Accounting for Managers: Interpreting accounting information for decision-making

158 ACCOUNTING FOR MANAGERS

Sales

Less cost of sales

Product costs

− direct or prime costs

Indirect costs

− indirect costs or production overhead

Plus/minus change in inventory

= Gross profit

Less selling, administration

and finance expenses

Period costs

Non-production overhead

= Operating profit

Total costs

= product costs + period costs

Figure 11.1 Cost classification

Distinguishing between production and non-production costs and between
materials, labour and overhead costs as direct or indirect iscontingenton the type
of product/service and the particular production process used in the organization.
Contingency theory is described later in this chapter. There are no strict rules, as
the classification of costs depends on the circumstances of each business and the
decisions made by the accountants in that business. Consequently, unlike financial
accounting, there is far greater variety between businesses – even in the same
industry – in how costs are treated for management accounting purposes.
Figure 11.1 shows the relationship between these different types of costs.

Calculating product/service costs...........................

We saw in Chapter 8 the important distinction between fixed and variable costs
and how the calculation of contribution (sales less variable costs) was important
for short-term decision-making. However, we also saw that in the longer term,
all the costs of a business must be recovered if it is to be profitable. To assist
with pricing and other decisions, accountants calculate the full or absorbed cost of
product/services.
As direct costs by definition are traceable, this element of product/service cost
is usually quite accurate. However indirect costs, which by their nature cannot be
traced to products/services, must in some way beallocatedover products/services
in order to calculate the full cost.Overhead allocationis the process of spreading
production overhead (i.e. those overheads that cannot be traced directly to prod-
ucts/services) equitably over the volume of production. The overhead allocation
problem can be seen in Figure 11.2.