Part –II

Management Accounting
 MANAGEMENT ACCOUNTING

• Management Accounting is the process within

an organization that provides information used
by managers in planning, implementing, &
controlling the organization’s activities.

• The process includes the identification,

measurement, accumulation, analysis,
preparation, interpretation & communication of
the information needed by management to
perform its functions.
Managerial Accounting and Financial
Accounting
 Little Insight to Management
Accounting
• M.A. provides historical & estimated information on full costs &
components of full costs structured by responsibility centers to
support the measurement & control purpose of management
accounting information;

• In Management Accounting, ‘COST’ is defined differently

depending on the purpose;
• that accounting numbers are approximations;
• that rarely they provide exactly the information needed;
• that much more than accounting information is needed in
solution of a problem; &
• that people, & not numbers, get things done.
COST ESTIMATION & MANAGEMENT
• COST: Resources sacrificed or forgone to achieve a
specific objective. Usually measured as the monetary
amount that must be paid to acquire goods & service.

• COST OBJECT: Any activity or item for which a separate

measurement of cost is desired. Any change made in
any of the cost drivers will cause a change in the total
cost.

• Expl.: No of units produced, No. of set-ups, No.of items

distributed etc.
 Flow of Manufacturing Activities
Materials Activity Production Activity Marketing Activity
(raw materials) (goods in process) (finished goods)
Goods in Process
Raw Materials Finished Goods
Beginning Inventory
Beginning Inventory Beginning Inventory

Raw Materials Used

Raw Materials Goods
Purchases Manufactured
Direct Labour Used

Factory Overhead
Used
Financial Reports Raw Materials Goods in Process Finished Goods Cost of Goods
Ending Inv. Ending Inv. Ending Inv. Sold (income
statement)
(balance sheet) (balance sheet) (balance sheet)
 COST SYSTEM
• A costing system accounts for costs in two basic
stages – Accumulation & then assignment/ allocation.

1. Cost Accumulation: Collection of cost data in an

organized way by means of an accounting system –
eg. Raw materials used, fuel consumed, labour
payment etc.

2. Cost Allocation: After accumulation, cost system

allocates or traces the cost to cost objects.
 Cost Allocation
Direct vs. Indirect Costs
• Direct Costs of a cost object are related to
the particular cost object & can be traced
to it in an economically feasible (cost
effective) way.
• Eg.: Cost of can or bottle is a direct cost of
a soft drink producer.
• ‘Cost Tracing’ is used to describe the
assignment of direct cost to particular cost
object.
 Indirect Cost
• Indirect costs of a cost object are related
to the particular cost object but can not be
traced to it in a cost effective way.
• Eg.: Cost of Quality – Control personnel
conducting tests on multiple soft-drink
products.
• ‘Cost Allocation’ is used to describe the
assignment of indirect costs to particular
cost object.
 Cost Allocation
Service Departments

Electricity Maintenance Factory

Accounting

Stage 1

Machining Assembly
Department Department

Stage 2

Job 236 Job 237 Job 238

 Elements of Cost
COST

Materials Labour Other Expenses

Indirect
Direct Indirect Direct Indirect

OVERHEADS

Production or Selling &

Works Overhead Distribution
Office & Administrative
Overhead
Overhead
 Statement of Cost
Direct Material
(+) Direct Labour Inventoriable Costs/
PRIME COST Unexpired Costs/
(+) Factory Overheads Manufacturing Cost
WORKS/FACTORY/
MANUFACTURING COST
(+) Office & Administrative Period Costs/
Overheads Expired Costs/
COST OF PRODUCTION Non- Manufacturing Expenses
(+) Selling & Distribution
Overheads
COST OF SALES

“Factory overheads’ are not expenses – they are part of Inventoriable

cost & will funnel into the expense stream only when the inventoriable
costs are released as ‘COGS’.
 Cost Classifications
• Costs can be classified by:
– Relevance
– Behaviour
 Costs Classification by Relevance

• Relevant
– If costs influence a decision
• Costs that are applicable to a particular decision.
• Costs that should have a bearing on which
alternative a manager selects.
• Costs that are avoidable.
• Future costs that differ between alternatives.
• Irrelevant
– If costs do not influence a decision
 Costs Classification by Relevance

• Sunk Costs
– All costs incurred in the past that cannot be changed by
any decision made now or in the future.
– should not be considered in decisions.
– Irrelevant
– Example: You bought an automobile that cost
Rs.30,000 two years ago. The Rs.30,000 cost is sunk
because whether you drive it, park it, trade it, or sell it,
you cannot change the Rs.30,000 cost.
 Costs Classification by Relevance

• Out-of-pocket costs
– require future outlays of cash
– associated with a particular decision
– relevant for future decisions
– Example: Considering the decision to take a
vacation or stay at home, if you choose a
vacation, you will only have travel costs (out-
of-pocket costs).
 Costs Classification by Relevance

• Opportunity Costs
– The potential benefit that is given up when one
alternative is selected over another.
– Example: If you were not attending college or
university, you could be earning Rs.25,000 per
year. Your opportunity cost of attending
college or university for one year is Rs.25,000.
 Costs Classification by Behavior

• Cost behavior refers to

– how a cost will react to changes in the level of business activity.

• Fixed costs
– Do not change when activity changes. Remains fixed in total for a
given period of time despite wide changes in the related level of
total activity or volume (within the relevant range).
These are period costs i.e. Lease rental, Insurance of
factory buildings etc.

• Variable costs
– Change in proportion to changes in the volume of activity. These
are basically product costs i.e. Direct Material Cost, Direct Labour
Costs, power, repair etc.
 Variable Costs
Total variable costs change when activity changes.
Variable costs per unit do not change as activity
increases.

Variable costs per unit

Total variable costs

Volume of activity Volume of activity

 Variable Cost Example
• Consider the case of Manufacturing plant
of Maruti at Gurgaon.
• Assume that Maruti buys a steering wheel
at Rs.3,000 for each of its Swift lxi model
Vehicle
• If Maruti produces 2,000 Swift-Lxi, total
cost of steering wheels would be
Rs.60,00,000.
 Variable Costs Example

Rs240 –
Rs180 –
Rs120 –
) 000’ 00(

Rs60 –
bai r a Vl at o T

–
–

0 1 2 3 4 5
Volume
(Thousands Swift cars)
 Fixed Cost
• Total fixed costs remain unchanged
when activity changes within a relevant range.
• Fixed costs per unit decline as activity increases.

Fixed costs per unit

Total fixed costs

Volume of Activity Volume of Activity

 Fixed Costs Example
Plant leasing cost is Rs.200,00,000 for its Gurgaon plant for a designated
range of number of vehicles assembled during a month.

Rs400 –
Rs300 –
Rs200 –
) 000’ 00(

Rs100 –
C de xi Fl at o T

–
–

0 1 2 3 4 5
Volume
(Thousands of vehicles)
 Relevant Range...
– is a band of volume in which a specific
relationship exists between cost and
volume.
• Outside the relevant range, the cost either
increases or decreases.
• A fixed cost is fixed only within a given
relevant range and a given time span.
 Relevant Range

160,000 –

120,000 – Relevant Range

80,000 –
( st s o C de xi F

40,000
–

–
0 5,000 10,000 15,000 20,000 25,000
Volume in Units
 Relevant Range – Step Cost
• Step-Wise Costs
– remain fixed over limited ranges of volumes but
increase by a lump sum when volume increases beyond
maximum amounts.
– Example: additional production supervisors must be
added when another shift is added.
Supervisory Salaries

Production Volume
 Mixed Cost
• Semi- fixed/ Semi-variable costs
– contain a combination of fixed and variable costs.
Total Compensation

ost
d c
xe Variable
mi
tal Sales Commissions
To

Fixed
Monthly salary
Sales
 Mixed Costs Example

• A mixed cost is part variable and part

fixed (as most of the costs are neither
perfectly fixed, nor perfectly variable).
• Assume a department of a company has
fixed costs of Rs.50 per month (Rs.600
per year).
• There are also variable costs of Rs.3 per
hour.
 Mixed Costs Example

Rs2,475 –
Rs2,100 –
Variable
Rs1,350 – Cost
st s o Cl at o T

Rs600 – Fixed
Cost
–

–
–
–

0 125 250 375 500 625

Volume (hours)
 Estimating Cost – Volume
Relationship

• Several methods are used to estimate the

cost volume relationship, i.e. to arrive at
the total fixed cost & the unit variable cost
in the equation –

• TC = TFC + (UVC * X)
 1. Judgment Method
• Using judgment in deciding how much of cost of each
item or category will vary with volume & what will be the
amount of fixed cost.
• Appropriate where;
• Cost estimation for a situation where historical data are
irrelevant viz, a proposal to introduce a new product with
a new process.
• The reliability of the results depends on the experience &
skill of the estimator.
• Also known as ‘Account-by-Account Method’ as the
analyst considers each account in the cost structure &
judges whether the costs in that account are variable,
fixed or semi-variable.
 2. High – Low Method
1. Estimate total costs at each two volume levels, which
identifies two points on the line – the upper & lower limits
of the relevant range are selected for the purpose.
2. Subtract total cost at lower volume from the higher one &
also subtract the corresponding lower volume from the
higher.
3. Divide the difference in cost by difference in volume to
arrive at the Unit Variable Cost (UVC).
4. Multiply either of the volumes by UVC & subtract the
result from the total cost at that volume to arrive at the
Fixed Cost.
 3. Scatter Diagram
• Make a diagram in which actual costs recorded in past
periods are plotted (on the vertical axis) against the
volume of levels in those periods ( on the horizontal
axis).
• Data on costs & volumes for each of the preceding
several months may be used for the purpose.
• Draw a line that best fits the observation by visual
inspection of the plotted points.
• The FC & TVC values are then determined by reading
the values for any two points on the line and using the
High-Low Method discussed previously.
Scatter diagram with High-Low Method of
Cost Estimation
x
Indirect 1,456 x x
x x Cost function =
Labour x x
Costs 710 x Rs(23.68 + 14.92)
per machine hour
Rs.

46 96
Machine Hours

Variable cost = Change in cost / Change in volume

= (Rs1,456 – Rs.710) / (96 - 46) = Rs.14.92
per MH
Fixed cost = Mixed cost at high point - variable cost
= Rs1,456 - (96 x Rs.14.92)
= Rs.23.68 per week
 Regression Analysis Method
• Regression analysis is a statistical method that measures
the average amount of change in the dependent variable
(x) that is associated with a unit change in one or more
independent variable (s)
• Simple linear regression - one independent variable
• Multiple regression - more than one independent variable
• Allows for the evaluation of the quality of the cost function
– Coefficient of determination (R-Squared) measures the
goodness of fit of the line to the underlying data
– t-value measures the potential error of the estimated
variables
 4. Linear Regression
Method of Least Square
• This approach provides two mathematical properties
that are missing in all previous methods.

• Σy = na + b Σx…………..(1)
• Σxy = a Σx + b Σx2 ……..(2)

• Where Σy = Total cost; Σx = Total Volume

• a= Total Fixed cost;
• b= Variable cost per unit;
• n= No. of time period
• Σxy = Cost, time, volume summed
 Nonlinearity Cost Function
Nonlinear cost function
• a cost function in which the graph of total costs versus a
single cost driver does not form a straight line within the
relevant range

Time
Nonlinear
Cost Function
(Learning Curve)
Cumulative
Total Volume
 Nonlinear Cost Functions
1. Economies of Scale
2. Quantity Discounts
3. Step Cost Functions – resources increase in
“lot-sizes,” not individual units
4. Learning Curves – labor hours consumed
decrease as workers learn their jobs and
become better at them
5. Experience Curve – broader application of
learning curve that includes downstream
activities including marketing and distribution
 Types of Learning Curves
• Cumulative Average-Time Learning Model –
cumulative average time per unit declines by a
constant percentage each time the cumulative
quantity of units produced doubles
• Incremental Unit-Time Learning Model –
incremental time needed to produce the last unit
declines by a constant percentage each time the
cumulative quantity of units produced doubles
 Data “Problems”
1. Some “variable” costs are actually allocated fixed
costs
2. Missing data points
3. Errors in recording data points
4. Lack of a homogeneous relationship between
the dependent variable pool and cost driver
5. Collection periods for variables differ
6. Relationship between cost and cost driver is
unstable
7. Impact of inflation on data points over time