Chapter 1

Part A: Costs

Management accounting concepts

Last updated November 202611 sectionsabout 10 min read

Key takeaways

Management accounting identifies, measures, analyses and communicates financial and operating information so managers can plan, control and make decisions; cost accounting is the part of it that records and reports costs.
Unlike financial accounting, management accounting is not required by law, has no prescribed format, looks forward as well as back, and accepts timely estimates over precise figures.
A cost centre accumulates and controls costs, a profit centre answers for both revenue and costs, and each is a responsibility centre whose manager is held accountable.
Cost control keeps actual spending within an accepted standard or budget, continuously; cost reduction permanently lowers the cost itself without impairing quality.
One cost can be classified several ways at once, by function, behaviour, nature, relation to the cost unit, time, relevance to a decision and production method, so read which basis a question asks for.

Management accounting turns the same underlying transactions financial accounting records into information built for a different reader, managers, running the business day to day, rather than outsiders assessing it after the fact. This chapter fixes the vocabulary and boundaries of that field.

Key terms

Cost

The amount of resource, usually expressed in money, given up or sacrificed to acquire or produce a good or service.

Cost unit/object

The unit of product, service, or activity for which a cost is separately measured, a unit produced, an order, a department, or a contract.

Cost accounting

The process of recording, classifying, allocating and reporting costs, chiefly to determine the cost of a product, service or activity.

Cost accountant

A professional responsible for recording, analysing and reporting on the costs an organisation incurs.

Management accounting

The wider process of identifying, measuring, analysing and communicating financial and operating information to help managers plan, control and make decisions, of which cost accounting is one part.

Management accountant

A professional who prepares and interprets management accounting information to support managers' planning and decision making.

Cost centre

A location, function, or item of equipment for which costs are accumulated and separately controlled.

Profit centre

A segment of a business whose manager is accountable for both the revenue it earns and the costs it incurs, and therefore for its profit.

Responsibility centre

Any organisational unit whose manager is held accountable for its performance, a cost centre, profit centre, revenue centre or investment centre depending on what the manager controls.

Role of management accounting

Providing information for planning, both short-term budgets and long-term strategy
Supporting control, by comparing actual performance against a plan or standard
Informing specific decisions such as pricing, product mix and make-or-buy choices (see the chapter on break-even analysis)
Motivating managers and employees through the targets a budget or standard sets
Evaluating performance of individuals, departments and the organisation as a whole
Communicating organisational objectives down through the management structure

Users of management accounting information

Executives

Use management accounting information for strategic decisions, resource allocation, and evaluating overall organisational performance.

Production managers

Use cost data (see the chapter on accounting for materials, labour and overheads) to control material, labour and overhead costs within their department, and to assess production efficiency.

Sales managers

Use cost and contribution information (see the chapter on break-even analysis) to guide pricing, product mix and sales targets.

Employees

Use budget and performance information where it affects their targets, bonus schemes or job security.

Management versus financial accounting

	Management accounting	Financial accounting
Primary users	Internal managers	External stakeholders (investors, lenders, tax authorities)
Legal requirement	Not required by law	Required by the Companies Act and tax law
Time orientation	Forward-looking (plans, budgets, forecasts) as well as historical	Historical, reports on a period already ended
Format	No prescribed format, tailored to management's need	Prescribed by accounting standards (IFRS)
Reporting frequency	As often as management needs, daily, weekly or monthly	Usually annual, with interim reports for some entities
Precision	Estimates and approximations are acceptable if timely	Requires greater accuracy and verifiability

Cost accounting and management accounting

Cost accounting is a subset of management accounting: it supplies the detailed cost data (per product, per department, per activity) that management accounting then analyses, interprets and presents for planning, control and decision making. Every cost accounting report is potentially useful to management accounting, but management accounting also draws on non-cost information, market data, non-financial performance measures, that cost accounting alone does not provide.

Limitations of management accounting

Based substantially on historical cost data, which may not reflect current replacement values
Relies on estimates and forecasts, which can prove inaccurate
Lacks a single prescribed format, making comparison between organisations difficult
Can be costly and time-consuming to maintain in detail
Its recommendations are only as good as the judgement of the manager interpreting them
Does not replace, only supplements, other management skills and experience

Cost control and cost reduction

Definitions

Cost control

The process of regulating actual costs against a predetermined standard or budget, to keep spending within an accepted level, a continuous, corrective activity.

Cost reduction

The deliberate, planned effort to permanently lower the cost of a product or service without impairing its quality or suitability, a one-off improvement in the cost itself.

Advantages of cost control

Keeps actual spending aligned with the budget, protecting profitability
Highlights variances early enough for corrective action to matter
Encourages departmental accountability for spending
Supports realistic future budgeting, since it shows where past estimates held or failed

Control versus reduction

	Cost control	Cost reduction
Nature	Regulatory, keeps cost within a set target	Corrective, permanently lowers the target itself
Approach	Continuous, ongoing monitoring	One-off or periodic improvement projects
Assumption about the standard	Assumes the current standard/budget is acceptable	Challenges whether the current cost level is the lowest achievable
Emphasis	Preventing costs from exceeding a plan	Finding a genuinely lower cost while maintaining quality

Choosing a cost accounting system

What a cost accounting system is

A cost accounting system is the set of procedures and records an organisation uses to accumulate, classify and report the cost of its products, services or activities.

Design factors

Nature of the business and its production or service process
Organisational structure and the size of the business
The cost of operating the system relative to the benefit it provides
Management's specific information needs
Flexibility to adapt as the business changes
Compatibility with existing financial accounting records

Professional ethics

A management accountant, like any accounting professional, is bound by a code of ethics; four principles recur across professional bodies' codes.

Competence

Maintain the professional knowledge and skill needed to provide a competent service, and act diligently in accordance with applicable technical and professional standards.

Confidentiality

Respect the confidentiality of information acquired through professional and business relationships, and not disclose or use it without proper authority.

Integrity

Be straightforward and honest in all professional and business relationships.

Credibility

Provide information that is reliable and relevant, so that it can be trusted and depended on by the users it is prepared for.

Cost classification

What cost classification is

Cost classification is the process of grouping costs according to their common characteristics, so they can be analysed and reported in whichever way best serves a given management purpose.

Why costs are classified

Determining the cost of a product, job or service (see the chapter on costing methods)
Planning and preparing budgets (see the chapter on budgeting)
Controlling costs by comparing actual against budgeted or standard cost
Supporting specific management decisions (see the chapter on break-even analysis)

Bases of classification

The same cost can be classified in several different ways at once, depending on what question is being asked of it.

Functions

Classifies cost by the business function that incurs it: production, administration, selling and distribution, and finance costs.

Behaviour

Classifies cost by how it responds to a change in activity level:

Fixed costs: unchanged in total as activity varies.
Variable costs: change in direct proportion to activity.
Semi-variable (mixed) costs: a fixed element plus a variable element, which the cost estimation techniques of the next chapter exist specifically to split.

Nature of expense

Classifies cost by the type of resource consumed: materials, labour, or expenses.

Relation to cost centre or cost unit

Classifies cost as:

Direct: traceable in full to a specific cost unit, direct material and direct labour.
Indirect/overhead: not traceable to one specific cost unit, and so shared across several, covered under overheads in the chapter on accounting for materials, labour and overheads.

Time

Classifies cost as historical (actual cost already incurred) or predetermined (a standard or budgeted cost estimated in advance, for control purposes).

Costs for management decision making

Classifies cost as relevant (a future cost that differs between the decision alternatives being compared) or irrelevant (unaffected by the decision, sunk costs), and as controllable or uncontrollable by a given manager.

Nature of production or process

Classifies cost by the production method used to accumulate it, job costing, batch costing, process costing or service costing (each covered in the chapter on costing methods).

Exam tip

A single cost, factory rent, say, is simultaneously an overhead (relation to cost unit), a fixed cost (behaviour), and a production or administration cost (function) depending on which classification a question is asking about. Read the question's classification basis carefully before answering.

Self-check

(a) Distinguish a cost centre from a profit centre. (3 marks)

(b) Classify factory rent under: (i) behaviour; (ii) relation to cost unit; (iii) function. (3 marks)

(d) State two limitations of management accounting. (2 marks)

Show worked answer

(a) A cost centre is a location, function or item of equipment for which costs are accumulated and separately controlled; a profit centre is a segment whose manager is accountable for both the revenue it earns and the costs it incurs, and therefore for its profit (3 marks).

(b) (i) Fixed cost; (ii) overhead/indirect cost, since it cannot be traced to one specific cost unit; (iii) typically a production or administration cost, depending on which part of the business occupies the space (3 marks).

(c) Cost control is the continuous process of regulating actual costs against a predetermined standard or budget, to keep spending within an accepted level; cost reduction is a deliberate, planned effort to permanently lower the cost itself without impairing quality, a one-off improvement rather than an ongoing regulatory activity (4 marks).

(d) Any two of: based substantially on historical cost data; relies on estimates and forecasts that can prove inaccurate; lacks a single prescribed format, making comparison difficult; can be costly and time-consuming to maintain in detail (2 marks).