Chapter 16
Management Accounting

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Managers deal with the operations of the business, and with information that is internal to the business. We call this operating information. It involves things like product costing information, payroll information and other sensitive or confidential information. For this reason, operating information is not released to the public, but is used by managers to improve business performance, and ensure the objectives of the company.

Manufacturing costs are first classified into direct material, direct labor and manufacturing overhead. With these definitions established, we introduce the critical distinction between product and period costs. This discussion in turn lays the foundation for introducing the manufacturing inventory accounts: raw materials, work-in-process, and finished goods.

The flow of costs through the inventory accounts is explained with the help of an extended illustration. The example includes a detailed analysis of the process of applying overhead using a predetermined rate. The text explains both the mechanics and the rationale underlying overhead application at this point, and calls attention to the potential weaknesses of volume based applications that will be addressed in later chapters.

The chapter closes with the development of financial statements for a manufacturing company. The schedule of cost of goods manufactured is introduced as a supplement to the financial statements intended to assist managers in evaluating the overall costs of manufactured products.
 

Management Accounting
Management (or managerial) accounting is intended to fulfill a large number of requirements. Financial accounting is intended to meet the needs of outside users of financial information, and follows GAAP. Management accounting is intended to satisfy the various needs of a large group of decision-makers inside the business, and does not follow GAAP.

A single set of financial statements satisfies the requirements of GAAP, but management accounting reports can be tailored for any situation and user. The form and format can vary widely, depending on the type of decision being analyzed.

You first need to learn to use a few basic concepts. After that, those concepts can be modified in an almost infinite number of ways to analyze business information, and make operating decisions.

A company's audited financial statements look backwards in to the prior year or years. But managers have to make decisions today, that affect the present and the future. Financial statements that are a year or more old are not very useful for the daily decisions managers have to make. They are more interested in current operating information, and projections about the future. They are also concerned with setting goals, measuring progress and achievement, eliminating waste, complying with government regulations, and a much, much more.

Accounting cycles

An accounting system is often organized into accounting cycles. These cycles are connected and interrelated. Costs flow the product costing system as illustrated in your text, and as described below. 
 

The Purchase/Payments cycle includes purchasing raw materials and supplies as needed, and paying the bills when they come due.

The Payroll cycle includes scheduling employees for production and paying them on regular intervals.

The Production cycle includes collecting materials, labor and overhead costs into an inventory cost pool called Work in Process. Once completed the product costs are transferred to Finished Goods inventory until the goods are sold.

Finally in the Sales/Receipts cycle sales are recorded when goods are sold, and Finished Goods costs are transferred to Cost of Goods Sold. Customers are billed and receipts are recorded when received.

Separating the accounting process lets us assign different people to different tasks. Many companies have large Accounts Payable, Accounts Receivable and Payroll departments, not to mention huge Production departments and many sales people. Separating activities into accounting cycles helps us understand and apply managerial controls to these activities. 

Manufacturing Costs
We study manufacturing environments because they are some of the most complex business environments. What we learn here can easily be transferred to other, less complex, situations. Management accounting is really much easier than financial accounting. We classify all costs as either manufacturing or non-manufacturing. 

We separate manufacturing costs into three categories:
Manufacturing costs relate to making a product. 

Direct Materials (DM) - raw materials and parts, directly traceable to the product. Materials must attach themselves to, and become part of, the finished product to be considered Direct Materials. 

Direct Labor (DL) - wages and other payroll costs of the employees that directly work to convert Direct Materials into finished products. These costs are directly traceable to the product.

Manufacturing Overhead (OHD) - all the other costs related to producing products that don't qualify as Direct Materials or Direct Labor. Picture a manufacturing plant and all the costs of the plant. Now subtract DM and DL. Everything that's left is Overhead. These costs are indirectly traceable to the product.
 

Non-Manufacturing Costs
Some costs are specifically not manufacturing costs, and therefore not DM, DL or OHD. These are costs not related to the manufacturing plant or producing the product. The include the following two categories:

Selling Costs
The costs associated with selling the product are Selling Costs. These include sales salaries and commissions, advertising, stores and their related fixtures and equipment. 

General and Administrative Costs
The costs associated with the central management and home office of a company, and general costs of being incorporated, are classified as General and Administrative (GA) costs. This includes buildings, offices, equipment, salaries, etc. that are part of the administrative arm of the business, provided these costs can't be traced directly or indirectly to the manufacturing function.

Period Costs
Some costs don't have any future value, and only relate to the current period. These include Selling costs and GA costs. Other period costs include income taxes and interest expense.
 

Inventories
There are three classifications of inventory.

Materials inventory - raw materials and parts used in producing goods

Work in process inventory (WIP)- all partially completed goods, not ready for sale

Finished goods inventory - all completed goods ready for sale
 

Cost Flow
We say that costs "flow" though a company. This means that we collect costs in the books in certain accounts, and transfer those costs to other accounts, in a way that resembles how those costs are actually incurred in the manufacturing process. 

In general here is the way costs flow through an accounting system:
 

Direct Materials > Direct Labor  ==> Mfg Overhead =>

Work in Process =>

Finished Goods=>

Cost of Goods Sold

These are the actual accounts that will be debited and credited in a way that approximates the way costs are actually incurred in the production process. These accounts are all debited to increase the account, and credited to decrease the account.

To move costs along we debit the account the cost is moving into, and credit the account the cost is moving from. Total cost increases as it moves along, just like a snowball gets bigger as you roll it around in the snow. As goods move through the manufacturing process they pick up all the related costs along the way. Materials and labor are added as the goods are worked on, and overhead is added along the way.

Let's look at how one unit of product picks up costs in its journey through the production process. Amalgamated Widget, Inc. produces a variety of widgets for home and commercial use. The production manager requisitions raw materials, from the Materials inventory. Materials inventory account is credited and the costs are transferred to the Work in Process inventory account.

Work is started in the shaping and forming department. Labor is added at this point by crediting Direct Labor and debiting Work in Process inventory. After the widgets are formed, they go to the finishing department. The appropriate finish is applied and the finished widget is sent to the packing department, where it is prepared for shipment. Additional Materials and Direct Labor costs are added to Work in Process in the finishing and packing departments. 

Overhead is added to the product cost at each stage of the operation by debiting Work in Process inventory and crediting the Overhead account. We will discuss Overhead allocation more in a moment. 

At this point the product is complete and ready for sale. The final cost is transferred to the Finished Goods inventory account. When the item is sold the cost will then be transferred to the Cost of Goods Sold account. 

The total cost of producing a widget accumulates as the widget moves along though the production process. 
 

Unit Product Costs
The word "unit" comes from the Latin unus, meaning one. The Spanish word uno comes from the same Latin root, and also means one. A Unit Cost is the cost of producing one unit of product. We might break that down into its component parts - labor, materials & overhead - perhaps in great detail.

Manufacturing companies usually make a large quantity of products at a time. Each batch of product may be thousands of units. In some cases production is done on an assembly line, and there is little distinction between departments, aside from those arbitrarily determined by management. 

Ultimately the company must set a selling price for its goods. Since goods are sold one at a time, the company must determine the total cost of producing a single unit of goods. Unit costs are tracked throughout the production cycle in some accounting systems. In other cases, unit costs are determined at the end of production, after all costs of production have been accumulated and the finished units have been counted.

It is important that you clearly distinguish between unit costs and total costs, in your mind, at all times in this class. 
 

Applying Overhead
Overhead consists of a large number of separate costs related to the manufacturing process. They are collected in a single account and allocated to the product cost using what is called an overhead application rate.

The overhead application rate is simply a way to divide the total overhead costs for a year, across all the units of goods produced that year. Here's the formula:

The overhead cost driver, is something related to production that can be used to help spread the total cost evenly to individual units of product. Sometimes that is simply the number of units of products produced in a given year. At other times that's not the best measure to use. For instance, hot dogs are produced by the tens-of-thousands per day, packed into boxes and sold by the palette load. The overhead cost applied to one hot dog would be a very small amount, and not very relevant to managers. They will apply overhead costs in a way relevant to the decisions they need to make.
 

Allocating overhead using labor hours
Labor hours are often used as a cost driver, to apply overhead. Total overhead costs are divided by total estimated labor hours to come up with a dollar rate per labor hour. Each time labor is recorded, a corresponding amount of overhead can also be allocated and recorded (transferred to WIP).

Advantages of using labor hours:
Tends to be a predictable & steady amount
Different pay rates among employees is irrelevant
Labor hours are closely related to production, so should be an accurate measure
 

Let's look at an example. The company estimates it will have 100,000 labor hours and spend $200,000 in overhead costs. The company records 8,300 labor hours this month. Their overhead allocation is:

$200,000 / 100,000 hours = $2 per labor hour x 8,300 hours = $16,600

The company would transfer $16,600 from the Overhead account to Work in Process for the month's production.
 

Allocating overhead using labor dollars
Some very large companies allocate overhead using labor dollars, because they have a large work force, and their total labor dollars tends to be a predictable amount. They may be operating under a labor contract. They may have a large and wide-spread work force.

Overhead costs are allocated in much the same manner as above, except that labor dollars would be used, instead of labor hours.
 

Other Overhead Allocation Methods
Some companies use other allocation methods for overhead. Whatever method is used should be a reliable and predictable method, where a cost driver or reasonable cause and effect relationship can be found between costs and production. 

Overhead costs are allocated using journal entries, which means that these managerial accounting entries will also affect the audited financial statements released to outsiders. The allocation method will come under the scrutiny of the company's auditors, so it should be a reasonable method that complies with GAAP.