Management Accounting – Concepts and Classification of Cost
Introduction3
Purpose of Cost Classification.3
Costs Analysis in the Selected Company4
Scope of Activities of the Company..4
The List of Costs for the First Quarter..5
Classification of the Listed Costs, Cost Allocation6
Costs Classification by Period7
Costs Classification by Behaviour.8
Costs Classification by Business Function8
Importance of Costs Classification and Costs Allocation.10
Importance of Cost Concepts for Decision-Making.10
Some Practical Aspects of Cost Concept Application11
References14
Management Accounting – Concepts and Classification of Cost
Introduction
One of the most important tasks of the management of any company is to get most out of its available resources, to achieve the greatest output of work. This requires information on the availability of such resources which is not provided by standard accounting. Therefore, to see the clear picture it is necessary to combine the financial accounting with the management accounting.
Management accounting is the process of analyzing of economic and financial information and preparing reports for internal users such as managers and stakeholders so that they can plan and control the business activities, estimate the future benefits, evaluate the performance of the business and make necessary adjustments in order to ensure the effectiveness and reach higher level of profitability (Managerial Accounting, 2015).
Cost Concept
Cost-related information plays the key role in the process of planning, directing and controlling of the business and it’s crucial for the management to understand the cost concept and the real meaning of the term cost for correct decision-making.
Cost refers to cash or equivalent sources used to obtain a product or service.
In order to guarantee the expected returns, to implement the planning and performance evaluating functions managers often use costing techniques that means identification and categorization of all costs involved in the operation for proper product pricing in order to maximize the profit and minimize the costs of the company. For that purpose it is vital for the management to understand the cost concept, analyze cost behavior and correctly apply the mechanism of cost allocation.
Purpose of Cost Classification
Depending on the purpose for which information about the costs is used, they can be classified in three ways:
direct and indirect costs;
product and period costs;
manufacturing and non-manufacturing costs;
prime cost and conversion cost;
fixed, variable and mixed costs;
relevant and irrelevant;
marginal and differential costs;
real and potential (possible) costs;
opportunity costs and sunk costs;
operational and administrative costs;
-controlled and uncontrolled costs
Costs Analysis in the Selected Company
Scope of Activities of the Company
Let us consider cost concept and possible incurred costs by the example of the following business organization: a small family run Coffee Shop was chosen for the discussion of cost concept in this work. (Acton Coffee House).
Coffee Shop is a small café that offers a variety of coffee, tea, fresh juice and smoothies. While sustainable growth and expansion are main business goals of the company it currently sells only two groups of products:
Coffee & tea
Fresh juices and smoothies
Two people are employed to serve customers: a barista looks after coffee and tea and an assistant prepares fresh juices and smoothies. A janitor (a cleaner) keeps areas and equipment clean and tidy, a maintenance worker ensures trouble-free performance of the equipment. A security guard provides a safe environment and prevents violence. An outsourced accountant is recruited to issue reports quarterly.
The List of Costs for the First Quarter
The costs for the first quarter are as follows:
Total tea & coffee sales and juices & smoothies sales were $70,000 & $80,000 respectively. 15,000 customers ordered tea or coffee while the number of customers ordering juices or smoothies was 12,000.
Classification of the Listed Costs, Cost Allocation
We can choose two cost objects for our case – hot beverages and fresh beverages, for which cost date is calculated. In order to estimate the performance of the products (for cost objects) and to make necessary adjustments the management accounting techniques are applied such as cost classification and cost allocation.
Coffee, tea, sugar, cream and material (fruit) for juices and smoothies can be identified as direct materials for this case - the traceable materials that are directly used in manufacturing of the product and become its integral part; indirect materials are cleaning supplies, napkins – are not raw materials, but can be considered as part of manufacturing supplies (BusinessDictionary).
Direct labor refers to the barista and the assistant work, other people, such as the janitor, the maintenance worker and the security guard, working not directly on the products, are referred to as indirect labor.
Manufacturing overheads are electricity, water, phone, rent, depreciation of equipment, music rentals, internet & wi-fi, magazines, transportation – manufacturing costs that cannot be traced directly to the produced units. Indirect raw materials and indirect labor are also included in this cost category (Manufacturing overhead, n.d.)
According to the cost concept product costs (costs of goods sold) consist of direct and indirect costs, where direct costs = direct materials costs + direct labor costs and indirect costs = overhead costs (including indirect materials and indirect labor).
For our case:
Indirect labor = cleaner worker salary + maintenance worker salary + security guard salary = 6,000 +8,000 +9,000 = 23,000 (salary of not directly involved in production employees).
Manufacturing overheads:
Cost of the commercial on local radio $1,000 can be categorized as marketing & selling costs; salary of the outsourced accountant $2,800 as administrative costs.
Costs Classification by Period
If we consider the cost classification by the time period during which they are incurred we can distinguish two categories of costs:
Product costs, which are assigned directly to production; and
Period cost – expenses deducted from the revenue in the same period as incurred = operating expenses (Cost finding, n.d.).
Product costs for the considered business = direct materials costs + direct labor costs + manufacturing overhead costs = 20,000 + 28,000 + 43,200 = $91,200
Period costs = marketing & selling costs + administrative costs = 1,000 +2,800 = $3,800
Costs Classification by Behaviour
Costs also can be classified by the reaction to changes in the level of activity (by behavior) within the relevant range into 3 groups:
Fixed cost – remains unchanged when the level of activity changes – rent and depreciation, musical rentals, internet, magazines, direct and indirect salaries, commercial and accounting
Variable cost – changes when the level of activity changes – direct and indirect materials, and transportation; and
Mixed cost – a combination of variable and fixed costs: phone, water, electricity
Such classification is based on how costs behavior responds to production, or a single unit produced and helps in predicting cost behavior:
Costs Classification by Business Function
In terms of business function costs can be categorized bases on the operational function:
Manufacturing costs - costs of making finished goods from the raw materials = direct material + direct labor + manufacturing
For the first quarter total manufacturing overheads (indirect costs) are $43,200 / total number of customers are 27,000 = $1.6 per customer which is a cost overhead = 20,000 + 28,000 + 43,200 = =$91,200; and
Non-manufacturing costs – marketing and administrative costs = $3,800
Though according to the purpose to provide service the customers the café is a service organization, such classification is not pure. By business category the considered business can be partly classified as a manufacturing organization because the raw materials are converted into offered to the customers finished product (tea, coffee, fresh juices) with three categories of costs incurred in producing:
Direct Raw Materials
Direct Labor
Overhead costs
For proper estimation of product cost indirect costs = manufacturing overheads should be allocated to cost objects considering the number of customers as a cost driver (a factor, which causes changes in total cost, whenever it changes).allocation base.
Manufacturing overheads allocated to Tea & Cofee = $1.6×15,000
Manufacturing overheads allocated to Fresh Juices & Smoothies = $1.6×12,000
The same is valid for marketing and administrative costs: $3,800 / 27,000 = $0.14074
Marketing & administrative costs allocated to Tea & Coffee = $0.14074×15,000
Manufacturing overheads allocated to Fresh Juices & Smoothies = $0.14074×12,000
Then a detailed cost is assigned to the products in the following way:
Importance of Costs Classification and Costs Allocation
It is important to apply the cost allocation as it provides basis for accurate calculation of costs that shows to the management which products are making money and which ones are bringing losses. If costs are wrongly allocated wrong price is charged to the customers, which can lead to wasting resources on unprofitable products.
The classifications of costs are important in providing useful information that makes it possible:
Importance of Cost Concepts for Decision-Making
The based on the reports information helps the inner management to make decisions on the performance of its business and timely take necessary actions. To make the best managerial and financial decisions they need to know all costs and above all to understand the components of the product costs. Cost analysis helps:
financial reporting;
predicting cost behavior;
assigning costs to cost objects;
decision making.
Some Practical Aspects of Cost Concept Application
Let us consider the importance of the cost concept by the example of the category of fixed, variable and mixed costs for managerial decision-making purpose.
The variable costs include the costs, which vary in proportion to the volume of production - raw materials and basic materials, wages of production workers, purchased products and semi-finished products, fuel and energy for technological needs, and etc. Besides direct material and labor costs variable costs are also the certain types of indirect material and labor costs - supporting materials, the costs of instruments, hourly wages of operator on computers, etc. Variable costs per unit are constant. In practice, this constancy is often violated. For example, in the procurement of raw materials in bulk supplier provides the buyer with a discount price. Cost of raw materials consumed depends on the structure of transport costs, replacement of one type of material by the other, and on a number of other factors. All of these factors should be taken into account by managers in planning the cost of materials and assessment of the effectiveness of their usage, while all these factors are not taken into consideration for accounting purposes.
The proportion of variable costs differs depending on the area of activity of organization: a manufacturing company has many variable costs like direct materials, direct labor, variable overhead, shipping costs, and clerical costs; a merchandising company usually has a high proportion of variable costs like cost of sales, commissions, shipping costs, and clerical costs; a high proportion of variable costs is always in a service company like cost of supplies, travel, and invoicing; a public utility tends to have fewer variable costs.
Mixed costs depend on the volume of production, but this relationship is not directly proportional. Part of this cost varies with the changes in output, and part remains unchanged. For example, phone charges consisting of a fixed monthly fee (fixed part) and the payment of long-distance and international calls (variable part. For planning and evaluation of mixed costs calculus coefficients are used which shows the dependence of these costs on production volume. Such coefficients are determined, as a rule, by the methods of correlation analysis.
Fixed costs practically do not depend on changes in the volume of production. Fixed costs include depreciation of buildings and facilities, salaries of administrative personnel, rent payments, and others. Fixed costs per unit fixed costs vary with changes in production volume. Thus there is an inverse proportional relationship. It should be noted that actually some of the fixed costs may be dependent on the production volume. For example, with a significant increase in output wages of managers can be increased, as well as their technical equipment (mobile telephones, transport, etc.). Fixed costs, while remaining independent on the volume of production, can be changed under the influence of other factors (rising prices with inflation, and so on). These changes should be taken into account by management when comparing the actual value with the planned general expenses. They should be taken into account when planning these constants for the following period expenses though they are not in introduced in the planning and accounting, as a rule, and are accepted as permanent.
It should be noted that the costs are fixed only within a certain level of business activity (volume of production or sales). With a substantial change in the level of business activity (the relevant level) fixed costs also change. Therefore if we consider the fixed costs over a long period of time (several years) we could see step changes in the nature of fixed costs.
Fixed costs can be committed – long-term costs, which can’t be significantly reduced in the short term, like real estate taxes and depreciation of equipment, and discretionary, which can be altered by managerial decision in the short term, like research and advertising costs.
The latest trend in many industries is toward increasing of fixed costs relative to variable costs, as many mundane tasks previously performed by workers are taken over by machines and knowledge employees are highly appreciated and are difficult to replace, that is why the salaries of these valued workers tend to be fixed rather than variable.
Thus, an importance of adding managerial accounting to the simple accounting operations is indisputable. The focus on the analysis and interpretation helps management to ensure the best results and achieve their goals with minimal resources, both in terms of volume and value.
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