UPDATES IN MANAGERIAL ACCOUNTING What is Managerial Accounting?

INTRODUCTION TO MANAGERIAL • Managerial accounting is the practice of

ACCOUNTING identifying, measuring, analyzing, interpreting,
and communicating financial information to
• Since its inception, accounting has been used
managers for the pursuit of an organization's
to track assets, liabilities, and the net change
goals.
in owner's equity, in addition to determining a
company's profitability. With the rise of business How Managerial Accounting Works
organizations, its role gradually expanded. The
• Managerial accounting aims to improve the
obligation to safeguard stockholders', creditors',
quality of information delivered to
and other third-party interests came with the
management about business operation metrics.
adoption of corporate ownership. Financial
Managerial accountants use information relating
accounting was established as a result of this
to the cost and sales revenue of goods and
responsibility and the passage of tax
services generated by the company. Cost
measures, particularly those that focused on
net income. accounting is a large subset of managerial
accounting that specifically focuses on
• Accounting professionals faced a new challenge capturing a company's total costs of
during the industrial revolution: providing production by assessing the variable costs
management with a solid foundation for of each step of production, as well as fixed
pricing their output and measuring profits. costs. It allows businesses to identify and
Cost accounting developed because of this new reduce unnecessary spending and maximize
role for the accountant. These changes made profits.
management more aware of how accounting
Characteristics
data could be used in decisions made by
management and how much management 1. Internally Focused: managerial accounting
relied on the accountant to help them do their focuses on providing information for internal users.
jobs. The accountant, on the other hand, is
aware of his supporting role in management 2. Internally Regulated: managerial accounting is
and continues to develop professionally to better not subject to external requirements of generally
understand management's needs and provide accepted accounting principles set by SEC and the
timely information to them. IASB. The frequency, format, content, and rules
for selecting inputs and processes and
• Accounting management has grown due to the preparing reports depend on the needs of the
need for economic data to be used as a basis for management.
decision-making, the development of scientific
management, and the ongoing expansion of 3. Future-Oriented: Although managerial
business organizations. accounting also records and reports events that
have already occurred, it strongly emphasizes
• The issue of allocating relatively limited providing information about future events, for
resources among various alternatives confronts planning and decision making.
every individual or business entity. Decisions
with significant financial repercussions must 4. Broad and Multidisciplinary: Managerial
be made with limited resources and the accounting information may be financial or
overarching goal of optimizing a company's nonfinancial and may be subjective in nature (e.g.
position, necessitating the use of prompt estimates). It includes aspects of managerial
information to guide the process. The economics, industrial engineering, and management
possibility of using accounting data for internal science as well as numerous other areas.
purposes was made clear by this information 5. Detailed: Managerial accounting provides
requirement. detailed measures and reports used to evaluate the
performance of entities, product lines, departments,
and managers.
Managerial Accounting vs. Financial Accounting • Financial accounting information is reported at
fixed intervals (monthly, quarterly, yearly) in
• The key difference between managerial
general-purpose financial statements. These
accounting and financial accounting relates to
financial statements—the income statement,
the intended users of the information.
retained earnings statement, balance sheet, and
Managerial accounting information is aimed
statement of cash flows—are prepared
at helping managers within the organization
according to generally accepted accounting
make well-informed business decisions, principles (GAAP).
while financial accounting is aimed at
providing financial information to parties • These statements are used by external users
outside the organization. such as the following:
• Financial accounting must conform to 1. Shareholders
certain standards, such as generally accepted 2. Creditors
accounting principles (GAAP). All publicly held 3. Government agencies
companies are required to complete their 4. The general public
financial statements in accordance with GAAP
• Managers of a company also use general-
as a requisite for maintaining their publicly traded
purpose financial statements. For example, in
status. Most other companies in the U.S.
planning future operations, managers often
conform to GAAP in order to meet debt
begin by evaluating the current income
covenants often required by financial institutions
statement and statement of cash flows.
offering lines of credit.
• Managerial accounting information is designed
• Because managerial accounting is not for
to meet the specific needs of a company’s
external users, it can be modified to meet the
management. This information includes the
needs of its intended users. This may vary
following:
considerably by company or even
by department within a company. For example, 1. Historical data, which provide objective
managers in the production department may measures of past operations
want to see their financial information displayed
as a percentage of units produced in the period. 2. Estimated data, which provide subjective
The HR department manager may be interested estimates about future decisions
in seeing a graph of salaries by employee over a • Management uses both types of information in
period of time. Managerial accounting is able directing daily operations, planning future
to meet the needs of both departments by operations, and developing business strategies.
offering information in whatever format is Unlike the financial statements prepared in
most beneficial to that specific need. financial accounting, managerial accounting
reports do not always have to be:
1. Prepared according to generally accepted
accounting principles. This is because only
the company’s management uses the
information. Also, in many cases, GAAP are
not relevant to the specific decision-making
needs of management.
2. Prepared at fixed intervals (monthly,
quarterly, yearly). Although some
management reports are prepared at fixed
intervals, most reports are prepared as
management needs the information.
3. Prepared for the business as a whole. Most
management reports are prepared for
products, projects, sales territories, or other
segments of the company.
Managerial Accounting in the Management may also lead to revising future plans. This
Process philosophy of controlling by comparing actual
and expected results is called management by
exception.
• Improving. Feedback is also used by
managers to support continuous process
improvement. Continuous process
improvement is the philosophy of continually
improving employees, business processes, and
products. The objective of continuous
improvement is to eliminate the source of
problems in a process. In this way, the right
products (services) are delivered in the right
quantities at the right time.
• Planning. Management uses planning in • Decision Making. Inherent in each of the
developing the company’s objectives (goals) preceding management processes is decision
and translating these objectives into courses making. In managing a company, management
of action. For example, a company may set an must continually decide among alternative
objective to increase market share by 15 percent actions. For example, in directing operations,
by introducing three new products. The actions managers must decide on an operating
to achieve this objective might be as follows: structure, training procedures, and staffing of
day-to-day operations.
1. Increase the advertising budget
2. Open a new sales territory • Managerial accounting supports managers in all
3. Increase the research and development phases of the management process. For
budget example, accounting reports comparing actual
and expected operating results aid managers in
• Planning may be classified as follows:
planning and improving current operations. Such
1. Strategic planning, which is a report might compare the actual and expected
developing long-term actions to costs of defective materials. If the cost of
achieve the company’s objectives. These defective materials is unusually high,
long-term actions are called strategies, management might decide to change suppliers.
which often involve periods of 5 to 10
Uses of Managerial Accounting
years.
2. Operational planning, which develops • As mentioned earlier, managerial accounting
short-term actions for managing the provides information and reports for managers to
day-to-day operations of the company. use in operating a business. Some examples of
how managerial accounting could be used by
• Directing. The process by which managers run Legend Guitars include the following:
day-to-day operations is called directing. An
example of directing is a production supervisor’s 1. The cost of manufacturing each guitar could
efforts to keep the production line moving without be used to determine its selling price.
interruption (downtime). A credit manager’s 2. Comparing the costs of guitars over time can
development of guidelines for assessing the be used to monitor and control the cost of direct
ability of potential customers to pay their bills is materials, direct labor, and factory overhead.
also an example of directing.
3. Performance reports could be used to identify
• Controlling. Monitoring operating results and any large amounts of scrap or employee
comparing actual results with the expected downtime. For example, large amounts of
results is controlling. This feedback allows unusable wood (scrap) after the cutting process
management to isolate areas for further should be investigated to determine the
investigation and possible remedial action. It
 underlying cause. Such scrap may be caused by management. For example, costs are often
saws that have not been properly maintained. classified by their relationship to a segment of
operations, called a cost object. A cost object
4. A report could analyze the potential
may be a product, a sales territory, a department,
efficiencies and dollar savings of purchasing a
or an activity, such as research and
new computerized saw to speed up the
development. Costs identified with cost objects
production process.
are either direct costs or indirect costs
5. A report could analyze how many guitars need
• Direct costs are identified with and can be
to be sold to cover operating costs and
traced to a cost object. For example, the cost of
expenses. Such information could be used to set
wood (materials) used by Legend Guitars in
monthly selling targets and bonuses for sales
manufacturing a guitar is a direct cost of the
personnel.
guitar.
KEY POINT
• Managerial accounting is a staff function that
supports the management process by
providing reports to aid management in
planning, directing, controlling, improving,
and decision making. This differs from
financial accounting, which provides
information to users outside of the • Indirect costs cannot be identified with or traced
organization. Managerial accounting reports to a cost object. For example, the salaries of the
are designed to meet the specific needs of Legend Guitars production supervisors are
management and aid management in indirect costs of producing a guitar. While the
planning long-term strategies and running production supervisors contribute to the
the day-to-day operations. production of a guitar, their salaries cannot be
identified with or traced to any individual guitar.
COSTS AND TERMINOLOGIES
• As a basis for illustration of manufacturing
operations, a guitar manufacturer, Legend
Guitars, is used.

• Depending on the cost object, a cost may be

either a direct or an indirect cost. For example,
the salaries of production supervisors are
indirect costs when the cost object is an
Direct and Indirect Costs individual guitar. If, however, the cost object is
Legend Guitars’ overall production process, then
• A cost is a payment of cash or the commitment the salaries of production supervisors are direct
to pay cash in the future for the purpose of costs.
generating revenues. For example, cash (or
credit) used to purchase equipment is the cost of
the equipment. If equipment is purchased by
exchanging assets other than cash, the current
market value of the assets given up is the cost of
the equipment purchased.
• In managerial accounting, costs are classified
according to the decision-making needs of
Manufacturing Costs Legend Guitars, direct labor cost includes the
wages of the employees who cut each guitar out
• The cost of a manufactured product includes the
of raw lumber and assemble it. Other examples
cost of materials used in making the product. In
of direct labor costs include mechanics’ wages
addition, the cost of a manufactured product
for repairing an automobile, machine operators’
includes the cost of converting the materials into
wages for manufacturing tools, and assemblers’
a finished product. For example, Legend Guitars
wages for assembling a laptop computer.
uses employees and machines to convert wood
(and other supplies) into finished guitars. Thus, • Like a direct materials cost, a direct labor cost
the cost of a finished guitar (the cost object) must be both of the following:
includes the following:
1. An integral part of the finished product
1. Direct materials cost 2. A significant portion of the total cost of the
2. Direct labor cost product
3. Factory overhead cost
• For Legend Guitars, the wages of the janitors
who clean the factory are not a direct labor cost.
This is because janitorial costs are not an
integral part or a significant cost of each guitar.
Instead, janitorial costs are classified as a factory
overhead cost, which is discussed next.
• Factory Overhead Cost Costs other than direct
• Direct Materials Cost Manufactured products materials cost and direct labor cost that are
begin with raw materials that are converted into incurred in the manufacturing process are
finished products. The cost of any material that combined and classified as factory overhead
is an integral part of the finished product is cost. Factory overhead is sometimes called
classified as a direct materials cost. For Legend manufacturing overhead or factory burden.
Guitars, direct materials cost includes the cost of • All factory overhead costs are indirect costs of
the wood used in producing each guitar. Other the product. Some factory overhead costs
examples of direct materials costs include the include the following:
cost of electronic components for a television,
silicon wafers for microcomputer chips, and tires 1. Heating and lighting the factory
for an automobile. 2. Repairing and maintaining factory equipment
3. Property taxes on factory buildings and land
• To be classified as a direct materials cost, the 4. Insurance on factory buildings
cost must be both of the following: 5. Depreciation on factory plant and equipment
1. An integral part of the finished product • Factory overhead cost also includes materials
2. A significant portion of the total cost of the and labor costs that do not enter directly into the
product finished product. Examples include the cost of oil
used to lubricate machinery and the wages of
• For Legend Guitars, the cost of the guitar strings janitorial and supervisory employees. Also, if the
is not a direct materials cost. This is because the costs of direct materials or direct labor are not a
cost of guitar strings is an insignificant part of the significant portion of the total product cost, these
total cost of each guitar. Instead, the cost of costs may be classified as factory overhead
guitar string is classified as a factory overhead costs.
cost, which is discussed later.
• For Legend Guitars, the costs of guitar strings
• Direct Labor Cost Most manufacturing and janitorial wages are factory overhead costs.
processes use employees to convert materials Additional factory overhead costs of making
into finished products. The cost of employee guitars are as follows:
wages that is an integral part of the finished
product is classified as direct labor cost. For 1. Sandpaper
2. Buffing compound
 3. Glue
4. Power (electricity) to run the machines
5. Depreciation of the machines and building
6. Salaries of production supervisors
• Prime Costs and Conversion Costs Direct
materials, direct labor, and factory overhead
costs may be grouped together for analysis and
reporting. Two such common groupings are as
follows:
1. Prime costs, which consist of direct materials
and direct labor costs
2. Conversion costs, which consist of direct
labor and factory overhead costs
Conversion costs are the costs of converting the
materials into a finished product. Direct labor is both
a prime cost and a conversion cost.

• Product Costs and Period Costs For financial

reporting purposes, costs are classified as
product costs or period costs.
1. Product costs consist of manufacturing
costs: direct materials, direct labor, and factory
overhead.
2. Period costs consist of selling and
administrative expenses. Selling expenses are
incurred in marketing the product and delivering
the product to customers. Administrative
expenses are incurred in managing the company
and are not directly related to the manufacturing
or selling functions.