ACCOUNTING AND FINANCE IN

BUSINESS
Management Accounting week 1
Introduction to Management Accounting
and Costing
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 Formative assessment
• Essay available on DUO. Deadline 6 December.
• MCQ test on Financial Accounting, available 27
November to 1 December at 5pm.

2
 Objective
• to consider the role of the management accounting function
• to introduce costing
• to identify cost classification methods
• to consider the traditional treatment of overheads, through absorption
costing
• reading; please see module handbook
• relevant to seminar 4

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 Learning Outcomes
After studying this topic students should be able to

• differentiate between Financial and Management Accounting.

• discuss the role of the management accounting function.
• apply a range of methods of classifying costs.
• explain the distinction between direct and indirect costs.
• identify a unit’s prime cost.
• apply a range of absorption bases to derive full product cost.

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 Accounting
• “the process of identifying, measuring &
communicating financial information about an entity
to permit informed judgements & decisions by users
of the information” American
Accounting Association (AAA 1966)

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 Satisfying user need
• For accounting to be useful, there must be a clear
understanding of for whom and for what purpose the
information will be used.
• Management accounting seeks to meet the needs of the
business’s managers whilst financial accounting seeks to
meet the needs of the other user groups.
• Management Accounting provides information for decision
making, planning and control.

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 Two main strands of accounting
Financial accounting: Record keeping and subsequent
processing and analysis which leads to the production of
periodic (annual) financial statements, usually to show
good stewardship; highly regulated and standardised.
Management Accounting: Accounting designed for
internal use, to provide information for decision making,
planning and control.

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 Management and Financial Accounting
 The strands differ as they cater for different user groups who have
different sets of decisions to make. Differences include:
1. types of reports produced, their range & degree of standardisation
2. the level of reporting detail and precision of information provided.
3. the time horizon
4. statutory & regulatory status
Management accounting outputs are more detailed, frequent,
prompt and future-oriented than those from financial reporting.
Key Managing Accounting activities
• Understanding cost structure, for pricing, planning &
cost control purposes.
• Periodic comparison of actual performance to
planned performance, which facilitates both control
of cost & performance evaluation, potentially
leading to changes in practice & procedures.
• Responding to resource restrictions
• Making decisions about output levels
• Forecasting revenues, outputs, inputs, cash flow.
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 Costs

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 Classifying Costs

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 Direct and Indirect costs
• Direct costs can be measured & traced directly to a unit of
output e.g. the cost of the wood, metal & labour time that
goes into making a table.
• Indirect costs or overheads are all other revenue costs
incurred to keep the business going. The range could be
extensive and the cost could be very significant.

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 Consider whether each cost below is direct or indirect
and classify by element & function.

• 1. office manager’s salary

• 2. insurance of plant
• 3. rent of factory
• 4. depreciation of delivery
vans
• 5. water rates
• 6. lubricant used to oil
machinery
• 7. production supervisor’s
salary

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 Consider whether each cost below is direct or indirect
and classify by element & function.

• 1. office manager’s salary • 1. indirect , labour administration

function
• 2. insurance of plant • 2. indirect, expense, production
• 3. rent of factory function
• 4. depreciation of delivery • 3. as (2)
vans • 4. indirect, expense, distribution
function
• 5. water rates
• 5. indirect, expense, across the
• 6. lubricant used to oil functions
machinery • 6. indirect, material, production
• 7. production supervisor’s function
• 7. indirect, labour, production
salary
function

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 Organising overheads
• Overheads are gathered into cost centres, being business segments
with which costs can be identified. Cost centres may correspond with
business functions e.g. production cost centre, selling cost centre,
distribution cost centre, administration cost centre.
• The gathering is achieved through either allocation or apportionment.
• Overheads specific to a cost centre/department are allocated to said
cost centre e.g. insurance of office computers is allocated to the
administrative cost centre.
• Shared or common overheads are apportioned across cost centres,
using an appropriate basis eg rent may be apportioned on the basis of
floor area, employer liability insurance on the basis of headcount…..

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 Costing

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 Cost Accounting

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 Costing: the basics
• What it costs you to make one unit of output or deliver one
unit of service.
• This allows you to both manage the cost & price your
product/service accordingly.
• Standard cost shows what it should cost to produce one
unit.

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 Standard Costing
• How much should our unit of activity cost, (under
given specified operating conditions)?
• Standard costs are set at the start of the period and
used by management for planning, control & pricing
purposes.
• Setting a standard cost entails
– Tracing of direct costs to units (prime cost) and
– Assignment of indirect costs (overheads) to units of
production.

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What is my cost per unit?

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 standard cost card

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 Lemon ltd
• Lemon Ltd is a new business about to launch its
products the Pip & the Squeak, for which costing
data is given on the following slide. The directors
have set a target profit for the period of at least
£4,000. The sales manager has proposed a mark up
on prime cost of 50% which gives a selling price of
£12.30 per Pip & £38.25 per Squeak.
• Construct the calculations from which these selling
prices have been derived & decide whether or not
you would endorse them.
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 Lemon Ltd: Pips & Squeaks
Table below shows standard inputs per unit
Pip Squeak
• materials (£5 per kg) 0.5 kg 0.75kg
• labour hours 1 4
• direct expenses £2.70 £1.75
• Grade 1 staff deployed on Pip production are paid £3 per hour &
grade 2 staff deployed on Squeak production are paid £5 an hour.
• projected production overheads in the period are £2,000 &
administration overheads are £1,000
• company plans to produce 500 units in the period (250 of each
product line).
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 Lemon Ltd

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 Lemon Ltd

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 Lemon Ltd
Pip Squeak total
revenue 3075 9562.5 12637.50
prime cost 2050 6375 8425.00
surplus 4212.50

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 Lemon Ltd
Pip Squeak total
revenue 3075 9562.5 12637.5
prime cost 2050 6375 8425
surplus 4212.5
overheads 3000
profit 1212.5

being (4.1 + 12.75) x 250 = 4212.50 - 3000

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 Dealing with overheads
• Absorption costing is one method of dealing with
overheads.
• It charges overheads to units by spreading them
across a base (such as output or labour activity) &
thus becomes part of the unit cost.

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 Absorption costing

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 Lemon Ltd
• Assuming overheads are spread across the total number of
units produced, calculate the full product cost & selling price
for each.
Pip Squeak
• Prime cost 8.20 25.50
• Production overhead
• Full production cost
• Admin overhead
• Full product cost

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 Lemon Ltd: with per unit absorption of overheads
• Pip Squeak
• Prime cost 8.20 25.50
• Production overhead 4.00 4.00
• Full production cost 12.20 29.50
• Admin overhead 2.00 2.00
• Full product cost 14.20 31.50
• Plus 50% mark up on cost 7.10 15.75
• Proposed selling price 21.30 47.25
• Total Overhead absorbed £1,500 £1,500
• Total profit (7.1 + 15.75) x 250 = £5,712.50

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• How is the profit achieved when mark up is
based on absorption costing £4,500 higher
than that achieved when mark up is based on
prime cost only?

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 Lemon Ltd
Assuming that the production overheads will
be absorbed instead on a labour hour basis (to
allow differentiation between the two product
lines) re-calculate the full product costs.

NB Admin overhead continue to be absorbed on

a per unit basis.

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 Lemon Ltd: absorption based on labour time

Labour hours for 250 pips 250

Labour hours for 250 squeaks 1000
Total labour hours in period 1250

Production overhead 2000

total labour hours 1250
Gives absorption rate of £1.60 per labour hour

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 Lemon Ltd (using labour time absorption basis for production overhead)
• Pip Squeak
• Prime cost 8.20 25.50
• Prod o’head 1 x 1.6 1.60
• Prod. o’head 4 x 1.60 6.40
• Full production cost 9.80 31.90
• Admin overhead 2.00 2.00
• Full product cost 11.80 33.90
• Plus 50% mark up on cost 5.90 16.95
• Proposed selling price 17.70 50.85
• Total Overhead absorbed £900 £2,100
• Total profit (5.90 + 16.95) x 250 = £5,712.50

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 Differential effect on unit costings & selling price of
different absorption bases

full unit cost Pip Squeak

based on absorption of prod. overhead at a flat rate per unit 14.20 31.50
absorbing production overhead on the basis of labour time 11.80 33.90
-2.40 +2.40

Unit selling price Pip Squeak

based on absorption of prod overhead at a flat rate per unit 21.30 47.25
absorbing production overhead on the basis of labour time 17.70 50.85
-3.60 +3.60

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Potential absorption bases include:

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 Labour cost basis of absorption
• Recalculate the full product cost of a Pip and a
Squeak using a labour cost basis of absorption for the
production overhead.

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 Lemon Ltd
Labour cost for 250 pips 250 x 1 hr x £3 = 750
Labour cost for 250 squeaks
250 x 4hrs x £5 5,000
Total labour cost in period £5,750

Production overhead x 100 = 2,000 x 100

total labour cost 5,750
Gives absorption rate of 34.8% of labour cost

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 Lemon Ltd (using labour cost absorption basis)
• Pip Squeak
• Prime cost 8.20 25.50
• Prod o’head 35% x 3 1.05
• Prod. o’head 35% x 20 7.00
• Full production cost 9.25 32.50
• Admin overhead 2.00 2.00
• Full product cost 11.25 34.50
• Plus 50% mark up on cost 5.625 17.25
• Proposed selling price 16.875 51.75
• Total Production O’head absorbed £262 £1750
• Total profit (5.625 + 17.25) x 250 = £5,718.75 (as before but subject to
£6 rounding difference)
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 The differential effect on unit & selling price of different
absorption bases

full unit cost Pip Squeak

based on absorption of prod. overhead at a flat rate per unit 14.20 31.50
absorbing production overhead on the basis of labour time 11.80 33.90
absorbing production overhead on the basis of labour cost 11.25 34.50

selling price Pip Squeak

based on absorption of prod. overhead at a flat rate per unit 21.30 47.25
absorbing production overhead on the basis of labour time 17.70 50.85
absorbing production overhead on the basis of labour cost 16.875 51.75

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 Absorption rates
• These are set at the planning stage, in anticipation of the period
of production. The most appropriate basis should be chosen for
each cost centre’s overheads.
• The rates should ensure that, given planned activity levels &
given accurately forecast overheads, the full overhead incurred
will be charged into the final product costs. These product costs
may then be used as a basis for planning and price-setting.
• If actual production levels &/or actual overheads incurred differ
from plan, then an adjustment to total profit will be made in the
accounts for any under or over absorption of overheads.

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• Bearing in mind what you have just learnt,
consider how a plumber who has been to
repair your boiler might derive the cost of the
job and the price he charges you, the
customer.

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