Management Accounting:

Introduction

M.S.Narasimhan

Indian Institute of Management, Bangalore

 Accounting System

• Information is key to the success of any business

• Accounting system generates a significant part of
the total information need of the organisation
• Accounting system consists of
– Financial Accounting ,Cost Accounting, Management
Accounting
• Business units now need not only information
relating to internal activities but also information
on competitors and environment
• Accounting profession is gearing for this change
M.S. Narasimhan, IIM-B
Financial, Cost and Management Accounting

Financial Management Cost

Accounting Accounting Accounting
 Financial vs. Management Accounting

Financial & Cost Accounting Management Accounting

• Tracks Historical data • Uses Historical & Forecast
• Internal Data • Internal & External Data
• Used for Internal/External • Used for Internal
Reporting Reporting and Decision
Making
• Governed by Law and • Free-format and changes
Regulations according to users’ needs
• Used by manager, lenders, • Exclusive use of managers
shareholders, suppliers, at different levels
government agencies, etc.

M.S. Narasimhan, IIM-B

 Recent Changes in Management Accounting

• Cost is not an expenditure and thus be controlled

• Cost is incurred in the process of value creation
and thus find ways to maximise the values
• Customer is not bearing the cost; customer decides
the cost
• Quality does not add cost; it reduces the cost
• Fixed cost is not irrelevant
• Significant part of cost incurred prior to
production and after sales
• Focus on customer profitability

M.S. Narasimhan, IIM-B

 Cost and “The Cost”

• Cost reflects a monetary measure of the resources

given up to attain some objective such as acquiring
a good or service.
• Different cost measures are used for different
situation e.g. historical/acquisition cost for balance
sheet and replacement cost for decision making.
• The term cost without a preceding adjective is thus
seldom used.
• Understanding on different types of costs is
essential for decision making.
M.S. Narasimhan, IIM-B
 Types of Costs

• Cost may be defined in a variety of ways depending

on the objectives and information desired
• Can be broadly grouped under four categories
– Associated with time of incurrence
– Reaction to changes in activity
– Classification on the Financial Statements
– Impact on decision making
• An item of cost can be categorized in more
than one depending on the need of the users
M.S. Narasimhan, IIM-B
 Costs associated with time of incurrence

• Historical Cost (past)

– incurred in the past and normally used in financial
accounting
– Rarely used for decision making
• Replacement Cost (present)
– Amount to be paid to replace an existing asset
– Used for insurance computation, replacement decision
and capital budgeting
• Budgeted Cost (future)
– Provision made in the budget and used for cost control

M.S. Narasimhan, IIM-B

 Cost Reactions to Changes in Activity
• Variable Cost
– cost that varies in total in direct proportion to changes in
activity e.g. material, component, sales commission, etc.
• Fixed Cost
– cost that remains constant within the relevant range of
activity e.g. Mangers’ salary, insurance, rent, interest ..
– Bedrock fixed and Managed fixed costs.
• Mixed Cost
– cost that has both fixed and variable component e.g.
consultant may charge a fixed fee plus per hour rate
• Step Cost
– Cost that shifts upward or downward when activity
changes by a certain interval or step
M.S. Narasimhan, IIM-B
 Cost Drivers, Relevant Range and Cost Behaviour

• Cost drivers enable the managers to understand the

relationship between the variable cost and changes
in the activity level
• Cost Driver is any factor (production unit, design,
customer, etc.) that affect costs.
• Fixed costs are fixed only for a relevant range and
time factor i.e. beyond this range and time, these
fixed cost also tend to show variation.
• Examples: Electricity Billing, Supervisor’s salary,
maintenance, etc.
M.S. Narasimhan, IIM-B
Cost Classification on the Financial Statements

• Unexpired Cost (balance sheet)

– Items in balance sheet offer benefits in the future also
• Expired Cost (income statement)
– Items in profit and loss account have already offered the
benefits after spending money
– Matching concept of accounting periodically transfers
unexpired cost to expired cost
• Product Cost
– Cost that are directly traceable in the product and
allocated overhead charges
• Period Cost
– Cost that are determined on the basis of period in
addition to other basis
M.S. Narasimhan, IIM-B
 Impact on Decision Making

• Relevant Cost (logically related)

• Out-of-pocket Cost (cash or incremental)
• Sunk Cost (historical)
• Opportunity Cost (forgone benefit)
• Direct Cost (traceable)
• Indirect Cost (nontraceable)

M.S. Narasimhan, IIM-B

 Alternative Method of Classifying Costs
• Business Function
– R&D, Design, Production, Marketing, Distribution,
Customer service, strategy and administration
• Assignment to a Cost Object or cost centre
– Direct and indirect costs
• Behaviour pattern in relation to changes of a cost
driver
– Variable and fixed costs
• Aggregate and Average i.e. total and unit costs
• Assets or expenses
– Inventoriable, noninventoriable and period costs.

M.S. Narasimhan, IIM-B

 Cost Flow

• Business units acquire certain tangible and

intangible products, add value and deliver to
customers
• Business units incur cost through out this
conversion process and in addition incur certain
period costs
• Analysis of cost flow at different stages is useful for
managerial decision making
• Costs are grouped under relevant heads depending
on the nature of business units
M.S. Narasimhan, IIM-B
 Analysis of Cost Flow
• Costs are incurred in small values at different
places and points of time
• Cost Objects or Cost Centres are first established
to collect the cost related to cost object
• Cost object can be a product, service, department,
territory or customer
• Costs directly identifiable to a product are charged
to the product
• Costs not directly identifiable to a product are
accumulated under different cost objects for
allocation
M.S. Narasimhan, IIM-B
Three Basic Functions of Management Accounting

Management Accounting

Product Costing Planning & Control

Job Costing Budgeting Decision Making
Process Costing Standards
Variance Analysis

Operational Strategic
C-V-P Analysis Value Chain Analysis
Relevant Costing ABC & ABM

M.S. Narasimhan, IIM-B

 Components of Product Cost

• Direct Material
• Direct Labour
• Factory Overhead
– Variable Overhead
– Fixed Overhead
• Administrative and Selling Overhead
• Prime Cost - Direct Material + Direct Labour
• Conversion Cost - Direct Labour + Factory OH
• Cost of Good Manufactured & Cost of Goods Sold

M.S. Narasimhan, IIM-B

 Cost of Goods Manufactured and Sold

Opening Balance of WIP 7250000

Raw Material Used (Op+P-Cl) 14200000
Direct Labour 21800000
Variable Overhead
Indirect Labour 4700000
Utilities 800000
Consumables 260000
5760000
------------
c/o 39010000
M.S. Narasimhan, IIM-B
 Cost of Goods Manufactured and Sold

b/f 39010000
Fixed Overhead
Supervisors’ Salary 1000000
Utilities 600000
Factory Property Tax 350000
Factory Insurance 150000
Factory Asset Depreciation 8600000 10700000
59710000
Closing Work in Progress 6800000
Cost of Goods Manufactured 52910000

M.S. Narasimhan, IIM-B

 Cost of Goods Manufactured and Sold

Opening Balance of Finished Goods 4370000

Cost of Goods Manufactured 52910000
Cost of Goods available for Sale 57280000
Closing Balance of Finished Goods 4580000
Cost of Goods Sold 52700000
Gross Profit 20% of CGS 10540000
Sales 63240000
Note: Administrative and Selling Overhead and
interest cost are recovered from gross profit.

M.S. Narasimhan, IIM-B

 Summary
• Costs are incurred throughout the business units
• An item of cost can be seen in different ways
• An understanding of different types of cost will be
useful to collect the relevant cost for decision
making
• Costing system collects cost under different heads
and trace it to products directly or indirectly
through allocation to find the cost of good
manufactured and cost of goods sold.
• An understanding of cost drivers to different cost
objects is essential to control the costs.
M.S. Narasimhan, IIM-B