Accounting for Decision Making and Control, 7th Edition [7th ed.] 0078136725, 9780078136726

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Seventh Edition

Accounting for Decision Making and Control Jerold L. Zimmerman University of Rochester

To: Conner, Easton, and Jillian

ACCOUNTING FOR DECISION MAKING AND CONTROL, SEVENTH EDITION Published by McGraw-Hill, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY 10020. Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. Previous editions © 2009, 2006, and 2003. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 DOW/DOW 1 0 9 8 7 6 5 4 3 2 1 0 ISBN MHID

978-0-07-813672-6 0-07-813672-5

Vice President & Editor-in-Chief: Brent Gordon Vice President of EDP: Sesha Bolisetty Editorial Director: Stewart Mattson Sponsoring Editor: Dick Hercher Marketing Manager: Sankha Basu Editorial Coordinator: Rebecca Mann Project Manager: Erin Melloy Design Coordinator: Brenda A. Rolwes Cover Designer: Studio Montage, St. Louis, Missouri Production Supervisor: Sue Culbertson Media Project Manager: Balaji Sundararaman Compositor: MPS Limited, A Macmillan Company Typeface: 10/12 Times New Roman Printer: R. R. Donnelley-Willard All credits appearing on page or at the end of the book are considered to be an extension of the copyright page. Library of Congress Cataloging-in-Publication Data Zimmerman, Jerold L., 1947Accounting for decision making and control / Jerold L. Zimmerman.—7th ed. p. cm. Includes bibliographical references and index. ISBN-13: 978-0-07-813672-6 (acid-free paper) ISBN-10: 0-07-813672-5 (acid-free paper) 1. Managerial accounting. I. Title. HF5657.4.Z55 2010 658.15'11—dc22 2009049120

www.mhhe.com

About the Author

Jerold L. Zimmerman Jerold Zimmerman is Ronald L. Bittner Professor at the William E. Simon Graduate School of Business, University of Rochester. He holds an undergraduate degree from the University of Colorado, Boulder, and a doctorate from the University of California, Berkeley. While at Rochester, Dr. Zimmerman has taught a variety of courses spanning accounting, finance, and economics. Accounting courses include nonprofit accounting, intermediate accounting, accounting theory, and managerial accounting. A deeper appreciation of the challenges of managing a complex organization was acquired by spending four years as Deputy Dean of the Simon School. Professor Zimmerman publishes widely in accounting on topics as diverse as cost allocations, Sarbanes-Oxley Act, disclosure, financial accounting theory, capital markets, and executive compensation. His paper “The Costs and Benefits of Cost Allocations” won the American Accounting Association’s Competitive Manuscript Contest. He is recognized for developing Positive Accounting Theory. This work, co-authored with colleague Ross Watts, at the Massachusetts Institute of Technology, received the American Institute of Certified Public Accountants’ Notable Contribution to the Accounting Literature Award for “Towards a Positive Theory of the Determination of Accounting Standards” and “The Demand for and Supply of Accounting Theories: The Market for Excuses.” Both papers appeared in the Accounting Review. Professors Watts and Zimmerman are also co-authors of the highly cited textbook Positive Accounting Theory (Prentice Hall, 1986). More recently, Professors Watts and Zimmerman received the 2004 American Accounting Association Seminal Contribution to the Literature award. Professor Zimmerman’s textbooks also include: Managerial Economics and Organizational Architecture with Clifford Smith and James Brickley, 5th ed. (McGraw-Hill/Irwin, 2009); and Management Accounting: Analysis and Interpretation with Cheryl McWatters and Dale Morse (Pearson Education Limited UK, 2008). He is a founding editor of the Journal of Accounting and Economics, published by North-Holland. This scientific journal is one of the most highly referenced accounting publications. He and his wife Dodie have two daughters, Daneille and Amy. Jerry has been known to occasionally engage friends and colleagues in an amicable diversion on the links.

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Preface

During their professional careers, managers in all organizations, profit and nonprofit, interact with their accounting systems. Sometimes managers use the accounting system to acquire information for decision making. At other times, the accounting system measures performance and thereby influences their behavior. The accounting system is both a source of information for decision making and part of the organization’s control mechanisms— thus, the title of the book, Accounting for Decision Making and Control. The purpose of this book is to provide students and managers with an understanding and appreciation of the strengths and limitations of an organization’s accounting system, thereby allowing them to be more intelligent users of these systems. This book provides a framework for thinking about accounting systems and a basis for analyzing proposed changes to these systems. The text demonstrates that managerial accounting is an integral part of the firm’s organizational architecture, not just an isolated set of computational topics.

Distinguishing Features Conceptual Framework

This book differs from other managerial accounting texts in several ways. The most important difference is that it offers a conceptual framework for the study of managerial accounting. This book relies on opportunity cost and organizational architecture as the underlying framework to organize the analysis. Opportunity cost is the conceptual foundation underlying decision making. While accounting-based costs are not opportunity costs, in some circumstances accounting costs provide a starting point to estimate opportunity costs. Organizational architecture provides the conceptual foundation to understand how accounting is employed as part of the organization’s control mechanism. These two concepts, opportunity costs and organizational architecture, provide the framework and illustrate the trade-offs created when accounting systems serve both functions: decision making and control.

Trade-Offs

This text emphasizes that there is no “free lunch”; improving an accounting system’s decision-making ability often reduces its effectiveness as a control device. Likewise, using an accounting system as a control mechanism usually comes at the expense of using the system for decision making. Most texts discuss the importance of deriving different estimates of costs for different purposes. Existing books do a good job illustrating how accounting costs developed for one purpose, such as inventory valuation, cannot be used without adjustment for other purposes, such as a make-or-buy decision. However, these books often leave the impression that one accounting system can be used for multiple purposes as long as the users make the appropriate adjustments in the data. What existing texts do not emphasize is the trade-off between designing the accounting system for decision making and designing it for control. For example, activity-based costing presumably improves the accounting system’s ability for decision making (pricing and product design), but existing texts do not address what activity-based costing gives up in terms of control. Accounting for Decision Making and Control emphasizes the trade-offs managers confront in an organization’s accounting system.

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Economic Darwinism

A central theme throughout this book is economic Darwinism, which simply implies that accounting systems that survive in competitive industries must be yielding benefits that are at least as large as their costs. While newer accounting innovations such as the balanced scorecard are described, the text also indicates through a series of company histories that many elements of today’s modern costing systems can be traced back to much earlier times. It is useful to understand that today’s managers are struggling with the same accounting issues as their predecessors, because today’s students will also be struggling with the same problems. These problems continue to exist because they involve making trade-offs, usually between systems for decision making (e.g., product pricing and make-or-buy decisions) versus control (e.g., performance evaluation). Accounting systems differ across firms and change as firms’ circumstances change. Today’s students will be making these trade-offs in the future. The current rage in managerial accounting texts is to present the latest, most up-to-date accounting system innovations. While recent innovations are important to discuss, they should be placed in their proper perspective. Traditional absorption costing systems have survived the test of time for hundreds of years. Accounting system innovations are new, not necessarily better. We certainly do not know if they will survive.

Logical Sequence

Another meaningful distinction between this text and other books in the field is that the chapters in this text build on one another. The first four chapters develop the opportunity cost and organization theory foundation for the course. The remaining chapters apply the foundation to analyzing specific topics such as budgets and standard costs. Most of the controversy in product costing involves apportioning overhead. Before absorption, variable, and activity-based costing are described, an earlier chapter provides a general analysis of cost allocation. This analysis is applied in later chapters as the analytic framework for choosing among the various product costing schemes. Other books emphasize a modular, flexible approach that allows instructors to devise their own sequence to the material, with the result that these courses often appear as a series of unrelated, disjointed topics without any underlying cohesive framework. This book has 14 chapters, compared with the usual 18–25. Instead of dividing a topic such as cost allocation into three small chapters, most topics are covered in one or at most two unified chapters.

End-of-Chapter Material

The end-of-chapter problem material is an integral part of any text, and especially important in Accounting for Decision Making and Control. The problems and cases are drawn from actual company applications described by former students based on their work experience. Many problems require students to develop critical thinking skills and to write short essays after preparing their numerical analyses. Good problems get students excited about the material and generate lively class discussions. Some problems do not have a single correct answer. Rather, they contain multiple dimensions demanding a broad managerial perspective. Marketing, finance, and human resource aspects of the situation are frequently posed. Few problems focus exclusively on computations.

Changes in the Seventh Edition Based on extensive feedback from instructors using the six editions and from my own teaching experience, the seventh edition focuses on improving the book’s readability and accessibility. In particular, the following changes have been made: • Each chapter has been updated and streamlined based on student and instructor feedback. More intuitive, easier-to-understand numerical examples have been added.

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• Additional actual company practices have been integrated into the text. • Sixteen new problems and cases supplement the existing problems. Users were uniform in their praise of the problem material. They found it challenged their students to critically analyze multidimensional issues while still requiring numerical problemsolving skills. Further problems and cases to complement this selection have been added.

Overview of Content Chapter 1 presents the book’s conceptual framework by using a simple decision context regarding accepting an incremental order from a current customer. The chapter describes why firms use a single accounting system and the concept of economic Darwinism, among other important topics. This chapter is an integral part of the text. Chapters 2, 4, and 5 present the underlying conceptual framework. The importance of opportunity costs in decision making, cost–volume–profit analysis, and the difference between accounting costs and opportunity costs are discussed in Chapter 2. Chapter 4 summarizes recent advances in the theory of organizations and Chapter 5 describes the crucial role of accounting as part of the firm’s organizational architecture. Chapter 3 on capital budgeting extends opportunity costs to a multiperiod setting. This chapter can be skipped without affecting the flow of later material. Alternatively, Chapter 3 can be assigned at the end of the course. Chapter 6 applies the conceptual framework and illustrates the trade-off managers must make between decision making and control in a budgeting system. Budgets are a decision-making tool to coordinate activities within the firm and are a device to control behavior. This chapter provides an in-depth illustration of how budgets are a significant part of an organization’s decision-making and control apparatus. Chapter 7 presents a general analysis of why managers allocate certain costs and the behavioral implications of these allocations. Cost allocations affect both decision making and incentives. Thus, there is again the trade-off between decision making and control. Chapter 8 continues the cost allocation discussion by describing the “death spiral” that can occur when significant fixed costs exist and excess capacity arises. This leads to an analysis of how to treat capacity costs—a trade-off between underutilization and overinvestment. Finally, several specific cost allocation methods such as service department costs and joint costs are described. Chapter 9 applies the general analysis of overhead allocation in Chapters 7 and 8 to the specific case of absorption costing in a manufacturing setting. The managerial implications of traditional absorption costing are provided in Chapters 10 and 11. Chapter 10 analyzes variable costing, and activity-based costing is the topic of Chapter 11. Variable costing is an interesting example of economic Darwinism. Proponents of variable costing argue that it does not distort decision making and therefore should be adopted. Nonetheless it is not widely practiced, probably because of tax, financial reporting, and control considerations. Chapter 12 discusses the decision-making and control implications of standard labor and material costs. Chapter 13 extends the discussion to overhead and marketing variances. Chapter 13 can be omitted without interrupting the flow of later material. Finally, Chapter 14 synthesizes the course by reviewing the conceptual framework and applying it to recent organizational innovations, such as Six Sigma, lean production, and the balanced scorecard. These innovations provide an opportunity to apply the analytic framework underlying the text.

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Overview of Table of Contents Chapter 1 Introduction

Chapter 4 Organizational Architecture

Chapter 2 The Nature of Costs

Chapter 5 Responsibility Accounting & Transfer Pricing

Chapter 3* Opportunity Cost of Capital and Capital Budgeting Chapter 6 Budgeting

Chapter 7 Cost Allocation: Theory

Chapter 8 Cost Allocation: Practices

Chapter 9 Absorption Cost Systems

Chapter 10 Criticisms of Absorption Cost Systems: Incentive to Overproduce

Chapter 11 Criticisms of Absorption Cost Systems: Inaccurate Product Costs

Chapter 12 Standard Costs: Direct Labor and Materials

Chapter 13* Overhead & Marketing Variances

Chapter 14 Management Accounting in a Changing Environment

*Chapter can be omitted without interrupting the flow of material.

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Using the Text This book assumes that the student is familiar with introductory financial accounting. Accounting for Decision Making and Control can be used in advanced undergraduate, graduate, or executive programs. It is being used widely outside the United States. While the book relies on opportunity costs and organizational economics, much of the discussion is at an intuitive level. To focus on the managerial implications of the material, journal entries are deliberately de-emphasized. The text is concise, which allows the instructor to supplement the course with additional outside readings or heavy problem assignments. The text has been used in a 10-week quarter course with few outside readings and two to three hours of homework assignments for every class period. MBA students find this challenging and rewarding. They report a better understanding of how to use accounting numbers, are more comfortable at preparing financial analyses, and are better able to take a set of facts and communicate a cogent analysis. Alternatively, the text can support a semester-length course. Executive MBA students praise the text’s real-world applicability, readability, and the relevance of the problem material. Some of the more challenging material is presented in appendixes following the chapters. Chapter 2’s appendix describes the pricing decision. Chapter 6’s appendix contains a comprehensive master budget. The reciprocal method for allocating service department costs is described in the appendix to Chapter 8. The appendixes to Chapter 9 describe process costing and demand shifts, fixed costs, and pricing. Appendixes can be deleted without affecting future chapter discussions.

Supplements

Online Learning Center (OLC): www.mhhe.com/zimerman7e. The Instructor Edition of Accounting for Decision Making and Control, 7e, OLC is password protected and a convenient place for instructors to access course supplements. Resources for professors include chapter-by-chapter teaching strategies, suggested problem assignments, recommended outside cases, lecture notes, sample syllabi, chapter PowerPoint presentations, and complete solutions to all problems and case material within the text. The Student Edition of Accounting for Decision Making and Control, 7e, OLC contains review material to help students study, including PowerPoint presentations and multiple-choice quizzes. Tegrity Campus: Lectures 24/7 Tegrity Campus is a service that makes class time available 24/7 by automatically capturing lectures in a searchable format for students to review when they study and complete assignments. With a simple one-click startand-stop process, you capture all computer screens and corresponding audio. Students can replay any part of any class with easy-to-use browser-based viewing. With Tegrity Campus, students quickly recall key moments by using Tegrity Campus’s unique search feature. To learn more about Tegrity, watch a two-minute Flash demo at http://tegritycampus .mhhe.com.

Acknowledgments William Vatter and George Benston motivated my interest in managerial accounting. The genesis for this book and its approach reflect the oral tradition of my colleagues, past and present, at the University of Rochester. William Meckling and Michael Jensen stimulated my thinking and provided much of the theoretical structure underlying the book, as anyone familiar with their work will attest. My long and productive collaboration with Ross Watts sharpened my analytical skills and further refined the approach. He also furnished most of the intellectual capital for Chapter 3, including the problem material. Ray Ball has been a

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constant source of ideas. Clifford Smith and James Brickley continue to enhance my economic education. Three colleagues, Andrew Christie, Dan Gode, and Scott Keating, supplied particularly insightful comments that enriched the analysis at critical junctions. Valuable comments from Anil Arya, Ron Dye, Andy Leone, K. Ramesh, Shyam Sunder, and Joseph Weintrop are gratefully acknowledged. This project benefited greatly from the honest and intelligent feedback of numerous instructors. I wish to thank Mahendra Gupta, Susan Hamlen, Badr Ismail, Charles Kile, Leslie Kren, Don May, William Mister, Mohamed Onsi, Ram Ramanan, Stephen Ryan, Michael Sandretto, Richard Sansing, Deniz Saral, Gary Schneider, Joe Weber, and William Yancey. This book also benefited from two other projects with which I have been involved. Writing Managerial Economics and Organizational Architecture (McGraw-Hill/Irwin, 2009) with James Brickley and Clifford Smith and Management Accounting: Analysis and Interpretation (Pearson Education, Limited (UK), 2008) with Cheryl McWatters and Dale Morse helped me to better understand how to present certain topics. To the numerous students who endured the development process, I owe an enormous debt of gratitude. I hope they learned as much from the material as I learned teaching them. Some were even kind enough to provide critiques and suggestions, in particular Jan Dick Eijkelboom. Others supplied, either directly or indirectly, the problem material in the text. The able research assistance of P. K. Madappa, Eamon Molloy, Jodi Parker, Steve Sanders, Richard Sloan, and especially Gary Hurst, contributed amply to the manuscript and problem material. Janice Willett and Barbara Schnathorst did a superb job of editing the manuscript and problem material. The very useful comments and suggestions from the following reviewers are greatly appreciated: Urton Anderson Howard M. Armitage Vidya Awasthi Kashi Balachandran Da-Hsien Bao Ron Barden Howard G. Berline Margaret Boldt David Borst Eric Bostwick Marvin L. Bouillon Wayne Bremser David Bukovinsky Linda Campbell William M. Cready James M. Emig Gary Fane Anita Feller Tahirih Foroughi Ivar Fris Jackson F. Gillespie Irving Gleim

Jon Glover Gus Gordon Sylwia Gornik-Tomaszewski Susan Haka Bert Horwitz Steven Huddart Robert Hurt Douglas A. Johnson Lawrence A. Klein Thomas Krissek A. Ronald Kucic Daniel Law Chi-Wen Jevons Lee Suzanne Lowensohn James R. Martin Alan H. McNamee Marilyn Okleshen Shailandra Pandit Sam Phillips Frank Probst Kamala Raghavan

Ram Ramanan William Rau Jane Reimers Thomas Ross Harold P. Roth P. N. Saksena Donald Samaleson Michael J. Sandretto Arnold Schneider Henry Schwarzbach Elizabeth J. Serapin Norman Shultz James C. Stallman William Thomas Stevens Monte R. Swain Clark Wheatley Lourdes F. White Paul F. Williams Robert W. Williamson Jeffrey A. Yost S. Mark Young

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Kathy Jones, my very able assistant, had the difficult and often impossible task of managing and editing the manuscript and instructor manual. She did a superb job. To my wife Dodie and daughters Daneille and Amy, thank you for setting the right priorities and for giving me the encouragement and environment to be productive. Finally, I wish to thank my parents for all their support. Jerold L. Zimmerman University of Rochester

Brief Contents

1

Introduction 1

2

The Nature of Costs 22

3

Opportunity Cost of Capital and Capital Budgeting 89

4

Organizational Architecture 135

5

Responsibility Accounting and Transfer Pricing 170

6

Budgeting 229

7

Cost Allocation: Theory 302

8

Cost Allocation: Practices 347

9

Absorption Cost Systems 409

10

Criticisms of Absorption Cost Systems: Incentive to Overproduce 468

11

Criticisms of Absorption Cost Systems: Inaccurate Product Costs 501

12

Standard Costs: Direct Labor and Materials 554

13

Overhead and Marketing Variances 592

14

Management Accounting in a Changing Environment 627

Solutions to Concept Questions Glossary 684 Index 693

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Contents

1

Introduction 1 A. B. C. D. E. F. G. H.

2

Managerial Accounting: Decision Making and Control 2 Design and Use of Cost Systems 4 Marmots and Grizzly Bears 8 Management Accountant’s Role in the Organization 10 Evolution of Management Accounting: A Framework for Change 13 Vortec Medical Probe Example 15 Outline of the Text 18 Summary 19

The Nature of Costs 22 A. Opportunity Costs 23 1. Characteristics of Opportunity Costs 24 2. Examples of Decisions Based on Opportunity Costs 24 B. Cost Variation 28 1. Fixed, Marginal, and Average Costs 28 2. Linear Approximations 31 3. Other Cost Behavior Patterns 32 4. Activity Measures 33 C. Cost–Volume–Profit Analysis 34 1. Copier Example 34 2. Calculating Break-Even and Target Profits 36 3. Limitations of Cost–Volume–Profit Analysis 40 4. Multiple Products 40 5. Operating Leverage 42 D. Opportunity Costs versus Accounting Costs 45 1. Period versus Product Costs 46 2. Direct Costs, Overhead Costs, and Opportunity Costs 46 E. Cost Estimation 50 1. Account Classification 50 2. Motion and Time Studies 50 F. Summary 50 Appendix: Costs and the Pricing Decision 51

3

Opportunity Cost of Capital and Capital Budgeting 89 A. Opportunity Cost of Capital 90 B. Interest Rate Fundamentals 93 1. Future Values 93 2. Present Values 94

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C.

D.

E.

F.

4

3. Present Value of a Cash Flow Stream 95 4. Perpetuities 96 5. Annuities 97 6. Multiple Cash Flows per Year 98 Capital Budgeting: The Basics 100 1. Decision to Acquire an MBA 100 2. Decision to Open a Video Rental Store 101 3. Essential Points about Capital Budgeting 102 Capital Budgeting: Some Complexities 104 1. Risk 104 2. Inflation 105 3. Taxes and Depreciation Tax Shields 107 Alternative Investment Criteria 109 1. Payback 109 2. Accounting Rate of Return 109 3. Internal Rate of Return (IRR) 111 4. Methods Used in Practice 114 Summary 115

Organizational Architecture 135 A. Basic Building Blocks 136 1. Self-Interested Behavior, Team Production, and Agency Costs 136 2. Decision Rights and Rights Systems 142 3. Role of Knowledge and Decision Making 142 4. Markets versus Firms 143 5. Influence Costs 145 B. Organizational Architecture 146 1. Three-Legged Stool 147 2. Decision Management versus Decision Control 150 C. Accounting’s Role in the Organization’s Architecture 152 D. Example of Accounting’s Role: Executive Compensation Contracts 155 E. Summary 157

5

Responsibility Accounting and Transfer Pricing 170 A. Responsibility Accounting 171 1. Cost Centers 171 2. Profit Centers 174 3. Investment Centers 175 4. Economic Value Added (EVA®) 180 5. Controllability Principle 183 B. Transfer Pricing 185 1. International Taxation 185 2. Economics of Transfer Pricing 187 3. Common Transfer Pricing Methods 191 4. Reorganization: The Solution If All Else Fails 197 5. Recap 197 C. Summary 199

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Budgeting 229 A. Generic Budgeting Systems 231 1. Country Club 231 2. Private University 236 3. Large Corporation 238 B. Trade-Off between Decision Management and Decision Control 241 1. Communicating Specialized Knowledge versus Performance Evaluation 242 2. Budget Ratcheting 242 3. Participative Budgeting 245 4. New Approaches to Budgeting 246 5. Managing the Trade-Off 249 C. Resolving Organizational Problems 249 1. Short-Run versus Long-Run Budgets 250 2. Line-Item Budgets 252 3. Budget Lapsing 253 4. Static versus Flexible Budgets 253 5. Incremental versus Zero-Based Budgets 257 D. Summary 258 Appendix: Comprehensive Master Budget Illustration 259

7

Cost Allocation: Theory 302 A. Pervasiveness of Cost Allocations 304 1. Manufacturing Organizations 305 2. Hospitals 306 3. Universities 306 B. Reasons to Allocate Costs 308 1. External Reporting/Taxes 308 2. Cost-Based Reimbursement 309 3. Decision Making and Control 311 C. Incentive/Organizational Reasons for Cost Allocations 312 1. Cost Allocations Are a Tax System 312 2. Taxing an Externality 313 3. Insulating versus Noninsulating Cost Allocations 319 D. Summary 322

8

Cost Allocation: Practices 347 A. Death Spiral 348 B. Allocating Capacity Costs: Depreciation 353 C. Allocating Service Department Costs 353 1. Direct Allocation Method 355 2. Step-Down Allocation Method 357 3. Service Department Costs and Transfer Pricing of Direct and Step-Down Methods 359 4. Reciprocal Allocation Method 362 5. Recap 364

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D. Joint Costs 364 1. Chickens 366 2. Net Realizable Value 367 3. Decision Making and Control 371 E. Segment Reporting and Joint Benefits 372 F. Summary 373 Appendix: Reciprocal Method for Allocating Service Department Costs 374

9

Absorption Cost Systems 409 A. Job Order Costing 411 B. Cost Flows through the T-Accounts 413 C. Allocating Overhead to Jobs 416 1. Overhead Rates 416 2. Over/Underabsorbed Overhead 417 3. Flexible Budgets to Estimate Overhead 420 4. Expected versus Normal Volume 423 D. Permanent versus Temporary Volume Changes 427 E. Plantwide versus Multiple Overhead Rates 428 F. Process Costing: The Extent of Averaging 432 G. Summary 433 Appendix A: Process Costing 433 Appendix B: Demand Shifts, Fixed Costs, and Pricing 439

10

Criticisms of Absorption Cost Systems: Incentive to Overproduce 468 A. Incentive to Overproduce 470 1. Example 470 2. Reducing the Overproduction Incentive 472 B. Variable (Direct) Costing 474 1. Background 474 2. Illustration of Variable Costing 474 3. Overproduction Incentive under Variable Costing 477 C. Problems with Variable Costing 478 1. Classifying Fixed Costs as Variable Costs 478 2. Ignores Opportunity Cost of Capacity 480 D. Beware of Unit Costs 481 E. Summary 483

11

Criticisms of Absorption Cost Systems: Inaccurate Product Costs 501 A. Inaccurate Product Costs 502 B. Activity-Based Costing 506 1. Choosing Cost Drivers 507 2. Absorption versus Activity-Based Costing: An Example 513 C. Analyzing Activity-Based Costing 517 1. Reasons for Implementing Activity-Based Costing 517 2. Benefits and Costs of Activity-Based Costing 519 3. ABC Measures Costs, Not Benefits 521 D. Acceptance of Activity-Based Costing 523 E. Summary 527

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Standard Costs: Direct Labor and Materials 554 A. Standard Costs 555 1. Reasons for Standard Costing 556 2. Setting and Revising Standards 557 3. Target Costing 561 B. Direct Labor and Materials Variances 562 1. Direct Labor Variances 563 2. Direct Materials Variances 567 3. Risk Reduction and Standard Costs 571 C. Incentive Effects of Direct Labor and Materials Variances 571 1. Build Inventories 572 2. Externalities 572 3. Discouraging Cooperation 573 4. Mutual Monitoring 573 5. Satisficing 573 D. Disposition of Standard Cost Variances 574 E. The Costs of Standard Costs 576 F. Summary 578

13

Overhead and Marketing Variances 592 A. Budgeted, Standard, and Actual Volume 593 B. Overhead Variances 596 1. Flexible Overhead Budget 596 2. Overhead Rate 597 3. Overhead Absorbed 598 4. Overhead Efficiency, Volume, and Spending Variances 599 5. Graphical Analysis 602 6. Inaccurate Flexible Overhead Budget 604 C. Marketing Variances 605 1. Price and Quantity Variances 605 2. Mix and Sales Variances 606 D. Summary 608

14

Management Accounting in a Changing Environment 627 A. Integrative Framework 628 1. Organizational Architecture 629 2. Business Strategy 630 3. Environmental and Competitive Forces Affecting Organizations 633 4. Implications 633 B. Organizational Innovations and Management Accounting 634 1. Total Quality Management (TQM) 635 2. Just-in-Time (JIT) Production 639 3. Six Sigma and Lean Production 642 4. Balanced Scorecard 644 C. When Should the Internal Accounting System Be Changed? 650 D. Summary 651 Solutions to Concept Questions 674 Glossary 684 Index 693

Chapter One

Introduction Chapter Outline A. Managerial Accounting: Decision Making and Control B. Design and Use of Cost Systems C. Marmots and Grizzly Bears D. Management Accountant’s Role in the Organization E. Evolution of Management Accounting: A Framework for Change F. Vortec Medical Probe Example G. Outline of the Text H. Summary

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Chapter 1

A. Managerial Accounting: Decision Making and Control Managers at BMW must decide which car models to produce, the quantity of each model to produce given the selling prices for the models, and how to manufacture the automobiles. They must decide which car parts, such as headlight assemblies, BMW should manufacture internally and which parts should be outsourced. They must decide not only on advertising, distribution, and product positioning to sell the cars, but also the quantity and quality of the various inputs to use. For example, they must determine which models will have leather seats and the quality of the leather to be used. How are future revenues and costs of proposed car models estimated? Similarly, in deciding which investment projects to accept, capital budgeting analysts require data on future cash flows. How are these numbers derived? How does one coordinate the activities of hundreds or thousands of employees in the firm so that these employees accept senior management’s leadership? At BMW and organizations small and large, managers must have good information to make all these decisions and the leadership abilities to get others to implement the decisions. Information about firms’ future costs and revenues is not readily available but must be estimated by managers. Organizations must obtain and disseminate the knowledge to make these decisions. Decision making is much easier with the requisite knowledge. Organizations’ internal information systems provide some of the knowledge for these pricing, production, capital budgeting, and marketing decisions. These systems range from the informal and the rudimentary to very sophisticated, computerized management information systems. The term information system should not be interpreted to mean a single, integrated system. Most information systems consist not only of formal, organized, tangible records such as payroll and purchasing documents but also informal, intangible bits of data such as memos, special studies, and managers’ impressions and opinions. The firm’s information system also contains nonfinancial information such as customer and employee satisfaction surveys. As firms grow from single proprietorships to large global corporations with tens of thousands of employees, managers lose the knowledge of enterprise affairs gained from personal, face-to-face contact in daily operations. Higher-level managers of larger firms come to rely more and more on formal operating reports. The internal accounting system, an important component of a firm’s information system, includes budgets, data on the costs of each product and current inventory, and periodic financial reports. In many cases, especially in small companies, these accounting reports are the only formalized part of the information system providing the knowledge for decision making. Many larger companies have other formalized, nonaccounting–based information systems, such as production planning systems. This book focuses on how internal accounting systems provide knowledge for decision making. After making decisions, managers must implement them in organizations in which the interests of the employees and the owners do not necessarily coincide. Just because senior managers announce a decision does not necessarily ensure that the decision will be implemented. Organizations do not have objectives; people do. A discussion of an organization’s objectives requires addressing the owners’ objectives. One common objective of owners is to maximize profits, or the difference between revenues and expenses. Maximizing firm value is equivalent to maximizing the stream of profits over the organization’s life. Employees, suppliers, and customers also have their own objectives—usually maximizing their self-interest. Not all owners care only about monetary flows. An owner of a professional sports team might care more about winning (subject to covering costs) than maximizing profits.

Introduction

3

Nonprofits do not have owners with the legal rights to the organization’s profits. Moreover, nonprofits seek to maximize their value by serving some social goal such as education, health care, or welfare. No matter what the firm’s objective, the organization will survive only if its inflow of resources (such as revenue) is at least as large as the outflow. Accounting information is useful to help manage the inflow and outflow of resources and to help align the owners’ and employees’ interests, no matter what objectives the owners wish to pursue. Throughout this book, we assume that individuals maximize their self-interest. The owners of the firm usually want to maximize profits, but managers and employees will do so only if it is in their interest. Hence, a conflict of interest exists between owners—who, in general, want higher profits—and employees—who want easier jobs, higher wages, and more fringe benefits. To control this conflict, senior managers and owners design systems to monitor employees’ behavior and incentive schemes that reward employees for generating more profits. Not-for-profit organizations face similar conflicts. Those people responsible for the nonprofit organization (boards of trustees and government officials) must design incentive schemes to motivate their employees to operate the organization efficiently. All successful firms must devise mechanisms that help align employee interests with maximizing the organization’s value. All of these mechanisms constitute the firm’s control system; they include performance measures and incentive compensation systems, promotions, demotions, and terminations, security guards and video surveillance, internal auditors, and the firm’s internal accounting system.1 As part of the firm’s control system, the internal accounting system helps align the interests of managers and shareholders to cause employees to maximize firm value. It sounds like a relatively easy task to design systems to ensure that employees maximize firm value. But a significant portion of this book demonstrates the exceedingly complex nature of aligning employee interests with those of the owners. Internal accounting systems serve two purposes: (1) to provide some of the knowledge necessary for planning and making decisions (decision making) and (2) to help motivate and monitor people in organizations (control). The most basic control use of accounting is to prevent fraud and embezzlement. Maintaining inventory records helps reduce employee theft. Accounting budgets, discussed more fully in Chapter 6, provide an example of both decision making and control. Asking each salesperson in the firm to forecast their next year’s sales is useful for planning next year’s production (decision making). However, if the salesperson’s sales forecast is used to benchmark their performance for compensation purposes (control), they have strong incentives to underestimate their budget forecasts. Using internal accounting systems for both decision making and control gives rise to the fundamental trade-off in these systems: A system cannot be designed to perform two tasks as well as a system that must perform only one task. Some ability to deliver knowledge for decision making is usually sacrificed to provide better motivation (control). The trade-off between providing knowledge for decision making and motivation/control arises continually throughout this text. This book is applications oriented: It describes how the accounting system assembles knowledge necessary for implementing decisions using the theories from microeconomics,

1

Control refers to the process that helps “ensure the proper behaviors of the people in the organization. These behaviors should be consistent with the organization’s strategy,” as noted in K Merchant, Control in Business Organizations (Boston: Pitman Publishing Inc., 1985), p. 4. Merchant provides an extensive discussion of control systems and a bibliography. In Theory of Accounting and Control (Cincinnati, OH: South-Western Publishing Company, 1997), S Sunder describes control as mitigating and resolving conflicts between employees, owners, suppliers, and customers that threaten to pull organizations apart.

4

Chapter 1

finance, operations management, and marketing. It also shows how the accounting system helps motivate employees to implement these decisions. Moreover, it stresses the continual trade-offs that must be made between the decision making and control functions of accounting. A survey of 2,000 senior-level executives (chief financial officers, vice presidents of finance, controllers, etc.) asked managers to rank the importance of various goals of their firm’s accounting system. The typical respondent was in a company with $300 million of sales and 1,700 employees. Eighty percent of the respondents reported that cost management (controlling costs) was a significant goal of their accounting system and was important to achieving their company’s overall strategic objective. Another top priority of their firm’s accounting system, even higher than cost management or strategic planning, is internal reporting and performance evaluation. These results indicate that firms use their internal accounting system both for decision making (strategic planning, cost reduction, financial management) and for controlling behavior (internal reporting and performance evaluation).2 The firm’s accounting system is very much a part of the fabric that helps hold the organization together. It provides knowledge for decision making, and it provides information for evaluating and motivating the behavior of individuals within the firm. Being such an integral part of the organization, the accounting system cannot be studied in isolation from the other mechanisms used for decision making or for reducing organizational problems. A firm’s internal accounting system should be examined from a broad perspective, as part of the larger organization design question facing managers. This book uses an economic perspective to study how accounting can motivate and control behavior in organizations. Besides economics, a variety of other paradigms also are used to investigate organizations: scientific management (Taylor), the bureaucratic school (Weber), the human relations approach (Mayo), human resource theory (Maslow, Rickert, Argyris), the decision-making school (Simon), and the political science school (Selznick). Behavior is a complex topic. No single theory or approach is likely to capture all the elements. However, understanding managerial accounting requires addressing the behavioral and organizational issue