Chapter One

The Accountant’s Role inan Organization

Learning objectives:
After learning this chapter you will be able to understand:
 The major purposes of management accounting system
 The newly evolving management themes.
 The elements of management control & Accounting information.
 Organization structure & the management accountant

Modern Cost Accounting &Management Accounting

The term management accountancy is of recent origin. The term Management
Accountancy was first used in 1950 by a team of accountants visiting USA
under the auspices of Anglo-American Council of Productivity. The terminology
for Cost Accountancy has no reference to the word management accountancy
before the report of this study group.
The study of modern Cost & Management Accounting yields insight into both
the accountants’ role and the managers’ role in an organization.
 How are these two roles related?
 How can accountants help managers?
This part of the course addresses these questions.

Managers as Customers of Accounting

Management Accounting ties management with accounting. Managers are the
customers of Management Accounting. To maximize the value, accountants
must focus on the challenges facing managers as much as on the technical
aspects of accounting measurement.

The Value Chain of the Business Function

The value chain is the sequence of business functions in which utility
(usefulness) adds to the products or services of an organization. Managers in
all areas of the value chain are customers of accounting information. The
business functions in the value chain are (1) “Research & Development;
(2)Design of Products, Services or Processes;(3)Production; (4)Marketing;
(5)Distribution; (6)Customer Services; and (7)Strategy & Administration”.

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Research & Development: The generation of, and the experimentation with,
ideas related to new products, services, or processes.
Design of Products, Services or Processes: The detailed planning and
engineering of products, services, or processes.
Production: The coordination and assembly of resources to produce a product
or deliver a service.
Marketing: the process by which individuals or groups (i) learn about the value
attributes of products or services, and (ii) purchase those products and
services.
Distribution: the mechanism by which products or services are delivered to
the customers.
Customer Services: The support activities provided to customers.
Strategy & Administration:Spans across all the individual business
functions. This category includes senior executives charged with the overall
responsibility for the organization. General administrative tasks such as
human resource management, legal matters, tax planning, and the like are
often included in the strategy and administrative function.
Accounting is a major means of helping managers:
(a) To administer each of the business functions presented above.
(b) To coordinate their activities within the framework of the organization as
a whole.

Broad Purposes of an Accounting System

Accounting Systems provide information for four broad purposes:
(a) Internal routine reporting for cost planning, cost control, and
performance evaluation.
(b) Internal routine reporting on profitability of products, services,
brand categories, customers, distribution channels, and the like.
(c) Internal non-routine reporting for strategic and tactical decisions,
and
(d) External reports.

The accountants’ task of supplying information has three facets:

In most organizations; management accountants perform Scorekeeping,
Attention Directing, and Problem Solving functions. The first function
emphasizes the importance of the integrity of accounting information, while
the other two functions emphasize the helper role of the accountant.

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Scorekeeping: The accumulation of data. This aspect of accounting enables
both internal and external parties to evaluate organization’s performance and
financial position.
Attention Directing: The reporting and interpretation of information that
helps managers focus on operating problems, imperfections, inefficiencies, and
opportunities. It is associated with the current planning and controland with
the analysis and investigation of recurring routine internal accounting reports.
Problem Solving: this aspect of accounting involves the concise quantification
of the relative merits of possible courses of action, often with recommendations
as to the best procedure. It is commonly associated with non-recurring
decisions, situations that require special accounting analysis of reports.

Newly Evolving Management Themes

Management accounting exists to help managers make better decisions.
Changes in the way managers operate require evaluating the design and
operation of the management accounting system.
Important management themes that are shaping developments in management
accounting systems include:
(a) The primacy of customer satisfaction;
(b) Linking planning and controlling for key success factors;
(c) Total value chain analysis;
(d) Dual internal/external focus; and
(e) Continuous improvement.
(a) Customer satisfaction is Priority one: Customers are pivotal to the
success of an organization. The number of organizations aiming to be
“customer driven” is large and increasing.

(b) Key success factors: are demanding ever-improving levels of

performance regarding several (even all) of the following factors:
Cost: organizations are under continuous pressure to reduce the cost of
the products or services they sell to their customers.
Quality: The quality of a product or service is its conformance with a
preannounced or pre-specified standard. Customers are expecting higher levels
of quality and less tolerant of lower quality than in the past.
Time: Time has many components, including the time taken to develop
and bring new products to market, the speed at which the organization
responds to customer requests, and the reliability with which promised delivery
dates are met. Organizations are under pressure to complete activities faster
and to meet promised due dates more reliable than in the past in order to
increase customer satisfaction.

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 Innovation: there is now heighten recognition that a “continuing flow of
innovative products or services is a prerequisite for the ongoing success of
most organizations.
Factors that affect directly customer satisfaction, such as cost, quality, time
and innovative products and services are termed “Key Success factors.”

(c) Total Value-chain Analysis: This theme has two related aspects:
(i) Treating each of the business functions as an essential and valuable
contributor, and
(ii) Integrating and coordinating the efforts of all business functions in
addition to developing the capabilities of each individual business
function.

(d) Dual internal/external focus: Managers operate in both aninternal

and external environment. The internal environment includes the
physical, human, and information aspects associated with each of the
individual business functions and how those functions themselves are
coordinated. The external environment includes customers, competitors,
suppliers, and government bodies. Successful organizations need to be
“fast” in order to respond to changes in both their internal and external
environments.

(e) Continuous improvement: Continues improvement by competitors

creates a ‘never-ending search” for higher levels of performance within
many organizations.
Phrases such as the following capture this theme:

 “ A journey with no end”

 “We are running harder just to stand still”
 “If you are going forward, you are going backwards’

The Japanese term for “continuous improvement” is “Kaizen,” and Toyota
Motor Company uses the phrase ‘Kaizen Management” to describe its
“commitment to Progress.”

The high level of interest managers has in benchmarking also illustrate this
theme. Benchmarking is the continuous process of measuring products,
services, or activities against the best level of performance that may be
found either inside or outside the organization.

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 Accounting as a Management Tool
Accounting helps planning, control, and decision making through
budgetsand other financial benchmarks: Its systematic recording of actual
results, its analysis of cost behavior, and its role in the performance
evaluation.
Management accountants and controllers are staff management in most
organizations, staff managers exist to provide advice and assistance to line
managers, who are directly responsible for attaining objectives of the
organization.
Management Accountants have important ethical responsibilities that are
related to Competence, Confidentiality, Integrity, and Objectivity.

Organizational Structure and the Management Accountant

A well-organized finance department is absolutely essential for the

efficient financial management of an enterprise. If finance department
does not operate well, the whole organizational activity will be ruined.

A self-explanatory organization structure of finance department in a large

organization is given below:

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Controller Treasurer

Functions: Functions:
1. Planning & Control 1. Provision of capital
2. Internal reports 2. Short-term financing
3. Evaluation & consulting 3. Banking & custody
4. External reporting 4. Credit & collections
5. Protecting of assets 5. Investments
6. Economic appraisal 6. Foreign exchange management

Chief Financial Officer

The chief financial officer (CFO) – also called the finance director – is
the senior officer empowered with oversight of the financial operations of
an organization. The responsibility of the CFO varies between
organizations, but they almost always include the following four areas:
 Controllership/ financial control
 Treasury
 Tax planning
 Internal audit

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In some organizations, the CFO also has responsibility for information
systems. In other organizations, an officer of equivalent rank to the CFO
– termed Chief Information Officer – has responsibility for information
systems.
Some people confuse the responsibility of the controller and the
treasurer. Their functions are listed above. The Controller is the
financial executive primary responsible for both the management
accounting and financial accounting. The Treasurer is the financial
executive who is primarily responsible for obtaining investment capital
and managing cash.

Ethical Responsibilities Management Accountants

Management Accountants have important ethical responsibilities that are related to
Competence, Confidentiality, Integrity, and Objectivity.
Competence
Professional accountants have a responsibility to:

 Maintain an appropriate level of professional competence by

ongoing development of their knowledge and skills.
 Perform their professional duties in accordance with relevant laws,
regulations, and technical standards.
 Prepare complete and clear reports and recommendations after
appropriate analysis of relevant and reliable information.
Confidentiality
Professional accountants have a responsibility to:

 Refrain from disclosing confidential information acquired in the

course of their work except when authorized, unless legally
obligated to do so.
 Inform subordinates as appropriate regarding the confidentiality of
information acquired in the course of their work and monitor their
activities to assure the maintenance of that confidentiality.
 Refrain from using or appearing to use confidential information
acquired in the course of their work for unethical or illegal
advantage either personally or through third parties.
Integrity
Professional accountants have a responsibility to:

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  Avoid actual or apparent conflicts of interest and advise all
appropriate parties of any potential conflict.
 Refrain from engaging in any activity that would prejudice their
ability to carry out their duties ethically.
 Refuse any gift, favor, or hospitality that would influence or would
appear to influence their actions.
 Refrain from either actively or passively subverting the attainment
of the organization’s legitimate and ethical objectives.
 Recognize and communicate professional limitations or other
constraints that would preclude responsible judgment or
successful performance of any activity.
 Communicate unfavorable as well as favorable information and
professional judgments or opinions.
 Refrain from engaging in or supporting any activity that would
discredit the profession.
Objectivity
Professional accountants have a responsibility to:

 Communicate information fairly and objectively.

 Disclose fully all relevant information that would reasonably be
expected to influence an intended user’s understanding of the
reports, comments, and recommendations presented.

Problem for Self-Study

Try to solve the following problem before the solution that follows.

Problem:

Lemlem Food Company incurred the following costs:

a. Purchase of Tomatoes by canning plant for Lemlem’s tomatoes Soup
products.
b. Materials purchased for redesigning for Biscuit Containers to make
Biscuits stay fresh longer.
c. Payment to Serawit & Mulualem, the advertising agency for the “Healthy
Request Line” of soup products.
d. Salaries of Food Technologists researching feasibility of a Pizza Sauce
that has zero calories.
e. Cost of legal and investment banking advice for the takeover bid of
Lemlem Company.

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 f. Cost of tell-free telephone line used for customer inquiries about possible
products defects in Lemlem Company.
g. Cost of Gloves used by line operators on the Lemlem Company breakfast
food production line.
h. Cost of hand held computers used by Lemlem Company delivery staff
serving major supermarket account.

Required:
Classify each of the cost items (a - h) into one of the parts of the value chain.

Solution:
a. Production
b. Distribution
c. Marketing
d. Research & development
e. Strategy & Administration
f. Customer Service
g. Production
h. Distribution

Cost Concepts & Cost Classifications

Introduction

The purpose of this chapter is to introduce cost concepts and measurements

that are widely used in Management Accounting. In the course of our study, we
will determine how costs are best measured for different purposes.

Cost Objective Defined

Costs are measured and used in many different ways by managers to fit the
requirements of various situations. Cost data are especially important in the
following areas:

(a) Planning – The estimation of future costs in budget preparation and in

decision making.

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 (b) Control – The measurement of costs incurred and the comparison of
those costs with budgets and standards in the process of directing and
controlling the enterprise.
(c) Income Statement – the determination of the costs associated with the
Goods Sold during the fiscal period and the costs of inventories
remaining at the end of the fiscal period.

A cost may be broadly defined as being a measurement, in monetary terms of

the amount of resources used for some purpose.

Accountants usually define cost as a resource sacrifice or foregone to achieve

specific objective.

To guide decisions, managers want to know the cost of something. We call this
something a “Cost Objective;” and define it as “anything for which a separate
measurement of costs is desired.

Examples include: a product, a service, a project, a customer, a brand

category, an activity, a department, and a program.

Cost objectives are chosen not for their own sake but for helping decision-
making.

Cost Accumulation & Cost Assignment

A costing system typically accounts for costs in two broad stages:

(1) It accumulates costs by some “natural” classification such as materials,

labor, fuel, advertising, shipping, and then
(2) It assigns these costs to cost objectives.

Cost accumulation is the collection of cost data in some organized way

through an accounting system.

Cost assignment is a general term that encompasses both:

(a) Tracing accumulated costs to cost objectives ; and

(b) Allocating accumulated costs to a cost objective.

Direct Costs & Indirect Costs

A major question concerning costs is whether they have a direct or an indirect
relationship to a particular cost objective.

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Direct costs of a cost objective: costs that are related to the cost objective
and can be traced to it in an economically feasible way.

Indirect costs of a cost objective: costs that are related to the cost objective
but cannot be traced to it in an economically feasible way.

Direct Costs Cost Tracing

Cost assignment Cost Objective

Indirect Costs Cost Allocation

Product Costing

The process of assigning costs to inventories as they are converted

from raw materials to finished goods is called Product Costing.

Product costs must be determined for the purpose of inventory valuation

and expense measurement in general purpose financial statements.
Product cost information is also used by management to plan and
control firm activities and pricing decisions.

Manufacturing Company
In a Manufacturing Company materials and other resources are purchased
and converted into finished products through the manufacturing process.
Product costs in a manufacturing company include all costs necessary for a
manufacture of a product. These costs are recorded as assets until the
product is sold and the revenue from the sales of the product is reported in the
income statement.

Manufacturing Cost Elements

We shall first distinguish Manufacturing from Non-manufacturing Costs.
Manufacturing (Product Costs) is those costs related to factory operations,
which are essential to the completion of a product. We shall further classify
Manufacturing Costs as Raw (Direct) Materials Costs, Direct Labor Costs,
and Manufacturing (Factory) Overhead Costs.

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Raw (Direct) materials are the materials which are the major components of
the finished product and can be clearly identified with the product.

Direct Labor is the labor which is used in actual producing of the product – for
instance that of the assembly line workers.

Manufacturing (Factory) overhead consists of all other costs related to the

manufacturing process but not classified as either Direct Materials or Direct
Labor – for example,Salaries of cleaners & forklift operators, cost of fuel &
oil,Depreciation of the Equipment used in the manufacturing process.

Non-manufacturing Costs consists of all other costs of running the business

and selling the product (i.e., Operating Expenses) and may be classified very
broadly as both Selling Expenses and Administrative Expenses.

We refer to the combination of Manufacturing and Non-manufacturing the Full

(Total) Cost of the product produced.
Let as summarize the classifications of the total costs for a manufacturing
company we have made so far.

ManufacturingCosts Raw(Direct)Material
A Manufacturing (Product costs) Direct Labor
Company Factory Overhead
Total Cost
Selling

Non-manufacturing Costs
(Period Costs) Administrative

Prime Costs and Conversion Costs

Two terms found in manufacturing costing systems are prime costs and
conversion costs.

Prime Costs: are all direct manufacturing costs. In the three-part

classification, noted above, Prime Costs would comprise Direct material Costs
and Direct labor Costs.

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Conversion Costs are all manufacturing costs other than direct material
Costs. These costs are for converting direct materials into finished goods.
Conversion costs would comprise direct labor and factory overhead.

Product versus Period Costs

Accountants make a distinction between the cost of manufactured products
and the costs incurred in non-manufacturing activities.

Product costs are recorded and carried as assets (inventories) at the time
products are made; they become expenses only when the product is sold. They
are costs associated with the purchase of Goods for Sale (in the case of
merchandise inventory) or costs associated with the acquisition and
conversion of materials and all other manufacturing inputs into goods for sale
(in the case of manufacturing inventories).Under GAAP, inventoriable costs
are restricted to manufacturing costs for manufacturing Sector Company.

Period costs are costs of “goods and services’ that are recorded as expenses
in the period in which they are consumed. They include costs initially recorded
as non-inventoriable capitalized costs (Building, equipment, and computers)
and costs recorded immediately as expenses as they are incurred (advertising
expense, administrative salaries, office supplies and the like.)

Manufacturing Inventories
In manufacturing firms, inventories typically play a more important role than
in other types of business. Service firms have no inventory that they hold for
resale to customers. Operating Supplies are carried only to facilitate the main
function of providing service. Merchandising firms acquire inventory for resale
to customers. A Merchandising firm may have many classifications of inventory
and many items within each inventory classification, but all inventory items
are ready made for sale.

A Manufacturing firm has three major levels of inventory:

1. Raw Materials Inventory
2. Work-In-Process Inventory, and
3. Finished Goods Inventory
Raw Materials (RM) Inventory is the basic inputs or ingredients that are
converted into final product through the production process.
Work-In-Process (WIP) Inventory is the second level of inventory in a
manufacturing firm. It consists of unfinished products that are in the process

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of being converted into final products. Many different products can be in work
in process simultaneously. For example, a Bakery may have a variety of
breads, cakes, and doughnuts in process at any given time.
Finished Goods Inventory is the final level of inventory consists of finished
goods, which are products ready for sale. In a multiple products manufacturing
firm, there are many different finished goods inventory items.

Analyzing Activity in Inventory Accounts

An understanding of account activity and accounts interrelationships is
extremely important for product costing and control. During any time period,
the activity in any account can be broken down into four parts.

Beginning balance + Increases – Decreases = Ending Balance

Knowing any three of these items, we can always find the fourth.
For example:
Cash Account Merchandise Inventory Accounts
Payable
Beginning Balance Beginning Balance Beginning
Balance
+ Cash receipts + Purchases + purchase on
account
= Total cash available = Total Inventory = Total Payable
- Cash disbursements - Cost of Goods Sold - Payment on
Account
= Ending Balance = Ending Balance = Ending Balance
Activity in one account always affects at least one other account. For example,
inventory purchased on account in a Merchandising firm “Increases”
(Debited) Merchandise Inventory and Accounts Payable (Credited). Inventory
issued to the factory in a manufacturing firm “Decreases” (Debited) Raw
Materials Inventory and “Increases” Work-In-Process Inventory (Credited).

Complete analyses of a manufacturing organization’s Inventory Account

relationships are presented below (Table 2.1).

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 Table 2.1: Analysis of Activity in Manufacturing Company’s Inventory
Accounts
______________________________________________________________________________
_____
Raw Materials Inventory Work-In-Process Inventory Finished Goods
Inventory
Beginning Balance Beginning Balance Beginning
Balance
Add: Add: Add:
Current Manufacturing Costs:
Purchase Cost of Goods
Direct Materials + Direct Labor
Manufactured
+ Factory Overhead

= Total available = Total Cost in Process = Total Available for

SaleMinus: Minus: Minus:

Cost of Materials Cost of Goods

Cost of
Placed in production Manufactured
Goods Sold

= Ending Balance = Ending Balance = Ending Balance

In Table 2.1 the cost of Raw Materials placed in Productiondecreases Raw

Materials Inventory and Increases Work-In-Process Inventory. The total
additions to Work-In-Process Inventory are collectively identified as Current
Manufacturing Costs and the total costs assigned to products completed are
collectively identified as the Cost of Goods Manufactured. The Cost of Goods
Manufactured id deducted from Work-In-Process Inventory and added to
Finished Goods Inventory. Once the relationship between inventories accounts
are known, items of interest, such as, the Cost of Materials Placed in
Production, the Cost of Goods Manufactured, and the Cost of Goods Sold
are readily determined. Consider the following illustration.

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ILLUSTARION

On September 30, 2015, the Beginning Inventory accounts Balances

of Harmon Manufacturing Company were:

Raw Materials Inventory --------------------- $5,000

Work-In-Process Inventory ----------------- $8,000

Finished Goods Inventory ------------------ $11,000

During the month of September, Raw Materials costing $12,000 were

purchased. Direct Labor and Factory Overhead costs were $20,000 and
$15,000 respectively.

The September 30, Ending Inventory Accounts Balances were as follows:

Raw Materials Inventory --------------------- $7,000

Work-In-Process Inventory ----------------- $14,000

Finished Goods Inventory ------------------ $6,000

An analysis of activity in inventory accounts is presented in Table 2.2.

This illustration focused on inventory account activity. Cost of Goods Sold

is, of course, just one item on the Income Statement. Harmon’s September
Income Statement would also include Revenue from sales and Expenses.
Harmon’s September 30 Balance Sheet would include inventories and many
other Assets as well as Liabilities and Owner’s Equity (Capital) accounts.

Because activity in one account always affects at least one other account, the
analysis here is complete. The acquisition of Raw Materials and Direct Labor
and the incurrence of Factory Overhead costs affect many other accounts.
We have ignored these accountsfor the movement in order to emphasize the
essential inventory relationships found on Product Costing under Cost
Accounting.

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Table 2.2: Analysis of Harmon Company’s Inventory Accounts
Raw Materials Inventory Account:

Beginning Balance ------------------------------------------------- $ 5,000

+ Purchases ----------------------------------------------------------- $12,000

Total available for use -------- --------------- ---------------------- $17,000

- Ending Balances -------------------------------------------------- $ 7,000

Cost ofMaterials Placed in Production (Direct Materials) - $10,000

Work-In-Process Inventory Account:

Beginning Balance ------------------------------------------------- $ 8,000

+ Current Manufacturing Costs:

Direct Material -------------- $10,000

Direct Labor ------------------ 20,000

Factory Overhead ------------ 15,000 45,000

Total Cost in Process ------------------------------------------------ $53,000

- Ending Balances --------------------------------------------------- $14,000

Cost of Goods Manufactured ------------------------------------ $39,000

Finished Goods Inventory Account:

Beginning Balance -------------------------------------------------- $11,000

+ Cost of Goods Manufactured ------------------------------------ $39,000

Total available for sale ---------------------------------------------- $50,000

- Ending Balances --------------------------------------------------- $ 6,000

Cost of Goods Sold ------------------------------------------------ $44,000

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Statement of Cost of Goods Manufactured
The activity in Raw Materials and Work-In-Process Inventory accounts is
formally summarized in a Statement of Cost of Goods Manufactured. Harmon’s
Manufacturing Company’s September 30, 2015 Statement of Cost of Goods
Manufactured is presented in Table 2.3 below. To show the relationship
between this Statement and Income Statement, Harmon’s September 30,
2015 Income Statement is also presented in Table 2.4. For this illustration
assume that the month’s Sales of $90,000 and Selling &Administrative
Expenses of $30,000.

Table 2.3: Statement of Cost of Goods Manufactured

HARMON MANUFACTURING COMPANY
STATEMENT OF COST OF GOODS MANUFACTURED
FOR MONTH ENDED SEPTEMBER 30, 2015

Current Manufacturing Costs:

Raw Materials Inventory 01/09/2015 $5,000

+ Purchases ----------------------------- 12,000

Total available for use ---------------- 17,000

- Raw Materials Inventory 30/09/2015 $7,000

Cost ofMaterials Placed in Production $10,000

Direct Labor --------------------------------- 20,000

Factory Overhead --------------------------- 15,000

45,000 Work-In-Process 01/09/2015
------------------------------------------ 8,000

Total Cost in Process ------------------------------------------------

53,000

Work-In-Process 30/09/2015 ------------------------------------------

14,000

Cost of Goods Manufactured ----------------------------------------- $39,000

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Note that the Cost of Goods Manufactured is similar to purchase for a
merchandising company. The “Purchase” in merchandising company
represents “The cost of goods bought” for sale to customers. The “Cost of
Goods Manufactured” in a manufacturing company represents “The cost of
goods produced”” for sale to customers.

Table 2.4: Income Statement

HARMON MANUFACTURING COMPANY
INCOME STATEMENT
FOR MONTH ENDED SEPTEMBER 30, 2015

Sales ------------------------------------------------------------------- $90,000

Cost of Goods Sold:
Finished Goods Inventory 01/09/2015------------ $11,000
+ Cost of Goods Manufactured --------------------- $39,000
Total available for sale ------------------------------- $50,000
Finished Goods Inventory 30/09/2015------------ $ 6,000 44,000
Gross Profit ----------------------------------------------------------- 46,000
- Selling & Administrative Expenses ------------------------------ 30,000
Net Income---------------------------------------------------------- $ 16,000

The three Inventory accounts together with other assets would appears in
Harmon’s September 30, 2015 Balance Sheet. A partial Balance sheet
appears below (Table 2.5).

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Table 2.5: Partial Balance Sheet
HARMON MANUFACTURING COMPANY
BALANCE SHEET
SEPTEMBER 30, 2015

Assets:
Current Assets:

Cash ---------------------------------------------------------- $12,000

Accounts Receivables -------------------------------------- 4,000
Raw Materials Inventory 30/09/2015 ------------------ 7,000
Work-In-Process 30/09/2015 --------------------------- 14,000
Finished Goods Inventory 30/09/2015------------------ 6,000
Total Current Assets ------------------------------------- $43,000

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