1.3 Managerial Accounting Terminology

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In this section, you will be introduced to the common terms and concepts used in management accounting. This introduction is meant as an overview; you will get detailed practice in each of these areas in subsequent topics.

Terms Used in Planning and Cost-Volume-Profit Analysis

This section introduces , which is a management tool primarily used in the planning process. The basic objective of C-V-P analysis is determining how a company's sales impact profits. For example, before opening a new Thai restaurant, the would-be restaurateur should calculate how many customers a day, on average, must be served in order to pay the rent and generate a reasonable profit. If the necessary number of customers to “break even” seems unreasonably high, the business plan must be revised or abandoned. This sounds like an obvious planning exercise, but too many small business owners neglect doing even this basic analysis.

To use C-V-P analysis successfully, a manager must categorize costs as either fixed or variable. The concept of fixed and variable costs is fairly simple. Total change in direct proportion to changes in some particular activity level, such as production or sales volumes. One example of a variable cost is the cost of materials (such as bolts of cloth in a clothing factory), which vary proportionately with the number of units produced. Sales commissions, which vary proportionately with sales volume, are also an example of a variable cost. Another way to think of a variable cost is that the cost is a set amount per unit—$10.00 per meal or $12,000 per car or $20 per book. The more meals or cars or books that are sold, the higher the total variable cost.

In contrast, remain constant in total, regardless of activity level, at least over a certain range of activity. Examples of fixed costs are rent, insurance, equipment depreciation, and supervisors' salaries. Regardless of changes in sales or production output, these costs typically remain constant. Using the Thai restaurant example, the rent on the restaurant location is a fixed cost because, no matter how many customers are attracted to the restaurant during the month, the monthly rent is typically still the same amount.

Obviously, to be successful, a business must first be able to pay for all of its costs. However, a good understanding of variable and fixed costs provides the organization with a clear view of how it can make a profit using C-V-P analysis. The basic C-V-P concept is that the difference, or margin, between sales and variable costs must first be used to cover fixed costs. Once the organization achieves that breakeven point, then the remaining margin becomes profit. For example, if the average variable cost to create a meal at a restaurant is $10 and the average price of a meal is $16, then each meal on average contributes $6 to cover the fixed costs of running the restaurant. If monthly fixed costs (such as rent, insurance, and so forth) at the restaurant are $9,000, then the owner needs to sell 1,500 meals ($9,000 ÷ $6) each month in order to break even. As you will see in Topic 7, C-V-P analysis is a simple but powerful tool that is core to the planning process.

Terms Related to Controlling Product Cost Flows

Imagine a trip to your favorite fast-food restaurant. Now consider all of the costs incurred by that entire fast-food organization, from the president's salary down to the cost of the lettuce for the sandwiches. For management accounting purposes, we can divide these costs into two groups, product costs and period costs. Costs closely associated with the products or services offered are called . Examples in a fast-food setting are the cost of the food, the wages of the food preparers, the salary of the store manager, and the rent on the store location. As you sit there, ready to bite into your sandwich, you can look around and see all of these costs. In this sense, they are closely associated with the product (the sandwich) and are classified as product costs. In a manufacturing company such as DuPont, product costs (often referred to as manufacturing costs) are all costs necessary to create finished goods ready for sale. They include all costs related to production: the factory manager's salary, depreciation and taxes on the factory building, wages of the factory workers, and the materials that go into the product. In a merchandising company such as Wal-Mart or Home Depot, product costs are the costs incurred to purchase goods and get them ready for resale to customers. In a service company such as the Union Pacific Railroad or Kelly Services (which provides temporary employees to other businesses), product costs (sometimes called cost of services) involve labor, supplies, and other costs directly related to providing services to customers.

are all costs incurred that are not closely associated with a specific product or service. In a fast-food setting, examples of period costs are the president's salary, advertising, and office costs incurred in the corporate headquarters. These costs are not directly associated with the sandwich that you are eating or the environment in which you are eating it. In general, the most common period costs are selling and administrative costs. Examples of selling costs are sales personnel salaries, advertising, and delivery costs. Examples of administrative costs are salaries of the president and controller, depreciation or rent on office buildings, taxes on assets used in administration, and other office expenditures such as postage, supplies, and utilities.

The labels “product” and “period” stem from the procedure followed in reporting these costs as expenses on the income statement. Product costs are expensed only when the products or services with which they are associated are sold. For example, if Wal-Mart sells two-thirds of the inventory it purchased during November, only the cost of the inventory sold (i.e., Cost of Goods Sold) becomes an expense on that month's income statement. The other third of the inventory cost remains an asset (i.e., Inventory) on the balance sheet. In contrast, all period costs are reported as an expense immediately in the period in which they are incurred. So, regardless of how many products are sold during the month, the president's entire salary for November is recognized as an expense on the November monthly income statement. Thus, these costs are called period costs because they are always expensed in the period (e.g., month) in which they are incurred.

Types of Product Costs

Now let's consider how you might measure and control product and period costs in a variety of organizations. How would you measure product costs for a merchandiser? Actually, that is a fairly easy question. The resources Home Depot spends to acquire store inventory for resale to customers clearly are product costs. As products are sold, these inventory costs become an expense on the income statement. What about the wages and salaries of Home Depot's cashiers, sales associates, and managers? Home Depot will likely categorize these costs as part of its selling and administrative expenses and treat them as a period cost on the income statement.

Now consider the same question for Ernst & Young, one of the largest certified public accounting (CPA) firms in the world. What are the products sold by this service firm? Ernst & Young sells the time of its tax accountants, auditors, and consultants. The salaries of these professionals represent the costs of its “product.” These costs are reported as the expense “cost of services sold” in the same period in which Ernst & Young reports the corresponding service revenue. Thus, if the consulting revenue from a specific job is reported in January advance each of these years by three years, e.g., 2008 to 2011, and 2009 to 2012, any product costs associated with that job which were incurred in are not expensed until January. As of the end of these costs are given a label such as “consulting projects in progress” or “unbilled services” and reported as inventory on the December 2008 balance sheet. Ernst & Young also employs many other people (such as clerks, secretaries, and office managers) to support the professionals and to administer office needs. The costs of these people are not closely associated with specific consulting jobs. Accordingly, the wages and salaries of these clerks and office managers, along with costs of office rent, desk supplies, and computers, are likely treated as period costs and recognized as selling and administrative expenses on the income statement in the period in which they are incurred.

When identifying product costs for control purposes, the most challenging organization to analyze is a manufacturing business. Does DuPont purchase inventory for resale? Actually, it does purchase some inventory, such as basic chemicals. But it doesn't simply turn around and resell these to customers. Significant processing has to take place before raw materials become a finished product ready for sale. DuPont must employ laborers to work with these chemicals, build factory buildings, and purchase manufacturing equipment. DuPont must also employ managers and other support personnel (such as engineers and custodians) to support the line workers' efforts to convert basic chemicals into finished products. These are all product costs. Basically, any cost required to get the product manufactured and ready for sale is a product cost.

To help management analyze the manufacturing cost of its products, product costs are divided into three components:

  • Direct materials

  • Direct labor

  • Manufacturing overhead

are materials that become part of the product and are traceable to it. Some materials, however, such as the glue and nails in a finished piece of furniture, are so minor and difficult to trace to a specific product that they are not considered direct materials, but rather . Indirect materials also include the materials and supplies used in nonproduction activities like maintenance and custodial processes. consists of the wages that are paid to those who physically work on the direct materials to transform them into a finished product. Conversely, wages and salaries paid to factory supervisors and management, maintenance staff, and factory security guards are treated as . includes all other costs incurred in the manufacturing process not specifically identified as direct materials or direct labor. Both indirect materials and indirect labor are included in manufacturing overhead. Figure 1-3 summarizes the relationship between product costs and period costs in various types of organizations. A solid understanding of product and period costs helps managers better understand and control costs of providing services, purchasing merchandise, or producing goods.

Terms Related to Evaluation and Decision Making

Managers are paid to make hard decisions as markets for particular products change based on developments in technology, new fads and trends in consumer taste, and increased pressure from new and existing competitors. Occasionally, the situation requires a serious look at the potential need to exit from a particular market or to drop a specific product line. Sometimes these decisions are motivated by the opportunity to enter a new market or add a new product line. For example, airlines are constantly evaluating whether to cut service on less-traveled routes or to increase or cut back the number of first-class seats. The decision to drop a product line is critical because subsequently reversing the decision can be difficult or impossible. Good management accounting can do much to facilitate the process of evaluating divisions, personnel, processes, and products. Conversely, a poor understanding of some critical management accounting concepts can lead to painful, if not potentially lethal, management decisions. To illustrate how accounting supports this evaluation process, it is important to understand some key management accounting terms.

Figure 1-3: Product Costs and Period Costs in Business Organizations

Direct and Indirect Costs

Just as fixed and variable costs are used in planning and product and period costs are used in controlling, there are ways to classify costs for evaluating performance. One of these classifications is direct costs and indirect costs. are costs that can be obviously and physically traced to a business unit or segment being analyzed. The unit may be a sales territory, product line, division, plant, or any other subdivision for which performance needs to be analyzed. Direct costs are often described as costs that could be saved if the segment were to be discontinued. Typically, many types of direct costs are variable, but some direct costs are fixed. For example, for a branch sales office, the cost of inventory and labor to run the store would be direct costs that are variable, while the cost to rent the building would be a direct cost that is fixed.

—sometimes referred to as common costs or joint costs—are costs that are normally incurred for the benefit of several segments. Indirect costs can also be either fixed or variable, although they are nearly always fixed. Sometimes these costs are allocated in order to be assigned to a segment. For example, consider a sales manager's salary. If a segment is defined as a branch sales office and a sales manager supervises only one segment, the manager's salary is likely a direct cost of that sales office. If the manager is responsible for several segments, however, the salary would then be an indirect cost to any one of the sales offices. Total indirect costs, like the manager's salary, normally do not change if one or more of the segments (in this case, the sales offices) are discontinued. Another example of an indirect cost may be manufacturing overhead. In most large organizations, many (but not all) types of manufacturing overhead costs are not directly identifiable with a specific product or product line. Hence, manufacturing overhead costs are typically classified as indirect costs to these products or product lines because they are incurred as a consequence of general or overall operating activities.

Costs are designated as either direct or indirect so that a business segment such as a division or product line can be evaluated on the basis of only those costs directly traceable or chargeable to it. Although companies sometimes allocate indirect costs among segments, such allocations often confuse the analysis of the segment's operations. By focusing only on direct costs, management can both identify segments where performance needs to be improved and recognize segments where performance is making a real contribution to overall company profits.

Differential Costs and Sunk Costs

The difference between direct costs and indirect costs is similar to the difference between another set of cost terms—differential costs and sunk costs. The of a decision—sometimes called avoidable costs, incremental costs, or relevant costs—are the future costs that change as a result of that decision. In deciding whether to drop a product line, there is likely little difference between the terms differential cost and direct cost. (The term differential is also commonly applied to future revenues that will be affected by the decision.) , on the other hand, are past costs that cannot be changed as the result of a future decision. This is not quite the same as indirect costs. Indirect costs are costs that are not affected by a particular decision. For example, whether DuPont decides to continue or discontinue a product line will likely not affect its general and administrative costs. These costs are indirect to a particular product line. This does not mean that management cannot change any of DuPont's general and administrative costs. It just means that a different management decision process is required to change these costs than the process used for evaluating the viability of a particular product line. If this sounds as though a cost could be indirect in one evaluation situation or direct in another, you're right. Defining a cost as direct or indirect depends on the object of the decision. On the other hand, sunk costs are not dependent at all on any decision object. A sunk cost is exactly what it sounds like—sunk! There is nothing a company can reasonably do to change a sunk cost.

As an example of sunk costs, assume you have basketball season tickets for a particular school. On the night of a game, a friend asks you to go to a movie with her. You have wanted to see the movie for a long time. If you decline because you have already purchased the basketball tickets and believe you must therefore go to the game, you may have made a decision based on the wrong analysis. The cost of the basketball tickets is a sunk cost. The only costs that are relevant to your decision this night are the costs associated with going to the movie, such as the ticket price, popcorn, and other goodies you might buy compared to any out-of-pocket costs you might incur at the basketball game.

Out-of-Pocket Costs and Opportunity Costs

At the most general level, costs can be separated into out-of-pocket costs and opportunity costs. require an outlay of cash or other resources. Many of the costs discussed thus far in this topic could be called out-of-pocket costs. If a fast-food restaurant is considering installing a drive-up window, the cost of construction is an out-of-pocket cost. When making decisions, naïve individuals and organizations usually consider only out-of-pocket costs. For example, an individual deciding whether to attend a movie might consider only the $9 cost of the ticket required to gain admittance. On the other hand, opportunity costs do not require an outlay of resources. Nevertheless, they are as important as out-of-pocket costs to good management decision making. are the benefits lost or forfeited as a result of selecting one alternative course of action over another. For example, choosing to go to a movie instead of working two hours at $8 per hour has an opportunity cost of $16, as well as an out-of-pocket cost of $9 for the ticket. Installing a drive-up window at a fast-food outlet may have several opportunity costs, such as lost seating or lost parking available to customers, which then lead to lost revenue.

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