Principles of Accounting, Volume 2: Managerial Accounting

Preface

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About *Principles of Accounting*

*Principles of Accounting* is designed to meet the scope and sequence requirements of a two-semester accounting course that covers the fundamentals of financial and managerial accounting. This book is specifically designed to appeal to both accounting and non-accounting majors, exposing students to the core concepts of accounting in familiar ways to build a strong foundation that can be applied across business fields. Each chapter opens with a relatable real-life scenario for today’s college student. Thoughtfully designed examples are presented throughout each chapter, allowing students to build on emerging accounting knowledge. Concepts are further reinforced through applicable connections to more detailed business processes. Students are immersed in the “why” as well as the “how” aspects of accounting in order to reinforce concepts and promote comprehension over rote memorization.

Additional resources

About the authors

**Senior contributing authors**

Accounting as a Tool for Managers

Why It Matters

Define Managerial Accounting and Identify the Three Primary Responsibilities of Management

Planning

One of the first items on a new company’s agenda is the creation of a mission statement. A mission statement is a short statement of a company’s purpose and focus. This statement should be broad enough that it will encompass future growth and changes of the company. [link] contains the mission statement of three different types of companies: a manufacturer, an e-commerce company, and a service company.

Controlling

To measure whether plans are meeting objectives or goals, management must put in place ways to assess success or lack of success. Controlling involves the monitoring of the planning objectives that were put into place. For example, if you have a retail store and you have a plan to minimize shoplifting, you can implement a control, such as antitheft tags that trigger an alarm when someone removes them from the store. You could also install in the ceilings cameras that provide a different view of customers shopping and therefore may catch a thief more easily or clearly. The antitheft tags and cameras serve as your controls against shoplifting.

Evaluating

Managers must ultimately determine whether the company has met the goals set in the planning phase. Evaluating, also called *assessing* or *analyzing*, involves comparing actual results against expected results, and it can occur at the product, department, division, and company levels. When there are deviations from the stated objectives, managers must decide what modifications are needed.

Distinguish between Financial and Managerial Accounting

Financial and Managerial Accounting Comparative

Managerial and financial accounting are used by every business, and there are important differences in their reporting functions. Those differences are detailed in [link].

Explain the Primary Roles and Skills Required of Managerial Accountants

Organizational Structure

Most companies have an organizational chart that displays the configuration and the delegation of authority in the decision-making processes ([link]). The structure helps define roles and responsibilities. The organizational charts provide guidance to employees and other stakeholders by outlining the official reporting affiliations that direct the workflow within the organization. If the company is particularly efficient, it also will include contact information within the chart. This is a convenient directory to circulate among employees. It helps them find a particular person in a certain position, or determine whom to speak to about certain areas within the company, or even identify a specific person’s supervisor to report positive or negative work behavior.

Careers

The field of managerial accounting, or corporate accounting, is composed of the financial and accounting responsibilities required to operate any type of business. Managerial accountants are employed within organizations to monitor costs, sales, budgets, and spending; conduct audits; predict future requirements; and aid the executive leaders of the organization with financial decision-making.

Certifications

There are many distinct accounting certifications that accountants can earn in order to improve their careers, attain promotions, and acquire raises in their pay. The certifications are somewhat different from each other and focused toward different career paths. Many accountants have more than one of these credentials to diversify their paths.

Describe the Role of the Institute of Management Accountants and the Use of Ethical Standards

Business Ethics

The IMA also develops standards and principles to help management accountants deal with ethical challenges. Trust is an important cornerstone of business interactions, both internal and external. When there is a lack of trust, it changes how decisions are made. Trust develops when there are good ethics: when people know right from wrong. Consider these three questions as put forth by the Institute of Business Ethics: (1) Do I mind others knowing what I have done? (2) Who does my decision affect or hurt? (3) Would my decision be considered fair to those affected? These questions can help evaluate the ethics of a decision.

Ethics Legislation

In response to several corporate scandals, the United States Congress passed the Sarbanes-Oxley Act of 2002 (SOX), also known as the “public company accounting reform.” It is a federal law (http://www.soxlaw.com/) that was a far-reaching reform of business practices. Its focus is primarily on public accounting firms that act as auditors of publicly traded corporations. The act intended to protect investors by enhancing the accuracy and reliability of corporate financial statements and disclosures. Thousands of corporations now must confirm that their accounting processes comply with SOX. The act itself is fairly detailed, but the most significant issues for compliance are as follows:

Describe Trends in Today’s Business Environment and Analyze Their Impact on Accounting

Technology

Business entities always look for ways to leverage technology. Any type of technology that can increase production, reduce costs, or increase safety will attract attention from the business world. There are many areas of technology that businesses have used already, but to continue reaping those benefits, these companies need to adjust quickly with the ever-advancing business technology.

Lean Practices

All companies want to be successful. This requires continuously trying to improve the function of the organization. A lean business model is one in which a company strives to eliminate waste in its products, services, and processes, while still fulfilling the company’s mission. This type of model was originally implemented by the Japanese automaker, Toyota Motor Corporation, soon after the end of World War II. The implications of an organization adopting a lean business model can be overall business improvement, but a lean business model can be difficult to implement because it often requires all systems and procedures that an organization follows to be readjusted and coordinated. Managerial accounting plays a vital role in the success and implementation of a lean business model by providing accurate cost and performance evaluation information. Entities must comprehend the nature and sources of costs and develop systems that encapsulate costs accurately. The better an organization is at controlling costs, the more it can improve its overall financial performance. Continuous improvement is the manufacturing process that rejects the ideas of “good enough.” It is an ongoing effort to improve processes, products, services, and practices. This philosophy has led organizations to adopt practices such as total quality management, just-in-time manufacturing, and Lean Six Sigma. The fundamental ideas of all of these involve continuous improvement; they differ only in focus.

Balanced Scorecard

The balanced scorecard (BSC) approach uses both financial and nonfinancial measures in evaluating all attributes of the organization’s procedures. This approach differs from the traditional approach of only using financial measures to evaluate a company. While financial measures are essential, they are only a portion of what needs to be evaluated. The balanced scorecard focuses on both high-level and low-level measures, using the company’s own strategic plan. This method assesses the organization in four separate perspectives:

Globalization

The development of business through international influence or extending social and cultural aspects around the world is known as globalization. It has expanded our competitive borders, giving customers more alternatives. Customers can order an item from another country with the click of a button and have that item delivered in a few days or less. How has globalization affected companies? Not only must they choose between ordering goods or components globally, but they must decide in which countries to sell their goods, and in which companies they may be able to establish factories.

Social Responsibility and Sustainability

What is sustainability, and what does it have to do with businesses? The United Nations definition is “the ability to meet the needs of the present without compromising the ability of future generations to meet their own needs.”[footnote] Usually, sustainability is viewed as having three components: economic, social, and environmental. Obviously, a business cannot continue into the future unless it is economically sound; however, if it maintains its economic status by depleting too many natural resources or paying illegal wages, then that company is not practicing good social responsibility.

“Sustainable Development.” General Assembly of the United Nations. http://www.un.org/en/ga/president/65/issues/sustdev.shtml

Building Blocks of Managerial Accounting

Why It Matters

Distinguish between Merchandising, Manufacturing, and Service Organizations

Merchandising Organizations

A merchandising firm is one of the most common types of businesses. A merchandising firm is a business that purchases finished products and resells them to consumers. Consider your local grocery store or retail clothing store. Both of these are merchandising firms. Often, merchandising firms are referred to as *resellers* or *retailers* since they are in the business of reselling a product to the consumer at a profit.

Manufacturing Organizations

A manufacturing organization is a business that uses parts, components, or raw materials to produce finished goods ([link]). These finished goods are sold either directly to the consumer or to other manufacturing firms that use them as a component part to produce a finished product. For example, Diehard manufactures automobile batteries that are sold directly to consumers by retail outlets such as AutoZone, Costco, and Advance Auto. However, these batteries are also sold to automobile manufacturers such as Ford, Chevrolet, or Toyota to be installed in cars during the manufacturing process. Regardless of who the final consumer of the final product is, Diehard must control its costs so that the sale of batteries generates revenue sufficient to keep the organization profitable.

Service Organizations

A service organization is a business that earns revenue by providing intangible products, those that have no physical substance. The service industry is a vital sector of the U.S. economy, providing 65% of the U.S. private-sector gross domestic product and more than 79% of U.S. private-sector jobs.[footnote] If tangible products, physical goods that customers can handle and see, are provided by a service organization, they are considered ancillary sources of revenue. Large service organizations such as airlines, insurance companies, and hospitals incur a variety of costs in the provision of their services. Costs such as labor, supplies, equipment, advertising, and facility maintenance can quickly spiral out of control if management is not careful. Therefore, although their cost drivers are sometimes not as complex as those of other types of firms, cost identification and control are every bit as important in the service industry.

John Ward. “The Services Sector: How Best to Measure It?” International Trade Administration. Oct. 2010. https://2016.trade.gov/publications/ita-newsletter/1010/services-sector-how-best-to-measure-it.asp. “United States GDP from Private Services Producing Industries.” Trading Economics / U.S. Bureau of Economic Analysis. July 2018. https://tradingeconomics.com/united-states/gdp-from-services. “Employment in Services (% of Total Employment) (Modeled ILO Estimate).” International Labour Organization, ILOSTAT database. The World Bank. Sept. 2018. https://data.worldbank.org/indicator/SL.SRV.EMPL.ZS.

Identify and Apply Basic Cost Behavior Patterns

Major Cost Behavior Patterns

Any discussion of costs begins with the understanding that most costs will be classified in one of three ways: fixed costs, variable costs, or mixed costs. The costs that don’t fall into one of these three categories are hybrid costs, which are examined only briefly because they are addressed in more advanced accounting courses. Because fixed and variable costs are the foundation of all other cost classifications, understanding whether a cost is a fixed cost or a variable cost is very important.

Effects of Changes in Activity Level on Unit Costs and Total Costs

We have spent considerable time identifying and describing the various ways that businesses categorize costs. However, categorization itself is not enough. It is important not only to understand the categorization of costs but to understand the relationships between changes in activity levels and the changes in costs in total. It is worth repeating that when a cost is considered to be fixed, that cost is only fixed for the relevant range. Once the boundary of the relevant range has been reached or moved beyond, fixed costs will change and then remain fixed for the new relevant range. Remember that, within a relevant range of activity, where the relevant range refers to a specific activity level that is bounded by a minimum and maximum amount, total fixed costs are constant, but costs change on a per-unit basis. Let’s examine an example that demonstrates how changes in activity can affect costs.

Comprehensive Example of the Effect on Changes in Activity Level on Costs

Pat is planning a three-day ski trip on his spring break after he works on a Habitat for Humanity project in Dallas. The costs for the trip are as follows:

Estimate a Variable and Fixed Cost Equation and Predict Future Costs

Functions of Cost Equations

The cost equation is a linear equation that takes into consideration total fixed costs, the fixed component of mixed costs, and variable cost per unit. Cost equations can use past data to determine patterns of past costs that can then project future costs, or they can use estimated or expected future data to estimate future costs. Recall the mixed cost equation:

Demonstration of the Scatter Graph Method to Calculate Future Costs at Varying Activity Levels

One of the assumptions that managers must make in order to use the cost equation is that the relationship between activity and costs is linear. In other words, costs rise in direct proportion to activity. A diagnostic tool that is used to verify this assumption is a scatter graph.

Demonstration of the High-Low Method to Calculate Future Costs at Varying Activity Levels

As you’ve learned, the purpose of identifying costs is to control them, and managers regularly use past costs to predict future costs. Since we know that variable costs change with the level of activity, we can conclude that there is *usually* a positive relationship between cost and activity: As one rises, so does the other. Ideally, this can be confirmed on a scatter graph. One of the simplest ways to analyze costs is to use the high-low method, a technique for separating the fixed and variable cost components of mixed costs. Using the highest and lowest levels of activity and their associated costs, we are able to estimate the variable cost components of mixed costs.

Cost-Volume-Profit Analysis

Why It Matters

Explain Contribution Margin and Calculate Contribution Margin per Unit, Contribution Margin Ratio, and Total Contribution Margin

Unit Contribution Margin

When the contribution margin is calculated on a per unit basis, it is referred to as the contribution margin per unit or unit contribution margin. You can find the contribution margin per unit using the equation shown below.

Contribution Margin Ratio

The contribution margin ratio is the percentage of a unit’s selling price that exceeds total unit variable costs. In other words, contribution margin is expressed as a percentage of sales price and is calculated using this formula:

Total Contribution Margin

This “big picture” is gained by calculating total contribution margin—the total amount by which total sales exceed total variable costs. We calculate total contribution margin by multiplying per unit contribution margin by sales volume or number of units sold. This approach allows managers to determine how much profit a company is making before paying its fixed expenses. For Hicks Manufacturing, if the managers want to determine how much their Blue Jay Model contributes to the overall profitability of the company, they can calculate total contribution margin as follows:

The Evolution of Cost-Volume-Profit Relationships

The CVP relationships of many organizations have become more complex recently because many labor-intensive jobs have been replaced by or supplemented with technology, changing both fixed and variable costs. For those organizations that are still labor-intensive, the labor costs tend to be variable costs, since at higher levels of activity there will be a demand for more labor usage. For example, assuming one worker is needed for every 50 customers per hour, we might need two workers for an average sales season, but during the Thanksgiving and Christmas season, the store might experience 250 customers per hour and thus would need five workers.

Calculate a Break-Even Point in Units and Dollars

Basics of the Break-Even Point

The break-even point is the dollar amount (total sales dollars) or production level (total units produced) at which the company has recovered all variable and fixed costs. In other words, no profit or loss occurs at break-even because Total Cost = Total Revenue. [link] illustrates the components of the break-even point:

Examples of the Effects of Variable and Fixed Costs in Determining the Break-Even Point

Companies typically do not want to simply break even, as they are in business to make a profit. Break-even analysis also can help companies determine the level of sales (in dollars or in units) that is needed to make a desired profit. The process for factoring a desired level of profit into a break-even analysis is to add the desired level of profit to the fixed costs and then calculate a new break-even point. We know that Hicks Manufacturing breaks even at 225 Blue Jay birdbaths, but what if they have a target profit for the month of July? They can simply add that target to their fixed costs. By calculating a target profit, they will produce and (hopefully) sell enough bird baths to cover both fixed costs and the target profit.

Application of Break-Even Concepts for a Service Organization

Because break-even analysis is applicable to any business enterprise, we can apply these same principles to a service organization. For example, Marshall & Hirito is a mid-sized accounting firm that provides a wide range of accounting services to its clients but relies heavily on personal income tax preparation for much of its revenue. They have analyzed the cost to the firm associated with preparing these returns. They have determined the following cost structure for the preparation of a standard 1040A Individual Income Tax Return:

Perform Break-Even Sensitivity Analysis for a Single Product Under Changing Business Situations

The Effects on Break-Even under Changing Business Conditions

Circumstances often change within a company, within an industry, or even within the economy that impact the decision-making of an organization. Sometimes, these effects are sudden and unexpected, for example, if a hurricane destroyed the factory of a company’s major supplier; other times, they occur more slowly, such as when union negotiations affect your labor costs. In either of these situations, costs to the company will be affected. Using CVP analysis, the company can predict how these changes will affect profits.

Changing a Single Variable

To demonstrate the effects of changing any one of these variables, consider Back Door Café, a small coffee shop that roasts its own beans to make espresso drinks and gourmet coffee. They also sell a variety of baked goods and T-shirts with their logo on them. They track their costs carefully and use CVP analysis to make sure that their sales cover their fixed costs and provide a reasonable level of profit for the owners.

Changing Multiple Variables

We have analyzed situations in which one variable changes, but often, more than one change will occur at a time. For example, a company may need to lower its selling price to compete, but they may also be able to lower certain variable costs by switching suppliers.

Perform Break-Even Sensitivity Analysis for a Multi-Product Environment Under Changing Business Situations

The Basics of Break-Even Analysis in a Multi-Product Environment

In order to perform a break-even analysis for a company that sells multiple products or provides multiple services, it is important to understand the concept of a sales mix. A sales mix represents the relative proportions of the products that a company sells—in other words, the percentage of the company’s total revenue that comes from product A, product B, product C, and so forth. Sales mix is important to business owners and managers because they seek to have a mix that maximizes profit, since not all products have the same profit margin. Companies can maximize their profits if they are able to achieve a sales mix that is heavy with high-margin products, goods, or services. If a company focuses on a sales mix heavy with low-margin items, overall company profitability will often suffer.

Calculating Break-Even Analysis in a Multi-Product Environment

When a company sells more than one product or provides more than one service, break-even analysis is more complex because not all of the products sell for the same price or have the same costs associated with them: Each product has its own margin. Consequently, the break-even point in a multi-product environment depends on the mix of products sold. Further, when the mix of products changes, so does the break-even point. If demand shifts and customers purchase more low-margin products, then the break-even point rises. Conversely, if customers purchase more high-margin products, the break-even point falls. In fact, even if total sales dollars remain unchanged, the break-even point can change based on the sales mix. Let’s look at an example of how break-even analysis works in a multi-product environment.

Calculate and Interpret a Company’s Margin of Safety and Operating Leverage

Margin of Safety

A company’s margin of safety is the difference between its current sales and its break-even sales. The margin of safety tells the company how much they could lose in sales before the company begins to lose money, or, in other words, before the company falls below the break-even point. The higher the margin of safety is, the lower the risk is of not breaking even or incurring a loss. In order to calculate margin of safety, we use the following formula:

Operating Leverage

In much the same way that managers control the risk of incurring a net loss by watching their margin of safety, being aware of the company’s operating leverage is critical to the financial well-being of the firm. Operating leverage is a measurement of how sensitive net operating income is to a percentage change in sales dollars. Typically, the higher the level of fixed costs, the higher the level of risk. However, as sales volumes increase, the payoff is typically greater with higher fixed costs than with higher variable costs. In other words, the higher the risk the greater the payoff.

Job Order Costing

Why It Matters

Distinguish between Job Order Costing and Process Costing

Job Order Costing versus Process Costing

Job order costing is an accounting system that traces the individual costs directly to a final job or service, instead of to the production department. It is used when goods are made to order or when individual costs are easy to trace to individual jobs, assuming that the additional information provides value. In these circumstances, the individual costs are easy to trace to the individual jobs.

Recording Costs in Job Order Costing versus Process Costing

Both job order costing and process costing track the costs of materials, labor, and overhead as components of virtually all products. The process of production does not change because of the costing method: The costing method is chosen based on the process of production and is intended to provide the most accurate representation of the costs incurred in the production process.

Describe and Identify the Three Major Components of Product Costs under Job Order Costing

Direct Materials

Direct materials are those materials that can be directly traced to the manufacturing of the product. Some examples of direct materials for different industries are shown in [link]. In order to respond quickly to production needs, companies need raw materials inventory on hand. While production volume might change, management does not want to stop production to wait for raw materials to be delivered. Further, a company needs raw materials on hand for future jobs as well as for the current job. The materials are sent to the production department as it is needed for production of the products.

Direct Labor

Direct labor is the total cost of wages, payroll taxes, payroll benefits, and similar expenses for the individuals who work directly on manufacturing a particular product. The direct labor costs for Dinosaur Vinyl to complete Job MAC001 occur in the production and finishing departments. In the production department, two individuals each work one hour at a rate of \$15 per hour, including taxes and benefits. The finishing department’s direct labor involves two individuals working one hour each at a rate of \$18 per hour. [link] shows the direct labor costs for Job MAC001.

Manufacturing Overhead

Recall that the costs of a manufactured item are direct materials, direct labor, and manufacturing overhead. Costs that support production but are not direct materials or direct labor are considered overhead. Manufacturing overhead has three components: indirect materials, indirect labor, and overhead.

Use the Job Order Costing Method to Trace the Flow of Product Costs through the Inventory Accounts

Raw Materials Inventory

Raw materials inventory is the total cost of materials that will be used in the production process. Usually, several accounts make up the raw materials inventory, and these can be actual accounts or accounts subsidiary to the general raw materials inventory account. In our example, Dinosaur Vinyl has several raw materials accounts: vinyl, red ink, black ink, gold ink, grommets, and wood.

Work in Process Inventory

In a job order cost system, the balance in the work in process inventory account is continually updated as job costs are recorded and is the total of all unfinished jobs, as shown on the individual job cost sheets.

Finished Goods Inventory

After each job has been completed and overhead has been applied, the product is transferred to the finished goods inventory where it stays until it is sold. As each job is transferred, the costs are summarized and transferred as well, and the job cost sheet is completed to show the actual production cost of the product and the sales price of the items produced.

Cost of Goods Sold

The cost of goods sold is the manufacturing cost of the items sold during the period. It is calculated by adding the beginning finished goods inventory and the cost of goods manufactured to arrive at the cost of goods available for sale. The cost of goods available for sale less the ending inventory results in the cost of goods sold.

Compute a Predetermined Overhead Rate and Apply Overhead to Production

Fundamental Characteristics of the Overhead Determination Environment

Added to these issues is the nature of establishing an overhead rate, which is often completed months before being applied to specific jobs. Establishing the overhead allocation rate first requires management to identify which expenses they consider manufacturing overhead and then to estimate the manufacturing overhead for the next year. Manufacturing overhead costs include all manufacturing costs except for direct materials and direct labor. Therefore, in order to estimate manufacturing overhead, management must estimate the future purchase prices of dozens, or sometimes hundreds, of individual components, such as utilities, raw materials, contract labor, or diesel fuel. Estimating overhead costs is difficult because many costs fluctuate significantly from when the overhead allocation rate is established to when its actual application occurs during the production process. You can envision the potential problems in creating an overhead allocation rate within these circumstances.

Determining Estimated Overhead Cost

The estimated or budgeted overhead is the amount of overhead determined during the budgeting process and consists of manufacturing costs but, as you have learned, excludes direct materials and direct labor. Examples of manufacturing overhead costs include indirect materials, indirect labor, manufacturing utilities, and manufacturing equipment depreciation. Another way to view it is overhead costs are those production costs that are not categorized as direct materials or direct labor.

Compute the Cost of a Job Using Job Order Costing

Determining the Costs of an Individual Job Using Job Order Costing

When a job is completed, the costs of the job—the direct materials, direct labor, and manufacturing overhead—are totaled on the job cost sheet, and the total amount is transferred to finished goods at the same time the product is transferred, either physically or legally, such as in the case of a home built by a contractor. Finally, when the product is sold, the sale is recorded at the sale price, while the cost is transferred from finished goods inventory to the cost of goods sold expense account. [link] shows the flow of costs from raw materials inventory to cost of goods sold.

Sample Cost Information for Dinosaur Vinyl

Dinosaur Vinyl worked on three jobs during the month: POR143, MAC001, and TRJ441, and a fourth Job SWM505 had been finished and moved to the finished goods inventory account during the previous month.

Mechanics of Job Order Costing for Dinosaur Vinyl

The amounts in raw materials, work in process, and finished goods inventories compose the total cost for each account, whereas the job cost sheets contain the costs for each individual job. A summary of the jobs for Dinosaur Vinyl is given in [link].

Determine and Dispose of Underapplied or Overapplied Overhead

Prepare Journal Entries for a Job Order Cost System

Journal Entries to Move Direct Materials, Direct Labor, and Overhead into Work in Process

Dinosaur Vinyl keeps track of its inventory and orders additional inventory to have on hand when the production department requests it. This inventory is not associated with any particular job, and the purchases stay in raw materials inventory until assigned to a specific job. For example, Dinosaur Vinyl purchased an additional \$10,000 of vinyl and \$500 of black ink to complete Macs & Cheese’s billboard. If the purchase is made on account, the entry is as shown:

Journal Entry to Move Work in Process Costs into Finished Goods

When each job and job order cost sheet have been completed, an entry is made to transfer the total cost from the work in process inventory to the finished goods inventory. The total cost of the product for Job MAC001 is \$931 and the entry is:

Journal Entries to Move Finished Goods into Cost of Goods Sold

When the sale has occurred, the goods are transferred to the buyer. The product is transferred from the finished goods inventory to cost of goods sold. A corresponding entry is also made to record the sale. The sign for Job MAC001 had a sales price of \$2,000 and a cost of \$931. These are the entries to record the transfer of goods and sale to the buyer:

Explain How a Job Order Cost System Applies to a Nonmanufacturing Environment

Fundamentals of the Job Order Costing Method for Service Entities

Instead of being dependent on materials, service industries depend on labor. Since their work is labor intensive, it makes sense to use labor as an activity base with billable hours often as the best allocation base. For example, in an audit, there often will be several accountants, with differing levels of experience and expertise involved in the assignment. The accounting firms have more billable hours at the staff level and fewer billable hours at the partner level. And since the firm bills the partner’s time at a significantly higher rate than the staff, it makes sense to apply overhead at the billable hours instead of the billable costs.

Service Entity Use of a Job Order Costing System

To understand how a service provider uses a job order cost system, let’s consider the case of IFixIT. IFixIT Systems is a Sony-authorized repair provider that fixes audiovisual equipment brought in by customers. IFixIT requires customers to pay \$50 to diagnose the problem. IFixIt pays its employees \$25 per hour and assigns overhead equal to its direct labor cost. The customers’ bills do not show overhead and are instead itemized as parts plus labor, where the cost for parts is the original cost plus a markup, and the labor rate is \$80 per hour.

Process Costing

Why It Matters

Compare and Contrast Job Order Costing and Process Costing

Basic Managerial Accounting Terms Used in Job Order Costing and Process Costing

Regardless of the costing system used, manufacturing costs consist of direct material, direct labor, and manufacturing overhead. [link] shows a partial organizational chart for Rock City Percussion, a drumstick manufacturer. In this example, two groups—administrative and manufacturing—report directly to the chief financial officer (CFO). Each group has a vice president responsible for several departments. The organizational chart also shows the departments that report to the production department, illustrating the production arrangement. The material storage unit stores the types of wood used (hickory, maple, and birch), the tips (nylon and felt), and packaging materials.

Equivalent Units

In a process cost system, costs are maintained by each department, and the method for determining the cost per individual unit is different than in a job order costing system. Rock City Percussion uses a process cost system because the drumsticks are produced in batches, and it is not economically feasible to trace the direct labor or direct material, like hickory, to a specific drumstick. Therefore, the costs are maintained by each department, rather than by job, as they are in job order costing.

Major Characteristics of Process Costing

Process costing is the optimal system for a company to use when the production process results in many similar units. It is used when production is continuous or occurs in large batches and it is difficult to trace a particular input cost to a specific individual product.

Similarities between Process Costing and Job Order Costing

Both process costing and job order costing maintain the costs of direct material, direct labor, and manufacturing overhead. The process of production does not change because of the costing method. The costing method is chosen based on the production process.

Explain and Identify Conversion Costs

Definition of Conversion Costs

Conversion costs are the total of direct labor and factory overhead costs. They are combined because it is the labor and overhead together that convert the raw material into the finished product. Remember that factory, manufacturing, or organizational overhead (you might see all three terms in practice) is composed of three sources: indirect materials, indirect labor, and all other overhead costs that are not indirect materials or indirect labor. Materials are often added in stages at discrete points of production, such as at the beginning, middle, or end of a process, but conversion is usually applied equally throughout the process. For example, in the opening example, David and William do not add direct material (ingredients) evenly throughout the cookie-making process. They are all added at the beginning of the production process, so they begin with the direct materials but add labor and overhead throughout the rest of the process.

Mechanics of Applying Conversion Costs

Let’s return to our drumstick example to learn how to work with conversion costs. Rock City Percussion has two departments critical to manufacturing drumsticks: the shaping and packaging departments.

Explain and Compute Equivalent Units and Total Cost of Production in an Initial Processing Stage

Step One: Determining the Units to Which Costs Will Be Assigned

In addition to the equivalent units, it is necessary to track the units completed as well as the units remaining in ending inventory. A similar process is used to account for the costs completed and transferred. Reconciling the number of units and the costs is part of the process costing system. The reconciliation involves the total of beginning inventory and units started into production. This total is called “units to account for,” while the total of beginning inventory costs and costs added to production is called “costs to be accounted for.” Knowing the total units or costs to account for is helpful since it also equals the units or costs transferred out plus the amount remaining in ending inventory.

Step Two: Computing the Equivalent Units of Production

All of the materials have been added to the shaping department, but all of the conversion elements have not; the numbers of equivalent units for material costs and for conversion costs remaining in ending inventory are different. All of the units transferred to the next department must be 100% complete with regard to that department’s cost or they would not be transferred. So the number of units transferred is the same for material units and for conversion units. The process cost system must calculate the equivalent units of production for units completed (with respect to materials and conversion) and for ending work in process with respect to materials and conversion.

Step Three: Determining the Cost per Equivalent Unit

Once the equivalent units for materials and conversion are known, the cost per equivalent unit is computed in a similar manner as the units accounted for. The costs for material and conversion need to reconcile with the total beginning inventory and the costs incurred for the department during that month.

Step Four: Allocating the Costs to the Units Transferred Out and Partially Completed in the Shaping Department

Now you can determine the cost of the units transferred out and the cost of the units still in process in the shaping department. To calculate the goods transferred out, simply take the units transferred out times the sum of the two equivalent unit costs (materials and conversion) because all items transferred to the next department are complete with respect to materials and conversion, so each unit brings all its costs. But the ending WIP value is determined by taking the product of the work in process material units and the cost per equivalent unit for materials plus the product of the work in process conversion units and the cost per equivalent unit for conversion.

Explain and Compute Equivalent Units and Total Cost of Production in a Subsequent Processing Stage

Step One: Determining the Stage 2 Units to Which Costs Will Be Assigned

In the initial manufacturing department, there is beginning inventory, and units are started in production. In subsequent stages, instead of starting new units, units are transferred in from the prior department, but the accounting process is the same. Returning to the example, Rock City Percussion had a beginning inventory of 750 units in the packaging department. When the 7,500 sticks are transferred into the packaging department from the shaping department, the total number of units to account for in the reconciliation is 8,250, which is the total of the beginning WIP and the units transferred in:

Step Two: Computing the Stage 2 Equivalent Units of Production

The only direct material added in the packaging department for the 5A sticks is packaging. The packaging materials are added at the beginning of the process, so all the materials have been added before the units are transferred out, but all of the conversion elements have not. As a result, the number of equivalent units for material costs and for conversion costs remaining in ending inventory is different for the testing and sorting department. As you’ve learned, all of the units transferred to the next department must be 100% complete with regard to that department’s cost, or they would not be transferred. The process cost system must calculate the equivalent units of production for units completed (with respect to materials and conversion) and for ending WIP with respect to materials and conversion.

Step Three: Determining the Stage 2 Cost per Equivalent Unit

Once the equivalent units for materials and conversion are known for the packaging department, the cost per equivalent unit is computed in a manner similar to the calculation for the units accounted for. The costs for material and conversion need to reconcile with the department’s beginning inventory and the costs incurred for the department during that month.

Step Four: Allocating the Costs to the Units in the Finishing Department

Now you can determine the cost of the units transferred out and the cost of the units still in process in the finishing department. For the goods transferred out, simply take the units transferred out times the sum of the two equivalent unit costs (materials and conversion) because all items transferred to the next department are complete with respect to materials and conversion, so each unit brings all its costs. But the ending WIP value is determined by taking the product of the work in process materials units and the cost per equivalent unit for materials plus the product of the work in process conversion units and the cost per equivalent unit for conversion.

Prepare Journal Entries for a Process Costing System

Purchased Materials for Multiple Departments

Each department within Rock City Percussion has a separate work in process inventory account. Raw materials totaling \$33,500 were ordered prior to being requisitioned by each department: \$25,000 for the shaping department and \$8,500 for the packaging department. The July 1 journal entry to record the purchases on account is:

Direct Materials Requisitioned by the Shaping and Packaging Departments and Indirect Material Used

During July, the shaping department requisitioned \$10,179 in direct material. Similar to job order costing, indirect material costs are accumulated in the manufacturing overhead account. The overhead costs are applied to each department based on a predetermined overhead rate. In the example, assume that there was an indirect material cost for water of \$400 in July that will be recorded as manufacturing overhead. The journal entry to record the requisition and usage of direct materials and overhead is:

Direct Labor Paid by All Production Departments

During July, the shaping department incurred \$15,000 in direct labor costs and \$600 in indirect labor. The journal entry to record the labor costs is:

Applied Manufacturing Overhead to All Production Departments

Manufacturing overhead includes indirect material, indirect labor, and other types of manufacturing overhead. It is difficult, if not impossible, to trace manufacturing overhead to a specific product, and yet, the total cost per unit needs to include overhead in order to make management decisions.

Transferred Costs of Finished Goods from the Shaping Department to the Packaging Department

When the units are transferred from the shaping department to the packaging department, they are transferred at \$3.97 per unit, as calculated previously. The amount transferred from the shaping department is the same amount listed on the production cost report in [link]. The journal entry is:

Transferred Goods from the Packaging Department to Finished Goods

The computation of inventory for the packaging department is shown in [link].

Recording the Cost of Goods Sold Out of the Finished Goods Inventory

Each unit is a package of two drumsticks that cost \$8.40 to make and sells for \$24.99. There are two transactions when recording a sale. One entry is to transfer the inventory from finished goods inventory to cost of goods sold and is at the cost of the product. The second transaction is to record the sale at the sales price. The compound entry to record both transactions for the sale of 500 units on account is:

Activity-Based, Variable, and Absorption Costing

Why It Matters

Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method

Component Categories under Traditional Allocation

Traditional allocation involves the allocation of factory overhead to products based on the volume of production resources consumed, such as the amount of direct labor hours consumed, direct labor cost, or machine hours used. In order to perform the traditional method, it is also important to understand each of the involved cost components: direct materials, direct labor, and manufacturing overhead. Direct materials and direct labor are cost categories that are relatively easy to trace to a product. Direct material comprises the supplies used in manufacturing that can be traced directly to the product. Direct labor is the work used in manufacturing that can be directly traced to the product. Although the processes for tracing the costs differ, both job order costing and process costing trace the material and labor through materials requisition requests and time cards or electronic mechanisms for measuring labor input. Job order costing traces the costs directly to the product, and process costing traces the costs to the manufacturing department.

Estimated Total Manufacturing Overhead Costs

The more challenging product component to track is manufacturing overhead. Overhead consists of indirect materials, indirect labor, and other costs closely associated with the manufacturing process but not tied to a specific product. Examples of other overhead costs include such items as depreciation on the factory machinery and insurance on the factory building. Indirect material comprises the supplies used in production that cannot be traced to an individual product, and indirect labor is the work done by employees not directly involved in the manufacturing process, such as the supervisors’ salaries or the maintenance staff’s wages. Because these costs cannot be traced directly to the product like direct costs are, they have to be allocated among all of the products produced and added, or applied, to the production and product cost.

Calculation of Predetermined Overhead and Total Cost under Traditional Allocation

The predetermined overhead rate is set at the beginning of the year and is calculated as the estimated (budgeted) overhead costs for the year divided by the estimated (budgeted) level of activity for the year. This activity base is often direct labor hours, direct labor costs, or machine hours. Once a company determines the overhead rate, it determines the overhead rate per unit and adds the overhead per unit cost to the direct material and direct labor costs for the product to find the total cost.

Describe and Identify Cost Drivers

Cost Drivers and Overhead

In today’s production environment, there are many activities within the production process that can contribute to the cost of the product, but determining the cost drivers may be complicated because some of those activities may change over time. Additionally, the appropriate level of assigning cost drivers needs to be determined. In some cases, overhead costs such as inspection increase with each unit inspected, and the costs need to be allocated on a per-unit level. In other cases, the overhead costs, such as machine setup costs, are incurred each time a batch of products is manufactured and need to be allocated at the batch level.

Identify Cost Drivers

How does a company determine its cost drivers for indirect materials, indirect labor, and other overhead costs? To begin the determination of appropriate cost drivers, an accountant analyzes the activities in the product production process that contribute to the cost of that product. An activity is any action that consumes company resources, such as taking orders for a product, setting up machines to produce the product, inspecting the product, and providing customer support before and through the order process. For example, Musicality’s direct costs can be traced to the products, but there are indirect costs associated with using various types of material for each product. While the Orchestra product has more intricate materials and labor, it has fewer costs associated with requisitioning and conveying materials to the production line than the other products have. Additionally, examining the inspection costs indicates the Orchestra product is a simple product to inspect, so random quality inspections are sufficient. But individual inspections for both the Solo and Band products are critical, and the overhead related to inspection costs should be based on the number of inspections.

Calculate Activity-Based Product Costs

Historical Perspective on Determination of Manufacturing Overhead Allocation

All products consist of material, labor, and overhead, and the major cost components have historically been materials and labor. Manufacturing overhead was not a large cost of the product, so an overhead allocation method based on labor or machine hours was logical. For example, as shown in [link], Musicality determined the direct costs and direct labor for their three products: Solo, Band, and Orchestra. Under the traditional method of costing, the predetermined overhead rate of \$2 per direct labor hour was computed by dividing the estimated overhead by the estimated direct labor hours. Based on the number of direct labor hours and the number of units produced for each product, the overhead per product is shown in [link].

Establishing an Activity-Based Costing System

ABC is a five-stage process that allocates overhead more precisely than traditional allocation does by applying it to the products that use those activities. ABC works best in complex processes where the expenses are not driven by a single cost driver. Instead, several cost drivers are used as the overhead costs are analyzed and grouped into activities, and each activity is allocated based on each group’s cost driver. The five stages of the ABC process are:

The Calculation of Product Costs Using the Activity-Based Costing Allocation Method

Musicality is considering switching to an activity-based costing approach for determining overhead and has collected data to help them decide which overhead allocation method they should use. Performing the analysis requires these steps:

The Service Industries and Their Use of the Activity-Based Costing Allocation Method

ABC costing was developed to help management understand manufacturing costs and how they can be better managed. However, the service industry can apply the same principles to improve its cost management. Direct material and direct labor costs range from nonexistent to minimal in the service industry, which makes the overhead application even more important. The number and types of cost pools may be completely different in the service industry as compared to the manufacturing industry. For example, the health-care industry may have different overhead costs and cost drivers for the treatment of illnesses than they have for injuries. Some of the overhead related to monitoring a patient’s health status may overlap, but most of the overhead related to diagnosis and treatment differ from each other.

Compare and Contrast Traditional and Activity-Based Costing Systems

Advantages and Disadvantages of the Traditional Method of Calculating Overhead

The traditional allocation system assigns manufacturing overhead based on a single cost driver, such as direct labor hours, direct labor dollars, or machine hours, and is optimal when there is a relationship between the activity base and overhead. This most often occurs when direct labor is a large part of the product cost. The theory supporting the single cost driver is that the cost driver selected increases as overhead increases, and further analysis is more costly than it is valuable. Each method has its advantages and disadvantages. These are advantages of the traditional method:

Advantages and Disadvantages of Creating an Activity-Based Costing System for Allocating Overhead

While ABC systems more accurately allocate the costs based on the various resources used to make the product, they cost more to use and, therefore, are not always the best method. Management needs to consider each system and how it will work within its own organization. Some advantages of activity-based costing include:

Compare and Contrast Variable and Absorption Costing

Variable Costing Versus Absorption Costing Methods

The difference between the absorption and variable costing methods centers on the treatment of fixed manufacturing overhead costs. Absorption costing “absorbs” all of the costs used in manufacturing and includes fixed manufacturing overhead as product costs. Absorption costing is in accordance with GAAP, because the product cost includes fixed overhead. Variable costing considers the variable overhead costs and does not consider fixed overhead as part of a product’s cost. It is not in accordance with GAAP, because fixed overhead is treated as a period cost and is not included in the cost of the product.

Advantages and Disadvantages of the Variable Costing Method

Variable costing only includes the product costs that vary with output, which typically include direct material, direct labor, and variable manufacturing overhead. Fixed overhead is not considered a product cost under variable costing. Fixed manufacturing overhead is still expensed on the income statement, but it is treated as a period cost charged against revenue for each period. It does not include a portion of fixed overhead costs that remains in inventory and is not expensed, as in absorption costing.

Advantages and Disadvantages of the Absorption Costing Method

Under the absorption costing method, all costs of production, whether fixed or variable, are considered product costs. This means that absorption costing allocates a portion of fixed manufacturing overhead to each product.

Comparing the Operating Income Statements for Both Methods Assuming No Ending Inventory in the First Year, and the Existence of Ending Inventory in the Second Year

In order to understand how to prepare income statements using both methods, consider a scenario in which a company has no ending inventory in the first year but does have ending inventory in the second year. Outdoor Nation, a manufacturer of residential, tabletop propane heaters, wants to determine whether absorption costing or variable costing is better for internal decision-making. It manufactures 5,000 units annually and sells them for \$15 per unit. The total of direct material, direct labor, and variable overhead is \$5 per unit with an additional \$1 in variable sales cost paid when the units are sold. Additionally, fixed overhead is \$15,000 per year, and fixed sales and administrative expenses are \$21,000 per year.

Budgeting

Why It Matters

Describe How and Why Managers Use Budgets

The Basics of Budgeting

All companies—large and small—have limits on the amount of money or resources they can receive and pay out. How these resources are used to reach their goals and objectives must be planned. The quantitative plan estimating when and how much cash or other resources will be received and when and how the cash or other resources will be used is the budget. As you’ve learned, some of the benefits of budgeting include improved communication, planning, coordination, and evaluation.

The Role of the Master Budget

Most organizations will create a master budget—whether that organization is large or small, public or private, or a merchandising, manufacturing, or service company. A master budget is one that includes two areas, operational and financial, each of which has its own sub-budgets. The operating budget spans several areas that help plan and manage day-to-day business. The financial budget depicts the expectations for cash inflows and outflows, including cash payments for planned operations, the purchase or sale of assets, the payment or financing of loans, and changes in equity. Each of the sub-budgets is made up of separate but interrelated budgets, and the number and type of separate budgets will differ depending on the type and size of the organization. For example, the sales budget predicts the sales expected for each quarter. The direct materials budget uses information from the sales budget to compute the number of units necessary for production. This information is used in other budgets, such as the direct materials budget, which plans when materials will be purchased, how much will be purchased, and how much that material should cost. You will review some specific examples of budgeting for direct materials in Prepare Operating Budgets.

The Role of Operating Budgets

An operating budget consists of the sales budget, production budget, direct material budget, direct labor budget, and overhead budget. These budgets serve to assist in planning and monitoring the day-to-day activities of the organization by informing management of how many units need to be produced, how much material needs to be ordered, how many labor hours need to be scheduled, and the amount of overhead expected to be incurred. The individual pieces of the operating budget collectively lead to the creation of the budgeted income statement. For example, Big Bad Bikes estimates it will sell 1,000 trainers for \$70 each in the first quarter and prepares a sales budget to show the sales by quarter. Management understands that it needs to have on hand the 1,000 trainers that it estimates will be sold. It also understands that additional inventory needs to be on hand in the event there are additional sales and to prepare for sales in the second quarter. This information is used to develop a production budget. Each trainer requires 3.2 pounds of material that usually costs \$1.25 per pound. Knowing how many units are to be produced and how much inventory needs to be on hand is used to develop a direct materials budget.

The Role of Financial Budgets

A financial budget consists of the cash budget, the budgeted balance sheet, and the budget for capital expenses. Similar to the individual budgets that make up the operating budgets, the financial budgets serve to assist with planning and monitoring the financing requirements of the organization. Management plans its capital asset needs and states them in the capital expense budget. Management addresses its collection and payment policies to determine when it will receive cash from sales and when it will pay the material, labor, and overhead expenses. The capital expense budget and the estimated payment and collection of cash allow management to build a cash budget and determine when it will need financing or have additional funds to pay back loans. These budgets taken together will be part of the budgeted balance sheet. [link] shows how these budgets relate.

Prepare Operating Budgets

Individual Operating Budgets

In order for an organization to align the budget with the strategic plan, it must budget for the day-to-day operations of the business. This means the company must understand when and how many sales will occur, as well as what expenses are required to generate those sales. In short, each component—sales, production, and other expenses—must be properly budgeted to generate the operating budget components and the resulting pro-forma budgeted income statement.

Prepare Financial Budgets

Individual Financial Budgets

Preparing a financial budget first requires preparing the capital asset budget, the cash budgets, and the budgeted balance sheet. The capital asset budget represents a significant investment in cash, and the amount is carried to the cash budget. Therefore, it needs to be prepared before the cash budget. If the cash will not be available, the capital asset budget can be adjusted and, again, carried to the cash budget.

Prepare Flexible Budgets

Flexible Budgets

A flexible budget is one based on different volumes of sales. A flexible budget flexes the static budget for each anticipated level of production. This flexibility allows management to estimate what the budgeted numbers would look like at various levels of sales. Flexible budgets are prepared at each analysis period (usually monthly), rather than in advance, since the idea is to compare the operating income to the expenses deemed appropriate at the actual production level.

Static versus Flexible Budgets

A static budget is one that is prepared based on a single level of output for a given period. The master budget, and all the budgets included in the master budget, are examples of static budgets. Actual results are compared to the static budget numbers as one means to evaluate company performance. However, this comparison may be like comparing apples to oranges because variable costs should follow production, which should follow sales. Thus, if sales differ from what is budgeted, then comparing actual costs to budgeted costs may not provide a clear indicator of how well the company is meeting its targets. A flexible budget created each period allows for a comparison of apples to apples because it will calculate budgeted costs based on the actual sales activity.

Budget with Varying Levels of Production

Companies develop a budget based on their expectations for their most likely level of sales and expenses. Often, a company can expect that their production and sales volume will vary from budget period to budget period. They can use their various expected levels of production to create a flexible budget that includes these different levels of production. Then, they can modify the flexible budget when they have their actual production volume and compare it to the flexible budget for the same production volume. A flexible budget is more complicated, requires a solid understanding of a company’s fixed and variable expenses, and allows for greater control over changes that occur throughout the year. For example, suppose a proposed sale of items does not occur because the expected client opted to go with another supplier. In a static budget situation, this would result in large variances in many accounts due to the static budget being set based on sales that included the potential large client. A flexible budget on the other hand would allow management to adjust their expectations in the budget for both changes in costs and revenue that would occur from the loss of the potential client. The changes made in the flexible budget would then be compared to what actually occurs to result in more realistic and representative variance. This ability to change the budget also makes it easier to pinpoint who is responsible if a revenue or cost target is missed.

Explain How Budgets Are Used to Evaluate Goals

Standard Costs and Variances

Why It Matters

Explain How and Why a Standard Cost Is Developed

Fundamentals of Standard Costs

It is important to establish standards for cost at the beginning of a period to prepare the budget; manage material, labor, and overhead costs; and create a reasonable sales price for a good. A standard cost is an expected cost that a company usually establishes at the beginning of a fiscal year for prices paid and amounts used. The standard cost is an expected amount paid for materials costs or labor rates. The standard quantity is the expected usage amount of materials or labor. A standard cost may be determined by past history or industry norms. The company can then compare the standard costs against its actual results to measure its efficiency. Sometimes when comparing standard costs against actual results, there is a difference.

Manufacturing Cost Variances

As you’ve learned, the standard price and standard quantity are anticipated amounts. Any change from these budgeted amounts will produce a variance. There can be variances for materials, labor, and overhead. Direct materials may have a variance in price of materials or quantity of materials used. Direct labor may have a variance in the rate paid to workers or the amount of time used to make a product. Overhead may produce a variance in expected fixed or variable costs, leading to possible differences in production capacity and management’s ability to control overhead. More specifics on the formulas, processes, and interpretations of the direct materials, direct labor, and overhead variances are discussed in each of this chapter’s following sections.

Compute and Evaluate Materials Variances

Fundamentals of Direct Materials Variances

The direct materials variances measure how efficient the company is at using materials as well as how effective it is at using materials. There are two components to a direct materials variance, the direct materials price variance and the direct materials quantity variance, which both compare the actual price or amount used to the standard amount.

Total Direct Materials Cost Variance

When a company makes a product and compares the actual materials cost to the standard materials cost, the result is the total direct materials cost variance.

Compute and Evaluate Labor Variances

Fundamentals of Direct Labor Variances

The direct labor variance measures how efficiently the company uses labor as well as how effective it is at pricing labor. There are two components to a labor variance, the direct labor rate variance and the direct labor time variance.

Compute and Evaluate Overhead Variances

Determination and Evaluation of Overhead Variance

In a standard cost system, overhead is applied to the goods based on a standard overhead rate. This is similar to the predetermined overhead rate used previously. The standard overhead rate is calculated by dividing budgeted overhead at a given level of production (known as normal capacity) by the level of activity required for that particular level of production.

Describe How Companies Use Variance Analysis

Responsibility Accounting and Decentralization

Why It Matters

Differentiate between Centralized and Decentralized Management

Management Control System

It is important for those studying business (and accounting, in particular) to understand the concept of a management control system. A management control system is a structure within an organization that allows managers to establish, implement, and monitor progress toward the strategic goals of the organization.

Centralized Organizations

Centralization is a business structure in which one individual makes the important decisions (such as resource allocation) and provides the primary strategic direction for the company. Most small businesses are centralized in that the owner makes all decisions regarding products, services, strategic direction, and most other significant areas. However, a business does not have to be small to be centralized. Apple is an example of a business with a centralized management structure. Within Apple, much of the decision-making responsibility lies with the Chief Executive Officer (CEO) Tim Cook, who assumed the leadership role within Apple following the death of Steve Jobs. Apple has long been viewed as an organization that maintains a high level of centralized control over the company’s strategic initiatives such as new product development, markets to operate in, and company acquisitions. Many businesses in rapidly changing technological environments have a centralized form of management structure. The decisions made by the lower level management are limited in a centralized environment.

Decentralized Organizations

Decentralization is a business structure in which the decision-making is made at various levels of the organization. Typically, decentralized businesses are divided into smaller segments or groups in order to make it easier to measure the performance of the company and the individuals within each of the sub-groups.

Daily and Strategic Decision-Making

An underlying assumption is that businesses possess a single structure (either centralized or decentralized) at any given point. That is not necessarily the case. For example, businesses often add employees who specialize in the various needs of the organization. Over the life of an organization, it is not uncommon for businesses to demonstrate aspects of both centralization and decentralization.

Describe How Decision-Making Differs between Centralized and Decentralized Environments

Organizational Charts

Many organizations use an organizational chart to graphically represent the authority for decision-making and oversight. Organizational charts are similar in appearance to flowcharts. An organizational chart for a centralized organization is shown in [link]. The middle tier represents position held by individuals or departments within the company. The lowest tier represents geographic locations in which the company operates. The lines connecting the boxes indicate the relationship among the segments and branch from the ultimate and decision-making authority. Organizational charts are typically arranged with the highest-ranking person (or group) listed at the top.

How Does Decision-Making Differ in a Centralized versus a Decentralized Environment?

The CEO of a centralized organization will determine the direction of the company and determine how to get the company to its goals. The steps necessary to reach these goals are then passed along to the lower-level managers who carry out these steps and report back to the CEO. The CEO would then evaluate the results and incorporate any necessary operational changes. On the other hand, the CEO of a decentralized organization will determine the goals of the company and either pass along the goals to the divisional managers for them to determine how to reach these goals or work with the managers to determine the strategic plans and how to meet the goals laid out by those plans. The divisional managers will then meet with the managers below them to determine the best way to reach these goals. The lower-level managers are responsible for carrying out the plan and reporting their results to the manager above them. The higher-level managers will combine the results of several managers and evaluate those results before sending them to the divisional manager.

Describe the Types of Responsibility Centers

Fundamentals of Responsibility Accounting and Responsibility Centers

Recall the discussion of management control systems. These systems allow management to establish, implement, monitor, and adjust the activities of the organization toward attainment of strategic goals. Responsibility accounting and the responsibility centers framework focuses on monitoring and adjusting activities, based on financial performance. This framework allows management to gain valuable feedback relating to the financial performance of the organization and to identify any segment activity where adjustments are necessary.

Types of Responsibility Centers

Organizations must exercise care when establishing responsibility centers. In a responsibility accounting framework, decision-making authority is delegated to a specific manager or director of each segment. The manager or director will, in turn, be evaluated based on the financial performance of that segment or responsibility center. It is important, therefore, to establish a responsibility accounting framework that allows for an adequate and equitable evaluation of the financial performance of the responsibility center (and, by default, the manager of the responsibility center) as well as the attainment of the organization’s strategic goals.

Describe the Effects of Various Decisions on Performance Evaluation of Responsibility Centers

Effects of Decisions on Performance Evaluation of Responsibility Centers

Suppose, as the manager of the maintenance department of a major airline, you become aware of a training session that is available to your mechanics. The disadvantages are that the training will require the mechanics to miss an entire week of work and the associated costs (travel, lodging, training session) are high. The advantage is that, as a result of the training, the time during which the planes are grounded for repairs will significantly decrease. What factors would influence your decision regarding whether or not to send mechanics to school? Considering the fact that each mechanic would miss an entire week of work, what factors would you consider in determining how many mechanics to send? Do these factors align with or conflict with what is best for the company or you as the department manager? Is there a way to quantify the investment in the training compared to the benefit of quicker repairs for the airplanes?

Application of Transfer Pricing

Transfer pricing can affect goal congruence—alignment between the goals of the segment or responsibility center, or even an individual manager, with the strategic goals of the organization. Recall what you’ve learned regarding segments of the business. Often, segments will be arranged by the type of product produced or service offered. Segments often sell products to external customers. For example, assume a soft drink company has a segment—called the blending department—dedicated to producing various types of soft drinks. The company may have an external customer to which it sells unique soft drink flavors that the customer will bottle under a different brand name (perhaps a store brand like Kroger or Meijer). The segment may also produce soft drinks for another segment within its own company—the bottling department, for example—for further processing and ultimate sale to external customers. When the internal transfer occurs between the blending segment and the bottling segment, the transaction will be structured as a sale for the blending segment and as a purchase for the bottling department. To facilitate the transaction, the company will establish a transfer price, even though the transaction is internal because each segment is responsible for its own profits and costs.

Available Transfer Pricing Approaches

There are three primary transfer pricing approaches: market-based prices, cost-based prices, or negotiated prices.

Other Transfer Pricing Issues

The three approaches to transfer pricing assume that the selling department has excess capacity to produce additional products to sell internally. What happens if the selling department does not have excess capacity—in other words, if the selling department can sell all that it produces to external customers? If an internal department wants to purchase goods from the selling department, what would be an appropriate selling price? In this case, the transfer price must take into consideration the opportunity cost of the contribution margin that would be lost from having to forego external sales in order to meet internal sales.

Transfer Pricing Example

Regal Paper has two divisions. The Paper Division produces copy paper, wrapping paper, and paper used on the outside of cardboard displays placed in grocery, office, and department stores. The Box Division produces cardboard boxes sold at Christmas, cardboard boxes purchased by manufacturers for packaging their goods, and cardboard displays for stores, particularly seasonal displays. Both divisions are profit centers, and each manager is evaluated and rewarded based on his division’s profitability. The Box Division has approached the Paper Division to buy paper needed to cover cardboard displays that have been ordered by several major snack food manufacturers for the upcoming Superbowl game. The Box Division has been buying the display coverings from an external seller for \$12.50 per unit. Currently, the Paper Division has excess capacity and can fill the order for the 500,000 display coverings that the Box Division is requesting.

Short-Term Decision Making

Why It Matters

Identify Relevant Information for Decision-Making

Relevant Information for Short-Term Decision-Making

Business decision-making can be outlined as a process that is applied by management with each decision that is made. The process of decision-making in a managerial business environment can be summed up in these steps.

Evaluate and Determine Whether to Accept or Reject a Special Order

Fundamentals of the Decision to Accept or Reject a Special Order

The starting point for making this decision is to assess the company’s normal production capacity. The normal capacity is the production level a company can achieve without adding additional production resources, such as additional equipment or labor. For example, if the company can produce 10,000 towels a month based on its current production capacity, and it is currently contracted to produce 9,000 a month, it could not take on a special one-time order for 3,000 towels without adding additional equipment or workers. Most companies do not work at maximum capacity; rather, they function at normal capacity, which is a concept related to a company’s relevant range. The relevant range is the quantitative range of units that can be produced based on the company’s current productive assets. These assets can include equipment capacity or its labor capacity. Labor capacity is typically easier to increase on a short-term basis than equipment capacity. The following example assumes that labor capacity is available, so only equipment capacity is considered in the example.

Sample Data

Franco, Inc., produces dental office examination chairs. Franco has the capacity to produce 5,000 chairs per year and currently is producing 4,000. Each chair retails for \$2,800, and the costs to produce a single chair consist of direct materials of \$750, direct labor of \$600, and variable overhead of \$300. Fixed overhead costs of \$1,350,000 are met by selling the first 3,000 chairs. Franco has received a special order from Ghanem, Inc., to buy 800 chairs for \$1,800. Should Franco accept the special order?

Calculations Using Sample Data

Franco is not operating at capacity and the special order does not take them over capacity. Additionally, all the fixed costs have already been met. Therefore, when evaluating the special order, Franco must determine if the special offer price will meet and exceed the costs to produce the chairs. [link] details the analysis.

Final Analysis of the Decision

The analysis of Franco’s options did not consider any qualitative factors, such as the impact on morale if the company is already at capacity and opts to implement overtime or hire temporary workers to fill the special order. The analysis also does not consider the effect on regular customers if management elects to meet the special order by not fulfilling some of the regular orders. Another consideration is the impact on existing customers if the price offered for the special order is lower than the regular price. These effects may create a bad dynamic between the company and its customers, or they may cause customers to seek products from competitors. As in the example, Franco would need to consider the impact of displacing other customers and the risk of losing business from regular customers, such as dental supply companies, if he is unable to meet their orders. The next step is to do an overall cost/benefit analysis in which Franco would consider not only the quantitative but the qualitative factors before making his final decision on whether or not to accept the special order.

Evaluate and Determine Whether to Make or Buy a Component

Fundamentals of the Decision to Make or to Buy

As with other decisions, the make-versus-buy decision involves both quantitative and qualitative analysis. The quantitative component requires cost analysis to determine which alternative is more cost effective. This cost analysis can be performed by looking at the cost to buy the component versus the cost to produce the component, which allows us to make a decision based on an analysis of unavoidable costs. For example, the costs to produce will include direct materials, direct labor, variable overhead, and fixed overhead. If the business chooses to buy the component instead, the avoidable costs will go away but unavoidable costs will remain and would need to be considered as part of the cost to buy the component.

Sample Data

Thermal Mugs, Inc., manufactures various types of leak-proof personal drink carriers. Thermal’s T6 container, its most insulated carrier, maintains the temperature of the liquid inside for 6 hours. Thermal has designed a new lid for the T6 carrier that allows for easier drinking and pouring. The cost to produce the new lid is \$2.19:

Calculations Using Sample Data

Calculations show that when the relevant costs are compared between the two alternatives, it is more cost effective for Thermal to produce the 120,000 units of the T6 lid internally than to purchase it from Plato.

Final Analysis of the Decision

The difference in these two presentations of the data emphasizes the importance of defining which costs are relevant, as improper cost identification can lead to bad decisions.

Evaluate and Determine Whether to Keep or Discontinue a Segment or Product

Fundamentals of the Decision to Keep or Discontinue a Segment or Product

Two basic approaches can be used to analyze data in this type of decision. One approach is to compare contribution margins and fixed costs. In this method, the contribution margins with and without the segment (or division or product line) are determined. The two contribution margins are compared and the alternative with the greatest contribution margin would be the chosen alternative because it provides the biggest contribution toward meeting fixed costs.

Sample Data

Suppose SnowBucks, Inc., has three product lines: snow boots, snow sporting equipment, and a clothing line for winter sports. It has been brought to senior management’s attention that the snow boot product line is unprofitable. [link] shows the data presented to senior management:

Calculations Using Sample Data

Based on the new information, a new analysis using a product line margin indicates the following:

Final Analysis of the Decision

This new analysis shows that when the relevant costs and revenues are considered, it is apparent the snow boot product line is contributing toward meeting the fixed costs of the organization and therefore to overall corporate profitability. The reason the snow boot product line was showing an operating loss was due to the allocation of common costs. Consideration should be given to the way allocated costs are assigned to the various products to determine if the allocation is logical or if another allocation method, such as one based on each product line’s percentage of the total corporate sales, would provide a better matching of costs and services provided by corporate headquarters. Management should also consider qualitative factors, such as the impact of removing one product line on the overall sales of the other products. If customers commonly buy snow boots and skis together, then discontinuing the snow boot line could impact the sales of snow skis.

Evaluate and Determine Whether to Sell or Process Further

Fundamentals of the Decision to Sell or Process Further

When facing the choice of selling or processing further, the company must determine the revenues that would be received if the product is sold at the split-off point versus the net revenues that would be received if the product is processed further. This requires knowing the additional costs of further processing. In general, if the differential revenue from further processing is greater than the differential costs, then it will be profitable to process a joint product after the split-off point. Any costs incurred prior to the split-off point are irrelevant to the decision to process further as those are sunk costs; only future costs are relevant costs.

Sample Data

Ainsley’s Apples grows organic apples and sells them to national grocery chains, local grocers, and markets. Ainsley purchased a machine for \$450,000 that sorts the apples by size. The largest apples are sold as loose apples to the various stores, the medium sized apples are bagged and sold to the grocers in their bagged state, and the smallest apples are sold to deep discounters or to a local manufacturing plant that processes the apples into applesauce. Ainsley is considering keeping the small apples and processing them into apple juice that would be sold under Ainsley’s own label to local grocers. The small apples currently sell to the deep discounters and local manufacturers for \$1.10 per dozen. The variable cost to prepare the small apples for sale, including transporting the apples, is \$0.30 per dozen. Ainsley can sell each gallon of organic apple juice for \$3.50 per gallon. It takes two dozen small apples to make one gallon of apple juice. The cost to produce the organic apple juice will be \$0.60 variable cost per gallon plus \$200,000 fixed costs for the one-year lease of the equipment needed to make and bottle the juice. Ainsley normally harvests and sells 2,400,000 small apples per year. Should Ainsley continue to sell the small apples to local grocers and the applesauce manufacturer or should Ainsley process the apples further into organic apple juice?

Calculations of Sample Data

In order to decide whether or not to process the small apples or to process them further into applesauce, Ainsley conducts an analysis of the relevant revenues and costs for the two alternatives: sell at split-off or process further into applesauce.

Final Analysis of the Decision

When making the decision to sell or process further, the company also must consider that processing a product further may create a new successful market or it may undercut sales of already existing products. For example, a furniture manufacturer that sells unfinished furniture may lose sales of the unfinished pieces if it decides to stain some pieces and sell them as finished products.

Evaluate and Determine How to Make Decisions When Resources Are Constrained

Fundamentals of How to Make Decisions When Resources are Constrained

As with other short-term decisions, a company must consider the relevant costs and revenues when making decisions when resources are constrained. Whether the organization facing a constraint is a merchandising, manufacturing, or service organization, the initial step in allocating scarce or constrained resources is to determine the unit contribution margin, which is the selling price per unit minus the variable cost per unit, for each product or service. The company should produce or provide the products or services that generate the highest contribution margin first, followed by those with the second highest, and so forth. The total contribution margin will be maximized by promoting those products or accepting those orders with the highest contribution margin in relation to the scarce resource. In other words, products or services should be ranked based on their unit contribution margin per production restraint, which is the unit contribution margin divided by the production restraint.

Sample Data

Wood World, Inc., produces wooden desks, chairs, and bookcases. These items are produced using the same machines, and there is a maximum of 80,000 machine-hours available during the year. The information about the production time and costs for these three items is:

Calculations Using Sample Data

To address this question, Wood World must find the contribution margin per machine-hour since machine-hours are the constraining factor for production.

Final Analysis of the Decisions

Wood World should fulfill the orders for bookcases first, desks second, and chairs last. The bookcases provide the highest contribution margin per machine-hour, followed by desks and then chairs. Maximizing the contribution margin per constraint, in this case per machine-hour, is the best way for Wood World to manage the constraint. How many of each item will be produced?

Capital Budgeting Decisions

Why It Matters

Describe Capital Investment Decisions and How They Are Applied

Fundamentals of Capital Investment Decisions

Capital investment (sometimes also referred to as capital budgeting) is a company’s contribution of funds toward the acquisition of long-lived (long-term or capital) assets for further growth. Long-term assets can include investments such as the purchase of new equipment, the replacement of old machinery, the expansion of operations into new facilities, or even the expansion into new products or markets. These capital expenditures are different from operating expenses. An operating expense is a regularly-occurring expense used to maintain the current operations of the company, but a capital expenditure is one used to grow the business and produce a future economic benefit.

Evaluate the Payback and Accounting Rate of Return in Capital Investment Decisions

Non-Time Value Methods

Non-time value methods do not compare the value of a dollar today to the value of a dollar in the future and are often used as screening tools. Two non-time value evaluative methods are the payback method and the accounting rate of return.

Explain the Time Value of Money and Calculate Present and Future Values of Lump Sums and Annuities

Time Value of Money Fundamentals

The concept of the time value of money asserts that the value of a dollar today is worth more than the value of a dollar in the future. This is typically because a dollar today can be used now to earn more money in the future. There is also, typically, the possibility of future inflation, which decreases the value of a dollar over time and could lead to a reduction in economic buying power.

Future Value

There are benefits to investing money now in hopes of a larger return in the future. These future earnings are possible because of interest payments received as an incentive for tying up money long-term. Knowing what these future earnings will be can help a business decide if the current investment is worth the long-term potential. Recall, the future value (FV) as the value of an investment after a certain period of time. Future value considers the initial amount invested, the time period of earnings, and the earnings interest rate in the calculation. For example, a bank would consider the future value of a loan based on whether a long-time client meets a certain interest rate return when determining whether to approve the loan.

Present Value

It is impossible to compare the value or potential purchasing power of the future dollar to today’s dollar; they exist in different times and have different values. Present value (PV) considers the future value of an investment expressed in today’s value. This allows a company to see if the investment’s initial cost is more or less than the future return. For example, a bank might consider the present value of giving a customer a loan before extending funds to ensure that the risk and the interest earned are worth the initial outlay of cash.

Use Discounted Cash Flow Models to Make Capital Investment Decisions

Fundamentals of the Discounted Cash Flow Model

The discount cash flow model assigns a value to a business opportunity using time-value measurement tools. The model considers future cash flows of the project, discounts them back to present time, and compares the outcome to an expected rate of return. If the outcome exceeds the expected rate of return and initial investment cost, the company would consider the investment. If the outcome does not exceed the expected rate of return or the initial investment, the company may not consider investment. When considering the discounted cash flow process, the time value of money plays a major role.

Time Value-Based Methods

As previously discussed, time value of money methods assume that the value of money today is worth more now than in the future. The payback period and accounting rate of return methods do not consider this concept when performing calculations and analyzing results. That is why they are typically only used as basic screening tools. To decide the best option between alternatives, a company performs preference measurement using tools, such as net present value and internal rate of return that do consider the time value of money concept. Net present value (NPV) discounts future cash flows to their present value at the expected rate of return and compares that to the initial investment. NPV does not determine the actual rate of return earned by a project. The internal rate of return (IRR) shows the profitability or growth potential of an investment at the point where NPV equals zero, so it determines the actual rate of return a project earns. As the name implies, net present value is stated in dollars, whereas the internal rate of return is stated as an interest rate. Both NPV and IRR require the company to determine a rate of return to be used as the target return rate, such as the minimum required rate of return or the weighted average cost of capital, which will be discussed in Balanced Scorecard and Other Performance Measures.

Final Summary of the Discounted Cash Flow Models

The internal rate of return (IRR) and the net present value (NPV) methods are types of discounted cash flow analysis that require taking estimated future payments from a project and discounting them into present values. The difference between the two methods is that the NPV calculation determines the project’s estimated return in dollars and the IRR provides the percentage rate of return from a project needed to break even.

Compare and Contrast Non-Time Value-Based Methods and Time Value-Based Methods in Capital Investment Decisions

Summary of the Strengths and Weaknesses of the Non-Time Value-Based Capital Budgeting Methods

Non-time value-based capital budgeting methods are best used in an initial screening process when there are many alternatives to choose from. Two such methods are payback method and accounting rate of return. Their strengths and weaknesses are discussed in [link] and [link].

Summary of the Strengths and Weaknesses of the Time Value-Based Capital Budgeting Methods

Time value-based capital budgeting methods are best used after an initial screening process, when a company is choosing between few alternatives. They help determine the best of the alternatives that a company should pursue. Two such methods are net present value and internal rate of return. Their strengths and weaknesses are presented in [link] and [link].

Final Comparison of the Four Capital Budgeting Options

A company will be presented with many alternatives for investment. It is up to management to analyze each investment’s possibilities using capital budgeting methods. The company will want to first screen each possibility with the payback method and accounting rate of return. The payback method will show the company how long it will take to recoup their investment, while accounting rate of return gives them the profitability of the alternatives. This screening will typically get rid of non-viable options and allow the company to further consider a select few alternatives. A more detailed analysis is found in time-value methods, such as net present value and internal rate of return. Net present value converts future cash flows into today’s valuation for comparability purposes to see if an initial outlay of cash is worth future earnings. The internal rate of return determines the minimum expected return on a project given the present value of cash flow expectations and the initial investment. Analyzing these opportunities, with consideration given to time value of money, allows a company to make an informed decision on how to make large capital expenditures.

Balanced Scorecard and Other Performance Measures

Why It Matters

Explain the Importance of Performance Measurement

Fundamentals of Performance Measurement

Performance measurement is used to motivate managers to make decisions that benefit the corporation and themselves. Therefore, the key to good performance measurement techniques is to set goals that are realistic and that incorporate decisions over which the manager has control. Then, the company can evaluate the manager based on controllable factors, which are the components of the organization for which the manager is responsible and that the manager can control, such as revenues, costs and procurement of long-term assets, and other possible factors. Recall that in Responsibility Accounting and Decentralization, you learned about responsibility centers, which are a means by which an organization can be divided based on factors that the manager can control. This makes it easier to align the goals of the manager with those of the organization and to design effective performance measures. The four types of responsibility centers are revenue centers, cost centers, profit centers, and investment centers.

Advantages Derived from Performance Measurement

Every business has a strategic plan, or a broad vision of how it will be in the future. This plan leads to goals that must be achieved to fulfill that vision. As shown in [link], a business will use the strategic plan to determine the goals needed to achieve the strategic vision. Once goals are determined, the business will decide on the appropriate actions necessary to meet the goals. Then, the business will implement, review, and adjust the goals as needed. Properly designed performance measures will help move the company toward meeting the goals of its strategic plan. Advantages of a good performance management system include increased employee retention and loyalty, better communication between the various levels of management, increased productivity, and increased efficiencies. In addition, a well-designed performance plan should lead to improved job satisfaction for the manager and increased personal wealth if the rewards are monetarily based. In summary, a company needs to first identify and create a strategy and then set the necessary goals, which will lead to actions, and finally to an applicable evaluation process.

Potential Limitations of Traditional Performance Measurement

What types of measures are used to evaluate management performance? Historically, performance measurement systems have been based on accounting or other quantitative numbers. One reason for this is that most accounting-based measures are easy to use due to their availability, since many accounting measures can be found in or generated from a company’s financial statements. Although this type of information is readily available, it does not mean the use of accounting numbers as performance measures is the best or only way to measure performance. One issue is that some accounting numbers can be affected by the actions of managers, and this may result in distorted performance results.

Identify the Characteristics of an Effective Performance Measure

Evaluate an Operating Segment or a Project Using Return on Investment, Residual Income, and Economic Value Added

Introduction to Return on Investment, Residual Income, and Economic Value Added as Evaluative Tools

One of the primary goals of a company is to be profitable. There are many ways a company can use profits. For example, companies can retain profits for future use, they can distribute them to shareholders in the form of dividends, or they can use the profits to pay off debts. However, none of these options actually contributes to the growth of the company. In order to stay profitable, a company must continuously evolve. A fourth option for the use of company profits is to reinvest the profits into the company in order to help it grow. For example, a company can buy new assets such as equipment, buildings, or patents; finance research and development; acquire other companies; or implement a vigorous advertising campaign. There are many options that will help the company to grow and to continue to be profitable.

Calculation and Interpretation of the Return on Investment

To put these concepts in context, consider a bakery called Scrumptious Sweets, Inc., that has three divisions and evaluates the managers of each of these decisions based on ROI. The following information is available for these divisions:

Calculation and Interpretation of the Residual Income

Another performance measure is residual income (RI), which shows the amount of income a given division (or project) is expected to earn in excess of a firm’s minimum return goal. Every company sets a minimum required rate of return on projects and investments, representing the minimum return, usually in percentage form, that a project or investment must produce in order for the company to be willing to undertake it. This return is used as a basis for evaluating investments so that the firm may meet its targets and goals, and ensures that only profitable projects will be accepted. (You will learn the theory and mechanics behind establishing a minimum required rate of return in advanced accounting courses.)

Calculation and Interpretation of Economic Value Added

Economic value added (EVA) is similar to RI but is a measure of shareholder wealth that is being created by a project, segment, or division. Companies want to maximize shareholder wealth, and to do that, they have to generate enough income to cover their cost of debt and their cost of equity, but also to have income available to shareholders. Just as in residual income, the goal is a positive EVA. A positive EVA indicates management has effectively used its capital assets to increase the value of the firm and thus the wealth of shareholders. EVA is computed as shown:

Considerations in Using the Three Evaluative Tools

One of the most challenging aspects of using ROI, RI, and EVA lies in the determination of the variables used to calculate these measures. Income and invested capital are factors in the ROI, RI, and EVA performance models, and each can be defined in several ways. Invested capital can be defined as fixed assets, productive assets, or operating assets. Fixed assets typically include only tangible long-term assets. Productive assets typically include inventory plus the fixed assets. Operating assets include productive assets plus intangible assets, and current assets. One problem is determining which assets the manager can control with his or her decision-making authority. Each definition of invested capital will have a different impact on the performance measure, whether that measure is ROI, RI, or EVA. Deciding how to define invested capital is further complicated when combined with the additional decision of whether to use net book value (depreciated value) or gross book value (nondepreciated value) of long-lived assets. Net book value is the historical cost of an asset minus any accumulated depreciation, whereas gross book value is merely the historical cost of the asset. Obviously at the time of acquisition of an asset, these two numbers are the same, but over time, net book value will decrease for any given asset, while gross book value will stay the same for that asset. Using gross book value will result in a higher value for invested capital than using net book value. Remember, net book value will vary based on the depreciation method employed—straight line versus double declining balance, for example. Thus, gross book value removes the effect of choosing different depreciation methods. Despite this, most companies use net book value in the computation of ROI since net book value aligns with their financial reporting of capital assets on the balance sheet at their net value. Assets can also be measured at fair value, also known as market value. This is the value at which the assets could be sold. Fair value is only used in special cases of computing ROI such as in computing ROI for a real estate investment. The reason fair value is not typically used for ROI is that the fair or market value is rarely known or determinable with certainty and is often very subjective, whereas both gross and book value are readily known and determinable.

Describe the Balanced Scorecard and Explain How It Is Used

History and Function of the Balanced Scorecard

Suppose you work in retail and your compensation consists of an hourly wage plus a bonus based on your sales. You have excellent interpersonal skills, and customers appreciate your help and often seek you out when they come to the store. Some of your customers will return on a different day, even making an extra trip to the store to make sure you are the employee who helps them. Sometimes these customers buy items and other times they do not, but they always come back. Your compensation does not include any acknowledgment of your attention to customers and your ability to keep them returning to the store, but consider how much more you could earn if this were the case. However, in order for compensation to include nonfinancial, or qualitative, factors, the store would need to track nonfinancial information, in addition to the financial, or quantitative, information already tracked in the accounting system. One way to track both qualitative and quantitative measures is to use a balanced scorecard.

Four Components of a Balanced Scorecard

To create a balanced scorecard, a company will start with its strategic goals and organize them into key areas. The four key areas used by Kaplan and Norton were financial perspective, internal operations perspective, customer perspective, and learning and growth ([link]).

Combining the Four Components of a Balanced Scorecard

Balanced scorecards can be created for any type of business and can be used at any level of the organization. An effective and successful balanced scorecard will start with the strategic plan or goals of the organization. Those goals are then restated based on the level of the organization to which the balanced scorecard pertains. A balanced scorecard for an entire organization will be broader and more general in terms of goals and measures than a balanced scorecard designed for a division manager. Balanced scorecards can even be created at the individual employee level either as an evaluation mechanism or as a means for the employee to set and monitor individual goals. Once the strategic goals of the organization are stated for the appropriate level for which the balanced scorecard is being created, then the measures for each of the categories of the balanced scorecard should be defined, being sure to consider the areas over which the division or individual does or does not have control. In addition, the variables have to be obtainable and measurable. Last, the measures must be useful, meaning that what is actually being measured must be informative, and there must be a basis of comparison—either company standards or individual targets. Using both quantitative and nonquantitative performance measures, along with long- and short-term measurements, can be very beneficial, as they can serve to motivate an employee while providing a clear framework of how that employee fits into the company’s strategic plan.

Final Summary of Quantitative and Quantitative Performance Measurement Tools

As the business environment changes, one thing stays the same: businesses want to be successful, to be profitable, and to meet their strategic goals. With these changes in the business environment come more varied responsibilities placed on managers. These changes occur due to an increased use of technology along with ever-increasing globalization. It is very important that an organization can appropriately measure whether employees are meeting these various responsibilities and reward them accordingly.

Sustainability Reporting

Why It Matters

Describe Sustainability and the Way It Creates Business Value

Sustainability Reporting

A sustainability report presents the economic, environmental and social effects that a corporation or organization was responsible for during the course of everyday business. Sustainability reporting aims to respond to the idea that companies can be held accountable for sustainability. In 1987, the former Norwegian Prime Minister, Gro Harlem Brundtland, chaired a World Commission on Environment and Development to both formulate proposals and increase understanding of and commitment to environment and development. The resulting Brundtland Commission Report laid the groundwork for the concept of sustainable development ([link]). This was defined as “development that meets the needs of the present without compromising the ability of future generations to meet their own needs.”[footnote]

NGO Committee on Education. “Report of the World Commission on Environment and Development: Our Common Future.” *UN Documents: Gathering a Body of Global Agreements*. August 4, 1987. http://www.un-documents.net/wced-ocf.htm

Historical Drivers of Contemporary Sustainability Reporting

Much of the drive to adopt sustainability reporting has resulted from the publicity surrounding corporate responses to specific crises. The three featured cases, on Union Carbide, Nestlé, and Johnson & Johnson, look at events that had such an impact on communities and the social conscience that they have contributed to shaping modern sustainability reporting and what society’s expectations of corporations are today. We first look at Union Carbide, whose actions, or lack of action, resulted in the deaths of thousands of impoverished Indians who lived in the shanty communities next to a facility of the U.S.-owned conglomerate. This case highlighted the power disparity between corporations and poor individuals and became a stark emblem of corporate disregard for the human toll of the quest for profit. We then consider the long running campaign against Nestlé Corporation, ongoing since the early 1980s. We will examine what Nestlé has attempted to do to mitigate the perception of exploitation which, some activists argue, is still a superficial response. Finally, we look at the reaction by Johnson & Johnson to the Tylenol poisoning crisis, which, while not of their making, is seen as a rapid and responsible response to ensure the well-being of the community, even if it initially came at considerable financial cost to the company.

Initial Sustainability Reports

Following the Brundtland Report, financial statement preparers began to ask how they might communicate not just the financial status of a company’s operations but the social and environmental status as well. The concept of a triple bottom line, also known as TBL or 3BL, was first proposed in 1997 by John Elkington to expand the traditional financial reporting framework so as to capture a firm’s social and environmental performance. Elkington also used the phrase *People, Planet, Profit* to explain the three focuses of triple bottom line reporting. By the late 1990s, companies were becoming more aware of triple bottom line reporting and were preparing sustainability reports on their own social, environmental, and economic impact. Another innovation was life-cycle or full-cost accounting. This reporting method took a “cradle to grave” approach to costing that put a price on the disposal of products at the end of their lives and then considered ways to minimize these costs by making adjustments in the design phase. This method also incorporated potential social, environmental, and economic costs (*externalities* in the language of economics) to attempt to identify all of the costs involved in production. For example, one early adopter of life-cycle accounting, Chrysler Corporation, considered all costs associated with each design phase and then made adjustments to the design. When its engineers developed an oil filter for a new vehicle, they estimated the material costs and hidden manufacturing expenses and also looked at liabilities associated with disposal of the filter. They found that the option with the lowest direct costs had hidden disposal costs that meant it was not the cheapest alternative.[footnote]

J. Fiksel, J. McDaniel, and D. Spitzley. “Measuring Product Sustainability.” *The Journal of Sustainable Product Design* July, no. 6 (1998): 7–18.

Current Examples of Sustainability in Business

The environment, human rights, employee relations, and philanthropy are all examples of topics on which corporations often report. When you think of sustainability in business, environmental sustainability might be the first area that comes to mind. Environmental sustainability is defined as rates of resource exploitation can be continued indefinitely without permanently depleting those resources. If these resources cannot be exploited indefinitely at the current rate, then the rate is not considered sustainable. A recent focus of environmental sustainability is climate change impacts. This focus has developed over the past three decades (although some contributors to climate change, such as pollution, have been a concern for much longer.). Climate change, in the context of sustainability, is a change in climate patterns caused by the increased levels of carbon dioxide (CO2) in the atmosphere attributed mainly to use of fossil fuels. Companies are increasingly expected to measure and reduce their carbon footprint, the amount of CO2 and other greenhouse gases they generate, in addition to adopting policies that are more environmentally friendly. For example, according to the sustainability report for Coca-Cola, in 2016 the company reduced the amount of CO2 embedded in the containers that hold their beverages by 14%.[footnote] Such corporate policies to reduce their carbon footprint can include reducing waste, especially of resources like water; switching to paperless record-keeping systems; designing environmentally friendly packaging; installing low-energy lighting, heating, and cooling in offices; recycling; and offering flexible working hours to minimize the time employees sit in traffic adding auto emissions to the environment. Industries that use or produce non-renewable resources as sources of energy, such as coal and oil, are significantly challenged to stay relevant in an era of new energy technologies like solar and wind power.

The Coca-Cola Company. “Infographic: 2016 Sustainability Highlights.” n.d. https://www.coca-colacompany.com/stories/2016-sustainability-highlights-infographic

Creating Business Value

In the past, firms increased business value by increasing revenue or reducing expenses. However, managers now are realizing that some consumers are willing to pay more to support a company whose philosophy aligns with their own values. If they believe a company is making a greater effort to reduce its carbon emissions than its competitors are or that it looks after its workers and their communities, consumers will pay more for the product or invest in the company because they believe the company is doing the right thing by the environment or society. Many investors demonstrate these same principles. Companies have many ways to inform investors and customers of their efforts to improve the three P’s—planet, people and profit—as you learned about in the discussion about the triple bottom line in the Initial Sustainability Reports section. While not every company officially reports a triple bottom line, many companies report their efforts to improve their impact on the planet and on people through various avenues such as in a formal corporate social responsibility report, on their website, or even through their advertising. It is often difficult to translate the effects of these efforts on the profits of the corporation; nonetheless, a company can often quantify the effects of their actions to help the planet, employees, and communities in other ways. Next, let’s examine efforts by a few such companies and the results they have achieved.

Identify User Needs for Information

Shareholders

Many consider the company’s shareholders to be its primary information user group. These equity investors may be small single investors or they may be part of an institutional investment fund charged with investing on behalf of its members. As shareholders they concern themselves with the future viability of the company and want profits to be sustained or increased over the long term. Shareholders often use financial ratios, such as earnings per share (EPS), return on investment (ROI), and the price/earnings ratio to evaluate the financial health and the sustainability of financial growth of the company. Shareholders not only evaluate whether there is current value in owning stock of the company but also whether there will continue to be value in owning that company’s stock. Otherwise the shareholder is likely to divest of their ownership interest.

Lenders

Sustainability reports provide useful information for lenders. Lenders want to know that the company borrowing from them does not have any going-concern risks that could affect its ability to repay the loan ([link]). They want to know the company will not be sued for human rights violations at home or abroad, be unable to repay its loans because consumer boycotts have hurt its cash flow, or that they maintain valuable property assets in high-risk areas. For example, after the 2017 Houston floods, a number of Houston-based banks were examined to find that they had a high level of exposure in commercial real estate in Houston.[footnote] This type of investment concentration in a single geographic area can be risky for lenders as a single disaster can have a more damaging effect than on a portfolio spread over a broader geographical area.

Ely Razin. “As Harvey Leaves Houston Reeling, These Banks Are More Exposed Than Others.” *Forbes*. August 31, 2017. https://www.forbes.com/sites/elyrazin/2017/08/31/as-harvey-leaves-houston-reeling-these-banks-are-more-exposed-than-others/#423dcb5e6355

Employees

Employees and potential employees want to know that the company they work for is concerned about their safety and is an ethical organization. They want assurance that they will be fairly compensated and that all employees have equal rights and opportunities, regardless of gender, race, religion, or sexual orientation.

Customers

Customers often have many choices about where to spend their hard-earned dollars. They want to know the companies to which they give that money reflect their own values and beliefs. If a company is seen to be uncaring about an issue, then customers may arrange campaigns to boycott the company (see the Nestlé story for an example of such consumer activism).

Governments and Regulators

Governments and regulators want to be able to see that a company is behaving responsibly. If they are confident that it is, there is less need to design laws and regulations that might restrict the company even more than if it undertook best-practice measures on its own. Many companies form industry alliance groups that aim to implement best practices in trade, social responsibility, or environmental initiatives.

Community

The community at large also wants to know that the organization is behaving at the level of society’s expectations. This reflects the existence of a social contract, the expectation that companies will hold to an unwritten contract with society as a whole. If a firm is undertaking actions that might harm society or that reject its general values, community backlash may cost the firm dearly.

Discuss Examples of Major Sustainability Initiatives

Global Reporting Initiative (GRI)

In 1997, a not-for-profit organization called the Global Reporting Initiative (GRI) was formed with the goal of increasing the number of companies that create sustainability reports as well as to provide those companies with guidance about how to report and establish some consistency in reporting (such as identifying common themes and components for reports). The idea is that as companies begin to create these reports, they become more aware of their impact on the sustainability of our world and are more likely to make positive changes to improve that impact. According to GRI, 92% of the Global 250 produced sustainability reports in 2016.

Sustainability Accounting Standards Board (SASB)

GRI standards were targeted at a variety of stakeholders, from the community at large to investors and lenders. This meant that the scope of disclosure encouraged by the GRI standards was perhaps too broad for companies that were primarily focused on reporting to investors in routine terms. Investors have their own unique needs related to sustainability information. Their concerns are related to the price and value of the organization, whereas other stakeholders are interested in how the company might affect them specifically. This effect may not even be financial; it could be whether the company pollutes in its local community, or it could be how a firm treats its workers.

Integrated Reporting

Even though companies were reporting through a range of mechanisms—sustainability reports, triple bottom line, and CSR reports—these methods of reporting were seen as fragmented and not integrating the financial and non-financial information into one report ([link]).[footnote] Also, the methods “failed to make the connection between the organization’s strategy, its financial performance and its performance on environmental, social and governance issues.”[footnote]

Wendy Stubbs, Colin Higgins, and Markus Milne. “Why Do Companies Not Produce Sustainability Reports?” November 12, 2012. *Business Strategy and the Environment* 22(7): 456–470.Harold P. Roth. “Is Integrated Reporting in the Future?” April 22, 2014. *CPA Journal* 84(3): 62-67. https://insurancenewsnet.com/oarticle/Is-Integrated-Reporting-in-the-Future-a-493109#.XC6i GGm1vpw

Future Issues in Sustainability

Financial Statement Analysis

Financial Statement Analysis

Financial statement analysis reviews financial information found on financial statements to make informed decisions about the business. The income statement, statement of retained earnings, balance sheet, and statement of cash flows, among other financial information, can be analyzed. The information obtained from this analysis can benefit decision-making for internal and external stakeholders and can give a company valuable information on overall performance and specific areas for improvement. The analysis can help them with budgeting, deciding where to cut costs, how to increase revenues, and future capital investments opportunities.

Horizontal Analysis

Horizontal analysis (also known as trend analysis) looks at trends over time on various financial statement line items. A company will look at one period (usually a year) and compare it to another period. For example, a company may compare sales from their current year to sales from the prior year. The trending of items on these financial statements can give a company valuable information on overall performance and specific areas for improvement. It is most valuable to do horizontal analysis for information over multiple periods to see how change is occurring for each line item. If multiple periods are not used, it can be difficult to identify a trend. The year being used for comparison purposes is called the base year (usually the prior period). The year of comparison for horizontal analysis is analyzed for dollar and percent changes against the base year.

Vertical Analysis

Vertical analysis shows a comparison of a line item within a statement to another line item within that same statement. For example, a company may compare cash to total assets in the current year. This allows a company to see what percentage of cash (the comparison line item) makes up total assets (the other line item) during the period. This is different from horizontal analysis, which compares across years. Vertical analysis compares line items within a statement in the current year. This can help a business to know how much of one item is contributing to overall operations. For example, a company may want to know how much inventory contributes to total assets. They can then use this information to make business decisions such as preparing the budget, cutting costs, increasing revenues, or capital investments.

Overview of Financial Ratios

Financial ratios help both internal and external users of information make informed decisions about a company. A stakeholder could be looking to invest, become a supplier, make a loan, or alter internal operations, among other things, based in part on the outcomes of ratio analysis. The information resulting from ratio analysis can be used to examine trends in performance, establish benchmarks for success, set budget expectations, and compare industry competitors. There are four main categories of ratios: liquidity, solvency, efficiency, and profitability. Note that while there are more ideal outcomes for some ratios, the industry in which the business operates can change the influence each of these outcomes has over stakeholder decisions. (You will learn more about ratios, industry standards, and ratio interpretation in advanced accounting courses.)

Advantages and Disadvantages of Financial Statement Analysis

There are several advantages and disadvantages to financial statement analysis. Financial statement analysis can show trends over time, which can be helpful in making future business decisions. Converting information to percentages or ratios eliminates some of the disparity between competitor sizes and operating abilities, making it easier for stakeholders to make informed decisions. It can assist with understanding the makeup of current operations within the business, and which shifts need to occur internally to increase productivity.

Time Value of Money

Present Value of \$1 Table

Present Value of an Ordinary Annuity Table

Future Value of \$1 Table

Future Value of an Ordinary Annuity Table

Suggested Resources

Sample Financial Statements

The following income statements and balance sheets show the finances of companies representing the manufacturing, retail, and service industries.

Accounting Software and Tools

The resources listed offer a variety of tutorials, training videos, and practice activities using software and tools common in accounting.

Personal Finance

These resources can assist you with personal financial planning.

Accounting-Related Organizations

A number of organizations are dedicated to regulating and supporting the variety of work undertaken in the discipline of accounting.

Accounting Exams and Certificates

These sites provide information on exams and professional certifications.