Managerial Accounting

Creating Value in a Dynamic Business Environment

Eighth edition

Cornell University

McGraw-HillIrwin

Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. LouisBangkok Bogota Caracas Kuala Lumpur Lisbon London Madrid Mexico CityMilan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto

Contents

The Changing Role of ManagerialAccounting in a Dynamic BusinessEnvironment 2

Managerial Accounting: A BusinessPartnership with Management 4

Managing Resources, Activities, andPeople 5

Decision Making 5

Planning 6

Directing Operational Activities 6

Controlling 6

How Managerial Accounting AddsA/alue to theOrganization 6

Objectives of Managerial AccountingActivity 6

The Balanced Scorecard 9

M.A.P. The Balanced Scorecard 10

Managerial versus FinancialAccounting 11

Managerial Accounting in Different Types ofOrganizations 12

Where Are Managerial Accountants Located inan Organization? 13

Organization Chart 13

Cross-Functional Deployment 14

Physical Location 15

Major Themes in Managerial Accounting 17

Information and Incentives 17

Behavioral Issues 18

Costs and Benefits 18

Evolution and Adaptation in ManagerialAccounting 18

M.A.P. The Internet as a Lifeline 22

Cost Management Systems 24

Strategic Cost Management and the ValueChain 25

The Ethical Climate of Business and the Roleof the Accountant 27

Managerial Accounting as a Career 28

Professional Organizations 28

Professional Certification 29

Professional Ethics 29

Focus on Ethics: IMA Statement of EthicalProfessional Practice 29

Chapter Summary 30

Key Terms 31

Review Questions 31

Exercises 32

Problems 32

Case 34

Basic Cost Management Conceptsand Accounting for MassCustomization Operations 36

What Do We Mean by a Cost? 36

Product Costs, Period Costs, andExpenses 39

Costs on Financial Statements 40

Income Statement 40

Balance Sheet 42

Note: Entries printed in blue denote topics that emphasizecontemporary issues in managerial accounting and cost management.

XXV

xxvi Contents

Manufacturing Operations and ManufacturingCosts 43

M.A.P. Mass Customization 44

Mass-Customization Manufacturing 44

Manufacturing Costs 45

Manufacturing Cost Flows 47Production Costs in Service Industry Firmsand Nonprofit Organizations 49

Basic Cost Management Concepts: DifferentCosts for Different Purposes 50

The Cost Driver Team 50

Variable and Fixed Costs 51

The Cost Management and ControlTeam 52

M.A.P. Airline Industry: Cost Structure,Cost Drivers, and a Shifting BusinessModel 54

The Outsourcing Action Team 56

Costs and Benefits of Information 59

Costs in the Service Industry 59

Focus on Ethics: Was WorldCom's ControllerJust Following Orders? 61

Chapter Summary 62

Review Problems on Cost Classifications 62

Key Terms 63

Review Questions 64

Exercises 64

Problems 67

Cases 77

Product Costing and CostAccumulation in a Batch ProductionEnvironment 80

Product and Service Costing 82

Product Costing in NonmanufacturingFirms 83

Flow of Costs in ManufacturingFirms 83

Types of Product-Costing Systems 85

Job-Order Costing Systems 85

Process-Costing Systems 86

Summary of Alternative Product-CostingSystems 86

Accumulating Costs in a Job-Order CostingSystem 86

Job-Cost Record 86

Direct-Material Costs 87

Direct-Labor Costs 89

Manufacturing-Overhead Costs 89

M.A.P. Supply Chain Management 90

Summary of Event Sequence in Job-OrderCosting 91

Illustration of Job-Order Costing 97

Purchase of Material 91

Use of Direct Material 93

Use of Indirect Material 93

Use of Direct Labor 93

Use of Indirect Labor 94

Incurrence of Manufacturing-OverheadCosts 94

Application of ManufacturingOverhead 95

Summary of OverheadAccounting 95

Selling and Administrative Costs 96

Completion of a Production Job 97

Sale of Goods 97

Underapplied and OverappliedOverhead 97

Schedule of Cost of GoodsManufactured 99

Schedule of Cost of GoodsSold 99

Posting Journal Entries to theLedger 100

Further Aspects of OverheadApplication 100

Actual and Normal Costing 100

Choosing the Cost Driver for OverheadApplication 100

Departmental Overhead Rates 103

Two-Stage Cost Allocation 704

Project Costing: Job-Order Costing inNonmanufacturing Organizations 105

Contents xxvii

Changing Technology in ManufacturingOperations 707

EDI and XML 108

M.A.P. Radio Frequency IdentificationSystems (RFID) 108

Use of Bar Codes 108

Focus on Ethics: Did Boeing ExploitAccounting Rules to Conceal Cost Overrunsand Production Snafus? 709

Chapter Summary 7 70

Review Problem on Job-OrderCosting 7 70

Key Terms 712

Review Questions 112

Exercises 712

Problems 7 78

Case 730

Process Costing and Hybrid Product-Costing Systems 134

Comparison of Job-Order Costing andProcess Costing 736

Flow of Costs 136

Differences Between Job-Order andProcess Costing 138

Equivalent Units: A Key Concept 738

Equivalent Units 138

Illustration of Process Costing 740

Basic Data for Illustration 141

M.A.P. New York Wine Industry 142

Weighted-Average Method of ProcessCosting 143

Other Issues in Process Costing 747

Actual versus Normal Costing 147

Other Cost Drivers for OverheadApplication 147

Subsequent ProductionDepartments 148

Hybrid Product-Costing Systems 748

Operation Costing for Batch ManufacturingProcesses 148

Chapter Summary 752

Review Problem on Process Costing 752

Key Terms 753

Review Questions 754

Exercises 754

Problems 757

Case 766

Activity-Based Costingand Management 168

Traditional, Volume-Based Product-CostingSystem 7 77

Trouble in Denver 171

Activity-Based Costing System 7 72

ABC Stage One 173

ABC Stage Two 174

Interpreting the ABC Product Costs 178

The Punch Line 179

Why Traditional, Volume-Based SystemsDistort Product Costs 180

M.A.P. Cost Distortion at RockwellInternational 182

Activity-Based Costing: Some KeyIssues 782

M.A.P. Cost Distortion at DHL 183

Cost Drivers 183

Collecting ABC Data 184

Activity Dictionary and Bill of Activities 186

Activity-Based Management 786

Two-Dimensional ABC 186

Using ABM to Identify Non-Value-AddedActivities and Costs 187

Customer-Profitability Analysis 789

Illustration of Customer-ProfitabilityAnalysis 190

xxviii Contents

M.A.P. Customer Profitability Analysis at BankOne Corp. - 191

Activity-Based Costing in the ServiceIndustry 792

M.A.P. Customer Profitability Analysis atBest Buy 193

Activity-Based Costing at Delaware MedicalCenter 194

Interpreting the Primary Care Unit's ABCInformation 197

Focus on Ethics: Ethical Issues SurroundingActivity-Based Costing 798

Chapter Summary 799

Review Problems on Cost Drivers andProduct-Cost Distortion 799

Key Terms 200

Appendix to Chapter 5: Just-in-Time Inventoryand Production Management 207

Review Questions 202

Exercises 203

Problems 209

Cases 228

6 Activity Analysis, Cost Behavior, andCost Estimation 232

Cost Behavior Patterns 235

Variable Costs 235

Step-Variable Costs 236

Fixed Costs 237

Step-Fixed Costs 237

Semivariable Cost 239

Curvilinear Cost 240

Using Cost Behavior Patterns to PredictCosts 241

M.A.P. Is Direct Labor a Variable or a FixedCost? 242

Engineered, Committed,and DiscretionaryCosts 243

Cost Behavior in Other Industries 244

Cost Estimation 244

Account-Classification Method 244

Visual-Fit Method 245

High-Low Method 247

Least-Squares Regression Method 248

Multiple Regression 250

Data Collection Problems 250

Engineering Method of CostEstimation 251

Effect of Learning on Cost Behavior 257

Focus on Ethics: Cisco Systems,Wal-Mart,Taco Bell, Starbucks, U-Haul, GeneralDynamics, and Farmer's Insurance: Is DirectLabor a Variable Cost? 253

Chapter Summary 253

Review Problems on Cost Behavior andEstimation 254

Key Terms 255

Appendix to Chapter 6: Least-SquaresRegression Using Microsoft Excel 255

Review Questions 257

Exercises 258

Problems 262

Cases 270

Cost-Volume-Profit Analysis 274

Illustration of Cost-Volume-ProfitAnalysis 277

Projected Expenses and Revenue 277

The Break-Even Point 278

Contribution-Margin Approach 278

Equation Approach 279

Graphing Cost-Volume-ProfitRelationships 280

Interpreting the CVP Graph 281

Alternative Format for the CVP Graph 283

Profit-Volume Graph 283

Target Net Profit 284

Contribution-Margin Approach 284

Contents xxix

Equation Approach 284

Graphical Approach 285

Applying CVP Analysis 285

Safety Margin 285

Changes in Fixed Expenses 285

Changes in the Unit ContributionMargin 286

Predicting Profit Given ExpectedVolume 287

Interdependent Changes in KeyVariables 288

CVP Information in Published AnnualReports 289

M.A.P. Airlines Keep a Close Eye on Break-Even Load Factors 289

CVP Analysis with Multiple Products 290

Assumptions Underlying CVP Analysis 292

Role of Computerized Planning Models andElectronic Spreadsheets 292

CVP Relationships and the IncomeStatement 293

Traditional Income Statement 293

Contribution Income Statement 293

Comparison of Traditional and ContributionIncome Statements 294 '

Cost Structure and Operating Leverage 295

Operating Leverage 296

M.A.P. Operating Leverage Helps These WebCompanies Become Profitable 297

Cost Structure and Operating Leverage:A Cost-Benefit Issue 298

M.A.P. Cost Structure and OperatingLeverage 299

CVP Analysis, Activity-Based Costing, andAdvanced Manufacturing Systems 299

A Move toward JIT and FlexibleManufacturing 300

Chapter Summary 302

Review Problem on Cost-Volume-ProfitAnalysis 303

Key Terms 303

Appendix to Chapter 7: Effect of IncomeTaxes 304

Review Questions 306

Exercises 307

Problems 309

Cases 327

Absorption and Variable Costing 324

Product Costs 326

Illustration of Absorption and VariableCosting 327

Absorption-Costing IncomeStatements 328

Variable-Costing IncomeStatements 328

Reconciling Income under Absorption andVariable Costing 329

Cost-Volume-Profit Analysis 331

Evaluation of Absorption and VariableCosting 332

M.A.P. IRS: Unique Product Packaging Is anInventoriable Cost 333

Throughput Costing 333

Throughput-Costing IncomeStatements 334

Focus on Ethics: Incentive to OverproduceInventory 335

Chapter Summary 335

Review Problem on Absorption and VariableCosting 336

Key Terms 337

Review Questions 337

Exercises 338

Problems 340

Cases 344

Profit Planning and Activity-BasedBudgeting 346

Purposes of Budgeting Systems 348

Types of Budgets 349

XXX Contents

The Master Budget: A Planning Tool 350

Sales of Services or Goods 350

Sales Forecasting 351

Operational Budgets 351

Budgeted Financial Statements 352

Nonprofit Organizations 352

M.A.P. Activity-Based Budgeting (ABB) atAmerican Express and AT&T Paradyne 353

Activity-Based Budgeting 353

Using Activity-Based Budgeting to Prepare theMaster Budget 354

Sales Budget 355Production Budget 356Direct-Material Budget 356Direct-Labor Budget 358Manufacturing-Overhead Budget 359Selling, General, and Administrative (SG&A)Expense Budget 360

Cash Receipts Budget 362Cash Disbursements Budget 363

Cash Budget: Combining Receipts andDisbursements 364

Budgeted Schedule of Cost of GoodsManufactured and Sold 365

Budgeted Income Statement 366

Budgeted Statement of Cash Flows 367

Budgeted Balance Sheet 368

Assumptions and Predictions Underlying theMaster Budget 369

Financial Planning Models 371

Budget Administration 372

M.A.P. Budget Administration at CornellUniversity 373

International Aspects of Budgeting 373

Budgeting Product Life-Cycle Costs 374

Behavioral Impact of Budgets 375

Budgetary Slack: Padding the Budget 375

Focus on Ethics: Is Padding the BudgetUnethical? 376

Participative Budgeting 377

Chapter Summary 377

Review Problem on Preparing Master BudgetSchedules 377

Key Terms 379Review Questions 380

Exercises 380

Problems 384

Cases 396

10 Standard Costing, OperationalPerformance Measures, and theBalanced Scorecard 402

Managing Costs 404

Management by Exception 405

Setting Standards 405

Methods for Setting Standards 405

Participation in Setting Standards 406

Perfection versus Practical Standards: ABehavioral Issue 406

Use of Standards by Service

Organizations 407

Cost Variance Analysis 407

Direct-Material Standards 408

Direct-Labor Standards 408

Standard Costs Given Actual Output 409

Analysis of Cost Variances 409

Direct-Material Variances 409

Direct-Labor Variances 411

M.A.P. Parker Hannifin Corporation's BrassProducts Division 413

Multiple Types of Direct Material or DirectLabor 413

Allowing for Spoilage or Defects 413

Significance of Cost Variances 474

A Statistical Approach 416

Behavioral Impact of StandardCosting 477

Controllability of Variances 477

Interaction among Variances 418

Standard Costs and Product Costing 479

Evaluation of Standard Costing Systems 420

Advantages of Standard Costing 420

Contents xxxi

Criticisms of Standard Costing in Today'sManufacturing Environment 420

M.A.P. Cost of Ownership 422

Operational Performance Measures in Today'sManufacturing Environment 422

Gain-Sharing Plans 425

The Balanced Scorecard 425

Lead and Lag Measures: The Key to theBalanced Scorecard 428

Linking the Balanced Scorecard toOrganizational Strategy 429

M.A.P. Linking the Balanced Scorecard toOrganizational Strategy 430

Focus on Ethics: Sacrificing Quality to CutStandard Costs 432

Chapter Summary 432

Review Problems on Standard Costing andOperational Performance Measures 433

Key Terms 435

Appendix to Chapter 10: Use of StandardCosts for Product Costing 435

Review Questions 437

Exercises 438

Problems 447

Cases 452

11 Flexible Budgeting and theManagement of Overhead and SupportActivity Costs 456

Overhead Budgets 458

Flexible Budgets 458

Advantages of Flexible Budgets 459

The Activity Measure 460

Flexible Overhead Budget Illustrated 467

Overhead Application in a Standard-CostingSystem 463

Choice of Activity Measure 464

Criteria for Choosing the ActivityMeasure 464

Cost Management Using OverheadCost Variances 465

Variable Overhead 466

Fixed Overhead 469

Overhead Cost Performance Report 477

M.A.P. Cost Management Systems inGermany 472

Activity-Based Flexible Budget 472

Flexible Budgeting in the ServiceIndustry 474

Focus on Ethics: Misstated Standards AffectAccuracy of Reports 476

Chapter Summary 477

Review Problem on Overhead Variances 477

Key Terms 478

Appendix A to Chapter 11: Standard Costsand Product Costing 479

Appendix B to Chapter 11: SalesVariances 480

Review Questions 487

Exercises 482

Problems 485

Cases 497

12 Responsibility Accounting, QualityControl, and Environmental CostManagement 500

Responsibility Centers 502

Illustration of ResponsibilityAccounting 503

Performance Reports 506

Budgets, Variance Analysis, andResponsibility Accounting 508

Cost Allocation 508

Cost Allocation Bases 508

Allocation Bases Based on Budgets 508

Activity-Based ResponsibilityAccounting 510

xxxii Contents

Behavioral Effects of ResponsibilityAccounting 570

Information versus Blame 510

Controllability 510

Motivating Desired Behavior 511

Segmented Reporting 577

Segments versus Segment Managers 512

Key Features of Segmented Reporting 513

Customer-Profitability Analysis and Activity-Based Costing 513

Total Quality Management 574

Measuring and Reporting QualityCosts 514

Changing Views of Optimal ProductQuality 516

M.A.P. Six Sigma for Quality Management andCost Reduction 518

ISO 9000 Standards 579

Environmental Cost Management 520

Classifying Environmental Costs 520

Managing Private Environmental Costs 521

Environmental Cost Strategies 522

Tie-In to the Responsibility-AccountingSystem 523

Focus on Ethics: Short-Sighted View of CostCutting 523

Chapter Summary 524

Review Problem on ResponsibilityAccounting 525

Key Terms 526

Review Questions 526

Exercises 527

Problems 530

Cases 538

13 Investment Centers and TransferPricing 542

Delegation of Decision Making 544

Obtaining Goal Congruence: A BehavioralChallenge 545

Adaptation of Management ControlSystems 545

Measuring Performance in InvestmentCenters 546

Return on Investment 546

Residual Income 548

Economic Value Added 551

M.A.P. Pay for Performance Basedon EVA 552

Measuring Income and Invested Capital 553

Invested Capital 553

Measuring Investment-Center Income 556

Inflation: Historical-Cost versus Current-Value Accounting 557

Other Issues in Segment PerformanceEvaluation 557

Alternatives to ROI, Residual Income, andEconomic Value Added (EVA) 557

Importance of NonfinancialInformation 558

Measuring Performance in NonprofitOrganizations 558

Transfer Pricing '559

Goal Congruence 559

General Transfer-Pricing Rule 560

Transfers Based on the External MarketPrice 563

Negotiated Transfer Prices 564

Cost-Based Transfer Prices 565

Standard versus Actual Costs 566

Undermining Divisional Autonomy 566

M.A.P. Transfer Pricing and Tax Issues 567

An International Perspective 567

Transfer Pricing in the Service Industry 568

Behavioral Issues: Risk Aversion andIncentives 568

Goal Congruence and Internal ControlSystems 569

Chapter Summary 570

Review Problems on Investment Centers andTransfer Pricing 570

Key Terms 577

Review Questions 572

Exercises 572

Problems 575

Cases 587

Contents xxxiii

14 Decision Making: Relevant Costs andBenefits 586

The Managerial Accountant's Role in DecisionMaking 588

Steps in the Decision-MakingProcess 589

Quantitative versus QualitativeAnalysis 589

Obtaining Information: Relevance, Accuracy,and Timeliness 590

Relevant Information 597

Unique versus Repetitive Decisions 591

Importance of Identifying Relevant Costsand Benefits 592

Identifying Relevant Costs and Benefits 592

Sunk Costs 592

Irrelevant Future Costs and Benefits 595

Opportunity Costs 595

Summary 596

Analysis of Special Decisions 596

Accept or Reject a Special Offer 596

Outsource a Product or Service 598

M.A.P. Outsourcing 599

Add or Drop a Service, Product, orDepartment 601

M.A.P. Adding a Service 603

Special Decisions in ManufacturingFirms 603

Joint Products: Sell or ProcessFurther 603

Decisions Involving LimitedResources 605

Uncertainty 607

Activity-Based Costing and Today's AdvancedManufacturing Environment 608

Conventional Outsourcing (Make-or-Buy)Analysis 609

Activity-Based Costing Analysis of theOutsourcing Decision 610

Other Issues in Decision Making 67 7

Incentives for Decision Makers 611

Short-Run versus Long-Run Decisions 612

Pitfalls to Avoid 612

Focus on Ethics: Effects of Decision to Close aDepartment and Outsource 673

Chapter Summary 674

Review Problem on Relevant Costs 674

Key Terms 675

Appendix to Chapter 14: LinearProgramming 675

Review Questions 677

Exercises 678

Problems 627

Cases 634

15 Target Costing and Cost Analysis forPricing Decisions 638

Major Influences on Pricing Decisions 640

Customer Demand 641

Actions of Competitors 641

Costs 641

Political, Legal, and Image-RelatedIssues 642

Economic Profit-Maximizing Pricing 643

Total Revenue, Demand, and MarginalRevenue Curves 643

Total Cost and Marginal Cost Curves 643

Profit-Maximizing Price and Quantity 646

Price Elasticity 646

Limitations of the Profit-MaximizingModel 646

Costs and Benefits of Information 648

Role of Accounting Product Costs inPricing 648

Cost-Pius Pricing 648

Absorption-Cost Pricing Formulas 650

Variable-Cost Pricing Formulas 650

Determining the Markup 650

xxxiv Contents

Cost-Pius Pricing: Summary andEvaluation 652

M.A.P. Price Competition and CostManagement 653

Strategic Pricing of New Products 653

Target Costing 654

M.A.P. Pricing on the Internet by "e-Tailers" 655

A Strategic Profit and Cost ManagementProcess 655

Activity-Based Costing and TargetCosting 657

Product-Cost Distortion and Pricing: TheRole of Activity-Based Costing 658

Value Engineering and Target Costing 658

Time and Material Pricing 660

Competitive Bidding 667

Effect of Antitrust Laws on Pricing 663

Chapter Summary 664

Review Problem on Cost-Pius Pricing 665

Key Terms 666

Review Questions 666

Exercises 667

Problems 670

Cases 676

16 Capital Expenditure Decisions 680Section 1: Discounted-Cash-FlowAnalysis 683

Net-Present-Value Method 684

Internal-Rate-of-Return Method 684

Comparing the NPV and IRR Methods 687

Assumptions Underlying Discounted Cash-Flow Analysis 687

Choosing the Hurdle Rate 688

Depreciable Assets 689

Comparing Two Investment Projects 689

Managerial Accountant's Role 689

Postaudit 692

Real Option Analysis 693

Section 2: Income Taxes and CapitalBudgeting 693

After-Tax Cash Flows 693

Accelerated Depreciation 696

Modified Accelerated Cost RecoverySystem (MACRS) 697

Gains and Losses on Disposal 700

Investment in Working Capital 701

Extended Illustration of Income-Tax Effectsin Capital Budgeting 702

M.A.P. Capital Budgeting at PharmaceuticalFirms 704

Ranking Investment Projects 705

Section 3: Alternative Methods for MakingInvestment Decisions 707

Payback Method 707

Accounting-Rate-of-Return Method 709

Estimating Cash Flows: The Role of Activity-Based Costing 77 7

Justification of Investments in AdvancedManufacturing Systems 772

Focus on Ethics: Dysfunctional Focus on EarlyCash Flows 773

Chapter Summary 774

Review Problems on Capital ExpenditureDecisions 774

Key Terms 775

Appendix A to Chapter 16: Future Value andPresent Value Tables 776

Appendix B to Chapter 16: Impact ofInflation 778

Review Questions 720

Exercises 727

Problems 724

Cases 730

17 Allocation of Support Activity Costsand Joint Costs 734

Section 1: Service Department CostAllocation 736

Contents XXXV

Direct Method 739

Step-Down Method 739

Reciprocal-Services Method 740

Fixed versus Variable Costs 741

M.A.P. Cost Management in the Health CareIndustry 743

Dual Cost Allocation 743

Allocate Budgeted Costs 744

Today's Advanced ManufacturingEnvironment 745

The Rise of Activity-Based Costing 746

Section 2: Joint Product Cost Allocation 746

Allocating Joint Costs 747

M.A.P. Joint Cost Allocation in the PetroleumIndustry 749

Chapter Summary 749

Review Problem on Service Department CostAllocation 749

Key Terms 750

Appendix to Chapter 17: Reciprocal-ServicesMethod 757

Review Questions 752

Exercises 753

Problems 755

Cases 760

Appendix I: The Sarbanes-Oxley Act,Internal Controls, and ManagementAccounting 762

Appendix II: Compound Interest and theConcept of Present Value 768

Appendix III: InventoryManagement 776

References for "In Their OwnWords" 784

Glossary 787

Photo Credits 798

Index of Companies andOrganizations 801

Index of Subjects 803