Chapter 1 - Management Accounting Vs Financial Accounting

WELCOME TO
GAMBY Medical
& Business
College
Cost and
Management
Accounting I
By - Animaw Yayeh (MBA, BA
and BSc)
CHAPTER 1 Management
accounting Vs financial accounting
Chapter Outline
1. Cost accounting
2. Costs in general
3. Cost accumulation
4. Financial statements and cost
terminology
5. Manufacturing costs
6. Three part and two classifications

and BSc)
1. Cost Accounting: Introduction
Accounting systems provide the
information found in the
 income statement,
 balance sheet,
 statement of cash flow, and
 performance reports, such as the cost
of serving customers or running an
advertising
Managers use accounting information to
administer the activities, businesses, or
functional areas they oversee and to
coordinate those activities, businesses, or
and BSc)
Cost Accounting …
Accounting in the modern times, has
two distinct functions to perform;
1. Historical Functions
2. Managerial Functions
Historical functions: This function is
concerned with recording, classifying,
summarizing and interpreting the past
transactions for an accounting period of
a business enterprise.
The objective of this function is to
report at regular interval to Yayeh
By - Animaw users by
(MBA, BA
means of financial statement.

and BSc)
Cost Accounting …
Managerial Functions: is concerned
with planning the future activities of
the enterprise and controlling the
operations of the business.
The objective of this function is to
promote maximum operational
efficiency.
In the early stages of the development
of accounting, the historical function
was the primary function of
accountants but these and BSc) days, the
Financial Accounting Vs Management Accounting
Financial accounting is aimed to provide
accounting information to external users.
Managerial Accounting is aimed to provide
accounting information to internal users.
Although there is a difference in the type
of information presented in financial and
managerial accounting, the underlying
objective is the same- to satisfy the
information needs of the user.

and BSc)
Financial Accounting Vs Management Accounting …
Financial Managerial
Accounting Accounting
It describes the It is used to help
performance of the management record,
business over a plan and control the
specific period. This activities of a business
specific period and to assist in the
referred to as decision making
“accounting process. It can be
period”. It has one prepared for any period
year long. (for daily, quarterly or
annually).
It is required by law There and BSc)
is no legal
The format of published There is no pre-
financial statement is determined format for
determined by several managerial
different regulatory accounting. It can be
bodies: Company Law, as detailed or brief as
Accounting standards, management wish.
Stock exchange etc.
Financial accounting Management
concentrate on the Accounting can focus
business as a whole on specific areas of a
rather than analyzing business activities.
the component parts of For example, it can
the business. provide insight into
For example, sales are performance
and BSc) of
Financial Managerial accounting
accounting usually include a wide
includes variety of financial and
information thatnon-financial
can only beinformation.
expressed in
Example, number and
monetary terms. productivity of
employees, sales
volumes (units sold)
etc.
Its focus is on Its focus is on reporting
reporting to to internal users
and BSc)
It provides financial It is not guided by
statements based Generally Accepted
on Generally Accounting Principles
Acceptable (GAAP).
Accounting
Principle (GAAP).
Financial Managerial accounting
accounting emphasis on the
presents a historic future, e.g., sales
perspective on the budget and on
financial influencing the
performance of the behavior of managers.
business. and BSc)

and BSc)
and BSc)
2. Cost Accounting
Cost accounting provides information for
management accounting and financial
accounting.
Cost accounting provides the detailed cost
information that management needs to
control current operations and plan for the
future.
Cost accounting measures, analyzes,
and reports financial and non-financial
information relating to the costs of
acquiring or using resources in an
organization. By - Animaw Yayeh (MBA, BA
and BSc)
All types of business entities
3. Cost in General
Managers’ activities and responsibilities in their
three broad functions: Planning, Directing,
Controlling, improving and decision making need
cost accounting information so as to proceed a
successful business.
Managers should ask questions such as the
following.
1. What costs are involved in making a product or
performing a service?
2. If we decrease production volume, will costs
decrease?
3. What impact will automation have on total costs?
4. How can we best control costs?
and BSc)
Cost in General …
The main objectives of costing are:
1) To ascertain the cost of products
and/or services
2) To determine selling price
3) To control costs and
4) To provide guidance to the
management for formulation of
policy.

and BSc)
4. Cost and Cost Terminologies
Accountants define cost as a resource
sacrificed or forgone to achieve a
specific objective.
A cost is a payment of cash or the
commitment to pay cash in the future for
the purpose of generating revenues.
A cost is usually measured as the
monetary amount that must be paid
to acquire goods or services.
An actual cost is the cost incurred (a
historical or past cost), asBy distinguished
- Animaw Yayeh (MBA, BA
and BSc)
from a budgeted cost, which is a
Cost and Cost Terminologies …
A cost object: is anything for which a
separate measurement of costs is desired.
A cost object may be a product, a sales
territory, a department, or an activity, such
as research and development.
 Example; product, department, customer,
geographical area, salesperson etc.
Direct costs - costs that have a
relationship with the cost object and can be
traced to that cost object in an economically
feasible (cost effective) way.
 The cost of wood (materials) used by
Legend Guitars in manufacturing a guitar
is a direct cost of the guitar.
and BSc)

Indirect costs of a cost object are related to the
particular cost object but cannot be traced to it
in an economically feasible (cost-effective) way.
 Example: Salary of supervisors who oversee
production of different soft drink products. Unlike
the cost of bottles of Pepsi-cola, it is so difficult
to trace supervisors cost s to Pepsi-cola line.
Such costs are allocated to products based on
some cost allocation base.

and BSc)
Thus, the term cost tracing is used to
describe the assignment of direct costs to a
particular cost object and the term cost
allocation is used to describe the assignment
of indirect costs to a particular cost object.
The distinction between a direct cost and
indirect cost depends on units of products,
activities, departments, organization etc.
So, a cost could be direct cost for one cost
object and an indirect cost to the other.

and BSc)
The term cost allocation is used to
describe the assignment of indirect
costs to a particular cost object.
Cost assignment is a general term
that encompasses both
(1) tracing direct costs to a cost object
and
(2) allocating indirect costs to a cost
object.
A cost driver is a variable, such as
the level of activity or volume that
and BSc)
5. Cost accumulation
Cost accumulation: is the collection
of costs in some organized way by
means of an accounting system, i.e.,
by some natural or self descriptive
classification.
E.g., material cost, labor cost, fuel,
Advertisement cost etc.
Cost accumulation is the collection
of cost data in some organized way by
means of an accounting system.
and BSc)
6. Financial Statements
The four financial statement are Balance Sheet,
Income Statement, Retained Earnings and Cash Flow
Statements.
The retained earnings and cash flow statements
for a manufacturing business are similar to those
illustrated in earlier chapters for service and
merchandising businesses.
However, the balance sheet and income statement
for a manufacturing business are more complex.
This is because a manufacturer makes the products
that it sells and, thus, must record and report product
costs.
The reporting of product costs primarily affects the
balance sheet and the income statement.
and BSc)
Balance Sheet for a Manufacturing Business
A manufacturing business reports three
types of inventory on its balance sheet as
follows:
1. Materials inventory (raw materials
inventory) consists of the costs of the
direct and indirect materials that have
not entered the manufacturing process.
2. Work in process inventory consists of
the direct materials, direct labor, and
factory overhead costs for products that
have entered the manufacturing
process, but are not yet completed (in
process). and BSc)
Balance Sheet - Inventories
Merchandising Manufacturing
Company Company
One category of May have three
inventory: inventories:
 Merchandise  Raw Materials
Inventory  Work in
Process
 Finished
Goods

and BSc)
Balance Sheet - Inventories
Merchandising Company Manufacturing
Company
Current assets: Current assets:
Cash $ 25,000 Cash
$ 21,000
Accounts receivable (net) 85,000 Accounts
receivable (net) 120,000
Merchandise inventory 142,000 Inventories:
Supplies 10,000 Finished goods
$62,500
Total current assets $ 262,000 Work in process
24,000
Materials
By - AnimawYayeh (MBA, BA
35,000 121,500 and BSc)
Income Statement for a Manufacturing Company
The income statements for merchandising and
manufacturing businesses differ primarily in
the reporting of the cost of merchandise
(goods) available for sale and sold during the
period. These differences are shown below.

and BSc)
A merchandising business purchases
merchandise ready for resale to
customers.
The total cost of the merchandise
available for sale during the period is
determined by adding the beginning
merchandise inventory to the net
purchases.
The cost of merchandise sold is
determined by subtracting the ending
merchandise inventory By from the cost
and BSc)
A manufacturer makes the products it
sells, using direct materials, direct labor,
and factory overhead.
The total cost of making products that are
available for sale during the period is
called the cost of goods manufactured.
The cost of finished goods available
for sale is determined by adding the
beginning finished goods inventory to the
cost of goods manufactured during the
period.
The cost of goods sold is determined
by subtracting the ending finished goods
and BSc)
Cost of goods manufactured is

required to determine the cost of
goods sold, and thus to prepare the
income statement.
The cost of goods manufactured is
often determined by preparing a
statement of cost of goods
manufactured.
This statement summarizes the cost of
goods manufactured during the period
as shown below. By - Animaw Yayeh (MBA, BA
and BSc)
Determining Cost of Goods
Manufactured
The statement of cost of goods
manufactured is prepared using the
following three steps:
 Step 1. Determine the cost of
materials used.
 Step 2. Determine the total
manufacturing costs incurred
 Step 3. Determine the cost of goods
manufactured.
and BSc)
Determining CGM …
Using the preceding data for Legend
Guitars, the preparation of the statement
of cost of goods manufactured is
illustrated below.
Step 1. The cost of materials used in
production is determined as follows:
Materials inventory, January 1, 2010
$ 65,000
Add materials purchased
100,000
Cost of materials available forYayeh
By - Animaw use (MBA, BA
$ 165,000 and BSc)

Determining CGM …
Step 2. The total manufacturing costs
incurred is determined as follows:
 Direct materials used in production (Step
1) $ 130,000
 Direct labor
110,000
 Factory overhead
44,000
 Total manufacturing costs incurred
$ 284,000
and BSc)
Determining CGM …
Step 3. The cost of goods
manufactured is determined as
follows:
Work in process inventory, January 1,
2010 $ 30,000
Total manufacturing costs incurred (Step
2) 284,000
Total manufacturing costs
$ 314,000
Less - work in process inventory, December 31,
2010 24,000 By - Animaw
and BSc)
Yayeh (MBA, BA

and BSc)

and BSc)
7. Manufacturing Cost
The cost of a manufactured product
includes the cost of materials used in
making the product.
In addition, the cost of a manufactured
product includes the cost of converting
the materials into a finished product
which include;
1. Direct Materials cost
2. Direct Labor Cost
3. Factory Overhead Cost
and BSc)
Manufacturing Cost…
Direct Materials - Cost Manufactured
products begin with raw materials that are
converted into finished products.
The cost of any material that is an integral
part of the finished product is classified as a
direct materials cost.
Example;
The cost of the wood used in producing
each guitar;
The cost of electronic components for a
television,
The cost of silicon wafers for
microcomputer chips, and
The cost of tires for an automobile.
and BSc)
To be classified as a direct materials cost, the
Direct Labor Cost - are costs to convert
materials into finished products.
The cost of employee wages that is an integral
part of the finished product is classified as
direct labor cost.
The wages of the employees who cut each
guitar out of raw lumber and assemble it.
Mechanics’ wages for repairing an
automobile, machine operators’ wages for
manufacturing tools, and assemblers’
wages for assembling a laptop computer.
Like a direct materials cost, a direct labor cost
must be both of the following:
1. An integral part of the finished
and BSc) product
Factory Overhead Cost - Costs other
than direct materials cost and direct labor
cost that are incurred in the
manufacturing process are combined and
classified as factory overhead cost.
Factory overhead is sometimes called
manufacturing overhead or factory
burden.
Costs that are indirectly associated with
manufacturing the product.
Includes all manufacturing costs except
direct materials and direct
andlabor.
BSc)
All factory overhead costs are indirect
costs of the product.
Some factory overhead costs include
the following:
1.Heating and lighting the factory
2.Repairing and maintaining factory
equipment
3.Property taxes on Machineries and
Equipment
4.Insurance on factory buildings
5.Depreciation on factory
and BSc) plant and
Factory overhead cost also includes
materials and labor costs that do not
enter directly into the finished product.
Examples include the cost of oil used
to lubricate machinery and the wages
of janitorial and supervisory
employees.
Also, if the costs of direct materials or
direct labor are not a significant
portion of the total product cost, these
costs may be classified asYayeh
By - Animaw factory
(MBA, BA
and BSc)
For Legend Guitars, the costs of guitar
strings and janitorial wages are factory
overhead costs.
Additional factory overhead costs of
making guitars are as follows:
1. Sandpaper
2. Power (electricity) to run the
machines
3. Buffing compound
4. Depreciation of the machines and
building By - Animaw Yayeh (MBA, BA
and BSc)
and BSc)
Mock Questions
Identify the following costs as Direct
Materials (DM), Direct Labor (DL), or
Factory Overhead (FO) for a baseball
glove manufacturer.
a. Leather used to make a baseball
glove
b.Coolants for machines that sew
baseball gloves
a. D
c. Wages of assemblyM line employees
d.Ink used to b. FOprint a player’s
c. DL
autograph on a baseball glove
d. FO and BSc)
Mock Questions
Which of the following is not an element of
manufacturing overhead?:
a. Sales manager’s salary.

b. Plant manager’s salary.
c. Factory repairman’s wages.
d. Product inspector’s salary.

and BSc)
Mock Questions
Indicate whether each of the following costs of
an automobile manufacturer would be
classified as direct materials, direct labor, or
manufacturing overhead.
DM
______ a. Windshield
DM
______ b. Engine
DL
______ c. Wages of assembly line worker
MO
______ d. Depreciation of factory machinery
MO
______ e. Factory machinery lubricants
DM
______ f. Tires
DM
______ g. Steering wheel
MO
______ h. Salary of painting supervisor
and BSc)
7. Three part and two classifications
 Manufacturing cost accounting systems vary among
companies.
 Some used three parts classification of
manufacturing costs and others use a two part
classification.
Three Part Classification:
 Direct Materials costs
 Direct Labor costs Prime Costs
 FOH costs Conversion Costs
♣ Prime costs are all direct manufacturing costs.

and BSc)
Three part and two …
 The Two Part classification:
Direct Material costs -----Prime cost

Factory Overhead costs----Conversion costs
 A two part classification is used if direct
manufacturing labor costs become immaterial in
an amount because of increased automation.
Prime costs = Direct material costs + Direct

manufacturing labor costs
Conversion costs = Direct manufacturing labor
costs + Manufacturing overhead costs

and BSc)
Classification of Cost
 Costs are classified into different categories on
the basis of different reasons:
1. Based on their traceability
2. Based on their behavior pattern
3. Based on function/operation/purpose
4. Based on timing they are charged against
revenue:
5. Cost Classifications for Decision
Making
and BSc)
Classification of Cost …
1. Based on their traceability to a particular cost
object
a. Direct Costs: costs that have a relationship
with the cost object and can be traced to that
cost object in an economically feasible (cost
effective) way.
b. Indirect Costs: costs that have a relationship
with the cost object bet cannot be traced to that
cost object in an economically feasible way.

and BSc)
2. Based on their behavior pattern
a. Variable costs: are total costs that changes in direct
proportion to changes in the level of activity but unit
costs remain constant. Example: Cost of bottles for
Pepsi-cola.
b. Fixed Costs: are total costs remain constant regardless of
the level of activity up to a certain relevant range but unit
costs vary according to the level of activity.
Example: Monthly salary of employees of Gondar
University for a year, rent, insurance, depreciation and
repairs
Costs are defined as variable or fixed with respect to a
specific cost object and for a given time period.
and BSc)
 Labor costs can be purely variable with respect
to units produced when workers are paid on a
unit basis.
 In contrast, labor costs may be classified as
fixed cost if the company agree with
employees to pay a certain amount of salary
per month regardless of volume of activity.

and BSc)
3. Based on function/operation/purpose
a. Manufacturing Costs: includes all costs incurred
in the factory up to the stage where the goods are
ready for dispatch. Example; material costs, labor
costs factory overhead costs
b. Administrative costs: are costs incurred for
formulating policies, directing organizations and
controlling operations. Example: Salary of
managers, clerical staffs, office rents etc.
c. Marketing costs: are costs related to selling and
distribution of goods and services. Example:
Transportation Costs, advertising costs
and BSc)
4. Based on timing they are charged against revenue:
a. Product costs: are costs that are necessary and integral
part of producing the finished product. They are
considered as an asset/inventory when they are incurred.
Under the matching principle, these costs do not become
expenses until the finished goods inventory is sold.
Example: Cost of direct material
b. Period Costs: are costs of income statement other than
cost of goods sold. They are treated as expense of the
period in which they are incurred because they are
expected to benefit revenue in the current period.
Example: Advertising costs
and BSc)
5. Cost Classifications for Decision Making;
 Managers usually follow a decision model for
choosing among different courses of action.
 A decision model is a formal method of
making a choice that often involves both
quantitative and qualitative analyses.
 Management accountants analyze and present
relevant data to guide managers’ decisions.
There are Five-Step Processes in Making
Decision

and BSc)
Five-Step Processes in Making Decision:
1. Identify the Problem and Uncertainties
2. Obtain Information; both historical cost
and other information
3. Make Predictions About the Future
4. Make Decisions by Choosing Among
Alternatives
5. Implement the Decision, Evaluate
Performance, and Learn

and BSc)
It is important to realize that every
decision involves a choice between at
least two alternatives.
The goal of making decisions is to
identify those costs that are either
relevant or irrelevant to the decision.
Costs and benefits that differ between
alternatives are relevant to the decision.
All other costs and benefits are irrelevant
and can and should be ignored.
To make decisions, it is essential to (MBA,
By - Animaw Yayeh have BA
a grasp on three concepts: Differential

and BSc)
Differential costs (or incremental
costs) is a difference in cost between
any two alternatives.
A difference in revenue between two
alternatives is called differential
revenue.
Differential costs can be either fixed
or variable.

and BSc)
1-59
Forexample, assume you have a job
paying $1,500 per month in your
hometown. You have a job offer in a
neighboring city that pays $2,000 per
month. The commuting cost to the city is
$300 per month. In this example, the
differential revenue is $500 and the
differentialrevenue
Differential cost is:is Differential
$300. The net
cost is:
differential
$2,000 – $1,500benefit
= $500 associated$300 with
accepting the new job is $200.
Net Differential Benefit is:
$200
and BSc)
An opportunity cost is the potential
benefit that is given up when one
alternative is selected over another.
These costs are not usually entered
into the accounting records of an
organization, but must be explicitly
considered in all decisions.
Example: If you were not attending
college, you could be earning $15,000
per year.
 Your opportunity cost of attending
and BSc)
A sunk cost is a cost that has already been
incurred & that cannot be changed by any
decision made now or in the future.
Sunk costs cannot be changed, they cannot
be differential costs; therefore, it should be
ignored in decision making.
Example: You bought an automobile that
cost $10,000 two years ago.
 The $10,000 cost is sunk because whether
you drive
 Suppose it, your
that park car
it, trade
could it,
beor sellnow
sold it, you
cannot
for change
$5,000. Is thisthe $10,000
a sunk cost?cost.
A. Yes, it is a
sunk cost. B. No, it is not a sunk cost.
and BSc)
Costing Systems
 Cost accounting systems measure, record, and report product
costs.
 Managers use product costs for setting product prices, controlling
operations, and developing financial statements.

 There are two main types of cost systems for manufacturing
operations to assign costs to products/services.

 These are;
1. Job-order /Specific order costing
2. Process Costing
and BSc)
Costing Systems …
A job order cost system provides
product costs for each quantity of product
that is manufactured called a job. Job
order cost systems are often used by
companies that manufacture custom
products for customers or batches of
similar products.
A process cost system provides product
costs for each manufacturing department
or process. Process cost systems are often
used by companies that manufacture units
of a product that are Byindistinguishable
from each other and are manufactured
and BSc)
er
p t
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T By - Animaw
and BSc)
Yayeh (MBA, BA

Chapter 1 - Management Accounting Vs Financial Accounting

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By - Animaw Yayeh (MBA, BA

means of financial statement.

By - Animaw Yayeh (MBA, BA

By - Animaw Yayeh (MBA, BA

By - Animaw Yayeh (MBA, BA

By - Animaw Yayeh (MBA, BA

By - Animaw Yayeh (MBA, BA

By - Animaw Yayeh (MBA, BA

By - Animaw Yayeh (MBA, BA

Cost of goods manufactured is

$ 165,000 and BSc)

By - Animaw Yayeh (MBA, BA

By - Animaw Yayeh (MBA, BA

a. Sales manager’s salary.

By - Animaw Yayeh (MBA, BA

♣ Prime costs are all direct manufacturing costs.

By - Animaw Yayeh (MBA, BA

Direct Material costs -----Prime cost

Prime costs = Direct material costs + Direct

By - Animaw Yayeh (MBA, BA

By - Animaw Yayeh (MBA, BA

By - Animaw Yayeh (MBA, BA

By - Animaw Yayeh (MBA, BA

By - Animaw Yayeh (MBA, BA

a grasp on three concepts: Differential

By - Animaw Yayeh (MBA, BA

operations, and developing financial statements.

operations to assign costs to products/services.

1. Job-order /Specific order costing

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