# Understanding Basic Management Accounting Terms and Concepts

Updated on July 21, 2014

## Understanding Basic Management Accounting

Management Accounting is one of the most feared subjects by Accountancy students. However, if you find the time to study the terms and concepts, you are bound to get an overview of a subject matter that is both interesting and enlightening. The basic concept covers the allocation of resource and the information needed to help managers make a decision. The study deals with management accounting systems and techniques to generate information for decision making.

Managers oftentimes deal with the internal workings of the operation that gives off information about material, labor, and overhead costs. The information may likewise include sensitive information about payroll, employee leaves, and other confidential matters. In this regard, these type of information are not released to the public but may be used by management in improving operations to increase corporate earnings.

## Topics Covered:

The topics covered by this article would include basic terms and concepts related to:

• Cost Behavior
• Cost Volume and Profit Relationship (CVP)
• Variable Cost
• Standard Cost
• Activity–Based Costing (ABC)
• Balance Score Card

## Cost Behavior

How cost will behave under different scenarios is an integral part of decision making. The three major classifications of costs are: variable, fixed and mixed cost. Mixed cost can be expressed in the formula Y = a + bX, where X represents the level of activity, Y is the total cost, a the fixed cost element, and b the variable cost per unit level of activity. Several methods are used to determine the fixed and variable component of mixed cost. If the relationship tends to be linear, a scatter graph analysis, using : quick and fast method, high-low method, and least square regression analysis may be done to determine the degree of correlation.

The quick and fast method makes use of a line, using its slope and intercept to determine the fixed and variable costs. The high-low method draws a straight line on the lowest and highest activity level to get the outcome. Computer applications can do the least square computations. However, even with regression analysis, the data must still be plotted to confirm that there is really a correlation between the different cost variables.

Managers use cost analysis in a manner that can be easily understood so they can make the right decision. The income statement can be prepared in a contribution margin format which classify costs by behavior rather than by function.This format and mode of analysis are done to simplify the understanding of the cost variables and its effect on operations.Doing so would make management come up with strategic decisions to enhance profitability and corporate longevity.

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## Cost Volume Profit Relationship (CVP)

CVP analysis is a decision model that answers critical questions on the correlation of profits to changes in prices, costs, and volume. The analysis of variables seeks to determine the company’s breakeven point, margin of safety, and the probable outcome if any changes in the cost variables occur. The analysis can be done either through graphical presentation or mathematical models.

The contribution margin ratio analysis depicts the percentage of the contribution margin to total sales. This analysis shows the effect of sales on operating income and is its impact on the breakeven point (BEP). The BEP is the level of sales that is needed to cover all indicated fixed cost. This mathematical technique can also be used to determine the level of sales that is needed to reach target incomes.

On the other hand, the margin of safety is the amount that is over and above the breakeven point which management would want to achieve for safety measure . The degree of operating leverage, determines the percentage of sales that would result in greater profitability due to the product sales mix. An example would be a multi-product company that depends on its various products to maximize its earnings.

Changes in the sales mix, or product line would have an effect on the company’s breakeven point and safety margin. Hence, a thorough study on the impact of each product on the product mix should be made to get the most profitable combination.

## Management Accounting Concepts in Table Format

Evaluation of Financial Statements
Areas Covered in Evaluation
Limitation of Analysis
Horizontal Analysis
Short term solvency
Information not absolute
Trend Percentages
Long term solvency
Limitation in accounting data
Common size Financial Statements
0perating Efficiency/Profitability
Quanti techniques not absolute
Financial Ratios
Segment Analysis
Personal bias of analyst

## Variable Costs

One method of determining product cost is through variable costing. Under this concept, only manufacturing cost that varies with output are considered as product cost. This includes direct material, direct labor, and variable overhead costs. Fixed manufacturing overhead cost is considered as period cost and recorded in the books when incurred.

Another method is absorption costing that treats a portion of fixed manufacturing cost as product cost. When these units are sold, the entire costs are charged against revenues as part of Cost of Goods Sold. Hence, under the absorption method, it is possible to shift the fixed manufacturing overhead cost from one period to the next.

The shifting of fixed manufacturing cost between periods may lead to an erratic fluctuation in net operating income and can lead to confusion and erroneous decisions. To safeguard against these errors, managers must be adequately informed about the changes that were made and the costs that were charged in the current period.

Variable costing is not used externally for tax purposes and with other governing agencies. It is used principally by managers for planning and control purposes. Variable costing approach works well with the CVP models.

## Activity Based Costing (ABC)

There are arguments regarding the use of traditional methods of accounting. These include defects on the proper cost allocation that oftentimes render decision making as inutile. An example of this would be a non-manufacturing costs that may not be assigned to a product, though identified with it. The traditional method is also prone to allocating idle capacity to products which oftentimes result to higher product cost. This method puts much reliance on labor costs and machine hours, that leads to the over costing of big volume products and under costing of low volume products resulting to a skewed application of costs.

ABC estimates the cost of resources that are consumed by each activity to produce a product. The premise is that, each product generates activities that consume costly resources - hence, it forms links from cost to cost objects. ABC is concerned with overhead – both manufacturing and non-manufacturing. Accounting for direct labor and materials remains the same as that of traditional methods. With the ABC, proper application is done on each product line based on the amount of activity that was consumed to produce each particular product. Idle capacity is not included on the computation of product cost.

## Quantitative Techniques for Decision Making

• Decision Making under Certainty and Uncertainty
• Use of Probabilities
• Payoff Tables
• Expected Value of Perfect Information
• Decision Tree Analysis
• Learning Curve
• Use of Simulation Techniques
• Monte Carlo Technique
• Sensitivity Analysis
• Queuing Theory

## Other Related Articles by Author:

The Best Accounting Software for Small to Medium Scale Business

New Government Accounting System of the Philippines

References:

Management Accounting by Wyzant.com

Management Accounting by imanet.org

Management Accounting by cimaglobal.com

Management Accounting by Elenita Balatbat, CPA

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