If melissa owns a software company that incurs no fixed costs, then

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Ninth Edition

Accounting for Decision Making and Control

Jerold L. Zimmerman University of Rochester

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ACCOUNTING FOR DECISION MAKING AND CONTROL, NINTH EDITION Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2017 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2014, 2009, and 2006. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

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Library of Congress Cataloging-in-Publication Data

Names: Zimmerman, Jerold L., 1947- author. Title: Accounting for decision making and control / Jerold L. Zimmerman, University of Rochester. Description: Ninth edition. | New York, NY : McGraw-Hill Education, [2017] Identifiers: LCCN 2015043326 | ISBN 9781259564550 (alk. paper) Subjects: LCSH: Managerial accounting. Classification: LCC HF5657.4 .Z55 2017 | DDC 658.15/11—dc23 LC record available at http://lccn.loc.gov/2015043326

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites.

www.mhhe.com

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About the Author

Jerold L. Zimmerman Jerold Zimmerman is Professor Emeritus at the William E. Simon Graduate School of Business, University of Rochester. He holds an undergraduate degree from the University of Colorado, Boulder, and a doctorate from the University of California, Berkeley.

While at Rochester, Dr. Zimmerman has taught a variety of courses spanning accounting, finance, and economics. Accounting courses include nonprofit accounting, intermediate accounting, accounting theory, and managerial accounting. A deeper appreciation of the challenges of managing complex organizations was acquired by serving as the Simon School’s Deputy Dean

and on the board of directors of several public corporations. Professor Zimmerman publishes widely in accounting on topics as diverse as cost

allocations, corporate governance, disclosure, financial accounting theory, capital markets, and executive compensation. His paper “The Costs and Benefits of Cost Allocations” won the American Accounting Association’s Competitive Manuscript Contest. He is recog- nized for developing Positive Accounting Theory. This work, co-authored with colleague Ross Watts, at the Massachusetts Institute of Technology, received the American Institute of Certified Public Accountants’ Notable Contribution to the Accounting Literature Award for “Towards a Positive Theory of the Determination of Accounting Standards” and “The Demand for and Supply of Accounting Theories: The Market for Excuses.” Both papers appeared in the Accounting Review. Professors Watts and Zimmerman are also co-authors of the highly cited textbook Positive Accounting Theory (Prentice Hall, 1986). Profes- sors Watts and Zimmerman received the 2004 American Accounting Association Semi- nal Contribution to the Literature award. Professor Zimmerman’s textbooks also include Managerial Economics and Organizational Architecture with Clifford Smith and James Brickley, 6th ed. (McGraw-Hill, 2016) and Management Accounting in a Dynamic Envi- ronment with Cheryl McWatters (Routledge UK, 2016). He is a founding editor of the Journal of Accounting and Economics, published by Elsevier. This scientific journal is one of the most highly referenced accounting publications.

He and his wife Dodie have two daughters, Daneille and Amy. Jerry has been known to occasionally engage friends and colleagues in an amicable diversion on the links.

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During their professional careers, managers in all organizations, profit and nonprofit, rely on their accounting systems. Sometimes managers use the accounting system to acquire information for decision making. At other times, the accounting system measures perfor- mance and thereby influences their behavior. The accounting system is both a source of information for decision making and part of the organization’s control mechanisms—thus, the title of the book, Accounting for Decision Making and Control.

The purpose of this book is to provide students and managers with an understand- ing and appreciation of the strengths and limitations of an organization’s accounting system, thereby allowing them to be more intelligent users of these systems. This book provides a framework for understanding accounting systems and a basis for analyzing proposed changes to these systems. The text demonstrates that managerial account- ing is an integral part of the firm’s organizational architecture, not just an isolated set of computational topics.

Changes in the Ninth Edition Feedback from reviewers and instructors using the prior editions and my own teaching experience provided the basis for the revision. In particular, the following changes have been made:

• Each chapter has been revised to further enhance readability and remove redundancy. • References to actual company practices have been updated. • Users were uniform in their praise of the problem material. They found it challenged

their students to critically analyze multidimensional issues while still requiring numerical problem-solving skills.

• The end-of-chapter problem material was revised by adding 45 new problems— including some related to health care and knowledge-based service firms—and removing outdated problems.

• The ninth edition is a more concise revision that presents the same fundamental con- cepts, learning objectives, and challenging critical thinking end-of-chapter materials as in prior editions.

Overview of Content Chapter 1 presents the book’s conceptual framework by using a simple decision context regarding accepting an incremental order from a current customer. The chapter describes why firms use a single accounting system and the concept of economic Darwinism, among other important topics. This chapter is an integral part of the text.

Preface

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Chapters 2, 4, and 5 present the underlying conceptual framework. The importance of opportunity costs in decision making, cost–volume–profit analysis, and the difference between accounting costs and opportunity costs are discussed in Chapter 2. Chapter 4 employs the economic theory of organizations and organizational architecture as the con- ceptual foundation to understand the role of the accounting system as part of the organiza- tion’s control mechanism. Chapter 5 describes the crucial role of accounting as part of the firm’s organizational architecture. Chapter 3 on capital budgeting extends opportunity costs to a multiperiod setting. This chapter can be skipped without affecting the flow of later material. Alternatively, Chapter 3 can be assigned at the end of the course.

Chapter 6 applies the conceptual framework and illustrates the trade-off managers face between decision making and control in a budgeting system. Budgets are a decision- making tool to coordinate activities within the firm and are a device to control behavior. This chapter provides an in-depth illustration of how budgets are an important part of an organization’s decision-making and control apparatus.

Chapter 7 presents a general analysis of why managers allocate certain costs and the behavioral implications of these allocations. Cost allocations affect both decision making and incentives. Again, managers face a trade-off between decision making and control. Chapter 8 continues the cost allocation discussion by describing the “death spiral” that can occur when significant fixed costs exist and excess capacity arises. This leads to an analysis of how to treat capacity costs—a trade-off between underutilization and overin- vestment. Finally, the chapter describes several specific cost allocation methods such as service department costs and joint costs.

Chapter 9 applies the general analysis of overhead allocation in Chapters 7 and 8 to the specific case of absorption costing in a manufacturing setting. The managerial implications of traditional absorption costing are provided in Chapters 10 and 11. Chapter 10 analyzes variable costing, and activity-based costing is the topic of Chapter 11. Variable costing is an interesting example of economic Darwinism. Proponents of variable costing argue that it does not distort decision making and therefore should be adopted. Nonetheless, it is not widely practiced, probably because of tax, financial reporting, and control considerations.

Chapter 12 discusses the decision-making and control implications of standard labor and material costs. Chapter 13 extends the discussion to overhead and marketing vari- ances. Chapters 12 and 13 can be omitted without interrupting the flow of later material. Finally, Chapter 14 synthesizes the course by reviewing the conceptual framework and applying it to various organizational innovations, such as total quality management, just in time, six sigma, lean production, and the balanced scorecard. These innovations provide an opportunity to apply the analytic framework underlying the text.

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Acknowledgments William Vatter and George Benston motivated my interest in managerial accounting. The genesis for this book and its approach reflect the oral tradition of my colleagues, past and present, at the University of Rochester. William Meckling and Michael Jensen stimu- lated my thinking and provided much of the theoretical structure underlying the book, as anyone familiar with their work will attest. My long and productive collaboration with Ross Watts sharpened my analytical skills and further refined the approach. He also fur- nished most of the intellectual capital for Chapter 3, including the problem material. Ray Ball has been a constant source of ideas. Clifford Smith and James Brickley continue to enhance my economic education. Three colleagues, Andrew Christie, Dan Gode, and Scott Keating, supplied particularly insightful comments that enriched the analysis at critical junctions. Valuable comments from Anil Arya, Ron Dye, Andy Leone, Dale Morse, Ram Ramanan, K. Ramesh, Shyam Sunder, and Joseph Weintrop are gratefully acknowledged.

This project benefited greatly from the honest and intelligent feedback of numerous instructors. I wish to thank Mahendra Gupta, Susan Hamlen, Badr Ismail, Charles Kile, Leslie Kren, Don May, William Mister, Mohamed Onsi, Ram Ramanan, Stephen Ryan, Michael Sandretto, Richard Sansing, Deniz Saral, Gary Schneider, Joe Weber, and William Yancey. This book also benefited from two other projects with which I have been involved. Writing Managerial Economics and Organizational Architecture (McGraw Hill Education, 2016) with James Brickley and Clifford Smith and Management Accounting in a Dynamic Environment (Routledge, 2016) with Cheryl McWatters helped me to better understand how to present certain topics.

To the numerous students who endured the development process, I owe an enormous debt of gratitude. I hope they learned as much from the material as I learned teaching them. Some were even kind enough to provide critiques and suggestions, in particular Jan Dick Eijkelboom. Others supplied, either directly or indirectly, the problem material in the text. The able research assistance of P. K. Madappa, Eamon Molloy, Jodi Parker, Steve Sand- ers, Richard Sloan, and especially Gary Hurst, contributed amply to the manuscript and problem material. Janice Willett and Barbara Schnathorst did a superb job of editing the manuscript and problem material.

The very useful comments and suggestions from the following reviewers are greatly appreciated:

Urton Anderson Howard M. Armitage Vidya Awasthi Kashi Balachandran Da-Hsien Bao Ron Barden Howard G. Berline Margaret Boldt David Borst Eric Bostwick Marvin L. Bouillon Wayne Bremser David Bukovinsky Linda Campbell

William M. Cready James M. Emig Gary Fane Anita Feller Tahirih Foroughi Ivar Fris Jackson F. Gillespie Irving Gleim Jon Glover Gus Gordon Sylwia Gornik-Tomaszewski Tony Greig Susan Haka Bert Horwitz

Steven Huddart Robert Hurt Douglas A. Johnson Lawrence A. Klein Thomas Krissek A. Ronald Kucic Daniel Law Chi-Wen Jevons Lee Suzanne Lowensohn James R. Martin Alan H. McNamee Marilyn Okleshen Shailandra Pandit Sam Phillips

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Frank Probst Kamala Raghavan William Rau Jane Reimers Thomas Ross Harold P. Roth P. N. Saksena Donald Samaleson Michael J. Sandretto

Richard Saouma Arnold Schneider Henry Schwarzbach Elizabeth J. Serapin Norman Shultz James C. Stallman William Thomas Stevens Monte R. Swain Heidi Tribunella

Clark Wheatley Lourdes F. White Paul F. Williams Robert W. Williamson Peggy Wright Jeffrey A. Yost S. Mark Young

To my wife Dodie and daughters Daneille and Amy, thank you for setting the right priorities and for giving me the encouragement and environment to be productive. Finally, I wish to thank my parents for all their support.

Jerold L. Zimmerman University of Rochester

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1 Introduction 1

2 The Nature of Costs 22

3 Opportunity Cost of Capital and Capital Budgeting 85

4 Organizational Architecture 127

5 Responsibility Accounting and Transfer Pricing 161

6 Budgeting 216

7 Cost Allocation: Theory 280

8 Cost Allocation: Practices 327

9 Absorption Cost Systems 392

10 Criticisms of Absorption Cost Systems: Incentive to Overproduce 448

11 Criticisms of Absorption Cost Systems: Inaccurate Product Costs 483

12 Standard Costs: Direct Labor and Materials 538

13 Overhead and Marketing Variances 575

14 Management Accounting in a Changing Environment 609

Solutions to Concept Questions 655 Glossary 665 Index 675

Brief Contents

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Contents

1 Introduction 1 A. Managerial Accounting: Decision Making and Control 2 B. Design and Use of Cost Systems 4 C. Marmots and Grizzly Bears 8 D. Management Accountant’s Role in the Organization 9 E. Evolution of Management Accounting: A Framework for Change 12 F. Vortec Medical Probe Example 15 G. Outline of the Text 18 H. Summary 18

2 The Nature of Costs 22 A. Opportunity Costs 23

1. Characteristics of Opportunity Costs 24 2. Examples of Decisions Based on Opportunity Costs 24

B. Cost Variation 29 1. Fixed, Marginal, and Average Costs 29 2. Linear Approximations 31 3. Other Cost Behavior Patterns 33 4. Activity Measures 33

C. Cost–Volume–Profit Analysis 35 1. Copier Example 35 2. Calculating Break-Even and Target Profits 36 3. Limitations of Cost–Volume–Profit Analysis 39 4. Multiple Products 41 5. Operating Leverage 42

D. Opportunity Costs versus Accounting Costs 45 1. Period versus Product Costs 46 2. Direct Costs, Overhead Costs, and Opportunity Costs 46

E. Cost Estimation 48 1. Account Classification 49 2. Motion and Time Studies 49

F. Summary 49 Appendix: Costs and the Pricing Decision 50

3 Opportunity Cost of Capital and Capital Budgeting 85 A. Opportunity Cost of Capital 86 B. Interest Rate Fundamentals 89

1. Future Values 89 2. Present Values 90

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3. Present Value of a Cash Flow Stream 91 4. Perpetuities 92 5. Annuities 93 6. Multiple Cash Flows per Year 94

C. Capital Budgeting: The Basics 96 1. Decision to Acquire an MBA 96 2. Decision to Open a Day Spa 97 3. Essential Points about Capital Budgeting 98

D. Capital Budgeting: Some Complexities 99 1. Risk 99 2. Inflation 100 3. Taxes and Depreciation Tax Shields 102

E. Alternative Investment Criteria 104 1. Payback 104 2. Accounting Rate of Return 105 3. Internal Rate of Return (IRR) 107 4. Methods Used in Practice 110

F. Summary 110

4 Organizational Architecture 127 A. Basic Building Blocks 128

1. Self-Interested Behavior, Team Production, and Agency Costs 128 2. Decision Rights and Rights Systems 133 3. Role of Knowledge and Decision Making 134 4. Markets versus Firms 135 5. Influence Costs 137

B. Organizational Architecture 139 1. Three-Legged Stool 139 2. Decision Management versus Decision Control 143

C. Accounting’s Role in the Organization’s Architecture 145 D. Example of Accounting’s Role: Executive Compensation Contracts 147 E. Summary 148

5 Responsibility Accounting and Transfer Pricing 161 A. Responsibility Accounting 162

1. Cost Centers 163 2. Profit Centers 165 3. Investment Centers 166 4. Economic Value Added (EVA®) 170 5. Controllability Principle 173

B. Transfer Pricing 175 1. International Taxation 175 2. Economics of Transfer Pricing 177 3. Common Transfer Pricing Methods 181 4. Reoragnization: The Solution if All Else Fails 186 5. Recap 186

C. Summary 188

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6 Budgeting 216 A. Generic Budgeting Systems 219

1. Country Club 219 2. Large Corporation 222

B. Trade-Off between Decision Management and Decision Control 226 1. Communicating Specialized Knowledge versus Performance

Evaluation 226 2. Budget Ratcheting 227 3. Participative Budgeting 229 4. New Approaches to Budgeting 230 5. Managing the Trade-Off 232

C. Resolving Organizational Problems 233 1. Short-Run versus Long-Run Budgets 233 2. Line-Item Budgets 235 3. Budget Lapsing 236 4. Static versus Flexible Budgets 236 5. Incremental versus Zero-Based Budgets 239

D. Summary 241 Appendix: Comprehensive Master Budget Illustration 242

7 Cost Allocation: Theory 280 A. Pervasiveness of Cost Allocations 281

1. Manufacturing Organizations 283 2. Hospitals 284 3. Universities 284

B. Reasons to Allocate Costs 286 1. External Reporting/Taxes 286 2. Cost-Based Reimbursement 287 3. Decision Making and Control 288

C. Incentive/Organizational Reasons for Cost Allocations 289 1. Cost Allocations Are a Tax System 289 2. Taxing an Externality 290 3. Insulating versus Noninsulating Cost Allocations 296

D. Summary 299

8 Cost Allocation: Practices 327 A. Death Spiral 328 B. Allocating Capacity Costs: Depreciation 333 C. Allocating Service Department Costs 333

1. Direct Allocation Method 335 2. Step-Down Allocation Method 337 3. Service Department Costs and Transfer Pricing of Direct

and Step-Down Methods 339 4. Reciprocal Allocation Method 342 5. Recap 344

D. Joint Costs 344

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1. Joint Cost Allocations and the Death Spiral 346 2. Net Realizable Value 348 3. Decision Making and Control 352

E. Segment Reporting and Joint Benefits 353 F. Summary 354 Appendix: Reciprocal Method for Allocating Service Department Costs 354

9 Absorption Cost Systems 392 A. Job Order Costing 394 B. Cost Flows through the T-Accounts 396 C. Allocating Overhead to Jobs 398

1. Overhead Rates 398 2. Over/Underabsorbed Overhead 400 3. Flexible Budgets to Estimate Overhead 403 4. Expected versus Normal Volume 406

D. Permanent versus Temporary Volume Changes 410 E. Plantwide versus Multiple Overhead Rates 411 F. Process Costing: The Extent of Averaging 415 G. Summary 416 Appendix A: Process Costing 416 Appendix B: Demand Shifts, Fixed Costs, and Pricing 422

10 Criticisms of Absorption Cost Systems: Incentive to Overproduce 448 A. Incentive to Overproduce 450

1. Example 450 2. Reducing the Overproduction Incentive 453

B. Variable (Direct) Costing 454 1. Background 454 2. Illustration of Variable Costing 454 3. Overproduction Incentive under Variable Costing 457

C. Problems with Variable Costing 458 1. Classifying Fixed Costs as Variable Costs 458 2. Variable Costing Excludes the Opportunity Cost of Capacity 460

D. Beware of Unit Costs 461 E. Summary 463

11 Criticisms of Absorption Cost Systems: Inaccurate Product Costs 483 A. Inaccurate Product Costs 484 B. Activity-Based Costing 488

1. Choosing Cost Drivers 489 2. Absorption versus Activity-Based Costing: An Example 495

C. Analyzing Activity-Based Costing 499 1. Reasons for Implementing Activity-Based Costing 499 2. Benefits and Costs of Activity-Based Costing 501 3. ABC Measures Costs, Not Benefits 503

D. Acceptance of Activity-Based Costing 505 E. Summary 509

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12 Standard Costs: Direct Labor and Materials 538 A. Standard Costs 539

1. Reasons for Standard Costing 540 2. Setting and Revising Standards 541 3. Target Costing 545

B. Direct Labor and Materials Variances 546 1. Direct Labor Variances 546 2. Direct Materials Variances 550 3. Risk Reduction and Standard Costs 554

C. Incentive Effects of Direct Labor and Materials Variances 554 1. Build Inventories 555 2. Externalities 555 3. Discouraging Cooperation 556 4. Mutual Monitoring 556 5. Satisficing 556

D. Disposition of Standard Cost Variances 557 E. The Costs of Standard Costs 559 F. Summary 561

13 Overhead and Marketing Variances 575 A. Budgeted, Standard, and Actual Volume 576 B. Overhead Variances 579

1. Flexible Overhead Budget 579 2. Overhead Rate 580 3. Overhead Absorbed 581 4. Overhead Efficiency, Volume, and Spending Variances 581 5. Graphical Analysis 585 6. Inaccurate Flexible Overhead Budget 587

C. Marketing Variances 588 1. Price and Quantity Variances 588 2. Mix and Sales Variances 589

D. Summary 591

14 Management Accounting in a Changing Environment 609 A. Integrative Framework 610

1. Organizational Architecture 611 2. Business Strategy 612 3. Environmental and Competitive Forces Affecting Organizations 615 4. Implications 615

B. Organizational Innovations and Management Accounting 616 1. Total Quality Management (TQM) 616 2. Just-in-Time (JIT) Production 621 3. Six Sigma and Lean Production 624 4. Balanced Scorecard 626

C. When Should the Internal Accounting System Be Changed? 632 D. Summary 633

Solutions to Concept Questions 655 Glossary 665 Index 675

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Chapter One

Introduction

Chapter Outline

A. Managerial Accounting: Decision Making and Control

B. Design and Use of Cost Systems C. Marmots and Grizzly Bears D. Management Accountant’s Role in the

Organization E. Evolution of Management Accounting:

A Framework for Change F. Vortec Medical Probe Example G. Outline of the Text H. Summary

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2 Chapter 1

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A. Managerial Accounting: Decision Making and Control Managers at Hyundai must decide which car models to produce, the quantity of each model to produce given the selling prices for the models, and how to manufacture the automobiles. They must decide which car parts, such as headlight assemblies, Hyundai should manufacture internally and which parts should be outsourced. They must decide not only on advertising, distribution, and product positioning to sell the cars, but also the quantity and quality of the various inputs to use. For example, they must determine which models will have leather seats and the quality of the leather to be used. Similarly, in decid- ing which investment projects to accept, capital budgeting analysts require data on future cash flows. How are these numbers derived? How does one coordinate the activities of hundreds or thousands of employees in the firm so that these employees accept senior management’s leadership? At Hyundai, and at other organizations small and large, manag- ers must have good information to make all these decisions and the leadership abilities to get others to implement the decisions.

Information about firms’ future costs and revenues is not readily available but must be estimated by managers. Organizations must obtain and disseminate the knowledge to make these decisions. Organizations’ internal information systems provide some of the knowledge for these pricing, production, capital budgeting, and marketing decisions. These systems range from the informal and the rudimentary to very sophisticated, electronic management information systems. The term information system should not be interpreted to mean a single, integrated system. Most information systems consist not only of formal, organized, tangible records such as payroll and purchasing documents but also informal, intangible bits of data such as memos, special studies, and managers’ impressions and opinions. The firm’s information system also contains nonfinancial information such as customer and employee satisfaction surveys. As firms grow from single proprietorships to large global corporations with tens of thousands of employees, managers lose the knowledge of enterprise affairs gained from personal, face-to-face contact in daily operations. Higher-level managers of larger firms come to rely more and more on formal operating reports.

The internal accounting system, an important component of a firm’s information system, includes budgets, data on the costs of each product and current inventory, and periodic financial reports. In many cases, especially in small companies, these accounting reports are the only formalized part of the information system providing the knowledge for decision making. Many larger companies have other formalized, nonaccounting–based information systems, such as production planning systems. This book focuses on how internal accounting systems provide knowledge for decision making.

After making decisions, managers must implement them in organizations in which the interests of the employees and the owners do not necessarily coincide. Just because senior managers announce a decision does not necessarily ensure that the decision will be implemented.

Organizations do not have objectives; people do. One common objective of owners of the organization is to maximize profits, or the difference between revenues and expenses. Maximizing firm value is equivalent to maximizing the stream of profits over the organiza- tion’s life. Employees, suppliers, and customers also have their own objectives—usually maximizing their self-interest.

Not all owners care only about monetary flows. An owner of a professional sports team might care more about winning (subject to covering costs) than maximizing profits. Nonprofits do not have owners with the legal rights to the organization’s profits. Moreover, nonprofits seek to maximize their value by serving some social goal such as education or health care.

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No matter what the firm’s objective, the organization will survive only if its inflow of resources (such as revenue) is at least as large as the outflow. Accounting information is useful to help manage the inflow and outflow of resources and to help align the owners’ and employees’ interests, no matter what objectives the owners wish to pursue.

Throughout this book, we assume that individuals maximize their self-interest. The owners of the firm usually want to maximize profits, but managers and employees will do so only if it is in their interest. Hence, a conflict of interest exists between owners—who, in general, want higher profits—and employees—who want easier jobs, higher wages, and more fringe benefits. To control this conflict, senior managers and owners design systems to monitor employees’ behavior and incentive schemes that reward employees for generat- ing more profits. Not-for-profit organizations face similar conflicts. Those people responsi- ble for the nonprofit organization (boards of trustees and government officials) must design incentive schemes to motivate their employees to operate the organization efficiently.

All successful firms must devise mechanisms that help align employee interests with maximizing the organization’s value. All of these mechanisms constitute the firm’s control system; they include performance measures and incentive compensation systems, promo- tions, demotions, and terminations, security guards and video surveillance, internal audi- tors, and the firm’s internal accounting system.1

As part of the firm’s control system, the internal accounting system helps align the interests of managers and shareholders to cause employees to maximize firm value. It sounds like a relatively easy task to design systems to ensure that employees maximize firm value. But a significant portion of this book demonstrates the exceedingly complex nature of aligning employee interests with those of the owners.

Internal accounting systems serve two purposes: (1) to provide some of the knowledge necessary for planning and making decisions (decision making) and (2) to help motivate and monitor people in organizations (control). The most basic control use of accounting is to prevent fraud and embezzlement. Maintaining inventory records helps reduce employee theft. Accounting budgets, discussed more fully in Chapter 6, provide an example of both decision making and control. Asking each salesperson in the firm to forecast his or her sales for the upcoming year is useful for planning next year’s production (decision making). However, if the salesperson’s sales forecast is used to benchmark performance for compen- sation purposes (control), he or she has strong incentives to underestimate those forecasts.

Using internal accounting systems for both decision making and control gives rise to the fundamental trade-off in these systems: A system cannot be designed to perform two tasks as well as a system that must perform only one task. Some ability to deliver knowl- edge for decision making is usually sacrificed to provide better motivation (control). The trade-off between providing knowledge for decision making and motivation/control arises continually throughout this text.

This book is applications oriented: It describes how the accounting system assembles knowledge necessary for implementing decisions using the theories from microeconomics, finance, operations management, and marketing. It also shows how the accounting system helps motivate employees to implement these decisions. Moreover, it stresses the continual trade-offs that must be made between the decision making and control functions of accounting.

1Control refers to the process that helps “ensure the proper behaviors of the people in the organization. These behaviors should be consistent with the organization’s strategy,” as noted in K. Merchant, Control in Business Organization (Boston: Pitman Publishing Inc., 1985), p. 4. Merchant provides an extensive discussion of control systems and a bibliography. In Theory of Accounting and Control (Cincinnati, OH: South-Western Publishing Company, 1997), S. Sunder describes control as mitigating and resolving conflicts among employees, owners, suppliers, and customers that threaten to pull organizations apart.

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A survey of senior-level executives (chief financial officers, vice presidents of finance, controllers, etc.) asked them to rank the importance of various goals of their firm’s account- ing system. Eighty percent of the respondents reported that cost management (controlling costs) was a significant goal of their accounting system and was important to achieving their company’s overall strategic objective. Another top priority of their firm’s account- ing system, even higher than cost management or strategic planning, is internal reporting and performance evaluation. These results indicate that firms use their internal accounting system both for decision making (strategic planning, cost reduction, financial manage- ment) and for controlling behavior (internal reporting and performance evaluation).2

The firm’s accounting system is very much a part of the fabric that helps hold the organization together. It provides knowledge for decision making, and it provides informa- tion for evaluating and motivating the behavior of individuals within the firm. Being such an integral part of the organization, the accounting system cannot be studied in isolation from the other mechanisms used for decision making or for reducing organizational prob- lems. A firm’s internal accounting system should be examined from a broad perspective, as part of the larger organization design question facing managers.

This book uses an economic perspective to study how accounting can motivate and control behavior in organizations. Besides economics, a variety of other paradigms also are used to investigate organizations: scientific management (Taylor), the bureaucratic school (Weber), the human relations approach (Mayo), human resource theory (Maslow, Rickert, Argyris), the decision-making school (Simon), and the political science school (Selznick). Behavior is a complex topic. No single theory or approach is likely to capture all the elements. However, understanding managerial accounting requires addressing the behav- ioral and organizational issues. Economics offers one useful and widely adopted framework.

B. Design and Use of Cost Systems Managers make decisions and monitor subordinates who make decisions. Both manag- ers and accountants must acquire sufficient familiarity with cost systems to perform their jobs. Accountants (often called controllers) are charged with designing, improving, and operating the firm’s accounting system—an integral part of both the decision-making and performance evaluation systems. Both managers and accountants must understand the strengths and weaknesses of current accounting systems. Internal accounting systems, like all systems within the firm, are constantly being refined and modified. Accountants’ responsibilities include making these changes.

An internal accounting system should have the following characteristics:

1. Provide the information necessary to assess the profitability of products or services and to optimally price and market these products or services.

2. Provide information to detect production inefficiencies to ensure that the proposed products and volumes are produced at minimum cost.

3. When combined with the performance evaluation and reward systems, create incentives for managers to maximize firm value.

4. Support the financial accounting and tax accounting reporting functions. (In some instances, these latter considerations dominate the first three.)

5. Contribute more to firm value than it costs.

2Ernst & Young and IMA, “State of Management Accounting,” www.imanet.org/pdf/SurveyofMgtAcctingEY .pdf, 2003.

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Figure 1–1 portrays the functions of the accounting system. In it, the accounting system supports both external and internal reporting systems. Examine the top half of Figure 1–1. The accounting procedures chosen for external reports to shareholders and taxing authorities are dictated in part by regulators. In the United States, the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) regulate the financial statements issued to shareholders. The Internal Revenue Service (IRS) administers the accounting procedures used in calculating corporate income taxes. If the firm is involved in international trade, foreign tax authorities prescribe the accounting rules applied in calculating foreign taxes. Regulatory agencies constrain public utilities’ and financial institutions’ accounting procedures.

Management compensation plans and debt contracts often rely on external reports. Senior managers’ bonuses are often based on accounting net income. Likewise, if the firm issues long-term bonds, it agrees in the debt covenants not to violate specified accounting- based constraints. For example, the bond contract might specify that the debt-to-equity ratio will not exceed some limit. Like taxes and regulation, compensation plans and debt covenants create incentives for managers to choose particular accounting procedures.3

As firms expand into international markets, external users of the firm’s financial state- ments become global. No longer are the firm’s shareholders, tax authorities, and regula- tors domestic. Rather, the firm’s internal and external reports are used internationally in a variety of ways.

The bottom of Figure 1–1 illustrates that internal reports are used for decision making as well as control of organizational problems. As discussed earlier, managers use a vari- ety of sources of data for making decisions. The internal accounting system provides one

3For further discussion of the incentives of managers to choose accounting methods, see R. Watts and J. Zimmerman, Positive Accounting Theory (Englewood Cliffs, NJ: Prentice Hall, 1986).

FIGURE 1–1

The multiple role of accounting systems

Taxing Authorities

Shareholders

Regulation Board of Directors

Senior Management Compensation Plans

Regulatory Authorities

SEC/FASB

IRS & Foreign Tax Authorities

External Reports

Accounting System

Internal Reports

Decision Making

Control of Organizational

Problems

Debt Covenants Bondholders

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important source. These internal reports are also used to evaluate and motivate (control) the behavior of managers in the firm. The internal accounting system reports on manag- ers’ performance and therefore provides incentives for them. Any changes to the internal accounting system can affect all the various uses of the resulting accounting numbers.

The internal and external reports are closely linked. The internal accounting system affords a more disaggregated view of the company. These internal reports are generated more frequently, usually monthly or even weekly or daily, whereas the external reports are provided quarterly for publicly traded U.S. companies. The internal reports offer costs and profits by specific products, customers, lines of business, and divisions of the com- pany. For example, the internal accounting system computes the unit cost of individual products as they are produced. These unit costs are then used to value the work-in-process and finished goods inventory, and to compute cost of goods sold. Chapter 9 describes the details of product costing.

Because internal accounting systems serve multiple users and have several purposes, the firm employs either multiple systems (one for each function) or one basic system that serves all three functions (decision making, performance evaluation, and external report- ing). Firms can either maintain a single set of books and use the same accounting methods for both internal and external reports, or they can keep multiple sets of books. The decision depends on the costs of writing and maintaining contracts based on accounting numbers, the costs from the dysfunctional internal decisions made using a single system, the addi- tional bookkeeping costs arising from the extra system, and the confusion of having to reconcile the different numbers arising from multiple accounting systems.

Inexpensive accounting software packages and falling costs of information technol- ogy have reduced some of the costs of maintaining multiple accounting systems. However, confusion arises when the systems report different numbers for the same concept. For example, when one system reports the manufacturing cost of a product as $12.56 and another system reports it at $17.19, managers wonder which system is producing the “right” number. Some managers may be using the $12.56 figure while others are using $17.19, causing inconsistency and uncertainty. Whenever two numbers for the same con- cept are produced, the natural tendency is to explain (i.e., reconcile) the differences. Managers involved in this reconciliation could have used this time in more productive ways. Also, using the same accounting system for multiple purposes increases the credibility of the financial reports for each purpose.4 With only one accounting system, the external auditor monitors the internal reporting system at little or no additional cost.

4A. Christie, “An Analysis of the Properties of Fair (Market) Value Accounting,” in Modernizing U.S. Securities Regulation: Economic and Legal Perspectives, K. Lehn and R. Kamphuis, eds. (Pittsburgh, PA: University of Pittsburgh, Joseph M. Katz Graduate School of Business, 1992).

Multiple accounting systems are confusing and can lead to errors. An extreme example of this occurred in 1999 when NASA lost its $125 million Mars spacecraft. Engineers at Lockheed Martin built the spacecraft and specified the spacecraft’s thrust in English pounds. But NASA scientists, navigating the craft, assumed the information was in metric newtons. As a result, the spacecraft was off course by 60 miles as it approached Mars and crashed. When two systems are being used to measure the same underlying event, people can forget which system is being used. SOURCE: A. Pollack, “Two Teams, Two Measures Equaled One Lost Spacecraft,” The New York Times. October 1, 1999, p. 1.

Managerial Application: Spaceship Lost Because Two Mea- sures Used

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Interestingly, a survey of large U.S. firms found that managers typically use the same accounting procedures for both external and internal reporting. More than 80 percent of chief financial officers (CFOs) report using the same accounting methods and report the same earnings internally and externally. In other words, most firms use “one number” for both external and internal communications. One CFO stated, “We make sure that every- thing that we have underneath—in terms of the detailed reporting—also rolls up basically to the same story that we’ve told externally.”5 Nothing prevents firms from using separate accounting systems for internal decision making and internal performance evaluation except the confusion generated and the extra data processing costs.

Probably the most important reason firms use a single accounting system is it allows reclassification of the data. An accounting system does not present a single, bottom-line num- ber, such as the “cost of publishing this textbook.” Rather, the system reports the components of the total cost of this textbook: the costs of proofreading, typesetting, paper, binding, cover, and so on. Managers in the firm then reclassify the information on the basis of different attri- butes and derive different cost numbers for different decisions. For example, if the publisher is considering translating this book into Chinese, not all the components used in calculating the U.S. costs are relevant. The Chinese edition might be printed on different paper stock with a different cover. The point is, a single accounting system usually offers enough flexibility for managers to reclassify, recombine, and reorganize the data for multiple purposes.

A single internal accounting system requires the firm to make trade-offs. A system that is best for performance measurement and control is unlikely to be the best for decision making. It’s like configuring a motorcycle for both off-road and on-road racing: Riders on bikes designed for both racing conditions probably won’t beat riders on specialized bikes designed for just one type of racing surface. Wherever a single accounting system exists, additional analyses arise. Managers making decisions find the accounting system less useful and devise other systems to augment the accounting numbers for decision-making purposes.

5Dichev, I.D., Graham, J.R., Campbell, H., and Rajgopal, S., 2013. “Earnings quality: evidence from the field,” Journal of Accounting and Economics, 56 (2–3), pp. 1–33.

“. . . cost accounting has a number of functions, calling for different, if not inconsistent, information. As a result, if cost accounting sets out, determined to discover what the cost of everything is and convinced in advance that there is one figure which can be found and which will furnish exactly the information which is desired for every pos- sible purpose, it will necessarily fail, because there is no such figure. If it finds a figure which is right for some purposes it must necessarily be wrong for others.” SOURCE: J. Clark, Studies in the Economics of Overhead Cost. (Chicago: University of Chicago Press, 1923), p. 234.

Historical Application: Different Costs for Different Purposes

Q1–1 What causes the conflict between using internal accounting systems for decision making and control?

Q1–2 Describe the different kinds of information provided by the internal accounting system.

Q1–3 Give three examples of the uses of an accounting system. Q1–4 List the characteristics of an internal accounting system. Q1–5 Do firms have multiple accounting systems? Why or why not?

Concept Questions

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C. Marmots and Grizzly Bears Managers often criticize accounting’s usefulness for making pricing or outsourcing deci- sions. Accounting data are based on historical costs rather than current values, and hence contain stale information. Why then do managers persist in using (presumably inferior) accounting information?

Before addressing this question, consider the parable of the marmots and the grizzly bears.6 Marmots are small groundhogs that are a principal food source for certain bears. Zoologists studying the ecology of marmots and bears observed bears digging and moving rocks in the autumn in search of marmots. They estimated that the calories expended searching for marmots exceeded the calories obtained from their consumption. A zoologist relying on Darwin’s theory of natural selection might conclude that searching for marmots is an inefficient use of the bear’s limited resources and thus these bears should become extinct. But fossils of marmot bones near bear remains suggest that bears have been search- ing for marmots for tens of thousands of years.

Because the bears survive, the benefits of consuming marmots must exceed the costs. Bears’ claws might be sharpened as a by-product of the digging involved in hunting for marmots. Sharp claws are useful in searching for food under the ice after winter’s hiberna- tion. Therefore, the benefit of sharpened claws and the calories derived from the marmots offset the calories consumed gathering the marmots.

What does the marmot-and-bear parable say about why managers persist in using apparently inferior accounting data in their decision making? As it turns out, the marmot- and-bear parable is an extremely important proposition in the social sciences known as economic Darwinism. In a competitive world, if surviving organizations use some oper- ating procedure (such as historical cost accounting) over long periods of time, then this procedure likely yields benefits in excess of its costs. Firms survive in competition by selling goods or services at lower prices than their competitors while still covering costs. Firms cannot survive by making more mistakes than their competitors.7

6This example is suggested by J. McGee, “Predatory Pricing Revisited,” Journal of Law & Economics. XXIII (October 1980), pp. 289–330.

7See A. Alchian, “Uncertainty, Evolution and Economic Theory,” Journal of Political Economy. 58 (June 1950), pp. 211–21.

Benchmarking is defined as a “process of continuously comparing and measur- ing an organization’s business processing against business leaders anywhere in the world to gain information which will help the organization take action to improve its performance.”

Economic Darwinism predicts that successful firm practices will be imitated. Benchmarking is the practice of imitating successful business practices. The practice of benchmarking dates back to 607, when Japan sent teams to China to learn the best practices in business, government, and education. Today, most large firms routinely conduct benchmarking studies to discover the best business practices and then imple- ment them in their firms. SOURCE: Society of Management Accountants of Canada, Benchmarking: A Survey of Canadian Practice (Hamilton, Ontario, Canada, 1994).

Terminology: Benchmark- ing and Economic Darwinism

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Economic Darwinism suggests that in successful (surviving) firms, things should not be fixed unless they are clearly broken. Currently, considerable attention is being directed at revising and updating firms’ internal accounting systems because many managers believe their current accounting systems are “broken” and require major overhaul. Alter- native internal accounting systems are being proposed, among them activity-based costing (ABC), balanced scorecards, economic value added (EVA), and Lean accounting systems. These systems are discussed and analyzed later in terms of their ability to help managers make better decisions, as well as to help provide better measures of performance for man- agers in organizations, thereby aligning managers’ and owners’ interests.

Although internal accounting systems may appear to have certain inconsistencies with some particular theory, these systems (like the bears searching for marmots) have survived the test of time and therefore are likely to be yielding unobserved benefits (like claw sharp- ening). This book discusses these additional benefits. Two caveats must be raised concern- ing too strict an application of economic Darwinism:

1. Some surviving operating procedures can be neutral mutations. Just because a system survives does not mean that its benefits exceed its costs. Benefits less costs might be close to zero.

2. Just because a given system survives does not mean it is optimal. A better system might exist but has not yet been discovered.

The fact that most managers use their accounting system as the primary formal infor- mation system suggests that these accounting systems are yielding total benefits that exceed their total costs. These benefits include financial and tax reporting, providing infor- mation for decision making, and creating internal incentives. The proposition that surviv- ing firms have efficient accounting systems does not imply that better systems do not exist, only that they have not yet been discovered. It is not necessarily the case that what is, is optimal. Economic Darwinism helps identify the costs and benefits of alternative internal accounting systems and is applied repeatedly throughout the book.

The well-known Italian Medici family had extensive banking interests and owned tex- tile plants in the fifteenth and sixteenth centuries. They also used sophisticated cost records to maintain control of their cloth production. These cost reports contained detailed data on the costs of purchasing, washing, beating, spinning, and weaving the wool, of supplies, and of overhead (tools, rent, and administrative expenses). Modern costing methodologies closely resemble these fifteenth-century cost systems, suggest- ing they yield benefits in excess of their costs. SOURCE: P. Garner, Evolution of Cost Accounting to 192. (Montgomery, AL: University of Alabama Press, 1954), pp. 12–13. Original source R de Roover, “A Florentine Firm of Cloth Manufacturers,” Speculu. XVI (January 1941), pp. 3–33.

Historical Application: Sixteenth- Century Cost Records

D. Management Accountant’s Role in the Organization To better understand internal accounting systems, it is useful to describe how firms orga- nize their accounting functions. No single organizational structure applies to all firms. Figure 1–2 presents one common organization chart. The design and operation of the internal and external accounting systems are the responsibility of the firm’s chief financial officer. The firm’s line-of-business or functional areas, such as marketing, manufacturing,

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and research and development, are combined and shown under a single organization, “oper- ating divisions.” The remaining staff and administrative functions include human resources, chief financial officer, legal, and other. In Figure 1–2, the CFO oversees all the financial and accounting functions in the firm and reports directly to the president. The CFO’s three major functions include controllership, treasury, and internal audit. Controllership involves tax administration, the internal and external accounting reports (including statutory filings with the Securities and Exchange Commission if the firm is publicly traded), and the plan- ning and control systems (including budgeting). Treasury involves short- and long-term financing, banking, credit and collections, investments, insurance, and capital budgeting. Depending on their size and structure, firms organize these functions differently. Figure 1–2 shows the internal audit group reporting directly to the CFO. In other firms, internal audit reports to the controller, the chief executive officer (CEO), or the board of directors.

The controller is the firm’s chief management accountant and is responsible for data collection and reporting. The controller compiles the data to prepare the firm’s balance sheet, income statement, and tax returns. In addition, this person prepares the internal reports for the various divisions and departments within the firm and helps the other man- agers by providing them with the data necessary to make decisions—as well as the data necessary to evaluate these managers’ performance.

Usually, each operating division or department has its own controller. For example, if a firm has several divisions, each division has its own division controller, who reports to both the division manager and the corporate controller. In Figure 1–2, the operating divi- sions have their own controllers. The division controller provides the corporate controller with periodic reports on the division’s operations. The division controller oversees the division’s budgets, payroll, inventory, and product costing system (which reports the cost of the division’s products and services). While most firms have division-level controllers, some firms centralize these functions to reduce staff so that all the division-level controller functions are performed centrally out of corporate headquarters.

The controllership function at the corporate, division, and plant levels involves assist- ing decision making and control. The controller must balance providing information to other managers for decision making against providing monitoring information to top exec- utives for use in controlling the behavior of lower-level managers.

FIGURE 1–2

Organization chart for a typical corporation

Board of Directors

President and Chief Executive Of�cer (CEO)

Human Resources

Chief Financial Of�cer (CFO) Legal Other

Operating Divisions

Treasury Controller InternalAudit

Controller– Operating Divisions

Tax FinancialReporting Cost

Accounting

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Besides overseeing the controllership and treasury functions in the firm, the chief financial officer usually has responsibility for the internal audit function. The internal audit group’s primary roles are to seek out and eliminate internal fraud and to provide internal consulting and risk management. The U.S. Sarbanes–Oxley Act of 2002 mandated numer- ous corporate governance reforms, such as requiring boards of directors of U.S. publicly traded companies to have audit committees composed of independent (outside) directors and requiring these companies to continuously test the effectiveness of the internal controls over their financial statements. This federal legislation indirectly expanded the internal audit group’s role. The internal audit group now works closely with the audit committee of the board of directors to help ensure the integrity of the firm’s financial statements by testing whether the firm’s accounting procedures are free of internal control deficiencies.

The Sarbanes–Oxley Act also requires companies to have corporate codes of conduct (ethics codes). While many firms had ethics codes prior to this act, these codes define hon- est and ethical conduct, including conflicts of interest between personal and professional relationships, compliance with applicable governmental laws, rules and regulations, and prompt internal reporting of code violations to the appropriate person in the company. The audit committee of the board of directors is responsible for overseeing compliance with the company’s code of conduct.

The importance of the internal control system cannot be stressed enough. Throughout this book, we use the term control to mean aligning the interests of employees with maxi- mizing the value of the firm. The most basic conflict of interest between employees and owners is employee theft. In fact, one study reports that the typical firm loses 5 percent of its revenues to fraud.8 To reduce the likelihood of embezzlement, firms install internal

8Association of Certified Fraud Examiners, “2014 Report to the Nation on Occupational Fraud and Abuse,” www.acfe.com.

In a study of 400 of the largest U.S. corporations, in 1960 none of the firms had a posi- tion entitled “Chief Financial Officer.” By the year 2000, 80 percent had a person hold- ing the title “CFO.” Prior to 1960, most large firms called their top accounting manager “Chief Accountant,” who typically was not part of the senior executive team. Several factors caused the elevation of “Chief Accountant” to “CFO,” who also became an inte- gral member of the firm’s senior executives. First, between 1960 and 2000, large U.S. firms became global, with operations in numerous countries requiring more complex financial transactions involving foreign currency hedging and multinational banking relations. Besides becoming global, large firms began to diversify their operations by entering into new lines of business. These firms became more complex, which neces- sitated more sophisticated reporting and control systems such as budgeting and monthly reports. To enter new markets, large firms began engaging in mergers and acquisitions as the capital markets developed to finance these transactions. The CFO played an integral role in valuing and financing acquisition targets. In addition, accounting rules became significantly more complicated, requiring sophisticated compliance capabilities. Thus, today’s CFOs have a much broader skill set and manage a larger portfolio of activities than their predecessors, and as such, their role and title in their firms has been elevated. SOURCES: L. Sjoblom and N. Michels-Kim, “Leading Nestle’s House of Finance,” Strategic Finance (September 2011), pp. 29–33 and D. Zorn, “Here a Chief, There a Chief: The Rise of the CFO in the American Firm,” American Sociological Review (June 2004), pp. 345–364.

Historical Application: The Rise of the CFO

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control systems, which are an integral part of their control system. Internal and external auditors’ first responsibility is to test the integrity of the firm’s internal controls. Fraud and theft are prevented not just by having security guards and door locks but also through a variety of procedures such as requiring checks above a certain amount to be authorized by two people. Internal control systems include internal procedures, codes of conduct, and policies that prohibit corruption, bribery, and kickbacks. Finally, internal control systems should prevent intentional (or accidental) financial misrepresentation by managers.

Q1–6 Define economic Darwinism. Q1–7 Describe the major functions of the chief financial officer.

Concept Questions

E. Evolution of Management Accounting: A Framework for Change Management accounting has evolved with the nature of organizations. Prior to 1800, most businesses were small, family-operated organizations. Management accounting was less important for these small firms. It was not critical for planning decisions and control rea- sons because the owner could directly observe the organization’s entire environment. The owner, who made all of the decisions, delegated little decision-making authority and had no need to devise elaborate formal systems to motivate employees. The owner observing slacking employees simply replaced them. Only as organizations grew larger with remote operations would management accounting become more important.

Most of today’s modern management accounting techniques were developed in the period from 1825 to 1925 with the growth of large organizations.9 Textile mills in the early nineteenth century grew by combining the multiple processes (spinning the thread, dying, weaving, etc.) of making cloth. These large firms developed systems to measure the cost per yard or per pound for the separate manufacturing processes. The cost data allowed managers to compare the cost of conducting a process inside the firm versus purchasing the process from external vendors. Similarly, the railroads of the 1850s to 1870s developed cost systems that reported cost per ton-mile and operating expenses per dollar of revenue. These measures allowed managers to increase their operating efficiencies. In the early 1900s, Andrew Carnegie (at what was to become U.S. Steel) devised a cost system that reported detailed unit cost figures for material and labor on a daily and weekly basis. This system allowed senior managers to maintain very tight controls on operations and gave them accurate and timely information on costs for pricing decisions. Merchandising firms such as Marshall Field’s and Sears, Roebuck developed gross margin (revenues less cost of goods sold) and stock-turn ratios (sales divided by inventory) to measure and evaluate performance. Manufacturing companies such as Du Pont Powder Company and General Motors developed performance measures to control their growing organizations.

In the period from 1925 to 1975, management accounting was heavily influenced by external considerations. Income taxes and financial accounting requirements (e.g., those of the Financial Accounting Standards Board) were major factors affecting management accounting.

Since 1975, two major environmental forces have changed organizations and caused managers to question whether traditional management accounting procedures

9P. Garner, Evolution of Cost Accounting to 1925 (Montgomery, AL: University of Alabama Press, 1954); and A. Chandler, The Visible Hand (Cambridge, MA: Harvard University Press, 1977).

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(pre-1975) are still appropriate. These environmental forces are (1) factory automation and computer/ information technology and (2) global competition. These environmental changes force managers to reconsider their organizational structure and their management accounting procedures.

According to IBM, “Every day, we create 2.5 quintillion bytes of data—so much that 90% of the data in the world today has been created in the last two years alone. This data comes from everywhere: sensors used to gather climate information, posts to social media sites, digital pictures and videos, purchase transaction records, and cell phone GPS signals to name a few. This data is ‘big data.’”

The future of finance and accounting professionals at many firms is to learn how to apply statistical and computer science techniques called “data analytics” to extract valuable insights about their customers, products, and competitors from their big data. For example, large online retailers constantly monitor the prices of products offered by competitors to adjust their prices dynamically throughout the day. Managers pore over data to uncover the causes behind the company’s sales, costs, and profits and to better understand what drive revenues and operating and sales expenses. Where and by which salespeople are different products sold? Why are certain stores or factories more profit- able? What are customers Tweeting or Facebook postings saying about our products and our competitors? SOURCES: www-01.ibm.com/software/data/bigdata/what-is-big-data.html. D. Katz “Accounting’s Big Data Problem,” CFO. com. (March 4, 2014)

Managerial Application: Big Data and Data Analytics

Information technology advances such as the Internet, intranets, wireless communica- tions, and faster microprocessors have had a big impact on internal accounting processes. More data are now available faster than ever before. Electronic data interchange, XHTML, e-mail, B2B (business-to-business) e-commerce, bar codes, data warehousing, and online analytical processing (OLAP) are just a few examples of new technology impacting man- agement accounting. For example, managers now have access to daily sales and operating costs in real time, as opposed to having to wait two weeks after the end of the calendar quarter for this information. Firms have cut the time needed to prepare budgets for the next fiscal year by several months because the information is transmitted electronically in standardized formats.

The history of management accounting illustrates how it has evolved in parallel with organizations’ structure. Management accounting provides information for planning decisions and control. It is useful for assigning decision-making authority, measuring performance, and determining rewards for individuals within the organization. Because management accounting is part of the organizational structure, it is not surprising that management accounting evolves in a parallel and consistent fashion with other parts of the organizational structure.

Figure 1–3 is a framework for understanding the role of accounting systems within firms and the forces that cause accounting systems to change. As described more fully in Chapter 14, environmental forces such as technological innovation and global competition change the organization’s business strategies. For example, the Internet has allowed banks to offer electronic, online banking services. To implement these new strategies, organiza- tions must adapt their organizational structure or architecture, which includes management accounting. An organization’s architecture (the topic of Chapter 4) is composed of three

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related processes: (1) the assignment of decision-making responsibilities, (2) the measure- ment of performance, and (3) the rewarding of individuals within the organization.

The first component of the organizational architecture is assigning responsibilities to the different members of the organization. Decision rights define the duties each member of an organization is expected to perform. The decision rights of a particular individual within an organization are specified by that person’s job description. Checkout clerks in grocery stores have the decision rights to collect cash from customers but don’t have the decision rights to accept certain types of checks. A manager must be called for that decision. A division manager may have the right to set prices on products but not the right to borrow money. The president usually retains the right to issue debt, subject to board of directors’ approval.

The next two parts of the organizational architecture are the performance evalua- tion and reward systems. To motivate individuals within the organization, organizations must have a system for measuring their performance and rewarding them. Performance measures for a salesperson could include total sales and customer satisfaction based on a survey of customers. Performance measures for a manufacturing unit might be number of units produced, total costs, and percentage of defective units. The internal accounting system is often an important part of the performance evaluation system.

Performance measures are extremely important because rewards are generally based on these measures. Rewards for individuals within organizations include wages and bonuses, prestige and greater decision rights, promotions, and job security. Because rewards are based on performance measures, individuals and groups are motivated to act to influence the performance measures. Therefore, the performance measures chosen influ- ence individual and group efforts within the organization. A poor choice of performance measures can lead to conflicts within the organization and derail efforts to achieve orga- nizational goals. For example, measuring the performance of a college president based on the number of students attending the college encourages the president to enroll ill-prepared students, thereby reducing the quality of the educational experience for other students.

As illustrated in Figure 1–3, changes in the business environment lead to new strate- gies and ultimately to changes in the firm’s organizational architecture, including changes in the accounting system to better align the interests of the employees with the objectives of the organization. The new organizational architecture provides incentives for members

FIGURE 1–3

Framework for organizational change and management accounting

Business Environment

Business Strategy

Incentive and Actions

Firm Value

Organizational Architecture

• Decision-Right Assignment • Performance Evaluation System

• Reward System

Incentives and Actions

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of the organization to make decisions, which leads to a change in the value of the organiza- tion. Within this framework, accounting assists in the control of the organization through the organization’s architecture and provides information for decision making. This frame- work for change is referred to throughout the book.

F. Vortec Medical Probe Example To illustrate some of the basic concepts developed in this text, suppose you have been asked to evaluate the following decision. Vortec Inc. manufactures a single product, a medical probe. Vortec sells the probes to distributors who then market them to physicians. Vortec has two divisions. The manufacturing division produces the probes; the market- ing division sells them to distributors. The marketing division is rewarded on the basis of sales revenues. The manufacturing division is evaluated and rewarded on the basis of the average unit cost of making the probes. The plant’s current volume is 100,000 probes per month. The following income statement summarizes last month’s operating results.

VORTEC MANUFACTURING Income Statement

Last Month

Sales revenue (100,000 units @ $5.00) $ 500,000 Cost of sales (100,000 units @ $4.50) 450,000 Operating margin $ 50,000 Less: Administrative expenses 27,500 Net income before taxes $ 22,500

Medsupplies is one of Vortec’s best distributors. Vortec sells 10,000 probes per month to Medsupplies at $5 per unit. Last week, Medsupplies asked Vortec’s marketing divi- sion to increase its monthly shipment to 12,000 units, provided that Vortec would sell the additional 2,000 units at $4 each. Medsupplies would continue to pay $5 for the original 10,000 units. Medsupplies argued that because this would be extra business for Vortec, no overhead should be charged on the additional 2,000 units. In this case, a $4 price should be adequate.

Vortec’s finance department estimates that with 102,000 probes the average cost is $4.47 per unit, and hence the $4 price offered by Medsupplies is too low. The cur- rent administrative expenses of $27,500 consist of office rent, property taxes, and interest and will not change if this special order is accepted. Should Vortec accept the Medsupplies offer?

Before examining whether the marketing and manufacturing divisions will accept the order, consider Medsupplies’s offer from the perspective of Vortec’s owners, who are interested in maximizing profits. The decision hinges on the cost to Vortec of selling an additional 2,000 units to Medsupplies. If the cost is more than $4 per unit, Vortec should reject the special order.

It is tempting to reject the offer because the $4 price does not cover the average total cost of $4.47. But will it cost Vortec $4.47 per unit for the 2,000-unit special order? Is $4.47 the cost per unit for each of the next 2,000 units?

To begin the analysis, two simplifying assumptions are made that are relaxed later:

• Vortec has excess capacity to produce the additional 2,000 probes. • Past historical costs are unbiased estimates of the future cash flows for producing the

special order.

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Based on these assumptions, we can compare the incremental revenue from the additional 2,000 units with its incremental cost:

Incremental revenue (2,000 units × $4.00) $8,000 Total cost @ 102,000 units (102,000 × $4.47) $455,940 Total cost @ 100,000 units (100,000 × $4.50) 450,000 Incremental cost of 2,000 units 5,940 Incremental profit of 2,000 units $2,060

The estimated incremental cost per unit of the 2,000 units is then

Change in total cost _________________ Change in volume = $455,940 − $450,000 ___________________ 2,000 = $2.97

The estimated cost per incremental unit is $2.97. Therefore, $2.97 is the average per-unit cost of the extra 2,000 probes. The $4.47 cost is the average cost of producing 102,000 units, which is more than the $2.97 incremental cost per unit of producing the extra 2,000 probes.

Based on the $2.97 estimated cost, Vortec should take the order. Is this the right decision? Not necessarily. There are some other considerations: 1. Will these 2,000 additional units affect the $5 price of the 100,000 probes? Will Vortec’s other distributors continue to pay $5 if Medsupplies buys 2,000 units at $4? What prevents Medsupplies from reselling the probes to Vortec’s other distributors at less than $5 per unit but above $4 per unit? Answering these questions requires management to acquire knowledge of the market for the probes. 2. What is the alternative use of the excess capacity consumed by the additional 2,000 probes? As plant utilization increases, congestion costs rise, production becomes less efficient, and the cost per unit rises. Congestion costs include the wages of the addi- tional production employees and supervisors required to move, store, expedite, and rework products as plant volume increases. The $2.97 incremental cost computed from the aver- age cost data provided above might not include the higher congestion costs as capacity is approached. This suggests that the $4.47 average cost estimate is wrong. Who provides this cost estimate and how accurate is it? Management must acquire knowledge of how costs behave at a higher volume. If Vortec accepts the Medsupplies offer, will Vortec be forced at some later date to forgo using this capacity for a more profitable project? 3. What costs will Vortec incur if the Medsupplies offer is rejected? Will Vortec lose the normal 10,000-unit Medsupplies order? If so, can this order be replaced? 4. Does the Robinson-Patman Act apply? The Robinson-Patman Act is a U.S. federal law prohibiting charging customers different prices if doing so is injurious to competi- tion. Thus, it may be illegal to sell an additional 2,000 units to Medsupplies at less than $5 per unit. Knowledge of U.S. antitrust laws must be acquired. Moreover, if Vortec sells internationally, it will have to research the antitrust laws of the various jurisdictions that might review the Medsupplies transaction.

We have analyzed the question of whether Medsupplies’ 2,000-unit special order maximizes the owners’ profit. The next question to address is whether the marketing and manufacturing divisions will accept Medsupplies’ offer. Recall that marketing is evalu- ated based on total revenues, and manufacturing is evaluated based on average unit costs. Therefore, marketing will want to accept the order as long as Medsupplies does not resell

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the probes to other Vortec distributors and as long as other Vortec distributors do not expect similar price concessions. Manufacturing will want to accept the order as long as it believes average unit costs will fall. Increasing production lowers average unit costs and makes it appear as though manufacturing has achieved cost reductions.

Suppose that accepting the Medsupplies offer will not adversely affect Vortec’s other sales, but the incremental cost of producing the 2,000 extra probes is really $4.08, not $2.97, because there will be overtime charges and additional factory congestion costs. Under these conditions, both marketing and manufacturing will want to accept the offer. Marketing increases total revenue and thus appears to have improved its performance. Manufacturing still lowers average unit costs from $4.50 to $4.4918 per unit:

($4.50 × 100,000) + ($4.08 × 2,000) ______________________________ 102,000 = $4.4918

However, the shareholders are worse off. Vortec’s cash flows are lower by $160 [or 2,000 units × ($4.00 − $4.08)]. The problem is not that the marketing and manufacturing managers are “making a mistake.” The problem is that their measures of performance are creating the wrong incentives. In particular, rewarding marketing for increasing total revenues and manufacturing for reducing average unit costs means there is no mechanism to ensure that the incremental revenues from the order ($8,000 = $4 × 2,000) are greater than the incremental costs ($8,160 = $4.08 × 2,000). Both marketing and manufacturing are doing what they were told to do (increase revenues and reduce average costs), but the firm’s cash flow falls because the incentive systems are poorly designed.

Four key points emerge from this example:

1. Beware of average costs. The $4.50 unit cost tells us little about how costs will vary with changes in volume. Just because a cost is stated in dollars per unit does not mean that producing one more unit will add that amount of incremental cost.

2. Use opportunity costs. Opportunity costs measure what the firm forgoes when it chooses a specific action. The notion of opportunity cost is crucial in decision making. The opportunity cost of the Medsupplies order is what Vortec forgoes by accepting the special order. What is the best alternative use of the plant capacity consumed by the Medsupplies special order? (More on this in Chapter 2.)

3. Supplement accounting data with other information. The accounting system contains important data relevant for estimating the cost of this special order from Medsupplies. But other knowledge that the accounting system cannot cap- ture must be assembled, such as what Medsupplies will do if Vortec rejects its offer. Managers usually augment accounting data with other knowledge such as customer demands, competitors’ plans, future technology, and government regulations.

4. Use accounting numbers as performance measures cautiously. Accounting num- bers such as revenues or average unit manufacturing costs are often used to evalu- ate managers’ performance. Just because managers are maximizing particular performance measures tailored for each manager does not necessarily cause firm profits to be maximized.

The Vortec example illustrates the importance of understanding how accounting num- bers are constructed, what they mean, and how they are used in decision making and con- trol. The accounting system is a very important source of information to managers, but it is not the sole source of all knowledge. Also, in the overly simplified context of the Vortec

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example, the problems with the incentive systems and with using unit costs are easy to detect. In a complex company with hundreds or thousands of products or services, such errors are very difficult to detect. Finally, for the sake of simplicity, the Vortec illustration ignores the use of the accounting system for external reporting.

G. Outline of the Text Internal accounting systems provide data for both decision making and control. The orga- nization of this book follows this dichotomy. The first part of the text (Chapters 2 through 5) describes how accounting systems are used in decision making and providing incentives in organizations. These chapters provide the conceptual framework for the remainder of the book. The next set of chapters (Chapters 6 through 8) describes basic topics in mana- gerial accounting, budgeting, and cost allocations. Budgets not only communicate knowl- edge within the firm for decision making but also serve as a control device and as a way to partition decision-making responsibility among the managers. Likewise, cost allocations serve decision-making and control functions. In analyzing the role of budgeting and cost allocations, these chapters draw on the first part of the text.

The next section of the text (Chapters 9 through 13) describes the prevalent account- ing system used in firms: absorption costing. Absorption cost systems are built around cost allocations. The systems used in manufacturing and service settings generate prod- uct or service costs built up from direct labor, direct material, and allocated overheads. After first describing these systems, we critically analyze them. A common criticism of absorption cost systems is that they produce inaccurate unit cost information, which can lead to dysfunctional decision making. Two alternative accounting systems (variable cost systems and activity-based cost systems) are compared and evaluated against a traditional absorption cost system. The next topic describes the use of standard costs as extensions of absorption cost systems. Standard costs provide benchmarks to calculate accounting variances: the difference between the actual costs and standard costs. These variances are performance measures and thus are part of the firm’s motivation and control system described earlier.

The last chapter (Chapter 14) expands the integrative approach summarized in section E of this chapter. This approach is then used to analyze four modifications of inter- nal cost systems: quality measurement systems, just-in-time production, six sigma and lean production, and balanced scorecards. These modifications are evaluated within a broad historical context. Just because these systems are new does not suggest they are better. Some have stood the test of time, while others have not.

H. Summary This book provides a framework for the analysis, use, and design of internal accounting systems. It explains how these systems are used for decision making and motivating people in organizations. Employees care about their self-interest, not the owners’ self-interest. Hence, owners must devise incentive systems to motivate their employees. Accounting numbers are used as measures of manag- ers’ performance and hence are part of the control system used to motivate managers. Most orga- nizations use a single internal accounting system as the primary data source for external reporting and internal uses. Applying the economic Darwinism principle, the costs of multiple systems likely outweigh the benefits for most firms. The costs are not only the direct costs of operating the system but also the indirect costs from dysfunctional decisions resulting from faulty information and poor performance evaluation systems. The remainder of this book addresses the costs and benefits of internal accounting systems.

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Problems P 1–1: MBA Students

One MBA student was overheard saying to another, “Accounting is baloney. I worked for a genetic engineering company and we never looked at the accounting numbers and our stock price was always growing.”

“I agree,” said the other. “I worked in a rust bucket company that managed everything by the numbers and we never improved our stock price very much.”

Evaluate these comments.

P 1–2: One Cost System Isn’t Enough

Robert S. Kaplan in “One Cost System Isn’t Enough” (Harvard Business Review. January–February 1988, pp. 61–66)

No single system can adequately answer the demands made by diverse functions of cost systems. While companies can use one method to capture all their detailed transactions data, the processing of this information for diverse purposes and audiences demands separate, customized development. Companies that try to satisfy all the needs for cost information with a single system have discovered they can’t perform important managerial functions adequately. Moreover, systems that work well for one company may fail in a different environment. Each company has to design methods that make sense for its particular products and processes. Of course, an argument for expanding the number of cost systems conflicts with a strongly ingrained financial culture to have only one measurement system for everyone.

Describe the costs and benefits of having a single measurement system.

P 1–3: U.S. and Japanese Tax Laws

Tax laws in Japan tie taxable income directly to the financial statements’ reported income. That is, to compute a Japanese firm’s tax liability, multiply the net income as reported to shareholders by the appropriate tax rate to derive the firm’s tax liability. In contrast, U.S. firms typically have more discretion in choosing different accounting procedures for calculating net income for shareholders (financial reporting) and taxes.

What effect would you expect these institutional differences in tax laws between the United States and Japan to have on internal accounting and reporting?

P 1–4: Using Accounting for Planning

The owner of a small software company felt his accounting system was useless. He stated, “Account- ing systems only generate historical costs. Historical costs are useless in my business because every- thing changes so rapidly.”

Required:

a. Are historical costs useless in rapidly changing environments? b. Should accounting systems be limited to historical costs?

P 1–5: Budgeting

Salespeople at a particular firm forecast what they expect to sell next period. Their supervisors then review the forecasts and make revisions. These forecasts are used to set production and purchasing plans. In addition, salespeople receive a fixed bonus of 20 percent of their salary if they meet or exceed their forecasts.

Discuss the incentives of the salespeople to forecast next-period sales accurately. Discuss the trade-off between using the budget for decision making versus using it as a control device.

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P 1–6: Golf Specialties

Golf Specialties (GS), a Belgian company, manufactures a variety of golf paraphernalia, such as head covers for woods, embroidered golf towels, and umbrellas. GS sells all its products exclusively in Europe through independent distributors. Given the popularity of Tiger Woods, one of GS’s more popular items is a head cover in the shape of a tiger.

GS is currently making 500 tiger head covers a week at a per unit cost of 3.50 euros, which includes both variable costs and allocated fixed costs. GS sells the tiger head covers to distributors for 4.25 euros. A distributor in Japan, Kojo Imports, wants to purchase 100 tiger head covers per week from GS and sell them in Japan. Kojo offers to pay GS 2 euros per head cover. GS has enough capacity to produce the additional 100 tiger head covers and estimates that if it accepts Kojo’s offer, the per unit cost of all 600 tiger head covers will be 3.10 euros. Assume the cost data provided (3.50 euros and 3.10 euros) are accurate estimates of GS’s costs of producing the tiger head covers. Further assume that GS’s variable cost per head cover does not vary with the number of head covers manufactured.

Required:

a. Given the data in the problem, what is GS’s weekly fixed cost of producing the tiger head covers?

b. To maximize firm value, should GS accept Kojo’s offer? Explain why or why not. c. Besides the data provided above, what other factors should GS consider before making a

decision to accept Kojo’s offer?

P 1–7: Parkview Hospital

Parkview Hospital, a regional hospital, serves a population of 400,000 people. The next closest hospital is 50 miles away. Parkview’s accounting system is adequate for patient billing. The system reports revenues generated per department but does not break down revenues by unit within depart- ments. For example, Parkview knows patient revenue for the entire psychiatric department but does not know revenues in the child and adolescent unit, the chemical dependence unit, or the neuropsy- chiatric unit.

Parkview receives its revenues from three principal sources: the federal government ( Medicare), the state government (Medicaid), and private insurance companies (Blue Cross–Blue Shield). Until recently, the private insurance companies continued to pay Parkview’s increasing costs and passed these on to the firms through higher premiums for their employees’ health insurance.

Last year Trans Insurance (TI) entered the market and began offering lower-cost health insur- ance to local firms. TI cut benefits offered and told Parkview that it would pay only a fixed dollar amount per patient. A typical firm could cut its health insurance premium 20 percent by switching to TI. TI was successful at taking 45 percent of the Blue Cross–Blue Shield customers. Firms that switched to TI faced stiff competition and sought to cut their health care costs.

Parkview management estimated that its revenues would fall 6 percent, or $3.2 million, next year because of TI’s lower reimbursements. Struggling with how to cope with lower revenues, Parkview began the complex process of deciding what programs to cut, how to shift the delivery of services from inpatient to outpatient clinics, and what programs to open to offset the revenue loss (e.g., open an outpatient depression clinic). Management can forecast some of the costs of the proposed changes, but many of its costs and revenues (such as the cost of the admissions office) have never been tracked to the individual clinical unit.

Required:

a. Was Parkview’s accounting system adequate 10 years ago? b. Is Parkview’s accounting system adequate today? c. What changes should Parkview make in its accounting system?

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P 1–8: Montana Pen Company

Montana Pen Company manufactures a full line of premium writing instruments. It has 12 different styles, and within each style, it offers ball point pens, fountain pens, mechanical pencils, and a roller ball pen. Most models also come in three finishes—gold, silver, and black matte. Montana Pen’s Bangkok, Thailand, plant manufactures four of the styles. The plant is currently producing the gold clip for the top of one of its pen styles, no. 872. Current production is 1,200 gold no. 872 pens each month at an average cost of 185 baht per gold clip. (One U.S. dollar currently buys 32 baht.) A Chinese manufacturer has offered to produce the same gold clip for 136 baht. This manufacturer will sell Montana Pen 400 clips per month. If it accepts the Chinese offer and cuts the production of the clips from 1,200 to 800, Montana Pen estimates that the cost of each clip it continues to produce will rise from 185 baht to 212.5 baht per gold clip.

Required:

a. Should Montana Pen outsource 400 gold clips for pen style no. 872 to the Chinese firm? Provide a written justification of your answer.

b. Given your answer in part (a), what additional information would you seek before deciding to outsource 400 gold clips per month to the Chinese firm?

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Chapter Two

The Nature of Costs

Chapter Outline

A. Opportunity Costs 1. Characteristics of Opportunity Costs

2. Examples of Decisions Based on Opportunity Costs

B. Cost Variation 1. Fixed, Marginal, and Average Costs

2. Linear Approximations

3. Other Cost Behavior Patterns

4. Activity Measures

C. Cost–Volume–Profit Analysis 1. Copier Example

2. Calculating Break-Even and Target Profits

3. Limitations of Cost–Volume–Profit Analysis

4. Multiple Products

5. Operating Leverage

D. Opportunity Costs versus Accounting Costs 1. Period versus Product Costs

2. Direct Costs, Overhead Costs, and Opportunity Costs

E. Cost Estimation 1. Account Classification

2. Motion and Time Studies

F. Summary Appendix: Costs and the Pricing Decision

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As described in Chapter 1, accounting systems measure costs that managers use for exter- nal reports, decision making, and controlling the behavior of people in the organization. Understanding how accounting systems calculate costs requires a thorough understanding of what cost means. Unfortunately, that simple term has multiple meanings. Saying a prod- uct costs $3.12 does not reveal what the $3.12 measures. Additional explanation is often needed to clarify the assumptions that underlie the calculation of cost. A large vocabu- lary exists to communicate more clearly which cost meaning is being conveyed. Some examples include average cost, common cost, full cost, historical cost, joint cost, marginal cost, period cost, product cost, standard cost, fixed cost, opportunity cost, sunk cost, and variable cost, just to name a few.

We begin this chapter with the concept of opportunity cost, a powerful tool for under- standing the myriad cost terms and for structuring managerial decisions. In addition, opportunity cost provides a benchmark against which accounting-based cost numbers can be compared and evaluated. Section B discusses how opportunity costs vary with changes in output. Section C extends this discussion to cost–volume–profit analysis. Section D compares and contrasts opportunity costs and accounting costs (which are very different). Section E describes some common methods for cost estimation.

A. Opportunity Costs When you make a decision, you incur a cost. Nobel Prize–winning economist Ronald Coase noted, “The cost of doing anything consists of the receipts that could have been obtained if that particular decision had not been taken.”1 This notion is called opportunity cost—the benefit forgone as a result of choosing one course of action rather than another. Cost is a sacrifice of resources. Using a resource for one purpose prevents its use else- where. The return forgone from its use elsewhere is the opportunity cost of its current use. The opportunity cost of a particular decision depends on the other alternatives available.

The alternative actions comprise the opportunity set. Before making a decision and calculating opportunity cost, the opportunity set itself must be enumerated. Thus, it is important to remember that opportunity costs can be determined only within the context of a specific decision and only after specifying all the alternative actions. For example, the opportunity set for this Friday night includes the movies, a concert, staying home and studying, staying home and watching television, inviting friends over, and so forth.

The opportunity cost concept focuses managers’ attention on the available alterna- tive courses of action. Suppose you are considering three job offers. Job A pays a salary of $100,000, job B pays $102,000, and job C pays $106,000. In addition, you value each job differently in terms of career potential, developing your human capital, and the type of work. Suppose you value these nonpecuniary aspects of the three jobs at $8,000 for A, $5,000 for B, and only $500 for C. The following table summarizes the total value of each job offer. You decide to take job A because it has the highest total pecuniary and nonpe- cuniary compensation. The opportunity cost of job A is $107,000 (or $102,000 + $5,000), representing the amount forgone by not accepting job B, the next best alternative.

Job Offer Salary $ Equivalent of Intangibles Total Value

A $100,000 $8,000 $108,000 B 102,000 5,000 107,000 C 106,000 500 106,500

1R. Coase, Business Organization and the Accountant, originally published in Accountant, 1938. Reprinted in L.S.E. Essays in Cost, ed. J. Buchanan and G. Thirlby (New York University Press, 1981), p. 108.

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The decision to continue to search for more job offers has an opportunity cost of $108,000 if job offer A expires. If you declined job offer L last week, which had a total value of $109,000, this job offer is no longer in the opportunity set and hence is not an opportunity cost of accepting job A now. Besides jobs A, B, and C, you learn there is a 0.9 probability of receiving job offer D, which has a total value of $110,000. If you wait for job D and you do not get it, you will be forced to work in a job valued at $48,000. Job D has an expected total value of $103,800 (or $110,000 × 0.9 + $48,000 × 0.1). Since job D’s opportunity cost of $108,000 (the next best alternative forgone) exceeds its expected value ($103,800), you should reject waiting for job offer D.

Opportunity costs are not necessarily the same as payments. The opportunity cost of taking job A included the forgone salary of $102,000 plus the $5,000 of intangibles from job B. The opportunity cost of going to a movie involves both the cash outlay for the ticket and popcorn, and also forgoing spending your time studying or attending a concert. Remem- ber, the opportunity cost of obtaining some good or service is what must be surrendered or forgone in order to get it. By taking job A, you forgo job B at $107,000.

Opportunity costs are forward looking. They are the estimated forgone benefits from actions that could, but will not, be undertaken. In contrast, accounting is based on his- torical costs in general. Historical costs are the resources expended for actions actually undertaken. Opportunity cost is based on anticipations; it is necessarily a forward-looking concept. Job offers B, C, and D are part of the opportunity set when you consider job A, but job offer L, which expired, is no longer part of the opportunity set. Your refusal of job L last week is not an opportunity cost of accepting job A now.

Opportunity costs differ from (accounting) expenses. Opportunity cost is the sacrifice of the best alternative for a given action. An (accounting) expense is a cost incurred to generate a revenue. For example, consider an auto dealer who sells a used car for $7,500. Suppose the dealer paid $6,500 for the car and the best alternative use of cars like this one is to sell them at auction for $7,200. The car’s opportunity cost in the decision to keep it for resale is $7,200, but in matching expenses to revenues, the accounting expense is $6,500. Financial accounting is concerned with matching expenses to revenues. In decision mak- ing, the concern is with estimating the opportunity cost of a proposed decision. We return to the difference between opportunity and accounting costs in section D.

Several examples illustrate opportunity costs. The first four examples pertain to raw mate- rials and inventories.

Opportunity cost of materials (no other uses) What is the opportunity cost of materials for a special order if the materials have no other use and a firm has these materials in stock? The firm paid $16,000 for the materials and anticipates no other orders in which it can use these materials. The opportunity cost of these materials is whatever scrap value they may have. If the materials have no alternative use and they have no storage or disposal cost, their opportunity cost is zero. In fact, the opportunity cost is negative if the firm incurs costs for storing the product and if disposal is costly.

Opportunity cost of materials (other uses) The opportunity cost of materials not yet purchased for a job is the estimated cash outflow necessary to secure their delivery. If the materials are already in stock, their opportunity cost is their highest-valued use elsewhere. If the materials will be used in another order,

1. Characteristics of Opportunity Costs

2Some of the examples presented here are drawn from Coase (1938), pp. 10–22.

2. Examples of Decisions Based on Opportunity Costs2

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using them now requires us to replace them in the future. Hence, the opportunity cost is the cost of replacement.

Interest on inventory as an opportunity cost An automobile manufacturer plans to introduce a new car model. Included in the opportu- nity cost of the new model are the payments for materials, labor, capital, promotion, and administration. Opportunity cost also contains the interest forgone on the additional inven- tory of cars and parts the firm carries as part of the normal operations of manufacturing and selling cars. If the average inventory of materials, work in process, and finished cars is $125 million and the market rate of interest for this type of investment is 10 percent, then the opportunity cost of interest on this investment is $12.5 million per year.

The next raw material example introduces the concept of sunk costs, expenditures that have already been made and are irrelevant for evaluating future alternatives.

Sunk costs and opportunity costs A firm paid $15,000 for a coil of stainless steel used in a special order. Twenty percent (or $3,000 of the original cost) of the coil remains. The remaining steel in the coil has no alternative use; a scrap steel dealer is willing to haul it away at no charge. The remaining

Many large corporations around the world now have sustainability programs that create long-term shareholder value by identifying opportunities and managing risks from eco- nomic, environmental, and social developments. For example, in 2013 the catastrophic collapse of the Rana Plaza building in Bangladesh killed more than 1,100 garment workers. This plant produced apparel for some of the world’s largest retailers such as H&M, Marks and Spencer, and Zara. Even though the plant was not owned by any of these retailers, they came under intense criticism by the media, governments, and customers for not imposing tighter building inspections of their Bangladesh supplier. Sustainability programs seek to identify, measure, and integrate social, environmental, and economic impacts into corporate strategy and into management decisions to man- age those impacts successfully and increase long-run profitability. As such, firms that outsource significant amounts of their products now proactively monitor the workplace safety of their suppliers. Before Nike introduces new footwear, the product design team compares alternative materials in terms of not just cost but also environmental impacts such as energy use, greenhouse gas emissions, water use, land use, and waste and chem- ical use. By improving the environment, Nike hopes to increase the future demand for its products.

Well-functioning sustainability programs capture the opportunity cost of decisions managers make today on future cash flows of the firm arising from social, environ- mental, and political processes. For example, Home Depot drops suppliers that violate its workplace standards for safety and child labor. By not doing business with such firms, Home Depot reduces its risk of costly publicity if a supplier has an adverse event. PepsiCo has conservation programs to reduce its water use to minimize future water shortages and scarcity, especially in the arid Middle East and Africa. Because water makes up most of Pepsi’s beverages, future water shortages can have a devastating impact on Pepsi’s products. In 2013, Pepsi estimated water-flow savings of more than 14 billion liters. Pepsi’s water sustainability program views the opportunity cost of not undertaking water conservation programs today to be quite high. SOURCE: M. Epstein and A. Buhovac, “A New Day for Sustainability,” Strategic Finance (July 2014) pp. 25–33. www.pepsico.com/Purpose/Environmental-Sustainability/Water

Managerial Application: Sustain- ability and Opportunity Costs

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$3,000 of the original cost is a sunk cost. Sunk costs are expenditures incurred in the past that cannot be recovered. The $3,000 is sunk because it has already been incurred and is not recoverable. Because it cannot be recovered, the $3,000 should not influence any decision. In this case, the remaining steel coil has a zero opportunity cost. Sunk costs are irrelevant for future uses of this stainless steel. Suppose the scrap dealer is willing to pay $500 for the remaining coil. Using the remainder in another job now has an opportunity cost of $500.

Remember that sunk costs are irrelevant for decision making unless you are the one who sunk them. However, sunk costs are not irrelevant as a control device. Holding managers responsible for past actions causes them to take more care in future decisions. Suppose $4 million was spent on new software that doesn’t work and the firm buys a commercial package to replace it. The manager responsible for the failed software devel- opment will be held accountable for the failure and will have incentives to consume more firm resources trying to either fix it or cover up its failure before this knowledge becomes widely known.

The next example applies the opportunity cost concept to evaluating alternatives regarding labor.

Opportunity cost of labor Suppose a firm’s work force cannot be changed because of existing labor agreements. Employees are guaranteed 40 hours of pay per week. For the next three weeks, only 35 hours of work per week per employee exists. What is the cost of taking a special order that will add five hours of work per employee? One is tempted to cost the five hours of labor in the special order at zero because these employees must be paid anyway. But the

Following the accounting scandal at Enron and the demise of Arthur Andersen, the U.S. government enacted the Sarbanes–Oxley Act of 2002, the “Public Company Account- ing Reform and Investor Protection Act.” This law has many provisions, including the requirement that large public companies and their auditors must report annually that management has “an adequate internal control structure and procedures for financial reporting.” This provision, known as section 404 of the act, caused the greatest concern among publicly traded companies.

In a survey of U.S. firms, CFO magazine reports that 48 percent of companies will spend at least $500,000 complying with Sarbanes–Oxley, with 52 percent reporting that their compliance has yielded no benefits for their company.

In addition to the direct costs of complying with Sarbanes–Oxley, the act is impos- ing significant opportunity costs on companies. The CFO of the $5 billion Constellation Energy Group believes that the law makes the “fear of personal liability so great that managers are afraid to take risks on innovation.” Some 33 percent of the CFO-surveyed companies have delayed or canceled projects so they can comply with the law. Finan- cial executives have less time to make strategic decisions as compliance efforts absorb 10 percent of a CFO’s time in 40 percent of the companies. More small, publicly traded companies are going private because the cost of remaining public has increased. This deprives these companies of the benefits of being public, such as access to public equity markets and liquidity for equity investments.

But not everyone has been harmed by Sarbanes–Oxley. The law has been a wind- fall for auditors, lawyers, and software firms. SOURCE: A. Nyberg, “Sticker Shock: The True Costs of Sarbanes-Oxley Compliance,” CFO, September 2003, pp. 51–62.

Managerial Application: The Costs of the Sarbanes– Oxley Act

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question remains: What will these employees do with the five hours if this special order is rejected? If they would do preventive maintenance on the machines or do general maintenance or improve their skills through training, then the opportunity cost of the labor for the special order is not zero but the value of the best forgone alternative use of the employees’ time.

Public accounting firms confront this issue. The summer months tend to be low- demand periods relative to year-end. How the firm prices summer (off-peak) audits depends in part on the perceived opportunity cost of the staff’s time.

If a firm owns long-lived assets such as buildings and equipment, understanding their opportunity costs involves alternative uses of these assets. The next three examples describe the opportunity costs of capital assets.

Asset depreciation as an opportunity cost Using assets can affect their value. Suppose a delivery van used four days a week can be sold next year for $34,000. If additional business is taken and the delivery van is used six days a week, its market value next year will be $28,000. Depreciation due to use for the additional business is $6,000 ($34,000 − $28,000). Additional labor for the driver’s time, maintenance, gasoline, and oil are required.

The opportunity cost of using an asset is the decline in its value. Accounting depreciation (such as straight-line depreciation) is based on historical costs. Accounting deprecia- tion does not necessarily reflect the opportunity cost of the van (its decline in value from use). However, accounting depreciation can be a reasonably accurate approximation of the decline in the market value of the asset. In any given year, accounting depreciation may not exactly capture the decline in the asset’s market value. However, over the asset’s economic life, accumulated accounting depreciation equals the decline in value. Holding managers responsible for accounting depreciation commits them to recovering the histori- cal cost of the asset in either additional revenues or cost savings.

Interest on an asset as an opportunity cost If the asset can be sold, then interest should be included as an opportunity cost. If the asset has no resale value, then obviously no interest is forgone. For example, a local area net- work and servers are purchased for $100,000. The interest rate is 8 percent. Should inter- est on the capital tied up in the hardware ($8,000) be included as a cost in the decision to continue to use the system? If the equipment has no market value, then interest is not a cost because the firm is not forgoing selling the hardware and earning interest on the proceeds. If the system can be sold, then the forgone interest on the proceeds is a cost. Chapter 3 presents an expanded discussion of the opportunity cost of a capital investment.

Opportunity cost of excess capacity Suppose a plant operates at 75 percent capacity. Is the firm forgoing profits on the 25 percent of idle capacity? It is usually optimal to have some “excess” capacity in order to absorb random shocks to normal production, such as machine breakdowns and demand fluctuations, which increase production time and costs. When plants are built, rarely are they expected to run at 100 percent capacity. As plant utilization increases, per-unit costs increase as congestion rises. The opportunity cost of increasing the plant’s expected utili- zation, say from 75 percent to 85 percent of capacity, is the higher production cost imposed on the existing units that currently utilize 75 percent of the capacity.

Consider this illustration. The following table lists the output of a plant in units of pro- duction and the average cost per unit. Average costs rise as volume increases because con- gestion increases. This causes more machine breakdowns, and indirect labor (expediters, material handlers, production schedulers) must be hired to manage the increased

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congestion. The plant is currently operating at 75 percent capacity (150 units) and incur- ring average costs of $6.04 per unit.

Units Capacity Average Cost

130 65% $6.00 140 70 6.02 150 75 6.04 160 80 6.06 170 85 6.08 180 90 6.11 190 95 6.15 200 100 6.20

Suppose production increases from 150 units (75 percent capacity) to 170 units (85 percent capacity). Increasing production by an extra 20 units causes the average cost of the base production of 150 units to rise from $6.04 to $6.08, or 4¢ per unit. The oppor- tunity cost of producing 20 more units is not the average cost of $6.08 but the incremental cost of the last 20 units, $6.38 (or [(170 × $6.08) − (150 × $6.04)] ÷ 20 units). Another way of computing the opportunity cost of the last 20 units is

$6 . 38 = $6 . 08 + ( 4¢ × 150 ) ÷ 20 Or the opportunity cost of producing 20 more units is composed of their average cost ($6.08) plus the cost increase that each of the 20 units imposes on the first 150 units [(4 ¢ × 150) ÷ 20].

The final example describes evaluating the opportunity costs of introducing new products.

Opportunity cost of product line cannibalization A company that produces tablet computers has 60 percent of a particular market niche. The company plans to introduce a new, high-end, faster tablet with additional features. The major competition for the new tablet is the firm’s current high-end tablet. In the first year, management projects sales of the new model to be 20,000 units. Sales of the exist- ing tablet are expected to fall by 7,000 units. Thus, the new tablet “cannibalizes” the old tablet’s sales by 7,000 units. Are the forgone profits from the 7,000 units that could have been sold an opportunity cost of introducing the new tablet? It depends on the opportunity set. If management expects competitors to introduce a device that competes with the old tablet, meaning that the company is likely to have lost those units anyway, then the profits forgone on the 7,000 units are not an opportunity cost of introducing the new tablet.

Q2–1 Define opportunity cost. Q2–2 What are some characteristics of opportunity costs? Q2–3 A firm paid $8,325 last year for some raw material it planned

to use in production. When is the $8,325 a good estimate of the opportunity cost of the material?

Q2–4 Define sunk cost and give an example. Q2–5 What are avoidable and unavoidable costs? How are they

related to opportunity costs?

Concept Questions

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B. Cost Variation Managers commonly decide how many units to produce or how much service to provide during a certain time period. Apple must decide how many Apple watches of a par- ticular model to manufacture next quarter. United Airlines must decide whether to fly a 90-passenger jet or a 130-passenger jet between Denver and Palm Springs next month. Making these decisions requires an understanding of how costs change with volume—the topic of this section.

Cost behavior is defined relative to some activity, such as the number of units produced, hours worked, pounds of ore mined, miles driven, or meals served. Usually, units produced is the measure of activity. For example, consider Figure 2–1, which illustrates the general relation between cost and units produced. Two important points emerge from Figure 2–1. First, even with no units produced, the firm still must incur some costs. The costs incurred when there is no production are called fixed costs. If the plant is idle, some costs such as property taxes, insurance, plant management, security, and so on must be incurred to pro- vide production capacity. For example, Intel acquires land and builds a plant to manufac- ture a specific quantity of microprocessors. It pays annual property taxes of $1.75 million on this land. The $1.75 million expenditure on property taxes is part of the cost Intel pays to have this manufacturing capacity at this plant.

Second, in general the cost curve is not a straight line as output expands, but rather is curvilinear. The particular shape of the curve arises because marginal cost varies with the level of production. Marginal cost is the cost of producing one more unit. In Figure 2–1, marginal cost is the slope of a line drawn tangent to the total cost curve. For the first few units, such as to the left of output level X, the slope of the tangent is quite steep. The marginal cost for the first few units is high because employees must be hired, suppli- ers must be found, and marketing channels must be opened. Therefore, the cost of starting operations and producing the first few units may be extremely high. Expanding output beyond the first few units allows the organization to achieve smooth, efficient production techniques. At normal production rates, the marginal cost of making additional units is rel- atively low. At high levels of output (output level Y), additional costs are incurred because of constraints on the use of space, machines, and employees. Machines are more likely to fail when operating at or near capacity. Labor costs increase because employees are paid for overtime. Therefore, the marginal cost of making additional units when operating near capacity is higher than under normal operations.

1. Fixed, Marginal, and Average Costs

FIGURE 2–1

Nonlinear cost curve

X Y

A

B

Total cost

Fixed cost

Units produced

Cost

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By definition, a fixed cost is not an opportunity cost of the decision to change the level of output. The decision to expand output usually does not affect property insurance premi- ums. Therefore, property insurance is a fixed cost with respect to volume and is not a cost when deciding to increase output.

The fact that a cost is fixed with respect to volume changes, however, does not mean that it cannot be managed or reduced. A firm can reduce insurance premiums by increas- ing deductibles or by lowering the risks being insured (installing fire alarms and sprinkler systems). Many fixed costs can be altered in the long run, in the sense that a particular plant can be closed. If a cost is fixed, this does not mean it is a constant and known with certainty. Fixed costs vary over time due to changes in prices. But fixed costs do not vary with changes in the number of units produced.

Another important cost term is average cost. Average cost per unit is calculated by dividing total cost by the number of units produced. Average cost is the slope of the line drawn from the origin to the total cost curve and is depicted in Figure 2–2 as the slope of the line from point O through point C.3 The average cost at output level Z represents the cost per unit of producing Z units. For the pattern of costs in Figure 2–2, the average cost per unit is very high at low levels of output but declines as output increases. The average cost per unit only increases as output nears capacity. Notice that at Z units of production, the average cost is larger than the marginal cost. (The slope of OC is steeper than the slope of the tangent at point C.)

3Recall that the slope of a line is the ratio of the change in its vertical distance divided by the change in its horizontal distance. In Figure 2–2, the slope of the line OC is the distance CZ divided by the distance OZ. CZ ÷ OZ is the total cost of producing Z units divided by Z units, which is the average cost of producing Z units.

MGM Studios produces and distributes entertainment products worldwide, including motion pictures, television programming, home video, interactive media, and music. The company owns a large film library, consisting of approximately 4,000 titles. MGM significantly improved its operating performance after a careful analysis of the fixed and variable costs of distributing movies to local cinemas. It reduced head count 10 percent and stopped distributing independent films through United International Pic- tures. It now distributes these films itself. This allowed MGM to convert a large fixed cost into a variable cost. SOURCE: L. Calabro, “Everything in Moderation,” CFO, February 2004, pp. 59–65.

Managerial Application: Metro- Goldwyn- Mayer Inc.

FIGURE 2–2

Average and marginal cost

O Z

C

Total cost

Fixed cost

Units produced

Cost

Marginal cost at Z is the slope of the line tangent at C

Average cost at Z is slope of the line from O to C

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The cost of changing production levels is not always easy to estimate. Estimating the total cost curve in Figure 2–1 requires knowledge of both fixed cost and how the total costs of facilities, labor, and materials varies as the rate of production increases. Such estimates are difficult to obtain, so managers often approximate these costs. One such approximation assumes the curve is linear instead of curvilinear.

An approximation of total cost in Figure 2–1 using a linear cost curve is displayed in Figure 2–3. In this figure, estimating total cost requires an estimate of the y-axis intercept and the slope of the straight line. The intercept, FC, approximates the fixed costs. The slope of the line is the variable cost per unit. Variable costs are the additional costs incurred when output is expanded. When Honda expands the production of minivans at a particular

2. Linear Approximations

Exercise 2–1

Suppose that a plant making steam boilers has the following costs per month:

Number of Boilers Total Cost

1 $ 50,000 2 98,000 3 144,000 4 184,000 5 225,000 6 270,000 7 315,000 8 368,000 9 423,000 10 480,000

Required:

a. What are the marginal and average costs for each level of output?

b. The plant is currently making and selling eight boilers per month. The company can sell another steam boiler for $53,000. Should the company accept the offer?

Solution:

a.

b. The company should reject the offer because the marginal cost of making the ninth boiler is $55,000, whereas the price is only $53,000. The average cost of $47,000 should not be used in this decision.

Number of Boilers Total Cost Marginal Cost Average Cost

1 $ 50,000 $50,000 $50,000 2 98,000 48,000 49,000 3 144,000 46,000 48,000 4 184,000 40,000 46,000 5 225,000 41,000 45,000 6 270,000 45,000 45,000 7 315,000 45,000 45,000 8 368,000 53,000 46,000 9 423,000 55,000 47,000

10 480,000 57,000 48,000

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plant from 200 to 250 vans per day, it must buy more parts, hire more employees, use more power, and so forth. All costs that increase when more vans are produced are variable costs.4

In Figure 2–3, the straight line is the sum of the fixed and variable cost approxima- tions of total cost. The line is closest to the total cost in the range of normal operations. This range between output levels X and Y is called the relevant range. The relevant range encompasses the rates of output for which the sum of fixed and variable costs closely approximates total cost. Because the slopes of the total cost curve and the fixed and vari- able cost curve are about the same, the variable cost is a close approximation of the mar- ginal cost. In the relevant range, variable cost can be used to estimate the cost of making additional units of output.

Notice that variable cost per unit approximates marginal cost per unit. The slope of the variable cost line is constant as the activity measure increases. Variable cost per unit is usually assumed to be constant. Later chapters relax this assumption. The terms marginal cost and variable cost are often used interchangeably, but the two are not necessarily the same. Marginal cost refers to the cost of the last unit produced and in most cases varies as volume changes. In some situations, marginal cost per unit does not vary with volume. Then marginal cost (per unit) and variable cost per unit are equal.

The straight-line approximation of total cost can be represented by the following equations:

Total cost = Fixed cost + Variable cost Total cost = Fixed cost + (Variable cost per unit)(Units produced)

TC = FC + VC × Q

where TC represents total cost, FC represents fixed cost, VC is variable cost per unit, and Q is the number of units. For example, suppose the fixed cost is $100,000 per month, the variable cost per unit is $3, and 15,000 units are to be manufactured. Total cost is calcu- lated to be $145,000 (or $100,000 + $3 × 15,000 units). The total cost of $145,000 is an estimate of the cost of manufacturing 15,000 units.

4While most managers understand intuitively the difference between fixed and variable costs, not everyone does. When asked the difference between a fixed cost and a variable cost, one employee replied, “A fixed cost? If it’s broke, I fix it and it costs me.” See R. Suskind, “Guys Holding Axes and Chainsaws Get to Use Any Name They Like,” The Wall Street Journal, February 26, 1992, p. B1.

FIGURE 2–3

Linear approximation of total cost

Y

A

Total cost

Fixed cost,

FC

Units produced

Costs

B

Total variable cost at Y

Fixed cost

X Relevant range

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Some costs vary with output (variable costs) and others do not (fixed costs). Between these two extreme cases are step costs and mixed (semivariable) costs. Each of these is described in turn and illustrated in Figure 2–4.

Step costs One type of cost behavior involves step costs, expenditures fixed over a range of output levels (line I in Figure 2–4). For example, each supervisor can monitor a fixed number of employees. As output expands and the number of supervisors increases with the number of employees, the resulting increases in supervisory personnel expenditures are a step func- tion. Likewise, once the number of transactions a computer system can process is exceeded, a larger machine is required. Expenditures on computers often behave as step costs.

Mixed (semivariable) costs Many costs cannot be neatly categorized as purely fixed or variable. The cost of electricity used by a firm is a good example. Producing more output requires some additional electric- ity. But some portion of the electric bill is just for turning on the lights and heating or cooling the plant whether the plant produces 1 unit or 50,000 units. In this case, the cost of electricity is a mixture of fixed and variable costs. Mixed or semivariable costs are cost categories that cannot be classified as being purely fixed or purely variable (line II in Figure 2–4).

The discussion so far has focused on how total cost varies with changes in output (units produced). Output is the measure of activity. Consider a steel mill that makes 1 million tons of two-inch steel plate in one month and 1 million tons of one-inch steel plate in the next month. The cost of the one-inch steel plate will likely be higher because more work is required to roll out the thinner plate. In this factory, costs vary not only with weight of the output but also with its thickness. In general, costs vary based on units produced as well as on the size, weight, and complexity of the product.

In many costing situations, managers choose a single activity measure, such as the total number of toys painted or pounds of toys painted. This activity measure is then assumed to be the primary cost driver. The cost driver is that measure of physical activity most highly associated with variations in cost. For example, in the painting department, the quantity of paint used often will be chosen as the cost driver if it has the highest association with total costs in the painting department.

An input measure, such as the quantity of paint used, is often used as a single cost driver to capture the many factors and to simplify the process of estimating total cost. The choice of the activity/volume measure is often critical to the perceived variation of costs. This issue is discussed in greater detail in Chapter 11.

3. Other Cost Behavior Patterns

4. Activity Measures

FIGURE 2–4

Step and mixed costs

II

Units produced

Total dollars

I Step cost

Mixed (semivariable)

cost

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The problem with using a single activity measure is that it can be correct for one class of decisions but incorrect for others. Such categorizations indicate how costs vary but only for that particular decision. For example, expanding the volume of an existing product in a given plant will cause a different set of costs to vary than will adding a new product line in the same plant or expanding the volume of a given product by building a new plant. Consider an automobile assembly line producing a single car model. Adding 125 cars per day of a second car model costs more than increasing production of the existing model by 125 cars. More labor is required to schedule, order parts, and store them for two different models than if just one model is produced. Thus, the variable costs of 125 cars depend on whether the additional cars are for an existing model or a new model.

Some costs are fixed with respect to some decisions but not others. Consider machine setups. Before a computer-controlled milling machine can begin milling parts, a technician must set up the machine by loading the proper computer program, loading the correct tools into the machine, adjusting the settings, making a few parts, and checking their tolerances. Once set up, the machine can produce a large number of parts without another machine setup. The cost of the setup is the cost of the technician’s time, the material used to check the machine, and the forgone profits of not using the machine while it is being set up. This setup cost is independent of the number of units produced and thus is a fixed cost. However, if the machine produces 1,000 parts per batch, expanding volume from 1,000 parts to 2,000 parts doubles the number of setups and doubles the setup costs. On the other hand, if the plant increases volume to 2,000 parts by doubling batch size, setup costs remain fixed. Therefore, classifying setup costs as being either fixed or variable can be right for some decisions and wrong for others, depending on whether batch sizes change. If some decisions cause batch sizes to change and others do not, then any classification of setup costs as fixed or variable will be wrong for some decisions.

Exercise 2–2

Total cost in the painting department of a toy factory varies not only with the number of toys painted but also with the sizes of the toys, the types of surfaces painted, the kinds of paint applied, and so on.

Paint costs $15 per gallon. To set up the painting machines to paint a part costs $500, which includes cleaning out the old color. Using the paint machine for one hour costs $70, which also includes the labor to operate it.

A particular part with 4,200 pieces in the batch requires 10 gallons of paint and eight hours of paint machine time.

Required:

Calculate the total cost to paint this batch.

Solution:

Using multiple activity bases, the cost of painting this part is calculated as

Setup cost $ 500 Paint 150 Machine time 560 Total painting cost $ 1,210

Notice that the cost of painting the parts includes a fixed setup cost of $500, which does not vary with the number of parts painted.

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C. Cost–Volume–Profit Analysis Once costs are classified into fixed/variable categories, managers can perform cost– volume–profit analysis. The following example illustrates the essential features of this analysis. Suppose Xerox Corp. has a walk-up copy division that places coin-operated color photocopying machines in public areas such as libraries, bookshops, and supermarkets. Customers pay 25¢ per copy and the store providing the space receives 5¢ per copy. Xerox provides the machine, paper, toner, and service. Machines are serviced every 20,000 cop- ies at an average cost of $200 per service call. Paper and toner cost 4¢ per copy. Xerox’s walk-up copy division is charged $150 per month per machine placed (the opportunity cost of the machine). The variable costs per copy are

Paper and toner $ 0.04 Store owner 0.05 Service ($200 ÷ 20,000) 0.01 Variable costs $ 0.10

The contribution margin is the difference between the price and the variable cost per copy. The contribution margin is the net receipts per copy that are contributed toward covering fixed costs and providing profits. In this example, the contribution margin is calculated as

Price $ 0.25 Less variable costs (0.10) Contribution margin $ 0.15

Given the contribution margin and monthly fixed costs, the number of copies each machine must sell monthly to recover fixed costs is the ratio of fixed costs to the contribution margin. This quantity of copies is called the break-even point and is cal- culated as

Break-even point = Fixed costs _______________ Contribution margin = $150 _____ $0.15 = 1, 000 copies

In other words, if the copier makes 1,000 copies each month, it produces net receipts (after variable costs) of $150 (or 1,000 × $0.15), which is just enough to recover the fixed costs.

The Xerox copier example illustrates that classifying costs into fixed and variable components provides a simple decision rule as to where to place copiers. If a store is

1. Copier Example

Q2–6 Define mixed cost and give an example. Q2–7 Define step cost and give an example. Q2–8 Define fixed cost. Q2–9 Define variable cost. Is it the same as marginal cost?

Explain.

Concept Questions

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expected to produce (or actually produces) fewer than 1,000 copies per month, a copier should not be located there. The break-even volume provides a useful management tool for where to place machines.

Let us study the cost–volume–profit analysis further. For simplicity, assume that production equals sales (to avoid inventory valuation issues such as the LIFO/FIFO choice). Also assume that the firm produces a single product. Figure 2–5 displays the total cost and reve- nue of producing various levels of output. The total revenue curve has a decreasing slope beyond some quantity because more unit sales can be achieved only at lower prices. At high prices, volumes are low. As prices fall, volume increases and the slope of the total revenue curve becomes less steep. The total cost curve, also nonlinear, is the same cost curve depicted in Figure 2–1. Break-even occurs when total revenues equal costs. In Figure 2–5, two break-even volumes exist, labeled “Break-even point 1” and “Break-even point 2.” The profit-maximizing point of output occurs when marginal revenue equals marginal cost (MC = MR). Marginal revenue refers to the receipts from the last unit sold. At any point, marginal revenue is the slope of the line just tangent to the total revenue curve.

As described in section B, it is difficult to estimate nonlinear functions. Linear approx- imations are often used. Figure 2–6 substitutes linear cost and linear revenue approxi- mations for nonlinear curves. Instead of allowing price to vary with quantity, assume a constant price, P. The total revenue function, TR, is then

TR = P × Q

where Q is output. If the firm can sell as much as it wants without affecting price, then assuming a linear revenue function, TR, does not distort the analysis. Likewise, total cost is assumed to follow a linear function of the form

TC = FC + VC × Q

where FC is the fixed cost and VC is the variable cost per unit. For the moment, ignore income taxes.

2. Calculating Break-Even and Target Profits

FIGURE 2–5

Total cost and revenue curves

Dollars Total cost

MR Total revenue

MC

FC

Break-even point 1

Pro�t- maximizing

point

Break-even point 2

Units produced

MC: Marginal cost is the slope of the total cost curve. MR: Marginal revenue is the slope of the total revenue curve. MC and MR are equal at the pro�t-maximizing point.

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Using linear functions allows managers to simplify analyzing how profits vary with output. In particular,

Profit = TR − TC = P × Q − VC × Q − FC (2.1) Profit = ( P − VC ) × Q − FC (2.2)

Break-even volume is the number of units sold that just covers fixed and variable costs. To find break-even volume, QBE, set equation (2.2) equal to zero and solve for QBE.

Profit = 0 = ( P − VC ) × Q BE − FC ( 2 . 3 )

Q BE = FC _____ P − VC = FC _________________ Contribution margin =

FC ___ CM

Price minus variable costs (P − VC), the contribution margin per unit (CM), is the profit per unit sold that can be used to cover fixed costs (FC). Contribution margin is important because it measures the incremental net receipts of selling one more unit. Refer to Figure 2–6. If units produced is less than the break-even point, a loss occurs. If output exceeds break-even quantity, a profit is earned.

Note that the estimated break-even point, QBE, will not exactly correspond to the “real” break-even point, where total revenue equals total cost. The discrepancy occurs because TR and TC do not represent exactly total revenue and total costs, respectively.

Suppose we want to make a target after-tax profit of ProfitT and the income tax rate is t. We can compute the number of units needed to make an after-tax profit by modifying equation (2.2) and solving for QT, target output:

Profit t = [ Q T × ( P − VC ) − FC ] × ( 1 − t ) (2.4)

Q T = Profit t __________ (1 − t) × CM +

FC ____ CM (2.5)

Instead of memorizing this formula, it is better to start with equation (2.1) or (2.2) and make the necessary modifications to solve the particular problem at hand. Exercise 2–3 illustrates how to modify the formula.

FIGURE 2–6

Linear approximations of cost and revenue curves and cost– volume–profit analysis

Dollars

Pro�t

Loss FC

Break-even point 1

TR

TC

Units produced

FC: Fixed cost TR: Total revenue equals a constant price times total output (P 3 Q) TC: Total cost equals �xed costs plus the variable cost per unit times output (FC 1 VC 3 Q)

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Exercise 2–3

DGA Tile manufactures ceramic flooring tiles. DGA’s annual fixed costs are $740,000. The variable cost of each tile is $0.25, and tiles are sold for $6.50. DGA has a combined state and federal tax rate of 45 percent.

Required:

a. How many tiles does DGA need to make and sell each year to earn an after-tax profit of $85,000?

b. DGA must pay 10 percent of before-tax profits as a royalty payment to its founder. Now how many tiles must DGA make and sell to generate $85,000 after taxes? (Assume the royalty payment is not a tax-deductible expense.)

Solution:

a. Let Q denote the number of tiles made and sold that generates $85,000 of after-tax profit. Given the preceding data, we can write

( $6.50 Q − $0 . 25 Q − $740, 000 ) ( 1 − 0 . 45 ) = $85, 000 ( 6 . 25 Q − $740, 000 ) × 0 . 55 = $85, 000

Solving for Q: $3.4375 Q = $85, 000 + $740, 000 × 0 . 55

Q = 143, 127 tiles

Therefore, to generate an after-tax profit of $85,000, about 143,000 tiles must be sold.

b. The formula with the royalty payment, R, is

($6.25 Q − $740,000) × 0.55 − R = $85,000 where

R = ( $6.25 Q − $740, 000 ) × 0 . 10 Substituting R into the earlier equation,

( $6.25 Q − $740, 000 ) ( 0.55 − 0.10 ) = $85, 000 Q = 148, 622

The following exercise illustrates another use of contribution margins. It involves choosing the most profitable product to produce when capacity is constrained.

Exercise 2–4

The Ralston Company produces three shirts. It only has 200 machine hours per day to produce shirts and has the following cost and production information:

Basic Deluxe Super

Selling price $7.50 $9 $13 Variable cost of production $6.00 $7 $7 Machine hours to complete one shirt 0.6 2 3 Demand per day (shirts) 50 50 50

Ralston has fixed costs of $75 per day. How many shirts of each type should be produced?

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The Ralston Company example illustrates a very simple situation in which there is only one constraint. If there are multiple constraints, linear programming is a useful tech- nique for identifying the profit-maximizing mix of products. The next section describes some of the shortcomings of cost–volume–profit analysis.

3. Limitations of Cost–Volume– Profit Analysis

Solution:

The opportunity cost of producing one type of shirt arises from not using those machine hours to produce another type of shirt. In this problem, to maximize firm profits in light of a capacity constraint, we must produce those products with the highest contribution margin per unit of capacity. First calculate the contribution margin per shirt and then convert this to the contribu- tion margin per machine hour.

Basic Deluxe Super

Selling price $7.50 $9 $13 Variable cost of production $6.00 $7 $7 Contribution margin per shirt $1.50 $2 $6 Hours to complete one shirt ÷ 0.6 ÷ 2 ÷ 3 Contribution margin per machine hour $2.50 $1 $2 Demand per day (shirts) 50 50 50 Production schedule (shirts) 50 10 50 × Hours to complete one shirt 0.6 2 3 Hours consumed 30 20 150

To maximize profits, Ralston should produce the shirt(s) with the highest contribution margin per unit of scarce resource (machine hours). This is an application of the opportu- nity cost principle. Even though super has the highest contribution margin per unit, basic has the highest contribution margin per machine hour. Therefore, to maximize profits, produce 50 units of basic, which will consume 30 hours (or 50 units × 0.6 hours per unit). Next, pro- duce 50 units of super, which consumes 150 hours of capacity. This leaves 20 hours of capac- ity to be used to produce 10 units of deluxe.

The preceding analysis suggests producing the market demand for basic and super but not for deluxe. Fixed costs never enter the analysis. By definition, fixed costs are fixed and cannot be relevant to the decision, which depends only on selling price, variable cost, and the capacity constraint.*

*One artificial aspect of this exercise is that the quantity demanded and the price are taken as constants. Clearly, at lower prices, more shirts will be demanded. Fixed demand is assumed to simplify the problem.

Exercise 2–5

Using equation (2.2), find the output, Q, that maximizes profits.

Solution:

Profits are maximized by setting output to infinity. That is, equation (2.2) cannot be used to maximize profits.

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Exercise 2–5 illustrates that cost–volume–profit analysis is not useful for choosing the profit-maximizing output quantity when both revenues and costs are assumed linear. Given this conclusion, what good is it? Cost–volume–profit analysis offers a useful place to start analyzing business problems. It gives managers an ability to do sensitivity analy- sis and ask simple what-if questions. And, as we saw in the copier example, break-even analysis can prove useful for certain types of decisions. However, several limitations of cost–volume–profit analysis exist:

1. Price and variable cost per unit must not vary with volume. 2. Cost–volume–profit is a single-period analysis. All revenues and costs occur in

the same time period. 3. Cost–volume–profit analysis assumes a single-product firm. All fixed costs are

incurred to produce a single product. If the firm produces multiple products, and fixed costs such as property taxes are incurred to produce multiple products, then the break-even point or target profit for any one of the products depends on the volume of the other products. With multiple products and common fixed costs, it is not meaningful to discuss the break-even point for just one product.

Although these limitations are important, cost–volume–profit analysis forces manag- ers to understand how costs and revenues vary with changes in output.

To manufacture a green, battery-powered automobile generates 30,000 pounds of carbon-dioxide emissions, compared to 14,000 pounds of carbon-dioxide emissions to produce a conventional gasoline-powered car. Much of the difference is due to the additional carbon dioxide needed to mine and produce lithium batteries. Each mile driven by the green car generates six ounces of carbon dioxide to produce the electric- ity to recharge the batteries, whereas an equivalent size gasoline-powered car generates twelve ounces per mile. Based on these data, one can calculate the number of miles a green car owner must drive before the battery-powered car produces less carbon- dioxide emissions than a conventional car. First, convert pounds of carbon dioxide to ounces of carbon dioxide:

30,000 pounds = 16 × 30,000 = 480,000 ounces

14,000 pounds = 16 ounces per pound × 14,000 pounds = 224,000 ounces

Next, calculate the break-even number of miles (M) where carbon dioxide is the same for the electric car and a conventional car.

480,000 + 6M = 224,000 + 12M

Solving for M:

256,000 = 6M

M = 42,667 miles

If, over the life of the green car, the owner drives less than about 43,000 miles, the green car generates more carbon dioxide than a conventional car. SOURCE: B. Lomberg, “Green Cars Have a Dirty Little Secret,” Wall Street Journal (March 11, 2013) p. A15.

Managerial Application: Break-Even Analysis of Carbon- Dioxide Emissions of Electric Car Batteries

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Notice in the earlier Xerox copier example that the assumptions underlying break- even analysis are not violated:

• Price does not vary with quantity. • Variable cost per unit does not vary with quantity. • Fixed costs are known. • There is a single product (copies). • All output is sold.

As we saw earlier, one limitation of cost–volume–profit analysis is that it applies only to firms making a single product. One way to overcome this limitation is to assume a constant output mix of bundles with fixed proportions of the multiple products. Then a break-even or a target profit number of bundles can be calculated.

For example, suppose a winery produces two types of wine: merlot and chablis. The following table summarizes prices and variable costs of the winery, which has fixed costs of $500,000 per year.

Merlot Chablis

Price per case $ 30 $ 20 Variable cost per case 20 15 Contribution margin per case $ 10 $ 5

For every case of merlot produced, three cases of chablis are produced. Define a wine bundle to consist of four cases of which one is merlot and three are chablis. Each wine bundle has revenues of $90 (1 × $30 + 3 × $20), variable costs of $65 (1 × $20 + 3 × $15), and a contribution margin of $25 (1 × $10 + 3 × $5). The number of bundles required to break even is:

Break-even number of bundles = Fixed costs _________________ Contribution margin = $500, 000 _______ $25 = 20, 000 bundles

Twenty thousand bundles needed to break even translate into 20,000 cases of merlot and 60,000 cases of chablis to break even. Hence, if a firm produces a variety of products in fixed proportions, then break-even analysis can be conducted by creating a standard bundle of products.

4. Multiple Products

Exercise 2–6

Using the preceding winery example, how many cases of merlot and chablis must be produced and sold to make an after-tax profit of $100,000 if the tax rate is 20 percent?

Solution:

The after-tax profit is calculated from the following equation:

After-tax profit = (1 − Tax rate) × (Revenues − Variable cost − Fixed costs) $100,000 = (1 − 20%) × ($90 B − $65 B − $500,000)

where B is the number of bundles. continued

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Separating costs into fixed and variable components is useful for calculating break-even points and for pricing decisions, and for deciding to take new orders. Understanding a product’s fixed and variable costs is also useful for strategic reasons.

The higher a firm’s fixed costs, the higher its operating leverage, which is the ratio of fixed costs to total costs. Operating leverage measures the sensitivity of profits to changes in sales. The higher the operating leverage, the greater the firm’s risk. In firms with high operating leverage, small percentage changes in sales lead to large percentage changes in net cash flows (and profits). Therefore, firms with high operating leverage have greater variability in cash flows and hence greater risk than firms with a lower ratio of fixed costs to total costs. High operating leverage firms face greater risk of failing if volumes stay low because they are unable to continue to generate enough cash to pay their high fixed costs.

To illustrate the importance of operating leverage, consider the illustration in Table 2–1. Two companies, HiLev and LoLev, each sell 10,000 units of an identical product for $8 per unit. At that level of production, both companies have identical total costs of $70,000, and both companies are making $10,000 in profits. Since three-sevenths of LoLev’s costs are fixed, whereas five-sevenths of HiLev’s costs are fixed, HiLev has more operating leverage.

5. Operating Leverage

Q2–10 What are the underlying assumptions in a cost–volume–profit analysis?

Q2–11 What are the benefits and limitations of cost–volume–profit analysis?

Concept Questions

Solving for B yields:

$100, 000 = . 8 × ( $25B − $500, 000 ) $100, 000 = $20B − $400, 000

B = $500, 000 / $20 B = 25, 000 bundles

In other words, 25,000 cases of merlot and 75,000 cases (3 × 25,000) of chablis must be sold to generate $100,000 after taxes. At these production levels, $100,000 of after-tax profit is generated as demonstrated by the following income statement:

Revenue—Merlot 25,000 × $30 $750,000 Revenue—Chablis 75,000 × $20 1,500,000 Total revenue $2,250,000 Less: Variable costs Merlot 25,000 × $20 $500,000 Chablis 75,000 × $15 1,125,000 Fixed costs 500,000 Total costs $2,125,000 Income before taxes $ 125,000 Taxes (20%) 25,000 Net income after taxes $ 100,000

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LoLev HiLev

Revenue 10,000 units @ $8 $80,000 $80,000 Variable costs 10,000 units @ $4 40,000

10,000 units @ $2 20,000 Fixed costs 30,000 50,000 Net income $10,000 $10,000

TABLE 2–1 Operating Leverage (Production and Sales Are 10,000 Units)

LoLev HiLev

Revenue 7,500 units @ $8 $60,000 $60,000 Variable costs 7,500 units @ $4 30,000

7,500 units @ $2 15,000 Fixed costs 30,000 50,000 Net income (loss) $ 0 $ (5,000)

TABLE 2–2 Operating Leverage (Production and Sales Are 7,500 Units)

TABLE 2–3 Operating Leverage (Production and Sales Are 12,500 Units)

LoLev HiLev

Revenue 12,500 units @ $8 $ 100,000 $ 100,000 Variable costs 12,500 units @ $4 50,000

12,500 units @ $2 25,000 Fixed costs 30,000 50,000 Net income $ 20,000 $ 25,000

Firms with low variable costs per unit can sustain larger short-term price cuts when faced with increased competition. For example, a firm selling a product for $10 per unit that has a variable cost of $7 per unit can cut the price to just above $7 (for short peri- ods of time) and still cover the variable costs of each unit. If that same firm has variable costs of $8 per unit, a price cut to below $8 causes a cash drain with each incremen- tal unit. Knowledge of a competitor’s cost structure is valuable strategic information in designing marketing campaigns. Estimating a firm’s riskiness also requires knowledge of operating leverage.

Suppose volume falls 25 percent. Table 2–2 indicates the impact on net income. In LoLev, net income falls to zero; in HiLev, a loss of $5,000 results. Table 2–3 illustrates that when volume increases 25 percent, HiLev has a greater increase in profits than LoLev. Operating leverage amplifies the earnings impact of a given percentage change in volume.

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Exercise 2–7

Two Internet retailers have the following data:

(millions) BuyEverything.com SportsWhere.com

Sales $120 $186 Variable costs 70 150 Fixed costs 40 24 Net income $ 10 $ 12

Required:

a. Which retailer has more operating leverage?

b. Suppose the sales of each retailer double. Which one’s net income shows the greatest percentage increase?

c. Calculate the percentage change in each retailer’s net income if sales fall 50 percent.

Solution:

a. BuyEverything.com’s operating leverage (as measured by the ratio of fixed to total cost) is .36 ($40/$110), and SportsWhere.com’s operating leverage is .14 ($24/$174). Hence, BuyEverything.com has more operating leverage.

b. The following table calculates how net income changes with a doubling of sales:

(millions) BuyEverything.com SportsWhere.com

Sales $240 $372 Variable costs 140 300 Fixed costs 40 24 Net income $ 60 $ 48 Prior net income $ 10 $ 12 % change 500%* 300%†

*($60 − $10)/$10 †($48 − $12)/$12

BuyEverything.com (which has more operating leverage from part a) shows the greatest percentage increase in net income.

c. The following table calculates how net income changes when sales fall 50 percent:

(millions) BuyEverything.com SportsWhere.com

Sales $60 $93 Variable costs 35 75 Fixed costs 40 24 Net income ($15) ($ 6) Prior net income $10 $12 % change −250%* −150%†

*(−$15 − $10)/$10 †(−$6 − $12)/$12

BuyEverything.com (which has more operating leverage from part a) shows the greatest percentage decrease in net income.

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D. Opportunity Costs versus Accounting Costs The theoretically correct way to evaluate choices requires estimating opportunity costs. Esti- mating opportunity costs requires the decision maker to formulate all possible actions (the opportunity set) and the forgone net receipts from each of those alternatives so that the highest net cash flows from the set of actions not undertaken can be calculated. This yields the oppor- tunity cost of the selected action. Such an exercise requires a special study for every decision, which is a time-consuming and costly activity. And after completing the study, the opportunity cost changes as the opportunity set changes. It is little wonder that managers devise shortcut approximations to estimating opportunity costs. Accounting-based costs are such a shortcut.

Accounting systems record “costs” after making the decisions. Accounting systems track asset conversions. When the firm acquires assets such as raw material, accountants record them in monetary terms (historical cost valuation). As the raw inputs are converted into intermediate products, accountants value the intermediate products at the historical costs of the raw inputs converted into the intermediate products. The in-process, partially completed units flowing through departments are recorded in the accounts at historical costs. If an employee who is paid $20 per hour completes an intermediate product in two hours, the accounting system increases the cost of the intermediate product by $40. Completion and sale of the manufactured unit causes the historical costs attached to it to be transferred from the inventory accounts to the expense account “cost of goods sold.” Accounting costs are not forward-looking opportunity costs; they look backward at the historical cost of the resources consumed to produce the prod- uct. Accounting systems produce accounting costs, not opportunity costs. However, account- ing costs often provide a reasonable approximation of opportunity costs. Over short periods of time, prices and costs do not change very much. Thus, accounting costs can be reasonably accurate estimates of opportunity costs of producing the same products again.

Besides providing data for decision making, internal accounting systems also provide data for controlling the behavior of people in organizations, as well as the data for external financial reporting. The resources consumed to produce this textbook might differ from the opportunity cost of a new textbook. But the historical cost of this book provides infor- mation to senior managers as to how well the persons responsible for producing this book discharged their duties. Valuing the ending inventory of books, calculating taxes payable, and computing net income require the historical cost of this textbook.

High-technology firms incur large fixed costs and relatively low variable costs to pro- duce intellectual property such as software and Web sites. This combination creates high operating leverage that causes these firms to be very risky. In good times, they are flying high. In weak times, there is very little they can do to trim expenses.

Inktomi Corp. was a high-flying software company. It spent $10 million develop- ing research engines and software to manage Web content. Once those fixed costs were incurred, each additional sale was almost pure profit. The president remarked, “You have no cost of goods. We don’t even ship a physical diskette anymore. Next to the federal government, this is the only business that’s allowed to print money.” All this has changed. Software development costs rose and sales nosedived, causing Inktomi to report a very large loss. Enormous fixed costs were required to research, develop, design, test, and market software. Intense competition and rapid obsolescence required high levels of spending each year. The result was a dramatic reversal of fortune lead- ing to big swings in profits, stock prices, and hiring when sales sagged. Inktomi did not survive the Internet bubble and was sold to Yahoo! in 2002. SOURCE: B. McClure, “Operating Leverage Captures Relationships,” www.investopedia.com, Dec 28, 2006

Managerial Application: New Econ- omy Firms and High Operating Leverage

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Cost systems do not focus on opportunity costs, nor can they, because opportunity costs depend on the particular decision being contemplated. Accounting systems cannot anticipate all future decisions. For example, suppose you purchased land on a busy com- mercial street last month, paying $1 million. If you open a fast-food restaurant on this land, you estimate it will be worth $1.6 million. If, on the other hand, you open a gas station, its value is estimated at $1.7 million. Using the land for a gas station costs you $1.6 million in terms of the next best forgone opportunity (the fast-food restaurant). The $1 million his- torical cost of the land, even though only one month old, is not the opportunity cost. Thus, the term cost can refer to accounting cost (historical amounts) or to opportunity cost (the amount forgone by some decision), two very different concepts. In some cases, the user’s meaning is obvious, but it is always important to question whether the term cost means opportunity cost or accounting cost.

To further understand how accounting costs differ from opportunity costs, we distinguish between product costs and period costs. Product costs include all those accounting costs incurred to manufacture a product. Product costs are inventoried and expensed only when the product is sold. Period costs are those costs that are expensed in the period in which they are incurred. They include all nonmanufacturing accounting costs incurred to sell the product. For example, administration, distribution, warehousing, selling, and advertising expenditures are period costs. Research and development is a period cost. Period costs are not part of the product’s cost included in inventory valuation.

Product costs include both fixed and variable manufacturing components. Likewise, period costs, the costs of distributing and selling the product, contain both fixed and variable components. Fixed period costs include salespersons’ salaries, advertising, and marketing costs. Examples of variable period costs include distribution costs and sales commissions.

Accounting systems, even those used for internal purposes, distinguish between prod- uct and period costs. In most situations, unit cost figures refer to product costs excluding all period costs. Suppose that the unit manufacturing cost of a particular cell phone is $23. Selling and distributing this product costs an additional $4 per unit. This $4 period cost includes both fixed and variable period costs. The total cost of manufacturing and selling each unit is $27. Many firms refer to the $23 product cost as a unit manufacturing cost (UMC). For decision-making purposes, both period ($4) and product ($23) costs must be considered, so it is important to remember that a UMC usually excludes period costs.

Period costs and product costs are historical costs. They are not opportunity costs. However, to the extent that the future looks a lot like the past, these historical costs can be useful predictors of opportunity costs.

The accounting concepts of direct costs versus overhead costs also illustrate the difference between opportunity and accounting costs. Direct costs and overhead costs form the core of this book, to which we will return in later chapters, particularly Chapters 9 through 13. But it is useful to introduce the terms now.