CH1 7

Chapter 1
Management accounting: information

for creating value and managing
resources
Copyright 2009 McGraw-Hill Australia Pty Ltd

PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith
Prepared by Kim Langfield-Smith
1-1
Outline
Australian organisations in the 21st century
What is management accounting?
Management accounting and financial accounting
information
Management accountants within organisations
Management accounting processes and techniques
Planning and control
Important considerations in the design of management
accounting systems
Management accounting and the changing business
environment
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Australian organisations in the

21st century
Increasing global competition in the 1990s
Reduction or elimination of input tariffs, quotas
and bounties
Deregulation of telecommunications industry
Corporatisation and privatisation of public sector
bodies competing with private sector
Changes in the regulation of labour markets
(Cont.)
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Australian organisations in the

21st century (cont.)
Shift from primary production to exporter of
resources, to manufacturer, to resurgence of
mineral resources
Australia is primarily a service-based economy
Rapid and unpredictable change
Increasing customer demands
Rise of the Internet and e-commerce
Climate change
New organisational structures, strategies and
management philosophies
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What is management
accounting?
the processes and techniques that focus on the
effective and efficient use of organisational
resources to support managers in their tasks of
enhancing both customer value and shareholder
value
(cont.)
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What is management
accounting? (cont.)
Customer value
The value that a customer places on particular features
of a product or service
Shareholder value
The value that shareholders or owners place on a
business
Resources
Financial and non-financial, including information, work
processes, employees, committed customers and
suppliers
Determine the capabilities and competencies of the
organisation
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Management accounting
systems
Systems that produce the information required by
managers to create value and manage resources
Include estimates of the costs of producing goods
and services, information for planning and
controlling operations and information for
measuring performance
Ad-hoc information to satisfy managers short term
and long term decision-making needs

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information
Focus is on the needs of managers within the organisation
Flexibility in the nature of information supplied
Influences
Managers information needs, nature of the resources they manage
Production and service technologies, organisational structure,
organisational size, the external environment, level of sophistication
of computer systems
Used by senior managers through to operational managers

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Management accounting and

financial accounting information
Financial accounting
The practice of preparing and reporting accounting
information for parties outside the organisation
Costing systems are common to both financial and

management accounting
A system that estimates the cost of goods and services
as well as the cost of organisational units, such as
departments

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Management accountants within

organisations
Most large organisations have a finance function
at the corporate level
Senior accountants
Financial controller, chief accountant, finance manager,
general manager (GM) of accounting, group accountant
Accounting staff may be found in each operating

division
Management accounting activities increasingly
involve managers from other functional areas of
the business
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processes and techniques
Support the organisations formulation and
implementation of strategy
Contribute to improving the organisations
competitive advantage in terms of quality, delivery,
time, flexibility, innovation and cost, through
modern process improvement and cost
management techniques
(cont.)
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processes and techniques (cont.)
Provide information to help manage resources,
through systems of planning and control
Provide estimates of the costs of an organisations
outputs, to support the strategic and operational
decision needs of managers

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strategy
Management accounting can support the organisation's
formulation and implementation of strategy
Vision
The desired future state or aspiration of an organisation
Used by senior managers to focus the attention and energies of
staff
Mission statement
Defines the purpose and boundaries of the organisation
(cont.)
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strategy (cont.)
Objectives
Specific statement of what the organisation aims to
achieve
Often quantified
Relates to a specific period of time
Strategies
The direction that the organisation intends to take over
the long term to meet its mission and achieve its
objectives
Focus on ways to manage the organisation's resources
to create value for customers and shareholders
(cont.)
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strategy (cont.)
Major decisions in formulating strategies
In what business will we operate?
How should we compete in that business?
What systems and structures should we have in place to support our
strategies?
Corporate strategy
Making choices about the types of businesses to operate in, which
businesses to acquire and divest, and how best to structure and finance
the organisation
In publicly listed companies, the choice of corporate strategy is influenced
by the expectations of major shareholders and securities market
(cont.)
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strategy (cont.)
Business (or competitive) strategy
The way a business competes within its chosen market
Distinct business strategies for each business unit
Strategy implementation
Putting plans into place to implement and support a
chosen business strategy
New structures, new systems, new production processes,
new marketing approaches, new HRM policies
(cont.)
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strategy (cont.)
Competitive advantage
Advantages that a business may have over another that
are difficult to imitate, achieved through ...
Cost leadership
Economies of production, superior process technologies,
tight cost control
Product differentiation
Superior quality, customer service, delivery performance,
product features
(cont.)
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strategy (cont.)
Strategic planning
Long-term planning, usually undertaken by senior
managers with a three- to five-year timeframe
Involves corporate strategy decisions
Draws on management accounting information
Implementing strategies
Managers at all levels share the responsibility for
implementation
Long-term plans linked to budgeting systems
Performance measurement systems compare actual
outcomes to targets
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Planning
A broad concept that is concerned with formulating
the direction for future operations
Allows an organisation to consider and specify all
resources needed in the future
Occurs at all levels of the organisation
A budget is an example of a short-term plan that
summarises the consequences of an organisations
operating activities for a specified time period

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Controlling
Involves putting mechanisms in place to ensure
that operations proceed according to plan and that
objectives are achieved
Management accounting information provides
information for control by comparing actual
performance with plans, targets or budgets
Control systems are the systems and procedures
that provide regular information to assist in control

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Costing goods and services

Estimates of the cost of producing goods and services are
needed to support a range of operational and strategic
decisions
Routine costing systems form part of the financial accounting
system, so product costs are prepared to meet external
reporting purposes
Product costs are sometimes produced outside of the financial
accounting system, to better meet managers decision-making
needs
These costs may not comply with GAAP or accounting standards

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Some important considerations

in the design of management
Behavioural issues
accounting
systems
Information may impact on individual behaviour, so
management accounting systems may have expected
and unexpected outcomes
A key purpose of management accounting systems is to
motivate managers and employees to direct their efforts
towards achieving the organisations goals
Budgeting systems, performance measurement and reward
systems may be used as motivational tools
(cont.)
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accounting
systems
There are costs and
benefits of(cont.)
generating and
providing management accounting information
Costs
Salary of accounting personnel

Purchasing and operating computers
Gathering, storing and processing data,
Managers time to read, understand and use the
information
(cont.)

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Benefits
accounting
systems (cont.)
Improved decisions
More effective planning

Greater operational efficiency at lower costs
Better control
Improved customer and shareholder value

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Management accounting design:

contingency and institutional
Contingency theory design is influenced by the
theories
organisational context
External environment, technology, organisational structure and size,
national and organisational culture, and strategy
These factors cause systems to be different
Institutional theory design is influenced by institutional

forces, which explain similarities
The need to achieve legitimacy within and beyond their organisation
The tendency for firms to imitate good practice of other firms

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responses to the changing
By the 1990s,
many organisations realised that
business
environment
they needed to improve their product and service

quality, delivery responsiveness and cost
performance in order to improve market share and
profits
Adoption of new management structures, systems
and practices, including new management
accounting techniques and systems
(cont.)

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business
Conventional environment
systems
(cont.)
Includes budgeting, costing systems and financial
performance measurement systems
In wide use for many decades and still used in many
organisations
Contemporary management accounting systems

Includes activity-based costing, performance measurement
systems (such as balanced scorecards), cost management
systems (such as business process re-engineering), new
approaches to customer profitability analysis and supplier cost
analysis
(cont.)
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(cont.)
business
Contemporaryenvironment
techniques have developed to support the
adoption of new structures, systems and practices
Some organisations continue to use conventional
management accounting systems, while others are
in the midst of implementing contemporary
systems

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Summary
Management accounting supports managers in enhancing
customer value and shareholder value
Systems to support formulation and implementation of strategy

Process improvements and cost management techniques
Information for planning and control
Product costs for strategic and operational decisions
Contemporary management accounting techniques have

developed to support new organisational structures, systems
and practices, which are a response to a rapidly changing
business environment

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Chapter 2
Management accounting: cost terms
and concepts

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Outline
Management accounting systems

Emphasis on costs
Cost classifications: different classifications for different purposes
Classifying costs according to their behaviour
Direct and indirect costs
Controllable and uncontrollable costs
Costs across the value chain
Manufacturing costs
Cost flows in a manufacturing business

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Management accounting systems

Management accounting systems are tailored to an
organisations needs
Components may include systems for
Costing
Budgeting
Performance measurement
Cost management
Conventional versus contemporary approaches

Contemporary approaches developed in the 1990s in response to
changes in the business environment

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Emphasis on costs
Why do management accountants pay so much attention to
costs?
Historic focus on production coststo value inventory and cost of goods
sold for external reporting
Ready availability of cost data within the transaction-based accounting
system
Importance of cost information in managers decisions
Non-financial information assumes increased importance in

contemporary management accounting systems
Used to make decisions and manage various sources of customer value
and shareholder wealth

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Cost classifications: different

classifications for different
Before we classify costs, we need to consider how
purposes
managers intend to use the information
Different costs and classifications are used for
different purposes
The same cost can be classified in a number of
ways depending on the intended use of the cost
information
(cont.)
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Cost classifications: different

classifications for different
What are costs?
purposes
(cont.)
Resources given up to achieve a particular objective
In financial accounting
if the benefit extends beyond the current accounting period
these costs are classified as assets
If the benefit is used up in the generation of revenue, the
costs are classified as expense
Measured in monetary terms

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Classifying costs according to

their behaviour
Managers must understand how costs change as

the level of activity in the business changes
The level of activity is the level of work performed in the
organisation
Units produced, kilometres driven, hours worked
Variable costs
Change in total in direct proportion to a change in the
level of activity
Fixed costs
Remain unchanged in total despite changes in the level
of activity

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Direct and indirect costs

An important function of management accounting
is to measure the cost of cost objects
Cost objects are the items for which management wants
a separate measure of costs
Products, projects, contracts and departments are
common cost objects in conventional costing systems
Contemporary costing systems may also include
activities and customers as cost objects
(cont.)
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Direct and indirect costs (cont.)

Responsibility centres
A responsibility centre is a unit of an organisation where the manager
is held accountable for the units activities and performance
The costing system may measure the costs of managers individual
areas of responsibility
Costs that can be traced to a particular responsibility centre are
direct costs of that centre
Costs that relate to responsibility centres but cannot be traced
precisely to specific responsibility centres are indirect costs of those
centres
(cont.)
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Direct and indirect costs (cont.)

Product costs
Manufacturing costs that can be traced to products in an economic
manner are direct product costs
Indirect costs are manufacturing costs that cannot be traced to products
in an economic manner
Whether a cost is classified as direct or indirect depends on the

nature of the cost object
Do we wish to know the cost of a department, a product, a project, or an
entire company?
A cost can be a direct cost of one cost object and an indirect cost of
another cost object

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Controllable and uncontrollable

costs
Managers performance evaluation can be

enhanced by classifying responsibility centre costs
as either controllable by the manager or
uncontrollable
Ideally, managers should be held responsible only
for costs they can control or significantly influence
Some costs are controllable in the long term but
not in the short term

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The value chain
A set of linked processes or activities that begins with
acquiring resources and ends with providing and
supporting products and services that customers value
Various cost classifications can be used within the

upstream, downstream and manufacturing areas
To assign cost to products and to provide other
information to help manage resources efficiently and
effectively and to create value
(cont.)
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(cont.)
Upstream costs
Research and development costs include the costs
involved in developing new products and processes
Design costs include the costs associated with designing
a product or production process
Supply costs are the costs of sourcing and managing
incoming parts, assemblies and supplies
(cont.)
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(cont.)
Production costs
The costs incurred to collect and assemble the resources used to

produce a product (i.e. goods or services)
Downstream costs
Marketing costs are the costs of selling products and the costs of
advertising and promotion
Distribution costs are the costs of storing, handling and shipping
finished products
Customer service costs are the costs of serving customers,
including after-sales service

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Manufacturing costs
Manufacturing costs are incurred within the factory area
Upstream and downstream costs are non-manufacturing
costs
Manufacturing costs include three categories: direct
material, direct labour and manufacturing overhead
This classification as direct or indirect cost assumes that products
are the relevant cost objects
Under conventional product costing, only manufacturing

costs are included in product costs
(cont.)
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Manufacturing costs (cont.)

Direct material is
Consumed in the manufacturing process

Physically incorporated into the finished products
Can be traced to products conveniently
Considered a variable cost
Direct labour
The cost of wages and labour on-costs for personnel who work directly on
the manufacture of a product
Usually treated as variable costs, however contractual arrangements
sometimes mean that such labour is a committed cost and so does not
vary with the level of production
(cont.)
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Manufacturing overhead
All manufacturing costs other than direct material and direct labour
Also called indirect manufacturing costs or factory burden
Includes the cost of indirect material and indirect labour,
depreciation and insurance on factory equipment, utilities and the
costs of support departments for manufacturing
Includes cost of overtime premium and idle time
Manufacturing support departments do not work directly on
producing products but are necessary for the manufacturing
process to occur
(cont.)
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Conversion costs
The total of direct labour cost and manufacturing
overhead cost
The cost of converting material into a product
Prime costs
The total of direct material cost and direct labour cost
The major cost associated with producing a product
(cont.)
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Contemporary costing systems analyse costs in
greater detail than conventional costing systems
Only direct material may be classified as direct product
costs
Labour costs may be analysed as part of activity costs, as
may some upstream and downstream costs
In many industries, direct material is the largest

proportion of the manufacturing cost and direct
labour costs are the smallest

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Product costs
Managers need estimates of product costs for different
purposes
In financial accounting reports
Product costs determine cost of goods sold
Product costs help value inventory on hand
All costs that are not product costs are called period costs
For management decision making

Definitions of product costs may include non-manufacturing costs
associated with developing, producing and selling the product

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Cost flows in a manufacturing

business
1. Material is purchased: the cost is added to raw
materials inventory
2. Direct materials are consumed in production: cost
is removed from raw materials inventory and
added to work in process inventory
Direct labour and manufacturing overhead are
accumulated in work in process inventory
(cont.)
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Cost flows in a manufacturing

business (cont.)
3. Products are completed: costs are transferred from
work in process inventory and added to finished
goods inventory
4. Products are sold: costs are transferred from
finished goods inventory to cost of goods sold
expense
Cost of goods sold is deducted from sales revenue
to determine gross profit
(cont.)
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Cost flows in manufacturing

business (cont.)
Raw materials, work in process and finished goods

inventory balances are reported in the Balance
Sheet
Cost of goods sold expense can be found in the
income statement
The schedule of cost of goods manufactured and
schedule of cost of goods sold summarise the flow
of manufacturing costs

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Summary
Management accounting systems are tailored to
an organisations needs
Costing systems focus on the cost of products and
organisational units and are a component of
management accounting systems
We can distinguish between conventional and
contemporary management accounting systems
There may be different costs for different purposes
Costs may be classified by behaviour, traceability,
controllability and function
(cont.)
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Summary (cont.)
In manufacturing businesses, production costs
typically consist of direct materials, direct labour
and manufacturing overhead, in line with external
reporting requirements
The definition of product costs needed to support
management decision making may be broader
than that used for external reporting purposes
Product costing systems track the manufacturing
costs from the beginning of production to finished
goods and link the product costing system to the
financial accounting reports
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Chapter 3
Cost behaviour, cost drivers and
cost estimation

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Outline
What are cost behaviour, cost estimation and cost
prediction?
Cost drivers
Cost behaviour patterns
The relevant range
Engineered, committed and discretionary costs
Cost structures in modern business environments
Cost estimation
Practical issues in cost estimation
3-66
What are cost behaviour, cost

estimation and cost prediction?
Cost behaviour
The relationship between a cost and the level of activity
or cost driver
Cost estimation
The process of determining the cost behaviour of a
particular cost item
Cost prediction
Using knowledge of cost behaviour to forecast the level
of cost at a particular level of activity

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Cost drivers
A cost driver
An activity or factor that causes costs to be incurred
Conventional approaches to understanding cost behaviour
assume that production or sales are the only cost driver
Variable costs are assumed to vary in proportion to the level of
production volume
Fixed costs remain unchanged as production costs increase or
decrease
Volume-based cost drivers include units produced, direct labour
hours, direct labour cost and machine hours
(cont.)
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Cost drivers (cont.)

Contemporary viewpoints recognise that there are a range of
possible cost drivers other than production volume
A non-volume cost driver is a cost driver not directly related to
production volume
Activity-based approaches classify activities and costs into four
levels
Unit
Batch
Product
Facility
(cont.)
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Unit level costs
Relate to activities performed for each unit produced
Use conventional volume-based cost drivers
Batch level costs

Relate to activities performed for a group of product units, such as a batch
or a delivery load
Product (or product-sustaining) level

Relates to activities performed for specific products or product groups
Facility level
Costs incurred to run the business, not caused by any particular product
(cont.)
3-71

Selecting the best cost drivers
Input or outputs?
Example of an input cost driver is the weight of material
Example of an output driver is the volume of production
Costbenefit principles will determine the choice
How detailed should the analysis be?

As the number of cost categories increases, the accuracy of the resulting
information should increase
Again, costbenefit criteria are important
Long or short term?

Cost behaviour and cost drivers can change over time
Choice depends on the intended purpose of the cost analysis
(cont.)
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Cost drivers for cost estimation or cost
management?
Cost drivers that are used to predict costs may differ
from those used to manage costs
Effective cost management requires the identification of
root cause cost drivers
The basic factors that cause a cost to be incurred
Search for the true causes of costs
(cont.)
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When choosing cost drivers the costs and benefits of
each driver must be assessed, taking into account
Reasons for analysing cost behaviour, such as cost
prediction, product costing, cost management, pricing
Timeframe for analysing the cost behaviour (short term or
long term)
Availability of data on cost drivers
Any other uses that the cost behaviour information might
serve

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Cost behaviour
The relationship between a cost and the level of activity (or
cost driver)
Variable costs
Fixed costs
Step-fixed costs
Semivariable costs
Curvilinear costs
(cont.)
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Cost behaviour patterns (cont.)

Variable costs
Total variable costs increase in direct proportion to
changes in the level of activity but the variable cost per
unit remains constant
The variable cost per unit is the slope of the cost line in
the following cost function:
Y = a + bX
Where Y = total cost
a = fixed cost component (the intercept on the vertical axis)
b = variable cost per unit of activity (the slope of the line)
X = the level of activity
(cont.)
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Fixed costs
As activity increases or decreases total fixed costs do not
change but fixed cost per unit changes
Fixed cost per unit is often calculated to use in product costs
but is of limited use in management decision making as it
does not reflect the way that fixed costs actually behave
Contemporary approaches to cost analysis recognise that
there are cost drivers for some of these fixed costs and very
few costs remain fixed
(cont.)
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Step-fixed costs
Remain fixed over a wide range of activity levels but jump to a
different amount for levels outside that range
Semivariable (or mixed) cost

Has both fixed and variable components
Curvilinear cost
Has a curved cost line but is often approximated as a semivariable
cost function
At lower levels of activity there is decreasing marginal cost
At higher levels of activity there is increasing marginal cost
(cont.)
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Cost behaviour and the relevant

range
The relevant range is the range of activity over which a
particular cost behaviour pattern is assumed to be valid. For
example,
The relevant range for the variable cost of electricity may hold for 200 to
800 batches of production per month, but outside of that range the
variable cost per unit may differ
The direct material cost per unit may only hold for production up to 1000
units per day, and for higher volumes the cost per unit may decrease due
to cheaper cost of buying material in larger quantities
The range of activity which is relevant for a particular cost

estimate should be specified

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Engineered, committed and

discretionary
costs
Distinction is useful when estimating costs for budgeting and planning
purposes
Engineered costs
Bear a defined physical relationship to the level of output
If we know the level of activity, we can predict total cost
Committed costs
Arise from an organisations basic structure and facilities, and are difficult to change in
the short term
Discretionary costs
Are the result of a management decision to spend a particular amount of money for
some purpose
Can be changed easily

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Shifting cost structures in modern

business environments
A decreasing proportion of production costs no longer
vary directly with production volume
As production becomes more automated there is less reliance
on labour and more reliance on equipment. Equipment costs
do not vary with production volume
Some employee wage agreements specify fixed salaries and
a stabilised workforce
Wages do not vary with production activity levels
More difficult to change the number of staff employed as activity
levels change

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Cost estimation
Approaches to cost estimation
Managerial judgment
Engineering approach
Quantitative analysis
Managerial judgment
Using experience and knowledge rather than formal analysis to classify
costs as variable, fixed or semivariable
Future costs are estimated by examining past costs and identifying
factors that might affect future costs
Reliability of cost estimates is dependent upon the ability of the manager
(cont.)
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Cost estimation (cont.)

The engineering approach
Studying processes that result in the incurrence of a cost
Focuses on the relationships that should exist between inputs and outputs
Using time and motion studies (or task analysis), where employees are
observed as they undertake tasks
These techniques are expensive and time-consuming
Useful when there is no reliable past data on which to base cost estimates
Most effective when there is a direct relationship between inputs and outputs
Activity-based approaches extend task analysis to the study of indirect
activities and costs
(cont.)
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Quantitative analysis
Formal analysis of past data to identify the relationships
between costs and activities
A scatter diagram can be useful to plot the data points and to
visualise the relationship between cost and the level of activity
The highlow method involves taking the two observations with
the highest and lowest level of activity to calculate the cost
function
Regression analysis is a statistical technique that uses a range
of observations to determine the cost function
(cont.)
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Regression analysis
A statistical technique used to estimate the relationship between a
dependent variable (cost) and independent variables (cost driver)
The line of best fit makes deviations between the cost line and the
data points as small as possible
Simple regression involves estimating the relationship between the
dependent variable (Y) and one independent variable (X)
Y = a + bX
More accurate than highlow method as it makes use of all data and
has statistical properties that allows inferences to be drawn between
cost and activity levels
(cont.)
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Cost estimation
Regression analysis
Multiple regression estimates a linear relationship
between one dependent variable and two or more
independent variables
Y = a + b1X1 + b2X2
The regression line can be evaluated using several
criteria:
Economic plausibilitydoes the regression line make
sense?
Goodness of fithow well does the line fit the data points?

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Data collection problems
Missing data
Outliersextreme observations of activity or costs
Mismatched time periods for dependent and independent
variables
Trade-offs in choosing the time periodthe number of
observations compared to the reliability of past data points as
predictors of future cost behaviour
Allocated fixed costs may be misleading
Inflation may cause past cost data to be less relevant
(cont.)
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(cont.)
Effect of learning on cost behaviour
In estimating labour costs for relatively new products or
processes, labour times per unit may decrease at varying
rates
Activity-based approaches allow more complex

cost behaviour patterns to be considered
Costs are assigned to activities
Unit, batch and product level costs are assumed to vary
in proportion to their cost drivers
(cont.)
3-95

(cont.)
The accuracy of cost functions
Sometimes budgets and cost estimates capture only

approximations of cost behaviours
Why?
Limited time and knowledge to undertake appropriate
quantitative techniques
The data required to estimate reliable cost functions may
not exist
A low priority may be given to determining accurate cost
behaviour and cost estimation
Subjective cost estimates may be considered good enough
for the firms needs
(cont.)
3-96

(cont.)
All cost functions are based on simplifying
assumptions, such as:
Cost behaviours depend on a single or only a few types
of activity
Cost behaviours are linear within a relevant range
Costs of producing more accurate cost estimates

need to be assessed against the likely benefits

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Summary
Understanding cost behaviour allows cost prediction for
planning and control
Conventional cost drivers are volume-based, but more
recently may be non-volume related
Cost behaviours range from variable to fixed
Costs can be estimated using managerial judgment,
engineering approaches and quantitative techniques
Cost estimation is fraught with a range of practical difficulties,
and the choice of technique involves a cost-benefit trade-off

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Chapter 4
Product costing systems

4-99
Outline
Product costing
Different costs for different purposes
Designing product costing systems
Flow of costs in manufacturing businesses
Allocating overhead costs to products
Accounting for manufacturing overheads
Types of product costing systems
Job costing
Process costing

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Product costing
Product costing systems
Accumulate product-related costs and use procedures to assign
them to the final products
In some businesses upstream and downstream costs are
regarded as product related
Upstream costsresearch and development, product design,
supply
Downstream costsmarketing, distribution, customer service
Product costs are the input to the product costing system

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Different product costs for

different purposes
Product costs can include upstream,
manufacturing and downstream costs
Inclusion of various costs depends on the
timeframe and type of decision to be made
Managers needs for product cost information will
vary depending on the type of decision to be made
and managers personal preferences
(cont.)
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different purposes (cont.)
Cost for inventory valuation for external reporting
must include only manufacturing costs
For long-term decisions about products a wider
definition may be used
Product costs are used to value inventory, for
short-term decision making and strategic decision
making, for planning and controlling costs and for
cost reimbursement
(cont.)
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different
purposes
(cont.)
Current or future product costs
Current product costs are relevant for inventory valuation
Future product costs may be relevant for input into some decisions such as
pricing
Frequency of cost information

Infrequently for long-term decisions or some short-term decisions
More regularly for inventory valuation
In summary, product costs may differ over

The range of costs included
Current or future costs
How frequently product costing information is required

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Designing product costing

systems
Identify the managers needs

All product cost information may not come from a
single product costing system
Future product costs
Long-term product costs
Inventory valuation
Cost and benefits of providing various cost

estimates must be compared

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Flow of costs in manufacturing

businesses
For inventory valuation in external financial reports
only manufacturing costs are assigned to
products, as required by Australian accounting
standards
Manufacturing costs consist of:
Direct material
Direct labour
(cont.)
4-108
Flow of costs in manufacturing

businesses (cont.)
Manufacturing costs flow through several manufacturing ledger
accounts
Raw materials inventory

Work in process inventory
Finished goods inventory
Cost of goods sold expense
Profit and loss account
Australian accounting standards require that upstream and

downstream costs are expensed in the period in which they are
incurred
May be included in product costs where relevant to managers decision making

4-109

4-110
Allocating overhead costs to

products
To estimate the cost of a product we need to identify the
cost of resources used to produce the product
Some resources are consumed directly by products and
are traced directly to each product
Direct material and direct labour
Overhead costs are essential to production but as they

have no observable relationship with the product they
need to be allocated to products
These cost are indirect costs to the product
(cont.)
4-111

products (cont.)
1. Aggregate overhead costs into cost pools
2. Identify the overhead cost driver(s)
The factor or activity that causes cost to be incurred
3. Calculate a predetermined (or budgeted) overhead rate

per unit of cost driver
4. Apply manufacturing overhead costs to products at the
budgeted (or predetermined) overhead rate, multiplied
by the quantity of cost driver consumed by the product

4-112
Accounting for manufacturing

overhead
Two types of manufacturing overhead are recorded in an

accounting system
Actual manufacturing overhead
Manufacturing overhead costs incurred throughout the accounting period
Debited to the manufacturing overhead account
Applied manufacturing overhead

Estimate of the overhead resources used to manufacture a product
Applied to products using a predetermined overhead rate
Credited to the manufacturing overhead account
(cont.)
4-113

4-114

overhead (cont.)
At the end of an accounting period total actual manufacturing
overhead may not equal total applied manufacturing
overhead
Disposing of underapplied or overapplied overhead at the end
of the accounting period
Close the underapplied or overapplied overhead to cost of goods sold
or
Prorate to cost of goods sold, work in process inventory and finished
goods inventory
(cont.)
4-115

overhead (cont.)
Most firms dispose of underapplied or overapplied
overhead at the end of the year only
monthly fluctuations may average out over a year
One reason for underapplied or overapplied

manufacturing overhead is an error or inaccuracy
in the predetermined overhead rate

4-116

Conventional product costing systems range from job
costing to process costing
Job costing
Manufacturing costs traced to individual jobs
Products produced in distinct jobs/batches which are
significantly different
Printers, furniture manufacturers, machinery manufacturers
Many service firms such as lawyers, accountants, consulting
engineers
(cont.)
4-117

(cont.)
Process costing
Production costs traced to process/department and

averaged across all units produced
Mass production or repetitive environment
Petrol production, processed food, chemical and plastics
manufacturers
Repetitive services such as routine processing of
cheques by banks, handling of licence applications by
government departments
(cont.)
4-118

(cont.)
Process costing involves
Estimating the cost of production processes
Calculating the average cost per unit by dividing the cost of
the process by the number of units produced
Where there are sequential processes, the costs of products
produced in one department are transferred into the next
department
Some product costing systems have features of both

job costing and process costing

4-119

4-120
Job costing
Bill of materialslists all the materials required for
a job
Material requisition formsauthorises the
movement of raw materials from the warehouse to
the production department
Job cost sheetsummarises the costs of direct
material, direct labour and manufacturing
overhead for a particular job
(cont.)
4-121
Job costing (cont.)

Purchase of materials
Raw material inventory
Account payable
xxxx
Transferring direct material to jobs

xxxx
Raw material inventory
xxxx
xxxx
(cont.)
4-122
Job costing (cont.)

Use of indirect material in production
xxxx
Manufacturing supplies inventory
xxxx
Charging direct labour to jobs
xxxx
Wages payable
xxxx
(cont.)
4-123
Job costing (cont.)

Accounting for indirect labour
Manufacturing overheadxxxx
Wages payable xxxx
Accounting for manufacturing expenses
Manufacturing overheadxxxx
Prepaid rent
xxxx
Depreciation on equipment
xxxx
etc.
(cont.)
4-124
Job costing (cont.)

Application of manufacturing overhead
xxxx
xxxx
Completion of production job
xxxx
xxxx
(cont.)
4-125
Job costing (cont.)

Sale of goods
Accounts receivable
Sales revenue
xxxx
Cost of goods sold

xxxx
xxxx
xxxx
(cont.)
4-126
Job costing (cont.)

Underapplied overhead
Cost of goods sold
xxxx
xxxx
Or the reverse entry if overhead is overapplied

4-127
Process costing
The approach taken in process costing depends on
The existence of work in process (WIP) inventory at the end of
the accounting period
The degree to which products are identical in their consumption
of direct material and specific production processes
Simple forms of process costing assume no WIP

inventory
More complex forms of process costing involving WIP
are covered in Chapter 5

4-128

4-129
Summary
Different measures of product costs are appropriate for
different purposes
Past costs for inventory valuation
Current and future costs for decision-making, which may include nonmanufacturing costs
Overhead costs are allocated to product costs according to

their consumption of an overhead cost driver
The choice of product costing system depends on the
characteristics of the product and production environment and
may range from job costing to process costing

4-130
Chapter 5
Process costing and operation
costing

5-131
Outline
Process costing
Process costing with work in process inventory
Calculation of equivalent units
The effects of beginning and ending work in process inventories
Process costing using the weighted average method
Process costing using the first-in, first-out (FIFO) method
Comparison of weighted average and FIFO
Process costing and spoilage
Operation costing
Other issues in process costing

5-132
Process costing
Job costing and process costing are two extremes of the
continuum of conventional product costing systems
Job costing systems accumulate the costs of
each job
Process costing systems accumulate the cost of each
process then average these costs across all units produced
Many businesses use a combination of job and process
costing; this is called hybrid costing
(cont.)
5-133
Process costing (cont.)

Used by businesses that mass-produce one product
or a small range of almost identical products
Involves a number of processes that are performed
repetitively
Used by oil refineries, food processors and manufacturers
of tobacco, chemicals and paper
Also used by producers of repetitive services such as
routine processing of cheques in banks and delivery of
standard letters in Australia Post
(cont.)
5-134
Process costing (cont.)

Two main steps
Estimate the cost of the production process
Calculate the average cost per unit by dividing the cost of the process
by the number of units produced
Process costing can occur where there is no opening or

closing WIP inventory (see Chapter 4)
More complex process costing takes account of WIP
inventory
Need to calculate equivalent units to apportion cost between new
production and inventory

5-135
Process costing with work in

process inventories
WIP inventory
Not all products are complete at the beginning or end of

the period (usually a month)
Production costs will be calculated after taking into

account
Units started in the previous period and completed in
current period (beginning WIP)
Units started and completed in the period
Units that are incomplete at the end of the period (ending
WIP)
(cont.)
5-136

process inventories (cont.)
Partially completed goods at the beginning or end

of the period change the way we allocate
production costs
Equivalent units
The amount of production inputs that have been applied
to the physical units during production
Physical units are all units currently in production whether
complete or incomplete
WIP inventory needs to be converted to equivalent units
to provide the basis for calculating product cost
(cont.)
5-137

process inventories (cont.)
Materials are input into production at various
stages
We usually assume that labour and overhead are
used uniformly throughout the production process
Treat collectively as conversion costs
Units in ending WIP are generally at different

stages of completion with respect to material and
conversion cost

5-138
Equivalent units
Equivalent units are used to calculated unit costs
when there is WIP
If WIP is 50% complete for 10 000 litres on hand at
the end of the month, it is
100% complete for direct materials, which are added at the
start of the process 10 000 equivalent units of material
50% complete for conversion costs, assuming that
conversion costs occur uniformly across the production
process 5000 equivalent units of conversion cost

5-139
The effects of beginning and

ending work in process inventories
Four steps in process costing
1. Analyse the physical flow of units
2. Calculate the equivalent units
3. Calculate the unit costs
4. Analyse the total costs
Products are costed using one of two assumptions

about product flow
Weighted average method
First in, first out (FIFO) method

5-140
Process costing using the

weighted average method
Step one: analyse the physical flow of units
Physical units Physical
in beginning + units
WIP
started
Physical units
completed
and
transferred
out
Physical
units in
ending WIP
(cont.)
5-141

weighted average method (cont.)
Step two: calculate the equivalent units
The equivalent units in beginning WIP are not identified
separately; this is a key feature of the weighted average
cost method
Equivalent
units
completed and
transferred out
Equivalent
units in ending
WIP
= Total equivalent
units
(cont.)
5-142

weighted average method (cont.)
Step three: calculate the unit costs
The cost per equivalent unit for direct material is the total direct material
costs divided by the total equivalent units
The cost per equivalent unit for conversion cost is the total conversion
cost divided by the total equivalent units
Under the weighted average method the cost per equivalent unit is based
on the total costs incurred including the cost of beginning WIP
Step four: analyse the total costs

The production cost of units are transferred to the next production process
or to finished goods
Cost of incomplete units remains in WIP

5-143

5-144

5-145

5-146
Process costing using the FIFO

method
Assumes that the WIP inventory is completed
before the production of new units commences
Step one: analyse the physical flow of units
Identical to the weighted average method
Step two: calculate the equivalent units

Under FIFO the equivalent units in opening WIP are
subtracted from total equivalent units to give equivalent
units of new production for the month
(cont.)
5-147

5-148
Process costing using the FIFO

method (cont.)
Step three: calculate the unit costs
Cost per equivalent unit is calculated for direct material (or conversion
cost) by dividing the direct material cost (or conversion cost) incurred
during the current month by the new equivalent units added during the
current month
Costs of opening inventory are not used in this calculation
Step four: analyse the total costs

Assumes that the units in beginning WIP are completed and transferred
out first
Costs of the beginning WIP are not mixed with those new costs incurred
during the current month

5-149

5-150

5-151

5-152
Comparison of weighted average

and FIFO methods
Key difference is the treatment of the beginning WIP
Under the weighted average method the cost of beginning
WIP and equivalent units of work done on WIP are included
in the calculation of the average cost per equivalent unit
Under FIFO the cost per equivalent unit is based only on
costs incurred in the current month
Weighted average is more commonly used than FIFO
Less complex and WIP inventory may be negligible
Cost of using FIFO may exceed the benefits

5-153

Spoilage cost: the cost of defective products and wasted
resources that cannot be recovered by rework or
recycling
When spoilage occurs there are three forms of output
Units completed and transferred out
Spoiled units
Unfinished units remaining in WIP
Spoiled units are costed using cost per equivalent unit

along with the other two outputs
(cont.)
5-154

(cont.)
Spoilage is accounted for depending on whether it is

normal or abnormal
Normal spoilage: inherent in the production process
and occurs even under efficient operating conditions
Included as part of the cost of good units completed
Abnormal spoilage: should not occur under efficient

operating conditions
Costs of abnormal spoilage are expensed

5-155
Operation costing
Some businesses have repetitive production processes
but produce a narrow range of products that differ in
some significant aspects
Different material inputs
Different combinations of specific production processes
In batch manufacturing processes individual product

lines are produced in large batches and require specific
combinations of direct materials and a specific
sequence of production processes
(cont.)
5-156

5-157
Operation costing (cont.)

Operation costing is a hybrid costing system
Used in a batch manufacturing environment
Contains features of both job costing and process costing
Direct material assigned to individual batches, as in job
costing
Conversion costs assigned to departments or processes
using a predetermined application rate, as in process
costing

5-158

5-159

Standard costs are more likely to be used than actual costs
Process costing and operation costs are consistent with
concepts of responsibility accounting
Processes or operations are usually performed in different departments
Departmental managers may be held responsible for the departments
costs and output produced
A predetermined overhead rate may be used in process

costing and a predetermined conversion cost rate in operation
costing
Underapplied or overapplied costs to be accounted for
(cont.)
5-160

(cont.)
Production units are usually used as the cost driver in
process costing and operation costing
Inputs such as machine hours or labour hours may be used as

cost drivers in operation costing
The percentage of completion is difficult to determine and

is often only a rough estimate
Sometimes businesses will ignore WIP inventories for simplicity
In service firms some routine, repetitive or similar services

can be costed using process or operation costing

5-161
Summary
Process costing suits businesses that mass-produce a small
range of products
Weighted average or FIFO methods may be used to assign
costs to products and inventory
The presence of WIP inventory requires calculation of
equivalent units
Simple forms of process costing do not entail the costing of WIP
inventory
Operation costing is a hybrid of job costing and process costing

5-162
Chapter 6
Service costing

6-163
Outline
What are service organisations?

Differences between service and manufacturing businesses
Value chains in service firms, retailers and wholesalers
Service production environments
Activity-based costing for services
Case study: Service costing at Adelaide Bank
When should firms estimate their service costs?
Flow of costs in service firms
Costing in retail and wholesale businesses

6-164
What are service organisations?

Organisations that deliver help, utility or care,
providing an experience, information or other
intellectual content where the majority of the value is
intangible rather than residing in any physical products
Service organisations dominate many economies
private sector, public sector, not-for profit sector

6-165
Differences between service and

manufacturing businesses
Most services are intangible
Service outputs are often heterogeneous
Services are often consumed as they are
produced
Services are perishable and cannot be stored
Some services entail some minor physical or
tangible aspects

6-166
Other aspects of services

Retailers and wholesalers are part of the service
sector
They have different characteristics to most service firms
Provide tangible goods as well as services
Services are produced outside the service sector

Most manufacturing firms provide a service component to
their product
Upstream and downstream segments of the value chain
may produce services

6-167

6-168
The value chain in service firms

Upstream activities and costs
Only large service firms may have research and development (R&D)
and design activities
Downstream activities and costs

Marketing and customer support
Production and delivery activities and costs

Production and delivery may occur simultaneously
Direct labour may dominate and materials may not be significant
Upstream and downstream costs may be regarded as

overhead costs for service costing purposes

6-169

6-170
The value chain for retailers and

wholesalers
Upstream activities and costs
R&D and design unlikely to be relevant
Purchasing activities important
Production activities and cost

The sales transaction and (sometimes) distribution are included
Sales and distribution may occur at the same time
Downstream activities and cost

Marketing activities, delivery and customer support are
important

6-171

6-172

Professional service firms
Staffed by professional staff who provide individual services to
customers
There are relatively few customers, despite having large numbers of
staff
The front office is more important than the back office
Service delivery involves people, more than equipment, and the
emphasis may be more on the how the service is delivered rather
than what is delivered
Examples: medical, legal, accounting, management consulting and
architectural businesses
(cont.)
6-173

(cont.)
Mass service entities
Involve many customers, each one requiring limited staff time

and limited customisation
Staff are mainly non-professional
Most of the value is in the back office not the front office
The service may involve equipment, and focus more on what is
delivered rather than how
Examples: bus and train companies, airline companies, post
offices, electricity suppliers, telecommunications companies and
public service organisations
(cont.)
6-174

(cont.)
Service shops
Fit between professional and mass service businesses
in terms of the number of customers, staff time and
degree of customisation
Examples: hotel chains, banks, cafs and restaurants,
print shops and car repair workshops
Some service entities have aspects of mass service and
professional service types

6-175

6-176
Job costing systems for

professional service firms
Professional service firms have limited material or
equipment and produce no inventories
Professional firms suit a job costing environment
Few clients and jobs
The production process for each client is unique
Labour cost can be traced directly to individual services in an
economic manner
Job billing rather than job costing may be used

6-177
Process costing systems for

(some) mass services
Services are produced in large quantities, so
individual tracking of costs is not feasible
Production processes are repetitive; there is
limited room for customisation
Various services consume similar resources
Substantial indirect labour
Costs tracked directly to production processes
Process costing will not provide accurate tracking
of costs to services, where the scope for discretion
in service delivery is high
6-178
Hybrid costing systems for

service shops and (other) mass
services
Suitable for some service shops and some mass
service entities
Varying degrees of customisation, standardisation
of processes and traceability of costs
Costing systems will vary on a continuum from job
costing to process costing

6-179
Activity-based costing for

services
Service entities often have high direct labour costs
that can be traced directly to services
Overhead costs can be allocated to services using
cost drivers
The greater the proportion of overhead costs
the greater the potential for inaccurate service costs
more benefits may be gained from accurate activitybased costing, versus conventional costing systems

6-180
Case study: Costing services at

Adelaide Bank
Job costinginvestment advisory services
Professional labour costs
Traced to jobs using an hourly rate
Hourly rate based on annual salary plus on-costs, divided
by billable hours
Overhead costs
Includes upstream and downstream costs
Identify the overhead cost driver, often professional labour
Predetermined overhead rate per dollar of professional
labour
(cont.)
6-181

Adelaide Bank (cont.)
Why estimate the cost of investment advisory
services?
A basis for setting fees
To assess the profitability of each service
To determine which service to promote, refine or
withdraw
To control costs
Job billing may be used rather than costing to

determine fees
Charge out rates per billable hour; includes an allowance
for overheads and required profit margin
(cont.)
6-182

Process costingATM services

Three processes
The provision of ATM service facilities

Initial transaction processing by front-end processor
Back-end processing
Few direct costs for the ATM transaction

Substantial indirect labour costs in front-end and backend processing
Substantial equipment-related costs
Degree of completion and transferred-in costs not
relevant
(cont.)
6-183

Why estimate ATM services?
To set fees
Assess the profit or loss associated with each transaction
Information for control
The cost per transaction should be used with

caution in decision making
Includes a high proportion of indirect costs which do not
behave on a per-unit basis
(cont.)
6-184

Hybrid costing
Some services are a mix of standardised processes and
customised features
Which costs should be included in service costs?

Upstream and downstream costs to suit managers
decision-making needs
Costing systems may cost only some services,

based on decision-making needs

6-185
When should firms estimate their

service costs?
No external reporting requirements to estimate
individual service costs
Service costing systems will be implemented
where benefits exceed costs
Cost and benefits are influenced by
Complexity of the costing system
Accuracy of the service cost information
Relevance of service cost information to managing
resources and creating value
(cont.)
6-186
When should firms estimate their

service costs? (cont.)
Relevance to creating value and managing resources
Managers can use service costs to assess service profitability,
decide what service to produce/offer, set prices/fees, and to
plan and control costs
Complexity, accuracy and relevance of service costing

will vary across different types of service environments
Service costing may be undertaken infrequently and
selectively to meet managers needs

6-187

6-188
Service costing in practice

Job costing is common in professional service firms and
some service shops
Costing systems in service firms tend to focus on the
costs of responsibility centres
Firms may choose to cost only some services to support
management decisions
The benefits of a costing system (or an individual costing
exercise) should be compared to the costs of setting up
the system

6-189

No inventory to value, so external reporting
requirements not relevant
Individual service costs are usually not
accumulated in the general ledger
Costs are shown as line item operating expenses,
not cost of goods sold (COGS) in income
statements
(cont.)
6-190

(cont.)
Service costs not usually integrated into the
accounting ledger, so overapplied or underapplied
overhead not relevant
Some service firms do need to account for workin-process (AASB 102)
Consist of accumulated costs of jobs, where fees are not
realised
Only production costs can be included

6-191
Costing in retail and wholesale

businesses
Two distinct aspects
Tangible goods are sold

There is a wide range of goods
Inventories and COGS are recorded in the

accounting ledger
Inventories must be valued at the end of an
accounting period at the lower of cost or net
realisable value
(cont.)
6-192

businesses (cont.)
Cost of goods sold
Cost of beginning inventory + purchases cost of ending

inventory
How may managers use COGS?

Assess the profitability of various product lines and
responsibility centres
Guide product pricing
Upstream and downstream costs may be included

to provide a more comprehensive estimate of
COGS for decision making
(cont.)
6-193

businesses (cont.)
A range of services may also be provided to
customers as part of the sales transaction and at
other points on the value chain
For accounting purposes, these costs are
expensed in the current accounting period
For management decisions, these service costs
may need to be identified to help manage
resources

6-194
Summary
Most service outputs are intangible, heterogeneous,
consumed as produced, perishable and cannot be stored
The type of service costing system may depend on the service
environment
Job costing may suit professional services
Process costing may suit mass services
Overhead costs may include upstream and downstream costs

Unlike in manufacturing, service costs are solely to support
managers decision making

6-195
Chapter 7
A closer look at
overhead costs

7-196
Outline
What are overhead costs?

Allocating indirect costs: some general principles
Allocating overhead costs to products
Activity-based costing compared with the two-stage cost
allocation process
Evaluating the alternatives for allocating overheads
Issues in estimating overhead rates
Allocating indirect costs to responsibility centres
Other issues in allocating support department costs

7-197
What are overhead costs?

For product costing these are indirect product
costs
For responsibility costing these are the indirect
costs of responsibility areas
Manufacturing overhead costs
All manufacturing costs other than direct material and
direct labour costs
(cont.)
7-198
What are overhead costs? (cont.)

Incurred for a variety of products and cannot be traced to
individual products
Can be traced to individual products but it is more
appropriate to treat this cost as a cost of all outputs
Includes depreciation, factory insurance, factory electricity
costs, cost of manufacturing support departments, indirect
materials, indirect labour
Non-manufacturing costs are all costs incurred outside of
manufacturing

7-199
Allocating indirect costs: some

general principles
Using cost pools
Cost assignment can take two forms
Direct costs can be traced directly to products
Indirect costs cannot be traced to cost objects; therefore
they need to be allocated
A cost pool is a collection of costs that are to be allocated

to cost objects
Have a common allocation base
Often used to simplify the allocation process
(cont.)
7-200

7-201
Allocating indirect costs: some

general principles (cont.)
Determining cost allocation bases
A cost allocation base is some factor or variable that
allows us to allocate costs in a cost pool to cost objects
Should be a cost driver
A cost driver is an activity or factor that causes a cost to

be incurred

7-202

products
Reliable product costs are important for a range of
management decisions
An important issue is how to allocate indirect costs
to obtain a reliable estimate of a products cost
Three possible approaches
A plantwide rate
Departmental rates
Activity-based costing
(cont.)
7-203

products (cont.)
Using a plantwide rate
A plantwide rate is a single overhead rate that is calculated
for the entire production plant
Three steps
Identify the overhead cost driver
Calculate the overhead rate per unit of cost driver
Apply the manufacturing overhead cost to the product
based on the predetermined overhead rate and the
products consumption of the cost driver
(cont.)
7-204

products (cont.)
Departmental overhead rates recognise that overheads in

each department may be driven by different cost drivers
Two-stage cost allocation for department overhead rates
Stage one: Overhead costs are assigned to production
departments
All manufacturing costs are distributed to each department,
involving tracing and allocating
Support department costs are reassigned to overhead cost pools
in the production departments
(cont.)
7-205

products (cont.)
Stage two: overhead costs are applied to products
Manufacturing overhead rates are calculated for each
production department
Predetermine
d
manufacturin
g overhead
rate
Applied
overhead
Budgeted manufacturing
overhead
Budgeted level of cost driver
= Predetermine Quantity of cost

d overhead
driver consumed
rate
by the product
(cont.)

7-206

7-207

products (cont.)
Activity-based costing can be used to allocate
overhead costs to products
Stage one: Overhead costs are assigned to activity
cost pools for significant activities (not
departments)
Stage two: Activity costs are applied to products
using a rate, based on the products consumption
of the activity
Activities
A unit of work performance within the organisation
7-208

7-209
Activity-based costing compared

with the two-stage cost
Departmental process
rates
allocation
Stage one: allocation bases used are ideally determined
by causal relationships
Stage two: one cost driver per department, with cost
drivers being measures of production volume
Activity-based costing
Focuses on the costs of activities
Has many activity cost pools and cost drivers which may
be volume or non-volume related

7-210
Evaluating the alternatives for

allocating overheads
Plantwide and departmental overhead costing
systems tend to overcost high-volume relatively
simple products and undercost low-volume
complex products
A system with multiple cost drivers and overhead
rates is more complicated and costly to operate,
compared with a single plantwide rate, but may
produce more accurate and useful information for
decision making

7-211
Issues in estimating overhead

rates
Identifying overhead cost drivers
What is the major factor that causes manufacturing
overhead to be incurred?
To what extent does the overhead cost vary in proportion
with the cost driver?
How easy is it to measure the cost driver?
It is difficult to identify one factor that is a dominant
cause of manufacturing costs, particularly at the plant or
department level
(cont.)
7-212

rates (cont.)
Volume-based cost drivers
Conventional costing systems assume that overhead costs
vary proportionally with production volume
Based on output: number of units produced
Based on inputs: direct labour hours, direct labour cost,
machine hours, direct material quantity
For plantwide rates, select a cost driver that is common to
all products
Cost drivers that are measured in dollars should be avoided
(cont.)
7-213

rates (cont.)
Non-volume-based cost drivers
Not all aspects of manufacturing overhead varies with
production volume
Need to be careful in assigning volume-based cost driver
to fixed costs
Activity-based costing recognises both volume-based
and non-volume-based cost drivers
(cont.)
7-214

rates (cont.)
Distinguishing between fixed and variable overheads
Helps managers to understand the behaviour of overhead
costs if fixed and variable overheads are separated
Dual overhead rates may be calculated
Variable costing allocates only variable overhead costs to
products
Product costs will not be more accurate if volume-based
cost drivers are used to allocate both fixed and variable
overheads to products
(cont.)
7-215

rates (cont.)
Budgeted versus actual overhead rates
Budgeted costs and amounts of cost drivers, rather than actual

costs and cost drivers, are used to calculate overhead rates
Trade-off between timeliness and accuracy
Budgeted rates calculated prior to the commencement of the year
More timely
Actual rates calculated after the end of the year

More accurate
Normal costing includes predetermined overhead rates, whereas

actual costing uses actual overhead rates
(cont.)
7-216

rates (cont.)
Over what period should overhead rates be set?
Yearly rates are generally used
Monthly rates tend to fluctuate due to price changes and
seasonal factors
A normalised overhead is an overhead rate calculated
over a relatively long period
Smooths out fluctuations in overhead rates, therefore
smoothing out product costs
(cont.)
7-217

rates (cont.)
Estimating the amount of a cost driver: the effects of capacity
Denominator volume: an estimate of the quantity of the cost driver used
to determine overhead rates
Expected use of cost driver, based on the budgeted volume or normal
volume
Normal volume: volume that will satisfy demand over the normal
business cycle (several years)
Expected supply of cost driver, based on theoretical capacity or practical
capacity
Theoretical capacity: maximum capacity that can be achieved
Practical capacity: allows for normal downtime

7-218
Allocating indirect costs to

responsibility centres
Levels of cost allocation
Corporate level: some head office costs are allocated to business units
Within business units: administrative costs of business units may be
allocated to operating units
Manufacturing plant: indirect manufacturing costs may be allocated to
production departments
Reasons for allocating costs to responsibility centres

Helps managers understand the economic effects of their decisions
Encourages a particular pattern of resource usage
Supports the product costing system
(cont.)
7-219
Allocating indirect costs to

responsibility
centres
(cont.)
General principles
Allocation bases should be cost drivers, where there is a clear and direct
relationship between the amount of cost driver and the level of cost.
Other criteria include
Benefits received
Ability to bear additional costs
Using budgeted, not actual, allocation data

Minimises the possibility that the activities of one department will affect the
costs allocated to other departments
Provides better information for managers to plan and control their use of
indirect resources

7-220
Allocating support department

costs
Informs user departments of the cost of the services that

they are using, to assist them with planning and control of
that usage
Allocation methods include
Direct: support department costs are allocated directly to
production departments
Step-down: partially recognises the services provided by one
support department to another
Reciprocal services: fully recognises the provision of services
between support departments
(cont.)
7-221
Allocating support department

costs (cont.)
Which allocation method is best?
Each method gives slightly different outcomes
Choice should be based on costs versus benefits
Consider allocation bases and their accuracy
Beware of arbitrary and inaccurate cost allocation
Where reciprocal relationships are strong, the reciprocal services

method may be more appropriate
The arbitrary nature of these cost allocation methods is a
limitation of conventional product costing systems
Activity-based costing may provide more reliable outcomes

7-222
Other issues in allocating

support department costs
In service organisations, there is no need to
distinguish between production and nonproduction areas in determining the costs of
service outputs
In flexible manufacturing systems, individual
products are created within the one defined work
area, so there is reduced need to allocate indirect
production costs to products

7-223
Summary
Overhead cost can be allocated to products using a plantwide
rate, department rates or activity-based costing methods
Ideally, cost drivers should be used as allocation bases
As the number of overhead rates increases the accuracy of the
product cost is likely to increase
Cost benefit considerations are relevant when choosing a
method for overhead allocation
Indirect costs can be allocated to user departments to
encourage users to manage their resources

7-224

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Chapter 1

Management accounting: information

Copyright 2009 McGraw-Hill Australia Pty Ltd

Australian organisations in the

Australian organisations in the

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Used by senior managers through to operational managers

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Management accounting and

Costing systems are common to both financial and

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Management accountants within

Accounting staff may be found in each operating

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Management accounting and

Management accounting and

Management accounting and

Management accounting and

Management accounting and

Management accounting and

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Costing goods and services

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Some important considerations

Some important considerations

Salary of accounting personnel

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Some important considerations

More effective planning

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Management accounting design:

Institutional theory design is influenced by institutional

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they needed to improve their product and service

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Contemporary management accounting systems

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Systems to support formulation and implementation of strategy

Contemporary management accounting techniques have

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Management accounting systems

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Management accounting systems

Conventional versus contemporary approaches

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Non-financial information assumes increased importance in

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Cost classifications: different

Cost classifications: different

Measured in monetary terms

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Classifying costs according to

Managers must understand how costs change as

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Direct and indirect costs