Fundamentals of Cost Accounting 2e

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1 Fundamentals of Cost Accounting 2e William N. Lanen University of Michigan Shannon W. Anderson Rice University Michael W. Maher University of California at Davis McGraw-Hill Irwin Boston EjSurr Ridge, IL Dubuque, IA New York San Francisco St. Louis Bangkok Bogota Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto

2 Contents Cost Accounting: Information for Decision Making 2 Value Creation in Organizations 3 Why Start with Value Creation? 3 Value Chain 3 Supply Chain and Distribution Chain 5 Using Cost Information to Increase Value 5 In Action: Palliative Care Unit 5 Accounting and the Value Chain 5 Accounting Systems 6 Financial Accounting 6 Cost Accounting 6 Cost Accounting and GAAP 7 Customers of Cost Accounting 7 Our Framework for Assessing Cost Accounting Systems 8 The Manager's Job Is to Make Decisions 9 Decision Making Requires Information 9 Finding and Eliminating Activities That Don't Add Value 9 Identifying Strategic Opportunities Using Cost Analysis 9 Owners Use Cost Information to Evaluate Managers 10 Cost Data for Managerial Decisions 10 Costs for Decision Making 10 Costs for Control and Evaluation 11 Different Data for Different Decisions 14 Trends in Cost Accounting throughout the Value Chain 14 Cost Accounting in Research and Development (R&D) 14 Cost Accounting in Design 14 Cost Accounting in Purchasing 15 Cost Accounting in Production 15 Cost Accounting in Marketing 16 Cost Accounting in Distribution 16 Cost Accounting in Customer Service 16 Enterprise Resource Planning 17 Creating Value in the Organization 17 Key Financial Players in the Organization 17 Choices: Ethical Issues for Accountants 18 What Makes Ethics So Important? 18 In Action: Channel Stuffing 19 Ethics 20 Sarbanes-Oxley Act of 2002 and Ethics 20 Cost Accounting and Other Business Disciplines 21 The Debrief 22 Summary 22 Key Terms 22 Appendix: Institute of Management Accountants Code of Ethics 23 Review Questions 24 Critical Analysis and Discussion Questions 25 Exercises 25 Problems 27 Solutions to Self-Study Questions 33 Cost Concepts and Behavior 34 What Is a Cost? 36 Cost versus Expenses 36 XXIV

3 Contents XXV Presentation of Costs in Financial Statements 37 In Action: A New Manufacturing Mantra 37 Service Organizations 38 Retail and Wholesale Companies 38 Manufacturing Companies 40 Direct and Indirect Manufacturing (Product) Costs 40 Prime Costs and Conversion Costs 41 Nonmanufacturing (Period) Costs 41 In Action: Indirect Costs in Banking 42 Cost Allocation 42 Direct versus Indirect Costs 43 Details of Manufacturing Cost Flows 44 How Costs Flow through the Statements 45 Income Statements 45 Cost of Goods Manufactured and Sold 45 Direct Materials 46 Work in Process 46 Finished Goods Inventory 47 Cost of Goods Manufactured and Sold Statement 47 An Interim Debrief 48 Cost Behavior 48 Fixed versus Variable Costs 49 Components of Product Costs 51 Unit Fixed Costs Can Be Misleading for Decision Making 51 How to Make Cost Information More Useful for Managers 55 Gross Margin versus Contribution Margin Income Statements 56 Developing Financial Statements for Decision Making 56 The Debrief 58 Summary 58 Key Terms 59 Review Questions 59 Critical Analysis and Discussion Questions 60 Exercises 60 Problems 67 ' : Solutions to Self-Study Questions 73 Fundamentals of Cost-Volume-Profit Analysis 76 Cost-Volume-Profit Analysis 77 Profit Equation 77 CVP Example 78 Graphic Presentation 81 Profit-Volume Model 82 Use of CVP to Analyze the Effect of Different Cost Structures 82 In Action: Effect of Cost Structure on Operating and Investing Decisions 84 Margin of Safety 85 CVP Analysis with Spreadsheets 85 Extensions of the CVP Model 86 Income Taxes 86 Multiproduct CVP Analysis 87 Alternative Cost Structures 88 Assumptions and Limitations of CVP Analysis 89 The Debrief 90 Summary 90 t Key Terms 91 Review Questions 91 Critical Analysis and Discussion Questions 91 Exercises 91 Problems 95 Solutions to Self-Study Questions 100 Fundamentals of Cost Analysis for Decision Making 102 Differential Analysis 103 Differential Costs versus Total Costs 104 Differential Analysis and Pricing Decisions 104 Short-Run versus Long-Run Pricing Decisions 105 Short-Run Pricing Decisions: Special Orders 105 Long-Run Pricing Decisions 107

4 xxvi Contents Long-Run versus Short-Run Pricing: Is There a Difference? 108 Cost Analysis for Pricing 108 In Action: Take Back Laws in Europe 109 Legal Issues Relating to Costs and Sales Prices 109 Predatory Pricing 109 Dumping 110 Price Discrimination 111 Peak-Load Pricing 111 Price Fixing 111 Use of Differential Analysis for Production Decisions 112 Make-It or Buy-It Decisions 112 Make-or-Buy Decisions Involving Differential Fixed Costs 112 Opportunity Costs of Making 115 Decision to Add or Drop a Product Line or Close a Business Unit 117 Product Choice Decisions 118 The Theory of Constraints 122 The Debrief 124 Summary 124 Key Terms 125 Review Questions 125 Critical Analysis and Discussion Questions 126 Exercises 126 Problems 131 Integrative Case 139 Solutions to Self-Study Questions 140 Cost Estimation 142 Why Estimate Costs? 143 Basic Cost Behavior Patterns 143 What Methods Are Used to Estimate Cost Behavior? 143 Engineering Method 144 Account Analysis Method l!44 Statistical Cost Estimation 146 In Action: Using Regression to Evaluate Cost Behavior 152 Multiple Regression 153 Practical Implementation Problems 154 Learning Phenomenon 156 In Action: Learning Curves, 156 Applications 157 How Is an Estimation Method Chosen? 159 Data Problems 159 Effect of Different Methods on Cost Estimates 160 The Debrief 161 Summary 162 Key Terms 163 Appendix A: Multiple Regression 163 Appendix B: Learning Curves 167 Review Questions 168 Critical Analysis and Discussion Questions 168 Exercises 169 Problems 174 Solutions to Self-Study Questions Fundamentals of Product and Service Costing 184 Cost Management Systems 185. Reasons to Calculate Product or Service Costs 185 In Action: Importance of Distinguishing between Production Costs and Overhead Costs 186 Cost Allocation and Product Costing 186 Cost Flow Diagram 187 Fundamental Themes Underlying the Design of Cost Systems for Managerial Purposes 187 Costing in a Single Product, Continuous Process Industry 188 Basic Cost Flow Model 188 Costing with No Work-in-Process Inventories 188 Costing with Ending Work-in-Process Inventories 189 Costing in a Multiple Product, Discrete Process Industry 190

5 Contents XXVII Predetermined Overhead Rates 192 Product Costing of Multiple Products 193 Choice of the Allocation Base for Predetermined Overhead Rate 193 Choosing among Possible Allocation Bases 194 Multiple Allocation Bases and Two-Stage Systems 195 Choice of Allocation Bases 196 Different Companies, Different Production and Costing Systems 197 Operations Costing: An Illustration 199 The Debrief 200 Summary 200 Key Terms 201 Review Questions 201 Critical Analysis and Discussion Questions 201 Exercises 202 Problems 206 Solutions to Self-Study Questions 208 Job Costing 210 Defining a Job 211 Using Accounting Records in a Job Shop 212 Computing the Cost of a Job 212 Production Process at InShape 212 Records of Costs at InShape 212 How Manufacturing Overhead Costs Are Recorded at InShape 215 In Action: Effect of Overhead Rates on Production Decisions 216 The Job Cost Sheet 218 Over- and Underapplied Overhead 218 An Alternative Method of Recording and Applying Manufacturing Overhead 220 Multiple Allocation Bases: The Two-Stage Approach 223 Summary of Steps in a Job Costing System 223 Using Job Costing in Service Organizations 223 Ethical Issues and Job Costing 225 Misstating Stage of Completion 226 Charging Costs to the Wrong Jobs 226 Misrepresenting the Cost of Jobs 226 Managing Projects 227 In Action: Determination of the Cost of Large Projects and Ethical Implications 229 The Debrief 229. Summary 229 Key Terms 230 j Review Questions 230 Critical Analysis and Discussion Questions 230 Exercises 231 Problems 234 Integrative Case 244 Solutions to Self-Study Questions Process Costing 246 Determining Equivalent Units 248 Using Product Costing in a Process Industry 249 Step 1: Measure the Physical Flow of Resources 249 Step 2: Compute the Equivalent Units of Production 249 In Action: Overstating Equivalent Units to Commit Fraud 250 Step 3: Identify the Product Costs for Which to Account 251 Time Out! We Need to Make an Assumption about Costs and the Work-in-Process Inventory 251 Step 4: Compute the Costs per Equivalent Unit: Weighted Average 252 Step 5: Assign Product Cost to Batches of Work: Weighted-Average Process Costing 253 Reporting This Information to Managers: The Production Cost Report 253 Sections 1 and 2: Managing the Physical Flow of Units 255 Sections 3, 4, and 5: Managing Costs 255

6 xxviii Contents Assigning Costs Using First-In, First-Out (FIFO) Process Costing 255 Step 1: Measure the Physical Flow of Resources 256 Step 2: Compute the Equivalent Units of Production 256 Step 3: Identify the Product Costs for Which to Account 258 Step 4: Compute the Costs per Equivalent Unit: FIFO 258 Step 5: Assign Product Cost: FIFO 259 How This Looks in T-Accounts 259 Determining Which Is Better: FIFO or Weighted Average? 260 Computing Product Costs: Summary of the Steps 260 Using Costs Transferred in from Prior Departments 261 Who Is Responsible for Costs Transferred in from Prior Departments? 262 Choosing between Job and Process Costing 264 Operation Costing 264 Product Costing in Operations 265 Operation Costing Illustration 265 Comparing Job, Process, and Operation Costing 268 The Debrief 268 Summary 269 Key Terms 269 Review Questions 270 Critical Analysis and Discussion Questions 270 Exercises 271 Problems 275 Solutions to Self-Study Questions Activity-Based Costing 286 Reported Product Costs and Decision Making 287 Dropping a Product 287 ;; The Death Spiral 289 Two-Stage Cost Allocation 290 Two-Stage Cost Allocation and the Choice of Cost Drivers 291 Plantwide versus Department-Specific Rates 293 Choice of Cost Allocation Methods: A Cost-Benefit Decision 294 Activity-Based Costing 295 In Action: Activity-Based Costing in a Not for Profit 296 Developing Activity-Based Costs 296 Cost Hierarchies 298 Activity-Based Costing Illustrated 299 Step 1: Identify the Activities 299 Step 2: Identify the Cost Drivers 300 Step 3: Compute the Cost Driver Rates 300 Step 4: Assign Costs Using Activity-Based Costing 300 Unit Costs Compared 302 Cost Flows through Accounts 302 Choice of Activity Bases in Modern Production Settings 304 In Action: Evidence on the Benefits of Activity-Based Costing 305 Activity-Based Costing in Administration 305 Who Uses ABC? 306 The Debrief 307 Summary 307 Key Terms 308 Review Questions 308 Critical Analysis and Discussion Questions 308 Exercises 309 Problems 314 Integrative Cases 320 Solutions to Self-Study Questions Fundamentals of Cost Management 326 Using Activity-Based Cost Management to Add Value 327

7 Contents xxix Using Activity-Based Cost Information to Improve Processes 329 Using Cost Hierarchies 330 Managing the Cost of Customers and Suppliers 330 Using Activity-Based Costing to Determine the Cost of Customers and Suppliers 331 Determining Why the Cost of Customers Matters 334 Using Cost of Customer Information to Manage Costs 334 In Action: Analyzing Customer Profitability at Best Buy 334 Determining the Cost of Suppliers 334 Capturing the Cost Savings 335 Managing the Cost of Capacity 336 Using and Supplying Resources 336 Computing the Cost of Unused Capacity 338 Assigning the Cost of Unused Capacity 340 Seasonal Demand and the Cost of Unused Capacity 340 Managing the Cost of Quality 342 How Can We Limit Conflict between Traditional Managerial Accounting Systems and Total Quality Management? 342 What Is Quality? 343 What Is the Cost of Quality? 343 Trade-Offs, Quality Control, and Failure Costs 345 In Action: Cost Elements Included in Reported Quality Costs 346 The Debrief 347 Summary 347 Key Terms 348 Review Questions 348 Critical Analysis and Discussion Questions 348 Exercises 349 Problems 354 Integrative Cases 358 Solutions to Self-Study Questions Service Department and Joint Cost Allocation 360 _ Service Department Cost Allocation 361 Methods of Allocating Service Department Costs 363 Allocation Bases 363 Direct Method 363 Step Method 366 In Action: Step Method at Stanford University 369 Reciprocal Method 369 Comparison of Direct, Step, and Reciprocal Methods 372 Allocation of Joint Costs 373 Joint Costing Defined 373 Reasons for Allocating Joint-Costs 374 Joint Cost Allocation Methods 375 Net Realizable Value Method 375 Physical Quantities Method 377 Evaluation of Joint Cost Methods 378 Deciding Whether to Sell Goods Now or Process Them Further 378 In Action: Different Demands for Different Parts 379 Decision of What to Do with By-Products 379 The Debrief 38*1 Summary 381 Key Terms 382 Appendix: Calculation of the Reciprocal Method Using Computer Spreadsheets 382 Review Questions 384 Critical Analysis and Discussion Questions 385 Exercises 385 Problems 389 Integrative Case 396 Solutions to Self-Study Questions Fundamentals of Management Control Systems 400 Why a Management Control System? 401 Alignment of Managerial and Organizational Interests 401 Evolution of the Control Problem: An Example 402

8 XXX Contents Decentralized Organizations 402 Why Decentralize the Organization? 403 Advantages of Decentralization 403 Disadvantages of Decentralization 403 Framework for Evaluating Management Control Systems 404 Organizational Environment and Strategy 404 Results of the Management Control System 405 Elements of a Management Control System 405 Balancing the Elements 406 Delegated Decision Authority: Responsibility Accounting 406 Cost Centers 406 Discretionary Cost Centers 407 Revenue Centers 407 Profit Centers 408 Investment Centers 408 Responsibility Centers and Organization Structure 408 Measuring Performance 408 Two Basic Questions 409 In Action: Teacher Pay and Student Performance 409 Cost Centers 409 Revenue Centers 410 Profit Centers 410 Investment Centers 411 Evaluating Performance 411 Relative Performance versus Absolute Performance Standards 411 Evaluating Managers' Performance versus Economic Performance of the Responsibility Center 411 Relative Performance Evaluations in Organizations 412 Compensation Systems 412 In Action: Beware of the "Kink" 413 Illustration: Corporate Cost Allocation 413 Incentive Problems with Allocated Costs 413 Effective Corporate Cost Allocation System 414 Do Performance Evaluation Systems Create Incentives to Commit Fraud? 415 Internal Controls to Protect Assets and Provide Quality Information 416 Internal Auditing 417 The Debrief 418 Summary 418 Key Terms 419 Review Questions 419 Critical Analysis and Discussion Questions 419 Exercises 420 Problems 423 Integrative Cases 426 Solutions to Self-Study Questions Planning and Budgeting 432 How Strategic Planning Increases Competitiveness 433 Overall Plan 434 Organization Goals 434 Strategic Long-Range Profit Plan 434 Master Budget (Tactical Short-Range Profit Plan): Tying the Strategic Plan to the Operating Plan 434 Human Element in Budgeting 435 Value of Employee Participation 436 Developing the Master Budget 436 Where to Start? 436 Sales Forecasting 437 Comprehensive Illustration 438 Forecasting Production 438 Forecasting Production Costs 439 Direct Labor 440 Overhead 440 Completing the Budgeted Cost of Goods Sold 441 Revising the Initial Budget 443

9 Contents XXXI Marketing and Administrative Budget 444 Pulling It Together into the Income Statement 444 Key Relationships: The Sales Cycle 446 Using Cash Flow Budgets to Estimate Cash Needs 447 Multiperiod Cash Flows 447 In Action: The "Curse " of Growth 449 Planning for the Assets and Liabilities on the Budgeted Balance Sheets 450 Big Picture: How It All Fits Together 450 Budgeting in Retail and Wholesale Organizations 450 Budgeting in Service Organizations 453 In Action: Budget Is the Law in Government 453 Ethical Problems in Budgeting 453 Budgeting under Uncertainty 454 The Debrief 455 Summary 455 Key Terms 456 Review Questions 456 Critical Analysis and Discussion Questions 457 Exercises 457 Problems 462 Integrative Case 467 Solutions to Self-Study Questions Business Unit Performance Measurement 472 Divisional Performance Measurement 473 In Action: What Determines Whether Firms Use Divisional Measures for Measuring Divisional Performance? 413 Accounting Income 474.; Computing Divisional Income 474 Advantages and Disadvantages of Divisional Income 475 Some Simple Financial Ratios 475 Return on Investment 476 Performance Measures for Control: A Short Detour 477 Limitations of ROI 477 Residual Income Measures 480 Limitations of Residual Income 481 Economic Value Added (EVA) 482 In Action: EVA at Best Buy 482 Limitations of EVA 484 In Action: Does Using Residual Income as a Performance Measure Affect Managers' Decisions? 484 Divisional Performance Measurement: A Summary 484 Measuring the Investment Base 485 Gross Book Value versus Net Book Value 485 Historical Cost versus Current Cost 485 Beginning, Ending, or Average Balance 486 Other Issues in Divisional Performance Measurement 488 The Debrief 488 Summary 489 Key Terms 489 Review Questions 489 Critical Analysis and Discussion Questions Exercises 490 Problems 493 Integrative Cases 496 Solutions to Self-Study Questions Transfer Pricing What Is Transfer Pricing and Why Is It Important? 505 Determining the Optimal Transfer Price 506 The Setting 506

10 XXXII Contents Determining Whether a Transfer Price Is Optimal 506 Case 1: A Perfect Intermediate Market for Wood 508 In Action: Transfer Pricing in State-Owned Enterprises 510 Case 2: No Intermediate Market 510 Optimal Transfer Price: A General Principle 513 Other Market Conditions 514 Applying the General Principle 514 How to Help Managers Achieve Their Goals While Achieving the Organization's Goals 515 Top-Management Intervention in Transfer Pricing 516 Centrally Established Transfer Price Policies 516 Establishing a Market Price Policy 516 Establishing a Cost-Basis Policy 517 Alternative Cost Measures 518 Remedying Motivational Problems of Transfer Pricing Policies 519 Negotiating the Transfer Price 519 Imperfect Markets 520 Global Practices 520 Multinational Transfer Pricing 521 In Action: Management Control and Tax Considerations in Transfer Pricing 522 Segment Reporting 522 The Debrief 523 Summary 523 Key Terms 524 Review Questions 524 Critical Analysis and Discussion Questions 524 Exercises 525 Problems 527 Integrative Cases 532 >) Solutions to Self-Study Questions Fundamentals of Variance Analysis 536 Using Budgets for Performance Evaluation 537 Profit Variance 538 In Action: When a Favorable Variance Might Not Mean "Good" News 538 Why Are Actual and Budgeted Results. Different? 539 Flexible Budgeting 540 s Comparing Budgets and Results 541 Sales Activity Variance 541 Profit Variance Analysis as a Key Tool for Managers 542 Sales Price Variance 544 Variable Production Cost Variances 544 Fixed Production Cost Variance 544 Marketing and Administrative Variances 544 Performance Measurement and Control in a Cost Center 544 Variable Production Costs 545 Variable Cost Variance Analysis 546 General Model 546 Direct Materials 547 Direct Labor 550 Variable Production Overhead 551 Variable Cost Variances Summarized in Graphic Form 552 Fixed Cost Variances 553 Fixed Cost Variances with Variable Costing 554 Absorption Costing: The Production Volume Variance 554 Summary of Overhead Variances 556 Key Points 557 In Action: Does Standard Costing Lead to Waste? 557 The Debrief 557 Summary 558 Key Terms 559

11 Contents XXXIII Appendix: Recording Costs in a Standard Cost System 559 Review Questions 562 Critical Analysis and Discussion Questions 562 Exercises 563 Problems 568 Integrative Case 574 Solutions to Self-Study Questions Additional Topics in Variance Analysis 580 Profit Variance Analysis When Units Produced Do Not Equal Units Sold In Action: Financial Analysis and Variance Analysis 583 Reconciling Variable Costing Budgets and Full Absorption Income Statements 583 Materials Purchases Do Not Equal Materials Used 584 Market Share Variance and Industry Volume Variance 586 Sales Activity Variances with Multiple Products 588 Evaluating Product Mix 588 Evaluating Sales Mix and Sales Quantity 588 In Action: Sales Mix and Financial Reporting 590 Production Mix and Yield Variances 590 Mix and Yield Variances in Manufacturing 590 Variance Analysis in Nonmanufacturing Settings 593 Using the Profit Variance Analysis in Service and Merchandise Organizations 593 Efficiency Measures 593 Mix and Yield Variances in Service Organizations 594 Keeping an Eye on Variances and Standards 595 $ How Many Variances to Calculate 595 When to Investigate Variances 595 Updating Standards 596 The Debrief 596 Summary 597 Key Terms 597 Review Questions 597 Critical Analysis and Discussion Questions 598 Exercises 598 Problems 600 Integrative Case 605 Solutions to Self-Study Questions Nonfinancial and Multiple Measures of Performance 610 Beyond the Accounting Numbers 611 Organizational Environment and Business Strategy 612 Responsibilities According to Level of Organization 612 Business Model 613 Multiple Measures pr a Single Measure of Performance? 614 Balanced Scorecard 615 Continuous Improvement and Benchmarking In Action: Supplier Scorecards at Sun Microsystems 621 In Action: Sources and Uses of Benchmarking Data 622 Performance Measurement for Control 623 Some Common Nonfinancial Performance Measures 623 Customer Satisfaction Performance Measures 623 Functional Performance Measures 624 Nonfinancial Performance and Activity-Based Management 625 Objective and Subjective Performance Measures

12 XXXIV Contents Employee Involvement 626 Difficulties in Implementing Nonfinancial Performance Measurement Systems 627 Fixation on Financial Measures 627 Reliability of Nonfinancial Measures 627 Lack of Correlation between Nonfinancial Measures and Financial Results 627 The Debrief 628 Critical Analysis and Discussion Questions 629 Exercises 630 Problems 631 Integrative Case 635 Solutions to Self-Study Questions 636 APPENDIX Capital Investment Decisions: An Overview A-l GLOSSARY G-l Summary 628 Key Terms 629 Review Questions 629 PHOTO CREDITS INDEX 1-1 C-l

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