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Managerial Accounting Unit 1: Managerial Accounting and Cost Concepts

Managerial accounting gives managers the cost information they need to plan, control and decide. This unit builds the vocabulary of cost classification that every later unit uses.

Covers: Managerial vs. financial accounting, Product vs. period costs, Direct materials, direct labor and overhead, Prime and conversion costs, Cost of goods manufactured and sold, Direct vs. indirect costs, Sunk, opportunity and differential costs

Study guide

Financial accounting reports to outsiders such as investors and lenders, follows GAAP and focuses on the past. Managerial accounting reports to people inside the company. It has no required format, uses estimates and forecasts freely, and often reports on segments such as a product line, department or store instead of the whole firm. Managers use it for three jobs: planning (setting goals and budgets), directing (running daily operations) and controlling (comparing actual results with the plan and acting on the differences). Because the reports are for decisions, timeliness and relevance matter more than precision, and a rough estimate today can be worth more than an exact number next quarter.

Manufacturing costs, also called product costs, have three parts. Direct materials are materials that become part of the product and can be traced to it easily, such as the wood in a table. Direct labor is the wages of workers who build the product by hand or with machines. Manufacturing overhead is every other factory cost: indirect materials like glue, indirect labor like supervisors and maintenance workers, factory rent, utilities, depreciation on equipment and idle time. Two useful subtotals combine these: prime cost is direct materials plus direct labor, and conversion cost is direct labor plus overhead, the cost of turning materials into product.

Product costs attach to units and sit in inventory until the units are sold, then flow to the income statement as cost of goods sold. Period costs, meaning selling and administrative costs, are expensed in the period incurred. A manufacturer has three inventory accounts. Raw materials holds materials not yet used, work in process holds partly finished units, and finished goods holds completed units waiting to be sold. The schedule of cost of goods manufactured ties them together: materials used = beginning raw materials + purchases - ending raw materials; total manufacturing cost = materials used + direct labor + overhead; COGM = beginning WIP + total manufacturing cost - ending WIP; COGS = beginning finished goods + COGM - ending finished goods.

Costs can also be classified by traceability and by their role in decisions. A direct cost can be traced to a cost object easily; an indirect cost cannot, and whether a cost is direct depends on which cost object you pick. A supervisor of one product line is direct to that line but indirect to each unit. For decisions, a differential cost is a future cost that differs between options, an opportunity cost is the benefit given up by choosing one option, and a sunk cost is a past cost no decision can change. Sunk costs are always irrelevant, while differential and opportunity costs drive good choices. Keep these labels in mind because they return in the relevant-costing and budgeting units.

Key ideas

• Managerial accounting serves internal users, looks forward and does not have to follow GAAP.
• Product costs (DM, DL, MOH) are inventoried and expensed as COGS only when units are sold.
• Period costs (selling and administrative) are expensed when incurred, regardless of production.
• Manufacturing overhead is every factory cost other than direct materials and direct labor.
• Prime cost = DM + DL, and conversion cost = DL + MOH; direct labor appears in both.
• Whether a cost is direct or indirect depends on the cost object being measured.
• Sunk costs are irrelevant to decisions; differential and opportunity costs are relevant.

Formulas and rules

Common mistakes

• Treating factory costs such as rent, utilities or supervisor pay as period costs instead of overhead.
• Mixing up prime cost (DM + DL) with conversion cost (DL + MOH).
• Using purchases of raw materials instead of materials used in the COGM schedule.
• Reversing the inventory adjustment, adding ending inventory and subtracting beginning inventory.
• Counting a sunk cost such as the original price of old equipment in a decision.

Before the test, make sure you can

• Explain three differences between managerial and financial accounting.
• Classify any cost as direct materials, direct labor, overhead or a period cost.
• Calculate prime cost and conversion cost.
• Prepare a schedule of cost of goods manufactured from raw data.
• Calculate cost of goods sold for a manufacturer and compare it with a merchandiser.
• Explain why the same cost can be direct for one cost object and indirect for another.
• Identify sunk, opportunity and differential costs in a decision scenario.

Words to know

Managerial accounting

Accounting information prepared for internal managers to plan, direct and control; not bound by GAAP.

Product cost

A cost of making a product (DM, DL, MOH) that is inventoried until the product is sold.

Period cost

A selling or administrative cost expensed in the period it is incurred.

Direct materials

Materials that become part of the finished product and can be traced to it easily.

Direct labor

Wages of workers who work directly on making the product.

Manufacturing overhead

All factory costs other than direct materials and direct labor, such as indirect labor, factory rent and depreciation.

Indirect materials

Minor materials such as glue or screws that are not traced to units and are recorded as overhead.

Prime cost

Direct materials plus direct labor.

Conversion cost

Direct labor plus manufacturing overhead: the cost of converting materials into product.

Work in process

Inventory account for units started but not finished.

Cost of goods manufactured

The cost of units completed during the period: beginning WIP + manufacturing costs - ending WIP.

Cost object

Anything for which a cost is measured, such as a product, department or customer.

Direct cost

A cost that can be traced to a cost object easily and economically.

Indirect cost

A cost that cannot be traced easily to a cost object and must be allocated.

Sunk cost

A cost already incurred that cannot be changed by any future decision.

Opportunity cost

The benefit given up when one alternative is chosen over another.

Differential cost

A future cost that differs between two alternatives; also called incremental cost.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.