In the Financial Accounting Series, we are mostly talking about merchandising-sector companies – businesses that purchase and resell inventory to make a profit. In management accounting, we are mostly talking about manufacturing-sector companies – those that acquire materials and components and convert them into finished goods.
There are several terms that are unique in a manufacturing-sector company –
Materials that eventually become part of finished goods. “Direct” means the cost of these materials can be easily traced to the finished goods. If you are running a furniture-manufacturing company, the wood used to assemble a chair will be considered direct materials. Not only is wood a type of material, we also expect the company to keep track of how much wood is used in the chair and how much each unit of wood costs. This way, you can trace the cost of wood to each chair
Compensation of workers that can be traced to the finished goods. Say you pay your front-line workers by piece-rate in the factory. You can trace how much labor cost is incurred in producing each chair. The compensation to these front-line workers will be considered as direct labor costs.
Other manufacturing costs that cannot be traced to the finished goods easily. Examples include maintenance of plant and machinery and compensation to managers who oversee the factory’s operations. It is hard to determine how much maintenance cost or managers’ salary is attributable to each chair.
Let’s have a closer look at the manufacturing business’s Income Statement:
Notice how the items are classified according to their functions. In the top part, we have manufacturing costs and in the bottom half, we have non-manufacturing costs.
An Introduction to Variable Costing
Is there another way of classifying costs? The answer is of course yes. We can classify costs according to their behavior. This type of classification is adopted in variable costing. Classification of costs by function like what we did above is adopted in absorption costing. Absorption costing and variable costing are two distinct methods of cost accounting, which we will explore more here.
Common Types of Cost Behavior
Variable costs: costs that change in total in proportion to level of activity (e.g. sales) or volume of output produced
Fixed costs: costs that remains unchanged in total even when level of activity or volume of output varies
You can reclassify costs according to their behaviors:
|Direct material||Variable: the amount of direct materials required is proportionately related to the production volume|
|Direct labor||Variable: the amount of direct labor required is proportionately related to the production volume|
|Manufacturing overhead||Usually split into the variable component and fixed componentThe variable component includes items like electricity used to power machinesThe fixed component includes items like compensation of factory managers|
|Marketing costs||Usually split into the variable component and fixed componentThe variable component includes items like commission to salespersons (commission is proportionately related to how much the salespersons sell)The fixed component includes items like advertising fees (advertising fee is fixed regardless of how much the company sells)|
|Administrative costs||Fixed: the salary of clerks or the rental of offices is fixed regardless of production and sales volume|
These are how the Income Statements look under absorption costing and variable costing:
Absorption costing and variable costing have their own merits. Absorption costing lets us know more about how different departments are doing (manufacturing vs. non-manufacturing). Variable costing, on the other hand, is useful for helping managers make decisions related to the production volume of the company.
Also note that the operating income is the same with absorption costing and variable costing in our example. This is the case when production volume equals sales volume (i.e. no unsold inventory at year-end). In the following article, we will look at what happens when production volume is not equal to sales volume.
Horngren, C., Datar, S., Rajan, M. (2015). An Introduction to Cost Terms and Purposes. In Cost Accounting: A Managerial Emphasis (Fifteenth ed.).