Financial accounting reports to people outside the business. Management accounting serves the people running it: owners, managers and teams who need to decide what to sell, at what price, how much to produce and where costs are out of control. Cost accounting is the part of it that measures what products, services and activities actually cost.
Management accounting is not bound by external reporting standards. Reports can be weekly, forward-looking, by product or branch, and as detailed as a decision requires.
What you will learn
- Classify costs by behaviour and by traceability
- Calculate contribution margin and break-even point
- Explain how budgets and budgetary control work
- Calculate and interpret basic variances
Classifying costs
The right classification depends on the question being asked.
| Classification | Categories | Useful for |
|---|---|---|
| By behaviour | Variable, fixed, semi-variable | Forecasting, break-even, pricing |
| By traceability | Direct, indirect (overheads) | Product costing |
| By function | Production, selling, administration | Financial statements, cost control |
| By relevance | Relevant, sunk, opportunity costs | One-off decisions |
Variable costs change in total with activity (materials, sales commission). Fixed costs stay the same in total within a relevant range of activity (rent, salaried staff). Semi-variable costs have both elements, such as an electricity bill with a standing charge and a usage charge.
A sunk cost has already been incurred and cannot be recovered, so it is irrelevant to future decisions. An opportunity cost is the benefit given up by choosing one option over another, and it is always relevant.
Contribution and break-even
Contribution is sales revenue minus variable costs. It is the amount available to cover fixed costs and then provide profit.
Contribution and break-even
Contribution per unit = Selling price − Variable cost per unit
Break-even units = Fixed costs ÷ Contribution per unit
Contribution margin ratio = Contribution ÷ Sales; Break-even revenue = Fixed costs ÷ Contribution margin ratio
Worked example: break-even and target profit
A bakery sells cakes at 800 each. Variable cost (ingredients, packaging, delivery) is 480 per cake. Monthly fixed costs are 240,000 (illustrative figures).
- Contribution per cake: 800 − 480 = 320.
- Break-even: 240,000 ÷ 320 = 750 cakes a month (revenue 750 × 800 = 600,000).
- Contribution margin ratio: 320 ÷ 800 = 40%. Check: 240,000 ÷ 0.40 = 600,000.
- To earn a profit of 96,000: (240,000 + 96,000) ÷ 320 = 1,050 cakes.
- Margin of safety at planned sales of 1,000 cakes: (1,000 − 750) ÷ 1,000 = 25% — sales could fall by a quarter before the bakery makes a loss.
Break-even chart for the bakery
Show the data
| Series | Cakes sold per month | Amount |
|---|---|---|
| Total revenue | 0 | 0 |
| Total revenue | 1,200 | 960,000 |
| Total cost | 0 | 240,000 |
| Total cost | 1,200 | 816,000 |
| Fixed cost | 0 | 240,000 |
| Fixed cost | 1,200 | 240,000 |
You can test these numbers with the ARBIMETRA break-even calculator. Break-even analysis assumes constant selling prices and variable costs per unit, fixed costs that do not change within the range, and (for several products) a constant sales mix. Outside those assumptions it is an approximation.
Product costing
To value inventory and set prices, a business needs the full cost of each product. Absorption costing assigns production overheads to products using an absorption rate, typically per machine hour or labour hour. Marginal costing treats only variable production costs as product costs and charges fixed overheads in the period. The two methods give different profits when inventory levels change, because absorption costing carries some fixed overhead forward in closing stock. External financial statements under IFRS require absorption of production overheads into inventory.
Activity-based costing (ABC) refines overhead allocation by linking costs to the activities that drive them, such as the number of set-ups or orders, which is useful when products use support resources very unevenly.
Budgets and budgetary control
A budget is a quantified plan for a future period. A typical master budget starts from the sales budget (usually the limiting factor) and builds production, purchasing, labour, overhead and cash budgets, ending with a budgeted income statement and balance sheet. Spreadsheet techniques for building them are covered in budgeting and cash flow models.
Budgetary control compares actual results with the budget, investigates significant differences and takes action. A flexible budget adjusts the budget to the actual level of activity, so managers are not blamed or praised simply because volume differed.
Variance analysis
A variance is the difference between an actual result and the budgeted or standard amount. It is favourable if it increases profit and adverse if it reduces it.
Worked example: materials variances
Standard: each cake uses 0.5 kg of flour at 100 per kg. In a month 1,000 cakes were made using 540 kg bought at 95 per kg (illustrative figures).
- Standard cost for actual output: 1,000 × 0.5 kg × 100 = 50,000.
- Actual cost: 540 × 95 = 51,300. Total variance: 1,300 adverse.
- Price variance: (100 − 95) × 540 = 2,700 favourable — flour was cheaper.
- Usage variance: (500 − 540) × 100 = 4,000 adverse — 40 kg more flour was used than the standard allows.
Check: 2,700 favourable − 4,000 adverse = 1,300 adverse. The cheaper flour may have been lower quality, causing more waste — variances point to questions rather than answers.
Benefits and limitations
Management accounting helps managers price products, choose between options, control costs and plan cash. Its limits come from its assumptions: costs are not always neatly fixed or variable, allocations of shared overhead involve judgement, and budgets built on unrealistic targets can encourage poor behaviour such as delaying necessary spending to meet a figure.
Common mistakes
- Including sunk costs in a decision about the future.
- Using a fully absorbed cost per unit to decide whether to accept a one-off order, when only the relevant (incremental) costs matter.
- Comparing actual results with a fixed budget at a very different activity level.
- Treating every adverse variance as a failure without investigating the cause.
Key terms
- Contribution — sales revenue minus variable costs.
- Break-even point — the level of sales at which profit is zero.
- Margin of safety — how far sales can fall before the break-even point is reached.
- Flexible budget — a budget adjusted to the actual level of activity.
- Variance — the difference between actual and budgeted or standard results.
Frequently asked questions
What is the difference between cost accounting and management accounting?
Cost accounting measures the cost of products, services and activities. Management accounting is broader: it uses cost information, along with budgets, forecasts and performance measures, to support planning and decisions.
Why is contribution more useful than profit per unit for decisions?
Fixed costs do not change with a single decision such as accepting an extra order. Contribution shows how much each additional unit adds towards covering those fixed costs and profit.
Should every variance be investigated?
No. Businesses usually investigate variances that are significant in size, persistent or controllable, because investigation itself has a cost.
Key takeaways
- Management accounting provides flexible, forward-looking information for internal decisions.
- Classifying costs by behaviour supports forecasting, break-even analysis and pricing.
- Break-even units equal fixed costs divided by contribution per unit.
- Budgets plan the future; budgetary control and variance analysis explain differences from the plan.