Cost concepts and behaviour
Managerial accounting supports decisions inside a business. It begins with understanding different kinds of costs and how they behave.
Managerial versus financial accounting
Managerial accounting provides information to internal decision-makers: managers planning, controlling, and making decisions. Unlike financial accounting, it is not bound by GAAP, focuses on the future as well as the past, reports on parts of the business (products, departments), and emphasises relevance and timeliness over strict precision.
Manufacturing costs
Manufacturers classify product costs as direct materials (materials traced to a product, such as wood in a table), direct labour (wages of workers who make the product), and manufacturing overhead (all other factory costs, such as factory rent, utilities, supervisors, and depreciation on machines). Selling and administrative costs are period costs, expensed when incurred.
Product and period costs
Product costs are attached to inventory and become cost of goods sold only when products are sold. Period costs, such as advertising and office salaries, are expensed in the period incurred. Manufacturers track inventory in three stages: raw materials, work in process, and finished goods.
Variable and fixed costs
Variable costs change in total in proportion to activity, such as materials per unit, while staying constant per unit. Fixed costs stay constant in total within a relevant range, such as rent, but fall per unit as output increases. Mixed (semi-variable) costs have both elements, such as a phone plan with a fixed fee plus usage charges.
The relevant range
Cost behaviour assumptions hold only within a relevant range of activity. If production doubles beyond the factory's capacity, fixed costs such as rent may step up because a new building is needed. Outside the relevant range, estimates must be revisited.
Separating mixed costs
Mixed costs can be split using the high-low method: variable cost per unit = (cost at highest activity - cost at lowest activity) / (highest activity - lowest activity); fixed cost = total cost - variable cost x activity. Regression analysis gives more accurate estimates using all data points.
The contribution margin income statement
A contribution margin income statement separates costs by behaviour: sales minus variable costs equals contribution margin, minus fixed costs equals operating income. Contribution margin shows how much each sale contributes to covering fixed costs and profit, and is central to decision-making.
Worked example
Utility costs were 7,000 dollars at 2,000 machine hours (lowest) and 12,000 at 4,500 hours (highest). Variable cost = (12,000 - 7,000) / (4,500 - 2,000) = 2 dollars per hour. Fixed cost = 12,000 - 2 x 4,500 = 3,000 dollars. The cost formula is 3,000 + 2 x hours; at 3,000 hours, expected cost is 9,000 dollars.
Key takeaways
Managerial accounting serves internal decisions, is not bound by GAAP, and looks forward. Product costs are direct materials, direct labour, and overhead; period costs are expensed when incurred. Variable costs change in total with activity; fixed costs stay constant in total within the relevant range; mixed costs combine both. The high-low method separates mixed costs. Contribution margin income statements organise costs by behaviour.
Flashcard
Information for internal decisions
Check your understanding
As production increases within the relevant range, what happens to fixed cost per unit?