1. Cost ManagementAccounting and ControlDon R. HansenOklahoma State UniversityMaryanne M. MowenOklahoma State UniversityFifth Edition

2. Cost Management: Accounting and Control, Fifth EditionDon R. Hansen and Maryanne M. MowenThomson Learning5 Shenton Way#01-01 UIC BuildingSingapore 068808CANADAThomson Nelson1120 Birchmount RoadToronto, OntarioCanada M1K 5G4AUSTRALIA/NEW ZEALANDThomson Learning Australia102 Dodds StreetSouthbank, Victoria 3006AustraliaUK/EUROPE/MIDDLEEAST/AFRICAThomson LearningHigh Holborn House50-51 Bedford RowLondon WC1R 4LRUnited KingdomLATIN AMERICAThomson LearningSeneca, 53Colonia Polanco11560 MexicoD.F.MexicoSPAIN (includes Portugal)Thomson ParaninfoCalle Magallanes, 2528015 Madrid, SpainVP/Editorial Director:Jack W. CalhounPublisher:Rob DeweyAquisitions Editor:Keith ChasseAssociate Developmental Editor:Allison RolfesMarketing Manager:Chris McNameeSenior Production Editor:Kara ZumBahlenManager of Technology, Editorial:Vicky TrueTechnology Project Editor:Sally NiemanWeb Coordinator:Kelly ReidSr. Manufacturing Coordinator:Doug WilkeProduction House:LEAP Publishing Services, Inc.Compositor:GGS Information Services, Inc.Printer:QuebecorWorld, Versailles, KYArt Director:Chris A. MillerCover and Internal Designer:Bethany CaseyCover Image:GettyImagesPhotography Manager:Deanna EttingerPhoto Researcher:Terri MillerCOPYRIGHT 2006Thomson South-Western, a part of The Thom-sonCorporation. Thomson, the Star logo, andSouth-Western are trademarks used hereinunder license.Printed in the United States of America1 2 3 4 5 08 07 06 05ISBN-13: 978-0-324-23310-0ISBN-10: 0-324-23310-8Library of Congress Control Number:2005920267ALL RIGHTS RESERVED.No part of this work covered by the copy-righthereon may be reproduced or used inany form or by any meansgraphic, elec-tronic,or mechanical, including photocopy-ing,recording, taping, Web distribution orinformation storage and retrieval systems, orin any other mannerwithout the writtenpermission of the publisher.For permission to use material from this textor product, submit a request online athttp://www.thomsonrights.com.For more information about our product,contact us at: Thomson Learning, AcademicResource Center, 1-800-423-0563Thomson Higher Education5191 Natorp BoulevardMason, Ohio, 45040USAASIA (including India) 3. To Our ParentsLindell and Leola Wise andJohn L. Myers and Marjorie H. Myers 4. This page intentionally left blank 5. vPrefaceOver the past twenty years, changes in the business environment have profoundly af-fectedcost accounting and cost management. A few examples of these changes are anincreased emphasis on providing value to customers, total quality management, time asa competitive element, advances in information and manufacturing technology, global-izationof markets, service industry growth, deregulation, and heightened awareness ofethical and environmental business practices. These changes are driven by the need tocreate and sustain a competitive advantage. For many firms, the information required torealize a competitive advantage can no longer be derived from a traditional cost manage-mentinformation system. The traditional system relies on functional-based costing andcontrol. In a functional-based system, costing and control are centered on organizationalfunctions. Unfortunately, this functional-based approach often fails to provide informationthat is detailed, accurate, and timely enough to support the requirements of this new envi-ronment.This has resulted in the emergence of an activity-based cost management system.Typically, an activity-based cost management system is more detailed and more accurate thana functional-based cost management system and, thus, more costly to operate. Furthermore,the need to add a formal guidance mechanism to the new activity-based system has createda demand for strategic-based cost management. Thus, the new cost management system mightbe more accurately referred to as an activity- and strategic-based cost management system. Theemergence and acceptance of activity- and strategic-based cost management therefore suggeststhat in many cases the benefits of this more sophisticated system outweigh its costs. On theother hand, the continued existence and reliance on functional-based systems suggests the op-positefor other firms.The coexistence of functional-based systems with activity- and strategic-based cost man-agementsystems necessitates the study of both systems, thus providing flexibility and depthof understanding. In creating a text on cost management, we had to decide how to designits structure. We believe that a systems approach provides a convenient and logical frame-work.Using a systems framework allows us to easily integrate the functional- and activity-basedapproaches in a way that students can easily grasp. Integration is achieved bydeveloping a common terminologya terminology that allows us to define each systemand discuss how they differ. Then the functional and activity-based approaches can be com-paredand contrasted as they are applied to costing, control, and decision making. We be-lievethis integration will allow students to appreciate the differences that exist betweenfunctional and activity-based approaches. This integration is especially useful in thedecision-making chapters, as it allows students to see how decisions change as the infor-mationsets change. For example, how does a make-or-buy decision change as we movefrom a functional-based, traditional cost management system to the richer, activity-basedcost management system?This text has been streamlined by combining and eliminating some material. Thenumber of chapters totals 21, as opposed to 24. Notably, international cost manage-menthas been eliminated as a separate chapter. Instead, important material has beenreorganized into decision-making chapters. More specific international cost topics areleft for international finance classes. Activity-based budgeting is now located in thebudgeting chapter, where it can be compared and contrasted with traditional bud-getingtopics. Activity-based costing is now located early in the text, in Chapter 4,where it can include traditional plantwide overhead rates and applications.AudienceThis text is written primarily for students at the undergraduate level. The text pre-sentsa thorough treatment of traditional and contemporary approaches to costmanagement, accounting, and control and can be used for a one- or two-semestercourse. In our opinion, the text also has sufficient depth for graduate-level courses.In fact, we have successfully used the text at the graduate level. 6. viPrefaceKey FeaturesWe feel that the text offers a number of distinctive and appealing featuresfeatures thatshould make it much easier to teach students about the emerging themes in todays busi-nessworld. One of our objectives was to reduce the time and resources expended by in-structorsso that students can be more readily exposed to todays topics and practices. Tohelp you understand the texts innovative approach, we have provided a detailed descrip-tionof its key features.StructureThe texts organization follows a systems framework and is divided into four parts:1. Part 1: Foundation Concepts. Chapters 1 through 4 introduce the basic concepts andtools associated with cost management information systems.2. Part 2: Fundamental Costing and Control. Chapters 5 through 10 provide thoroughcoverage of product costing, planning, and control in both functional-based and activity-basedcosting systems.3. Part 3: Advanced Costing and Control. Chapters 11 through 16 present the key elementsof the new cost management approaches. Examples of the topics covered in this sectioninclude activity-based customer and supplier costing, strategic cost management, activity-basedbudgeting, activity-based management, process value analysis, target costing, kaizencosting, quality costing, productivity, environmental cost management, and the BalancedScorecard.4. Part 4: Decision Making. Chapters 17 through 21 bring the costing and control tools to-getherin the discussion of decision making.This editions structure permits integrated coverage of both the traditional and activity-basedcosting systems. In this way, students can see how each system can be used for costing, con-trol,and decision making and can evaluate the advantages and disadvantages of each system.This approach helps students to see how cost management is applied to problems in todaysworld and to understand the richness of the approaches to business problems.Contemporary TopicsThe emerging themes of cost management are covered in depth. We have provided aframework for comprehensively treating both functional-based and activity-based topics.A common terminology links the two approaches; however, the functional- and activity-basedapproaches differ enough to warrant separate and comprehensive treatments. Thenature and extent of the coverage of contemporary topics is described below. As thissummary reveals, there is sufficient coverage of activity- and strategic-based topics toprovide a course that strongly emphasizes these themes.Historical PerspectiveChapter 1 provides a brief history of cost accounting. The historical perspective allowsstudents to see why functional-based cost management systems work well in some set-tingsbut no longer work for other settings. The forces that are changing cost man-agementpractices are described. The changing role of the management accountantis also covered with particular emphasis on why the development of a cross-functionalexpertise is so critical in todays environment.Value Chain AnalysisThe provision of value to customers is illustrated by the internal value chain, whichis first introduced in Chapter 1 and defined and illustrated more completely inChapter 2. Chapter 11 provides a detailed discussion of value chain analysis and 7. viiPrefaceintroduces the industrial value chain. Value chain analysis means that managers mustunderstand and exploit internal and external linkages so that a sustainable competitiveadvantage can be achieved. Exploitation of these linkages requires a detailed under-standingof the costs associated with both internal and external factors. This edition ex-pandsthe treatment of value chain analysis by introducing, defining, and illustratingactivity-based supplier costing and activity-based customer costing. The costing examplesdeveloped show how the value chain concepts can be operationalizeda characteristicnot clearly described by other treatments. Thus, we believe that the operational examplesare a significant feature of the text.Accounting and Cost Management SystemsIn Chapter 2, the accounting information system and its different subsystems are defined.Distinctions are made between the financial accounting and the cost management informa-tionsystems and the differing purposes they serve. The cost management information sys-temis broken down into the cost accounting information system and the operational controlsystem. The differences between functional-based and activity-based cost management systemsare defined and illustrated. The criteria for choosing an activity-based system over a functional-basedsystem are also discussed.In Chapter 2, three methods of cost assignment are delineated: direct tracing, driver trac-ing,and allocation. Activity drivers are also defined. Once the general cost assignment modelis established, the model is used to help students understand the differences between functional-basedand activity-based cost management systems. A clear understanding of how the two sys-temsdiffer is fundamental to the organizational structure that the text follows.Activity Costs Change as Activity Usage ChangesChapter 3 is a comprehensive treatment of cost behavior. First, we define variable, fixed, andmixed activity cost behavior. Then, we discuss the activity resource usage model and detailthe impact of flexible and committed resources on cost. Finally, we describe the methods ofbreaking out fixed and variable activity costs. This text goes beyond the typical text in ex-plainingto students how to use the computer spreadsheet programs to perform regressionanalysis. The chapter on cost behavior analysis is more general than usual chapters that treatthe subject. Traditional treatment usually focuses on cost as a function of production vol-ume.We break away from this pattern and focus on cost as a function of changes in ac-tivityusage with changes in production activity as a special case. The activity resourceusage model is used to define activity cost behavior (in terms of when resources are ac-quired)and is defined and discussed in Chapter 3. This resource usage model plays animportant role in numerous contemporary applications. It is used in value chain analy-sis(Chapter 11), activity-based management (Chapter 12), and tactical decision and rel-evantcosting analysis (Chapter 18). The extensive applications of the activity resourceusage model represent a unique feature of the text.Activity-Based CostingMuch has been written on the uses and applications of ABC. This text presents acomprehensive approach to activity-based costing and management. The activity-basedproduct costing model is introduced in Chapter 2 and described in detail inChapter 4. In this chapter, the advantages of ABC over functional-based costing arerelated. A completed discussion of how to design an ABC system is given. This in-cludesidentifying activities, creating an activity dictionary, assigning costs to activ-ities,classifying activities as primary and secondary, and assigning costs to products.We have added new material that explores methods on simplifying a complex ABCsystem. The objectives of these methods are to reduce the number of drivers andactivities used without significant reductions in product-costing accuracy. To fullyunderstand how an ABC system works, students must understand the data needed 8. viiiPrefaceto support the system. Thus, we show how the general ledger system must be un-bundledto provide activity information. We also define and illustrate an ABC relationaldatabase. This unique feature of the text helps the student understand the very practi-calrequirements of an ABC system.Activity-Based BudgetingActivity-based budgeting is now combined with traditional budgeting concepts in Chap-ter8. This integrated treatment helps students to see how budgets can be extended withthe power of activity-based cost concepts. This chapter introduces the basics of activity-basedbudgeting and gives an expanded example in a service setting. Flexible budgetingand the behavioral impact of budgets are also included in this chapter.Just-in-Time EffectsJIT manufacturing and purchasing are defined and their own cost management practices dis-cussedin Chapters 11 and 21. JIT is compared and contrasted with traditional manufactur-ingpractices. The effects on areas such as cost traceability, inventory management, productcosting, and responsibility accounting are carefully delineated.Life Cycle Cost ManagementIn Chapter 11, we define and contrast three different life cycle viewpoints: production life cy-cle,marketing life cycle, and consumable life cycle. We then show how these concepts can beused for strategic planning and analysis. In later chapters, we show how life cycle concepts areuseful for pricing and profitability analysis (Chapter 19). The use of life cycle costing for en-vironmentalcost management is also discussed (Chapter 16). The breadth, depth, and nu-merousexamples illustrating life cycle cost applications allow the student to see the powerand scope of this methodology.Activity-Based Management and the Balanced ScorecardThere are three types of responsibility accounting systems: functional-based, activity-based,and strategic-based. These three systems are compared and contrasted, and the activity-andstrategic-based responsibility accounting systems are discussed in detail. Activity-basedresponsibility accounting focuses on controlling and managing processes. The mechanismfor doing this process value analysis is defined and thoroughly discussed in Chapter 12.Numerous examples are given to facilitate understanding. Value-added and non-value-addedcost reports are described. Activity-based responsibility accounting also covers ac-tivitymeasures of performance, which are thoroughly covered in Chapter 13. TheBalanced Scorecard is equivalent to what we are calling strategic-based responsibility ac-counting.The basic concepts and methods of the Balanced Scorecard are presented inChapter 13.Costs of Quality: Measurement and ControlOften, textual treatments simply define quality costs and present cost of quality re-ports.We go beyond this simple presentation (in Chapter 14) and discuss cost ofquality performance reporting. We also describe quality activities in terms of theirvalue-added content. Finally, we introduce and describe ISO 9000, an importantquality assurance and reporting system that many firms must now follow.Productivity: Measurement and ControlThe new manufacturing environment demands innovative approaches to perfor-mancemeasurement. Productivity is one of these approaches; yet it is either onlysuperficially discussed in most cost and management accounting texts or not 9. ixPrefacetreated at all. In Chapter 15, we offer a thorough treatment of the topic, includingsome new material on how to measure activity and process productivity.Strategic Cost ManagementA detailed introduction to strategic cost management is provided in Chapter 11. Un-derstandingstrategic cost analysis is a vital part of the new manufacturing environment.Strategic cost management is defined and illustrated. Strategic positioning is discussed.Structural and executional cost drivers are introduced. Value chain analysis is describedwith the focus on activity-based supplier and customer costing. The role of target costingin strategic cost management is also emphasized.Environmental Costs: Measurement and ControlChapter 16 reflects the growing strategic importance of environmental cost management.This chapter introduces and discusses the concept of ecoefficiency. It also defines, classifies,and illustrates the reporting of environmental costs and how to assign those costs to prod-uctsand processes. The role of life-cycle costing in environmental cost management is de-tailed.Finally, we describe ways the Balanced Scorecard can be extended to include anenvironmental perspective.Theory of ConstraintsWe introduce the theory of constraints (TOC) in Chapter 21. A linear programming frame-workis used to facilitate the description of TOC and provide a setting where students can seethe value of linear programming. In fact, our treatment of linear programming is motivatedby the need to develop the underlying concepts so that TOC can be presented and discussed.This edition expands the coverage of TOC by adding a discussion of constraint accounting.Service Sector FocusThe significance of the service sector is recognized in this text through the extensive appli-cationof cost management principles to services. The text explains that services are not sim-plyless complicated manufacturing settings but instead have their own characteristics. Thesecharacteristics require modification of cost management accounting principles. Sections ad-dressingservices appear in a number of chapters, including product costing, pricing, andquality and productivity measurement.Professional EthicsStrong professional ethics need to be part of every accountants personal foundation. Weare convinced that students are interested in ethical dimensions of business and can betaught areas in which ethical conflicts occur. Chapter 1 introduces the role of ethics andreprints the ethical standards developed by the Institute of Management Accountants.To reinforce coverage of ethics, every chapter includes an ethics case for discussion. Inaddition, many chapters include sections on ethics. For example, Chapter 19, on pric-ingand revenue analysis, includes material on the ethical dimensions of pricing.Behavioral IssuesEthical behavior is just one aspect of human behavior that is affected by cost man-agementsystems. The systems used for planning, control, and decision making canaffect the way in which people act. Insights from behavioral decision theory are pre-sentedin appropriate sections of the text. For example, a discussion of the waysprofit measurement can affect peoples behavior is included in Chapter 19. Chap-ter8, on activity-based budgeting, includes a section on the behavioral impact ofbudgets. We believe that an integration of behavioral issues with accounting is-suesleads to a more complete understanding of the role of the accountant today. 10. xPrefaceReal World ExamplesOur years of experience in teaching cost and management accounting have convincedus that students like and understand real world applications of accounting concepts.These real world examples make the abstract accounting ideas concrete and providemeaning and color. Besides, theyre interesting and fun. Therefore, real world examplesare integrated throughout every chapter. Use of color for company names that appearin the chapters and the company index at the end of the text will help you locate theseexamples.Outstanding PedagogyWe think of this text as a tool that can help students learn cost accounting and cost man-agementconcepts. Of paramount importance is text readability. We have tried to write a veryreadable text and to provide numerous examples, real world applications, and illustrations ofimportant cost accounting and cost management concepts. Specific student-friendly featuresof the pedagogy include the following: Whenever possible, graphical exhibits are provided to illustrate concepts. In our experience,some students need to see the concept; thus, we have attempted to portray key conceptsto enhance understanding. Of course, many numerical examples are also provided. All chapters (except Chapter 1) include at least one review problem and solution. Theseproblems demonstrate the computational aspects of chapter materials and reinforce the stu-dentsunderstanding of chapter concepts before they undertake end-of-chapter materials. A glossary of key terms is included at the end of the text. Key terms lists at the end of eachchapter identify text pages for fuller explanation. All chapters include comprehensive end-of-chapter materials. These are divided into Ques-tionsfor Writing and Discussion, Exercises, and Problems. The Questions for Writ-ingand Discussion emphasize communication skill development. Exercises and Problemsto support every learning objective are included, and the relevant topics and learning ob-jectivesare noted in the text margins. The exercises and problems are graduated in diffi-cultyfrom easy to challenging. CMA exam problems are included to enable the studentto practice relevant problem material. Each chapter includes at least one ethics case. Allchapters also include a cyber research case to give students practice in doing research onthe Internet. This edition continues to offer cooperative learning exercises in the end-of-chapter ma-terialsin each chapter. These exercises encourage students to work in groups to solvecost management problems. Spreadsheet template problems are identified in the end-of-chapter materials with anappropriate icon. These problems are designed to help students use spreadsheet ap-plicationsto solve cost accounting problems.Comprehensive Supplements PackageCheck Figures. Key figures for solutions to selected problems and cases are pro-videdin the solutions manual as an aid to students as they prepare their answers.Instructors may copy and distribute these as they see fit.Study Guide, 0-324-23311-6 (Prepared by Al Chen, North Car-olinaState University). The study guide provides a detailed review of eachchapter and allows students to check their understanding of the material through 11. xiPrefacereview questions and exercises. Specifically, students are provided with learning objec-tives,a chapter summary, a chapter review correlated to the learning objectives, self-testquestions and exercises, and a Can You? Checklist that helps test their knowledgeof key concepts in the chapter. Answers are provided for all assignment material.Instructors Manual, 0-324-23321-3 (Prepared by Kim Foreman,James Madison University). The instructors manual contains a complete set oflecture notes for each chapter, a listing of all exercises and problems with estimated dif-ficultyand time required for solution, and a set of transparency masters.Solutions Manual, 0-324-23313-2 (Prepared by Don Hansen andMaryanne Mowen). The solutions manual contains the solutions for all end-of-chapterquestions, exercises, and problems. Solutions have been error-checked to ensuretheir accuracy and reliability.Solutions Transparencies, 0-324-23314-0. Acetate transparencies for selected so-lutionsare available to adopters of the fifth edition.Test Bank, 0-324-23315-9 (Prepared by Jane Stoneback, Central Con-necticutState University). Extensively revised for the fifth edition, the test bank offersmultiple-choice problems, short problems, and essay problems. Designed to make exam prepa-rationas convenient as possible for the instructor, each test bank chapter contains enough ques-tionsand problems to permit the preparation of several exams without repetition of material.ExamView Testing Software. This supplement contains all of the questions in theprinted test bank. This program is an easy-to-use test creation software compatible with Mi-crosoftWindows. Instructors can add or edit questions, instructions, and answers, and selectquestions (randomly or numerically) by previewing them on the screen. Instructors can alsocreate and administer quizzes online, whether over the Internet, a local area network (LAN),or a wide area network (WAN).Spreadsheet Templates (Prepared by Michael Blue, Bloomsburg Uni-versity).Spreadsheet templates using Microsoft Excel provide outlined formats of solu-tionsfor selected end-of-chapter exercises and problems. These exercises and problems areidentified with a margin symbol. The templates allow students to develop spreadsheet andwhat-if analysis skills.PowerPoint Slides (Prepared by Peggy Hussey). Selected transparencies ofkey concepts and exhibits from the text are available in PowerPoint presentation soft-ware.These slides provide a comprehensive outline of each chapter.Instructors Resource CD-ROM, 0-324-23317-5. Key instructor ancillar-ies(solutions manual, instructors manual, test bank, and PowerPoint slides) are pro-videdon CD-ROM, giving instructors the ultimate tool for customizing lecturesand presentations.Web Site (http://hansen.swlearning.com). A Web site designed specifi-callyfor Cost Management, fifth edition, provides online and downloadable resourcesfor both instructors and students. The Web site features an interactive study centerorganized by chapter, with learning objectives, Web links, glossaries, and onlinequizzes with automatic feedback.Personal Trainer 3.0, 0-324-31164-8. Instructors consistently citereading the text and completing graded homework assignments as a key to studentsuccess in managerial accounting; however, finding time to grade homework is dif-ficult.Personal Trainer solves this problem by allowing professors to assign text-bookexercises and problems. Personal Trainer will grade the homework and thenpost the grade into a full-blown gradebook, all in real time! Personal Trainer is 12. xiiPrefacean Internet-based homework tutor where students can complete the textbook home-workassignments, receive hints, submit their answers and then receive immediate feed-backon their answers.WebTutor Advantage with Personal Trainer. WebTutor Advantage com-plementsCost Management, fifth edition, by providing interactive reinforcement. Web-Tutors online teaching and learning environment brings together content management,assessment, communication, and collaboration capabilities for enhancing in-class instruc-tionor for delivering distance learning. For more information, including a demo, visit http://webtutor.swlearning.com/.The Business & Company Resource Center. An easy way to give students ac-cessto a dynamic database of business information and resources is offered by way of theBusiness & Company Resource Center (BCRC). The BCRC provides online access to a widevariety of global business information including current articles and business journals, de-tailedcompany and industry information, investment reports, stock quotes, and much more.The BCRC saves valuable time and provides students a safe resource in which to hone theirresearch skills and develop their analytical abilities. Other benefits of the BCRC include: Convenient access from anywhere with an Internet connection, allowing students to accessinformation at school, at home, or on the go. A powerful and time-saving research tool for studentswhether they are completing a caseanalysis, preparing for a presentation, creating a business plan, or writing a reaction paper. Serving as an online coursepack, allowing instructors to assign readings and research-basedassignments or projects without the inconvenience of library reserves, permissions, and printedmaterials. Acts as a filter, eliminating the junk information often found when searching the Inter-net,providing only high-quality, safe, and reliable news and information sources. Infomarks that make it easy to assign homework, share articles, create journal lists, andsave searches. Instructors can combine the BCRC with their favorite Harvard BusinessSchool Publishing cases to provide students a case analysis research tool at no additionalcost. Contact your local Thomson South-Western representative to learn how to includeBusiness & Company Resource Center with your text.Harvard Business Case Studies. The leader in business education publishing part-nerswith the leader in business cases to offer Harvard Business Case Studies. As part ofThomson South-Westerns commitment to giving customers the greatest choice of teach-ingand learning solutions possible, we are proud to be an official distributor of HarvardBusiness School Publishing case collections and article reprints. The combination of pre-eminentcases and articles from Harvard Business School Publishing with the unparal-leledscope and depth of customizable content from Thomson Business & ProfessionalPublishing provides instructors and students with a wide array of learning materials. Youcan draw from multiple resources and disciplines to match the unique needs of yourcourse. This bundling offers the following conveniences: For Instructors: Instructors can work with one source instead of multiple vendors,allowing the local Thomson representative to manage the prompt delivery of teach-ingresources and students materials. For Students: Pricing for cases is very affordableand when packaged with the text-book,students receive a significant discount on the text and coursepak. Ordering: Once you have identified the cases and articles you want to use, sim-plyuse an order form provided by your Thomson representative to indicate yourselections and packaging preferences. Once you return your form, you will be con-tactedwithin 48 hours by a Thomson Custom representative to confirm your or-derand walk you through the rest of the process.Combine Harvard Business School cases and articles with the BCRC and take yourcoursepak to the next level. Contact your sales representative for details. 13. xiiiAcknowledgmentsMany people have helped us to write this text. We appreciate the comments of re-viewersand others who have helped make this a more readable text.Jack Bailes, Oregon State UniversityFrank Collins, Schreiner CollegeMichael Cornick, University of North CarolinaCharlotteAlan B. Czyzewski, Indiana State UniversityJohn B. Duncan, University of Louisiana at MonroeFara Elikai, University of North Carolina at WilmingtonAlan H. Friedberg, Florida Atlantic UniversityDonald W. Gribben, Southern Illinois UniversityJeri W. Griego, Laramie County Community CollegeJan Richard Heier, Auburn University at MontgomeryEleanor G. Henry, State University of New York at OswegoJames Holmes, University of KentuckyDavid R. Honodel, University of DenverDick Houser, Northern Arizona UniversityK. E. Hughes II, Louisiana State UniversityBill Joyce, Eastern Illinois UniversityLeslie Kren, University of WisconsinMilwaukeeRon Kucic, University of DenverAmy Hing-Ling Lau, The Hong Kong Polytechnic UniversityOtto Martinson, Old Dominion UniversityWilliam Ortega, Western Washington UniversityJoseph Weintrop, Baruch CollegeSpecial thanks are due to our verifiers, Judy Beebe of Western Oregon University, James Emigof Villanova University, and Kim Richardson of James Madison University. They error-checkedthe study guide, solutions manual, and test bank. Their efforts helped us to produce a higher-qualitytext and supplement package.To the many students at Oklahoma State University who have reacted to the materialin Cost Management: Accounting and Control, we owe special thanks. Students representour true constituency. The common sense and good humor of our student reviewers haveresulted in a clearer, more readable text.We also want to express our gratitude to the Institute of Management Accountantsfor its permission to use adapted problems from past CMA examinations and to reprintthe ethical standards of conduct for management accountants. We are also grateful to theAmerican Institute of Certified Public Accountants for allowing us to adapt selected ques-tionsfrom past CPA examinations.Finally, we wish to acknowledge the exceptional efforts of our project team at South-Western Publishing and Litten Editing and Production (LEAP). Allison Rolfes, devel-opmentaleditor extraordinaire, consistently provided outstanding support. Her orga-nizationaland creative skills, not to mention flexibility and unflagging good humor,made this book a reality. Kara ZumBahlen, production editor, with Malvine Littenand Denise Morton of LEAP, took manuscript and transformed it into a text suitedfor the 21st century. Bethany Casey, designer, and Deanna Ettinger, photo manager,helped us transform abstract accounting concepts into state-of-the-art graphics andphotos. The support and creative efforts of Keith Chasse, acquisitions editor, andChris McNamee, marketing manager, are much appreciated.Don R. Hansen and Maryanne M. Mowen 14. This page intentionally left blank 15. xvAbout the AuthorsDon R. HansenDr. Don R. Hansen is Head of the School of Accounting at Oklahoma State Univer-sity.He received his Ph.D. from the University of Arizona in 1977. He has an under-graduatedegree in mathematics from Brigham Young University. His research interestsinclude activity-based costing and mathematical modeling. He has published articles inboth accounting and engineering journals including The Accounting Review, The Jour-nalof Management Accounting Research, Accounting Horizons, and IIE Transactions. Hehas served on the editorial board of The Accounting Review. His outside interests includefamily, church activities, reading, movies, watching sports, and studying Spanish.Maryanne M. MowenDr. Maryanne M. Mowen is Associate Professor of Accounting at Oklahoma State Univer-sity.She received her Ph.D. from Arizona State University in 1979. Dr. Mowen brings aninterdisciplinary perspective to teaching and writing in cost and management accounting,with degrees in history and economics. In addition, she does research in areas of behavioraldecision making, activity-based costing, and the impact of the Sarbanes-Oxley Act. She haspublished articles in journals such as Decision Science, The Journal of Economics and Psychol-ogy,and The Journal of Management Accounting Research. Dr. Mowens interests outside theclassroom include reading mysteries, traveling, and working crossword puzzles. 16. This page intentionally left blank 17. xviiBrief ContentsPart 1: Foundation Concepts 1CHAPTER 1 Introduction to Cost Management 3CHAPTER 2 Basic Cost Management Concepts 28CHAPTER 3 Cost Behavior 67CHAPTER 4 Activity-Based Costing 121Part 2: Fundamental Costing and Control 178CHAPTER 5 Product and Service Costing: Job-Order System 180CHAPTER 6 Product and Service Costing: A Process SystemsApproach 226CHAPTER 7 Allocating Costs of Support Departments and JointProducts 276CHAPTER 8 Budgeting for Planning and Control 325CHAPTER 9 Standard Costing: A Functional-Based ControlApproach 382CHAPTER 10 Decentralization: Responsibility Accounting,Performance Evaluation, and Transfer Pricing 430Part 3: Advanced Costing and Control 484CHAPTER 11 Strategic Cost Management 486CHAPTER 12 Activity-Based Management 548CHAPTER 13 The Balanced Scorecard: Strategic-Based Control 590CHAPTER 14 Quality Cost Management 621CHAPTER 15 Productivity Measurement and Control 664CHAPTER 16 Environmental Costs: Measurement and Control 695Part 4: Decision Making 734CHAPTER 17 Cost-Volume-Profit Analysis 736CHAPTER 18 Activity Resource Usage Model and Tactical DecisionMaking 781CHAPTER 19 Pricing and Profitability Analysis 823CHAPTER 20 Capital Investment 878CHAPTER 21 Inventory Management: Economic Order Quantity,JIT, and the Theory of Constraints 929Glossary 967Subject Index 979Company Index 1003 18. This page intentionally left blank 19. xixContentsPart 1: Foundation Concepts 1CHAPTER 1 Introduction to Cost Management 3Financial Accounting versus Cost Management 3Factors Affecting Cost Management 4Global Competition 5 Growth of the Service Industry 5 Advancesin Information Technology 5 Advances in the ManufacturingEnvironment 6 Customer Orientation 8 New ProductDevelopment 8 Total Quality Management 8 Time as aCompetitive Element 9 Efficiency 9A Systems Approach 10Cost Management: A Cross-Functional Perspective 11The Need for Flexibility 11 Behavioral Impact of CostInformation 12The Role of Todays Cost and ManagementAccountant 12Line and Staff Positions 12 Information for Planning, Controlling,Continuous Improvement, and Decision Making 14Accounting and Ethical Conduct 15Benefits of Ethical Behavior 15 Standards of Ethical Conduct forManagement Accountants 16Certification 16The Certificate in Management Accounting 18 The Certificate inPublic Accounting 18 The Certificate in Internal Auditing 18CHAPTER 2 Basic Cost Management Concepts 28A Systems Framework 29Accounting Information Systems 29 Relationship to OtherOperational Systems and Functions 32 Different Systems forDifferent Purposes 32Cost Assignment: Direct Tracing, Driver Tracing, andAllocation 34Cost Objects 35 Accuracy of Assignments 35Product and Service Costs 37Different Costs for Different Purposes 38 Product Costs andExternal Financial Reporting 39External Financial Statements 41Income Statement: Manufacturing Firm 42 Income Statement:Service Organization 45Functional-Based and Activity-Based Cost ManagementSystems 45Functional-Based Cost Management Systems: A Brief Overview 45Activity-Based Cost Management Systems: A Brief Overview 46Choice of a Cost Management System 48CHAPTER 3 Cost Behavior 67Basics of Cost Behavior 68Measures of Activity Output 68 Fixed Costs 68 Variable Costs 70Linearity Assumption 71 Mixed Costs 72 Time Horizon 73 20. xxContentsResources, Activities, and Cost Behavior 74Flexible Resources 75 Committed Resources 75 Implications forControl and Decision Making 76 Step-Cost Behavior 77 Activitiesand Mixed Cost Behavior 79Methods for Separating Mixed Costs into Fixed andVariable Components 80The High-Low Method 81 Scatterplot Method 82 The Method ofLeast Squares 85 Using Regression Programs 87Reliability of Cost Formulas 89Hypothesis Test of Parameters 89 Goodness of Fit Measures 89Confidence Intervals 90Multiple Regression 93The Learning Curve and Nonlinear Cost Behavior 95Cumulative Average-Time Learning Curve 95 Incremental Unit-Time Learning Curve 97Managerial Judgment 98CHAPTER 4 Activity-Based Costing 121Unit-Level Product Costing 122Overhead Assignment: Plantwide Rates 123 Disposition of OverheadVariances 124 Overhead Application: Departmental Rates 126Limitations of Plantwide and Departmental Rates 127Non-Unit-Related Overhead Costs 127 Product Diversity 128An Example Illustrating the Failure of Unit-Based OverheadRates 128Activity-Based Costing System 133Activity Identification, Definition, and Classification 134 AssigningCosts to Activities 138 Assigning Secondary Activity Costs toPrimary Activities 139 Cost Objects and Bills of Activities 140Activity Rates and Product Costing 140 Classifying Activities 142Reducing the Size and Complexity of an ABC System 142Approximately Relevant ABC Systems 143 Equally AccurateReduced ABC Systems 144ABC System Concepts 146ABC Database 147 ABC and ERP Systems 148Part 2: Fundamental Costing and Control 178CHAPTER 5 Product and Service Costing:Job-Order System 180Characteristics of the Production Process 180Manufacturing Firms versus Service Firms 181 Unique versusStandardized Products and Services 184Setting Up the Cost Accounting System 185Cost Accumulation 186 Cost Measurement 186 CostAssignment 188 Choosing the Activity Level 190The Job-Order Costing System: General Description 191Overview of the Job-Order Costing System 191 MaterialsRequisitions 192 Job Time Tickets 193 Overhead Application 194Unit Cost Calculation 195 21. xxiContentsJob-Order Costing: Specific Cost Flow Description 195Accounting for Direct Materials 196 Accounting for Direct LaborCost 196 Accounting for Overhead 198 Accounting for FinishedGoods Inventory 199 Accounting for Cost of Goods Sold 201Accounting for Nonmanufacturing Costs 203Single versus Multiple Overhead Rates 204Appendix: Accounting for Spoilage in a TraditionalJob-Order System 206CHAPTER 6 Product and Service Costing: A Process SystemsApproach 226Process-Costing Systems: Basic Operational and CostConcepts 226Cost Flows 227 The Production Report 229 Unit Costs 230Process Costing with No Work-in-ProcessInventories 231Service Organizations 231 JIT Manufacturing Firms 232The Role of Activity-Based Costing 232Process Costing with Ending Work-in-ProcessInventories 233Equivalent Units as Output Measures 233 Cost of ProductionReport Illustrated 234 Nonuniform Application of ProductiveInputs 235 Beginning Work-in-Process Inventories 236FIFO Costing Method 236Step 1: Physical Flow Analysis 237 Step 2: Calculation of EquivalentUnits 238 Step 3: Computation of Unit Cost 238 Step 4:Valuation of Inventories 238 Step 5: Cost Reconciliation 239Journal Entries 241Weighted Average Costing Method 241Step 1: Physical Flow Analysis 241 Step 2: Calculation of EquivalentUnits 241 Step 3: Computation of Unit Cost 242 Step 4:Valuation of Inventories 243 Step 5: Cost Reconciliation 243Production Report 243 FIFO Compared with WeightedAverage 243Treatment of Transferred-In Goods 245Step 1: Physical Flow Schedule 247 Step 2: Calculation ofEquivalent Units 247 Step 3: Computation of Unit Costs 247Step 4: Valuation of Inventories 247Operation Costing 249Basics of Operation Costing 249 Operation Costing Example 250Appendix: Spoiled Units 252CHAPTER 7 Allocating Costs of Support Departments and JointProducts 276An Overview of Cost Allocation 276Types of Departments 277 Types of Allocation Bases 279Objectives of Allocation 280Allocating One Departments Costs to AnotherDepartment 282A Single Charging Rate 282 Dual Charging Rates 283 Budgetedversus Actual Usage 285 Fixed versus Variable Bases: A Note ofCaution 287 22. xxiiContentsChoosing a Support Department Cost AllocationMethod 288Direct Method of Allocation 288 Sequential Method ofAllocation 290 Reciprocal Method of Allocation 291 Comparisonof the Three Methods 294Departmental Overhead Rates and Product Costing 295Accounting for Joint Production Processes 296Cost Separability and the Need for Allocation 297 Distinction andSimilarity between Joint Products and By-Products 298 Accountingfor Joint Product Costs 299 Allocation Based on Relative MarketValue 301CHAPTER 8 Budgeting for Planning and Control 325The Role of Budgeting in Planning and Control 326Purposes of Budgeting 326 The Budgeting Process 327 GatheringInformation for Budgeting 329Preparing the Operating Budget 331Operating Budgets for Merchandising and Service Firms 337Preparing the Financial Budget 338The Cash Budget 338 Budgeted Balance Sheet 342 Shortcomingsof the Traditional Master Budgeting Process 342Flexible Budgets for Planning and Control 345Static Budgets versus Flexible Budgets 345Activity-Based Budgets 351The Behavioral Dimension of Budgeting 355Characteristics of a Good Budgetary System 356CHAPTER 9 Standard Costing: A Functional-Based ControlApproach 382Developing Unit Input Standards 383Establishing Standards 383 Usage of Standard Costing Systems 384Standard Cost Sheets 385Variance Analysis and Accounting: Direct Materials andDirect Labor 387Calculating Direct Materials Price and Usage Variances 388Accounting for Direct Materials Price and Usage Variances 391Calculating Direct Labor Variances 391 Accounting for the DirectLabor Rate and Efficiency Variances 393 Investigating DirectMaterials and Labor Variances 393 Disposition of Direct Materialsand Direct Labor Variances 395Variance Analysis: Overhead Costs 396Four-Variance Method: The Two Variable Overhead Variances 396Four-Variance Analysis: The Two Fixed Overhead Variances 400Accounting for Overhead Variances 404 Two- and Three-VarianceAnalyses 405Mix and Yield Variances: Materials and Labor 407Direct Materials Mix and Yield Variances 407 Direct Labor Mix andYield Variances 408 23. xxiiiContentsCHAPTER 10 Decentralization: Responsibility Accounting,Performance Evaluation, and Transfer Pricing 430Responsibility Accounting 431Types of Responsibility Centers 431 The Role of Information andAccountability 431Decentralization 432Reasons for Decentralization 432 The Units of Decentralization 434Measuring the Performance of Investment Centers 435Return on Investment 435 Residual Income 439 Economic ValueAdded 441 Multiple Measures of Performance 444Measuring and Rewarding the Performance ofManagers 445Incentive Pay for ManagersEncouraging Goal Congruence 445Managerial Rewards 445 Measuring Performance in theMultinational Firm 448Transfer Pricing 450The Impact of Transfer Pricing on Income 450Setting Transfer Prices 451Market Price 451 Negotiated Transfer Prices 452 Cost-BasedTransfer Prices 457 Transfer Pricing and the MultinationalFirm 459Part 3: Advanced Costing and Control 484CHAPTER 11 Strategic Cost Management 486Strategic Cost Management: Basic Concepts 487Strategic Positioning: The Key to Creating and Sustaining aCompetitive Advantage 487 Value-Chain Framework, Linkages, andActivities 489 Organizational Activities and Cost Drivers 491Operational Activities and Drivers 492Value-Chain Analysis 493Exploiting Internal Linkages 493 Exploiting Supplier Linkages 496Exploiting Customer Linkages 498Life-Cycle Cost Management 501Product Life-Cycle Viewpoints 501 Interactive Viewpoint 503 Roleof Target Costing 507Just-In-Time (JIT) Manufacturing and Purchasing 509Inventory Effects 510 Plant Layout 511 Grouping ofEmployees 512 Employee Empowerment 513 Total QualityControl 513JIT and Its Effect on the Cost Management System 513Traceability of Overhead Costs 514 Product Costing 515 JITsEffect on Job-Order and Process-Costing Systems 516 BackflushCosting 516CHAPTER 12 Activity-Based Management 548The Relationship of Activity-Based Costing and Activity-Based Management 549 24. Process Value Analysis 550Driver Analysis: Defining Root Causes 550 Activity Analysis:Identifying and Assessing Value Content 550 Assessing ActivityPerformance 553Financial Measures of Activity Efficiency 554Reporting Value- and Non-Value-Added Costs 554 Trend Reportingof Non-Value-Added Costs 556 Drivers and Behavioral Effects 557The Role of Kaizen Standards 557 Benchmarking 558 ActivityFlexible Budgeting 559 Activity Capacity Management 562Implementing Activity-Based Management 563Discussion of the ABM Implementation Model 563 Why ABMImplementations Fail 565Financial-Based versus Activity-Based ResponsibilityAccounting 566Assigning Responsibility 567 Establishing Performance Measures 568Evaluating Performance 569 Assigning Rewards 570CHAPTER 13 The Balanced Scorecard: Strategic-Based Control 590Activity-Based versus Strategic-Based ResponsibilityAccounting 591Assigning Responsibility 592 Establishing Performance Measures 592Performance Measurement and Evaluation 594 AssigningRewards 595Basic Concepts of the Balanced Scorecard 595Strategy Translation 595 The Financial Perspective, Objectives, andMeasures 596 Customer Perspective, Objectives, and Measures 598Process Perspective, Objectives, and Measures 599 Learning andGrowth Perspective 602Linking Measures to Strategy 603The Concept of a Testable Strategy 604 Strategic Feedback 605Strategic Alignment 606Communicating the Strategy 606 Targets and Incentives 607Resource Allocation 608CHAPTER 14 Quality Cost Management 621Costs of Quality 622The Meaning of Quality 623 Defining Quality Costs 624 QualityCost Measurement 625Reporting Quality Costs 628Quality Cost Reports 628 Distribution of Quality Costs: TheAcceptable Quality View 628 Distribution of Quality Costs: Zero-Defects View 630 The Role of Activity-Based Cost Management 632Quality Cost Information and Decision Making 633Decision Making Contexts 633 Certifying Quality ThroughISO 9000 635Controlling Quality Costs 637Choosing the Quality Standard 637 Types of Quality PerformanceReports 639xxivContents 25. xxvContentsCHAPTER 15 Productivity Measurement and Control 664Productive Efficiency 665Partial Productivity Measurement 665Partial Productivity Measurement Defined 666 Partial Measures andMeasuring Changes in Productive Efficiency 667 Advantages ofPartial Measures 668 Disadvantages of Partial Measures 668Total Productivity Measurement 668Profile Productivity Measurement 668 Profit-Linked ProductivityMeasurement 670 Price-Recovery Component 672Measuring Changes in Activity and Process Efficiency 672Activity Productivity Analysis 673 Process Productivity Analysis 675Process Productivity Model 676 Quality and Productivity 679CHAPTER 16 Environmental Costs: Measurement and Control 695Defining, Measuring, and Controlling EnvironmentalCosts 696The Ecoefficiency Paradigm 696 Competing Paradigms 698Environmental Costs Defined 699 Environmental Cost Report 700Environmental Cost Reduction 702 An Environmental FinancialReport 704Environmental Costing 705Environmental Product Costs 705 Unit-Based EnvironmentalCost Assignments 705 Activity-Based Environmental CostAssignments 706Life-Cycle Cost Assessment 707Product Life Cycle 707 Assessment Stages 708Strategic-Based Environmental ResponsibilityAccounting 711Environmental Perspective 711 The Role of ActivityManagement 713Part 4: Decision Making 734CHAPTER 17 Cost-Volume-Profit Analysis 736The Break-Even Point in Units 737Operating-Income Approach 737 Contribution-MarginApproach 738 Profit Targets 739 After-Tax Profit Targets 740Break-Even Point in Sales Dollars 741Profit Targets 744 Comparison of the Two Approaches 745Multiple-Product Analysis 745Break-Even Point in Units 745 Sales Dollars Approach 748Graphical Representation of CVP Relationships 749The Profit-Volume Graph 749 The Cost-Volume-Profit Graph 749Assumptions of Cost-Volume-Profit Analysis 751Changes in the CVP Variables 753Introducing Risk and Uncertainty 755 Sensitivity Analysis andCVP 759 26. CVP Analysis and Activity-Based Costing 759Example Comparing Conventional and ABC Analysis 760 StrategicImplications: Conventional CVP Analysis versus ABC Analysis 761CVP Analysis and JIT 762CHAPTER 18 Activity Resource Usage Model and Tactical DecisionMaking 781Tactical Decision Making 782The Tactical Decision-Making Process 782 Qualitative Factors 784Relevant Costs and Revenues 785Relevant Costs Illustrated 785 Irrelevant Cost Illustrated 786Relevant Costs and Benefits in International Trade 786Relevancy, Cost Behavior, and the Activity Resource UsageModel 788Flexible Resources 788 Committed Resources 788Illustrative Examples of Tactical Decision Making 790Make-or-Buy Decisions 790 Keep-or-Drop Decisions 794 Special-Order Decisions 797 Decisions to Sell or Process Further 799Relevant Costing and Ethical Behavior 801CHAPTER 19 Pricing and Profitability Analysis 823Basic Pricing Concepts 824Demand and Supply 824 Price Elasticity of Demand 824 MarketStructure and Price 825Pricing Policies 826Cost-Based Pricing 826 Target Costing and Pricing 828 OtherPricing Policies 829The Legal System and Pricing 829Predatory Pricing 829 Price Discrimination 830 Ethics 831Measuring Profit 832Reasons for Measuring Profit 832 Absorption-Costing Approach toMeasuring Profit 834 Variable-Costing Approach to MeasuringProfit 836Profitability of Segments 839Profit by Product Line 839 Divisional Profit 843 CustomerProfitability 843 Overall Profit 845Analysis of Profit-Related Variances 846Sales Price and Price Volume Variances 846 Contribution MarginVariance 847 Market Share and Market Size Variances 848The Product Life Cycle 849Limitations of Profit Measurement 852CHAPTER 20 Capital Investment 878Capital Investment Decisions 879Payback and Accounting Rate of Return: NondiscountingMethods 881Payback Period 881 Accounting Rate of Return 883xxviContents 27. xxviiContentsThe Net Present Value Method 883The Meaning of NPV 884 Weighted Average Cost of Capital 884An Example Illustrating Weighted Average Cost of Capital 885Internal Rate of Return 885Example with Uniform Cash Flows 885 IRR and Uneven CashFlows 887NPV versus IRR: Mutually Exclusive Projects 887NPV Compared with IRR 888 Example: Mutually ExclusiveProjects 890Computing After-Tax Cash Flows 890Inflationary Adjustments 892 Conversion of Gross Cash Flows toAfter-Tax Cash Flows 892Capital Investment: Advanced Technology andEnvironmental Considerations 899How Investment Differs 900 How Estimates of Operating CashFlows Differ 900 An Example: Investing in AdvancedTechnology 901 Salvage Value 902 Discount Rates 903Appendix A: Present Value Concepts 905Future Value 905 Present Value 906 Present Value of an UnevenSeries of Cash Flows 906 Present Value of a Uniform Series of CashFlows 907Appendix B: Present Value Tables 908CHAPTER 21 Inventory Management: Economic Order Quantity,JIT, and the Theory of Constraints 929Just-in-Case Inventory Management 930Justifying Inventory 930 Economic Order Quantity: A Model forBalancing Acquisition and Carrying Costs 931 Calculating EOQ 932When to Order or Produce 933 Demand Uncertainty andReordering 933 An Example Involving Setups 934 EOQ andInventory Management 934JIT Inventory Management 935A Pull System 936 Setup and Carrying Costs: The JIT Approach 937Due-Date Performance: The JIT Solution 938 Avoidance ofShutdown and Process Reliability: The JIT Approach 938 Discountsand Price Increases: JIT Purchasing versus Holding Inventories 941JITs Limitations 941Basic Concepts of Constrained Optimization 943One Binding Internal Constraint 943 Internal Binding Constraintand External Binding Constraint 944 Multiple Internal BindingConstraints 944Theory of Constraints 947Operational Measures 947 Five-Step Method for ImprovingPerformance 949Glossary 967Subject Index 979Company Index 1003 28. This page intentionally left blank 29. Cost ManagementAccounting and Control 30. FOUNDATION CONCEPTSP A R T1h t tp://hansen.swlearning.com RUBBERBALL PRODUCTIONS/GETTY IMAGES 31. 1 Introduction To Cost Management2 Basic Cost Management Concepts3 Cost Behavior4 Activity-Based CostingC H A P T E Rto Cost Management1 RUBBERBALL PRODUCTIONS/GETTY IMAGES 32. This page intentionally left blank 33. C H A P T E R13Introduction to Cost ManagementAFTER STUDYING THIS CHAPTER, YOU SHOULD BE ABLE TO:1. List the similarities and differences betweenfinancial accounting and cost management.2. Identify the current factors affecting cost man-agement.3. Discuss the importance of the accounting systemfor internal and external reporting.4. Discuss the need for todays cost accountant toacquire cross-functional expertise.5. Describe how management accountants functionwithin an organization.6. Understand the importance of ethical behaviorfor management accountants.7. Identify the three forms of certification availableto internal accountants. Financial Accounting versus Cost ManagementThe accounting information system within an organization has two major subsystems: a financial accountingsystem and a cost management accounting system. One of the major differences between the two systemsis the targeted user. Financial accounting is devoted to providing information for external users, includ-inginvestors, creditors (e.g., banks and suppliers), and government agencies. These external users find theinformation helpful in making decisions to buy or sell shares of stock, buy bonds, issue loans and regula-toryacts, and in making other financial decisions. Because the information needs of this group of external PHOTODISC GREEN/GETTY IMAGES 34. 4 Part 1 Foundation Conceptsusers are so diverse and the information must be so highly reliable, the financial ac-countingsystem is designed in accordance with clearly defined accounting rules andformats, or generally accepted accounting principles (GAAP). Cost management pro-ducesinformation for internal users. Specifically, cost management identifies, collects,measures, classifies, and reports information that is useful to managers for determiningthe cost of products, customers, and suppliers, and other relevant objects and for plan-ning,controlling, making continuous improvements, and decision making.Cost management has a much broader focus than that found in traditional costingsystems. It is not only concerned with how much something costs but also with thefactors that drive costs, such as cycle time, quality, and process productivity. Thus, costmanagement requires a deep understanding of a firms cost structure. Managers mustbe able to determine the long- and short-run costs of activities and processes as well asthe costs of goods, services, customers, suppliers, and other objects of interest. Causesof these costs are also carefully studied.The costs of activities and processes do not appear on the financial statements. Yet,knowing these costs and their underlying causes is critical for companies engaging insuch tasks as continuous improvement, total quality management, environmental costmanagement, productivity enhancement, and strategic cost management.Cost management encompasses both the cost accounting and the management ac-countinginformation systems. Cost accounting attempts to satisfy costing objectives forboth financial and management accounting. When cost accounting is used to complywith a financial accounting objective, it measures and assigns costs in accordance withGAAP. When used for internal purposes, cost accounting provides cost informationabout products, customers, services, projects, activities, processes, and other details thatmay be of interest to management. The cost information provided plays an importantsupport role for planning, controlling, and decision making. This information need not,and often should not, follow GAAP.Management accounting is concerned specifically with how cost information andother financial and nonfinancial information should be used for planning, controlling,continuous improvement, and decision making. Management accounting has an over-allobjective of making sure that organizations make effective use of resources so thatvalue is maximized for shareholders and customers and other interested shareholders.Porsche, Stihl, DaimlerChrysler, and other German companies view management ac-countingas a distinct discipline and typically employ as many or more staff in man-agementaccounting as in financial accounting.1It should be emphasized that both the cost management information system andthe financial accounting information system are part of the total accounting informa-tionsystem. Unfortunately, the content of the cost management accounting system isall too often driven by the needs of the financial accounting system. The reports of bothcost management and financial accounting are frequently derived from the same data-base,which was originally established to support the reporting requirements of finan-cialaccounting. Many organizations need to expand this database, or create additionaldatabases, in order to satisfy more fully the needs of internal users. For example, a firmsprofitability is of interest to investors, but managers need to know the profitability ofindividual products. The accounting system should be designed to provide both totalprofits and profits for individual products. The key point here is flexibilitythe ac-countingsystem should be able to supply different data for different purposes.Factors Affecting Cost ManagementOver the last 25 years, worldwide competitive pressures, deregulation, growth in theservice industry, and advances in information and manufacturing technology haveOBJECTIVE1List the similari-tiesand differ-encesbetweenfinancial account-ingand costmanagement.1. Paul A. Sharman, German Cost Accounting, Strategic Finance (December 2003): 3038.OBJECTIVE2Identify the cur-rentfactorsaffecting costmanagement. 35. Chapter 1 Introduction to Cost Management 5changed the nature of our economy and caused many manufacturing and service in-dustriesto dramatically change the way in which they operate. These changes, in turn,have prompted the development of innovative and relevant cost management practices.For example, activity-based accounting systems have been developed and implementedin many organizations. Additionally, the focus of cost management accounting systemshas been broadened to enable managers to better serve the needs of customers andmanage the firms business processes that are used to create customer value. A firm canestablish a competitive advantage by providing more customer value for less cost thanits competitors. To secure and maintain a competitive advantage, managers seek to im-provetime-based performance, quality, and efficiency. Accounting information must beproduced to support these three fundamental organizational goals.Global CompetitionVastly improved transportation and communication systems have led to a global marketfor many manufacturing and service firms. Several decades ago, firms neither knew norcared what similar firms in Japan, France, Germany, and Singapore were producing.These foreign firms were not competitors since their markets were separated by geo-graphicaldistance. Now, both small and large firms are affected by the opportunities of-feredby global competition. Stillwater Designs, a small firm that designs and marketsKicker speakers, has significant markets in Europe. The manufacture of the Kicker speak-ersis mostly outsourced to Asian producers. At the other end of the size scale, Procter& Gamble, The Coca-Cola Company, and Mars, Inc., are developing sizable marketsin China. Automobiles, currently being made in Japan, can be in the United States intwo weeks. Investment bankers and management consultants can communicate with for-eignoffices instantly. Improved transportation and communication in conjunction withhigher quality products that carry lower prices have upped the ante for all firms. Thisnew competitive environment has increased the demand not only for more cost infor-mationbut also for more accurate cost information. Cost information plays a vital rolein reducing costs, improving productivity, and assessing product-line profitability.Growth of the Service IndustryAs traditional industries have declined in importance, the service sector of the economyhas increased in importance. The service sector now comprises approximately three-quartersof the U.S. economy and employment. Many servicesamong them account-ingservices, transportation, and medical servicesare exported. Experts predict that thissector will continue to expand in size and importance as service productivity grows. Dereg-ulationof many services (e.g., airlines and telecommunications in the past and utilities inthe present) has increased competition in the service industry. Many service organizationsare scrambling to survive. The increased competition has made managers in this industrymore conscious of the need to have accurate cost information for planning, controlling,continuous improvement, and decision making. Thus, the changes in the service sectoradd to the demand for innovative and relevant cost management information.Advances in Information TechnologyThree significant advances relate to information technology. One is intimately connectedwith computer-integrated applications. With automated manufacturing, computers areused to monitor and control operations. Because a computer is being used, a consid-erableamount of useful information can be collected, and managers can be informedabout what is happening within an organization almost as it happens. It is now possi-bleto track products continuously as they move through the factory and to report (ona real-time basis) such information as units produced, material used, scrap generated,and product cost. The outcome is an operational information system that fully inte-gratesmanufacturing with marketing and accounting data. 36. 6 Part 1 Foundation ConceptsEnterprise resource planning (ERP) software has the objective of providing anintegrated system capabilitya system that can run all the operations of a company andprovide access to real-time data from the various functional areas of a company. Usingthis real-time data enables managers to continuously improve the efficiency of organi-zationalunits and processes. To support continuous improvement, information that istimely, accurate, and detailed is needed.Automation and integration increase both the quantity (detail) and the timelinessof information. For managers to fully exploit the value of the more complex informa-tionsystem, they must have access to the data of the systemthey must be able to ex-tractand analyze the data from the information system quickly and efficiently. This, inturn, implies that the tools for analysis must be powerful.The second major advance supplies the required tools: the availability of personalcomputers (PCs), online analytic programs (OLAP), and decision-support systems(DSS). The PC serves as a communications link to the companys information system,and OLAP and DSS supply managers with the capability to use that information. PCsand software aids are available to managers in all types of organizations. Often, a PCacts as a networking terminal and is connected to an organizations database, allowingmanagers to access information more quickly, do their own analyses, and prepare manyof their own reports. The ability to enhance the accuracy of product costing is nowavailable. Because of advances in information technology, cost accountants have theflexibility to respond to the managerial need for more complex product costing meth-odssuch as activity-based costing (ABC).ABC software is classified as online analytic software. Online analytic applicationsfunction independently of an organizations core transactions but at the same time aredependent on the data resident in an ERP system.2 ABC software typically interfaceswith DSS software and other online analytic software to facilitate applications such ascost estimating, product pricing, and planning and budgeting. This vast computing ca-pabilitynow makes it possible for accountants to generate individualized reports on anas-needed basis. Many firms have found that the increased responsiveness of a con-temporarycost management system has allowed them to realize significant cost savingsby eliminating the huge volume of internally generated monthly financial reports.The third major advance is the emergence of electronic commerce. Electronic com-merce(e-commerce) is any form of business that is executed using information andcommunications technology. Internet trading, electronic data interchange, and bar cod-ingare examples of e-commerce. Internet trading allows buyers and sellers to come to-getherand execute transactions from diverse locations and circumstances. Internet tradingallows a company to act as a virtual organization, thus reducing overhead. Electronicdata interchange (EDI) involves the exchange of documents between computers usingtelephone lines and is widely used for purchasing and distribution. The sharing of in-formationamong trading partners reduces costs and improves customer relations, thusleading to a stronger competitive position. EDI is an integral part of supply chain man-agement(value-chain management). Supply chain management is the management ofproducts and services from the acquisition of raw materials through manufacturing, ware-housing,distribution, wholesaling, and retailing. The emergence of EDI and supply chainmanagement has increased the importance of costing out activities in the value chain anddetermining the cost to the company of different suppliers and customers.Advances in the Manufacturing EnvironmentManufacturing management approaches such as the theory of constraints and just-in-timehave allowed firms to increase quality, reduce inventories, eliminate waste, and re-2. R. Shaw, ABC and ERP: Partners at Last? Management Accounting (November 1998): 5658. 37. Chapter 1 Introduction to Cost Management 7duce costs. Automated manufacturing has produced similar outcomes. The impact ofimproved manufacturing technology and practices on cost management is significant.Product costing systems, control systems, allocation, inventory management, cost struc-ture,capital budgeting, variable costing, and many other accounting practices are be-ingaffected.Theory of ConstraintsThe theory of constraints is a method used to continuously improve manufacturingand nonmanufacturing activities. It is characterized as a thinking process that beginsby recognizing that all resources are finite. Some resources, however, are more criticalthan others. The most critical limiting factor, called a constraint, becomes the focus ofattention. By managing this constraint, performance can be improved. To manage theconstraint, it must be identified and exploited (i.e., performance must be maximized sub-jectto the constraint). All other actions are subordinate to the exploitation decision. Fi-nally,to improve performance, the constraint must be elevated. The process is repeateduntil the constraint is eliminated (i.e., it is no longer the critical performance limitingfactor). The process then begins anew with the resource that has now become the crit-icallimiting factor. Using this method, lead times and, thus, inventories can be reduced.Just-in-Time ManufacturingA demand-pull system, just-in-time (JIT) manufacturing strives to produce a prod-uctonly when it is needed and only in the quantities demanded by customers. Demand,measured by customer orders, pulls products through the manufacturing process. Eachoperation produces only what is necessary to satisfy the demand of the succeeding op-eration.No production takes place until a signal from a succeeding process indicatesthe need to produce. Parts and materials arrive just in time to be used in production.JIT manufacturing typically reduces inventories to much lower levels (theoreticallyto insignificant levels) than those found in conventional systems, increases the empha-sison quality control, and produces fundamental changes in the way production is or-ganizedand carried out. Basically, JIT manufacturing focuses on continual improvementby reducing inventory costs and dealing with other economic problems. Reducing in-ventoriesfrees up capital that can be used for more productive investments. Increasingquality enhances the competitive ability of the firm. Finally, changing from a traditionalmanufacturing setup to JIT manufacturing allows the firm to focus more on qualityand productivity and, at the same time, allows a more accurate assessment of what itcosts to produce products.Computer-Integrated ManufacturingAutomation of the manufacturing environment allows firms to reduce inventory, in-creaseproductive capacity, improve quality and service, decrease processing time, andincrease output. Automation can produce a competitive advantage for a firm. The im-plementationof an automated manufacturing facility typically follows JIT and is a re-sponseto the increased needs for quality and shorter response times. As more firmsautomate, competitive pressures will force other firms to do likewise. For many manu-facturingfirms, automation may be equivalent to survival.The three possible levels of automation are (1) the stand-alone piece of equipment,(2) the cell, and (3) the completely integrated factory. Before a firm attempts any levelof automation, it should first do all it can to produce a more focused, simplified man-ufacturingprocess. For example, most of the benefits of going to a completely inte-gratedfactory can often be achieved simply by implementing JIT manufacturing.If automation is justified, it may mean installation of a computer-integrated man-ufacturing(CIM) system. CIM implies the following capabilities: (1) the products are 38. 8 Part 1 Foundation Conceptsdesigned through the use of a computer-assisted design (CAD) system; (2) a computer-assistedengineering (CAE) system is used to test the design; (3) the product is manu-facturedusing a computer-assisted manufacturing (CAM) system (CAMs usecomputer-controlled machines and robots); and (4) an information system connects thevarious automated components.A particular type of CAM is the flexible manufacturing system. Flexible manufac-turingsystems are capable of producing a family of products from start to finish usingrobots and other automated equipment under the control of a mainframe computer.This ability to produce a variety of products with the same set of equipment is clearlyadvantageous.Customer OrientationFirms are concentrating on the delivery of value to the customer with the objective ofestablishing a competitive advantage. Accountants and managers refer to a firms valuechain as the set of activities required to design, develop, produce, market, and deliverproducts and services to customers. As a result, a key question to be asked about anyprocess or activity is whether it is important to the customer. The cost managementsystem must track information relating to a wide variety of activities important to cus-tomers(e.g., product quality, environmental performance, new product development,and delivery performance). Customers now count the delivery of the product or serviceas part of the product. Companies must compete not only in technological and man-ufacturingterms but also in terms of the speed of delivery and response. Firms like Fed-eralExpress have exploited this desire by identifying and developing a market the U.S.Post Office could not serve.Companies have internal customers as well. The staff functions of a company existto serve the line functions. The accounting department creates cost reports for pro-ductionmanagers. Accounting departments that are customer driven assess the valueof the reports to be sure that they communicate significant information in a timely andreadable fashion. Reports that do not measure up are dropped.New Product DevelopmentA high proportion of production costs are committed during the development and de-signstage of new products. The effects of product development decisions on other partsof the firms value chain are now widely acknowledged. This recognition has produceda demand for more sophisticated cost management procedures relating to new productdevelopmentprocedures such as target costing and activity-based management. Tar-getcosting encourages managers to assess the overall cost impact of product designsover the products life cycle and simultaneously provides incentives to make designchanges to reduce costs. Activity-based management identifies the activities producedat each stage of the development process and assesses their costs. Activity-based man-agementis complimentary to target costing because it enables managers to identify theactivities that do not add value and then eliminate them so that overall life cycle costscan be reduced.Total Quality ManagementContinuous improvement and elimination of waste are the two foundation principlesthat govern a state of manufacturing excellence. Manufacturing excellence is the key tosurvival in todays world-class competitive environment. Producing products and servicesthat actually perform according to specifications and with little waste are the twin ob-jectivesof world-class firms. A philosophy of total quality management, in which man-agersstrive to create an environment that will enable organizations to produce defect-freeproducts and services, has replaced the acceptable quality attitudes of the past. 39. Chapter 1 Introduction to Cost Management 9The emphasis on quality applies to services as well as products. Boeing AerospaceSupport (AS) provides maintenance and training support for Boeing aircraft. From1999 to 2003, AS significantly improved the quality of its services. From 1998 to 2003,the exceptional and very good responses on customer satisfaction surveys increasedby more than 23 percent. On-time delivery of maintenance services was about 95 per-cent.For one program, the turn-around time was about three days for AS, while itscompetitors were taking up to 40 days for the same services. As a consequence of theimproved quality, AS more than doubled its revenues from 1999 to 2003 (especiallyimpressive given that the market growth was flat during this period). The company alsoreceived the 2003 Malcolm Baldrige National Quality Award in the service category.3The message is clear. Pursuing an objective of improving quality promises majorbenefits. Cost management supports this objective by providing crucial information con-cerningquality-related activities and quality costs. Managers need to know which quality-relatedactivities add value and which ones do not. They also need to know what qualitycosts are and how they change over time.Time as a Competitive ElementTime is a crucial element in all phases of the value chain. Firms can reduce time to mar-ketby redesigning products and processes, by eliminating waste, and by eliminatingnon-value-added activities. Firms can reduce the time spent on delivery of products orservices, reworking a product, and unnecessary movements of materials andsubassemblies.Decreasing non-value-added time appears to go hand-in-hand with increasing qual-ity.With quality improvements, the need for rework decreases, and the time to pro-ducea good product decreases. The overall objective is to increase customerresponsiveness.Time and product life cycles are related. The rate of technological innovation hasincreased for many industries, and the life of a particular product can be quite short.Managers must be able to respond quickly and decisively to changing market condi-tions.Information to allow them to accomplish this goal must be available. Hewlett-Packard has found that it is better to be 50 percent over budget in new productdevelopment than to be six months late. This correlation between cost and time is apart of the cost management system.EfficiencyWhile quality and time are important, improving these dimensions without corre-spondingimprovements in financial performance may be futile, if not fatal. Improvingefficiency is also a vital concern. Both financial and nonfinancial measures of efficiencyare needed. Cost is a critical measure of efficiency. Trends in costs over time and mea-suresof productivity changes can provide important measures of the efficacy of con-tinuousimprovement decisions. For these efficiency measures to be of value, costs mustbe properly defined, measured, and accurately assigned.Production of output must be related to the inputs required, and the overall fi-nancialeffect of productivity changes should be calculated. Activity-based costing andprofit-linked productivity measurement are responses to these demands. Activity-basedcosting is a relatively new approach to cost accounting that provides more accurate andmeaningful cost assignments. By analyzing underlying activities and processes, elimi-natingthose that do not add value, and enhancing those that do add value, dramaticincreases in efficiency can be realized.3. As reported at http://www.nist.gov/public_affairs/releases/2003baldrigewinners.htm on May 5, 2004. 40. 10 Part 1 Foundation ConceptsA Systems ApproachThe accounting system can be viewed as an approach to record transactions. A firmmay develop a system that ranges from simple to complex, depending on the underly-ingprocesses it describes. The financial system of a typical college student is quite sim-ple.It may consist of a checkbook and a wallet. Cash on hand may be counted whennecessary to see if a purchase is possible. Similarly, from time to time, the checkbookis balanced to see if the banks view is similar to the checkbook holders view. Thereprobably is not much paperwork and no need for a journal and chart of accounts. Oneindividual is responsible for purchases and payments. However, as the entity grows, sayas a small business with several employees, the simple system does not work. One per-soncannot keep track of all the detail; several people may be responsible for paymentsand purchases as well as sales. Certain standardized techniques are required.The systems approach for the modern company is a data-based, relationship account-ingapproach. Exhibit 1-1 shows the traditional accounting system as a funnel. Transac-tionsoccur, and supporting documents are accumulated. These documents contain a wealthof data. For example, a purchase order may show the type, amount, and cost of the ma-terialsto be purchased, as well as the date and the individual who requested the materials.This purchase is then entered into the journal, yet only the date, account name, and dol-laramount are retained. In other words, much potentially useful information is eliminated.Next, the amounts in the journal are aggregated in the general ledger; thus, moreinformation is lost at this stage. Finally, the ledger amounts are summarized in finan-cialreportsand still more information is deleted.The data-based, or relationship, accounting system preserves information. The rec-tanglein Exhibit 1-1 represents the new accounting system. All information pertinentto a transaction is entered into a database. Various users of information can extract whatthey need from the database and create custom accounting reports. Information is notOBJECTIVE3Discuss the im-portanceof theaccounting sys-temfor internaland externalreporting.EXHIBIT 1-1 Accounting SystemTraditional Accounting System versus Data-Based RelationshipTransactions TransactionsJournalEntriesPosting toAccountsFinancialReportsCustomReportCustomReportCustomReportCustomReport 41. Chapter 1 Introduction to Cost Management 11lost; it is still available for other users with different needs. If a salesperson writes up anorder, data on the customers name and address, product ordered, quantity, price, anddate to be delivered are entered into the database. The marketing manager may use in-formationon the price and quantity ordered to determine the sales commission. Theproduction manager may need information on product type, quantity, and delivery dateto schedule production.The moving force behind this shift from an external report-based accounting sys-temto a relationship-based accounting system is the widespread availability of tech-nology.Powerful personal computers and networked systems make the accountingsystem available to a wide variety of users within the company.The development and adoption of powerful ERP programs (e.g., SAP, Oracle,PeopleSoft, and JD Edwards) have moved the concept of an integrated database fromthe realm of theory to reality. This has forced a shift in perspective. An ERP system in-tegratesmany information systems into one enterprise-wide system. This directly impactscosting systems such as activity-based costing (ABC). An ERP system provides access totimely informationboth financial and nonfinancialabout many organizational unitsand processes. This facilitates the adoption and implementation of an ABC system.Cost Management:A Cross-Functional PerspectiveTodays cost accountant must understand many functions of a businesss value chain,from manufacturing to marketing to distribution to customer service. This need is par-ticularlyimportant when the company is involved in international trade. Definitions ofproduct cost vary. The companys internal accountants have moved beyond the tradi-tionalmanufacturing cost approach to a more inclusive approach. This newer approachto product costing may take into account the costs of the value-chain activities definedby initial design and engineering, manufacturing, distribution, sales, and service. An in-dividualwho is well schooled in the various definitions of cost and who understandsthe shifting definitions of cost from the short run to the long run can be invaluable indetermining what information is relevant in decision making.Individuals with the ability to think cross-functionally can shift perspectives, ex-pandingtheir understanding of problems and their solutions. Japanese automakers gottheir idea for JIT manufacturing from Taiichi Ohnos (the creator of Toyotas JIT pro-ductionsystem) 1956 trip to the United States. He toured American automobile fac-toriesand American supermarkets. The impressive array of goods in the supermarketsand their constant turnover led to Ohnos comprehension of the way that grocery cus-tomerspulled products through the stores. That understanding led to Toyotas at-temptto pull parts through production precisely when and where needed.4Why try to relate cost management to marketing, management, and logistics? On-timedelivery affects costs. Cycle time affects costs. The way orders are received andprocessed from customers affects costs. The way goods are purchased and delivered af-fectscostsas do the quality of the components purchased and the reliability of sup-pliers.It is clearly difficultif not impossibleto manage costs unless there is interactionand cooperation among all parts of a company.The Need for FlexibilityNo one cost management system exists. Costs important to one firm may be irrelevantto another. Similarly, costs that are important in one context to a firm are unimportantin other contexts.OBJECTIVE 4Discuss the needfor todays costaccountant toacquire cross-functionalexpertise.4. Jeremy Main, How to Steal the Best Ideas Around, Fortune (October 19, 1992): 102106. 42. 12 Part 1 Foundation ConceptsA member of the board of directors for Stillwaters Mission of Hope, a nonprofitshelter for the homeless, asked his accountant how to value the building used as theshelter. In other words, what did it cost? The accountants answer was: Why do youwant to know? If you need to know the value for insurance purposesto determinehow much insurance to buythen perhaps replacement cost would be the answer. Ifyou are trying to set a price to sell the building (and build another one elsewhere), thencurrent market value of the real estate would be the answer. If you need the cost forthe balance sheet, then historical cost is required by GAAP. Different costs are neededfor different purposes. The intelligent cost accountant must find the reason for the ques-tionin order to suggest an appropriate answer. A good cost management system facil-itatesthese answers.An understanding of the structure of the business environment in which the com-panyoperates is an important input in designing a cost management system. A primarydistinction is made between manufacturing and service firms. However, overlap occursbecause some manufacturing firms emphasize service to customers while some servicefirms emphasize the quality of their product. Retailing is another classification, andits needs would require still another system.Behavioral Impact of Cost InformationCost information is not neutral; it does not stand in the background, merely reflectingwhat has happened in an unbiased way. Instead, the cost management information sys-temalso shapes business. By keeping track of certain information, business owners aresaying that these things are important. The ignoring of other information implies thatit is not important. An old joke states that an accountant is someone who knows thecost of everything and the value of nothing.Todays accountant must be an expert at valuing things. This includes methods (1)of costing and achieving quality, (2) of differentiating between value-added and non-value-added activities, and (3) of measuring and accounting for productivity. Thus, it iscrucial that owners, managers, and accountants be aware of the signals that are being sentout by the accounting information system and ensure that correct signals are being sent.The Role of Todays Cost andManagement AccountantWorld-class firms are those that are at the cutting edge of customer support. They knowtheir market and their product. They strive continually to improve product design, man-ufacture,and delivery. These companies can compete with the best of the best in aglobal environment. Accountants, too, can be termed world class. Those who merit thisdesignation are intelligent and well prepared. They not only have the education andtraining to accumulate and provide financial information, but they stay up to date intheir field and in business. In addition, world-class accountants must be familiar withthe customs and financial accounting rules of the countries in which their firm operates.Line and Staff Positi