MANAGERIAL ACCOUNTING

MANAGERIAL ACCOUNTING SECOND EDITION Karen Wilken Braun Case Western Reserve University Wendy M. Tietz Kent State University Walter T. Harrison, Jr. Baylor University Prentice Hall Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City Sao Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo

CONTENTS % ^i Introduction to Managerial Accounting 2 if J What is Managerial Accounting? 4 Managers' Four Primary Responsibilities 4 A Road Map: How Managerial Accounting Fits In 5 Differences Between Managerial Accounting and Financial Accounting 5 What Role do Management Accountants Play? 7 Organizational Structure 7 The Changing Roles of Management Accountants 8 The Skills Required of Management Accountants 9 Professional Association 10 Average Salaries of Management Accountants 11 Ethics 11 Examples of Ethical Dilemmas 12 DECISION GUIDELINES 14 SUMMARY PROBLEM 1 15 What Regulatory and Business Issues Affect Today's Management Accountants? 16 Sarbanes-Oxley Act of 2002 16 International Financial Reporting Standards (IFRS) 17 Extensible Business Reporting Language (XBRL) 18 Shifting Economy 18 How do Companies Compete in Today's Global Marketplace? 19 Sustainability and Social Responsibility 19 Tools for Time-Based Competition 20 Total Quality Management 21 DECISION GUIDELINES 22 SUMMARY PROBLEM 2 22 REVIEW 23 Accounting Vocabulary 23 Quick Check 23 Assess Your Progress 24 Apply Your Knowledge 38 _^ g u j ( j n g Blocks of Managerial < / Accounting 42 v^l ly' What are the Most Common Business Sectors and Their Activities? 44 Service, Merchandising, and Manufacturing Companies 44 Which Business Activities Make up the Value Chain? 46 Coordinating Activities Across the Value Chain 47 How do Companies Define Cost? 48 Cost Objects, Direct Costs, and Indirect Costs 48 Costs for Internal Decision Making and External Reporting 49 Merchandising Companies' Inventoriable Product Costs 51 Manufacturing Companies' Inventoriable Product Costs 51 IV Review: Inventoriable Product Costs or Period Costs? 53 Prime and Conversion Costs 53 Additional Labor Compensation Costs 53 DECISION GUIDELINES 54 SUMMARY PROBLEM 1 55 How are Inventoriable Product Costs and Period Costs Shown in the Financial Statements? 56 Service Companies 56 Merchandising Companies 57 Manufacturing Companies 57 Comparing Balance Sheets 61 What Other Cost Terms are Used by Managers? 62 Controllable Versus Uncontrollable Costs 62 Relevant and Irrelevant Costs 62 Fixed and Variable Costs 63 How Manufacturing Costs Behave 63 Calculating Total and Average Costs 64 DECISION GUIDELINES 66 SUMMARY PROBLEM 2 67 REVIEW 68 Accounting Vocabulary 68 Quick Check 69 Assess Your Progress 69 Apply Your Knowledge 92 H i Job Costing 96 : What Methods are Used to Determine the \ ''-' ) Cost of Manufacturing a Product? 98 Process Costing 98 Job Costing 99 How do Manufacturers Determine a Job's Cost? 100 Overview: Flow of Inventory Through a Manufacturing System 100 Scheduling Production 101 Purchasing Raw Materials 102 Using a Job Cost Record to Accumulate Job Costs 103 Tracing Direct Materials Cost to a Job 104 Tracing Direct Labor Cost to a Job 107 Allocating Manufacturing Overhead to a Job 107 Completing the Job Cost Record and Using it to Make Business Decisions 111 DECISION GUIDELINES 113 SUMMARY PROBLEM 1 114 How do Managers Deal with Underallocated or Overallocated Manufacturing Overhead? 115 How do Manufacturers Treat Non-Manufacturing Costs? 117 What Journal Entries are Needed in a Manufacturer's Job Costing System? 118 DECISION GUIDELINES 126 SUMMARY PROBLEM 2 126

Contents APPENDIX 3 A 129 How do Service Firms Use Job Costing to Determine the Amount to Bill Clients? 129 What Costs are Considered Direct Costs of Serving the Client? 129 What Costs are Considered Indirect Costs of Serving the Client? 130 Finding the Total Cost of the Job and Adding a Profit Markup 131 Invoicing the Client Using a Professional Billing Rate 131 What Journal Entries are Needed in a Service Firm's Job Costing System? 132 REVIEW 132 Accounting Vocabulary 132 - Quick Check 133 Assess Your Progress 134 Apply Your Knowledge 162 CHAPTER 3 DEMO DOC: JOB COSTING FOR MANUFACTURERS 167 % ^ Activity-Based Costing, Lean I >i I Production, and the Costs of '^...}.J Quality 170 Why and How do Companies Refine Their Cost Allocation Systems? 172 Simple Cost Allocation Systems Can Lead to Cost Distortion 172 Review: Using a Plantwide Overhead Rate to Allocate Indirect Costs 173 / Using Departmental Overhead Rates to Allocate Indirect Costs 174 Using Activity-Based Costing to Allocate Indirect Costs 179 How do Managers Use the Improved Cost Information? 185 Activity-Based Management (ABM) 185 Passing the Cost Benefit Test 187 DECISION GUIDELINES 189 SUMMARY PROBLEM 1 190 How do Traditional and Lean Production Systems Differ? 191 Traditional Production Systems 192 Lean Production Systems 192 How do Managers Improve Quality? 195 Costs of Quality 195 Using the Costs of Quality Framework to Aid Decisions 198 DECISION GUIDELINES 200 SUMMARY PROBLEM 2 200 REVIEW 202 Accounting Vocabulary 202 Quick Check 202 Assess Your Progress 203 Apply Your Knowledge 230 (cc Process Costing 234 Process Costing: An Overview 236 Two Basic Costing Systems: Job Costing and Process Costing 236 How Does the Flow of Costs Differ Between Job and Process Costing? 236 What are the Building Blocks of Process Costing? 240 Conversion Costs 240 Equivalent Units 240 Inventory Flow Assumptions 241 How Does Process Costing Work in the First Processing Department? 242 Step 1: Summarize the Flow of Physical Units 244 Step 2: Compute Output in Terms of Equivalent Units 245 Step 3: Summarize Total Costs to Account For 246. Step 4: Compute the Cost per Equivalent Unit 247 Step 5: Assign Total Costs to Units Completed and to Units in Ending Work in Process Inventory 247 Average Unit Costs 248 What Journal Entries are Needed in a Process Costing System? 248 DECISION GUIDELINES 250 SUMMARY PROBLEM 1 251 How Does Process Costing Work in a Second or Later Processing Department? 253 Process Costing in SeaView's Insertion Department 253 Steps 1 and 2: Summarize the Flow of Physical Units and Compute Output in Terms of Equivalent Units 254 Steps 3 and 4: Summarize Total Costs to Account for arid Compute the Cost per Equivalent Unit 256 Step 5: Assign Total Costs to Units Completed and to Units in Ending Work in Process Inventory 257 Unit Costs and Gross Profit 258 Production Cost Reports 259 Journal Entries in a Second Processing Department 259 DECISION GUIDELINES 262 SUMMARY PROBLEM 2 263 REVIEW 266 Accounting Vocabulary 266 Quick Check 266 Assess Your Progress 267 Apply Your Knowledge 290 CHAPTER 5 DEMO DOC: ILLUSTRATING PROCESS COSTING 295 Cost Behavior 298 Cost Behavior: How do Changes in Volume Affect Costs? 300 Variable Costs 300 Fixed Costs 303 Mixed Costs 305 Relevant Range 307 Other Cost Behaviors 309 DECISION GUIDELINES 310 SUMMARY PROBLEM 1 311

VI Contents How do Managers Determine Cost Behavior? 312 Account Analysis 312 Scatter Plots 312 High-Low Method 315 Regression Analysis 316 Predicting Costs 319 Data Concerns 319 What is a Contribution Margin Income Statement? 320 Traditional Income Statements are Organized by Cost Function 320 Contribution Margin Income Statements are Organized by Cost Behavior 321 DECISION GUIDELINES 322 SUMMARY PROBLEM 2 322 APPENDIX 6A 325 How Does Variable Costing Differ from Absorption Costing? 325 Variable Versus Absorption Costing: Sportade 326 Reconciling the Difference in Income 329 Absorption Costing and Manager's Incentives 330 DECISION GUIDELINES 331 SUMMARY PROBLEM 3 332 REVIEW 333 Accounting Vocabulary 333 Quick Check 334 Assess Your Progress 334 Apply Your Knowledge 358 ; ] Cost-Volume-Prof it ; Analysis 362 '..._"_ v How Does Cost-Volume-Profit Analysis Help Managers? 364 Data Required for Effective CVP Analysis 364 CVP Assumptions 364 The Unit Contribution Margin 365 The Contribution Margin Ratio 366 How do Managers Find the Breakeven Point? 368 The Income Statement Approach 368 The Shortcut Approach Using the Unit Contribution Margin 369 The Shortcut Approach Using the Contribution Margin Ratio 370 How do Managers Find the Volume Needed to Earn a Target Profit? 370 How Much Must We Sell to Earn a Target Profit? 370 Graphing CVP Relationships 372 DECISION GUIDELINES 373 SUMMARY PROBLEM 1 374 How do Managers Use CVP to Plan for Changing Business Conditions? 376 Changing the Sales Price 376 Changing Variable Costs 378 Changing Fixed Costs 379 Changing the Mix of Products Offered for Sale 381 Information Technology and Sensitivity Analysis 384 What are Some Common Indicators of Risk? 384 Margin of Safety 384 Operating Leverage 385 DECISION GUIDELINES 389 SUMMARY PROBLEM 2 389 REVIEW 391 Accounting Vocabulary 391 Quick Check 392 Assess Your Progress 392 Apply Your Knowledge 410 CHAPTER 7 DEMO DOC: USING CVP FOR SENSITIVITY ANALYSIS 415 E Short-Term Business *" f ; j Decisions 420 / How do Managers Make Decisions? 422 Relevant Information 422 Relevant Nonfinancial Information 424 Keys to Making Short-Term Special Decisions 424 How do Managers Make Special Order and Regular Pricing Decisions? 425 Special Sales Order Decisions 425 Regular Pricing Decisions 428 DECISION GUIDELINES 432 SUMMARY PROBLEM 1 433 How do Managers Make Other Special Business Decisions? 435 Decisions to Drop Products, Departments, or Territories 435 Product Mix Decisions 439 Outsourcing Decisions (Make-or-Buy) 441 Sell As Is or Process Further Decisions 445 DECISION GUIDELINES 446 SUMMARY PROBLEM 2 447 REVIEW 448 Accounting Vocabulary 448 Quick Check 448 Assess Your Progress 449 Apply Your Knowledge 469 % r "\ The Master Budget and <! Responsibility Accounting 474 J ^ How and Why do Managers Use Budgets? 476 How are Budgets Used? 476 How are Budgets Developed? 476 What are the Benefits of Budgeting? 478 What is the Master Budget? 479 How are the Operating Budgets Prepared? 480 Sales Budget 480 Production Budget 481 Direct Materials Budget 482 Direct Labor Budget 484 Manufacturing Overhead Budget 484

Contents VII, Operating Expenses Budget 485 Budgeted Income Statement 486 DECISION GUIDELINES 488 SUMMARY PROBLEM 1 488 How are the Financial Budgets Prepared? 490 Capital Expenditure Budget 490 Cash Collections Budget 491 Cash Payments Budget 492 Combined Cash Budget 493 Budgeted Balance Sheet 495 Sensitivity Analysis 496 What is Responsibility Accounting? 497 Four Types of Responsibility Centers 497 Responsibility Accounting Performance Reports 498 DECISION GUIDELINES 501 SUMMARY PROBLEM 2 502 APPENDIX 9A 504 The Master Budget for Service and Merchandising Companies 504 REVIEW 505 Accounting Vocabulary 505 Quick Check 506 Assess Your Progress 506 Apply Your Knowledge 541 CHAPTER 9 DEMO DOC: PRODUCTION AND DIRECT MATERIALS BUDGETS 547 Flexible Budgets and Standard Costs 552 vl r.y How do Managers Use Flexible Budgets? 554 What Is a Static Budget? 554 What Is a Flexible Budget? 554 Using Flexible Budgets for Planning 554 Using Flexible Budgets for Evaluating Performance 557 How do Managers Compute the Sales Volume Variance and Flexible Budget Variance? 558 Sales Volume Variance 560 Flexible Budget Variance 560 Interpreting the Variances 561 DECISION GUIDELINES 562 SUMMARY PROBLEM 1 563 What are Standard Costs? 564 Quantity Standards 564 Price Standards 564 Standard Manufacturing Overhead Rates 565 Standard Cost of Inputs 566 How do Managers Use Standard Costs to Analyze Direct Material and Direct Labor Variances? 567 Direct Material Variances 569 Direct Labor Variances 572 Price and Efficiency Variances: Three Common Pitfalls 575 Using Variances 575 How do Managers Use Standard Costs to Analyze Manufacturing Overhead Variances? 577 Overhead Flexible Budget Variance 577 Production Volume Variance 578 Overview of Kool-Time's Manufacturing Overhead Variances 579 DECISION GUIDELINES 580 SUMMARY PROBLEM 2 581 APPENDIX 10A 582 Standard Cost Accounting Systems 582 Journal Entries 583 Standard Cost Income Statement for Management 585 REVIEW 587 Accounting Vocabulary 587 Quick Check 587 Assess Your Progress 588 Apply Your Knowledge '611 % ; /^ Performance Evaluation and < i ji the Balanced Scorecard 616 '"vf. Why do Companies Decentralize Operations? 618 Advantages of Decentralization 618 Disadvantages of Decentralization 618 Responsibility Centers 619 What are Performance Evaluation Systems? 620 Goals of Performance Evaluation Systems 620 Limitations of Financial Performance Measurement 621 The Balanced Scorecard 621 The Four Perspectives of the Balanced Scorecard 622 DECISION GUIDELINES 626 SUMMARY PROBLEM 1 627 How do Managers Evaluate the Financial Performance of Cost, Revenue, and Profit Centers? 628 Cost Center Performance Reports 628 Revenue Center Performance Reports 629 Profit Center Performance Reports 629 How do Managers Evaluate the Financial Performance of Investment Centers? 631 Return on Investment (ROI) 632 Residual Income (RI) 634 Economic Value Added (EVA) 636 Limitations of Financial Performance Measures 637 DECISION GUIDELINES 639 SUMMARY PROBLEM 2 640 Appendix 11A 641 Allocating Service Department Costs 641 REVIEW 643 Accounting Vocabulary 643 Quick Check 643 Assess Your Progress 644 Apply Your Knowledge 665

VIM Contents ^, Capital Investment j Decisions and the Time Value ^J:^ of Money 668 ; < What is Capital Budgeting? 670 Four Popular Methods of Capital Budgeting Analysis 670 Focus on Cash Flows 670 Capital Budgeting Process 671 How do Managers Calculate the Payback Period and Accounting Rate of Return? 672 Payback Period 672 Accounting Rate of Return (ARR) 675 DECISION GUIDELINES 677 SUMMARY PROBLEM 1 678 How do Managers Compute the Time Value of Money? 679 Factors Affecting the Time Value of Money 679 Future Values and Present Values: Points Along the Time Continuum 680 Future Value and Present Value Factors 681 Calculating Future Values of Single Sums and Annuities Using FV Factors 682 Calculating Present Values of Single Sums and Annuities Using PV Factors 683 How do Managers Calculate the Net Present Value and Internal Rate of Return? 686 Net Present Value (NPV) 687 Internal Rate of Return (IRR) 691 How do the Capital Budgeting Methods Compare? 694 DECISION GUIDELINES 695 SUMMARY PROBLEM 2 695 APPENDIX 12A 696 Present Value Tables and Future Value Tables 696 Table A Present Value of $1 696 Table B Present Value of Annuity of $1 697 Table C Future Value of Annuity of $1 698 Table D Future Value of Annuity of $1 699 APPENDIX 12B 700 Using a TI-83, TI-83 Plus, TI-84, or TI-84 Plus Calculator to Perform Time Value of Money Calculations 700 REVIEW 704 Accounting Vocabulary 704 Quick Check 705 Assess Your Progress 706 Apply Your Knowledge 719 E.-N Statement of Cash Flows 722 < What is the Statement of Cash Flows? 724 \" J Three Types of Activities That Generate and Use Cash 725 Two Methods of Presenting Operating Activities 727 DECISION GUIDELINES 728 SUMMARY PROBLEM 1 728 How is the Statement of Cash Flows Prepared Using the Indirect Method? 729 Information Needed to Prepare the Statement of Cash Flows 729 Preparing the Cash Flows from Operating Activities 730 Preparing the Cash Flows from Investing Activities 735 Preparing the Cash Flows from Financing Activities 737 Interpreting the Statement of Cash Flows 739 Recap: Steps to Preparing the Statement of Cash Flows Using the Indirect Method 740 How is the Statement of Cash Flows Prepared Using the Direct Method? 740 Overview 740 Determining Cash Payments and Receipts 741 DECISION GUIDELINES 744 SUMMARY PROBLEM 2 745 REVIEW 748 Accounting Vocabulary 748 Quick Check 749 Assess Your Progress 750 Apply Your Knowledge 772 i ; ~) Financial Statement ;, ; Analysis 774 K " J What are the Most Common Methods of Analysis? 776 Horizontal Analysis 776 Horizontal Analysis of the Income Statement 778 Horizontal Analysis of the Balance Sheet 778 Trend Percentages 778 Vertical Analysis 780 How do we Compare One Company with Another? 781 DECISION GUIDELINES 783 SUMMARY PROBLEM 1 783 What are Some of the Most Common Financial Ratios? 786 Measuring Ability to Pay Current Liabilities 786 Measuring Ability to Sell Inventory and Collect Receivables 787 Measuring Ability to Pay Long-Term Debt 789 Measuring Profitability 790 Analyzing Stock Investments 792 Red Flags in Financial Statement Analysis 793 DECISION GUIDELINES 794 SUMMARY PROBLEM 2 796 REVIEW 799 Accounting Vocabulary 799 Quick Check 800 Assess Your Progress 801 Apply Your Knowledge 822 Photo Credits 826 Company Index 1-1 Glindex (combined Glossary/Index) I-4