Managerial and Financial Accounting Concepts Explained

1. Managerial Versus Financial Accounting Differences

Financial accounting is concerned with reporting financial information to external parties, such as stockholders, creditors, and regulators. Managerial accounting is concerned with providing information to managers for use within the organization.

• Financial accounting emphasizes the financial consequences of past transactions, objectivity and verifiability, precision, and companywide performance.
• Managerial accounting emphasizes decisions affecting the future, relevance, timeliness, and segment performance.

Financial accounting is mandatory for external reports and must comply with rules, such as Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), whereas managerial accounting is not mandatory and does not need to comply with externally imposed rules.

2. Planning and Control at a Television Network

Consider a major television network. Managers engage in various planning and control activities:

Planning Activities (Five Examples)

1. Estimating the advertising revenues for a future period.
2. Estimating the total expenses for a future period, including the salaries of all actors, news reporters, and sportscasters.
3. Planning how many new television shows to introduce to the market.
4. Planning each television show’s designated broadcast time slot.
5. Planning the network’s advertising activities and expenditures.

Controlling Activities (Five Examples)

1. Comparing the actual number of viewers for each show to its viewership projections.
2. Comparing the actual costs of producing a made-for-television movie to its budget.
3. Comparing the revenues earned from broadcasting a sporting event to the costs incurred to broadcast that event.
4. Comparing the actual costs of running a production studio to the budget.
5. Comparing the actual cost of providing global, on-location news coverage to the budget.

3. Make-or-Buy Decision Factors

When deciding whether to continue making a component part or to begin buying it from an overseas supplier, both quantitative and qualitative factors influence the decision:

• Quantitative Analysis: Focuses on determining potential cost savings from buying the part rather than making it.
• Qualitative Analysis: Focuses on broader issues such as strategy, risks, and corporate social responsibility.

For instance, if the part is critical to the organization’s strategy, the company may continue making it despite potential cost savings from outsourcing. If the overseas supplier might create quality control problems threatening consumer welfare, the risks of outsourcing may outweigh cost savings. Furthermore, from a social responsibility standpoint, a company might avoid outsourcing if it results in layoffs at its domestic manufacturing facility.

4. Purposes of Budget Preparation

Companies prepare budgets to translate plans into formal quantitative terms. Budgets serve several purposes:

• Forcing managers to plan ahead.
• Allocating resources across departments.
• Coordinating activities across departments.
• Establishing goals that motivate people.
• Evaluating and rewarding employees.

These various purposes often conflict, making budgeting one of management’s most challenging activities.

5. Major Elements of Product Costs

The three major elements of product costs in a manufacturing company are:

1. Direct Materials
2. Direct Labor
3. Manufacturing Overhead

6. Cost Definitions

Definitions for key cost terms:

• (a) Direct Materials: An integral part of a finished product whose costs can be conveniently traced to it.
• (b) Indirect Materials: Generally small material items (like glue and nails). They may be integral to the product, but their costs are traced to the product only at great cost or inconvenience.
• (c) Direct Labor: Labor costs that can be easily traced to particular products; also called “touch labor.”
• (d) Indirect Labor: Labor costs of workers like janitors, supervisors, and materials handlers that cannot be conveniently traced to particular products. These costs support production but the workers do not directly work on the product.
• (e) Manufacturing Overhead: Includes all manufacturing costs except direct materials and direct labor. Consequently, it includes indirect materials and indirect labor, as well as other manufacturing costs.

7. Product Cost Versus Period Cost

A product cost is any cost involved in purchasing or manufacturing goods. For manufactured goods, these costs include direct materials, direct labor, and manufacturing overhead. A period cost is a cost taken directly to the income statement as an expense in the period in which it is incurred.

8. Cost Classification Distinctions

• (a) Variable Cost: The variable cost per unit is constant, but total variable cost changes in direct proportion to changes in volume.
• (b) Fixed Cost: The total fixed cost is constant within the relevant range. The average fixed cost per unit varies inversely with changes in volume.
• (c) Mixed Cost: A mixed cost contains both variable and fixed cost elements.

9. Effect of Volume Increase on Costs

When volume increases:

• a. Unit fixed costs: Decrease as volume increases.
• b. Unit variable costs: Remain constant as volume increases.
• c. Total fixed costs: Remain constant as volume increases.
• d. Total variable costs: Increase as volume increases.

10. Cost Behavior Terminology

• (a) Cost Behavior: Refers to the way costs change in response to changes in a measure of activity such as sales volume, production volume, or orders processed.
• (b) Relevant Range: The range of activity within which assumptions about variable and fixed cost behavior are valid.

11. Activity Base for Variable Costs

An activity base is a measure of whatever causes the incurrence of a variable cost. Examples of activity bases include units produced, units sold, letters typed, beds in a hospital, meals served in a cafe, or service calls made.

12. Defending Linear Cost Assumptions

The linear assumption between cost and volume can be defended because the cost formula is reasonably valid, provided it is used only within the relevant range, even if many costs are curvilinear in nature.

13. Discretionary Versus Committed Fixed Costs

• Discretionary Fixed Cost: Has a fairly short planning horizon (usually a year). These costs arise from annual management decisions to spend on items like advertising, research, and management development.
• Committed Fixed Cost: Has a long planning horizon (generally many years). These costs relate to a company’s investment in facilities, equipment, and basic organization, and are “locked in” for many years once incurred.

14. Relevant Range and Fixed Costs

Yes, the concept of the relevant range applies to fixed costs. As the anticipated level of activity changes, the level of fixed costs needed to support operations may also change. Most fixed costs adjust upward and downward in large steps, rather than remaining absolutely fixed across all ranges of activity.

15. High-Low Method Disadvantage

The major disadvantage of the high-low method is that it uses only two points (the highest and lowest activity levels) to determine a cost formula. These two points are likely to be less than typical because they represent extremes of activity.

16. Mixed Cost Formula Components

The general formula for a mixed cost is Y = a + bX.

• The “a” term represents the fixed cost.
• The “b” term represents the variable cost per unit of activity.