1

Chapter One

Introduction

Chapter Outline

A. Managerial Accounting: Decision Makingand Control

B. Design and Use of Cost Systems

C. Marmots and Grizzly Bears

D. Management Accountant’s Role in theOrganization

E. Evolution of Management Accounting:A Framework for Change

F. Vortec Medical Probe Example

G. Outline of the Text

H. Summary

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A. Managerial Accounting: Decision Making and Control

Managers at BMW must decide which car models to produce, the quantity of eachmodel to produce given the selling prices for the models, and how to manufacturethe automobiles. They must decide which car parts, such as headlight assemblies,BMW should manufacture internally and which parts should be outsourced. Theymust decide not only on advertising, distribution, and product positioning to sellthe cars, but also the quantity and quality of the various inputs to use. For exam-ple, they must determine which models will have leather seats and the quality ofthe leather to be used.

How are future revenues and costs of proposed car models estimated? Simi-larly, in deciding which investment projects to accept, capital budgeting analystsrequire data on future cash flows. How are these numbers derived? How does onecoordinate the activities of hundreds or thousands of employees in the firm so thatthese employees accept senior management’s leadership? At BMW and corpora-tions everywhere, managers must have good information to make all these deci-sions and the leadership abilities to get others to implement the decisions.

Information about firms’ future costs and revenues is not readily available butmust be estimated by managers. Organizations must obtain and disseminate theknowledge to make these decisions. Decision making is much easier with the req-uisite knowledge. Price theory, finance, operations management, and marketingprovide the principles underlying profit-maximizing management.

Organizations’ internal information systems provide some of the knowledgefor these pricing, production, capital budgeting, and marketing decisions. Thesesystems range from the informal and the rudimentary to very sophisticated, com-puterized management information systems. The term information system shouldnot be interpreted to mean a single, integrated system. Most information systemsconsist not only of formal, organized, tangible records such as payroll and pur-chasing documents but also informal, intangible bits of data such as memos, spe-cial studies, and managers’ impressions and opinions. The firm’s informationsystem also contains nonfinancial information such as customer and employee sat-isfaction surveys. As firms grow from single proprietorships to large global corpo-rations with tens of thousands of employees, managers lose the knowledge ofenterprise affairs gained from personal, face-to-face contact in daily operations.Higher-level managers of larger firms come to rely more and more on formal oper-ating reports.

The internal accounting system, an important component of a firm’s informa-tion system, includes budgets, data on the costs of each product and current in-ventory, and periodic financial reports. In many cases, especially in smallcompanies, these accounting reports are the only formalized part of the informa-tion system providing the knowledge for decision making. Many larger companieshave other formalized, nonaccounting–based information systems, such as pro-duction planning systems. This book focuses on how internal accounting systemsprovide knowledge for decision making.

After making decisions, managers must implement them in organizations inwhich the interests of the employees and the owners do not necessarily coincide.Just because senior managers announce a decision does not necessarily ensure thatthe decision will be implemented. Throughout this book, we assume that individ-uals maximize their self-interest. The owners of the firm usually want to maximizeprofits, but managers and employees will do so only if it is in their interest. Hence,

2 Chapter 1

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a conflict of interest exists between owners—who, in general, want higher profits—and employees—who want easier jobs, higher wages, and more fringe benefits. Tocontrol this conflict, senior managers and owners design systems to monitor em-ployees’ behavior and incentive schemes that reward employees for generatingmore profits. Not-for-profit organizations face similar conflicts. Those people re-sponsible for the nonprofit organization (boards of trustees and government offi-cials) must design incentive schemes to motivate their employees to operate theorganization efficiently.

One of the functions of the firm’s internal accounting system is to help alignthe interests of managers and shareholders to cause employees to maximize firmvalue. It sounds like a relatively easy task to design systems to ensure that em-ployees maximize firm value. But a significant portion of this book demonstratesthe exceedingly complex nature of aligning employee interests with those of theowners.

Organization theory is a large, diverse literature that describes the importanceof incentives, alternative organizational structures, and control in multipersonorganizations.1 This book views one role of the internal accounting system as amonitoring mechanism used by organizations to better align the employees’and owners’ interests. In particular, the internal accounting system is part of theperformance evaluation system for motivating and monitoring employees inorganizations.

Internal accounting systems serve two purposes: (1) to provide some ofthe knowledge necessary for planning and making decisions (decision making), and(2) to help motivate and monitor people in organizations (control). The most basic

Introduction 3

Objectives ofOrganizations

Organizations do not have objectives; people do. A discussion of an organiza-tion’s objectives requires addressing the owners’ objectives. One common ob-jective of owners is to maximize profits, or the difference between revenues andexpenses. Maximizing firm value is equivalent to maximizing the stream ofprofits over the organization’s life. Employees, suppliers, and customers alsohave their own objectives—usually maximizing their self-interest.

Not all owners care only about monetary flows. An owner of a professionalsports team might care more about winning (subject to covering costs) thanmaximizing profits. Other goals owners might pursue include maximizing thewelfare of the organization’s members, as in the case of a private club.

No matter what objective the owners seek to pursue, the organization willsurvive only if its inflow of resources (such as revenue) is at least as large as theoutflow. Accounting information is useful to help manage the inflow and out-flow of resources and to help align the owners’ and employees’ interests, nomatter what objectives the owners wish to pursue.

1 Control refers to the process that helps “ensure the proper behaviors of the people in the organization.These behaviors should be consistent with the organization’s strategy,” as noted in K Merchant, Control inBusiness Organizations (Boston: Pitman Publishing Inc., 1985), p. 4. Merchant provides an extensive discussionof control systems and a bibliography. In Theory of Accounting and Control (Cincinnati, OH: South-WesternPublishing Company, 1997), S Sunder describes control as mitigating and resolving conflicts betweenemployees, owners, suppliers, and customers that threaten to pull organizations apart.

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control use of accounting is to prevent fraud and embezzlement. Maintaining in-ventory records helps reduce employee theft. Accounting budgets, discussed morefully in Chapter 6, provide an example of both decision making and control. Ask-ing each salesperson in the firm to forecast next year’s sales in his or her territoryand then aggregating across all salespeople produces an estimate of the firm’s bud-geted sales. This estimate is very useful for planning next year’s most efficient pro-duction methods (decision making). Many firms also use the salespersons’forecasted sales amount to benchmark actual sales. Salespeople who beat theirforecasts receive bonuses. Basing bonuses on beating budgeted sales targets is anexample of using accounting numbers for control. Clearly, when salespeople knowthat their sales forecasts will be used in their compensation, they have strong in-centives to underestimate their budget forecasts.

Using internal accounting systems for both decision making and control givesrise to the fundamental trade-off in these systems: A system cannot be designed toperform two tasks as well as a system that must perform only one task. Some abil-ity to deliver knowledge for decision making is usually sacrificed to provide bettermotivation (control). The trade-off between providing knowledge for decisionmaking and motivation/control arises continually throughout this text.

This book is applications oriented: It describes how the accounting system as-sembles knowledge necessary for implementing decisions using the theories frommicroeconomics, finance, operations management, and marketing. It also showshow the accounting system helps motivate employees to implement these deci-sions. Moreover, it stresses the continual trade-offs that must be made between thedecision making and control functions of accounting.

A survey of the 49 largest banks and savings and loans in the United Statesasked managers to rank the importance of the various goals of their firm’s ac-counting system. Table 1–1 indicates that product development and pricing wasthe most important goal and achieving cost reductions was the second most im-portant goal. Performance evaluation was third most important—but it wasranked as the first or second most important goal by 41.7 percent of the bank ex-ecutives. These results indicate that large banks use their accounting systems fordecision making (product development, pricing, and cost control) and for con-trolling behavior (performance evaluation).2

4 Chapter 1

2 M Gardner and L Lammers, “Cost Accounting in Large Banks,” Management Accounting, April 1988,pp. 34–39.

TABLE 1–1 Importance of Accounting Goals in Large Banks

Second Third Fourth Most Most Most Most Least

Goal of Cost Accounting Systems Important Important Important Important Important Total

Product development and pricing 61.2% 24.5% 14.3% 0.0% 0.0% 100%Achieving cost reductions 22.4 42.9 26.5 8.2 0.0 100Performance evaluation 14.6 27.1 35.4 18.7 4.2 100Industry cost comparison 2.3 23.3 20.9 58.2 16.3 100

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The firm’s accounting system is very much a part of the fabric that helps holdthe organization together. It provides knowledge for decision making, and it pro-vides information for evaluating and motivating the behavior of individualswithin the firm. Being such an integral part of the organization, the accountingsystem cannot be studied in isolation from the other mechanisms used for decisionmaking or for reducing organizational problems. A firm’s internal accounting sys-tem should be examined from a broad perspective, as part of the larger organiza-tion design question facing managers.

B. Design and Use of Cost SystemsManagers make decisions and monitor subordinates who make decisions. Bothmanagers and accountants must acquire sufficient familiarity with cost systems toperform their jobs. Accountants (often called controllers) are charged with design-ing, improving, and operating the firm’s accounting system—an integral part ofboth the decision-making and performance evaluation systems. Both managersand accountants must understand the strengths and weaknesses of current ac-counting systems. Internal accounting systems, like all systems within the firm, areconstantly being refined and modified. Accountants’ responsibilities include mak-ing these changes.

An internal accounting system should have the following characteristics:

1. Provide the information necessary to identify the most profitable productsand the pricing and marketing strategies to achieve the desired volumelevels.

2. Provide information to detect production inefficiencies to ensure that theproposed products and volumes are produced at minimum cost.

3. When combined with the performance evaluation and reward systems,create incentives for managers to maximize firm value.

Introduction 5

AlternativeApproaches toOrganizationalTheory

This book uses an economic perspective to study how accounting can motivateand control behavior in organizations. Besides economics, a variety of otherparadigms also are used to investigate organizations: scientific management(Taylor), the bureaucratic school (Weber), the human relations approach(Mayo), human resource theory (Maslow, Rickert, Argyris), the decision-making school (Simon), and the political science school (Selznick). For ex-ample, one branch of the human relations approach holds that “good leadership”generates greater productivity. A “good leader” is democratic rather thanauthoritarian, is employee-centered rather than production-centered, and caresabout employees rather than bureaucratic rules.

Behavior is a complex topic. No single theory or approach is likely to cap-ture all the elements. However, understanding managerial accounting requiresaddressing the behavioral and organizational issues. Economics is one usefultechnique.SOURCE: V Narayanan and R Nath, Organization Theory: A Strategic Approach (Burr Ridge, IL: Richard D. Irwin, 1993),pp. 28–47; and C Perrow, Complex Organizations: A Critical Essay (New York: Random House, 1986), p. 85.

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4. Support the financial accounting and tax accounting reportingfunctions. (In some instances, these latter considerations dominatethe first three.)

5. Contribute more to firm value than it costs.

Figure 1–1 portrays the functions of the accounting system. In it, the ac-counting system supports both external and internal reporting systems. Examinethe top half of Figure 1–1. The accounting procedures chosen for external reportsto shareholders and taxing authorities are dictated in part by regulators. TheSecurities and Exchange Commission (SEC) and the Financial AccountingStandards Board (FASB) regulate the financial statements issued to shareholders.The Internal Revenue Service (IRS) regulates the accounting procedures used incalculating corporate income taxes. If the firm is involved in international trade,foreign tax authorities prescribe the accounting rules applied in calculating foreign

6 Chapter 1

ManagementInnovations

Activity-based cost (ABC) systems first assign costs to activities in the pro-duction process and then either directly trace, or allocate, these costs to prod-ucts using various methods that most accurately capture how the costs vary.

Balanced score card provides a comprehensive framework that links afirm’s strategic objectives to a coherent set of performance measures.

Benchmarking involves studying the best-performing organizations pro-viding similar activities or products, thereby improving the operations of workprocesses.

Computer-aided manufacturing (CAM) uses programmable robots to per-form functions such as welding car bodies and inserting electronic componentsin circuit boards. In addition to saving on some labor costs, robots have the ad-vantage of being faster and more precise. CAM increases flexibility becausemanufacturing processes can be more quickly shifted from making one productto making another.

Electronic Data Interchange (EDI) is the direct exchange of data such aspurchase orders and invoices between organizations via computer networks.

Enterprise Resource Planning (ERP) is an integrated, automated,computer-based system that tracks production by job, work center, and activityand then shares the information enterprisewide in real time.

Just-in-time (JIT) production is a manufacturing process designed to pro-vide products as they are needed. Plants using JIT make a product when an or-der is received rather than making and holding it until it is sold or discarded. Bymaking the product only when ordered, fewer units are wasted due to obsoles-cence. Organizations shift to JIT in part because of technological changes. Forexample, the advent of bar coding and the instant reporting of sales to suppli-ers allows customers to reduce inventory and allows suppliers to replenish in-ventory when needed.

Total quality management (TQM) is a philosophy of continually loweringcosts and improving the provision of services and products to customers. Qual-ity is defined by the customer and quality involves everyone within the organi-zation. A shift to TQM means empowering employees to reduce costs andaccommodate customer demands.

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taxes. Regulatory agencies constrain public utilities’ and financial institutions’ ac-counting procedures.3

Management compensation plans and debt contracts often rely on externalreports. Senior managers’ bonuses are often based on accounting net income.Likewise, if the firm issues long-term bonds, it agrees in the debt covenants not toviolate specified accounting-based constraints. For example, the bond contractmight specify that the debt-to-equity ratio will not exceed some limit. Like taxesand regulation, compensation plans and debt covenants create incentives formanagers to choose particular accounting procedures.4

As firms expand into international markets, external users of the firm’s finan-cial statements become global. No longer are the firm’s shareholders, tax authori-ties, and regulators domestic. Rather, the firm’s internal and external reports areused internationally in a variety of ways.

The bottom of Figure 1–1 illustrates that internal reports are used for decisionmaking as well as control of organizational problems. As discussed earlier, man-agers use a variety of sources of data for making decisions. The internal account-ing system provides one important source. These internal reports are also used to

Introduction 7

TaxingAuthorities

Shareholders

Regulation Board of Directors

Senior ManagementCompensation Plans

RegulatoryAuthorities

SEC/FASB

IRS & ForeignTax Authorities

ExternalReports

AccountingSystem

InternalReports

DecisionMaking

Control ofOrganizational

Problems

Debt Covenants Bondholders

FIGURE 1–1The multiple role ofaccounting systems

3 Tax laws can affect financial reporting and internal reporting. For example, a 1973 U.S. tax code changethat allowed firms to exclude manufacturing depreciation from inventories and write it off directly againsttaxable income of the period if the same method was used for external financial reporting. Such a provisionreduces taxes for most firms, although few firms adopted the procedure. See E Noreen and R Bowen, “TaxIncentives and the Decision to Capitalize or Expense Manufacturing Overhead,” Accounting Horizons, 1989.

4 For further discussion of the incentives of managers to choose accounting methods, see R Watts andJ Zimmerman, Positive Accounting Theory (Englewood Cliffs, NJ: Prentice Hall, 1986); and R Watts andJ Zimmerman, “Positive Accounting Theory: A Ten-Year Perspective,” Accounting Review 65 (January 1990),pp. 131–56.

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evaluate and motivate (control) the behavior of managers in the firm. The inter-nal accounting system reports on managers’ performance and therefore providesincentives for them. Any changes to the internal accounting system can affect allthe various uses of the resulting accounting numbers.

Because internal systems serve multiple users and have several purposes, thefirm employs either multiple systems (one for each function) or one basic systemthat serves all three functions (decision making, performance evaluation, and ex-ternal reporting). Firms can either maintain a single set of books and use the sameaccounting methods for both internal and external reports, or they can keep mul-tiple sets of books. The decision depends on the costs of writing and maintainingcontracts based on accounting numbers, the costs from the dysfunctional internaldecisions made using a single system, the additional bookkeeping costs arisingfrom the extra system, and the confusion of having to reconcile the different num-bers arising from multiple accounting systems.

In some cases inexpensive accounting software packages and falling costs ofcomputers have reduced the additional costs of maintaining multiple accountingsystems. However, confusion arises when the systems report different numbers forthe same concept. For example, when one system reports the manufacturing costof a product as $12.56 and another system reports a unit cost of $17.19, managerswonder which system is producing the “right” number. Some managers may be us-ing the $12.56 figure while others are using the $17.19 figure, causing inconsis-tency and uncertainty. Whenever two numbers for the same concept areproduced, the natural tendency is to explain (i.e., reconcile) the differences. Man-agers involved in this reconciliation could have used this time in more productiveways. Also, using the same accounting system for multiple purposes increases thecredibility of the financial reports for each purpose.5 With only one accountingsystem, the external audit monitors the internal reporting system at little or no ad-ditional cost.

Interestingly, a survey of large U.S. firms found that managers typically use thesame accounting procedures for both external and internal reporting. For exam-ple, the same accounting rules for leases are used for both internal and external re-porting by 93 percent of the firms. Likewise, 79 percent of the firms use the same

8 Chapter 1

SpaceshipLost BecauseTwo MeasuresUsed

Multiple accounting systems are confusing and can lead to errors. An extremeexample of this occurred in 1999 when NASA lost its $125 million Mars space-craft. Engineers at Lockheed Martin built the spacecraft and specified thespacecraft’s thrust in English pounds. But NASA scientists, navigating thecraft, assumed the information was in metric newtons. As a result, the space-craft was off course by 60 miles as it approached Mars and crashed. Whenevertwo systems are being used to measure the same underlying event, people canforget which system is being used.

SOURCE: A Pollack, “Two Teams, Two Measures Equaled One Lost Spacecraft,” The New York Times, October 1, 1999, p. 1.

5A Christie, “An Analysis of the Properties of Fair (Market) Value Accounting,” Modernizing U.S.Securities Regulation: Economic and Legal Perspectives, K Lehn and R Kamphuis, eds. (Pittsburgh, PA: Universityof Pittsburgh, Joseph M. Katz Graduate School of Business, 1992).

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procedures for inventory accounting and 92 percent use the same procedures fordepreciation accounting.6 Nothing prevents firms from using separate accountingsystems for internal decision making and internal performance evaluation exceptthe confusion generated and the extra data processing costs.

Probably the most important reason firms use a single accounting system is itallows reclassification of the data. An accounting system does not present a single,

Introduction 9

Managers’Views onTheirAccountingSystems

A survey of 44 U.S. manufacturing plants found that plant managers over-whelmingly agreed that their accounting system fully meets the requirementsfor external reporting and cost control. However, when asked if their account-ing system meets their requirements for making operating decisions, they gavesignificantly lower marks. In another survey, 261 plant managers were asked toidentify the major problems with their current cost system. The following per-centages show how many plant managers selected each item as a key problem.(Percentages add to more than 100 percent because plant managers could selectmore than one problem.)

Provides inadequate information for product costing/pricing 53%Lack of information for management decision making 52Unsatisfactory operating performance measures 33Lack of information for valid worker performance evaluation 30Performance measures are not meaningful for competitive analysis 27Performance measures are inconsistent with firm strategy 18Other 17

Notice that operating managers (plant managers) are more likely to faultthe accounting system for decision making than for motivation and control.These findings, and those of other researchers, indicate that internal account-ing systems are less useful as a source of knowledge for decision making than forexternal reporting and control.SOURCE: U Karmarkar, P Lederer, and J Zimmerman, “Choosing Manufacturing Production Control and Cost AccountingSystems,” in Measures for Manufacturing Excellence, ed. R Kaplan (Boston: Harvard Business School, 1990); and A Sullivanand K Smith, “What Is Really Happening to Cost Management Systems in U.S. Manufacturing,” Review of Business Studies2 (1993), pp. 51–68.

DifferentCosts forDifferentPurposes

“If there is a central thesis in this discussion it is this: that cost accounting hasa number of functions, calling for different, if not inconsistent, information. Asa result, if cost accounting sets out, determined to discover what the cost ofeverything is and convinced in advance that there is one figure which can befound and which will furnish exactly the information which is desired for everypossible purpose, it will necessarily fail, because there is no such figure. If itfinds a figure which is right for some purposes it must necessarily be wrong forothers.”SOURCE: J Clark, Studies in the Economics of Overhead Costs (Chicago: University of Chicago Press, 1923), p. 234.

6 R Vancil, Decentralization: Managerial Ambiguity by Design (Burr Ridge, IL: Dow Jones-Irwin, 1979), p. 360.

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bottom-line number, such as the “cost of publishing this textbook.” Rather, thesystem reports the components of the total cost of this textbook: the costs ofproofreading, typesetting, paper, binding, cover, and so on. Managers in the firmthen reclassify the information on the basis of different attributes and derive dif-ferent cost numbers for different decisions. For example, if the publisher is consid-ering translating this book into Russian, not all the components used incalculating the U.S. costs are relevant. The Russian edition might be printed ondifferent paper stock with a different cover. The point is, a single accounting sys-tem usually offers enough flexibility for managers to reclassify, recombine, and re-organize the data for multiple purposes.

A single internal accounting system requires the firm to make trade-offs. Asystem that is best for performance measurement and control is unlikely to be thebest for decision making. It’s like configuring a motorcycle for both off-road andon-road racing: Riders on bikes designed for both racing conditions probablywon’t beat riders on specialized bikes designed for just one type of racing surface.Wherever a single accounting system exists, additional analyses arise. Managersmaking decisions find the accounting system less useful and devise other systemsto augment the accounting numbers for decision-making purposes.

Q1–1 What causes the conflict between using internalaccounting systems for decision making and control?

Q1–2 Describe the different kinds of information provided bythe internal accounting system.

Q1–3 Give three examples of the uses of an accounting system.Q1–4 List the characteristics of an internal accounting system.Q1–5 Do firms have multiple accounting systems? Why or why

not?

C. Marmots and Grizzly BearsEconomists and operating managers often criticize accounting data for decisionmaking. Accounting data are often not in the form managers want for decisionmaking. For example, the book value of a plant (historical cost less accumulatedaccounting depreciation) does not necessarily indicate the market or selling valueof the plant, which is what a manager wants to know when contemplating shut-ting down the plant. Why do managers persist in using (presumably inferior) ac-counting information?

Before addressing this question, consider the parable of the marmots and thegrizzly bears.7 Marmots are small groundhogs that are a principal food source forcertain bears. Zoologists studying the ecology of marmots and bears observed bearsdigging and moving rocks in the autumn in search of marmots. They estimatedthat the calories expended searching for marmots exceeded the calories obtained

ConceptQuestions

10 Chapter 1

7 This example is suggested by J McGee, “Predatory Pricing Revisited,” Journal of Law & Economics XXIII(October 1980), pp. 289–330.

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from their consumption. A zoologist relying on Darwin’s theory of natural selec-tion might conclude that searching for marmots is an inefficient use of the bear’slimited resources and thus these bears should become extinct. But fossils of mar-mot bones near bear remains suggest that bears have been searching for marmotsfor a long time.

Since the bears survive, the benefits of consuming for marmots must exceedthe costs. Bears’ claws might be sharpened as a by-product of the digging involvedin hunting for marmots. Sharp claws are useful in searching for food under the iceafter winter’s hibernation. Therefore, the benefit of sharpened claws and thecalories derived from the marmots offset the calories consumed gathering themarmots.

What does the marmot-and-bear parable say about why managers persist in us-ing apparently inferior accounting data in their decision making? As it turns out,the marmot-and-bear parable is an extremely important proposition in the socialsciences known as economic Darwinism. In a competitive world, if surviving orga-nizations use some operating procedure (such as historical cost accounting) overlong periods of time, then this procedure likely yields benefits in excess of its costs.Firms survive in competition by selling goods or services at lower prices than theircompetitors while still covering costs. Firms cannot survive by making more mis-takes than their competitors.8

Economic Darwinism suggests that in successful (surviving) firms, thingsshould not be fixed unless they are clearly broken. Currently, considerable atten-tion is being directed at revising and updating firms’ internal accounting systemsbecause many managers believe their current accounting systems are “broken” andrequire major overhaul. Alternative internal accounting systems are being pro-posed, among them activity-based costing (ABC), balanced score cards, economicvalue added (EVA), and total quality management (TQM) accounting systems.These systems are discussed and analyzed later in terms of their ability to helpmanagers make better decisions as well as to help provide better measures of per-formance for managers in organizations, thereby aligning managers’ and owners’interests.

Introduction 11

8 See A Alchian, “Uncertainty, Evolution and Economic Theory,” Journal of Political Economy 58 (June1950), pp. 211–21.

Benchmarkingand EconomicDarwinism

Benchmarking is defined as “a . . . process of continuously comparing and mea-suring an organization’s business processing against business leaders anywherein the world to gain information which will help the organization take actionto improve its performance.”

Economic Darwinism predicts that successful firm practices will be imi-tated. Benchmarking is the practice of imitating successful business practices.The practice of benchmarking dates back to 607, when Japan sent teams toChina to learn the best practices in business, government, and education. To-day, most large firms routinely conduct benchmarking studies to discover thebest business practices and then implement them in their own firms.SOURCE: Society of Management Accountants of Canada, Benchmarking: A Survey of Canadian Practice (Hamilton,Ontario, Canada, 1994).

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Although internal accounting systems may appear to have certain inconsis-tencies with some particular theory, these systems (like the bears searching formarmots) have survived the test of time and therefore are likely to be yielding un-observed benefits (like claw sharpening). This book discusses these additionalbenefits. Two caveats must be raised concerning too strict an application of eco-nomic Darwinism:

1. Some surviving operating procedures can be neutral mutations. Justbecause a system survives does not mean that its benefits exceed its costs.Benefits less costs might be close to zero.

2. Just because a given system survives does not mean it is optimal. A bettersystem might exist but has not yet been discovered.

The fact that most managers use their accounting system as the primary for-mal information system suggests that these accounting systems are yielding totalbenefits that exceed their total costs. These benefits include financial and tax re-porting, providing information for decision making, and creating internal incen-tives. The proposition that surviving firms have efficient accounting systems doesnot imply that better systems do not exist, only that they have not yet been dis-covered. It is not necessarily the case that what is, is optimal. Economic Darwin-ism helps identify the costs and benefits of alternative internal accounting systemsand is applied repeatedly throughout the book.

12 Chapter 1

ApplyingEconomicDarwinism inBusiness

“My partner and I are succeeding in building our company largely because weapply the notion of economic Darwinism to our thinking about how to add valueto our clients with our technology. The reason the marmots and grizzly bearsparable seems to continually arise at work is precisely the ‘Dumb Zoologist Hy-pothesis.’ Except we call it the ‘Dumb Venture Capitalist Hypothesis’ or the‘Dumb Dot-com Founder Hypothesis.’ We also are highly critical of the nu-merous companies that have been abundantly funded, only to fail because their‘brilliant ideas’ ignored economic Darwinism. The marmot story seems to applyuniversally in these situations.”SOURCE: John Oliver, president, Digital Footbridge Inc. MBA, 1995 from Yale University.

Sixteenth-Century CostRecords

The well-known Italian Medici family had extensive banking interests andowned textile plants in the fifteenth and sixteenth centuries. They also used so-phisticated cost records to maintain control of their cloth production. Thesecost reports contained detailed data on the costs of purchasing, washing, beat-ing, spinning, and weaving the wool, of supplies, and of overhead (tools, rent,and administrative expenses). This evidence indicates that managers of thesefirms kept detailed records of their production costs.SOURCE: P Garner, Evolution of Cost Accounting to 1925 (Montgomery, AL: University of Alabama Press, 1954), pp. 12–13.Original source R de Roover, “A Florentine Firm of Cloth Manufacturers,” Speculum XVI (January 1941), pp. 3–33.

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D. Management Accountant’s Role in the OrganizationTo better understand internal accounting systems, it is useful to spend a momentconsidering how firms organize their accounting functions. No single organiza-tional structure applies to all firms. Figure 1–2 presents one common organizationchart. The design and operation of the internal and external accounting systemsare the responsibility of the firm’s chief financial officer (CFO). The firm’s line-of-business or functional areas, such as marketing, manufacturing, and research anddevelopment, are shown under a single organization, operating divisions. The re-maining staff and administrative functions include human resources, chief finan-cial officer, legal, and other. In Figure 1–2, the chief financial officer oversees allthe financial and accounting functions in the firm and reports directly to the pres-ident. The chief financial officer’s three major functions include: controllership,treasury, and internal audit. Controllership involves tax administration, the inter-nal and external accounting systems, and the planning and control systems (in-cluding budgeting and governmental reporting). Treasury involves short- andlong-term financing, banking, credit and collections, investments, insurance, andcapital budgeting. Depending on their size and structure, firms organize thesefunctions differently. Figure 1–2 shows the internal audit group reporting directlyto the chief financial officer. In other firms, internal audit reports to the con-troller, the chief executive officer, or the board of directors.9

The controller is the firm’s chief management accountant and is responsiblefor data collection and reporting. The controller compiles the data for balancesheets and income statements and for preparing the firm’s tax returns. In ad-dition, this person prepares the internal reports for the various divisions and departments within the firm and helps the other managers by providingthem with the data necessary to make decisions—as well as the data necessary toevaluate these managers’ performance.

Introduction 13

Board of Directors

Staff and Administrative Departments

President and ChiefExecutive Officer

HumanResources

OperatingDivisions

Controller—OperatingDivisions

Chief FinancialOfficer

Legal Other

Controller TreasuryInternalAudit

TaxFinancialReporting

CostAccounting

FIGURE 1–2Organization chartfor a typicalcorporation

9 J Schiff, New Directions in Internal Auditing (New York: Conference Board, 1990), p. 13.

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Usually, each operating division or department has its own controller. For ex-ample, if a firm has several manufacturing plants, each plant has its own plantcontroller, who reports to both the plant manager and the corporate controller. InFigure 1–2, the operating divisions have their own controllers. The plant con-troller provides the corporate controller with periodic reports on the plant’s oper-ations. The plant controller oversees the plant’s budgets, payroll, inventory, andproduct costing system (which reports the cost of units manufactured at theplant). While most firms have plant-level controllers, some firms centralize thesefunctions to reduce staff, so that all the plant-level controller functions are per-formed centrally out of corporate headquarters.

14 Chapter 1

TheController’sJob

Controllers’ responsibilities are wide ranging:

• “There is no business agenda the controller does not influencesubstantially.”

• “Their scope of responsibility touches every function of the company.”• “[They] oversee the tidal wave of information that now floods into a

company.”• Controllers often oversee reengineering administrative functions, install

new measurement metrics such as TQM, ABC, and EVA, and oversee thefirm’s employees’ compensation, benefits, and retirement plans.

• “Controllers are often asked to distill different information from differentsources and then get a report into the hands of the CFO [chief financialofficer].”

• “You have to have a mastery of computer systems. . . . The controller isresponsible for IS [information systems] these days.”

• “More time is spent wrestling with the steady stream of pronouncementsfrom various accounting standard-setting bodies.”

SOURCE: J Goff, “Controller Burnout,” CFO, September 1995, pp. 56–62.

Super CFOs(ChiefFinancialOfficers)

Fortune magazine describes the new breed of CFOs as earning millions of dol-lars because they can create billions of dollars for the shareholders. Someeven earn more than sports superstars. Top CFOs are described as “superbgeneral managers who on top of strong financial and deal-making skills canoften boast a grasp of operations or a keen sense of strategy. Instead of simplymeasuring value, today’s CFOs create it.” One of the best super CFOs is JudyLewent of Merck, a large pharmaceutical company. She redesigned the wayMerck estimated the profitability of new drugs. Instead of thinking it was los-ing money on R&D, Lewent devised a financial model that showed it wasmaking money. This persuaded management to increase the R&D budgetfrom $426 million in 1985 to $1.2 billion in 1995. Over the same time period,the stock price increased 39 percent as new, more profitable products came tomarket.SOURCE: Fortune (November 13, 1995), p. 162.

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The controllership function at the corporate, division, and plant levels in-volves assisting decision making and control. The controller must balance pro-viding information to other managers for decision making against providingmonitoring information to top executives for use in controlling the behavior oflower-level managers.

We cannot stress the importance of the internal control system too much.Throughout this book, we use the term control to mean motivating employees toact in the owners’ interests. The most basic conflict of interest between employ-ees and owners is employee theft. To reduce the likelihood of embezzlement, firmsinstall internal control systems, which are an integral part of the firm’s control sys-tem. Internal and external auditors’ first responsibility is to test the integrity of thefirm’s internal controls. Fraud and theft are prevented not just by having securityguards and door locks but also by having procedures that require checks above acertain amount to be authorized by two people. Internal control systems includeinternal procedures, codes of conduct, and policies that prohibit corruption,bribery, and kickbacks. Finally, internal control systems should prevent inten-tional (or accidental) financial misrepresentation by managers.

Q1–6 Define economic Darwinism.

Q1–7 Describe the major functions of the chief financial officer.ConceptQuestions

Introduction 15

The “NewAccounting”

A survey of 300 practicing U.S. accountants described the changing role ofmanagement accountants:

Management accountants were not participants in the decision-making process. In-stead, they functioned as support staff for the decision makers and were often in-formed of decisions after the fact. The bulk of their time was spent in the mechanicalaspects of accounting . . . They were, in fact, the scorekeepers, the bean counters, thecorporate cops.

The role of management accountants is very different in 1999. Growing numbers ofmanagement accountants spend the bulk of their time as internal consultants or busi-ness analysts within their companies. Technological advances have liberated them fromthe mechanical aspects of accounting. They spend less time preparing standardized re-ports and more time analyzing and interpreting information. Management accountantswork on cross-functional teams, have extensive face-to-face communications with peo-ple throughout their organizations, and are actively involved in decision making.

The role of management accountants has evolved from serving internal customersinto being a business partner. A business partner is an equal member of the decision-making team. As a business partner, a management accountant has the authority andresponsibility to tell an operating executive why particular types of information may ormay not be relevant to the business decision at hand, and is expected to suggest ways toimprove the quality of the decision.

Notice that management accountants in this description perform both decision-making activities and control activities (corporate cop).SOURCE: G Siegel, Counting More, Counting Less, Transformations in the Management Accounting Profession: The 1999Practice Analysis of Management Accounting (Montvale, NJ: Institute of Management Accountants, 1999), pp. 4–5.

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E. Evolution of Management Accounting: A Framework for ChangeManagement accounting has evolved with the nature of organizations. Prior to1800, most businesses were small, family-operated organizations. Management ac-counting was less important for these small firms. It was not critical for planningdecisions and control reasons because the owner could directly observe theorganization’s entire environment. The owner, who made all of the decisions, del-egated little decision-making authority and had no need to worry about motiva-tion. Only as organizations grew larger would management accounting becomemore important.

Most of today’s modern management accounting techniques were developedin the period from 1825 to 1925 with the growth of large organizations.10 Textilemills in the early nineteenth century grew by combining the multiple processes(spinning the thread, dying, weaving, etc.) of making cloth. These large firms de-veloped systems to measure the cost per yard or per pound for the separate manu-facturing processes. The cost data allowed managers to compare the cost ofconducting a process inside the firm versus purchasing the process from externalvendors. Similarly, the railroads of the 1850s to 1870s developed cost systems thatreported cost per ton-mile and operating expenses per dollar of revenue. Thesemeasures allowed managers to increase their operating efficiencies. In the early1900s, Andrew Carnegie (at what was to become U.S. Steel) devised a cost systemthat reported detailed unit cost figures for material and labor on a daily and weeklybasis. This system allowed senior managers to maintain very tight controls on op-erations and gave them accurate and timely information on marginal costs forpricing decisions. Merchandising firms such as Marshall Field’s and Sears, Roe-buck developed gross margin (revenues less cost of goods sold) and stock-turnratios (sales divided by inventory) to measure and evaluate performance.Manufacturing companies such as Du Pont Powder Company and General Motorswere also active in developing performance measures to control their growingorganizations.

In the period from 1925 to 1975, management accounting was heavily influ-enced by external considerations. Income taxes and financial accounting require-ments (e.g., those of the Financial Accounting Standards Board) were the majorfactors affecting management accounting.

Since 1975, two major environmental forces have changed organizations andcaused managers to question whether traditional management accounting proce-dures (pre-1975) are still appropriate. These environmental forces are (1) factoryautomation and computer/information technology and (2) global competition. Toadapt to these environmental forces, organizations must reconsider their organiza-tional structure and their management accounting procedures.

Information technology advances such as the Internet, intranets, wireless com-munications, and faster microprocessors have had a big impact on internal ac-counting processes. More data are now available faster than ever before. Electronicdata interchange, XTML, e-mail, B2B e-commerce, data warehousing, and onlineanalytical processing (OLAP) are just a few examples of new technology impactingmanagement accounting. For example, managers now have access to daily sales andoperating costs in real time, as opposed to having to wait two weeks after the end

16 Chapter 1

10 P Garner, Evolution of Cost Accounting to 1925 (Montgomery, AL: University of Alabama Press, 1954);and A Chandler, The Visible Hand (Cambridge, MA: Harvard University Press, 1977).

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of the calendar quarter for this information. Firms have cut the time needed to pre-pare budgets for the next fiscal year by several months because the information istransmitted electronically in standardized electronic spreadsheets such as Excel.

The brief history of management accounting from 1825 to the present illus-trates how management accounting has evolved in parallel with organizations’structure. Management accounting is used to provide information for planning de-cisions and control. It is useful for assigning decision-making authority, measuringperformance, and determining rewards for individuals within the organization. Be-cause management accounting is part of the organizational structure, the fact thatmanagement accounting evolves in a parallel and consistent fashion with otherparts of the organizational structure is not surprising.

Figure 1–3 is a framework for understanding the role of accounting systemswithin firms and the forces that cause accounting systems to change. As describedmore fully in Chapter 14, environmental forces such as technological innovationand global competition change the organization’s business strategies. For example,the Internet has allowed banks to offer electronic, online banking services. To im-plement these new strategies, organizations must adapt their organizational struc-ture or architecture, which includes management accounting. An organization’sarchitecture (the topic of Chapter 4) is composed of three related processes: (1) theassignment of decision-making responsibilities, (2) the measurement of perfor-mance, and (3) the rewarding of individuals within the organization.

The first component of the organizational architecture is the determination ofthe responsibilities of the different members of the organization. Decision rights de-fine the duties each member of an organization is expected to perform. The decisionrights of a particular individual within an organization are specified by that person’sjob description. Checkout clerks in grocery stores have the decision rights to collectcash from customers but don’t have the decision rights to accept certain types ofchecks. A manager must be called for that decision. A division manager may havethe right to set prices on products but not the right to borrow money by issuingdebt. The president or the board of directors usually retains the right to issue debt.

The next two parts of the organizational architecture are the performanceevaluation and reward systems. To motivate individuals within the organization,

Introduction 17

Business Environment

Business Strategy

Incentive and Actions

Firm Value

Organizational Architecture

• Decision-Right Assignment• Performance Evaluation System

• Reward System

Incentives and Actions

FIGURE 1–3Framework fororganizationalchange andmanagementaccounting

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organizations must have a system for measuring their performance and rewardingthem. Performance measures for a salesperson could include total sales and cus-tomer satisfaction based on a survey of customers. Performance measures for amanufacturing unit could include number of units produced, total costs, and per-centage of defective units. The internal accounting system is often an importantpart of the performance evaluation system.

Performance measures are extremely important because rewards are generallybased on performance measures. Rewards for individuals within organizations in-clude wages and bonuses, prestige and greater decision rights, promotions, and jobsecurity. Because rewards are based on performance measures, individuals andgroups are motivated to act to influence the performance measures. Therefore, theperformance measures influence the direction of individual and group effortswithin the organization. A poor choice of performance measures can lead to con-flicts within the organization and derail efforts to achieve organizational goals. Forexample, measuring the performance of a college president based on the numberof students attending the college encourages the president to allow ill-preparedstudents to enter the college and reduces the quality of the educational experiencefor other students.

As illustrated in Figure 1–3, changes in the business environment lead to newstrategies and ultimately to changes in the firm’s organizational architecture, in-cluding changes in the accounting system to better align the interests of the em-ployees to the objectives of the organization. The new organizational architectureprovides incentives for members of the organization to make decisions, whichleads to a change in the value of the organization. The roles of accounting in thisframework include assisting in the control of the organization through the organi-zation’s architecture and providing information for decision making. This frame-work for change will be referred to throughout the book.

F. Vortec Medical Probe ExampleTo illustrate some of the basic concepts developed in this text, suppose you havebeen asked to evaluate the following decision. Vortec Inc. manufactures a singleproduct, a medical probe. Vortec sells the probes to wholesalers who then marketthem to physicians. Vortec has two divisions. The manufacturing division pro-duces the probes; the marketing division sells them to wholesalers. The marketingdivision is rewarded on the basis of sales revenues. The manufacturing division isevaluated and rewarded on the basis of the average unit cost of making the probes.The plant’s current volume is 100,000 probes per month. The following incomestatement summarizes last month’s operating results.

VORTEC MANUFACTURINGIncome Statement

Last Month

Sales revenue (100,000 units @ $5.00) $500,000Cost of sales (100,000 units @ $4.50) 450,000

Operating margin $ 50,000Less: Administrative expenses 27,500

Net income before taxes $ 22,500

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Medsupplies is one of Vortec’s best customers. Vortec sells 10,000 probes permonth to Medsupplies at $5 per unit. Last week Medsupplies asked Vortec’s mar-keting division to increase its monthly shipment to 12,000 units, provided thatVortec would sell the additional 2,000 units at $4 each. Medsupplies would con-tinue to pay $5 for the original 10,000 units. Medsupplies argued that because thiswould be extra business for Vortec, no overhead should be charged on the addi-tional 2,000 units. In this case, a $4 price should be adequate.

Vortec’s finance department estimates that with 102,000 probes the averagecost is $4.47 per unit, and hence the $4 price offered by Medsupplies is too low.The current administrative expenses of $27,500 consist of office rent, propertytaxes, and interest and will not change if this special order is accepted. ShouldVortec accept the Medsupplies offer?

Before examining whether the marketing and manufacturing divisions will ac-cept the order, consider Medsupplies’s offer from the perspective of Vortec’s own-ers, who are interested in maximizing profits. The decision hinges on the cost toVortec of selling an additional 2,000 units to Medsupplies. If the cost is more than$4 per unit, Vortec should reject the special order.

It is tempting to reject the offer because the $4 price does not cover the aver-age total cost of $4.47. But will it cost Vortec $4.47 per unit for the 2,000-unit spe-cial order? Is $4.47 the cost per unit for each of the next 2,000 units?

To begin the analysis, two simplifying assumptions are made that are relaxedlater:

• Vortec has excess capacity to produce the additional 2,000 probes.• Past historical costs are unbiased estimates of the future cash flows for

producing the special order.

Based on these assumptions, we can compare the incremental revenue fromthe additional 2,000 units with its incremental cost:

Incremental revenue (2,000 units � $4.00) $8,000Total cost @ 102,000 units (102,000 � $4.47) $455,940Total cost @ 100,000 units (100,000 � $4.50) 450,000

Incremental cost of 2,000 units 5,940

Incremental profit of 2,000 units $2,060

The estimated incremental cost per unit of the 2,000 units is then

The estimated cost per incremental unit is $2.97. Therefore, $2.97 is the av-erage per-unit cost of the extra 2,000 probes. The $4.47 cost is the average cost ofproducing 102,000 units, which is more than the $2.97 incremental cost per unitof producing the extra 2,000 probes.

Based on the $2.97 estimated cost, Vortec should take the order. Is this theright decision? Not necessarily. There are some other considerations:

1. Will these 2,000 additional units affect the $5 price of the 100,000 probes?Will Vortec’s other customers continue to pay $5 if Medsupplies buys 2,000 units

Change in total costChange in volume

�$455,940 � $450,000

2,000� $2.97

Introduction 19

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at $4? What prevents Medsupplies from reselling the probes to Vortec’s othercustomers at less than $5 per unit but above $4 per unit? Answering these ques-tions requires management to acquire knowledge of the market for the probes.

2. What is the alternative use of the excess capacity consumed by the addi-tional 2,000 probes? As plant utilization increases, congestion costs rise, produc-tion becomes less efficient, and the cost per unit rises. Congestion costs includethe wages of the additional production employees and supervisors required tomove, store, expedite, and rework products as plant volume increases. The $2.97incremental cost computed from the average cost data on page 19 might not in-clude the higher congestion costs as capacity is approached. This suggests that the$4.47 average cost estimate is wrong. Who provides this cost estimate and how ac-curate is it? Management must acquire knowledge of how costs behave at highvolume. If Vortec accepts the Medsupplies offer, will Vortec be forced at some laterdate to forgo using this capacity for a more profitable project?

3. What costs will Vortec incur if the Medsupplies offer is rejected? WillVortec lose the normal 10,000-unit Medsupplies order? If so, can this order bereplaced?

4. Does the Robinson-Patman Act apply? The Robinson-Patman Act is a U.S.federal law prohibiting charging customers different prices if doing so is injuri-ous to competition. Thus, it may be illegal to sell an additional 2,000 units toMedsupplies at less than $5 per unit. Knowledge of U.S. antitrust laws must beacquired. Moreover, if Vortec sells internationally, it will have to research the antitrust laws of the various jurisdictions that might review the Medsuppliestransaction.

We have analyzed the question of whether Medsupplies’s 2,000-unit ordermaximizes the owners’ profit. The next question to address is whether the mar-keting and manufacturing divisions will accept Medsupplies’s offer. Recall thatmarketing is evaluated based on total revenues and manufacturing is evaluatedbased on average unit costs. Therefore, marketing will want to accept the order aslong as Medsupplies does not resell the probes to other Vortec customers and aslong as other Vortec customers do not expect similar price concessions. Manufac-turing will want to accept the order as long as it believes average unit costs willfall. Increasing production lowers average unit costs and makes it appear as thoughmanufacturing has achieved cost reductions.

Suppose that accepting the Medsupplies offer will not adversely affect Vortec’sother sales, but the incremental cost of producing the 2,000 extra probes is really$4.08, not $2.97, because there will be overtime charges and additional factorycongestion costs. Under these conditions, both marketing and manufacturing willwant to accept the offer. Marketing increases total revenue and thus appears tohave improved its performance. Manufacturing still lowers average unit costs from$4.50 to $4.4918 per unit:

However, the shareholders are worse off. Vortec’s cash flows are lower by $160 (or2,000 units � [$4.00 � $4.08]). The problem is not that the marketing and man-ufacturing managers are “making a mistake.” The problem is that the measures ofperformance are creating the wrong incentives. In particular, rewarding marketingfor increasing total revenues and manufacturing for reducing average unit costsmeans there is no mechanism to ensure that the incremental revenues from the

$4.4918 �($4.50 � 100,000) � ($4.08 � 2,000)

102,000

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order ($8,000 � $4 � 2,000) are greater than the incremental costs ($8,160 �$4.08 � 2,000). Both marketing and manufacturing are doing what they were toldto do (increase revenues and reduce average costs), but the value of the firm fallsbecause the incentive systems are poorly designed.

Four key points emerge from this example:

1. Beware of average costs. The $4.50 unit cost tells us little about how costswill vary with changes in volume. Just because a cost is stated in dollarsper unit does not mean that producing one more unit will add thatamount of incremental cost.

2. Use opportunity costs. Opportunity costs measure what the firm forgoeswhen it chooses a specific action. The notion of opportunity cost iscrucial in decision making. The opportunity cost of the Medsuppliesorder is what Vortec forgoes by accepting the special order. What is thebest alternative use of the plant capacity consumed by the Medsuppliesspecial order? (More on this in Chapter 2.)

3. Supplement accounting data with other information. The accounting systemcontains important data relevant for estimating the cost of this specialorder from Medsupplies. But other knowledge that the accounting systemcannot capture must be assembled, such as what Medsupplies will do ifVortec rejects its offer. Managers usually augment accounting data withother knowledge such as customer demands, competitors’ plans, futuretechnology, and government regulations.

4. Use accounting numbers as performance measures cautiously. Accountingnumbers such as revenues or average unit manufacturing costs are oftenused to evaluate managers’ performance. Just because managers aremaximizing particular performance measures tailored for each managerdoes not necessarily cause firm profits to be maximized.

The Vortec example illustrates the importance of understanding how ac-counting numbers are constructed, what they mean, and how they are used in de-cision making and control. The accounting system is a very important source ofinformation to managers, but it is not the sole source of all knowledge. Also, inthe overly simplified context of the Vortec example, the problems with the in-centive systems and with using unit costs are easy to detect. In a complex com-pany with hundreds or thousands of products, however, such errors are verydifficult to detect. Finally, for the sake of simplicity, the Vortec illustration ignoresthe use of the accounting system for external reporting.

G. Outline of the TextInternal accounting systems provide data for both decision making and control.The organization of this book follows this dichotomy. The first part of the text(Chapters 2 through 5) describes how accounting systems are used in decisionmaking and providing incentives in organizations. These chapters provide theconceptual framework for the remainder of the book. The next set of chapters(Chapters 6 through 8) describes basic topics in managerial accounting, budget-ing, and cost allocations. Budgets not only are a mechanism for communicatingknowledge within the firm for decision making but also serve as a control deviceand as a way to partition decision-making responsibility among the man-agers. Likewise, cost allocations serve decision-making and control functions. In

Introduction 21

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analyzing the role of budgeting and cost allocations, these chapters draw on thefirst part of the text.

The next section of the text (Chapters 9 through 13) describes the prevalentaccounting system used in firms: absorption costing. Absorption cost systems arebuilt around cost allocations. The systems used in manufacturing and service set-tings generate product costs built up from direct labor, direct material, and allo-cated overheads. After first describing these systems, we critically analyze them. Acommon criticism of absorption cost systems is that they produce inaccurate unitcost information, which can lead to dysfunctional decision making. Two alterna-tive accounting systems (variable cost systems and activity-based cost systems) arecompared and evaluated against a traditional absorption cost system. The con-ceptual framework in the first part of the text is used for this analysis. The nexttopic describes the use of standard costs as extensions of absorption cost systems.Standard costs provide benchmarks and are used to calculate accounting vari-ances: the difference between the actual costs and standard costs. These variancesare performance measures and thus are part of the firm’s motivation and controlsystem described earlier.

The last chapter (Chapter 14) expands the integrative approach summarizedin section E of this chapter. This approach is then used to analyze three modifica-tions of internal cost systems: quality measurement systems, just-in-time produc-tion, and balanced scorecards. These recent modifications are evaluated within abroad historical context. Just because these systems are new does not suggest theyare better. They have not stood the test of time. Economic Darwinism, or compe-tition from other systems, does not yet allow us to conclude that these new systemsare better.

H. SummaryThis book provides a framework for the analysis, use, and design of internal ac-counting systems. It explains how these systems are used for decision making andmotivating people in organizations. Employees care about their self-interest, notthe owners’ self-interest. Hence, owners must devise incentive systems. Account-ing numbers are used as measures of managers’ performance and hence are part ofthe control system used to motivate managers. Most firms use a single internal ac-counting system as the primary data source for external reporting and internal uses.The fact that managers rely heavily on accounting numbers is not fully understood.Applying the economic Darwinism principle, the costs of multiple systems mustoutweigh the benefits for most firms. The costs are not only the direct costs of op-erating the system but also the indirect costs from dysfunctional decisions resultingfrom faulty information and poor performance evaluation systems. The remainderof this book addresses the costs and benefits of internal accounting systems.

ProblemsP 1–1: MBA Students

One MBA student was overheard saying to another, “Accounting is baloney. Iworked for a genetic engineering company and we never looked at the accountingnumbers and our stock price was always growing.”

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“I agree,” said the other. “I worked in a rust bucket company that managedeverything by the numbers and we never improved our stock price very much.”

Evaluate these comments.SOURCE: K Gartrell.

P 1–2: One Cost System Isn’t Enough

Robert S. Kaplan in “One Cost System Isn’t Enough” (Harvard Business Review,January–February 1988, pp. 61–66) states,

No single system can adequately answer the demands made by diverse functions of cost sys-tems. While companies can use one method to capture all their detailed transactions data,the processing of this information for diverse purposes and audiences demands separate, cus-tomized development. Companies that try to satisfy all the needs for cost information with asingle system have discovered they can’t perform important managerial functions adequately.Moreover, systems that work well for one company may fail in a different environment. Eachcompany has to design methods that make sense for its particular products and processes.

Of course, an argument for expanding the number of cost systems conflicts with astrongly ingrained financial culture to have only one measurement system for everyone.

Critically evaluate the preceding quote.

P 1–3: U.S. and Japanese Tax Laws

Tax laws in Japan tie taxable income directly to the financial statements’ reportedincome. That is, to compute a Japanese firm’s tax liability, multiply the net in-come as reported to shareholders by the appropriate tax rate to derive the firm’stax liability. In contrast, U.S. firms typically have more discretion in choosing dif-ferent accounting procedures for calculating net income for shareholders (finan-cial reporting) and taxes.

What effect would you expect these institutional differences in tax laws be-tween the United States and Japan to have on internal accounting and reporting?

P 1–4: Managers Need Accounting Information

The opening paragraph of an accounting textbook says, “Managers need accountinginformation and need to know how to use it.”11 Critically evaluate this statement.

P 1–5: Using Accounting for Planning

The owner of a small software company felt his accounting system was useless. Hestated, “Accounting systems only generate historical costs. Historical costs are use-less in my business because everything changes so rapidly.”

a. Are historical costs useless in rapidly changing environments?b. Should accounting systems be limited to historical costs?

P 1–6: Goals of a Corporation

A finance professor and a marketing professor were recently comparing notes ontheir perceptions of corporations. The finance professor claimed that the goal of acorporation should be to maximize the value to the shareholders. The marketingprofessor claimed that the goal of a corporation should be to satisfy customers.

What are the similarities and differences in these two goals?

Introduction 23

11 D Hansen and M Mowen, Management Accounting, 3rd ed. (Cincinnati: South-Western Publishing Co.,1994), p. 3.

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P 1–7: Budgeting

Salespeople at a particular firm forecast what they expect to sell next period. Theirsupervisors then review the forecasts and make revisions. These forecasts are usedto set production and purchasing plans. In addition, salespeople receive a fixedbonus of 20 percent of their salary if they exceed their forecasts.

Discuss the incentives of the salespeople to forecast next-period sales accu-rately. Discuss the trade-off between using the budget for decision making versususing it as a control device.

P 1-8: Golf Specialties

Golf Specialties (GS), a Belgian company, manufactures a variety of golf para-phernalia, such as head covers for woods, embroidered golf towels, and umbrellas.GS sells all its products exclusively in Europe through independent distributors.Given the popularity of Tiger Woods, one of GS’s more popular items is a headcover in the shape of a tiger.

GS is currently making 500 tiger head covers a week at a per unit cost of 3.50euros, which includes both variable costs and allocated fixed costs. GS sells thetiger head covers to distributors for 4.25 euros. A distributor in Japan, Kojo Im-ports, wants to purchase 100 tiger head covers per week from GS and sell them inJapan. Kojo offers to pay GS 2 euros per head cover. GS has enough capacity toproduce the additional 100 tiger head covers and estimates that if it accepts Kojo’soffer, the per unit cost of all 600 tiger head covers will be 3.10 euros. Assume thecost data provided (3.50 euros and 3.10 euros) are accurate estimates of GS’s costsof producing the tiger head covers. Further assume that GS’s variable cost per headcover does not vary with the number of head covers manufactured.

Required:a. To maximize firm value, should GS accept Kojo’s offer? Explain why or

why not.b. Given the data in the problem, what is GS’s weekly fixed cost of

producing the tiger head covers? c. Besides the data provided above, what other factors should GS consider

before making a decision to accept Kojo’s offer?

P 1–9: Parkview Hospital

Parkview Hospital, a regional hospital, serves a population of 400,000 people. Thenext closest hospital is 50 miles away. Parkview’s accounting system is adequate forpatient billing. The system reports revenues generated per department but doesnot break down revenues by unit within departments. For example, Parkviewknows patient revenue for the entire psychiatric department but does not knowrevenues in the child and adolescent unit, the chemical dependence unit, or theneuropsychiatric unit.

Parkview receives its revenues from three principal sources: the federal gov-ernment (Medicare), the state government (Medicaid), and private insurancecompanies (Blue Cross–Blue Shield). Until recently, the private insurance com-panies continued to pay Parkview’s increasing costs and passed these on to thefirms through higher premiums for their employees’ health insurance.

Last year Trans Insurance (TI) entered the market and began offering lower-cost health insurance to local firms. TI cut benefits offered and told Parkview that

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it would pay only a fixed dollar amount per patient. A typical firm could cut itshealth insurance premium 20 percent by switching to TI. TI was successful at tak-ing 45 percent of the Blue Cross–Blue Shield customers. These firms faced stiffcompetition and sought to cut their health care costs.

Parkview management estimated that its revenues would fall 6 percent or $3.2million next year because of TI’s lower reimbursements. Struggling with how tocope with lower revenues, Parkview began the complex process of what programsto cut, how to shift the delivery of services from inpatient to outpatient clinics,and what programs to open to offset the revenue loss (for example, open an out-patient depression clinic). Management can forecast some of the costs of the pro-posed changes, but many of its costs and revenues (such as the cost of theadmissions office) have never been tracked to the individual clinical unit.

Required:a. Was Parkview’s accounting system adequate 10 years ago?b. Is Parkview’s accounting system adequate today?c. What changes should Parkview make in its accounting system?

P 1–10: Montana Pen Company

Montana Pen Company manufactures a full line of premium writing instruments.It has 12 different styles and within each style, it offers ball point pens, fountainpens, mechanical pencils, and a roller ball pen. Most models also come in threefinishes—gold, silver, and black matte. Montana Pen’s Bangkok, Thailand, plantmanufactures four of the styles. The plant is currently producing the gold clip forthe top of one of its pen styles, no. 872. Current production is 1,200 gold no. 872pens each month at an average cost of 185 baht per gold clip. (One U.S. dollarcurrently buys 35 baht.) A Chinese manufacturer has offered to produce the samegold clip for 136 baht. This manufacturer will sell Montana Pen 400 clips permonth. If it accepts the Chinese offer and cuts the production of the clips from1,200 to 800, Montana Pen estimates that the cost of each clip it continues toproduce will rise from 185 baht to 212.5 baht per gold clip.

Required:a. Should Montana Pen outsource 400 gold clips for pen style no. 872 to the

Chinese firm? Provide a written justification of your answer.b. Given your answer in part (a), what additional information would you

seek before deciding to outsource 400 gold clips per month to theChinese firm?

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