Managerial Accounting

Managerial Accounting Creating Value in a Dynamic Business Environment Ninth edition Ronald W. Hilton Cornell University Me Grain/ Hill McGraw-Hill Irwin

1 The Changing Role of Managerial Accounting in a Dynamic Business Environment 2 Managerial Accounting: A Business Partnership with Management 5 Managing Resources, Activities, and People 5 Decision Making 5 Planning 6 Directing Operational Activities 6 Controlling 6 How Managerial Accounting Adds Value to the Organization 6 Objectives of Managerial Accounting Activity 6 The Balanced Scorecard 9 M.A.P. The Balanced Scorecard 10 Managerial versus Financial Accounting 11 Managerial Accounting in Different Types of Organizations 12 Where Are Managerial Accountants Located in an Organization? 13 Organization Chart 13 Cross-Functional Deployment 16 Physical Location 16 Major Themes in Managerial Accounting 17 Information and Incentives 17 Behavioral Issues 18 Costs and Benefits 18 Management of Capacity and Capacity Costs 18 Evolution and Adaptation in Managerial Accounting 20 M.A.P. The Internet as a Lifeline 22 Cost Management Systems 25 Strategic Cost Management and the Value Chain 25 The Ethical Climate of Business and the Role of the Accountant 27 Managerial Accounting as a Career 28 Professional Organizations 28 Professional Certification 29 Professional Ethics 29 Focus on Ethics: IMA Statement of Ethical Professional Practice 29 Chapter Summary 30 Key Terms 31 Review Questions 31 Exercises 32 Problems 33 Case 35 Basic Cost Management Concepts and Accounting for Mass Customization Operations 36 What Do We Mean by a Cost? 38 Product Costs, Period Costs, and Expenses 39 Costs on Financial Statements 40 Income Statement 40 Balance Sheet 42 Note: Entries printed in blue denote topics that emphasize contemporary issues in managerial accounting and cost management. xxiii

xxiv Contents Manufacturing Operations and Manufacturing Costs 43 M.A.P. Mass Customization 44 Mass-Customization Manufacturing 44 Manufacturing Costs 45 Manufacturing Cost Flows 47 Production Costs in Service Industry Firms and Nonprofit Organizations 48 Basic Cost Management Concepts: Different Costs for Different Purposes 50 The Cost Driver Team 50 Variable and Fixed Costs 51 The Cost Management and Control Team 52 M.A.P. Airline Industry: Cost Structure, Cost Drivers, and a Shifting Business Model 54 The Outsourcing Action Team 55 Costs and Benefits of Information 59 Costs in the Service Industry 59 Focus on Ethics: Was WorldCom's Controller Just Following Orders? 61 Chapter Summary 62 Review Problems on Cost Classifications 62 Key Terms 64 Review Questions 64 Exercises 65 Problems 68 Cases 77 Product Costing and Cost Accumulation in a Batch Production Environment 80 Product and Service Costing 82 Product Costing in Nonmanufacturing Firms 83 Flow of Costs in Manufacturing Firms 83 Types of Product-Costing Systems 85 Job-Order Costing Systems 85 Process-Costing Systems 86 Summary of Alternative Systems 86 Product-Costing Accumulating Costs in a Job-Order Costing System 86 Job-Cost Record 86 Direct-Material Costs 87 Direct-Labor Costs 89 Manufacturing-Overhead Costs 89 M.A.P. Supply Chain Management 90 Summary of Event Sequence in Job-Order Costing 91 Illustration of Job-Order Costing 91 Purchase of Material 93 Use of Direct Material 93 Use of Indirect Material 93 Use of Direct Labor 94 Use of Indirect Labor 94 Incurrence of Manufacturing-Overhead Costs 94 Application of Manufacturing Overhead 95 Summary of Overhead Accounting 96 Selling and Administrative Costs 96 Completion of a Production Job 97 Sale of Goods 97 Underapplied and Overapplied Overhead 97 Schedule of Cost of Goods Manufactured 99 Schedule of Cost of Goods Sold 99 Posting Journal Entries to the Ledger 100 Further Aspects of Overhead Application 100 Actual and Normal Costing 100 Choosing the Cost Driver for Overhead Application 103 Departmental Overhead Rates 103 Two-Stage Cost Allocation 104 Project Costing: Job-Order Costing in / Nonmanufacturing Organizations 705 Changing Technology in Manufacturing Operations 107 EDI and XML 107 Use of Bar Codes 108 M.A.P. Radio Frequency Identification Systems (RFID) 108

Contents XXV Focus on Ethics: Did Boeing Exploit Accounting Rules to Conceal Cost Overruns and Production Snafus? 709 Chapter Summary 7 70 Review Problem on Job-Order Costing 7 70 Key Terms 772 Review Questions 712 Exercises 772 Problems 718 Cases 730 Process Costing and Hybrid Product-Costing Systems 134 Comparison of Job-Order Costing and Process Costing 736 Flow of Costs 136 Differences Between Job-Order and Process Costing 138 / Equivalent Units: A Key Concept 738 Equivalent Units 138 Illustration of Process Costing 740 Basic Data for Illustration 141 M.A.P. New York Wine Industry 142 Weighted-Average Method of Process Costing 143 Other Issues in Process Costing 747 Actual versus Normal Costing 147 Other Cost Drivers for Overhead Application 147 Subsequent Production Departments Hybrid Product-Costing Systems 748 Operation Costing for Batch Manufacturing Processes 148 Chapter Summary 752 Review Problem on Process Costing 752 Key Terms 754 Review Questions 754 Exercises 754 Problems 757 Cases 765 748 Activity-Based Costing and Management 168 Traditional, Volume-Based Product-Costing System 7 77 Trouble in Denver 171 Activity-Based Costing System 7 72 ABC Stage One 173 ABC Stage Two 174 Interpreting the ABC Product Costs 178 The Punch Line 179 Why Traditional, Volume-Based Systems Distort Product Costs 180 M.A.P. Cost Distortion at Rockwell International 182 Activity-Based Costing: Some Key Issues 782 M.A.P. Cost Distortion at DHL 183 Cost Drivers 183 Collecting ABC Data 184 Activity Dictionary and Bill of Activities 185 Activity-Based Management 786 Two-Dimensional ABC 186 Using ABM to Identify Non-Value-Added Activities and Costs 186 Customer-Profitability Analysis 789 Illustration of Customer-Profitability Analysis 189 M.A.P. Customer Profitability Analysis at Bank One Corp. 191 Activity-Based Costing in the Service Industry 792 M.A.P. Customer Profitability Analysis at Best Buy 193 Activity-Based Costing at Delaware Medical Center 194 Interpreting the Primary Care Unit's ABC Information 195 Focus on Ethics: Ethical Issues Surrounding Activity-Based Costing 797

xxvi Contents Chapter Summary 798 Review Problems on Cost Drivers and Product-Cost Distortion 799 Key Terms 200 Appendix to Chapter 5: Just-in-Time Inventory and Production Management 207 Review Questions 202 Exercises 203 Problems 209 Cases 227 Chapter Summary 253 Review Problems on Cost Behavior and Estimation 254 Key Terms 255 Appendix to Chapter 6: Least-Squares Regression Using Microsoft Excel 256 Review Questions 258 Exercises 258 Problems 263 Cases 277 6 Activity Analysis, Cost Behavior, and Cost Estimation 232 Cost Behavior Patterns 235 Variable Costs 235 Step-Variable Costs 236 Fixed Costs 237 Step-Fixed Costs 237 Semivariable Cost 239 Curvilinear Cost 240 Using Cost Behavior Patterns to Predict Costs 241 M.A.P. Is Direct Labor a Variable or a Fixed Cost? 242 Engineered, Committed, and Discretionary Costs 243 Cost Behavior in Other Industries 244 Cost Estimation 244 Account-Classification Method 244 Visual-Fit Method 245 High-Low Method 247 Least-Squares Regression Method 248 Multiple Regression 250 Data Collection Problems 250 Engineering Method of Cost Estimation 251 Effect of Learning on Cost Behavior 257 Focus on Ethics: Cisco Systems, Walmart, Taco Bell, Starbucks, U-Haul, General Dynamics, and Farmer's Insurance: Is Direct Labor a Variable Cost? 253 Cost-Volume-Profit Analysis 274 Illustration of Cost-Volume-Profit Analysis 277 Projected Expenses and Revenue 277 The Break-Even Point 278 Contribution-Margin Approach 279 Equation Approach 279 Graphing Cost-Volume-Profit Relationships 280 Interpreting the CVP Graph 281 Alternative Format for the CVP Graph 283 Profit-Volume Graph 283 Target Net Profit 284 Contribution-Margin Approach 284 Equation Approach 284 Graphical Approach 285 Applying CVP Analysis 285 Safety Margin 285 Changes in Fixed Expenses 285 Changes in the Unit Contribution Margin 286 Predicting Profit Given Expected Volume 287 Interdependent Changes in Key Variables 288 CVP Information in Published Annual Reports 289

Contents xxvii M.A.P. Airlines Keep a Close Eye on Break- Even Load Factors 289 CVP Analysis with Multiple Products 290 Assumptions Underlying CVP Analysis 292 Role of Computerized Planning Models and Electronic Spreadsheets 292 CVP Relationships and the Income Statement 293 Traditional Income Statement 293 Contribution Income Statement 293 Comparison of Traditional and Contribution Income Statements 294 Cost Structure and Operating Leverage 295 Operating Leverage 296 M.A.P. Operating Leverage Helps Web Companies Become Profitable 297 Cost Structure and Operating Leverage: A Cost-Benefit Issue 298 M.A.P. Cost Structure and Operating Leverage 299 CVP Analysis, Activity-Based Costing, and Advanced Manufacturing Systems 299 A Move toward JIT and Flexible Manufacturing 300 Chapter Summary 302 / Review Problem on Cost-Volume-Profit Analysis 303 Key Terms 304 Appendix to Chapter 7: Effect of Income Taxes 304 Review Questions 307 Exercises 308 Problems 370 Cases 327 8 Absorption and Variable Costing Product Costs 326 Illustration of Absorption and Variable Costing 327 324 Absorption-Costing Income Statements 328 Variable-Costing Income Statements 328 Reconciling Income under Absorption and Variable Costing 329 Cost- Volume-Profit Analysis 331 Evaluation of Absorption and Variable Costing 332 M.A.P. IRS: Unique Product Packaging Is an Inventoriable Cost 333 Throughput Costing 333 Throughput-Costing Income Statements 334 Focus on Ethics: Incentive to Overproduce Inventory 335 Chapter Summary 335 Review Problem on Absorption and Variable Costing 336 Key Terms 337 Review Questions 338 Exercises 338 Problems 340 Cases 344 9 Profit Planning and Activity-Based Budgeting 346 Purposes of Budgeting Systems 348 Types of Budgets 349 The Master Budget: A Planning Tool 350 Sales of Services or Goods 350 Sales Forecasting 350 Operational Budgets 351 Budgeted Financial Statements 352 Nonprofit Organizations 352

xxviii Contents M.A.P. Activity-Based Budgeting (ABB) at American Express and AT&T Paradyne 353 Activity-Based Budgeting 353 Using Activity-Based Budgeting to Prepare the Master Budget 355 Sales Budget 355 Production Budget 356 Direct-Material Budget 356 Direct-Labor Budget 358 Manufacturing-Overhead Budget 359 Selling, General, and Administrative (SG&A) Expense Budget 360 Cash Receipts Budget 362 Cash Disbursements Budget 363 Cash Budget: Combining Receipts and Disbursements 364 Budgeted Schedule of Cost of Goods Manufactured and Sold 365 Budgeted Income Statement 366 Budgeted Statement of Cash Flows 367 Budgeted Balance Sheet 368 Assumptions and Predictions Underlying the Master Budget 369 Financial Planning Models 371 Budget Administration 372 M.A.P. Budget Administration at Cornell University 373 International Aspects of Budgeting 373 Budgeting Product Life-Cycle Costs 374 Behavioral Impact of Budgets 375 Budgetary Slack: Padding the Budget 375 Participative Budgeting 376 Focus on Ethics: Is Padding the Budget Unethical? 376 Chapter Summary 377 Review Problem on Preparing Master Budget Schedules 377 Key Terms 379 Review Questions 380 Exercises 380 Problems 384 Cases 398 10 Standard Costing, Operational Performance Measures, and the Balanced Scorecard 404 Managing Costs 406 Management by Exception 407 Setting Standards 407 Methods for Setting Standards 407 Participation in Setting Standards 408 Perfection versus Practical Standards: A Behavioral Issue 408 Use of Standards by Service Organizations 409 Cost Variance Analysis 409 Direct-Material Standards 410 Direct-Labor Standards 410 Standard Costs Given Actual Output 411 Analysis of Cost Variances 411 Direct-Material Variances 411 Direct-Labor Variances 413 M.A.P. Parker Hannifin Corporation's Brass Products Division 415 Multiple Types of Direct Material or Direct Labor 415 Allowing for Spoilage or Defects 415 Significance of Cost Variances 476 A Statistical Approach 418 Behavioral Impact of Standard Costing 479 Controllability of Variances 479 Interaction among Variances 420 Standard Costs and Product Costing 427 Evaluation of Standard Costing Systems 422 Advantages of Standard Costing 422 Criticisms of Standard Costing in Today's Manufacturing Environment 422 M.A.P. Cost of Ownership 424

Contents xxix Operational Performance Measures in Today's Manufacturing Environment 424 Gain-Sharing Plans 427 The Balanced Scorecard 427 Lead and Lag Measures: The Key to the Balanced Scorecard 430 Linking the Balanced Scorecard to Organizational Strategy 431 M.A.P. Linking the Balanced Scorecard to Organizational Strategy 432 Focus on Ethics: Sacrificing Quality to Cut Standard Costs 434 Chapter Summary 434 Review Problems on Standard Costing and Operational Performance Measures 435 Key Terms 437 Appendix to Chapter 10: Use of Standard Costs for Product Costing 438 Review Questions 440 Exercises 440 > Problems 443 Cases 454 Overhead Cost Performance Report 473 M.A.P. Cost Management Systems in Germany 474 Activity-Based Flexible Budget 474 Flexible Budgeting in the Service Industry 476 Focus on Ethics: Misstated Standards Affect Accuracy of Reports 478 Chapter Summary 479 Review Problem on Overhead Variances 480 Key Terms 487 Appendix A to Chapter 11: Standard Costs and Product Costing 487 Appendix B to Chapter 11: Sales Variances 483 Review Questions 484 Exercises 485 Problems 488 Cases 500 11 Flexible Budgeting and the Management of Overhead and Support Activity Costs 458 Overhead Budgets 460 Flexible Budgets 461 Advantages of Flexible Budgets 461 The Activity Measure 462 Flexible Overhead Budget Illustrated 463 Formula Flexible Budget 463 Overhead Application in a Standard-Costing System 465 Choice of Activity Measure 466 Criteria for Choosing the Activity Measure 466 Cost Management Using Overhead Cost Variances 467 Variable Overhead 468 Fixed Overhead 471 12 Responsibility Accounting, Quality Control, and Environmental Cost Management 504 Responsibility Centers 506 Illustration of Responsibility Accounting 507 Performance Reports 570 Budgets, Variance Analysis, and Responsibility Accounting 512 Cost Allocation 512 Cost Allocation Bases 512 Allocation Bases Based on Budgets 512 Activity-Based Responsibility Accounting 514 Behavioral Effects of Responsibility Accounting 574 Information versus Blame 514 Controllability 514 Motivating Desired Behavior 515

XXX Contents Segmented Reporting 575 Segments versus Segment Managers 516 Key Features of Segmented Reporting 517 Customer-Profitability Analysis and Activity- Based Costing 517 Total Quality Management 578 Measuring and Reporting Quality Costs 518 Changing Views of Optimal Product Quality 520 M.A.P. Six Sigma for Quality Management and Cost Reduction 522 ISO 9000 Standards 523 Environmental Cost Management 524 Classifying Environmental Costs 524 Managing Private Environmental Costs 525 Environmental Cost Strategies 527 Tie-In to the Responsibility-Accounting System 527 Focus on Ethics: Short-Sighted View of Cost Cutting 527 Chapter Summary 528 Review Problem on Responsibility Accounting 529 Key Terms 530 Review Questions 537 Exercises 537 Problems 534 Cases 542 13 Investment Centers and Transfer Pricing 546 Delegation of Decision Making 548 Obtaining Goal Congruence: A Behavioral Challenge 549 Adaptation of Management Control Systems 549 Measuring Performance in Investment Centers 550 Return on Investment 550 Residual Income 552 Economic Value Added 555 M.A.P. Pay for Performance Based on EVA 556 Measuring Income and Invested Capital 557 Invested Capital 557 Measuring Investment-Center Income 560 Inflation: Historical-Cost versus Current- Value Accounting 561 Other Issues in Segment Performance Evaluation 567 Alternatives to ROI, Residual Income, and Economic Value Added (EVA) 561 Importance of Nonfinancial Information 562 Measuring Performance in Nonprofit Organizations 562 Transfer Pricing 563 Goal Congruence 563 General Transfer-Pricing Rule 564 Transfers Based on the External Market Price 567 Negotiated Transfer Prices 568 Cost-Based Transfer Prices 569 Standard versus Actual Costs 570 Undermining Divisional Autonomy 570 An International Perspective 570 M.A.P. Transfer Pricing and Tax Issues 571 Transfer Pricing in the Service Industry 572 Behavioral Issues: Risk Aversion and Incentives 572 Goal Congruence and Internal Control Systems 573 Chapter Summary 574 Review Problems on Investment Centers and Transfer Pricing 574 Key Terms 576 Review Questions 576 Exercises 576 Problems 579 Cases 585

Contents xxxi 14 Decision Making: Relevant Costs and Benefits 590 The Managerial Accountant's Role in Decision Making 592 Steps in the Decision-Making Process 593 Quantitative versus Qualitative Analysis 593 Obtaining Information: Relevance, Accuracy, and Timeliness 594 Relevant Information 595 Unique versus Repetitive Decisions 595 Importance of Identifying Relevant Costs and Benefits 596 9 Identifying Relevant Costs and Benefits 596 Sunk Costs 596 Irrelevant Future Costs and Benefits 599 Opportunity Costs 599 Summary 600, Analysis of Special Decisions 600 Accept or Reject a Special Offer 600 Outsource a Product or Service 602 M.A.P. Outsourcing 603 Add or Drop a Service, Product, or Department 605 M.A.P. Adding a Service 607 Special Decisions in Manufacturing Firms 607 Joint Products: Sell or Process Further 607 Decisions Involving Limited Resources 609 Uncertainty 611 Activity-Based Costing and Today's Advanced Manufacturing Environment 672 Conventional Outsourcing (Make-or-Buy) Analysis 613 Activity-Based Costing Analysis of the Outsourcing Decision 614 Other Issues in Decision Making 675 Incentives for Decision Makers 615 Short-Run versus Long-Run Decisions 616 Pitfalls to Avoid 616 Focus on Ethics: Effects of Decision to Close a Department and Outsource 67 7 Chapter Summary 678 Review Problem on Relevant Costs 678 Key Terms 679 Appendix to Chapter 14: Linear Programming 620 Review Questions 622 Exercises 623 Problems 626 Cases 639 15 Target Costing and Cost Analysis for Pricing Decisions 642 Major Influences on Pricing Decisions 644 Customer Demand 645 Actions of Competitors 645 Costs 645 Political, Legal, and Image-Related Issues 646 Economic Profit-Maximizing Pricing 646 v Total Revenue, Demand, and Marginal Revenue Curves 646 Total Cost and Marginal Cost Curves 648 Profit-Maximizing Price and Quantity 648 Price Elasticity 651 Limitations of the Profit-Maximizing Model 651 Costs and Benefits of Information 651 Role of Accounting Product Costs in Pricing 652 Cost-Pius Pricing 652 Absorption-Cost Pricing Formulas 653 Variable-Cost Pricing Formulas 654 Determining the Markup 654 M.A.P. Price Competition and Cost Management 656 Cost-Pius Pricing: Summary and Evaluation 656

xxxii Contents Strategic Pricing of New Products 657 Target Costing 657 M.A.P. Pricing on the Internet by "e-tailers" 658 A Strategic Profit and Cost Management Process 658 Activity-Based Costing and Target Costing 660 Product-Cost Distortion and Pricing: The Role of Activity-Based Costing 660 Value Engineering and Target Costing 661 Time and Material Pricing 662 Competitive Bidding 664 Effect of Antitrust Laws on Pricing 666 Chapter Summary 667 Review Problem on Cost-Pius Pricing 668 Key Terms 669 Review Questions 670 Exercises 670 Problems 673 Cases 680 16 Capital Expenditure Decisions 684 Section 1: Discounted-Cash-Flow Analysis 687 Net-Present-Value Method 688 Internal-Rate-of-Return Method 688 Comparing the NPV and IRR Methods 691 Assumptions Underlying Discounted-Cash- Flow Analysis 691 Choosing the Hurdle Rate 692 Depreciable Assets 693 Comparing Two Investment Projects 693 Managerial Accountant's Role 696 Postaudit 696 Real Option Analysis 697 Section 2: Income Taxes and Capital Budgeting 697 After-Tax Cash Flows 697 Accelerated Depreciation 700 Modified Accelerated Cost Recovery System (MACRS) 701 Gains and Losses on Disposal 703 Investment in Working Capital 704 Extended Illustration of Income-Tax Effects in Capital Budgeting 705 M.A.P. Capital Budgeting at Pharmaceutical Firms 708 Ranking Investment Projects 709 Section 3: Alternative Methods for Making Investment Decisions 770 Payback Method 711 Accounting-Rate-of-Return Method 712 Estimating Cash Flows: The Role of Activity- Based Costing 775 Justification of Investments in Advanced Manufacturing Systems 775 Focus on Ethics: Dysfunctional Focus on Early Cash Flows 776 Chapter Summary 778 Review Problems on Capital Expenditure Decisions 779 Key Terms 720 Appendix A to Chapter 16: Future Value and Present Value Tables 720 Appendix B to Chapter 16: Impact of Inflation 722 Review Questions 725 Exercises 725 Problems 728 Cases 735 17 Allocation of Support Activity Costs and Joint Costs 738 Section 1: Service Department Cost Allocation 740 Direct Method 743 Step-Down Method 743 Reciprocal-Services Method 744 Fixed versus Variable Costs 745

Contents xxxiii M.A.P. Cost Management in the Health Care Industry 747 Dual Cost Allocation 74 7 Allocate Budgeted Costs 748 Today's Advanced Manufacturing Environment 749 The Rise of Activity-Based Costing 750 Section 2: Joint Product Cost Allocation 750 Allocating Joint Costs 751 M.A.P. Joint Cost Allocation in the Petroleum Industry 752 Chapter Summary 753 Review Problem on Service Department Cost Allocation 754 Key Terms 755 Appendix to Chapter 17: Reciprocal-Services Method 755 Review Questions 757 Exercises 757 Problems 759 Cases 764 Appendix I: The Sarbanes-Oxley Act, Internal Controls, and Management Accounting 766 Appendix II: Compound Interest and the Concept of Present Value 772 Appendix III: Inventory Management 780 References for "In Their Own Words" 786 Glossary 789 Photo Credits 800 Index of Companies and Organizations 801 Index of Subjects 803