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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

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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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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.