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Objectives (Week 1) * Explain the role of budgets and performance reports in the management decision-making process. * Evaluate the role of ethics in accounting decision making. * Evaluate relevant accounting information for business decision making. Highlights to Remember (Ch 1) 1 Describe the major users and uses of accounting information. Internal managers use accounting information for making short-term planning and control decisions, for making non-routine decisions, and for formulating overall policies and long-range plans. External users, such as investors and regulators, use published financial statements to make investment decisions, regulatory rulings, and many other decisions. Managers use accounting information to answer scorekeeping, attention-directing, and problem-solving questions. 2 Explain why ethics is important to management accountants. Integrity is essential to accountants because they provide information that users must trust to be right. Users of accounting information cannot directly assess the quality of that information, and if they cannot rely on accountants to produce unbiased information, the information will have little value to the users. 3 Describe the cost-benefit and behavioral issues involved in designing an accounting system. Companies design management accounting information systems for the benefit of managers. These systems should be judged by a cost-benefit criterion—the benefits of better decisions should exceed the cost of the system. Behavioral factors—how the system affects managers and their decisions—greatly affect the benefit of a system. 4 Explain the role of budgets and performance reports in planning and control. Budgets and performance reports are essential tools for planning and control. Budgets result from the planning process. Managers use them to translate the organization’s goals into action. A performance report compares actual results to the budget. Managers use these reports to monitor, evaluate, and reward performance and, thus, exercise control. 5 Discuss the role accountants play in the company’s value-chain functions. Accountants play a key role in planning and control. Throughout the company’s value chain, accountants gather and report cost and revenue information for decision makers. 6 Contrast the functions of controllers and treasurers. Accountants are staff employees who provide information and advice for line managers. The head of accounting is often called the controller. Unlike the treasurer, who is concerned mainly with financial matters such as raising capital and investing excess funds, the controller measures and reports on operating performance. 7 Explain why accounting is important in a variety of career paths. Accounting skills are useful in many functional areas of an organization. Management accountants often work with managers throughout the company and learn much from them. This exposure makes management accountants prime candidates for promotions to operating and executive positions. 8 Identify current trends in management accounting. Many factors have caused changes in accounting systems in recent years. Most significant are a shift to a service-based economy, increased global competition, advances in technology, and changed business processes. Without continuous adaptation and improvement, accounting systems would soon become obsolete. 9 Appreciate the importance of standards of ethical conduct to professional accountants. Users of accounting information expect both external and internal accountants to adhere to high standards of ethical conduct. Many ethical dilemmas, however, require value judgments, not the simple application of standards. Highlights to Remember (Ch 5) 1 Discriminate between relevant and irrelevant information for making decisions. To be relevant to a particular decision, a cost (or revenue) must meet two criteria: (1) It must be an expected future cost (or revenue), and (2) it must have an element of difference among the alternative courses of action. 2 Apply the decision process to make business decisions. All managers make business decisions based on some decision process. The best processes help decision making by focusing the manager’s attention on relevant information. 3 Construct absorption and contribution-margin income statements, and identify their relevance for decision making. The major difference between the absorption and contribution-margin formats for the income statement is that the contribution-margin format focuses on cost behavior (fixed and variable), whereas the absorption format reports costs by business functions (manufacturing versus nonmanufacturing). The contribution-margin approach makes it easier for managers to evaluate the effects of changes in volume on income and thus is well suited for shorter-run decision making. 4 Decide to accept or reject a special order using the contribution-margin technique. Decisions to accept or reject a special sales order should use the contribution-margin technique and focus on the additional revenues and additional costs of the order. 5 Explain why pricing decisions depend on the characteristics of the market. Market demand and supply, the degree of competition, and marginal revenue and marginal cost concepts impact market price and must be incorporated into any pricing decision. 6 Identify the factors that influence pricing decisions in practice. Market conditions, the law, customers, competitors, and costs influence pricing decisions. The degree that management actions can affect price and cost determines the most effective approach to use for pricing and cost management purposes. 7 Compute a target sales price by various approaches, and compare the advantages and disadvantages of these approaches. Companies use cost-plus pricing for products when management actions can influence the market price. They can add profit markups to a variety of cost bases including variable manufacturing costs, all variable costs, full manufacturing costs, or all costs. The contribution margin approach to pricing has the advantage of providing detailed cost behavior information that is consistent with cost-volume-profit analysis. 8 Use target costing to decide whether to add a new product. When market conditions are such that management cannot influence prices, companies must focus on cost control and reduction. They use target costing primarily for new products, especially during the design phase of the value chain. They deduct a desired target margin from the market-established price to determine the target cost. Cost management then focuses on controlling and reducing costs over the product’s life cycle to achieve that target cost. Highlights to Remember (Ch 6) 1 Use a differential analysis to examine income effects across alternatives, and show that an opportunity cost analysis yields identical results. An incremental analysis is a valuable tool for analyzing decisions; it focuses on the relevant items in the situation. One should always consider opportunity costs when deciding on the use of limited resources. The opportunity cost of a course of action is the maximum profit forgone from other alternative actions. Decision makers may fail to consider opportunity costs because accountants do not report them in the financial accounting system. 2 Decide whether to make or to buy certain parts or products. One of the most important production decisions is the make-or-buy decision. Should a company make its own parts or products or should it buy them from outside sources' Both qualitative and quantitative factors affect this decision. In applying relevant cost analysis to a make-or-buy situation, a key factor to consider is the use of facilities. 3 Choose whether to add or delete a product line using relevant information. Relevant information also plays an important role in decisions about adding or deleting products, services, or departments. Decisions on whether to delete a department or product line require analysis of the revenues forgone and the costs saved from the deletion. 4 Compute the optimal product mix when production is constrained by a scarce resource. When production is constrained by a limiting resource, the key to obtaining the maximum profit from a given capacity is to obtain the greatest possible contribution to profit per unit of the limiting or scarce resource. 5 Decide whether a joint product should be processed beyond the split-off point. Another typical production situation is deciding whether to process further a joint product or sell it at the split-off point. The relevant information for this decision includes the costs that differ beyond the split-off point. Joint costs that occur before split-off are irrelevant. 6 Decide whether to keep or replace equipment. In the decision to keep or replace equipment, the book value of old equipment is irrelevant. This sunk cost is a past or historical cost that a company has already incurred. Relevant costs normally include the disposal value of old equipment, the cost of new equipment, and the difference in the annual operating costs. 7 Identify irrelevant and misspecified costs. In certain production decisions, it is important to recognize and identify irrelevant costs. In the decision to dispose of obsolete inventory, the original cost of the inventory is irrelevant because there is no way to restore the resources used to buy or produce the inventory. Unit fixed costs can be misleading because of the differences in the assumed level of volume on which they are based. The more units a company makes, the lower the unit fixed cost will be. If a salesperson assumes a company will produce 100,000 units and it actually produces only 30,000 units, the unit costs will be understated. You can avoid being misled by unit costs by always using total fixed costs. 8 Discuss how performance measures can affect decision making. If companies evaluate managers using performance measures that are not in line with relevant decision criteria, there could be a conflict of interest. Managers often make decisions based on how the decision affects their performance measures. Thus, performance measures work best when they are consistent with the long-term good of the company. Objectives (Week 2) * Apply the concepts, techniques, and conventions of basic financial accounting. * Identify how measurement conventions affect financial reporting. Determine the relationships between the elements of the four financial statements. Highlights to Remember (Ch 15) 1 Read and interpret basic financial statements. An underlying structure of concepts, techniques, and conventions provides a basis for accounting practice. We present two basic financial statements, the balance sheet (or statement of financial position) and income statement, in this chapter. Their main elements are assets, liabilities, owners’ equity, revenues, and expenses. Income statements and balance sheets are linked because the revenues and expenses appearing on income statements are components of stockholders’ equity. Revenues increase stockholders’ equity, and expenses decrease stockholders’ equity. 2 Analyze typical business transactions using the balance sheet equation. The balance sheet equation provides a framework for recording accounting transactions: assets = liabilities + owners’ equity. 3 Distinguish between the accrual basis of accounting and the cash basis of accounting. The accrual basis is the heart of accounting. Under accrual accounting, companies recognize revenues as they earn and realize them, and they record expenses as they use resources, not necessarily when they receive or pay cash. Do not confuse expense with the term cash payment, or revenue with the term cash receipt. 4 Relate the measurement of expenses to the expiration of assets. At the end of each accounting period, companies must make adjustments so that they can present financial statements on a full-fledged accrual basis. The major adjustments are for (a) expiration of unexpired costs, (b) recognition (earning) of unearned revenues, (c) accrual of unrecorded expenses, and (d) accrual of unrecorded revenues. 5 Explain the nature of dividends and retained earnings. Dividends are not expenses; they are distributions of assets that reduce ownership claims. Similarly, retained earnings is not cash; it is a claim against total assets. 6 Select relevant items from a set of data and assemble them into a balance sheet and an income statement. After a company records transactions and makes adjustments, it can compile the data into financial statements. The remaining balances in the accounts comprise the balance sheet. The changes in the retained earnings account form the basis for the income statement. The changes in retained earnings link the income statement with the balance sheet. 7 Distinguish between the reporting of corporate owners’ equity and the reporting of owners’ equity for partnerships and sole proprietorships. Entities can be organized as corporations, partnerships, or sole proprietorships. The type of organization does not affect most accounting entries. Only the owners’ equity section will differ among organizational types. 8 Identify how the measurement conventions of recognition, matching and cost recovery, and stable monetary unit affect financial reporting. Three major conventions that affect accounting are recognition, matching and cost recovery, and stable monetary unit. Recognition determines when companies record revenues in the income statement, matching and cost recovery specify when to record expenses, and stable monetary units justify use of a unit of currency (the dollar in the United States) to measure accounting transactions. Highlights to Remember (Ch 16) 1 Recognize and define the main types of assets in the balance sheet of a corporation. Assets are divided into current and noncurrent categories. Common current assets are cash, accounts receivable, inventories, and prepaid expenses. The largest noncurrent (or fixed) asset is generally property, plant, and equipment, which accountants list at acquisition cost less accumulated depreciation. 2 Recognize and define the main types of liabilities in the balance sheet of a corporation. Liabilities are divided into current liabilities and long-term liabilities. Current liabilities include notes payable and accounts payable. Long-term debt in the form of debentures or mortgages is the most common noncurrent liability. 3 Recognize and define the main elements of the stockholders’ equity section of the balance sheet of a corporation. Stockholders’ equity contains paid-in capital and retained earnings. Paid-in capital is often divided into a par value amount and an amount in excess of par value. 4 Recognize and define the principal elements in the income statement of a corporation. Income statements contain revenues and expenses. Multistep income statements have some of the following subtotals: gross profit (gross margin), operating income, and income before income taxes. 5 Recognize and define the elements that cause a change in retained earnings. Net income increases retained earnings and losses and dividends decrease them. For large profitable companies, retained earnings may be by far the largest component of stockholders’ equity. 6 Identify activities that affect cash, and classify them as operating, investing, or financing activities. The statement of cash flows lists cash inflows and cash outflows in one of three categories. Operating cash flows include collections from customers and payments to suppliers. Investing cash flows include purchases and sales of fixed assets. Financing cash flows include borrowings and repayment of borrowings, sales of shares of stock, and payment of dividends. Objectives (Week 3) * Evaluate how cost behavior affects selection of cost drivers and management decisions. * Analyze the cost-volume-profit relationships to predict effects of changes in sales or costs, including the break-even sales volume. * Compare and contrast the different methods of measuring cost functions. Explain how cost accounting systems are used to determine the cost of a product, service, customer, or other cost objective. Highlights to Remember (Ch 2) 1 Explain how cost drivers affect cost behavior. A cost driver is an output measure that causes the use of costly resources. When the level of an activity changes, the level of the cost driver or output measure will also change, causing changes in costs. 2 Show how changes in cost-driver levels affect variable and fixed costs. Different types of costs behave in different ways. If the cost of the resource used changes in proportion to changes in the cost driver level, the resource is a variable-cost resource (its costs are variable). If the cost of the resource used does not change because of cost-driver level changes, the resource is a fixed-cost resource (its costs are fixed). 3 Calculate break-even sales volume in total dollars and total units. We can approach CVP analysis (sometimes called break-even analysis) graphically or with equations. To calculate the break-even point in total units, divide the fixed costs by the unit contribution margin. To calculate the break-even point in total dollars (sales dollars), divide the fixed costs by the contribution-margin ratio. Highlights to Remember (Ch 3) 1 Explain step- and mixed-cost behavior. Cost behavior refers to how costs change as levels of an organization’s activities change. Costs can behave as fixed, variable, step, or mixed costs. Step and mixed costs both combine aspects of variable- and fixed-cost behavior. Step costs form graphs that look like steps. Costs will remain fixed within a given range of activity or cost-driver level, but then will rise or fall abruptly when the cost-driver level is outside this range. Mixed costs involve a fixed element and a variable element of cost behavior. Unlike step costs, mixed costs have a single fixed cost at all levels of activity, and in addition have a variable cost element that increases proportionately with activity. 2 Explain management influences on cost behavior. Managers can affect the costs and cost behavior patterns of their companies through the decisions they make. Decisions on product and service features, capacity, technology, and cost-control incentives, for example, can all affect cost behavior. 3 Measure and mathematically express cost functions and use them to predict costs. The first step in estimating or predicting costs is measuring cost behavior. This is done by finding a cost function. This is an algebraic equation that describes the relationship between a cost and its cost driver(s). To be useful for decision-making purposes, cost functions should be plausible and reliable. 4 Describe the importance of activity analysis for measuring cost functions. Activity analysis is the process of identifying the best cost drivers to use for cost estimation and prediction and determining how they affect the costs of making a product or service. This is an essential step in understanding and predicting costs. 5 Measure cost behavior using the engineering analysis, account analysis, high-low, visual-fit, and least-squares regression methods. Once analysts have identified cost drivers, they can use one of several methods to determine the cost function. Engineering analysis focuses on what costs should be by systematically reviewing the materials, supplies, labor, support services, and facilities needed for a given level of production. Account analysis involves examining all accounts in terms of an appropriate cost driver and classifying each account as either fixed or variable with respect to the driver. The cost function consists of the variable cost per cost-driver unit multiplied by the amount of the cost driver plus the total fixed cost. The high-low, visual-fit, and least-squares methods all use historical data to determine cost functions. Of these three methods, high-low is the easiest, although least-squares is the most reliable. Highlights to Remember (Ch 4) 1 Describe the purposes of cost management systems. Cost management systems provide cost information for external financial reporting, for strategic decision making, and for operational cost control. 2 Explain the relationship among cost, cost object, cost accumulation, and cost assignment. Cost accounting systems provide cost information about various types of objects—products, customers, activities, and so on. To do this, a system first accumulates resource costs by natural classifications, such as materials, labor, and energy. Then, it assigns these costs to cost objects, either tracing them directly or assigning them indirectly through allocation. 3 Distinguish between direct and indirect costs. Accountants can specifically and exclusively identify direct costs with a cost object in an economically feasible way. When this is not possible, accountants may allocate costs to cost objects using a cost driver. Such costs are called indirect costs. The greater the proportion of direct costs, the greater the accuracy of the cost system. When the GPK AND ABC: SUPPORT FOR SHORT-TERM AND LONG-TERM DECISIONS 4 Explain the major reasons for allocating costs. The four main purposes of cost allocation are to predict the economic effects of planning and control decisions, to motivate managers and employees, to measure the costs of inventory and cost of goods sold, and to justify costs for pricing or reimbursement. Some costs are unallocated because the accountants can determine no plausible and reliable relationship between resource costs and cost objects. 5 Identify the main types of manufacturing costs: direct materials, direct labor, and indirect production costs. The main types of manufacturing costs are direct materials, direct labor, and indirect production costs. Accountants can trace direct materials and direct labor to most cost objects, and they allocate the indirect production costs using a cost allocation base. 6 Explain how the financial statements of merchandisers and manufacturers differ because of the types of goods they sell. The primary difference between the financial statements of a merchandiser and a manufacturer is the reporting of inventories. A merchandiser has only one type of inventory whereas a manufacturer has three types of inventory—raw materials, work-in-process, and finished goods. 7 Understand the main differences between traditional and activity-based costing systems and why ABC systems provide value to managers. Traditional systems usually allocate only the indirect costs of the production function. ABC systems allocate many (and sometimes all) of the costs of the value-chain functions. Traditional costing accumulates costs using categories such as direct material, direct labor, and production overhead. ABC systems accumulate costs by activities required to produce a product or service. The key value of ABC systems is in their increased costing accuracy and better information provided that can lead to process improvements. 8 Use activity-based management (ABM) to make strategic and operational control decisions. Activity-based management is using ABC information to improve operations. A key advantage of an activity-based costing system is its ability to aid managers in decision making. ABC improves the accuracy of cost estimates, including product and customer costs and the costs of value-added versus non-value- added activities. ABC also improves managers’ understanding of operations. Managers can focus their attention on making strategic decisions, such as product mix, pricing, and process improvements. 9 Describe the steps in designing an activity-based costing system (Appendix 4). Designing and implementing an activity-based costing system involves four steps. First, managers determine the cost objects, key activities, and resources used, and they identify cost drivers (output measures) for each resource and activity. Second, they determine the relationship among cost objects, activities, and resources. The third step is collecting cost and operating data. The last step is to calculate and interpret the new activity based information. Often, this last step requires the use of a computer due to the complexity of many ABC systems. Objectives (Week 4) * Explain the major components, advantages, and disadvantages of a master budget. * Assess the risks associated with sales forecasting. Construct an activity-based flexible budget. Highlights to Remember (Ch 7) 1 Explain how budgets facilitate planning and coordination. A budget expresses, in quantitative terms, an organization’s objectives and possible steps for achieving them. Thus, a budget is a tool that helps managers in both their planning and control functions. Budgets provide a mechanism for communication between units and across levels of the organization. In an environment that encourages open communication of the opportunities and challenges facing the organization, the budget process allows managers to coordinate ongoing activities and plan for the future. 2 Anticipate possible human relations problems caused by budgets. The success of a budget depends heavily on employee reaction to it. Negative attitudes toward budgets often prevent realization of many of the potential benefits. Such attitudes are usually caused by managers who use budgets only to limit spending or to punish employees. Budgets generally are more useful when all affected parties participate in their preparation. 3 Explain potentially dysfunctional incentives in the budget process. When managers want to increase the resources allocated to their unit or when managers are evaluated based on performance relative to budgeted amounts, there are incentives to bias the information that goes into their budgets. When managers are compensated using typical bonus schemes, there may be pressure to report inflated results and incentives to make short-run decisions that are not in the best long-run interests of the organization. Not only do such incentives lead managers to make poor decisions, they undercut efforts to maintain high ethical standards in the organization. 4 Explain the difficulties of sales forecasting. Sales forecasting combines various techniques as well as opinions of sales staff and management. Sales forecasters must consider many factors such as past patterns of sales, economic conditions, and competitors’ actions. Sales forecasting is difficult because of its complexity and the rapid changes in the business environment in which most companies operate. 5 Explain the major features and advantages of a master budget. The two major parts of a master budget are the operating budget and the financial budget. Advantages of budgets include formalization of planning, providing a framework for judging performance, and aiding managers in communicating and coordinating their efforts. 6 Follow the principal steps in preparing a master budget. Master budgets typically cover relatively short periods—usually one month to one year. The steps involved in preparing the master budget vary across organizations but follow the general outline given on pages 307–308. Invariably, the first step is to forecast sales or service levels. The next step should be to forecast cost-driver activity levels, given expected sales and service. Using these forecasts and knowledge of cost behavior, collection patterns, and so on, managers can prepare the operating and financing budgets. 7 Prepare the operating budget and the supporting schedules. The operating budget includes the income statement for the budget period. Managers prepare it using the following supporting schedules: sales budget, purchases budget, and operating expense budget. 8 Prepare the financial budget. The second major part of the master budget is the financial budget. The financial budget consists of a cash budget, capital budget, and a budgeted balance sheet. Managers prepare the cash budget from the following supporting schedules: cash collections, disbursements for purchases, disbursements for operating expenses, and other disbursements. Highlights to Remember (Ch 8) 1 Distinguish between flexible budgets and static budgets. Flexible budgets are geared to changing levels of cost-driver activity rather than to the single level of the static budget. Organizations tailor flexible budgets to particular levels of sales or cost-driver activity—before or after the fact. Flexible budgets tell how much revenue and cost to expect for any level of activity. 2 Use flexible-budget formulas to construct a flexible budget based on the volume of sales. Cost functions, or flexible-budget formulas, reflect fixed- and variable-cost behavior and allow managers to compute budgets for any output or cost-driver activity level. We compute the flexible-budget amounts for variable costs by multiplying the variable cost per cost-driver unit times the level of activity, as measured in cost-driver units. The flexible-budgeted fixed cost is a lump sum, independent of the level of activity (within the relevant range). 3 Prepare an activity-based flexible budget. When a significant portion of operating costs varies with cost drivers other than units of production, a company benefits from using activity-based flexible budgets. These budgets are based on budgeted costs for each activity and related cost driver. 4 Explain the performance evaluation relationship between static budgets, flexible budgets, and actual results. The differences or variances between the static budget and the flexible budget are due to activity levels, not cost control. We call these variances activity-level variances. The variances between the flexible budget and actual results are called flexible-budget variances. 5 Compute activity-level variances and flexible-budget variances. The flexible-budget variance is the difference between the actual result and the corresponding flexible-budget amount. The activitylevel variance is the difference between the static budget and the corresponding flexible budget amount. 6 Compute and interpret price and quantity variances for inputs based on cost-driver activity. Managers often want to subdivide flexible-budget variances for variable inputs into price (or rate or spending) and quantity (or usage or efficiency) variances. Price variances reflect the effects of changing input prices, holding inputs constant at actual input use. Quantity variances reflect the effects of different levels of input usage, holding prices constant at expected prices. 7 Compute variable overhead spending and efficiency variances. The variable-overhead spending variance is the difference between the actual variable overhead and the amount of variable overhead budgeted for the actual level of cost-driver activity. The variable-overhead efficiency variance is the difference between the actual cost-driver activity and the amount of cost-driver activity allowed for the actual output achieved, costed at the standard variable-overhead rate. 8 Compute the fixed overhead spending variance. The fixed overhead spending variance is the difference between the actual fixed overhead expenditures and the budgeted amount of fixed overhead. Objectives (Week 5) * Explain the methods of cost allocation. * Analyze how factory overhead is applied to products. * Compare and contrast uses of variable and absorption costing. Highlights to Remember (Ch 12) 1 Describe the general framework for cost allocation. Direct and indirect costs are assigned to various cost objects including service departments, producing departments, products, and customers. All organizations allocate indirect costs to producing departments and to the products or services delivered to customers. These allocations often include the costs of service departments. Some organizations carry cost allocation one more step—to customers. 2 Allocate the variable and fixed costs of service departments to other organizational units. Companies should use the dual method of allocation for service department costs. They should allocate variable costs using budgeted cost rates times the actual cost-driver level. They should allocate fixed costs using budgeted percent of capacity available for use times the total budgeted fixed costs. 3 Use the direct and step-down methods to allocate service department costs to user departments. When service departments support other service departments in addition to producing departments, there are two methods for allocation. The direct method ignores other service departments when allocating costs. The step-down method recognizes other service departments’ use of services. 4 Integrate service department allocation systems with traditional and ABC systems to allocate total systems costs to product or service cost objects. When a company’s products or services are the cost object, it should integrate its service department allocation with the allocation system used to cost final cost objects. The text discusses two approaches that companies frequently use: the traditional and ABC approaches. The ABC approach provides more accurate estimates of product or service costs than the traditional approach but is more costly to maintain. 5 Allocate costs associated with customer actions to customers. Customer profitability is a function of product mix and the cost to serve. Activities that can drive up the costs to serve customers include small order quantities, pre-sales work, order changes, returns, special delivery requirements, and post-sales work. Highlights to Remember (Ch 13) 1 Compute budgeted factory-overhead rates and apply factory overhead to production. Accountants usually apply indirect manufacturing costs (factory overhead) to products using budgeted overhead rates. They compute the rates by dividing total budgeted overhead by a measure of cost-allocation base activity such as expected machine hours. 2 Determine and use appropriate cost-allocation bases for overhead application to products and services. There should be a strong cause-and-effect relationship between cost-allocation bases and the overhead costs that are applied using these bases. 3 Identify the meaning and purpose of normalized overhead rates. Budgeted overhead rates are usually annual averages. The resulting product costs are normal costs, consisting of actual direct materials plus actual direct labor plus applied overhead using the budgeted rates. Normal product costs are often more useful than true actual costs for decision-making and inventory-costing purposes. 4 Construct an income statement using the variable-costing approach. Two major methods of product costing are variable (contribution approach) and absorption costing. The variable-costing method emphasizes the effects of cost behavior on income. This method excludes fixed manufacturing overhead from the cost of products and expenses it immediately. 5 Construct an income statement using the absorption-costing approach. The absorption or traditional approach ignores cost behavior distinctions. As a result, all costs incurred in the production of goods become part of the inventory cost. Thus, we add fixed manufacturing overhead to inventory and it appears on the income statement only when the company sells the goods. 6 Compute the production-volume variance and show how it should appear in the income statement. Whenever a company employs the absorption method and the actual production volume does not equal the expected (budgeted) volume that it uses for computing the fixed-overhead rate, a production-volume variance arises. When the actual volume is less than budgeted, the variance is unfavorable and the amount is equal to the fixed-overhead rate times the difference between the budgeted and actual volume. The opposite is true when actual production volume exceeds budgeted production volume; that is, a favorable volume variance arises. Both types of variances are usually adjustments to the current period income. Favorable variances increase current-period income and unfavorable variances reduce current-period income. 7 Explain why a company might prefer to use a variable-costing approach. Companies that use operating income to measure results usually prefer variable costing. This is because changes in production volume affect absorption-costing income but not variable-costing income. A company that wants to focus managers’ energies on sales would prefer to use variable costing, since the level of sales is the primary driver of variable-costing income. Objectives (Week 6) * Evaluate how managers use control systems to achieve organizational goals. Compute return on investment, residual income, and economic value added. Highlights to Remember (Ch 9) 1 Describe the relationship of management control systems to organizational goals. The starting point for designing and evaluating a management control system is the identification of organizational goals as specified by top management. 2 Use responsibility accounting to define an organizational subunit as a cost center, a profit center, or an investment center. Responsibility accounting assigns revenue and cost objectives to the management of the subunit that has the greatest influence over them. Cost centers focus on costs only, profit centers on both revenues and costs, and investment centers on profits relative to the amount invested. 3 Develop performance measures and use them to monitor the achievements of an organization. A well-designed management control system measures both financial and nonfinancial performance. Superior nonfinancial performance usually leads to superior financial performance in time. The performance measures should tell managers how well they are meeting the organization’s goals. 4 Explain the importance of evaluating performance and describe how it impacts motivation, goal congruence, and employee effort. The way an organization measures and evaluates performance affects individuals’ behavior. The more that it ties rewards to performance measures, the more incentive there is to improve the measures. Poorly designed measures may actually work against the organization’s goals. 5 Prepare segment income statements for evaluating profit and investment centers using the contribution margin and controllable-cost concepts. The contribution approach to measuring a segment’s income aids performance evaluation by separating a segment’s costs into those controllable by the segment management and those beyond management’s control. It allows separate evaluation of a segment as an economic investment and the performance of the segment’s manager. 6 Use a balanced scorecard to recognize both financial and nonfinancial measures of performance. The balanced scorecard helps managers monitor actions that are designed to meet the various goals of the organization. It contains key performance indicators that measure how well the organization is meeting its goals. 7 Measure performance against quality, cycle time, and productivity objectives. Measuring performance in areas such as quality, cycle time, and productivity causes employees to direct attention to those areas. Achieving goals in these nonfinancial measures can help meet long-run financial objectives. 8 Describe the difficulties of management control in service and nonprofit organizations. Management control in service and nonprofit organizations is difficult because of a number of factors, chief of which is a relative lack of clearly observable outcomes. Highlights to Remember (Ch 10) 1 Define decentralization and identify its expected benefits and costs. As companies grow, the ability of managers to effectively plan and control becomes more difficult because top managers are further removed from day-to-day operations. One approach to effective planning and control in large companies is to decentralize decision making. This means that top management gives mid- and lower-level managers the freedom to make decisions that impact the subunit’s performance. The more that decision making is delegated, the greater the decentralization. Often, the subunit manager is most knowledgeable of the factors that management should consider in the decision-making process. 2 Distinguish between responsibility centers and decentralization. Top management must design the management control system so that it motivates managers to act in the best interests of the company. This is done through the choice of responsibility centers and the appropriate performance metrics and rewards. The degree of decentralization does not depend upon the type of responsibility center chosen. For example, a cost-center manager in one company may have more decision-making authority than does a profit-center manager in a highly centralized company. 3 Explain how the linking of rewards to responsibility-center performance metrics affects incentives and risk. It is generally a good idea to link managers’ rewards to responsibility-center results. Top management should use performance metrics for the responsibility center that promote goal congruence. However, linking rewards to results creates risk for the manager. The greater the influence of uncontrollable factors on a manager’s reward, the more risk the manager bears. 4 Compute ROI, economic profit, and economic value added (EVA) and contrast them as criteria for judging the performance of organization segments. It is typical to measure the results of investment centers using a set of performance metrics that include financial measures, such as return on investment (ROI), economic profit, or economic value added (EVA). ROI is any income measure divided by the dollar amount invested and is expressed as a percentage. Economic profit, or economic value added, is operating income less a capital charge based on the capital invested (cost of capital). It is an absolute dollar amount. 5 Compare the advantages and disadvantages of various bases for measuring the invested capital used by organization segments. The way an organization measures invested capital determines the precise motivation provided by ROI, economic profit, or EVA. Managers will try to reduce assets or increase liabilities that a company includes in their division’s investment base. They will adopt more conservative asset replacement policies if the company uses net book value rather than gross book value in measuring the assets. 6 Define transfer prices and identify their purpose. In large companies with many different segments, one segment often provides products or services to another segment. Deciding on the amount the selling division should charge the buying division for these transfers (the transfer price) is difficult. Companies use various types of transfer pricing policies. The overall purpose of transfer prices is to motivate managers to act in the best interests of the company, not just the segment. 7 State the general rule for transfer pricing and use it to assess transfer prices based on total costs, variable costs, and market prices. As a general rule, transfer prices should approximate the outlay cost plus opportunity cost of the producing segment. Each type of transfer price has its own advantages and disadvantages. Each has a situation where it works best, and each can lead to dysfunctional decisions in some instances. Cost-based prices are readily available, but if a company uses actual costs, the receiving segment manager does not know the cost in advance, which makes cost planning difficult. When a competitive market exists for the product or service, using market-based transfer prices usually leads to goal congruence and optimal decisions. When idle capacity exists in the segment providing the product or service, the use of variable cost as the transfer price usually leads to goal congruence. 8 Identify the factors affecting multinational transfer prices. Multinational organizations often use transfer prices as a means of minimizing worldwide income taxes, import duties, and tariffs. 9 Explain how controllability and management by objectives (MBO) aid the implementation of management control systems. Regardless of what measures a management control system uses, when used to evaluate managers, measures should focus on only the controllable aspects of performance. MBO can focus attention on performance compared to expectations, which is better than evaluations based on absolute profitability. Misuse of budgets and performance metrics can motivate managers to violate ethical standards.