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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.