2 -1

CHAPTER
Basic
Management
Accounting
Concepts
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Objectives
1. Describe the cost assignment process.
Afterand
2. Define tangible studying this products and
intangible
explain whychapter, youdifferent
there are should product cost
definitions. be able to:
3. Prepare income statements for manufacturing
and service organizations.
4. Outline the differences between functional-
based and activity-based management
accounting systems.
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Objectives

1
Describe
the cost assignment process
 Cost Assignment: Direct Tracing, Driver 2 -4

Tracing, and Allocation

1. To study management accounting, it is necessary to
understand the meaning of cost and the associated
cost terminology.
2. Assigning costs to products, services, customers,
and other objects of managerial interest is one of the
principal objectives of a management accounting
information system.
3. Increasing the accuracy of cost assignments
produces higher-quality information, which can then
be used to make better decisions.
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CostI see… It’s aordollar

is the cash cash-equivalent value
sacrificed for goods
measure of the and services that is
expected to bring
resources used atocurrent orExactly
future what is
benefit atogiven
achieve meant by “cost”?
the organization.
benefit.
 2 -6

Opportunity cost is the benefit given up or

sacrificed when one alternative is chosen over
another.
Example: A firm may invest $100,000 in inventory for a year
instead of investing the capital in a productive
investment that would yield a 12 percent rate of return.
The opportunity cost of the capital tied up in inventory
is $12,000 (0.12 X $100,000) and is part of the cost of
carrying the inventory.

Expense: Expired costs are called expenses. In

each period, expenses are deducted from revenues
in the income statement to determine the period's
profit.
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A cost object is any item such as products, customers,

departments, projects, activities, and so on, for which
costs are measured and assigned.
Activities not only act as cost objects but also play a
prominent role in assigning costs to other cost objects.
Example: A bicycle is a cost object when you are determining
the cost to produce a bicycle.

An activity is a basic unit of work performed within an

organization.
Example: Setting up equipment, moving materials,
maintaining equipment, designing products, etc.
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Accuracy of Assignment:
The notion of accuracy is not evaluated based on
knowledge of some underlying "true" cost. Rather,
it is a relative concept and has to do with the
reasonableness and logic of the cost assignment
methods used. The objective is to measure and
assign, as well as possible, the cost of the resources
consumed by a cost object.

Distorted cost assignments can produce erroneous

decisions and bad evaluations.
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Traceability is the ability to assign a cost to a cost

object in an economically feasible way by means of a
cause-and-effect relationship.
Cost Classification
It is possible for a particular cost item to be classified
as both a direct cost and an indirect cost.

Management accounting systems typically deal with

many cost objects.
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Methods Tracing
Tracing costs to cost objects can occur in one of two
ways: (1) direct tracing or (2) driver tracing.
(1) Direct Tracing: is the process of identifying and assigning
costs that are exclusively and physically associated with a
cost object to that cost object.
(2) Driver Tracing: is the use of drivers to assign costs to cost
objects. In a cost assignment context, drivers are observable
causal factors that measure a cost object's resource
consumption.
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Traceability

Direct costs are those costs that can be easily

and accurately traced to a cost object.

Example: If a hospital is the cost object,

the cost of heating and
cooling the hospital is
a direct cost.
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Indirect costs are those costs that cannot be easily and

accurately traced to a cost object.
Example: The salary of a plant manager, where
departments within the plant are defined
as the cost objects.
Allocation
Indirect costs are those costs that cannot be assigned
to cost objects using either direct or driver tracing.
This means that no causal relationship exists between
the cost and the cost object or that tracing is not
economically feasible. Assignment of indirect costs to
cost objects is called allocation. Since no causal
relationship exists, allocating indirect costs is based on
convenience or some assumed linkage.
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Tracing is the actual assignment of costs to a cost

object using an observable measure of the resources
consumed by the cost object. Tracing costs to cost
objects can occur in the following two ways:
Direct tracing is the process of identifying and assigning
costs that are exclusively and physically associated with a
cost object to that cost object.
Driver tracing is the use of drivers to assign costs to cost
objects. Drivers are observable causal factors that
measure a cost object’s resource consumption.
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Three Method of Assigning Cost to cost object

Direct tracing
The most accurate; it relies on physically observable, exclusive causal
relationships.
Driver tracing
Driver tracing, in terms of cost assignment accuracy, follows direct
tracing. Driver tracing relies on causal factors, called drivers, to assign
costs to cost objects. The accuracy of driver tracing depends on the
quality of the causal relationship described by the driver. Identifying
drivers and assessing the quality of the causal relationship is much
more costly than either direct tracing or allocation.
Allocation
In fact, one advantage of allocation is its simplicity and low cost of
implementation. However, allocation is the least accurate cost
assignment method, and its use should be minimized (avoided where
possible).
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Cost Assignment Methods

Cost of Resources

Direct Driver
Allocation
Tracing Tracing

Physical Causal Assumed

Observation Relationship Relationship

Cost Objects
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Objectives

2
Define tangible and intangible products
and explain why there are different
product cost definitions
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Two types of output

Tangible Product
are goods produced by converting raw materials through
the use of labor and capital inputs, such as plant, land, and
machinery.
Organizations are called manufacturing organizations.
Service
are tasks or activities performed for a customer or an
activity performed, by a customer using an organization's
products or facilities.
Organizations are called service organizations.
 Interface of Services with 2 -18

Management Accounting
Services cannot be stored.
No patent protection.
1. Intangibility Cannot display or
Services benefits expire
communicate services.
2. Perishability quickly. directly
Customer
Price difficult to set.
Services
involvedmay be repeated
with
3. Inseparability often for oneofcustomer.
production service.
Centralized mass
4. Heterogeneity production
Wide of in
variation services
service
difficult.
products possible.
Derived Properties
 Interface of Services with 2 -19

Management Accounting
No inventories.
Strong ethical code.
1. Intangibility Price difficult to set.
Demand for more accurate
No inventories.
2. Perishability Costs often accounted
cost for
Need assignments.
standards and
for by customer type.
consistent high quality.
3. Inseparability Demand for and
Productivity measure-
quality
ment and control
measurement andof
4. Heterogeneity quality to
control maintain
must be
consistency.
ongoing.
Total quality manage-
Impact on Management
Accounting ment critical.
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Product cost is a cost assignment that

supports a well-specified managerial
object. Thus, what product cost means
depends on the managerial objective
being served.
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• To support strategic profitability analysis,

management needs information about all
the revenues and costs associated with a
product.
• In this case, a value-chain product cost is
appropriate because it accounts for all the
costs necessary to assess strategic
profitability.
• A firm's internal value chain is the set of
all activities required to design, develop,
produce, market, distribute, and service a
product.
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Design

Service Develop

The Internal
Value chain
analysis

Distribute Produce

Market
Product Costs and External Financial 2 -23

Reporting

 Production costs are those costs associated with

the manufacture of goods or the provision of
services.
 Nonproduction costs are those costs associated
with the functions of designing, developing,
marketing, distribution, customer service, and
general administration.
 Product Costing Definitions 2 -24

Value-Chain Operating Product Traditional Product

Product Costs Costs Costs
Research and
Development

Production Production Production

Marketing Marketing

Customer Customer
Service Service
Pricing Decisions Strategic Design Decisions External Financial
Product-Mix Decisions Tactical Profitability Reporting
Strategic Profitability Analysis
Analysis
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Direct materials are those materials that are directly

traceable to the goods or services being produced.
Steel in an automobile
Wood in furniture
Alcohol in cologne
Denim in jeans
Braces for correcting teeth
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Direct labor is the labor that is directly traceable to

the goods or services being produced.
Workers on an assembly
line at Chrysler
A chef in a restaurant
A surgical nurse attending
an open heart operation
Airline pilot
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Overhead are all other production costs.

 Depreciation on building
and equipment
 Maintenance
 Supplies
 Supervision
 Power
 Property taxes
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Noninventoriable (period) costs

are expensed in the period in
which they are incurred.

 Salaries and commissions of

sales personnel (marketing)
 Advertising (marketing)
 Legal fees (administrative)
 Printing the annual report
(administrative)
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Prime Cost :
Direct Materials Costs + Direct Labor Costs

Conversion Cost:
Direct Labor Costs + Overhead Costs
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Objectives

3
Prepare income statements for
manufacturing and service
organizations
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External
Financial
Statements
 Manufacturing Organization 2 -32
2-20

Income Statement
For the Year Ended December 31, 2004
Sales $2,800,000
Less cost of goods sold:
Beginning finished goods inventory $ 500,000
Add: Cost of goods manufactured 1,200,000
Cost of goods available for sale $1,700,000
Less: Ending finished goods inventory 300,000 1,400,000
Gross margin $1,400,000
Less operating expenses:
Selling expenses $ 600,000
Administrative expenses 300,000 900,000
Income before taxes $ 500,000
 Statement of Cost of Goods Manufactured 2 -33
2-21

For the Year Ended December 31, 2004

Direct materials:
Beginning inventory $200,000
Add: Purchases 450,000
Materials available $650,000
Less: Ending inventory 50,000
Direct materials used $ 600,000
Direct labor 350,000
Manufacturing overhead:
Indirect labor $122,500
Depreciation 177,500
Rent 50,000
Utilities 37,500
Property taxes 12,500
Maintenance 50,000 450,000
Total manufacturing costs added $1,400,000
continued on next slide
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Total manufacturing costs added $1,400,000

Add: Beginning work in process 200,000
Total manufacturing costs $1,600,000
Less: Ending work in process 400,000
Cost of goods manufactured $1,200,000

Work in process consists of all

partially completed units found in
production at a given point in time.
 Service Organization 2 -35
2-23

Income Statement
For the Year Ended December 31, 2004
Sales $300,000
Less expenses:
Cost of services sold:
Beginning work in process $ 5,000
Service costs added:
Direct materials $ 40,000
Direct labor 80,000
Overhead 100,000 220,000
Total $225,000
Less: Ending work in process 10,000 215,000
Gross margin $ 85,000
Less operating expenses:
Selling expenses $ 8,000
Administrative expenses 22,000 30,000
Income before income taxes $ 55,000
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Objectives

4
Outline the differences between
functional-based and activity-based
management accounting systems
 Functional-Based 2 -37

Management Model
Cost View

Resources

Operational View

Efficiency Performance
Functions
Analysis Analysis

Products
 Activity-Based 2 -38

Management Model
Cost View

Resources

Process View

Driver Performance
Activities
Analysis Analysis
Why? What? How Well?

Products and
Customers

Functional-Based
1. Unit-based drivers
2. Allocation-intensive
3. Narrow and rigid product
costing
4. Focus on managing cost
5. Sparse activity information
6. Maximization of individual
unit performance
7. Use of financial measures of
performance
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Activity-Based
1. Unit- and nonunit-based
drivers
2. Tracing intensive
3. Broad, flexible product
costing
4. Focus on managing
activities
5. Detailed activity
information
6. Systematic performance
maximization
7. Use of both financial and
nonfinancial measures of
performance
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Chapter Two

The End
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