Throughput Accounting 1 · Lesson 1 of 6
What management accounting is for
Financial, cost and management accounting answer different questions. See how product cost is built, why companies use it to link daily decisions to profit, and face three questions your intuition may get wrong.
Why this matters
When businesses fail, the cause is rarely a lack of effort or a bad product. Very often it is a long run of reasonable-looking decisions, each one backed by the numbers, that together moved the company away from profit. One study of failed businesses put financial mismanagement behind the great majority of them.
Most of those decisions were local: which product to push, which order to take, which machine to buy. This course is about how those local decisions are connected to the company’s profit, and why the most common way of connecting them points the wrong way so often.
Three kinds of accounting
Think back to your management classes. What is the difference between these three?
- Financial accounting reports what happened: the balance sheet, the profit and loss statement and the cash flow statement for a past period. It is written for shareholders, lenders and tax authorities, and it follows strict rules.
- Management accounting looks forward. It gives managers the information to make decisions that move the organisation towards its goal, and it should show how a local decision affects global performance.
- Cost accounting is one tool used inside management accounting: it works out what each product, process or department “costs”.
Financial accounting must follow the rules. Management accounting has only one test: does it lead to the right decision?
Why companies use cost accounting
A company is judged on net profit and return on investment. But nobody can check net profit before deciding whether to run one more batch today. The numbers that measure the whole company are too far from the shop floor.
Cost accounting was built to be the bridge: give every product a cost, and every local decision can be judged by its effect on that cost. Managers use product cost to answer questions like these:
- What is the true cost of this product? Which products are the most profitable, and which lose money?
- Should we launch this product? What price should we charge?
- Should we outsource this process?
- Is this improvement worth the money? Should we buy this machine?
- Where should we start improving efficiency?
If the bridge is sound, all these decisions add up to more profit. If it is not, they can each look right and together make the company poorer.
Where it came from
Cost accounting grew up before 1900, pricing rail freight and textiles, and was developed into a management system by large manufacturers such as General Motors in the 1920s. In that world most workers were paid by the piece, so labour really did rise and fall with every unit made, and overheads were small. Allocating a little overhead to each product hardly changed the answer.
Keep that history in mind. The question this course keeps asking is: is that still true today?
How product cost is built
Every costing method splits a product’s cost in two:
- Direct cost: what can be traced to the product itself, like material and packaging.
- Indirect cost: what is shared across products, like wages, supervision, rent and power. It is spread over products with an allocation basis, usually direct labour hours or machine minutes. Absorption costing and activity-based costing differ mainly in how they choose the basis.
Here is how it works. Product A has ₹100 of direct cost and takes 60 minutes. Product B has ₹150 of direct cost and takes 90 minutes. Labour costs ₹1,000 for an 8-hour day, so ₹1,000 ÷ 480 minutes ≈ ₹2.08 a minute.
| Product A | Product B | |
|---|---|---|
| Direct cost | ₹100 | ₹150 |
| Time | 60 min | 90 min |
| Indirect cost (time × ₹2.08) | ₹125 | ₹187.50 |
| Product cost | ₹225 | ₹337.50 |
Pause and think: if the plant makes one more Product A tomorrow, how much more will the company spend?
- ₹225, the product cost
- About ₹100, the material: the wages are paid whether or not the extra unit is made
- ₹125, the labour
- Nothing at all
Unless people are paid by the piece, or the extra unit needs overtime, the ₹1,000 a day is spent either way. Only the ₹100 of material really changes. The other ₹125 of “product cost” is a share of an expense that doesn’t move. Hold on to that difference: the rest of the course grows out of it.
Three questions for your intuition
These aren’t trick questions. Answer from experience, and note your answers.
1. Will producing and selling more of the high-margin products always raise the company’s profit?
- Yes, always
- Not necessarily
Most managers say yes; the cost report is built on that belief. In lesson 2, the P&Q plant will put it to the test.
2. Can selling a product below its cost make a loss-making company profitable?
- Yes, it can
- No, it can only deepen the loss
It sounds impossible. Lesson 4 shows a plant that does exactly that.
3. Can an action that reduces product cost reduce the company’s profit?
- Yes, it can
- No: lower cost always means higher profit
Lesson 5 shows two improvement proposals where the cost report picks the one that earns nothing.
If any of your answers turn out to be wrong, ask yourself a bigger question: how are companies making these decisions every day?
Check your understanding
Answer all five. Get four right to complete the lesson.
1. Which kind of accounting exists to support decisions about the future?
- Financial accounting
- Tax accounting
- Management accounting
- Auditing
Financial accounting reports the past; management accounting supports decisions.
2. Why do companies use product cost?
- As a bridge between local decisions and the company’s profit
- Because the tax law requires it for every decision
- To set wages
- To value the brand
Net profit is too far from daily decisions, so product cost stands in for it.
3. Indirect costs are spread over products using…
- The selling price
- The customer’s location
- The number of salespeople
- An allocation basis, such as labour hours or machine minutes
That basis is how a shared expense becomes part of a product’s cost.
4. Product B takes 90 minutes and labour costs ₹1,000 for a 480-minute day. Its allocated indirect cost is about…
- ₹90
- ₹187.50
- ₹1,000
- ₹337.50
90 × ₹1,000 ÷ 480 = ₹187.50. Add the ₹150 of direct cost and the product cost is ₹337.50.
5. Allocating overhead caused little harm when cost accounting was developed because…
- Computers did the sums
- Products were simpler to sell
- Labour was paid by the piece and overheads were small
- Prices never changed
Then, most cost really did vary with each unit. Today wages and overheads are mostly fixed for the period.