What is the Importance of Cost Accounting in a Business Assignment | Online Assignment

Chapter One. Cost Accounting: Information for Decision Making

Chapter One Sections

Value Creation in Organizations

LO 1-1

Describe the way managers use accounting information to create value in organizations.

Why Start with Value Creation?

We start our discussion with the concepts of value creation and the value chain because in cost accounting our goal is to assist managers in achieving the maximum value for their organizations. Measuring the effects of decisions on the value of the organization is one of the fundamental services of cost accounting. As providers of information (accountants) or as the users of information (managers), we have to understand how the information can and will be used to increase value. We can then come back to questions about how to design accounting systems that accomplish this goal.

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Value Chain

The value chain is the set of activities that transforms raw resources into the goods and services end users (households, for example) purchase and consume. It also includes the treatment or disposal of any waste generated by the end users. As an example, the value chain for gasoline stretches from the search and drilling for oil, through refining the oil into gasoline, to the distribution of gasoline to retail outlets such as convenience stores, and, finally, to the treatment of the emissions produced by automobiles or the waste oil recycled at a service station.

In much of our discussion about cost accounting, we will be concerned with the part of the value chain that comprises the activities of a single organization (a firm, for example). However, an important objective of modern cost accounting is to ensure that the entire value chain is as efficient as possible. It is necessary for the firm to coordinate with vendors and suppliers and with distributors and customers to achieve this objective. In the gasoline example, ExxonMobil must work with suppliers of drilling equipment to ensure the equipment is available when needed. It also needs to work with owners of its On the Run franchises to ensure that gasoline is delivered to the stations as needed.

The cost accounting system provides much of the information necessary for this coordination. Therefore, at times we will also consider where in the value chain it is most efficient to perform an activity.

The value-added activities that the firms in the chain perform are those that customers perceive as adding utility to the goods or services they purchase. The value chain comprises activities from research and development (R&D) through the production process to customer service. Managers evaluate these activities to determine how they contribute to the final product’s service, quality, and cost.

Exhibit 1.1 identifies the individual components of the value chain and provides examples of the activities in each component, along with some of the costs associated with these activities. Although the list of value chain components in Exhibit 1.1 suggests a sequential process, many of the components overlap. For example, the R&D and design processes might take place simultaneously. Feedback from production workers on existing products might be incorporated in the development of new models of a product. Companies such as Apple solicit “feature requests” from customers for new versions of software.

Exhibit 1.1The Value Chain Components, Example Activities, and Example Costs

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Most organizations operate under the assumption that each of the value chain components adds value to the product or service. Before product ideas are formulated, no value exists. Once an idea is established, however, value is created. When research and development of the product begins, value increases. As the product reaches the design phase, value continues to increase. Each component adds value to the product or service.

You may have noticed that administrative functions are not included as part of the value chain. They are included instead in every business function of the value chain. For example, human resource management is involved in hiring employees for all business value chain functions. Accounting personnel and other managers use cost information from each business function to evaluate employee and departmental performance. Many administrative areas cover each value chain business function.

Supply Chain and Distribution Chain

Firms buy resources from suppliers (other companies, employees, etc.). These suppliers form the supply chain for the firm. Firms also sell their products to distributors and customers. This is the distribution chain of the firm. At times in our discussion, we will consider the companies and individuals supplying to or buying from a firm and the effect of the firm’s decisions on these suppliers and customers. We can think of these suppliers and customers as being on the firm’s boundaries. Thus, the supply chain and distribution chain are the parts of the value chain outside the firm.

The value chain is important because it creates the value for which the customer is willing to pay. The customer is not particularly concerned with how work is divided among firms producing the product or providing the service. Therefore, one decision firms must make is where in the value chain a value-added component is performed most cost effectively. Suppose, for example, that some inventory is necessary to provide timely delivery to the customer. Managers need accounting systems that will allow them to determine whether the firm or its supplier can hold the inventory at the lower cost.

Business Application Focus on the Supply Chain

Customers are concerned with the total cost of producing a product or service (because of the effect on its price), but are not concerned about which firm in the supply chain incurred the cost. Therefore, companies think about not only reducing their own costs but also reducing costs in the entire chain. The supply chain for cars and trucks includes multiple suppliers of parts and components. Chrysler LLC has set a goal of reducing its supply chain costs by 25 percent over three years. John Campi, executive vice president for procurement, explains that this does not mean that Chrysler will simply pay its suppliers 25 percent less, but, “[I]t means, between us, we have to find ways to improve our supply chain operations.”

Source: P. Gupta, “Chrysler Aims to Cut Supply Chain Costs by 25 Percent,” Reuters, August 15, 2008.

Using Cost Information to Increase Value

How can cost information add value to the organization? The answer to this question depends on whether the information provided improves managers’ decisions. Suppose a production process is selected based on cost information indicating that the process would be less costly than all other options. Clearly, the information adds value to the process and its products. The measurement and reporting of costs is a valuable activity. Suppose cost information is received too late to help managers make a decision. Such information would not add value.

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Accounting and the Value Chain

If you have taken a financial accounting course, you focused, for the most part, on preparing and interpreting financial statements for the firm as a whole. You were probably not concerned with what stage in the value chain produced profits. In cost accounting, as we will see, we need to understand how the individual stages contribute to value and how to work with other managers to improve performance. Although financial accounting and cost accounting are related, there are important differences.

Accounting Systems

LO 1-2

Distinguish between the uses and users of cost accounting and financial accounting information.

All accounting systems are designed to provide information to decision makers. However, it is convenient to classify accounting systems based on the primary user of the information. Investors (or potential investors), creditors, government agencies, tax authorities, and so on are outside the organization. Managers are inside the organization. The classification of accounting systems into financial and cost (or managerial) systems captures this distinction between decision makers.

Financial Accounting

Financial accounting information is designed for decision makers who are not directly involved in the daily management of the firm. These users of the information are often external to the firm. The information, at least for firms that are publicly traded, is public and typically available on the company’s Web site. The managers in the company are keenly interested in the information contained in the financial accounting reports generated. However, the information is not sufficient for making operational decisions.

Individuals making decisions using financial accounting data are often interested in comparing firms, deciding whether, for example, to invest in Bank of America or Wells Fargo Bank. An important characteristic of financial accounting data is that it be comparable across firms. That is, it is important that when an investor looks at, say, revenue for Bank of America, it represents the same thing that revenue for Wells Fargo Bank does. As a result, financial accounting systems are characterized by a set of rules that define how transactions will be treated.

Cost Accounting

Cost accounting information is designed for managers. Because the managers are making decisions only for their own organization, there is no need for the information to be comparable to similar information in other organizations. Instead, the important criterion is that the information be relevant for the decisions that managers operating in a particular business environment with a particular strategy make. Cost accounting information is commonly used in developing financial accounting information, but we are concerned primarily with its use by managers to make decisions.

This book is about accounting for costs; it is for those who currently (or will) use or prepare cost information. The book’s perspective is that managers (you) add value to the organization by the decisions they (you) make. From a different perspective, accountants (you) add value by providing good information to managers making the decision. The better the decisions, the better the performance of your organization, whether it is a manufacturing firm, a bank, a not-for-profit hospital, a government agency, a school club, or, yes, even a business school. We have already identified some of the decisions managers make and will discuss many of the current trends in cost accounting. We do this to highlight the theme we follow throughout: The cost accounting system is not designed in a vacuum. It is the result of the decisions managers in an organization make and the business environment in which they make them.

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Exhibit 1.2 summarizes some of the major differences between financial and cost accounting.

Exhibit 1.2Comparison of Financial and Cost Accounting

Cost Accounting, GAAP, and IFRS

The primary purpose of financial accounting is to provide investors (for example, shareholders) or creditors (for example, banks) information regarding company and management performance. The financial data prepared for this purpose are governed by generally accepted accounting principles (GAAP) in the United States and international financial reporting standards (IFRS) in many other countries. GAAP and IFRS provide consistency in the accounting data used for reporting purposes from one company to the next. This means that the cost accounting information used to compute cost of goods sold, inventory values, and other financial accounting information used for external reporting must be prepared in accordance with GAAP or IFRS. Although GAAP and IFRS are converging, differences remain. For the reasons discussed in the next paragraph, these differences are not important for our discussion, but you should remain aware of them.

In contrast to cost data for financial reporting to shareholders, cost data for managerial use (that is, within the organization) need not comply with GAAP or IFRS. Management is free to set its own definitions for cost information. Indeed, the accounting data used for external reporting are often entirely inappropriate for managerial decision making. For example, managerial decisions deal with the future, so estimates of future costs are more valuable for decision making than are the historical and current costs that are reported externally. Unless we state otherwise, we assume that the cost information is being developed for internal use by managers and does not have to comply with GAAP or IFRS.

This does not mean there is no “right” or “wrong” way to account for costs. It does mean that the best, or correct, accounting for costs is the method that provides relevant information to the decision maker so that he or she can make the best decision.

Customers of Cost Accounting

To management, customers are the most important participants in a business. Without customers, the organization loses its ability and its reason to exist; customers provide the organization’s focus. There are fewer and fewer markets in which managers can assume that they face little or no competition for the customer’s patronage.

Cost information itself is a product with its own customers. The customers are managers. At the production level, where products are assembled or services are performed, information is needed to control and improve operations. This information is provided frequently and is used to track the efficiency of the activities being performed. For example, if the average defect rate is 1 percent in a manufacturing process and data from the cost accounting system indicate a defect rate of 2 percent on the previous day, shop-floor employees would use this information to identify what caused the defect rate to increase and to correct the problem.

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At the middle management level, where managers supervise work and make operating decisions, cost information is used to identify problems by highlighting when some aspect of operations is different from expectations. At the executive level, financial information is used to assess the company’s overall performance. This information is more strategic in nature and typically is provided on a monthly, quarterly, or annual basis. Cost accountants must work with the users (or customers) of cost accounting information to provide the best possible information for managerial purposes.

Many proponents of improvements in business have been highly critical of cost accounting practices in companies. Many of the criticisms—which we discuss throughout the book—are warranted. The problem, however, is more with the misuse of cost accounting information, not the information itself. The most serious problems with accounting systems appear to occur when managers attempt to use accounting information that was developed for external reporting for decision making. Making decisions often requires different information from that provided in financial statements to shareholders. It is important that companies realize that different uses of accounting information require different types of accounting information.

Our Framework for Assessing Cost Accounting Systems

Individuals form organizations to achieve some common goal. Although the focus in this book is on economic organizations, such as the firm, most of what we discuss applies equally well to social, religious, or political organizations. The ability of organizations to remain viable and achieve their goals, whether profit, community well-being, or political influence, depends on the decisions made by managers of the organization.

Throughout the text, we emphasize that it is individuals (people) who make decisions. This theme and the following framework give us a common basis we can use to assess alternative accounting systems:

• Decisions determine the performance of the organization.

• Managers use information from the accounting system to make decisions.

• Owners evaluate organizational and managerial performance with accounting information.

The Manager’s Job Is to Make Decisions

LO 1-3

Explain how cost accounting information is used for decision making and performance evaluation in organizations.

Why do organizations employ people? What do they do to add value? For line employees, those directly involved in production or who interact with customers, the answer to this question is clear. They produce the product or service and deal with the customer. The job of managers, however, is more difficult to describe because it tends to be varied and ambiguous. The common theme among all managerial jobs, however, is decision making. Managers are paid to make decisions.

Decision Making Requires Information

Accounting systems are important because they are a primary source of information for managers. We describe here some common decisions that managers make. Many, if not most, decisions require information that is likely to come from the accounting system. Our concern with the accounting system is whether it is providing the “best” information to managers. The decisions managers make will be only as good as the information they have.

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Finding and Eliminating Activities That Don’t Add Value

How do managers use cost information to make decisions that increase value? In their quest to improve the production process, companies seek to identify and eliminate nonvalue-added activities, which often result from the current product or process design. If a poor facility layout exists and work-in-process inventory must be moved during the production process, the company is likely to be performing nonvalue-added activities.

Why do managers want to eliminate nonvalue-added activities? An important concept in cost accounting is that activities cause costs. Moving inventory is a nonvalue-added activity that causes costs (for example, wages for employees and costs of equipment to move the goods). Reworking defective units is another common example of a nonvalue-added activity. In general, if activities that do not add value to the company can be eliminated, then costs associated with them will also be eliminated.

A well-designed cost accounting system also can identify nonvalue-added activities that cross boundaries in the value chain. For example, companies such as Steelcase, an office furniture manufacturer, have found it worthwhile to allow customers to order products using automated systems such as electronic data interchange (edi) rather than preparing orders and sending them by fax. This change has eliminated the need for two organizations to enter an order into the production scheduling system. (One was the customer preparing the fax and the other was the manufacturer retyping or scanning the fax into the scheduling system.) Not only does this save order entry costs, but it reduces the chances of costly errors in the order.

A major activity of managers is evaluating proposed changes in the organization. Ideas often sound reasonable, but if their benefits (typically measured in savings or increased profits) do not outweigh the costs, management will likely decide against them. The concept of considering both the costs and benefits of a proposal is cost-benefit analysis. Managers should perform cost-benefit analyses to assess whether proposed changes in an organization are worthwhile. The concept of cost-benefit analysis applies equally to deciding whether to implement a new cost accounting system. The benefits from an improved cost accounting system come from better decision making. If the benefits do not exceed the cost of implementing and maintaining the new system, managers will not implement it.

Identifying Strategic Opportunities Using Cost Analysis

Using the value chain and other information about the costs of activities, companies can identify strategic advantages in the marketplace. For example, if a company can eliminate nonvalue-added activities, it can reduce costs without reducing the value of the product to customers. By reducing costs, the company can lower the price it charges customers, giving it a cost advantage over competitors. Or the company can use the resources saved from eliminating nonvalue-added activities to provide better service to customers.

Alternatively, a company can identify activities that customers value and which the company can provide at lower cost. Many logistics companies, such as Owens & Minor, a hospital supply company, offer their customers consulting services and inventory management.

The idea here is simple. Look for activities that do or do not add value. If your company can save money by eliminating those that do not, then do so. You will save your company money. Implement those activities that do. In both cases, you will make the organization more competitive.

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Owners Use Cost Information to Evaluate Managers

We have seen that it is important that managers make good decisions if they are to increase organizational value, but how will we know if they make good decisions? If managers own the organization, it is their money and resources that are at risk. We can assume that they will make decisions that are in their own interest. In other words, the interest of the organization and the owner-manager can be assumed to be the same, or aligned. However, most large organizations, especially businesses, are not owned by the managers but by a large number of shareholders. Most of these shareholders are not involved in managing the business. Therefore, there is a second role of the accounting system in addition to aiding managerial decision making. It is to provide information, perhaps indirectly through financial reports, to the owners of the organization about the performance of the organization and the manager.

Cost Data for Managerial Decisions

This book covers many topics on the use of cost data for managers. The following sections provide examples of these topics.

Costs for Decision Making

One of the most difficult tasks in calculating the financial consequences of alternatives is estimating how costs (or revenues or assets) among the alternatives will differ. For example, Carmen’s Cookies has been making and selling a variety of cookies through a small store downtown. One of Carmen’s customers, the manager of the local coffee shop, suggests to Carmen that she expand her operation and sell some of her cookies wholesale to coffee shops, grocery stores, and the local university food service. The key is to determine which would be more profitable: remain the same size or expand operations.

Now Carmen has the difficult task of estimating how revenues and costs will change if she expands into this new distribution channel. She uses her work experience and knowledge of the company’s costs to estimate cost changes. She identifies cost drivers, which are factors that cause costs. For example, to make cookies requires labor. Therefore, the number of cookies made is a cost driver that causes, or drives, labor costs. To estimate the effect of adding a wholesale channel, Carmen estimates how many additional cookies she would have to make. Based on that estimate, she determines the additional costs and revenues to the company that selling additional cookies will generate.

Do we “know” how this decision will affect the firm? We do not, of course. These are estimates that require making many assumptions and forecasts, some of which may not be realized. This is what makes this type of analysis both fun and challenging. In business, nobody knows for certain what will happen in the future. In making decisions, however, managers constantly must try to predict future events. Cost accounting has more to do with estimating future costs than recording past costs. For decision making, information about the past is a means to an end; it helps you predict what will happen in the future.

To complete the example, assume that Carmen estimates that her revenues would increase by 35 percent; food costs, labor, and utilities would increase 50 percent; rent per month would not change; and other costs would increase by 20 percent if she starts to sell through other outlets. Carmen enters the data into a spreadsheet to estimate how profits would change if she were to add the new channel. See Columns 1 and 2 of Exhibit 1.3 for her present and estimated costs, revenues, and profits. The costs shown in Column 3 are the differences between those in Columns 1 and 2.

Exhibit 1.3Differential Costs, Revenues, and Profits

We refer to the costs and revenues that appear in Column 3 as differential costs and differential revenues. These are the costs and revenues, respectively, that change in response to a particular course of action. The costs in Column 3 of Exhibit 1.3 are differential costs because they differ if Carmen decides to sell cookies through the wholesale channel.

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The analysis shows a $405 increase in operating profits if Carmen sells to the other stores. Based on this analysis, Carmen decides to expand her distribution channels. Note that only differential costs and revenues affect the decision. For example, rent does not change, so it is irrelevant to the decision.

In Chapters 2 through 11, we discuss methods to estimate and analyze costs, as well as how accounting systems record and report cost information.

Business Application Fast-Food Chain Menu Items and Costs

It is not just small businesses that think about costs. With an increase in food and energy prices, fast-food chains, such as Burger King and McDonald’s, are considering alternative ways to prepare some of their basic items. For example,

This month, McDonald’s Corp. said it’s testing less expensive ways to make its $1 double cheeseburger; already, some restaurants are selling the burger with one slice of cheese instead of two. And in an interview, Burger King Holdings Inc. CEO John Chidsey said the chain is testing a smalIer Whopper Jr. hamburger as it tries to overcome high ingredient costs.

In these examples, increases in costs that are outside of the firm’s control (food and energy, for example), combined with a reluctance to raise prices, mean that other costs must be closely monitored so that profits will not be eroded.

Source: J. Jargon, “Food Makers Scrimp on Ingredients in an Effort to Fatten Their Profits,” The Wall Street Journal, August 23, 2008.

Costs for Control and Evaluation

An organization of any but the smallest size divides responsibility for specific functions among its employees. These functions are grouped into organizational units. The units, which may be called departments, divisions, segments, or subsidiaries, specify the reporting relations within the firm. These relations are often shown on an organization chart. The organizational units can be based on products, geography, or business function. We use the general term responsibility center to refer to these units. The manager assigned to lead the unit is accountable for, that is, has responsibility for, the unit’s operations and resources.

For example, the chief of internal medicine is responsible for the operations of a particular part of a hospital. The president of General Motors Europe is responsible for most of the company’s operations in Europe. The president of a company is responsible for the entire company.

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Consider Carmen’s Cookies. When she first opened the store, Carmen managed the entire operation herself. As the enterprise became more successful, she added a new location exclusively to serve the wholesale distribution network. She then hired two managers: Ray Adams to manage the original retail store and Cathy Peterson to manage the wholesale network. Carmen, as president, oversaw the entire operation. See the top part of Exhibit 1.4 for the company’s organization chart.

Exhibit 1.4Responsibility Centers, Revenues, and Costs

Exhibit 1.4 also includes the company income statement, along with the statements for the two centers. Each manager is responsible for the revenues and costs of his or her center. The Total column is for the entire company. Note that the costs at the bottom of the income statement are not assigned to the centers; they are the costs of running the company. These costs are not the particular responsibility of either Ray or Cathy. Consider the other (administrative) costs. Carmen, not Ray or Cathy, is responsible for designing the administrative systems (e.g., accounting and payroll), so she manages this cost as part of her responsibility to run the entire organization. Ray and Cathy, on the other hand, focus on managing food and labor costs (other than their own salaries) and responsibility center revenues.

Budgeting You have probably had to budget—for college, a vacation, or living expenses. Even the wealthiest people should budget to make the best use of their resources. (For some, budgeting could be one reason for their wealth.) Budgeting is very important to the financial success of individuals and organizations.

Each responsibility center in an organization typically has a budget that is its financial plan for the revenues and resources needed to carry out its tasks and meet its financial goals. Budgeting helps managers decide whether their goals can be achieved and, if not, what modifications are necessary.

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Managers are responsible for achieving the targets set in the budget. The resources that a manager actually uses are compared with the amount budgeted to assess the responsibility center’s and the manager’s performance. For example, managers in an automobile dealership compare the daily sales to a budget every day. (Sometimes that budget is the sales achieved on a comparable day in the previous year.) Every day, managers of United Airlines compare the percentage of their airplanes’ seats filled (the load factor) to a budget. Every day, managers of hotels and hospitals compare their occupancy rates to their budgets. By comparing actual results with budgets, managers can do things to change their activities or revise their goals and plans.

As part of the planning and control process, managers prepare budgets containing expectations about revenues and costs for the coming period. At the end of the period, they compare actual results with the budget. This allows them to see whether changes can be made to improve future operations. See Exhibit 1.5 for the type of statement used to compare actual results with the planning budget for Carmen’s Cookies.

Exhibit 1.5Budget versus Actual Data

For instance, Ray observes that the retail responsibility center sold 32,000 cookies as budgeted but that actual costs were higher than budgeted. Costs that appear to need follow-up are those for eggs, chocolate, and nuts. Should Ray inquire whether there was waste in using eggs? Did the cost of nuts per pound rise unexpectedly? Was the company buying chocolate from the best source? Was there theft of the chocolate? As we will see, even costs that are lower than expected (like flour) should be evaluated. For example, is lower quality flour being purchased? These are just a few questions that the information in Exhibit 1.5 would prompt.

We discuss developing budgets and measuring the performance of managers and responsibility centers in Chapters 12 through 18.

Different Data for Different Decisions

One principle of cost accounting is that different decisions often require different cost data. “One size fits all” does not apply to cost accounting. Each time you face a cost information problem in your career, you should first learn how the data will be used. Are the data needed to value inventories in financial reports to shareholders? Are they for managers’ use in evaluating performance? Are the data to be used for decision making? The answers to these questions will guide your selection of the most appropriate accounting data.

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Self-Study Questions

1. Suppose that all of the costs for Carmen’s Cookies (Exhibit 1.3) were differential and increased proportionately with sales revenue. What would have been the impact on profits of adding the new distribution channel?

1. For what decisions would estimated cost information be useful if you were a hospital administrator? The director of a museum? The marketing vice president of a bank?

The solutions to these questions are at the end of the chapter.

Trends in Cost Accounting throughout the Value Chain

LO 1-4

Identify current trends in cost accounting.

Cost accounting continues to experience dramatic changes. Developments in information technology (IT) have nearly eliminated manual bookkeeping. Emphasis on cost control is increasing in banks, hospitals, manufacturing industries (from computers to automobiles), airlines, school districts, and many other organizations that have traditionally not focused on it. Cost accounting has become a necessity in virtually every organization, including fast-food outlets, professional organizations, and government agencies.

One reason for this rapid change is that managers at each stage of the value chain require information on the performance of products, services, suppliers, customers, and employees. Managers of the activities and cost accountants must work together at each stage to make decisions that increase firm value. Because these processes themselves have undergone great change in recent years, cost accountants and cost accounting methods must continuously adapt to changes in all business areas.

Cost Accounting in Research and Development (R&D)

Lean manufacturing techniques, in which Toyota Motor Company is considered a leader, are not simply about production. Companies partner with suppliers in the development stage to ensure cost-effective designs for products. Product engineers need cost accounting information to make decisions about alternative materials. For example, Johnson Controls, a manufacturer of automobile seats, needs to make trade-offs between the cost and weight of materials, which is an important factor in fuel economy and the cost of recycling the materials at the end of the car’s life.

Cost Accounting in Design

An important activity in product development is design. Product designers must write detailed specifications on a product’s design and manufacture. The design of a product can have a significant impact on the cost to manufacture it. Designs that are complex might add additional functions, which, while making a product more desirable, may also require complex and expensive manufacturing processes. Design for manufacturing (DFM) is the concept that manufacturing cost and complexity need to be considered in the design of the product. Cost accountants help designers understand the trade-off by using methods such as activity-based costing, which considers the activities or processes that will be required to bring a product to market. Hewlett-Packard, for example, uses activity-based costing methods to communicate to designers the costs of alternative designs of testing equipment.

Activity-based costing is a product costing method that has received a great deal of attention since the 1990s. This costing method is more detailed and complicated than conventional costing methods, but it can provide more accurate cost numbers. ABC assigns costs to products based on several different activities, depending on how they drive costs, whereas traditional costing methods assign costs to products based on only one or two factors, generally based on volume. In general, ABC provides more detailed cost information, enabling managers to make more informed decisions.

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Cost Accounting in Purchasing

Companies now partner with suppliers to increase the efficiency in the supply chain. Partnering requires information on the performance of partners to ensure the relationship adds value. Performance measures are being used to evaluate the performance of key suppliers and business partners. For example, United Technologies and Sun Microsystems both maintain extensive supplier metrics systems. Sun Microsystems also includes an effort to “value” nonperformance in understanding the effect of suppliers on Sun’s value.

The use of cost accounting methods such as target costing, activity-based costing, performance measures, and incentive systems that support teamwork, helps firms such as FedEx and Dell Inc. manage their partnerships to keep the supply chain “lean” and add value throughout the chain. Some firms, for example, Sainsbury, a supermarket chain in the United Kingdom, maintain a Web portal for their suppliers that allows them to see their own performance over time and compare it to the average performance of other comparable suppliers. In the United States, Boeing Aircraft and United Technologies also use the Internet to provide comparative performance data to suppliers.

These approaches to managing suppliers allow firms to support continual improvement throughout the supply chain by facilitating benchmarking. Using benchmarking methods, managers measure a company’s own products, services, and activities against the best levels of performance that can be found either inside or outside the manager’s own organization. Because managers seek continual improvement, they do not treat benchmarking as a one-time event but as an ongoing process.

Cost Accounting in Production

Operations managers and financial accountants use cost information in the production stage to understand and report the costs of the multiple products produced. One of the most important developments in production, associated with lean manufacturing, is the use of just-in-time (JIT) methods. Using just-in-time methods, companies produce or purchase units just in time for use, keeping inventories at a minimum. If inventories are low, accountants can spend less time on inventory valuation for external reporting and more time on managerial activities.

The economic justification for JIT comes from the trade-off between the costs of setup and stock-outs as compared with the costs of holding inventory (obsolescence, storage space and associated tax and insurance, and costs associated with organizing and keeping track of inventory). Modern cost accounting systems have helped managers better understand the relative costs so that appropriate inventory policies can be set and targeted improvements sought.

Firms that use lean manufacturing techniques look to the cost accounting system to support these techniques by providing useful measurements at the work cell or process level. Lean accounting systems provide these measures. In addition, these systems are designed to avoid unnecessary transactions, in effect eliminating “waste” from the accounting processes, just as lean manufacturing is designed to eliminate waste from the manufacturing process.

The production process is not limited to manufacturing. Service firms, such as banks, insurance companies, and theme parks, produce or provide services demanded by customers. Efficient use of capacity (employees) in providing services is critical in increasing value. Managers look to cost accounting information to help them understand and plan capacity. For example, the brokerage firm Charles Schwab uses ABC information to allocate costs and thus determine the costs of capacity in various operational processes. The firm then builds up the product cost according to its use of time in regard to the key processes.

Cost Accounting in Marketing

Marketing managers require cost accounting information to understand the profitability of different customer groups. Advances in accounting information systems that capture data at various levels of detail have made possible customer relationship management (CRM), which allows firms to target more precisely those customers who are profitable by assessing the costs to serve a customer along with the revenues a customer generates. For example, Harrah’s Entertainment is able to compete on the basis of providing complimentary services to customers (typically called “comping”) based on their expected personal profitability.

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Cost Accounting in Distribution

Earlier, we said that managers use accounting information to determine where in the supply chain value-added activities will take place. Cost accountants work with managers to estimate whether it is more efficient (less costly) to perform an activity in the firm or to have another firm produce the product or perform the service. This is referred to as outsourcing. Firms frequently consider activities in the distribution stage for outsourcing. As business becomes more global, specialized information on markets, regulations, and customs is critical to the speed of delivery. As a result, cost information often identifies specialized companies as being more efficient in distributing products, as opposed to handling distribution internally.

The Japanese camera manufacturer Nikon, for example, now relies on UPS for distribution where it used to handle this activity internally. Many distribution companies such as UPS and FedEx, in fact, have developed entirely new businesses consulting with firms in regard to distribution solutions. These consulting services rely heavily on cost information to identify cost-effective distribution systems.

Cost Accounting in Customer Service

Many companies have adopted the concept of total quality management (TQM), which means that the organization is managed to excel on all dimensions and the customer ultimately defines quality. The customers determine the company’s performance standards according to what is important to them (which is not necessarily what is important to product engineers, accountants, or marketers). Companies can indicate the high quality to consumers through the product warranty. Cost accountants help managers make decisions about quality in two ways. First, cost of quality (COQ) systems identify the costs associated with producing defective units as well as the lost sales associated with poor-quality products. Second, they provide information on the projected warranty claims, which can be compared to the increase in revenues estimated from offering a longer or more comprehensive warranty.

For example, Korean manufacturer Hyundai Motors determined that its quality improvements justified offering a 10-year warranty, something unique in the automobile industry. This decision was based on estimates of warranty costs and studies concerning the sales impact of the longer warranty.

Enterprise Resource Planning

We have seen how cost accounting is used throughout the value chain. It is important that the information be consistent in all components of the chain.

As the cost of information technology falls and the value of information increases, managers have adopted enterprise resource planning (ERP) systems. ERP systems are integrated information systems that link various activities in an organization. Typical systems include modules for production, purchasing, human resources, and finance. By integrating these systems, managers hope to avoid lost orders, duplication of effort, and costly studies to determine what is the current state of the enterprise.

Because all of the company’s systems are integrated, the potential for ERP to provide information on costs of products and services is large. Implementation problems and the scale of the task in large firms (enterprises) have kept many companies from realizing that potential so far. However, with the increased emphasis on internal control from the Sarbanes-Oxley Act (discussed later in the chapter), ERP systems will become even more valuable.

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Creating Value in the Organization

These trends in the way organizations do business create exciting times in cost accounting and excellent future opportunities for you to make important contributions to organizations. Keep in mind that these new methods are not ends in themselves. They are tools to help you add value to organizations and their employees, customers, shareholders, and communities.

Self-Study Question

1. What are the major causes of changes in cost accounting systems in recent years?

The solution to this question is at the end of the chapter.

Key Financial Players in the Organization

All managers in the organization, not just financial professionals, use cost accounting information. Because our focus is on cost accounting and decision making, we will often be viewing a decision from an operational manager’s perspective. For example, we might look at a pricing decision or a sourcing decision that a marketing or production manager has to make.

As a financial or operational manager in an organization, you will work closely with many financial professionals. See Exhibit 1.6 for a list of the typical financial titles in organizations and examples of their activities. If you work in the accounting or finance function in an organization, you are likely to have one of these jobs. If you are an auditor or consultant, you will work with many of these financial managers. If you work in marketing, operations, or management, these financial managers will be on one of many teams working with you.

Exhibit 1.6Key Financial Managers in an Organization

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Whatever your job, you will work in cross-functional teams of people from many areas such as engineering, production, marketing, finance, and accounting. Consider a project designed to identify a new design for an airplane. Cross-functional teams add value to decision making by:

• Bringing a variety of expertise and perspectives to the problem.

• Ensuring that the product is appropriate for its customer base (requiring interaction between engineering and marketing).

• Giving production a chance to formulate an efficient production process (requiring interaction between engineering and production).

• Obtaining financing for the project (requiring interaction among all groups, including finance and accounting).

• Determining whether the project is economically feasible (requiring interaction among all functions).

Choices: Ethical Issues for Accountants

LO 1-5

Understand ethical issues faced by accountants and ways to deal with ethical problems that you face in your career.

We have discussed decisions that you will make in using or preparing cost accounting information. Now, we alert you to ethical issues that you will have to face. The sooner you are aware of these issues, the better you will be able to deal with them in your career. The design of cost systems is ultimately about the assignment of costs to various activities, products, projects, corporate units, and people. How that is done affects prices, reimbursement, and pay. As you know from current events, the design of the cost accounting system has the potential to be misused to defraud customers, employees, or shareholders. As a user or preparer of cost information, you need to be aware of the implications of the way in which information is used. Most important, you need to be aware of when the system has the potential for abuse.

What Makes Ethics So Important?

Accountants report information that can have a substantial impact on the careers of managers. Managers are generally held accountable for achieving financial performance targets. Failure to achieve them can have serious negative consequences for the managers, including losing their jobs. If a division or company is having trouble achieving financial performance targets, accountants may find themselves under pressure by management to make accounting choices that will improve performance reports.

As a professional accountant, manager, or business owner, you will face ethical situations on an everyday basis. Your personal ethical choices can affect not only your own self-image but also others’ perception of you. Ultimately, the ethical decisions you make directly influence the type of life you are likely to lead. You should confront ethical dilemmas bearing in mind the type of life that you want to lead.

Many students think that businesspeople who are unethical are sleazy characters. In fact, most are hard-working people who are surprised that they have gotten caught up in unethical activities. Even people who commit organizational crimes are often surprised by their own behavior. A former federal prosecutor told us, “Most businesspeople who commit crimes are very surprised that they did what they did.” For example, a few years ago, numerous executives of companies in the DRAM market, such as Samsung and Infineon, were charged with price-fixing. (DRAM stands for “dynamic random access memory,” which is the type of memory used in most personal computers.) Many of these executives did jail time for an activity that was intended to benefit their companies, not themselves. Most of them did not realize that exchanging information with competitors was illegal.

Unethical behavior often leads to illegal activities as managers attempt to improve reported results. See the Business Application item on options backdating for an example and the text in this section for some approaches to handling ethical problems.

© Photodisc/Getty Images, RF

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In an attempt to influence the accounting profession, many of its professional organizations such as the Institute of Management Accountants (IMA), Institute of Internal Auditors (IIA), and the American Institute of Certified Public Accountants (AICPA) have developed codes of ethics to which their members are expected to adhere. Similarly, businesses such as Johnson & Johnson generally use these codes as a public statement of their commitment to certain business practices with respect to their customers and as a guide for their employees.

Throughout this book, we include discussions of ethical issues. Our aim is to make you aware of potential problems that you and your colleagues will face in your careers. Many accountants, managers, and business owners have found themselves in serious trouble because they did many small things, none of which appeared seriously wrong, only to find that these small things added up to big trouble. If you know the warning signs of potential ethical problems, you will have a chance to protect yourself and set the proper moral tone for your company and your profession at the same time.

The IMA code of conduct appears in the Appendix to this chapter. In its “Statement of Ethical Professional Practice,” the IMA states that management (and cost) accountants have a responsibility to maintain the highest levels of ethical conduct. They also have a responsibility to maintain professional competency, refrain from disclosing confidential information, and maintain integrity and objectivity in their work. These standards recommend that accountants faced with ethical conflicts follow the established policies that deal with them. If the policies do not resolve the conflict, accountants should consider discussing the matter with superiors, potentially as high as the audit committee of the board of directors. In extreme cases, the accountant could have no alternative but to resign.

Many people believe that the appropriate way to deal with ethical issues is not by requiring employees to read and sign codes of ethics but to rely on more fundamental concepts of right and wrong. Codes of conduct look good on paper, but ultimately much of ethical behavior comes from an individual’s personal beliefs. We are certain that you will be faced with important ethical choices during your career, and we wish you well in making the right choices.

Ethics

The IMA Code of Ethics discusses the steps cost accountants should take when faced with an ethical conflict. Essentially, these steps are:

• DISCUSS the conflict with your immediate superior or, if the conflict involves your superior, the next level in authority. This might require contacting the board of directors or an appropriate committee of the board, such as the audit committee or the executive committee;

• CLARIFY the relevant issues and concepts by discussions with a disinterested party or by contacting an appropriate and confidential ethics “hotline”;

• CONSULT your attorney about your rights and obligations.

During the wave of corporate scandals after the turn of the century, two accountants distinguished themselves for their courage in bringing unethical behavior to light. These two accountants, Cynthia Cooper at WorldCom and Sherron Watkins at Enron, along with an FBI agent, were named Persons of the Year by Time magazine. Although these accountants have been publicly applauded for their courage and integrity, they were heavily criticized for not being team players when they brought their concerns to top management. But they held their ground and would not back down. You, too, might be called upon by circumstances to blow the whistle on unethical practices where you work.

The Sarbanes-Oxley Act of 2002 and Ethics

When the public perception of widespread ethical problems in business exists, the result is often legislation making certain conduct not only unethical but also illegal. In the late 1990s and early 2000s, the investing and consuming public became aware of several practices, including manipulation of accounting results, designed to increase the compensation of managers at several firms. These practices came to light with the failure of many of these businesses when the “tech bubble” burst in early 2000.

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The United States Congress passed legislation in 2002 that was intended to address some of the more serious problems of corporate governance. The legislation, termed the Sarbanes-Oxley Act of 2002, has many provisions and affects both companies and accounting firms. For our purposes, some of the important provisions concern those in Title III and Title IV that deal with corporate responsibility and enhanced financial disclosure, respectively. The CEO and CFO are responsible for signing financial statements and stipulating that the financial statements do not omit material information. The requirement that these officers sign the company’s financial statements makes it clear that the “buck stops” with the CEO and CFO and that they are personally responsible for the financial statements. They cannot legitimately claim that lower-level managers or employees misled them about the financial statements, as was stated by defendant executives in many fraud trials in the past. We have learned that top executives are taking this sign-off very seriously, especially knowing that misrepresentation of their company’s financial reports could mean substantial prison time. They must further disclose that they have evaluated the company’s internal controls and that they have notified the company’s auditors and the audit committee of the board of any fraud that involves management.

Section 404 of Title IV requires managers to attest to the adequacy of their internal controls. Good internal controls assure that financial records accurately and fairly reflect transactions and that expenditures are in accordance with the authorization of company management and directors. Further, good internal controls help protect against the unauthorized purchase, use, or sale of company assets.

An example of an internal control is the requirement that two people, not just one, sign checks. Requiring two people to sign checks reduces the probability that someone will divert the company’s cash to personal use.

Sarbanes-Oxley is important for managers who design cost information systems. Whether the cost information is used for pricing decisions or performance evaluation, the manager must be aware of the potential that the resulting information could be misleading or support fraudulent activity. Compliance with Sarbanes-Oxley does not, however, mean that the manager has met all of his or her ethical responsibilities. Sarbanes-Oxley is a law; ethics is based on behavior. The IMA guidelines suggest you answer the following questions when faced with an ethical dilemma:

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• Will my actions be fair and just to all parties affected?

• Would I be pleased to have my closest friends learn of my actions?

Business Application Options Backdating at Apple

Stock options are a popular compensation tool used to motivate senior executives. Recently, executives at several companies have been accused of setting an earlier date for an option grant than the day the option actually is awarded. (If the stock price had been rising, this would increase the value of the option to the executive.) Such a decision requires the firm to recognize as cost of compensation the difference between the stock price on the date of the grant and the stock price on the earlier date indicated. Failure to do so is potentially fraudulent.

One company accused of backdating is Apple, Inc. Two senior executives, the general counsel and the chief financial officer, settled charges with the Securities and Exchange Commission (SEC) over the matter. After an internal investigation, Apple’s Board of Directors, “admitted to frequent backdating but exonerated [CEO Steven P.] Jobs—in part because Jobs ‘did not appreciate the accounting implications’ of backdating.” (Because the backdating took place in 2001, the CEO was not required to attest to the financial statements, indicating his knowledge of the accounting implications of transactions.) Part IV.2 of the Code of Ethics of the Institute of Management Accounting (see Appendix) requires members to:

Disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, analyses, or recommendations.

The former CFO claims that he “warned Jobs at the time that Apple would likely need to take an accounting charge if it issued options on any day other than January 2.”

Sources: P. Burrows, “Parting Shots at Apple’s Jobs,” BusinessWeek, April 27, 2007; IMA, http://www.imanet.org/docs/default-source/press_releases/statement-of-ethical-professional-practice_2-2-12.pdf?sfvrsn=2.

Consider the Business Application discussion of options backdating. You as the manager or cost accountant need to be aware of the powerful incentives created by performance measurement and compensation systems and how those incentives could lead to unethical (or even illegal) conduct. For example, imagine the pressure you would feel to remain silent about unfavorable accounting implications of actions that your boss (the CEO) wanted to take. You would probably find it difficult to tell your boss about these implications, especially when he or she would stand to benefit personally from the actions.

Self-Study Question

1. What are the three essential steps a cost accountant should take when faced with an ethical conflict?

The solution to this question is at the end of the chapter.

Cost Accounting and Other Business Disciplines

Finally, keep in mind that cost accounting does not exist in a vacuum. The boundary between what is cost accounting and what belongs in another discipline is often blurred. This is natural because in the “real world,” problems are generally multidisciplinary. Production managers use cost accounting data to make scheduling and inventory decisions requiring concepts from operations. We will look to some concepts from organizational behavior because changes in the cost accounting system must be implemented by individuals in the organization who will react in different ways. Marketing issues arise when we use cost accounting data to evaluate pricing decisions. Throughout the book, we will venture into these other disciplines as a matter of course.

The Debrief

Carmen takes a break from her classes and talks about what she has learned:

Before taking this class, I wondered whether I should quit the cookie business and take a job with another firm. What I learned just from the introduction to my cost accounting class is that there are tools that I can learn to use to identify areas for improvement and that can help me analyze some of the decisions I have to make.

The example of finding other activities that can add value made me think of something I can add to my business—party planning! I sell a lot of cookies to parents for birthday parties; it would not be difficult to supply other food, party favors, and so on.

I’ve decided to stick with the store. I am especially excited that I will learn how to combine what I learn in cost accounting with what I will learn in marketing, operations, finance, and management.

Carmen identified three important things she picked up from the introduction:

1. Her cookie store is made up of a series of activities (the value chain) that combine to add value to the business.

1. She can use cost information to help her make decisions to increase value, but this information needs to be tailored to the decision she is trying to make.

1. Business decisions, including the development and use of accounting information, often require us to ask not just what is best in terms of increasing value, but also what is ethical. Accountants, like all managers, need to understand the ethical implications of their actions.