My colleague Nick and I regular disagreements about which type of accounting is the best. I remind him that management accounting is exciting, glamorous and sexy whereas financial accounting is dull, mechanical and could be done by a trained monkey. He replies that management accounting is often based on guesswork and estimate whilst financial accounting is an important process in recording historic results, protecting shareholder value and ensuring corporate accountability. He has yet to realise that he is unwittingly proving my point.
Management accounting is the best
Management accounting is a key aspect of your AAT studies and there are a number of specific topics that you will cover (including budgeting and forecasting, performance evaluation and variance analysis, and decision-making) but the area that I would like to talk about here is costing classification.
Costing is the process of identifying the cost per unit of production. If I am a manufacturer of cars (or cakes or chairs for that matter) it is incredibly useful to know how much each unit costs me to produce for a number of reasons, including:
- Valuing units of inventory at the end of a period
- Identifying where cost savings can be made
- Perhaps most importantly, setting a profitable selling price
A typical starting point of this process is to start breaking down the costs of the business into a variety of sensible categories.
There are a number of different ways that you can break down costs into different groups, or cost classifications
Classifying costs by function
When we classify costs by ‘function’ we are thinking about which location within the business they are incurred in.
- Production costs are incurred in the factory where physical production occurs
- Non-production costs are incurred elsewhere in the business, for example:
- Administration costs are incurred as part of the administrative function
- Selling costs relate to the process of stimulating demand and advertising products
- Distribution costs are incurred in the process of delivering finished goods to customers
- Finance costs would be those incurred as part of raising finance and paying interest
Classifying costs by behaviour
When we talk about the ‘behaviour’ of a cost we mean the way that the cost is affected by changes in the volume of production.
- Fixed costs are unaffected by the volume of production so stay the same whether you make 5,000 units or 10,000 units.
- Variable costs change in line with any changes in production volume so if you double production you double the cost.
One thing to note is that when we describe a cost as ‘fixed’ that doesn’t mean it will never change, just that it is not affected by changes in volume. For instance, your factory rent can go up each year but your landlord isn’t interested in how many cars you make.
Classifying costs by element
- Material costs are the purchase of anything physical
- Labour costs are when we pay for the time of a member of staff
- Expenses relate to anything other than material and labour
Classifying costs by nature
This is often the hardest cost classification for students to get their heads around.
- Direct costs can be ‘traced’ to a single unit of production. The total of all direct costs is the ‘prime’ cost.
- Indirect costs cannot be traced to a single unit of production but are ‘shared’ over many units. Indirect costs are often called ‘overheads’.
You have to remember that our categories of cost overlap:
The purchase of wheels used in assembling cars can be thought of as:
- Production costs as they are used in the factory
- Variable costs as an increase in the number of cars made will mean more wheels being bought
- Material costs as the wheels are a physical product
- Direct costs as you could trace four wheels to a single car assembled
The monthly salary of a factory supervisor could be seen as:
- Production costs as the supervisor works in the factory
- Fixed as the monthly salary paid will be the same no matter how many cars are made
- Labour costs as they relate to paying for someone’s time
- Indirect as you cannot trace the monthly salary paid to a single car
The quarterly electricity bill for lighting the accounts department would be:
- Non-production costs as the accountants don’t work in the factory
- Fixed as the bill will have no link to the number of cars being assembled in the factory
- An expense as it is not material or labour
- Indirect as a bill for three months will be shared over all of the production in that quarter
Whilst we are on the subject of terminology, we also have a blog on bookkeeping terminology here.