Chapter 3: Management Accounting

Information System
• Contents of the chapter
1. What is Management Accounting?
2. Functions of management accounting
3. Management Accounting Framework
4. Accounting for Manufacturing Operations
5. Inventories of a Manufacturing Business
6. The Flow of Physical Goods
7. The Flow of Manufacturing Costs
8. Overhead Application Rates
9. Financial Statements of Manufacturing
Organizations
1
 What is Management Accounting?
• It is important to make quality
decisions for the organization in this
complex and competitive business
environment.
• Management accounting is the process
of preparing reports about business
operations that help managers make
short-term and long-term decisions.
• It helps a business pursue its goals by
identifying, measuring, analyzing,
interpreting and communicating
information to managers. 2
• Management accounting provides up-to-
date financial and non-financial data
to the key decision-makers to effectively
run the business.
• Management accounting is basically a
branch of accounting that includes
planning and controlling of business
operation.
• Management accounting helps the
management in formulating policies by
collecting information, processing it
and making it useful for them.
3
 The main functions of
management accounting
1. Helping Forecast the Future-budgeting
2. Helping in Make-or-buy, special order
Decisions, add/drop business segment
3. Forecasting Cash Flows-cash flow
analysis
4. Helping Understand Performance
Variances-Variance Analysis
5. Analyzing the profitability
4
 Management Accounting Framework

Management accounting and

assigning decision-making authority.

Accounting systems help to identify

who has authority over assets.

Accounting information supports

planning and decision-making.

Accounting reports provide a means of

monitoring, evaluating, and rewarding performance.
 Accounting for Manufacturing
Operations
Steps in the Manufacturing Process:

Buy raw Convert raw materials Sell finished

materials. into finished goods. goods.

Direct Direct labor and

Cost of goods
materials manufacturing
sold.
costs. overhead costs.
 Direct Materials
Raw materials &
component parts Can be traced
that become an directly and
integral part of conveniently to
finished products. products.

If materials cannot be traced directly to products, the materials are

considered indirect and are part of manufacturing overhead.
 Direct Labor

Includes the payroll cost of direct workers.

Direct labor Wage Those employees who

× work directly on the
hours rate goods being
manufactured.
 Direct Labor

Includes the payroll cost of direct workers.

The cost of employees who do

not work directly on the goods
Those employees who
is considered indirect labor and work directly on the
is part of manufacturing goods being
overhead. manufactured.
 Manufacturing Overhead
All manufacturing costs other than direct
materials and direct labor.

Includes:
• Indirect materials.
• Indirect labor.
• Depreciation
Machinery and
equipment
• Cost of regulatory
compliance.
• Depreciation on factory,
plant
 Manufacturing Overhead
All manufacturing costs other than direct
materials and direct labor.

Includes:
⚫ Indirect materials.
⚫ Indirect labor. Does not include selling
⚫ Machinery and or general and
administrative
equipment costs. expenses.
⚫ Cost of regulatory
compliance.
 Manufacturing Overhead

The cost to
produce a unit of
product includes:
⚫Direct material
⚫Direct labor
⚫Manufacturing
overhead
 Manufacturing Overhead

The cost to
produce a unit of
product includes:
⚫Direct material
Manufacturing overhead must be
⚫Direct labor mathematically allocated to each
unit of product using a
⚫Manufacturing predetermined overhead
application rate.
overhead
 Product Costs Versus Period
Costs
Balance Sheet
Product Costs
(manufacturing Current assets and
costs) inventory
as
incurred
When goods are
sold.
Income Statement

Revenue
Period Costs
CGS
(operating expenses
Gross profit
and income taxes.)
Expenses
Net income.
as
incurred
 Inventories of a Manufacturing
Business

Raw materials - inventory on hand and

available for use.

Finished goods- Work in process -

completed goods partially completed
awaiting sale. goods.
 The Flow of Physical Goods
Materials
Direct Direct Factory
Warehouse
materials materials used
purchased

Direct labor &

Manufacturing overhead
Finished goods

Finished goods
Warehouse
Goods sold
 The Flow of Manufacturing Costs

Direct Materials Direct Work in Process

materials Inventory materials used Inventory
purchased

$$$ $$$ $$$ $$$

Direct labor &

Manufacturing overhead
Cost of goods
manufactured
Cost of Goods Finished Goods
Sold Inventory

$$$ $$$ $$$

 Financial Statements of Manufacturing
Organizations
1. Income statement
Sales-----------------------------------------------xx
Deduct: CGS*------------------------------------xx
Gross Profit---------------------------------------xx
Operating Expenses:
Selling Expenses……………………………....xx
Administrative Expense………..................xx
Profit from operation----------------------------xx
Deduct: Interest Expenses---------------------xx
Profit after Interest------------------------------xx
Deduct: Profit tax--------------------------------xx
Net profit/income-------------------------------xx
 Schedule of Cost of Goods Sold
• Beginning FG Inventory------------------------xx
• Add: Cost of goods Manufactured-----------xx
• Cost of FG available for sale-------------------xx
• Less: Ending FG Inventory--------------------xx
• Cost of goods sold---------------------------------xx

19
 Cost of Goods Manufactured Schedule
❑ Beginning DM inventory…………...xx
❑ Add: DM Purchased………………….xx

❑ DM Available for use ………………..xx

❑ Ending DM Inventory………………...xx

❑ DM Used …………………………….…xx

❑ Add: Direct Labor …………………….xx

❑ MOH Cost incurred……………........xx

❑ Add: Beginning WIP Inventory …….xx

❑ Total Mfg Cost to account for …….xx

❑ Deduct: Ending WIP Inventory ……xx

Cost of Goods Manufactured ………..xx 20

 The Flow of Manufacturing Costs
Example

• Pure-Ice Inc. had $52,000 of inventory in

direct materials inventory on January 1,
2002.
• During the year, Pure-Ice purchased
$586,000 of additional direct materials.
• At December 31, 2002, $78,000 of the
direct materials were still on hand.
• How much direct material was placed
into production during 2002?
 The Flow of Manufacturing Costs
Example

Beginning materials
inventory $ 52,000
+ Materials purchased 586,000
Materials available to be
=
placed into production 638,000
Materials placed into
–
production ??
= Ending materials inventory
$ 78,000
The Flow of Manufacturing Costs
Example

Beginning materials
inventory $ 52,000
+ Materials purchased 586,000
Materials available to be
=
placed into production 638,000
Materials placed into
–
production 560,000
Ending materials
=
inventory $ 78,000
 The Flow of Manufacturing Costs
Example

In addition to the direct materials, Pure-Ice

incurred $306,000 of direct labor cost during
2002. Manufacturing overhead for 2002 was
$724,000.
Pure-Ice started 2002 with $132,000 in work in
process. During 2002, units costing $1,480,000
were transferred to finished goods inventory.
What is the ending balance in work in
process at December 31, 2002?
 Example: The Flow of
Manufacturing Costs
Beginning work in
process inventory $ 132,000
+ Manufacturing costs
added 1,590,000
= Total costs in process
during
Direct the year $ 560,000 1,722,000
Materials
–Direct
CostLabor
of goods 306,000
completed during the
Manufacturing
year (1,480,000)
Overhead 724,000
= Ending work in
Total costs added
process inventory ?
during the year $ 1,590,000
 Example: The Flow of Manufacturing
Costs
Beginning work in
process inventory $ 132,000
+ Manufacturing costs
added 1,590,000
= Total costs in process
during the year 1,722,000
– Cost of goods
completed during the
year (1,480,000)
= Ending work in
process inventory $ 242,000
Overhead Application Rates
The overhead application rate expresses an
expected relationship between
manufacturing overhead costs and some
activity base related to the production
process.

Overhead Estimated Estimated Units

Application = Overhead ÷ in the Activity
Rate Costs Base
Overhead Application Rates
Overhead costs are estimated based
on budgets and using mathematical
estimation techniques.

Overhead Estimated Estimated Units

Application = Overhead ÷ in the Activity
Rate Costs Base
Overhead Application Rates
• The base is the activity that “drives” the
cost, called the cost driver.
• Direct labor hours and machine hours are
commonly used cost drivers.

Overhead Estimated Estimated Units

Application = Overhead ÷ in the Activity
Rate Costs Base
 Example: Overhead Application
Rates

Big “T” Company produces engines for big

trucks. Total overhead for 2002 is estimated to be
$2,600,000. Big “T” applies overhead based on
machine hours. Big “T” estimates machine hours
for 2002 to be 162,500 hours.
Compute Big “T’s” predetermined overhead
rate for 2002.
 Overhead Application Rates Example

Overhead Estimated Estimated

Application = Overhead ÷ Units in the
Rate Costs Activity Base
= $ 2,600,000 ÷ 162,500
= $ 16.00 per hour
 Overhead Application Rates Example

Overhead Estimated Estimated

Application = Overhead ÷ Units in the
Rate Costs Activity Base
= $ 2,600,000 ÷ 162,500
= $ 16.00 per hour
 Overhead Application Rates

Some companies use different cost drivers

for different manufacturing activities, a
process called ACTIVITY BASED COSTING.

Overhead Estimated Estimated Units

Application = Overhead ÷ in the Activity
Rate Costs Base
 Determining the Cost of Goods
Manufactured

A schedule of the cost of goods

manufactured is prepared to assist
managers in understanding and
evaluating the overall cost of
manufacturing products.
 CONQUEST, INC.
Schedule of the Cost of Finished Goods Manufactured
For the Year Ended December 31, 2002

Work in process inventory,

beg. $ 30,000
Manufacturing cost assigned
to production:
Direct Materials $ 150,000
Direct Labor 300,000
Manufacturing overhead 360,000
Total manufacturing
costs 810,000
Total cost of all work in
process during the year 840,000
Less: Work in process
 Beginning finished goods
inventory $ 150,000
Add: Cost of finished goods
manufactured during the year
CONQUEST, INC.
Schedule of the Cost of Finished Goods Manufactured
800,000
Cost of finished goods
For the Year Ended December 31, 2001

Work in process inventory, beg. $ 30,000

Manufacturing cost assigned to
available for sale 950,000
production:
Direct Materials Less:
$ Ending finished goods
150,000
Direct Labor 300,000
Manufacturing overhead inventory
360,000 168,000
Total manufacturing costs 810,000
Total cost of all work in process
Cost of Goods Sold $ 782,000
during the year $ 840,000
The cost of goods
Less: Work in process
inventory, end of year (40,000) completed during the
Cost of finished goods manufactured $ 800,000 period is used to compute
COGS for the period.
 CONQUEST, INC.
Income Statement
The income For the Year Ended December 31, 2002
statement is
prepared using
established Sales $ 1,300,000
financial
accounting
Cost of Goods Sold 782,000
procedures. Gross profit on sales $ 518,000
Operating expenses 400,000
Income from operations $ 118,000
Less: Interest expense 18,000
Income before income
taxes $ 100,000
Income tax expense 30,000
Net income $ 70,000
 Illustration: The following year-end information is taken from the
December 31, 2005 adjusted trial balance and other records of Wanza
Company.
Account Balance(in Birr)
Account Balance(in
Advertising expense 30,000 Birr)
Depreciation expense – Factory equipment 36,000 Rent expense – office space 30,000
Rent expense – Selling space 30,000
Depreciation expense – Selling equipment 10,000
Rent expense- factory building 70,000
Depreciation expense –Office equipment 10,000

Direct labor 700,000 Sales 5,000,000

Factory supervision 100,000 Sales discounts 100,000

Factory supplies used 10,000
Sales salaries expense 400,000
Factory utilities 40,000
Raw materials, December 31, 2004 200,000
Income taxes expense 250,000

Indirect labor 60,000 Raw materials, December 31, 2005 250,000

Maintenance expense – Factory equipment 50,000

Goods in process, December 31, 2004 50,000
Miscellaneous manufacturing costs 10,000
Goods in process, December 31, 2005 60,000
Office salaries expense 70,000

Raw materials purchases 930,000

Finished goods, December 31, 2004 180,000

Raw materials discount 30,000 Finished goods, December 31, 2005 38

150,000
 Required
1. Determine the prime cost of the Company
– Prime Cost =DMC+DLC
2. Determine the total conversion cost of the
Company
– Conversion Cost=DLC+MOHC
3. Determine the period cost of the Company
– Period Costs=Selling Expenses +Administrative
Expenses
4. Prepare Schedule of goods manufactured for
the year ended Dec 31, 2005.
– The CGM=RMC+DLC+MOH+BWIP-EWIP
5. Prepare cost of goods sold for the year ended
Dec 31, 2005.
– The CGS=BFGI +CGM-EFGI
6. Prepare income statement/profit or loss
account for the year ended Dec 31, 2005.
– Profit/Loss=TR-CGS-S&A Expenses
39
Textbook and Reading
Williams, Haka, Bettner and Carcello,
Financial and Managerial Accounting -
The Basis for Business Decisions; 18th
edition, Tata McGraw-Hill Edition

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