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Management Accounting

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The term ‘cost’ is very common term in management accounting. Manufacturing firms incur various costs during the process of production. According to Hafeez, the term ‘cost’ refers to “something of value given up in exchange for something else” (2010). Hafeez also states that cost is the price paid in order to obtain a given good or service. This is inclusive of time, labor, money, and physical materials. The Indian based Institute of Cost and Work Accounts (ICWA) defines cost as “measurement in monetary terms of the amount of resources used for the purpose of production of goods or rending services” (Basic Cost Concepts, n.d.). Generally, cost is the amount of expenses in monetary terms, incurred in production of a good or in rendering of a service. In specific reference to manufacturing firms, the term ‘cost’ refers to the sum of resources used in production of a given quantity of goods (Bhattacharyya, 2005). The concepts of cost in manufacturing firms revolve around three main items: material, labor, and expenses. Material, labor, and expenses are the cost components of manufacturing firms.

During the manufacturing process, materials are required. Materials are the substances from which a given product/good is made (Bhattacharyya, 2005). They can be either in a raw state or in a manufactured/processed state. For example, to manufacture baking flour, wheat is required, while to manufacture baked items such as cakes, wheat flour is required. There are two main categories of materials. They are direct materials and indirect materials (Bhattacharyya, 2005). Direct materials are those materials that are easily identified as the main components of a given good. On the other hand, indirect materials are those materials that are not easily identified in given good.

Blue Pacific Fine Foods SDN BHD is one of the manufacturing firms in the Malaysian food industry. Blue Pacific Fine Foods deals with importation, and local wholesaling and retailing of food products such as pastas, seafood, dairy products, seasonings and spices, and antipastas (Blue Pacific Fine Foods SDN BHD, 2012). An example of direct materials used by Blue Pacific Fine Foods would include wheat flour for manufacturing pastas, milk for manufacturing diary items, and vegetables such as cucumber and lettuces for manufacturing seasoning and spices, among others. Indirect materials would include coloring agents used for coloring different food types, sodium used to add taste to food products, and water.

Labor is the human effort or machines effort, or a combination, used to convert materials to final products (Crosson & Needles, 2010). Just like materials, labor is also divided into two groups: direct labor and indirect labor. Direct labor is that labor that is easily traceable in the conversion of certain materials into finished goods. In manufacturing firms, direct labor is also known as manufacturing wages or process labor. Contrary, indirect labor is that labor, which is not easily traceable in conversion of materials into finished goods. Usually, indirect labor is the labor employed in a manufacturing firm for undertaking incidental tasks. Examples of direct labor in Blue Pacific Fine Foods include cost of a quality assurance officer who tests the resulting food product to ensure it is of quality and cost of wages paid to individuals who clean raw materials and prepare them for processing. Examples of indirect labor in Blue Pacific would include salary of salespersons, wages paid to storekeepers, and salary paid to works managers.

Expenses are costs, incurred in the production/manufacturing process other than materials and labor. Expenses are also divided into two groups: direct and indirect expenses (Crosson & Needles, 2010). Direct expenses are those expenses that are easily traceable to a specific cost center. A cost center is an item, location, or a person, for which costs maybe ascertained (Crosson & Needles, 2010). All direct costs, apart from direct materials and labor are direct expenses. Conversely, indirect expenses are those expenses that are not easily traceable in a given cost center or unit. All expenses used in the manufacturing process, apart from indirect materials and labor, are indirect expenses. In Blue Pacific Fine Foods, examples of direct expenses would include cost of machines and equipments used in the manufacturing process, inward carriage charges, and fees paid to specialists or consultants in the food manufacturing process. On the other hand, indirect expenses would include depreciation of fixed assets, insurance fee, repair of premises, and land or building rates and rent.

Therefore, the following is a list of some of the costs that would be present in Blue Pacific Fine Foods. Direct materials cost, for example, cost of milk, vegetables, and wheat flour; indirect materials cost, for example, cost of water, sodium, and coloring agents; direct labor costs, for example, wages to individuals working inside the processing unit and salaries to quality assurance officers; indirect labor costs, for example, salaries to work managers and wages to salesperson and storekeepers. Others are direct expenses, for example, cost of manufacturing machines and equipments, and inward carriage charges; and indirect expenses, for example, depreciation, insurance, rates, rents, and taxes.

There are different classifications of costs. Usually, there are three bases under which, cost are classified. They are cost behavior, cost relation to cost centre, and cost by inventory basis. Behavior cost basis entails classifying costs depending on their reaction to various production changes (Lal, 2008). Fixed, variable, and semi-variable costs are classified using the behavior cost basis. Usually, fixed costs do not react significantly to changes in production. For example, in Blue Pacific Fine Foods decides to reduce its volume of production by a half, the depreciation cost of the machines would remain the same, despite the reduced volume of production. However, the decision to lower the volume of production would result into reduced cost of materials by a half. Direct material and labor costs are variable costs because they vary exactly with the proportion of production.

Cost relation to cost centre basis of classifying costs entails grouping costs according to their traceability to the finished goods (Lal, 2008). This basis of classifying costs, groups all costs into direct and indirect costs. Direct costs are made of costs of direct materials, labor, and expenses while indirect costs are made of cost of indirect materials, labor, and expenses. On the other hand, costs by inventory basis of classifying costs entail separating costs that are directly chargeable in a product and its stock value, from those that are not directly charged in a product and its stock value at the end of given period. There are only two cost groups under this category: product costs and period costs. Product costs are those costs, which are easily traceable in a product, and whose values are transferred as part of stock to the next accounting period (Lal, 2008). They include direct material, direct labor, direct expenses, and manufacturing overheads. Period costs are costs, which are not easily traceable in a given product, and values of which are not transferred to the stock value of a given product at the end of an accounting period, but are charged against the revenue of the period in which they occurred (Lal, 2008). They include fixed costs, selling and distribution costs, and administrative costs.

In reference to the aforementioned list of possible costs in Blue Pacific Fine Foods, direct materials, which are variable costs, and depreciation expenses, which are fixed costs, would be classified using cost behavior basis. Direct materials, labor, and expenses, which are direct costs, and indirect materials, labor, and expenses, which are indirect costs, would be classified using cost relation to cost centre basis. Finally, the costs that would be classified using cost by inventory basis would include direct materials, direct labor, direct expenses, and manufacturing overheads: production costs, and depreciation, insurance, printing and stationary, salaries to administrative staff, and premises rent and rates: period costs.

When preparing financial statements, specifically the income statement, manufacturing companies use either marginal costing or absorption costing methods. Under marginal costing, the unit cost of every item produced consist of costs, which vary with the amount of output produce (Garrison & Noreen, 1994). They are direct materials, direct labor, and a variable percentage of manufacturing overheads. Other costs such as fixed costs and selling and administrative costs are not termed as part of unit product cost. In addition, they are not included in the value of the inventory at the end of an accounting period. On the other hand, under absorption costing, both variable and fixed costs compose the unit product costs (Garrison & Noreen, 1994). All cost, involved in the production process of a given good, and are treated as product costs. These include direct materials, labor, and expenses; indirect materials, labor, and expenses; manufacturing overheads; and fixed costs. Under absorption costing method, a small amount of variable as well as fixed cost is allocated to each unit of production (Variable Costing vs. Absorption Costing, 2011). Below is a graphical illustration of the differences between marginal costing and absorption costing system.

Marginal Costing

 

Absorption Costing

Product Cost

Direct materials

Product Cost

 

Direct labor

 

 

Variable manufacturing overhead

 

Period Cost

Fixed manufacturing overheads

 

 

Variable selling and distribution expenses

Period Cost

 

Fixed selling and distribution expenses

 

  Source: Variable Costing vs. Absorption Costing, 2011

To illustrate the calculation of unit product cost and net income under both marginal and absorption costing methods, consider the following data from Blue Pacific Fine Foods:

Units produced

20,000

Units sold

18,000

Sales price

$15.00

Direct materials cost per unit

$4.00

Direct labor cost per unit

$3.00

Variable manufacturing cost per unit

$2.00

Variable sales cost per unit

$1.00

Fixed manufacturing overheads

$20,000

Fixed selling costs

$10,000

 Cost per unit under absorption costing system

Direct Materials Cost per Unit

$4.00

Direct Labor Cost Per Unit

$3.00

Variable Manufacturing Cost Per unit

$2.00

Fixed Manufacturing Overhead Per unit

$20,000/ 20,000 units $1.00

Cost per unit

$10.00

Cost per unit under marginal costing system

Direct Materials Cost per Unit

$4.00

Direct Labor Cost Per Unit

$3.00

Variable Manufacturing Cost Per unit

$2.00

Total Cost Per Unit

$9.00

Blue Pacific Fine Foods SDN BHD

Income Statement for the year ended 31 December 2011

[Marginal Costing System]

Sales

15 x 18,000 units

 

 

 

$270,000

Cost of Goods Sold

 

 

 

 

 

Beginning Inventory

 

0

 

 

 

Cost of Goods Manufactured

$9 x 20,000

$180,000

 

 

 

Goods Available for Sale

 

180,000

 

 

 

Ending Inventory

$9 x 2,000

(18,000)

 

 

 

Variable Cost of Goods Sold

 

 

162,000

 

 

Variable Selling

$1 x 18,000

 

18,000

 

Total Variable Costs

 

 

 

180,000

Contribution Margin

 

 

 

90,000

Fixed Manufacturing Overhead

 

 

 

(20,000)

Fixed Selling

 

 

 

 

(10,000)

Net Income

 

 

 

 

$60,000

           

Blue Pacific Fine Foods SDN BHD

Income Statement for the year ended 31 December 2011

[Absorption Costing System]

Sales

15 x 18,000 units

 

 

$270,000

Cost of Goods Sold

 

 

 

 

 

Beginning Inventory

 

0

 

 

Cost of Goods Manufactured

$10 x 20,000

$200,000

 

 

Goods Available for Sale

 

200,000

 

 

Ending Inventory

$10 x 2,000

(20,000)

 

 

Cost of Goods Sold

 

 

180,000

Gross Profit

 

 

 

 

90,000

Variable Selling

 

 

$1 x 18,000

 

(18,000)

Fixed Selling

 

 

 

 

(10,000)

Net Income

 

 

 

 

$62,000

Conclusion

Manufacturing firms incur various costs, which include costs of materials, labor, and manufacturing expenses. The concepts of cost revolve around these three cost items. Manufacturing costs can be classified using three different bases: cost behavior, cost relation to cost centre, and cost by inventory basis. Regardless of the method used to classify cost, manufacturing firms use either absorption costing or marginal costing system to evaluate the unit cost of every unit of production, and subsequently prepare income statements at the end of accounting period. Under marginal costing, the value of fixed costs is not considered when determining the unit product cost. However, under absorption costing, a small amount of fixed cost is distributed to every unit of production.

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