Cost Accounting 14th Edition Carter THONISON eeCustom Editor: Greg Albert Marketing Coordinators: Lindsay Annett and Sara Mercurio Production /Manufacturing Supervisor: Donna M. Brown © 2006 Carter Printed in the United States of America 123456789 08 07 06 For more information, please contact Thomson Custom Solutions, 5191 Natorp Boulevard, Mason, OH 45040. Or you can visit our Internet site at www.thomsoncustom.com ALL RIGHTS RESERVED. No part of this work covered by the THOMSON eS es Cost Accounting Carter Project Coordinator: Dave Lyons Pre-Media Services Supervisor: Dan Plofchan Rights and Permissions Specialist: Kalina Hintz copyright hereon may be reproduced or used in any form or by any means — graphic, electronic, or mechanical, including photocopying, recording, taping, Web distribution or information storage and retrieval systems —without the written permission of the author, Carter. The Adaptable Courseware Program consists of products and additions to existing Thomson Custom Solutions products that are produced from camera-ready copy. Senior Prepress Special Kim Fry Cover Design: Phoenix Creative Printer: Quebecor, Taunton Peer review, class testing, and accuracy are primarily tk responsibility of the author‘ For permission to use materia from this text or product, contact us by Tel (800) 730-2214 Fax (800) 730 2215, www.thomsonrights.com Cost Accounting/ Carter 14th Edition p. 960 ISBN 0-759-33809-4Preface Globalization, increased competition, and new technologies have forced many companies to reevaluate their business. This reevaluation led to changes in management philosophy and in business systems, which in turn required accountants to reevaluate the usefulness of information the accounting system provides to management. Accounting systems created primarily to provide information for external reporting, or created at a time when manu- facturing technologies and systems were essentially labor driven, are no longer adequate. The information provided by obsolete accounting systems is sometimes useless and some- times dangerously misleading. To provide information needed by management, accountants began to redesign accounting systems. Different kinds of data are needed for different kinds of decisions, and different kinds of business systems require different kinds of accounting systems to pro- vide that data. As business systems change, accounting systems are reevaluated and, in some cases, changed. Recognizing these relationships leads to developing and implement- ing new measurement systems, such as quality costing, activity based costing, and back- flush costing, as well as to increased use of nonfinancial performance measures. ‘The fourteenth edition of Cost Accounting emphasizes the use of accounting informa tion in planning and controlling a business and in supporting management decisions, including strategic decisions that position the firm to compete better. To be effective, the accounting system must be tailored to the particular business systems employed. Since the goods and services produced by different companies vary substantially, the business sys tems required for production and marketing vary as well. Because of these differences, there is no one accounting system or alternative superior to all others. The best accounting system depends on the business system and the information needs of management To prepare the student, this textbook not only demonstrates the mechanics of alterna- tive accounting systems and techniques but also explains the logic behind different alter- natives, The objective is to help the student learn to look at the business first and then to design an accounting system that can collect and generate the kind of information needed This textbook is designed to provide the necessary background for those who prepare accounting information and for those who use the information. This book presents not only the systems of collecting, organizing, processing, and reporting economic data, but also the uses of accounting information in making decisions. This dual emphasis is needed because (J) the accountant must understand how information will be used in order to design an accounting system to collect and report the information needed, and (2) the user of accounting information must understand how the accounting system works in order to use the information appropriately and know its limitations. Highlights of Changes in the Fourteenth Edition The textbook has undergone revisions to make it shorter and better written, with the goal of assisting both student and instructor. As with the preceding edition, considerable effort has been made to enhance clarity, The primary changes from the thirteenth edition are: ation. 1. Several chapters have been edited to improve clarity and brevity of pre 2. Chapter 2 has been updated by the addition of an appendix on the Balanced Scorecardiv Preface 3. Approximately one-fourth of the problems and exercises have been revised. In some of the chapters that are likely to be of higher importance to many instructors, over one-third of the problems and exercises have been revised Organization of the Book The organization of the materials presented is designed to provide maximum flexibility in meeting different course objectives. Part One presents material that forms a foundation for understanding the basic concepts and objectives of costmanagerial accounting systems. It thoroughly discusses the cost concept, cost objects, classification of cost, and cost behav- ior. Part Two then discusses and illustrates the flow of cost in manufacturing and services businesses. It begins with a general explanation of the flow of costs through the accounts and then expands into an in-depth discussion of the two basic costing systems: job order costing and process costing. Part Two includes the cost of quality, accounting for produc- tion losses, and joint- and by-product costing, Part Three focuses on an in-depth under- standing of the elements of cost—materials, labor, and overhead—from both the planning and control perspectives. Part Four elaborates on the heart of planning and control: static and flexible budgeting, responsibility accounting and reporting, and standard costing. Part Five deals with the analysis of costs and profits, including direct costing, the theory of constraints, cost- volume-profit analysis, differential cost analysis, capital expenditure planning and analysis, decision making under uncertainty, profit performance measurements, and transfer pricing. Organization for Instruction The presentation of the fundamental theoretical and practical aspects of cost accounting provides wide flexibility for classroom usage. In addition to its applicability to the tradi- tional two-semester course sequence, this textbook may be used in a variety of one- semester courses. For these alternative courses, a suggested outline, by chapter numbers, follows: Course Description ‘Textbook Chapters Cost Accounting (iwo semesters) Chapters 1-14 (first semester) Chapters 15-25 (second semester) Cost Accounting (one semester) Chapters 1-14 and 17 Cost Control (one semester) Chapters 1-4, 9-14, and 17-19 Budgetary Control (one semester) Chapters 1-4, 15-19, and 22-23 Cost Analysis (one semester) Chapters 14-25, End of Chapter Materials End-of-chapter materials, many of which are revised, include discussion questions, exer- cises, problems, and cases. For each topic, these materials afford coverage of relevant concepts and techniques at progressive levels in the learning process, thereby providing @ significant student-learning benefit. Selected exercises and problems with which theCost Accounting 14" Edition x template diskette may be used are designated by symbols in the margin, The end-of-chap- ter materials include numerous items from the examinations administered by the America Institute of Certified Public Accountants (AICPA adapted), the Institute of Management Accounting (ICMA adapted), the Certified General Accountants’ Association of Canada , (CGA-Canada Adapted), and the Society of Management Accountants of Canada ((CMA- Canada’). Learning and Teaching Aids that Accompany the Book For the Instructor Solutions Manual. This manual contains detailed solutions to the end-of chapter materi- als, including the discussion questions, exercises, problems, and cases. In addition, a list- ing of items coded for use with the template diskette is provided Test Bank, prepared by Edward J. VanDerbeck of Xavier University, Cincinnati. A test bank of multiple choice questions and examination problems accompanied by solutions is available to the instructor, The Test Bank is designed to save time in preparing and grad- ing periodic tests and final examinations. Spreadsheet Applications, These template diskettes are used with Microsoft Excel! for solving selected end-of-chapter exercises and problems identified in the textbook with the symbol in the margin. The diskettes, which also provide a Microsoft Excel tutorial, are provided free of charge to instructors at educational institutions who adopt this text. For the Student Study Guide, prepared by Edward J. VanDerbeck. This study guide contains a brief sum- mary of each chapter, as well as questions and exercises with answers, thus providing stu- dents with immediate feedback on their comprehension of material Practice Cases, prepared by William K. Carter. job order case and a process cost case are available. Each case acquaints students with basic accounting and analytical character- istics with a minimum of time-consuming detail. Solutions are provided for the instructor. Acknowledgements Special thanks are due to Greg Albert, whose tireless efforts were indispensable in produc- this edition. July 2005 William K. Carter 1 "Microsoft" and “Excel” are registered trademarks of Microsolt Corporation. Any reference to Microsoft or Excel felers to this footnote.vi Preface About the Author William K. Carter teaches management accounting at the McIntire School of Commerce, University of Virginia. He eared BS and MS degrees in accounting from the University of Southern Mississippi and a PhD from Oklahoma State University, and he is a CPA. He has written articles on accounting, accounting education, marketing, and finance, which have appeared in a variety of journals including The Accounting Review and the Journal of Accountancy. He has published cases on cost accounting, business policy, the balanced scorecard, and activity based costing Dr. Carter has served on committees of the American Assembly of Collegiate Schools of Business and the American Accounting Association, and on the editorial boards of The Journal of Accounting Education and the Education Section of The Accounting Review. He has testified as an expert witness in litigation involving accounting matters and has con- ducted consulting engagements and executive development programs for business and industry, Dr. Carter is a member of the Institute of Management Accountants, the American Institute of CPAs, and the American Accounting Association Management Accounting Section. Dedication to my wife, Imelda Smith Carter, for her patience and many sacrifices.Contents in Brief Part 1 Costs: Concepts and Obje 1 Management, the Controller, and Cost Accounting tecsseeeee E 2 — Cost Concepts and the Cost Accounting Information System . wreieen Pel 3 Cost Behavior Analysis 6 bees o sess BI Part2 Cost Accumulation Cost Systems and Cost Accumulation. ....-. +. impeyecemcsen 48 Job Order Costing - es Process Costing .....+++6+++ cee ceceeeee 6 ‘The Cost of Quality and Accounting for Production Losses... 0... woo Costing By-Products and Joint Products... ......2-0ee0ee0eeeeee eres 8 wulaHe Part 3. Planning and Control of Costs 9 Materials: Controlling, Costing, and Planning . 9-1 10 Just-in-Time and Backflushing : 10-1 11 Labor: Controlling and Accounting for Costs il 12 Factory Overhead: Planned, Actual, and Applied 12-1 13. Factory Overhead: Departmentalization 31 14 Activity Accounting: Activity-Based Costing and Activity-Based Management .....0. 006020020202 eeee 0 wee . 14d Part 4 Budgeting and Standard Costs 15 Budgeting: Profits, Sales, Costs, and Expenses ....... 0.220005 eS 16 Budgeting: Capital Expenditures, Research and Development Expenditures, and Cash; PERT/COSt.....064002200e000eeeeeeees cece GL 17 Responsibility Accounting and Reporting. . . . ete eer 17-1 18 Standard Costing: Setting Standards and Analyzing Variances sos eeseeecceee 18d 19 Standard Costing: Incorporating Standards into the Accounting Records........e0000ee00eeeereeeeee eae eer 19-1 Part 5 Analysis of Costs and Profits 20 Direct Costing, CVP Analysis, and the Theory of Constraints. 20-1 21 Differential Cost Analysis : 21-1 22 Planning for Capital Expenditures 22-1 23, Economic Evaluation of Capital 2Bel 24 ‘ 24-1 35 Profit Performance Measurements and Intracompany ‘Transfer Pricing. . ceeeee . veeeeeee SENOS Te se wee 25-1 Glossary Gl Ll Index. vilContents Part 1 Costs: Concepts and Objectives Chapter 1 Management, the Controller, and Cost Accounting. . Learning Objectives ... Management Planning Organizing Control Authority, Responsibility, and Accountabil The Organization Chart ene ‘The Controller's Participation in Planning and Control... ‘The Cost Department . . The Role of Cost Accounting Budgeting ; Controlling Costs Pricing Determining Profits ...... Choosing Among Alternatives .. Cost Accounting and Manufacturing Technology Certification and Ethics. Influence of Private and Governmental Organizations an Taxation . Cost Accounting Standards Board... Chapter 2. Cost Concepts and the Cost Accounting Information System... Learning Objectives . . The Cost Concept ...... Cost Objects... Traceability of Costs to Cost Objects. 2ost Traceability in Service Industries. The Cost Accounting Information System Chart of Accounts Electronic Data Processing. ....... Sensitivity to Changing Methods Nonfinancial Performance Measures Classifications of Costs. ..... Costs in Relation to the Product Costs in Relation to the Volume of Production Costs in Relation to Manufacturing Departments or Other Segments. Costs in Relation to an A¢ ounting Period wee Costs in Relation to a Decision, Action, or Evaluation . Appendix: The Balanced Scorecard ........ The Scorecard Perspectives A Series of Predictions : ‘orecards Aid in Communication. .Anal Cost Accounting 14* Edition ix Chapter 3 Cost Behavior Analysis Learning Objectives Classifying Cost Fixed Cost Variable Cost. Semivariable Cost Separating Fixed and Var High and Low Points Method ple Costs, Scattergraph Method . eee cee 37 Method of Least Squares 39 Method of Least Squares for Multiple Independent Variables. 3-16 Part 2 Cost Accumulation Chapter 4 Cost Systems and Cost Accumulation ......0..-+ Learning Objectives Flow of Production Costs Reporting the Results of Operations Income Statement Balance Sheet : tement of Cash Flows . . vanes Cost Systems Cost Accumulation Job Order Costing Process Costin Aspects Common to Both Job Order and Proces Blended Methods Backflush Costing a Fayeh Fr Costing Chapter 5 Job Order Costing .... Seemn 4g greens even Learning Objectives pec eeaeresnanc oe Overview of Job Order Costing Accounting for Materials feel rseoreeeneeees Materials Purchased gees v canons Materials Used ........e000e00eee Accounting for Labor Factory Labor Cost Incurred . . Factory Labor Costs Distributed Accounting for Factory Overhead. Actual Factory Overhead Incurred... Estimated Factory Overhead Applied . Accounting for Jobs Completed and Products Sold... Job Order Costing in Service Businesses .‘Table of Contents Chapter 6 Process Costing............0.00000085 hee 6-1 Learning Objectives Te 61 Process Cost Accumulation............ cece Gl Costing by Departments . 62 Physical Production Flow nee “ 6-3 Accounting'for Materials, Labor, and Factory Overhead Costs - 64 ‘The Cost of Production Report [ 6-7 Increase in Quantity of Production When Materials Are Added . . 6-1 Appendix: Process Costing with a Fifo Cost Flow Assumption ........... 6-15 Increase in Quantity of Production When Materials Are Added . . 6-19 Chapter 7 ‘The Cost of Quality and Accounting for Production Losses rl Learning Objectives ; Tl The Cost of Quality. . 72 ‘Types of Quality Costs 7-2 ‘Total Quality Management 72 Continuous Quality Improvement 14 Measuring and Reporting the Cost of Quality 76 Accounting for Production Losses in a Job Order Cost System 7-7 Accounting for Scrap shdoeatg elie cusine «seompg mee © 5a 1 Accounting for Spoiled Goods. . 18 Accounting for Rework iets Seheeeul 4 as 7-10 Accounting for Production Losses in a Process Cost System 7-12 Spoilage Auributable to Internal Failures. 7-12 Normal Production Shrinkage bettessssssees 716 Appendix: Process Costing with a Fifo Cost Flow Assumption se. 7-20 Spoilage Attribute to Internal Failures... vevvveeteteeeeeeeee 7-20 Normal Production Shrinkage .......... fp omneanoes 7:24 Chapter 8 Costing By-Products and Joint Products. 81 Learning Objectives . 8-1 By-Products and Joint Products Defined . 8&1 Nature of By-Products and Joint Products 8-2 Joint Costs...... a, 82 Difficulties in Costing By-Products and Joint Products. 8.2 Methods of Costing By-Products . . 83 Method 1: Recognition of Gross Revenue. Msinrueassnes 84 Method 2: Recognition of Net Revenue... cece 8S Method 3: Replacement Cost Method : teicns 8S Method 4: Market Value (Reversal Cost) Method ..........2.022222. 86 Underlying Accounting Theory ... : 87 Methods of Allocating Joint Production Cost to Joint Products 8.7 Market Value Method ......00.cccccecsesesseeeceeeeeeeeeeeee 8-7 Average Unit Cost Method... : wees 8410 Weighted-Average Method : wad ipwint femineceatsers » el0 Quantitative Unit Method. . boos o 8-11 Federal Income Tax Laws and the Costing of Joint Products and By-Products... 8-12 Joint Cost Analysis for Managerial Decisions and Profitability Analysis... 8-12 Ethical Considerations : 8-13Cost Accounting 14" Edition xi Part 3 Planning and Control of Costs Chapter 9 Materials: Controlling, Costing, and Planning ...........---- 91 Learning Objectives ..... ee 9-1 Materials Procurement and Use o1 Purchase of Materials 92 Purchases of Supplies, Services, and Repairs .... . 93 Purchasing Forms . ageing «5 ace tn 93 Receiving . - - oF Invoice Approval and Data Processing 9.5 Cost of Acquiring Materials 96 Storage and Use of Materials 9.8 Issuing and Costing Matei 2 oe 98 Materials Subsidiary Records phe eens - 99 Quantitative Models... cee fees 9-10 Planning Materials Requirements. . . . ce 9-10 Economic Order Quantity... Reet The EOQ Formula and Production Runs. . ne $8 RSEE S 944 Determining the Time to Order eee od Order Point Formula... 5 9-45 Computer Simulation for Materials Requirements Planning... 9-17 Materials Control 9-17 Materials Control Methods 918 Control of Obsolete and Surplus Inventor . 9-19 Appendix: Inventory Costing Methods. 9:19 First In, Fitst Out (Fif0).... 0002 -000ee eee e esse eeeeneerees 9.20 Average Cost. - Last In, First Out (Lifo) Comparison of Costing Methods CASB Costing of Materials Lower of Cost or Market . Interim Financial Reporting of Inventory... - 9-24 Chapter 10. Just-in-Time and Backflushing wsonsunercosersuen Tel Learning Objet . : : 10-1 Just-in-Time 10-1 JIT and Velocity 10-3 JIT and Production Losses 10-4 JIT and Purchasi seen 10-6 JIT and Factory Organization 10-7 JIT—A Balanced View om 10-8 Backflushing : 10-9 The Essence of Buckflush Costing, 2 10-10 A Basic Financial Accounting Analogy... sees . wees 10-11 Ilustration of Backflush Costing . .. . cuoumernensré [OntTable of Contents Chapter 11 Labo Controlling and Accounting for Costs. ...... Hel Learning Objectives 1-1 Productivity and Labor Costs lel Planning Product ies . 12 Measuring Productivity . apcaSiga Economic Impact of Productivity... ser Increasing Productivity by Better Management of Human Resources... 11-3, Incentive Wage Plans iE. 5.1 ton s . bd Purpose of an Incentive Wage Plan... . bene raerianeace 4 ‘Types of Incentive Wage Plans. veceeeee eee es 1-5 Organizational Incentive (Gainsharing) Plans ce cesses UT ‘Time Standards and Learning Curve Theory ..... temnenmres TGS Organization for Labor Cost Accounting and Control . ... 11-10 Personnel Department. . vecetteeteeeeeeeeeeee TEU Production Planning Department... .. . i . HII Timekeeping Department.............. 11-12 Payroll Department EE Meld Cost Department... vee UIAIS Department Interelationships and Labor Cost Control and Accounting - Ethical Considerations: Appendix: Accounting for Personnel-Related Costs . Overtime Earnings .............. Bonus Payments and Deferred Compensation Plans... oss Vacation Pay Guaranteed Annual Wage Plans Pension Plans 5 Additional Legislation Affecting Labor-Related Costs Labor-Related Deductions . Recording Labor Costs. . Chapter 12 Factory Overhead: Planned, Actual, and Applied.............. 12-1 Learning Objectives . . “RNG Page 5 cist» ‘The Nature of Factory Overhead... Use of a Predetermined Overhead Rate... Factors Considered in Selecting Overhead Rates Base to Be Used......... Selection of Activity Level Including or Excluding Fixed Overhead Calculation of an Overhead Rate Actual Factory Overhead ... . Applied Overhead and the Over- of Underapplied Amount. . Applying Factory Overhead . eos Over: or Underapplied Factory Overhead . Disposition of Over- or Underapplied Amount Changing Overhead Rates...Cost Accounting 14" Edi jon Chapter 13 Factory Overhead: Departmentalization. Learning Objectives . Departmentalization < Producing and Service Departments. Selection of Producing Department : Selection of Service Departments ....... Direct Departmental Costs Supervision, Indirect Labor, and Overtime . Labor Fringe Benefits Indirect Materials and Supplies ......... 0060005 Repairs and Maintenance Equipment Depreciation Indirect Departmental Costs . Establishing Departmental Overhead Rates Estimating Direct Departmental Costs Factory Survey . Estimating and Allocating Indirect Costs Distributing Service Department Costs Calculating Departmental Overhead Rates, Using Departmental Overhead Rates Actual Factory Overhead—Departmentalized Steps at End of Fiscal Period Muhtiple Overhead Rates. . Overhead Departmentalization in Nonmanufacturing Businesses and Not-for Profit Organizations . . . Chapter 14 Activity Accounting: Activity-Based Costing and Activity-Based Management . Learning Objectives Activity-Based Costing Levels of Costs and Drivers oo Comparison of ABC and Traditional Costing «+... ABC and Product Cost Distortion Strategic Advantage of ABC... . Example of ABC Implementation. : Strengths and Weaknesses of ABC......... Activity-Based Management. . . . . Behavioral Changes Cost Control Part 4 Budgeting and Standard Costs Chapter 15 Budgeting: Profits, Sales, Costs, and Expenses Leaming Objectives . Profit Planning. ..... Setting Profit Objective Long-Range Profit Planningxiv ‘Table of Contents Short-Range Budgets .........0605 sab rise - 15:3 Advantages of Profit Planning fee cece 154 Limitations of Profit Planning .........6...0. . wim 154 Principles of Budgeting. : og v0.8 Sree, 155. The Budget Commitee. ... ¥ sey on - 155 Budget Development and Implementation 15-6 Budgeting and Human Behavior 15-7 The Complete Periodic Budget, . 15-8 Sales Budget... 15-8 Production Budget 15-12 Manufacturing Budgets 15-13 Budgeting Commercial Expenses. 15-19 Budgeted Incom 15-22 cece 15-23 Chapter 16 Budget pital Expenditures, Research and Development Expenditures, and Cash; PERT/Cost 16-1 Learning Objectives 16-1 Capital Expenditures Budget . .. peaeah - . 16-1 Evaluating Capital Expenditures ........0.... 16-2 Short- and Long-Range Capital Expenditures 16-2 Research and Development Budget . ee 16-2 Form of a Research and Development Budget estamos 163 Accounting for Research and Development Costs ....... 164. Cash Budget _ Pei 16-5 Purpose and Nature of a Cash Budget 16-5 Preparation of a Periodic Cash Budget 16-6 Development of Daily Cash Budget Detail . 16-7 Electronic Cash Management 16-8 Planning and Budgeting for Nonmanufacturing Businesses and Not-for-Profit Organ Nonmanufacturing Businesse: Not-for-Profit Organiza Zero-Base Budgeting Computerized Budgeting Prospective Financial Informan stem... The PERT/Cost System Computer Applications... Probabilistic Budgets seeeene a 17-1 Learning Objectives .......... se IT Responsibility Accountin 17-1 c sin 17-2 Determining Who Controls Cost . MLE ESEE Pian icine ns 1903Cost Accounting 14" Edition XY Responsibility for Overhead Costs Responsibility Reporting ...........+ Fundamental Characteristics of Responsibility Reports Responsibility-Reporting Systems Illustrated Reviewing the Reporting Stucture The Flexible Budget and Variance Analysis Preparing a Flexible Budget Preparing a Variance Report... Responsibility Accounting and Reporti Dysfunctional Behavior of Managers. Usefulness of the Data to Managers. . An Alternative View Chapter 18 Standard Costing: Setting Standards and Analyzing Variances... oon vee 181 Learning Objectives ... . is an : 18-1 Usefulness of Standard Costs. : ee 18-1 Setting Standards, (isone 18-3 Determining Standard Production. 18-5 tandard Cost Variances ..... wine - 18-7 Determini Materials Standards and Variances 18-7 Labor Standards and Variances. . 18-9 Factory Overhead Standards and Variances « 18-11 Mix and Yield Variances . .. ee vee : » 1816 Mix Variance 18-16 Yield Variance. . . 18-17 lustration of Mix and Yield Variane 18-17 Responsibility and Control of Variances 18-19 Causes of Variances - : a cess 18-20 Tolerance Limits for Variance Control... ++ 5 3 18-26 Overemphasizing Variances . .- iene 18-26 Appendix: Alternative Factory Overhead Variance Methods... 18-28, Alternative Three-Variance Method Four-Variance Method . . . to Chapter 19 Standard Costing: Incorporating Standards into the Accounting Records Learning Objectives ....- 03 Recording Standard Cost Variances in the Accounts... + Standard Cost Accounting for Materials. Method 1. . oe re Method 2.......00208++ . sen CaN Method 3..... cunone otha : ee Standard Cost Accounting for Labor Standard Cost Accounting for Factory Overhead . . ‘Two- Variance Method Three-Variance Method Standard Cost Accounting for Completed Products...xvi ‘Table of Contents Disposition of Variances . 19-7 Variances Treated as Period Expenses. 19-7 Variances Allocated to Cost of Goods Sold and Ending Inventories 19-10 The Logie of Disposing of Varia 19-12 Disposition of Variances for Interi 19-14 Revision of Standard Costs....... 19-14 Broad Applicability of Standard Co: 19-15 Appendix: Alternative Factory Overhead Variance Method 19-16 Alternative Three-Variance Method... . cone 19-16 Four-Variance Method . Se 19-16 Part 5 Analysis of Costs and Profits Chapter 20 Direct Costing, Cost-Volume-Profit Analysis, and the Theory of Constraints... 20-1 Learning Objectives 20-1 Direct Costing . 20-2 Contribution Margin Defined . 20-2 Internal Uses of Direct Costing . .. 20-3 External Uses of Direct Costing. 20-7 Cost-Volume-Profit A 20-13 Constructing a Bi 20-16 Cost-Volume-Pro 20-18 The Theory of Constr 20-23 Measures Used in the Theory of Constraints 20-24 Using the Theory of Constraints 20-24 Examples of TOC Implementation. 20-25 Embracing TOC as an Accounting Tool. 20-26 Chapter 21 Differential Cost Analysis 21-1 Learning Objectiv nat sing 21-1 Differential Cost Studies. 24-1 Examples of Differential Cost Studies .. Accepting Additional Orders : 21-4 ing the Price of a Special Order 21-5 or-Buy Decisions . 21-7 ms to Shut Down Facilities 21-9 Decisions to Discontinue Products. 2-1 Additional Applications of Differen 21-13 Appendix: Linear Programming 24-17 Maximization of Contribution Margin 21-17 Minimization of Cost . si ceeeeee 21-21 Simplex Method . es +. 21-22 Chapter 22 Planning for Capital Expenditures....0..0.......0.4 te. 928 Learning Objectives E i tg ae 2-1 Planning for Capital Expenditures rn 1Cost Accounting 14" Edition Relating Plans to Objectives... .. rer Structuring the Framework Searching for Proposals . : . Budgeting Capital Expenditures. egnexamns Requesting Authority for Expenditures Ethical Considerations . ee Evaluating Capital Expenditures Classification of Capital Expendiaes Estimating Cash Flows Inflationary Considerations in the Estimation of Cash Flows... Income Tax Considerations in the Estimation of Cash Flows Economic Evaluation of Cash Flows ...... er Controlling Capital Expenditures .......+.+ ce Control While in Process - Follow-up of Project Results, Chapter 23 Economic Evaluation of Capital Expenditures .. Learning Objectives ‘The Cost of Capital . Economic Evaluation Techniques The Payback Period Method : ‘The Accounting Rate of Retuin Method ‘The Net Present Value Method The Internal Rate of Return Method The Error Cushion Purchasing versus Leasing Chapter 24 Decision Making Under Uncertainty . Learning Object beens Using Probabilities in Decision Making. Determining the Best Strategy Under Uncertainty Payoff Tables . Decision Trees .. ae Continuous Probability Distributions Monte Carlo Simulations a Considering Uncertainty in Capital Expenditure Evaluation Independent Cash Flows. . Perfectly Correlated Cash Flows Mixed Cash Flows Evaluating Investment Risk - Incorporating Nonquantitative Factors into the Analysis ......0. ves,‘Table of Contents Chapter 25. Profit Performance Measurements and Glossary . Intracompany Transfer Pricing .. seesereeserees 25h Learning Objectives ... veces cee 25e1 Rate of Return on Capital Employed . . The Formula ‘The Formula’s Underlying Data. . Using the Rate of Return on Capital Employed. . Divisional Rates of Return Urine Graphs as Operating Guides... . Advantages of Using the Return on Capital Employed Limitations of Using the Return on Capital Enployea : Multiple Performance Measures. vee Management Incentive Compensation Plans Selecting Performance Measures Intracompany Transfer Pricing ....... 7 Transfer Pricing Based on Cost Market-Based Transfer Pricing. Cost-Plus Transfer Pricing . Negotiated Transfer Pricing Arbitrary Transfer Pricing Dual Transfer Pricing ....... Index . ‘sie eines s ower e 6 ERR GUHA Yate ai seeeeeee ELPART 1 Costs: Concepts and Objectives Chapter 1 > Management, the Controller, and Cost Accounting Chapter 2 > Cost Concepts and the Cost Accounting Information System Chapter 3 > Cost Behavior AnalysisChapter 1 Management, the Controller, and Cost Accounting Learning Objectives After studying this chapter, you will be able to: 1. Model the management process as three interrelated activities: planning, organizing, and control, 2. Identify and distinguish three kinds of plans: short-range, long-range, and strategic. 3. Identify and differentiate the tasks in which management is aided by information about costs and benefits. 4, Identify which of the management accountant’s ethical responsibilities apply to partic ular ethical issue. 5, State the role of the pronouncements of the Cost Accounting Standards Board. This chapter describes the environment of cost accounting from internal and external per- spectives. Within the organization, cost accounting is presented as part of the management function, and the roles of the controller and cost department are discussed. In the external environment, the certification movement, ethical expectations, and other private and gov- emmental influences on cost accounting are examined. Management 5 Management is composed of three groups: (1) operating management, consisting of super iors: (©) middle management, represented by department heads, division managers, and branch managers: and (3) executive management, consisting of the president, executive vice-presidents, and executives in charge of marketing, purchasing, engineering, manufac- turing, finance, and accounting. Management consists of many activities, including making decisions, giving orders, establishing policies, providing work and rewards, and hiring people to carry out polici Management sets objectives to be achieved by integrating its knowledge and skills with the abilities of the employees. Planning and control may be the centerpiece of an organiza- tion’s approach to management. This was true in many organizations in the past Alternatively, planning and control may be pushed into the background and become almost invisible to line workers unless a major problem or failure occurs. Even when the planning and control functions are not in the forefront of day-to-day activities, management still must effectively perform the basic functions of planning, organizing, and control to be suc cessful. All three functions require participation by all management levels. Planning and control are divided for theoretical purposes, just as time frames are divided imo discrete operating periods. However, these divisions are artificially designed for the convenience of analysis and do not reflect the dynamic way in which an entity evolves. Iné bea aie youwerneg~ Jerproqcave- Fo cua PMT Ww ae Part 1 > Costs: Concepts and Objectives and interwoven processes. Time and control are simultaneous, inseparable, frames such as short- and long-range periods are not clearly distinguishable. Control of an activity takes place simultaneously with the planning for the next cycle of that same activity, other planning for longer and shorter cycles of activity, and the control of other activities, Planning Planning, the construction of a detailed operating program, is the process of sensing exter nal opportunities and threats, determining desirable objectives, and employing resources to accomplish these objectives. Planning investigates the nature of the company’s business, its major policies, and the timing of major action steps. Eifective planning is based on analyses of facts and requires reflective thinking, imagination, and foresight. An example of routine planning is the estimation of an organization's daily cash bal- ances for the next 30 days, with plans made to buy or sell short-term investments on cer- tain days so that the cash balance stays within a desired range. This kind of planning is so routine that the personnel involved are not likely to see that their work involves decisions of any kind; the decisions are all “programmed.” At the other extreme, examples of non- routine planning include executive management's responses to the appearance of a new, major competitor, a new or proposed government regulation of the industry, or a revolu- ionary new technology. This kind of planning involves so many unique, complex deci- sions that it defies any attempt to reduce all the relevant variables and the relationships among them into a “programmable” task Effective planning requires participation and coordination of all parts of the entity. Planning includes determining company objectives, which are measurable targets or results, In stating the objectives of a business, many people first think of profit. Although Profit is indispensable in a successful business, it is only one goal and cannot be the sole objective. The companies best able to maximize profits are those that produce goods or services at an excellent level of quality and value, in a volume, at a time and place, at a Cost, and at a price that will win cooperation of employees, gain the goodwill of customers, and meet social responsibilities. Three kinds of plans are identifiable in business entities. Strategic plans are formu- lated at the highest levels of management, take the broadest view of the company and its environment, are the least quantifiable, and are formulated at irregular intervals by an essentially unsystematic process that begins with identifying an external threat or oppor- ‘unity. Strategic planning decisions shape the future nature of the firm, its products, and its customers, and they have the potential to alter the external environment Short-range plans, often called budgets, are sufficiently detailed to permit prepara tion of budgeted financial statements for the entity as of a future date (typically the end of the budget period). These plans are prepared through a systematized process, are highly quantified, are expressed in financial terms, focus mainly on the organization itself by tak- ing the external environment as a given, and usually are prepared for periods of a month, quarter, or year. In addition to these two kinds of plans are the long-range plans prepared by some enti- ties. Long-range plans, or long-range budgets, typically extend three to five years into the future. In terms of their degree of detail and quantifiability, long-range plans are an inter- mediate step between short-range plans and strategic plans. For example, a long-range plan may culminate in a highly summarized set of financial statements or other quantified objectives such as targeted financial ratios (e.g. earnings per share) as of a date five yearsChapter 1 >> Management, the Controller, and Cost Accounting 13 in the future. As a long-range plan is revised and refined during the early portions of the arting point for successive sets of short-range plans. planning period, it serves as a si Organizing Organizing is the establishment of the framework within which activities are to be per- —> formed. The terms organize and organization refer to the systematization of interdependent parts into one unit. Organizing requires bringing the many functional units of an enterprise into a coordinated structure and assigning authority and responsibility to individuals. Organizing efforts include motivating people to work together for the good of the company. Organization usually involves the establishment of functional divisions, departments, sections, or branches. These units are created to permit specialization of labor. A manuf turing firm, for example, usually consists of three fundamental units: manufacturing, market- ing, and administration. Within these units, departments are formed according to the nature, location, and amount of work, the degree of specialization, and the number of employees Management assigns work to each organizational unit created. An effective division of work among employees is vital in attaining company objectives. Also important are the relationships among managers and between superiors and subordinates. Control — Control is management's systematic effort to achieve objectives. Activities are continually legge Bedeger s ron Panne ya monitored to see that results stay within desired boundaries. Actual results of each activ- ity are compared with plans, and if significant differences are noted, remedial actions may ) be taken. Figure 1-1 illustrates the control process, using top management as an example: Similar relationships exist at all management levels within the organization. ‘The concept of control in business differs from that used in engineering, where con- trols are designed to work continuously, to use physical measures as their information inputs, and to work largely independently of human decision making. Thermostats and fuses are simple examples of engineering controls. In contrast, the control process in busi- ness always includes a human decision maker. In addition, the information on which con- trol actions are based includes financial information, and the control activity is periodic rather than continuous. Soting Odectves sdakeg "assis ans. rettons 2 Policy Decisions | y v ‘BOARD OF DIRECTORS | PRESIDENT o ot MARKETING MANUFACTURING FINANCE ENGINEERING EXECUTIVE COMMITTEE MANAGER | , Y Y | a“ 4+ | Leasing 10 NewDeciers |___Jesues |g ata Assembled in COST anor BUDGET DEPARTHENTS wealcatons FIGURE 1-1 Control DiagramPart 1 > Costs: Concepts and Objectives The concept of control in business also differs from that used in military and police work, in which the need for coercive force is always possible, although undesirable, in achieving control. In business, control is achieved through others’ actions only with their cooperat Authority, Responsibility, and Accountability Ina small firm, planning and control are performed by a single person, usually the owner or general manager intimately familiar with the firm’s products, processes, financing, and customers. In a large company with many organizational units and a variety of products or services, planning and control are larger tasks. Large firms assign planning and control functions to many people, so that reports and corrective actions will not be too far removed from the activity being controlled. Authority is the power to direct others to perform or not perform activities. Authority is the key 10 the managerial job and the basis for responsibility. It is the force that binds the organization together, Authority originates with executive management, which dele- gates it to lower levels. Delegation is essential to organizational structure. Through dele- gation, a manager’s area of influence is extended, but the manager remains responsible for delegated functions because delegation does not remove responsibility. Responsibility, or obligation, is closely related to authority. It originates principally in the superior-subordinate relationship in that the superior has the authority to require specific work from others. If subordinates accept the obligation to perform, they create their own responsibility. The superior still is ultimately responsible for subordinates’ performance. One facet of responsibility is aecountability—reporting results to higher authority. Reporting is important because it enables measuremént of the extent to which objectives are reached. Usually accountability is imposed on an individual rather than a group. This principle of individual accountability is well established in both profit and nonprofit organ- izations. If the organizational structure permits pooling of judgment, responsibility is fused and accountability nullified. The Organization Chart An organization chart shows an entity's principal management positions, helps to define authority, responsibility, and accountability, and is essential in developing a cost account- ing system capable of reporting the responsibilities of individuals. The coordinated devel- opment of a company’s organization with the cost and budgetary system leads to an approach to accounting and reporting called responsibility accounting Most organization charts are based on the line-staff concept. The assumption of this concept is that all positions or functional units can be categorized into two groups: the line, which makes decisions, and the staff, which gives advice and performs technical functions, A line-staff organization chart is illustrated in Figure 1-2 Another type of organization chart is based on the functional-teamwork concept of management, which emphasizes the most important functions of an enterprise: resources, processes, and human interrelations, The resources function involves the acquisition, dis- posal, and prudent management of a wide variety of resources—tangible and intangible, human and physical. The processes function dei ities such as product design, research and development, purchasing, manufacturing, advertising, marketing, and billing.een, vodawy deine prot ‘Chapter 1 > Management, the Controller, and Cost Accounting 1-5 STOCKHOLDERS BOARD OF DIRECTORS PRESIDENT SECRETARY — oe ——.——————j | | | | VICE-PRESIDENT «VICE-PRESIDENT —_ VICE-PRESIDENT ‘WaRKETING WANUPRETURING "RESEARCH AND TREASURER CONTROLLER DeveLomMeNT | | | \ WORKS MANAGER WORKS MANAGER DjAECTOR GENERAL cost PRODUCTION PERNT ENGINEERING INOUSTHIAL RELATIONS ACCOUNTING | ACCOUNTING OPERATING | EMPLOYMENT TAXES INTERNAL PLANNING —}— | sranoanos ene AUDITING | DEPARTMENTS wer OPERATIONAL DEPARTMENTS eLEARES GENERAL ‘OFFICE t+ | MANAGEMENT MAINTENANCE — meio FIGURE 1-2 Organization Chart Based on Line-Staff Concept ‘The human interrelations function directs the company’s efforts concerning the behavior of people inside and outside the company. A functional-teamwork organization chart is illustrated in Fi re | The Controller’s Participation in Planning and Control The controller is the executive manager responsible for the accounting function. The con- troller coordinates management's participation in planning and controlling the attainment of objectives. in determining the effectiveness of policies, and in creating organizational structures and processes. The controller also is responsible for observing methods of plan- ning and control throughout the enterprise and for proposing improvements in them. Effective control depends on communicating information to management. By issuing performance reports, the controller advises other managers of activities requiring correc- tive action, These reports emphasize deviations from a predetermined plan, following the principle of management by exception. The principle of management by exception is a belief that managers should be provided with information that directs their attention to activities that require corrective action. The concept is premised on the belief that man- agers do not have time to review every action of every subordinate nor to consult with cach subordinate prior to each action. This is not to say that managers’ main task is correcting probiems or “putting out fires.” but simply that managers need not take actions in the many areas where the work is proceeding as planned1-6 Part 1 > Costs: Concepts and Objectives STOCKHOLDERS BOARD OF DIRECTORS | DIRECTOR OF qn ce iin cee Mes ire foe oncetes oa peat ASSISTANT. oinecToa oF DIRECTOR OF DIRECTOR OF DIRECTOR OF MANAGERIAL RESOURCES PROCESS ACTIVITIES wuNan ee | INTERRELATIONS ASSISTANT ASSISTANT ASSISTANT DIRECTOR OF: DIRECTOR OF DIRECTOR OF; ua Resounces PRODUCTS & SERVICES |- STOCKHOLDER & FINANCIAL ance MANUFACTURING COMMUNITY RELATIONS PHYSICAL ASSETS MARKETING LABOR & EMPLOYEE RELATIONS INTANGIBLE ASSETS CUSTOMER RELATIONS PUBLIC & COMMUNITY RELATIONS GGOVERHENT RELATIONS FIGURE 1-3 Organization Chart Based on Functional-Teamwork Concept Using the accounting system and other systems, the controller provides information for planning a company’s future and for controlling its activities, This information goes far beyond the basic financial statements. Investors, government agencies, and other external parties also receive information by which management’ effectiveness may be judged. This information is usually communicated to external users by means of quarterly and annual reports that include financial statements but lack the depth of explanatory detail available to internal decision makers. The Cost Department The cost department, under the direction of the controller, is responsible for gathering, compiling, and communicating information regarding a company's activities. This depart- ment analyzes costs and issues performance reports and other decision-making data to managers for use in controlling and improving operations. Analysis of costs and prepara- tion of reports are facilitated by proper division of functions within the cost department and by coordination with other accounting functions, such as general accounting. The costChapter 1 > Management, the Control und Cost Accounting, 17 department also coordinates with the manufacturing, personnel, treasury, marketing, pub- lations, legal, and other departments. The manufacturing departments, under the direction of engineers and factory superin- tendents, design and control production. In research and design, cost estimates are used in deciding whether to accept, improve. or reject a design. Likewise, scheduling, production, and inspection are measured for etficiency in terms of quantity, quality, costs, and, to the extent practical, benefits, The personnel department interviews and selects employees and maintains personnel »* records, including wage rates. This information forms the basis for computing payroll costs and for calculating the labor-related costs of any activity, service, or good produced The treasury department is responsible for financial administration of a company. In Scheduling cash requirements and expectations, it relies on budgets and related reports from the cost department. ‘The marketing department needs a quality product at a competitive price to attra tomers, Prices generally are not set merely by adding a predetermined percentage to cost, but costs cannot be ignored. Marketing managers use cost data to determine which products are profitable and to determine sales policies, plan promotions, and evaluate market segments The public relations department has the function of maintaining good relations between the company and its public, especially its customers and stockholders. Points of friction are likely to include prices, wages, profits, and dividends. The cost department pro- vides information for public releases concerning these areas The legal department uses cost information as an aid in maintaining compliance with contracts and laws, including the Equal Pay Act, union contracts, the Robinson-Patman Act. the Employee Retirement Security Act of 1974, and the income tax, social security, and unemployment compensation laws, all of which can affect costs. cus- The Role of Cost Accounting In the past, cost accounting was widely regarded as the calculation of the inventory cost presented in the balance sheet and cost of goods sold figure in the income statement. This view limits the broad range of information that managers need for decision making to nothing more than the product cost data that satisfy external reporting rules. Examples of these rules are income tax regulations, accounting rules prescribed for goverument con- tracts, and generally accepted accounting principles (GAAP). Such a restrictive definition is inappropriate today and is certainly an inaccurate description of the uses of cost infor- * mation, Cost accounting furnishes management with necessary tools for planning and con- trolling activities, improving quality and efficiency, and making both routine and strategic decisions. The collection, presentation, and analysis of information regarding costs and benefits helps management accomplish the following tasks: Creating and executing plans and budgets for operating under expected competi- tive and economic conditions. An important aspect of plans is their potential for motivating people to perform in a way consistent with company goals. Establishing costing methods that permit control of activities, reductions of costs, and improvements of quality. 3. Controlling physical quantities of inventory, and determining the cost of each product or service produced for the purpose of pricing and.for evaluating the per- ya A formance of a product, department, or division.18 Part 1 > Costs: Concepts and Objectives aot 4. Determining company costs and profit for an annual accounting period or a shorter ow period. This includes determining the cost of inventory and cost of goods sold according to external reporting rules Choosing among two or more short-run or long-run alternatives that might alter revenues or costs. Notice the distinction between determining the cost of a product in.task 3 and the cost ing of inventory for external reporting in task 4. The distinction is that the cost of a prod- uct (task 3) can be calculated for many purposes, including predicting costs and making decisions, while inventory costing for external reporting (task 4) deals with satisfying external reporting rules. In very simple production settings, the two are often the same. For example, if all units produced in a facility are alike, any reasonable way of dividing the total cost equally among the units will suffice for both external reporting and for many decision-making purposes. Although the costs incurred in such a setting may be large and complex, the product line is extremely Simple—all units are identical—and so the costing of each unit of the product is simple, too. This is the model of manufacturing that is often assumed in economic theory. Many actual manufacturing settings are much more complicated than the economist’s model. A firm can produce a diverse product line in a single facility, where the same resources are used very differently in producing different products. In addition to a diverse product line, some settings exhibit complex cost structures, and the combination of the two makes it difficult to predict or identify the costs of producing one unit of one product. In these settings, the challenge to cost accounting is to measure the cost of all the things con- sumed in making a unit or lot of a product. When precision is needed in such a calculation (for example, in quoting a fiercely competitive price to a customer who needs a million units or batches), then the level of detail needed in calculating cost goes far beyond any- thing required by external reporting rules Service businesses provide excellent examples of the distinction between tasks 3 and 4. Consider a walk-in medical clinic, auto oil-change and lubrication shop, ot hairdresser, in which all jobs are of such short duration that there are no fully or partially completed Jobs on hand at the end of a business day. In such a setting, the inventory costing role in external reporting (task 4) simply does not exist, but product costs (task 3) still must be known by management to permit decisions such as which services to provide and what prices to charge. In sum, the information needs of managers range from simple to complex, and depend on the nature of products and processes, the particular decision to be made, the competi- tive environment, and other factors. In contrast, the nature of inventory costing required in external reporting is constant through time unless an external reporting rule is changed. In addition, inventory costing must satisfy only the following: (1) it must be based on actual historical costs, verifiable through documented transactions; (2) it must be consistent from. period to period; and (3) it must include all manufacturing costs in the cost calculated for cach unit of output The simplest cost accounting systems can generate product cost data that satisfy external reporting rules (task 4), There is a dangerous tendency among some executiv to endorse only the cost accounting effort needed for external reporting, ignoring man- agers’ potentially much greater needs for detailed, reliable product cost information (task 3)Chapter 1 > Management, the Controller, and Cost Accounting 19 Budgeting The budget is the quantified. writien expression of management's plans. All levels of man- agement should be involved in ereating it. A workable budget promotes coordination of personnel, clarification of policies, and crystallization of plans. It also creates greater Inter- nal harmony and unanimity of purpose among managers and workers. In recent years, considerable attention has been given to the behavioral implications of providing managers with data required for planning and control, Budgeting plays an important role in influencing individual and group behavior at all stages of the manage- ment process, including (1) setting goals, (2) informing individuals about what they should ails, (3) motivating desirable performance, (4) contribute to the accomplishment of the evaluating performance, and (5) suggesting when corrective action should be taken. In short, accountants cannot ignore the behavioral sciences (psychology, social psychology, and sc ioral function. Managers’ attitudes toward the budget depend a great deal on relationships within the cment group. Guided by the company plan, with opportunities for increased com- pensation, greater satisfaction, and eventually promotion, middle and lower management can achieve remarkable results. A discordant management group, unwilling to accept the budget's underlying assumptions, may perform unacceptably. “The following clements have been suggested as means for motivating personnel to aim for goals set forth in a budget." ology) because the decision-making function of accounting is essentially a behav- man: maintains a clearly understood relation- A compensation system that builds ship between results and rewards. 2. A system for performance appraisal that employees understand with regard to their individual effectiveness and key results, their tasks and their responsibilities, their degree and span of influence in decision making, as well as the time allowed to judge their results 3. A system of communication that allows employees to query their superiors with trust and honest communication. A system of promotion that generates and sustains employee faith in its validity and judgment A system of employee support through coaching, counseling, and career planning. ‘A system that considers not only company objectives, but also employees’ skills and capacities. ‘A system that does not settle for mediocrity, but reaches for realistic and attainable Standards, stressing improvement and providing an environment in which the con- cept of excellence can grow Empirical research in this field contributes to a useful understanding of the inter- relationships of budgeting and human behavior, Numerous research projects have been undertaken and more are needed. Illustrating the insights that such studies provide, one reseurch project indicated that budgetary participation and budget goal clarity had signifi- cant positive effects on managers’ attitudes and performance, while excessively high goals had adverse effects. The study also found that budgetary evaluation and feedback exerted 41 €. Sussman, “Motivating Financial Personne!” The Journal of Accountancy, Vel. 141, No.2, p &1-10 Part 1 > Costs: Concepts and Objectives only weak effects on managers’ attitudes and performance.’ Budgeting is examined in depth in Chapters 15, 16, and 17. Controlling Costs fic individuals who are also % ~ The responsibility for cost control should be assigned to spk 3) gs eg accountable for budgeting the costs under their control. Each manager's responsibilities gf FF > should be limited to the cosis and revenies Ihat are conteallabie by the manager, and per- YS 2 formance is generally measured by comparing actual costs and revenues with the budget. Re OX Systems designed to achieve these goals are called responsibility accounting systems. ¢ To aid in controlling costs, the cost accountant may use predetermined cost amounts ey called standard costs. Standard costs also can be the foundation for budgets and cost reports, Standard costs are examined in Chapters 18 and 19. Another important aspect of cost control is the identification of the costs of different s rather than the costs of different departments and products. In a complex produc tion setting, often only a small fraction of total activity actually adds value to the final &,, put. Other activities, called non-value-added activities, generally are a result of the 3 ¥ complexity of production settings and are not specific to the production of any particular © © good or service. Examples of non-value-added a 's in a factory are retrieving, han dling, and moving materials; expediting; holding inventories; and reworking defective Reporting the costs of non-value-added activities is a first step toward their reduc- tion or elimination Pricing Management's pricing policy ideally should assure long-run recovery of all costs and a profit, even under adverse conditions. Although supply and demand usually are determin- ing factors in pricing, the establishment of a profitable sales price requires consideration of costs. Competitively bidding on a proposed job, for example, is a difficult pricing deci- sion if there is little or no past experience with the kind of good or service involved Determining Profits Cost accounting is used to calculate the cost of the output sold during a period; this and other costs are matched with revenues to calculate profits. Costs and profits may be reported for segments of the firm or for the entire firm, depending on management's needs and the external reporting requirements. The matching process involves identifying short-run and long-run costs, and variable and fixed (capacity) costs. Variable manufacturing costs are assigned first to the units man- ufactured and then matched with revenue when those units are sold. (Nonmanufacturing costs, both fixed and variable, typically are matched with revenues of the period.) Fixed manufacturing costs are matched with revenues by one of the following alternatives: *lzzeltin Kenis, “Etfects of Budgetary Goal Characteristics on Managerial Attitudes and Perlormance; The Accounting Review, Vol, LIV, No, 4, pp. 707-721Chapter 1 > Man troller, and Cost Accounting 1a 1. Matching total fixed costs of a period with revenues of that period; this alternative is called direct costing or variable costing Matching some or ali of the fixed manufacturing co: is are then expensed as part of the income statement’s cost of th units of product; these ods sold fig ce ony WG ure when the related units are sold. This alternative is called absorption costing gan and is required for GAAP and income tax reporting, These alternatives give the same reported results in the long run but yield a different profit for individual short periods such as years. These alternatives are examined in more detail in Chapter 20. Choosing Among Alternatives Cost accounting provides information concerning the different revenues and costs that might result from alternative actions. Based on this information, management makes short- range and long-range decisions concerning entering new markets, developing new prod- ucts, discontinuing individual products or whole product lines, buying versus making @ necessary component of a product, and buying versus leasing equipment. In the decisions ting products, reliable cost information is espe- cially crucial to the competitive success of the firm, Misstated costs create the possibility that undesirable business might be initiated or continued and desirable business rejected. In these ways. cost information plays an essential role in identifying, evaluating, and nization. to add new products and discontinue ex selecting strategies for the o1 Cost Accounting and Manufacturing Technology Factory automation, which has spread rapidly, results in capital-intensive processes, often with computerized systems that use robot-controlled machinery. Automation is expensive, however, and is not a cure-all for an obsolete production process. Many problems are rooted in systems and attitudes, and by focusing on those areas first, the firm can reap even greater gains from automation, In automating a process, employee involvement and moti- vation are the first step. and simplification of the existing process is second. Only then should a large investment in automation be considered, Innovative and experimental appli- cations, including changes in systems and attitudes, now permeate business from product cturing process, inventory management, qual- design to production scheduling, the manuf: ity control, and strategic decision making. Changes in manufacturing technology have spawned a long list of new terminology, including computer-aided design (CAD), computer-aided engineering (CAE), computer- aided manufacturing (CAM), just-in-time production (JIT), computer numerical control machinery (CNC), optimized production technology (OPT), the theory of constraints (TOC), fiexible manufacturing systems (FMS), and computer-integrated manufacturing (CIM). These innovations are discussed in appropriate places throughout this text. 2 the nature of costs, producing, for example, lower inv less use of labor, and increasing levels of fixed costs. In thi challenged to evolve and take on increased relevance. tion has become a competitive weapon. ntory new environment, cost echnology is chang level accounting systems are bei Reliable cost accounting infor12 Part 1 > Costs: Concepts and Objectives Certification and Ethics Persons engaged in cost accounting or other accounting functions within an organization are referred to as “management iccountants” or “financial managers.” They may also be referred to by their professional certifications, Certified Management Accountant (CMA) and Certified Financial Manager (CFM), which are formal recognition of professional compe- tence and educational achiovement in the field. Requirements for the CMA and CFM certifi- cates include passing demanding examinations offered by the Institute of Ce Management Accountants and completing two years of professional experienc In 1983 the National Association of Accountants—later renamed the Institute of Management Accountants (IMA)—issued a code of ethics, Although individuals practicing as independent certified public accountants had long been subject to a code of conduct, these standards were the first ever issued for management accountants. This code of ethics was ‘modified in 1997. The result, Standards of Ethical Conduct for Practitioners of Management Accounting and Financial Management, is presented in Exhibit 1-1. Among the published codes of ethics of various professional groups, these Standards of Ethical Conduct are dis- tinct in that they prescribe steps to be followed in resolving an ethical conflict. Influence of Private and Governmental Organizations Occasionally the research and pronouncements of professional organizations contribute to the development of cost accounting. These organizations include the Financial Accounting Standards Board (FASB), the Governmental Accounting Standards Board (GASB), the American Institute of Certified Public Accountants (AICPA), the Institute of Management Accountants (IMA), the American Accounting Association (AAA), and the Financial Executives Institute (FED). In addition, cost accounting can be influenced by university esearch, individuals, and private companies. The rapid growth of international business has led several international organizations to become involved in accounting, including cost accounting. These organizations include the International Accounting Standards Board (IASB) and the Organization for Economic Cooperation and Development (OECD). In the public sector, there are federal, state, and local government regulations embodied in many accounting systems. At the national level, the Internal Revenue Service (IRS) and the Cost Accounting Standards Board (CASB) have a significant influence on cost accounting Taxation Federal income tax liability is determined according to the Internal Revenue Code (Title 26 of the United States Code) as enacted and amended by Congress. The Treasury Department, acting under authority granted by Congress, issues regulations (Title 26 of the Code of Federal Regulations) which interpret the tax statutes enacted by Congress. The Internal Revenue Service, a branch of the Treasury Department, collects taxes and issues rulings and Procedures as guidance to taxpayers. Revenue Rulings and Revenue Procedures are pub- lished weekly in the Jniernal Revenue Bullet: and semiannually in the Cumulative Bulletin The influence of these statutes, regulations, rulings, and procedures cannot be ignored. Similar considerations apply for state and local income taxation. Management's planning decision making must consider tax consequences at all these levels.Chapter 1 > M agement, the Controller, and Cost Accounting 113 Practitioners of management accounting and financial man- agement have an obligation to the organizations they serve, their profession, the public, and themselves to maintain the highest standards of ethical conduct. In recognition of this, obligation, the Institute of Management Accountants has promulgated the following standards of ethical conduct for practitioners of management accounting and financial man- agement. Adherence to these standards, both domestically land internationally, is integral to achieving the Objectives of Management Accounting. Practitioners of management accounting and financial management shall not commit acts contrary to these standards nor shail they condone the com- mission of such acts by others within their organizations. Competence” Practitioners of management accounting and financial management have a responsibilty to: ~ Maintain an appropriate level of professional competence by ongoing development oftheir knowledge and skills, ~ Perform their professional duties in accordance with rel ‘vant laws, regulations, and technical standaves. ~ Prepare complete and clear reports and recommenda- tions after appropriate analysis of relevant and reliable information Sat Aegan) va R taper or Confidentiality Practitioners of management accounting and financial management have a responsibiliy to: Retrain from disclosing confidential information acquired in the course of their work except when authorized, unless legally obligated to d0 so. » Inform subordinates as appropriate regarding the con- fidentialty of information acquired in the course ot their work and monitor their activities to assure the maintenance of that confidentiality “> Retrain from using or appearing to use confidential information acquired in the course of their work for unethical or illegal advantage either personally or through third parties, Integrity ~ Practitioners of management accounting and financial management have a responsibilty to: > Avoid actual or apparent conllcts of interest and advise all appropriate parties of any potential conflict. “= Refrain from engaging in any activity that would preju- dice their ability to carry out their duties ethically. “+ Refuse any gift, favor, or hospitality that would influ- tence or would appear to influence their actions. “> Refrain from either actively or passively subverting the attainment of the organization's legitimate and ethical objectives, Recognize and communicate professional limitations or other constraints that would preclude responsible judg- ‘ment or successful performance of an activity. > Communicate unfavorable as well as favorable infor mation and professional judgments or opinions. > Refrain from engaging in or supporting any activity that would discredit the profession. Objectivity ~ Practitioners of management accounting and financial ‘management have a responsibilty 10: = Communicate information faitly and objectively “> Disclose fully all relevant information that could rea- sonably be expected to influence an intended user's, understanding of the reports, comments, and recom- ‘mendations presented. Resolution of Ethical Conflict In applying the standards of ethical conduct, practitioners of management accounting and financial management may ‘encounter problems in identifying unethical behavior or in resolving an ethical conllict. When faced with significant ethical issues, practitioners of management accounting and financial ‘management should follow the established policies of the organization bearing on the resolution of such conflict. It these policies do not resolve the ethical conflict, such practitioner should consider the following courses of action: ‘> Discuss such problems with the immediate superior except when it appears that the superior is involved, in which case the problem should be presented initially to the next higher managerial level. Ia satisfactory reso- lution cannot be achieved when the problem is initially presented, submit the issues to the next higher mana: gerial level If the immediate superior is the chief executive offi- cer, or equivalent, the acceptable reviewing authority may be a group such as the audit committee, execu- tive committee, board of directors, board of trustees, for owners. Contact with levels above the immediate superior should be initiated only with the superior's knowledge, assuming the superior is not involved, Except where legally prescribed, communication of such problems to authorities or individuals not ‘employed or engaged by the organization is not con- sidered appropriate. + Clarify relevant ethical issues by confidential discus- sion with an objective advisor (e.g.. IMA Ethics Counseling Service) to obtain a belter understanding of possible courses of action. “> Consult your own attorney as to legal obligations and fights concerning the ethical conflict. + ithe ethical contict stil exists after exhausting all lev- els of internal review, there may be no other recourse (on significant matters than to resign from the organiza tion and to submit an informative memorandum to an appropriate representative of the organization. After resignation, depending on the nature of the ethical con- flict, it may also be appropriate to notify other parties. EXHIBIT 1-1 Standards of Ethical Conduct for Practitioners of Management Accounting and Financial Management S-Standards ot Ethical Conduct for Practitioners of Management Accounting and Financial Management” (New York: Institute of Management Accountants, 1997). All rights esen Reprinted with permission,Lid Part 1 > Cos : Concepts and Objectives Cost Accounting Standards Board The Cost Accounting Standards Board, established by Congress in 1970, sets cost account- ing standards for domestic companies that are awarded large federal contracts or subcon- tracts, whether civilian or defense related. In 1980 the CASB was dissolved because Congress believed the board's purpose had been accomplished; however, the board's stan- dards became part of all major federal procurement regulations and remained in effect. Congress reestablished the board in 1988, ‘The CASB issues Cost Accounting Standards (CASs) that address all aspects of cost allocation affecting the cost of federal contracts, including methods of allocation, defini- tion and measurement of costs which may be allocated, and determination of the account- ing period to which costs are assignable. Full allocation of all costs of a period, including administrative expenses and all other indirect costs, is the basis for determining the cost of a contract Although specific CASs are discussed where appropriate in subsequent chapters, it should be noted here that four of the standards—numbers 409, 414, 416, and 417—have a potential impact far beyond the government contracting area. CAS 409 requires contrac- tors to depreciate their assets for contract-costing purposes over lives that are based on documented historical usefulness, irrespective of the lives used for financial and tax report- ing. CASs 414 and 417 recognize as a contract cost the imputed cost of capital committed to facilities, thereby overturning the government's long-standing practice of disallowing imerest and other financing costs. CAS 416, in contrast to financial reporting and income tax rules, recognizes a cost for self-insurance; under this standard, a long-term average loss is assigned to cach period regardless of the timing of actual losses. As a condition of contracting, contractors can be required to disclose their cost accounting practices. Disclosures include the major elements of direct costs, methods used to charge materials costs (fifo, lifo, standard cost, etc.), methods of charging direct labor (actual rates, average rates, standard rates, etc.), and the allocation bases used for charging indirect costs to contractsChapter 1 > Management, the Controller, and Cust Accounting Summary Key Terms Management can be viewed as encompassing the processes of planning. organizing, and control. The management team includes the controller, who coordinates planning and con- ol for the firm, The cost department coordinates with other departments and plays a cen- wal role in budgeting, cost control, pricing, reporting, and choosing among alternatives. Both professional certification and a code of ethics now exist for management account- ants. These and other external constraints exert significant influence on cost accounting, planning (1-2) strategic plans (1-2) short-range plans (1-2) long-range plans (1-2) organizing (1-3) control (1-3) authority (1-4) responsibility (1-4) accountability (1-4) organization chart (1-4) responsibility accou controller (1-5) management by exception (1-5) budget (1-9) responsibility accounting systems (1-10) standard costs (1-10) non-value-added activities (1-10) ect costing or variable costing (1-11) absorption costing (1-11) Certified Management Accountant (CMA) (1-12) Certified Financial Manager (CFM) (1-12) 1 (1-4) Discussion Questions Qui Define the concepts of planning and control and discuss how they relate to each other and contribute to progress toward achieving objectives. Distinguish between short-range and long-range plans. Distinguish between long-range plans and strategic plans. Is responsibility accounting identical with the concept of accountability? Explain. In what manner does the controller exercise control over the activities of other members of management?Q1-6 Qu7 Qs Qr9 Q1-10 Qi Exercises Ell E12 E1-3 Part 1 > Costs: Concepts and Objectives Discuss the functions of the cost department, Numerous nonaccounting departments require cost data and must also provide data to the cost department. Discuss. Why must the controller be aware of developments in the field of communications? Why is the budget an essential tool in cost planning? Will the IMA’s Standards of Ethical Conduct prevent management fraud? Explain. How are CASB standards defined and what degree of authority do they have? Planning and Control. In practice, planning and control are inseparable. One example of their inseparability is the fact that the results of control activities serve as inputs for the next planning cycle: for example, a control effort or investigation may point to a flaw in planning, and the flaw is then corrected in formulating the next period’s plans. 1g how planning and control are Required: Give at least two other examples sho inseparable. Planning. Each of the following numbered items is an example of one of the three kinds of planning. Required: Identify each numbered item as A, B, or C. A= an example of a short-range plan B = an example of a long-range plan C= an example of a strategic plan (1) A forecast made in 1999 of total sales expected in the years 2000, 2001, and 2002 (2) The number of units of product expected to be sold in the next year (3) A plan for discontinuing one of the two divisions of the company (4) Estimates of quarterly net income for the remaining three quarters of the current year (5) A plan to be the first company to establish a biomedical research lab on an orbiting space station (© A 1998 sinking-fund agreement calling for annual cash deposits sufficient to retire outstanding bonds that will mature in the year 2008 Control. Each of the following paragraphs describes a kind of control: (a) Itis desired to keep water in a tank at a level of one to two inches below the brim. A water pressure line is installed in the tank with a valve to start and stop the flow, an arm attached to the valve, and a hollow plastic float on the end of the arm. Whenever the water level is two inches or more below the brim, the float drops low enough to open the valve. When the water level is one inch from the brim, the float raises the arm which closes the valve. (b) A student desires to earn a grade average of at least 90% in a cost accounting course. On the first quiz, the student receives a grade of 80%. Upon learning of this grade, theChapter 1 > Management, the Coutrolier, Cases Chl ind Cast Accounting, 17 student decides to study more earnestly and to do more homework problems before each of the reniaining quizzes. () A home owner has worked hard to make a lawn free of weeds and wants to keep it that way during an upcoming two-year absence. Before leaving, the home owner contracts with the local franchise of WeedChem Company for five lawn treatments per year for two years. The treatments are guaranteed to control weeds, (d) Alter suffering heavy castalties in a three-day battle, friendly forces gained control of Hill 334 and captured the enemy communications post at that location. Required: (1) Determine which one of the four paragraphs describes kind of control that comes closest to what control means in managing a business. Explain. (2) Take each one of the other three paragraphs, in turn, and explain why it lacks one or more essential attributes of management control Ethies. Adam Williams was recently hired as assistant controller of GroChem Inc., which processes chemicals for use in fertilizers, Williams was selected for this position because of his past experience in the chemical-processing field, In his first month on the job, Williams made a point of getting to know the people responsible for the plant operations and learning how things are done at GroChem: During a conversation with the pkint supervisor, Williams asked about the company procedures for handling toxie waste materials. The plant supervisor replied that he was not involved with the disposal of wastes and suggested that Williams might be wise to ignore this issue, This response strengthened Williams’ determination to probe this area further, to be sure that the company was not vulnerable to litigation. On further investigation, Williams discovered evidence that GroChem uses a nearby residential landiill to dump toxic wastes. It appears that some members of GroChem’s nd may have been involved in arranging for ir, the controller, gement team are aware of this situation mping, but Williams was unable to determine whether his supe this d is involved. GroChem does not have an established policy on how to resolve issues such as this. Uncertain how be should proceed, Williams began to consider his options by outlining the following three alternative courses of action (a) Seek the advice of his superior, the controller. (b) Anonymously release the information to the local newspaper. (c) Discuss the situation with an outside member of the Board of Directors with whom he is acquainted. Requ (1) In light of the fact that Williams had been hired only recently and that his job is not aastes, does he have an ethical responsibility to take some hical Conduct to support your answer. ply to Williams” involved in the dumping of action? Cite the Standards of (2) Which of the 15 responsibilities in Standards of Ethical Conduc situation?C13 Part 1 > Costs: Concepts and Objectives (3) For each of the three alternate courses of action that Williams has outlined, explain whether or not the action is appropriate. (4) Without prejudice to your answer to requirement 3, assume that Williams seeks the advice of his superior, the controller, and discovers that the controller is involved in dumping the toxic wastes. Identify the steps that Williams should take to resolve thi situation (ICMA adapted) Ethics, The Alert Company is a closely held investment-services group that has been very successful over the past five years, consistently providing most members of the top man- agement group with 50% bonuses. In addition, both the chief financial officer and the chief executive officer have received 100% bonuses. Alert expects this trend to continue. Recently the top management group of Alert, which holds 35% of the outstanding common stock, learned that major corporation is interested in acquiring Alert. Alert’s management is concerned that this corporation may make an attractive offer to the other stockholders and that management will be unable to prevent the takeover. If the acquisi- tion occurs, this executive group is uncertain about continued employment in the new cor- porate structure. As a consequence, the management group is considering changes to several accounting policies and practices which, while not in accordance with generally cepted accounting principles, would make the company a less attractive aequisition. The chief financial officer has told Roger Deerling, Alent’s controller, to implement some of these changes, Deerling has also been informed by the chief financial officer that Alert’s management does not intend to disclose these changes immediately to anyone outside the top management group. Required: (1) Which of the 15 responsibilities in Standards of Ethical Conduct apply to the chief financial officer's behavior? (2) Which of the 15 responsi situation? (3) Identify the steps Deerling should take to resolve this situation. (4) What social and ethical responsibilities should Alert’s management consider before mounting the takeover defense described above? ties in Standards of Ethical Conduct apply to Deerling’s (ICMA adapted) cs. Allstar Brands, headquartered in Cincinnati, is a large, diversified manufacturer with plants located throughout North and South America and the Pacific Rim. The com- pany has a strong commitment to equal opportunity employment and emphasizes this commitment in frequent communications with management and supervisory personnel. In several locations, Allstar has training programs directed at improving the skill levels of minority groups. In addition, to ensure that the corporate policy is implemented, all super- visory personnel must attend seminars on nondiscriminatory personnel practices. Allstar’s Manufacturing Accounting Department (MAD) is located at the Cincinnati headquarters. MAD not only performs the traditional functions of manufacturing account ing, but also designs nonfinancial performance measurement systems and other tools and Programs to support Allstar’s total quality management (TQM) philosophy. Employment in MAD is considered a management accounting career choice and can also serve as a step to a higher position in another department. Roger Dixon, MAD director, has the authorityChapter 1 > Management, the Controller, and Cost Accounting 1-19 ci-4 to hire all department personnel. Dixon delegates the initial screening of all job applica- tions and some preliminary interviews to one of his senior management accountants, Peter Foxworth, Foxworth then recommends candidates to Dixon for further consideration. This arrangement has been in place for two years. Foxworth is concerned that during this time, Dixon has not hired any minority applicants, despite the fact that many were qualified. Several minority candidates recommended by Foxworth were not even interviewed by Dixon, When asked about these conditions, Dixon told Foxworth to pay attention to his own responsibilities Foxworth believes Dixon has intentionally discriminated against minority applicants and that Dixon’s behavior must be corrected, Foxworth is uncertain how he should proceed because Allstar Brands does not have an established policy on how to resolve such issues. Foxworth is considering taking one of the three following alternative courses of action: (a) Discuss Dixon's behavior with the director of Personnel, who is a management peer of Dixon. (b) Informally discuss Dixon’s behavior and ways to change it with a group of MAD sen- ior management accountants. (c) Discuss Dixon’s behavior privately with the chief financial officer, Dixon's supervisor. Required: (1) Which of the 15 responsibilities in Standards of Ethical Conduct apply 1 Dixon's 2) Which of the 15 responsibilities in Standards of Ethical Conduct apply to Foxworth’s situation? (3) For each of the three alternative courses of action Foxworth is considering, explain whether or not the action is appropriate. (4) Identify the steps that Foxworth should take in attempting to resolve this situation (ICMA adapted) Ethics. Joseph Rodriquez is the controller of the Ceramics Division (CD) of Northeastern Company. Rodriquez reports directly to the CD general manager, Susan Czeisla, One of Rodriquez’s responsibilities is obtaining data from all CD department managers to prepare annual budgets. The current year’s budget reflects a CD sales increase of 8% over last year, compared with the usual 4% to 6% annual sales increases experienced in the past. The CD sales manager has assured Rodriquez that the 8% increase is attainable, and the CD pro- duction manager has pointed out that the plant operated at only 75% of capacity last year, so ample production capacity is available to sustain the planned sales increase. At the end of the first quarter of the current year, CD sales were 1% below budget. Rodriquez was then instructed by Czeisla to revise the budget to reflect a 12% sales increase over last year. Rodriquez expressed surprise at this request but was assured by Czeisla that, “our salespeople can produce a 12% inerease over last year, and the budget should show it that way. . . .,The budget must show it that way to help us convince the bank that we'll be able to repay the loan we'll be applying for in the second quarter.” With this assurance, Rodriquez revised the budget to reflect the 12% increase. ‘At the end of the second quarter, CD sales were 3% below the revised budget. Czeisla he budget again, this time to reflect a 14% sales increase instructed Rodriquez to revis over last year. “In preparing our application for the bank loan, we found the figures weren’t coming out quite right for the loan amount we need, We'll be applying at a different bank now, and the 14% sales inerease will take care of the problem with the figures. I've been1.20 CLs Part 1 > Costs: Concepts and Objectives assured by our salespeople that if'a 14% increase is what the company needs, then they can give me 14%, so that’s what were going to do. They're team players, Joseph, and I know you'll be a team player, too.” Required: (1) Which of the 15. responsib Rodriquez’s situation? (2) What might Rodriquez have done differently to avoid or mitigate this problem? (3) In addition to his ethical responsibilities to CD, what other ethical responsibilities does Rodriquez need to consider? in the Standards of Ethical Conduct apply to ties. Ethics. Mary Jones is controller of the Non-Ferrous Metals Division of Southeast Manufacturing Incorporated (SMI) in Tuscaloosa, Alabama, Last year, she served as her division’s representative on an SMI corporate-level task force charged with developing specific objectives and performance specifications for a new computer system that is to be purchased this year. Due to her pivotal role on that task force, she has just been named to a new SMI corporate-level committee charged with reviewing, evaluating, and ranking the 10 to 20 proposals that SMI expects to receive from computer vendors now that SMI has put the proposed system out for bids A single parent, Jones expects to incur over $400,000 in medical expenses resulting from treatments for her youngest child, who has contracted a potentially fatal disease Approximately $150,000 of that amount will not be covered by insurance. Due to this per- gated some career opportunities that would ice benefits, but no position has been ison situation, Jones has inve: sonal finan involve higher salary and more generous insura offered to her. Her most recent interview was for the controller position at C Systems, a supplier of large-scale computer hardware and custom-designed software. Crimson Systems’ vice-president for finance declined to offer Jones the controller position, but instead said, “We're offering you a temporary consulting engagement— Sunday afternoons for the next four months—helping us write our proposal for the SMI job; your fee will be $500 per hour.” (1) Which of the 15 responsibilities in the Standards of Ethicat Conduct apply to Jones? situation? (2) What might Jones have done in her interview with Crimson Systems to precipitate thi problem? (3) What might Jones have done differently to avoid or mitigate this problem? (4) In addition to her ethical responsibilities to SMI, what other ethical responsibilities does Jones have to consider?maue Ox phe = Co yf cont faepmss Chapter 2 cy - jus ee % Boe ot? Cost Concepts and the Cost Accounting Information System Learning Objectives After studying this chapter, you will be able to: Define the term cost object and give examples of cost objects relevant to different types of decisions. Describe several degrees of cost traceability cost. State the considerations involved in creating a cost accounting information system. Explain why increased attention is being given to nonfinancial performance measures. Name and describe the ways costs are classified. implied by the terms direct cost and indirect Cost accounting was once considered to apply only to manufacturing. Today, however, every type and size of organization benefits from the use of cost accounting. For example, cost accounting is used by financial institutions, transportation companies, professional service firms, hospitals, churches, schools, colleges, universities, and governmental units, as well as the marketing and administrative activities of manufacturing firms. Chapter | introduced cost accounting as part of the management function and described influences on cost accounting from internal and external environments. This chapter presents the fundamental concepts of cost accounting and introduces cost account- 4s an information system. The Cost Concept = Cost concepts have developed according to the needs of accountants, economists, and engineers. Accountants have defined cost as “an exchange price, a forgoing, a sacrifice made to seCure benefit. In financial accounting, the forgoing or sacrifice at date of acqui- sition is represented by a current or future diminution in cash or other assets.”! Frequently the term cost is used synonymously with expense. However, an expense may be defined as a measured outflow of goods or services, which is matched with rev- enue to determine income, or as: the decrease in net assets as a result of the use of economic services in the cre- ation of revenues or of the imposition of taxes by governmental units. Expense is measured by the amount of the decrease in assets or the increase in liabilities related ‘Robert T. Sprouse and Maurice Moonite, Accounting Research Study No. 3, "A Tentative Set of Broad ‘Accounting Principles for Business Enterprises,’ (New York: American Institute of Certiied Public Accountants, 1962), p. 25.22 11> Costs: Concepts and Objectives to the production and delivery of goods and the rendering of services . . . expense in its broadest sense includes ail expired costs which are deductible from revenues. To contrast cost and expense, consider a purchase of raw materials for cash. Because net assets are unaffected, there is no expense. The firm’s resources are simply converted from cash to materials. The materials are acquired at some cost, but they are not yet an expense. When the firm later sells the output into which the raw materials have been incor- porated, the cost of the materials is written off among expenses on the income statement. Every expense is a cost, but not every cost is an expense; assets are costs, for example, but they are not (yet) expenses, The term cost is made specific when it is modified by such descriptions as direct, prime, conversion, indirect, fixed, variable, controllable, product, period, joint, estimated, standard, sunk, or out of pocket. Each modification implies a certain attribute that is impor- tant in measuring cost. Each of these costs is recorded and accumulated when management assigns costs to inventories, prepares financial statements, plans and controls costs, makes strategic plans and decisions, chooses among alternatives, motivates personnel, and evalu- ates performance. The accountant involved in planning and decision making must also work with future, replacement, differential, and opportunity costs, none of which is recorded and reported in external financial statements. Cost Objects A cost object, or cost objective, is defined as any item or activity for which costs are accu- mulated and measured. The following items and activities can be cost objects: Product Process Batch of lke units Department Customer order Division Contract Project Product line Strategic goal The concept of a cost object is one of the most pervasive ideas in accounting. The selection of a cost object provides the answer to the most fundamental question about cost: The cost of what’ Because of the multiple needs in cost finding, planning, and control, cost accounting sys tems are multidimensional. For example, it is necessary to assign costs to each product unit, but also necessary to plan and control costs for which individual managers are assigned responsibility, on a departmental, geographical, or functional basis. The design of cost accounting systems and their implementation must address these multiple requitements. Traceability of Costs to Cost Objects Once the cost object is selected, measurement of costs depends heavily on the traceability Of costs to the cost object. The traceability of costs determines how objective, reliable, and meaningful the resulting cost measure will be, and therefore how confident a decision maker can be in understanding and relying on the cost measure as a basis for prediction and decision making. * bid, p. 49.ble get > tree abit cet Chapter 2. > Cost Concepts and the Cost Accounting Information System 23 of charac The traceability of costs to a cost object varies by degree. A common way terizing costs is to label them as either direct or indirect costs of a particular cost object, as if there were only two degrees of traceability. In fact, degrees of traceability exist along a continuum. To illustrate the different degrees of traceability on the continuum, the cost object is defined here as a product unit. This is the most commonly used definition; for example, when the terms direct cost and indirect cost are used without a specified cost object, it ts customary to assume that a single unit of product is the cost object. At the extreme of directly traceable costs are those items that can be physically or cou- tractually identified as components of the finished unit of product. For example, the unit can be examined, weighed, and measured to find the type and quantity of each raw mate- rial and component part incorporated in it, and royalty or patent license agreements can be read to find what fee is owed to a patent holder for permission to manufacture the unit. These are the clearest examples of direct cost Near that extreme are the costs that can be empirically traced to the unit's production by observing the production process. These include: the labor expended to convert raw materials into finished product and some material-handling labor; paper patterns and other materials that are consumed in the production of each unit but are not physically ineorpo- rated into it; and some energy costs. OF course, not all items that are physically or empir- ically traceable to a unit will be important enough to justify the effort required to trace and record them. Whether tracing is justified depends on how precise a measure of direct costs is needed and how difficult or costly the tracing will be. For that reason, cost accounting systems generally treat as direct costs only some of the cost items that conceivably could be traced directly to the product unit Beyond those cost items that are physically, contractually, or empirically traceable, some degree of arbitrariness enters any attempt to identify additional costs for a product unit, For example, the traceable material and labor costs of a small number of defective units that may be produced along with the good units could be included logically as part of the cost of the good units. But exactly how much should be included is subject to debate. Is it the average actual amount of the cost of defective units? Is it the actual amount that occurs on the next production run? Or is it the amount that would occur under ideal con- ditions (which may be zero)? Even when the purpose of the ultimate cost measure is known in advance, the answer to this question is not always clear. Moving from this extreme toward the middle of the continuum, we find costs traceable to a batch or lot of like units of the product, such as setup cost (the cost of adjusting machinery before the batch can be produced). Setup cost can be identified with a single product unit in the batch only by means of an allocation: the setup costs can be divided by the actual number of units produced in a batch, or by the normal number, or by the ideal number. Again, an essentially arbitrary choice is required if these costs are to be allocated to each unit of product. Notice that if the batch is defined as the cost object, setup costs can be classified as directly traceable. Further along on the continuum are costs traceable to all the units of a particular product ever produced. These include the costs of initial product design, development, testing, process engineering, and worker training. To identify these with a single prod- tuct tnit requires allocation over the total number of units of the product to be produced in the entire product life cycle. That number of units is generally difficult to predict, and even the most experienced manager in the industry would estimate it with considerable forecasting errorQ2-20 Q2-21 Q2-22 Q2-23 Exercises E2-1 E2-2 Part 1 > Costs: Concepts and Objectives (Appendix) Which perspective of a balanced scorecard reports on the organization's most important work, the work in which the organization must excel in order to be s\ (Appendix) Within the financial perspective of a balanced scorecard, how might the per- formance measures be different for a new, start-up company, versus a company whose products face obsolescence, versus most other companies? (Appendix) When a scorecard is interpreted as representing predictions about how the organization intends to succeed, the predictions follow a certain sequence through the scorecard’s four perspectives. List the four perspectives in that sequence. (Appendix) Certain conditions play roles in producing a particular desired result Sometimes conditions can be described as sufficient. Sometimes a condition is said to be necessary. If list of conditions is so complete that achieving all of them will always pro- duce the desired result, then the list collectively constitutes “sufficient conditions.” If fail- ure to achieve one particular condition will always make the desired result impossible, regardless of achieving the other conditions, then that one condition is called a “necessary condition.” In the design of a good balanced scorecard, do excellent growth and learning, excellent internal business processes, and excellent customer relationships constitute a list of sufficient conditions for sustaining financial success, or do they represent necessary conditions for sustaining financial success? Manufacturing Costs. For each bicycle produced, Matheson Company incurs direct material cost of $6, direct labor of $3, and variable factory overhead of $1. Matheson’s fixed factory overhead totals $1,000 per month. Required: (1) Identify the prime cost per unit. (2) Identify the variable conversion cost per unit. (3) Identify the variabie manufacturing cost per unit. (4) Calculate total manufacturing costs that should be incurred in a month in which 500 bicycles are produced. Manufacturing Costs. The estimated unit costs for CNR Inc., when it is operating at a production and sales level of 12,000 units, are as follows: Estimated Cost Item Unit Cost Direct materials ...sescersctrrsnen seve $32 Direct 1ab0%. on... errseenen 10 Variable factory overhead....... 15 Fixed factory overhead, i 6 Variable marketing 3 Fixed marketing ..... 4 Require (1) Identify the estimated conversion cost per unit. (2) Identify the estimated prime cost per unit (3) Determine the estimated total variable cost per unitgyeet © trace jae ato Chapter 2 > Cost Concepts and the Cost Accounting Information ee, A common, The traceability of costs to a cost object varies by deg terizing costs is to label them as either direct or indirect costs of a particular cost object, as if there were only two degrees of traceability. In fact, degrees of traceability exist along a continuum. To illustrate the different degrees of traceability on the continuum, the cost object is defined here as a product unit. This is the most commonly used definition; for example, when the terms direct cost and indirect cost are used without a specified cost object. it 1s customary to assume that a single unit of product is the cost object ‘At the extreme of directly traceable costs are those items that can be physically or con- tractually identified as components of the finished unit of product. For example, the unit can be examined, weighed, and measured to find the type and quantity of each raw mate- rial and component part incorporated in it, and royalty or patent license agreements can be read to find what fee is owed to a patent holder for permission to manufacture the unit “These are the clearest examples of direct costs. Near that extreme are the costs that can be empirically traced to the unit's production by observing the production process. These include: the labor expended to convert raw materials into finished product and some material-handling labor; paper patterns and other materials that are consumed in the production of each unit but are not physically incorpo- rated into it; and some energy costs. Of course, not all items that are physically or empir- ically traceable to a unit will be important enough to justify the effort required to trace and record them. Whether tracing is justified depends on how precise a measure of direct costs is needed and how difficult of costly the tracing will be. For that reason, cost accounting systems generally treat as direct costs only some of the cost items that conceivably could be traced directly to the product unit. Beyond those cost items that are physically, contractually, or empirically traceable, some degree of arbitrariness enters any attempt to identify additional costs for a product unit. For example, the traceable material and labor costs of a small number of defective units that may be produced along with the good units could be included logically as part of the cost of the good units. But exactly how much should be included is subject to debate. Is it the average actual amount of the cost of defective units? Is it the actual amount that ‘occurs on the next production run? Or is it the amount that would occur under ideal con- ditions (which may be zero)? Even when the purpose of the ultimate cost measure is known in advance, the answer to this question is not always clear. Moving from this extreme toward the middle of the continuum, we find costs traceable to a batch or lot of like units of the product, such as setup cost (the cost of adjusting machinery before the batch can be produced). Setup cost can be identified with a single product unit in the batch only by means of an allocation: the setup costs can be divided by the actual number of units produced in a batch, or by the normal number, or by the ideal number. Again, an essentially arbitrary choice is required if these costs are to be allocated to each unit of product. Notice that if the batch is defined as the cost object, setup costs can be classified as directly traceable Further along on the continuum are costs traceable to all the units of a particular product ever produced. These include the costs of initial product design, development, testing, process engineering, and worker training. To identify these with a single prod- uct unit requires allocation over the total number of units of the product to be produced in the entire product life cycle. That number of units is generally difficult to predict, and even the most experienced manager in the industry would estimate it with considerable forecasting error.222 Part 1 > Costs: Concepts and Object Key Terms cost object (2-2) bility (2-2) chart of accounts ( 1 processing (2-6) data processing system (2-6) manufacturing cost (2-10) prime cost (2-10) conversion cost (2-10) direct materials (2-10) direct labor (2-10) factory overhead (2-10) indirect mate! indirect labor (2-10) computer-integrated manufacturing (CIM) (2-12) commercial expenses (2-12) marketing expenses (2-12) administrative expenses (2-12) variable costs (2-12) fixed costs (2-12) semivariable costs (2-13) producing department (2-14) service department (2-14) direct departmental cost (2-14) indirect departmental cost (2-14) common costs (2-15) joint costs (2-15) capital expenditure (2-15) revenue expenditure (2-15) Discussion Questions Q2-1 (a) Explain the terms cosd and expense as they are used for financial reporting. The expla- nation should indicate distinguishing characteristics of the terms, their similarities, and interrelationships. (b) Classify each of the following items as a cost, expense, or other category. Explain how the classification of each item can change. (1) cost of goods sold (2) uncollectible accounts expense (3) depreciation expense for plant machinery (4) organization costs (5) spoiled goods Q2-2. What are cost objects and why are they important’? Q2-3 (a) Why is the choice of a cost object important in classifying costs as direct or indirect? (b) Give an example of how the choice of a different cost object changes the direct or indi- rect clussification of a single item of cost