ACC406 Chapter 2 Publisher Notes

Chapter 2: Basic Managerial Accounting Concepts

Learning Objectives

• Explain the meaning of cost: Understand the nature of cost as a critical component in managerial decision-making and its role in assessing financial performance.

• Define various types of costs: Identify and categorize different cost types associated with manufacturing products and services, including selling and administrative costs. This understanding is crucial for effective budgeting and forecasting.

• Prepare comprehensive income statements: Learn how to construct income statements for both manufacturing and service organizations. Incorporate all relevant cost classifications and revenue streams, ensuring accurate representation of financial health.

CPA Competencies

• Evaluate cost classifications and methods: Develop and apply various costing techniques to assess and manage ongoing operational efficiency, leading to informed management decisions.

• Cost management techniques: Analyze and recommend specific cost management strategies aligned with business objectives to improve bottom-line performance.

• Perform sensitivity analysis: Evaluate how variations in costs and revenues impact profit margins and operational capacity, guiding strategic planning and risk management.

• Analyze compensation strategies: Investigate the effects of different employee compensation methods on organizational performance and motivate effective employee engagement and satisfaction.

Cost and Cost Assignment

Definition of Cost

Cost refers to the monetary expenditure or resources sacrificed for obtaining goods or services that provide a benefit to the organization. It encompasses both direct and indirect costs, contributing to overall expenses. Understanding cost is imperative since

• It also plays a pivotal role in revenue generation.

• The relationship between revenues and costs is critical: costs incurred during revenue production expire upon sale and are classified as expenses. For an organization to maintain sustainability, it is essential that revenues consistently exceed costs.

Income Statement Structure

Income Statement Formula

The basic formula for an income statement is:Revenue - Expenses = ProfitThis formula succinctly encapsulates the financial performance of a business during a specified accounting period.

• Revenues > Costs = Profits

• Revenues = Costs = Zero profits

• Revenues < Costs = Losses

Components of Income Statement

An income statement typically includes several key components:

• Sales Revenue: Total income from sales of goods or services before deducting expenses.

• Cost of Goods Sold (COGS): Direct costs attributable to the production of goods sold, including material and labor costs.

• Gross Profit: Difference between sales revenue and COGS, representing the profit before operating expenses.

• Operating Expenses: Indirect costs related to running the business, categorized into selling, general, and administrative expenses (SG&A).

• Operating Income: Gross profit minus operating expenses, indicating profitability from core operations.

• Other Income and Expenses: Non-operating items, including interest, gains/losses from asset sales, affecting total net income.

Cost vs. Price

Example

A furniture manufacturer purchasing $10,000 in lumber represents the cost of materials. In contrast, the price reflects the amount charged to customers for finished products. The distinction is crucial because:

• Cost: Involves expenses incurred in production.

• Price: Must account for profit margins and market dynamics. Adjusting either affects the profitability and sustainability of the business model.

Cost Accumulation

Cost accumulation is the systematic process of measuring, tracking, and recording costs related to production and operations. Efficient cost management requires:

• Monitoring expenses by department to trace cost origins.

• Precise assignment of costs to specific cost objects, facilitating detailed financial analysis.

• This process ensures companies recognize areas for cost savings and efficiency enhancements.

Assigning Costs to Cost Objects

Cost objects are entities to which costs are assigned, allowing managers to encode costs correctly for better decision-making. Common cost objects include:

• Products: Individual items produced or sold.

• Services: Activities performed for clients or customers.

• Customers: Costs associated with serving specific clientele.

• Departments: Costs allocated to various organizational units or teams.

• Geographic Regions: Tracking costs related to specific locations, enhancing regional performance assessment.

Cost Classification

Cost classification aids management in decision-making by grouping costs based on specific criteria. Common classifications include:

• Direct Costs: Easily traceable costs tied directly to a cost object, such as raw materials used in production.

• Indirect Costs: Costs that cannot be directly traced to a specific cost object, often referred to as overhead; these include utilities, salaries of support staff, etc.

Cost Classification by Activity Level

• Fixed Costs: Remain unchanged regardless of production levels; e.g., rent and salaries.

• Variable Costs: Fluctuate directly with production volume; e.g., material costs.

• Mixed Costs: Contain both fixed and variable components; e.g., utility bills with a base fee plus a usage charge.

Classification for Financial Statements

• Product Costs: Incurred in the production process and include direct materials, direct labor, and manufacturing overhead; they are treated as inventory until sold.

• Period Costs: Non-manufacturing costs expensed in the period incurred, such as administrative salaries and marketing expenses.

• Prime Cost: The total of direct materials and direct labor costs associated with production.

• Conversion Cost: Total of direct labor and manufacturing overhead costs necessary to convert raw materials into finished goods.

Understanding Product and Service Costs

It is crucial to appreciate the respective cost structures of products and services to manage finances efficiently:

• Products: These are tangible goods with identifiable cost structures; their costs are easier to quantify.

• Services: Intangible offerings often tied to customer interaction, necessitating consideration of special characteristics such as:

  • Intangibility: Cannot be produced in advance or stored.

  • Perishability: Services cannot be saved for later use; they must be consumed at the point of delivery.

  • Variability: Quality can vary based on production circumstances, which can impact costs and customer satisfaction.

Cost of Goods Manufactured (COGM)

Total COGM Formula

Total COGM can be calculated using the formula:Direct Materials Cost + Direct Labor + Manufacturing Overhead.This figure reflects the total cost incurred to produce goods available for sale during a specific reporting period. The transition from inventory to expense occurs upon the sale of goods, impacting the company’s profit margins.

Income Statement for Manufacturing and Service Firms

The income statement must capture all costs related to production and service delivery accurately. The calculation for Cost of Goods Sold (COGS) involves:Beginning Inventory + COGM - Ending Inventory = COGS.To assess financial viability, the gross margin must be calculated: Sales Revenue - COGS. This assessment assists in determining operating income, which accounts for additional operating costs incurred throughout the reporting period.

Cornerstone Case Studies

Example 1: Calculating Direct Materials Used

To calculate the total direct materials used, apply the formula:Total Direct Materials Used = Beginning Inventory + Purchases - Ending Inventory.This calculation ensures accurate tracking of materials entering and exiting inventory, which is essential for maintaining effective production control.

Example 2: Calculating Cost of Goods Manufactured

• Process: Identify direct materials, direct labor, and manufacturing overhead.

• Apply the COGM formula systematically to ensure all components are included.This meticulous process strengthens financial reporting and enhances operational efficiency.

Conclusion

Embracing effective accounting practices empowers organizations to achieve a clear, transparent understanding of their cost structures compared to traditional methods that often obscure financial implications. A detailed comprehension of costs equips management with the insights required to make informed strategic decisions, fostering enhanced financial performance and operational efficiency within the organization.