Lecture 5 BS1209 (without solutions) copy

Key Agenda Topics

• Differences between financial and management accounting.

• Definition and classification of costs:

  • Direct vs. Indirect Costs

  • Product vs. Period Costs

  • Fixed vs. Variable Costs

• Understanding semi-variable costs and the high-low method.

• Step costs and their characteristics.

Financial vs. Managerial Accounting

• Accounting Definition: A process of identifying, recording, processing, summarizing, and reporting economic information for decision-makers.

• Financial Accounting: Focused on external reporting with specific needs for users like investors and creditors.

• Management Accounting: Tailored for internal decision-making needs.

Comparison of Financial and Managerial Accounting

• Nature of Reports:

  • Financial Accounting: General purpose, usually historical.

  • Management Accounting: Specific purpose, often includes future projections.

• Detail Level:

  • Financial Accounting: Broad overview.

  • Management Accounting: Often very detailed.

• Regulations:

  • Financial Accounting: Regulated and standardized.

  • Management Accounting: Unregulated.

Accounting Information in Management Decisions

• Core Areas:

  • Cost management and control.

  • Formulating objectives and strategies.

  • Performance evaluation and control.

  • Determining costs and benefits for investment appraisal.

  • Resource management.

Cost Definitions

• Cost: Defined by various measures, including historical cost (amount paid for goods/services) and opportunity cost (value of the next best alternative).

• Relevance of Costs: For a future outlay cost to be relevant, it must relate to business objectives, be a future cost, and vary with the decision.

Relevant Costs Include:

• Opportunity Costs

• Differential Future Outlay Costs

Irrelevant Costs Include:

• All Past Costs

• Non-Differential Future Outlay Costs

• All Committed Costs

Cost Classification

• Costs can be classified based on the purpose:

  • Direct Costs: Specifically associated with a cost unit (e.g., direct labor, direct material).

  • Indirect Costs: Cannot be directly attributed to specific products/services (e.g., manufacturing overheads).

  • Product Costs: Associated with the manufacture of goods/services and included in inventory (e.g., raw materials).

  • Period Costs: Relate to a specific time frame and not included in inventory valuation.

Detailed Examples of Direct and Indirect Costs

• Direct Costs:

  • Direct labor: Wages of employees directly involved in production.

  • Direct material: Costs of raw materials used in production.

  • Direct expenses: Specific costs like machinery rental for production.

• Indirect Costs (Overheads):

  • Manufacturing overheads: Includes factory rent, machinery depreciation, supervisors’ salaries, utilities.

Cost Types with Examples

• Fixed Costs: Do not vary with activity levels, remain constant in the short term (e.g., rent).

• Variable Costs: Fluctuate with changes in activity levels, total variable costs increase as activity increases but remain constant per unit.

• Semi-variable Costs: Have both fixed and variable components (e.g., rent plus utility bills).

Exploring Step Costs

• Defined as costs that remain constant within certain activity ranges but increase once thresholds are crossed (e.g., needing additional employees to handle increased customer volume).

Real-Life Application: Decision-Making with Cost Information

• Managers utilize cost information in planning and control as a critical factor in making strategic decisions and evaluations.