Traceable costs are also called

chapter 1

Managerial Accounting and Cost Concepts

Learning Objectives

After studying Chapter 1, you will be able to:

• Distinguish between financial accounting and managerial accounting.

• Recognize the primary ethical responsibilities of the management accountant.

• Define, distinguish, and illustrate key cost concepts.

• Understand the differences in cost flows among service, merchandising, and manu- facturing enterprises.

• Explain product cost elements.

• Describe and formulate a cost function.

• Distinguish between the behavior of variable and fixed costs.

• Introduce the concept of contribution margin and its variations.

Blend Images/SuperStock

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CHAPTER 1Chapter Outline

Chapter Outline

1.1 The Dual Roles of Accounting Information Financial Accounting Managerial Accounting Differences between Managerial and Financial Accounting

1.2 Role of the Management Accountant Management Accountant Certified Management Accountant Ethical Conduct of Management Accountants

1.3 The Nature of Cost

1.4 Comparing Service, Merchandising, and Manufacturing Organizations Service Organizations Merchandising Organizations Manufacturing Organizations Traditional Groupings of Product Costs

1.5 Cost Behavior Variable Costs Fixed Costs Expressing Variable and Fixed Costs–A Cost Function Relevant Range Semivariable and Semifixed Costs

1.6 Cost Concepts for Planning and Controlling Direct Costs Versus Indirect Costs Controllable Costs Versus Noncontrollable Costs

1.7 Contribution Margin and Its Many Versions Variable Contribution Margin–Per Unit, Ratio, and Total Dollars Controllable and Direct Contribution Margins Illustration of All Contribution Margin Concepts

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CHAPTER 1Introduction

The Controller’s Work Day: Where Did the Time Go?

It’s early October. Mary Rosen, Controller of Herschel Software Products, has just arrived at her office at about 7:30 a.m. She scans her e-mail messages, checks her electronic calendar, and looks through her in-basket. She says, “Wow, another ‘nor- mal’ day!” She wonders if she’ll make her tennis date with her husband at 6 p.m. Her calendar shows:

9:00 Meet with division head of Customer Support to discuss next year’s bud- get numbers. Review preliminary budget numbers before meeting.

10:00 Meet with accounting systems analysts to discuss status of a project to improve the firm’s monthly management “plan versus actual” reporting system.

11:30 Hold a quick session with Marketing Vice-President, Gary Martin, to dis- cuss pricing negotiations with new customer.

12:15 Have working lunch with corporate attorney to discuss customer contract wording for a new product being introduced early next year.

2:00 With budget manager, review September’s actual results and budget com- parisons and identify problem areas. Also, review third quarter results before her presentation to the President at Friday’s staff meeting.

4:00 p.m. Review a special cost-volume-profit study of Herschel software products, relative to the firm’s strategic plan’s profitability goals.

She also knows that she needs to:

• respond to four e-mail questions about product costs and operating expenses;

• talk to Steve Simcha, New Product Development Vice-President, about a serious cost-overrun problem with a new product project;

• prepare a presentation on cash flows for the firm’s strategic planning meeting next month; and

• write a memo supporting the spending of $100,000 by the Marketing Vice- President on media contracts.

Every meeting, discussion, and decision that Mary has today, and every day, uses accounting information. She must generate relevant data in the right form and at the right time. She and her fellow managers must understand cost behavior, cost/benefit analyses, plan versus actual comparisons, and how to use information to achieve Her- schel Software Products’ long-term and short-term goals.

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CHAPTER 1Section 1.1 The Dual Roles of Accounting Information

Managers make decisions. Managers select one alternative from a set of choices. Making the best choice depends on the manager’s goals, the expected results from each alterna- tive, and the information available when the decision is made. Decision-making infor- mation is the focus of this text. Collecting, classifying, reporting, and analyzing relevant information are fundamental to every action that managers take. Management accoun- tants prepare information for decision makers. In this chapter, the stage is set for discuss- ing how management accountants are involved in decision making. First, we discuss the distinction between financial and managerial accounting.

1.1 The Dual Roles of Accounting Information

The accounting system generates the information that satisfies two reporting needs that coexist within an organization: financial accounting and managerial accounting. Fig- ure 1.1 shows the primary interested parties and the typical reports generated to serve these two user groups.

Figure 1.1: Scope of financial and managerial accounting

Financial Accounting Financial accounting is the branch of accounting that organizes accounting information for presentation to interested parties outside of the organization. The primary financial accounting reports are the balance sheet (often called a statement of financial position), the income statement, and the statement of cash flows. The balance sheet is a summary of assets, liabilities, and shareholders’ equity at a specified point in time. The income state- ment reports revenues and expenses resulting from the company’s operations for a par- ticular time period. The statement of cash flows shows the sources and uses of cash over a time period for operating, investing, and financing activities.

FINANCIAL ACCOUNTING

Interested Parties

Shareholder Investment analysts Creditors Labor unions Employees Managers Customers & vendors Government agencies Industry associations

Typical Reports

Income statements Balance sheets Cash–flow statements Tax returns Regulatory reports

MANAGERIAL ACCOUNTING

Interested Parties

Managers: Executive Middle Supervisory Other employees

Typical Reports

Budgets and plans Budget versus actual Product cost Cost control Decision analyses Segment performance Cash–flows forecasts Financial statements Internal audits

ACCOUNT INFORMATION

RESPONSIBILITIES

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CHAPTER 1Section 1.1 The Dual Roles of Accounting Information

Most businesses are complex, and guidelines (known as generally accepted accounting principles or GAAP) are provided for financial reporting. The Financial Accounting Stan- dards Board (FASB), the Security and Exchange Commission (SEC), and the Public Com- pany Accounting Oversight Board (PCAOB) oversee the development of these principles, corporate financial reporting responsibilities, and internal control standards. Internation- ally, while each country has developed its own accounting principles, the International Accounting Standards Board has taken on an increasingly important role.

Owners, Investors, and Creditors

Shareholder-owned firms rely heavily on owners, investors, and creditors (providers of short-term credit and long-term loans) for sources of capital. Shareholders and investors use accounting reports to decide whether to buy, sell, or hold the firm’s stock. Also, credi- tors assess whether the firm is able to pay its debts on time.

Taxing Authorities

The assessment of many taxes is based on accounting information submitted by the taxpayer. Examples of such taxes include income taxes, sales taxes, use taxes, franchise taxes, excise taxes, property taxes, and gift and estate taxes. In most cases, the dominant taxing authority is the federal government and its tax collection agency, the Internal Revenue Service.

Regulatory Agencies

Local, state, and federal agencies regulate a substantial portion of business activity in the United States. Much regulation is implemented through or involves accounting reports.

Industry Associations

Most industries have an association that gathers important statistics about the national and international industry. A large part of the information they provide comes from accounting reports provided by member firms.

Managers and Employees

Managers typically have direct vested interests in their firms’ results. Performance bonuses, stock options, and incentive compensation programs are common. Thus, man- agers are not passive observers as to how certain transactions are recorded. Firm policies, performance evaluation methods, and compensation systems should encourage manag- ers to act in the best interests of themselves and the firm as a whole.

The firm’s executives are responsible to the board of directors and shareholders for the firm’s financial results. Numerous examples of changes in high-level executive positions reaffirm the importance of achieving strong profits to remain in power and employed. Based in part on financial statement information, employees make decisions about con- tinued employment, union wage demands and contract negotiations, adequacy of pen- sion plans, and employee stock purchase or savings plans. Profit sharing may encourage employees to want the company to be financially successful.

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CHAPTER 1Section 1.2 Role of the Management Accountant

Managerial Accounting

Managerial accounting is the branch of accounting that meets managers’ information needs. Because managerial accounting is designed to assist the firm’s managers in mak- ing business decisions, relatively few restrictions are imposed by regulatory bodies and generally accepted accounting principles. Therefore, a manager must define which data are relevant for a particular purpose and which are not.

Differences Between Managerial and Financial Accounting

Several important differences distinguish managerial accounting from financial accounting. First, managerial accounting is not subject to the same rules and principles as is financial accounting. In many cases, “common sense” is the most important guide for decision makers.

A second difference is that financial accounting relies on accounting principles structured around the accounting equation. Management reports, on the other hand, are designed to meet managers’ needs. These reports often use estimates and forecasts, use different values for the same events, do not balance in a debit/credit sense, and are designed for particular decisions or analyses. The expression different costs for different purposes has long been used to describe relevance. Relevant information has an impact on the decision analysis. Irrelevant data have no impact.

Another difference is that managerial accounting focuses on segments of the organization as well as on the whole organization. The primary interest of financial accounting is the company as a whole. In managerial accounting, however, the segment is of major impor- tance. Segments may be products, projects, divisions, plants, branches, regions, or any other subset of the business. Tracing or allocating costs, revenues, and assets to segments creates difficult issues for managerial accountants.

Two important similarities do exist. The transaction and accounting information systems discussed earlier are used to generate the data inputs for both financial statements and management reports. Therefore, when the system accumulates and classifies information, it should do so in formats that accommodate both types of accounting. The other similar- ity is the manner in which accountants measure costs, define assets, and specify account- ing periods. Many concepts underlie accounting information, whether the data are later used for financial or managerial reporting. Recording the results of events is often based on rationales that are common to both financial and managerial accounting. We must understand what is a common thread and what must be independently collected.

1.2 Role of the Management Accountant

Although the top accounting-oriented people in an organization are the chief financial officer and the controller, the accounting and financial management functions con- tain a range of jobs. A variety of careers is available as shown in Figure 1.2; these careers can frequently be paths to executive management.

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CHAPTER 1Section 1.2 Role of the Management Accountant

Management Accountant

A management accountant maintains accounting records, prepares financial state- ments, generates managerial reports and analyses, and coordinates budgeting efforts. The management accountant is an advisor, an internal consultant, and an integral part of management. The controller is responsible for managing the entire accounting function. The controller influences management when answering questions like: What informa- tion should be reported? What format best displays the information? How can data be collected and processed? By the nature of the job, the management accountant applies management principles and often is a major player in decision making itself.

Figure 1.2: Management accounting job titles

Certified Management Accountant

The Certified Management Accounting program recognizes a person’s achievement of a specific level of knowledge and professional skill. Becoming a Certified Management Accountant (CMA) is considered an important professional step for anyone desiring to become a management accounting or financial executive. The CMA program was founded on the principle that a management accountant is a contributor to and a participant in management.

To qualify for the CMA designation, candidates must pass a comprehensive examination and meet specific educational and professional standards. To remain a CMA, a person must meet continuing educational requirements and adhere to the program’s “Standards of Ethical Conduct for Management Accountants.” The Institute of Management Accoun- tants (IMA) is the professional organization of management accountants and sponsors the CMA designation.

Accounting systems analyst Bid cost estimator Budget performance analyst Capital investment analyst Cast disbursement manager Cash flow analyst Cash receipts manager Computer controls auditor Corporate financial accountant Corporate tax planner Cost accountant Cost forecasting analyst Customer or sales analyst Efficiency cost analyst

Internal auditor International controller

Labor negotiations cost analyst Master budget coordinator

Payroll accountant Physical asset accountant

Plant controller Product cost/profit analyst

Project controller Risk management analyst

Quality cost analyst Statistical cost analyst

Strategic planner Transfer pricing analyst

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CHAPTER 1Section 1.2 Role of the Management Accountant

Ethical Conduct of Management Accountants

In the preceding pages, we discussed managers’ needs for accounting information. We assumed that whatever information the accounting system generates is presented and used in an ethical manner. Ethical conduct is a necessary asset of a managerial accountant. The credibility of the information provided, analyses done, and opinions offered depends heavily on the reputation of the responsible accountant. Independence, competence, lack of bias or favoritism, trust, and objectivity are key elements in establishing credibility.

While true for all managers, management accountants in particular must maintain integ- rity and ethical behavior and must make top management aware of unethical behavior on the part of others within the organization. This does not mean the management accoun- tant is a police officer. Rather, the management accountant promotes and encourages ethi- cal behavior in all aspects of business life.

Ethical standards of businesspersons have been given much more visibility and scrutiny in recent years. Issues which appear again and again in management careers test the ethi- cal standards of everyone. Among common ethical issues are:

• Business practices and policies. Practices that seem harmless on the surface may encourage or require employees or managers to be deceitful or dishonest.

• Objective reporting. Because situations exist where prejudiced reporting of cer- tain numbers may influence decisions, accountants are guided by goals of unbi- ased reporting and professional judgment.

• Colleague behavior. Even if we have high ethical standards, people around us may not be so disposed. Many policies and internal controls are in place in organizations to prevent wrongdoing and to encourage proper behavior. In addi- tion, you should not compromise your personal integrity by condoning unethical behavior in others.

• Competitors. Winning is part of the business “game.” But to do so in a fair envi- ronment is critical. Using true product and competitor data, following corporate policies, and abhorring bribes, kickbacks, and other similar payments are easy examples. Many firms provide behavior guidelines and policies to purchasing and sales personnel who are at particular risk in giving and receiving favors and improper inducements.

• Tax avoidance and evasion. Tax burdens can be significant. Proper planning and careful use of tax laws to minimize the organization’s tax liability are acceptable. Tax avoidance is legitimate. Inappropriate use of the same laws or use of deceit to hide income or overstate deductions is tax evasion, which is unethical as well as illegal.

• Confidentiality. Keeping secrets is still “in.” Internal data are developed for managers’ use. Disclosures outside the firm often require review and approv- als. Privacy of competitive, personnel, and negotiating data is critical. Negative examples of overheard conversations in elevators, on golf courses, and at lunches that lead to lost business, embarrassment, and law suits are unfortunately com- mon. Confidentiality also demands that “insider” information should not be used for anyone’s personal advantage.

• Appearance of independence. The accountant should be independent in situ- ations where the resulting information is used for analysis and decision mak- ing. Independence applies to both actual independence and the appearance of

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CHAPTER 1Section 1.2 Role of the Management Accountant

independence. If it appears that the management accountant is biased because of that person’s conduct, associations, or vested interests (possible promotion, salary increases or bonuses, or investments), the information provided is tainted and open to doubt by other decision makers.

• Corporate loyalty and personal advancement. Many situations exist in which, because of an unethical act, the reputation of the firm itself is in danger. Alter- nately, an unethical act may seem to ensure your personal enhancement in some manner. Sometimes reporting an unethical act will endanger the future of the person reporting the act. These are all difficult dilemmas, pitting right against wrong, and not always in an obvious way.

While space and time do not allow us to develop approaches for resolving these problems here, it is clear that ethical issues underlie management accountants’ professional and day-to- day activities. Each chapter will raise and discuss ethical issues related to those special topics.

Each person must develop a method of handling ethical problems. Of primary importance is the ability to see an ethical dilemma when it faces us. Once identified, the situation may well cause us to request advice. Numerous sources are available for guidance, including:

• Personal values. We would like to think that our own value system is “ethical” and provides enough guidance. Clearly, this is our main line of defense against “wrong.”

• Corporate policies and ethics statements. Many firms have statements on expected employee behavior or written policies and procedures on how a range of situations should be handled. These statements do set limits or barriers and may describe expected levels of behavior.

• Laws. “If it’s legal, it must be okay” is often used a basis for defining ethical behavior. This is absolutely not true. Laws are developed in a political process, often without much serious consideration for the ethical conduct of any parties involved. It’s highly probable that if the behavior is illegal, it is also unethical.

Contemporary Practice 1.1

Corporate Greed vs. an Ethics Code

The names are infamous: WorldCom, Adelphia, Enron, Tyco, Arthur Andersen, and Martha Stewart, among numerous others. All have suf- fered unethical behavior at very high levels. The “bad deeds” of manag-

ers, auditors, accountants, CEOs, and CFOs in these firms range from simple inappropriate “favors” to outright theft, lies, deceit, and intentional deception. The basic integrity of business itself rests on individual honesty, professional competence, proper accounting, and acceptance of a code of ethical conduct. Codes of ethical conduct cannot prevent unethical behavior, but hindsight definitely points to fundamental violations of the man- agement accountant’s code of ethics. The code of ethics presented in Figure 1.3 should set a high standard for managerial reporting and use by both managerial accountants and executives. (Haywood & Wygal, 2004, pp. 45-49)

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CHAPTER 1Section 1.2 Role of the Management Accountant

• Professional standards. Most professions have developed a statement of ethical standards for their members. Figure 1.3 presents a statement developed for man- agement accountants. These statements are basic standards of behavior and give professional guidance in many areas.

• Supervisors, internal auditors, and other company officials. These are often persons with more experience and broader understanding of conflicting issues and of corporate attitudes. An ethical situation, however, may involve a supervi- sor or other corporate official, which may make the dilemma much more sensi- tive and severe. A few companies have created an ombudsperson position to assist employees in handling delicate situations.

• Counselors from outside of the organization. This is a last resort and generally violates another ethical consideration—confidentiality. While close friends, a spouse, or a personal counselor may seem like logical sources of advice and sup- port, the nature of the dilemma may well require confidentiality until all other avenues of resolution are exhausted. Merely consulting outsiders presents seri- ous risks of unauthorized disclosure which may only further complicate an issue.

Even though all of these options may exist, we each need to develop a rational approach to identifying, analyzing, and deciding on ethical issues that confront us. Management accountants must be aware of ethical dilemmas, perhaps more than the typical manager, because of their responsibility for decision-making information and their involvement in many decision-making processes.

The Institute of Management Accountants believes ethics is a cornerstone of its organiza- tion and recognizes the importance of providing ethical guidance. The IMA has developed Standards of Ethical Professional Practice. That statement is presented in Figure 1.3. The Standards are broken into four sections: competence, confidentiality, integrity, and cred- ibility. Competence refers to the skills that the accountant brings to the job. Confidentiality is defined as protecting the access to and use of information. Integrity focuses primarily on the personal behavior and interactions of the management accountant. Credibility, as defined here, is primarily directed toward disclosure of unbiased information.

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CHAPTER 1Section 1.2 Role of the Management Accountant

Figure 1.3: Institute of Management Accountants’ Standards of Ethical Professional Practice

“Standards of Ethical Professional Practice,” Institute of Management Accountants, Montvale, N.J., 2012. Retrieved from http://www.imanet.org/PDFs/Public/Press_Releases/STATEMENT OF ETHICAL PROFESSIONAL PRACTICE_2.2.12.pdf

Much of managerial accounting deals with cost information. Understanding cost behav- ior and knowing which costs to consider and which to ignore are critical to making deci- sions in business and in everyday life situations. Managers use cost information in many different ways. Cost data are especially important in these areas:

• Planning. Estimating future costs in preparing budgets and in projecting operat- ing activities.

• Decision making. Selecting and formatting costs relevant to a wide variety of decision-making processes.

• Cost control. Measuring costs incurred; comparing these costs with budgets, goals, targets, or standards; and evaluating differences or variances.

• Income measurement. Determining the costs of products and services sold to determine this time period’s profitability for the entire business or some segment of the business, such as a contract, a product, or a customer.

I. COMPETENCE Each member has a responsibility to: 1. Maintain an appropriate level of professional expertise by continually developing knowldge and skills. 2. Perform professional duties in accordance with relelvant laws, regulations, and technical standards. 3. Provide decision support information and recommendations that are accurate, clear, concise, and timely. 4. Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance or an activity.

II. CONFIDENTIALITY Each member has a responsibility to: 1. Keep information confidential except when disclosure is authorized or legally required. 2. Inform all relevant parties regarding appropriate use of confindential information. Monitor subordinates’ activities to ensure compliance. 3. Refrain from using confidential information for unethical or illegal advantage.

III. INTEGRITY Each member has a responsibility to: 1. Mitigate actual conflicts of interest, regularly communicate with business associates to avoid apparent conflicts of interest. Advise all parties of any potential conflicts. 2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. 3. Abstain from engaging in or supporing any activity that might discredit that profession.

IV. CREDIBILITY Each member has a responsibility to: 1. Communicate information fairly and objectively. 2. Disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, analyses, or recommendations. 3. Disclose delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organization policy and/or applicable law.

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CHAPTER 1Section 1.3 The Nature of Cost

1.3 The Nature of Cost

Cost, broadly defined, is the amount of resource given up to gain a specific objective or object. Generally, cost refers to the monetary measurement (exchange price) attached to acquiring goods and services consumed by some activity. Cash outlays are monetary measurements; occasionally, goods and services are also obtained by exchanging other assets, such as receivables or property, or by taking on debt.

The cost objective is defined as anything for which one accumulates costs. A cost objec- tive is the reason for making decisions, costing products, planning spending levels, or evaluating actual performances. It is the “why” of cost analysis.

Business people undertake activities to achieve some output or result. Often these activi- ties incur costs—purchasing materials, hiring people, and renting space—and are known as cost drivers. To achieve a cost objective, activities occur and resources are used. And resources cost money. Determining a product’s cost means finding the cause-and-effect connection between inputs and outputs. A cost driver link activities that create outputs and resources that are used.

Figure 1.4 presents the fundamental relationship among resources, activities, and prod- ucts. Activities are at the core of all we do in business. Activities drive the use of resources; from the activities, come products. This is the traditional input-to-output cycle, under- standing that work is done in the middle box—meaning tasks are performed with labor, machines, or hired resources. Costs are incurred by cost drivers and are attached to the products, given whatever cost objective managers have in mind for particular decision. These linkages will be used over and over as we progress through our costing analyses to aid decision making, particularly in Chapter 9.

Figure 1.4: Activity-centered costing relationships

Cost, in many respects, is an elusive term. It is a noun that needs an adjective, such as incremental, average, or avoidable. Cost has meaning only for a particular purpose and situation. Consequently, meaningful use of the term “cost” requires an adjective to define its use. Each adjective indicates certain attributes, and those attributes dictate the rele- vance of each cost.

Outputs

Cost Objective

Inputs

Costs

Work

Cost Drivers

ProductsActivitiesResources

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CHAPTER 1Section 1.4 Comparing Service, Merchandising, and Manufacturing Organizations

Since costs are resources given up to obtain a specific good or service, that good or service may be consumed or it may still be an asset at the end of an accounting period. In many managerial analyses, the distinction among cost, expense, and asset is clouded. The words cost and expense are used interchangeably, as is done throughout this text. Yet for profit measurement, cost dollars imply assets, and expenses are subtracted from revenues.

1.4 Comparing Service, Merchandising, and Manufacturing Organizations

Many similarities exist when we compare service, merchandising, and manufacturing organizations. Providing a service to a client in a law firm or repairing a washing machine in a fix-it shop has strong similarities to manufacturing calculators in spite of dif- ferent physical and business settings. In service industries, resources are brought together to provide the service, just as they are brought together to create a product in a factory environment.

Differences in measuring profits are largely a function of inventoried costs. Service firms have only supplies inventories. Merchandising firms buy and sell products and hold merchandise inventories. Manufacturing firms buy materials and convert these inputs into saleable products. Inventories here include yet-to-be-used materials, work in process inventory (partially complete products), and finished goods inventory (completed and ready-to-sell products). Figure 1.5 compares income statements and selected balance sheet accounts for the three business types.

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CHAPTER 1Section 1.4 Comparing Service, Merchandising, and Manufacturing Organizations

Figure 1.5: Measuring income in service, merchandising, and manufacturing firms

Service Organizations A service business performs an activity for a fee. Costs of performing the service may include salaries of professionals and support personnel, supplies, purchased services, and routine costs such as rent and utilities. In Figure 1.5, the expenses of Kalwerisky Consul- tants, a public relations firm, are reported as either direct client expenses or operating expenses. Some service organizations report all expenses as operating expenses.