Chapter 11: Introduction to managerial accounting

With this chapter the course turns from financial to managerial accounting: information for people inside the company. The chapter explains what managers do and how accounting helps them, how costs are classified (direct and indirect, product and period, prime and conversion), and how a manufacturer prepares its statements with the schedule of cost of goods manufactured. The case class on Tata Steel links these ideas to a real steel producer.

Managerial versus financial accounting

Managers and their functions

An organisation chart shows departments, divisions and who is responsible for them. The board of directors, elected by the stockholders, develops the strategic goals; the chief executive officer (CEO) is ultimately responsible for carrying out the plans. Positions are either line positions, directly involved in delivering goods or services to customers (production, sales), or staff positions, which support the line (accounting, human resources, IT).

Managers have three functions:

• Planning: choosing goals and deciding how to achieve them. Strategic planning is about long-term strategy; operational planning about short-term, day-to-day actions.
• Directing: running the day-to-day operations.
• Controlling: monitoring operations and comparing results with the plan to keep the company on track.

The Institute of Management Accountants (IMA) expects managerial accountants to uphold four standards: competence, confidentiality, integrity and credibility, under the principles of honesty, fairness, objectivity and responsibility. When facing a dilemma, they first follow company policy, then discuss it with their supervisor, an objective adviser or an attorney. Example from the slides: a controller wants to bill two orders on 31 December that will only be finished and shipped on 3 January, to show a profit this year. That violates the revenue recognition principle; the staff accountant should try to get the goods actually shipped in December, otherwise refuse, and if necessary report the matter to the controller's superior.

Service, merchandising and manufacturing companies

• Service companies sell time, skill and knowledge (law firms, the Big Four accounting firms). No inventory; only revenues and expenses.
• Merchandising companies resell products bought from suppliers (supermarkets, bookstores, platforms such as Bol and Amazon). One inventory account: merchandise inventory. Cost of goods sold = beginning inventory + purchases − ending inventory.
• Manufacturing companies convert raw materials into new products with labour, equipment and facilities (Apple, Samsung, Tata Steel). Three inventory accounts: raw materials (RM), work-in-process (WIP), goods started but not finished, and finished goods (FG), completed but not yet sold.

Classifying costs

A cost object is anything for which managers want a separate cost measurement: a product, a job, a department, a customer. A direct cost can be traced to the cost object easily and cost-effectively; an indirect cost cannot (for a steel mill: gas, water, electricity, cleaning, rent of the plant).

A manufacturer's product costs consist of three parts:

• Direct materials (DM): raw materials that become part of the product (iron ore in steel).
• Direct labor (DL): wages of the employees who work on the product.
• Manufacturing overhead (MOH): all indirect production costs: indirect materials (glue, screws), indirect labour (supervisors, maintenance, cleaners), plant depreciation, rent, utilities, insurance and property taxes of the factory.

Product costs are the costs of buying or making a product (DM, DL and MOH). They are first recorded as inventory and become an expense (cost of goods sold) only when the product is sold. Period costs are all non-manufacturing costs (selling and administrative expenses, interest, taxes); they are expensed in the period incurred. Freight out and advertising are period costs, not overhead.

Financial statements of a manufacturer

Costs flow through the inventory accounts: purchases go into raw materials; direct materials used, direct labour and overhead go into work-in-process; completed goods move to finished goods (cost of goods manufactured); sold goods move to cost of goods sold. Every inventory account follows the same pattern: beginning balance + additions − ending balance = amount used, manufactured or sold.

A merchandiser with beginning inventory 8,000, purchases 165,000 and ending inventory 13,000 has COGS of 160,000. A manufacturer with beginning FG 12,250, COGM 172,250 and ending FG 15,000 has COGS of 169,500. Unit product cost = COGM / units produced.

Managerial accounting in service and merchandising companies

Service and merchandising firms also need unit costs, for example to set prices. Smart Touch Learning spent $3,900 on 1,950 e-learning services: $2 per service. In the exercise The Glass Company spends $20,470 to repair 200 windshields: $102.35 each, well above the manager's $80 target.

Business trends

• A shift towards a service and platform economy (Booking.com, Airbnb, Amazon, Uber).
• Global competition and time-based competition, supported by enterprise resource planning (ERP) systems that integrate all company data, e-commerce, and just-in-time (JIT) management, which keeps inventories minimal.
• Total quality management (TQM): continuous improvement of products and processes; every step in the value chain (research and development, design, production, marketing, distribution, customer service) should add value.
• The triple bottom line: the economic, social and environmental impact of a business, or profit, people and planet. Customers and investors increasingly choose companies on labour practices and sustainability.

Case: Tata Steel

Tata Steel (with a large plant in IJmuiden) makes steel from iron ore and scrap in three stages: primary steelmaking (smelting iron into steel), secondary (adding or removing elements such as alloys and dissolved gases) and tertiary (casting into sheets, rolls and other forms). Steel is mass-produced through uniform steps, so Tata Steel uses process costing (chapter 13). Unique products such as a villa or a superyacht use job order costing (chapter 12).

Besides direct materials and direct labour, the mill has large indirect costs: cleaning, gas, water, electricity, rent. These must be allocated to the products with a predetermined overhead rate. In a fictitious example Tata Steel expects overhead of €20 million and 1 million direct labour hours at €50 an hour, so labour costs of €50 million: