activity.

Examples of semi-variable costs:

– electricity bills (fixed standing charge plus variable cost per unit of
electricity consumed)
– telephone bills (fixed line rental plus variable cost per call).

The high/low method used for separating a semi-variable Cost

Variable cost/unit= high cost - low costs

High units – low units

The total cost of a semi-variable cost is:

Total costs = Total fixed costs + (Variable cost per unit × Activity level)
Question
Output (units) Total cost ($)
200 7,000
300 8,000
400 9,000

Required:
(a) Calculate the variable cost per unit.
(b) Calculate the total fixed cost.
(c) Estimate the total cost if output is 350 units.
(d) Estimate the total cost if output is 600 units.

Question 2

The total costs incurred at various output levels in a factory have been
measured as follows: components.
Output Total
(units) cost
($)
26 6,566
30 6,510
33 6,800
44 6,985
48 7,380
50 7,310

Required:
Using the high/low method, analyz the total cost into fixed and variable