Cost Accounting Tranidtions and Innovations by Raiborn 4th Edition

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1 Introduction to Cost and Management Accounting in a Global Business Environment CHAPTER LEARNING OBJECTIVES After completing this chapter you should be able to answer the following questions: 1 How do financial and management accounting relate to each other 2 How does cost accounting relate to financial and management accounting 3 What is the role of a code of ethics in guiding the behaviors of an organization’s global workforce 4 What factors have influenced the globalization of businesses and why have these factors been significant 5 What are the primary factors and constraints that influence an organization’s strategy and why are these factors important 6 How does an organization’s competitive environment impact its strategy and how might an organization respond to competition 7 How does the accounting function impact an organization’s ability to successfully achieve its strategic goals and objectives 8 Why is a company segment’s mission affected by product life cycle 9 What is the value chain and why is it important in managing a business

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ABN AMRO Bank INTRODUCING he Netherlands-based bank ABN AMRO was formed in 1990 when Algemene Bank Nederland merged with Amsterdam-Rotterdam Bank. Following the merger ABN AMRO has established itself as a global bank with operations in 76 countries and territories including the United States where the bank has a 16 share of the Midwest market. ABN AMRO’s global expansion was driven initially by mergers but more recently by innovative web- based delivery of products and services. By traditional measures such as its 505 billion in as- sets and its capital position ABN AMRO is the largest bank in Holland the fourth largest in Europe and the eighth largest in the world. ABN AMRO’s core lending business is solid. Over half of ABN AMRO’s revenues come from Dutch clients—a very stable source of business that includes such companies as Royal Dutch Shell Philips Electronics and Unilever. ABN AMRO formulated an identity statement in 1992 to reflect its corporate aspirations: “ABN AMRO Bank is a long-established solid multi-faceted bank of international reputation and standing. We will strive to fulfill the bank’s ambition in being a frontrunner in value-added banking both on a local and worldwide level. . . .” The corporate values statement was formalized in 1997 although the values have been important priorities since the bank was established in the 1800s. The four values forming the basis of the bank’s activities are integrity teamwork respect and professionalism. Bank managers believe that the values need to be formalized even though they are and should be self-evident. The formalization provides external parties criteria by which the bank can be assessed. ABN AMRO perceives its corporate identity and values as the underlying tenets of the organization. ABN AMRO is successfully pursuing a corporate identity as a “bank of international reputation and standing.” ABN AMRO was ranked as the fifth largest commercial and savings bank and the seventy-third largest corporation in the 1999 Fortune Global 500. The corporation with its foreign subsidiaries and affiliates is com- prised of over 3500 branches and offices in 76 countries and territories across five continents. Although international trade was once confined to extremely large cor- porations such as ABN AMRO the explosion of World Wide Web usage has en- abled any business with the right infrastructure capabilities and the necessary funds for Web site development to market its products and services around the world. Organizations operating globally face three primary challenges. First managers must understand factors influencing international business markets so they can iden- tify locations in which the company has the strengths and desire to compete. Sec- ond managers must devise a long-term plan to achieve organizational goals. Third the company must devise information systems that keep operations consistent with its plans and goals. This chapter introduces cost accounting and describes the global environment of business international market structures trade agreements e-commerce and legal and ethical considerations. It addresses the importance of strategic planning and links strategy creation and implementation to the accounting information system. The chapter discussion applies equally well to large and small profit-seeking businesses and most discussion is appropriate for not-for-profit and governmental entities. SOURCE: Chris Costanzo “ABN AMRO Says Web Will Anchor Its Expansion” American Banker December 9 1999 p. 16. 3 T INTRODUCTION TO COST ACCOUNTING To manage a diverse international banking organization ABN AMRO’s leaders need monetary and nonmonetary information that helps them to analyze and solve

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problems by reducing uncertainty. Accounting often referred to as the language of business provides much of that necessary information. Accounting language has two primary “variations”: financial accounting and management accounting. Cost accounting is a bridge between financial and management accounting. Accounting information addresses three different functions: 1 providing infor- mation to external parties stockholders creditors and various regulatory bodies for investment and credit decisions 2 estimating the cost of products produced and services provided by the organization and 3 providing information useful to internal managers who are responsible for planning controlling decision making and evaluating performance. Financial accounting is designed to meet external in- formation needs and to comply with generally accepted accounting principles. Man- agement accounting attempts to satisfy internal information needs and to provide product costing information for external financial statements. The primary differ- ences between these two accounting disciplines are given in Exhibit 1–1. Financial accounting must comply with the generally accepted accounting prin- ciples currently established by the Financial Accounting Standards Board FASB a private-sector body. The information used in financial accounting is typically historical quantifiable monetary and verifiable. These characteristics are essential to the uniformity and consistency needed for external financial statements. Finan- cial accounting information is usually quite aggregated and related to the organi- zation as a whole. In some cases a regulatory agency such as the Securities and Exchange Commission SEC or an industry commission such as banking or in- surance may mandate financial accounting practices. In other cases financial ac- counting information is required for obtaining loans preparing tax returns and un- derstanding how well or poorly the business is performing. By comparison management accounting provides information for internal users. Because managers are often concerned with individual parts or segments of the business rather than the whole organization management accounting information commonly addresses such individualized concerns rather than the “big picture” of financial accounting. Management accounting is not required to adhere to gener- ally accepted accounting principles in providing information for managers’ inter- nal purposes. It is however expected to be flexible in serving management’s needs Part 1 Overview 4 Financial Accounting Management Accounting Primary users External Internal Primary organizational focus Whole aggregated Parts segmented Information characteristics Must be May be • Historical • Current or forecasted • Quantitative • Quantitative or qualitative • Monetary • Monetary or nonmonetary • Verifiable • Timely and at a minimum reasonably estimated Overriding criteria Generally accepted Situational relevance accounting principles usefulness Consistency Benefits in excess of costs Verifiability Flexibility Recordkeeping Formal Combination of formal and informal EXHIBIT 1–1 Financial and Management Accounting Differences

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and to be useful to managers’ functions. A related criterion is that information should be developed and provided only if the cost of producing that information is less than the benefit of having it. This is known as cost-benefit analysis. These two criteria though must be combined with the financial accounting information criteria of verifiability uniformity and consistency because all accounting docu- ments and information whether internal or external must be grounded in reality rather than whim. The objectives and nature of financial and management accounting differ but all accounting information tends to rely on the same basic data system and set of accounts. The accounting system provides management with a means by which costs are accumulated from input of materials through the production process un- til completion and ultimately to cost of goods sold. Although technology has im- proved to the point that a company can have different accounting systems de- signed for different purposes some companies still rely on a single system to supply the basic accounting information. The single system typically focuses on providing information for financial accounting purposes but its informational output can be adapted to meet most internal management requirements. Relationship of Financial and Management Accounting to Cost Accounting Cost accounting is defined as “a technique or method for determining the cost of a project process or thing. . . . This cost is determined by direct measurement arbitrary assignment or systematic and rational allocation.” 1 The appropriate method of determining cost depends on the circumstances that generate the need for in- formation. Various costing methods are illustrated throughout the text. Central to a cost accounting system is the process for tracing various input costs to an organization’s outputs products or services. This process uses the traditional accounting form of recordkeeping—general and subsidiary ledger accounts. Accounts containing cost and management accounting information include those dealing with sales procurement materials and plant assets production and inventory person- nel payroll delivery financing and funds management. 2 Not all cost information is Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 5 How do financial and management accounting relate to each other 1 How does cost accounting relate to financial and management accounting cost accounting 2 1 Institute of Management Accountants formerly National Association of Accountants Statements on Management Accounting Number 2: Management Accounting Terminology Montvale N.J.: NAA June 1 1983 p. 25. 2 With reference to accounts this text will focus primarily on the set of accounts that depicts the internal flow of costs. This manufacturer of televisions must use cost accounting tech- niques to determine financial statement valuations for product inventory and cost of goods sold.

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reproduced on the financial statements however. Correspondingly not all financial accounting information is useful to managers in performing their daily functions. Cost accounting creates an overlap between financial accounting and man- agement accounting. Cost accounting integrates with financial accounting by pro- viding product costing information for financial statements and with management accounting by providing some of the quantitative cost-based information managers need to perform their tasks. Exhibit 1–2 depicts the relationship of cost account- ing to the larger systems of financial and management accounting. None of the three areas should be viewed as a separate and exclusive “type” of accounting. The boundaries of each are not clearly and definitively drawn and because of changing technology and information needs are becoming increasingly blurred. Part 1 Overview 6 EXHIBIT 1–2 Accounting Information System Components and Relationships Cost provides information for inventory and cost of goods sold or cost of services rendered for the financial statements Flows into For use by Financial Accounting provides information for periodic financial statements Monetary information Management Accounting provides information for internal management AIS output to be combined with other external information by managers to use in Decision making Planning Controlling Evaluating performance External parties including shareholders Internal accountants Management Internal accountants gather data for Analysis Nonmonetary information 1 23 4 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33

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The cost accounting overlap causes the financial and management accounting systems to articulate or be joined together to form an informational network. Be- cause these two systems articulate accountants must understand how cost ac- counting provides costs for financial statements and supports management infor- mation needs. Organizations that do not manufacture products may not require elaborate cost accounting systems. However even service companies need to un- derstand how much their services cost so that they can determine whether it is cost-effective to be engaged in particular business activities. Management and Cost Accounting Standards Management accountants can use different costs and different information for dif- ferent purposes because their discipline is not required to adhere to generally ac- cepted accounting principles when providing information for managers’ internal use. In the United States financial accounting standards are established by the Fi- nancial Accounting Standards Board FASB a private-sector body. No similar board exists to define universal management accounting standards. However a public- sector board called the Cost Accounting Standards Board CASB was established in 1970 by the U.S. Congress to promulgate uniform cost accounting standards for defense contractors and federal agencies. The CASB produced 20 cost accounting standards of which one has been withdrawn from its inception until it was terminated in 1980. The CASB was recre- ated in 1988 as an independent board of the Office of Federal Procurement Pol- icy. The board’s objectives are to • Increase the degree of uniformity in cost accounting practices among govern- ment contractors in like circumstances • Establish consistency in cost accounting practices in like circumstances by each individual contractor over time and • Require contractors to disclose their cost accounting practices in writing. 3 Although CASB standards do not constitute a comprehensive set of rules compliance is required for companies bidding on or pricing cost-related contracts for the federal government. An organization important to the practice of management and cost accounting is the Institute of Management Accountants or the IMA. The IMA is a voluntary membership organization of accountants finance specialists academics and oth- ers. It sponsors two major certification programs: Certified Management Accoun- tant CMA and Certified in Financial Management CFM. The IMA also issues direc- tives on the practice of management and cost accounting called Statements on Management Accounting or SMAs. The SMAs unlike the pronouncements of the CASB are not legally binding standards but they undergo a rigorous develop- mental and exposure process that ensures their wide support. An organization similar to the IMA is the Society of Management Accountants of Canada which also issues guidelines on the practice of management account- ing. These Management Accounting Guidelines MAGs like the SMAs are not re- quirements for organizational accounting but are merely suggestions. Although the IMA Cost Accounting Standards Board and Society of Manage- ment Accountants of Canada have been instrumental in standards development much of the body of knowledge and practice in management accounting has been provided by industry practice and economic and finance theory. Thus no “official” agency publishes generic management accounting standards for all companies but there is wide acceptance of and therefore authority for the methods presented in the text. The development of cost and management accounting standards and Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 7 3 Robert B. Hubbard “Return of the Cost Accounting Standards Board” Management Accounting October 1990 p. 56.

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practices indicates that management accountants are interested and involved in pro- fessional recognition. Another indication of this movement is the adoption of ethics codes by both the IMA and the various provincial societies in Canada. Ethics for Management Accountant Professionals Because of the pervasive nature of management accounting and the organizational level at which many management accountants work the IMA believed that some guidelines were necessary to help its members with ethical dilemmas. Thus State- ment on Management Accounting 1C Standards of Ethical Conduct for Manage- ment Accountants was adopted in June 1983. These standards are in the areas of competence confidentiality integrity and objectivity. The IMA Code of Ethics is reproduced in Exhibit 1–3. Part 1 Overview 8 What is the role of a code of ethics in guiding the behaviors of an organization’s global workforce 3 COMPETENCE Practitioners of management accounting and financial management have responsibility to: • Maintain an appropriate level of professional competence by ongoing development of their knowledge and skills. • Perform their professional duties in accordance with relevant laws regulations and technical standards. • Prepare complete and clear reports and recommendations after appropriate analyses of relevant and reliable information. CONFIDENTIALITY Practitioners of management accounting and financial management have responsibility to: • Refrain from disclosing confidential information acquired in the course of their work except when authorized unless legally obligated to do so. • Inform subordinates as appropriate regarding the confidentiality of information acquired in the course of their work and monitor their activities to assure the maintenance of that confidentiality. • Refrain from using or appearing to use confidential information acquired in the course of their work for unethical or illegal advantage either personally or through third parties. INTEGRITY Practitioners of management accounting and financial management have responsibility to: • Avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict. • Refrain from engaging in any activity that would prejudice their ability to carry out their duties ethically. • Refuse any gift favor or hospitality that would influence or would appear to influence their actions. • Refrain from either actively or passively subverting the attainment of the organization’s legitimate and ethical objectives. • Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity. • Communicate unfavorable as well as favorable information and professional judgments or opinions. • Refrain from engaging in or supporting any activity that would discredit the profession. OBJECTIVITY Practitioners of management accounting and financial management have responsibility to: • Communicate information fairly and objectively. • Disclose fully all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports comments and recommendations presented. SOURCE: May 1 2000 10:30 a.m. State- ments on Management Accounting Number 1C: Standards of Ethical Conduct for Management Accountants Mont- vale N.J.: NAA June 1 1983. Copyright by Institute of Management Accountants formerly National Association of Accountants Montvale N.J. EXHIBIT 1–3 Standards of Ethical Conduct for Management Accountants

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Accountants have always been regarded as individuals of conviction trust and integrity. The most important of all the standards listed are those designated un- der integrity. These statements reflect honesty of character and embody the essence and intent of U.S. laws and moral codes. Standards of integrity should be foremost in business dealings on individual group and corporate levels. To summarize cost accounting allows organizations to determine a reliable and reasonable measurement of “costs” and “benefits.” These costs and benefits may relate to particular products customers divisions or other objects. Much of this text is dedicated to discussing the various methods tools and techniques used in cost accounting. However before providing that discussion the balance of this chapter and Chapter 2 provide important descriptive information about trends in business today as well as information about important practices widely used by managers. This descriptive information will establish a context for understanding the practice of cost accounting in the contemporary organization. One of the big influences on current business practices is globalization. Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 9 THE GLOBAL ENVIRONMENT OF BUSINESS Most businesses participate in the global economy which encompasses the in- ternational trade of goods and services movement of labor and flows of capital and information. 4 The world has essentially become smaller through improved tech- nology and communication abilities as well as trade agreements that promote the international movement of goods and services among countries. Exhibit 1–4 pro- vides the results of a survey of Fortune 1000 executives about the primary factors that encourage the globalization of business. Currently the evolution of Web-based technology is dramatically affecting international business. E-Commerce Electronic commerce e-commerce is any business activity that uses the Internet and World Wide Web to engage in financial transactions. But e-commerce had its beginnings in two important events that occurred before a computer was even developed: 1 the introduction of wireless money transfers in 1871 by Western Union and 2 the introduction in 1914 of the first consumer charge card. These inventions alone however were not enough to produce global opportunities for business. What factors have influenced the globalization of businesses and why have these factors been significant global economy 4 4 Paul Krugman Peddling Prosperity quoted by Alan Farnham in “Global—or Just Globaloney” Fortune June 27 1994 p. 98. Percentage Indicating Factor as Factor Primary in Globalization Trend Technology 43 Competition 29 The Economy 21 Better Communications 17 Need for New Markets/Growth 13 Deregulation 11 Access to Information 9 Legislation 7 Ease of Entering New Market 5 SOURCE: Deloitte Touche LLP Survey of American Business Leaders: Information Technology November 1996 pp. 1–11. Reprinted with permission from Deloitte Touche. EXHIBIT 1–4 Factors Driving Business Globalization e-commerce

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Web sites of manufacturers and retailers worldwide can be accessed by po- tential customers 24 hours a day. Businesses and consumers can view products and the way they work or fit together on computer or television screens. Cus- tomers can access product information and order and pay for their choices with- out picking up the phone or leaving home or the office. In the world of banking and financial services bills can be paid balances accessed loans and insurance obtained and stocks traded. Some of the numerous positives and negatives of having e-commerce capa- bility are provided in Exhibit 1–5. In some cases a seller’s positive may be a buyer’s negative: the ability to accumulate use reuse and instantaneously transmit cus- tomer information “can if not managed carefully diminish personal privacy.” 5 But the current drawbacks to e-commerce will not stop the ever-increasing us- age of this sales and purchasing medium. More and more merchants will develop sites that are easy and safe to use by customers but that inhibit hackers from caus- ing internal problems. The rapid expansion of e-commerce illustrates the success of its positives and necessitates the correction of its negatives. Trade Agreements Encouragement of a global economy has been fostered not only by e-commerce but also by government and business leaders worldwide who have made economic integration a paramount concern. Economic integration refers to creating multi- country markets by developing transnational rules that reduce the fiscal and phys- ical barriers to trade as well as encourage greater economic cooperation among countries. Most economic integration occurs through the institution of trade agree- ments allowing consumers the opportunity to choose from a significantly larger se- lection of goods than that previously available. Many of these agreements encom- pass a limited number of countries in close geographic proximity but the General Agreement on Tariffs and Trade GATT involves over 100 nations worldwide. Trade agreements have created access to more markets with vast numbers of new customers new vendor sources for materials and labor and opportunities for new production operations. In turn competitive pressures from the need to meet or beat prices and quality of international competitors force organizations to focus on cost control quality improvements rapid time-to-market and dedicated cus- tomer service. The accompanying News Note on page 12 reveals an interesting outcome from the North American Free Trade Agreement. As companies become more globally competitive consumers’ choices are often made on the bases of price quality access time of availability and design rather than on whether the goods were made domestically or in another country. Globalization Considerations There is no question that globalization is occurring and at a remarkably rapid rate. But operating in foreign markets may create situations that vary dramatically from those found only in domestic markets. Considerations about risk legal standards and ethical behaviors can be vastly dissimilar between and among different for- eign markets. RISK CONSIDERATIONS Numerous risks exist in any business environment. But when a business decides to enter markets outside its domicile it needs to carefully evaluate the potential risks. Some of the risks depend on the level of economic development of the coun- try in which operations are being considered these risks often include political and Part 1 Overview 10 5 W. J. Clinton and A. Gore Jr. A Framework for Global Electronic Commerce April 4 1999 p. 12. economic integration

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Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 11 Merchant Customer Positives: • Convenience No downtime Around-the-clock availability for and Real-time accumulation of customer product information and efficiency and product/service data purchases Ease of updating product/service Access to international merchants information Ease of use Ease of obtaining feedback on Ease of comparison shopping customer satisfaction or Ease of providing feedback providing customer service Ease of gaining information on Comparative ease of business products/services from other start-up companies or individuals Ease of access to new markets Ability to receive instantaneous Ease of instantaneous communication communications from merchants • Cost savings Staff paperwork and inventory Access is local rather than reduction long-distance No need for around-the-clock Rapid access to on-line staffing to take orders technical support Less expensive to testmarket new products Lower transaction costs such as those related to errors or electronic data interchange Wide dissemination of information at nominal incremental cost after start-up Inexpensive method of document transfer Ability to use site as an employment recruiting tool Negatives: • Privacy Lack of standardized international Questionable ability to obtain privacy policies redress if personal information Theft of passwords or exploitation is used improperly of unprotected connections to take Theft of passwords credit over Web sites and corporate card numbers etc. allowing computers unauthorized purchases • Legality Lack of international laws Questionable ability to governing transactions obtain redress if decisions Questionable ability to ensure are made on inaccurate or intellectual property protection incomplete information Difficulty of assessing compliance with tax regulations in all business jurisdictions • Costs Cost of Web site development Cost of “distraction time” including need for multiple from Net surfing languages maintenance and Possibility of purchasing security including firewalls from a fraudulent business or and data encryption a business that will not Potential for internal network correct problems such as shutdown from e-mail complaints damaged merchandise such as those related to Possibility of purchasing inappropriate advertising counterfeit goods Losses due to fraudulent sales • Other Potential for sites to be accessed Poor customer service due to by improper parties e.g. minors merchant’s inability to Some products/services may be too manage increased e-commerce complex for e-commerce e.g. Difficulty in using site health care Difficulty in finding specific site product or service EXHIBIT 1–5 The Realities of E-Commerce

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currency risks. Political risks include the potential for expropriation or nationaliza- tion of assets and the potential for change in business legal or tax treatment under new political leadership. Currency risks can cause widely unpredictable results. For example ABN AMRO acquired 40 percent of Banco Real Brazil for 2.1 billion Brazil’s currency de- valuation three months after the purchase caused two situations. First depending on the depth of the recession there may be a significant level of loans that “go bad.” But second the devaluation made the acquisition much less expensive for ABN AMRO. 6 Risks relating to cultural differences are more subtle. The business must assess whether product names and slogans will translate correctly whether gender issues such as female supervisors will create labor problems and whether products re- flect the lifestyles or product preferences of different global customers. To illus- trate this latter point consider that diet cola comprises about 25 percent of all Coca-Cola and PepsiCo beverage brands sold in the United States. However these companies which have just begun selling diet colas in India forecast a maximum long-term market share of only 3 percent of that country’s sales. Diet foods are a new concept in a country where malnutrition was a recent phenomenon. “There is a deep-seated feeling that anything labeled ‘diet’ is meant for a sick person such as a diabetic or someone with heart problems.” 7 Exhibit 1–6 provides numerous considerations in a business risk framework. These items must be evaluated whether a business is operating domestically or in- ternationally. The difference in the evaluation process is often the greater depth of Part 1 Overview 12 Taking Business South NEWS NOTE INTERNATIONAL Among chief executives Phillip Martin is unique. He runs a conglomerate that does everything from making auto parts to running casinos. And he is a real chief as in chief of the Mississippi Band of Choctaw Indians. Over the past 30 years he has helped to bring a wealth of jobs within the border of the 25000-acre Choctaw reservation. The profits from Chief Martin’s enterprises have given the Choctaws employment opportunities they never had before and they have elected to send low-skilled work south and bring higher-paying jobs to their community. So like so many other U.S. CEOs Martin has taken busi- ness to Mexico. Chahta Enterprise is the first Native American-owned company to leave the reservation and take a giant step into the global economy. “We started in this business competing with the Japanese but now all our competition is coming from Mexico” says the 73-year-old chief. Mr. Martin says the North American Free Trade Agreement meant that Chahta had to join the migration south or lose its auto- mobile industry contracts. The Choctaws opened a fac- tory in Sonora Mexico in 1998 and its 1400 employ- ees—none Choctaws—assemble wire harnesses for Ford Motor Co. A second Chahta plant in Mexico mak- ing car-stereo components is scheduled to open in late 1999. Chahta had to invest more than 1 million to build a factory that met Ford’s price and quality demands. A typ- ical employee at the Mexican plant makes 6 per day for work that would cost 7 to 12 per hour in Mississippi. The Sonora plant manager explains how the economics of the auto industry forced the Choctaws to relocate in Mexico: a door lock electrical cluster that Ford paid 65 to 70 for in 1994 now sells for 50. And car makers keep pounding away for every penny that Chahta and all other suppliers can reduce costs. But going south has bene- fited the Choctaw Nation. Chahta’s 1999 Mexican oper- ations were expected to gross over 100 million which will be used to fund other investments to create jobs in tribal schools and in the hotels casinos and golf courses that dot the reservation in Mississippi as well as an Amer- ican Greetings Co. printing operation. SOURCE: Adapted from Joel Millman “Choctaw Chief Leads His Mississippi Tribe into the Global Market” The Wall Street Journal July 23 1999 p. B1. 6 Deborah Orr “Dutch Colonizers” Forbes June 14 1999 p. 119. 7 Miriam Jordan “Debut of Rival Diet Colas in India Leaves a Bitter Taste” The Wall Street Journal July 21 1999 p. B1.

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knowledge necessary and the greater potential for change when operating in for- eign markets. The corporate implications of many of these items can be minimized or exploited depending on the business’s ability to respond to change and to man- age uncertainty. LEGAL CONSIDERATIONS Domestic and international laws and treaties can significantly affect how an orga- nization legally obtains new business reduces costs or conducts operating activi- ties. Laws represent codified societal rules and can change as the society for which they are established changes. For example Communism’s fall resulted in new laws promoting for-profit businesses in the former Soviet Union. Britain in the face of budget troubles changed its laws to allow privatization of some utility companies. China in pursuit of a more open international trade position altered its laws to allow some foreign banks including ABN AMRO to have full-fledged branches in Beijing. These examples represent a small proportion of how laws regarding busi- ness activities change as society changes. Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 13 Strategic Risks—Risks that relate to doing the wrong thing. Environment Risks: • Natural and manmade disasters • Political/country • Laws and regulations • Industry • Competitors • Financial markets Organization Risks: • Corporate Objectives and Strategies: planning resource allocation monitoring mergers acquisitions and divestitures joint ventures and alliances • Leadership: vision judgment succession planning tone at the top • Management: accountability authority responsibility • Corporate Governance: ethics reputation values fraud and illegal acts • Investor/Creditor Relations • Human Resources: performance rewards benefits workplace environment diversity Operating Risks—Risks that relate to doing the right things the wrong way. • Workforce: hiring knowledge and skills development and training size safety • Suppliers: outsourcing procurement practices availability price and quality of suppliers’ products and services • Physical Plant: capacity technology/obsolescence • Protection: physical plant and other tangible assets knowledge and other intellectual property • Products and Services: development quality pricing cost delivery consumer protection technology/obsolescence • Customers: needs satisfaction credit • Regulatory Compliance: employment products and services environmental antitrust laws Financial Risks—Risks that relate to losing financial resources or incurring unacceptable liabilities. • Capital/Financing: availability interest rates creditworthiness • Investing: cash availability securities receivables inventories derivatives • Regulatory Compliance: securities law taxation Information Risks—Risks that relate to inaccurate or irrelevant information unreliable systems and inaccurate or misleading reports. • Information Systems: reliability sufficiency protection technology • Strategic Information: relevance and accuracy of measurements availability assumptions • Operating Information: relevance and accuracy of measurements availability regulatory reporting • Financial Information: relevance and accuracy of measurements accounting budgets taxation financial reporting regulatory reporting SOURCE: Deloitte Touche LLP Perspectives on Risk New York: 1997 pp. 12 24 25. Reprinted with permission from Deloitte Touche. EXHIBIT 1–6 A Business Risk Framework

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Most government regulations seek to encourage an environment in which busi- nesses can succeed. As indicated in the accompanying News Note regulatory agen- cies monitor business practices for activities detrimental to healthy commerce. Many early U.S. laws relating to business were concerned with regulating cer- tain industries on which the public depended such as telecommunications utili- ties airlines and trucking. With substantial deregulation American laws are now more concerned with issues such as fair disclosure of corporate information prod- uct safety and environmental protection. Companies might even be held “liable for human rights abuses against indigenous people in foreign countries even if the companies are not directly involved” if the abuses took place near company operations. 8 Freeport-McMoRan Copper Gold and Unocal Corp. both have been sued in the United States because of alleged military abuses in respectively In- donesia and Myanmar. Organizations are becoming more active in defining responsible corporate be- havior and this trend is likely to continue. Irresponsible behavior tends to invite an increase in governmental monitoring and regulation. For example after many American companies were found to have given bribes in connection with business activities the United States passed the Foreign Corrupt Practices Act FCPA in 1977. This law prohibits U.S. corporations from offering or giving bribes directly or indirectly to foreign officials to influence those individuals or cause them to use their influence to help businesses obtain or retain business. The act is directed at payments that cause officials to act in a way specified by the firm rather than in a way prescribed by their official duties. ETHICAL CONSIDERATIONS In contrast to laws ethical standards represent beliefs about moral and immoral behaviors. Because beliefs are inherently personal some differences in moral per- spectives exist among all individuals. However the moral perspective is generally more homogeneous within a given society than it is across societies. In a business context ethical standards are norms for individual conduct in making decisions and engaging in business transactions. Also many professions have established ethical standards for their practitioners such as those promulgated by the IMA. Part 1 Overview 14 Unacceptable Rebates NEWS NOTE INTERNATIONAL In July 1999 the European Union’s executive body the European Commission conducted raids to examine doc- uments and gather evidence...that could lead to a full- blown antitrust action against Coca-Cola. The raids fo- cused on suspicions that Coke was illegally using rebates to enhance its market share—charges Coke denied. In Europe the company outsells PepsiCo Inc. and other ri- vals in soft-drink sales by vast margins. For instance in Germany Coke’s share of the soft-drink market is 55 compared to Pepsi’s 5. The raids focused on rebates to distributors. Such re- bates aren’t necessarily illegal in the 15-nation EU but EU authorities say they can be illegal in some cases if paid by companies that dominate their markets. In the Coke case the commission is looking for evidence that the U.S. company stifled competition with several types of rebates. Among them are rebates on sales that boost Coke’s market share at the expense of rivals and rebates given to distributors who agree to sell the full range of Coke products or stop buying from competitors. SOURCE: Brandon Mitchener and Betsy McKay “EU Raids Coca-Cola’s Euro- pean Offices on Suspicions of Illegal Use of Rebates” The Wall Street Jour- nal July 22 1999 p. A4. 8 Stewart Yerton “World Will Watch Lawsuits’ Outcome” New Orleans The Times-Picayune May 11 1997 p. F-1. Foreign Corrupt Practices Act FCPA ethical standard

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In general ethical standards for business conduct are higher in most industri- alized and economically developed countries than in less developed countries. But the standards and their enforcement vary greatly from one industrialized country to another. Thus because of the tremendous variations companies should develop internal norms for conduct such as a code of ethics to ensure that certain be- haviors are consistent in all of its geographical operating segments. There must also be respect for local customs and traditions if they do not violate the accepted ethical and legal standards of the company and its domicile country. One cannot categorize all business practices as either ethical or unethical there must be a moral free space 9 that allows managers and employees to make decisions within the bounds of reason. The accompanying News Note about Texas Instruments TI addresses this issue. It is important for an organization to have and support a code of conduct that promotes integrity of behavior at all organizational levels. Companies can use a variety of methods to communicate corporate ethical values to all employees. For instance in 1997 Lockheed Martin developed an interactive board game featuring Scott Adams’ Dilbert character and a multitude of potential practical ethical chal- lenges to be addressed by employee teams. Texas Instruments uses an alternative method an ethical “quick test” for its employees facing an ethical decision: • Is the action legal • Does it comply with our values • If you do it will you feel bad • How will it look in the newspaper • If you know it’s wrong don’t do it • If you’re not sure ask. • Keep asking until you get an answer. 10 Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 15 Addressing Ethical Challenges at TI NEWS NOTE ETHICS “Ethical questions face businesspeople every day es- pecially when a company is involved in worldwide mar- kets” said Carl Skooglund former TI vice president and director of ethics. The challenge is “to provide tools to our employees so that they can make the tough quick decisions on the fly on the firing line. And make them correctly. There are two elements to making decisions and taking action on behalf of an organization: 1 a clear understanding of the organization’s values principles and ethical expectations and 2 sound personal judg- ment and appropriate choices.” TI has adopted a three-level approach to ethical in- tegrity on a global level. The first level asks whether there is compliance with all legal requirements on a local level. The second level addresses whether there are local busi- ness practices or requirements that will impact interac- tions with other parts of the world. The third level asks whether some business practices need to be adapted to fit local laws and customers of a specific locale. What may be believed to be proper in one country may not migrate well to another. And on what basis can universal stan- dards be defined that apply to TI employees everywhere Today no rulebook or library of policies is going to guide ethical actions. “They must be guided by a shared understanding of basic values and principles of integrity. And they must be supported by resources that will help people to recognize when the caution lights should come on and to know where they can seek expert advice quickly. TI’s reputation is completely in our hands to be enhanced or damaged by the nature of our actions” con- cluded Skooglund. SOURCE: Texas Instruments “Ethics in the Global Market” corp/docs/company/citizen/ethics/market.shtml August 13 1999. 9 Thomas Donaldson “Values in Tension: Ethics Away from Home” Harvard Business Review September–October 1996 p. 56. 10 Texas Instruments “The TI Ethics Quick Test” August 13 1999.

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The high quality of international competition today requires managers to de- velop systematic disciplined approaches to running their organizations. As shown in Exhibit 1–2 managers have four primary functions to execute in which ac- counting information is consumed. These functions are planning controlling de- cision making and evaluating performance. The first function planning requires management to develop a road map that lays out the future course for operations. This road map also serves an important role in the design of the organization’s ac- counting and control systems. Part 1 Overview 16 ORGANIZATIONAL STRATEGY In responding to the challenges of e-commerce and globalization managers must consider the organization’s mission and correspondingly the underlying strategy that links its mission to actual activities. An organization’s mission statement should 1 clearly state what the organization wants to accomplish and 2 express how that organization uniquely meets its targeted customers’ needs with its prod- ucts and services. As indicated in the following News Note a mission statement should be an organizational road map. The mission statement may and most likely should be modified over time. Not adapting the mission statement probably means the organization is stagnating and not facing the ever-changing business environment. For instance Hibernia Cor- poration’s mission statement in 1994 was “to be recognized by 1996 as the best provider of financial services throughout Louisiana.” By 1997 the mission state- ment was “By 1999 we will be recognized by our customers employees and shareholders as the best financial services company in each of our markets.” 11 Only three years yet a dramatic difference: the corporation had engaged in multiple bank merger opportunities outside Louisiana and was looking for more. Translating the organization’s mission into the specific activities and resources needed for achievement is called planning. The long-term dynamic plan that in- What are the primary factors and constraints that influence an organization’s strategy and why are these factors important mission statement 5 Where Are We Going NEWS NOTE GENERAL BUSINESS Imagine yourself driving down a dark road. You have no idea where you are going let alone how you are going to get there. To your dismay a storm crops up rain pelt- ing the window so hard you can barely see anything out- side. You may decide to stop the car and just sit there. Moving on or parked you are going nowhere fast. One of the main reasons for writing a mission state- ment is to develop a road map showing management where the company should be going and giving general directions for how to get there. In addition to the mission statement strategic plans should be developed that give detailed information about specific roads the company should travel to arrive at its mission destination. When defining organization objectives mission state- ments should reflect the environment in which the orga- nization operates as well as the competencies and com- petitive advantages that the organization possesses. A good mission statement says clearly and exactly what an organization expects to accomplish. Many companies have eloquently stated missions but they often neglect one of the most important characteristics of a solid mis- sion statement: the objectives must be measurable. To know where you are on the road you need mile mark- ers. To know where you are going you need signs and landmarks. Unless a company has specific measurement standards it will not be able to determine if it has achieved its mission. SOURCE: James A. Bailey “Measuring Your Mission” Management Accounting December 1996 pp. 44–45. Copyright Institute of Management Accountants Montvale N.J. 11 Hibernia Corporation 1994 and 1997 annual reports. planning

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dicates how the organizational goals and objectives will be fulfilled through satisfac- tion of customer needs or wants reflects strategy. Strategy can also be defined as: the art of creating value. It provides the intellectual frameworks concep- tual models and governing ideas that allow a company’s managers to identify opportunities for bringing value to customers and for delivering value at a profit. In this respect strategy is the way a company defines its business and links to- gether the only two resources that really matter in today’s economy: knowledge and relationships or an organization’s competencies and its customers. 12 An organization’s strategy tries to match its internal skills and resources to the opportunities found in the external environment. 13 Small organizations may have a single strategy while large organizations often have an overall entity strategy as well as individual strategies for each business unit such as a division. The busi- ness units’ strategies should flow from the overall strategy to ensure that effective and efficient resource allocations are made an overriding corporate culture is de- veloped and organizational direction is enhanced. For instance at ABN AMRO the Netherlands Division strategy is to position the bank as a provider of integrated banking and insurance products the strategy for Central/Eastern Europe is strong internal growth and selective acquisition and the strategy for Asia/Pacific is to raise the profitability of core corporate banking activities. Exhibit 1–7 provides a checklist of questions that help indicate whether an or- ganization has a comprehensive strategy in place. Small businesses may need to substitute “product lines” for “business segments” in answering the questions. Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 17 strategy 12 Richard Normann and Rafael Ramirez “From Value Chain to Value Constellation: Designing Interactive Strategy” Harvard Business Review July–August 1993 p. 65. 13 Thomas S. Bateman and Scott A. Snell Management: Building Competitive Advantage Chicago: Irwin 1996 p. 117. 1. Who are your five most important competitors 2. Is your firm more or less profitable than these firms 3. Do you generally have higher or lower prices than these firms for equivalent product/ser- vice offerings Is this difference due mainly to the mix of customers to different costs or to different requirements for profit 4. Do you have higher or lower relative costs than your main competitors Where in the cost structure for example cost of raw materials cost of product cost of selling cost of dis- tributing cost of advertising and marketing are the differences most pronounced 5. What are the different business segments which account for 80 percent of your profits You will probably find that you are in many more segments than you thought and that their profit variability is much greater than you thought. If you cannot define the segments that constitute 80 percent of your total profits you need to conduct a detailed product line profitability review. 6. In each of the business segments defined above how large are you relative to the largest of your competitors Are you gaining or losing relative market share 7. In each of your important business segments what are your customers’ and potential cus- tomers’ most important purchase criteria 8. How do you and your main competitors in each segment rate on these market purchase criteria 9. What are the main strengths of the company as a whole based on aggregating customers’ views of your firm in the segments that comprise most of your profits What other com- petencies do you believe the firm has and why do they seem to be not appreciated by the market 10. Which are your priority segments and where is it most important to the firm as a whole that you gain market share How confident are you that you will achieve this given that other firms may have targeted the same segments for share gain What is your competitive ad- vantage in these segments and how sure are you that this advantage is real rather than imagined If you are not gaining relative market share the advantage is probably illusory. SOURCE: The Financial Times Guide to Management and Finance London: Financial Times/Pearson Education Limited 1994 p. 359. Reprinted with permission. EXHIBIT 1–7 Does Your Organization Have a Good Strategy

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Part 1 Overview 18 INFLUENCES ON ORGANIZATIONAL STRATEGY Because each organization is unique even those in the same industries employ different strategies that are feasible and likely to be successful. Exhibit 1–8 pro- vides a model of the major factors that influence an organization’s strategy. These factors include organizational structure core competencies organizational con- straints organizational culture and environmental constraints. Organizational Structure An organization is composed of people resources other than people and com- mitments that are acquired and arranged to achieve specified goals and objectives. EXHIBIT 1–8 Factors Influencing Organizational Strategy Organizational Structure Strategic long-term Planning Tactical short-term Planning Core Competencies Organizational Constraints Organizational Culture Environmental Constraints Organizational Goals and Objectives Organizational Mission

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Goals are desired results expressed in qualitative terms. For example a typical goal of profit-oriented firms is to maximize shareholder wealth. Goals are also likely to be formulated for other major stakeholders such as customers employees and suppliers. In contrast objectives are quantitatively expressed results that can be achieved during a pre-established period or by a specified date. Objectives should logically be used to measure progress in achieving goals. For example one of ABN AMRO’s goals is to become a leading bank in the euro. In pursuit of that goal the bank established an objective of having all of its systems euro-compatible by Jan- uary 1 1999 when the euro was introduced. The objective was achieved at tremen- dous cost but management believes that ABN AMRO’s new ability to offer har- monized banking services throughout Euroland will be worth the investment. 14 An organization’s structure normally evolves from its mission goals and man- agerial personalities. Organizational structure reflects the way in which authority and responsibility for making decisions is distributed in an organization. Authority refers to the right usually by virtue of position or rank to use resources to accom- plish a task or achieve an objective. Responsibility is the obligation to accomplish a task or achieve an objective. A continuum of feasible structures reflects the extent of authority and respon- sibility of managers and employees. At one end of the continuum is centralization where top management retains all authority for making decisions. Centralized firms often have difficulty diversifying operations because top management might lack the necessary and critical industry-specific knowledge. The people who deal di- rectly with the issues whether problems or opportunities have the most relevant information and can best foresee the decision consequences are not making the decisions. At the other end of the continuum is decentralization in which the authority for making decisions is distributed to many organizational personnel including lower-level managers and possibly line employees. In today’s fast-changing and competitive operating environment implementation of a decentralized organiza- tional structure in a large firm is almost imperative and typically cost-beneficial. However for decentralization to work effectively there must be employee empow- erment which means that people are given the authority and responsibility to make their own decisions about their work. A decision to decentralize is also a decision to use responsibility accounting which is discussed in Chapter 18. Most organizations operate at some point on the continuum other than at ei- ther of the ends. Thus a top management decision might be the location of a new division while the ongoing operating decisions of that division might lie with the new division manager. Long-term strategic decisions for the division might be made by the division manager in conjunction with top management. Core Competencies In addition to organizational structure an organization’s strategy is influenced by its core competencies. A core competency is any critical function or activity in which one organization seeks a higher proficiency than its competitors making it the root of competitiveness and competitive advantage. “Core competencies are different for every organization they are so to speak part of an organization’s personality.” 15 Technological innovation engineering product development and after-sale service are some examples of core competencies. The Japanese elec- tronics industry is viewed as having a core competency in miniaturization of elec- tronics. MCI and Disney believe they have core competencies respectively in com- munications and entertainment. The accompanying News Note further examines core competencies. Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 19 goal objective organizational structure authority responsibility centralization 14 ABN AMRO Holding N.V. Annual Report 1998 pp. 18–19. 15 Peter F. Drucker “The Information Executives Truly Need” Harvard Business Review January–February 1995 p. 60. decentralization empowerment core competency

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But core competencies are likely to change over time. Consider that Rolls- Royce plc once one of the most respected names in luxury automobiles sold its motorcar division in 1972. Company management decided its priority should be products resulting from its core gas-turbine technologies. Thus the company be- gan focusing on civilian and military aircraft engines and power generation and improving its service parts and repair business. Business boomed for Rolls-Royce: in 1987 RR engines were used on only six types of civil airframes in 1999 they were used on 30 types deployed in 37 of the top 50 airlines. 16 Organizational Constraints Numerous organizational constraints may affect a firm’s strategy options. In almost all instances these hindrances are short-term because they can be overcome by existing business opportunities. Two common organizational constraints involve monetary capital and intellectual capital. Decisions to minimize or eliminate each of these constraints can be analyzed using capital budgeting analysis which is cov- ered in Chapter 14. MONETARY CAPITAL Strategy implementation generally requires a monetary investment and all organiza- tions are constrained by the level and cost of available capital. Although companies almost always can acquire additional capital through borrowings or equity sales man- agement should decide whether 1 the capital could be obtained at a reasonable cost and 2 a reallocation of existing capital would be more effective and efficient. INTELLECTUAL CAPITAL Another potentially significant constraint on strategy is the level of the firm’s in- tellectual capital IC. Many definitions exist for IC but all have a common thread of intangibility. Intellectual capital reflects the “invisible” assets that provide dis- tinct intrinsic organizational value but which are not shown on balance sheets. Part 1 Overview 20 Finding Core Competencies NEWS NOTE GENERAL BUSINESS Core competencies are the combination of attributes that make an organization’s products/services different and more importantly make customers want to buy those products/services. Organizations compete for customers revenue market share etc. with products/services that meet customers’ needs. Accordingly without core com- petencies organizations cannot compete. Identifying core competencies involves research of a representative sample of customers retailers their cus- tomers consumers suppliers and other industry ex- perts. Ask questions about what attributes differentiate the organization’s products/services over those of com- petitors. Follow up answers to questions with more ques- tions then explore for the underlying core products/ services that differentiate. The unique combination of knowledge special skills proprietary technologies and/ or unique operating methods will be identified. While some organizations compete for current core competencies smart organizations also compete for core competencies that can gain them competitive advantage in the future. How fast can the organization acquire and develop these core competencies and at what cost A company’s ability to successfully find and integrate these future core competencies will determine its ability to de- liver future products/services their future scope the de- gree of differentiation the costs and the price the mar- ket will pay. SOURCE: Adapted from interview with Maurice Greaver “Strategic Outsourcing” August 14 1999. 16 Robert T. Scott “Rolls Chief Has Profits Flying High” New Orleans The Times-Picayune April 27 1999 pp. C-1 10. intellectual capital http://www.Rolls-Royce .com

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One expansion of the definition is that IC encompasses human structural and relationship capital. 17 Human capital is reflected in the knowledge and creativity of an organization’s personnel and is a source of strategic innovation and renewal. Human capital may provide at least until adopted by others the company a core competency. Structural capital such as information systems and technology allows human capital to be used. Structural capital “doesn’t go home at night or quit and hire on with a rival it puts new ideas to work and it can be used again and again to cre- ate value just as a die can stamp out part after part.” 18 Acquiring new technology is one way to create new strategic opportunities by allowing a company to do things better or faster—assuming that the company has trained its human capital in the use of that technology. Relationship capital reflects ongoing interactions between the organization and its customers and suppliers. These relationships should be respectively profitable and cost-beneficial. In many respects the customer element of relationship capital is the most valuable part of an organization’s intellectual capital: without customers to purchase products and services an organization would have no need to em- ploy human or structural capital. Organizational Culture Going global implementing employee empowerment and investing in new forms of capital are all decisions that require organizational change. An organization’s ability to change depends heavily on its organizational culture. Organizational culture is the set of basic assumptions about the organization its goals and its business practices. Culture describes an organization’s norms in internal and external as well as formal and informal transactions. Culture refers to the values beliefs and attitudes that permeate a business. If strategy defines where a company wants to go culture determines how— maybe whether—it gets there. Every business has some kind of culture just be- cause it’s an organization of human beings. But most businesses never give the topic a second thought. Their culture is to do things the way they always have or the way everybody else does them. A few companies by contrast have explicit highly distinctive cultures— strong focused cultures that stick out from the crowd like the Grateful Dead at a marching-band convention. For example Southwest Airlines is famous for its wild and woolly—not to say manic—culture. Everybody at Southwest from CEO Herb Kelleher to the newest gate attendant pitches in to make sure that customers have a good time and that airplanes get unloaded and reloaded and back in the air fast.” 19 Organizational culture is heavily influenced by the culture of the nation in which the organization is domiciled the extent of diversity in the workforce and the personal styles and philosophies of the top management team. These variables play a significant role in determining whether the communication system tends to be formal or informal whether authority is likely to be centralized or decentral- ized whether relations with employees tend to be antagonistic or cooperative and how control systems are designed and used. Like many of the other influences on organizational strategy organizational culture can change over time. In most cases however culture is more likely to change due to new management rather than be- cause existing managers changed their style. Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 21 17 Thomas A. Stewart Intellectual Capital New York: Currency/Doubleday 1999 pp. 75–77. 18 Thomas A. Stewart “Your Company’s Most Valuable Asset: Intellectual Capital” Fortune October 3 1994 pp. 71–72. 19 John Case “Corporate Culture” Inc. November 1996 pp. 46–47. organizational culture

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Environmental Constraints A final factor affecting strategy is the environment in which the organization op- erates. An environmental constraint is any limitation on strategy brought about by external differences in culture competitive market structures fiscal policy such as taxation structures laws or political situations. Because an organization’s man- agement cannot directly control environmental constraints these factors tend to be long-run rather than short-run. Wal-Mart provides an excellent example of the influence of environmental con- straints on organizational strategy. Wal-Mart first entered Europe in 1997 by pur- chasing a chain of German retail stores. Germany unfortunately is known for high labor costs surly employees and a variety of arcane restrictions about zoning pricing and operating hours. Wal-Mart had to discontinue its “Ten-Foot Rule” re- quiring employees to speak to customers within ten feet of them and encourag- ing employees to be customer friendly. Some stores do not bag purchases because the practice is unheard of in Germany. But the company cannot refund customers the price difference on an item sold elsewhere for less because it is illegal in Ger- many. Nor can the associates receive Wal-Mart stock options because they are dif- ficult and expensive to grant under German law. 20 Part 1 Overview 22 environmental constraint 20 Jeremy Kahn “Wal-Mart Goes Shopping in Europe” Fortune June 7 1999 pp. 105ff. 21 Michael Porter Competitive Advantage: Creating and Sustaining Superior Performance New York: Free Press 1985 p. 17. Less Costs More NEWS NOTE GENERAL BUSINESS For 675 a night guests at the Meridian Club on a pri- vate island in the Caribbean get a room with no televi- sion no radio no telephone and no air conditioning— “almost like a motel room” says JoAnn Setzer of Sacramento California. Call it downscale deluxe and call it trendy. Ms. Set- zer isn’t complaining she visits Meridian every year. And many well-heeled tourists apparently have similar tastes. These days some of the most sought-after resorts are those that charge a whole lot but offer next to nothing in the way of amenities and nothing at all when it comes to technological innovations. Deliberately distancing themselves from the far more numerous luxury hotels that boast every possible crea- ture comfort and convenience these spartan resorts proudly specialize in the experience of . . . nada. Such resorts insist that simplicity is part of an indus- trywide trend in travel. But travel-industry consultants warn that the tactic is risky. The demand for less-is-more luxury is small they say and suited for only a few mostly older resorts rather than a chain. SOURCE: Adapted from Lisa Miller “Stifling Heat No Room Service . . . and Sky- High Prices” The Wall Street Journal June 27 1997 p. B1. RESPONSES TO COMPETITION An organization operating in a competitive market structure may choose to avoid competition through differentiation or cost leadership. 21 A company choosing a dif- ferentiation strategy distinguishes its product or service from that of competitors by adding enough value including quality and/or features that customers are will- ing to pay a higher price. Differentiation is often related to the product or service distribution system or advertising. The accompanying News Note illustrates a slightly different version of differentiation strategy: including substantially fewer features and charging higher prices How does an organization’s competitive environment impact its strategy and how might an organization respond to competition differentiation strategy 6

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Competition may also be avoided by establishing a position of cost leader- ship that is by becoming the low-cost producer/provider and thus being able to charge low prices that emphasize cost efficiencies. In this strategy competitors cannot compete on price and must differentiate their products/services from the cost leader. In today’s business environment maintaining a competitive advantage by avoid- ing competition can be difficult. Within a short time competitors are generally able to duplicate the factors that originally provided the competitive advantage. For many companies the future key to success may be to confront competition by identifying and exploiting temporary opportunities for advantage. In a con- frontation strategy an organization tries to differentiate its products/services by introducing new features or tries to develop a price leadership position by dropping prices even though competitors will rapidly bring out equivalent prod- ucts and match price changes. 22 Although potentially necessary a confrontation strategy is by its very nature less profitable for companies than differentiation or cost leadership. To assess all of the varying internal and external factors that affect strategic planning an organization needs to have a well-designed business intelligence BI system. This system represents the “formal process for gathering and ana- lyzing information and producing intelligence to meet decision-making needs.” 23 A BI system requires knowledge of markets technologies and competitors as shown in Exhibit 1–9. In addition to the need for information about external influences the BI sys- tem should provide management comprehensive information about internal func- tions and processes including organizational strengths and constraints. 24 Informa- tion provided by this system will be of great importance in helping managers perform their organizational functions especially strategic and tactical planning. Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 23 cost leadership confrontation strategy business intelligence BI system 22 Robin Cooper When Lean Enterprises Collide Boston: Harvard Business School Press 1995 p. 11. 23 “U.S. Companies Slow to Develop Business Intelligence” Deloitte Touche Review October 16 1995 p. 1. 24 For more information see the Society of Management Accountants of Canada’s Management Accounting Guideline 39: De- veloping Comprehensive Competitor Intelligence. EXHIBIT 1–9 Levels of Intelligence Gathering Broadest scope including environmental scanning market research and analysis and competitive intelligence Broad scope assimilating all of the competitor intelligence provides an early warning of opportunities and threats such as new acquisitions or alliances and future competitive products and services Narrow focus on an individual competitor profile Business Intelligence Competitive Intelligence Competitor Analysis SOURCE: Reprinted from an article “The Management Accountant as Intelligence Agent” appearing in CMA Manage- ment Magazine formerly CMA Magazine by Stan Whiteley February 1996 p. 3 with permission of CMA of Canada.

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Part 1 Overview 24 ROLE OF ACCOUNTING IN ORGANIZATIONS When setting strategy managers must consider the opportunities and threats pro- vided by the entity’s customers competition and environment and must analyze those opportunities and threats relative to the entity’s strengths and weaknesses. Such an analysis is the first part of the model shown in Exhibit 1–10. Next man- agement must consider the impact the selected strategies will have on organiza- tional stakeholders. In a profit-oriented business strategies should promote a pri- mary goal of profit generation so that customers are served effectively shareholders can obtain wealth maximization employees can retain their jobs and increase their personal human capital and creditors can be paid. Therefore management must consider the financial implications of its chosen strategies. Profitability is typically achieved by delivering to customers the products and services they desire on time and at reasonable prices. Profit measurement is one function of the accounting information system. To best assess financial implications of organizational strategies detailed short-term tactical plans should be prepared in the form of a budget. If the projected financial results are unacceptable man- agement will revise either the objectives or the strategies selected to achieve those objectives. Although the financial accounting system is extremely important in assessing current or projected profitability that system does not provide all the information needed by management to make decisions. “Exclusive focus on the financial re- sults and budgets does not encourage managers to invest and build for longer- How does the accounting function impact an organization’s ability to successfully achieve its strategic goals and objectives 7 EXHIBIT 1–10 The Planning Process Company: Strengths and Weaknesses Set Objectives Develop Strategies Determine Financial Implications Acceptable No Yes Threats and Opportunities: Customers Competition Environment Implement SOURCE: Adapted with permission from Roland T. Rust Anthony J. Zahorik and Timothy L. Keiningham Return on Quality Chicago: Probus Publishing Company 1994 p. 116.

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term competitive advantage.” 25 Also according to noted management author Peter Drucker: The standard concepts and tools of traditional financial reporting are in- adequate to control operations because all they provide is a view of the skele- ton of a business. What’s needed is a way to examine the soft tissue. Financial accounting balance sheets profit-and-loss statements allocations of costs etc. are an X-ray of the enterprise’s skeleton. But in as much as the diseases we most commonly die from—heart disease cancer Parkinson’s—do not show in a skeletal X-ray a loss of market standing and failure to innovate do not register in the accountant’s figures until the damage is done. 26 Organizations now have the technological capabilities to easily expand data collection activities to satisfy both external and internal information requirements. Accounting information is often a primary basis for making strategic decisions and for measuring and evaluating managerial efficiency and effectiveness. To provide the correct management incentives accounting measurements should be tied to the established mission. In large organizations an individual segment or division may pursue one of three generic organizational missions: build hold or harvest as defined in Exhibit 1–11. Segments with a build mission require the most strategic planning because they are to be operated for the long run. Segments with a harvest mission require lit- tle strategic planning their role is to generate cash and at some point they will probably be sold or spun off as other company segments begin to mature. Segment mission is directly related to the product life cycle or the sequen- tial stages that a product passes through from idea conception until discontinua- tion of the product. The five stages of the product life cycle are design and de- velopment introduction growth maturity and decline. The build mission is appropriate for products that are in the early stages of the product life cycle and the harvest mission is appropriate for products in the final stages of the life cycle. Accordingly long-term performance measures are more appropriate for build mis- sions and shorter-term performance measures are more appropriate for harvest missions. For example increase in market share would be a long-term measure while annual profitability would be a short-term measure. Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 25 25 Michael Goold and John Quinn Strategic Control: Milestones for Long-Term Performance London: The Economics Books Ltd/ Hutchison 1990 cited in Tony Barnes Kaizen Strategies for Successful Leadership London: Pitman Publishing 1996 p. 135. 26 “Drucker on Soft Tissue Metrics” Datamation September 1 1994 p. 64. • Build—This mission implies a goal of increased market share even at the expense of short-term earnings and cash flow. A business unit that follows this mission is expected to be a net user of cash that is the cash flow from its current operations would usually be insufficient to meet its capital investment needs. Business units with “low market share” in “high-growth industries” typically pursue a build mission. • Hold—This mission is geared to the protection of the business unit’s market share and competitive position. The cash outflows for a business unit that follows this mission generally equal the cash inflows. Businesses with “high market share” in “high-growth industries” typically pursue a hold mission. • Harvest—The harvest mission implies a goal of maximizing short-term earnings and cash flow even at the expense of market share. A business unit that follows the harvest mission is a net supplier of cash. Businesses with “high market share” in “low-growth industries” typically pursue a harvest mission. SOURCE: Vijay Govindarajan and John K. Shank “Strategic Cost Management: Tailoring Controls to Strategies” The Journal of Cost Management Fall 1992. © 1992 Warren Gorham Lamont. Reprinted with permission of RIA. EXHIBIT 1–11 Generic Strategic Missions Why is a company segment’s mission affected by product life cycle product life cycle 8

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Additionally the measurement system will need to be modified when an orga- nization begins to empower its employees and use work teams. Group rather than individual performance will need to be assessed and nonfinancial measures are often more appropriate than financial ones to make this assessment. Accounting can help derive the new measurements tie them to organizational goals and ob- jectives and integrate them with an organizational pay-for-performance plan. The degree of decentralization must reflect consideration of among other things how rapidly decisions need to be made the willingness of upper manage- ment to allow subordinates to make potentially poor decisions and the level of training required so that workers can understand and evaluate the consequences of their decisions. Decisions should be made only after comparing implementation costs such as employee training with expected benefits such as better commu- nication more rapid decisions and higher levels of employee skills. In evaluating core competencies an organization must analyze its activities and compare them to internal or external benchmark measurements. Some comparison metrics will often relate to costs: how does the cost of making a product or per- forming a service internally compare to the price of external acquisition To make fair comparisons a company must be reasonably certain of the validity of its costs. Unfortunately a recent survey of over 200 financial and operating executives in North America showed that less than half of the respondents were confident of their cost data. They wanted “more accurate timely and detailed information from their systems.” 27 To help provide such information some companies use activity- based costing which is discussed in Chapter 4. In assessing alternative strategies that require substantial monetary investments such as investing in new technology or opening a foreign production facility managers compare the investment’s costs and benefits. Often as with other strate- gic decisions cost details may be more attainable than benefit details. Managers aided by financial personnel must then make quantitative estimates of the invest- ment’s qualitative benefits for instance allowing the company to be the first to bring a product or service to market. The accompanying News Note addresses the significance of estimating future benefits from investments. From an accounting standpoint there is frequently a mismatch in the timing of costs and benefits. Costs are recorded and recognized in the early years of many strategic decisions whereas benefits created by these decisions are either recog- nized in later years or possibly not at all because they are nonmonetary in nature. For example financial accounting does not recognize the qualitative organizational benefits of faster delivery time customer satisfaction and more rapid development time for new products. Consequently measurement methods other than traditional financial accounting ones are necessary to help managers better evaluate the strate- gic implications of organizational investments. Strategic resource management SRM involves the organizational planning for deployment of resources to create value for customers and shareholders. Key attributes in the success of SRM are the management of information and of change in responding to threats and opportunities. SRM is concerned with the following issues: 28 • how to deploy resources to support strategies • how resources are used in or recovered from change processes • how customer value and shareholder value will serve as guides to the effective use of resources and • how resources are to be deployed and redeployed over time. Part 1 Overview 26 27 Mary Lee Geishecker “New Technologies Support ABC” Management Accounting March 1996 p. 44. 28 Adapted from W. P. Birkett “Management Accounting and Knowledge Management” Management Accounting November 1995 pp. 44–48. strategic resource management SRM

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These areas cannot be measured by financial accounting because they often relate to nonmonetary benefits. Thus management accounting provides the necessary es- timates to help managers address these issues and focus on strategic objectives. The foundation of SRM is the value chain supply chain or the set of processes that convert inputs into products and services for the firm’s customers. As shown in Exhibit 1–12 the value chain includes both internal and supplier processes. Man- agers can use the value chain to determine which activities create customer value as reflected in product/service prices and thus revenues earned. By reducing or eliminating activities that add no value within the value chain firms can become more efficient and effective. For their contributions to the value chain employees earn compensation and suppliers earn revenues. Successful firms will gain the cooperation of everyone in the value chain and communicate a perspective that today’s competition is between value chains more so than between individual businesses. Once this concept is ac- cepted members of the value chain become aware that information must be shared among all entities in the value chain. The arrows in Exhibit 1–12 indicate information flows that provide the key linkages between managing resources and managing change in a business. Man- agers as the agents of change must understand internal organizational processes external markets customers available and visionary technologies current and fu- ture competitors and operating environments. This knowledge helps managers to respond proactively to new market opportunities and to competitors’ actions. Much of the information required by managers comes from the business intelligence sys- tem which includes the accounting information system discussed earlier in this chapter. One of the most significant challenges of managing an organization is bal- ancing the short-run and long-run demands for resources. Resources include all or- ganizational assets including people. In the contemporary business environment managers must be able to balance short-term and long-term considerations as well as recognize and prioritize strategic resource needs. In addition managers must be careful to structure strategic initiatives such that they allow flexibility in day-to-day Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 27 Less Time Means More Profits NEWS NOTE GENERAL BUSINESS General Motors Corp. said sophisticated new computer and digital-imaging tools are expected to cut product- development costs as much as 200 million for a given global car or truck program. Because of these tools GM is making substantial progress in one of the core arenas of competition in the auto industry. An auto maker’s ca- pacity to develop new cars and trucks quickly can give it an edge in responding to swings in customer demand. In the 1990s for example GM’s inability to move quickly left it way behind in various high-profit truck segments. And savings on engineering and tooling costs translate directly into profit. Central to GM’s transformation is the adoption of “an integrated portfolio of computer math-based tools.” This means that all of the various design and manufacturing activities use the same software package which turns every aspect of a vehicle into digital and mathematical models. GM is spending about 1 billion a year on this sort of computing. GM uses these tools to take a vehicle design from a designer’s initial computer-screen pen strokes all the way into production. This saves money by eliminating the need for physical models cutting down engineering changes reducing lead times 50 percent for ordering production tooling and making it possible to solve man- ufacturing problems in “virtual” factories instead of real ones. GM now takes about 24 months from design until the start of production down from 42 months in 1994. SOURCE: Adapted from Robert L. Simison “GM Turns to Computers to Cut Development Costs” The Wall Street Journal October 12 1998 p. B4. What is the value chain and why is it important in managing a business value chain 9

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management. Stated another way in making long-term commitments of resources managers must consider how those commitments affect short-term management of resources. Information is the key to successfully analyzing and resolving all of these decision situations—and much of that information is provided by an organization’s accounting system. Part 1 Overview 28 EXHIBIT 1–12 The Value Chain and Strategic Resource Management Customer/ Market Revenues Products/Services Profits Capital Compensation Labor Inputs Payments Employees Shareholders Suppliers STRATEGIC RESOURCE MANAGEMENT Value Chain Value Chain ABN AMRO Bank REVISITING BN AMRO sees itself as a prominent universal banking group with a strong international focus. Its strength lies on the one hand in its extensive worldwide network of branches and subsidiaries with highly qualified staff and on the other hand in the integrated delivery of banking services to all customer segments through every available channel of distribution. Embedded in the organi- zation is a corporate culture based on the four corporate values integrity teamwork respect and professionalism that guide daily activities. In its quest to provide value-added services to clients the bank has a virtual product for corporations willing to outsource their accounts receivables operations. In effect the bank’s service would start by generating the invoice for the client and end with dunning its customers if it came to that. Other new cash management products include IntelliTracs an interactive automated payments tracking system and Facet a global system that enables correspon- dent banks to initiate faster and more accurate payment A

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Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 29 SOURCE: ABN AMRO Holding N.V. Annual Report 1998 Chris Costanzo “ABN AMRO Says Web Will Anchor Its Expansion” American Banker December 9 1999 p. 16. transactions from anywhere in the world. Both products use cutting-edge technology keeping the bank abreast of other leading global banks. Three important policy support divisions at ABN AMRO are Planning Control Financial Accounting and Management Accounting. The PC area is responsible for formulating corporate strategy and objectives translating these into financial plans and engaging in investor relations. Financial Accounting compiles analyzes and provides financial information to group management in respect to domestic and international operations as well as preparing financial statements. Management Accounting responsi- bilities include developing and implementing instruments for analyzing product customer and distribution channel profitability engaging in medium- and long-range planning and budgeting offering organizational advice supporting strategic planning conducting operations research and providing policy support advice. ABN AMRO has retail banking operations in 23 coun- tries. The bank intends to expand in these markets using the Internet. In Europe web-based expansion will be more important than in other markets because defensive govern- ments have frequently blocked the bank’s merger-based expansion strategy. To ensure the Internet gets deployed effectively throughout its markets ABN AMRO has formed a team with responsibility for examining Web plans on a case-by-case basis. The approach offers “a disconnect from the yearly budget approval process” said a senior executive of the bank. The disconnect ensures the Internet expansion strategy will not wither on the vine for want of resources. Accounting information addresses three different functions: 1 providing informa- tion to external parties stockholders creditors and various regulatory bodies for investment and credit decisions 2 estimating the cost of products produced and services provided by the organization and 3 providing information useful to in- ternal managers who are responsible for planning controlling decision making and evaluating performance. Financial accounting is designed to meet external in- formation needs and to comply with generally accepted accounting principles. Man- agement accounting attempts to satisfy internal information needs and to provide product costing information for external financial statements. Cost accounting creates an overlap between financial accounting and man- agement accounting. Cost accounting integrates with financial accounting by pro- viding product costing information for financial statements and with management accounting by providing some of the quantitative cost-based information managers need to perform their tasks. Most companies must now adapt to operating in a globally competitive envi- ronment. E-commerce is taking hold and is certain to be the norm of the future. Governments have established trade arrangements including the General Agree- ment on Tariffs and Trade European Union and North American Free Trade Agree- ment to reduce tariff barriers and foster global competition. Although an open global business environment provides new opportunities it often creates greater risks strategic operating financial and information and requires knowledge of and adherence to differing legal requirements. Additionally the ethical norms may vary by location but a solid corporate code of ethics should help a company oper- ate in a consistent moral way throughout the world. Organizational strategy should be based on a mission statement that indicates what the organization wants to accomplish and how it will meet customer needs. Goals and objectives should flow from that statement. Strategy options may be con- strained by numerous factors. How the organization is structured provides some constraints on who within the entity has authority and responsibility for tasks. The core competencies of an organization dictate internal strengths and capabilities and thus help indicate appropriate business functions to outsource. Strategy may also CHAPTER SUMMARY

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be constrained by the level of capital monetary or intellectual available to the or- ganization. Organizational culture provides a foundation for normal business prac- tices and protocol for interactions among employees managers customers sup- pliers and the public. Lastly environmental factors such as market structures government regulations and national cultures may help or hinder strategic options. A business intelligence system can help management understand the factors that influence the organization’s choice of strategies. Accounting provides important information for an organization’s management. Strategic resource management links organizational strategy to resource deploy- ment. SRM’s key focus is the value chain or the string of activities that convert or- ganizational inputs into outputs. The accounting information system is comprised of the cost financial and management accounting functions—all of which provide essential information that supports strategic resource management. Part 1 Overview 30 KEY TERMS authority p. 19 business intelligence BI system p. 23 centralization p. 19 confrontation strategy p. 23 core competency p. 19 cost accounting p. 5 cost leadership strategy p. 23 decentralization p. 19 differentiation strategy p. 22 e-commerce p. 9 economic integration p. 10 empowerment p. 19 environmental constraint p. 22 ethical standards p. 14 Foreign Corrupt Practices Act FCPA p. 14 global economy p. 9 goals p. 19 intellectual capital p. 20 mission statement p. 16 objectives p. 19 organizational culture p. 21 organizational structure p. 19 planning p. 16 product life cycle p. 25 responsibility p. 19 strategic resource management SRM p. 26 strategy p. 17 value chain p. 27 1. Discuss how financial cost and managerial accounting interface. Is one more important than another Discuss the rationale for your answer. 2. Flexibility is said to be the hallmark of modern management accounting whereas standardization and consistency describe financial accounting. Explain why the focus of these two accounting systems differs. 3. Is cost accounting a subset of management accounting or is management ac- counting a subset of cost accounting Why 4. Why would operating in a global rather than a strictly domestic marketplace create a need for additional information for management Discuss some of the additional information you think managers would need and why such infor- mation would be valuable. 5. Discuss the validity of the following statement “Only large companies such as those that are publicly held and listed on a major stock exchange have the opportunity to operate in a global marketplace.” QUESTIONS

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6. Would you purchase products from Internet sources Why or why not If you have purchased from the Internet did you experience any problems If so what were they and were they easily eliminated 7. The AICPA has introduced CPA WebTrust to reduce or eliminate some prob- lems related to engaging in e-commerce. Use the Internet to prepare a short discussion about WebTrust. What organizations are included in the WebTrust index 8. Why are economic trade agreements so important to the globalization of busi- ness 9. Use the Internet to find two businesses that have benefited and two businesses that have been disadvantaged by NAFTA. Briefly discuss the situations of each of these four businesses. 10. Use the Internet to find how the euro has impacted businesses in the last six months. 11. What political and cultural issues might affect an American or a Canadian company considering opening a business in Russia 12. Use the Internet to find five domestic companies that have introduced in for- eign countries what you would consider “radically” different products than those sold domestically. Discuss why these differences might exist. Hint: Food and drink companies are good candidates for this question. 13. Select a category of risk from Exhibit 1–6. Briefly explain some differences in the risks that would be experienced for the listed factors between your coun- try and another selected country. 14. How do government regulations affect planning processes in the business or- ganizations in your country 15. Why should businesses concern themselves with a clean environment when it might be substantially less expensive to pollute thus making their products cheaper for consumers 16. Compare and contrast legal and ethical standards. 17. Use the Internet to find three companies that have been indicted for or con- victed of violating the Foreign Corrupt Practices Act. In what countries were these companies offering bribes Do you think the American companies be- lieved that without bribery they could not have operated on a “level playing field” Discuss your response. 18. What factors impede the development of an international code of ethics for profit-oriented businesses Do you believe these factors can be overcome through the passage of laws Discuss the rationale for your answer. 19. Why is a code of ethics a necessity in any organization 20. Use the Internet to find the ethics codes for three businesses. How do these codes differ Which do you think is better and why 21. Why is a mission statement important to an organization 22. Select three large publicly held companies in the same industry. Use the In- ternet to access their Web sites and find a mission statement for each. How do these mission statements differ and how are they similar Assuming that you are the president of a new company in this industry write a mission state- ment for your company. 23. What is organizational strategy Why would each organization have a unique strategy or set of strategies 24. Are the financial implications of strategic planning more important in a busi- ness than in a not-for-profit organization Why or why not 25. Distinguish between goals and objectives. What goals do you hope to achieve by taking this course What objectives can you establish to measure the degree to which you achieve these stated goals 26. Differentiate between authority and responsibility. Can you have one without the other Explain. Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 31

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27. In what types of organizations or under what organizational conditions would centralization be a more useful structure than decentralization Would decen- tralization be more useful than centralization 28. Use the Internet to find three companies that have recently changed their or- ganizational structures. How were the companies restructured and what rea- sons were given for the change 29. If you were Dean of your College how would you more fully empower your students relative to their college studies 30. What is a core competency and how do core competencies impact the feasi- ble set of alternative organizational strategies 31. “If an organization can borrow money or sell stock it does not have a capital constraint.” Is this statement true or false Discuss the rationale for your answer. 32. Differentiate between human structural and relationship forms of intellectual capital. Which do you believe is more important in each of the following or- ganizations: a start-up software development company a car dealership a uni- versity a hospital and Coca-Cola Provide reasons for your answers. 33. How can a change in governmental laws or regulations create a strategic op- portunity for an organization Give an example. 34. Define each of the strategies an organization may pursue to avoid competi- tion and discuss the benefits of each type of strategy. 35. Why would a useful business intelligence system contain substantial informa- tion about an organization’s competitors 36. What are the three generic segment missions and how are these missions re- lated to the concept of product life cycle 37. What is strategic resource management Why is financial accounting an insuf- ficient information source for strategic resource management 38. What is the value chain of an organization and how does it interface with strategic resource management Part 1 Overview 32 39. Terminology Match the following lettered items on the left with the appro- priate numbered description on the right. a. Authority 1. A target expressed in quantitative b. Centralization terms c. Core competency 2. The right to use resources to d. Decentralization accomplish something e. Empowerment 3. An expression of an organization’s f. Goal future path g. Mission 4. A process that an organization does h. Objective better than other organizations i. Planning 5. A desired result expressed j. Responsibility qualitatively 6. A situation in which all decisions are made by top management 7. The obligation to accomplish something 8. A situation in which employees are allowed to make decisions about their work 9. The process of determining long-term and short-term strategies 10. A situation in which many decisions are made by subordinate managers EXERCISES

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40. Terminology Match the following lettered items on the left with the appro- priate numbered description on the right. a. Business intelligence system 1. An organization’s intangible assets b. Differentiation of skill knowledge and information c. E-commerce 2. A belief about moral and immoral d. Economic integration behavior e. Ethical standard 3. The long-term plan related to f. Intellectual capital organizational goals and objectives g. Organizational culture 4. The way in which authority and h. Organizational structure responsibility are distributed in an i. Strategy organization j. Value chain 5. The basic assumptions about an organization its goals and its practices 6. A strategy based on differentiating products or services from those of competitors 7. The source of information about external competitors and markets 8. The processes of an organization and its suppliers to convert inputs into products and services structure 9. The process of using the Internet to buy and sell goods 10. The process of creating multi-country markets 41. Accounting information You are the owner and manager of a small auto re- pair shop that does routine maintenance major repairs and body work. Busi- ness is good and your monthly financial statements show that your shop is consistently profitable. Cash flow is becoming a small problem however and you may need to take out a loan from the bank. You have also been receiv- ing customer complaints about time delays and price increases. a. What accounting information do you think is most important to take with you to discuss a possible loan with your banker b. What accounting information do you think is most important in ascertain- ing the business activities of your repair shop in regard to addressing time delays and price increases What about nonaccounting information c. Can the various information in parts a and b be gathered from the ac- counting records directly Indirectly If not at all where would you need to look for such information 42. Globalization The 1996 annual report of Callaway Golf Company head- quartered in California was slightly untraditional in that the opening “letter” to shareholders was given not only in English but also in German French Spanish Japanese and Chinese. a. Discuss the costs and benefits of a U.S.-based company taking the time to provide such translations. b. What additional information would you want to have to assess how such translations are related to Callaway’s strategic plans 43. E-commerce A new aspect of e-commerce is home management services. An- dersen Consulting predicts that “the market for on-line orders of food house- hold goods and services will mushroom from 100 million in 1997 to 57 bil- lion or more by 2007.” 29 Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 33 29 Jane Hodges “On the Web It’s Slow Food” Fortune October 26 1998 p. 262. http://andersenconsulting .com

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You own a grocery store in downtown San Francisco and have decided to allow on-line customer orders and provide delivery. a. What problems could arise from the on-line ordering How would you and your staff solve these issues b. What problems could arise from the delivery process How would you and your staff solve these issues 44. E-commerce It is predicted that e-commerce will help speed the process of a single European market by forming “eZones” or “regions of Internet com- merce between cross-border constituencies.” 30 Use library and Internet re- sources to gather information and write a short description on how e-com- merce has affected European market harmonization. 45. Trade agreements You have been appointed to a business advisory group in your country to consider the implementation of the NAFTA. What issues relative to implementation concern you and why 46. Business risks You have just been promoted to manage a branch location of a regional bank. a. Provide three examples of the strategic operating financial and informa- tion risks that your organization faces. b. What might you do to minimize the impacts of each of these risks 47. Mission Obtain a copy of your college’s mission statement. Draft a mission statement for this class that supports the college’s mission statement. a. How does your mission statement reflect the goals and objectives of the college’s mission statement b. How can you measure the successful accomplishment of your college’s objectives 48. Strategy You are the manager of the local Home Depot store. What are the five factors that you believe to be most critical to the success of your organi- zation How would these factors influence your store’s strategy 49. Strategy You are the manager of a small restaurant in your hometown. a. What information would you want to have in making the decision whether to add chicken fajitas and Boston clam chowder to your menu b. Why would each of the above information items be significant 50. Empowerment Early this year you started a house-cleaning service and now have 20 customers. Because of other obligations including classes you have had to hire three employees. a. What types of business activities would you empower these employees to handle and why b. What types of business activities would you keep for yourself and why 51. Core competencies As a team make a list of the core competencies of your college or university and explain why you believe these items to be core com- petencies. Make appointments with the dean one vice president and if pos- sible the president of your college or university and without sharing your list ask these individuals what they believe the core competencies to be and why. Prepare a written or video presentation that summarizes compares and con- trasts all the lists. Share copies of your presentation with all the individuals you contacted. 52. Intellectual capital Use library and Internet resources to research the inclu- sion of intellectual capital measurement at Skandia a Swedish financial services company. Write a short paper describing the company’s IC measurement process. Part 1 Overview 34 30 Robert F. Randall “Internet Will Speed Europe Market Harmonization” Strategic Finance May 1999 p. 20. .com

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53. Organizational culture Southwest Airlines is known for its “wacky” organi- zational culture. Use library and Internet resources to research this culture and write a brief paper about how you believe the culture has impacted Southwest’s strategy and organizational profitability. 54. Competition strategy Choose a company that might utilize each of the fol- lowing strategies relative to its competitors and discuss the benefits that might be realized from that strategy. Indicate the industry in which the company does business and the company’s primary competitors. a. Differentiation b. Cost leadership c. Confrontation 55. Value chain You are the management accountant for a manufacturer of break- fast cereals. You’ve been asked to prepare a presentation that will illustrate the company’s value chain. a. What activities or types of companies would you include in the upstream supplier part of the value chain b. What internal activities would you include in the value chain c. What activities or types of companies would you include in the down- stream distribution and retailing part of the value chain 56. Organizational accountants Use library and Internet resources to find how the jobs of management accountants have changed in the last 10 years. a. Prepare a “then vs. now” comparison. b. What five skills do you believe are the most important for management accountants to possess Discuss the rationale for your choices. Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 35 57. E-commerce Competition in your industry is becoming fierce and you decide to begin selling on-line. Select one of the following industries and research the benefits and problems of e-commerce by a company in that industry. One ar- ticle is suggested as a starting point for each industry. a. Banking Paul Beckett “American Express Starts Online Bank An Increas- ingly Competitive Business” The Wall Street Journal July 23 1999. b. Brokerage Shawn Tully “Will the Web Eat Wall Street” Fortune August 2 1999. c. Automobile sales Fara Warner “ AutoNations Team Up to Offer Online Car-Buying Service” The Wall Street Journal July 28 1999. 58. Mission statement You have owned Lee Construction for 15 years and em- ploy 100 employees. Business has been profitable but you are concerned that the locale in which your business is based may soon experience a downturn in growth. One way you have decided to help prepare for such an event is to engage in a higher level of strategic planning beginning with a mission statement for your company. Note: The December 1996 Management Ac- counting article “Measuring Your Mission” may provide a useful starting point. a. How does a mission statement add strength to the strategic planning process b. Who should be involved in developing a mission statement and why c. What factors should be considered in the development of a mission state- ment Why are these factors important d. Prepare a mission statement for Lee Construction and discuss how your mission statement will provide benefits to tactical in addition to strategic planning. CASES

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Part 1 Overview 36 59. Benefits of successful planning Successful business organizations appear to be those that have clearly defined long-range goals and a well-planned strat- egy to reach those goals. These successful organizations understand their mar- kets as well as the internal strengths and weaknesses of the organizations. These organizations take advantage of this knowledge to grow through in- ternal development or acquisitions in a consistent and disciplined manner. a. Discuss the need for long-range goals for business organizations. b. Discuss how long-range goals are set. c. Define the concepts of strategic planning and management control. Dis- cuss how they relate to each other and contribute to progress toward the attainment of long-range goals. CMA adapted 60. Strategy Dell Computer Co. has a straightforward business strategy: “Elimi- nate middlemen and don’t build PCs until you have firm orders in hand.” 31 a. Dell is gaining a large European market share using its uniquely American strategy. Provide some reasons why a U.S. strategy might not be accepted by overseas customers. b. Dell once tried to enter the retail sales market instead of relying on direct sales. Research Dell’s attempt at a different strategic approach and discuss its outcome. 61. Strategy Select a major company in a well-known industry. Use library In- ternet and other resources to answer as completely as possible the questions in Exhibit 1–7 about the company you have chosen. 62. Organizational constraints Four common organizational constraints involve monetary capital intellectual capital technology and organizational structure. Additionally the environment in which the organization operates may present one or more types of constraints cultural fiscal legal/regulatory or political. a. Discuss whether each of these constraints might or might not be influen- tial in the following types of organizations: 1. City Hall in a major metropolitan city 2. a franchised quick-copy business 3. a newly opened firm of attorneys all of whom recently graduated from law school 4. an international oil exploration and production company Explain the rationale for each of your answers. b. For each of the previously listed organizations discuss your perceptions of which of the constraints would be most critical and why. c. For each of the previously listed organizations discuss your perceptions of whether human or structural capital would be most important and why. 63. Organizational culture The United States provides an ethnically racially and culturally diverse workplace. It has been argued that this plurality may be a competitive handicap for U.S. businesses. For example communicating may be difficult because some workers do not speak English motivating workers may be complicated because workers have diverse work ethics and work scheduling may be difficult because of differing religions and ethnic holidays. It has been argued that Japan has a competitive advantage because its popu- lation is much more homogeneous. a. What are the advantages of a pluralistic society in the global marketplace b. On balance does America’s plurality give it a competitive advantage or place it at a competitive disadvantage Discuss. 64. Competition You recently received a very large inheritance and have decided to buy an existing business or open a new business. Given your interests you have narrowed your choices to the following: 31 Silvia Ascarelli “Dell Finds U.S. Strategy Works in Europe” The Wall Street Journal February 3 1997.

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• Purchase the existing cable company in your regional area. • Purchase an airline that operates in most areas of the country. • Open a plant to manufacture and sell hot-sauce domestically and in Cen- tral and South America. • Buy franchises for and open 15 locations of a fast-food restaurant in areas of the former Soviet Union. a. Discuss the competitive influences that will impact each of your potential businesses. b. How would the tactics of product/service differentiation cost leadership or confrontation work in each of your potential businesses c. What would be the most critical factors for each of your potential businesses d. Which business would you open and why 65. Value chain Strategic alliances are important parts of the value chain. In many organizations suppliers are beginning to provide more and more input into customer activities. a. In the United States when would a strategic alliance be considered illegal b. What would you perceive to be the primary reasons for pursuing a strate- gic alliance c. You are the manager of a catalog company that sells flowers and plants. With whom would you want to establish strategic alliances What issues might you want to specify prior to engaging in the alliance Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 37 66. Many individuals do not shop on-line because of the risk of theft of passwords credit card numbers and so forth. Do you believe that this risk is a significant one Discuss the rationale for your answer. 67. You are a senior manager at a large domestic firm. All senior managers and the board of directors are scheduled for a meeting next week to discuss the opportunities for e-business. The CEO has asked you to be prepared to start the discussion by developing questions that should be addressed before em- barking on such a strategy. Categorize your questions as follows: a. executive focus on strategy and risks b. customers c. products and services d. value chain e. competition f. business processes and technology g. regulatory and tax environment 68. The Foreign Corrupt Practices Act FCPA prohibits U.S. firms from giving bribes in foreign countries although giving bribes is customary in some countries and non-U.S. companies operating in foreign countries may not be similarly re- stricted. Thus adherence to the FCPA could make competing with non-U.S. firms more difficult in foreign countries. Do you think that bribery should be considered so ethically repugnant to Americans that companies are asked to forego a foreign custom and hence the profits that could be obtained through observance of the custom Prepare both a pro and a con position for your answer assuming you will be asked to defend one position or the other. 69. As chief legal officer in a well-respected company making lifesaving drugs Alistair had been asked by his board of directors to look into rumors of price-fixing in the firm’s European offices. His board has a very strong ethics REALITY CHECK

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policy and especially wary of price-fixing bribery kick-backs and other un- ethical activities that can plague overseas operations. After conducting detailed interviews in Europe for several months Alistair was satisfied that the rumors were groundless. As one of the European man- agers said “There’s no issue here.” But he added “if you really want some- thing to investigate look into the Bosnia contract.” Over the months Alistair kept hearing about “the Bosnia contract.” So when he had finished his report on the price-fixing rumors he decided to delve into the other matter. The contract he discovered had been ordinary in almost every respect: A major relief organization had contracted with his com- pany to supply one million inexpensive kits of medicine for delivery into the war-torn regions of Bosnia. Like most such contracts with charitable organiza- tions it contained hardly any profit for his firm. What he found strange however was the payment of an extraordinarily large commission to a Romanian distributor to deliver the kits deep into Bosnia. Seeking out the executive in his own firm who had negotiated the contract he had one question in mind: Was this a bribe Yes and no said the executive. According to the Romanian distributor the backs of the delivery trucks were loaded with the kits—and the glove com- partments were stuffed with cash. That way when the drivers were stopped at roadblocks set up by local militia units operating all across Bosnia they could pay whatever was demanded and continue their journey. In the past he noted drivers without cash had been taken from their trucks and shot. For the kits to be delivered this was a cost of doing business. Alistair felt sure that none of the money had flowed back to the execu- tive whose only motive was to get the kits delivered. And by this time the deliveries had already been made. Yet Alistair still faced a dilemma. Should he draft a separate report to the board on this most unorthodox contract—possi- bly causing great harm to the executive who had negotiated it or embarrass- ment to the relief organization which was aware of the commission Or should he keep silent Everything in Alistair’s background with his company told him that this contract was not the way to do business. Bribery he knew was sim- ply unacceptable to the board who felt strongly that once that barrier was breached there would be no stopping the shakedowns in the future. But everything in his makeup as a compassionate being told him that pro- viding medicine for the wounded was of overriding importance and that the normal ethics of commerce didn’t apply in a war zone. What should Alistair do 70. “Few trends could so thoroughly undermine the very foundation of our free society” writes Milton Friedman in Capitalism and Freedom “as the accep- tance by corporate officials of a social responsibility other than to make as much money for their shareholders as possible.” a. Discuss your reactions to this quote from a legal standpoint. b. Discuss your reactions to this quote from an ethical standpoint. c. How would you resolve any conflicts that exist between your two answers 71. Mission statements are supposed to indicate what an organization does and why it exists. Some of them however are simply empty words with little or no substance and with few people using them to guide activities. a. Why does an organization need a mission statement Or does it b. How might a mission statement help an organization in its pursuit of eth- ical behavior from employees c. How might a mission statement help an organization in its pursuit of pro- duction of high-quality products and provision of high levels of customer service Part 1 Overview 38

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72. Intellectual capital is extremely important to the longevity of an organization. There are however “intellectual capital pirates” who make their livings from stealing. a. Assume that you have made several popular recordings. These recordings are being pirated overseas. Discuss how you view these intellectual capital pirates and what if anything should be done to them. b. Copying a computer software program is also intellectual capital piracy. Do you perceive any difference between this type of copying and the copy- ing of recordings Discuss the rationale for your answer. 73. Accounting has a long history of being an ethical profession. In recent years however some companies have asked their accountants to help “manage earnings.” a. What does it mean to “manage earnings” b. List several companies that have been accused of “managing earnings.” c. Who is more likely to be involved in such a situation: the financial accoun- tant or the management accountant Why d. Do you believe that “managing earnings” is ethical Discuss the rationale for your answer. Chapter 1 Introduction to Cost and Management Accounting in a Global Business Environment 39

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2 Introduction to Cost Management Systems CHAPTER LEARNING OBJECTIVES After completing this chapter you should be able to answer the following questions: 1 Why do organizations have management control systems 2 What is a cost management system and what are its primary goals 3 What major factors influence the design of a cost management system 4 Why should one consider organizational form structure and culture when designing a cost management system 5 How do the internal and external operating environments impact the cost management system 6 What three groups of elements affect the design of a cost management system and how are these elements used 7 How is gap analysis used in the implementation of a cost management system

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Motorola Inc. INTRODUCING hen times are tough some people eat their seed corn. Motorola managers are planting theirs. Despite recent struggles in businesses such as cellu- lar phones and satellites this big electronics company is boosting efforts in basic research that might not pay off for several years. Motorola’s initiative is not yet in the league of such companies as International Business Ma- chines Corp. or Lucent Technologies but it is taking the company in some unusual directions. The biggest breakthrough so far has been organiza- tional. This past November Motorola combined separate research groups for wireless communications chips and other products into a single corporate entity called Motorola Labs. The goal was to reduce duplication spend funds more efficiently and develop ideas faster. Surprisingly the move didn’t mean cost savings after looking at other big companies’ research arms Motorola officials concluded they were spending too little. “We dis- covered there’s a relatively steady proportion spent on re- search: about one percent of prior-year revenues. We were a little below that” recalls Dennis Robertson Mo- torola’s chief technology officer. Motorola began loosening the spending spigot. The one percent goal with Motorola’s 1998 revenue of 30 bil- lion would be 300 million a year. While Robertson didn’t give precise figures he said Motorola is getting close to the target. There is an old adage that declares “you have to spend money to make money.” The adage expresses the idea that revenues cannot be produced without first in- curring costs. Motorola managers have recognized the necessity of incurring costs to realize revenues by increasing expenditures on research and development with the expectation that an increase in revenues will follow. However the managers have also recognized that costs must be contained for the relationships among costs revenues and profits to be satisfactory—a large amount of costs cannot be incurred to produce a modest amount of revenue. Motorola managers acted to con- tain costs when they created Motorola Labs “to spend funds more efficiently. . . .” A fundamental concern managers have in executing their duties is how their actions affect costs incurred and benefits received by their employers. Ultimately most models applied by managers reduce to a comparative analysis of costs ver- sus benefits. Financial experts especially accountants bear the primary responsi- bility for providing managers with information about measurements of costs and benefits. In Chapter 1 the differences and similarities among the disciplines of financial management and cost accounting were discussed. Cost accounting was shown to play a role in both internal and external reporting. Also the linkages between cost accounting and the specific managerial functions of planning controlling decision making and performance evaluation were shown. Cost accounting practices are increasingly being scrutinized by financial ex- perts who hope to improve the relevance of the information they provide to man- agers and external parties. As shown in Exhibit 2–1 cost accounting has recently become the top financial function target for reengineering according to a 1998 membership survey of the Institute of Management Accountants. Because a given cost accounting system is typically cast in two separate often competing roles and because the financial reporting role often dominates the management role cost accounting information is frequently found to be of limited value to managers. SOURCE: Quentin Hardy “Business Brief—Motorola Inc.: Wireless Divisions to Add 1400 Workers by Year-End” The Wall Street Journal June 17 1999 p. B6. Permission conveyed through the Copyright Clearance Center. 41 W

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INTRODUCTION TO MANAGEMENT INFORMATION AND CONTROL SYSTEMS A cost management system is part of an overall management information and con- trol system. Exhibit 2–2 illustrates the types of information needed in an organization The problem is that the dictates of financial reporting are very different from those of strategic cost management. For financial reporting purposes cost infor- mation can be highly aggregated historical and must be consistent with GAAP. In contrast the cost information required for management purposes may be seg- mented current and relevant for a particular purpose. Consequently the cost in- formation provided by the financial reporting system is of little value for cost man- agement purposes. 1 In redesigning cost accounting systems the general internal use of information and the specific application of information to manage costs are getting increased attention. This chapter discusses concepts and approaches to designing informa- tion systems that support the internal use of accounting and other information to manage costs. The perspective taken is that a cost management system is an inte- gral part of an organization’s overall management information and control systems. An emphasis is placed on the main factors that determine the structure and suc- cess of a cost management system the factors that influence the design of such a system and the elements that comprise the system. The next section provides a broad introduction to management information and control systems. It offers a foundation and context for understanding the roles of the cost management system. Part 1 Overview 42 EXHIBIT 2–1 Which Finance Functions Are You Reengineering Percentage of respondents restructuring this area 0 10 20 30 40 50 60 70 80 Cost accounting Financial accounting Accounts payable Accounts receivable Travel/Entertainment Other SOURCE: Staff “Cost Accounting Systems Become Top Target of Reengineering in the Finance Function” Cost Man- agement Update a publication of the Cost Management Group of IMA July/August p. 3. Copyright by Institute of Management Accountants Montvale N.J. 1 Robin Cooper and Regine Slagmulder “Strategic Cost Management: Introduction to Enterprise-wide Cost Management” Man- agement Accounting August 1998 p. 17. Why do organizations have management control systems 1 What is a cost management system and what are its primary goals 2

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for individuals to perform their managerial functions. The exhibit also demonstrates the demand from external parties for information from the firm. A management information system MIS is a structure of interrelated elements that collects or- ganizes and communicates data to managers so they may plan control make de- cisions and evaluate performance. A MIS emphasizes satisfying internal demands for information rather than external demands. In most modern organizations the MIS is computerized for ease of access to information reliability of input and pro- cessing and ability to simulate outcomes of alternative situations. As Exhibit 2–2 illustrates the accounting personnel are charged with the task of providing information to interested external parties such as creditors the gov- ernment for mandatory reporting to the Internal Revenue Service Securities and Exchange Commission and other regulatory bodies and suppliers in regard to payments and purchases. External intelligence is also gathered from these parties as well as from competitors. Managers use internally and externally generated in- formation to govern their organizations. Because one of the managerial functions requiring information is control the MIS is part of the management control system MCS. As illustrated in Exhibit 2–3 a control system has the following four primary components: Chapter 2 Introduction to Cost Management Systems 43 management information system MIS EXHIBIT 2–2 Information Flows and Types of Information Clients: Customers Students Patients Citizens Suppliers Competition Creditors Government The Organization Intelligence information external flows inward External operating environment Organizational communications external flows outward Intraorganization information horizontal and vertical flows 1. Planning information 2. Control information 3. Decision information 4. Performance information Information flows both to and from an organization. Once inside the organization it flows both vertically and horizontally. SOURCE adapted: James H. Donnelly Jr. James L. Gibson and John M. Ivancevich Fundamentals of Management Plano TX: Business Publications Inc. 1987 p. 565. management control system MCS

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1. A detector or sensor which is a measuring device that identifies what is actu- ally happening in the process being controlled. 2. An assessor which is a device for determining the significance of what is hap- pening. Usually significance is assessed by comparing the information on what is actually happening with some standard or expectation of what should be happening. 3. An effector which is a device that alters behavior if the assessor indicates the need for doing so. This device is often called “feedback.” 4. A communications network which transmits information between the detec- tor and the assessor and between the assessor and the effector. 2 It is through these system elements that information about actual organizational ocurrences is gathered comparisons are made against plans changes are effected when necessary and communications take place among appropriate parties. For example source documents detectors gather information about sales that is com- pared to the budgets assessor. If sales revenues are below budget management may issue communications network a variance report effector to encourage the sales staff to increase volume. However even given the same information different managers may interpret it differently and respond accordingly. In this respect a management control sys- tem is not merely mechanical it requires judgment. Thus a management control system may be referred to as a black box: an operation whose exact nature can- not be observed. 3 Regardless of the specific actions taken a management control system should serve to guide organizations in designing and implementing strate- gies such that organizational goals and objectives are achieved. Most businesses have a variety of control systems in place. For example a control system may reflect a set of procedures for screening potential suppliers or employees a set of criteria to evaluate potential and existing investments or a statistical control process to monitor and evaluate quality. Another important part of the management information and control systems is the cost management system. Part 1 Overview 44 EXHIBIT 2–3 Elements of a Control System Control device 2. Assessor—Comparison with standard. 3. Effector—Behavior altering communication if needed. 1. Detector—Observes information about what is happening. Entity being controlled SOURCE: Robert N. Anthony and Vijay Govindarajan Management Control Systems Chicago: Irwin 1995 p. 4. Reprinted by permission of The McGraw-Hill Companies. 2 Robert N. Anthony and Vijay Govindarajan Management Control Systems Chicago: Irwin 1995 p. 3. 3 Ibid. p. 6.

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Chapter 2 Introduction to Cost Management Systems 45 Short Run Long Run Objective Organizational efficiency Survival Focus Specific costs: Cost categories: • manufacturing • customers • service • suppliers • marketing • products • administration • distribution channels Important characteristics Timely Periodic of information Accurate Reasonably accurate Highly specific Broad focus Short-term Long-term SOURCE: Adapted from: Robin Cooper and Regine Slagmulder “Operational Improvement and Strategic Costing” Management Accounting September 1998 pp. 12–13. EXHIBIT 2–4 Dual Focus of Cost Management System DEFINING A COST MANAGEMENT SYSTEM A cost management system CMS consists of a set of formal methods developed for planning and controlling an organization’s cost-generating activities relative to its short-term objectives and long-term strategies. Business entities face two major challenges: achieving profitability in the short run and maintaining a competitive position in the long run. An effective cost management system must provide man- agers the information needed to meet both of these challenges. Exhibit 2–4 summarizes the differences in the information requirements for or- ganizational success in the short run and long run. The short-run requirement is that revenues exceed costs—the organization must make efficient use of its re- sources relative to the revenues that are generated. Specific cost information is needed and must be delivered in a timely fashion to an individual who is in a po- sition to influence the cost. Short-run information requirements are often described as relating to operational management. Meeting the long-run objective survival depends on acquiring the right inputs from the right suppliers selling the right mix of products to the right customers and using the most appropriate channels of distribution. These decisions require only periodic information that is reasonably accurate. Long-run information re- quirements are often described as relating to strategic management. The information generated from the CMS should benefit all functional areas of the entity. Thus the system should integrate the areas shown in Exhibit 2–5 and should “improve the quality content relevance and timing of cost information that managers use for short-term and long-term decision making.” 4 Crossing all functional areas a cost management system can be viewed as hav- ing six primary goals: 1 develop reasonably accurate product costs especially through the use of cost drivers activities that have direct cause-and-effect rela- tionships with costs 2 assess product/service life-cycle performance 3 improve understanding of processes and activities 4 control costs 5 measure perfor- mance and 6 allow the pursuit of organizational strategies. First and foremost a CMS should provide the means to develop accurate prod- uct or service costs. This requires that the system be designed to use cost driver information to trace costs to products and services. The system does not have to be the most accurate but it should match benefits of additional accuracy with ex- penses of achieving additional accuracy. Traceability has been made easier by im- proved information technology including bar coding. What major factors influence the design of a cost management system cost management system CMS 3 4 Steven C. Schnoebelen “Integrating an Advanced Cost Management System into Operating Systems Part 2” Journal of Cost Management Spring 1993 p. 60. cost driver

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The product/service costs generated by the cost management system are the input to managerial processes. These costs are used to plan prepare financial state- ments assess individual product/service profitability and period profitability es- tablish prices for cost-plus contracts and create a basis for performance measure- ments. If the input costs generated by the CMS are not reasonably accurate the output of the preceding processes will be inappropriate for control and decision- making purposes. Although product/service profitability may be calculated periodically as a re- quirement for external reporting the financial accounting system does not reflect life-cycle information. The cost management system should provide information about the life-cycle performance of a product or service. Without life-cycle infor- mation managers will not have a basis to relate costs incurred in one stage of the life cycle to costs and profitability of other stages. For example managers may not recognize that strong investment in the development and design stage could pro- vide significant rewards in later stages by minimizing costs of engineering changes and potential quality-related costs. Further if development/design cost is not traced to the related product or service managers may not be able to recognize organi- zational investment “disasters.” A cost management system should help managers comprehend business processes and organizational activities. Only by understanding how an activity is ac- complished and the reasons for cost incurrence can managers make cost-beneficial improvements in the production and processing systems. Managers of a company desiring to implement new technology or production systems must recognize what costs and benefits will flow from such actions these assessments can be made only if the managers understand how the processes and activities will differ after the change. The original purpose of a cost accounting system was to control costs. This is still an important function of cost management systems given the current global competitive environment. A cost can be controlled only when the related activity Part 1 Overview 46 EXHIBIT 2–5 An Integrated Cost Management System Cost Accounting Marketing Financial Accounting Quality Control Research and Development Production Planning and Scheduling Inventory Management Production Reporting SOURCE: Robert McIlhattan “The Path to Total Cost Management” Emerging Practices in Cost Management Barry J. Brinker ed. Boston Warren Gorham Lamont 1990 p. 178. Reprinted with permission of RIA.

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is monitored the cost driver is known and the information is available. For ex- ample if units are spoiled in a process the CMS should provide information on spoilage quantity and cost rather than “burying” that information in other cost cat- egories. Additionally the cost management system should allow managers to un- derstand the process so that the underlying causes of the spoilage can be deter- mined. Armed with this information managers can compare the costs of fixing the process with the benefits to be provided. The information generated from a cost management system should help man- agers measure and evaluate performance. The measurements may be used to eval- uate human or equipment performance or to evaluate future investment opportu- nities. As indicated in the accompanying News Note one of the critical decisions managers must make involves trade-offs between long-run strategic benefits and short-run operational benefits. Chapter 2 Introduction to Cost Management Systems 47 A Little Pain Now for a Potential Big Gain Later NEWS NOTE GENERAL BUSINESS Inc. posted a 138 million net loss for the second quarter of 1999 and warned that future results would be affected by heavy spending on bigger ware- houses. It followed this up with the assertion that three new strategic initiatives—on-line auctions toy sales and electronic sales—were off to brisk starts. The latest results mark yet another quarter in which the Seattle-based on-line merchant has pursued brand build- ing and rapid revenue growth at the expense of near-term profitability. For the quarter revenue nearly tripled to 314.4 million from the year-earlier 116 million. Amazon noted that total customer accounts grew to 10.7 million as of June 30 up 2.3 million from the March 31 tally. How- ever even with the huge growth in revenues the loss posted for the second quarter exceeded the total rev- enues generated in the same quarter for the prior year. In a conference call with investors CEO Jeff Bezos cautioned: “We’re new to these businesses. I can guar- antee you we won’t operate as efficiently in the near term as we would like.” That means ordering more inventory than needed and building warehouses before they are fully needed. That can affect profit margins according to Bezos but he defended it as the right choice for Ama- zon’s long-term growth. SOURCE: George Anders “Amazon Posts 138 Million Loss but Sales Surge” The Wall Street Journal July 22 1999 p. B6. Permission conveyed through the Copyright Clearance Center. Financial accounting requires that research and development costs be expensed when in- curred. However because these costs are essential to any result- ing product a cost manage- ment system would trace them to that product as part of life-cycle costing.

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Lastly to maintain a competitive position in an industry a firm must generate the information necessary to define and implement its organizational strategies. As discussed in Chapter 1 strategy is the link between an organization’s goals and objectives and the operational activities executed by the organization. In the current global market firms must be certain that such a linkage exists. Information pro- vided by a CMS enables managers to perform strategic analyses on issues such as determining core competencies and organizational constraints from a cost-benefit perspective and assessing the positive and negative financial and nonfinancial fac- tors of strategic and operational plans. The News Note about illustrates how managers must consider trade-offs between the benefits of incurring costs for short-term and long-term benefits. Thus the cost management system is essential to the generation of information for effective strategic resource management. Because the world of business competition is dynamic and creative managers are constantly devising new business practices and innovative approaches to com- petition a cost management system must be dynamic. The following section dis- cusses the issues affecting the design and ongoing development of cost manage- ment systems in a continually evolving organization. Part 1 Overview 48 DESIGNING A COST MANAGEMENT SYSTEM In designing and revising a cost management system managers and accountants must be attuned to the unique characteristics of their firms. A generic cost man- agement system cannot be “pulled off the shelf” and applied to any organization. Each firm warrants a cost management system that is tailored to its situation. How- ever some overriding factors are important in designing a cost management sys- tem. These factors are depicted in Exhibit 2–6 and are described in this section. Organizational Form Structure and Culture An entity’s legal nature reflects its organizational form. Selecting the organiza- tional form is one of the most important decisions business owners make. This choice affects the costs of raising capital operating the business including taxa- tion issues and possibly litigating. The available organizational form alternatives have increased remarkably in recent years. The most popular form for large publicly traded businesses is the corporation. However smaller businesses or cooperative ventures between large businesses also use general partnerships limited partnerships limited liability partnerships LLPs and limited liability companies LLCs. These latter two forms have recently emerged due to new federal state and international legislation. Both the LLP and LLC pro- vide more protection for a partner’s personal assets than a general partnership in the event of litigation that leads to firm liquidation. Accordingly LLPs and LLCs may offer better control for legal costs than general partnerships. Organizational form also helps determine who has the statutory authority to make decisions for the firm. In a general partnership all partners are allowed to make business decisions as a mere incidence of ownership. Alternatively in a cor- poration individual shareholders must act through a board of directors who in turn typically rely on professional managers. This ability to “centralize” authority is regarded as one of the primary advantages of the corporate organizational form and to some extent is available in limited partnerships LLPs and LLCs. Once the organizational form is selected top managers are responsible for cre- ating a structure that is best suited to achieving the firm’s goals and objectives. Or- ganizational structure introduced in Chapter 1 refers to how authority and re- sponsibility for decision making are distributed in the entity. 5 Top managers make Why should one consider organizational form structure and culture when designing a cost management system organizational form 4 5 Organizational structure is discussed in detail in Chapter 1 and later in this chapter.

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judgments about how to organize subunits and the extent to which authority will be decentralized. Although the current competitive environment is conducive to strong decentralization top managers usually retain authority over operations that can be performed more economically centrally because of economies of scale. For example financing personnel and certain accounting functions may be maintained “at headquarters” rather than being delegated to organizational subunits. In designing the organizational structure top managers normally will try to group subunits either geographically or by similar missions or natural product clus- ters. These aggregation processes provide effective cost management because of proximity or similarity of the units under a single manager’s control. For example relative to similarity of mission Chapter 1 introduced three generic missions build harvest and hold for business subunits. Subunits pursuing a “build” mission are using more cash than they are generating. Such subunits are investing cash with an expectation of future returns. At the other extreme subunits pursu- ing a “harvest” mission are expected to generate excess cash and have a much shorter investment horizon. If one manager were responsible for subunits that rep- resented both build and harvest missions it would be difficult for top management Chapter 2 Introduction to Cost Management Systems 49 EXHIBIT 2–6 Design of a Cost Management System ANALYZE • Organizational form structure and culture • Organizational mission and core competencies • Operations including suppliers and competitive environment and strategies DETERMINE desired outputs performance measures and reports of CMS to support above items Must consider • Motivational elements • Informational elements • Reporting elements PERFORM gap analysis between desired output and output of current cost accounting/MIS systems • Prioritize differences • Develop and deploy key improvements to CMS IMPROVE A CMS is never “finished.” It requires a continuous improvement cycle to reflect organizational and environmental changes. ASSESS gap reduction generated by improvements

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to design proper incentives and performance evaluation measures for the subunit manager or to evaluate his or her cost management effectiveness and efficiency. Different cost management tools are used for different subunit missions. If a spe- cific cost management tool is to be applied to an entire subunit but there is a mix of missions across that subunit’s components there is greater potential for making poor decisions. The extent to which managers decentralize also determines who will be held accountable for cost management and organizational control. An information sys- tem must provide relevant and timely information to persons who are making de- cisions that have cost control implications and a control system must be in place to evaluate the quality of those decisions. An entity’s culture also plays an important role in setting up a cost manage- ment system. Organizational culture refers to the underlying set of assumptions about the entity and the goals processes practices and values that are shared by its members. To illustrate the effect of organizational culture on the cost manage- ment system consider ATT prior to its divestiture. It was an organization char- acterized by “bureaucracy centralized control nepotism a welfare mentality in which workers were ‘taken care of’ strong socialization processes and little con- cern for efficiency. . . .” 6 In such a culture the requirements of a cost management system would have been limited because few individuals needed information de- cisions were made at the top of the organization and cost control was not a con- sideration because costs were passed on to customers through the rate structure. After divestiture the company’s culture changed to embrace decentralized decision making cost efficiency and individual responsibility and accountability. Support- ing such a changed culture requires different types quantities and distributions of cost management information. The values-based aspects of organizational culture are also extremely important in assessing the cost management system. For example one part of Birmingham Steel Corporation’s mission statement is “to be the lowest-cost highest-quality man- ufacturer of steel products in the markets served.” 7 Without a well designed cost management system Birmingham Steel could not evaluate how well it is progressing toward the accomplishment of that mission. Thus the cost management system is instrumental in providing a foundation for companies with an organizational culture that emphasizes total quality management. Organizational Mission and Core Competencies Knowledge of the organization’s mission and core competencies is a key consid- eration in the design of a cost management system. The mission provides a long- term goal toward which the organization wishes to move. If the mission that the entity wishes to achieve is unknown it does not matter what information is gen- erated by the cost management system—or any other information system As discussed in Chapter 1 in pursuing the business mission companies may avoid or confront competition. For example companies may try to avoid compe- tition by attempting to be more adept in some way than other entities. The generic paths a company may take to avoid competition include differentiation and cost leadership. 8 In the current global environment it is often difficult to maintain a competi- tive advantage under either a differentiation or cost leadership strategy. Competi- tors are becoming skilled at duplicating the specific competencies that gave rise to the original competitive advantage. For many companies the key to success in the future may be to confront competition by identifying and exploiting temporary Part 1 Overview 50 6 Thomas S. Bateman and Scott A. Snell Management Building Competitive Advantage Chicago: Irwin 1996 p. 268. 7 Birmingham Steel Corporation 1995 Annual Report p. 1. 8 Michael Porter Competitive Advantage: Creating and Sustaining Superior Performance New York: Free Press 1985 p. 17.

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opportunities for advantage. In a confrontation strategy companies “still try to dif- ferentiate their products by introducing new features or try to develop a price leadership position by dropping prices . . . but the companies assume that their competitors will rapidly bring out products that are equivalent and match any price changes.” 9 Although it may be necessary a confrontation strategy is by its very nature less profitable for companies than differentiation or cost leadership. Exhibit 2–7 shows how the strategy of the firm together with the life-cycle stages of products determines what a firm must do well to be successful at any point in time. This exhibit illustrates how the information requirements of man- agers change over time as the life cycle evolves and thus are dependent upon the strategy being pursued. The globalization of markets has created in many industries competition among equals. Today many firms are capable of delivering products and services that are Chapter 2 Introduction to Cost Management Systems 51 9 Robin Cooper When Lean Enterprises Collide Boston: Harvard Business School Press 1995 p. 11. LIFE-CYCLE STAGE Product Strategy Introduction Growth Maturity Decline Differentiation Product RD Strengthen Exploit Divest/spin off and design distinctive competitive operations are critical. product advantage. early. competencies Establish and formalize Maintain Relate presence in product heavy product service to market and support marketing new products. product structure. emphasis. distinctiveness. Marketing is critical. Cost Leadership Process RD Quickly Make no major Manage and design determine product reduce and are critical. product cost changes. control costs. structure and Manage high viability. Standardization Reduce costs present is critical. capacity and with low volume. Establish or evaluate increase low-cost market share alternatives and/or e.g. make distribution outsource channels. shutdown. Confrontation Minimize Establish Refine product Develop product market manufacturability existing development leadership and process distribution time. and reliability. network for new reliability. products. Design to facilitate Provide Increase and Emphasize process distribution innovate exceptional flexibility. for quick distribution service delivery. efforts. options. SOURCE: B. Douglas Clinton and Aaron H. Graves “Product Value Analysis: Strategic Analysis Over the Entire Product Life Cycle” Journal of Cost Management May/June 1999 p. 23. © 1999 Warren Gorham Lamont. Reprinted with permission of RIA. EXHIBIT 2–7 Strategy and Life-Cycle Stage Determine Critical Organizational Activities

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qualitatively and functionally equivalent. Without being able to distinguish one competitor’s products from those of another based on quality or functionality the consumer’s focus switches to price. In turn price-based competition changes the internal focus to costs. One industry currently particularly affected by price-based competition is communication. The accompanying News Note illustrates the shift to an intensive internal focus on costs. Clarification of mission can be served by identifying the organization’s core competencies which are dimensions of operations that are key to an organiza- tion’s survival. Most organizations would consider timeliness quality customer ser- vice efficiency and cost control and responsiveness to change as five critical com- petencies. Once managers have gained consensus on an entity’s core competencies the cost management system can be designed to 1 gather information related to measurement of those items and 2 generate output about those competencies in forms that are useful to interested parties. Competitive Environment and Strategies Once the organizational “big picture” has been established managers can assess internal specifics related to the design of a cost management system. A primary consideration is the firm’s cost structure. Traditionally cost structure has been defined in terms of how costs change relative to changes in production or sales volume. As firms have become increasingly dependent on automated technology it has become more difficult to control costs through sales and production. Many tech- nology costs are associated with plant equipment and infrastructure investments that provide the capacity to produce goods and services. Higher proportions of these costs exist in industries that depend on technology for competing on the bases of quality and price. Manufacturing and service firms have aggressively adopted advanced technology. The data shown in Exhibit 2–8 reveal the effects of technology on the efficiency of particular industries. 10 Sales per employee tradi- tionally has been viewed as a measure of organizational productivity. Technology acquisition and employee training are now regarded as principal sources of pro- ductivity improvement. Part 1 Overview 52 How Do You Raise Profits without Raising Prices NEWS NOTE GENERAL BUSINESS At a town meeting with employees early in 1999 ATT Corp.’s chief financial officer Daniel E. Somers was asked if the company was through with its battle to cut costs. “No we’re not” Somers recalls answering. “We think of costs the way we used to think of price. It’s some- thing we’re constantly working on.” It’s not just high-tech companies fighting this battle. Ingersoll-Rand Co. of Woodcliff Lake N.J. saw its aver- age selling price for products from door locks to industrial pumps increase just under 1 percent in 1998 after no in- crease in 1997. “In all of our business plans we really don’t count on price to increase our profits” said David W. Devonshire Ingersoll-Rand’s chief financial officer. “We really rely on what we’re doing on the cost side.” “Raising prices was just an easier way of making money than all of the other things you could think of” says Roseanne M. Cahn economist at Credit Suisse First Boston. “This is now getting into manager’s psyches that you do not have pricing power and guess what you have to do something else to make money.” SOURCE: Darren McDermott “Cost-Consciousness Beats ‘Pricing Power’ ” The Wall Street Journal May 3 1999 p. A1. Permission conveyed through the Copyright Clearance Center. How do the internal and external operating environments impact the cost management system cost structure 5 10 These data are not adjusted for inflation. http://www.ingersoll-rand .com

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The cost management implications of this shift in cost structure are significant. Most importantly because most technology costs are not susceptible to short-run control cost management efforts are increasingly directed toward the longer term. Also managing costs is increasingly a matter of capacity management: high ca- pacity utilization if accompanied by high sales volumes allows a firm to reduce its per-unit costs in pursuing a cost leadership strategy. A second implication of the changing cost structure is the firm’s flexibility to respond to changing short-term conditions. As the proportion of costs relating to technology investment increases a firm has less flexibility to take short-term ac- tions that would reduce costs with no long-term adverse consequences. 11 In pursuing either a differentiation or cost leadership strategy the management of high technology costs requires beating competitors to the market with new prod- ucts. The importance of timeliness is illustrated in the following quote: There are numerous innovations which have maximized a market window to achieve phenomenal success—Polaroid is a case in point. Equally there have been numerous high-quality products that arrived too late either because the market had been acquired by a competitor or because the need no longer ex- isted. By the time Head began to produce oversized tennis racquets Prince had cornered the market. 12 Being first to market may allow a company to set a price that leads to a large market share which in turn may lead to an industry position of cost leader. Al- ternatively the leading edge company may set a product price that provides a sub- stantial per-unit profit for all sales generated before competitors are able to offer alternative products. Rapid time-to-market requires fast development of new prod- ucts and services. Time-to-market is critical in the high-tech industry because profitability depends on selling an adequate number of units at an acceptable price. Because the price per unit has been falling steadily for years getting a new product to the market late can be disastrous. The risk is described by Richard O’Brien an economist for Hewlett-Packard in the following quote: 13 Chapter 2 Introduction to Cost Management Systems 53 YEAR Percentage Industry 1978 1998 Increase Agriculture and forestry 37 100 270 Air transportation 67 166 248 Computers 47 259 551 Grocery stores 85 143 168 Hotels and motels 21 51 243 Mining 80 102 128 Petroleum refining 265 710 268 Pharmaceuticals 66 270 409 Plastics 59 141 239 Restaurants 40 44 110 Steel works 85 327 385 Telephone and telegraph 68 208 306 Textiles 54 127 235 Trucking 66 157 238 SOURCE: COMPUSTAT an electronic financial data source published by Standard and Poors. EXHIBIT 2–8 Average Sales in thousands per Employee by Industry 11 Many of the new fixed costs would be regarded as “committed” rather than “discretionary.” See Chapter 15 for additional details. 12 Simon Cooper “There Is No Point Putting a Wind Spoiler on the Back of a Turtle” CMA Magazine February 1996 p. 4. 13 Darren McDermott “Cost Consciousness Beats ‘Pricing Power’ ” The Wall Street Journal May 3 1999 p. A1.

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“Product life cycles keep shrinking. If you can’t get to market on time you will have missed your chance because the price point will have moved.” Reducing time-to-market is one way a company can cut costs. Exhibit 2–9 lists other ways most of which are associated with the earlier stages of the product life cycle. Thus as has been previously mentioned product profitability is largely de- termined by an effective design and development process. Getting products to market quickly and profitably requires a compromise be- tween the advantages of product innovation and superior product design. Rapid time-to-market may mean that a firm incurs costs associated with design flaws such as the costs of engineering changes that could have been avoided if more time had been allowed for the product’s development. Also if a flawed product is mar- keted costs will likely be incurred for returns warranty work or customer “bad will” regarding the firm’s reputation for product quality. Time-to-market is important because of the competitive advantages it offers and because of compressed product life cycles. Both of these factors have a sig- nificant effect on cost management systems as discussed in the accompanying News Note. Another aspect of an organization’s operating environment is supplier relations. Many companies that have formed strategic alliances with suppliers have found such relationships to be effective cost control mechanisms. For example by in- volving suppliers early in the design and development stage of new products a better design for manufacturability will be achieved and the likelihood of meeting cost targets will be improved. Additionally if information systems of customers and suppliers are linked electronically the capabilities and functions of systems must be considered in designing the CMS. Another operating environment consideration in the design of a cost manage- ment system is the need to integrate the organization’s current information sys- tems. The “feeder” systems such as payroll inventory valuation budgeting and costing that are in place should be evaluated to answer the following questions: • What data are being gathered and in what form • What outputs are being generated and in what form • How do the current systems interact with one another and how effective are those interactions Part 1 Overview 54 • Develop new production processes • Capture learning curve and experience effects • Increase capacity utilization • Use focused factory arrangement — reduces coordination costs • Design for manufacturability — reduces assembly time — reduces training costs — reduces warranty costs — reduces required number of spare parts • Design for logistical support • Design for reliability • Design for maintainability • Adopt advanced manufacturing technologies — reduces inventory levels — reduces required production floor space — reduces defects rework and quality costs SOURCE: Adapted from Gerald I. Susman “Product Life Cycle Management” Journal of Cost Management Summer 1989 pp. 8–22. © 1999 Warren Gorham Lamont. Reprinted with permission of RIA. EXHIBIT 2–9 Actions to Substantially Reduce Product Costs

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• Is the current chart of accounts appropriate for the cost management informa- tion desired • What significant information issues such as yield spoilage and cycle time are not currently being addressed by the information system and could those issues be integrated into the current feeder systems With knowledge of the preceding information management must analyze the cost-benefit trade-offs that relate to the design of the cost management system. As the costs of gathering processing and communicating information decrease or as the quantity and intensity of competition increase more sophisticated cost management systems are required. Additionally as companies focus on customer satisfaction and expand their product or service offerings more sophisticated cost management sys- tems are needed. In these conditions the generation of “better” cost information is essential to long-run organizational survival and short-run profitability. Even with appropriate information systems in place there is no guarantee that managers will make decisions consistent with organizational strategies. Proper in- centives and reporting systems must be incorporated into the CMS for managers to make appropriate decisions. This is the subject of the following section. Chapter 2 Introduction to Cost Management Systems 55 Can a David Survive Among the Goliaths NEWS NOTE INTERNATIONAL Honda Motor Co.’s ability to shave more savings from its manufacturing operations will be one of the keys to the company’s drive to prove that an automaker doesn’t have to be huge to survive says the company’s president. Honda’s go-it-alone strategy challenges industry wis- dom that bigger is better and that a manufacturing scale of at least four million vehicles a year is needed to de- fray the cost of developing technologies such as envi- ronmentally friendly engines. Instead Honda wants to re- main small but double its efficiency level. “Who says you have to be a member of the four mil- lion club to survive” asks Honda’s president Hiroyuki Yoshino. “If you spend small then you don’t have to sell a lot to be profitable.” Yoshino says staying ahead of the competition to come up with cleaner gasoline engines and zero-emission “green car” power sources such as fuel cells is vital to Honda’s survival. But equally important he says will be the ability to design cars and standardize manufacturing tools to eliminate costly retooling for model changeovers and new-product launches and thus give Honda the agility and flexibility to meet sudden shifts in consumer tastes. The company is experimenting with new manufactur- ing methods at its Canadian assembly line for minivans and introducing some of those methods at its facilities in Japan. In the next several years Honda “should become capable of halving the time and cost for a new-model in- troduction” asserts Masaki Iwai Honda’s senior manag- ing director which he believes would lower the bar for turning a profit. SOURCE: Norihiko Shirouzu “Honda Bucks Industry Wisdom Aiming to Be Small and Efficient” The Wall Street Journal July 9 1999 p. A12. Permission con- veyed through the Copyright Clearance Center. ELEMENTS OF A COST MANAGEMENT SYSTEM A cost management system is composed of three primary elements: motivational elements information elements and reporting elements. These elements are de- tailed in Exhibit 2–10. The elements as a whole must be internally consistent and the individually selected elements must be consistent with the strategies and mis- sions of the subunits. Different aspects of these elements may be used for differ- ent purposes. For example numerous measures of performance can be specified but only certain measures will be appropriate for specific purposes. What three groups of elements affect the design of a cost management system and how are these elements used 6

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Motivational Elements Performance measurements are chosen so as to be consistent with organizational goals and objectives and to “drive” managers toward designated achievements. These measurements which are discussed in depth in Chapters 20 and 21 may be quantitative or nonquantitative financial or nonfinancial and short-term or long- term. For example if a subunit is expected to generate a specified dollar amount of profit for the year the performance measure has been set to be quantitative fi- nancial and short-term. A longer-term performance measure might be an average increase in profit or change in stock price over a five-to-ten-year period. Today performance measures and rewards are designed not only to motivate employees and managers to act in the best interest of the organization but also to help recruit and retain qualified employees. These roles are illustrated in the ac- companying News Note. The performance measurement system should encourage managers to act in the best interest of the organization and its subunits and to support organizational missions and competitive strategies. Once defined the nature of the criteria used to measure performance should be linked to the organizational incentive system because as implied in the News Note “you get what you measure.” This linkage sends the message to managers that they will be rewarded in line with the quality of their organizational and subunit decisions and thereby their contributions to achieving the organizational missions. In addition to performance measures different forms of rewards have different incentive effects and can reflect different time orientations. In general longer-term incentives encourage managers to be more long-term oriented in their decisions while short-term incentives encourage managers to be focused on the near future. To illustrate cash is the most obvious reward for short-term performance. All managers receive some compensation in cash for paying living expenses. How- ever once a manager receives a cash reward its value is not dependent on future performance. In contrast a stock option that is not exercisable until a future time Part 1 Overview 56 EXHIBIT 2–10 Cost Management System Elements • Performance measurements • Reward structure • Support of organizational mission and competitive strategy • Preparation of financial statements • Provision of details for responsibility accounting system • Support of budgeting process • Emphasis on product life cycle • Differentiation of value–added and non–value–added activities • Support of cost reduction initiatives • Focus on cost control • Assessment of core competencies and analysis of make–or–outsource decisions MOTIVATIONAL ELEMENTS INFORMATIONAL ELEMENTS REPORTING ELEMENTS

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provides a manager with an incentive to be more concerned about long-term per- formance. The ultimate value of the stock option is determined in the future when the option is exercised rather than on the date it is received. Thus the option’s value is related more to long-term than to short-term organizational performance. Performance rewards for top management may consist of both short-term and long-term incentives. Normally a major incentive is performance-based pay that is tied to the firm’s stock price. The rewards for subunit managers should be based on the specific subunit’s mission. Managers of subunits charged with a “build” mission should receive long-term incentives. These managers need to be concerned about long-term success and be willing to make short-term sacrifices for long-term gains. Alternatively managers of subunits charged with a “harvest” mission must be more oriented to the short term. These subunits are expected to squeeze out as much cash and profit as possible from their operations. Accordingly incentives should be in place to encourage these managers to have a short-term focus in decision making. Profit sharing refers to compensation that is contingent on the level of or- ganizational profit generated. This type of pay is a powerful incentive and is now used in virtually every U.S. industry. Today’s companies experiment with a variety of incentives as a “carrots” to induce employees and managers to act in the best interest of customers and shareholders. As indicated in the following News Note not all of these efforts are successful. Selection of performance measurements and the reward structure is important because managers evaluate decision alternatives based on how the outcomes may impact the selected performance measurement and reward criteria. Because higher performance equals a larger reward the cost management system must have spec- ified performance “yardsticks” and provide measurement information to the ap- propriate individuals for evaluation purposes. Performance measurement is mean- ingful only in a comparative or relative sense. Typically current performance is assessed relative to past or expected performance or as illustrated in the follow- ing News Note relative to peers. Chapter 2 Introduction to Cost Management Systems 57 What’s in It for Me NEWS NOTE GENERAL BUSINESS Aon Consulting’s 1998 America at Work Survey of 1800 employees measures critical factors that employees weigh when making employment decisions. Results of the survey support both sides of the retention equation. On the intrinsic or environmental side opportunities for learning and growth top the list of reasons for employees to stay with their employers. On the extrinsic or more tangible side meaningful rewards and recognition of performance are highly correlated with employee commitment. In fact salary and benefits are viewed as two of the most im- portant factors affecting employment decisions. Traditionally compensation systems have been de- signed to attract retain motivate and reward employ- ees by being externally competitive and internally equi- table. Unquestionably these are noble intentions. However the actual plan design that’s in place at many organizations was originally conceived in the 1950s when the world of work looked very different from what it does today. It was a time when fairness was defined as “sameness” when employment was for a lifetime and when following procedure was far more critical to suc- cess than innovation and gaining competitive advantage. Today compensation systems must support the mis- sion and culture of the organization and communicate to employees what is important why they are important and what their role is in ensuring the ongoing viability of the organization. Compensation systems are incredibly pow- erful communication tools to apply to a workforce look- ing for answers to the fundamental questions “Why am I here” “What am I contributing” and “How well am I being recognized for my contribution” Basically if em- ployees feel good about the answers to those questions they stay if they don’t they go. SOURCE: Valerie L. Williams and Jennifer E. Sunderland “New Pay Programs Boost Retention” Workforce May 1999 pp. 36–40. Permission conveyed through the Copyright Clearance Center. profit sharing

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Informational Elements The accounting function in an organization is expected to support managers in the areas of planning controlling decision making and performance evaluation. These roles converge in a system designed for cost management. Relative to the plan- ning role the cost management system should provide a sound foundation for the financial budgeting process. Budgets provide both a specification of expected achievement as well as a benchmark against which to compare actual performance. A CMS like a traditional cost accounting system should be able to provide the financial information needed for budget preparation. But in addition a well designed CMS will disclose the cost drivers for activities so that more useful simulations of alternative scenarios can be made. The same system can highlight any activities that have a poor cost-benefit relationship so that these activities can be reduced or eliminated. This helps re- duce budget preparation time. “By reducing the length of the budgeting cycle and making the process more efficient the informational benefit of semiannual or quar- terly budgeting may become practical.” 14 As firms find it more difficult to maintain a competitive advantage they must place greater emphasis on managing the product life cycle. In such an environ- ment firms often use innovative tools many of which are discussed in later chap- ters to provide information relevant to assessing their competitive positions. As discussed earlier in this chapter most actions available to managers to control costs are concentrated in the earliest stages of the product life cycle. Accordingly in- formation relevant to managing costs must be focused on decisions made during those stages—that information will be provided by a well designed and integrated cost management system. The life cycle of many products will become shorter as firms become more and more adept at duplicating their competitors’ offerings. In the future managers Part 1 Overview 58 Show Me the Money NEWS NOTE ETHICS Dave Kerr knew his sales team’s compensation plan just wasn’t working the way it should. For one thing star sales- people weren’t bringing home substantially more money than the lowest performers. But even slower sellers who were favored by the imbalance in the system weren’t re- ally happy. “No one thought their quota was fair” says Kerr director of strategic planning for Knoll Pharmaceu- ticals in Mount Olive New Jersey. “We spent too much time setting managing and adjudicating complaints about the quotas—it was just a massive unproductive effort every four months.” So in 1996 Kerr went to the extreme and dumped the quota system for all 600 of Knoll’s field salespeople. To- day Knoll’s incentive compensation plan is based on comparing performance of reps against that of their col- leagues so they’re not selling in a vacuum. Here’s how it works. Incentive money is put into a companywide pool that grows or shrinks with the company’s earnings. Reps can earn a larger or smaller share of the pool depending on both the absolute volume growth and the percentage of volume growth for individual products. Relative pay- ments are determined in advance. For example the top seller might make three times the average the lowest performing seller might earn nothing and the average seller would make an average amount. “What makes the plan more fair” Kerr says “is that employees are mea- sured only against those with similar sales potential.” SOURCE: Tricia Campbell “Quashing the Quota System” Sales Marketing Management July 1999 p. 89. Permission conveyed through the Copyright Clearance Center. 14 Steven C. Schnoebelen “Integrating an Advanced Cost Management System Into Operating Systems Part 2” Journal of Cost Management Spring 1993 p. 63.

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will confront the fact that products will spend less time in the maturity stage of the product life cycle. In this competitive environment firms will be forced to find ways to continue to squeeze out cash from their mature products to support de- velopment of new products. Additionally the future will place greater emphasis on a firm’s ability to adapt to changing competitive conditions. Flexibility will be an important organizational attribute and will cause managers to change the em- phasis of control systems as shown in Exhibit 2–11. To provide information relevant to product design and development the ac- counting information system must be able to relate resource consumption and cost to alternative product and process designs. Computer simulation models are use- ful in relating products to activities. 15 In addition to focusing information on the front end of the product life cycle the capital spending is becoming an increas- ingly important tool in cost management especially relative to new technology ac- quisition decisions. Decisions made with regard to capital investments affect the future cost structure of firms and hence the extent to which short-term actions can effect a change in the level of total costs. Lastly the system should produce cost information with minimal distortions from improper or inaccurate allocations or from improper exclusions. Improper exclusions usually relate to the influence of financial accounting such as the man- date to expense product development or distribution costs. If the system minimizes these cost distortions the cost assignments are more relevant for control purposes and for internal decision making. The information required to support decisions depends on the unique situa- tional factors of the firm and its subunits. The information system must enable the decision maker to evaluate how alternative decision choices would impact the items that are used to measure and evaluate the decision maker’s performance. Techniques such as relevant costing quality cost management job order and process costing and cost-volume-profit analysis discussed in later chapters relate to the role of cost information in decision making. Many decisions involve com- paring the benefit received from some course of action such as serving a given customer to the costs of the action costs of providing services. Only if the cost data contain minimal distortion can managers make valid cost-benefit assessments. Chapter 2 Introduction to Cost Management Systems 59 15 Using computer models is an element of process cost management. For more details see “Process Cost Management” by Thomas G. Greenwood and James M. Reeve in the Journal of Cost Management Winter 1994 pp. 4–19. From To Strategic Focus Achieving financial Achieving operational results: sales objectives: low cost costs and profits quality sales mix on-time delivery and capacity usage Product Sales Submitting bids and Developing Partnerships taking orders and creating sales opportunities Budgeting Developing annual Ongoing planning and plans frequent budget revisions Culture Meeting project Learning and improving expectations upon processes SOURCE: Ralph E. Drtina and Gary A. Monetti “Controlling Flexible Business Strategies” Journal of Cost Manage- ment Fall 1995 pp. 42–49. © 1995 Warren Gorham Lamont. Reprinted with permission of RIA. EXHIBIT 2–11 Shift in Control Emphasis in Future Competitive Environment

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Reporting Elements The reporting elements of a cost management system refer to methods of provid- ing information to persons in evaluative roles. First and foremost the CMS must be effective in generating fundamental financial statement information including in- ventory valuation and cost of sales information. This information is not necessar- ily the same as that being used for internal planning control decision making or performance evaluation. But if the feeder systems to the CMS have been appro- priately integrated and the system itself designed to minimize distortions there should be little difficulty generating an “external” product or service cost. In addition to financial statement valuations the reporting elements of the cost management system must address internal needs of a responsibility accounting system. This system provides information to top management about the perfor- mance of an organizational subunit and its manager. 16 For each subunit the re- sponsibility accounting system separately tracks costs and if appropriate revenues. Performance reports are useful only to the extent that the measured performance of a given manager or subunit can be compared to a meaningful baseline. The normal baseline is a measure of expected performance. Expected performance can be denoted in financial terms such as budgetary figures or in nonfinancial terms such as throughput customer satisfaction measures lead time capacity utilization and research and development activities. By comparing expected and actual performance top managers are able to determine which managers and subunits performed ac- cording to expectations and which exceeded or failed to meet expectations. Using this information that has been processed and formulated by the cost management system top managers link decisions about managerial rewards to performance. Exhibit 2–12 demonstrates a typical performance measurement system that gathers data from four perspectives: internal innovation customer and stockholder. The movement toward decentralization has increased the importance of an ef- fective reporting system. With decentralization top managers must depend on the reporting system to keep all organizational subunits aligned with their subunit mis- sions and organizational goals and objectives. A cost management system is not designed to “cut” costs. It exists to ensure that a satisfactory yield revenue is re- alized from the incurrence of costs. Accordingly cost management begins with an understanding that different costs are incurred for different purposes. Some costs are incurred to yield immediate benefits others are expected to yield benefits in the near or distant future. Part 1 Overview 60 responsibility accounting system 16 Responsibility accounting concepts are discussed in detail in Chapters 18 through 21. EXHIBIT 2–12 Performance Evaluation from Multiple Perspectives How are we doing Internal perspective Stockholders Customers Innovation

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Only by linking costs to activities and activities to strategies can the yield on costs be understood. Thus to achieve effective cost management it is useful to start by sorting organizational activities according to their strategic roles. This logic suggests that organizational management is made easier by breaking down oper- ations into subunits. By so doing top managers can assign responsibility and ac- countability for distinct subunit missions to a particular manager. In turn by cre- ating the proper incentives for each subunit manager top management will have set the stage for each subunit manager to act in the best interest of the overall or- ganization. This linkage is the start of a process that focuses a specific subunit manager’s attention on a set of costs and activities that uniquely relates to the sub- unit’s organizational mission. For subunit managers to effectively manage costs each must be provided with relevant information. Because the nature and time horizon of decisions made by managers vary across subunits each manager requires unique information. Ac- countants face the task of providing information to each subunit manager that is tailored to the particular context. In addition to information about decision alter- natives managers need to know how the alternatives are likely to impact their ex- pected rewards. The role of a reporting system is to compare benchmark performance to actual performance for each manager. On the basis of this comparison the relative rewards of subunit managers are determined. Accordingly this comparison is a key source of motivation for subunit managers to act in the best interest of the organization. Optimal organizational performance is realized only if there is consistency for each subunit across the elements of motivation information and reporting. Man- agers of subunits with a “build” mission need information tailored to their com- petitive strategies and focused on the early stages of the product life cycle. Their incentives to manage costs need to be relatively long-term and their reward struc- tures should emphasize success in the areas of product development and design and market share growth. Alternatively subunit managers of mature businesses need information that pertains more to short-term competition. Their reward and reporting structures should emphasize near-term profit and cash flow. One of the evolving challenges in today’s business environment is the man- agement of activities across an entire supply chain. Competition is prevalent among supply or “value” chains as well as individual businesses. Thus future financial specialists will develop only cost management systems that include activities not occurring within single firms but occurring within a supply chain and involving several firms. Since most businesses have a CMS in place most CMS design and implemen- tation issues relate to modifications in cost management systems. The modification of existing systems is discussed next. Chapter 2 Introduction to Cost Management Systems 61 CMS IMPLEMENTATION Once the organization and its subunits have been structured and the elements of the cost management system determined the current information systems should be evaluated. A gap analysis is necessary to compare the information that is needed to the information that is currently available or to determine how well desired information outputs coincide with current outputs. Any difference repre- sents a “gap” to be overcome. In many situations it is impossible to eliminate all system gaps in the short term potentially because of software or hardware capability or availability. Meth- ods of reducing or eliminating the gaps including all related technical require- ments and changes to existing feeder systems should be specified in detail. These details should be expressed qualitatively and quantitatively in terms of costs and benefits. How is gap analysis used in the implementation of a cost management system 7

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In the event of limited resources top management may then prioritize the dif- ferences as to which gap issues to address and in which order. As system imple- mentation proceeds management should assess the effectiveness of the improve- ments and determine the need for other improvements. Once the CMS has been established previously identified gaps may become irrelevant or may rise in rank of priority. Only through continuous improvement efforts can the cost manage- ment system provide an ongoing viable network of information to users. Technology’s impact on cost management system design and implementation is significant. With advancements in technology it is becoming possible to link the feeder systems of a company into a truly integrated cost management system. Enterprise resource planning ERP systems are packaged business software systems that allow companies to 1 automate and integrate the majority of their business processes 2 share common data and practices across the entire enterprise and 3 produce and access information in a real-time environment. 17 The ERP soft- ware often involves 30 separate modules that collect data from individual processes in the firm sales shipping distribution etc. and assemble that data in a form accessible by all managers. ERP is discussed in detail in Chapter 17. Part 1 Overview 62 enterprise resource planning ERP Motorola Inc. REVISITING he consolidation of Motorola’s separate research programs into Motorola Labs is already starting to pay dividends. The consolidation has made it possible for Motorola to tweak a single innovation for several products. A new semiconductor for sending video signals for exam- ple works in both an experimental wireless phone and a set-top box for interactive TV. The chip’s key elements are also used in a device for fingerprint identification on com- puter keyboards soon to be a product that eliminates the need for passwords. Other efforts are more speculative. With DNA Mo- torola researchers are trying to exploit the attractions of pairs of organic acids using the links to lay down pat- terns of chip circuitry. The effort reflects management’s in- terest in moving Motorola into biotechnology the labs in- tend to use DNA to help map genetic sequences to find abnormalities that could lead to diseases. In looking for new ways to make wireless networks more efficient Motorola scientists developed a computer program that mimics a city full of roaming pager and cell- phone users. The permutations are virtually infinite: a su- percomputer using the software working at 100 billion in- structions per second can create only about 10 seconds of a real-time simulation in an hour of number crunching. But the software has led to design improvements that can cut dropped cellular calls by 50 percent Motorola re- searchers say. Motorola also is building an enormous internal library of maps and related materials to help decision making in construction projects. The system will include information such as how many pumps a gas station will have what payment systems it will use and how fuel will be stored and mixed. These industry “road maps” could be the foundation of a future design and consulting business the company says. SOURCE: Quentin Hardy “Business Brief—Motorola Inc.: Wireless Divisions to Add 1400 Workers by Year-End” The Wall Street Journal June 17 1999 p. B6. Permission conveyed through the Copyright Clearance Center. T 17 Win G. Jordan and Kip R. Krumwiede “ERP Implementers Beware” Cost Management Update March 1999 pp. 1–4.

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Chapter 2 Introduction to Cost Management Systems 63 As first discussed in Chapter 1 cost accounting’s role in management accounting is to provide information for managers’ planning controlling decision-making and performance evaluation needs. This chapter discusses the role of accountants and accounting information in developing a formal system of cost management. A cost management system is a subpart of a firm’s information and control sys- tems. A management information system is a structure that organizes and com- municates data to managers. Control systems exist to guide organizations in achiev- ing their goals and objectives. They have four primary components: detectors assessors effectors and a communications network. A cost management system consists of a set of formal methods developed for planning and controlling an organization’s cost-generating activities relative to its goals and objectives. This system serves multiple purposes: to develop product costs assess product/service profitability improve understanding of how processes affect costs facilitate cost control measure performance and implement organiza- tional strategies. It is not feasible to simply adopt a generic “off-the-shelf” cost management system. As in the design of any control system managers must be sensitive to the unique aspects of their organizations. Three factors that specifically should be taken into account in designing a control system are the organizational form structure and culture organizational mission and critical success factors and the competi- tive environment. A cost management system’s design is based on elements from three groups of management control tools. The selected elements of the system should be in- ternally consistent and be consistent with the missions of the individual subunits. The three groups of control tools are motivational elements informational elements and reporting elements. The motivational elements exist to provide managers the incentive to take the actions that are in the best interest of their subunits and the overall organization. Managers are motivated to do the right thing when the rewards they receive for their efforts are linked to the quality of decisions they make on behalf of the or- ganization and their specific subunits. The informational elements provide managers with relevant data. Accountants play a primary role in information management and are charged with maintaining an information system that is useful in performance measurement of managers and subunits and in making managerial decisions. To compete in the global environ- ment firms are developing new techniques to provide information relevant to as- sessing their competitive positions. The reporting elements exist to provide information regarding managerial per- formance. For accounting this is sometimes referred to as the “scorekeeping” role. A responsibility accounting system provides information to top management about the performance of an organizational subunit and its manager. Gap analysis is the key to identifying differences gaps between the ideal cost management system and the existing system. By prioritizing the order in which gaps are to be closed managers can proceed in an orderly manner with updating the cost management system. Because business processes are constantly evolving the cost management system must be continuously evaluated and up- dated so that it provides the information and motivation that managers currently require. CHAPTER SUMMARY

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Part 1 Overview 64 Cost Management System Conceptual Design Principles “In 1986 Computer Aided Manufacturing-International Inc. CAM-I formed a con- sortium of progressive industrial organizations professional accounting firms and government agencies to define the role of cost management in the new advanced manufacturing environment.” 18 One outcome of this consortium was a conceptual framework of principles listed in Exhibit 2–13 for designing a cost management system. If a CMS provides the suggested information relating to costs performance measurements and investment management that system will be relevant to man- agement’s decision-making needs. Although compatible with existing cost ac- counting systems the set of principles as a whole suggests a radical departure from traditional practices. The practices focus management attention on organizational activities product life cycles integrating cost management and performance mea- surement and integrating investment management and strategic management. APPENDIX 18 Berliner and Brimson Cost Management p. vii. Cost Principles • Identify costs of non-value-added activities to improve use of resources. • Recognize holding costs as a non-value-added activity traceable directly to a product. • Significant costs should be directly traceable to management reporting objectives. • Separate cost centers should be established for each homogeneous group of activities consistent with organizational responsibility. • Activity-based cost accumulation and reporting will improve cost traceability. • Separate bases for allocations should be developed to reflect causal relations between activity costs and management reporting objectives. • Costs should be consistent with the requirement to support life-cycle management. • Technology costs should be assigned directly to products. • Actual product cost should be measured against target cost to support elimination of waste. • Cost-effective approaches for internal control should be developed as a company automates. Performance Measurement Principles • Performance measures should establish congruence with a company’s objectives. • Performance measures should be established for significant activities. • Performance measures should be established to improve visibility of cost drivers. • Financial and nonfinancial activities should be included in the performance measurement system. Investment Management Principles • Investment management should be viewed as more than the capital budgeting process. • Investment management decisions should be consistent with company goals. • Multiple criteria should be used to evaluate investment decisions. • Investments and attendant risks should be considered interrelated elements of an investment strategy. • Activity data should be traceable to the specific investment opportunity. • Investment management decisions should support the reduction or elimination of non- value-added activities. • Investment management decisions should support achieving target cost. SOURCE: Callie Berliner and James A. Brimson eds. Cost Management for Today’s Advanced Manufacturing Boston: Harvard Business School Press 1988 pp. 13–18. Reprinted by permission of Harvard Business School Press. Copy- right 1988 by CAM-1. EXHIBIT 2–13 CMS Conceptual Design Principles

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Chapter 2 Introduction to Cost Management Systems 65 1. Why must a company spend money to make money What do you predict would occur to a company’s revenues if that company achieved its objective of incurring annual operating costs of 0 2. Why are so many companies presently redesigning their cost accounting systems 3. How can a company evaluate whether it is effectively managing its costs 4. Why is an effective management information system a key element of an effec- tive management control system 5. What is a control system What purpose does a control system serve in an or- ganization 6. Why would an organization have multiple control systems in place 7. Why does an effective cost management system necessarily have both a short- term and long-term focus 8. Why would management be willing to accept somewhat inaccurate costs from the cost management system What sacrifices would be necessary to obtain more accurate costs 9. List some examples of costs that a cost management system might treat dif- ferently for internal and external purposes. Why would these treatments be ap- propriate 10. How can an integrated cost management system help managers understand and evaluate the effectiveness and efficiency of business processes 11. Is cost reduction the primary purpose of a cost management system Discuss the rationale for your answer. 12. Why is it not possible for a cost management system to simply be “pulled off the shelf” 13. How does the choice of organizational form influence the design of a firm’s cost management system 14. What information could be generated from a cost management system that would help an organization manage its core competencies 15. Describe characteristics of organizations in which centralized control would be effective and those in which decentralized control would be effective. 16. Would you prefer to work as an employee in an organization that had cen- tralized or decentralized control Discuss the reasons for your answer. 17. List five types of cost management information that would be most useful to an organizational subunit that was engaged in a a build b harvest or c hold mission. 18. Discuss ways in which organizational culture could be used as a control mech- anism. 19. Compare the description in the chapter of ATT prior to divestiture with the former Soviet Union prior to perestroika. How has the culture of each of these entities changed over time How would these changes affect the types of in- formation needed by managers/leaders QUESTIONS KEY TERMS cost driver p. 45 cost management system CMS p. 45 cost structure p. 52 enterprise resource planning ERP p. 62 management control system MCS p. 43 management information system MIS p. 43 organizational form p. 48 profit sharing p. 57 responsibility accounting system p. 60

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20. Why would a cost management system within a company pursuing con- frontational competition be required to provide information about competitors 21. How does the life-cycle stage of a product influence the nature of information that is required to successfully manage costs of that product 22. In the present highly competitive environment why has cost management risen to such a high level of concern while price management has declined in importance 23. What do you believe the core competencies of your college or university to be Why did you choose these 24. Why can “dollar sales per employee” be viewed as a measure of organizational productivity What actions can managers take to increase productivity 25. Give three examples of industries in which time-to-market is critical. Give three examples of industries in which time-to-market is almost irrelevant. Discuss the reasons for importance or lack thereof in each industry. 26. Why is the supply chain or value chain becoming an increased focus of cost management systems 27. What are feeder systems and why are they important in the design of a cost management system 28. Which is most important in the design of a cost management system: motiva- tional elements informational elements or reporting elements Discuss the ra- tionale for your answer. 29. “A firm cannot be successful unless short-term profits are achieved.” Is this statement true or false Why 30. Provide three examples from your academic career of the truthfulness of the statement “you get what you measure.” 31. Why do companies measure their performance from a variety of perspectives e.g. shareholder customer rather than a single perspective 32. What is gap analysis and what role does it play in the implementation of a cost management system 33. Appendix What was CAM-I and why was it organized Part 1 Overview 66 34. Cost management and strategy Assume that you are a financial analyst and you have just been handed a 2000 financial report of Firm X a large global pharmaceutical firm. The company competes in both traditional pharmaceuti- cal products and the evolving biotechnology products. Also assume that you have been given the following data on the pharmaceutical industry. Firm X Industry Average Sales 5.0 billion 1.2 billion Net income 1.3 billion 0.12 billion Advertising 0.1 billion 0.2 billion Research and development 0.4 billion 0.3 billion New investment in facilities 0.5 billion 0.3 billion Given the above data evaluate the cost management performance of Firm X. 35. Cost management system benefits Consider the following excerpt regarding advertising agencies: The latest study on advertising agency performance from the Incorporated Society of British Advertisers found that agencies are failing to provide adequate service to develop trusting relationships be innovative be efficient control costs and keep their promises. Agency staff are difficult to reach planners are lack- EXERCISES

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ing when it comes to monitoring and evaluating advertising creatives still do not listen to advertisers’ concerns or understand their target markets and pro- duction departments fail to deliver value for money or meet budgets. On a grander scale the majority of advertisers do not feel that their agencies provide competent advice on business and marketing issues. SOURCE: Ruth Nicholas “Survey Finds Ad Agency Still Failing Clients.” From an original article in the 3 June 1999 issue of Marketing with the permission of Haymarket Business Publications Ltd. Given the problems plaguing advertising agencies discuss how an inte- grated cost management system could help individual ad agencies become more competitive. 36. Organizational form As a team of three or as individuals write a paper that compares and contrasts the corporate general partnership limited partnership LLP and LLC forms of business. At a minimum include in your discussion is- sues related to the following: formation capital generation managerial authority and responsibility taxation ownership liability and implications for success in mission and objectives. 37. Cost management and organizational culture Use Internet resources to com- pare and contrast the organizational cultures and operating performance of any two firms in the same industry. Following are possible pairs to compare. 1. Delta Air Lines and Southwest Airlines and 2. Exxon and Royal Dutch Shell and .com 3. Nordstrom’s and Wal-Mart and http://www 4. Haggar and Levi-Strauss and 5. IBM and Dell Computer and In your discussion address the following questions: a. Which of the pair is the better operating performer b. Do you believe that organizational culture has any relationship to the dif- ferences in operations 38. Organizational strategy Use Internet resources to find a company regard- less of where they are domiciled whose managers have chosen to a avoid competition through differentiation b avoid competition through cost lead- ership and c confront competitors head-on. Prepare an analysis of each of these company’s strategies and discuss your perception of how well that strat- egy has worked. 39. Cost management and organizational objectives In a team of three prepare an oral presentation discussing how accounting information can a help and b hinder an organization’s progress toward its mission and objectives. Be sure to differentiate between the effects of what you perceive as “traditional” ver- sus “nontraditional” accounting information. 40. Organizational culture Write a paper describing the organizational culture at a job you have held or at the college or university that you attend. Be sure to include a discussion of the value system and how it was communicated to new employees or new students. 41. Cost management and strategy change The following excerpt illustrates a strategy change by Corel the software company. Corel’s problems originated four years ago when the company purchased the WordPerfect word-processing software from Novell Inc. and started waging war with Microsoft for the top retail sales spot in packaged office suites. Within months of the 124 million acquisition Corel transformed the moribund Chapter 2 Introduction to Cost Management Systems 67

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WordPerfect into the centerpiece of a rival to Microsoft’s Office package which included a word processor a spreadsheet graphics software and a personal organizer. For two months in 1995 Corel’s package edged out Microsoft’s in retail sales. But the early success was deceptive. Corel sacrificed profit for market share by marketing its office suite at about half the retail price of Microsoft’s Office. Meanwhile Corel’s aggressive advertising campaign including title sponsorship of the women’s professional tennis tour and national television commercials in the United States drained the company’s meager resources. When Microsoft in- troduced its own upgraded Office 97 suite the battle was over. To reverse its fortunes Corel is slashing costs. . . . For instance it is spend- ing much less than before to attract new office-software customers. SOURCE: Adapted from Julian Beltrame “Corel Stages Comeback from Battle with Microsoft—Cost Cutting Refocusing on Corel Products Move Company Into the Black” The Wall Street Journal August 9 1999 p. B4. Corel’s change in cost management has resulted in the company’s return to profitable operations. The change in cost management resulting in “slash- ing costs” implies that the company has changed its strategy. Discuss how the firm’s strategy might have changed such that the firm’s new strategy would be consistent with the change in cost management that is described in the article. Part 1 Overview 68 42. Information and cost management Consider the following excerpt about cus- tomer communication. Companies worldwide lose millions of dollars each year because they fail to communicate with customers and suppliers. These and other supply chain inefficiencies are pointed out in the results of two surveys issued by KPMG Con- sulting a part of KPMG Peat Marwick LLP. “Most companies think they’re more efficient than they really are” said Thomas Wilde of KPMG. “It’s either too painful to make the necessary organi- zational changes to become more efficient or the benefits are not clear to them.” Supplier and customer involvement is essential to efficient supply chain management yet 29 of companies report their suppliers have no involvement in their inventory management according to the survey. Another 22 of com- panies report no involvement from their customers when planning manufac- turing requirements. “It’s as if a tire company just guessed at the number it needed to manufacture every year without talking to auto manufacturers first” said Steven Y. Gold KPMG partner. The problem is particularly acute in consumer markets. While 96 of re- tailers share information with customers/suppliers 79 are using outdated modes of communication such as paper or fax. SOURCE: Anonymous “Companies Lose Millions by Ignoring Customers in Supply Chain Forecasting and Inventory Control” Cost Management Update 87 May 1998 p. 3. Select a major manufacturing company in your area. For this company prepare a table identifying specific ways in which an improved system of com- munications with suppliers and customers could result in specific cost savings for the manufacturing firm its suppliers or its customers. Organize your table in three columns as follows. Specific Information Information Specific Cost to Be Obtained Source to Be Reduced CASES

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43. Alternative cost management strategies Robert L. Wehling Procter Gamble’s senior vice president for advertising and market research would like to wean Americans off coupons. His relentless cost-control efforts which PG began in the manufacturing area in 1993 have led to moves to eliminate couponing increase print adver- tising and curb growth in PG’s marketing spending. In fact fewer than 2 of the 291.9 billion coupons that companies dis- tributed in 1995 were redeemed. . . . PG has been plowing back savings from cost-cutting initiatives into low- ering prices on most of its 300 brands. Since 1992–93 the list prices on PG brands excluding coffee have declined by 1 billion. Prices on diapers and detergents have particularly declined. In February PG eliminated all promotional coupons in three New York state markets—in a test that many industry watchers doubted could be suc- cessfully expanded nationwide because coupons are such an integral part of American consumers’ psyche. Until PG came along no company had risked eliminating all coupons in a big geographical market despite the growing consensus among major mar- keters that coupons are expensive and turn brand-loyal customers into bargain hunters who select brands based on short-term price promotions. PG spent 3.3 billion in 1995 on advertising. Its popular brand names include Tide Vicks Cover Girl and Pampers. SOURCE: Raju Narisetti “PG Ad Chief Plots Demise of the Coupon” The Wall Street Journal April 17 1996 pp. B1 B5A. Permission conveyed through the Copyright Clearance Center. a. What costs and benefits did PG likely consider in its decision to discon- tinue the use of coupons to promote its products b. What is PG’s apparent market strategy in deciding to lower prices Explain. c. What risks should PG take into account before discontinuing the use of coupons nationwide 44. Cost management and customer service The following excerpt illustrates how one company experienced negative fallout due to cost-cutting measures. In Digital Equipment Corp.’s 1994 reorganization its second in as many years the company eliminated hundreds of sales and marketing jobs in its health- industries group which had been bringing in 800 million of annual revenue by selling computers to hospitals and other health-care providers worldwide. Digital says it cut costs and positions because it had to act fast. It was los- ing about 3 million a day and its cost of sales was much higher than that of its rivals. Robert B. Palmer the chief executive officer of the Maynard Massa- chusetts company saw across-the-board cuts in all units regardless of prof- itability as the way to go. . . . But in the health-industries group the cutbacks imposed unexpected costs. Digital disrupted longstanding ties between its veteran salespeople and major cus- tomers by transferring their accounts to new sales divisions. It also switched hun- dreds of smaller accounts to outside distributors without notifying the customers. At the industry’s annual conference “I had customers coming up to me and saying ‘I haven’t seen a Digital sales rep in nine months. Whom do I talk to now’ ” recalls Joseph Lesica a former marketing manager in the group who resigned last year. “That really hurt our credibility. I was embarrassed.” Resellers of Digital computers who account for most of its health-care sales also complained about diminished technology and sales support. “There were months when you couldn’t find anybody with a Digital badge” complains an official at one former reseller who had been accustomed to Digital sales reps Chapter 2 Introduction to Cost Management Systems 69

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accompanying him on customer calls. “They walked away from large numbers of clients.” Adds Richard Tarrant chief executive of IDX Systems Corp. a Burlington Vermont reseller that used to have an exclusive arrangement with Digital “Now they’re just one of several vendors we use.” Many Digital customers turned to International Business Machines Corp. IBM and Hewlett-Packard Co. and so did some employees of Digital’s down- sized health-care group. Lesica says some laid-off workers went to Hewlett- Packard and quickly set about bringing Digital clients with them. “That’s an- other way Digital shot itself in the foot” he says. SOURCE: Alex Markels and Matt Murray “Call It Dumbsizing: Why Some Companies Regret Cost-Cutting” The Wall Street Journal May 4 1996 pp. A1 A6. Permission conveyed through the Copyright Clearance Center. a. What is the implied mission build hold or harvest of the health-industries group of Digital Explain. b. Describe the circumstances in which “across-the-board” cuts in spending represent a rational approach to cost management. c. When Digital decided to cut costs what were the apparent criteria used to determine which costs to cut d. How could a better integrated cost management system have helped Dig- ital avoid the adverse effects of its cost-cutting efforts 45. Cost management: short-term vs. long-term Flatland Metals Co. produces steel products for a variety of customers. One division of the company is Residen- tial Products Division created in the late 1940s. Since that time this division’s principal products have been galvanized steel components used in garage door installations. The division has been continuously profitable since 1950 and in 1996 it generated profits of 10 million on sales of 300 million. However over the past ten years growth in the division has been slow profitability has become stagnant and few new products have been devel- oped although the garage door components market has matured. The presi- dent of the company John Stamp has asked his senior staff to evaluate the operations of the Residential Products Division and to make recommendations for changes that would improve its operations. The staff uncovered the fol- lowing facts: • Tracinda Green age 53 has been president of the division for the past fif- teen years. • Green receives a compensation package that includes a salary of 175000 annually plus a cash bonus based on achievement of the budgeted level of annual profit. • Growth in sales in the residential metal products industry has averaged 12 percent annually over the past decade. Most of the growth has occurred in ornamental products used in residential privacy fencing. • Nationally the division’s market share in the overall residential metal prod- ucts industry has dropped from 12 percent to 7 percent during the past ten years and has dropped from 40 percent to 25 percent for garage door components. • The division maintains its own information systems. The systems in use today are mostly the same systems that were in place fifteen years ago however some of the manual systems have been computerized e.g. pay- roll accounts payable accounting. • The division has no customer service department. A small sales staff solicits and takes orders by phone from national distribution chains. • The major intra-division communication tool is the annual operating budget. No formal statements have been prepared in the division regarding strate- gies mission values goals and objectives or identifying core competencies. Part 1 Overview 70

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Given the introductory paragraphs and the facts from the staff of the com- pany’s president identify the major problems in the Residential Products Division and develop recommendations to address the problems you have identified. 46. Cost management and profitability The following excerpt deals with Nord- strom’s cost-cutting efforts. Nordstrom’s Inc. a retailing-industry laggard in profits has been under- going an effort to cut costs. But can the department store chain do that while maintaining its famously obsessive level of customer service “The biggest challenge is to keep the culture in the organization while mak- ing the necessary changes for the new millennium” says Jennifer Black presi- dent and analyst at Black Co. in Portland Oregon. The good news is that Nordstrom’s lags so far behind the industry’s most ef- ficient and profitable department store operators that it can cut a lot of costs without gutting the sales staff. “There is so much at this company that hasn’t been done” Black says. “They’ve only skimmed the surface.” For instance May Department Stores Co. based in St. Louis boasts a 12.5 operating margin while Nordstrom’s was among retailing’s lowest at 5.6 for 1998. Nordstrom’s certainly has opportunity for improvement. Its sales per square foot of store space at 382 for 1998 are the envy of the industry. May’s sales per square foot were just 201. But inefficient operations have prevented Nordstrom’s from boosting its bot- tom line despite its higher sales. Becoming efficient requires Nordstrom’s fam- ily which owns a controlling 35 percent stake in the company to embrace change at what has been an insular operation. So far the family is talking the talk. “Nothing is sacred” says 36-year-old William Nordstrom. SOURCE: Calmetta Y. Coleman “Nordstrom’s Tries to Cut Costs While Maintaining Service—Retailer Consolidates Op- erations That Have Weighed on Its Bottom Line” The Wall Street Journal April 8 1999 p. B4. Permission conveyed through the Copyright Clearance Center. a. What is Nordstrom’s strategy as implied by the discussion in the news article b. Given your answer to part a discuss how as a paid consultant to Nord- strom’s you would go about developing a plan to recommend cost man- agement changes at the company. 47. Cost management and product life cycle Ford Motor Co. reported a 58 per- cent drop in its fourth-quarter profits as a result of the heavy costs of launch- ing new vehicles. And officials predicted that similar costs will continue to de- press earnings through the first half of this year. Ford launched its Taurus sedan its biggest-selling car in the fourth quar- ter while preparing for the debut of its F-series pickup trucks. The two vehi- cle lines account for sales of more than one million vehicles each year. In the first half of 1996 Ford also plans to introduce a new version of its Escort small car another of Ford’s top sellers. “The time to make changes is when you are strong” said David McCammon Ford’s vice president of finance. He said the automaker still managed to finish 1995 with 12.4 billion in cash despite a drop in full-year reported profit of 22. SOURCE: Adapted from Oscar Suris “Ford’s Net Declined 58 Percent in Fourth Period” The Wall Street Journal February 1 1996 pp. A3–A4. a. Why would Ford’s reported profits for 1995 have dropped because of the launching of new vehicles b. How would Ford’s reported profit have differed if the company had used life-cycle costing techniques to account for the costs of launching new products c. Explain what McCammon meant when he said “The time to make changes is when you are strong.” continued Chapter 2 Introduction to Cost Management Systems 71 http://www2.nordstrom .com http://www.fordvehicles .com

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d. By management’s willingness to proceed with launching new products even though doing so lowers reported profits for the current year what can be inferred about the motivational elements in Ford’s cost manage- ment system Part 1 Overview 72 48. A joke making the rounds in Philadelphia-area doctors’ lounges goes like this: Leonard Abramson chief executive officer of U.S. Healthcare Inc. the big health-maintenance company dies and goes to heaven where he tells God what a great place it is. “Don’t get too comfortable” God advised “You’re only ap- proved for a three-day stay.” That’s the kind of cost control that the messianic Abramson understands. In the past two years U.S. Healthcare has slashed the fees it pays to specialists and hospitals by 12 percent to 20 percent and sometimes more these providers say. In the past year it has cut members’ days in hospitals by 11 percent. In- creasingly it asks specialists and hospitals to assume the financial risk for pro- cedures that cost more than anticipated. U.S. Healthcare is widely considered one of the country’s toughest HMO companies and one of the most innovative. It keeps 30 cents of every premium dollar to pay for salaries marketing administration and shareholder dividends nearly 10 cents more than the industry average. It zealously tracks the perfor- mance of doctors and hospitals paying more to those whose quality scores are high. It is earning robust profits—up 99 percent in the past 24 months—while rocking the tradition-bound health-care markets along the East Coast. “Unless you change the culture of the community you’re working in you’re not changing health care” Abramson declares. In the health-care community U.S. Healthcare has both staunch support- ers and critics. Consider the following additional information: • Last year Abramson earned 9.8 million in salary bonuses and stock op- tions. Critics suggest this is excessive pay and takes resources that could oth- erwise have been applied to benefit patients. Abramson says in a free mar- ket economy large rewards flow to those who provide superior performance. • Critics claim U.S. Healthcare selects service providers based on price rather than quality. • The company pays doctors to take training courses such as one in breast cancer screening techniques. • The company has an information system that allows it to rank hospitals according to infection rates of urology patients by the length of stay for coronary-bypass surgery or by the number of babies delivered by Ce- sarean. The company shows the comparative data to its service providers and uses it as leverage in negotiations. • The company is increasingly using performance-based pay contracts for its service providers. • All of U.S. Healthcare’s HMOs have earned three-year accreditation from the National Committee for Quality Assurance this is the best performance of any U.S. managed-care company. Examine the preceding information and discuss your opinion as to whether U.S. Healthcare is applying an ethical approach to the management of health- care costs. Where possible use concepts presented in the chapter to defend your position. REALITY CHECK

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49. John Strazzanti is president of Com-Corp Industries a 13 million 100-employee metal-stamping shop he incorporated in Cleveland in 1980. He’d started out as a machine operator with a tool-and-die manufacturer rapidly climbing the ladder to become general manager of another stamping company. Along the way he didn’t just dream about what he’d change if he were a company president. He figured out ways to make his dreams a reality. Dateline Cleveland 1977 Packie Presser was vice president of the noto- riously demanding local chapter of the teamsters’ union. The chapter controlled a metal-stamping plant where Strazzanti had just been promoted from floor su- pervisor to general manager. Strazzanti recalls: Two coworkers marched into my office. It was a hot summer day they had had a few beers at lunch and were fired up. They worked hard in the ware- house and saw the engineers working in the air-conditioning and getting paid a lot more. They didn’t think it was fair and wanted more money. I knew I was in a no-win situation. If I told them I thought they were being paid fairly that’s what they expected they were going to argue and they weren’t going to be happy with the results. If I gave them more money I was being unfair to every- body else. So I took out a legal pad and I told them to write down whatever they wanted to be paid. Thirty days from that date they would get that pay—with one caveat. During the 30 days I would shop for replacements for them. If I could get highly qualified people to work for anything less than that number they would have to take a hike. They asked for time to think about it and never came back with a number. A lot of these guys think that if a company fills an order for a million dol- lars it earns a million dollars in profit. I realized that if workers understood how a company earned a profit and how it had to be competitive a lot of the resentment between managers and employees could be eliminated. And they needed to understand that if they improved their job skills they could receive a higher wage. SOURCE: Anonymous “If I Were President. . . ” Inc. April 1995 pp. 56–61. Permission conveyed through the Copy- right Clearance Center. a. How does the sharing of information in an organization contribute to the empowerment of employees in a decentralized organizational structure to enhance their performance and that of the organization b. In a decentralized organization how does the sharing of information al- low employees to better understand their organizational roles relative to the roles of others c. In a decentralized organization how does quality control depend on wide- spread distribution of information 50. The motivational elements of a cost management system are integral to the success of cost management goals. It is understood that the stronger the indi- vidual incentive to manage costs correctly the greater is the likelihood that a given manager will act to manage costs effectively. Currently many employers provide fringe benefits to their employees that may provide a significant social benefit but that do not necessarily provide the strongest incentive to effectively manage costs. A significant employee benefit of this type is employer-provided health care. Discuss whether employers have an ethical responsibility to their employees and to society to provide health coverage to their employees given that other forms of compensation that pro- vide more powerful incentives could be offered to employees instead of health coverage. Chapter 2 Introduction to Cost Management Systems 73

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3 Organizational Cost Flows CHAPTER LEARNING OBJECTIVES After completing this chapter you should be able to answer the following questions: 1 How are costs classified and why are such classifications useful 2 How does the conversion process occur in manufacturing and service companies 3 What assumptions do accountants make about cost behavior and why are these assumptions necessary 4 How are the high-low method and least squares regression analysis Appendix used in analyzing mixed costs 5 What product cost categories exist and what items compose those categories 6 Why and how are overhead costs allocated to products and services 7 What causes underapplied or overapplied overhead and how is it treated at the end of a period 8 How is cost of goods manufactured calculated

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Wisconsin Film Bag INTRODUCING isconsin Film Bag WFB headquartered in Shawano Wisconsin is a custom manufacturer of high-quality polyethylene bags and film for a variety of packaging applications such as food electronics and other manufactured products. WFB serves a market niche that requires Manufactured to Order quality prod- ucts. The company focuses on “time-sensitive” low-volume orders including smaller lighter gauge bags bakery bags parts bags and specialized packaging bags from which most large competitors shy away. WFB’s ability to produce a broad range of polyethyl- ene products low overhead short lead times production efficiencies and “in-line” bag-making capabilities compet- itively position the company and enhance its potential to acquire new customers. The company’s success in the last several years can be attributed to its service to customers—ranging from short lead times quick responses to requests for quota- tions flexible manufacturing and scheduling immediate problem solving by customer service representatives to training of distributor sales representatives by WFB employees. Raw materials consist primarily of prime and offgrade low-density and linear low-density polyethylene resin pel- lets. Management splits purchases among suppliers to ensure competitive pricing and stable supply during times of shortage. Approximately 50 percent of WFB’s annual requirements are purchased from a variety of vendors under long-term contract. WFB has two plants: one in Shawano Wisconsin and the other in Hartland Wisconsin. The Shawano plant operates two 12-hour shifts 363 days annually. Each pro- duction line is comprised of a machine operator and each shift includes a lead operator an extruder technician and a quality control specialist. WFB’s plant layout and paral- lel production lines allow it to achieve a high degree of workforce flexibility thus avoiding unnecessary use of manpower and excess material handling. Every product or service has costs for material labor and overhead associated with it. Cost reflects the monetary measure of resources given up to attain an objective such as acquiring a good or service. However like many other words the term cost must be defined more specifically before “the cost” can be determined. Thus a preceding adjective is generally used to specify the type of cost being considered. Different definitions for the term cost are used in different situations for different pur- poses. For example the value presented on the balance sheet for an asset is an unexpired cost but the portion of an asset’s value consumed or sacrificed dur- ing a period is presented as an expense or expired cost on the income statement. Before being able to effectively communicate information to others accountants must clearly understand the differences among the various types of costs their com- putations and their usage. This chapter provides the terminology that is necessary to understand and articulate cost and management accounting information. The chapter also presents cost flows and accumulation in a production environment. Costs are commonly defined based on the objective or information desired and in terms of their relationship to the following four items: 1 time of incidence e.g. historical or budgeted 2 reaction to changes in activity e.g. variable fixed or mixed 3 classification on the financial statements e.g. unexpired or expired and 4 impact on decision making e.g. relevant or irrelevant. These categories are not mutually exclusive a cost may be defined in one way at one time and in another way at a different time. The first three cost classifications are discussed in this chapter. Costs related to decision making are covered at various points through- out the text. SOURCE: Corporate Headquarters Wisconsin Film Bag 3100 E. Richmond Street Shawano WI 54166. 77 W cost unexpired cost expired cost

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Part 2 Systems and Methods of Product Costing 78 COST CLASSIFICATIONS ON THE FINANCIAL STATEMENTS The balance sheet and income statement are two financial statements prepared by a company. The balance sheet is a statement of unexpired costs assets and eq- uities liabilities and owners’ capital the income statement is a statement of rev- enues and expired costs expenses and losses. The concept of matching revenues and expenses on the income statement is central to financial accounting. The match- ing concept provides a basis for deciding when an unexpired cost becomes an ex- pired cost and is moved from an asset category to an expense or loss category. Expenses and losses differ in that expenses are intentionally incurred in the process of generating revenues and losses are unintentionally incurred in the con- text of business operations. Cost of goods sold and expired selling and adminis- trative costs are examples of expenses. Costs incurred for damage related to fires for abnormal production waste and for the sale of a machine at below book value are examples of losses. Costs can also be classified as either product or period costs. Product costs are related to making or acquiring the products or providing the services that di- rectly generate the revenues of an entity period costs are related to other busi- ness functions such as selling and administration. Product costs are also called inventoriable costs and include the cost of di- rect material direct labor and overhead. Any readily identifiable part of a prod- uct such as the clay in a vase is a direct material. Direct material includes raw materials purchased components from contract manufacturers and manufactured subassemblies. Direct labor refers to the time spent by individuals who work specifically on manufacturing a product or performing a service. At WFB the people handling the polyethylene material for storage bags are considered direct labor and their wages are direct labor costs. Any factory or production cost that is indirect to the product or service and accordingly does not include direct material and direct labor is overhead. This cost element includes factory supervisors’ salaries depreciation on the machines producing plastic food storage bags and in- surance on the production facilities. The sum of direct labor and overhead costs is referred to as conversion cost. Direct material direct labor and overhead are discussed in depth later in the chapter. Precise classification of some costs into one of these categories may be difficult and judgment may be required in the classification process. Period costs are generally more closely associated with a particular time pe- riod rather than with making or acquiring a product or performing a service. Pe- riod costs that have future benefit are classified as assets whereas those deemed to have no future benefit are expensed as incurred. Prepaid insurance on an ad- ministration building represents an unexpired period cost when the premium pe- riod passes the insurance becomes an expired period cost insurance expense. Salaries paid to the sales force and depreciation on computers in the administra- tive area are also period costs. Mention must be made of one specific type of period cost: distribution. A dis- tribution cost is any cost incurred to warehouse transport or deliver a product or service. Although distribution costs are expensed as incurred managers should remember that these costs relate directly to products and services and should not adopt an “out-of-sight out-of-mind” attitude about these costs simply because they have been expensed for financial accounting purposes. Distribution costs must be planned for in relationship to product/service volume and these costs must be controlled for profitability to result from sales. Thus even though distribution costs are not technically considered part of product cost they can have a major impact on managerial decision making. 1 How are costs classified and why are such classifications useful 1 product cost period cost inventoriable cost direct material direct labor overhead conversion cost distribution cost 1 The uniform capitalization rules unicap rules of the Tax Reform Act of 1986 caused many manufacturers wholesalers and re- tailers to expand the types and amounts of nonproduction-area costs that are treated as product costs for tax purposes. The uni- cap rules require that distribution costs for warehousing be considered part of product cost but not distribution costs for market- ing and customer delivery. The rationale for such treatment is that such warehousing costs are incidental to production or acquisition.

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Chapter 3 Organizational Cost Flows 79 THE CONVERSION PROCESS In general product costs are incurred in the production or conversion area and period costs are incurred in all nonproduction or nonconversion areas. 2 To some extent all organizations convert or change inputs into outputs. Inputs typically consist of material labor and overhead. The output of a conversion process is usually either products or services. Exhibit 3–1 compares the conversion activities of different types of organizations. Note that many service companies engage in a high degree of conversion. Firms of professionals such as accountants architects attorneys engineers and surveyors convert labor and other resource inputs ma- terial and overhead into completed jobs audit reports building plans contracts blueprints and property survey reports. Firms that engage in only low or moderate degrees of conversion can conve- niently expense insignificant costs of labor and overhead related to conversion. The savings in clerical cost from expensing outweigh the value of any slightly im- proved information that might result from assigning such costs to products or ser- vices. For example when employees open shipping containers hang clothing on racks and tag merchandise with sales tickets a labor cost for conversion is in- curred. Retail clothing stores however do not try to attach the stockpeople’s wages to inventory such labor costs are treated as period costs and are expensed when they are incurred. In contrast in high-conversion firms the informational benefits gained from accumulating the material labor and overhead costs of the output produced sig- nificantly exceed the clerical accumulation costs. For instance to immediately ex- pense labor costs incurred for workers constructing a building would be inappro- priate these costs are treated as product costs and inventoried as part of the cost of the construction job until the building is completed. For convenience a manufacturer is defined as any company engaged in a high degree of conversion of raw material input into other tangible output. Man- ufacturers typically use people and machines to convert raw material to output that has substance and can if desired be physically inspected. A service company refers to a firm engaged in a high or moderate degree of conversion using a sig- nificant amount of labor. A service company’s output may be tangible an archi- tectural drawing or intangible insurance protection and normally cannot be in- spected prior to use. Service firms may be profit-making businesses or not-for-profit organizations. How does the conversion process occur in manufacturing and service companies 2 2 It is less common but possible for a cost incurred outside the production area to be in direct support of production and therefore considered a product cost. An example of this situation is the salary of a product cost analyst who is based at corporate headquarters this cost is part of overhead. Low Degree of Conversion Moderate Degree of Conversion High Degree of Conversion adding only the convenience of washing testing packaging causing a major transformation from having merchandise when where labeling etc. input to output and in the assortment needed by customers Retailing companies that act as mere Retailing companies that make small Manufacturing construction agricultural conduits between suppliers and consumers visible additions to the output prior to architectural auditing firms mining and department stores gas stations jewelry sale or delivery florists meat markets printing companies restaurants stores travel agencies oil-change businesses EXHIBIT 3–1 Degrees of Conversion in Firms manufacturer service company

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Firms engaging in only low or moderate degrees of conversion ordinarily have only one inventory account Merchandise Inventory. In contrast manufacturers normally use three inventory accounts: 1 Raw Material Inventory 2 Work in Process Inventory for partially converted goods and 3 Finished Goods Inven- tory. Service firms will have an inventory account for the supplies used in the con- version process and may have a Work in Process Inventory account but these firms do not normally have a Finished Goods Inventory account because services typically cannot be warehoused. If collection is yet to be made for a completed service engagement the service firm has a receivable from its client instead of Fin- ished Goods Inventory. Retailers versus Manufacturers/Service Companies Retail companies purchase goods in finished or almost finished condition thus those goods typically need little if any conversion before being sold to customers. Costs associated with such inventory are usually easy to determine as are the val- uations for financial statement presentation. In comparison manufacturers and service companies engage in activities that in- volve the physical transformation of inputs into respectively finished products and services. The materials or supplies and conversion costs of manufacturers and ser- vice companies must be assigned to output to determine cost of inventory produced and cost of goods sold or services rendered. Cost accounting provides the structure and process for assigning material and conversion costs to products and services. Exhibit 3–2 compares the input–output relationships of a retail company with those of a manufacturing/service company. This exhibit illustrates that the primary difference between retail companies and manufacturing/service companies is the absence or presence of the area labeled “the production center.” This center in- volves the conversion of raw material to final products. Input factors flow into the production center and are transformed and stored there until the goods or services are completed. If the output is a product it can be warehoused and/or displayed until it is sold. Service outputs are directly provided to the client commissioning the work. As mentioned previously the time effort and cost of conversion in a retail business are not as significant as they are in a manufacturing or service company. Thus although a retailer could have a department such as one that adds store name labels to goods that might be viewed as a “mini” production center most often retailers have no designated “production center.” Exhibit 3–2 reflects an accrual-based accounting system in which costs flow from the various inventory accounts on the balance sheet through if necessary the production center. The cost accumulation process begins when raw materials or supplies are placed into production. As work progresses on a product or ser- vice costs are accumulated in the firm’s accounting records. Accumulating costs in appropriate inventory accounts allows businesses to match the costs of buying or manufacturing a product or providing a service with the revenues generated when the goods or services are sold. At the point of sale these product/service costs will flow from an inventory account to cost of goods sold or cost of services rendered on the income statement. Manufacturers versus Service Companies Several differences in accounting for production activities exist between a manufac- turer and a service company. A manufacturer must account for raw materials work in process and finished goods to maintain control over the production process. An accrual accounting system is essential for such organizations so that the total production costs can be accumulated as the goods flow through the manufacturing Part 2 Systems and Methods of Product Costing 80

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process. On the other hand most service firms need only to keep track of their work in process incomplete jobs. Such accounting is acceptable because service firms normally have few if any materials costs other than supplies for work not started. As mentioned earlier because services generally cannot be warehoused costs of finished jobs are usually transferred immediately to the income statement to be matched against job revenues rather than being carried on the balance sheet in a finished goods account. Chapter 3 Organizational Cost Flows 81 EXHIBIT 3–2 Business Input/Output Relationships Retail Merchandising Company INPUT OUTPUT INPUT OUTPUT Manufacturing/Service Company Product Service Sell deliver and bill to customer cost transferred to income statement as Cost of Goods Sold Sell deliver and bill to customer cost transferred to income state- ment as Cost of Services Rendered Warehouse and/or display carried on balance sheet as Finished Goods Inventory It is this process of conversion that creates the need for cost accounting Conversion of production input factors into finished output. Partially completed work is stored here until completed cost carried on balance sheet as Work in Process Inventory. Manage production labor and other overhead resources used in conversion What was produced The Production Center Purchase products for resale Warehouse and/or display cost carried on balance sheet as Merchandise Inventory Purchase raw materials or supplies Warehouse raw materials or supplies cost carried on balance sheet as Raw Materials or Supplies Inventory

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Despite the accounting differences among retailers manufacturers and service firms each type of organization can use cost and management accounting con- cepts and techniques although in different degrees. Managers in all firms engage in planning controlling evaluating performance and making decisions. Thus man- agement accounting is appropriate for all firms. Cost accounting techniques are es- sential to all firms engaged in significant conversion activities. In most companies managers are constantly looking for ways to reduce costs cost accounting and management accounting are used extensively in this pursuit. Regardless of how costs are classified managers are continuously looking for new and better ways to reduce costs without sacrificing quality or productivity. Consider some of DaimlerChrysler’s management plans to save 3 billion annually in various activities: • Advanced technologies: Eliminate overlapping research into fuel cells electric cars and advanced diesel engines. • Finance: Reduce back-office costs and coordinate tax planning and other activities. • Purchasing: Consolidate parts and equipment buying. DaimlerChrysler is ex- pected to follow Chrysler’s system of working with suppliers. • Joint production: Build Daimler sport-utility vehicles at a plant in Austria where Chrysler makes Jeeps and minivans. • New products: Possibly cooperate on future products such as minivans. • New markets: Cooperate in emerging markets such as Latin America and Asia perhaps with joint ventures. 3 Part 2 Systems and Methods of Product Costing 82 3 Gregory White and Brian Coleman “Chrysler Daimler Focus on Value of Stock” The Wall Street Journal September 21 1998 p. A3. STAGES OF PRODUCTION The production or conversion process can be viewed in three stages: 1 work not started raw materials 2 work in process and 3 finished work. Costs are as- sociated with each processing stage. The stages of production in a manufacturing firm and some costs associated with each stage are illustrated in Exhibit 3–3. In the first stage of processing the cost incurred reflects the prices paid for raw ma- terials and/or supplies. As work progresses through the second stage accrual-based accounting requires that labor and overhead costs related to the conversion of raw materials or supplies be accumulated and attached to the goods. The total costs incurred in stages 1 and 2 equal the total production cost of finished goods in stage 3. Cost accounting uses the Raw Material Work in Process and Finished Goods Inventory accounts to accumulate the processing costs and assign them to the goods produced. The three inventory accounts relate to the three stages of production shown in Exhibit 3–3 and form a common database for cost management and fi- nancial accounting information. In a service firm the work-not-started stage of processing normally consists of the cost of supplies needed to perform the services Supplies Inventory. When supplies are placed into work in process labor and overhead are added to achieve finished results. Determining the cost of services provided is extremely important in both profit-oriented service businesses and not-for-profit entities. For instance architectural firms need to accumulate the costs incurred for designs and models of each project and hospitals need to accumulate the costs incurred by each pa- tient during his or her hospital stay. http://www.daimler

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Chapter 3 Organizational Cost Flows 83 EXHIBIT 3–3 Stages and Costs of Production WORK NOT STARTED Raw Materials WORK IN PROCESS FINISHED WORK To Finished Goods until sold To Cost of Goods Sold when sold Total Production Cost Cleaning production facilities— part of overhead Supervision—part of overhead Electricity—part of overhead Income Statement Stage 1 Stage 2 Stage 3 Dye Polyethylene For bags and other products Packages and Cartons Convert material direct labor overhead Cutting forming direct labor overhead Sorting and assembling direct labor Packing and placing in cartons direct labor Balance Sheet COST REACTIONS TO CHANGES IN ACTIVITY Accountants describe a given cost’s behavior pattern according to the way its total cost rather than its unit cost reacts to changes in a related activity measure. Every cost in an organization will change if activity levels are shifted to extremes or if the time span is long enough. However a total cost may be observed to behave within a period in relation to limited changes in an associated activity measure. Activity measures include production service and sales volumes hours of machine time used pounds of material moved and number of purchase orders sent. To What assumptions do accountants make about cost behavior and why are these assumptions necessary 3

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properly identify analyze and use cost behavior information a time frame must be specified to indicate how far into the future a cost should be examined and a particular range of activity must be assumed. For example the standard-sized con- tainer of polyethylene material for WFB to make a production run might increase by 1 next year but by 5 by the year 2010. If WFB’s management is planning for next year the 1 increase is relevant but the 5 increase is not. The assumed range of activity that reflects the company’s normal operating range is referred to as the relevant range. Within the relevant range the two most common cost behav- iors are variable and fixed. A cost that varies in total in direct proportion to changes in activity is a variable cost. Examples include the costs of materials wages and sales commissions. Vari- able costs can be extremely important in the total profit picture of a company be- cause every time a product is produced and/or sold or a service is rendered and/or sold a corresponding amount of that variable cost is incurred. Because the total cost varies in direct proportion to changes in activity a variable cost is a constant amount per unit. Although accountants view variable costs as linear economists view these costs as curvilinear as shown in Exhibit 3–4. The cost line slopes upward at a given rate until a range of activity is reached in which the average variable cost rate becomes fairly constant. Within this range the firm experiences benefits such as discounts on material prices improved worker skill and productivity and other operating efficiencies. Beyond this range the slope becomes quite steep as the entity enters a range of activity in which certain operating factors cause the average variable cost to increase. In this range the firm finds that costs rise rapidly due to worker crowding equipment shortages and other operating inefficiencies. Although the curvilinear graph is more correct it is not as easy to use in planning or control- ling costs. To illustrate how to determine a variable cost assume that Smith Company makes lawnmowers with batteries attached to start them electrically. Each battery costs a constant 8 as long as the company produces within the relevant range of 0 to 3000 mowers annually. Within this range total battery cost can be calculated as 8 multiplied by the number of mowers produced. For instance if 2500 mowers were produced total variable cost of batteries is 20000 8 2500 mowers. Part 2 Systems and Methods of Product Costing 84 relevant range variable cost EXHIBIT 3–4 Economic Representation of a Variable Cost Costs Activity Relevant range

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If the firm advances to a new relevant range and makes between 3001 units and 7000 mowers annually the new unit cost would drop to 6. Total battery cost for making for example 5800 mowers annually would be 34800 6 5800 mowers. In contrast a cost that remains constant in total within the relevant range of activity is considered a fixed cost. Many fixed costs are incurred to provide a firm with production capacity. Fixed costs include salaries as opposed to wages de- preciation other than that computed under the units-of-production method and insurance. On a per-unit basis a fixed cost varies inversely with changes in the level of activity: the per-unit fixed cost decreases with increases in the activity level and increases with decreases in the activity level. If a greater proportion of ca- pacity is used then fixed costs per unit are lower. To illustrate how to determine the total and unit amounts of a fixed cost sup- pose that Smith Company rents for 12000 annually manufacturing facilities in which its operating relevant range is 0 to 8000 mowers annually. However if Smith Company wants to produce between 8001 and 12000 mowers it can rent an ad- jacent building for an additional 4000 thus making the annual total fixed rent 16000 in that higher capacity range. If the firm produces fewer than 8001 mowers its total fixed annual facility rental cost is 12000. Unit fixed cost can be found by dividing 12000 by the number of units produced. For instance if 6000 units were made the fixed facil- ity rental cost per mower would be 2 12000 6000 mowers. If Smith Company rents the second facility then total fixed rent would be 16000 for this new relevant range of 8001 to 12000 mowers annually. Suppose that Smith made 10000 mowers in a given year. The unit fixed cost for facilities rental can be calculated as 1.60 16000 10000 mowers. The respective total cost and unit cost definitions for variable and fixed cost behaviors are presented in Exhibit 3–5. Consider the following excerpt regarding automobile manufacturing costs and prices: The ultimate culprit of widely fluctuating costs and therefore prices of cars explains Bill Pochiluk a partner at PriceWaterhouse Coopers LLP is the auto industry’s excess capacity. When the manufacturers can’t sell as many vehicles as they can build the fixed costs of the assembly plants drive up the cost of each vehicle. Thus the automakers use incentives so they can sell more cars and thus keep production up and unit costs down. 4 Chapter 3 Organizational Cost Flows 85 fixed cost EXHIBIT 3–5 Comparative Total and Unit Cost Behavior Definitions Total Cost Unit Cost Variable Cost Fixed Cost Remains constant throughout the relevant range Is constant throughout the relevant range Varies inversely with changes in activity throughout the relevant range Varies in direct proportion to changes in activity 4 Al Haas “Falling Prices Make It a Vintage Year for Used-Car Buying” The New Orleans Times-Picayune July 3 1998 p. F1.

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In the long run however even fixed costs will not remain constant. Business will increase or decrease sufficiently that production capacity may be added or sold. Alternatively management may decide to “trade” fixed and variable costs for one another. For example if WFB installed new more highly computerized equip- ment that decision would generate an additional fixed cost for depreciation and eliminate the variable cost of some hourly production workers. If WFB decided to outsource its data processing support function the com- pany might be able to trade its fixed costs of depreciation of data processing equip- ment and personnel salaries for a variable cost based on transaction volume. Whether variable costs are traded for fixed or vice versa a shift in costs from one type of cost behavior to another changes the basic cost structure of a company and can have a significant impact on profits. Other costs exist that are not strictly variable or fixed. For example a mixed cost has both a variable and a fixed component. On a per-unit basis a mixed cost does not fluctuate in direct proportion to changes in activity nor does it remain constant with changes in activity. An electric bill that is computed as a flat charge for basic service the fixed component plus a stated rate for each kilowatt-hour of usage the variable component is an example of a mixed cost. Exhibit 3–6 shows a graph for Grand Polymers’ electricity charge from its power company which consists of 500 per month plus 0.018 per kilowatt-hour kwh used. In a month when Grand Polymers uses 80000 kwhs of electricity its total electricity bill is 1940 500 0.018 80000. If 90000 kwhs are used the electricity bill is 2120. Another type of cost shifts upward or downward when activity changes by a certain interval or “step.” A step cost can be variable or fixed. Step variable costs have small steps and step fixed costs have large steps. For example a water bill computed as 0.002 per gallon for up to 1000 gallons 0.003 per gallon for 1001 to 2000 gallons 0.005 per gallon for 2001 to 3000 gallons is an example of a step variable cost. In contrast the salary cost for an airline ticket agent who can serve 3500 customers per month is 3200 per month. If airline volume increases from 10000 customers to 12800 customers the airline will need four ticket agents rather than three. Each additional 3500 passengers will result in an additional step fixed cost of 3200. Understanding the types of behavior exhibited by costs is necessary to make valid estimates of total costs at various activity levels. Although all costs do not Part 2 Systems and Methods of Product Costing 86 mixed cost step cost EXHIBIT 3–6 Graph of a Mixed Cost 80000 Total Electricity Cost 500 2120 1940 Total cost line Variable Component Fixed Component 90000 Number of Kilowatt-Hours Used Slope Variable cost of 0.018/kWh

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conform strictly to the aforementioned behavioral categories the categories repre- sent the types of cost behavior typically encountered in business. Cost accountants generally separate mixed costs into their variable and fixed components so that the behavior of these costs is more readily apparent. When step variable or step fixed costs exist accountants must choose a specific relevant range of activity that will allow step variable costs to be treated as variable and step fixed costs to be treated as fixed. By separating mixed costs into their variable and fixed components and by specifying a relevant range for step costs accountants force all costs into either variable or fixed categories as an approximation of true cost behavior. Assum- ing a variable cost to be constant per unit and a fixed cost to be constant in total within the relevant range can be justified for two reasons. First the as- sumed conditions approximate reality and if the company operates only within the relevant range of activity the cost behaviors selected are appropriate. Sec- ond selection of a constant per-unit variable cost and a constant total fixed cost provides a convenient stable measurement for use in planning controlling and decision making. To make these generalizations about variable and fixed costs accountants can use predictors for cost changes. A predictor is an activity measure that when changed is accompanied by consistent observable changes in a cost item. How- ever simply because the two items change together does not prove that the pre- dictor causes the change in the other item. For instance assume that every time the mosquito control truck sprays in a particular neighborhood the local high school principal wears a black dress. If this is consistent observable behavior you can use the mosquito truck spraying incident to predict that the principal will wear her black dress—but the spraying does not cause the principal to wear that black dress In contrast a predictor that has a direct cause and effect relation to a cost is called a cost driver. For example production volume has a direct effect on the total cost of raw material used and can be said to “drive” that cost. Thus pro- duction volume can be used as a valid predictor of that cost. In most situations the cause–effect relationship is less clear because costs are commonly caused by multiple factors. For example factors including production volume material quality worker skill levels and level of automation affect quality control costs. Although determining which factor actually caused a specific change in a quality control cost may be difficult any of these factors could be chosen to predict that cost if confi- dence exists about the factor’s relationship with cost changes. To be used as a pre- dictor the factor and the cost need only change together in a foreseeable manner. Traditionally a single predictor has been used to predict all types of costs. Ac- countants and managers however are realizing that single predictors do not nec- essarily provide the most reasonable forecasts. This realization has caused a move- ment toward activity-based costing Chapter 4 which uses different cost drivers to predict different costs. Production volume for instance would be a valid cost driver for the cost of standard-sized containers of polyethylene material but the number of vendors used might be a more realistic driver for WFB’s purchasing department costs. 5 Separating Mixed Costs As discussed earlier in this chapter accountants assume that costs are linear rather than curvilinear. Because of this assumption the general formula for a straight line Chapter 3 Organizational Cost Flows 87 predictor cost driver 5 Using multiple cost drivers for illustrative purposes in the text would be unwieldy. Therefore except when topics such as activity-based costing are being discussed examples will typically make use of a single cost driver.

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can be used to describe any type of cost within a relevant range of activity. The straight-line formula is y a bX where y total cost dependent variable a fixed portion of total cost b unit change of variable cost relative to unit changes in activity X activity base to which y is being related the predictor cost driver or independent variable If a cost is entirely variable the a value in the formula will be zero. If the cost is entirely fixed the b value in the formula will be zero. If a cost is mixed it is nec- essary to determine formula values for both a and b. HIGH-LOW METHOD The high-low method analyzes a mixed cost by first selecting two observation points in a data set: the highest and lowest levels of activity if these points are within the relevant range. Activity levels are used because activities cause costs to change and not the reverse. Occasionally operations may occur at a level outside the relevant range a rush special order may be taken that requires excess labor or machine time or distortions might occur in a normal cost within the relevant range a leak in a water pipe goes unnoticed for a period of time. Such nonrep- resentative or abnormal observations are called outliers and should be disregarded when analyzing a mixed cost. Next changes in activity and cost are determined by subtracting low values from high values. These changes are used to calculate the b variable unit cost value in the y a bX formula as follows: b The b value is the unit variable cost per measure of activity. This value is multi- plied by the activity level to determine the amount of total variable cost contained in total cost at either high or low level of activity. The fixed portion of a mixed cost is then found by subtracting total variable cost from total cost. Total mixed cost changes with changes in activity. The change in the total mixed cost is equal to the change in activity times the unit variable cost the fixed cost element does not fluctuate with changes in activity. Exhibit 3–7 illustrates the high-low method using machine hours and utility cost information for the Cutting and Mounting Department of the Indianapolis Di- vision of Alexander Polymers International. Information was gathered for the eight months prior to setting the predetermined overhead rate for 2001. During 2000 the department’s normal operating range of activity was between 4500 and 9000 machine hours per month. For the Cutting and Mounting Department the March observation is an outlier substantially in excess of normal activity levels and should not be used in the analysis of utility cost. One potential weakness of the high-low method is that outliers may be inad- vertently used in the calculation. Estimates of future costs calculated from a line drawn using such points will not be indicative of actual costs and probably are not good predictions. A second weakness is that this method considers only two data Change in the Total Cost Change in Activity Level Cost at High Activity Level Cost at Low Activity Level High Activity Level Low Activity Level Part 2 Systems and Methods of Product Costing 88 How are the high-low method and least squares regression analysis Appendix used in analyzing mixed costs high-low method outlier 4

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points. A more precise method of analyzing mixed costs is least squares regression analysis which is presented in the Appendix at the end of this chapter. Chapter 3 Organizational Cost Flows 89 The following machine hours and utility cost information is available: Machine Utility Month Hours Cost January 4800 192 February 9000 350 March 11000 390 Outlier April 4900 186 May 4600 218 June 8900 347 July 5900 248 August 5500 231 STEP 1: Select the highest and lowest levels of activity within the relevant range and obtain the costs associated with those levels. These levels and costs are 9000 and 4600 hours and 350 and 218 respectively. STEP 2: Calculate the change in cost compared to the change in activity. Machine Associated Hours Total Cost High activity 9000 350 Low activity 4600 218 Changes 4400 132 STEP 3: Determine the relationship of cost change to activity change to find the variable cost element. b 132 4400 MH 0.03 per machine hour STEP 4: Compute total variable cost TVC at either level of activity. High level of activity: TVC 0.039000 270 Low level of activity: TVC 0.034600 138 STEP 5: Subtract total variable cost from total cost at the associated level of activity to determine fixed cost. High level of activity: a 350 270 80 Low level of activity: a 218 138 80 STEP 6: Substitute the fixed and variable cost values in the straight-line formula to get an equation that can be used to estimate total cost at any level of activity within the relevant range. y 80 0.03X where X machine hours EXHIBIT 3–7 Analysis of Mixed Cost COMPONENTS OF PRODUCT COST Product costs are related to the products or services that generate an entity’s rev- enues. These costs can be separated into three components: direct material direct labor and production overhead. 6 A direct cost is one that is distinctly traceable What product cost categories exist and what items compose these categories direct cost 5 6 This definition of product cost is the traditional one and is referred to as absorption cost. Another product costing method called variable costing excludes the fixed overhead component. Absorption and variable costing are compared in Chapter 11.

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to a specified cost object. A cost object is anything of interest or useful informa- tional value such as a product service department division or territory. Costs that must be allocated or assigned to a cost object using one or more predictors or cost drivers are called indirect or common costs. Different cost objects may be designated for different decisions. As the cost object changes the costs that are direct and indirect to it may also change. For instance if a production division is specified as the cost object the production division manager’s salary is direct. If instead the cost object is a sales territory and the production division operates in more than one territory the production division manager’s salary is indirect. Direct Material Any readily identifiable part of a product is called a direct material. Direct material costs theoretically should include the cost of all materials used in the manufacture of a product or performance of a service. However some material costs are not conveniently or practically traceable from an accounting standpoint. Such costs are treated and classified as indirect costs. For example in producing gallon-sized kitchen storage bags see Exhibit 3–3 the polyethylene raw material dye to high- light the bag zippers and packaging for the bags are all costs for the materials needed in production. Because the dye cost is not easily traceable or monetarily significant to WFB’s production cost this cost may be classified and accounted for as an indirect material and included as part of overhead. In a service business direct materials are often insignificant or may not be eas- ily traced to a designated cost object. For instance in a telephone company the department responsible for new customer hook-ups could be designated as a cost object. Although the cost of preprinted application forms might be significant enough to trace directly to this department the cost of other departmental sup- plies such as pens paper and paperclips might be relatively inconvenient to trace and thus would be treated as overhead. Managers usually try to keep the cost of raw materials at the lowest price pos- sible within the context of satisfactory quality. However as indicated in the fol- lowing News Note on page 91 enlightened businesspeople are now more often taking a longer run view that considers the economic health of their raw material suppliers. Direct Labor Direct labor refers to the individuals who work specifically on manufacturing a product or performing a service. Another perspective of direct labor is that it directly adds value to the final product or service. The chef preparing the meals at the local restaurant and the dental hygienist at the dental clinic represent direct labor workers. Direct labor cost consists of wages or salaries paid to direct labor employees. Such wages and salaries must also be conveniently traceable to the product or ser- vice. Direct labor cost should include basic compensation production efficiency bonuses and the employer’s share of Social Security and Medicare taxes. In addi- tion if a company’s operations are relatively stable direct labor cost should in- clude all employer-paid insurance costs holiday and vacation pay and pension and other retirement benefits. 7 As with materials some labor costs that theoretically should be considered di- rect are treated as indirect. The first reason for this treatment is that specifically tracing the particular labor costs to production may be inefficient. For instance Part 2 Systems and Methods of Product Costing 90 cost object indirect cost 7 Institute of Management Accountants formerly National Association of Accountants Statements on Management Account- ing Number 4C: Definition and Measurement of Direct Labor Cost Montvale N.J.: NAA June 13 1985 p. 4.

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fringe benefit costs should be treated as direct labor cost but many companies do not have stable workforces that would allow a reasonable estimate of fringe ben- efit costs. Alternatively the time effort and cost of such tracing might not be worth the additional accuracy it would provide. Thus the treatment of employee fringe benefits as indirect costs is often based on clerical cost efficiencies. Second treating certain labor costs as direct may result in erroneous informa- tion about product or service costs. Assume that WFB employs 20 workers in its cutting room and that these workers are paid 8 per hour and time and a half 12 for overtime. One week the employees worked a total of 1000 hours or 200 hours of overtime to complete all production orders. Of the total employee labor payroll of 8800 only 8000 1000 hours 8 per hour would be clas- sified as direct labor cost. The remaining 800 200 hours 4 per hour would be considered overhead. If the overtime cost were assigned to products made dur- ing the overtime hours these products would appear to have a labor cost 50 per- cent greater than items made during regular working hours. Because scheduling of particular production runs is random the items completed during overtime hours should not be forced to bear overtime charges. Therefore costs for overtime or shift premiums are usually considered overhead rather than direct labor cost and are allocated among all units. There are however some occasions when costs such as overtime should not be considered overhead. If a customer requests a job to be scheduled during overtime hours or is in a rush and requests overtime to be worked overtime or shift premiums should be considered direct labor and be attached to the job that created the costs. Assume that in July the purchasing agent for People’s Seafood Stores ordered a large shipment of gallon-sized freezer bags to be delivered in Chapter 3 Organizational Cost Flows 91 Showing Concern for Suppliers NEWS NOTE GENERAL BUSINESS As farmers saw hog prices plunge to Depression-era lows this winter they felt as if salt were being rubbed into their wounds. For even as they were losing heavily somebody down the line—big meat packers or supermarket chains —seemed to be getting rich on pigs. The price of pork at the supermarket was staying about as high as ever. “These big companies are essentially saying ‘Your goods are worth 20—we’ll pay you 4’ ” says Tom Dewig a local businessman. “That’s what our farmers are going through.” At his meat shop Mr. Dewig rushed to a monitor each morning to check the price of hogs unable to believe his eyes. “We’d sit there and look at the thing and say ‘It can’t go any lower.’ But it did” he says shaking his head. “The next day we’d say ‘It can’t go any lower.’ But it did again.” Mr. Dewig had always said that no hog should sell for less than 30 cents a pound. So when the market price dipped into the mid-20s in September and October he continued paying farmers 30 knowing that even at that price he could profit handily. By Halloween though the price farmers could get elsewhere was down almost to 20 cents. Mr. Dewig finally broke his rule and started pay- ing less than 30 cents. “I lowered my standards” he says. When the market fell to the teens Mr. Dewig set him- self a new floor: 20 cents a pound. But then in mid- December prices briefly dipped below 10 cents a pound —about a 60-year low—and Mr. Dewig lowered his stan- dards again. Still on a day when another plant was of- fering farmers 11.5 cents a pound Mr. Dewig offered a nickel more. For his hog-farmer neighbors the above-market prices Dewig paid helped ease both losses and resent- ment. “He’s fair” says Ray Rexing who has sold hogs to Mr. Dewig since 1970. Mr. Joe Knapp is of two minds. Mr. Dewig “under- stands we’re losing our a— and he’s making money faster than he can rake it in” the farmer says. But the next mo- ment he recalls the losses Mr. Dewig himself took two or three years ago when hog farmers were doing well and calls him a “dang good guy.” SOURCE: Carl Quintanilla “Hog Raiser’s Pain Puts an Old-Style Butcher on the Knife-Edge” The Wall Street Journal March 24 1999 pp. A1 A8.

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three days for a local seafood festival. To produce this order WFB workers had to work overtime. People’s Seafood Stores’ bill for the shipment should reflect the overtime charges. Because people historically performed the majority of production activity di- rect labor once represented a primary production cost. Now in highly automated work environments direct labor often comprises less than 10 to 15 percent of to- tal manufacturing cost. Soon managers may find that almost all direct labor cost is replaced with a new production cost—the cost of robots and other fully auto- mated machinery. Consider the accompanying News Note regarding the diminished cost and size of direct labor in the era of high technology. Overhead Overhead is any factory or production cost that is indirect to manufacturing a prod- uct or providing a service and accordingly does not include direct material and direct labor. Overhead does include indirect material and indirect labor as well as any and all other costs incurred in the production area. 8 As direct labor has be- come a progressively smaller proportion of product cost in recent years overhead has become progressively larger and merits much greater attention than in the past. The following comments reflect these fundamental changes in the way manufac- turing is conducted: Automation technology and computerization have shifted costs making the typical manufacturing process less labor intensive and more capital inten- sive. This shift has changed the cost profile of many industries. No longer do di- rect materials and labor costs make up the major portion of total product cost. Instead overhead which is shared by many products and services is the dom- inant cost. 9 Part 2 Systems and Methods of Product Costing 92 Workers who specifically work on a product should be classified as direct labor and their wages can be assigned without any allocation method to production. Why and how are overhead costs allocated to products and services 6 8 Another term used for overhead is burden. Although this is the term under which the definition appears in SMA No. 2 Man- agement Accounting Terminology the authors believe that this term is unacceptable because it connotes costs that are extra unnecessary or oppressive. Overhead costs are essential to the conversion process but simply cannot be traced directly to output. 9 Sidney J. Baxendale and Michael J. Spurlock “Does Activity-Based Cost Management Have Any Relevance for Electricity” Public Utilities Fortnightly July 15 1997 p. 32.

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Overhead costs are either variable or fixed based on their behavior in response to changes in production volume or some other activity measure. Variable over- head includes the costs of indirect material indirect labor paid on an hourly ba- sis such as wages for forklift operators material handlers and others who sup- port the production assembly and/or service process lubricants used for machine maintenance and the variable portion of factory electricity charges. Depreciation calculated using either the units-of-production or service life method is also a vari- able overhead cost this depreciation method reflects a decline in machine utility based on usage rather than time passage and is appropriate in an automated plant. Fixed overhead comprises costs such as straight-line depreciation on factory plant assets factory license fees and factory insurance and property taxes. Fixed indirect labor costs include salaries for production supervisors shift superinten- dents and plant managers. The fixed portion of factory mixed costs such as main- tenance and utilities is also part of fixed overhead. An example of fixed overhead for a professional sports team is depreciation of arena seating. The accompanying News Note on page 94 discusses a trend in cost management that does not sit too well with some sports fans. One important overhead cost is the amount spent on quality. Quality is a managerial concern on two general levels. First product or service quality from the consumer perspective is an important consideration because consumers want the best quality they can find for the money. Second managers are concerned about production process quality because higher process quality leads to greater Chapter 3 Organizational Cost Flows 93 Firms See High-Wage Germany in A New Light NEWS NOTE INTERNATIONAL They’re still talking about it. The roof-raising ceremony for Motorola’s new 110-million cellular-telephone factory in Germany in 1998 was one of a kind. But how typical is Motorola with its big investment in Germany Isn’t this the land of the fading economic mir- acle The place where consumer demand is flat on its back and where no one can agree on how to bring down unemployment hovering near the double digits Is Mo- torola crazy to bet on Germany German manufacturing labor costs may be the highest in the world—more than 31 an hour or nearly twice the U.S. figure—and people here may regularly disappear for the world’s longest va- cations and sick leaves. You can’t lay off thousands here in one fell swoop. Consider Varta a big German maker of batteries. Un- til last year it was making small rechargeable “button- cell” batteries at a big plant in Singapore a city-state known for its disciplined work force and other competi- tive strengths. That plant had seven production lines and employed about 500 people. But in 1995—way too early to be influenced by the current Asian financial upheavals—Varta decided to move its button-cell operation back home to Germany. Here according to board member Wout van der Kooij Varta has been able to set up far more modern machin- ery and beginning this year is able to produce 50 more batteries than in Singapore in a tenth the space. Only 70 Germans will be needed to run the plant. “If you need to pay only 70 people then the high wage cost of Germany is not relevant anymore” Van der Kooij said. “What is relevant” he said “is Germany’s techno- logical infrastructure: the host of skilled electrochemical engineers and related technicians available on the job market. Electrochemists are virtually nonexistent in South- east Asia” Van der Kooij said. But with their abundance here in Germany Varta could install its state-of-the-art equipment confident of maintaining it repairing it and buying needed supplies without ever leaving the com- pany’s own backyard. Because the German working class tends to be so well-educated Norbert Quinkert Motorola Country Manager said “Motorola’s existing cell-phone factory here has higher productivity than the company’s other such plants in China Scotland and Illinois. The only bad mark Motorola’s German plant gets” he said “is for its high direct labor costs—but labor accounts for only 2 of the total cost of manufacturing a cellular phone.” SOURCE: Mary Williams Walsh “Firms See High-Wage Germany in a New Light” Los Angeles Times—Sunday Home Edition April 12 1998 p. D1. magic redskins

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customer satisfaction through minimizing production cycle time cost and defects. Both levels of quality generate costs that often total 20 to 25 percent of sales. 10 The two categories of quality costs are the cost of control and the cost of failure to control. The cost of control includes prevention and appraisal costs. Prevention costs are incurred to improve quality by precluding product defects and dysfunctional processing from occurring. Amounts spent on implementing training programs re- searching customer needs and acquiring improved production equipment are pre- vention costs. Amounts incurred for monitoring or inspection are called appraisal costs these costs compensate for mistakes not eliminated through prevention. The second category of quality costs is failure costs which may be internal such as scrap and rework or external such as product returns caused by qual- ity problems warranty costs and complaint department costs. Expenditures made for prevention will minimize the costs that will be incurred for appraisal and fail- ure. Quality costs are discussed in greater depth in Chapter 8. In manufacturing quality costs may be variable in relation to the quantity of defective output step fixed with increases at specific levels of defective output or fixed. Rework cost approaches zero if the quantity of defective output is also nearly zero. However these costs would be extremely high if the number of defective parts produced were high. In contrast training expenditures are set by manage- ment and might not vary regardless of the quantity of defective output produced in a given period. Part 2 Systems and Methods of Product Costing 94 Stadium Squeeze Play NEWS NOTE QUALITY At a time when most indoor arenas are spending millions of dollars on a slew of upgrades from cigar bars to gourmet chow one aspect of the fan experience is qui- etly shrinking: seat size. Indeed many sports patrons are being stuffed into chairs that are about as wide as a com- puter keyboard or the average coach-class airplane seat. And it’s only getting worse. A new basketball and hockey arena that’s being built in Atlanta will be state- of-the-art in all respects except one: seats that could be as narrow as 18 inches in some places. Another Den- ver’s Pepsi Center plans to jam in up to 30 more seats per row. For their part National Basketball Association teams and stadium officials say they’re simply trying to keep pace with the soaring player salaries and construction costs. At today’s ticket prices one general-admission seat can generate 1 million in revenue over a facility’s lifetime experts say. “If the Orlando Magic hadn’t reno- vated its arena to fit an additional 2000 seats four years ago” says team executive Pat Williams “the Magic would have had to hike ticket prices to an untenable level.” “I know some longtime fans will never get over it” Mr. Williams says “But without the extra seats we would have been priced out of business.” “It’s like a sardine can” says a longtime Washington Redskins fan who has season tickets at the team’s new Jack Kent Cooke Stadium in suburban Maryland. “It’s good to have someone you love sitting next to you.” Back in Portland Jerry Nothman a former season ticket holder didn’t like his new basketball arena seat. Arena officials say it’s possible some fans might have wound up in narrower chairs when the team moved there in 1995. But they insist that the average seat size is still pretty much the same. But Mr. Nothman isn’t buying it. And he’s not buying season tickets anymore either. Last year he declined to renew them for the first time in 22 years. “It was insult- ing” he says. “I don’t mind sitting on a wooden bench for 7 but if someone is going to charge me 60 I ex- pect a certain comfort level.” SOURCE: Sam Walker “Stadium Squeeze Play” The Wall Street Journal March 26 1999 pp. W1 W4. Permission conveyed through the Copyright Clearance Center. 10 “Measuring the Cost of Quality Takes Creativity” Grant Thornton Manufacturing Issues Spring 1991 p. 1.

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Chapter 3 Organizational Cost Flows 95 ACCUMULATION AND ALLOCATION OF OVERHEAD Direct material and direct labor are easily traced to a product or service. Overhead on the other hand must be accumulated over a period and allocated to the prod- ucts manufactured or services rendered during that time. Cost allocation refers to the assignment of an indirect cost to one or more cost objects using some rea- sonable basis. This section of the chapter discusses underlying reasons for cost allocation use of predetermined overhead rates separation of mixed costs into variable and fixed elements and capacity measures that can be used to compute predetermined overhead rates. Why Overhead Costs Are Allocated Many accounting procedures are based on allocations. Cost allocations can be made over several time periods or within a single time period. For example in financial accounting a building’s cost is allocated through depreciation charges over its use- ful or service life. This process is necessary to fulfill the matching principle. In cost accounting production overhead costs are allocated within a period through the use of predictors or cost drivers to products or services. This process reflects ap- plication of the cost principle which requires that all production or acquisition costs attach to the units produced services rendered or units purchased. Overhead costs are allocated to cost objects for three reasons: 1 to determine a full cost of the cost object 2 to motivate the manager in charge of the cost ob- ject to manage it efficiently and 3 to compare alternative courses of action for management planning controlling and decision making. 11 The first reason relates to financial statement valuations. Under generally accepted accounting principles GAAP “full cost” must include allocated production overhead. In contrast the assignment of nonfactory overhead costs to products is not normally allowed un- der GAAP. 12 The other two reasons for overhead allocations are related to inter- nal purposes and thus no hard-and-fast rules apply to the overhead allocation process. Regardless of why overhead costs are allocated the method and basis of the allocation process should be rational and systematic so that the resulting informa- tion is useful for product costing and managerial purposes. Traditionally the in- formation generated for satisfying the “full cost” objective was also used for the second and third objectives. However because the first purpose is externally fo- cused and the others are internally focused different methods can be used to pro- vide different costs for different needs. Predetermined Overhead Rates In an actual cost system actual direct material and direct labor costs are accu- mulated in Work in Process Inventory as the costs are incurred. Actual production overhead costs are accumulated separately in an Overhead Control account and are assigned to Work in Process Inventory at the end of a period or at completion of production. The use of an actual cost system is generally considered to be less than desir- able because all production overhead information must be available before any cost allocation can be made to products or services. For example the cost of products and services produced in May could not be calculated until the May electricity bill is received in June. 11 Institute of Management Accountants Statements on Management Accounting Number 4B: Allocation of Service and Adminis- trative Costs Montvale N.J.: NAA June 13 1985 pp. 9–10. 12 Although potentially unacceptable for GAAP certain nonfactory overhead costs must be assigned to products for tax purposes. actual cost system cost allocation

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An alternative to an actual cost system is a normal cost system which uses actual direct material and direct labor costs and a predetermined overhead OH rate or rates. A predetermined overhead rate or overhead application rate is a budgeted and constant charge per unit of activity that is used to assign overhead cost from an Overhead Control account to Work in Process Inventory for the pe- riod’s production or services. Three primary reasons exist for using predetermined overhead rates in prod- uct costing. First a predetermined rate allows overhead to be assigned during the period to the goods produced or services rendered. Thus a predetermined over- head rate improves the timeliness though it reduces the precision of information. Second predetermined overhead rates compensate for fluctuations in actual overhead costs that are unrelated to activity. Overhead may vary monthly because of seasonal or calendar factors. For example factory utility costs may be highest in the summer. If monthly production were constant and actual overhead were as- signed to production the increase in utilities would cause product cost per unit to be higher in the summer than in the rest of the year. If a company produced 3000 units of its sole product in each of the months of April and July but utilities were 600 in April and 900 in July then the average actual utilities cost per unit for April would be 0.20 600 3000 units and 0.30 900 3000 in July. Al- though one such cost difference may not be significant numerous differences of this type could cause a large distortion in unit cost. Third predetermined overhead rates overcome the problem of fluctuations in activity levels that have no impact on actual fixed overhead costs. Even if total production overhead were the same for each period changes in activity would cause a per-unit change in cost because of the fixed cost element of overhead. If a company incurred 600 utilities cost in each of October and November but pro- duced 3750 units of product in October and 3000 units of product in November its average actual unit cost for utilities would be 0.16 600 3750 units in Oc- tober but 0.20 600 3000 units in November. Although one such overhead cost difference caused by fluctuation in production activity may not be significant numerous differences of this type could cause a large distortion in unit cost. Use of an annual predetermined overhead rate would overcome the variations demon- strated by the examples above through application of a uniform rate of overhead to all units produced throughout the year. To calculate a predetermined OH rate divide the total budgeted overhead cost at a specific activity level by the related activity level for a specific period: Predetermined OH Rate Overhead cost and its related activity measure are typically budgeted for one year “unless the production/marketing cycle of the entity is such that the use of a longer or shorter period would clearly provide more useful informa- tion.” 13 For example the use of a longer period would be appropriate in a com- pany engaged in activities such as constructing ships bridges or high-rise office buildings. A company should use an activity base that is logically related to overhead cost incurrence. The activity base that may first be considered is production vol- ume but this base is reasonable if the company manufactures only one type of product or renders only one type of service. If multiple products or services exist a summation of production volumes cannot be made to determine “activity” because of the heterogeneous nature of the items. To most effectively allocate overhead to heterogeneous products a measure of activity must be determined that is common to all output. The activity base Total Budgeted OH Cost at a Specified Activity Level Volume of Specified Activity Level Part 2 Systems and Methods of Product Costing 96 normal cost system predetermined overhead rate 13 Institute of Management Accountants Statements on Management Accounting Number 2G: Accounting for Indirect Production Costs Montvale N.J.: NAA June 1 1987 p. 11.

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should be a cost driver that directly causes the incurrence of overhead costs. Di- rect labor hours and direct labor dollars have been commonly used measures of activity however the deficiencies caused by using these bases are becoming more apparent as companies become increasingly automated. Using direct labor to al- locate overhead costs in automated plants results in extremely high overhead rates because the costs are applied over a smaller number of labor hours or dollars. In automated plants machine hours may be more appropriate for allocating over- head than either direct labor base. Other traditional measures include number of purchase orders and product-related physical characteristics such as tons or gal- lons. Additionally innovative new measures for overhead allocation include num- ber or time of machine setups number of parts quantity of material handling time and number of product defects. APPLYING OVERHEAD TO PRODUCTION The predetermined overhead rates are used throughout the year to apply overhead to Work in Process Inventory. Overhead may be applied as production occurs when goods or services are transferred out of Work in Process Inventory or at the end of each month. Under real-time systems in use today overhead is frequently applied continuously. Applied overhead is the amount of overhead assigned to Work in Process Inventory as a result of incurring the activity that was used to de- velop the application rate. Application is made using the predetermined rates and the actual levels of activity. Overhead can be recorded either in separate accounts for actual and applied overhead or in a single account. If actual and applied accounts are separated the applied account is a contra account to the actual overhead account and is closed against it at year-end. The alternative more convenient recordkeeping option is to maintain one general ledger account that is debited for actual overhead costs and credited for applied overhead. This method is used throughout the text. Additionally overhead may be recorded in a single overhead account or in separate accounts for the variable and fixed components. Exhibit 3–8 presents the alternative overhead recording possibilities. If separate rates are used to apply variable and fixed overhead the general ledger would most commonly contain separate variable and fixed overhead ac- counts. When separate accounts are used mixed costs must be separated into their variable and fixed components or assigned to either the variable or fixed overhead general ledger account. Because overhead costs in an automated factory represent an ever larger part of product cost the benefits of separating costs according to their behavior are thought to be greater than the time and effort expended to make that separation. Chapter 3 Organizational Cost Flows 97 EXHIBIT 3–8 Cost Accounting System Possibilities for Manufacturing Overhead VOH Actual XXX VOH Applied YYY VOH Actual Applied XXX YYY Manufacturing Overhead Total Total actual applied XXX YYY XX YY FOH Actual XX FOH Applied YY FOH Actual Applied XX YY Separate Accounts For Actual Applied and For Variable Fixed Combined Accounts For Actual Applied Separate Accounts For Variable Fixed Combined Account For Actual Applied and For Variable Fixed applied overhead

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Regardless of the number combined or separate or type plantwide or de- partmental of predetermined overhead rates used actual overhead costs are deb- ited to the appropriate overhead general ledger accounts and credited to the var- ious sources of overhead costs. Applied overhead is debited to Work in Process Inventory and credited to the overhead general ledger accounts. Actual activity causes actual overhead costs to be incurred and overhead to be applied to Work in Process Inventory. Thus actual and applied overhead costs are both related to actual activity and only by actual activity are they related to each other. Assume that during March 2001 the Cutting and Mounting Department incurs 5000 machine hours. Actual variable and fixed overhead costs for the month were 10400 and 7300 respectively. Assume also that applied variable overhead for March is 10000 5000 2.00 and applied fixed overhead is 7150 5000 1.43. The journal entries to record actual and applied overhead for March 2001 are Variable Manufacturing Overhead 10400 Fixed Manufacturing Overhead 7300 Various Accounts 17700 To record actual manufacturing overhead. Work in Process Inventory 17150 Variable Manufacturing Overhead 10000 Fixed Manufacturing Overhead 7150 To apply variable and fixed manufacturing overhead to WIP. At year-end actual overhead will differ from applied overhead and the difference is referred to as underapplied or overapplied overhead. Underapplied overhead means that the overhead applied to Work in Process Inventory is less than actual overhead overapplied overhead means that the overhead applied to Work in Process Inventory is greater than actual overhead. Underapplied or overapplied overhead must be closed at year-end because a single year’s activity level was used to determine the overhead rates. DISPOSITION OF UNDERAPPLIED AND OVERAPPLIED OVERHEAD Disposition of underapplied or overapplied overhead depends on the significance of the amount involved. If the amount is immaterial it is closed to Cost of Goods Sold. When overhead is underapplied debit balance an insufficient amount of overhead was applied to production and the closing process causes Cost of Goods Sold to increase. Alternatively overapplied overhead credit balance reflects the fact that too much overhead was applied to production so closing overapplied overhead causes Cost of Goods Sold to decrease. To illustrate this entry note that the Cutting and Mounting Department has an overhead credit balance at year-end of 40000 in Manufacturing Overhead as presented in the upper left section of Exhibit 3–9 we first assume this amount to be immaterial for illustrative purposes. The journal entry to close overapplied overhead that is assumed to be immaterial is Manufacturing Overhead 40000 Cost of Goods Sold 40000 If the amount of underapplied or overapplied overhead is significant it should be allocated among the accounts containing applied overhead: Work in Process Inventory Finished Goods Inventory and Cost of Goods Sold. A significant amount of underapplied or overapplied overhead means that the balances in these accounts are quite different from what they would have been if actual overhead costs had been assigned to production. Allocation restates the account balances to conform more closely to actual historical cost as required for external reporting by gener- ally accepted accounting principles. Exhibit 3–9 uses assumed data for the Cutting and Mounting Department to illustrate the proration of overapplied overhead among the necessary accounts had the amount been underapplied the accounts debited Part 2 Systems and Methods of Product Costing 98 underapplied overhead overapplied overhead What causes underapplied or overapplied overhead and how is it treated at the end of a period 7

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and credited in the journal entry would be the reverse of that presented for over- applied overhead. A single overhead account is used in this illustration. Theoretically underapplied or overapplied overhead should be allocated based on the amounts of applied overhead contained in each account rather than on total account balances. Use of total account balances could cause distortion because they contain direct material and direct labor costs that are not related to actual or applied overhead. In spite of this potential distortion use of total balances is more common in practice for two reasons. First the theoretical method is complex and requires de- tailed account analysis. Second overhead tends to lose its identity after leaving Work in Process Inventory thus making more difficult the determination of the amount of overhead in Finished Goods Inventory and Cost of Goods Sold account balances. ALTERNATIVE CAPACITY MEASURES One primary cause of underapplied or overapplied overhead is a difference in budgeted and actual costs. Another cause is a difference in the level of activity or capacity chosen to compute the predetermined overhead and the actual activ- ity incurred. Capacity refers to a measure of production volume or some other activity base. Alternative measures of activity include theoretical practical normal and expected capacity. The estimated maximum potential activity for a specified time is the theoretical capacity. This measure assumes that all factors are operating in a technically and humanly perfect manner. Theoretical capacity disregards realities such as machinery breakdowns and reduced or stopped plant operations on holidays. Choice of this level of activity provides a probable outcome of a material amount of underapplied overhead cost. Chapter 3 Organizational Cost Flows 99 Manufacturing Overhead Account Balances Actual 220000 Work in Process Inventory 45640 Applied 260000 Finished Goods Inventory 78240 Overapplied 40000 Cost of Goods Sold 528120 1. Add balances of accounts and determine proportional relationships: Balance Proportion Percentage Work in Process 45640 45640 652000 7 Finished Goods 78240 78240 652000 12 Cost of Goods Sold 528120 528120 652000 81 Total 652000 100 2. Multiply percentages times overapplied overhead amount to determine the amount of adjustment needed: Adjustment Account Overapplied OH Amount Work in Process 7 40000 2800 Finished Goods 12 40000 4800 Cost of Goods Sold 81 40000 32400 3. Prepare journal entry to close manufacturing overhead account and assign adjustment amount to appropriate accounts: Manufacturing Overhead 40000 Work in Process Inventory 2800 Finished Goods Inventory 4800 Cost of Goods Sold 32400 EXHIBIT 3–9 Proration of Overapplied Overhead capacity theoretical capacity

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Reducing theoretical capacity by ongoing regular operating interruptions such as holidays downtime and start-up time provides the practical capacity that could be achieved during regular working hours. Consideration of historical and estimated future production levels and the cyclical fluctuations provides a normal capacity measure that encompasses the long run 5 to 10 years average activity of the firm. This measure represents a reasonably attainable level of activity but will not provide costs that are most similar to actual historical costs. Thus many firms use expected annual capacity as the selected measure of activity. Expected capacity is a short-run concept that represents the anticipated activity level of the firm for the upcoming period based on projected product demand. It is determined dur- ing the budgeting process conducted in preparation of the master budget for that period. The process for preparing the master budget is presented in Chapter 13. If actual results are close to budgeted results in both dollars and volume this measure should result in product costs that most closely reflect actual costs and thus an immaterial amount of underapplied or overapplied overhead. 14 Part 2 Systems and Methods of Product Costing 100 practical capacity normal capacity expected capacity 14 Except where otherwise noted in the text expected annual capacity has been chosen as the basis to calculate the prede- termined fixed manufacturing overhead rate because it is believed to be the most prevalent practice. This choice however may not be the most effective for planning and control purposes as is discussed further in Chapter 10 with regard to standard cost variances. ACCUMULATION OF PRODUCT COSTS—ACTUAL COST SYSTEM Product costs can be accumulated using either a perpetual or a periodic inventory system. In a perpetual inventory system all product costs flow through Work in Process Inventory to Finished Goods Inventory and ultimately to Cost of Goods Sold. The perpetual system continuously provides current information for financial statement preparation and for inventory and cost control. Because the costs of maintaining a perpetual system have diminished significantly as computerized pro- duction bar coding and information processing have become more pervasive this text assumes that all companies discussed use a perpetual system. The Midwestern Polyethylene Products Corporation is used to illustrate the flow of product costs in a manufacturing organization. The April 1 2001 inventory ac- count balances for Midwestern were as follows: Raw Material Inventory all direct 73000 Work in Process Inventory 145000 and Finished Goods Inventory 87400. Midwestern uses separate variable and fixed accounts to record the in- currence of overhead. In this illustration actual overhead costs are used to apply overhead to Work in Process Inventory. However an additional brief illustration applying predetermined overhead in a normal cost system is presented in the section following the current illustration. The following transactions keyed to the journal entries in Exhibit 3–10 represent Midwestern’s activity for April. During the month Midwestern’s purchasing agent bought 280000 of direct materials on account entry 1 and the warehouse manager transferred 284000 of materials into the production area entry 2. Production wages for the month totaled 530000 of which 436000 was for direct labor entry 3. April salaries for the production supervisor was 20000 entry 4. April utility cost of 28000 was accrued analyzing this cost indicated that 16000 was variable and 12000 was fixed entry 5. Supplies costing 5200 were removed from inventory and placed into the production process entry 6. Also Midwestern paid 7000 for April’s property taxes on the factory entry 7 depreciated the factory assets 56880 entry 8 and recorded the expiration of 3000 of prepaid insurance on the fac- tory assets entry 9. Entry 10 shows the application of actual overhead to Work in Process Inventory for respectively variable and fixed overhead for Midwestern during April. During April 1058200 of goods were completed and transferred to

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Chapter 3 Organizational Cost Flows 101 1 Raw Materials Inventory 280000 Accounts Payable 280000 To record cost of direct materials purchased on account. 2 Work in Process Inventory 284000 Raw Materials Inventory 284000 To record direct materials transferred to production. 3 Work in Process Inventory 436000 Variable Overhead Control 94000 Salaries Wages Payable 530000 To accrue factory wages for direct and indirect labor. 4 Fixed Overhead Control 20000 Salaries Wages Payable 20000 To accrue production supervisors salaries. 5 Variable Overhead Control 16000 Fixed Overhead Control 12000 Utilities Payable 28000 To record mixed utility cost in its variable and fixed amounts. 6 Variable Overhead Control 5200 Supplies Inventory 5200 To record supplies used. 7 Fixed Overhead Control 7000 Cash 7000 To record payment for factory property taxes for the period. 8 Fixed Overhead Control 56880 Accumulated Depreciation—Equipment 56880 To record depreciation on factory assets for the period. 9 Fixed Overhead Control 3000 Prepaid Insurance 3000 To record expiration of prepaid insurance on factory assets. 10 Work in Process Inventory 214080 Variable Overhead Control 115200 Fixed Overhead Control 98880 To record the application of actual overhead costs to Work in Process Inventory. 11 Finished Goods Inventory 1058200 Work in Process Inventory 1058200 To record the transfer of work completed during the period. 12 Accounts Receivable 1460000 Sales 1460000 To record the selling price of goods sold on account during the period. 13 Cost of Goods Sold 1054000 Finished Goods Inventory 1054000 To record cost of goods sold for the period. EXHIBIT 3–10 Midwestern Polyethylene Products Corporation— April 2001 Journal Entries Finished Goods Inventory entry 11. Sales of 1460000 on account were recorded during the month entry 12 the goods that were sold had a total cost of 1054000 entry 13. An abbreviated presentation of the cost flows is shown in selected T-accounts in Exhibit 3–11.

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Part 2 Systems and Methods of Product Costing 102 EXHIBIT 3–11 Selected T-Accounts for Midwestern Polyethylene Products Corporation Raw Materials Inventory Beg. bal. 73000 2 284000 1 280000 End. bal. 69000 Work in Process Inventory Beg. bal. 145000 11 1058200 2 DM 284000 3 DL 436000 10 OH 214080 End. bal. 20880 Fixed Overhead Control 4 20000 10 98880 5 12000 7 7000 8 56880 9 3000 Finished Goods Inventory Beg. bal. 87400 13 CGS 1054000 11 CGM 1058200 End. bal. 91600 Cost of Goods Sold 13 CGS 1054000 Variable Overhead Control 3 94000 10 115200 5 16000 6 5200 COST OF GOODS MANUFACTURED AND SOLD The T-accounts in Exhibit 3–11 provide detailed information about the cost of ma- terials used goods transferred from work in process and goods sold. This infor- mation is needed to prepare financial statements. Because most managers do not have access to the detailed accounting records they need to have the flow of costs and the calculation of important income statement amounts presented in a for- malized manner. Therefore a schedule of cost of goods manufactured CGM is prepared as a preliminary step to the determination of cost of goods sold CGS. 15 CGM is the total production cost of the goods that were completed and transferred to Finished Goods Inventory during the period. This amount is similar to the cost of net purchases in the cost of goods sold schedule for a retailer. Formal schedules of cost of goods manufactured and cost of goods sold are presented in Exhibit 3–12 using the amounts shown in Exhibits 3–10 and 3–11. The schedule of cost of goods manufactured starts with the beginning balance of Work in Process WIP Inventory and details all product cost components. The cost of materials used in production during the period is equal to the beginning bal- ance of Raw Materials Inventory plus raw materials purchased minus the ending balance of Raw Materials Inventory. If Raw Materials Inventory includes both di- rect and indirect materials the cost of direct material used is assigned to WIP In- ventory and the cost of indirect materials used is included in variable overhead. Because direct labor cannot be warehoused all charges for direct labor during the period are part of WIP Inventory. Variable and fixed overhead costs are added to direct material and direct labor costs to determine total manufacturing costs. Beginning Work in Process Inventory cost is added to total current period manufacturing costs to obtain a subtotal amount that can be referred to as “total costs to account for.” The value of ending WIP Inventory is calculated through techniques discussed later in the text and subtracted from the subtotal to pro- vide the cost of goods manufactured during the period. The schedule of cost of How is cost of goods manufactured calculated cost of goods manufactured 8 15 A service business prepares a schedule of cost of services rendered.

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goods manufactured is usually prepared only as an internal schedule and is not provided to external parties. In the schedule of cost of goods sold cost of goods manufactured is added to the beginning balance of Finished Goods FG Inventory to find the cost of goods available for sale during the period. The ending FG Inventory is calculated by multiplying a physical unit count times a unit cost. If a perpetual inventory sys- tem is used the actual amount of ending FG Inventory can be compared to that which should be on hand based on the finished goods account balance recorded at the end of the period. Any differences can be attributed to losses that might have arisen from theft breakage evaporation or accounting errors. Ending Fin- ished Goods Inventory is subtracted from the cost of goods available for sale to determine cost of goods sold. Chapter 3 Organizational Cost Flows 103 MIDWESTERN POLYETHYLENE PRODUCTS CORPORATION Schedule of Cost of Goods Manufactured For the Month Ended April 30 2001 Beginning balance of Work in Process 4/1/01 145000 Manufacturing costs for the period: Raw materials all direct: Beginning balance 73000 Purchases of materials 280000 Raw materials available 353000 Ending balance 69000 Total raw materials used 284000 Direct labor 436000 Variable overhead: Indirect labor 94000 Utilities 16000 Supplies 5200 115200 Fixed overhead: Supervisor’s salary 20000 Utilities 12000 Factory property taxes 7000 Factory asset depreciation 56880 Factory insurance 3000 98880 Total current period manufacturing costs 934080 Total costs to account for 1079080 Ending work in process 4/30/01 20880 Cost of goods manufactured 1058200 MIDWESTERN POLYETHYLENE PRODUCTS CORPORATION Schedule of Cost of Goods Sold For the Month Ended April 30 2001 Beginning Finished Goods 4/1/01 87400 Cost of Goods Manufactured 1058200 Cost of Goods Available for Sale 1145600 Ending Finished Goods 4/30/01 91600 Cost of Goods Sold 1054000 EXHIBIT 3–12 Cost of Goods Manufactured and Cost of Goods Sold Schedules ACCUMULATION OF PRODUCT COSTS—NORMAL COST SYSTEM In a normal cost system only entry 10 which applies overhead to WIP Inventory is different from that presented in Exhibit 3–10. Assume for the purpose of illus- trating what happens using a normal cost system that the predetermined variable

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overhead rate is 2.40 per machine hour that the predetermined fixed overhead rate is 2.04 per machine hour and that 48000 machine hours were incurred by Midwestern in April. These statistics are used to exactly match the information in the actual cost illustration above and for simplifying the illustration by precluding the presence of under- or overapplied overhead for April at Midwestern. However predetermined overhead most often does not match actual overhead. Monthly under- or overapplied overhead that does occur is accumulated and dis- posed of at year-end in the manner described earlier in this chapter. In a normal cost system entry 10 of Exhibit 3–10 is the only entry that is different from its counterpart in an actual cost system because instead of applying actual overhead predetermined overhead is applied to WIP Inventory. Although the numbers appear to be the same amounts in this simplified case as in the original entry 10 the man- ner in which they are derived is entirely different and in a realistic setting the dollar amounts are virtually always different. In a normal cost setting the credits to the variable and fixed overhead accounts are calculated as follows: Variable overhead credit 2.40 48000 machine hours 115200 Fixed overhead credit 2.06 48000 machine hours 98880 The debit to WIP Inventory is the sum of these two credits: WIP Inventory debit 115200 98880 214080 The complete entry follows: 10 Work in Process Inventory 214080 Variable Overhead Control 115200 Fixed Overhead Control 98880 To record the application of predetermined overhead costs to WIP Inventory. Some accountants prefer to streamline the presentation of the Schedule of Cost of Goods Manufactured and Sold when perpetual inventory accounting is used. Such an alternative is presented in Exhibit 3–13 in addition the use of normal costing supports condensing the overhead presentation further. Part 2 Systems and Methods of Product Costing 104 MIDWESTERN POLYETHYLENE PRODUCTS CORPORATION Schedule of Cost of Goods Manufactured For the Month Ended April 30 2001 Beginning balance of Work in Process 4/1/01 145000 Manufacturing costs for the period: Total raw materials used 284000 Direct labor 436000 Variable overhead applied 115200 Fixed overhead applied 98880 Total current period manufacturing costs 934080 Total costs to account for 1079080 Ending Work in Process 4/30/01 20880 Cost of goods manufactured 1058200 continued EXHIBIT 3–13 Cost of Goods Manufactured and Cost of Goods Sold Schedules

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Chapter 3 Organizational Cost Flows 105 MIDWESTERN POLYETHYLENE PRODUCTS CORPORATION Schedule of Cost of Goods Sold For the Month Ended April 30 2001 Beginning Finished Goods 4/1/01 87400 Cost of Goods Manufactured 1058200 Cost of Goods Available for Sale 1145600 Ending Finished Goods 4/30/01 91600 Cost of Goods Sold 1054000 EXHIBIT 3–13 Concluded Wisconsin Film Bag REVISITING isconsin Film Bag has grown 500 percent since Jack Riopelle president and chief operat- ing officer helped purchase the firm in 1993. The work- force has expanded from 43 employees in 1993 to 285 employees in 1999 currently. At that time WFB annual sales exceed 30 million. WFB’s vision statement is as follows: Wisconsin Film Bag will become the standard by which our competitors measure themselves. We in- tend to be known as the company people want to work for buy from and sell to. This will be accom- plished by achieving the following: 1. We will maintain a consistent attitude toward em- ployee involvement and incorporate unconditional integrity in all interactions with customers suppli- ers employees shareholders and the community. 2. We are committed to sustained profitable growth with a dedication toward excellence in quality service and creativity. We will also commit human and capital resources to improve our quality control costs and expand our capabilities to meet our customers’ needs. 3. We will strive for preferred vendor status from each of our customers and universal respect from all our competitors. 4. We will become an industry leader by making environmentally conscious decisions in every- thing we do. There is much evidence that the firm is progressing toward this vision. Not only has the firm grown at a fast pace but it has also tried to be a good environmental neighbor and a good citizen. The firm’s first repelletizer which repelletizes produc- tion scrap and purchased film scrap was installed in May 1995. This has allowed the firm to reuse its own internally generated scrap and to use purchased scrap from outside sources saving over 100000 annually in raw material cost for production of “non-food-grade” products. When WFB recently opened its Hartland Wisconsin facility it had trouble staffing manufacturing operations because Western Waukesha County is a white-collar com- munity. So the firm tapped into the area’s long-term unem- ployed providing assistance in locating competent day care reliable transportation and training in life skills such as reading a ruler using a calculator looking someone in the eyes while talking and budgeting paychecks. New employees receive company T-shirts so they’re dressed the same as the old-timers. WFB assigns a 24-hour “Re- tention Specialist” to each new hire to help resolve per- sonal issues. In 1999 WFB received two awards: “Employer of the Year” from the Private Industry Council of Waukesha- Ozaukee-Washington counties and one of the 15 “Exem- plary Employers” in the State of Wisconsin at the Sixth Annual Governor’s Employment and Training Conference. W SOURCE: Corporate Headquarters—Wisconsin Film Bag 3100 E. Richmond Street Shawano WI 54166.

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Part 2 Systems and Methods of Product Costing 106 This chapter presents a variety of definitions and classifications of cost. Historical replacement and budgeted costs are typically associated with time. Historical costs are used for external financial statements replacement and bud- geted costs are more often used by managers in conducting their planning con- trolling and decision-making functions. Variable fixed mixed and step costs describe cost behavior within the con- text of a relevant range. Total variable cost varies directly and proportionately with changes in activity variable costs are constant on a per-unit basis. Costs that re- main constant in total regardless of changes in activity are fixed. On a per-unit basis fixed costs vary inversely with activity changes. Mixed costs contain both a variable and fixed component and are usually separated using the high-low method or least squares regression analysis into these components for product costing and management’s uses. Step costs can be variable or fixed depending on the size of the “step” change small or large respectively that occurs relative to the change in activity. Accountants select a relevant range that allows step variable costs to be treated as variable and step fixed costs to be treated as fixed. For financial statements costs are either considered unexpired and reported on the balance sheet as assets or expired and reported on the income statement as expenses or losses. Costs may also be viewed as product or period costs. Prod- uct costs are inventoried and include direct material direct labor and manufac- turing overhead. When the products are sold these costs expire and become cost of goods sold expense. Period costs are incurred outside the production area and are usually associated with the functions of selling administrating and financing. Costs are also said to be direct or indirect relative to a cost object. The mate- rial and labor costs of production that are physically and conveniently traceable to products are direct costs. All other costs incurred in the production area are indi- rect and are referred to as manufacturing overhead. The extensive activity required to convert raw materials into finished goods distinguishes manufacturers and service companies from retailers. This conversion process necessitates that all factory costs be accumulated and reported as product costs under accrual accounting. A predetermined overhead rate is calculated by dividing the upcoming period’s budgeted overhead costs by a selected level of activity. Budgeted overhead costs at various levels of activity are shown on a flexible budget which is discussed in Chapter 10 on standard costing. Predetermined overhead rates eliminate the prob- lems caused by delays in obtaining actual cost data make the overhead allocation process more effective and allocate a uniform amount of overhead to goods or services based on related production efforts. The activity base chosen to compute a predetermined overhead rate should be logically related to cost changes and be a direct causal factor of that cost a cost driver rather than simply a predictor. Units of output are a valid measure only if the company produces a single product. When a company uses a predetermined overhead rate underapplied or over- applied overhead results at the end of the year. This amount if insignificant should be closed to Cost of Goods Sold or if significant allocated among Work in Process Inventory Finished Goods Inventory and Cost of Goods Sold. An internal management report known as the cost of goods manufactured schedule traces the flow of costs into the production area and through conversion into finished goods. This report provides the necessary information to prepare the cost of goods sold section of a manufacturer’s income statement. CHAPTER SUMMARY

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Chapter 3 Organizational Cost Flows 107 Plantwide versus Departmental Overhead Application Rates The Indianapolis Division of Alexander Polymers International is used to illustrate the calculation of a single plantwide overhead application rate. This division con- tains two departments Cutting and Mounting and Packaging. At the end of 2000 division management budgets its 2001 activity level at 75000 machine hours and manufacturing overhead costs at 399750. If a plantwide predetermined overhead application rate is calculated on per machine hour: Plantwide OH Rate 5.33 Although a single plantwide overhead rate can be computed such a process is frequently not adequate. In most companies work is performed differently in different departments or organizational units. For example although machine hours may be an appropriate activity base in a highly automated department direct labor hours DLHs may be better for assigning overhead in a labor-intensive department. In the quality control area number of defects may provide the best allocation base. Thus because homogeneity is more likely within a department than among depart- ments separate departmental rates are generally thought to provide managers more useful information than plantwide rates. Exhibit 3–14 presents the calculations of separate departmental and plantwide overhead rates for the Indianapolis Division of Alexander Polymers International. The Cutting and Mounting Department is highly automated and therefore uses machine hours as its overhead cost driver. In contrast the Packaging Department is more labor intensive and uses DLHs. Least Squares Regression Analysis Least squares regression analysis is a statistical technique that analyzes the re- lationship between dependent and independent variables. Least squares is used to develop an equation that predicts an unknown value of a dependent variable 399750 75000 MH Total Budgeted OH Cost at a Specific Activity Level Volume of Specified Activity Level APPENDIX Cutting and Mounting Packaging Budgeted annual overhead 240100 159650 Budgeted annual direct labor hours DLHs 5400 20600 Budgeted annual machine hours MHs 70000 5000 Departmental overhead rates: Cutting and Mounting automated: 240100 70000 MHs 3.43 per MH Packaging manual: 159650 20600 DLHs 7.75 per DLH Total plantwide overhead 240100 159650 399750 Plantwide overhead rate using DLHs: 399750 26000 DLHs 15.375 per DLH Plantwide overhead rate using MHs: 399750 75000 MHs 5.33 per MH EXHIBIT 3–14 Departmental versus Plantwide Overhead Rates least squares regression analysis dependent variable

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cost from the known values of one or more independent variables activity. When multiple independent variables exist least squares regression also helps to select the independent variable that is the best predictor of the dependent vari- able. For example managers can use least squares to decide whether machine hours direct labor hours or pounds of material moved best explain and predict changes in a specific overhead cost. 16 Simple regression analysis uses one independent variable to predict the de- pendent variable. Simple linear regression uses the y a bX formula for a straight line. In multiple regression two or more independent variables are used to predict the dependent variable. All examples in this appendix use simple re- gression and assume that a linear relationship exists between variables so that each one-unit change in the independent variable produces a constant unit change in the dependent variable. 17 The least squares method mathematically fits the best possible regression line to observed data points. A regression line is any line that goes through the means or averages of the independent and dependent variables in a set of observations. Numerous straight lines can be drawn through any set of data observations but most of these lines would provide a poor fit. Least squares regression analysis finds the line of “best fit” for the observed data. This line of best fit is found by predicting the a and b values in a straight-line formula using the actual activity and cost values y values from the observations. The equations necessary to compute b and a values using the method of least squares are as follows 18 : b a y bx where x mean of the independent variable y mean of the dependent variable n number of observations Using the Cutting and Mounting Department data for the Indianapolis Division of Alexander Polymers International presented in the chapter in Exhibit 3–7 and excluding the March outlier the following calculations can be made: x y xy x 2 4800 192 921600 23040000 9000 350 3150000 81000000 4900 186 911400 24010000 4600 218 1002800 21160000 8900 347 3088300 79210000 5900 248 1463200 34810000 5500 231 1270500 30250000 43600 1772 11807800 293480000 xy nx y x 2 nx 2 Part 2 Systems and Methods of Product Costing 108 16 Further discussion of finding independent variables that best predict the value of the dependent variable can be found in most textbooks on statistical methods treating regression analysis under the headings of dispersion coefficient of correlation coefficient of determination or standard error of the estimate. 17 Curvilinear relationships between variables also exist. For example quality defects dependent variable tend to increase at an increasing rate in relationship to machinery age independent variable. 18 These equations are derived from mathematical computations beyond the scope of this text but which are found in many statistics books. The symbol means “the summation of.” independent variable simple regression multiple regression regression line

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The mean of x x is 6228.57 43600 7 and the mean of y y is 253.14 1772 7. Thus b 0.035 a 253.14 0.035 6228.57 35.14 Thus the b variable cost and a fixed cost values for the department’s utility costs are 0.035 and 35.14 respectively. By using these values predicted costs y c values can be computed for each actual activity level. The line that is drawn through all of the y c values will be the line of best fit for the data. Because actual costs do not generally fall directly on the regression line and predicted costs naturally do there are differences between these two costs at their related activity levels. It is acceptable for the regression line not to pass through any or all of the actual observation points because the line has been determined to mathematically “fit” the data. 770898.53 21914410.29 11807800 76228.57253.14 293480000 76228.576228.57 Chapter 3 Organizational Cost Flows 109 actual cost system p. 95 applied overhead p. 97 capacity p. 99 conversion cost p. 78 cost p. 77 cost allocation p. 95 cost driver p. 87 cost object p. 90 cost of goods manufactured p. 102 dependent variable p. 107 direct cost p. 89 direct labor p. 78 direct material p. 78 distribution cost p. 78 expected capacity p. 100 expired cost p. 77 fixed cost p. 85 high-low method p. 88 historical cost p. 98 independent variable p. 108 indirect cost p. 90 inventoriable cost p. 78 least squares regression analysis p. 107 manufacturer p. 79 mixed cost p. 86 multiple regression p. 108 normal capacity p. 100 normal cost system p. 96 outlier p. 88 overapplied overhead p. 98 overhead p. 78 period cost p. 78 practical capacity p. 100 predetermined overhead rate p. 96 predictor p. 87 product cost p. 78 regression line p. 108 relevant range p. 84 service company p. 79 simple regression p. 108 step cost p. 86 theoretical capacity p. 99 underapplied overhead p. 98 unexpired cost p. 77 variable cost p. 84 KEY TERMS

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Part 2 Systems and Methods of Product Costing 110 Predetermined Overhead Rate Predetermined OH Rate Can be separate variable and fixed rates or a combined rate High-Low Method Using assumed amounts Independent Dependent Variable Total Total Variable Associated Variable Cost Fixed Activity Total Cost Rate Activity Cost “High” level 14000 18000 11200 6800 “Low” level 9000 14000 7200 6800 Differences 5000 4000 0.80 variable cost per unit of activity Least Squares Regression Analysis The equations necessary to compute b and a values using the method of least squares are as follows: b a y bx where x mean of the independent variable y mean of the dependent variable n number of observations Underapplied and Overapplied Overhead Overhead Control XXX Various accounts XXX Actual overhead is debited to the overhead general ledger account. Work in Process Inventory YYY Overhead Control YYY Applied overhead is debited to WIP and credited to the overhead general ledger account. A debit balance in Manufacturing Overhead at the end of the period is underap- plied overhead a credit balance is overapplied overhead. The debit or credit bal- ance in the overhead account is closed at the end of the period to CGS or pro- rated to WIP FG and CGS. xy nx y x 2 nx 2 Total Budgeted Overhead Cost Total Budgeted Level of Volume or Activity SOLUTION STRATEGIES

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Chapter 3 Organizational Cost Flows 111 Raw Direct Materials Inventory Purchases Issuances Wages Payable Wages owed Manufacturing Overhead Supplies used Indirect labor Electricity cost Depreciation expense Rent expense Assigned to Work in Process Work in Process Inventory Direct materials Direct labor Overhead Cost of goods completed Finished Goods Inventory Cost of goods completed Cost of goods sold Cost of Goods Sold Cost of goods sold Direct Labor Work in Process Inventory Finished Goods Inventory Cost of Goods Sold FLOW OF COSTS Direct Materials Manufacturing Overhead Cost of Goods Manufactured Beginning balance of Work in Process Inventory XXX Manufacturing costs for the period: Raw materials all direct: Beginning balance XXX Purchases of materials XXX Raw materials available for use XXX Ending balance XXX Direct materials used XXX Direct labor XXX Variable overhead XXX Fixed overhead XXX Total current period manufacturing costs XXX Total costs to account for XXX Ending balance of Work in Process Inventory XXX Cost of goods manufactured XXX

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Cost of Goods Sold Beginning balance of Finished Goods Inventory XXX Cost of goods manufactured XXX Cost of goods available for sale XXX Ending balance of Finished Goods Inventory XXX Cost of goods sold XXX Part 2 Systems and Methods of Product Costing 112 BagsSoStrong Company had the following account balances as of August 1 2001: Raw Materials direct and indirect Inventory 9300 Work in Process Inventory 14000 Finished Goods Inventory 18000 During August the company incurred the following factory costs: • Purchased 82000 of raw materials on account. • Issued 90000 of raw materials of which 67000 were direct to the product. • Factory payroll of 44000 was accrued 31000 was for direct labor and the rest was for supervisors. • Utility costs were accrued at 3500 of these costs 800 were fixed. • Property taxes on the factory were accrued in the amount of 1000. • Prepaid insurance of 800 on factory equipment expired in August. • Straight-line depreciation on factory equipment was 20000. • Predetermined overhead of 62500 28000 variable and 34500 fixed was applied to Work in Process Inventory. • Goods costing 170000 were transferred to Finished Goods Inventory. • Sales on account totaled 350000. • Cost of goods sold was 175000. • Selling and administrative costs were 140000 credit “Various Accounts”. • Ending Work in Process Inventory is 3300. Required: a. Journalize the transactions for August. b. Prepare a schedule of cost of goods manufactured for August using normal costing. c. Prepare an income statement including a detailed schedule of cost of goods sold. Solution to Demonstration Problem a. 1 Raw Materials Inventory 82000 Accounts Payable 82000 2 Work in Process Inventory 67000 Variable Overhead Control 23000 Raw Materials Inventory 90000 3 Work in Process Inventory 31000 Fixed Overhead Control 13000 Salaries and Wages Payable 44000 4 Variable Overhead Control 2700 Fixed Overhead Control 800 Utilities Payable 3500 DEMONSTRATION PROBLEM

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5 Fixed Overhead Control 1000 Property Taxes Payable 1000 6 Fixed Overhead Control 800 Prepaid Insurance 800 7 Fixed Overhead Control 20000 Accumulated Depreciation—Factory Equipment 20000 8 Work in Process Inventory 62500 Variable Overhead Control 28000 Fixed Overhead Control 34500 9 Finished Goods Inventory 171200 Work in Process Inventory 171200 10 Accounts Receivable 350000 Sales 350000 11 Cost of Goods Sold 175000 Finished Goods Inventory 175000 12 Selling Administrative Expenses 140000 Various Accounts 140000 b. BAGSSOSTRONG Cost of Goods Manufactured Schedule For Month Ended August 31 2001 Balance of Work in Process Inventory 8/1/01 14000 Manufacturing costs for the period: Raw materials: Beginning balance 9300 Purchases of materials 82000 Raw materials available 91300 Indirect materials used 23000 Ending balance 1300 24300 Total direct materials used 67000 Direct labor 31000 Variable overhead 28000 Fixed overhead 34500 Total current period manufacturing costs 160500 Total costs to account for 174500 Balance of Work in Process Inventory 8/31/01 3300 Cost of goods manufactured 171200 During August factory overhead was overapplied by 1200. Underapplied or overapplied overhead is accumulated throughout the year and disposed of at year end. c. BAGSSOSTRONG Income Statement For the Month Ended August 31 2001 Sales 350000 Cost of Goods Sold Finished Goods 8/1/01 18000 Cost of Goods Manufactured 171200 Cost of Goods Available 189200 Finished Goods 8/31/01 13000 Cost of Goods Sold 176200 Gross Margin 173800 Selling Administrative Expenses 140000 Income from Operations 33800 Chapter 3 Organizational Cost Flows 113

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Part 2 Systems and Methods of Product Costing 114 1. Distinguish among the cost accounting uses of historical costs replacement costs and budgeted costs. 2. How does a company determine its relevant range of activity Of what use to managers is the concept of a relevant range of activity 3. Why is a cost referred to as variable if it remains constant per unit for all vol- ume levels within the relevant range 4. Would it be true that fixed costs will never change in an organization Explain the rationale for your answer. 5. What is the difference between a variable and a mixed cost given that each changes in total with changes in activity levels 6. How do predictors and cost drivers differ Why is such a distinction important 7. The high-low method of analyzing mixed costs uses only two observation points: the high and the low points of activity. Are these always the best points for prediction purposes Why or why not 8. Relative to a set of data observations what is an outlier Why is it inappro- priate to use outliers to determine the cost formula for a mixed cost 9. What is a product cost What types of costs are included in product costs for retailers manufacturers and service companies 10. What is a period cost What types of costs are included in period costs for retailers manufacturers and service companies 11. Are all product costs unexpired costs and all period costs expired costs Explain. 12. How is the concept of a direct cost related to that of a cost object 13. Why are some material and labor costs that should in theory be considered direct costs instead accounted for as indirect costs 14. What is the process of conversion and why does this process create a need for cost accounting 15. What inventory accounts are shown on the balance sheet of a manufacturer and what information is contained in each of these accounts 16. Is allocation of manufacturing overhead to products necessary for external re- porting purposes Internal purposes Provide explanations for your answers. 17. Compare and contrast a normal cost system and an actual cost system. Rela- tive to an actual cost system what are the advantages associated with the use of a normal cost system What are the disadvantages 18. Discuss the reasons a company would use a predetermined overhead rate rather than apply actual overhead to products or services. 19. When a normal cost system is used how are costs removed from a single Manufacturing Overhead account and charged to Work in Process Inventory 20. What recordkeeping options are available to account for overhead costs in a normal cost system Which would be easiest Which would provide the best information and why 21. If overhead was materially underapplied for a year how would it be treated at year-end Why is this treatment appropriate 22. What factors can cause overhead to be underapplied or overapplied Are all of these factors controllable by management Why or why not 23. Why can it be said that the cost of goods manufactured schedule shows the flow of production costs in a manufacturing company 24. Why is the amount of cost of goods manufactured different from the amount of cost of goods sold Could there be a situation in which these amounts are equal If so explain. 25. Appendix Why are departmental overhead rates more useful for managerial decision making than plantwide rates Separate variable and fixed rates rather than total rates QUESTIONS

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26. Appendix Why would regression analysis provide a more accurate cost for- mula for a mixed cost than the high-low method 27. Using the Internet find an article about costs. List and define as many differ- ent types of costs from the article as you can. Chapter 3 Organizational Cost Flows 115 28. Terminology Match the following lettered terms on the left with the appro- priate numbered description on the right. a. Budgeted cost 1. An expense or loss b. Direct cost 2. A cost that remains constant on a c. Distribution cost per-unit basis d. Expired cost 3. A cost associated with a specific cost e. Fixed cost object f. Inventoriable cost 4. Direct material direct labor and g. Period cost manufacturing overhead h. Product cost 5. Product cost i. Variable cost 6. A cost that varies inversely on a per-unit basis with changes in activity 7. A cost primarily associated with the passage of time rather than production activity 8. An expected future cost 9. A cost of transporting a product 29. Cost classifications Indicate whether each item listed below is a variable V fixed F or mixed M cost and whether it is a product or service PT cost or a period PD cost. If some items have alternative answers indicate the al- ternatives and the reasons for them. a. Wages of forklift operators who move finished goods from a central ware- house to the loading dock. b. Paper towels used in factory restrooms. c. Insurance premiums paid on the headquarters of a manufacturing company. d. Columnar paper used in an accounting firm. e. Cost of labels attached to shirts made by a company. f. Wages of factory maintenance workers. g. Property taxes on a manufacturing plant. h. Salaries of secretaries in a law firm. i. Freight costs of acquiring raw materials from suppliers. j. Cost of wax to make candles. k. Cost of radioactive material used to generate power in a nuclear power plant. 30. Company type Indicate whether each of the following terms is associated with a manufacturing Mfg. a retailing or merchandising Mer. or a service Ser. company. There can be more than one correct answer for each term. a. Prepaid rent b. Merchandise inventory c. Cost of goods sold d. Sales salaries expense e. Finished goods inventory f. Depreciation—factory equipment g. Cost of services rendered h. Auditing fees expense i. Direct labor wages EXERCISES

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31. Degrees of conversion Indicate whether each of the following types of orga- nizations is characterized by a high low or moderate degree of conversion. a. Bakery in a grocery store b. Convenience store c. Christmas tree farm d. Textbook publisher e. Sporting goods retailer f. Auto manufacturer g. Cranberry farm h. Custom print shop i. Italian restaurant j. Concert ticket seller 32. Cost behavior O’Malley Company produces baseball caps. The company in- curred the following costs to produce 2000 caps last month: Cardboard for the bills 1200 Cloth materials 2000 Plastic for headband straps 1500 Straight-line depreciation 1800 Supervisors’ salaries 4800 Utilities 900 Total 12200 a. What did each cap component cost on a per-unit basis b. What is the probable type of behavior that each of the costs exhibits c. The company expects to produce 2500 caps this month. Would you expect each type of cost to increase or decrease Why Why can’t the total cost of 2500 caps be determined 33. Cost behavior The Hudson Company manufactures high-pressure garden hoses. Costs incurred in the production process include a rubber material used to make the hoses steel mesh used in the hoses depreciation on the factory building and utilities to run production machinery. Graph the most likely cost behavior for each of these costs and show what type of cost behavior is in- dicated by each cost. 34. Total cost determination with mixed cost Heathcliff Accounting Services pays 400 per month for a tax software license. In addition variable charges average 15 for every tax return the firm prepares. a. Determine the total cost and the cost per unit if the firm expects to prepare the following number of tax returns in March 2000: 1. 150 2. 300 3. 600 b. Why does the cost per unit change in each of the three cases above 35. High-low method Information about Brightman Corporation’s utility cost for the first six months of 2001 follows. The company’s cost accountant wants to use the high-low method to develop a cost formula to predict future charges and believes that the number of machine hours is an appropriate cost driver. Machine Utility Month Hours Expense January 68000 1220 February 62000 1172 March 66300 1014 April 64000 1195 May 67500 1300 June 62500 1150 Part 2 Systems and Methods of Product Costing 116

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a. What is the cost formula for utility expense b. What would be the budgeted utility cost for September 2001 if 64750 machine hours are projected 36. High-low method The Evanstonian builds tabletop replicas of some of the most famous lighthouses in North America. The company is highly automated and thus maintenance cost is a significant organizational expense. The com- pany’s owner has decided to use machine hours as a basis for predicting main- tenance costs and has gathered the following data from the prior eight months of operations: Number of Maintenance Machine Hours Costs 3000 980 4500 690 8000 510 7000 600 6000 550 9000 440 3500 840 5500 600 a. Using the high-low method determine the cost formula for maintenance costs. b. What aspect of the estimated equation is bothersome Provide an explana- tion for this situation. c. Within the relevant range can the formula be reliably used to predict main- tenance costs Can the a and b values in the cost formula be interpreted as fixed and variable costs Why or why not 37. Predictors and cost drivers team activity Accountants often use factors that change in a consistent pattern with costs to explain or predict cost behavior. a. As a team of three or four select factors to predict or explain the behavior of the following costs: 1. Salesperson’s travel expenses 2. Raw material costs at a pizza restaurant 3. Paper costs in a College of Business 4. Maintenance costs for a lawn service company b. Prepare a presentation of your chosen factors that also addresses whether the factors could be used as cost drivers in addition to predictors. 38. Direct vs. indirect costs Babin Cutlery Inc. manufactures kitchen knives. Fol- lowing are some costs incurred in the factory in 2000 for knife production: Material Costs: Stainless steel 400000 Equipment oil and grease 8000 Plastic and fiberglass for handles 15000 Wooden knife racks for customer storage 9200 Labor Costs: Equipment operators 200000 Equipment mechanics 50000 Factory supervisors 118000 a. What is the direct material cost for 2000 b. What is the direct labor cost for 2000 c. What are the indirect material and total indirect labor overhead costs for 2000 39. Direct vs. indirect costs Midwestern State University’s College of Business has five departments: Accounting Finance Management Marketing and Decision Sciences. Each department chairperson is responsible for the department’s Chapter 3 Organizational Cost Flows 117

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budget preparation. Indicate whether each of the following costs incurred in the Marketing Department is direct or indirect to the department: a. Chairperson’s salary b. Cost of computer time of campus mainframe used by members of the department c. Marketing faculty salaries d. Cost of equipment purchased by the department from allocated state funds e. Cost of travel by department faculty paid from externally generated funds contributed directly to the department f. Cost of secretarial salaries secretaries are shared by the entire college g. Depreciation allocation of the college building cost for the number of offices used by department faculty h. Cost of periodicals/books purchased by the department 40. Labor cost classification House Home Inc. produces a variety of household products. The firm operates 24 hours per day with three daily work shifts. The first-shift workers receive “regular pay.” The second shift receives a 10 percent pay premium and the third shift receives a 20 percent pay premium. In addition when production is scheduled on weekends the firm pays an overtime premium of 50 percent based on the pay rate for first-shift employees. Labor premiums are included in overhead. The August 2001 factory payroll is as follows: Total wages for August for 18000 hours 168000 Normal hourly wage for Shift 1 employees 8 Total regular hours worked split evenly among the three shifts 15000 a. How many overtime hours were worked in August b. How much of the total labor cost should be charged to direct labor To overhead c. What amount of overhead was for second- and third-shift premiums For overtime premiums 41. Product and period costs Alexander Company incurred the following costs in August 2000: • Paid a six-month premium for insurance of company headquarters 12000. • Paid three months of property taxes on its factory building 7500. • Paid a 40000 bonus to the company president. • Accrued 10000 of utility costs of which 30 percent was for the head- quarters and the remainder for the factory. a. What expired period cost is associated with the August information b. What unexpired period cost is associated with the August information c. What product cost is associated with the August information d. Discuss why the product cost cannot be described specifically as expired or unexpired in this situation. 42. Essay A portion of the costs incurred by business organizations is designated as direct labor cost. As used in practice the term direct labor cost has a wide variety of meanings. Unless the meaning intended in a given context is clear misunderstanding and confusion are likely to ensue. If a user does not un- derstand the elements included in direct labor cost erroneous interpretations of the numbers may occur and could result in poor management decisions. In addition to understanding the conceptual definition of direct labor cost management accountants must understand how direct labor cost should be measured. Write a paper that discusses the following issues: a. Distinguish between direct labor and indirect labor. b. Discuss why some nonproductive labor time such as coffee breaks personal time can be and often is treated as direct labor whereas other nonproduc- tive time such as downtime or training is treated as indirect labor. Part 2 Systems and Methods of Product Costing 118

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c. Following are labor cost elements that a company has classified as direct labor manufacturing overhead or either direct labor or manufacturing over- head depending on the situation. • Direct labor: Included in the company’s direct labor are cost production efficiency bonuses and certain benefits for direct labor workers such as FICA employer’s portion group life insurance vacation pay and work- ers’ compensation insurance. • Manufacturing overhead: Included in the company’s overhead are costs for wage continuation plans in the event of illness the company-sponsored cafeteria the personnel department and recreational facilities. • Direct labor or manufacturing overhead: Included in the “situational” cat- egory are maintenance expense overtime premiums and shift premiums. Explain the rationale used by the company in classifying the cost elements in each of the three presented categories. d. The two aspects of measuring direct labor costs are 1 the quantity of la- bor effort that is to be included that is the types of hours that are to be counted and 2 the unit price by which each of these quantities is mul- tiplied to arrive at a monetary cost. Why are these considered separate and distinct aspects of measuring labor cost CMA adapted 43. Predetermined overhead rate Walton Company has developed a monthly overhead cost formula of 2760 4 per direct labor hour for 2000. The firm’s 2000 expected annual capacity is 24000 direct labor hours to be incurred evenly each month. Two direct labor hours are required to make one unit of the company’s product. a. Determine the total overhead to be applied to each unit of product in 2000. b. Prepare journal entries to record the application of overhead to Work in Process Inventory and the incurrence of 10430 of actual overhead in a month in which 1850 direct labor hours were worked. 44. Overhead application Brooke Associates applies overhead at a combined rate for fixed and variable overhead of 175 percent of professional labor costs. During the first three months of 2000 the following professional labor costs and actual overhead costs were incurred: Month Professional Labor Cost Actual Overhead January 270000 480000 February 247500 427800 March 255000 450000 a. How much overhead was applied to the services provided each month by the firm b. What was underapplied or overapplied overhead for each of the three months and for the quarter 45. Underapplied or overapplied overhead At the end of 2000 Schmitt Corpora- tion has the following account balances: Manufacturing Overhead credit 20000 Work in Process Inventory 128000 Finished Goods Inventory 32000 Cost of Goods Sold 240000 a. Prepare the necessary journal entry to close the overhead account if the balance is considered immaterial. b. Prepare the necessary journal entry to close the overhead account if the balance is considered material. c. Which method do you feel is more appropriate for the company and why Chapter 3 Organizational Cost Flows 119

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46. Underapplied or overapplied overhead Hume Company uses a normal cost system. At year-end the balance in the manufacturing overhead control ac- count is a 50000 debit. Information concerning relevant account balances at year-end is as follows: Cost of Work in Process Finished Goods Goods Sold Direct materials 20000 40000 60000 Direct labor 10000 20000 25000 Factory overhead 20000 40000 50000 50000 100000 135000 a. What overhead rate was used during the year b. Provide arguments to be used for deciding whether to prorate the balance in the overhead account at year-end. c. Prorate the overhead account balance based on the relative balances of the appropriate accounts. d. Prorate the overhead account balance based on the relative overhead com- ponents of the appropriate account balances. e. Identify some possible reasons why the company had a debit balance in the overhead account at year-end. 47. CGM and CGS Holiday Products Company had the following inventory bal- ances at the beginning and end of March 2000: March 1 2000 March 31 2000 Raw Materials Inventory 12000 16000 Work in Process Inventory 68000 84000 Finished Goods Inventory 32000 24000 All raw materials are direct to the production process. The following information is also available about March manufacturing costs: Cost of raw materials used 128000 Direct labor cost 162000 Factory overhead 116000 a. Calculate the cost of goods manufactured for March. b. Determine the cost of goods sold for March. 48. Cost of services rendered The following information is related to the Perrrfect Veterinary Clinic for April 2001 the firm’s first month in operation: Veterinarian salaries for April 12000 Assistants’ salaries for April 4200 Medical supplies purchased in April 1800 Utilities for month 80 percent related to animal treatment 900 Office salaries for April 20 percent related to animal treatment 2600 Medical supplies on hand at April 30 800 Depreciation on medical equipment for April 600 Building rental 70 percent related to animal treatment 700 Compute the cost of services rendered. 49. CGM and CGS Cathy’s Custom Clocks’ August 2001 cost of goods sold was 2300000. August 31 work in process was 40 percent of the August 1 work Part 2 Systems and Methods of Product Costing 120

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in process. Overhead was 225 percent of direct labor cost. During August 768500 of direct materials were purchased. Other August information follows: Inventories August 1 2001 August 31 2001 Direct materials 30000 42000 Work in process 90000 Finished goods 125000 98000 a. Prepare a schedule of the cost of goods sold for August. b. Prepare the August cost of goods manufactured schedule. c. What was the amount of direct production costs incurred in August d. What was the amount of conversion costs incurred in August 50. Financial statement classifications Cajun Airboats purchased a plastics ex- truding machine for 100000 to make boat hulls. During its first operating year the machine produced 5000 units and depreciation was calculated to be 12500 on the machine. The company sold 4000 of the hulls. a. What part of the 100000 machine cost is expired b. Where would each of the amounts related to this machine appear on the financial statements 51. Appendix–Least squares Below are data on number of shipments received and the cost of receiving reports for Pacific Supply Company for the first seven weeks of 2000: Number of Cost of Shipments Received Receiving Report 100 175 87 162 80 154 70 142 105 185 115 200 120 202 a. Using the least squares method develop the equation for predicting weekly receiving report costs based on the number of shipments received. b. What is the predicted amount of receiving report costs for a month as- sume a month is exactly four weeks in which 390 shipments are received 52. Appendix–Least squares Tom’s Charters operates a fleet of powerboats in Fort Myers Florida. Tom wants to develop a cost formula for labor costs a mixed cost. He has gathered the following data on labor costs and two potential pre- dictive bases: number of charters and gross receipts: Number of Month Labor Costs Charters Gross Receipts January 16000 10 12000 February 18400 14 18000 March 24000 22 26000 April 28400 28 36000 May 37000 40 60000 June 56000 62 82000 July 68000 100 120000 August 60000 90 100000 September 48000 80 96000 Using the least squares method develop a labor cost formula using each prediction base. Chapter 3 Organizational Cost Flows 121

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Part 2 Systems and Methods of Product Costing 122 53. Cost behavior Officestuff Ink makes stationery sets. In an average month the firm produces 200000 boxes of stationery each box contains 50 pages of sta- tionery and 40 envelope sets. Production costs are incurred for paper ink glue and boxes. The company manufactures this product in batches of 500 boxes of a specific stationery design. The following data have been extracted from the company’s accounting records for April 2000: Cost of paper for each batch 10 Cost of ink and glue for each batch 1 Cost of 500 boxes for each batch 32 Direct labor for producing each batch 16 Labor costs for each batch design 40 Overhead charges total 20400 per month these are considered fully fixed for purposes of cost estimation. a. What is the cost per box of stationery based on average production volume b. If sales volume increases to 300000 boxes per month what will be the cost per box assuming that cost behavior patterns remain the same as in April c. If sales are 300000 boxes per month but the firm does not want the cost per box to exceed its current level based on part a above what amount can the company pay for labor design costs assuming all other costs are the same as April levels d. Assume that Officestuff Ink is now able to sell on average each box of stationery at a price of 5. If the company is able to increase its volume to 300000 boxes per month what sales price per box will generate the same gross margin that the firm is now achieving on 200000 boxes per month e. Would it be possible to lower total costs by producing more boxes per batch even if the total volume of 200000 is maintained Explain. 54. Cost behavior A company’s cost structure may contain numerous different cost behavior patterns. Below are descriptions of several different costs match these to the appropriate graphs. On each graph the vertical axis represents cost and the horizontal axis represents level of activity or volume. Identify by letter the graph that illustrates each of the following cost be- havior patterns. Graphs can be used more than once. PROBLEMS AB C EF GH IJ K L D

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1. Cost of raw materials where the cost decreases by 0.06 per unit for each of the first 150 units purchased after which it remains constant at 2.75 per unit. 2. City water bill which is computed as follows: First 750000 gallons or less 1000 flat fee Next 15000 gallons 0.002 per gallon used Next 15000 gallons 0.005 per gallon used Next 15000 gallons 0.008 per gallon used Etc. Etc. 3. Rent on a factory building donated by the city where the agreement pro- vides for a fixed-fee payment unless 250000 labor hours are worked in which case no rent needs to be paid. 4. Cost of raw materials used. 5. Electricity bill—a flat fixed charge of 250 plus a variable cost after 150000 kilowatt-hours are used. 6. Salaries of maintenance workers if one maintenance worker is needed for every 1000 hours or less of machine time. 7. Depreciation of equipment using the straight-line method. 8. Rent on a factory building donated by the county where the agreement provides for a monthly rental of 100000 less 1 for each labor hour worked in excess of 200000 hours. However a minimum rental payment of 20000 must be made each month. 9. Rent on a machine that is billed at 1000 for up to 500 hours of machine time. After 500 hours of machine time an additional charge of 1 per hour is paid up to a maximum charge of 2500 per period. AICPA adapted 55. Cost classifications Donald Trumpett is a house painter who incurred the fol- lowing costs during June 2001 when he painted four houses. He spent 1000 on paint 50 on mineral spirits and 100 on brushes. He also bought two pairs of coveralls for 50 each he wears coveralls only while he works. Dur- ing the first week of June Donald placed a 60 ad for his business in the clas- sifieds. He had to hire an assistant for one of the painting jobs the assistant was paid 12 per hour and worked 25 hours. Being a very methodical person Donald kept detailed records of his mileage to and from each painting job. His average operating cost per mile for his van is 0.32. He found a 15 receipt in his van for a metropolitan map that he purchased in June. The map is used as a part of contact file for refer- ral work and for bids that he has made on potential jobs. He also had 15 in receipts for bridge tolls 1 per trip for a painting job he did across the river. Near the end of June Donald decided to go camping and he turned down a job on which he had bid 2800. He called the homeowner long distance at a cost of 1.60 to explain his reasons for declining the job. Using the headings below indicate how each of the June costs incurred by Donald would be classified. Assume that the cost object is a house-painting job. Type of Cost Variable Fixed Direct Indirect Period Product 56. Analyzing mixed costs Frances’ Dairy determined that the total overhead rate for costing purposes is 6.70 per cow per day referred to as an “animal day”. Of this 6.30 is the variable portion. Cost information for two levels of monthly activity within the relevant range follow: Chapter 3 Organizational Cost Flows 123

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4000 6000 Animal Days Animal Days Overhead cost: Indirect materials 6400 9600 Indirect labor 14000 20000 Maintenance 2600 3400 Utilities 2000 3000 All other 3800 5400 a. Determine the fixed and variable values for each of the above overhead items and determine the total overhead cost formula. b. Assume that the total overhead rate is based on expected annual capac- ity. What is this level of activity for the company c. Determine expected overhead costs at the expected annual capacity. d. If the company raises its expected capacity by 3000 animal days above the present level calculate a new total overhead rate for product costing. 57. High-low least squares regression Andrews Company manufactures insulated windows. The firm has encountered a problem in budgeting repairs and main- tenance. The cost is apparently a mixed cost and varies most directly with ma- chine hours worked. However management does not know the exact rela- tionship between machine hours and repairs and maintenance. The following data have been gathered from recent operations and may help describe the relationship: Month Machine Hours Repairs and Maintenance May 1400 9000 June 1700 9525 July 2000 10900 August 1900 10719 September 2300 11670 October 2700 13154 November 2500 13000 December 2200 11578 a. How can you tell from the data that repairs and maintenance is a mixed cost b. Use the high-low method to estimate a cost formula for repairs and main- tenance. c. Use least squares regression to estimate a cost formula for repairs and maintenance. d. Does the answer to part b or c provide the better estimate of the rela- tionship between repairs and maintenance costs and machine hours Why 58. Mixed costs and predetermined overhead rates two bases King-O’Brien En- terprises makes fiberglass swimming pools in a two-department process: Pro- duction and Installation. Production is highly automated and machine hours are used as the basis for allocating departmental overhead. Installation is labor intensive and uses direct labor hours to apply overhead. Cost information for various activity levels follows for each department: ACTIVITY IN MACHINE HOURS MHs Low High 3000 4000 5000 Production overhead costs: Variable 12150 16200 20250 Fixed 7950 7950 7950 Total 20100 24150 28200 Part 2 Systems and Methods of Product Costing 124

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ACTIVITY IN DIRECT LABOR HOURS DLHs Low High 1000 2000 3000 Installation overhead costs: Variable 14250 28500 42750 Fixed 6150 6150 6150 Total 20400 34650 48900 Each pool is estimated to require 500 machine hours in Production and 250 hours of direct labor in Installation. Expected annual capacity is 120 pools. The company plans to produce and install 10 pools next month. a. Compute the variable and fixed values in the formula y a bX for each department. b. Prepare a budget for next month’s variable fixed and total overhead costs for each department assuming expected production is 10 pools. c. Calculate the predetermined total overhead cost to be applied to each pool scheduled for production in the coming month if expected annual capac- ity is used to calculate the predetermined overhead rates. 59. Journal entries Ballyhoo Rags makes evening dresses. The following infor- mation has been gathered from the company records for 2001 the first year of company operations. Work in Process Inventory at the end of 2001 was 25500. Direct material purchased on account 330000 Direct material issued to production 294000 Direct labor payroll accrued 215000 Indirect labor payroll accrued 62000 Factory insurance expired 2500 Factory utilities paid 14300 Depreciation on factory equipment recorded 21700 Factory rent paid 84000 Sales on account 958000 The company’s gross profit rate for the year was 35 percent. a. Compute the cost of goods sold for 2001. b. What was the total cost of goods manufactured for 2001 c. If net income was 60300 what were total selling and administrative ex- penses for the year d. Prepare journal entries to record the flow of costs for the year assuming the company uses a perpetual inventory system. 60. Journal entries Mundell Company applies overhead at the rate of 4 per di- rect labor hour. The following transactions occurred during April 2000: 1. Direct material issued to production 160000. 2. Direct labor cost paid 35000 hours at 16 per hour. 3. Indirect labor cost accrued 7500 hours at 9 per hour. 4. Depreciation on factory assets recorded 37200. 5. Supervisors’ salaries paid 15000. 6. Indirect materials issued to production 9000. 7. Goods costing 840000 were completed and transferred to finished goods. a. Prepare journal entries for the above transactions using a single overhead account and assuming the Raw Materials Inventory account contains only direct materials. b. If Work in Process Inventory had a beginning balance of 55620 what is the ending balance c. Was overhead underapplied or overapplied for the month By how much Chapter 3 Organizational Cost Flows 125

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61. CGM and CGS VitalStrength Inc. began business in October 2000. The firm makes an exercise machine for home and gym use. Below are data taken from the firm’s accounting records that pertain to its first year of operations. Direct material purchased on account 213000 Direct material issued to production 192000 Direct labor payroll accrued 114000 Indirect labor payroll paid 45300 Factory insurance expired 2700 Factory utilities paid 8900 Factory depreciation recorded 18700 Ending Work in Process Inventory 48 units 32000 Ending Finished Goods Inventory 30 units 45600 Sales on account 1060 per unit 212000 a. How many units did the company sell in its first year How many units were completed in the first year b. What was the cost of goods manufactured c. What was the per-unit cost of goods manufactured d. What was cost of goods sold in the first year e. What was the company’s first-year gross margin 62. Product and period costs CGM and CGS At the beginning of August 2001 Brennan Corporation had the following account balances: Raw Materials Inventory both direct and indirect 8000 Work in Process Inventory 13000 Finished Goods Inventory 5000 During August the following transactions took place. 1. Raw materials were purchased on account 75000. 2. Direct materials 21200 and indirect materials 2500 were issued to production. 3. Factory payroll consisted of 50000 for direct labor employees and 7000 for indirect labor employees. 4. Office salaries totaled 21100 for the month. 5. Utilities of 8700 were accrued 70 percent of the utilities cost is for the factory area. 6. Depreciation of 9000 was recorded on plant assets 80 percent of the depreciation is related to factory machinery and equipment. 7. Rent of 12000 was paid on the building. The factory occupies 60 percent of the building. 8. At the end of August the Work in Process Inventory balance was 8300. 9. At the end of August the balance in Finished Goods Inventory was 8900. Brennan uses an actual cost system and debits actual overhead costs in- curred to Work in Process. a. Determine the total amount of product cost cost of goods manufactured and period cost incurred during August 2001. b. Compute the cost of goods sold for August 2001. c. What level of August sales would have generated net income of 27700 63. CGM and CGS Catherine’s Collectibles produces objets d’art. The company’s Raw Materials Inventory account includes the costs of both direct and indirect materials. Account balances for the company at the beginning and end of July 2000 are shown below. July 1 2000 July 31 2000 Raw Materials Inventory 23300 17400 Work in Process Inventory 36600 30000 Finished Goods Inventory 18000 26200 Part 2 Systems and Methods of Product Costing 126

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During the month Catherine’s Collectibles purchased 85000 of raw materi- als direct materials used during the period amounted to 68000. Factory pay- roll costs for July were 91300 of which 85 percent was related to direct la- bor. Overhead charges for depreciation insurance utilities and maintenance totaled 81200 for July. a. Prepare a schedule of cost of goods manufactured. b. Prepare a schedule of cost of goods sold. 64. Plant vs. department OH rates Bass Fine Furniture has two departments: Fab- rication and Finishing. Fabrication is composed of 2 workers and 25 machines and Finishing has 25 workers and 3 machines. One of the company’s prod- ucts passes through both departments and uses the following quantities of di- rect labor and machine time: Fabrication Finishing Machine hours 8.00 0.15 Direct labor hours 0.02 2.00 Following are the budgeted overhead costs and volumes for each department for the upcoming year: Fabrication Finishing Estimated overhead 624240 324000 Estimated machine hours 72000 9300 Estimated direct labor hours 4800 48000 a. What is the plantwide rate for overhead application based on machine hours for the upcoming year How much overhead will be assigned to each unit using this rate b. The company’s auditors inform Bass that it would be more appropriate to use machine hours as the application base in Fabrication and direct labor hours in Finishing. What would the rates be for each department How much overhead would have been assigned to each unit of product using departmental rates Chapter 3 Organizational Cost Flows 127 65. Missing data The Hurlstone Company suffered major losses in a fire on April 18 2000. In addition to destroying several buildings the blaze destroyed the company’s work in process for an entire product line. Fortunately the com- pany was insured. However the company needs to substantiate the amount of the claim. To this end the company has gathered the following informa- tion that pertains to production and sales of the affected product line: 1. The company’s sales for the first 18 days of April amounted to 230000. Normally this product line generates a gross profit equal to 30 percent of sales. 2. Finished Goods Inventory was 29000 on April 1 and 42500 on April 18. 3. On April 1 Work in Process Inventory was 48000. 4. During the first 18 days of April the company incurred the following costs: Direct materials used 76000 Direct labor 44000 Manufacturing overhead applied 42000 CASE

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a. Determine the value of Work in Process Inventory that was destroyed by the fire. b. What other information might the insurance company require How would management determine or estimate this information Part 2 Systems and Methods of Product Costing 128 66. An extremely important and expensive variable cost per employee is health care provided by the employer. This cost is expected to rise each year as more and more expensive technology is used on patients and as the costs of that technology are passed along through the insurance company to the employer. One simple way to reduce these variable costs is to cut back on employee in- surance coverage. a. Discuss the ethical implications of reducing employee health care cover- age to cut back on the variable costs incurred by the employer. b. Assume that you are an employer with 600 employees. You are forced to cut back on some insurance benefits. Your coverage currently includes the following items: mental health coverage long-term disability convalescent facility care nonemergency but medically necessary procedures depen- dent coverage and life insurance. Select the two you would eliminate or dramatically reduce and provide reasons for your selections. c. Prepare a plan that might allow you to “trade” some variable employee health care costs for a fixed or mixed cost. 67. Outsourcing is a frequently used method of cost cutting or of eliminating or- ganizational activities that are not viewed as core competencies. However out- sourcing also creates new costs and sometimes new problems. Some companies have found themselves locked into long-term contracts with outside suppliers that are no longer competitive. Indeed multimillion-dollar technology-outsourcing contracts are often so complex that companies are hiring consultants at very high fees simply to evaluate the proposals. SOURCE: John A. Byrne “Has Outsourcing Gone Too Far” Business Week April 1 1996 p. 27. a. Discuss some benefits and drawbacks to outsourcing the following activities: 1 finance function 2 data-processing function and 3 travel arrangements. b. How might outsourcing of manufacturing functions affect the 1 preven- tion 2 appraisal and 3 failure costs of a company c. What effect might outsourcing of each of the activities in part a have on an organization’s corporate culture 68. Frequently corporations issue forecasts of earnings for the upcoming year. Such forecasts require estimations of both costs and revenues. Search the Internet for a discussion of a revision in the earnings forecast of any company. Rela- tive to the original forecast did the revision indicate earnings would be higher or lower Discuss the reasons given for the revision in the forecasted earnings. 69. Global Tool Die Maker is bidding on a contract with the government of Manatuka. The contract is a cost-plus situation with an add-on profit margin of 50 percent. Direct material and direct labor are expected to total 15 per unit. Variable overhead is estimated at 4 per unit. Total fixed overhead to produce the 50000 units needed by the government is 1400000. By acquir- ing the machinery and supervisory support needed to produce the 50000 units Global Tool will obtain the actual capacity to produce 80000 units. a. Should the price bid by Global Tool include a fixed overhead cost of 28 per unit or 17.50 How were these two amounts determined Which of REALITY CHECK

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these two amounts would be more likely to cause Global Tool to obtain the contract Why b. Assume that Global Tool set a bid price of 54.75 and obtained the contract. After producing the units Global Tool submitted an invoice to the govern- ment of Manatuka for 3525000. The minister of finance for the country requests an explanation. Can you provide one c. Global Tool uses the excess capacity to produce an additional 30000 units while making the units for Manatuka. These units are sold to another buyer. Is it ethical to present a 3525000 bill to Manatuka Discuss. d. Global Tool does not use the excess capacity while making the units for Manatuka. However several months after that contract was completed the company begins production of additional units. Was it ethical to present a 3525000 bill to Manatuka Discuss. e. Global Tool does not use the excess capacity because no other buyer exists for units of this type. Was it ethical to make a bid based on a fixed over- head rate per unit of 54.75 Discuss. Chapter 3 Organizational Cost Flows 129

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4 Activity-Based Cost Systems for Management CHAPTER LEARNING OBJECTIVES After completing this chapter you should be able to answer these questions: 1 What is the focus of activity-based management 2 Why do non-value-added activities cause costs to increase unnecessarily 3 Why must cost drivers be designated in an activity-based costing system 4 How does activity-based costing differ from a traditional cost accounting system 5 How does the installation of an activity-based costing system affect behavior 6 What is attribute-based costing and how does it extend activity-based costing 7 When is activity-based costing appropriate in an organization

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Carrier Corporation INTRODUCING arrier a United Technologies’ company is the world’s largest manufacturer of air conditioning and heating products. Competition is intense however and among its six largest competitors Carrier is the only one that is not Japanese owned. The director of cost improve- ment for Carrier’s worldwide operations notes that Carrier’s customers demand “a wide range of products that have unquestionable quality and include state-of-the-art features. Further they expect these products to be delivered when needed at a competitive price.” As the industry leader Carrier strives to maintain its dominant position through innovative product design product differentiation high-quality low-cost manufactur- ing zero defects and cost leadership and time-based competition. To achieve these objectives Carrier has im- plemented a series of improvement initiatives including just-in-time product and process standardization strategic outsourcing supply chain management target costing and performance measurement. Complexity reduction is a com- mon goal among each of these initiatives. These changes instituted by Carrier were in response to both internal and external challenges. While Carrier’s manufacturing environment was chang- ing dramatically at the plant level its parent company United Technologies continued to emphasize financial reporting and control at the corporate level and placed relatively little emphasis on developing modern cost man- agement systems for its manufacturing plants. Therefore the manufacturing plants lacked the cost management information that was needed to support the improvement initiatives adequately and profitability suffered. “The in- tense competition coupled with ever increasing customer demands had made it difficult to maintain adequate profit margins on many products. Accordingly Carrier’s North American Operations profitability had dropped significantly below historical levels.” Carrier needed what it describes as a set of “enablers” or tools to support the development of cost-effective prod- uct designs and manufacturing processes. Activity-based cost management ABCM was selected as the enabler that provides the necessary financial and activity informa- tion. Following its implementation ABCM has been used by Carrier to quantify the benefits of redesigning plant layouts using common parts outsourcing strengthening supplier and customer relationships and developing alter- native product designs. In some cases even though man- agement knows intuitively how to improve its operations until the improvements are quantified they are not acted on. Carrier Corporation like many other manufacturers recognized that its accounting reports were not providing managers with the information and details needed to make good business decisions in a global economy. This flaw was caused in part by the company’s traditional overhead allocation system that was in use. The tra- ditional system discussed in Chapter 3 is geared to satisfy external reporting re- quirements but often does a less than adequate job of meeting management needs. Carrier investigated its cost accounting system and found that some basic changes were necessary. Management concluded that overhead allocations using a minimal number of rates and cost drivers did not provide realistic information for man- agerial functions. This chapter presents topics that are at the forefront of managerial accounting literature and result from the intensely competitive nature of the global economy. First the chapter presents the reasons that companies now focus on value-added and non-value-added activities and explains how activities rather than volume measures can be used to determine product and service costs and to measure per- formance. Then basics of activity-based costing as well as some criticisms of this technique are discussed and illustrated. SOURCE: Dan W. Swenson “Managing Costs through Complexity Reduction at Carrier Corporation” Strategic Finance April 1998 pp. 20–28. 131 C

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Part 2 Systems and Methods of Product Costing 132 ACTIVITY-BASED MANAGEMENT Product cost determination although specifically designated as an accounting func- tion is a major concern of all managers. For example product costs affect deci- sions on corporate strategy Is it profitable to be in this particular market mar- keting How should this product be priced and finance Should investments be made in additional plant assets to manufacture this product. In theory what a product or service costs to produce or perform would not matter if enough cus- tomers were willing to buy that product or service at a price high enough to cover costs and provide a reasonable profit margin. In reality customers purchase some- thing only if it provides acceptable value for the price being charged. Management then should be concerned about whether customers perceive an equitable relationship between selling price and value. Activity-based management focuses on the activities incurred during the production or performance process as a way to improve the value received by a customer and the resulting profit achieved by providing this value. The concepts covered by activity-based management are shown in Exhibit 4–1 and are discussed in this and other chapters. These concepts help companies to produce more efficiently determine costs more accurately and control and evaluate performance more effectively. A primary component of activity- based management is activity analysis which is the process of studying activities to classify them and to devise ways of minimizing or eliminating non-value-added activities. Value-Added versus Non-Value-Added Activities In a business context an activity is defined as a repetitive action performed in ful- fillment of business functions. If one takes a black-or-white perspective activities are either value-added or non-value-added. A value-added VA activity increases the worth of a product or service to a customer and is one for which the customer is willing to pay. Alternatively a non-value-added NVA activity increases the time spent on a product or service but does not increase its worth. Non-value-added activities are unnecessary from the perspective of the customer which means they What is the focus of activity- based management 1 activity analysis EXHIBIT 4–1 The Activity-Based Management Umbrella ACTIVITY-BASED MANAGEMENT Activity analysis Cost driver analysis Activity-based costing Continuous improvement Operational control Performance evaluation Business process reengineering Why do non-value-added activities cause costs to increase unnecessarily activity 2

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create costs that can be eliminated without affecting the market value or quality of the product or service. Businesses also experience significant non-value-added time and activities. Some NVA activities are essential to business operations but customers would not willingly choose to pay for these activities. These activities are known as business- value-added activities. For instance companies must prepare invoices as docu- mentation for sales and collections. Customers know this activity must occur that it creates costs and that product selling prices must be set to cover the costs of this activity. However because invoice preparation adds no direct value to products and services customers would prefer not to have to pay for this activity. In striving to manage the relationship between price charged to and value re- ceived by the customer firms are increasingly turning to their suppliers for help. The accompanying News Note indicates how electronics manufacturers depend on their suppliers not only for efficient and effective delivery of necessary components but also for the ideas that lead to new generations of products. To help in activity analysis managers should first identify organizational processes. “Processes include production distribution selling administration and other company functions. A company should define a process before it attempts to associate related activities to the defined process. Processes should not be forced or defined to fit activities activities should fit processes.” 1 Processes are commonly horizontal in nature across organizational functions and overlap multiple func- tional areas. For example any production process also affects engineering pur- chasing warehousing accounting personnel and marketing. For each distinct process a process map or detailed flowchart should be prepared that indicates every step that goes into making or doing something. All steps and all affected areas must be included not just the obvious ones. For ex- ample storing newly purchased parts would not be on a typical list of “Steps in Making Product X” but when materials and supplies are purchased they are commonly stored until needed. Storage uses facilities that cost money and time is Chapter 4 Activity-Based Cost Systems for Management 133 business-value-added activity Sorting Suppliers for Competitive Advantage NEWS NOTE QUALITY Supplier evaluation programs have never been more im- portant in the electronics industry. Electronics Original Equipment Manufacturers OEMs are relying on suppliers not only to supply parts but to develop new technologies that OEMs will need for future products. With new product development time for some equipment being six months or less and with life cycles being two years or less for many products reliance on suppliers will continue to grow. In recent years IBM has reduced its number of sup- pliers aggregating more business with fewer suppliers. To determine which suppliers to use and how much business to give each IBM evaluates them on price quality deliv- ery and technology. However each criterion is weighted differently depending on the commodity that the supplier produces. “We base the technology rating on what’s going on in the supplier’s lab” says Gene Richter chief procurement officer. “Is the supplier going to be the first to be quali- fied on a 1 gigabit DRAM or the last Does the supplier offer a full breadth of memory products or only one nar- row niche Is the supplier going to be the leader in the next generation in new technology It can be very sub- jective. It’s hard to sort the top three but it’s easy to tell the top three from the bottom three” says Richter. SOURCE: James Carbone “Evaluation Programs Determine Top Suppliers” Pur- chasing November 18 1999 pp. 31–35. 1 Charles D. Mecimore and Alice T. Bell “Are We Ready for Fourth-Generation ABC” Management Accounting January 1995 p. 24. process map

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required to move the items in and out resulting in labor costs. Each process map is unique and based on the results of a management and employee team’s study. Once the process map has been developed a value chart can be constructed that identifies the stages and time spent in those stages from beginning to end of a process. Time can be consumed in four general ways: processing or service inspection transfer and idle. The actual time that it takes to perform the functions necessary to manufacture the product or perform the service is the processing or service time this quantity of time is value-added. Performing quality control re- sults in inspection time whereas moving products or components from one place to another constitutes transfer time. Lastly storage time and time spent waiting at a production operation for processing are idle time. Inspection time transfer time and idle time are all non-value-added. Thus the cycle or lead time from the receipt of an order to completion of a product or performance of a service is equal to value-added processing time plus non-value-added time. Although viewing inspection time and transfer time as non-value-added is the- oretically correct few companies can completely eliminate all quality control func- tions and all transfer time. Understanding the non-value-added nature of these func- tions however should help managers strive to minimize such activities to the extent possible. Thus companies should view value-added and non-value-added activities as occurring on a continuum and concentrate on attempting to eliminate or minimize those activities that add the most time and cost and the least value. Exhibit 4–2 illustrates a value chart for a chemical product made by Titan Chem- ical. Note the excessive time consumed by simply storing and moving materials. Value is added to products only during the times that production actually occurs thus Titan Company’s entire production sequence has only 5.5 days of value-added time. Part 2 Systems and Methods of Product Costing 134 value chart processing service time inspection time transfer time idle time cycle lead time EXHIBIT 4–2 Value Chart for Titan Chemical Receiving 2 Operations Average time days Assembling Quality control 1 Storage 10–15 Move to production .5 Waiting for use 3 Setup of machinery .5 Assembly 3 Move to inspection .5 Move to finishing .5 Operations Average time days Finishing Receiving .5 Move to production .5 Waiting for use 5–12 Setup of machinery .5 Packaging .5 Move to dockside .5 Storage 1.5 Finishing 2 Inspection .5 Ship to customer 1–4 Total time in Assembling: Total time in Finishing: Total processing time: Total value-added time: Total non-value-added time: 21.0 – 26.0 days 12.5 – 22.5 days 33.5 – 48.5 days 5.5 – 5.5 days 28.0 – 43.0 days Assembling value-added time: Finishing value-added time: Total value-added time: 3.0 days 2.5 days 5.5 days Non-Value-Added Activities Value-Added Activities

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In some instances a company may question whether the time spent in pack- aging is value-added. Packaging is essential for some products but unnecessary for others and because packaging takes up about a third of the U.S. landfills and cre- ates a substantial amount of cost companies and consumers are beginning to fo- cus their attention on reducing or eliminating packaging. Manufacturing Cycle Efficiency Dividing value-added processing time by total cycle time provides a measure of efficiency referred to as manufacturing cycle efficiency MCE. A service com- pany would compute service cycle efficiency by dividing actual service time by total cycle time. If a company’s production time were 3 hours and its total cycle time were 24 hours its manufacturing cycle efficiency would be 12.5 3 24 percent. Although the ultimate goal of 100 percent efficiency can never be achieved typically value is added to the product only 10 percent of the time from receipt of the parts until shipment to the customer. Ninety percent of the cycle time is waste. A product is much like a magnet. The longer the cycle time the more the product attracts and creates cost. 2 A just-in-time manufacturing process seeks to achieve substantially higher effi- ciency by producing components and goods at the precise time they are needed by either the next production station or the consumer. Thus a significant amount of idle time especially in storage is eliminated. Raising MCE can also be achieved by installing and using automated technology such as flexible manufacturing systems. In a retail environment cycle time relates to the length of time from ordering an item to selling that item. Non-value-added activities in retail include shipping time from the supplier receiving delays for counting merchandise and any stor- age time between receipt and sale. In a service company cycle time refers to the time between the service order and service completion. All time spent on activi- ties that are not actual service performance or are nonactivities such as delays in beginning a job are considered non-value-added for that job. Non-value-added activities can be attributed to systemic physical and human factors. For example systemic causes could include a processing requirement that products be manufactured in large batches to minimize setup cost or that service jobs be taken in order of urgency. Physical factors contribute to non-value-added activities because in many instances plant and machine layout do not provide for the most efficient transfer of products. This factor is especially apparent in multistory buildings in which receiving and shipping are on the ground floor but storage and production are on upper floors. People may also be responsible for non-value-added activities because of improper skills or training or the need to be sociable. Attempts to reduce non-value-added activities should be directed at all of these causes but it is imperative that the “Willie Sutton” rule be applied. This rule is named for the bank robber who when asked why he robbed banks replied “That’s where the money is.” The NVA activities that create the most costs should be the ones that management concentrates its efforts on reducing or eliminating. The sys- tem must be changed to reflect a new management philosophy regarding perfor- mance measures and determination of product cost. Physical factors must be changed as much as possible to eliminate layout difficulties and machine bottle- necks and people must accept and work toward total quality control. Focusing attention on eliminating non-value-added activities should cause product/service quality to increase and cycle time and cost to decrease. Chapter 4 Activity-Based Cost Systems for Management 135 manufacturing cycle efficiency MCE 2 Tom E. Pryor “Activity Accounting: The Key to Waste Reduction” Accounting Systems Journal Fall 1990 p. 38.

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Although constructing value charts for every product or service would be time consuming a few such charts can quickly indicate where a company is losing time and money through non-value-added activities. Using amounts such as deprecia- tion on storage facilities wages for employees who handle warehousing and the cost of capital on working capital funds tied up in stored inventory can provide an estimate of the amount by which costs could be reduced through the elimina- tion of non-value-added activities. Part 2 Systems and Methods of Product Costing 136 COST DRIVER ANALYSIS Companies engage in many activities that consume resources and thus cause costs to be incurred. All activities have cost drivers defined in Chapter 3 as the factors having direct cause–effect relationships to a cost. Many cost drivers may be iden- tified for an individual business unit. For example cost drivers for factory insur- ance are number of employees value of property plant and equipment and num- ber of accidents or claims during a specified time period. Cost drivers affecting the entire plant include inventory size physical layout and number of different prod- ucts produced. Cost drivers are classified as volume-related such as machine hours and non-volume-related which generally reflect the incurrence of specific trans- actions such as setups work orders or distance traveled. A greater number of cost drivers can be identified than should be used for cost accumulation or activity elimination. Management should limit the cost drivers selected to a reasonable number and ascertain that the cost of measuring a driver does not exceed the benefit of using it. A cost driver should be easy to under- stand directly related to the activity being performed and appropriate for perfor- mance measurement. Costs have traditionally been accumulated into one or two cost pools total factory overhead or variable and fixed factory overhead and one or two drivers direct labor hours and/or machine hours have been used to assign costs to prod- ucts. These procedures cause few if any problems for financial statement prepa- ration. However the use of single cost pools and single drivers may produce il- logical product or service costs for internal managerial use in complex production or service environments. Exhibit 4–3 indicates how activity analysis is combined with cost driver analy- sis to create a tool for managing costs. While cost driver analysis identifies the ac- tivities causing costs to be incurred the activity analysis highlights activities that are not value-adding and can be targeted for elimination to reduce costs and prod- uct prices. To reflect the more complex environments the accounting system must first recognize that costs are created and incurred because their drivers occur at differ- ent levels. 3 This realization necessitates using cost driver analysis which inves- tigates quantifies and explains the relationships of drivers and their related costs. Traditionally cost drivers were viewed only at the unit level for example how many hours of labor or machine time did it take to produce a product or render a service These drivers create unit-level costs meaning that they are caused by the production or acquisition of a single unit of product or the delivery of a single unit of service. Other drivers and their costs are incurred for broader-based cate- gories or levels of activity. These broader-based activity levels have successively wider scopes of influence on products and product types. The categories are clas- sified as batch product or process and organizational or facility levels. Examples of the kinds of costs that occur at the various levels are given in Exhibit 4–4. Why must cost drivers be designated in an activity-based costing system 3 cost driver analysis unit-level costs 3 This hierarchy of costs was introduced by Robin Cooper in “Cost Classification in Unit-Based and Activity-Based Manufac- turing Cost Systems” Journal of Cost Management Fall 1990 p. 6.

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Chapter 4 Activity-Based Cost Systems for Management 137 EXHIBIT 4–3 ABC Data and Cost Management Benchmark: How do we do against competitors Activity analysis: How can we get better Service-level analysis: How much will the customer or end consumer pay Accumulated costs Cost drivers SOURCE: Michael Gering “Activity-Based Costing and Performance Improvement” Management Accounting London March 1999 p. 25. EXHIBIT 4–4 Levels of Costs Unit-Level Costs Classification Levels Direct material Direct labor Some machine costs if traceable Types of Costs Once for each unit produced Necessity of Cost Batch-Level Costs Purchase orders Setup Inspection Movement Scrap if related to the batch Once for each batch produced Product/Process- Level Costs Engineering change orders Equipment maintenance Product development Scrap if related to product design Supports a product type or a process Organizational or Facility Costs Building depreciation Plant or division manager’s salary Organizational advertising Supports the overall production or service process

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Costs that are caused by a group of things being made handled or processed at a single time are referred to as batch-level costs. A good example of a batch- level cost is the cost of setting up a machine. Assume that setting up a machine to cast product parts costs 900. Two different parts are to be manufactured dur- ing the day therefore two setups will be needed at a total cost of 1800. The first run will generate 3000 Type A parts the second run will generate 600 Type B parts. These quantities are specifically needed for production because the com- pany is on a just-in-time production system. If a unit-based cost driver volume were used the total setup cost of 1800 would be divided by 3600 parts giving a cost per part of 0.50. This method would assign the majority of the cost to Type A parts 3000 0.50 1500. However because the cost is actually created by a batch-level driver 900 should be spread over 3000 Type A parts for a cost of 0.30 per part and 900 should be spread over 600 Type B parts for a cost of 1.50 per part. Using a batch-level perspective indicates the commonality of the cost to the units within the batch and is more indicative of the relationship between the activity setup and the driver different production runs. A cost caused by the development production or acquisition of different items is called a product-level or process-level cost. To illustrate this level of cost assume that the engineering department of Carrier Corp. issued five engineering change orders ECOs during May. Of these ECOs four related to Product R one related to Product S and none related to Product T. Each ECO costs 7500 to issue. During May the company produced 1000 units of Product R 1500 units of Product S and 5000 units of Product T. If ECO costs were treated as unit-level costs the total ECO cost of 37500 would be spread over the 7500 units produced at a cost per unit of 5. However this method inappropriately assigns 25000 of ECO cost to Product T which had no engineering change orders issued for it Using a product/ process-level driver number of ECOs for ECO costs would assign 30000 of costs to Product R and 7500 to Product S. These amounts would be assigned to R and S but not simply to the current month’s production. The ECO cost should be allocated to all current and future R and S units produced while these ECOs are in effect because the products manufactured using the changed design benefit from the costs of the ECOs. This allocation reflects the use of a life-cycle concept. Part 2 Systems and Methods of Product Costing 138 This plant bottles several differ- ent types of juices. The costs of the gallon of orange juice and the plastic jug are unit-level costs. The setup cost of filling the vat with orange juice is a batch-level cost. The cost of developing each juice recipe is a process-level cost. And finally the cost of depreciation on the equipment and building is an organizational-level cost. batch-level cost product-level process- level cost

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Certain costs at the organizational level are incurred for the singular purpose of supporting continuing facility operations. These organizational-level costs are common to many different activities and products or services and can be prorated to products only on an arbitrary basis. Although organizational-level costs theoretically should not be assigned to products at all some companies attach them to goods produced or services rendered because the amounts are insignificant relative to all other costs. Accountants have traditionally and incorrectly assumed that if costs did not vary with changes in production at the unit level those costs were fixed rather than variable. In reality batch product/process and organizational level costs are all variable but they vary for reasons other than changes in production volume. Therefore to determine a valid estimate of product or service cost costs should be accumulated at each successively higher level of costs. Because unit batch and product/process level costs are all associated with units of products merely at dif- ferent levels these costs can be summed at the product level to match with the revenues generated by product sales. Organizational-level costs are not product re- lated thus they should only be subtracted in total from net product revenues. Exhibit 4–5 illustrates how costs collected at the unit batch and product/process levels can be used to generate a total product cost. Each product cost would be multiplied by the number of units sold and that amount of cost of goods sold would be subtracted from total product revenues to obtain a product line profit or loss item. These computations would be performed for each product line and summed to determine net product income or loss from which the unassigned organizational- level costs would be subtracted to find company profit or loss for internal manage- ment use. In this model the traditional distinction discussed in Chapter 3 between product and period costs can be and is ignored. The emphasis is on refining prod- uct profitability analysis for internal management purposes rather than for external financial statements. Because the product/period cost distinction required by gen- erally accepted accounting principles is not recognized the model presented in Exhibit 4–5 is not currently acceptable for external reporting. Data for a sample manufacturing company with three products are presented in Exhibit 4–6 to illustrate the difference in information that would result from rec- ognizing multiple cost levels. Before recognizing that some costs were incurred at the batch product and organizational level the company accumulated and allo- cated its factory overhead costs among its three products on a machine hour MH basis. Each product requires one machine hour but Product D is a low-volume special-order line. As shown in the first section of Exhibit 4–6 cost information in- dicated that Product D was a profitable product. After analyzing its activities the company began capturing costs at the different levels and assigning them to prod- ucts based on appropriate cost drivers. The individual details for this overhead as- signment are not shown but the final assignments and resulting product prof- itability figures are presented in the second section of Exhibit 4–6. This more refined approach to assigning costs shows that Product D is actually unprofitable. Costs are incurred because firms engage in a variety of activities and these activities consume company resources. Accountants have traditionally used a trans- action basis to accumulate costs and additionally have focused on the cost in- curred rather than the source of the cost. However managers now believe that the “conventional transaction-driven system is costly to administer fails to control costs and usually yields erroneous product cost data.” 4 Traditional cost allocations tend to subsidize low-volume specialty products by misallocating overhead to high-volume standard products. This problem occurs because costs of the extra activities needed to make specialty products are assigned Chapter 4 Activity-Based Cost Systems for Management 139 organizational-level cost 4 Richard J. Schonberger “World-Class Performance Management” in Peter B. B. Turney ed. Performance Excellence in Man- ufacturing and Service Organizations Sarasota Fla.: American Accounting Association 1990 p. 1.

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Part 2 Systems and Methods of Product Costing 140 EXHIBIT 4–5 Determining Product Profitability and Company Profit Allocate over number of units expected to be produced in related product line Allocate over number of units in batch Allocate over number of units produced Cost per unit Total product cost per unit Total product revenue 1 above Total product cost 2 above Net product margin All other net product margins Total margin provided by products Product Unit Selling Price Product Unit Volume Total product revenue 1 Company profit or loss Cost per unit in batch PRODUCT/PROCESS- LEVEL COSTS Engineering changes Product development Product design • • • BATCH-LEVEL COSTS Machine setup Purchasing/ ordering Material handling • • • UNIT-LEVEL COSTS Direct material Direct labor Machine energy • • • ORGANIZATIONAL- or FACILITY-LEVEL COSTS Cost per unit in product line Total Product Cost per Unit Product Unit Volume Total product cost 2 Corporate/divisional administration Facility depreciation • • Calculations are made for each product line using the same method as above. Some of these costs may be assignable to specific products or services and would be included in determining product cost per unit.

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using the one or very few drivers of traditional costing—and usually these drivers are volume based. Interestingly as long ago as 1954 William J. Vatter noted that “just as soon as cost accounting is found inadequate for the needs it is supposed to meet just as soon as cost accounting does not provide the data which man- agement must have cost accounting will either change to meet those needs or it will be replaced with something else.” 5 The time has come for cost accounting to change by utilizing new bases on which to collect and assign costs. Those bases are the activities that drive or create the costs. Chapter 4 Activity-Based Cost Systems for Management 141 Total overhead cost 1505250 Total machine hours 111500 Overhead rate per machine hour 13.50 PRODUCT C PRODUCT D PRODUCT E 5000 UNITS 1500 UNITS 105000 UNITS Unit Total Unit Total Unit Total Total Product revenue 50.00 250000 45.00 67500 40.00 4200000 4517500 Product costs Direct 20.00 100000 20.00 30000 9.00 945000 OH per MH 13.50 67500 13.50 20250 13.50 1417500 Total 33.50 167500 33.50 50250 22.50 2362500 2580250 Net income 82500 17250 1837500 1937250 PRODUCT C PRODUCT D PRODUCT E 5000 UNITS 1500 UNITS 105000 UNITS Unit Total Unit Total Unit Total Total Product revenue 50 250000 45 67500 40 4200000 4517500 Product costs Direct 20 100000 20 30000 9 945000 Overhead Unit level 8 40000 12 18000 6 630000 Batch level 9 45000 19 28500 3 315000 Product level 3 15000 15 22500 2 210000 Total 40 200000 66 99000 20 2100000 2399000 Product line income or loss 50000 31500 2100000 2118500 Organizational-level costs 181250 Net income 1937250 EXHIBIT 4–6 Product Profitability Analysis 5 William J. Vatter “Tailor-Making Cost Data for Specific Uses” in L. S. Rosen ed. Topics in Managerial Accounting Toronto: McGraw-Hill Ryerson Ltd. 1954 p. 194. How does activity-based costing differ from a traditional cost accounting system 4 ACTIVITY-BASED COSTING Recognizing that several levels of costs exist accumulating costs into related cost pools and using multiple cost drivers to assign costs to products and services are the three fundamental components of activity-based costing ABC. ABC is a cost accounting system that focuses on the various activities performed in an organi- zation and collects costs on the basis of the underlying nature and extent of those activities. This costing method focuses on attaching costs to products and services based on the activities conducted to produce perform distribute or support those products and services. The accompanying News Note illustrates use of ABC at the U.S. Postal Service.

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Managers in many manufacturing companies are concerned about the product costing information being provided by the traditional cost accounting systems. The general consensus is that product costs currently being developed are useful in preparing financial statements but are often of limited use for management deci- sion making. Activity-based costing on the other hand is useful in companies hav- ing the following characteristics: 1.the production or performance of a wide variety of products or services 2.high overhead costs that are not proportional to the unit volume of individual products 3.significant automation that has made it increasingly more difficult to assign overhead to products using the traditional direct labor or machine-hour bases 4.profit margins that are difficult to explain and 5.hard-to-make products that show big profits and easy-to-make products that show losses. 6 Companies having the above characteristics may want to reevaluate their cost sys- tems and implement activity-based costing. Two-Step Allocation After being recorded in the general ledger and subledger accounts costs are ac- cumulated in activity center cost pools. An activity center is a segment of the production or service process for which management wants a separate report of Part 2 Systems and Methods of Product Costing 142 Paying the Postman NEWS NOTE GENERAL BUSINESS The U.S. Postal Service USPS is a unique federal entity in several respects. First the USPS in essence oper- ates in a manner similar to many private sector compa- nies. The USPS provides a variety of services generates revenue from these services and incurs costs and ex- penses as a result of its operations. Second the USPS is unique in that it is open to private sector competition. Competition includes companies such as Federal Ex- press United Parcel Service Mail Boxes Etc. and a host of other similar companies. Few other governmental agencies or departments operate in a similar business environment. Retailers as well as USPS competitors have long ac- cepted credit cards as payments for goods and services. Moreover new technologies are beginning to lead to a “cashless” world. Customers are seeking convenience and value while businesses are striving for increased sales and guaranteed payment. Given the competitive forces facing the USPS and the rapid pace at which new technologies are becoming available USPS manage- ment realized that it had to use innovative business meth- ods to maintain and increase its market share against the competition and provide increased value to its customers while ensuring cost effectiveness. Based on this evaluation of its position in the market- place the USPS engaged Coopers and Lybrand CL to conduct activity-based cost studies of its key revenue collection processes for a national credit card and debit card program. To obtain an understanding of the cash check and credit/debit card activities CL reviewed USPS data and procedure manuals interviewed USPS headquarters staff and conducted telephone surveys of front window supervisors and district office accounting personnel. Using an activity-based cost modeling ap- proach CL defined the cash and check process in terms of the activities that link together to make the processes. In summarizing its findings CL reported that “Credit and debit card processing costs are relatively high at the moment due to the normal impact of process start-up low initial volume and high initial implementation costs. However as volumes continue to grow projected credit and debit card costs can become competitive with cur- rent cash and check processing costs. now PricewaterhouseCoopers SOURCE: Terrell L. Carter Ali M. Sedaghat and Thomas D. Williams “How ABC Costs Changed the Post Office” Strategic Finance February 1998 pp. 20–36. 6 Robin Cooper “You Need a New Cost System When...” Harvard Business Review January–February 1989 pp. 77–82. How does the installation of an activity-based costing system affect behavior activity center 5

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Chapter 4 Activity-Based Cost Systems for Management 143 the costs of activities performed. In defining these centers management should consider the following issues: geographical proximity of equipment defined cen- ters of managerial responsibility magnitude of product costs and a need to keep the number of activity centers manageable. Costs having the same driver are ac- cumulated in pools reflecting the appropriate level of cost incurrence unit batch or product/process. The fact that a relationship exists between a cost pool and a cost driver indicates that if the cost driver can be reduced or eliminated the re- lated cost should also be reduced or eliminated. Gathering costs in pools reflecting the same cost drivers allows managers to recognize cross-functional activities in an organization. In the past some compa- nies may have accumulated overhead in smaller-than-plantwide pools but this ac- cumulation was typically performed on a department-by-department basis. Thus the process reflected a vertical-function approach to cost accumulation. But pro- duction and service activities are horizontal by nature. A product or service flows through an organization affecting numerous departments as it goes. Using a cost driver approach to develop cost pools allows managers to more clearly focus on the various cost impacts created in making a product or performing a service than was possible traditionally. After accumulation costs are allocated out of the activity center cost pools and assigned to products and services by use of a second driver. These drivers are often referred to as activity drivers. An activity driver measures the demands placed on activities and thus the resources consumed by products and services. An activity driver selected often indicates an activity’s output. The process of cost assignment is the same as the overhead application process illustrated in Chapter 3. Exhibit 4–7 illustrates this two-step process of tracing costs to products and services in an ABC system. activity driver EXHIBIT 4–7 Tracing Costs in an Activity- Based Costing System Setup Cost Overhead Dollars Consumed Machine Power Cost Warehouse Cost Number of setups Number of machine hours Square footage of occupied space Number of setup hours Processing time per unit Storage time per square foot occupied COSTS INITIALLY RECORDED By department and general ledger accounts COST DRIVER Used to assign costs to cost pools ACTIVITY CENTER COST POOL ACTIVITY DRIVER Used to assign costs to cost objects COST OBJECTS resulting from Value- Added Activities Non-Value- Added Activities Work to eliminate or reduce Individual products

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As noted in Exhibit 4–7 the cost drivers for the collection stage may differ from the activity drivers used for the allocation stage because some activity center costs are not traceable to lower levels of activity. Costs at the lowest unit level of activity should be allocated to products by use of volume- or unit-based dri- vers. Costs incurred at higher batch and product/process levels may also be al- located to products by use of volume-related drivers but the volume measure should include only those units associated with the batch or the product/process— not total production or service volume. Exhibit 4–8 provides some common drivers for various activity centers. Activity-Based Costing Illustrated An ABC example is shown in Exhibit 4–9. Information is gathered about the ac- tivities and costs for a factory maintenance department. Costs are then assigned to specific products based on activities. This department allocates its total personnel cost among the three activities performed in that department based on the num- ber of employees in those areas. This allocation reflects the fact that occurrences of a specific activity rather than volume of production or service are indicative of work performed in the department. This company manufactures Product Z which is a rather complex unit with relatively low demand. The cost allocated to Product Z with the activity-based cost- ing system is 132 percent higher than the cost allocated with the traditional allo- cation system 1.564 versus 0.675 Discrepancies in costs between traditional and activity-based costing methods are not uncommon. Activity-based costing systems indicate that significant resources are consumed by low-volume products and complex production operations. Stud- ies have shown that after the implementation of activity-based costing the costs of high-volume standard products have often been too high and using ABC have declined anywhere from 10 to 30 percent. Low-volume complex specialty prod- uct costs tend to increase from 100 to 500 percent although in some cases these costs have risen by 1000 to 5000 percent 7 Thus activity-based costing typically Part 2 Systems and Methods of Product Costing 144 Activity Center Activity Drivers Accounting Reports requested dollars expended Personnel Job change actions hiring actions training hours counseling hours Data processing Reports requested transactions processed programming hours program change requests Production engineering Hours spent in each shop job specification changes requested product change notices processed Quality control Hours spent in each shop defects discovered samples analyzed Plant services Preventive maintenance cycles hours spent in each shop repair and maintenance actions Material services Dollar value of requisitions number of transactions processed number of personnel in direct support Utilities Direct usage metered to shop space occupied Production shops Fixed per-job charge setups made direct labor machine hours number of moves material applied SOURCE: Michael D. Woods “Completing the Picture: Economic Choices with ABC” Management Accounting De- cember 1992 p. 54. Reprinted from Management Accounting. Copyright by Institute of Management Accountants Montvale N.J. EXHIBIT 4–8 Activity Drivers 7 Peter B. B. Turney An Introduction to Activity-Based Costing ABC Technologies Inc. 1990 video.

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shifts a substantial amount of overhead cost from standard high-volume products to premium special-order low-volume products as shown in Exhibit 4–10. The ABC costs of moderate products and services those that are neither extremely sim- ple nor complex nor produced in extremely low or high volumes tend to remain approximately the same as the costs calculated using traditional costing methods. Although the preceding discussion addresses costs normally considered prod- uct costs activity-based costing is just as applicable to service department costs. Many companies use an activity-based costing system to allocate corporate over- head costs to their revenue-producing units based on the number of reports doc- uments customers or other reasonable measures of activity. Short-Term and Long-Term Variable Costs Short-term variable costs increase or decrease corresponding with changes in the volume of activity. Costs that do not move in relation to volume have conven- tionally been accepted as fixed. “Generally however as a business expands costs tend to be far more variable than they should be and when it contracts they are far more fixed than they should be.” 8 Professor Robert Kaplan of Harvard Univer- sity considers the ability of “fixed” costs to change under the “Rule of One” which means that possessing or using more than one unit of a resource is evidence that Chapter 4 Activity-Based Cost Systems for Management 145 Factory Maintenance Department: The company’s conventional system assigns the personnel costs of this department to products using direct labor hours DLHs the department has 9 employees and incurred 450000 of personnel costs in the current year or 50000 per employee. Expected DLHs are 200000. ABC ALLOCATION Stage 1 Trace costs from general ledger and subsidiary ledger accounts to activity center pools according to number of employees: Regular maintenance—uses 5 employees 250000 is allocated to this activity second-stage allocation to be based on machine hours MHs Preventive maintenance—uses 2 employees 100000 is allocated to this activity second-stage allocation to be based on number of setups Repairs—uses 2 employees 100000 is allocated to this activity second-stage allocation is based on number of machine starts Stage 2 Allocate activity center cost pools to products using cost drivers chosen for each cost pool. 2001 activity of second-stage drivers: 500000 MHs 5000 setups 100000 machine starts Step 1: Allocate costs per unit of activity of second-stage cost drivers. Regular maintenance—250000 500000 MHs 0.50 per MH Preventive maintenance—100000 5000 setups 20 per setup Repairs—100000 100000 machine starts 1 per machine start Step 2: Allocate costs to products using quantity of second-stage cost drivers consumed in making these products. The following quantities of activity are relevant to Product Z: 30000 MHs 30 setups 40 machine starts and 3000 DLHs out of a total of 200000 DLHs in 2001. Ten thousand units of Product Z were manufactured during 2001. ABC Allocation to Product Z 30000 0.50 30 20 40 1 15640 for 10000 units or 1.564 per unit Traditional Allocation to Product Z 450000 200000 DLHs 2.25 per DLH 3000 2.25 6750 for 10000 units or 0.675 per unit EXHIBIT 4–9 Illustration of Activity-Based Costing Allocation 8 B. Charles Ames and James D. Hlavacek “Vital Truths About Managing Your Costs” Harvard Business Review January– February 1990 p. 145.

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the resource is variable. 9 Because of this logic many people have come to view fixed costs as long-term variable costs for which suitable usually non-volume- related cost drivers simply need to be identified. Two significant cost drivers that cause long-term variable costs to change but which traditionally have been disregarded are product variety and product com- plexity. Product variety refers to the number of different types of products made product complexity refers to the number of components included in a product process complexity refers to the number of processes through which a product flows. These items create additional overhead such as warehousing purchasing setups and inspections so long-term variable costs tend to increase as the number and types of products increase. Therefore managers should use these cost drivers in applying ABC. Attribute-Based Costing Attribute-based costing ABC II an extension of activity-based costing employs detailed cost–benefit analyses relating to information on customer needs in terms of performance attributes of a product such as reliability durability responsiveness and so forth and the costs of the incremental improvements necessary to obtain these attributes. ABC II employs planned costs rather than past costs because as discussed earlier such a high percentage of a product’s life-cycle costs are locked in during the product’s development stage. The approach focuses on satisfying cus- tomer needs by searching for the optimum enhancement of customer utility through comparisons of alternatives for attribute enhancements relative to the costs of pro- ducing those enhancements. 10 Part 2 Systems and Methods of Product Costing 146 EXHIBIT 4–10 Traditional versus ABC Overhead Allocations 300000 150000 50000 325000 125000 50000 Traditional Overhead Allocation amounts assumed Total overhead of 500000 allocated alternatively: Activity- Based Costing Overhead Allocation amounts assumed Standard Product Moderate Product Premium Product Standard Product Moderate Product Premium Product long-term variable cost product variety product complexity process complexity 9 Patrick L. Romano “Activity Accounting: An Update—Part 2” Management Accounting June 1989 p. 63. 10 For additional information see Mike Walker “Attribute Based Costing” Australian Accountant March 1992 pp. 42–45. What is attribute-based costing and how does it extend activity- based costing attribute-based costing ABC II 6

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Chapter 4 Activity-Based Cost Systems for Management 147 11 T. L. Estrin Jeffrey Kantor and David Albers “Is ABC Suitable for Your Company” Management Accounting April 1994 p. 40. 12 Harold P. Roth and A. Faye Borthick “Are You Distorting Costs by Violating ABC Assumptions” Management Accounting November 1991 pp. 39–40. 13 B. Joseph Pine “Customers Don’t Want Choices” The Wall Street Journal April 18 1994 p. A12. DETERMINING WHETHER ABC IS APPROPRIATE A vital loss of information may occur in an accounting system that ignores activ- ity and cost relationships. Not every accounting system using direct labor or ma- chine hours as the cost driver is providing inadequate or inaccurate cost informa- tion. However some general clues may alert managers to the need to review the cost data being provided by a conventional accounting system. Some of these clues are more relevant to manufacturing entities but others are equally appropriate for both manufacturing and service businesses. Consider the following: For a given organization is it likely that ABC will produce costs that are significantly different from those that are generated with conventional ac- counting and does it seem likely that those costs will be “better” The factors in- volved here include: • the number and diversity of products or services produced • the diversity and differential degree of support services used for different products • the extent to which common processes are used • the effectiveness of current cost allocation methods • and the rate of growth of period costs. If information that is considered “better” is generated by ABC will the new information change the dependent decisions made by the management The factors involved here are: • management’s freedom to set prices • the ratio of period costs to total costs • strategic considerations • the climate and culture of cost reduction in the company • and the frequency of analysis that is desirable or necessary. 11 Two primary underlying assumptions that companies must consider before adopt- ing ABC are that the costs in each cost pool are 1 driven by homogeneous ac- tivities and 2 strictly proportional to the activity. 12 If these assumptions are met the following circumstances may indicate a need to consider using activity-based costing. With Product Variety and Product Complexity Product variety is commonly associated with a need to consider activity-based cost- ing. Products may be variations of the same product line such as Hallmark’s dif- ferent types of greeting cards or they may be in numerous product families such as Procter Gamble’s detergents diapers fabric softeners and shampoos. In either case product additions cause numerous overhead costs to increase. In the quest for product variety many companies are striving for mass cus- tomization of products through the use of flexible manufacturing systems. Such personalized production can often be conducted at a relatively low cost. Although such customization may please some customers it does have some drawbacks. First there may simply be too many choices. For instance at GE Fanuc a Charlottesville Virginia manufacturer customers had to look through several 4-inch-thick binders of components to design a custom-made product—an extremely time-consuming project. 13 Nissan reportedly had 87 different varieties of steering wheels but cus- tomers did not want many of them and disliked having to choose from so many mass customization When is activity-based costing appropriate in an organization 7 http://www.nissanmotors .com

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options. 14 Second mass customization creates a tremendous opportunity for errors. And third most companies have found that customers given the wide variety of choices typically make selections from a rather small percentage of the total. At Toyota investigation of purchases revealed that 20 percent of the product varieties accounted for 80 percent of the sales. 15 This 20:80 ratio is a fairly common one and is referred to as the Pareto principle after the Italian economist Vilfredo Pareto. 16 Companies with complex products services or processes may want to inves- tigate ways to reduce that complexity. Management may want to review the de- sign of the company’s products and processes to standardize them and reduce the number of different components tools and processes required. Products should be designed to consider the Pareto principle and take advantage of commonality of parts. An analysis of components will generally reveal that 20 percent of the components are used in 80 percent of the products. If this is the case then com- panies need to consider two other factors. First are the remaining components used in key products If so could equal quality be achieved by using the more common parts If not can the products be sold for a premium price to cover the costs associated with the use of low-volume components Second are the parts specified for use in products purchased by important customers who are willing to pay a premium price for the products If so the benefits from the complexity may be worth the cost. However would customers be equally satisfied if more common parts were used and the product price were reduced Complexity is ac- ceptable only if it is value-added from the customer’s point of view. Process complexity may develop over time or it may exist because of a lack of sufficient planning in product development. Processes are complex when they create difficulties for the people attempting to perform production operations phys- ical straining awkwardness of motions or wasted motions or for the people us- ing manufacturing machinery multiple and/or detailed setups lengthy transfer time between machine processes recalibration of instruments and so on. Process com- plexity reflects numerous non-value-added activities and thus causes time delays and cost increases. A company can employ simultaneous engineering to reduce both product and process complexity. Simultaneous or concurrent engineering refers to the continuous involvement of all primary functions and personnel contributing to a product’s origination and production from the beginning of a project. Multifunc- tional teams design the product by considering customer expectations vendor ca- pabilities parts commonality and production process compatibility. Such an inte- grated design effort is referred to as a design-for-manufacturability approach. Simultaneous engineering helps companies to shorten the time-to-market for new products and minimize complexity and cost. Many traditional cost systems are not designed to account for information such as how many different parts are used in a product so management cannot iden- tify products made with low-volume or unique components. Activity-based costing systems are flexible and can gather such details so that persons involved in reengi- neering efforts have information about relationships among activities and cost drivers. Armed with these data reengineering efforts can be focused on the pri- mary causes of process complexity and on the causes that create the highest levels of waste. Part 2 Systems and Methods of Product Costing 148 Pareto principle 14 B. Joseph Pine II Bart Victor and Andrew C. Boynton “Making Mass Customization Work” Harvard Business Review Sep- tember–October 1993 p. 110. 15 Ibid p. 108. 16 Pareto found that about 85 percent of Milan’s wealth was held by about 15 percent of the people. The term Pareto prin- ciple was coined by Joseph Juran in relationship to quality problems. Juran found that a high proportion of such problems were caused by a small number of process characteristics the vital few whereas the majority of process characteristics the trivial many accounted for only a small proportion of quality problems. simultaneous concurrent engineering

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With Lack of Commonality in Overhead Costs Certain products and services create substantially more overhead costs than others. Although some of these additional overhead costs may be caused by product va- riety or product/process complexity others may be related to support services. For example some products require significant levels of advertising some use high cost distribution channels and some necessitate the use of high-technology machinery. “A software distribution company for example discovered that a supposedly prof- itable high-margin product was generating so many calls to its help line that it was actually a money loser. Dropping that one product improved company profitability by nearly 10.” 17 If only one or two overhead pools are used overhead related to specific products will be spread over all products. The result will be increased costs for products that are not responsible for the increased overhead. With Problems in Current Cost Allocations If a company has undergone one or more significant changes in its products or processes such as increased product variety or business process reengineering managers and accountants need to investigate whether the existing cost system still provides a reasonable estimate of product or service cost. Many companies that have automated their production processes have experienced large reductions in labor and large increases in overhead costs. In such companies using direct labor as an overhead allocation base produces extraordinarily high application rates. Prior to the introduction of ABC at Harris Semiconductor Sector the overhead applica- tion rate per area ranged from 800 to 1800 percent of the direct labor costs. This process resulted in 90 to 95 percent of all costs being allocated on a “mere 5–10 percent i.e. direct labor costs of the cost base.” 18 Products made using automated equipment tend to be charged an insufficient amount of overhead whereas prod- ucts made using high proportions of direct labor tend to be overcharged. Traditional cost allocations also generally emphasize the assignment of product costs to products at the same time the majority of period costs are expensed as incurred. Activity-based costing recognizes that some period costs such as RD and distribution may be distinctly and reasonably associated with specific prod- ucts and thus should be traced and allocated to those products. This recognition changes the traditional view of product versus period cost. And as indicated in the News Note on page 150 ABC information can be used with diplomacy to evaluate customer profitability. With Changes in Business Environment A change in a company’s competitive environment may also require better cost in- formation. Increased competition may occur for several reasons: 1 other compa- nies have recognized the profit potential of a particular product or service 2 the product or service has become cost-feasible to make or perform or 3 an indus- try has been deregulated. If many new companies are competing for old business the best estimate of product or service cost must be available to management so that profit margins and prices can be reasonably set. Changes in management strategy can also signal a need for a new cost system. For example if management wants to begin new operations the cost system must be capable of providing information on how costs will change. Confirming manage- ment’s view of costs to the traditional variable versus fixed classifications may not allow such information to be effectively developed. Viewing costs as short-term Chapter 4 Activity-Based Cost Systems for Management 149 17 Srikumar S. Rao “True Cost” Financial World September 25 1995 pp. 62–63. 18 Christopher R. Dedera “Harris Semiconductor ABC: Worldwide Implementation and Total Integration” Journal of Cost Man- agement Spring 1996 p. 44.

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variable versus long-term variable focuses on cost drivers and on the changes the planned operations will have on activities and costs. Continuous improvement recognizes the concepts of eliminating non-value- added activities to reduce cycle time making products or performing services with zero defects reducing product costs on an ongoing basis and simplifying products and processes. Activity-based costing by promoting an understanding of cost drivers allows the non-value-added activities to be identified and their causes eliminated or reduced. Part 2 Systems and Methods of Product Costing 150 Measuring Customers to Manage Profits NEWS NOTE GENERAL BUSINESS Activity-based costing differs from conventional costing in that it uses cost drivers to assign costs. By under- standing the overhead that a particular customer or prod- uct really uses ABC pinpoints customer profitability in a way that conventional accounting cannot. The first shock comes when customers or products previously believed to be profitable are shown to consume more resources than the revenue that they generate. Take for example the owner of a chain of pharma- ceutical companies who wanted to reprice his products. He focused on assigning the transaction and holding costs associated with each product and used ABC to put in place a quick but fairly accurate system. Not sur- prisingly many small items generated costs well out of line with the accounting system and the Christmas break was used to reprice the items in the warehouse and on his shelves. Unfortunately the new pricing was not well received the business underwent a shock and his man- agement team spent the next four months back-peddling with their customers. Big changes whether they are performed inside or across the boundaries of the organization require care- ful diplomacy. Knowing the costs of your products sets a target. Implementing that target requires careful steps. In big companies this usually requires the input of var- ious players of multifunctional teams that negotiate joint solutions with suppliers and customers. Often this leads to dramatic solutions that no one party would have reached on its own—standard packaging availability of forecasts more frequent deliveries cheaper materials for noncritical parts. ABC provides the tools to negotiate these solutions. By negotiating what the customer is prepared to pay for we are able to minimize total costs across the entire value chain and add value for the final user. SOURCE: Michael Gering “Activity-Based Costing and the Customer” Manage- ment Accounting London April 1999 pp. 26–27. continuous improvement CRITICISMS OF ACTIVITY-BASED COSTING Realistically assessing new models and accounting approaches for what they can help managers accomplish is always important. However no currently existing ac- counting technique or system will provide management with exact cost informa- tion for every product or with the information needed to make consistently perfect decisions. Activity-based costing although it typically provides better information than was generated under the traditional overhead allocation process is not a panacea for all managerial concerns. The following are some of this method’s shortcomings. First ABC requires a significant amount of time and thus cost to implement. If implementation is to be successful substantial support is needed throughout the firm. An environment for change must be created that requires overcoming a va- riety of individual organizational and environmental barriers. Individual barriers are typically related to 1 fear of the unknown or shift in status quo 2 poten- tial loss of status or 3 a necessity to learn new skills. Organizational barriers are often related to “territorial” hierarchical or corporate culture issues. Environmental barriers are often built by employee groups including unions regulatory agencies or other stakeholders of interest.

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To overcome these barriers a firm must first recognize that these barriers ex- ist second investigate their causes and third communicate information about the “what” “why” and “how” of ABC to all concerned parties. Top management must be involved with and support the implementation process. Lack of commitment or involvement by top management will make any meaningful progress slow and dif- ficult. Additionally employees and managers must be educated in some nontradi- tional techniques that include new terminology concepts and performance mea- surements. Assuming that top management supports the changes in the internal accounting system and that employees are educated about the system additional time will be required to analyze the activities taking place in the activity centers trace costs to those activities and determine the cost drivers. Another problem with ABC is that it does not conform specifically with gen- erally accepted accounting principles GAAP. ABC would suggest that some non- product costs such as those in research and development be allocated to prod- ucts whereas certain other traditionally designated product costs such as factory building depreciation not be allocated to products. Therefore most companies have used ABC for internal reporting while continuing to maintain their general and subsidiary ledger accounts and prepare their external financial statements on the basis of a more “traditional” system—requiring two product costing systems and causing even more costs to be incurred. As ABC systems become more widely accepted more companies may choose to refine how ABC and GAAP determine product cost to make those definitions more compatible and thereby eliminate the need for two costing systems. One final criticism that has been leveled at activity-based costing is that it does not promote total quality management TQM and continuous improvement. Dr. H. Thomas Johnson the Retzlaff Professor of Quality Management at Portland State University has issued the following cautions: The decade of the 1970s ushered in a new competitive environment—call it the global economy—in which accounting information is not capable of guid- ing companies toward competitiveness and long-term profitability. Activity-based prescriptions for improved competitiveness usually entail steps that lead to selling more or doing less of what should not be sold or done in the first place. Indeed activity-based cost information does nothing to change old remote-control top-down management behavior. Simply because improved cost information becomes available a company does not change its commitment to mass-produce output at high speed to control costs by encouraging people to manipulate processes and to persuade customers to buy output the company has produced to cover its costs. American businesses will not become long-term global competitors until they change the way managers think. No cost infor- mation not even activity-based cost management information will do that. 19 Companies attempting to implement ABC as a cure-all for product failures vol- ume declines or financial losses will quickly recognize that Professor Johnson is correct. However companies can implement ABC and its related management tech- niques in support of and in conjunction with TQM JIT or any of the other world- class methodologies. Companies doing so will provide the customer with the best variety price quality service and lead time of which they are capable. Not coin- cidentally they should find their businesses booming. Activity-based costing and activity-based management are effective in supporting continuous improvement short lead times and flexible manufacturing by helping managers to • identify and monitor significant technology costs • trace many technology costs directly to products • promote increase in market share Chapter 4 Activity-Based Cost Systems for Management 151 19 H. Thomas Johnson “It’s Time to Stop Overselling Activity-Based Concepts” Management Accounting September 1992 pp. 31 33.

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• identify the cost drivers that create or influence cost • identify activities that do not contribute to perceived customer value i.e. non- value-added activities or waste • understand the impact of new technologies on all elements of performance • translate company goals into activity goals • analyze the performance of activities across business functions • analyze performance problems and • promote standards of excellence. In summary ABC is an improved cost accounting tool that helps managers know how the score is kept so that they can play the game more competitively. Part 2 Systems and Methods of Product Costing 152 Carrier Corporation REVISITING he American Productivity and Quality Center APQC and the Consortium for Advanced Manufacturing International CAM-I recently sponsored a study to bench- mark best practices in the installation and use of activity- based cost management systems. Seven hundred and fifty manufacturing and service organizations were invited to participate in the study and 166 responded by complet- ing a 20-page survey instrument. The survey results and telephone interviews were then used to select 15 “best practice” companies. The best practice companies were selected based on their ABCM system’s maturity the breadth of their ABCM applications the extent of their system’s integration and their level of success with ABCM. Carrier Corporation participated in the survey and was selected as one of the best practice companies. Carrier currently has more than a dozen manufacturing sites located throughout the world and it was Carrier’s McMinville Tenn. manufacturing plant that was identified as the best practice site. Carrier’s complexity reduction program along with its other improvement initiatives have combined to produce tangible results. For example the firm has eliminated some product lines moved subassemblies to point of use outsourced some conversion operations outsourced prod- uct lines and created a greater understanding of how complexity affects costs. But more work needs to be done for Carrier to maintain its competitive edge. In the current competitive environment Carrier is striving to better under- stand cost behavior and the steps the company can take to maintain its position as the world’s largest manufacturer of air conditioning and heating products. Even though Carrier’s management believes that product and process complexity hurts profitability it needs hard financial data. ABCM provides Carrier managers the information they need to make difficult decisions. SOURCE: Dan W. Swenson “Managing Costs through Complexity Reduction at Carrier Corporation” Strategic Finance April 1998 pp. 20–28. T Significant changes have taken place in the business environment. These changes have caused concern about the reliability of cost information generated by a system primarily intended to provide product costs for external financial statements. To make profits given the present competitive environment and consumer focus on product price and quality businesses must find ways to minimize costs. Costs can be reduced without reducing quality by decreasing the number of non- value-added organizational activities. Process mapping can be performed to see all CHAPTER SUMMARY

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the VA and NVA activities that take place in the production of a product or the performance of a service. Value is added to products only during the times when processing manufacturing company performance service company or display retail company is actually taking place. Inspection time transfer time and idle time all add to cycle time and cost but not to value. The proportion of total cycle time spent in value-added processing is referred to as manufacturing cycle efficiency. A third category of activities known as business-value-added activities also exists. Although not wanting to pay for these activities customers know the ac- tivities are necessary expenses incurred by a business to conduct operations. In addition to activity analysis activity-based management is also concerned with finding and selecting activity cost pools and identifying the set of cost drivers that best represents the firm’s activities and are the underlying causes of costs. Management should first investigate activities that reflect the major and most sig- nificant processes conducted by the company. These activities normally overlap several functional areas and occur horizontally across the firm’s departmental lines. A new method of cost assignment more compatible with the increased high- technology environment in which business operates is activity-based costing ABC. ABC assigns costs to products on the basis of the types and quantities of activities that must be performed to create those products. This costing system accumulates costs for activity centers in multiple cost pools at a variety of levels unit batch product and organizational and then allocates these costs using multiple cost dri- vers both volume- and non-volume-related. Thus costs are assigned more accu- rately and managers can focus on controlling activities that cause costs rather than trying to control the costs that result from the activities. The use of activity-based costing should provide a more realistic picture of actual production cost than has traditionally been available. Product variety and process complexity often cause a business’s costs to increase because of increases in non-value-added activities. Simultaneous engineering using multifunctional teams can help firms to accelerate the time-to-market of new prod- ucts and reduce the complexity and costs of these new products and the processes by which they are made. Chapter 4 Activity-Based Cost Systems for Management 153 KEY TERMS activity p. 132 activity analysis p. 132 activity center p. 142 activity driver p. 143 attribute-based costing ABC II p. 146 batch-level cost p. 138 business-value-added activity p. 133 continuous improvement p. 150 cost driver analysis p. 136 cycle lead time p. 134 idle time p. 134 inspection time p. 134 long-term variable cost p. 146 manufacturing cycle efficiency MCE p. 135 mass customization p. 147 organizational-level cost p. 139 Pareto principle p. 148 process complexity p. 146 process map p. 133 processing service time p. 134 product complexity p. 146 product-level process-level cost p. 138 product variety p. 146 simultaneous concurrent engineering p. 148 transfer time p. 134 unit-level cost p. 136 value chart p. 134

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Part 2 Systems and Methods of Product Costing 154 Manufacturing Cycle Efficiency Cycle Time Processing Time Inspection Time Transfer Time Idle Time MCE Value-Added Processing Time Total Cycle Time Activity-Based Costing 1. Determine the activity centers of the organization. 2. Determine departmental activities and efforts needed to conduct those activities that is the cost drivers. 3. Determine departmental resources consumed in conducting activities and allo- cate costs of these resources to activity centers based on the cost drivers. 4. Determine activities needed to manufacture products or provide revenue- producing services that is the activity drivers. 5. Allocate costs to products and services based on activities and cost drivers involved. SOLUTION STRATEGIES Pierre Press prepares two versions of gourmet cookbooks: One is paperback and the other is hand-sewn and leather bound. Management is considering publishing only the higher quality book. The firm assigns its 500000 of overhead to the two types of books. The overhead is composed of 200000 of utilities and 300000 of quality control inspectors’ salaries. Some additional data follow: Paperback Leather Bound Revenues 1600000 1400000 Direct costs 1250000 600000 Production units 500000 350000 Machine hours 42500 7500 Inspections 2500 12500 Required: a. Compute the overhead cost that should be allocated to each type of cookbook using cost drivers appropriate for each type of overhead cost. b. The firm has used machine hours to allocate overhead in the past. Should Pierre Press stop producing the paperback cookbooks Explain why manage- ment was considering this action and what its decision should be. Solution to Demonstration Problem a. Paperback Leather Bound Total Machine hours 42500 7500 50000 Rate per MH 200000 50000 4 4 4 Utility cost 170000 30000 200000 Number of inspections 2500 12500 15000 Rate per inspection 300000 15000 20 20 20 Quality inspection cost 50000 250000 300000 Total traceable overhead costs 220000 280000 500000 b. Income calculation using machine hours to allocate utilities and inspection hours to allocate inspectors’ salaries to products: DEMONSTRATION PROBLEM

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Using the traditional cost driver machine hours the following results had been achieved given a 10 charge 500000 50000 per MH: Paperback Leather Bound Revenue 1600000 1400000 Direct costs 1250000 600000 Overhead 425000 75000 Total costs 1675000 675000 Margin 75000 725000 The reason paperbacks were erroneously thought to be unprofitable was caused by the method of allocating overhead. The firm should continue producing paperbacks as shown in the following calculations. Paperback Leather Bound Revenue 1600000 1400000 Direct costs 1250000 600000 Overhead 220000 280000 Total costs 1470000 880000 Margin 130000 520000 Chapter 4 Activity-Based Cost Systems for Management 155 1. What is activity-based management ABM and what are the specific manage- ment tools that fall beneath the ABM umbrella 2. Define value-added activities and non-value-added activities. Compare and give three examples of each type. 3. Why are value-added activities defined from a customer viewpoint 4. What management opportunity is associated with identifying the non-value- added activities in a production process 5. In a televised football game what activities are value added What activities are non-value-added Would everyone agree with your choices Why or why not 6. How is a process map used to identify opportunities for cost savings 7. What is manufacturing cycle efficiency What would its value be in an opti- mized manufacturing environment and why 8. What is a cost driver and how is it used Give four examples of cost drivers. 9. Do cost drivers exist in a traditional accounting system Are they designated as such How if at all does the use of cost drivers differ between a traditional accounting system and an activity-based costing system 10. What is activity analysis and how is it used in concert with cost driver analy- sis to manage costs 11. What is activity-based costing How does it differ from traditional product cost- ing approaches 12. Why do the more traditional methods of overhead assignment “overload” stan- dard high-volume products with overhead costs and how does ABC improve overhead assignments 13. What characteristics of a company would generally indicate that activity-based costing might improve product costing 14. Why does activity-based costing require that costs be aggregated at different levels 15. List the benefits of activity-based costing. How could these reduce costs 16. Traditional costing systems often differentiate between fixed and variable costs. How does the ABC philosophy address fixed and variable costs QUESTIONS

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17. How does attribute-based costing extend the concept of activity-based costing 18. Are all companies likely to benefit to an equal extent from adopting ABC Discuss. 19. Significant hurdles are often encountered in adopting ABC including a large time commitment. What specific activities associated with ABC adoption re- quire large investments of time Part 2 Systems and Methods of Product Costing 156 20. Terminology Match the following lettered terms on the left with the appro- priate numbered description on the right. a. Activity driver 1. Non-value-added use of time b. Cost driver analysis 2. Cost explained well by traditional c. Cycle time cost drivers d. Idle time 3. Driver of some costs e. Long-term variable cost 4. Time from receipt of order to f. Mass customization delivery of product g. Product complexity 5. Cost not usually assigned to h. Organizational-level cost products under ABC i. Unit-level cost 6. Personalized production j. Value chart 7. Establishing cost causality 8. Measure of activity demand 9. Indicator of activities and their time 10. Costs traditionally known as fixed 21. Terminology Match the following lettered terms on the left with the appro- priate numbered description on the right. a. Activity analysis 1. Setup cost b. Activity-based costing 2. A costing system that uses multiple c. Attribute-based costing cost drivers d. Batch-level cost 3. A process of involving all affected e. Manufacturing cycle efficiency personnel from the beginning of a f. Non-value-added activity project g. Process map 4. An approach to associate costs with h. Research and development activities i. Simultaneous engineering 5. A tool to find the cost of product j. Value-added activity features 6. A flowchart indicating all steps in producing a product or performing a service 7. Idle time transfer time or storage time 8. Actual production time divided by total cycle time 9. Product/process level cost 10. Something that increases worth of a product or service 22. Activity analysis Conveyance Systems is investigating the costs of schedule changes in its factory. Following is a list of the activities estimated times and average costs required for a single schedule change. EXERCISES

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Activity Estimated Time Average Cost Review impact of orders 30 min–2 hrs 300 Reschedule orders 15 min–24 hrs 800 Lost sales Unreliable customer service Reschedule production orders 15 min–1 hr 75 Contact production supervisor 5 min 5 Stop production and change over Generate paperwork to return materials Return and locate material excess inventory 20 min–6 hrs 1500 Generate new production paperwork 15 min–4 hrs 500 Change routings Change bill of materials Change procurement schedule 10 min–8 hrs 2100 Purchase orders Inventory Collect paperwork from the floor 15 min 75 Review new line schedule 15 min–30 min 100 Overtime premiums 3 hrs–10 hrs 1000 Total 6455 a. Which of the above if any are value-added activities b. What is the cost driver in this situation c. How can the cost driver be controlled and the activities eliminated 23. Cycle time and MCE The following functions are performed in making salad dressing at A-1 Toppings. Function Time Minutes Receiving ingredients 45 Moving ingredients to stockroom 15 Storing ingredients in stockroom 3600 Moving ingredients from stockroom 15 Mixing ingredients 30 Cooking ingredients 90 Bottling ingredients 90 Moving bottled dressing to warehouse 20 Storing bottled dressing in warehouse 5040 Moving bottled dressing from warehouse to trucks 30 a. Calculate the cycle time of this manufacturing process. b. Calculate the manufacturing cycle efficiency of this process. c. What could A-1 Toppings do to improve its MCE 24. Identifying cost drivers The Fast Lane is a highly automated fast-food restau- rant that relies on sophisticated computer-controlled equipment to prepare and deliver food to customers. Operationally and organizationally the restaurant operates like other major franchise fast-food restaurants. Determine whether each of the following costs are unit level U batch level B product/process level P or organizational level O. a. Store manager’s salary b. Frozen french fries c. Napkins d. Oil for the deep-fat fryer e. Maintenance of the restaurant building f. Wages of employees who clear and clean tables g. Electricity expense for the pizza oven h. Property taxes i. Depreciation on kitchen equipment j. Refrigeration of raw materials Chapter 4 Activity-Based Cost Systems for Management 157

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25. Cost drivers For each of the following important costs in manufacturing com- panies identify a cost driver and explain why it is appropriate. a. Equipment maintenance b. Building utilities c. Computer operations d. Quality control e. Material handling f. Material storage g. Factory depreciation h. Setup cost i. Engineering changes j. Advertising expense k. Freight costs for materials 26. Cost allocation using cost drivers Peterson Wholesale has an in-house legal department whose activities fall into one of three major categories. Recently operating costs in the department have risen dramatically. Management has de- cided to implement an activity-based costing system to help control costs and charge in-house users for the legal services provided. The principal expense in the legal department is professional salaries and the estimated cost of pro- fessional salaries associated with each activity follow: Reviewing supplier or customer contracts Contracts 400000 Reviewing regulatory compliance issues Regulation 250000 Court actions Court 350000 Management has determined that the appropriate cost allocation base for Con- tracts is the number of pages in the contract reviewed for Regulation the al- location base is the number of reviews and for Court the allocation base is professional hours. For 2001 the legal department reviewed 20000 pages of contracts responded to 500 regulatory review requests and logged 3000 pro- fessional hours in court. a. Determine the allocation rate for each activity in the legal department. b. What amount would be charged to a producing department that had 1000 pages of contracts reviewed made 15 regulatory review requests and con- sumed 250 professional hours in court services during the year c. How can the developed rates be used for evaluating output relative to cost incurred in the legal department What alternative does the firm have to maintaining an internal legal department and how might this choice affect costs 27. Activity-based costing Management at Cooper Steel Co. has decided to insti- tute a pilot activity-based costing project in its eight-person purchasing de- partment. Annual departmental costs are 790000. Because finding the best supplier takes the majority of effort in the department most of the costs are allocated to this area. Activity Allocation Measure Number of People Total Cost Find best suppliers Number of telephone calls 5 500000 Issue purchase orders Number of purchase orders 2 200000 Review receiving reports Number of receiving reports 1 90000 During the year the purchasing department made 250000 telephone calls issued 25000 purchase orders and reviewed 15000 receiving reports. Many purchase orders are received in a single shipment. One product manufactured by Cooper Steel required the following pur- chasing department activities: 235 telephone calls 70 purchase orders and 22 receipts. Part 2 Systems and Methods of Product Costing 158

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a. What amount of purchasing department cost should be assigned to this product b. If 300 units of the product are manufactured during the year what is the purchasing department cost per unit 28. Product profitability Lawn Management Systems LMS manufactures two products: lawnmowers and garden tractors. Lawnmowers are relatively simple to produce and are made in large quantities. Garden tractors must be more customized to individual wholesale customer specifications. LMS sells 50000 lawnmowers and 10000 garden tractors annually. Revenues and costs incurred for each product are as follows: Lawnmowers Garden Tractors Revenue 8000000 8800000 Direct material 2000000 1800000 Direct labor 1200000 4000000 Overhead Labor is paid 20 per hour manufacturing overhead totals 2210000 and ad- ministrative expenses equal 1612000. a. Calculate the profit loss on each product if overhead and administrative expenses are assigned to the products using a direct labor hour base. b. Calculate the profit loss on each product if overhead is assigned to prod- ucts using a direct labor hour base but administrative expenses are deducted from total company income rather than being allocated to products. c. Does your answer in part a or part b provide the better representation of the profit contributed by each product Explain. 29. Value chart You are the new controller of a small shop that manufactures special-order desk nameplate stands. As you review the records you find that all the orders are shipped late the average process time for any order is three weeks and the time actually spent in production operations is two days. The president of the company has called you in to discuss missed delivery dates. Prepare an oral presentation for the executive officers in which you address the following: a. Possible causes of the problem. b. How a value chart could be used to address the problem. 30. Controlling overhead Industrial Paints Inc. has engaged you to help the com- pany analyze and update its costing and pricing practices. The company prod- uct line has changed over time from general paints to specialized marine coat- ings. Although some large orders are received the majority of business is now generated from products designed and produced in small lot sizes to meet specifically detailed environmental and technical requirements. The company has experienced tremendous overhead growth including costs in customer service production scheduling inventory control and labo- ratory work. Factory overhead has essentially doubled since the shift in prod- uct lines. Management believes that large orders are being penalized and small orders are receiving favorable cost and therefore selling price treatment. a. Indicate why the shift in product lines would have caused such major in- creases in overhead. b. Is it possible that management is correct in its belief about the costs of large and small orders If so why c. Write a memo to management suggesting how it might change the cost accounting system to reflect the changes in the business. 31. Traditional vs. ABC methods Many companies now recognize that their cost systems are inadequate in the context of today’s powerful global competition. Managers in companies selling multiple products are making important product Chapter 4 Activity-Based Cost Systems for Management 159

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decisions based on distorted cost information because most cost systems de- signed in the past focused on inventory measurement. To elevate the level of management information current literature suggests that companies should have as many as three cost systems for 1 inventory measurement 2 oper- ational control and 3 activity-based costing. a. Discuss why the traditional cost information system originally developed for valuing inventory distorts product cost information. b. Identify the purpose and characteristics of each of the following cost systems: 1. Inventory measurement 2. Activity-based costing c. Describe the benefits that management can obtain from using activity-based costing. d. List the steps that a company using a traditional cost system would take to implement activity-based costing. CMA adapted Part 2 Systems and Methods of Product Costing 160 32. Identifying non-value-added activities Stacy Kroger is planning to build a concrete walkway for her home during her annual vacation. She has prepared the following schedule of how her time on the project will be allocated: Purchase materials 4 hours Obtain rental equipment 2 hours Remove sod and level site 10 hours Build forms for concrete 12 hours Mix and pour concrete into forms 5 hours Level concrete and smooth 2 hours Let dry 24 hours Remove forms from concrete 1 hour Return rental tools 1 hour Clean up 2 hours a. Identify the value-added activities. How much total time is value-added b. Identify the non-value-added activities. How much total time is spent per- forming non-value-added activities c. Calculate the manufacturing cycle efficiency. 33. Activity analysis MCE Southern Living constructs log cabin vacation houses in the Tennessee mountains for customers. As the company’s consultant you developed the following value chart: Operations Average Number of Days Receiving materials 2 Storing materials 4 Measuring and cutting materials 3 Handling materials 7 Setting up and moving scaffolding 6 Assembling materials 7 Building fireplace 9 Pegging logs 4 Cutting and framing doors and windows 3 Sealing joints 4 Inspecting property county inspectors 3 a. What are the value-added activities and their total time b. What are the non-value-added activities and their total time PROBLEMS

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c. Calculate the manufacturing cycle efficiency of the process. d. Prepare a one-minute presentation explaining the difference between value- added and non-value-added activities. 34. Activity-based costing Patio Solutions makes umbrellas gazebos and lawn chairs. The company uses a traditional overhead allocation scheme and assigns overhead to products at the rate of 10 per direct labor hour. In 2000 the company produced 100000 umbrellas 10000 gazebos and 30000 lawn chairs and incurred 2000000 of manufacturing overhead costs. The cost per unit for each product group in 2000 was as follows: Umbrellas Gazebos Lawn Chairs Direct material 4.00 40.00 4.00 Direct labor 6.00 45.00 15.00 Overhead 8.00 60.00 20.00 Total 18.00 145.00 39.00 Because profitability has been lagging and competition has been getting more keen Patio Solutions is considering implementing an activity-based costing sys- tem for 2001. In analyzing the 2000 data management determined that all 2000000 of factory overhead could be assigned to four basic activities: qual- ity control setups material handling and equipment operation. Data from 2000 on the costs associated with each of the four activities follows: Quality Control Setups Material Handling Equipment Operation Total Costs 100000 100000 300000 1500000 2000000 Management determined that the following allocation bases and total 2000 vol- umes for each allocation base could have been used for ABC: Activity Base Volume Quality control Number of units produced 140000 Setups Number of setups 1000 Material handling Pounds of material used 2000000 Equipment operation Number of machine hours 1000000 Volume measures for 2000 for each product and each allocation base were as follows: Umbrellas Gazebos Lawn Chairs Number of units 100000 10000 30000 Number of setups 200 400 400 Pounds of material 400000 1000000 600000 Number of machine hours 200000 400000 400000 a. For 2000 determine the total overhead allocated to each product group using the traditional allocation based on direct labor hours. b. For 2000 determine the total overhead that would have been allocated to each product group if activity-based costing were used. Compute the cost per unit for each product group. c. Patio Solutions has a policy of setting selling prices based on product costs. How would the sales prices using activity-based costing differ from those obtained using the traditional overhead allocation 35. Activity-based costing Williams Components Company manufactures two products. Following is a production and cost analysis for each product for the year 2000. Chapter 4 Activity-Based Cost Systems for Management 161

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Both Cost Component Product A Product B Products Cost Units produced 10000 10000 20000 Raw materials used units X 50000 50000 100000 800000 Y 100000 100000 200000 Labor hours used Department 1: 681000 Direct labor 375000 20000 5000 25000 Indirect labor Inspection 2500 2500 5000 Machine operations 5000 10000 15000 Setups 200 200 400 Department 2: 462000 Direct labor 200000 5000 5000 10000 Indirect labor Inspection 2500 5000 7500 Machine operations 1000 4000 5000 Setups 200 400 600 Machine hours used Department 1 5000 10000 15000 400000 Department 2 5000 20000 25000 800000 Power used kw-hours 400000 Department 1 1500000 Department 2 8500000 Other activity data: Building occupancy 1000000 Purchasing 100000 Number of purchase orders Material X 200 Material Y 300 Square feet occupied Purchasing 10000 Power 40000 Department 1 200000 Department 2 250000 Roberto Lopez the firm’s cost accountant has just returned from a seminar on activity-based costing. To apply the concepts he has learned he decides to an- alyze the costs incurred for Products A and B from an activity basis. In doing so he specifies the following first and second allocation processes: FIRST STAGE: ALLOCATIONS TO DEPARTMENTS Cost Pool Cost Object Activity Allocation Base Power Departments Kilowatt-hours Purchasing Materials Number of purchase orders Building occupancy Departments Square feet occupied SECOND STAGE: ALLOCATIONS TO PRODUCTS Cost Pool Cost Object Activity Allocation Base Departments: Indirect labor Products Hours worked Power Products Machine hours Machinery-related Products Machine hours Building occupancy Products Machine hours Materials: Purchasing Products Materials used SOURCE: From Harold P. Roth and A. Faye Borthick “Getting Closer to Real Product Costs” Management Accounting May 1989 pp. 28–33. Reprinted from Management Accounting. Copyright by Institute of Management Accountants Montvale N.J. Part 2 Systems and Methods of Product Costing 162

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a. Determine the total overhead for Williams Components Company. b. Determine the plantwide overhead rate for the company assuming the use of direct labor hours. c. Determine the cost per unit of Product A and Product B using the over- head application rate found in part b. d. Using the step-down approach determine the cost allocations to depart- ments first-stage allocations. Allocate in the following order: building oc- cupancy purchasing and power. e. Using the allocations found in part d determine the cost allocations to products second-stage allocations. f. Determine the cost per unit of Product A and Product B using the over- head allocations found in part e. 36. Using ABC to set price The budgeted manufacturing overhead costs of Garage Door Company for 2001 are as follows: Type of Cost Cost Amount Electric power 500000 Work cells 3000000 Material handling 1000000 Quality control inspections 1000000 Product runs machine setups 500000 Total budgeted overhead costs 6000000 For the last five years the cost accounting department has been charging over- head production costs based on machine hours. The estimated budgeted ca- pacity for 2001 is 1000000 machine hours. Jason Tracy president of Garage Door recently attended a seminar on ac- tivity-based costing. He now believes that ABC results in more reliable cost data that in turn will give the company an edge in pricing over its competi- tors. On the president’s request the production manager provided the follow- ing data regarding expected 2001 activity for the cost drivers of the preceding budgeted overhead costs. Type of Costs Activity Drivers Electric power 100000 kilowatt-hours Work cells 600000 square feet Material handling 200000 material moves Quality control inspections 100000 inspections Product runs machine setups 50000 product runs Linda Ryan the VP of marketing received an offer to sell 5000 doors to a lo- cal construction company. Linda asks the head of cost accounting to prepare cost estimates for producing the 5000 doors. The head of cost accounting ac- cumulated the following data concerning production of 5000 doors: Direct material cost 100000 Direct labor cost 300000 Machine hours 10000 Direct labor hours 15000 Electric power—kilowatt-hours 1000 Work cells—square feet 8000 Number of material handling moves 100 Number of quality control inspections 50 Number of product runs setups 25 SOURCE: Adapted from Nabil Hassa Herbert E. Brown and Paul M. Saunders “Management Accounting Case Study: Beaver Window Inc.” Management Accounting Campus Report Fall 1990. Copyright Institute of Management Accoun- tants Montvale N.J. a. What is the predetermined overhead rate if the traditional measure of ma- chine hours is used continued Chapter 4 Activity-Based Cost Systems for Management 163

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b. What is the manufacturing cost per door as presently accounted for c. What is the manufacturing cost per door under the proposed ABC method d. If the two cost systems will result in different cost estimates which cost accounting system is preferable as a pricing base and why 37. Activity driver analysis and decision making High Plains Manufacturing Prod- ucts is concerned about its ability to control factory labor-related costs. The company has recently finished an analysis of these costs for 2001. Following is a summary of the major categories of labor costs identified by High Plain’s accounting department: Category Amount Base wages 42000000 Health care benefits 7000000 Payroll taxes 3360000 Overtime 5800000 Training 1250000 Retirement benefits 4600000 Workers’ compensation 800000 Listed below are some of the potential cost drivers identified by the company for labor-related costs along with their 2001 volume levels. Potential Activity Driver 2001 Volume Level Average number of factory employees 1400 Number of new hires 200 Number of regular labor hours worked 2100000 Number of overtime hours worked 192000 Total factory wages 47800000 Volume of production in units 8000000 Number of production process changes 400 Number of production schedule changes 250 a. For each cost pool determine the cost per unit of the activity driver us- ing the activity driver that you believe has the closest relationship to the cost pool. b. Based on your judgments and calculations in part a which activity dri- ver should receive the most attention from company managers in their ef- forts to control labor-related costs How much of the total labor-related cost is attributable to this activity driver c. In the contemporary environment many firms are asking their employees to work record levels of overtime. What activity driver does this practice suggest is a major contributor to labor-related costs Explain. 38. Activity-based costing and pricing Covington Community Hospital has found itself under increasing pressure to be accountable for the charges it assesses its patients. Its current pricing system is ad hoc based on pricing norms for the geographical area and it only explicitly considers direct costs for surgery medication and other treatments. Covington’s controller has suggested that the hospital try to improve its pricing policies by seeking a tighter relationship be- tween costs and pricing. This approach would make prices for services less arbitrary. As a first step the controller has determined that most costs can be assigned to one of three cost pools. The three cost pools follow along with the estimated amounts and activity drivers. Activity Center Amount Activity Driver Quantity Professional salaries 900000 Professional hours 30000 hours Building costs 450000 Square feet used 15000 sq. ft. Risk management 320000 Patients served 1000 patients Part 2 Systems and Methods of Product Costing 164

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The hospital provides service in three broad categories. The services are listed below with their volume measures for the activity centers. Service Professional Hours Square Feet Number of Patients Surgery 6000 1200 200 Housing patients 20000 12000 500 Outpatient care 4000 1800 300 a. Determine the allocation rates for each activity center cost pool. b. Allocate the activity center costs to the three services provided by the hospital. c. What bases might be used as cost drivers to allocate the service center costs among the patients served by the hospital Defend your selections. 39. Determining product cost Belton Furniture Corporation has identified activity centers to which overhead costs are assigned. The cost pool amounts for these centers and their selected activity drivers for 2000 are as follows. Activity Centers Costs Activity Drivers Utilities 300000 60000 machine hours Scheduling and setup 273000 780 setups Material handling 640000 1600000 pounds of material The company’s products and other operating statistics follow: PRODUCTS ABC Direct costs 80000 80000 90000 Machine hours 30000 10000 20000 Number of setups 130 380 270 Pounds of material 500000 300000 800000 Number of units produced 40000 20000 60000 Direct labor hours 32000 18000 50000 a. Determine unit product cost using the appropriate cost drivers for each of the products. b. Before it installed an ABC system the company used a conventional cost- ing system and allocated factory overhead to products using direct labor hours. The firm operates in a competitive market and product prices were set at cost plus a 20 percent markup. 1. Calculate unit costs based on conventional costing. 2. Determine selling prices based on unit costs for conventional costing and for ABC costs. c. Discuss the problems related to setting prices based on conventional cost- ing and explain how ABC improves the information. Chapter 4 Activity-Based Cost Systems for Management 165 40. Product complexity Tektronix Inc. is a world leader in the production of elec- tronic test and measurement instruments. The company experienced almost uninterrupted growth through the 1980s but in the 1990s the low-priced end of the Portables Division product line was challenged by an aggressive low- price strategy of several Japanese competitors. These Japanese companies set prices 25 percent below Tektronix’s prevailing prices. To compete the division CASES

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needed to reduce costs and increase customer value by increasing operational efficiency. Steps were taken to implement just-in-time delivery and scheduling tech- niques a total quality control program and people involvement techniques that moved responsibility for problem solving down to the operating level of the division. The results of these changes were impressive: substantial reduc- tions in cycle time direct labor hours per unit and inventory levels as well as increases in output dollars per person per day and operating income. The cost accounting system was providing information however that did not seem to support the changes. Total overhead cost for the division was 10000000 of this part 55 seemed to be related to materials and the remainder 45 to conversion. Material-related costs pertain to procurement receiving inspection stockroom personnel etc. Conversion-related costs pertain to direct labor supervision and process-related engineering. All overhead was applied on the basis of direct labor. The division decided to concentrate efforts on revamping the application system for material-related overhead. Managers believed the majority of ma- terial overhead MOH costs were related to the maintenance and handling of each different part number. Other types of MOH costs were costs due to the value of parts absolute number of parts and each use of a different part number. At this time the division used 8000 different parts and in extremely differ- ent quantities. For example annual usage of one part was 35000 units usage of another part was only 200 units. The division decided that MOH costs would decrease if a smaller number of different parts were used in the products. SOURCE: Adapted from Michael A. Robinson ed. Cases from Management Accounting Practice No. 5 Montvale N.J.: National Association of Accountants 1989 pp. 13–17. Copyright by Institute of Management Accountants formerly National Association of Accountants Montvale N.J. a. Give some reasons that materials overhead MOH would decrease if parts were standardized. b. Using the numbers given above develop a cost allocation method for MOH to quantify and communicate the strategy of parts standardization. c. Explain how the use of the method developed in part b would support the strategy of parts standardization. d. Is any method that applies the entire MOH cost pool on the basis of one cost driver sufficiently accurate for complex products Explain. e. Are MOH product costing rates developed for management reporting ap- propriate for inventory valuation for external reporting Why or why not 41. Activity-based costing Kendall Corporation manufactures several different types of printed circuit boards however two of the boards account for the majority of the company’s sales. The first of these boards a television TV cir- cuit board has been a standard in the industry for several years. The market for this type of board is competitive and therefore price sensitive. Kendall plans to sell 65000 of the TV circuit boards in 2000 at a price of 150 per unit. The second high-volume product a personal computer PC circuit board is a recent addition to Kendall’s product line. Because the PC board incorpo- rates the latest technology it can be sold at a premium price the 2000 plans include the sale of 40000 PC boards at 300 per unit. Kendall’s management group is meeting to discuss strategies for 2000 and the current topic of conversation is how to spend the sales and promotion dol- lars for next year. The sales manager believes that the market share for the TV board could be expanded by concentrating Kendall’s promotional efforts in this area. In response to this suggestion the production manager said “Why don’t you go after a bigger market for the PC board The cost sheets that I get show that the contribution from the PC board is more than double the contribution Part 2 Systems and Methods of Product Costing 166

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from the TV board. I know we get a premium price for the PC board selling it should help overall profitability.” Kendall uses a standard cost system and the following data apply to the TV and PC boards. TV Board PC Board Direct material 80 140 Direct labor 1.5 hours 4 hours Machine time 0.5 hours 1.5 hours Variable factory overhead is applied on the basis of direct labor hours. For 2000 variable factory overhead is budgeted at 1120000 and direct labor hours are estimated at 280000. The hourly rates for machine time and direct labor are 10 and 14 respectively. Kendall applies a material handling charge at 10 percent of material cost this material handling charge is not included in variable factory overhead. Total 2000 expenditures for materials are budgeted at 10600000. Ed Welch Kendall’s controller believes that before the management group proceeds with the discussion about allocated sales and promotional dollars to individual products it might be worthwhile to look at these products on the basis of the activities involved in their production. As he explained to the group “Activity-based costing integrates the cost of all activities known as cost drivers into individual product costs rather than including these costs in over- head pools.” Welch has prepared the following schedule to help the manage- ment group understand this concept. Annual Activity Budgeted Cost Cost Driver for Cost Driver Material overhead: Procurement 400000 Number of parts 4000000 parts Production scheduling 220000 Number of boards 110000 boards Packaging and shipping 440000 Number of boards 110000 boards 1060000 Variable overhead: Machine setup 446000 Number of setups 278750 setups Hazardous waste disposal 48000 Pounds of waste 16000 pounds Quality control 560000 Number of inspections 160000 inspections General supplies 66000 Number of boards 110000 boards 1120000 Annual Activity Budgeted Cost Cost Driver for Cost Driver Manufacturing: Machine insertion 1200000 Number of parts 3000000 parts Manual insertion 4000000 Number of parts 1000000 parts Wave soldering 132000 Number of boards 110000 boards 5332000 REQUIRED PER UNIT TV Board PC Board Parts 25 55 Machine insertions of parts 24 35 Manual insertions of parts 1 20 Machine setups 2 3 Hazardous waste 0.02 lb. 0.35 lb. Inspections 1 2 Chapter 4 Activity-Based Cost Systems for Management 167

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“Using this information” Welch explained “we can calculate an activity-based cost for each TV board and each PC board and then compare it to the stan- dard cost we have been using. The only cost that remains the same for both cost methods is the cost of direct materials. The cost drivers will replace the direct labor machine time and overhead costs in the standard cost.” a. Identify at least four general advantages associated with activity-based costing. b. On the basis of standard costs calculate the total contribution expected in 2000 for Kendall Corporation’s 1. TV board. 2. PC board. c. On the basis of activity-based costs calculate the total contribution ex- pected in 2000 for Kendall Corporation’s 1. TV board. 2. PC board. d. Explain how the comparison of the results of the two costing methods may impact the decisions made by Kendall Corporation’s management group. CMA adapted 42. Activity-based costing Miami Valley Architects Inc. provides a wide range of engineering and architectural consulting services through its three branch offices in Columbus Cincinnati and Dayton. The company allocates resources and bonuses to the three branches based on the net income reported for the period. The following presents the results of 2001 performance in thousands. Columbus Cincinnati Dayton Total Sales 1500 1419 1067 3986 Less: Direct labor 382 317 317 1016 Direct material 281 421 185 887 Overhead 710 589 589 1888 Net income 127 92 24 195 Overhead items are accumulated in one overhead pool and allocated to the branches based on direct labor dollars. For 2001 this predetermined overhead rate was 1.859 for every direct labor dollar incurred by an office. The over- head pool includes rent depreciation taxes and so on regardless of which office incurred the expense. This method of accumulating costs forces the of- fices to absorb a portion of the overhead incurred by other offices. Management is concerned with the results of the 2001 performance re- ports. During a review of the overhead it became apparent that many items of overhead are not correlated to the movement in direct labor dollars as pre- viously assumed. Management decided that applying overhead based on ac- tivity-based costing and direct tracing where possible should provide a more accurate picture of the profitability of each branch. An analysis of the overhead revealed that the following dollars for rent utilities depreciation taxes and so on could be traced directly to the office that incurred the overhead in thousands. Columbus Cincinnati Dayton Total Direct overhead 180 270 177 627 Activity pools and activity drivers were determined from the accounting records and staff surveys as follows: Part 2 Systems and Methods of Product Costing 168

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OF ACTIVITIES BY LOCATION Activity Pools Activity Driver Columbus Cincinnati Dayton General Administration 409000 Direct Labor 382413 317086 317188 Project Costing 48000 of Timesheet Entries 6000 3800 3500 Accounts Payable/Receiving 139000 of Vendor Invoices 1020 850 400 Accounts Receivable 47000 of Client Invoices 588 444 96 Payroll/Mail Sort Delivery 30000 of Employees 23 26 18 Personnel Recruiting 38000 of New Hires 8 4 7 Employee Insurance Processing 14000 Insurance Claims Filed 230 260 180 Proposals 139000 of Proposals 200 250 60 Sales Meetings/Sales Aids 202000 Contracted Sales 1824439 1399617 571208 Shipping 24000 of Projects 99 124 30 Ordering 48000 of Purchase Orders 135 110 80 Duplicating Costs 46000 of Copies Duplicated 162500 146250 65000 Blueprinting 77000 of Blueprints 39000 31200 16000 1261000 Chapter 4 Activity-Based Cost Systems for Management 169 a. What overhead costs should be assigned to each branch based on activity- based costing concepts b. What is the contribution of each branch before subtracting the results obtained in part a c. What is the profitability of each branch office using activity-based costing d. Evaluate the concerns of management regarding the traditional costing tech- nique currently used. IMA adapted 43. Activity-based costing and pricing Joey Lutz owns and manages a commer- cial cold-storage warehouse. He stores a vast variety of perishable goods for his customers. Historically he has charged customers using a flat rate of 0.04 per pound per month for goods stored. His cold-storage warehouse has 100000 cubic feet of storage capacity. In the past two years Lutz has become dissatisfied with the profitability of the warehouse operation. Despite the fact that the warehouse remains rel- atively full revenues have not kept pace with operating costs. Recently Lutz approached his accountant Jill Green about using activity-based costing to im- prove his understanding of the causes of costs and revise the pricing formula. Green has determined that most costs can be associated with one of four ac- tivities. Those activities and their related costs volume measures and volume levels for 2001 follow: Activity Cost Monthly Volume Measure Send/receive goods 6000 Weight in pounds—500000 Store goods 4000 Volume in cubic feet—80000 Move goods 5000 Volume in square feet—5000 Identify goods 2000 Number of packages—500 SOURCE: Adapted from Harold P. Roth and Linda T. Sims “Costing for Warehousing and Distribution” Management Accounting August 1991 pp. 42–45. Reprinted from Management Accounting. Copyright by Institute of Management Accountants Montvale N.J. a. Based on the activity cost and volume data determine the amount of cost assigned to the following customers whose goods were all received on the first day of last month. Customer Weight of Order Cubic Feet Square Feet Number of Packages Jones 40000 3000 300 5 Hansen 40000 2000 200 20 Assad 40000 1000 1000 80

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b. Determine the price to be charged to each customer under the existing pricing plan. c. Determine the price to be charged using ABC assuming Lutz would base the price on the cost determined in part a plus a markup of 40 percent. d. How well does Lutz’s existing pricing plan capture the costs incurred to provide the warehouse services Explain. Part 2 Systems and Methods of Product Costing 170 44. Many manufacturers are deciding to no longer service small retailers. For ex- ample some companies have policies to serve only customers who purchase 10000 or more of products from the companies annually. The companies defend such policies on the basis that they allow the companies to better serve their larger outlet which handle more volume and more diverse product lines. a. Relate the concepts in the chapter to the decision of manufacturers to drop small customers. b. Are there any ethical implications of eliminating groups of customers that may be less profitable than others c. Does activity-based costing adequately account for all costs that are related to a decision to eliminate a particular customer base Hint: Consider op- portunity costs such as those related to reputation. 45. Evidence suggests that ABM implementations are more likely to succeed in more open organizations. The ground is especially fertile for companies that have a stated interest in becoming world-class competitors and have backed these ambitions up with other initiatives. ABM dovetails with these initiatives and they reinforce each other. A clear commitment from top management is also essential. SOURCE: Helen Thorne and Bruce Gurd “Some Human Aspects of Implementing Activity-Based Management” Journal of Cost Management Fall 1995 p. 51. a. What are some of the “other initiatives” to which the article would be refer- ring b. How might activity-based management and activity-based costing help a company in its quest to achieve world-class status c. Would it be equally important to have top management support if a com- pany was instituting activity-based costing rather than activity-based man- agement Justify your answer. d. Assume you are a member of top management in a large organization. Do you think implementation of ABM or ABC would be more valuable Ex- plain the rationale for your answer. 46. As the chief executive officer of a large corporation you have made a deci- sion after discussion with production and accounting personnel to implement activity-based management concepts. Your goal is to reduce cycle time and thus costs. A primary way to accomplish this goal is to install highly auto- mated equipment in your plant which would then displace approximately 60 percent of your workforce. Your company is the major employer in the area of the country where it is located. a. Discuss the pros and cons of installing the equipment from the perspec- tive of your 1 stockholders 2 employees and 3 customers. b. How would you explain to a worker that his or her job is non-value-added c. What alternatives might you have that could accomplish the goal of re- ducing cycle time but not create economic havoc for the local area REALITY CHECK

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5 Job Order Costing CHAPTER LEARNING OBJECTIVES After completing this chapter you should be able to answer the following questions: 1 How do job order and process costing systems and how do actual normal and standard costing valuation methods differ 2 In what production situations is a job order costing system appropriate and why 3 What constitutes a “job” from an accounting standpoint 4 What purposes are served by the primary documents used in a job order costing system 5 What journal entries are used to accumulate costs in a job order costing system 6 How do technological changes impact the gathering and use of information in job order costing systems 7 How are standard costs used in a job order costing system 8 How does information from a job order costing system support management decision making

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Aker Gulf Marine INTRODUCING ker Gulf Marine AGM is known throughout the Gulf Coast oil and gas industry as a small firm that executes big projects—very big projects. Situated on the shore of the Gulf of Mexico near the city of Corpus Christi Texas AGM builds offshore oil rigs often in cooperative ventures with other firms. AGM serves as a contractor to the major firms that ex- tract oil and gas from the Gulf of Mexico and other offshore locations. At any particular time the company will have sev- eral projects in progress. Like most contractors AGM gets business from the oil producers only when it is the success- ful bidder on construction contracts. The reputation of the company as an innovative high-quality producer is often a factor in the ability of the company to win contracts. AGM’s expertise is in engineering and converting various stock metal materials into mammoth integrated structures often weighing thousands of tons. For example a recently completed project nicknamed “Mars” and con- tracted by Shell Oil required AGM to build a system to anchor a floating oil platform in 3000 feet of water. The massive platform is designed to accommodate 106 workers and 24 well slots. The anchoring system consists of 12 “tendons” each 28 inches in diameter and one-half mile in length. The system is engineered to withstand 140-mph winds and 70-foot waves. Combined the platform and anchoring system weigh over 36000 tons. The Mars plat- form connects to a pipeline that moves the oil 116 miles to shore in southern Louisiana. As a builder of offshore oil production equipment AGM has several significant constraints in its operations. For example because completed projects must be floated to their permanent locations AGM must have its production facilities located on a deep-water channel with access to the Gulf. Also because the projects are physically very large most production occurs in the open air with little protection from the weather including hurricanes and other adverse weather conditions. Finally the completed projects must be assembled on location in the open ocean. The installation process exposes the various components to the risks of adverse weather and seas. At AGM and other custom manufacturers most business is conducted through a process of competitive bidding. In this process a company must accurately esti- mate the costs of making products associated with each contract. Competitive bid- ding is complicated by the nature of custom manufacturing—each bid may involve unique products. For example at AGM the only common aspects of all products are the materials used and the conversion processes. Because each bid/order is substantially different from all others contract pricing and cost control cannot be based on an accounting system that aggregates costs across contracts. Thus AGM uses job order costing to accumulate the costs of each job contract separately from all other jobs. A primary role for cost accounting is to determine the cost of an organization’s products or services. Just as various methods first-in first-out last-in first-out av- erage specific identification exist to determine inventory valuation and cost of goods sold for a retailer different methods are available to value inventory and calculate product cost in a manufacturing or service environment. The method cho- sen depends on the product or service and the company’s conversion processes. A cost flow assumption is required for processes in which costs cannot be identi- fied with and attached to specific units of production. This chapter is the first of a sequence of chapters that will present methods of product costing. The chapter first distinguishes between two primary costing systems job order and process and then discusses three methods of valuation that can be used within these systems actual normal and standard. The remainder of the chapter focuses on the job order costing system such as that used by AGM. SOURCE: Anonymous “Offshore Technology—Mars Shell Oil Field Project—Gulf of Mexico” 173 A

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Part 2 Systems and Methods of Product Costing 174 METHODS OF PRODUCT COSTING Before the cost of products can be computed a determination must be made about 1 the product costing system and 2 the valuation method to be used. The prod- uct costing system defines the cost object and the method of assigning costs to production. The valuation method specifies how product costs will be measured. Companies must have both a cost system and a valuation method six possible combinations exist as shown in Exhibit 5–1. 1 Costing Systems Job order and process costing are the two primary cost systems. A job order cost- ing system is used by entities that make perform relatively small quantities or distinct batches of identifiable unique products services. For example job order costing is appropriate for a publishing company that produces educational text- books an accountant who prepares tax returns an architectural firm that designs commercial buildings and a research firm that performs product development stud- ies. In each instance the organization produces tailor-made goods or services that conform to specifications designated by the purchaser of those goods or services. Services in general are typically user specific so job order costing systems are com- monly used in such businesses. In these various settings the word “job” is syn- onymous with engagement project and contract. The other primary product costing system a process costing system is used by entities that produce large quantities of homogeneous goods. Process costing is appropriate for companies that mass manufacture products such as bricks gasoline detergent and breakfast cereal. The output of a single process in a mass manufac- turing situation is homogeneous thus within a given period one unit of output cannot be readily identified with specific input costs. This characteristic of process How do job order and process costing systems and how do actual normal and standard costing valuation methods differ 1 1 A third and fourth dimension cost accumulation and cost presentation are also necessary in this model. These dimensions relate to the use of absorption or variable costing and are covered in Chapter 12. EXHIBIT 5–1 Costing Systems and Inventory Valuation Actual DM Actual DL Actual OH assigned to job after end of period Actual DM Actual DL OH applied using predetermined rates at completion of job or end of period predetermined rates times actual input Standard DM and/or Standard DL OH applied using predetermined rates when goods are completed or at end of period predetermined rates times standard input Actual DM Actual DL Actual OH assigned to job after end of period using FIFO or weighted average cost flow Standard DM Standard DL Standard OH using predetermined rates will always be FIFO cost flow Actual DM Actual DL OH applied using predetermined rates using FIFO or weighted average cost flow COST ACCUMULATION SYSTEM JOB ORDER Actual Normal Standard PROCESS METHOD OF VALUATION job order costing system process costing system

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costing systems makes a cost flow assumption necessary. Cost flow assumptions provide a means for accountants to assign costs to products without regard for the actual physical flow of units. Process costing systems covered in Chapters 6 and 7 allow the use of either a weighted average or FIFO cost flow assumption. The accompanying News Note discusses a small enterprise that manufactures custom golf clubs. This firm is different from most of the companies that mass manufacture clubs. Although the individual featured in the News Note would likely use a job order costing system most firms in the industry would appropriately use process costing. Valuation Methods The three valuation methods shown in Exhibit 5–1 are actual normal and stan- dard costing. A company using the actual costs of direct materials direct labor and overhead to determine work in process inventory cost is employing an actual cost system. Service businesses that have few customers and/or low volume such as some advertising agencies or consulting firms may use an actual cost system. However because of the reasons discussed in Chapter 3 many companies mod- ify actual cost systems by using predetermined overhead rates rather than actual overhead costs. This combination of actual direct materials and direct labor costs with predetermined overhead rates is called a normal cost system. If the predeter- mined rate is substantially equivalent to what the actual rate would have been for an annual period its use provides acceptable and useful costs. Companies using either job order or process costing may employ standards or predetermined benchmarks for costs to be incurred and/or quantities to be used. In a standard cost system unit norms or standards are developed for direct mate- rial and direct labor quantities and/or costs. Overhead is applied to production us- ing a predetermined rate that is considered the standard. These standards can then be used to plan for future activities and cost incurrence and to value inventories. Both actual and standard costs are recorded in the accounting records to provide an essential element of cost control—having norms against which actual costs of operations can be compared. A standard cost system allows companies to quickly recognize deviations or variances from normal production costs and to correct prob- lems resulting from excess usage and/or costs. Actual costing systems do not provide this benefit and normal costing systems cannot provide it in relation to materials and labor. Chapter 5 Job Order Costing 175 Puttering around Building Golf Clubs NEWS NOTE GENERAL BUSINESS It’s the start of the Greater Greensboro Chrysler Classic and the pros are practicing at the Forest Oaks Country Club driving range when Tim West arrives to hawk his wares. Measured by money alone Mr. West is a bit player in the burgeoning 6 billion golf equipment market. Most of his rivals deliver products for industry titans such as For- tune Brands Inc. Mr. West in contrast is an independent representing start-ups and other tiny companies that can’t afford to pay endorsements. With no expense ac- count he must rely on guile persuasion and his “Book of Love” a meticulously maintained notebook in which he records players’ preferences down to such details as the no-rib grip favored by John Daly or a club-shaft weight down to the gram. On the road he uses the book to build custom clubs from scratch usually in one of the machine-shop trailers that follow the tour and are subsidized by big equipment makers. “I love machines” he says assembling a hybrid while hunched over a pot of smelly glue. SOURCE: Adapted from Christopher Cooper “Even Golf Pros Need Help and Tim West Tries Hard to Give It—He Persuades Them to Test New Gear That May Offer That Always-Needed Edge” The Wall Street Journal May 28 1998 p. A1. http://www.fortunebrands .com

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Because the use of predetermined overhead rates is more common than the use of actual overhead costs this chapter addresses a job order/normal cost sys- tem and describes some job order/standard cost combinations. 2 Part 2 Systems and Methods of Product Costing 176 2 Although actual overhead may be assigned to jobs such an approach would be less customary because total overhead would not be known until the period was over causing an unwarranted delay in overhead assignment. Activity-based costing can increase the validity of tracing overhead costs to specific products or jobs. 3 To eliminate the need for repetition units should be read to mean either products or services because job order costing is ap- plicable to both manufacturing and service companies. For the same reason produced can mean manufactured or performed. JOB ORDER COSTING SYSTEM Product costing is concerned with 1 cost identification 2 cost measurement and 3 product cost assignment. In a job order costing system costs are accu- mulated individually on a per-job basis. A job is a single unit or group of units identifiable as being produced to distinct customer specifications. 3 Each job is treated as a unique cost entity or cost object. Costs of different jobs are maintained in separate subsidiary ledger accounts and are not added together or commingled in those ledger accounts. The logic of separating costs for individual jobs is shown by the example given in Exhibit 5–2. Assume Island Marine a builder of offshore oil production equip- ment produced three products in March: a production platform a barge designed to deliver offshore products to their installation sites and an assembly of compo- nents built by other firms into a completed oil rig. The quantity of resources used for each project is clearly unique. Each product required a different amount of ma- terial and different conversion operations. Because each contract is distinctive the costs of those products cannot logically be averaged—a unique cost must be de- termined for each contract. Exhibit 5–2 provides the Work in Process Inventory control and subsidiary ledger accounts for Island Marine’s product costing system. The usual production costs of direct material direct labor and overhead are accumulated for each con- tract. Actual direct material and direct labor costs are combined with an overhead cost that is computed as a predetermined overhead rate multiplied by some actual cost driver such as direct labor hours cost or quantity of materials used or num- ber of material requisitions. Normal cost valuation is used because although ac- tual direct material and direct labor costs are fairly easy to identify and associate with a particular job overhead costs are usually not traceable to specific jobs and must be allocated to production. For example Island Marine’s March utility costs are related to all jobs worked on during that month. Accurately determining which jobs created the need for a given amount of water heat or electricity would be almost impossible. To ensure the proper recording of costs the amounts appearing in the sub- sidiary ledger accounts are periodically compared with and reconciled to the Work in Process Inventory control account in the general ledger. This reconciliation is indicated by the equality of the assumed ending balances of the subsidiary ledger accounts with the WIP Inventory control account in Exhibit 5–2. The output of any job can be a single unit or multiple similar or dissimilar units. With multiple outputs a unit cost can be computed only if the units are sim- ilar or if costs are accumulated for each separate unit such as through an identi- fication number. For example Seagate Technology produces compact disk drives to the specifications of a variety of companies including Compaq. Seagate can de- termine the cost per disk drive for each company by accumulating the costs per batch of homogeneous products in different production runs and treating each pro- duction run as a separate job. In such cases production costs of each job batch can be commingled because the units within the batch are not distinguishable and the total cost can be averaged over the number of units produced in the batch to In what production situations is a job order costing system appropriate and why job 2 What constitutes a “job” from an accounting standpoint 3

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determine a cost per unit. If the output consists of dissimilar units for which indi- vidual cost information is not gathered no cost per unit can be determined although it is still possible to know the total job cost. Chapter 5 Job Order Costing 177 GENERAL LEDGER Work in Process Inventory Control Direct materials actual XXX Transferred to finished Direct labor actual XXX goods could also be Overhead predetermined next department XXX rate actual activity XX Ending balance 2548000 EXHIBIT 5–2 Separate Subsidiary Ledger Accounts for Jobs SUBSIDIARY LEDGER Job 301 Exxon Platform Direct materials actual XXX Direct labor actual XXX Overhead predetermined rate actual activity XX Ending balance 1417000 Job 318 Delivery Barge Direct materials actual XXX Direct labor actual XXX Overhead predetermined rate actual activity XX Ending balance 319000 Job 541 Rig Assembly Direct materials actual XX Direct labor actual XXX Overhead predetermined rate actual activity XX Ending balance 812000 JOB ORDER COSTING: DETAILS AND DOCUMENTS A job can be categorized by the stage of its production cycle. There are three stages of production: 1 contracted for but not yet started 2 in process and 3 completed. 4 What purposes are served by the primary documents used in a job order costing system 4 4 In concept there could be four categories. The third and fourth categories would distinguish between products completed but not sold and products completed and sold. However the usual case is that firms using a job order costing system produce only products for which there is a current demand. Consequently there is usually no inventory of finished products that await sale.

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Because a company using job order costing is making products according to user specifications jobs might occasionally require unique raw material. Thus some raw material may not be acquired until a job is under contract and it is known that production will occur. The raw material acquired although often separately distinguishable and related to specific jobs is accounted for in a single general ledger control account Raw Material Inventory with subsidiary ledger backup. The material may however be designated in the storeroom and possibly in the subsidiary records as being “held for use in Job XX.” Such designations should keep the material from being used on a job other than the one for which it was acquired. Material Requisitions When material is needed to begin a job a material requisition form shown in Exhibit 5–3 is prepared so that the material can be released from the warehouse and sent to the production area. This source document indicates the types and quantities of materials to be placed into production or used to perform a service job. Such documents are usually prenumbered and come in multiple-copy sets so that completed copies can be maintained in the warehouse in the department and with each job. Completed material requisition forms are important for a company’s audit trail because they provide the ability to trace responsibility for material cost and to verify the flow of material from the warehouse to the department for the job receiving the material. These forms release warehouse personnel from further responsibility for issued materials and assign responsibility to the requisitioning de- partment. Although hardcopy material requisition forms may still be used it is in- creasingly common for this document to exist only electronically. When material is issued its cost is released from Raw Material Inventory and if direct to the job is sent to Work in Process Inventory. If the Raw Material In- ventory account also contains indirect material the costs of these issuances are as- signed to Manufacturing Overhead. Thus the journal entry will be as follows: Work in Process Inventory if direct XXX Manufacturing Overhead if indirect XXX Raw Material Inventory XXX Part 2 Systems and Methods of Product Costing 178 What journal entries are used to accumulate costs in a job order costing system material requisition form 5 EXHIBIT 5–3 Material Requisition Form Date Job Number Authorized by Received by Department Issued by Inspected by No. 341 Item No. Part No. Description Unit of Measure Quantity Required Quantity Issued Unit Cost Total Cost

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When the first direct material associated with a job is issued to production that job moves to the second stage of its production cycle—being in process. When a job enters this stage cost accumulation must begin using the primary account- ing document in a job order system—the job order cost sheet or job cost record. Job Order Cost Sheet The source document that provides virtually all financial information about a par- ticular job is the job order cost sheet. The set of job order cost sheets for all un- completed jobs comprises the Work in Process Inventory subsidiary ledger. Total costs contained on the job order cost sheets for all uncompleted jobs should rec- oncile to the Work in Process Inventory control account balance in the general ledger as shown in Exhibit 5–2. The top portion of a job order cost sheet includes a job number a descrip- tion of the task customer identification various scheduling information delivery instructions and contract price. The remainder of the form details actual costs for material labor and applied overhead. The form also might include budgeted cost information especially if such information is used to estimate the job’s selling price or support a bid price. In bid pricing budgeted and actual costs should be com- pared at the end of a job to determine any deviations from estimates. Like the ma- terial requisition form the job cost sheet exists only electronically in many com- panies today. Exhibit 5–4 illustrates a job order cost sheet for Island Marine. The company has contracted to produce a floating hull that will serve as a platform for an off- shore oil rig. All of Island Marine’s job order cost sheets include a section for bud- geted data so that budget-to-actual comparisons can be made for planning and control purposes. Direct material and direct labor costs are assigned and posted to jobs as work on the job is performed. Direct material information is gathered from the material requisition forms and direct labor information is found on employee time sheets or employee labor tickets. Employee time sheets are discussed in the next section. Overhead is applied to production at Island Marine based on departmental rates. Each department may have more than one rate. For example in the Cutting Forming Department the overhead rates for 2000 are as follows: Labor-related costs: 25 per direct labor hour Machine-related costs: 45 per machine hour Employee Time Sheets An employee time sheet Exhibit 5–5 page 181 indicates for each employee the jobs worked on and the direct labor time consumed. These time sheets are most reliable if the employees fill them in as the day progresses. Work arriving at an employee station is accompanied by a tag or bar code specifying its job order number. The time work is started and stopped are noted on the time sheet. 5 These time sheets should be collected and reviewed by supervisors to ensure that the information is as accurate as possible. The time sheet shown in Exhibit 5–5 is appropriate only if employees are asked to record their time and work manually. The time sheet information is the same as that which would be recorded if a computer were used to track employee tasks as is the norm in larger businesses. In fact larger businesses today use electronic time-keeping software. Employees simply swipe an employee ID card and a job Chapter 5 Job Order Costing 179 job order cost sheet employee time sheet 5 Alternatives to daily time sheets are job time tickets that supervisors give to employees as they are assigned new jobs and supervisors’ records of which employees worked on what jobs for what period of time. The latter alternative is extremely diffi- cult if a supervisor is overseeing a large number of employees or if employees are dispersed through a large section of the plant.

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Part 2 Systems and Methods of Product Costing 180 Job Number 323 Customer Name and Address: Description of Job: Dolphin Petroleum Co. Hull for floating rig 9901 La. Freeway Per specifications in bid agreement 913 New Orleans LA dated 2/01/00 Contract Agreement Date: 3/25/00 Scheduled Starting Date: 6/5/00 Agreed Completion Date: 7/01/01 Contract Price 21000000 Actual Completion Date: Delivery Instructions: Floating: ICW at New Orleans CUTTING FORMING OVERHEAD BASED ON DIRECT MATERIALS DIRECT LABOR OF LABOR HOURS OF MACHINE HOURS EST. 6140000 EST. 1100000 EST. 500000 EST. 750000 Date Source Amount Date Source Amount Date Source Amount Date Source Amount WELDING ASSEMBLY SAME FORMAT AS ABOVE BUT WITH DIFFERENT OH RATES PAINTING FINISHING SAME FORMAT AS ABOVE BUT WITH DIFFERENT OH RATES SUMMARY THOUSANDS OF DOLLARS CUTTING FORMING WELDING ASSEMBLY PAINTING FINISHING Actual Budget Actual Budget Actual Budget Direct materials 6140 1200 400 Direct labor 1100 2100 700 Overhead labor 500 400 450 Overhead machine 750 520 370 Totals 8490 4220 1920 Actual Budget Final Costs: Cutting Forming 8490 Welding Assembly 4220 Painting Finishing 1920 Totals 14630 EXHIBIT 5–4 Island Marine’s Job Order Cost Sheet card through a reader when they switch from one job to another. This software allows labor costs to be accumulated by job and department. In highly automated factories employee time sheets may not be extremely use- ful or necessary documents because of the low proportion of direct labor cost to total cost. However machine time can be tracked through the use of machine clocks or counters in the same way as human labor. As jobs are transferred from one machine to another the clock or counter can be reset to mark the start and

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stop times. Machine times can then be equated to employee-operator time. An- other convenient way to track employee time is through bar codes that can be scanned as products pass through individual workstations. At one large Midwest plumbing manufacturer for example a bar coding system was implemented for time-and-attendance and shop-floor control systems. “In less than two years the company eliminated eleven different forms that were used when time and in- spection data were recorded manually. Inspector efficiency improved by 10 to 12 percent in part because the inspector never touched a piece of paper other than a bar code label.” 6 Transferring employee time sheet or alternative source document information to the job order cost sheet requires a knowledge of employee labor rates. Wage rates are found in employee personnel files. Time spent on the job is multiplied by the employee’s wage rate and the amounts are summed to find total direct la- bor cost for the period. The summation is recorded on the job order cost sheet. Time sheet information is also used for payroll preparation the journal entry to record the information is Work in Process Inventory if direct XXX Manufacturing Overhead if indirect XXX Salaries and Wages Payable XXX After these uses time sheets are filed and retained so they can be referenced if necessary for any future information needs. If total actual labor costs for the job dif- fer significantly from the original estimate the manager responsible for labor cost control may be asked to clarify the reasons underlying the situation. In addition if a job is to be billed at cost plus a specified profit margin a cost-plus contract the number of hours worked may be audited by the buyer. This situation is quite com- mon and especially important when dealing with government contracts. Therefore Chapter 5 Job Order Costing 181 EXHIBIT 5–5 Employee Time Sheet For Week Ending Department Employee Name Employee ID No. Code Description Job Number Start Time Day circle Total Hours Type of Work Stop Time M T W Th F S M T W Th F S M T W Th F S M T W Th F S M T W Th F S M T W Th F S Employee Signature Supervisor’s Signature for overtime 6 Thomas Tyson “The Use of Bar Coding in Activity-Based Costing Journal of Cost Management Winter 1991 pp. 52–53. cost-plus contract

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hours not worked directly on the contracted job cannot be arbitrarily or incorrectly charged to the cost-plus job without the potential for detection. Last time sheets provide information on overtime hours. Under the Fair Labor Standards Act overtime must generally be paid at a time-and-a-half rate to all nonmanagement employees when they work more than 40 hours in a week. Overhead Overhead costs can be substantial in manufacturing and service organizations. As in- dicated in the following News Note the ability to estimate and correctly apply over- head is a major factor in the relative success of custom producers. As suggested by the News Note activity-based costing presented in Chapter 4 can be effectively used in a custom job production environment. Actual overhead incurred during production is included in the Manufacturing Overhead control account. If actual overhead is applied to jobs the cost accountant will wait until the end of the period and divide the actual overhead incurred in each designated cost pool by a related measure of activity or cost driver. Actual overhead would be applied to jobs by multiplying the actual overhead rate by the actual measure of activity associated with each job. More commonly overhead is applied to jobs using one or more annualized pre- determined overhead application rates. Overhead is assigned to jobs by multiplying the predetermined rate by the actual measure of the activity base that was incurred during the period for each job. This method is normal costing. Part 2 Systems and Methods of Product Costing 182 High Tech Is High Overhead NEWS NOTE GENERAL BUSINESS A few years ago an aerospace manufacturer of high- precision aircraft components was approached by one of its customers who was looking for additional machine capacity to support an overload situation in the cus- tomer’s site. What an opportunity to sell excess machine hours and reap a great reward The sales and manu- facturing managers were all set to bid a rate to the cus- tomer when the new controller stepped in and said “Wait before you bid let me review the numbers.” A little surprised the managers gave the controller a couple of days to look at the bid. The manufacturer was a large job shop with a variety of machine-shop-type equipment ranging from simple drill presses to extremely complex high-precision finish- ing machines. Job costing used direct labor dollars as the overhead allocation base and although the manu- facturing overhead rate for the plant was now almost 300 percent of direct labor nobody had questioned how jobs had been priced in the past. Pricing was simply the number of direct labor hours times the direct labor rate plus overhead at the 300 percent rate plus 20 percent for administrative expense plus a further fee represent- ing expected profit normally 12 percent of cost. There- fore in this case direct labor of 21.25 per hour was grossed up to provide a manufacturing rate including overhead of 85 per direct labor hour. The reality of the situation was however that the cus- tomer was not buying the average shop. The customer wanted to buy specific high-precision finishing machines to complete work started in its own facility. What the con- troller sensed in the situation was that the normal pricing model might not work in this case. His approach to an- alyzing the opportunity was to take each machine and trace to it as best he could the actual resources con- sumed by the equipment including supplies electricity maintenance setup tools and fixtures space quality control scheduling material handling etc. He still had to add some cost for management and shared facilities. Much to his horror he discovered that the real cost of the machines ranged from 225 to as much as 350 per operating hour. Astonishingly not one machine had an hourly cost lower than the proposed selling price. Prices based on the revised higher level rates per machine were quoted to the customer and most were accepted. SOURCE: Reprinted from an article appearing in CMA Management Magazine for- merly CMA Magazine by Murray A. Best CMA with permission of CMA Canada.

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When predetermined rates are used overhead is applied at the end of the period or at completion of production whichever is earlier. Overhead is applied at the end of each period so that the Work in Process Inventory account contains costs for all three product elements direct material direct labor and overhead. Overhead is applied to Work in Process Inventory at completion so that a proper product cost can be transferred to Finished Goods Inventory. The journal entry to apply overhead follows. Work in Process Inventory XXX Manufacturing Overhead XXX Completion of Production When a job is completed its total cost is transferred to Finished Goods Inventory. Finished Goods Inventory XXX Work in Process Inventory XXX Job order cost sheets for completed jobs are removed from the WIP subsidiary ledger and become the subsidiary ledger for the Finished Goods Inventory control account. When a job is sold the cost contained in Finished Goods Inventory for that job is transferred to Cost of Goods Sold. Cost of Goods Sold XXX Finished Goods Inventory XXX Such a cost transfer presumes the use of a perpetual inventory system which is common in a job order costing environment because goods are generally easily identified and tracked. Job order cost sheets for completed jobs are kept in a company’s permanent files. A completed job order cost sheet provides management with a historical sum- mary about total costs and if appropriate the cost per finished unit for a given job. The cost per unit may be helpful for planning and control purposes as well as for bidding on future contracts. If a job was exceptionally profitable manage- ment might decide to pursue additional similar jobs. If a job was unprofitable the job order cost sheet may provide indications of areas in which cost control was lax. Such areas are more readily identifiable if the job order cost sheet presents the original budgeted cost information. Unlike the case of a retailer or wholesaler most businesses that use job order costing have little finished goods inventory. Because they build custom products only when a specific customer contracts for a particular service or product does production occur. Then on completion the costs of the product or service may flow immediately to Cost of Goods Sold. Chapter 5 Job Order Costing 183 JOB ORDER COSTING AND TECHNOLOGY The trend in job order costing is to automate the data collection and data entry functions required to support the accounting system. By automating recordkeep- ing functions not only are production employees relieved of that burden but the electronically stored data can be accessed to serve many purposes. For example the data from a completed job can be used as inputs for projecting the costs that are the bases for setting bid prices on future jobs. Regardless of whether the data entry process is automated virtually all product costing software contains a job costing module even very inexpensive off-the-shelf programs. And as indicated in the accompanying News Note there is a significant role for public accountants in vending software to smaller manufacturing firms. How do technological changes impact the gathering and use of information in job order costing systems 6

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Within many companies intranets are being created to manage the informa- tion pertaining to jobs. An intranet is a mechanism for sharing information and delivering data from corporate databases to the local-area network LAN desktops. Intranets use Web technology and are restricted networks that can enhance com- munication and distribute information. 7 Exhibit 5–6 provides an illustration of the types of information that can be accessed on an intranet. As shown in Exhibit 5–6 much information relevant to managing the produc- tion of a particular job is available on-line to managers. From contract information and technical specifications to cost budgets actual costs incurred and stage of pro- duction measurements data are instantly available to managers. As data input func- tions are automated the data available on the Intranet become more and more up to the minute or real time. Chapter 17 addresses more fully the automation and integration of information systems. In any job order costing system the individual job is the focal point. The next section presents a comprehensive job order costing situation using information from Island Marine the company introduced earlier. Part 2 Systems and Methods of Product Costing 184 Middle Market Manufacturing Going “Soft” for CPAs NEWS NOTE GENERAL BUSINESS The market for selling technology products and consult- ing services to middle-market manufacturers is as abun- dant as Mike Meyers’s chest hair in the latest Austin Pow- ers movie but some observers of this niche industry doubt that many practitioners will capitalize on it. Major middle-market accounting software vendors— Great Plains Sage SBT Solomon and Epicor—are rapidly adding manufacturing capabilities to their core accounting technologies. And they are looking to their reseller channels whose makeup is often as much as 30 percent CPAs for help in reaching that market. The move is both fueling and being fueled by middle- market manufacturers’ expanding technology appetite. “Five years ago a manufacturer had to be 20 million a year in revenues to automate now the 5 million-a-year companies are automating and doing so rapidly with the right partners” said Jim Kent of the Kent Group an An- dover-based reseller of Macola an established manu- facturing software specialist. “There’s a huge opportunity for CPAs to work with manufacturers who want their manufacturing and ac- counting systems to work together” said David Lahey president of Lahey Financial Systems which expects to expand dramatically by virtue of now being sold exclu- sively by SBT and its reseller channel. Lahey whose company has been developing manu- facturing software since 1984 claims that most mid- market manufacturers have not in the past focused on accounting software and now they’re being forced to take on integrated multiple-application programs. “They’re being forced to play catch-up and CPAs are a logical party to help them deal with systems that directly integrate accounting and manufacturing solutions” he explained. Brian Sittley president of Productivity Management a South Bend Ind. reseller of SBT said the manufactur- ing industry technology consulting opportunity is partic- ularly keen for CPAs well versed in cost accounting. SOURCE: John Covaleski “Manufacturing Niche May Be Too Hairy for CPAs” Accounting Today July 26–August 8 1999 pp. 22 28. © Faulkner Gray republished with permission. intranet 7 Lawrence Barkowski “Intranets for Projects and Cost Management in Manufacturing” Cost Engineering June 1999 p. 33. JOB ORDER COSTING ILLUSTRATION Island Marine sets bid prices based on its costs. Over the long term the company has a goal of realizing a gross profit equal to 25 percent of the bid price. This level of gross profit is sufficient to generate a reasonable profit after covering selling and administrative costs. In more competitive circumstances such as when the company has too much unused capacity bid prices may be set lower to increase the likelihood http://www.greatplains .com

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of successful bids. If the company has little unused capacity it may set bid prices somewhat higher so that the likelihood of successfully bidding on too many con- tracts is reduced. To help in establishing the bid price on the hull for the floating platform Island Marine’s cost accountant provided the vice president of sales with the budgeted cost information shown earlier in Exhibit 5–4. The vice president of sales believed that a bid price slightly above normal levels was possible because of the non- competitive nature of this particular market. Accordingly the vice president set the sales price to yield a gross margin of roughly 30.3 percent 21000000 14630000 21000000. This sales price was agreed to by the customer in a contract dated March 25 2000. Island Marine’s managers scheduled the job to begin on June 5 2000 and to be completed by July 1 2001. The job is assigned the num- ber 323 for identification purposes. The following journal entries illustrate the flow of costs for the Cutting Form- ing Department of Island Marine during June 2000. Work on several contracts in- cluding Job 323 was performed in Cutting Forming during that month. In entries 1 2 and 4 that follow separate WIP inventory accounting is shown for costs related to Job 323 and to other jobs. In practice the Work in Process control account for a given department would be debited only once for all costs assigned to it. The details for posting to the individual job cost records would be presented in the journal entry explanations. All amounts are shown in thousands of dollars. 1. During June 2000 material requisition forms 340–355 indicated that 2925 of raw materials were issued from the warehouse to the Cutting Forming Department. This amount included 1982 of direct materials used on Job 323 and 723 of direct materials used on other jobs. The remaining 120 of raw materials issued during June were indirect materials. Chapter 5 Job Order Costing 185 Project Management Library ❏ Instructions on how to use the project intranet site ❏ Project manager manuals ❏ Policy and procedure manuals ❏ Templates and forms ❏ Project management training exercises General Project Information ❏ Project descriptions ❏ Photos of project progress ❏ Contract information ❏ Phone and e-mail directories ❏ Project team rosters ❏ Document control logs ❏ Scope documents ❏ Closure documents ❏ Links to project control tools ❏ Links to electronic document retrieval systems Technical Information ❏ Drawing logs ❏ Detailed budgets and physical estimates ❏ Specifications ❏ Bill of materials by department ❏ Punch lists ❏ Links to drawing databases Management Information ❏ Meeting minutes ❏ Daily logs ❏ Project schedules ❏ Task and resource checklists ❏ Shutdown and look-ahead reports ❏ Work-hour estimates ❏ Change notices ❏ Labor hours worked ❏ Earned value Financial Information ❏ Project cost sheet ❏ Funding requests for each cost account ❏ Cash flow projections and budgets ❏ Original cost budgets and adjustments ❏ Contract status reports ❏ Departmental budget reports ❏ Links to mainframe sessions for requisitions and purchase order tracking ❏ Companywide financial statements EXHIBIT 5–6 Project Management Site Content SOURCE: Lawrence Barkowski “Intranets for Project and Cost Management in Manufacturing” Cost Engineering June 1999 p. 36. Reprinted with permission of AACE International 209 Prairie Ave. Suite 100 Morgantown WV 25601 USA. Internet: E-mail:

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Work in Process Inventory—Cutting Forming Job 323 1982 Work in Process Inventory—Cutting Forming other jobs 723 Manufacturing Overhead—Cutting Forming indirect materials 120 Raw Material Inventory 2825 To record direct and indirect materials issued per requisitions during June. 2. The June time sheets and payroll summaries for the Cutting Forming Depart- ment nonsalaried workers were used to trace direct and indirect labor to that department. Total labor cost for the Cutting Forming Department for June was 417. Job 323 required 310 of direct labor cost combining the two bi- weekly pay periods in June. The remaining jobs in process required 45 of direct labor cost and indirect labor cost for the month totaled 32. Work in Process Inventory—Cutting Forming Job 323 310 Work in Process Inventory—Cutting Forming other jobs 45 Manufacturing Overhead—Cutting Forming indirect labor 32 Wages Payable 387 To record wages associated with Cutting Forming during June. 3. The Cutting Forming Department incurred overhead costs in addition to in- direct materials and indirect labor during June. Factory building and equip- ment depreciation of 65 was recorded for April. Insurance on the factory building 12 for the month had been prepaid and had expired. The 88 bill for June factory utility costs was received and would be paid in July. Repairs and maintenance costs of 63 were paid in cash. Overhead costs of 27 for items such as supplies used supervisors’ salaries and so forth were incurred these costs are credited to “Various accounts” for illustrative purposes. The fol- lowing entry summarizes the accumulation of these other actual overhead costs for June. Manufacturing Overhead—Cutting Forming 255 Accumulated Depreciation 65 Prepaid Insurance 12 Utilities Payable 88 Cash 63 Various accounts 27 To record actual overhead costs of the Cutting Forming Department during June exclusive of indirect materials and indirect nonsalaried labor. 4. Island Marine prepares financial statements at month end. To do so Work in Process Inventory must include all production costs: direct material direct labor and overhead. The company allocates overhead to the Cutting Forming Work in Process Inventory based on two predetermined overhead rates: 25 per direct labor hour and 45 per machine hour. In June the employees committed 6200 hours of direct labor time to Job 323 and 3000 machine hours were consumed on that job. The other jobs worked on during the month received total applied overhead of 88000 1000 direct labor hours assumed 25 plus 1400 machine hours assumed 45. Work in Process Inventory—Cutting Forming Job 323 290 Work in Process Inventory—Cutting Forming other jobs 88 Manufacturing Overhead—Cutting Forming 378 To apply overhead to Cutting Forming work in process for June using predetermined application rates. Notice that the amount of actual overhead for June 120 32 255 407 in the Cutting Forming Department is not equal to the amount of over- head applied to that department’s Work in Process Inventory 378. This 29 Part 2 Systems and Methods of Product Costing 186

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difference is the underapplied overhead for the month. Because the predeter- mined rates were based on annual estimates differences in actual and applied overhead accumulate during the year. Underapplied or overapplied overhead will be closed at year-end as shown in Chapter 3 to either Cost of Goods Sold if the amount is immaterial or to Work in Process Inventory Finished Goods Inventory and Cost of Goods Sold if the amount is material. The preceding entries for the Cutting Forming Department would be simi- lar to the entries made in each of the other departments of Island Marine. Direct material and direct labor data are posted to each job order cost sheet frequently usually daily entries are posted to the general ledger control accounts for longer intervals usually monthly. Job 323 will be executed by three departments of Island Marine. Other jobs accepted by the company may involve a different combination of departments and different conversion operations within departments. In this company jobs flow con- secutively from one department to the next. In other types of job shops different departments may work on the same job concurrently. Similar entries for Job 323 are made throughout the production process and Exhibit 5–7 shows the cost sheet at the job’s completion. Note that direct material requisitions direct labor cost and applied overhead shown previously in entries 1 2 and 4 are posted on the job cost sheet. Other entries are not detailed. When the job is completed its costs are transferred to Finished Goods Inven- tory. The journal entries related to completion and sale are as follows: Finished Goods Inventory—Job 323 14283 Work in Process Inventory—Cutting Forming 8289 Work in Process Inventory—Welding Assembly 4153 Work in Process Inventory—Painting Finishing 1841 Cost of Goods Sold—Job 323 14283 Finished Goods Inventory—Job 323 14283 Accounts Receivable—Dolphin Petroleum Co. 21000 Sales 21000 The completed job order cost sheet can be used by managers in all depart- ments to determine how well costs were controlled. Overall costs were below the budgeted level. The Cutting Forming Department experienced lower costs than budgeted in all categories except machine-related overhead. In the Welding As- sembly Department actual direct material costs were well below budget. However direct labor costs were above budget and this caused labor-related overhead to be above budget. Machine-related overhead was significantly below budget. Painting and Finishing costs overall were significantly below budget. Only machine-related overhead exceeded the budgeted amount. Summarizing costs were well controlled on this job because total actual costs were substantially below the budgeted amounts approximately 2.37 percent below budget. In the remainder of the chapter the use of job order costing data to support management decision making and improve cost control is discussed. The next sec- tion discusses how standard costs rather than actual costs can be used to improve cost management. Chapter 5 Job Order Costing 187 JOB ORDER COSTING USING STANDARD COSTS The Island Marine example illustrates the use of actual historical cost data for direct material and direct labor in a job order costing system. However using actual direct material and direct labor costs may cause the costs of similar units to fluctuate from period to period or job to job because of changes in component costs. Use of How are standard costs used in a job order costing system 7

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standard costs for direct material and direct labor can minimize the effects of such cost fluctuations in the same way that predetermined rates do for overhead costs. A standard cost system determines product cost by using in the inventory accounts predetermined norms for prices and/or quantities of component ele- ments. After production is complete the standard production cost is compared to the actual production cost to determine the efficiency of the production process. A difference between the actual quantity price or rate and its related standard is called a variance. Part 2 Systems and Methods of Product Costing 188 Job Number 323 Customer Name and Address: Description of Job: Dolphin Petroleum Co. Hull for floating rig 9901 La. Freeway Per specifications in bid agreement 913 New Orleans LA dated 2/01/00 Contract Agreement Date: 3/25/00 Scheduled Starting Date: 6/5/00 Agreed Completion Date: 7/01/01 Contract Price 21000000 Actual Completion Date: Delivery Instructions: Floating: ICW at New Orleans CUTTING FORMING OVERHEAD BASED ON DIRECT MATERIALS DIRECT LABOR OF LABOR HOURS OF MACHINE HOURS EST. 6140000 EST. 1100000 EST. 500000 EST. 750000 Date Source Amount Date Source Amount Date Source Amount Date Source Amount 6/30 MR 340 1982 6/30 payroll 310 6/30 payroll 155 6/30 Machine 135 MR 355 hour meters WELDING ASSEMBLY SAME FORMAT AS ABOVE BUT WITH DIFFERENT OH RATES PAINTING FINISHING SAME FORMAT AS ABOVE BUT WITH DIFFERENT OH RATES SUMMARY THOUSANDS OF DOLLARS CUTTING FORMING WELDING ASSEMBLY PAINTING FINISHING Actual Budget Actual Budget Actual Budget Direct materials 6056 6140 1134 1200 380 400 Direct labor 1010 1100 2120 2100 650 700 Overhead labor 460 500 420 400 430 450 Overhead machine 763 750 479 520 381 370 Totals 8289 8490 4153 4220 1841 1920 Actual Budget Final Costs: Cutting Forming 8289 8490 Welding Assembly 4153 4220 Painting Finishing 1841 1920 Totals 14283 14630 EXHIBIT 5–7 Island Marine’s Completed Job Order Cost Sheet standard cost system variance

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Standards can be used in a job order system only if a company typically en- gages in jobs that produce fairly similar products. One type of standard job order costing system uses standards only for input prices of material and/or rates for la- bor. This process is reasonable if all output relies on basically the same kinds of material and/or labor. If standards are used for price or rate amounts only the debits to Work in Process Inventory become a combination of actual and standard information: actual quantities at standard prices or rates. Jones Brothers a house-painting company located in Indiana illustrates the use of price and rate standards. Management has decided that because of the cli- mate one specific brand of paint costing 30 per gallon is the best to use. Painters employed by the company are paid 12 per hour. These two amounts can be used as price and rate standards for Jones Brothers. No standards can be set for the quantity of paint that will be used on a job or the amount of time the job will re- quire because those items will vary with the quantity and texture of wood on the structure and the size of the structure being painted. Assume that Jones Brothers paints a house requiring 50 gallons of paint and 80 hours of labor time. The standard paint and labor costs respectively are 1500 50 30 and 960 80 12. Assume Jones Brothers bought the paint when it was on sale so the actual price paid was 27 per gallon or a total of 1350. Comparing this price to the standard results in a 150 favorable material price vari- ance 50 gallons at 3 per gallon. If the actual labor rate paid to painters was 11 per hour there would be an 80 favorable 80 hours at 1 per hour labor rate variance. Other job order companies produce output that is homogeneous enough to allow standards to be developed for both quantities and prices for material and labor. Such companies usually use distinct production runs for numerous similar products. In such circumstances the output is homogeneous for each run unlike the heterogeneous output of Jones Brothers. Green Manufacturing Inc. is a job order manufacturer that uses both price and quantity material and labor standards. Green manufactures wooden flower boxes that are retailed through several chains of garden supply stores. The boxes are contracted for on a job order basis because the retailing chains tend to demand changes in style color and size with each spring gardening season. Green pro- duces the boxes in distinct production runs each month for each retail chain. Price and quantity standards for direct material and direct labor have been established and are used to compare the estimated and actual costs of monthly production runs for each type of box produced. The standards set for boxes sold to Mountain Gardens are as follows: 8 linear feet of 1” 10” redwood plank at 0.60 per linear foot 1.4 direct labor hours at 9 per direct labor hour In June 2000 boxes were produced for Mountain Gardens. Actual wood used was 16300 linear feet which was purchased at 0.58 per linear foot. Direct labor em- ployees worked 2700 hours at an average labor rate of 9.10. From this information it can be concluded that Green used 300 linear feet of redwood above the standard quantity for the job 16300 8 2000. This us- age causes an unfavorable material quantity variance of 180 at the 0.60 standard price 0.60 300 linear feet. The actual redwood used was purchased at 0.02 below the standard price per linear foot which results in a 326 0.02 16300 favorable material price variance. The actual DLHs used were 100 less than standard 2700 1.4 hours 2000 which results in a favorable labor quantity variance of 900 9 standard rate 100 hours. The work crew earned 0.10 per hour above standard which translates to a 270 unfavorable labor rate variance 0.10 2700. A summary of variances follows: Chapter 5 Job Order Costing 189

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Direct material quantity variance 180 unfavorable Direct material price variance 326 favorable Direct labor quantity variance 900 favorable Direct labor rate variance 270 unfavorable Net variance cost less than expected 776 favorable From a financial perspective Green controlled its total material and labor costs well on the Mountain Garden job. Variances can be computed for actual-to-standard differences regardless of whether standards have been established for both quantities and prices or for prices/rates only. Standard costs for material and labor provide the same types of benefits as predetermined overhead rates: more timely information and compar- isons against actual amounts. A predetermined overhead rate is in essence a type of standard. It establishes a constant amount of overhead assignable as a component of product cost and eliminates any immediate need for actual overhead information in the calculation of product cost. More is presented on standards and variances in Chapter 10. Standard cost job order systems are reasonable substitutes for actual or nor- mal costing systems as long as the standard cost systems provide managers with useful information. Any type of product costing system is acceptable in practice if it is effective and efficient in serving the company’s unique production needs pro- vides the information desired by management and can be implemented at a cost that is reasonable when compared to the benefits to be received. These criteria apply equally well to both manufacturers and service companies. Part 2 Systems and Methods of Product Costing 190 JOB ORDER COSTING TO ASSIST MANAGERS Managers are interested in controlling costs in each department as well as for each job. Actual direct material direct labor and factory overhead costs are accumu- lated in departmental accounts and are periodically compared to budgets so that managers can respond to significant deviations. Transactions must be recorded in a consistent complete and accurate manner to have information on actual costs available for periodic comparisons. Managers may stress different types of cost con- trol in different types of businesses. The major difference in job order costing for a service organization and a man- ufacturing firm is that most service organizations use an insignificant amount of materials relative to the value of labor for each job. In such cases direct material may be treated for the sake of convenience as part of overhead rather than ac- counted for separately. A few service organizations such as in the medical indus- try may use some costly materials. Accountants in some service companies may trace only direct labor to jobs and allocate all other production costs. These cost allocations may be accomplished most effectively by using a predetermined rate per direct labor hour or per direct labor dollar. Other cost drivers may also be used as possible overhead allocation bases. Knowing the costs of individual jobs allows managers to better estimate future job costs and establish realistic bids and selling prices. The use of budgets and standards in a job order costing system provides information against which actual costs can be compared at regular time intervals for control purposes. These com- parisons can also furnish some performance evaluation information. The following two examples demonstrate the usefulness of job order costing to managers. Custom Systems: An Illustration of Job Costing Information Custom Systems is an engineering firm that specializes in concrete structures. The firm has a diverse set of clients and types of jobs. Josh Bradley is the founder and president. Mr. Bradley wants to know which clients are the most profitable and which How does information from a job order costing system support management decision making 8

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Chapter 5 Job Order Costing 191 Periodically comparing actual to budgeted costs for a job will help managers engage in ongoing cost control activities. Waiting to make such a comparison until job completion provides information that can impact future jobs but not the one just finished. are the least profitable. To determine this information he requested a breakdown of profits per job measured on both a percentage and an absolute dollar basis. Mr. Bradley discovered that the company did not maintain records of costs per client-job. Costs had been accumulated only by type—travel entertainment and so forth. Ms. Tobias the sales manager was certain that the largest profits came from the company’s largest accounts. A careful job cost analysis found that the largest accounts contributed the most revenue to the firm but the smallest per- centage and absolute dollars of incremental profits. Until the president requested this information no one had totaled the costs of recruiting each client or the travel entertainment and other costs associated with maintaining each client. A company that has a large number of jobs that vary in size time or effort may not know which jobs are responsible for disproportionately large costs. Job order costing can assist in determining which jobs are truly profitable and can help managers to better monitor costs. As a result of the cost analysis Mr. Bradley changed the company’s marketing strategy. The firm began concentrating its ef- forts on smaller clients who were located closer to the primary office. These ef- forts caused profits to substantially increase because significantly fewer costs were incurred for travel and entertainment. A job order costing system was implemented to track the per-period and total costs associated with each client. Unprofitable ac- counts were dropped and account managers felt more responsibility to monitor and control costs related to their particular accounts. Monihan’s Boatworks Monihan’s Boatworks manufactures three types of boats to customer specifications. 8 Before job order costing was instituted the managers had no means of determining 8 This example is based on an article by Leonard A. Robinson and Loudell Ellis Robinson “Steering a Boat Maker Through Cost Shoals” Management Accounting January 1983 pp. 60–66.

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the costs associated with the production of each type of boat. When a customer provided yacht specifications and asked what the selling price would be managers merely estimated costs in what they felt was a reasonable manner. In fact during the construction process no costs were assigned to Work in Process Inventory all production costs were sent to Finished Goods Inventory. After implementing a job order costing system Monihan’s Boatworks had bet- ter control over its inventory better inventory valuations for financial statements and better information with which to prevent part stockouts not having parts in inventory and production stoppages. The job order costing system provided man- agers with information on what work was currently in process and at what cost. From this information they were better able to judge whether additional work could be accepted and when current work would be completed. Because job or- der costing assigns costs to Work in Process Inventory balance sheet figures were more accurate. As material was issued to production the use of material requisi- tion forms produced inventory records that were more current and reflective of raw material quantities on hand. Finally the use of a job order costing system gave managers an informed means by which to estimate costs and more adequately price future jobs. Whether an entity is a manufacturer or service organization that tailors its output to customer specifications company management will find that job order costing techniques will help in the managerial functions. This cost system is useful for de- termining the cost of goods produced or services rendered in companies that are able to attach costs to specific jobs. As product variety increases the size of pro- duction lots for many items shrinks and job order costing becomes more applic- able. Custom-made goods may become the norm rather than the exception in an environment that relies on flexible manufacturing systems and computer-integrated manufacturing. Part 2 Systems and Methods of Product Costing 192 Aker Gulf Marine REVISITING ker Gulf Marine is a relatively young firm having been established in 1991. The firm is typical of many new businesses formed today in that it is a partner- ship of two larger older firms: Aker Maritime and Peter Kiewit Sons’ Inc. AGM is a successful company compet- ing in a cyclical industry. To keep operations profitable and functioning near capacity the company must continu- ally find ways to differentiate itself from competitors. To successfully bid projects the firm must carefully monitor and control costs. In part this requires managers to achieve high levels of quality minimize waste and scrapped materials utilize recycled materials and main- tain a clean safe work environment. Safety is a crucial is- sue both from a cost and personnel perspective because risks of injury to employees is inherently high in rig con- struction. The company has implemented several success- ful programs to involve employees in safety and quality training. AGM has also invested heavily in capital equipment to leverage technology. Recently the firm built a facility to house certain production operations such as painting that are sensitive to weather effects. Also the company has built a massive specialized lifting device that domi- nates the Corpus Christi Bay skyline. This lifting device is capable of moving 4800-ton product components from the land-based construction yard to the firm’s dockage on the intracoastal waterway. Today AGM’s products can be found offshore in the Gulf of Mexico West Africa and South America. SOURCES: Discussions with company personnel Anonymous “Aker Gulf Marine” A

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Chapter 5 Job Order Costing 193 A cost accounting system should be compatible with the manufacturing environ- ment in which it is used. Job order costing and process costing are two traditional cost accounting systems. Job order costing is used in companies that make a lim- ited quantity of products or provide a limited number of services uniquely tailored to customer specifications. This system is especially appropriate and useful for many service businesses such as advertising legal and architectural firms. Process costing is appropriate in production situations in which large quantities of homo- geneous products are manufactured on a continuous flow basis. A job order costing system considers the “job” as the cost object for which costs are accumulated. A job can consist of one or more units of output and job costs are accumulated on a job order cost sheet. Job order cost sheets for un- completed jobs serve as the Work in Process Inventory subsidiary ledger. Cost sheets for completed jobs not yet delivered to customers constitute the Finished Goods Inventory subsidiary ledger and cost sheets for completed and sold jobs compose the Cost of Goods Sold subsidiary ledger. In an actual or a normal cost job order system direct material and direct la- bor are traced respectively using material requisition forms and employee time sheets to individual jobs in process. Service companies may not attempt to trace direct material to jobs but instead consider the costs of direct material to be part of overhead. Tracing is not considered necessary when the materials cost is in- significant in relation to the job’s total cost. Technology is playing an increasing role in aiding the management of jobs and in tracking job costs. Even basic accounting software typically has a job costing module. By automating the data entry processes more accurate and timely data are gathered and employees are relieved of the recurring burden of logging data. The latest technology being adopted in job shops is project management software. These programs allow operational and financial data about jobs to be shared throughout the firm. Intranets are being created to facilitate the dissemination of this information. In an actual cost system actual overhead is assigned to jobs. More commonly however a normal costing system is used in which overhead is applied using one or more predetermined overhead rates multiplied by the actual activity bases in- curred. Overhead is applied to Work in Process Inventory at the end of the month or when the job is complete whichever is earlier. Standard costing can be utilized in a job shop environment. Standards may be established both for the quantities of production inputs and the prices of those in- puts. By using standard costs rather than actual costs managers have a basis for evaluating the efficiency of operations. Differences between actual costs and stan- dard costs are captured in variance accounts. By analyzing the variances managers gain an understanding of the factors that cause costs to differ from the expected amounts. Standard costing is most easily adopted in job shops that routinely pro- duce batches of similar products. Job order costing assists management in planning controlling decision mak- ing and evaluating performance. It allows managers to trace costs associated with specific current jobs to better estimate costs for future jobs. Additionally managers using job order costing can better control the costs associated with current pro- duction especially if comparisons with budgets or standards are used. Attachment of costs to jobs is also necessary to price jobs that are contracted on a cost-plus basis. Last because costs are accumulated by jobs managers can more readily de- termine which jobs or types of jobs are most profitable to the organization. CHAPTER SUMMARY

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Part 2 Systems and Methods of Product Costing 194 KEY TERMS cost-plus contract p. 181 employee time sheet p. 179 intranet p. 184 job p. 176 job order cost sheet p. 179 job order costing system p. 174 material requisition form p. 178 process costing system p. 174 standard cost system p. 188 variance p. 188 Basic Journal Entries in a Job Order Costing System Raw Material Inventory XXX Accounts Payable XXX To record the purchase of raw materials. Work in Process Inventory—Dept. Job XXX Manufacturing Overhead XXX Raw Material Inventory XXX To record the issuance of direct and indirect materials requisitioned for a specific job. Work in Process Inventory—Dept. Job XXX Manufacturing Overhead XXX Wages Payable XXX To record direct and indirect labor payroll for production employees. Manufacturing Overhead XXX Various accounts XXX To record the incurrence of actual overhead costs. Account titles to be credited must be specified in an actual journal entry. Work in Process Inventory—Dept. Job XXX Manufacturing Overhead XXX To apply overhead to a specific job. This may be actual OH or OH applied using a predetermined rate. Predetermined OH is applied at job completion or end of period whichever is earlier. Finished Goods Inventory Job XXX Work in Process Inventory XXX To record the transfer of completed goods from WIP to FG. Accounts Receivable XXX Sales XXX To record the sale of goods on account. Cost of Goods Sold XXX Finished Goods Inventory XXX To record the cost of the goods sold. SOLUTION STRATEGIES Advanced Exploration is a newly formed firm that conducts marine research in the Gulf of Mexico for contract customers. Organizationally the firm is composed of two departments: Offshore Operations and Lab Research. The Offshore Operations DEMONSTRATION PROBLEM

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Chapter 5 Job Order Costing 195 Department is responsible for gathering test samples and drilling operations on the ocean floor. The Lab Research Department is responsible for analysis of samples and other data gathered by Offshore Operations. In its first month of operations March 2001 Advanced Exploration obtained contracts for three research projects: Job 1: Drill collect and analyze samples from 10 sites for a major oil company. Job 2: Collect and analyze samples for specific toxins off the coast of Louisiana for the U.S. government. Job 3: Evaluate 12 existing offshore wells for the presence of oil seepage for a major oil company. Advanced Exploration contracts with its customers on a cost-plus basis that is the price charged is equal to costs plus a profit equal to 10 percent of costs. The firm uses a job order costing system based on normal costs. Overhead is applied in the Offshore Operations Department at the predetermined rate of 2000 per hour of research vessel use RVH. In the Lab Research Department overhead is applied at the predetermined rate of 45 per professional labor hour PLH. For March 2001 significant transactions are summarized here: 1. Materials and test components were purchased on account: 110000. 2. Materials were requisitioned for use in the three research projects by the Offshore Operations Department all of these materials are regarded as direct: Job 1— 40000 Job 2—28000 and Job 3—10000. Materials were issued to the Lab Research Department: Job 1—8000 Job 2—6000 and Job 3—4500. 3. The time sheets and payroll summaries indicated the following direct labor costs were incurred: Offshore Operations Lab Research Job 1 60000 56000 Job 2 50000 20000 Job 3 45000 16000 4. Indirect research costs were incurred in each department: Offshore Operations Lab Research Labor 120000 10000 Utilities/Fuel 290000 5000 Depreciation 330000 80000 5. Overhead was applied based on the predetermined overhead rates in effect in each department. Offshore Operations had 360 RVHs 170 RVHs on Job 1 90 RVHs on Job 2 and 100 RVHs on Job 3 and Lab Research worked 2300 PLHs 1400 PLHs on Job 1 500 PLHs on Job 2 and 400 PLHs on Job 3 for the year. 6. Job 1 was completed and cash was collected for the agreed-on price of cost plus 10 percent. At the end of the month Jobs 2 and 3 were only partially complete. 7. Any underapplied or overapplied overhead is assigned to Cost of Goods Sold. Required: a. Record the journal entries for transactions 1 through 7. b. As of the end of March 2001 determine the total cost assigned to Jobs 2 and 3. Solution to Demonstration Problem a. 1. Raw Material Inventory 110000 Accounts Payable 110000 To record purchase of materials.

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2. WIP Inventory—Offshore Operations Job 1 40000 WIP Inventory—Offshore Operations Job 2 28000 WIP Inventory—Offshore Operations Job 3 10000 Raw Material Inventory 78000 To record requisition and issuance of materials to Offshore Operations. WIP Inventory—Lab Research Job 1 8000 WIP Inventory—Lab Research Job 2 6000 WIP Inventory—Lab Research Job 3 4500 Raw Material Inventory 18500 To record requisition and issuance of materials to Lab Research. 3. WIP Inventory—Offshore Operations Job 1 60000 WIP Inventory—Offshore Operations Job 2 50000 WIP Inventory—Offshore Operations Job 3 45000 Wages Payable 155000 To record direct labor costs for Offshore Operations. WIP Inventory—Lab Research Job 1 56000 WIP Inventory—Lab Research Job 2 20000 WIP Inventory—Lab Research Job 3 16000 Wages Payable 92000 To record direct labor costs for Lab Research. 4. Research Overhead—Offshore Operations 740000 Research Overhead—Lab Research 95000 Wages Payable 130000 Utilities/Fuel Payable 295000 Accumulated Depreciation 410000 To record indirect research costs. 5. WIP Inventory—Offshore Operations Job 1 340000 WIP Inventory—Offshore Operations Job 2 180000 WIP Inventory—Offshore Operations Job 3 200000 Research Overhead—Offshore Operations 720000 To record application of research overhead. WIP Inventory—Lab Research Job 1 63000 WIP Inventory—Lab Research Job 2 22500 WIP Inventory—Lab Research Job 3 18000 Research Overhead—Lab Research 103500 To record application of research overhead. 6. Finished Goods Inventory 567000 WIP Inventory—Offshore Operations 440000 WIP Inventory—Lab Research 127000 To record completion of Job 1. Cash 623700 Research Revenues 623700 To record sale of Job 1. Cost of Goods Sold 567000 Finished Goods Inventory 567000 To record cost of sales for Job 1. 7. Cost of Goods Sold 11500 Research Overhead—Lab Research 8500 Research Overhead—Offshore Operations 20000 To assign underapplied and overapplied overhead to cost of goods sold. Job 1 costs 40000 8000 60000 56000 340000 63000 567000 Revenue Job 1 567000 1.10 623700 Part 2 Systems and Methods of Product Costing 196

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b. Job 2 Job 3 Direct material—Offshore Operations 28000 10000 Direct labor—Offshore Operations 50000 45000 Research overhead—Offshore Operations 180000 200000 Direct material—Lab Research 6000 4500 Direct labor—Lab Research 20000 16000 Research overhead—Lab Research 22500 18000 Totals 306500 293500 Chapter 5 Job Order Costing 197 1. When a company produces custom products to the specifications of its cus- tomers why should it not aggregate costs across customer orders to determine the prices to be charged 2. What production conditions are necessary for a company to use job order costing 3. What is the alternative to the use of a job order costing system In what type of production environment would this alternative costing system be found 4. Identify the three valuation methods discussed in the chapter. What are the differences among these methods 5. In a job order costing system what is a job 6. What are the three stages of production of a job Of what use is cost infor- mation pertaining to completed jobs 7. What are the principal documents used in a job order costing system and what are their purposes 8. Why is the material requisition form an important document in a company’s audit trail 9. What is a job order cost sheet and what information does it contain How do job order cost sheets relate to control accounts for Work in Process Finished Goods and Cost of Goods Sold 10. Of what use to management are job order cost sheets Why do some job or- der cost sheets contain columns for both budgeted and actual costs 11. “Because the costs of each job are included in the job order cost sheet they do not need to be recorded in the general ledger.” Is this statement true or false and why 12. Which document in a job order costing system would show the amount of overtime worked by a specific individual Explain. 13. Is an actual overhead application rate better than a predetermined overhead rate Why or why not 14. What creates underapplied or overapplied overhead when applying overhead to jobs 15. What is the principal difference in job order costing between service and manu- facturing firms 16. How is the cost of goods sold determined in a company that uses job order costing 17. How are the advancement of technology and the development of new soft- ware affecting the accounting function in job order costing systems 18. Many software companies produce custom programs for computerized ac- counting applications. Search the Internet and find two or more companies that make software for job order costing job costing. Read the ads and de- scriptions of the job order costing software and identify five of the most im- portant capabilities or modules that the software company offers. Write one QUESTIONS

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to two pages describing how these modules might be used in a company that custom manufactures robotic equipment used in manufacturing applications. 19. What differences exist between job order costing based on actual costs and job order costing based on standard costs Why would a company use a stan- dard cost job order system 20. If a company produces a given type of product only one time will standard costing be as useful as if the company continually produces the same type of product Explain. 21. How does a firm use information on “variances” in a standard costing system to control costs 22. How can the implementation of a job order costing system help improve man- agerial decision making Part 2 Systems and Methods of Product Costing 198 23. Classifying For each of the following firms determine whether it is more likely to use job order or process costing. This firm a. does custom printing. b. manufactures paint. c. is involved in landscape architecture. d. is an automobile repair shop. e. provides public accounting services. f. manufactures hair spray and hand lotion. g. is a hospital. h. cans vegetables and fruits. i. designs custom software. j. provides property management services for a variety of real estate develop- ments. 24. Journal entries Olson Inc. produces custom-made floor tiles. During June 2001 the following information was obtained relating to operations and production: 1. Direct material purchased on account 85000. 2. Direct material issued to jobs 81900. 3. Direct labor hours incurred 1700. All direct factory employees were paid 18 per hour. 4. Actual factory overhead costs incurred for the month totaled 41100. This overhead consisted of 9000 of supervisory salaries 17500 of deprecia- tion charges 3600 of insurance 6250 of indirect material and 4750 of utilities. Salaries insurance and utilities were paid in cash and indirect material was removed from the supplies account. 5. Overhead is applied to production at the rate of 25 per direct labor hour. The beginning balances of Raw Material Inventory and Work in Process Inventory were 4150 and 11150 respectively. The ending balance in Work in Process Inventory was 2350. a. Prepare journal entries for the above transactions. b. Determine the balances in Raw Material Inventory and Work in Process Inventory at the end of the month. c. Determine the cost of the goods completed during June. If 5000 similar units were completed what was the cost per unit d. What is the amount of underapplied or overapplied overhead at the end of June 25. Journal entries cost flows U Store It produces customized storage buildings that serve the midwest U.S. market. For February 2001 the company incurred the following costs: EXERCISES

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Direct material purchased on account 19000 Direct material used for jobs Job 217 11200 Job 218 1800 Other jobs 13400 26400 Direct labor costs for month Job 217 2600 Job 218 3500 Other jobs 4900 11000 Actual overhead costs for February 18900 The February beginning balance in Work in Process Inventory was 4200 which consisted of 2800 for Job 217 and 1400 for Job 218. The Febru- ary beginning balance in Direct Material Inventory was 12300. Actual overhead is applied to jobs on the basis of direct labor cost. Job 217 was completed and transferred to finished goods during February. It was then sold for cash at 140 percent of cost. a. Prepare journal entries to record the above information. b. Determine the February ending balance in Work in Process Inventory and the amount of the balance related to Job 218. 26. Cost flows Custom Landscapes began operations on March 1 2001. Its Work in Process Inventory account on March 31 appeared as follows: Work in Process Inventory Direct material 554400 Cost of completed jobs Direct labor 384000 Applied overhead 345600 The company applies overhead on the basis of direct labor cost. Only one job was still in process on March 31. That job had 132600 in direct material and 93600 in direct labor cost assigned to it. a. What was the predetermined overhead application rate b. How much cost was transferred out for jobs completed during March 27. Normal versus actual costing For fiscal year 2001 Lazlow Metalworks esti- mated it would incur total overhead costs of 1200000 and work 40000 ma- chine hours. During January 2001 the company worked exclusively on one job Job 1211. It incurred January costs as follows: Direct material usage 121000 Direct labor 1400 hours 30800 Manufacturing overhead: Rent 11200 Utilities 15200 Insurance 32100 Labor 15500 Depreciation 23700 Maintenance 10800 Total OH 108500 Machine hours worked in January: 3400 a. Assuming the company uses an actual cost system compute the January costs assigned to Job 1211. b. Assuming the company uses a normal cost system compute the January costs assigned to Job 1211. c. What is the major factor driving the difference between your answers in parts a and b Chapter 5 Job Order Costing 199

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As the accountant of Integrated Solutions you must find the following: a. Cost of goods sold for the year. b. Cost of goods completed during the year. c. Cost of direct material used during the year. d. Amount of applied factory overhead during the year. e. Cost of direct material purchased during the year. 29. Departmental overhead rates Ashford Paving Company uses a predetermined overhead rate to apply overhead to jobs and the company employs a job or- der costing system. Overhead is applied to jobs in the Mixing Department based on the number of machine hours used whereas Paving Department overhead is applied on the basis of direct labor hours. In December 2000 the company estimated the following data for its two departments for 2001: Mixing Department Paving Department Direct labor hours 1000 3500 Machine hours 7500 1500 Budgeted overhead cost 60000 98000 a. Compute the predetermined overhead rate that should be used in each de- partment of the Ashford Paving Company. b. Job 116 was started and completed during March 2001. The job cost sheet shows the following information: Mixing Department Paving Department Direct material 5800 700 Direct labor cost 60 525 Direct labor hours 12 60 Machine hours 80 22 c. Compute the overhead applied to Job 116 for each department and in total. d. If the company had computed a companywide rate for overhead rather than departmental rates do you feel that such a rate would be indicative of the actual overhead cost of each job Explain. Part 2 Systems and Methods of Product Costing 200 Direct Material Inventory Beg. bal. 6150 Purchases 2050 Finished Goods Inventory Beg. bal. 22500 Goods completed 342500 21000 Work in Process Inventory Beg. bal. 14000 Direct mat. Direct labor 45000 Overhead 12000 Cost of Goods Sold 28. Cost flows Integrated Solutions manufactures hardware for local-area networks. The firm applies overhead to jobs at a rate of 120 percent of direct labor cost. On December 31 2001 a flood destroyed many of the firm’s computerized cost records. Only the following information for 2001 was available from the records:

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30. Job cost and pricing Jason Hart is an attorney who employs a job order cost- ing system related to his client engagements. Hart is currently working on a case for Janice Keene. During the first four months of 2001 Hart logged 85 hours on the Keene case. In addition to direct hours spent by Hart his secretary has worked 14 hours typing and copying 126 pages of documents related to the Keene case. Hart’s secretary works 160 hours per month and is paid a salary of 1800 per month. The average cost per copy is 0.04 for paper toner and machine rental. Telephone charges for long-distance calls on the case totaled 165.50. Last Hart has estimated that total office overhead for rent utilities parking and so on amount to 7200 per month and that during a normal month he is at the office 120 hours. a. Hart feels that his time at a minimum is worth 40 per hour and he wishes to cover all direct and allocated indirect costs related to a case. What minimum charge per hour rounded to the nearest dollar should Hart charge Keene Hint: Include office overhead. b. All the hours that Hart spends at the office are not necessarily billable hours. In addition Hart did not take into consideration certain other ex- penses such as license fees country club dues automobile costs and other miscellaneous expenses when he determined the amount of overhead per month. Therefore to cover nonbillable time as well as other costs Hart feels that billing each client for direct costs plus allocated indirect costs plus 50 percent margin on his time and overhead is reasonable. What will Hart charge Keene in total for the time spent on her case 31. Underapplied or overapplied overhead For 2001 Ainsworth Rafter Co. applied overhead to jobs using a predetermined overhead rate of 23.20 per machine hour. This rate was derived by dividing the company’s total budgeted over- head of 556800 by the 24000 machine hours anticipated for the year. At the end of 2001 the company’s manufacturing overhead control ac- count had debits totaling 562600. Actual machine hours for the year totaled 24900. a. How much overhead should be debited to Work in Process Inventory for 2001 b. Is overhead underapplied or overapplied and by how much c. Job 47 consumed 750 machine hours during 2001. How much overhead should be assigned to this job for the year d. Describe the disposition of the underapplied or overapplied overhead de- termined in part b. 32. Assigning costs to jobs Westside Racing uses a job order costing system in which overhead is applied to jobs at a predetermined rate of 2.20 per direct labor dollar. During April 2001 the company spent 13900 on direct labor re- lated to Job 344. In addition the company incurred direct material costs of 24800 on this job during the month. Budgeted factory overhead for the com- pany for the year was 660000. a. Give the journal entry to apply overhead to all jobs if April’s total direct labor cost was 30100. b. How much overhead from part a was assigned to Job 344 c. If Job 344 had a balance of 14350 on April 1 what was the balance on April 30 d. Demonstrate how the company arrived at the predetermined overhead rate. Include the amount of budgeted direct labor costs for the year in your answer. 33. Assigning costs to jobs cost flows Martha’s Interiors an interior decorating firm uses a job order costing system and applies overhead to jobs using a pre- determined rate of 60 percent of direct labor cost. At the beginning of June Chapter 5 Job Order Costing 201

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2002 Job 918 was the only job in process. Costs of Job 918 included direct material of 16500 direct labor of 2400 and applied overhead of 1440. During June the company began work on Jobs 919 920 and 921 and pur- chased and issued 34700 of direct material. Direct labor cost for the month totaled 12600. Job 920 had not been completed at the end of June and its direct material and direct labor charges were 6700 and 1300 respectively. All the other jobs were completed in June. a. What was the total cost of Job 920 as of the end of June 2002 b. What was the cost of goods manufactured for June 2002 c. If actual overhead for June was 8700 was the overhead underapplied or overapplied for the month By how much 34. Assigning costs to jobs Ace Show is an advertising consultant. Recently he has been working with his accountant to develop a formal accounting system. His accountant has suggested the use of a job order costing system to simplify costing procedures. During September Ace and his staff worked on jobs for the following companies: Angston Westside Randall Company Manufacturing Inc. Direct material cost 4500 8100 9600 Direct labor cost 1800 9450 20250 Number of ads designed 5 10 15 Ace is able to trace direct material to each job because most of the cost asso- ciated with material is related to photography and duplicating. The accountant has told Joe that a reasonable charge for overhead based on previous infor- mation is 55 per direct labor hour. The normal labor cost per hour is 45. a. Determine the total cost for each of the advertising accounts for the month. b. Determine the cost per ad developed for each client. c. Ace has been charging 4500 per ad developed. What was his net income for the month if actual overhead for the month was 40000 d. Do you have any suggestions for Ace about the way he bills his clients for developing ads 35. Standard costing Corner Kopy Inc. incurred the following direct material costs in November 2002 for high-volume routine print jobs: Actual unit purchase price 0.015 per sheet Quantity purchased in November 480000 sheets Quantity used in November 480000 sheets Standard quantity allowed for good production 460000 sheets Standard unit price 0.017 per sheet Calculate the material price variance and the material quantity variance. 36. Standard costing Carolina Mfg. uses a standard cost system. The company experienced the following results related to direct labor in December 2002: Actual hours worked 45500 Actual direct labor rate 9.25 Standard hours allowed for production 44200 Standard direct labor rate 9.75 a. Calculate the total actual payroll. b. Determine the labor rate variance. c. Determine the labor quantity variance. 37. Standard costing Gone To The Birds employs a job order costing system based on standard costs. For one of its products a small teak-rimmed concrete bird bath Product No. 17 the standard costs per unit are as follows: Part 2 Systems and Methods of Product Costing 202

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Direct material 10 Direct labor 18 Manufacturing overhead 15 a. Record the journal entry for the transfer of direct material into production for 800 units of Product No. 17. b. Compute the total cost assigned to the 800 units of Product No. 17 and record the journal entry to recognize the completion of the 800 units. c. Record the journal entries associated with the sale of the 800 units of Prod- uct No. 17 for 44300. 38. Cost control Baltimore Fabricated Steel Products Company produces a variety of steel drums that are used as storage containers for various chemical prod- ucts. One of the products the firm produces is a 55-gallon drum. In the past year the company produced this drum on four separate occasions for four dif- ferent customers. Some financial details of each of the four orders follow. Date Job No. Quantity Bid Price Budgeted Cost Actual Cost Jan. 17 2118 30000 150000 120000 145000 Mar. 13 2789 25000 125000 100000 122000 Oct. 20 4300 40000 200000 160000 193000 Dec. 3 4990 35000 175000 140000 174000 Baltimore Fabricated Steel Products Company uses a job order costing system and obtains jobs based on competitive bidding. For each project a budget is developed. As the controller of the company write a memo to company man- agement describing any problems that you perceive in the data presented and steps to be taken to eliminate the recurrence of these problems. 39. Production and marketing environment When it comes to tortillas Americans and Mexicans have distinctly different tastes. Americans are content to purchase mass-produced prepackaged tortillas from their local grocery stores. Regional and national brands dominate sales. In Mexico more than 95 percent of all tortillas are sold in little shops licensed by the government. These outlets many grinding tortillas on hand-powered conveyor belts are virtual monopolies in their neighborhoods with a captive market that so far has resisted modern sales efforts. Assume that you are involved in developing a strategy for your employer a U.S. food company to produce tortillas. You are considering competing in both the United States and Mexico. Write a brief report recommending how your com- pany should produce and market tortillas in each country. Also describe the product costing system that you would recommend for each country. SOURCE: Adapted from Joel Millman “Mexican Tortilla Firms Stage U.S. Bake-Off” The Wall Street Journal May 10 1996 p. A6. 40. Cost manipulation Excel Communications is a direct sales marketer of long- distance phone services. The company earns revenues by selling long-distance services to new subscribers. The company is preparing to “go public” through an initial public offering IPO of its stock. As with any IPO the trick for an investment analyst is to determine the value of the stock. One of the controversial valuation issues for Excel is how to treat the costs the firm incurs to obtain subscribers. Excel defers a large portion of the costs it incurs to sign up new subscribers—85 million in the first two months of 1996 alone. Excel amortizes these costs and revenue over 12 months as a way to “appropriately match revenues and expenses.” SOURCE: Adapted from Jeff D. Opdyke “Excel’s Accounting Methods Raise Red Flags Among IPO Watchers” The Wall Street Journal May 8 1996 p. T2. Chapter 5 Job Order Costing 203

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Put yourself into the position of a stock analyst. Write a report for your investor clientele explaining the effect of Excel’s accounting methods on its level of reported net income. Be sure to include a discussion of whether this accounting method provides a fair picture of the firm’s “economic earnings.” 41. Cost management A focus on the customer may lead companies to join forces with erstwhile competitors. “If a customer is looking for a solution to a business problem then it’s quite common for us to work together with a competitor to find that exact solution” says Jim Mavel CEO and president of Scan-Optics Inc. a 57 million Manchester Connecticut firm that manufactures and supports high-performance scanners develops software and offers professional services. “We also sometimes bid against that firm for other projects at the same time.” In some cases as part of a prearranged deal Scan-Optics will win a contract and subcontract with a competitor that vied for but lost that same deal. In rarer cases Scan-Optics incorporates a competitor’s products or services into a bid for work the competitor is also seeking. In what may be a glimpse of the complicated business relationships of the future a company could find itself serving as competitor supplier customer and partner to another firm on an given day says Barry Nalebuff Yale University School of Management professor. In today’s complex intertwined economy the business-as-war winner-take- all mindset doesn’t cut it says Nalebuff. Better to get a piece of the pie he says than no portion at all. SOURCE: Harvey Meyer “My Enemy My Friend” Journal of Business Strategy Sept.–Oct. 1998 p. 42. © Faulkner Gray reprinted with permission. a. How does the contemporary use of joint ventures and other cooperative arrangements with other firms add complexity to the accounting function for a business managing its costs b. Why is it necessary for managers and accountants not to look only inside the firm to manage costs but to also look outside the firm Part 2 Systems and Methods of Product Costing 204 42. Journal entries Sunny Day Awning Company installs awnings on residential and commercial structures. The company had the following transactions for February 2002: • Purchased 440000 of building raw material on account. • Issued 370000 of building direct material to jobs. • Issued 60000 of building indirect material for use on jobs. • Accrued wages payable of 594000 of which 474000 could be traced directly to particular jobs. • Applied overhead to jobs on the basis of 60 percent of direct labor cost. • Completed jobs costing 666000. For these jobs revenues of 824000 were collected. Make all appropriate journal entries for the above transactions. Hint: There is no finished goods inventory. 43. Journal entries Canton Refrigeration uses a job order costing system based on actual costs. The following transactions relate to a single period in which the beginning Direct Material Inventory was 10000 Work in Process Inventory was 25000 and Finished Goods Inventory was 21000. • Direct material purchases on account were 70000. • Direct labor cost for the period totaled 75500 for 8000 direct labor hours. • Actual overhead costs were 72000. PROBLEMS

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• Actual overhead is applied to production based on direct labor hours. • The ending inventory of Direct Material Inventory was 3000. • The ending inventory of Work in Process Inventory was 10500. • Of the goods finished during the period goods costing 95000 were sold for 133000. Prepare all journal entries for the above transactions and determine the end- ing balance in Finished Goods Inventory. 44. Journal entries assigning costs to jobs Alpha Mechanical uses a job order cost- ing system. On September 1 2002 the company had the following account balances: Raw Material Inventory 332400 Work in Process Inventory 1056300 Cost of Goods Sold 4732000 Work in Process Inventory is the control account for the job cost subsidiary ledger. On September 1 the three accounts in the job cost ledger had the fol- lowing balances: Job 75 593200 Job 78 316800 Job 82 146300 The following transactions occurred during September: Sept. 1 Purchased 940000 of raw material on account. 4 Issued 950000 of raw material as follows: Job 75 43800 Job 78 227800 Job 82 396600 Job 86 256200 indirect material 25600. 15 Prepared and paid the factory payroll for Sept. 1–15 in the amount of 368500. Analysis of the payroll for Sept. 1–15 reveals the following information as to where labor effort was devoted: Job 75 4430 hours 44300 Job 78 11160 hours 111600 Job 82 12150 hours 121500 Job 86 5540 hours 55400 Indirect wages 35700 16 Alpha Mechanical applies manufacturing overhead to jobs at a rate of 7.50 per direct labor hour each time the payroll is made. 16 Job 75 was completed and accepted by the customer and billed at a selling price of cost plus 25 percent. 20 Paid the following monthly factory bills: utilities 17200 rent 38300 and accounts payable accrued in August 91000. 24 Purchased raw material on account 412000. 25 Issued raw material as follows: Job 78 74400 Job 82 108300 Job 86 192500 and indirect material 27200. 30 Recorded additional factory overhead costs as follows: depreciation 206500 expired prepaid insurance 35100 and accrued taxes and licenses 13000. 30 Recorded the gross salaries and wages for the factory payroll for Sept. 16–30 of 357200. Analysis of the payroll follows: Job 78 8840 hours 88400 Job 82 11650 hours 116500 Job 86 11980 hours 119800 Indirect wages 32500 30 Applied overhead for the second half of the month to jobs. Chapter 5 Job Order Costing 205

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a. Prepare journal entries for the transactions for September 2002. b. Use T-accounts to post the information from the journal entries in part a to the job cost subsidiary accounts and to general ledger accounts. c. Reconcile the September 30 balances in the subsidiary ledger with the Work in Process Inventory account in the general ledger. d. Determine the amount of underapplied or overapplied overhead for Sep- tember. 45. Journal entries cost flows Specialty Components began 2002 with three jobs in process: TYPE OF COST Job No. Direct Material Direct Labor Overhead Total 247 77200 91400 34732 203332 251 176600 209800 79724 466124 253 145400 169600 64448 379448 Totals 399200 470800 178904 1048904 During 2002 the following transactions occurred: 1. The firm purchased and paid for 532000 of raw material. 2. Factory payroll records revealed the following: • Indirect labor incurred was 54000. • Direct labor incurred was 602800 and was associated with the jobs as follows: Job No. Direct Labor Cost 247 17400 251 8800 253 21000 254 136600 255 145000 256 94600 257 179400 3. Material requisition forms issued during the year revealed the following: • Indirect material issued totaled 76000. • Direct material issued totaled 468400 and was associated with jobs as follows: Job No. Direct Material Cost 247 14400 251 6200 253 16800 254 103200 255 119800 256 72800 257 135200 4. Overhead is applied to jobs on the basis of direct labor cost. Management budgeted overhead of 240000 and total direct labor cost of 600000 for 2002. Actual total factory overhead costs including indirect labor and in- direct material for the year were 244400. 5. Jobs 247 through 255 were completed and delivered to customers C.O.D. The revenue on these jobs was 2264774. a. Prepare journal entries for all of the above events. b. Determine ending balances for jobs still in process. c. Determine cost of jobs completed adjusted for underapplied or overap- plied overhead. Part 2 Systems and Methods of Product Costing 206

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46. Simple inventory calculation Production data for the first week in November 2002 for Illinois Lighting were as follows: WORK IN PROCESS INVENTORY Job No. Material Labor Machine Time Overhead Nov. 1 411 950 18 hours 25 hours 1 412 620 5 hours 15 hours 7 417 310 4 hours 8 hours Finished Goods Inventory Nov. 1: 11900 Finished Goods Inventory Nov. 7: 0 MATERIAL RECORDS Inv. 11/1 Purchases Issuances Inv. 11/7 Aluminum 4150 49150 29350 Steel 6400 13250 17100 Other 2900 11775 12950 Direct labor hours worked: 340. Labor cost is 15 per direct labor hour. Ma- chine hours worked: 600 Job 411 175 hours Job 412 240 hours and Job 417 185 hours. Overhead for first week in November: Depreciation 4500 Supervisor salaries 7200 Indirect labor 4175 Insurance 1400 Utilities 1125 Total 18400 Overhead is charged to production at a rate of 30 per machine hour. Un- derapplied or overapplied overhead is treated as an adjustment to Cost of Goods Sold at year-end. All company jobs are consecutively numbered and all work not in ending Finished Goods Inventory has been completed and sold. a. Calculate the value of beginning Work in Process Inventory. b. What is the value at the end of November of 1 the three material ac- counts 2 Work in Process Inventory and 3 Cost of Goods Sold 47. Job cost sheet analysis As a candidate for a cost accounting position with Global Construction you have been asked to take a quiz to demonstrate your knowledge of job order costing. Global’s job order costing system is based on normal costs and overhead is applied based on direct labor cost. The follow- ing records pertaining to May have been provided to you: Job No. Direct Material Direct Labor Applied Overhead Total Cost 167 17703 6920 7960 32583 169 54936 7240 8328 70504 170 1218 2000 2300 5518 171 154215 28500 43700 226415 172 28845 2200 2532 33577 To explain the missing job number you are informed that Job 168 had been completed in April. You are also told that Job 167 was the only job in process at the beginning of May. At that time the job had been assigned 12900 for direct material and 3600 for direct labor. At the end of May Job 171 had not been completed all others had. You are to provide answers to the fol- lowing questions: Chapter 5 Job Order Costing 207

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a. What is the predetermined overhead rate used by Global Construction b. What was the total cost of beginning Work in Process Inventory c. What were total direct manufacturing costs incurred for May d. What was cost of goods manufactured for May 48. Departmental rates The Houston Custom Tile Corporation has two depart- ments: Mixing and Drying. All jobs go through each department and the com- pany uses a job order costing system. The company applies overhead to jobs based on labor hours in Mixing and on machine hours in Drying. In Decem- ber 2001 corporate management estimated the following production data for 2002 in setting its predetermined overhead rates: Mixing Drying Machine hours 7200 104000 Direct labor hours 88000 12400 Departmental overhead 374000 494000 Two jobs completed during 2002 were 2296 and 2297. The job order cost sheets showed the following information about these jobs: Job 2296 Job 2297 Direct material cost 4875 6300 Direct labor hours—Mixing 425 510 Machine hours—Mixing 40 45 Direct labor hours—Drying 20 23 Machine hours—Drying 110 125 Direct labor workers are paid 9 per hour in the Mixing Department and 22 per hour in Drying. a. Compute the predetermined overhead rates used in Mixing and Drying for 2002. b. Compute the direct labor cost associated with each job for both departments. c. Compute the amount of overhead assigned to each job in each department. d. Determine the total cost of Jobs 2296 and 2297. e. Actual data for 2002 for each department follow. What is the amount of underapplied or overapplied overhead for each department for the year ended December 31 2002 Mixing Drying Machine hours 7400 106800 Direct labor hours 86400 12600 Overhead 362000 512000 49. Comprehensive In May 2002 Aztec Construction Company was the success- ful bidder on a contract to build a pedestrian overpass in Flagstaff Arizona. The firm utilizes a job order costing system and this job was assigned Job 515. The contract price for the overpass was 450000. The owners of Aztec Construction agreed to a completion date of December 15 2002 for the con- tract. The firm’s engineering and cost accounting departments estimated the following costs for completion of the overpass: 120000 for direct material 135000 for direct labor and 81000 for overhead. The firm began work on the overpass in August. During August direct material cost assigned to Job 515 was 30900 and direct labor cost associ- ated with Job 515 was 47520. The firm uses a predetermined overhead rate of 60 percent of direct labor cost. Aztec Construction also worked on several other jobs during August and incurred the following costs: Part 2 Systems and Methods of Product Costing 208

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Direct labor including Job 515 252000 Indirect labor 27900 Administrative salaries and wages 19800 Depreciation on construction equipment 13200 Depreciation on office equipment 3900 Client entertainment on accounts payable 5550 Advertising for firm paid in cash 3300 Indirect material from supplies inventory 9300 Miscellaneous expenses design related to be paid in the following month 5100 Accrued utilities for office 900 for construction 2700 3600 During August Aztec Construction completed several jobs that had been in process before the beginning of the month. These completed jobs generated 312000 of revenues for the company. The related job cost sheets showed costs associated with those jobs of 214500. At the beginning of August Aztec Construction had Work in Process Inventory of 135900. a. Prepare a job order cost sheet for Job 515 including all job details and post the appropriate cost information for August. b. Prepare journal entries for the above information. c. Prepare a Schedule of Cost of Goods Manufactured for August for Aztec Construction Company. d. Assuming the company pays income tax at a 40 percent rate prepare an income statement for August. 50. Comprehensive Enforcer Inc. designs and manufactures perimeter fencing for large retail and commercial buildings. Each job goes through three stages: design production and installation. Three jobs were started and completed during the first week of May 2002. There were no jobs in process at the end of April 2002. Information for the three departments for the first week in May follows: DEPARTMENT Job 2019 Design Production Installation Direct labor hours 100 NA 70 Machine hours NA 90 NA Direct labor cost 10200 4250 1260 Direct material 1200 14550 1300 Job 2020 Design Production Installation Direct labor hours 85 NA 80 Machine hours NA 300 NA Direct labor cost 8670 7450 1440 Direct material 1025 33600 4600 Job 2021 Design Production Installation Direct labor hours 90 NA 410 Machine hours NA 120 NA Direct labor cost 9180 2950 1900 Direct material 2200 29000 1300 Overhead is applied using departmental rates. Design and Installation use direct labor cost as the base with rates of 40 and 90 percent respectively. Pro- duction uses machine hours as the base with a rate of 15 per hour. Actual overhead in the Design Department for the month was 12200. Ac- tual overhead costs for the Production and Installation Departments were 7200 and 3850 respectively. Chapter 5 Job Order Costing 209

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a. Determine the overhead to be applied to each job. By how much is the overhead underapplied or overapplied in each department For the com- pany b. Assume no journal entries have been made to Work in Process Inventory. Make all necessary entries to both the subsidiary ledger and general ledger accounts. c. Calculate the total cost for each job. 51. Standard costing One of the products made by Factory Logistics is a robotic conveyor system. A single model Model No. 89 accounts for approximately 60 percent of the company’s annual sales. Because the company has pro- duced and expects to continue to produce a significant quantity of this model the company uses a standard costing system to account for Model No. 89 production costs. The company has a separate plant that is strictly dedicated to Model No. 89 production. The standard costs to produce a single unit follow: Direct material 7000 pounds 14000 Direct labor 430 hours at 20.00 per hour 8600 Overhead 19000 Total standard cost 41600 For the 200 units of Model No. 89 produced in 2002 the actual costs were Direct material 1500000 pounds 2900000 Direct labor 89200 hours 1739400 Overhead 3700000 Total actual cost 8339400 a. Compute a separate variance between actual and standard cost for direct material direct labor and manufacturing overhead for the Model No. 89 units produced in 2002. b. Is the direct material variance found in part a driven primarily by the price per pound difference between standard and actual or the quantity difference between standard and actual Explain. 52. Standard costing Trailer Solutions uses a job order costing system. During July 2002 the company worked on two production runs of the same product a trailer hitch component. These units were included in Jobs 918 and 2002. Job 918 consisted of 1200 units of the product and Job 2002 contained 2000 units. The hitch components are made from 1/2” sheet metal. Because the trailer hitch component is a product that is routinely produced for one of Trailer Solution’s long-term customers standard costs have been developed for its production. The standard cost of material for each unit is 4.50 each unit contains six pounds of material. The standard direct labor time per unit is six minutes for workers earning a rate of 20 per hour. The actual costs recorded for each job were as follows: Direct Material Direct Labor Job 918 7500 pounds 5250 130 hours 2470 Job 2002 11800 pounds 9440 230 hours 4255 a. What is the standard cost of each trailer hitch component b. What was the total standard cost assigned to each of the jobs c. Compute the variances for direct material and for direct labor for each job. d. Why should variances be computed separately for each job rather than for the aggregate annual trailer hitch component production Part 2 Systems and Methods of Product Costing 210

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Chapter 5 Job Order Costing 211 53. Comprehensive job cost sheet The Big Plains Construction Company builds bridges. For the months of October and November 2001 the firm worked ex- clusively on a bridge spanning the Niobrara River in northern Nebraska. The firm is organized into two departments. The Precast Department builds structural elements of the bridges in temporary plants located near the construction sites. The Construction Department operates at the bridge site and assembles the pre- cast structural elements. Estimated costs for the Niobrara River Bridge for the Pre- cast Department were 150000 for direct labor 310500 for direct material and 110000 for overhead. For the Construction Department estimated costs for the Niobrara River Bridge were 160000 for direct labor 50000 for direct material and 160000 for overhead. Overhead is applied on the last day of each month. Overhead application rates for the Precast and Construction Departments are 18 per machine hour and 100 percent of direct labor cost respectively. TRANSACTIONS FOR OCTOBER Oct. 1 150000 of material was purchased on account for the Precast Department to begin building structural elements. All of the material issued to production 130000 was considered direct. 5 Utilities were installed at the bridge site at a total cost of 15000. 8 Rent was paid for the temporary construction site housing the Precast Department 4000. 15 Bridge support pillars were completed by the Precast Department and transferred to the construction site. 20 30000 of machine rental expense was incurred by the Construction Department for clearing the bridge site and digging foundations for bridge supports. 24 Additional material costing 285000 was purchased on account. 31 The company paid the following bills for the Precast Department: utilities 7000 direct labor 45000 insurance 6220 and supervision and other indirect labor costs 7900. Departmental depreciation was recorded 15200. The company also paid bills for the Construction Department: utilities 2300 direct labor16300 indirect labor 5700 and insurance 1900. Departmental depreciation was recorded on equipment 8750. 31 A check was issued to pay for the material purchased on October 1 and October 24. 31 Overhead was applied to production in each department 2000 machine hours were worked in the Precast Department in October. TRANSACTIONS FOR NOVEMBER Nov. 1 Additional structural elements were transferred from the Precast Department to the construction site. The Construction Department incurred a cash cost of 5000 to rent a crane. 4 200000 of material was issued to the Precast Department. Of this amount 165000 was considered direct. 8 Rent of 4000 was paid in cash for the temporary site occupied by the Precast Department. 15 85000 of material was issued to the Construction Department. Of this amount 40000 was considered direct. 18 Additional structural elements were transferred from the Precast Department to the construction site. 24 The final batch of structural elements was transferred from the Precast Department to the construction site. 29 The bridge was completed. 30 The company paid final bills for the month in the Precast Department: utilities 15000 direct labor 115000 insurance 9350 and supervision and other indirect labor costs 14500. Depreciation was recorded 15200. The company also paid bills for the Construction Department: utilities 4900 direct labor 134300 indirect labor 15200 and insurance 5400. Depreciation was recorded on equipment 18350. 30 Overhead was applied in each department. The Precast Department recorded 3950 machine hours in November. 30 The company billed the state of Nebraska for the completed bridge at the contract price of 1550000. CASES

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a. Prepare all necessary journal entries for the preceding transactions. For purposes of this problem it is not necessary to transfer direct material and direct labor from one department into the other. b. Post all entries to T-accounts. c. Prepare a job order cost sheet which includes estimated costs for the con- struction of the bridge. 54. Comprehensive Young Stuff is a manufacturer of furnishings for infants and children. The company uses a job order cost system. Young Stuff’s Work in Process Inventory on April 30 2002 consisted of the following jobs: Job No. Items Units Accumulated Cost CBS102 Cribs 20000 900000 PLP086 Playpens 15000 420000 DRS114 Dressers 25000 1570000 The company’s finished goods inventory carried on a FIFO basis consists of five items: Item Quantity and Unit Cost Total Cost Cribs 7500 units 64 480000 Strollers 13000 units 23 299000 Carriages 11200 units 102 1142400 Dressers 21000 units 55 1155000 Playpens 19400 units 35 679000 3755400 Young Stuff applies factory overhead on the basis of direct labor hours. The company’s factory overhead budget for the year ending May 31 2002 totals 4500000 and the company plans to expend 600000 direct labor hours during this period. Through the first 11 months of the year a total of 555000 direct labor hours were worked and total factory overhead amounted to 4273500. At the end of April the balance in Young Stuff’s Material Inventory ac- count which includes both raw material and purchased parts was 668000. Additions to and requisitions from the material inventory during May included the following: Raw Material Parts Purchased Additions 242000 396000 Requisitions: Job CBS102 51000 104000 Job PLP086 3000 10800 Job DRS114 124000 87000 Job STR077 10000 strollers 62000 81000 Job CRG098 5000 carriages 65000 187000 During May Young Stuff’s factory payroll consisted of the following: Job No. Hours Cost CBS102 12000 122400 PLP086 4400 43200 DRS114 19500 200500 STR077 3500 30000 CRG098 14000 138000 Indirect 3000 29400 Supervision 57600 621100 Part 2 Systems and Methods of Product Costing 212

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The jobs that were completed in and the unit sales for May follow: Job No. Items Quantity Completed CBS102 Cribs 20000 PLP086 Playpens 15000 STR077 Strollers 10000 CRG098 Carriages 5000 Items Quantity Shipped Cribs 17500 Playpens 21000 Strollers 14000 Dressers 18000 Carriages 6000 a. Describe when it is appropriate for a company to use a job order costing system. b. Calculate the dollar balance in Young Stuff’s Work in Process Inventory account as of May 31 2002. c. Calculate the dollar amount related to the playpens in Young Stuff’s Fin- ished Goods Inventory as of May 31 2002. d. Explain the treatment of underapplied or overapplied overhead when us- ing a job order costing system. CMA adapted 55. Missing amounts Downstream Manufacturing Company realized too late that it had made a mistake locating its controller’s office and its electronic data pro- cessing system in the basement. Because of the spring thaw the Mississippi River overflowed on May 2 and flooded the company’s basement. Electronic data storage was beyond retrieval and the company had not provided off-site storage of data. Some of the paper printouts were located but were badly faded and only partially legible. On May 3 when the river subsided company ac- countants were able to assemble the following factory-related data from the debris and from discussions with various knowledgeable personnel. Data about the following accounts were found: • Raw Material includes indirect material Inventory: Balance April 1 was 4800. • Work in Process Inventory: Balance April 1 was 7700. • Finished Goods Inventory: Balance April 30 was 6600. • Total company payroll cost for April was 29200. • Accounts payable balance April 30 was 18000. • Indirect material used in April cost 5800. • Other nonmaterial and nonlabor overhead items for April totaled 2500. Payroll records kept at an across-town service center that processes the com- pany’s payroll showed that April’s direct labor amounted to 18200 and rep- resented 4400 labor hours. Indirect factory labor amounted to 5400 in April. The president’s office had a file copy of the production budget for the cur- rent year. It revealed that the predetermined manufacturing overhead applica- tion rate is based on planned annual direct labor hours of 50400 and expected factory overhead of 151200. Discussion with the factory superintendent indicated that only two jobs re- mained unfinished on April 30. Fortunately the superintendent also had copies of the job cost sheets that showed a combined total of 2400 of direct mate- rial and 4500 of direct labor. The direct labor hours on these jobs totaled 1072. Both of these jobs had been started during the current period. A badly faded copy of April’s Cost of Goods Manufactured and Sold sched- ule showed cost of goods manufactured was 48000 and the April 1 Finished Goods Inventory was 8400. Chapter 5 Job Order Costing 213

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The treasurer’s office files copies of paid invoices chronologically. All in- voices are for raw material purchased on account. Examination of these files revealed that unpaid invoices on April 1 amounted to 6100 28000 of pur- chases had been made during April and 18000 of unpaid invoices existed on April 30. a. Calculate the cost of direct material used in April. b. Calculate the cost of raw material issued in April. c. Calculate the April 30 balance of Raw Material Inventory. d. Determine the amount of underapplied or overapplied overhead for April. e. What is the Cost of Goods Sold for April Part 2 Systems and Methods of Product Costing 214 56. One of the main points of using a job order costing system is to achieve prof- itability by charging a price for each job that is proportionate to the related costs. The fundamental underlying concept is that the buyer of the product should be charged a price that exceeds all of the costs related to the job con- tract—thus the price reflects the cost. However there are settings in which the price charged to the consumer does not reflect the costs incurred by the vendor to serve that customer. This is the situation in a recent case heard by the U.S. Supreme Court. The case in- volves the University of Wisconsin which charges all students a user fee then redistributes these fees to student organizations. The purpose of collecting the fee is to ensure that money is available to support diversity of thought and speech in student organizations. Even un- popular causes were supported so that the students would hear many voices. In total the fee subsidized about 125 student groups. However a group of students filed suit claiming that students should not be required to fund causes that are inconsistent with their personal beliefs. a. In your opinion how would diversity of thought be affected if a student were allowed to select the organizations that would receive the student’s user fee e.g. as with dues b. Is the University of Wisconsin treating its students ethically by charging them to support student organizations that conflict with students’ personal beliefs 57. In 1995 British steelmaker Ispat purchased Kazakhstan’s largest steel plant: Little known outside the steel world Ispat has in recent months assumed a new visibility—as an example of Western companies’ problems in the former Soviet Union. Hundreds of its employees come to work drunk its biggest cus- tomer is broke and Chechen gunmen have been spotted prowling the plant’s perimeter threatening suppliers and hitting customers up for bribes. Despite all their experience in the developing world the Ispat officials at Karmet “are up against problems we never dreamed about” says Lakshmi Mittal the company’s chairman. Since arriving Ispat has ladled out 11 million for back pay 31 million to repay debts to raw material suppliers and 75 million to begin rebuilding the crumbling plant. Overall the company has pledged to pay 450 million over the next four years plus an additional 550 million for new technology. Because the company is the first Karmet owner in years to have any money it was quickly viewed as a soft target. The local union is seeking a 75 increase in workers’ pay and a Temirtau child-care center is hitting up plant managers for more money. REALITY CHECK

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Soon after Ispat arrived a man claiming to represent a society for the blind asked the company for donations. If Ispat would donate steel he said the society could resell it and raise money. After the company agreed 68 other societies for the blind turned up. “Karmet in 1995 was not a steel plant. It was looked upon more as a social institution” says Arabinda Tripathy Ispat’s personnel director. So Ispat embarked on an ambitious goal—to teach its workers about capi- talism. Senior managers get a weeklong course beginning with the basics of how a market economy works and progressing to discuss how profits are calculated. SOURCE: Kyle Pope “Saga on the Steppes: A Steelmaker Built Up By Buying Cheap Mills Finally Meets Its Match” The Wall Street Journal May 2 1996 pp. A1 A6. Reprinted by permission of The Wall Street Journal © 1996 Dow Jones Company Inc. All rights reserved worldwide. Permission conveyed through the Copyright Clearance Center. a. How would the quality considerations in the Temirtau Kazakhstan steel plant be fundamentally different from quality considerations in a more developed nation b. Should the ethical standards of conduct be different for managers in the Temirtau plant than in other plants operated by Ispat Explain. 58. From William J. Fife Jr. chairman of Giddings Lewis Inc.: “The labor content of a product today is probably less than 15. So I don’t care how much I cut direct labor it’s not going to get to the bottom line. We have to get at overhead costs.” Today U.S. firms have some of the highest overhead burdens of all global companies. Much of the higher overhead cost is associated with the tiered management structures prevalent in the United States. The layers of white-collar managers create a tremendous cost disadvantage. The redundant layers of management are associated with the traditional notion that employees need to be supervised to maintain productivity and control quality. SOURCE: Adapted from Thane Peterson “Can Corporate America Get Out From Under Its Overhead” Business Week May 18 1992 p. 102. a. With appropriate training of blue-collar workers in American industry how can layers of white-collar managers be eliminated and productivity and quality increased b. How does the traditionally hostile relationship between white-collar man- agers and blue-collar workers place American firms at a disadvantage in the global market relative to countries that have traditionally fostered co- operation among all employees 59. Cyclemakers Group of Washdyke near Timaru New Zealand is lifting its profile locally and overseas in the cycling world through its custom-built bike service. Although the prospect of sitting astride a 10-speed may not be everyone’s idea of relaxation at least now they can dictate their choice of seat—or for that matter their choice of frame wheels gears and the other bits and pieces that Cyclemakers imports from the major branded overseas manufacturers. The com- pany has built simulators so people can try out a range of configurations to see what measurements suit. They can then choose from an enormous range of components of varying sizes and prices including the color and style of the paint job. “We’re doing it at a price not much greater than an off-the-peg production bike because we use a computerised system. The idea has proven very successful here and in Australia. It’s not a large percentage of business yet but has provided a lot at the top end” says Bryan Jackson managing director. SOURCE: “Boosting Bike Sales” NZ Business November 1992 p. 33. NZ Business is published by Profile Publishing Ltd. P.O. Box 5544 Auckland New Zealand Chapter 5 Job Order Costing 215

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a. Why would Cyclemakers be able to produce custom-made bicycles for almost the same cost as mass-produced ones b. Would you expect the quality of the custom-produced bicycles to be higher or lower than the mass-produced ones Discuss the rationale for your answer. c. Why would the custom-made bicycles “provide a lot at the top end” show a high profit margin 60. Two types of contracts are commonly used when private firms contract to pro- vide services to governmental agencies: cost-plus and fixed-price contracts. The cost-plus contract allows the contracting firm to recover the costs associated with providing the product or service plus a reasonable profit. The fixed-price contract provides for a fixed payment to the contractor. When a fixed-price contract is used the contractor’s profits will be based on its ability to control costs relative to the price received. A Wall Street Journal article announced that in May 1996 Alliant Tech- systems Inc. was being investigated for the way that it accounted for its gov- ernment contracts. Specifically the company was being investigated because of suspicions that costs related to fixed-price government contracts were be- ing shifted to cost-plus government contracts. SOURCE: Andy Pasztor “Alliant Unit Is Said to Face Criminal Probe” The Wall Street Journal May 3 1996 pp. A3 A6. Reprinted by permission of The Wall Street Journal © 1996 Dow Jones Company Inc. All rights reserved worldwide. a. Why would a company that conducts work under both cost-plus and fixed- price contracts have an incentive to shift costs from the fixed-price to the cost-plus contracts b. From an ethical perspective do you feel such cost shifting is ever justified Explain. Part 2 Systems and Methods of Product Costing 216

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6 Process Costing CHAPTER LEARNING OBJECTIVES After completing this chapter you should be able to answer the following questions: 1 How is process costing different from job order costing 2 Why are equivalent units of production used in process costing 3 How are equivalent units of production determined using the weighted average and FIFO methods of process costing 4 How are unit costs and inventory values determined using the weighted average and FIFO methods of process costing 5 How can standard costs be used in a process costing system 6 Why would a company use a hybrid costing system 7 Appendix What alternative methods can be used to calculate equivalent units of production

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Lumina Candles Art INTRODUCING elly Borsheim started Lumina Candles Art a home-based business located in Cedar Creek Texas in the early 1990s. While working for a photo lab in college in the 1980s Kelly had supplemented her income by selling fine art photography and shooting occasional wedding jobs. This led to an abiding interest in art and she would later attend art school. A friend Jamshid gave Kelly a beeswax honeycomb candle that she still has. Kelly decided to find out what it took to make one. She started making and selling only a few natural candles later adding colors a few at a time to test the market. Even though she was still working 60 hours a week at the photo lab Kelly continued to develop the candle and art business. She left the photo industry in 1995 and in the following year another friend Mark showed Kelly how the Internet worked. He also gave her a basic HTML lesson along with a list of sources for teaching herself how to do more. In May 1996 she launched her Web site. Although she still sells beeswax candles via local shows she now relies mainly on the Internet for customers. In making candles Lumina uses two different processes. One process is used to make hand-rolled 100 percent beeswax candles and the other process is used to make solid beeswax candles natural or scented in molds. Either process produces a variety of shapes sizes and colors of candles. The company must account for the direct material direct labor and manufacturing overhead for each pro- duction run of candles. The hand-rolled candle process is more labor intensive. Direct material includes beeswax non- toxic and odorless aniline dyes essential oils and wicks. At Lumina Candles Art Lumina the primary products are manufactured in a continuous flow process and each unit of output is identical to each other unit. Because Lumina production differs so dramatically from the products made by a company tailoring unique products to individual customer specifications as de- scribed in Chapter 5 the two companies’ product costing systems also differ. Job order costing is appropriate for companies making products or providing services in limited quantities that conform to customer specifications. In contrast Lumina uses process costing to accumulate and assign costs to units of produc- tion. This costing method is also used by manufacturers of candy products bricks gasoline paper and food products among many other types of firms. Both job order and process costing systems accumulate costs by cost compo- nent in each production department. However the two systems assign costs to de- partmental output differently. In a job order system costs are assigned to specific jobs and then to the units composing the job. Process costing uses an averaging technique to assign the costs directly to the units produced during the period. In both costing systems unit costs are transferred as goods are moved from one department to the next so that a total production cost can be accumulated. This chapter presents process costing procedures and illustrates the weighted average and FIFO methods of calculating unit cost in a process costing system. These methods differ only in the treatment of beginning inventory units and costs. Once unit cost is determined total costs are assigned to the units transferred out of a department and to that department’s ending inventory. The chapter also illustrates a standard cost process costing system which is an often-used simplification of the FIFO process costing system. SOURCE: Lumina Candles Art Web site: 219 http:// K How is process costing different from job order costing 1

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Part 2 Systems and Methods of Product Costing 220 INTRODUCTION TO PROCESS COSTING Assigning costs to units of production is an averaging process. In the easiest pos- sible situation a product’s actual unit cost is found by dividing a period’s depart- mental production costs by that period’s departmental production quantity. This average is expressed by the following formula: Unit Cost Peter Longmore describes the overall simplicity of the process costing process in the following excerpt: Process costing is applicable to production involving a continuous process resulting in a high volume of identical or almost identical units of output. While there are a number of complexities attached to process costing the basic idea involves nothing more than calculating an average cost per unit. As such the technique is divisible into 3 stages: 1 Measure the productive output in a pe- riod. 2 Measure the cost incurred in the period. 3 Calculate the average cost by spreading the total cost across the total output. 1 The Numerator The formula numerator is obtained by accumulating departmental costs incurred in a single period. Because most companies make more than one type of product costs must be accumulated by product within each department. Costs can be accumulated by using different Work in Process Inventory accounts for each product and for each department through which that product passes. Alternatively costs can be accumu- lated using departmental Work in Process Inventory control accounts that are sup- ported by detailed subsidiary ledgers containing specific product information. Cost accumulation in a process costing system differs from that in a job order costing system in two ways: 1 the quantity of production for which costs are ac- cumulated at any one time and 2 the cost object to which the costs are assigned. Suppose that Lumina occasionally contracts to hand-make four-foot candles for spe- cial religious occasions. For these orders the company would use job order cost- ing. The direct material and direct labor costs associated with each four-foot can- dle would be accumulated and assigned directly to the buyer’s job. After each job is completed the total material labor and allocated overhead costs are known and job cost can be determined. In contrast for its traditional candles Lumina would use a process costing sys- tem to accumulate periodic costs for each department and each product. Because a variety of sizes colors and scents of candles are manufactured each period the costs assignable to each type of product must be individually designated and at- tached to the specific production runs. These costs are then assigned to the units worked on during the period. Exhibit 6–1 presents the source documents used to make initial cost assign- ments to production departments during a period. Costs are reassigned at the end of the period usually each month from the departments to the units produced. As goods are transferred from one department to the next the related departmental production costs are also transferred. When products are complete their costs are transferred from Work in Process Inventory to Finished Goods Inventory. As in job order costing the direct material and direct labor components of product cost present relatively few problems for cost accumulation and assignment. Sum of Production Costs Production Quantity 1 Peter Longmore “Process Costing Demystified” Accountancy October 1994 p. 88.

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Direct material cost can be measured from material requisition slips direct labor can be determined from employee time sheets and wage rates for the period. In contrast overhead is indirectly assigned to output. If total overhead costs are relatively constant from period to period and production volume is relatively steady over time actual overhead costs provide a fairly uniform production cost and may be used for product costing. If such conditions do not exist using actual overhead for product costing would result in fluctuating unit costs and therefore predetermined application rates are more appropriate. In both job order costing and process costing systems firms may change the definitions of cost pools or adopt new schemes for assigning overhead costs to production. Such changes may be desirable as managers find new ways to struc- ture production activities and develop new management methods. The changes in management practices create challenges for accountants in creating accounting sys- tems that provide useful information to managers. The Denominator The denominator in the unit cost formula represents total departmental production for the period. If all units were 100 percent complete at the end of each accounting period units could simply be counted to obtain the denominator. But in most production processes Work in Process WIP Inventory exists which consists of partially completed units. Any partially completed ending inventory of the current period becomes the partially completed beginning inventory of the next period. Process costing assigns costs to both fully and partially completed units by math- ematically converting partially completed units to equivalent whole units. Chapter 6 Process Costing 221 EXHIBIT 6–1 Cost Flows and Cost Assignment PROCESSING DEPARTMENT PACKAGING DEPARTMENT FINISHED GOODS WAREHOUSE Products A B and C Direct Labor Factory Overhead Raw Material Direct Labor Factory Overhead Material Requisition Documents Employee Time Sheets Adjusting Journal Entries Employee Time Sheets Adjusting Journal Entries Input Costs Assigned to Products Input Costs Assigned to Products PRODUCT A Tapers PRODUCT B Candles in Jars PRODUCT C Votives Transferred In PRODUCT A Transferred In PRODUCT B Transferred In PRODUCT C

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Units in beginning WIP Inventory were started last period but will be com- pleted during the current period. This two-period production sequence means that some costs for these units were incurred last period and additional costs will be incurred in the current period. Additionally the partially completed units in ending WIP Inventory were started in the current period but will not be completed until next period. Therefore current period production efforts on ending WIP Inventory units cause some costs to be incurred in this period and more costs will need to be incurred next period. Physical inspection of the units in ending inventory is needed to determine the proportion of ending WIP Inventory that was completed during the current period. The mathematical complement to this proportion represents the work that needs to be completed next period. Inspection at the end of last period provided information on the proportion of work that needed to be completed this period on beginning inventory. Equivalent Units of Production The physical flow of units through a department and the manufacturing effort ex- pended in a department during a period normally occur in the following order: • units started in the previous period and finished in the present period • units started in the present period and finished in the present period and • units started in the present period and not finished in the present period. Because of these mixed manufacturing efforts production cannot be measured by counting whole units. Accountants use a concept known as equivalent units of production to measure the quantity of production achieved during a period. Equivalent units of production EUP are an approximation of the number of whole units of output that could have been produced during a period from the actual effort expended during that period. EUPs are calculated by multiplying the number of actual but incomplete units produced by the respective percentage degree of completion. The following simple example indicates how equivalent units are calculated. Assume the cooking department of a company had no beginning inventory in November. During November the department worked on 220000 units: 200000 units were completed and 20000 units were 40 percent complete at the end of the period. The EUP for the period are 208000 200000 100 20000 40. Part 2 Systems and Methods of Product Costing 222 Why are equivalent units of production used in process costing 2 equivalent units of production WEIGHTED AVERAGE AND FIFO PROCESS COSTING METHODS The two methods of accounting for cost flows in process costing are 1 weighted average and 2 FIFO. These methods relate to the manner in which cost flows are assumed to occur in the production process. In a very general way these process costing approaches can be related to the cost flow methods used in financial accounting. In a retail business the weighted average method is used to determine an average cost per unit of inventory. This cost is computed by dividing the total cost of goods available by total units available. Total cost and total units are found by adding purchases to beginning inventory. Costs and units of the current period are not distinguished in any way from those on hand at the end of the prior period. In contrast the FIFO method of accounting for merchandise inventory separates goods by when they were purchased and at what cost. The costs of beginning inventory are the first costs sent to Cost of Goods Sold units remaining in the end- ing inventory are assigned costs based on the most recent purchase prices. How are equivalent units of production determined using the weighted average and FIFO methods of process costing 3

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The use of these methods for costing the production of a manufacturing firm is similar to their use by a retailer. The weighted average method computes a single average cost per unit of the combined beginning inventory and current period production. The FIFO method separates beginning inventory and current period production and their costs so that a current period cost per unit can be calculated. The denominator used in the cost formula to determine unit cost dif- fers depending on which of the two methods is used. 2 In almost all cases some direct material must be introduced at the start of a production process or there would be no need for labor or overhead to be in- curred. For example to make its various products Lumina introduces wax at the start of a process. Any material added at the start of production is 100 percent complete throughout the process regardless of the percentage of completion of la- bor and overhead. Most production processes require multiple direct materials. Additional materials may be added at any point or even continuously during processing. A material such as a box may even be added at the end of processing. During the production process the product is 0 percent complete as to the box although other materials may be complete and some labor and overhead may have been incurred. The production flow for candles shown in Exhibit 6–2 visually illustrates the need for separate EUP computations for each cost component. The material “wax” is 100 percent complete at any point in the process after the start of production no additional wax is added later in production. When enough labor and overhead have been added to melt the wax and reach the 20 percent completion point ad- ditional materials coloring and scent are added. Prior to 20 percent completion these materials were 0 percent complete after the 20 percent point these materi- als are 100 percent complete. The wick is added at the 50 percent completion point and the candles are packaged when processing is 99 percent finished after Chapter 6 Process Costing 223 weighted average method FIFO method 2 Note that the term denominator is used here rather than equivalent units of production. Based on its definition EUPs are related to current period productive activity. Thus for any given set of production facts there is only one true measure of equivalent units produced—regardless of the cost flow assumption used—and that measure is FIFO EUP. However this fact has been obscured over time due to continued references to the “EUP” computation for weighted average. Thus the term EUP has taken on a generic use to mean “the denominator used to compute the unit cost of production for a period in a process costing system.” We use EUP in this generic manner throughout the discussion of process costing. EXHIBIT 6–2 Candle Manufacturing Process— Production Department WAX WAX Color Color and and Scent Scent START END Wax added 100 complete. Labor and overhead 5 complete. Coloring and scent added 100 complete. Labor and overhead 20 complete. Wick added 100 complete. Labor and overhead 50 complete. Box is added. 100 complete. Labor and overhead 100 complete after packaging. Labor and Overhead Added Continuously WAX BOX Wax is poured from vats into separate candle molds. Wick Color and Scent Individual candles are cut.

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which the candles are 100 percent complete. Thus boxes are 0 percent complete throughout production when the candles are packaged the product is complete and is transferred to the finished goods warehouse or directly to customers. If 8000 candles are assumed to be 75 percent complete as to labor and over- head at the end of a period those candles would be 100 percent complete as to wax coloring and scent and wicks and 0 percent complete as to boxes. The EUP calculations would indicate that there are 8000 EUPs for wax coloring and scent and wicks and 0 EUPs for boxes. The labor and overhead conversion compo- nents of cost would have an equivalency of 6000 candles because the product is 75 percent complete and labor and overhead are added continuously during the process. 3 When overhead is applied on a direct labor basis or when direct labor and overhead are added to the product at the same rate a single percentage of com- pletion estimate can be made and used for both conversion cost components. How- ever because cost drivers other than direct labor are increasingly being used to apply overhead costs single computations for “conversion EUP” will be made less often. For example the cost driver for the utilities portion of overhead cost may be machine hours the cost driver for the materials handling portion of overhead cost may be pounds of material. The increased use of multiple cost pools and/or activity-based costing concepts makes it less likely that the degrees of completion for the direct labor and overhead components of processing will be equal. The ac- companying News Note page 225 discusses a European view of process costing. The calculation of equivalent units of production requires that a process cost flow method be specified. A detailed example of the calculations of equivalent units of production and cost assignment for each of the cost flow methods is pre- sented in the next section. Part 2 Systems and Methods of Product Costing 224 3 Although the same number of equivalent units results for wax coloring and scent and wicks and for labor and overhead separate calculations of unit cost may be desirable for each component. These separate calculations would give managers more information for planning and control purposes. Managers must weigh the costs of making separate calculations against the benefits from having the additional information. For illustrative purposes however single computations will be made when cost components are at equal percentages of completion. 4 A third category spoilage/breakage does exist. It is assumed at this point that such happenings do not occur. Chapter 7 covers accounting for spoilage in process costing situations. EUP CALCULATIONS AND COST ASSIGNMENTS One purpose of any costing system is to determine a product cost for use on financial statements. When goods are transferred from Work in Process Inventory to Finished Goods Inventory or another department a cost must be assigned to those goods. In addition at the end of any period a value must be assigned to goods that are only partially complete and still remain in Work in Process Inven- tory. Exhibit 6–3 on page 226 outlines the steps necessary in a process costing sys- tem to determine the costs assignable to the units completed and to those still in ending inventory at the end of a period. Each of these steps is discussed and then a complete example is provided for both weighted average and FIFO costing. The first step is to calculate the total physical units for which the department is responsible or the total units to account for. This amount is equal to the total number of whole and partial units worked on in the department during the current period: beginning inventory units plus units started. Second determine what happened to the units to account for during the period. This step also requires the use of physical units. Units may fit into one of two cat- egories: 1 completed and transferred or 2 partially completed and remaining in ending Work in Process Inventory. 4 How are unit costs and inventory values determined using the weighted average and FIFO methods of process costing total units to account for 4

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At this point verify that the total units for which the department was account- able are equal to the total units that were accounted for. If these amounts are not equal any additional computations will be incorrect. Third use either the weighted average or FIFO method to determine the equiv- alent units of production for each cost component. If all materials are at the same degree of completion a single materials computation can be made. If multiple materials are used and are placed into production at different points multiple EUP calculations may be necessary for materials. If overhead is based on direct labor or if these two factors are always at the same degree of completion a single EUP can be computed for conversion. If neither condition exists separate EUP schedules must be prepared for labor and overhead. 5 Chapter 6 Process Costing 225 Costing Is a Three-Step Process NEWS NOTE INTERNATIONAL Besides control and budgeting costing is essential to the managerial accounting activities in a company. Costing relates to how many expenses were used up by a prod- uct a product group a particular activity or a set of busi- ness activities. . . . Profits that are disclosed in financial statements are of the most aggregate nature. While segmental prof- its can provide detailed information for the external ana- lyst management often wants to identify the factors con- tributing to company profits with much greater accuracy. Deriving product cost and comparing it with the prices charged is such a detailed analysis. The difference of these two called contribution gives insights into the prof- itability of the company’s various activities. First one has to separate product cost from period cost. Second direct product costs are allocated to the individual products whereas indirect costs are allocated to cost centers. Third indirect costs are attributed from the center to the products according to their usage. The sum of direct and allocated indirect cost forms the prod- uct cost. Costing has a strong tradition in manufacturing. Thus costing procedures typically recognize selling general and administrative expenses SGA as period costs that are not attributable to individual products or prod- uct groups. Product costs are principally expenses for material labor and machinery in the form of deprecia- tion. Other product costs might include expenses as various as light heating insurance waste and so on. Having separated product from period cost one can tackle the second step of allocating direct cost to a prod- uct or any other cost object subject to managerial analy- sis. Direct costs are expenses incurred uniquely for a particular product. This is quite obviously the case for material bills but international differences exist in the treatment of labor. While Anglo-American systems treat labor other than su- pervisory as a direct cost continental European prac- tice often regards all labor cost as indirect. This is due to the different regulatory practices reflecting the lower flexibility that continental labor law permits. For conve- nience reasons direct material also includes a surcharge for the administrative cost of material handling. The third step of costing—attribution of indirect cost— is the most important for achieving accuracy. All indirect costs sometimes referred to as overhead are first allo- cated to cost pools. Cost pools can be areas of decision making responsibility centers service departments or simple physical entities such as machines. A cost pool absorbs all those costs that vary with a certain cost dri- ver activity measure it is this cost driver that reflects the services rendered to a product. SOURCE: Chris Higson “Counting the Cost” Financial Times November 17 1995 Mastering Management—Part 44 p. iv. Reprinted with permission from Financial Times. 5 As discussed in Chapter 4 overhead can be applied to products using a variety of traditional direct labor hours or machine hours or nontraditional such as number of machine setups pounds of material moved and/or number of material requisi- tions bases. The number of equivalent unit computations that need to be made results from the number of different cost pools and overhead allocation bases established in a company. Some highly automated manufacturers may not have a direct labor category. The quantity of direct labor may be so nominal that it is included in a conversion category and not accounted for separately.

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Fourth find the total cost to account for which includes the balance in Work in Process Inventory at the beginning of the period plus all current costs for direct material direct labor and overhead. Fifth compute the cost per equivalent unit for each cost component using either the weighted average or FIFO equivalent units of production calculated in step 3. Sixth use the costs computed in step 5 to assign costs from the production process to the units completed and transferred and to the units remaining in end- ing Work in Process Inventory. The Decorative Waxes Company is used to demonstrate the steps involved in the computation of equivalent units of production and cost assignment for both Part 2 Systems and Methods of Product Costing 226 EXHIBIT 6–3 Steps in Process Costing or Weighted average FIFO + Beginning inventory costs Current costs or Weighted average FIFO or Transferred out FG or next department Ending inventory WIP 1 COMMENTS 2 4 6 5 3 Determine the units in the process. Identify groups of units to be costed beginning work in process started and completed and ending work in process. Identify the related effort incurred for each unit group by cost component i.e. material labor overhead. Determine the costs that have been incurred. Calculate the EUP cost to be assigned per cost component. Calculate the total cost to be assigned to each group of units worked on during the period. Calculate the physical units to account for: Beginning WIP units plus units started Verify that the total costs transferred out plus the costs in ending inventory equal step 4 Assign the costs to inventories Determine the equivalent units of production Verify that step 2 equals step 1 Calculate the physical units accounted for: Units transferred out plus units in ending inventory Determine the total cost to account for Calculate the cost per equivalent unit If not recalculate steps 1 and 2. If not recalculate steps 4 5 and 6. total cost to account for

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methods of process costing. The Decorative Waxes Company makes a variety of sizes and types of candles. One candle made by the Decorative Waxes Company is three inches wide and six inches tall. The company views the manufacturing process of this product as a single department with a single direct material: wax. The company treats the costs of coloring scent and wicks as overhead and candles are not packaged. Because the wax is added at the start of processing all inventories are 100 percent complete as to material as soon as processing has begun. Labor and overhead are assumed to be added at the same rate throughout the produc- tion process. Exhibit 6–4 presents information for April 2000 regarding the candle maker’s production inventories and costs. Although figures are given for both candles transferred and in ending inventory providing both of these figures is not essential. The number of candles remaining in ending inventory on April 30 can be calculated by subtracting the candles that were completed and transferred during the period from the total candles to account for. Alternatively the number of candles transferred can be computed as the total candles to account for minus the candles in ending inventory. The Decorative Waxes Company information is used to illustrate each step listed in Exhibit 6–3. Weighted Average Method STEP 1: CALCULATE THE TOTAL UNITS TO ACCOUNT FOR Candles in beginning inventory 25000 Candles started during current period 510000 Candles to account for 535000 STEP 2: CALCULATE THE TOTAL UNITS ACCOUNTED FOR Candles completed and transferred 523000 Candles in ending WIP inventory 12000 Candles accounted for 535000 The items detailed in this step indicate the categories to which costs will be assigned in the final step. The number of candles accounted for in step 2 equals the number of candles to account for in step 1. STEP 3: DETERMINE THE EQUIVALENT UNITS OF PRODUCTION The weighted average EUP computation uses the number of whole candles in be- ginning inventory and the number of candles started and completed during the Chapter 6 Process Costing 227 Candles in beginning inventory 40 complete as to labor and overhead or conversion 25000 Candles started during current period 510000 Candles completed and transferred to finished goods 523000 Candles in ending inventory 80 complete as to labor and overhead or conversion 12000 Costs of beginning inventory: Direct material 42650 Direct labor 1400 Overhead 15752 59802 Current period costs: Direct material 433500 Direct labor 75777 Overhead 263913 773190 EXHIBIT 6–4 Production and Cost Information—April 1 2000

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period. Units started and completed during a period equals the total units com- pleted during the current period minus the units in beginning inventory. 6 For the Decorative Waxes Company the candles started and completed in April are 498000 523000 25000. Ending inventory is 100 percent complete as to material be- cause all material is added at the start of production. The ending inventory is 80 percent complete as to labor and overhead conversion one EUP computation can be made because these cost elements are assumed to be added at the same rate throughout the production process. The weighted average computation for equivalent units of production is as follows 7 : Conversion DM Labor Overhead Beginning inventory whole candles 25000 25000 Candles started and completed 498000 498000 Ending inventory whole candles complete 12000 9600 Equivalent units of production 535000 532600 STEP 4: DETERMINE THE TOTAL COST TO ACCOUNT FOR The total cost to account for equals beginning inventory cost plus current period costs. Note that information is provided in Exhibit 6–4 on the cost for each ele- ment of production—direct material direct labor and overhead. Production costs can be determined from the departmental Work in Process Inventory accounts and their subsidiary details. These costs come from transfers of direct material from the storeroom incurrence of direct labor and either actual or applied overhead amounts. The sum of direct labor and overhead costs is the conversion cost. For the Decorative Waxes Company the total cost to account for is 832992. DM DL OH Total Beginning inventory costs 42650 1400 15752 59802 Current period costs 433500 75777 263913 773190 To account for 476150 77177 279665 832992 Total cost is assigned to the goods transferred to Finished Goods Inventory or al- ternatively to the next department and to ending Work in Process Inventory in relation to the whole units or equivalent whole units contained in each category. STEP 5: CALCULATE THE COST PER EQUIVALENT UNIT OF PRODUCTION A cost per equivalent unit of production must be computed for each cost compo- nent for which a separate calculation of EUP is made. Under the weighted average method the costs of beginning inventory and the current period are summed for each cost component and averaged over that component’s weighted average equiv- alent units of production. This calculation for unit cost for each cost component at the end of the period is shown below: Unit Cost Total Cost Incurred Total Equivalent Units of Effort Beginning Inventory Cost Current Period Cost Weighted Average Equivalent Units of Production Part 2 Systems and Methods of Product Costing 228 units started and completed 6 Units started and completed can also be computed as the units started during the current period minus the units not fin- ished or the units in ending inventory. 7 Different approaches exist to compute equivalent units of production and unit costs under weighted average and FIFO. The models presented in this chapter represent the computations that we have found to be the most readily understood and that best assist students in a clear and unambiguous reconciliation of these two methods. However two other valid and commonly used approaches for computing and reconciling weighted average and FIFO equivalent units of production and unit costs are presented in the Appendix to this chapter.

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This computation divides total cost by total units—the common weighted average approach that produces an average component cost per unit. Because labor and overhead are at the same degree of completion their costs can be combined and shown as a single conversion cost per equivalent unit. The Decorative Waxes Com- pany’s weighted average calculations for cost per EUP for material and conversion are shown below: Direct Material Conversion Total Beginning inventory costs 42650 17152 59802 Current period costs 433500 339690 773190 Total cost per component 476150 356842 832992 Divided by EUP step 3 535000 532600 Cost per EUP 0.89 0.67 1.56 The amounts for the product cost components material and conversion are summed to find the total production cost for all whole candles completed during April. For the Decorative Waxes Company this cost is 1.56. STEP 6: ASSIGN COSTS TO INVENTORIES This step assigns total production costs to units of product. Cost assignment in a department involves determining the cost of 1 the goods completed and trans- ferred during the period and 2 the units in ending Work in Process Inventory. Using the weighted average method the cost of goods transferred is found by multiplying the total number of units transferred by a cost per unit that combines all the costs of the components or the total cost per EUP. Because this method is based on an averaging technique that combines both prior and current period work it does not matter in which period the transferred units were started. All units and all costs have been commingled. The total cost transferred for the Dec- orative Waxes Company for April is 815880 1.56 523000. Ending WIP Inventory cost is calculated based on the equivalent units of pro- duction for each cost component. The equivalent units of production for each com- ponent are multiplied by the component cost per unit computed in step 5. The cost of ending inventory using the weighted average method using the previously determined equivalent units is as follows: Ending inventory Direct material 12000 0.89 10680 Conversion 9600 0.67 6432 Total cost of ending inventory 17112 The total costs assigned to units transferred and units in ending inventory must equal the total cost to account for. For the Decorative Waxes Company total cost to account for step 4 was determined as 832992 which equals transferred cost 815880 plus cost of ending Work in Process Inventory 17112. The steps just discussed can be combined into a cost of production report. This document details all manufacturing quantities and costs shows the computation of cost per EUP and indicates the cost assignment to goods produced during the period. Exhibit 6–5 shows the Decorative Waxes Company’s cost of production report using the weighted average method. FIFO Method Steps 1 and 2 are the same for the FIFO method as for the weighted average method because these two steps involve the use of physical units. Chapter 6 Process Costing 229 cost of production report

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STEP 3: DETERMINE THE EQUIVALENT UNITS OF PRODUCTION Under FIFO the work performed last period is not commingled with work of the current period. The EUP schedule for FIFO is DM Conversion Candles in beginning inventory completed in the current period 0 15000 Candles started and completed 498000 498000 Ending inventory whole candles complete 12000 9600 Equivalent units of production 510000 522600 Under FIFO only the work performed on the beginning inventory during the current period is shown in the EUP schedule this work equals the whole units in beginning inventory times 1 the percentage of work done in the prior period. No additional material is needed in April to complete the 25000 candles in the beginning inventory. Because beginning inventory was 40 per- cent complete as to labor and overhead the company needs to do 60 percent of the conversion work on the goods in the current period or the equivalent of 15000 candles 25000 60. Part 2 Systems and Methods of Product Costing 230 EQUIVALENT UNITS PRODUCTION DATA OF PRODUCTION Whole Direct Units Material Conversion Beginning inventory 25000 25000 10000 Candles started 510000 Candles to account for 535000 Beginning inventory completed 25000 0 15000 Started and completed 498000 498000 498000 Candles completed 523000 Ending WIP inventory 12000 12000 9600 Candles accounted for 535000 535000 532600 COST DATA Direct Total Material Conversion Costs in beginning inventory 59802 42650 17152 Current period costs 773190 433500 339690 Total cost to account for 832992 476150 356842 Divided by EUP 535000 532600 Cost per EUP 1.56 0.89 0.67 COST ASSIGNMENT Transferred 523000 1.56 815880 Ending inventory Direct material 12000 0.89 10680 Conversion 12000 80 0.67 6432 17112 Total cost accounted for 832992 Fully complete as to material 40 complete as to conversion. Fully complete as to material 80 complete as to conversion. EXHIBIT 6–5 Cost of Production Report for the Month Ended April 30 2000 Weighted Average Method

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Except for the different treatment of units in beginning inventory the remaining figures in the FIFO EUP schedule are the same as for the weighted average method. Thus the only EUP difference between the two methods is equal to the number of candles in beginning inventory times the percentage of work performed in the prior period as shown below: DM Conversion FIFO EUP 510000 522600 Beginning inventory 25000 units work done in prior period: 100 material 40 conversion 25000 10000 WA EUP 535000 532600 STEP 4: DETERMINE THE TOTAL COST TO ACCOUNT FOR This step is the same as it was under the weighted average method the total cost to account for is 832992. STEP 5: CALCULATE THE COST PER EQUIVALENT UNIT OF PRODUCTION Because cost determination is based on equivalent units of production different results will be obtained for the weighted average and FIFO methods. The calcu- lations for cost per equivalent unit reflect the difference in quantity that each method uses for beginning inventory. The EUP calculation for FIFO ignores work performed on beginning inventory during the prior period therefore the FIFO cost compu- tation per EUP also ignores prior period costs and uses only costs incurred in the current period. The FIFO cost per EUP calculation is shown here: Direct Material Conversion Total Current period costs 433500 339690 773190 Divided by EUP step 3 510000 522600 Cost per EUP 0.85 0.65 1.50 It is useful to recognize the difference between the two total cost computations. The weighted average total cost of 1.56 is the average total cost of each candle completed during April regardless of when production was begun. The FIFO total cost of 1.50 is the total cost of each candle produced both started and completed during the period. The 0.06 difference is caused by the difference in treatment of beginning work in process costs. STEP 6: ASSIGN COSTS TO INVENTORIES The FIFO method assumes that the units in beginning inventory are the first units completed during the current period and thus are the first units transferred. The remaining units transferred during the period were both started and completed in the current period. As shown in the cost of production report in Exhibit 6–6 the two-step computation needed to determine the cost of goods transferred distinctly presents this FIFO logic. The first part of the cost assignment for units transferred relates to the units that were in beginning inventory. These units had the cost of material and some labor and overhead costs applied at the start of the period. These costs were not included in the cost per EUP calculations in step 5. The costs to finish these units were incurred in the current period. To determine the total cost of producing the units in beginning inventory the beginning inventory costs are added to the current period costs that were needed to complete the goods. Next the cost of the units started and completed in the current period is computed using current period costs. This cost assignment process for the Decorative Waxes Company which had a Chapter 6 Process Costing 231

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beginning April inventory of 25000 candles and transferred 523000 candles during the month is as follows: Transferred 1 Beginning inventory prior period costs 59802 Completion of beginning inventory: Direct material 0 0.85 0 Conversion 25000 60 0.65 9750 Total cost of beginning inventory transferred 69552 2 Candles started and completed 498000 1.50 747000 Total cost transferred 816552 The beginning inventory was 100 percent complete as to wax at the beginning of April therefore no additional costs for wax need to be added during the period. Conversion at the start of the month was only 40 percent complete so 60 percent of the labor and overhead or 15000 equivalent units is added during April at current period costs. The candles started and completed are costed at the total Part 2 Systems and Methods of Product Costing 232 EQUIVALENT UNITS PRODUCTION DATA OF PRODUCTION Whole Direct Units Material Conversion Beginning inventory 25000 Candles started 510000 Candles to account for 535000 Beginning inventory completed 25000 0 15000 Started and completed 498000 498000 498000 Candles completed 523000 Ending inventory 12000 12000 9600 Candles accounted for 535000 510000 522600 COST DATA Direct Total Material Conversion Costs in beginning inventory 59802 Current period costs 773190 433500 339690 Total cost to account for 832992 Divided by EUP 510000 522600 Current period cost per EUP 1.50 0.85 0.65 COST ASSIGNMENT Transferred Beginning inventory costs 59802 Cost to complete: Conversion 15000 0.65 9750 69552 Started and completed 498000 1.50 747000 Total cost transferred 816552 Ending inventory Direct material 12000 0.85 10200 Conversion 9600 0.65 6240 16440 Total cost accounted for 832992 Fully complete as to material 40 complete as to conversion. Fully complete as to material 80 complete as to conversion. EXHIBIT 6–6 Cost of Production Report for Month Ended April 30 2000 FIFO Method

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current period FIFO cost of 1.50 because these candles were fully manufactured during the current period. 8 The process of calculating the FIFO cost of ending Work in Process Inventory is the same as under the weighted average method. Ending work in process cost using FIFO is as follows: Ending inventory Direct material 12000 0.85 10200 Conversion 9600 0.65 6240 Total cost of ending inventory 16440 The total cost of the candles transferred 816552 plus the cost of the candles in ending inventory 16440 equals the total cost to be accounted for 832992. Summary journal entries and T-accounts for the Decorative Waxes Company for April are given in Exhibit 6–7 on next page. It is assumed that 520000 candles were sold on account for 3.00 per candle and that a perpetual FIFO inventory system is in use. Assume that the Decorative Waxes Company began April with no Finished Goods Inventory. Weighted average amounts are shown where they would differ from FIFO. Chapter 6 Process Costing 233 8 Because of FIFO’s two-step process to determine cost of units transferred a question exists as to how to calculate a per-unit cost for the units that were in beginning inventory and those that were started and completed in the current period. The reso- lution of this question is found in the use of either the strict or the modified FIFO method. If strict FIFO is used beginning inventory units are transferred out at their total completed cost the units started and com- pleted during the current period are transferred at a separate and distinct current period cost. For the Decorative Candle Com- pany use of strict FIFO means that the 25000 candles in beginning inventory are transferred at a cost per unit of 2.78 69552 25000. The candles started and completed in April are transferred at the current period cost of 1.50 computed in step 5. If strict FIFO is used the costs of these two groups should be reported separately and not added together to get a total transferred cost. However unless the difference between the unit costs of beginning inventory units and of units started and completed is significant there is no need to maintain the distinction. The costs of the two groups can be combined and averaged over all of the units transferred in a process known as the modified FIFO method. For the Decorative Waxes Company modified FIFO assigns an average cost of 1.56 per candle 816552 523000 to all candles transferred from the department. Modified FIFO allows the next department or Finished Goods Inventory to account for all units received during the period at the same cost per unit. This method is useful when products are processed through several departments so that the number of separate unit costs to be accounted for does not become excessive. PROCESS COSTING IN A MULTIDEPARTMENT SETTING Most companies have multiple rather than single department processing facilities. In a multidepartment-processing environment goods are transferred from a pre- decessor department to a successor department. For example if the candles at the Decorative Waxes Company were boxed by the dozen the company’s manufac- turing activities could be viewed as occurring in two departments: Processing and Packaging. Manufacturing costs always follow the physical flow of goods. Therefore the costs of the completed units of predecessor departments are treated as input material costs in successor departments. Such a sequential treatment requires the use of an additional cost component element called “transferred-in” or “prior department cost.” This element always has a percentage of completion factor of 100 percent because the goods would not have been transferred out of the pre- decessor department if they had not been fully complete. The transferred-in ele- ment is handled the same as any other cost element in the calculations of EUP and cost per EUP. A successor department might add additional raw materials to the units trans- ferred in or might simply provide additional labor with the corresponding incur- rence of overhead. Anything added in the successor department requires its own cost element column for calculating equivalent units of production and cost per equivalent unit unless the additional elements have the same degree of comple- tion in which case they can be combined.

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Part 2 Systems and Methods of Product Costing 234 1. Work in Process Inventory 433500 Raw Material Inventory 433500 To record issuance of materials to production Exhibit 6–4. 2. Work in Process Inventory 75777 Wages Payable 75777 To accrue wages for direct labor Exhibit 6–4. 3. Manufacturing Overhead 263913 Various accounts 263913 To record actual overhead costs Exhibit 6–4. 4. Work in Process Inventory 263913 Manufacturing Overhead 263913 To apply actual overhead to production. 5. Finished Goods Inventory 816552 Work in Process Inventory 816552 To transfer cost of completed candles to finished goods Exhibit 6–6. Entry would be for 815880 if weighted average were used—Exhibit 6–5. 6. Cost of Goods Sold 812052 Finished Goods Inventory 812052 To transfer cost of goods sold using strict FIFO: First 25000 units 69552 Remaining 495000 units at 1.50 742500 812052 Entry would be for 811200 if weighted average were used: 520000 1.56. 7. Accounts Receivable 1560000 Sales 1560000 To record sales on account 520000 candles 3.00. EXHIBIT 6–7 Process Costing Journal Entries and T-Accounts Work in Process Inventory Beginning balance 59802 Cost of goods manufactured 816552 Direct material 433500 Direct labor 75777 Applied overhead 263913 Ending balance 16440 Finished Goods Inventory Beginning balance 0 Cost of goods sold 812052 Cost of goods manufactured 816552 Ending balance 3000 1.50 4500 Cost of Goods Sold April CGS 812052

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Occasionally successor departments might change the unit of measure used in predecessor departments. For example when the Decorative Waxes Company produces candles the measure in the Processing Department would be number of candles the measure in the Packaging Department would be number of boxes of a dozen candles. The demonstration problem at the end of the chapter provides a complete example of predecessor and successor department activities. Chapter 6 Process Costing 235 Hershey Kisses ® like most other food products are manufactured in a plant that uses process costing. Costs for chocolate melting and shaping would be accumulated in the first depart- ment. The Kisses would then be transferred to a second depart- ment to be wrapped and bagged in packages of various sizes. How can standard costs be used in a process costing system 5 PROCESS COSTING WITH STANDARD COSTS Companies may prefer to use standard rather than actual historical costs for in- ventory valuation purposes. Actual costing requires that a new production cost be computed each production period. Once a production process is established how- ever the “new” costs are often not materially different from the “old” costs so standards for each cost element can be developed and used as predetermined cost benchmarks to simplify the costing process and eliminate periodic cost recompu- tations. Standards do need to be reviewed and possibly revised at a minimum of once per year to keep the amounts current. Calculations for equivalent units of production for standard process costing are identical to those of FIFO process costing. Unlike the weighted average method the emphasis of both standard costing and FIFO are on the measurement and con- trol of current production and current period costs. The weighted average method commingles units and costs of the prior period with those of the current period. This commingling reduces the emphasis on current effort that standard costing is intended to represent and measure. The use of standard costs allows material labor and overhead variances to be measured during the period. To show the differences between using actual and

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standard process costing the Decorative Waxes Company example is continued. The company’s April production and standard cost information is given in Exhibit 6–8. The beginning inventory cost data have been restated from the original to reflect standard costs and to demonstrate the effect of consistent use of standard costs over successive periods. Beginning inventory consisted of 25000 units that were fully complete as to material and 40 percent complete as to conversion. There- fore the standard cost of beginning inventory is as follows: Material 25000 100 0.86 21500 Labor 25000 40 0.15 1500 Overhead 25000 40 0.48 4800 Total 27800 Exhibit 6–9 presents the cost of production report using the Decorative Waxes Company’s standard cost information. 9 When a standard cost system is used inventories are stated at standard rather than actual costs. Summary journal entries for the Decorative Waxes Company’s April production assuming a standard cost FIFO process costing system and amounts from Exhibit 6–9 are as follows: 1. WIP Inventory is debited for 438600: the standard cost 428280 of mater- ial used to complete 498000 units that were started in April plus the standard cost 10320 for the material used to produce ending work in process. Raw Material Inventory is credited for the actual cost of the material withdrawn dur- ing April 433500. Work in Process Inventory 438600 Raw Material Inventory 433500 Direct Material Variance 5100 To record issuance of material at standard and variance from standard. Part 2 Systems and Methods of Product Costing 236 Production Data Beginning inventory 100 40 25000 Units started 510000 Ending inventory 100 80 12000 Standard Cost of Production Direct material 0.86 Direct labor 0.15 Overhead 0.48 Total 1.49 Equivalent Units of Production repeated from Exhibit 6–6: DM Conversion BI candles not complete at start of period 0 15000 Candles started and completed 498000 498000 EI candles complete at end of period 12000 9600 Equivalent units of production 510000 522600 EXHIBIT 6–8 Production and Cost Data Standard Costing 9 Total material labor and overhead variances are shown for the Decorative Waxes Company in Exhibit 6–9. More detailed variances are presented in Chapter 10 on standard costing. Additionally variances from actual costs must be closed at the end of a period. If the variances are immaterial they can be closed to Cost of Goods Sold otherwise they should be allocated among the appropriate inventory accounts and Cost of Goods Sold.

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2. WIP Inventory is debited for the standard cost of labor allowed based on the equivalent units produced in April. The EUPs for the month reflect the pro- duction necessary to complete the beginning inventory 15000 candles plus the candles started and completed 498000 plus the work performed on the ending inventory candles 9600 or a total of 522600 EUP. Multiplying this equivalent production by the standard labor cost per candle of 0.15 gives a total of 78390. Work in Process Inventory 78390 Wages Payable 75777 Direct Labor Variance 2613 To accrue direct labor cost assign it to WIP Inventory at standard and record direct labor variance. 3. Actual factory overhead incurred in April is 263913. Manufacturing Overhead 263913 Various accounts 263913 To record actual overhead cost for April. 4. WIP Inventory is debited for the standard cost of overhead based on the EUPs produced in April. Because labor and overhead are consumed at the same rate Chapter 6 Process Costing 237 COSTS TO BE ACCOUNTED FOR Direct Direct Material Labor Overhead Total Total costs BWIP at standard 21500 1500 4800 27800 Current period actual 433500 75777 263913 773190 1 Total 455000 77277 268713 800990 COST ASSIGNMENT AT STANDARD Transferred BI cost 21500 1500 4800 27800 Cost to complete DL 15000 0.15 2250 OH 15000 0.48 7200 Total cost to complete 9450 Started and completed DM 498000 0.86 428280 DL 498000 0.15 74700 OH 498000 0.48 239040 Total started and completed 742020 Ending inventory DM 12000 0.86 10320 DL 9600 0.15 1440 OH 9600 0.48 4608 Total WIP ending 16368 2 Total standard cost assigned 460100 79890 255648 795638 Variances from actual 1 2 5100 2613 13065 5352 Total costs accounted for 455000 77277 268713 800990 NOTE: Favorable variances are shown in parentheses. Beginning work in process is carried at standard costs rather than actual. Therefore no portion of the variance is attributable to BWIP. Any variance that might have been associated with BWIP was measured and identified with the prior period. EXHIBIT 6–9 Cost of Production Report for Month Ended April 30 2000 Standard Costing

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equivalent production is the same as in entry 2: 522600 EUPs. Multiplying the EUPs by the standard overhead application rate of 0.48 per candle gives 250848. Work in Process Inventory 250848 Manufacturing Overhead Variance 13065 Manufacturing Overhead 263913 To apply overhead to WIP Inventory and record the overhead variance. 5. Finished Goods Inventory is debited for the total standard cost 779270 of all 523000 candles completed during the month 1.49 523000. Finished Goods Inventory 779270 Work in Process Inventory 779270 To transfer standard cost of completed candles to FG Inventory. A standard costing system eliminates the need to be concerned about differ- entiating between the per-unit cost of the beginning inventory units that were com- pleted and the per-unit cost of the units started and completed in the current period. All units flowing out of a department are costed at the standard or “normal” production cost for each cost component: direct material direct labor and over- head. Thus recordkeeping is simplified and variations from the norm are high- lighted in the period of incurrence. Standard cost systems are discussed in depth in Chapter 10. Standard costing not only simplifies the cost flows in a process costing system but it also provides a useful tool to control costs. By developing standards man- agers have a benchmark against which actual costs can be compared. Variances serve to identify differences between the benchmark standard cost and the ac- tual cost. By striving to control variances managers control costs. Managers should also compare their firm’s costs to costs incurred by other firms. Part 2 Systems and Methods of Product Costing 238 HYBRID COSTING SYSTEMS Many companies are now able to customize what were previously mass-produced items. In such circumstances neither job order nor process costing techniques are perfectly suited to attach costs to output. Thus companies may choose to use a hybrid costing system that is appropriate for their particular processing situation. A hybrid costing system combines certain characteristics of a job order system and a process costing system. A hybrid system would be used for example in a manu- facturing environment in which various product lines have different direct materials but similar processing techniques. To illustrate the need for hybrid systems assume you order an automobile with the following options: leather seats a Bose stereo system and compact disk player cruise control and pearlized paint. The costs of all options need to be traced specif- ically to your car but the assembly processes for all the cars produced by the plant are similar. The job order costing feature of tracing direct materials to specific jobs is combined with the process costing feature of averaging labor and overhead costs over all homogeneous production to derive the total cost of the automobile you ordered. It would not be feasible to try to use a job order costing system to trace labor or overhead cost to your car individually and it would be improper to av- erage the costs of your options over all the cars produced during the period. The accompanying News Note reflects a build-to-order approach in the automobile industry. Why would a company use a hybrid costing system hybrid costing system 6

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A hybrid costing system is appropriate for companies producing items such as furniture clothing or jam. In each instance numerous kinds of raw materials could be used to create similar output. A table may be made from oak teak or mahogany a blouse may be made from silk cotton or polyester and jam may be made from peach strawberries or marmalade. The material cost for a batch run would need to be traced separately but the production process of the batch is repetitive. Hybrid costing systems allow accounting systems to portray more accurately the actual type of manufacturing activities in which companies are engaged. Job order costing and process costing are two ends of a continuum and as is typically the case for any continuum neither end is necessarily the norm. As flexible manu- facturing increases so will the use of hybrid costing systems. Chapter 6 Process Costing 239 Computer Techniques for Car Production NEWS NOTE GENERAL BUSINESS Toyota Motor Corp. announced in 1999 that it would soon begin producing the Camry Solara coupe to customer order in just five days and it would do the same for other models starting later in that year. The announcement surprised an industry that typically requires 30 to 60 days to produce a custom order. The Toyota announcement raises two questions. First will the automobile industry which now predominantly fol- lows a “make to stock” model in North America change to “make to order” which is more common in Europe and in Japan Second will Toyota gain a significant com- petitive advantage by making this transition first This is a serious question and the personal-computer industry shows why. By making and delivering personal computers to order Dell Computer catapulted itself from a crowded field to become an industry leader. In just a few years Dell picked up more than six percentage points in market share. But until now no major manufacturer was prepared to offer quick custom-order delivery. Some visionaries en- visioned a 15-day car but no one thought it was just around the corner. There is plenty of skepticism about whether Toyota can achieve a five-day car without mak- ing unacceptable compromises in flexibility and total de- livery lead time. Toyota’s announcement however leaves little room for doubt about the company’s strategy. It was not a trial balloon but a confident statement of intent. How much of a competitive advantage can Toyota gain from a five-day car The Dell success story offers an in- teresting parallel although Dell sells directly to customers while Toyota will continue to sell through dealers. Even so Toyota can derive savings from a build-to-order strategy as it can help dealers drive down retail inventories. SOURCE: Jeffrey Bodenstab “An Automaker Tries the Dell Way” The Wall Street Journal August 30 1999 p. A26. Permission conveyed through the Copyright Clearance Center. Lumina Candles Art REVISITING eeswax is one of nature’s useful and fragrant gifts. It takes about 160000 bees to produce 60 pounds of honey that only yield about one pound of beeswax. Naturally fragrant beeswax is dripless burns cleaner and lasts longer than petroleum-based waxes. Beeswax candles also burn without creating smoke. To demonstrate how long a beeswax candle can last Kelly Borsheim timed an eight- inch pillar candle that after 60 hours still had greater than half remaining. At that point she discontinued timing it. Lumina Candles Art is somewhat of a diversified home-based business. Not only does the company provide all the supplies and instructions needed to make beeswax http:// B http:// http://

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Part 2 Systems and Methods of Product Costing 240 SOURCE: Lumina Candles Art Web site: candles but Kelly also creates award-winning artistic sculptures and paintings. In addition Kelly provides art lessons in creating both sculpture and painting. Kelly Borsheim is devoted to helping aspiring candle makers and artists succeed not only in their production of beautiful works but also in their success as business people. For example the Lumina Candles Art Web site provides a section entitled “Tips on How to Start Your Own Candle Business.” The Web site also includes other sections on effective management and marketing for candle and art business ventures. Process costing is an averaging method used to assign costs to output in manu- facturing situations producing large quantities of homogeneous products. A process costing system may use either the weighted average or FIFO method to compute equivalent units of and assign costs to production. The difference between the two methods lies solely in the treatment of the work performed in the prior period on the beginning work in process inventory. Under the weighted average method work performed in the prior period is combined with current period work and the total costs are averaged over all units. Using the FIFO method work performed in the last period on beginning work in process inventory is not commingled with current period work nor are costs of beginning work in process added to current period costs to derive unit production cost. With FIFO current period costs are divided by current period production to generate a unit production cost related entirely to work actually performed in the current period. Six steps must be taken when deriving and assigning product cost under a process costing system: 1. Calculate the total number of physical units to account for. 2. Calculate the physical units accounted for by tracing the physical flow of units. This step involves identifying the groups to which costs are to be assigned transferred out of or remaining in ending inventory. 3. Determine the number of equivalent units of production either on the weighted average or FIFO basis for each cost component. The cost components include transferred-in if multidepartmental direct material direct labor and overhead. In cases of multiple materials having different degrees of completion each material is considered a separate cost component. If overhead is applied on a direct labor basis or is incurred at the same rate as direct labor labor and over- head can be combined as one cost component and referred to as “conversion.” 4. Determine the total cost to account for which is the sum of beginning inven- tory costs and all production costs incurred for the current period. 5. Calculate the cost per equivalent unit of production for each cost component. 6. Assign the costs to the units transferred and the units in ending work in process inventory. The method of cost assignment depends on whether weighted average or FIFO costing is used. The total of the costs assigned to units trans- ferred and to units in ending work in process inventory must equal the total cost to account for. The FIFO method of process costing can be combined with standard costs so that a “normal” production cost is assigned each period to equivalent units of out- put. This technique allows managers to quickly recognize and investigate significant deviations from normal production costs. CHAPTER SUMMARY

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Hybrid costing systems allow companies to combine the characteristics of both job order and process costing systems. Direct material or direct labor that is related to a particular batch of goods can be traced to those specific goods using job order costing. Cost components that are common to numerous batches of output are accounted for using process costing techniques. Chapter 6 Process Costing 241 Alternative Calculations of Weighted Average and FIFO Methods Various methods are used to compute equivalent units of production under the weighted average and FIFO methods. One of the most common variations is the following EUP calculation for weighted average: Units transferred whole units Ending work in process equivalent units Weighted average EUP Once the weighted average EUP figure is available the FIFO equivalent units can be quickly derived by subtracting the equivalent units in beginning work in process inventory that had been produced in the previous period: Weighted average EUP Beginning work in process equivalent units FIFO EUP This computation is appropriate for the following reason: The weighted average method concentrates on the units that were completed during the period as well as the units that were started but not completed during the period. Unlike FIFO the weighted average method does not exclude the equivalent units that were in begin- ning inventory. Thus to convert from weighted average to FIFO simply remove the equivalent units produced in the previous period from beginning work in process. The Decorative Waxes Company’s April production data presented in the chapter are repeated here to illustrate these alternative calculations for the weighted average and FIFO methods. Candles in beginning work in process 100 complete as to material 40 complete as to conversion costs 25000 Candles started during the month 510000 Candles completed during the month 523000 Candles in ending work in process 100 complete as to material 80 complete as to conversion costs 12000 Using these data the EUPs are computed as follows: DM Conversion Candles transferred 523000 523000 Ending work in process equivalent units 12000 candles 100 and 80 complete 12000 9600 Weighted average EUP 535000 532600 Beginning work in process equivalent units produced in previous period 25000 candles 100 and 40 complete 25000 10000 FIFO EUP 510000 522600 APPENDIX What alternative methods can be used to calculate equivalent units of production 7

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The distinct relationship between the weighted average and FIFO costing mod- els can also be used to derive the equivalent units of production calculations. This method begins with the total number of units to account for in the period. From this amount the EUPs to be completed next period are subtracted to give the weighted average EUP. Next as in the method shown above the equivalent units completed in the prior period the beginning Work in Process Inventory are de- ducted to give the FIFO equivalent units of production. Using the Decorative Waxes Company data these computations are as follows: DM Conversion Total units to account for 535000 535000 EUP to be completed next period ending inventory not completed: 12000 0 12000 20 2400 Weighted average EUP 535000 532600 EUP completed in prior period beginning inventory completed last period: 25000 100 25000 40 25000 10000 FIFO EUP 510000 522600 These alternative calculations can either be used to confirm answers found by using beginning inventory units units started and completed and ending inven- tory units or as a shortcut to initially compute equivalent units of production. Part 2 Systems and Methods of Product Costing 242 KEY TERMS cost of production report p. 229 equivalent units of production EUP p. 222 FIFO method of process costing p. 223 hybrid costing system p. 238 total cost to account for p. 226 total units to account for p. 224 units started and completed p. 228 weighted average method of process costing p. 223 Steps in Process Costing Computations 1. Compute the total units to account for in physical units: Beginning inventory in physical units Units started or transferred in during period 2. Compute units accounted for in physical units: Units completed and transferred Ending inventory in physical units 3. Compute equivalent units of production per cost component: a. Weighted average Beginning inventory in physical units Units started and completed Ending inventory complete SOLUTION STRATEGIES

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b. FIFO Beginning inventory not complete at start of period Units started and completed Ending inventory complete Units started and completed Units transferred Units in beginning inventory. 4. Compute total cost to account for: Costs in beginning inventory Costs of current period 5. Compute cost per equivalent unit per cost component: a. Weighted average Cost of component in beginning inventory Cost of component for current period Total cost of component EUP for component b. FIFO Cost of component for current period EUP for component 6. Assign costs to inventories: a. Weighted average 1 Transferred: Units transferred Total cost per EUP for all components 2 Ending inventory: EUP for each component Cost per EUP for each component b. FIFO 1 Transferred: Beginning inventory costs Beginning inventory not complete at beginning of period for each component Cost per EUP for each component Units started and completed Total cost per EUP for all components 2 Ending inventory: EUP for each component Cost per EUP for each component Chapter 6 Process Costing 243 The Sporting Bag Company manufactures golf bags in a two-department process: Assembly and Finishing. The Assembly Department uses weighted average cost- ing the cost driver for overhead in this department is unrelated to direct labor. The Finishing Department adds the hardware to the assembled bags and uses FIFO costing. Overhead is applied to the bags in this department on a direct labor basis. During June the following production data and costs have been gathered: DEMONSTRATION PROBLEM

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ASSEMBLY DEPARTMENT: UNITS Beginning work in process 100 complete for material 40 complete for labor 30 complete for overhead 250 Units started 8800 Ending work in process 100 complete for material 70 complete for labor 90 complete for overhead 400 ASSEMBLY DEPARTMENT: COSTS Material Direct Labor Overhead Total Beginning inventory 3755 690 250 4695 Current 100320 63606 27681 191607 Totals 104075 64296 27931 196302 FINISHING DEPARTMENT: UNITS Beginning work in process 100 complete for transferred-in 15 complete for material 40 complete for conversion 100 Units transferred in 8650 Ending work in process 100 complete for transferred-in 30 complete for material 65 complete for conversion 200 FINISHING DEPARTMENT: COSTS Transferred-In Direct Material Conversion Total Beginning inventory 2176 30 95 2301 Current 188570 15471 21600 225641 Totals 190746 15501 21695 227942 Required: a. Prepare a cost of production report for the Assembly Department. b. Prepare a cost of production report for the Finishing Department. Solution to Demonstration Problem a. EQUIVALENT UNITS OF PRODUCTION Whole Direct Direct Units Material Labor Overhead Beginning inventory 250 250 100 75 Units started 8800 Units to account for 9050 BWIP completed 250 0 150 175 Started and completed 8400 8400 8400 8400 Units completed 8650 Ending inventory 400 400 280 360 Units accounted for 9050 Weighted average EUP 9050 8930 9010 Part 2 Systems and Methods of Product Costing 244

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COST DATA Whole Direct Direct Units Material Labor Overhead Total BWIP costs 4695 3755 690 250 Current period costs 191607 100320 63606 27681 Total costs 196302 104075 64296 27931 Divided by EUP 9050 8930 9010 Cost per EUP 21.80 11.50 7.20 3.10 COST ASSIGNMENT Transferred out 8650 21.80 188570 Ending inventory Direct material 400 11.50 4600 Direct labor 280 7.20 2016 Overhead 360 3.10 1116 7732 Total cost accounted for 196302 b. EQUIVALENT UNITS OF PRODUCTION Whole Direct Units Transferred-In Material Conversion Beginning inventory 100 Units started 8650 Units to account for 8750 BWIP completed 100 0 85 60 Started and completed 8450 8450 8450 8450 Units completed 8550 Ending inventory 200 200 60 130 Units accounted for 8750 FIFO EUP 8650 8595 8640 COST DATA Total BWIP costs 2301 Current period costs 225641 188570 15471 21600 Total costs 227942 Divided by EUP 8650 8595 8640 Cost per EUP 26.10 21.80 1.80 2.50 COST ASSIGNMENT Transferred out Beginning inventory cost 2301 Cost to complete: Transferred-in 0 21.80 0 Direct material 85 1.80 153 Conversion 60 2.50 150 2604 Started and completed 8450 26.10 220545 Ending inventory Transferred-in 200 21.80 4360 Direct material 60 1.80 108 Conversion 130 2.50 325 4793 Total cost accounted for 227942 Chapter 6 Process Costing 245

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Part 2 Systems and Methods of Product Costing 246 1. What are the typical characteristics of a company that should employ a process costing system 2. Why is the process of assigning costs to products essentially an averaging process 3. How are job order and process costing similar How do they differ 4. Why are equivalent units of production used as an output measure in process costing In your answer be sure to address the problems created by partially completed inventories. 5. What creates the difference between weighted average and FIFO equivalent units of production Which EUP calculation more accurately portrays the ac- tual flow of units through a manufacturing process and why 6. Why is it necessary to calculate separate equivalent units of production for each cost component of a product Are there times when separate EUP sched- ules are not necessary and if so why 7. How are units “started and completed” in the current period calculated Is this figure used in both weighted average and FIFO cost assignment Why or why not 8. In which of the six basic steps used in process costing are physical units used and in which are equivalent units of production used Are there steps in which neither physical nor equivalent units are used Why or why not 9. How is the unit cost for each cost component assigned to the units produced during the current period under a the weighted average method and b the FIFO method 10. What is the purpose of the cost of production report How would such a re- port assist accountants in making journal entries for a period 11. Would it be correct to subtract the cost computed for EWIP from the total costs to account for as a shortcut to determine the cost of goods transferred out If you answered yes is there a risk in doing this 12. Why does the “Transferred Out” section of the FIFO method cost of produc- tion report include multiple computations whereas the same section for the weighted average report only includes one computation 13. How does process costing in a multidepartmental manufacturing environment differ from that of a single-department manufacturing environment Why does this difference exist 14. Why are the EUP calculations made for standard process costing the same as the EUP calculations for FIFO process costing 15. How are inventories accounted for under a standard process costing system What information is provided to management when inventories are accounted for in this manner 16. What is a hybrid costing system Under what circumstances is the use of such a system appropriate 17. Find five companies in different industries on the Internet that you believe use process costing. Name these companies provide their Web addresses in- dicate what products they make and discuss why you believe they use process costing. QUESTIONS 18. EUP weighted average Newton Quiches uses a weighted average process costing system. All material is added at the start of the production process. Di- rect labor and overhead are added at the same rate throughout the process. Newton’s records indicate the following production for October 2000: EXERCISES

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Beginning inventory 70 complete as to conversion 120000 units Started during October 170000 units Completed during October 260000 units Ending inventory for October is 20 percent complete as to conversion. a. What are the equivalent units of production for direct material b. What are the equivalent units of production for labor and overhead 19. EUP FIFO Assume that Newton Quiches in Exercise 18 uses the FIFO method of process costing. a. What are the equivalent units of production for direct material b. What are the equivalent units of production for labor and overhead 20. EUP weighted average FIFO McArthur Corporation makes toy metal soldiers in a one-department production process. All metal is added at the beginning of the process. Paint for the figures and the plastic bags for packaging are considered indirect materials. The following information is available relative to September 2000 production activities: Beginning inventory: 75000 figures 60 complete as to labor 85 complete as to overhead Started into production: metal for 250000 figures which were cast during the month Ending inventory: 30000 figures 70 complete as to labor 90 complete as to overhead a. Compute the EUP for direct material direct labor and overhead using weighted average process costing. b. Compute the EUP for direct material direct labor and overhead using FIFO process costing. c. Reconcile the calculations in parts a and b. 21. Cost per EUP weighted average Flickering Figurines manufactures wax fig- urines. In October 2000 company production is 26800 equivalent units for direct material 24400 equivalent units for labor and 21000 equivalent units for overhead. During October direct material and conversion costs incurred are as follows: Direct material 78880 Direct labor 122400 Overhead 42600 Beginning inventory costs for October were 14920 for direct material 36200 for labor and 9900 for overhead. What is the weighted average cost per equivalent unit for the cost components for October 22. Cost per EUP FIFO Assume that Flickering Figurines in Exercise 21 had 3600 EUP for direct material in October’s beginning inventory 4000 EUP for direct labor and 3960 EUP for overhead. What was the FIFO cost per equivalent unit for direct material labor and overhead for October 23. Cost per EUP weighted average FIFO Garden Edges manufactures concrete garden border sections. May 2001 production and cost information are as follows: WA EUP: Direct material 40000 sections Direct labor 38000 sections Overhead 37500 sections FIFO EUP: Direct material 30000 sections Direct labor 31000 sections Overhead 33000 sections BI costs: Direct material 5300 Direct labor 1580 Overhead 3630 Current period costs: Direct material 13500 Direct labor 8680 Overhead 21120 Chapter 6 Process Costing 247

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All material is added at the beginning of processing. a. What is the total cost to account for b. Using weighted average process costing what is the cost per equivalent unit for each cost component c. Using FIFO process costing what is the cost per equivalent unit for each cost component d. How many units were in beginning inventory and at what percentage of completion was each cost component 24. EUP cost per EUP weighted average TakeThat manufactures canisters of mace. On August 1 2001 the company had 4800 units in beginning Work in Process Inventory that were 100 percent complete as to canisters 60 percent complete as to other materials 10 percent complete as to direct labor and 20 percent complete as to overhead. During August TakeThat started 22500 units into the manufacturing process. Ending Work in Process Inventory included 3600 units that were 100 percent complete as to canisters 30 percent complete as to other materials 25 percent complete as to direct labor and 30 percent complete as to overhead. Cost information for the month follows: Beginning inventory: Canisters 8175 Other direct materials 3393 Direct labor 1212 Overhead 1038 August costs: Canisters 39600 Other direct materials 20148 Direct labor 61812 Overhead 43734 Prepare a schedule showing TakeThat’s August 2001 computation of weighted average equivalent units of production and cost per equivalent unit. 25. EUP cost per EUP FIFO ReallyRoll makes skateboards and uses a FIFO process costing system. The company began April 2001 with 1000 boards in process that were 70 percent complete as to material and 85 percent complete as to conversion. During the month 3800 additional boards were started. On April 30 800 boards were still in process 60 percent complete as to material and 70 percent complete as to conversion. Cost information for April 2001 is as follows: Beginning inventory costs: Direct material 13181 Conversion 6732 Current period costs: Direct material 71064 Conversion 29309 a. Calculate EUP for each cost component using the FIFO method. b. Calculate cost per EUP for each cost component. 26. Cost assignment weighted average Thomson Co. uses weighted average process costing. The company’s cost accountant has determined the following produc- tion and cost per EUP information for January 2001: Units transferred out during month 256000 Units in ending inventory 100 complete as to direct material 80 complete as to direct labor 95 complete as to overhead 37000 Direct material cost per EUP 3.75 Direct labor cost per EUP 4.96 Overhead cost per EUP 5.10 a. What is the cost of the goods transferred during January b. What is the cost of the goods in ending inventory at January 31 2001 c. What is the total cost to account for during January Part 2 Systems and Methods of Product Costing 248

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27. Cost assignment FIFO In November 2000 Walker Corporation computed its costs per equivalent unit under FIFO process costing as follows: Raw material 12.75 Packaging 1.50 Direct labor 6.42 Overhead 3.87 The raw material is added at the start of processing. Packaging is added at the end of the production process immediately before the units are transferred to the finished goods warehouse. Beginning inventory cost was 513405 and consisted of: • 344520 raw material cost for 27000 EUP • 95931 direct labor cost for 14850 EUP and • 72954 overhead cost for 18900 EUP. Walker transferred a total of 185000 units to finished goods during November which left 16000 units in ending inventory. The EI units were 20 percent com- plete as to direct labor and 35 percent complete as to overhead. a. What percentage complete were the beginning inventory units as to raw material Packaging Direct labor Overhead b. What was the total cost of the completed beginning inventory units c. What was the cost of the units started and completed in November d. What was the cost of November’s ending inventory 28. EUP cost per EUP cost assignment FIFO weighted average Berne Company mass produces miniature speakers for portable CD players. The following T- account presents the firm’s cost information for February 2001: Work in Process Inventory 2/1 Direct material cost in BI 1027 2/1 Conversion cost in BI 588 Feb. DM received 11682 Feb. DL incurred 2513 Feb. OH applied to production 1257 The company had 400 units in process on February 1. These units were 40 percent complete as to material and 30 percent complete as to conversion. During February the firm started 1500 units and ended the month with 150 units still in process. The units in ending WIP Inventory were 20 percent com- plete as to material and 70 percent complete as to conversion. a. Compute the unit costs for February under the FIFO method for direct material and for conversion. b. Compute the unit costs for February under the weighted average method for direct material and for conversion. c. Determine the total costs transferred to Finished Goods Inventory during February using the FIFO method. 29. EUP weighted average FIFO two departments Jones Metals has two pro- cessing departments Fabrication and Assembly. Metal is placed into produc- tion in the Fabrication Department where it is cut formed or ground into var- ious components. These components are transferred to Assembly where they are welded polished and hot-dip galvanized with sealant. The production data follow for these two departments for March 2001: Chapter 6 Process Costing 249

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Fabrication Beginning WIP inventory 100 complete as to material 45 complete as to conversion 5000 Units started during month 39000 Ending WIP inventory 100 complete as to material 80 complete as to conversion 6800 Assembly Beginning WIP inventory 0 complete as to sealant 15 complete as to conversion 1500 Units started during month Ending WIP inventory 100 complete as to sealant 75 complete as to conversion 4600 a. Determine the equivalent units of production for each cost component for each department under the weighted average method. b. Determine the equivalent units of production for each cost component for each department under the FIFO method. 30. Standard process costing variances DiskCity Products manufactures 3.5-inch preformatted computer disks and uses a standard process costing system. All material is added at the start of production and labor and overhead are incurred equally throughout the process. The standard cost of one disk is as follows: Direct material 0.13 Direct labor 0.02 Overhead 0.11 Total cost 0.26 The following production and cost data are applicable to April 2001: Beginning inventory 45 complete 17000 units Started in April 130000 units Ending inventory 65 complete 14400 units Current cost of direct material 18400 Current cost of direct labor 2598 Current cost of overhead 15000 a. What cost is carried as the April beginning balance of Work in Process Inventory b. What cost is carried as the April ending balance of Work in Process Inventory c. What cost is transferred to Finished Goods Inventory for April d. Using the FIFO method what are the total direct material direct labor and overhead variances for April 31. Standard process costing Tico Company uses a standard FIFO process cost- ing system to account for its tortilla manufacturing process. The tortillas are packaged and sold by the dozen. The company has set the following standards for production of each one-dozen package: Direct material—ingredients 0.35 Direct material—package 0.05 Direct labor 0.07 Overhead 0.13 Total cost 0.60 On June 1 the company had 7200 individual tortillas in process these were 100 percent complete as to ingredients 0 percent complete as to the packag- ing and 30 percent complete as to labor and overhead. One hundred forty- four thousand tortillas were started during June and 147960 were finished. The Part 2 Systems and Methods of Product Costing 250

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ending inventory was 100 percent complete as to ingredients 0 percent com- plete as to the packaging and 60 percent complete as to labor and overhead. a. What were the equivalent units of production for June b. What was the cost of the packages transferred to Finished Goods Inventory during June c. What was the cost of the ending Work in Process Inventory for June 32. Hybrid costing Carolina Coats makes casual coats one size fits most. Each coat goes through the same conversion process but three types of fabric Dacron denim or cotton are available. The company uses a standard cost- ing system and standard costs for each type of coat follow: Dacron Denim Cotton Material 5 yards 10 5 12 Direct labor 2 hours 12 12 12 Overhead based on 1.5 machine hours 9 9 9 Total 31 26 33 Material is added at the start of production. In March 2001 there was no begin- ning Work in Process Inventory and 1500 coats were started into production. Of these 200 were Dacron 600 were denim and 700 were cotton. At the end of March 300 jackets 50 Dacron 100 denim and 150 cotton were not yet completed. The stage of completion for each cost component for the 300 un- finished jackets is as follows: Material 100 complete Direct labor 25 complete Overhead 35 complete a. Determine the total cost of the coats completed and transferred to Finished Goods Inventory. b. Determine the total cost of the coats in ending Work in Process Inventory. Chapter 6 Process Costing 251 33. EUP weighted average FIFO Patio Company produces outdoor brooms. On April 30 2001 the firm had 3600 units in process that were 70 percent com- plete as to material 40 percent complete as to direct labor and 30 percent complete as to overhead. During May 186000 brooms were started. Records indicate that 184200 units were transferred to Finished Goods Inventory in May. Ending units in process were 40 percent complete as to material 25 per- cent complete as to direct labor and 10 percent complete as to overhead. a. Calculate the physical units to account for in May. b. How many units were started and completed during May c. Determine May’s EUP for each category using the weighted average method. d. Determine May’s EUP for each category using the FIFO method. e. Reconcile your answers to parts c and d. 34. EUP weighted average FIFO The Midwest Coal Company mines and processes coal that is sold to four power plants in central Pennsylvania. The company employs a process costing system to assign production costs to the coal it processes. For the third week in March 2001 the firm had a beginning Work in Process Inventory of 50000 tons of ore that were 100 percent com- plete as to material and 30 percent complete as to conversion. During the week an additional 200000 tons of ore were started in process. At the end of PROBLEMS

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the week 35000 tons remained in Work in Process Inventory and were 70 percent complete as to material and 60 percent complete as to conversion. For the third week in March: a. Compute the total units to account for. b. Determine how many units were started and completed. c. Determine the equivalent units of production using the weighted average method. d. Determine the equivalent units of production using the FIFO method. 35. Weighted average Frankfurt Products manufactures an electronic language trans- lator. The device can translate seven languages in either direction. Analysis of beginning Work in Process Inventory for February 2001 revealed the following: 800 Units Percent Complete Cost Incurred Material 45 8700 Direct labor 65 3800 Overhead 40 6600 Total beginning WIP 19100 During February Frankfurt Products started production of another 3800 trans- lators and incurred 85380 for material 23560 for direct labor and 65720 for overhead. On February 28 the company had 400 units in process 70 per- cent complete as to material 90 percent complete as to direct labor and 80 percent complete as to overhead. a. Prepare a cost of production report for February using the weighted aver- age method. b. Journalize the February transactions. c. Prepare T-accounts to represent the flow of costs for Frankfurt Products for February. Use “XXX” where amounts are unknown and identify what each unknown amount represents. 36. Weighted average Alt Enterprises manufactures belt buckles in a single-step production process. To determine the proper valuations for inventory balances and Cost of Goods Sold you have obtained the following information for August 2001: Whole Cost of Cost of Units Material Labor Beginning work in process 400000 400000 630000 Units started during period 2000000 2600000 3990000 Units transferred to finished goods 1800000 Beginning inventory units were 100 percent complete as to material but only 80 percent complete as to labor and overhead. The ending inventory units were 100 percent complete as to material and 50 percent complete as to conversion. Overhead is applied to production at the rate of 60 percent of direct labor cost. a. Prepare a schedule to compute equivalent units of production by cost com- ponent assuming the weighted average method. b. Determine the unit production costs for material and conversion. c. Calculate the costs assigned to completed units and ending inventory for August 2000. 37. Weighted average You have just been hired as the cost accountant for Sun Valley Micro a producer of personal computer cases. This position has been vacant for one month. John Amos manager of the firm’s tax department has performed some computations for last month’s information however he con- fesses to you that he doesn’t remember a great deal about cost accounting. In the production process materials are added at the beginning of pro- duction and overhead is applied to each product at the rate of 70 percent of Part 2 Systems and Methods of Product Costing 252

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direct labor cost. There was no Finished Goods Inventory at the beginning of July. A review of the firm’s inventory cost records provides you with the follow- ing information: Units DM Cost DL Cost Work in Process 7/1/00 70 complete as to labor and overhead 100000 750000 215000 Units started in production 1300000 Costs for July 4850000 3265000 Work in Process 7/31/00 40 complete as to labor and overhead 400000 At the end of July the cost of Finished Goods Inventory was determined to be 124033. a. Prepare schedules for July 2000 to compute the following: 1. Equivalent units of production using the weighted average method. 2. Unit production costs for material labor and overhead. 3. Cost of Goods Sold. b. Prepare the journal entries to record the July transfer of completed goods and the July cost of goods sold. CPA adapted 38. FIFO cost per EUP The following information has been gathered from the records of Jack’s Snacks for August 2001. The firm makes a variety of snacks the information presented here is for a cashew and dried mango mix. Materi- als are added at the beginning of processing overhead is applied on a direct labor basis. The mix is transferred to a second department for packaging. Jack’s uses a FIFO process costing system. Beginning WIP inventory 40 complete as to conversion 5000 pounds Mix started in August 90400 pounds Ending WIP inventory 70 complete as to conversion 4000 pounds Materials cost incurred in August 415840 Conversion costs incurred in August 106030 Beginning inventory cost totaled 13875. For August 2001 compute the follow- ing: a. Equivalent units of production by cost component. b. Cost per equivalent unit by cost component. c. Cost of mix transferred to the packaging department in August. d. Cost of August’s ending inventory. 39. Cost assignment FIFO Green Seasons Processors is a contract manufacturer for the Delectable Dressing Company. Green Seasons uses a FIFO process cost- ing system to account for the production of its salad dressing. All ingredients are added at the start of the process. Delectable provides reusable vats to Green Seasons for the completed product to be shipped to Delectable for bottling so Green Seasons incurs no packaging costs. April 2001 production and cost in- formation for Green Seasons Processors is as follows: Gallons of dressing in beginning inventory 37000 Gallons transferred out during April 243000 Gallons of dressing in ending inventory 23500 Costs of beginning inventory: Direct material 181300 Direct labor 45695 Overhead 50320 Costs incurred in April: Direct material 1131435 Direct labor 452976 Overhead 770133 Chapter 6 Process Costing 253

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The beginning and ending inventories had the following degrees of comple- tion each for labor and overhead: Beginning Inventory Ending Inventory Direct labor 35 25 Overhead 60 30 a. How many gallons of dressing ingredients were started in April b. What is the total cost of the completed beginning inventory c. What is the total cost of goods completed during April d. What is the average cost per gallon of all goods completed during April e. What is the cost of April’s ending WIP inventory 40. Weighted average FIFO In a single-process production system the Cleopatra Corporation produces press-on fingernails. For October 2000 the company’s accounting records reflected the following: Beginning Work in Process Inventory 100 complete as to material 30 complete as to direct labor 60 complete as to overhead 6000 units Units started during the month 45000 units Ending Work in Process Inventory 100 complete as to material 40 complete as to direct labor 70 complete as to overhead 10000 units Cost Component Beginning Inventory October Material 4980 45000 Direct labor 450 21600 Overhead 3180 33300 a. For October prepare a cost of production report assuming the company uses the weighted average method. b. For October prepare a cost of production report assuming the company uses the FIFO method. 41. FIFO second department Bixby Company makes porcelain kitchen sinks in a process requiring operations in three separate departments: Molding Curing and Finishing. Materials are first introduced in the molding operation and additional material is added during the curing process. The following infor- mation is available for the Curing Department for May 2001: Beginning WIP Inventory degree of completion: transferred-in 100 direct material 80 direct labor 40 overhead 30 8000 units Transferred-in from Molding 40000 units Ending WIP Inventory degree of completion: transferred-in 100 direct material 70 direct labor 50 overhead 40 4000 units Transferred to Finishing units Cost Component Beginning Inventory Current Period Transferred-in 66000 320000 Direct material 24960 161600 Direct labor 6720 85600 Overhead 3580 43200 Prepare in good form a cost of production report for the Curing Department for May 2001. CPA adapted 42. Two departments weighted average The Best of the Season Corporation makes plastic Christmas trees in two departments: Cutting and Boxing. In the Cutting Department wire wrapped with green “needles” is placed into production at Part 2 Systems and Methods of Product Costing 254

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the beginning of the process and is cut to various lengths depending on the size of the trees being made at that time. The “branches” are then transferred to the Boxing Department where the lengths are separated into the necessary groups to make a tree. These are then placed in boxes and immediately sent to Finished Goods. The following data are available related to the October 2000 production in each of the two departments: PERCENT OF COMPLETION Units Transferred-in Material Conversion Cutting Department Beginning inventory 9000 N/A 100 30 Started in process 35000 Ending inventory 3600 N/A 100 70 Boxing Department Beginning inventory 2500 100 0 55 Transferred-in Ending inventory 1200 100 0 60 COSTS Transferred-in Material Conversion Cutting Department Beginning inventory N/A 13250 5550 Current period 52750 80290 Boxing Department Beginning inventory 9608 0 550 Current period 12510 20660 a. Prepare a cost of production report for the Cutting Department assuming a weighted average method. b. Using the data developed from part a prepare a cost of production re- port for the Boxing Department also using the weighted average method. 43. Cost flows: multiple departments Sharp Corporation produces accent stripes for automobiles in 50-inch rolls. Each roll passes through three departments Striping Adhesion and Packaging before it is ready for shipment to auto- mobile dealers and detailing shops. Product costs are tracked by department and assigned using a process costing system. Overhead is applied to production in each department at a rate of 60 percent of the department’s direct labor cost. The following information pertains to departmental operations for June 2001: Chapter 6 Process Costing 255 Work in Process—Striping Beginning 20000 DM 90000 DL 80000 Overhead Ending 17000 Work in Process—Packaging Beginning 150000 Transferred-in DM DL Overhead 90000 Ending 90000 Work in Process—Adhesion Beginning 70000 Transferred-in DM 60000 480000 DL Overhead Ending 20000 Finished Goods Beginning 185000 CGM 830000 720000 Ending

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a. What was the cost of goods transferred from the Striping Department to the Adhesion Department for the month b. How much direct labor cost was incurred in the Adhesion Department How much overhead was assigned to production in the Adhesion Department for the month c. How much direct material cost was charged to products passing through the Packaging Department d. Prepare the journal entries for all interdepartmental transfers of products and the cost of the units sold during June 2001. 44. Comprehensive two departments Safe-N-Sound makes a backyard fencing system for pet owners in a two-stage production system. In Process 1 wood is cut and assembled into six-foot fence sections. In Process 2 the sections are pressure treated to resist the effects of weather and then coated with a wood preservative. The following production and cost data are available for March 2001 units are six-foot fence sections: Units Cutting Process Pressure Process Beginning WIP Inventory March 1 1300 900 Complete as to material 80 0 Complete as to conversion 75 60 Units started in March 4800 Units completed in March 4500 Ending WIP Inventory March 31 1100 Complete as to material 40 0 Complete as to conversion 20 40 Costs Beginning WIP Inventory Transferred-in 4725 Material 2130 0 Conversion 3175 1674 Current Transferred-in Material 8800 4995 Conversion 12735 13560 a. Prepare EUP schedules for both the cutting and pressure processes. Use the FIFO method. b. Determine the cost per equivalent unit for the cutting process assuming a FIFO method. c. Assign costs to goods transferred and to inventory in the cutting process on a FIFO basis. d. Transfer the FIFO costs to the pressure process. Determine cost per EUP on a modified FIFO basis. See footnote 8 page 233. e. Assign costs to goods transferred and to inventory in the pressure process on a modified FIFO basis. f. Assuming there was no beginning or ending inventory of Finished Goods Inventory for March what was Cost of Goods Sold for March 45. Standard process costing HealthySight is a manufacturer of high-quality lenses for sunglasses and ski goggles. HealthySight uses a standard process costing system and carries inventories at standard. In May 2001 the following data were available: Standard Cost of 1 Unit Direct material 4.50 Conversion 12.50 Total manufacturing cost 17.00 Part 2 Systems and Methods of Product Costing 256

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Beginning WIP Inventory 10000 units 100 DM 70 conversion Started in May 180000 units Completed in May 160000 units Ending WIP Inventory units 100 DM 60 conversion Actual costs for May Direct material 781000 Conversion 2045000 Total actual cost 2826000 a. Prepare an equivalent units of production schedule. b. Prepare a cost of production report and assign costs to goods transferred and to inventory. c. Calculate and label the variances and charge them to Cost of Goods Sold. 46. Multiproduct hybrid costing Be-At-Ease Industries manufactures a series of three models of molded plastic chairs: standard can be stacked deluxe with arms and executive with arms and padding all are variations of the same design. The company uses batch manufacturing and has a hybrid costing system. Be-At-Ease has an extrusion operation and subsequent operations to form trim and finish the chairs. Plastic sheets are produced by the extrusion oper- ation some of which are sold directly to other manufacturers. During the form- ing operation the remaining plastic sheets are molded into chair seats and the legs are added the standard model is sold after this operation. During the trim operation the arms are added to the deluxe and executive models and the chair edges are smoothed. Only the executive model enters the finish opera- tion where the padding is added. All of the units produced receive the same steps within each operation. The July production run had a total manufacturing cost of 898000. The units of production and direct material costs incurred were as follows: Units Extrusion Form Trim Finish Produced Materials Materials Materials Materials Plastic sheets 5000 60000 Standard model 6000 72000 24000 Deluxe model 3000 36000 12000 9000 Executive model 2000 24000 8000 6000 12000 16000 192000 44000 15000 12000 Manufacturing costs applied during July were as follows: Extrusion Form Trim Finish Operation Operation Operation Operation Direct labor 152000 60000 30000 18000 Factory overhead 240000 72000 39000 24000 a. For each product produced by Be-At-Ease during July determine the 1. Unit cost. 2. Total cost. Be sure to account for all costs incurred during the month and support your answer with appropriate calculations. b. Without prejudice to your answer in part a assume that 1000 units of the deluxe model remained in Work in Process Inventory at the end of the month. These units were 100 percent complete in the trim operation. Determine the value of the 1000 units of the deluxe model in Be-At-Ease’s Work in Process Inventory at the end of July. CMA adapted Chapter 6 Process Costing 257

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Part 2 Systems and Methods of Product Costing 258 47. WA and FIFO Rainbow Paints makes quality paint sold at premium prices in one production department. Production begins with the blending of various chemicals which are added at the beginning of the process and ends with the canning of the paint. Canning occurs when the mixture reaches the 90 per- cent stage of completion. The gallon cans are then transferred to the Shipping Department for crating and shipment. Labor and overhead are added contin- uously throughout the process. Factory overhead is applied at the rate of 3 per direct labor hour. Prior to May when a change in the process was implemented work in process inventories were insignificant. The change in process enables greater production but results in large amounts of work in process. The company has always used the weighted average method to determine equivalent production and unit costs. Now production management is considering changing from the weighted average method to the first-in first-out method. The following data relate to actual production during May: Costs for May Work in process inventory May 1 Direct material—chemicals 45600 Direct labor 10 per hour 6250 Factory overhead 1875 Current month Direct material—chemicals 228400 Direct material—cans 7000 Direct labor 10 per hour 35000 Factory overhead 10500 Units for May Gallons Work in process inventory May 1 25 complete 4000 Sent to Shipping Department 20000 Started in May 21000 Work in process inventory May 31 80 complete 5000 a. Prepare a cost of production report for each cost element for May using the weighted average method. b. Prepare a cost of production report for each cost element for May using the FIFO method. c. Discuss the advantages and disadvantages of using the weighted average method versus the FIFO method and explain under what circumstances each method should be used. CMA adapted CASE 48. The term total cost to account for has been used in this chapter and in another setting earlier in the text. Find that earlier reference to this term and write a brief report explaining whether or not the term is being used consistently in both places. 49. The weighted average and FIFO methods generally result in approximately the same unit costs because costs do not usually vary dramatically from period to period. Discuss some reasons for exceptions to this observation. REALITY CHECK

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50. Cost accountants use the concept of equivalent units of production EUP to measure actual production for a period in a process costing environment. Write a memo describing what EUP measures and why it is necessary to use EUP to determine actual production for a period. 51. Search the Internet to identify a vendor of process costing software. Read the on-line literature provided by the vendor regarding the software. Then briefly describe the major features of the software in the areas of product costing cost budgeting and cost control. 52. In a team of three or four people choose a company whose mass production process you would like to learn. Use the library the Internet and if possible personal resources to gather information. Prepare a visual representation sim- ilar to Exhibit 6–2 of that production process. In this illustration indicate the approximate percentage of completion points at which various materials are added and where/how labor and overhead flow into and through the process. Assume that 1000 units of product are flowing through your production process and are now at the 60 percent completion point as to labor. Prepare a written explanation about the quantity of direct material equivalent units that are in- cluded in the 1000 units. Also explain how much overhead activity and cost have occurred and why the overhead percentage is the same as or different from the percentage of completion for labor. 53. Find a Web site or current professional article discussing developments in the pharmaceutical/medical devices industry. Read the materials on that site about evolving practices in the industry to improve cost effectiveness of operations. Discuss how the industry’s new practices will affect process costing in the phar- maceutical industry. Which cost pools direct material direct labor manufac- turing overhead will be affected by the emerging practices Also address whether any of the evolving practices would be better served by life cycle costing. 54. Find the Web page for Agile Software. Provide its Web address and discuss the nature of this Internet-based software and how it can affect cost accounting practices in industries that manufacture complex products. Chapter 6 Process Costing 259

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7 Special Production Issues: Lost Units and Accretion CHAPTER LEARNING OBJECTIVES After completing this chapter you should be able to answer the following questions: 1 What is an accepted quality level and how does it relate to zero tolerance for errors and defects 2 Why do lost units occur in manufacturing processes 3 How do normal and abnormal losses of units differ and how is each treated in an EUP schedule 4 How are the costs of each type of loss assigned 5 How are rework costs of defective units treated 6 How are losses treated in a job order costing system 7 How does accretion of units affect the EUP schedule and costs per unit 8 What is the cost of quality products

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General Electric Company INTRODUCING homas Alva Edison invented the first successful incandescent light bulb in 1879. Shortly thereafter General Electric GE began providing power and lighting up America and the world. General Electric Company was formed in 1892 through a merger of Edison Electric Light Company and Thomson-Houston Company. Today GE is the world’s largest diversified services company as well as a provider of high-quality high- technology industrial and consumer products. While main- taining world-class leadership in its beginnings in providing power systems and electric lighting the company has ex- panded into many areas. A few examples include aircraft engines medical systems financial services television broadcasting and transportation systems. GE consists of more than three dozen businesses operating in 100 com- panies around the globe. Although widely diverse GE businesses are also highly familial and share information resources technology and intellectual capital. GE’s sharing among all its businesses includes: 1. a common operating system and a social architecture characterized by boundaryless behavior 2. a common leadership development system 3. one set of common values and 4. four common initiatives—globalization product services e-business and Six Sigma quality. Six Sigma is a quality management term used to define a process for eliminating variation and therefore eliminating defects. Statistically Six Sigma quality means improving manufacturing quality to six standard deviations from the specification limit. This translates to a rate of 3.4 defects out of a million items processed. GE is absolutely committed to delivering flawless products and services to its customers. At GE the Six Sigma initiative is in its fifth year—its fifth trip through the operating system. From a standing start in 1996 with no financial benefit to the company it has flourished to the point where it provided more than 2 billion in benefits in 1999 with much more to come this decade. Unlike the General Electric GE processes that have been subjected to zero-defect tolerance most companies tolerate some level of defects by establishing an accepted quality level AQL for their production or service processes. AQL is the maximum limit for the number of defects or errors in a process. If the percentage of defects or errors is less than the AQL the company considers that it has performed at an acceptable quality level. Companies viewed as having world-class status in a particular endeavor seek to continuously tighten the accepted quality level. Thus producing goods with zero defects and performing services with zero errors are laudable goals and ones toward which domestic and foreign companies are striving. The examples in Chapter 6 assumed that all units to be accounted for have either been transferred or are in ending work in process inventory however almost every process produces some units that are spoiled or do not meet production specifications. Phenomena in the production process also may cause the total units accounted for to be less than the total units to account for. In other situations unrelated to spoiled units the addition or expansion of materials after the start of the process may cause the units accounted for to be greater than those to be accounted for originally or in a previous department. This chapter covers these more complex issues of process costing. Spoiled and defective units reworking of defective units and accretion require adjustments to the equivalent units of production EUP schedule and cost assignments made at the end of a period. The last section of this chapter discusses controlling quality so that only a minimal number of inferior goods are produced. SOURCES: General Electric Company Web site June 2000 Robert Buderi “The Six Sigma Approach Revs Up” Upside May 2000 p. 50. 261 T What is an accepted quality level and how does it relate to zero tolerance for errors and defects accepted quality level AQL 1

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Part 2 Systems and Methods of Product Costing 262 LOSS OF UNITS Few if any processes combine material labor and overhead with no loss of units. Some of these losses such as evaporation leakage or oxidation are inherent in the production process. For example when Starbucks roasts coffee beans approximately 20 percent of the original weight is lost from water evaporation. This situation results in shrinkage. Modifying the production process to reduce or eliminate the causes of shrinkage may be difficult impossible or simply not cost beneficial. Spoilage of some food products occurs simply by exposure to the atmosphere wherever perishable foods are processed or stored. In this regard Louisiana State University and SIRA Technologies have developed a new monitoring system for meat that can enable meat processors and food retailers to better regulate the safety requirements for storage and prevent loss of reputation and revenue from selling meat containing harmful bacteria. The technology uses a bar code treated with an- tibodies that are sensitive to virulent strains of bacteria. 1 As discussed in the ac- companying News Note spoilage of meats and other perishable foods awaiting customer purchases in supermarkets can be further prevented by covering refrig- eration cases each night. At other times errors in the production process either by humans or machines cause a loss of units through rejection at inspection for failure to meet appropriate quality standards or designated product specifications. Whether these lost units are Why do lost units occur in manufacturing processes shrinkage 2 1 Ginger Koloszyc “New Bar-Code Technology Detects Meat Spoilage” Stores October 1998 p. 72. Closing the Curtain on Contaminants NEWS NOTE QUALITY It is estimated that 75 of the supermarkets in North America are closed to the public for 6 to 8 hours at night. With little effort these supermarkets could claim dollars that are lost during the stores’ closed hours from unnec- essary energy consumption and premature spoilage of many perishable products. Open refrigerated display cases are the best way for retailers to present fresh merchandise to consumers. Un- fortunately these cases are also open to the effects of heat and UV radiation from the store environment. There is often a misconception that the refrigerated air escapes from the display case. However heat or warm air is actually drawn toward the colder air raising the temperatures in the display case this causes mer- chandise to warm up and compressors to operate more frequently. More frequent compressor operation and exposed products must be tolerated so that consumers can shop freely but when the store is closed simple steps can be taken to reduce store energy consumption and extend product shelf life with ideal cold temperatures. To solve this problem an efficient temperature barrier is needed between the opening of the display case and the store interior. The ideal thermal barrier arrangement must have several qualities to be effective in increasing store profit: • Reasonable cost and quick initial payback period • Simple and quick to put in operation • No interference with customer access to fresh mer- chandise when the store is open • No disturbance to the cosmetic appearance of the store • Durable commercial quality • Hygienic will not rust or attract dust mold and mildew • Simple quick cleaning maintenance that can be done when cleaning the case and • Effective in the reflection of heat and UV radiation. A vertical rolling curtain permanently attached to the top of the display was agreed upon as the simplest and eas- iest to use arrangement. To adapt to this arrangement a 99 pure aluminum heat-reflective fabric was developed. To provide strength to the woven aluminum fabric and elim- inate oxidation it is coated with a thin transparent film. SOURCE: Staff “The Big Cover-Up in the Refrigeration Case” Air Conditioning Heating and Refrigeration News April 3 2000 pp. 27ff. http://www.siratechnologies .com

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considered defective or spoiled depends on their ability to be economically re- worked. Economically reworked means that 1 the unit can be reprocessed to a sufficient quality level to be salable through normal distribution channels and 2 incremental rework cost is less than incremental revenue from the sale of re- worked units. A defective unit can be economically reworked but a spoiled unit cannot. An inspector in the company making the product determines which are defective and which are spoiled. To illustrate the difference between defective and spoiled units assume you order blackened redfish at a restaurant. You are now the control inspector. If the redfish brought to you is barely blackened it is a defective unit because the chef can cook it longer to bring it up to “product specifications.” The incremental rev- enue is the selling price of the redfish the incremental cost is a few moments of the chef’s time. However if the fish brought to you is blackened to a cinder it is a spoiled unit because it cannot be reworked. Therefore a newly cooked black- ened redfish would have to be provided. A normal loss of units falls within a tolerance level expected during pro- duction. Management creates a range of tolerance of spoiled units specified by the accepted quality level as mentioned in the beginning of this chapter. If a com- pany had set its quality goal as 98 percent of goods produced the company would have been expecting a normal loss of 2 percent. Any loss in excess of the AQL is an abnormal loss. Thus the difference between normal and abnormal loss is merely one of degree and is determined by management. A variety of methods can be used to account for units lost during production. Selection of the most appropriate method depends on two factors: 1 the cause of the decrease and 2 management expectations regarding lost units. Under- standing why units decreased during production requires detailed knowledge of the manufacturing process. Management’s expectations are important to determine the acceptable loss quantities from defects spoilage or shrinkage as well as the revenue and cost considerations of defective and spoiled units. Chapter 7 Special Production Issues: Lost Units and Accretion 263 economically reworked defective unit spoiled unit How do normal and abnormal losses of units differ and how is each treated in an EUP schedule normal loss abnormal loss 3 TYPES OF LOST UNITS In developing the product design manufacturing process and product quality management selects a combination of material labor and overhead from the wide resource spectrum available. This combination is chosen to provide the lowest long- run cost per unit and to achieve the designated product specifications—including those for quality. In making this resource combination choice managers recognize that for most combinations some degree of production error may occur that will result in lost units. Given the resource choices made by management the quan- tity or percentage of lost units to be generated in a given period or production run should be reasonably estimable. This estimate is the normal loss because it is planned for and expected. Normal loss is usually calculated on the basis of good output or actual input. Some companies may estimate the normal loss to be quite high because the lowest cost material labor or overhead support is chosen. For example assume that Scrape Manufacturing Ltd. chooses to install the least advanced lowest cost machinery for production purposes because its workers do not have the educa- tional or technological skills to handle the more advanced equipment. The installed equipment may have fewer quality checks and thus produce more spoiled units than the more advanced equipment. Scrape’s managers have decided that the costs of upgrading worker skills were greater than the cost of lost units. Another reason for high estimated normal losses relates not to the resources chosen but to a problem inherent in the product design or in the production process. In other cases based on cost-benefit analysis managers may find that a problem would cost more to eliminate than to tolerate. For example assume a

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machine malfunctions once every 100 production runs and improperly blends in- gredients. The machine processes 50000 runs each year and the ingredients in each run cost 10. Correcting the problem has been estimated to cost 20000 per year. Spoilage cost is 5000 per year 500 spoiled batches 10 worth of ingre- dients plus a minimal amount of overhead costs. If company employees are aware of the malfunction and catch every improperly blended run accepting the spoilage is less expensive than correcting the problem. If alternatively the spoiled runs are allowed to leave the plant they may create substantial quality failure costs in the form of dissatisfied customers and/or salespeople who might receive the spoiled product. Managers in world-class com- panies should be aware that the estimate of the cost to develop a new customer is 50000 five times as much as the estimated cost of keeping an existing one. 2 In making their cost-benefit analysis managers must be certain to quantify all the costs both direct and indirect involved in spoilage problems. An abnormal loss is a loss in excess of the normal predicted tolerance limits. Thus when an abnormal loss occurs so does a normal loss unless zero defects have been set as the AQL. Abnormal losses generally arise because of human or machine error during the production process. For example if the tolerances on one of a company’s production machines were set incorrectly a significant quan- tity of defective products might be produced before the error was noticed. Because abnormal losses result from nonrandom special adverse conditions and actions they are more likely to be preventable than some types of normal losses. Realistically units are lost in a production process at a specific point. How- ever accounting for lost units requires that the loss be specified as being either continuous or discrete. For example the weight loss in roasting coffee beans and the relatively continual breakage of fragile glass ornaments can be considered continuous losses because they occur fairly uniformly throughout the production process. In contrast a discrete loss is assumed to occur at a specific point. Examples of discrete losses include adding the wrong amount of vinegar to a recipe for salad dressing or attaching a part to a motor upside down. The units are only deemed lost and unacceptable when a quality check is performed. Therefore regardless of where in the process the units were truly “lost” the loss point is always deemed to be an inspection point. Thus units that have passed an inspection point should be good units relative to the specific characteristics inspected whereas units that have not yet passed an inspection point may be good or may be defective/spoiled. Control points can be either built into the system or performed by inspectors. The former requires an investment in prevention costs the latter results in appraisal costs. Both are effective but prevention is often more efficient because acceptable quality cannot be inspected into a product it must be a part of the production process. Investments to prevent lost units may relate either to people or machines. Prevention costs and appraisal costs are formally defined in Chapter 8. In determining how many quality control inspection points machine or human to install management must weigh the costs of having more inspections against the savings resulting from 1 not applying additional material labor and overhead to products that are already spoiled or defective direct savings and 2 the reduction or elimination of internal and external failure costs indirect savings. Quality control points should always be placed before any bottlenecks in the production system so that the bottleneck resource is not used to process already defective/spoiled units. Additionally a process that generates a continuous defect/spoilage loss requires a quality control point at the end of production otherwise some defective/spoiled units would not be found and would be sent to customers creating external failure costs. Failure costs are formally defined in Chapter 8. Part 2 Systems and Methods of Product Costing 264 2 Peter L. Grieco Jr. “World-Class Customers” Executive Excellence February 1996 p. 10. continuous loss discrete loss

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Chapter 7 Special Production Issues: Lost Units and Accretion 265 How are the costs of each type of loss assigned 4 ACCOUNTING FOR LOST UNITS The method of accounting for the cost of lost units depends on whether the loss is considered normal or abnormal and whether the loss occurred continuously in the process or at a discrete point. Exhibit 7–1 summarizes the accounting for the cost of lost units. The traditional method of accounting for normal losses is simple. Normal loss cost is considered a product cost and is included as part of the cost of the good units resulting from the process. Thus the cost of the loss is inventoried in Work in Process and Finished Goods Inventories and expensed only when the good units are sold. This treatment has been considered appropriate because normal losses have been viewed as unavoidable costs in the production of good units. If the loss results from shrinkage caused by the production process such as the weight loss of roasting coffee beans this treatment seems logical. Alternatively consider the company producing fragile scientific lenses: If the company allows for losses by virtue of the level at which some acceptable qual- ity was set then management will not receive valuable information about the cost of quality losses. In contrast if the same company were to institute a zero-defect policy there would by definition be no “normal” loss. All losses would be outside the tolerance specifications for acceptable quality. The costs of normal shrinkage and normal continuous losses are handled through the method of neglect which simply excludes the spoiled units in the equivalent units schedule. Ignoring the spoilage results in a smaller number of equivalent units of production EUP and by dividing production costs by a smaller EUP raises the cost per equivalent unit. Thus the cost of lost units is spread pro- portionately over the good units transferred and those remaining in Work in Process Inventory. Alternatively the cost of normal discrete losses is assigned only to units that have passed the inspection point. Such units should be good units relative to the inspected characteristic whereas the units prior to this point may be good or may be defective/spoiled. Assigning loss costs to units that may be found to be defective/ spoiled in the next period would not be reasonable. EXHIBIT 7–1 Continuous versus Discrete Losses Uniformly throughout process or Absorbed by all units in ending inventory and transferred out on an EUP basis At inspection point or at end of process Absorbed by all units past inspection point in ending inventory and transferred out on an EUP basis Type Continuous Assumed to Occur May Be Cost Handled How Discrete Normal Cost Assigned To Written off as a loss on an EUP basis Abnormal Product Period or Normal Abnormal Product Period Written off as a loss on an EUP basis method of neglect

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Regardless of whether defects/spoilage occur in a continuous or discrete fash- ion the cost of abnormal losses should be accumulated and treated as a loss in the period in which those losses occurred. This treatment is justified by the cost principle discussed in financial accounting. The cost principle allows only costs that are necessary to acquire or produce inventory to attach to it. All unnecessary costs are written off in the period in which they are incurred. Because abnormal losses are not necessary to the production of good units and the cost is avoidable in the future any abnormal loss cost is regarded as a period cost. This cost should be brought to the attention of the production manager who should then investi- gate the causes of the loss to determine how to prevent future similar occurrences. Abnormal loss cost is always accounted for on an equivalent unit basis. Part 2 Systems and Methods of Product Costing 266 ILLUSTRATIONS OF LOST UNITS To best understand how to account for a process that creates lost goods it is help- ful to know the answers to the following questions: 1. What is the process flow 2. Where is material added during the process 3. How are labor and overhead applied This answer is usually “Continuously” but not necessarily at the same rate. 4. At what stage of completion was the beginning inventory and what is the end- ing inventory 5. Where are the quality control inspection points 6. How do defective/spoiled units occur Continuously or discretely Impervious Inc. is used to illustrate several alternative situations regarding the handling of lost units in a process costing environment. Impervious produces a high- tech very durable nonfade once color pigment is added paint base material— hereafter simply referred to as paint—for appliances and equipment. The paint is produced in a single department and then sold to appliance and equipment man- ufacturers. All materials are added at the start of the process and conversion costs are applied uniformly throughout the production process. Recyclable containers are provided by buyers and therefore are not a cost to Impervious. The company uses the FIFO method of calculating equivalent units. Spoilage in the production of CD-ROMs can occur from a wide variety of causes and at numerous points in the produc- tion process. Because spoilage tends to be machine-related quality checks are built into the production system and are often performed robotically. However the final quality control analysis is performed by a replication operator.

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Situation 1—Normal Loss Only Loss Occurs Throughout Production Process Continuous During processing the paint is mechanically blended and cooked resulting in a normal loss from shrinkage. Mechanical malfunctions sometimes occur and when they do cause some spoilage. Any decrease of 10 percent or less of the gallons placed into production for a period is considered normal. The April 2000 data for Impervious are given below: GALLONS Beginning inventory 60 complete 2000 Started during month 15000 Gallons completed and transferred 13200 Ending inventory 75 complete 2500 Lost gallons normal 1300 COSTS Beginning inventory: Material 15000 Conversion 1620 16620 Current period: Material 102750 Conversion 19425 122175 Total costs 138795 To visualize the manufacturing process for Impervious a flow diagram can be constructed. Such a diagram provides distinct definitive answers to all of the ques- tions asked at the beginning of this section. Flow Diagram →Conversion cost applied uniformly throughout → ↑ ↑↑ ↑   60 75 100 Material Beginning Ending Inspection added inventory inventory point     → Continuous reduction in units shrinkage → The steps discussed in Chapter 6 on process costing are followed to determine the units accountable for units accounted for equivalent units of production costs accountable for cost per equivalent unit and cost assignment. These steps are pre- sented in the cost of production report shown in Exhibit 7–2. The department is accountable for 17000 gallons of paint: 2000 gallons in be- ginning inventory plus 15000 gallons started into processing during April. Only 15700 gallons 13200 completed and 2500 in ending inventory are accounted for prior to considering the processing loss. The 1300 lost gallons are included in the schedule of gallons accounted for to balance to the total 17000 gallons but these gallons are not extended into the computation of equivalent units of production. Using the method of neglect these gallons simply “disappear” in the EUP sched- ule. Thus the cost per equivalent gallon of the remaining good production of the period is higher for each cost component. Had the lost gallons been used in the denominator of the cost per EUP com- putation the cost per EUP would have been smaller and the material cost per unit would have been 6.85 102750 15000. Because the lost units do not appear in the cost assignment section their costs must be assigned only to good production. The use of the lower cost per EUP would not allow all of the costs to be accounted for in Exhibit 7–2. Chapter 7 Special Production Issues: Lost Units and Accretion 267

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Accounting for normal continuous shrinkage or defects/spoilage is the eas- iest of the types of lost unit computations. There is however a theoretical prob- lem with this computation when a company uses weighted average process cost- ing. The units in ending Work in Process Inventory have lost unit cost assigned to them in the current period and will have lost unit cost assigned again in the next period. But even with this flaw this method provides a reasonable measure of unit cost if the rate of spoilage is consistent from period to period. Situation 2—Normal Spoilage Only Spoilage Determined at Final Inspection Point in Production Process Discrete This example uses the same basic cost and unit information given above for Im- pervious Inc. except that no shrinkage occurs. Instead the paint is inspected at the end of the production process. Any spoiled gallons are removed and discarded at inspection a machine malfunction or an improper blending of a batch of paint usually causes spoilage. Any spoilage of 10 percent or less of the gallons placed into production during the period is considered normal. A production flow diagram is shown at the top of the next page. Part 2 Systems and Methods of Product Costing 268 PRODUCTION DATA EQUIVALENT UNITS Whole Units Material Conversion Beginning inventory 100 60 2000 Gallons started 15000 Gallons to account for 17000 Beginning inventory completed 0 40 2000 0 800 Gallons started and completed 11200 11200 11200 Total gallons completed 13200 Ending inventory 100 75 2500 2500 1875 Normal shrinkage 1300 Gallons accounted for 17000 13700 13875 COST DATA Total Material Conversion Beginning inventory costs 16620 Current costs 122175 102750 19425 Total costs 138795 Divided by EUP 13700 13875 Cost per FIFO EUP 8.90 7.50 1.40 COST ASSIGNMENT Transferred: Beginning inventory 16620 Cost to complete: Conversion 800 1.40 1120 Total cost of beginning inventory 17740 Started and completed 11200 8.90 99680 Total cost of gallons transferred 117420 Ending inventory: Material 2500 7.50 18750 Conversion 1875 1.40 2625 21375 Total costs accounted for 138795 EXHIBIT 7–2 Cost of Production Report for Month Ended April 30 2000 FIFO method Normal continuous shrinkage

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→Conversion cost applied uniformly throughout → ↑ ↑↑ ↑   60 75 100 Material Beginning Ending Inspection added inventory inventory point discrete spoilage In this situation the spoiled gallons of product are included in the equivalent unit schedule. Because the inspection point is at 100 percent completion all work has been performed on the spoiled gallons and all costs have been incurred to produce those gallons. By including the spoiled gallons at 100 percent completion in the EUP schedule cost per gallon reflects the cost that would have been in- curred had all production been good production. Cost of the spoiled gallons is assigned solely to the completed units. Because ending Work in Process Inventory has not yet passed the inspection point this in- ventory may contain its own normal spoilage which will be detected next period. The cost of production report for Situation 2 is shown in Exhibit 7–3. Situation 3—Normal Spoilage Only Spoilage Determined During Production Process Discrete In this example Impervious Inc. inspects the paint when the conversion process is 50 percent complete. The only difference between this example and the previous one is that for April the ending Work in Process Inventory has passed the inspection point. Because of this difference spoilage cost must be allocated to both the gallons transferred and to ending inventory. Although the ending inventory could become spoiled during the remainder of processing it is either highly unlikely or the cost Chapter 7 Special Production Issues: Lost Units and Accretion 269 PRODUCTION DATA EQUIVALENT UNITS Whole Units Material Conversion Beginning inventory 100 60 2000 Gallons started 15000 Gallons to account for 17000 Beginning inventory completed 0 40 2000 0 800 Gallons started and completed 11200 11200 11200 Total gallons completed 13200 Ending inventory 100 75 2500 2500 1875 Normal spoilage 100 100 1300 1300 1300 Gallons accounted for 17000 15000 15175 COST DATA Total Material Conversion Beginning inventory costs 16620 Current costs 122175 102750 19425 Total costs 138795 Divided by EUP 15000 15175 Cost per FIFO EUP 8.13 6.85 1.28 continued EXHIBIT 7–3 Cost of Production Report for Month Ended April 30 2000 FIFO method Normal discrete spoilage

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is so minimal that Impervious cannot justify the need for an end-of-process in- spection. The flow diagram for this situation follows: → Conversion cost applied uniformly throughout → ↑ ↑↑ ↑ ↑   50 60 75 100 Material Inspection Beginning Ending added point inventory inventory discrete spoilage Using the same data as in the two previous situations Exhibit 7–4 provides the cost per gallon and cost assignment for this situation. Spoiled gallons are ex- tended in the EUP schedule at the inspection point degree of completion 100 per- cent for material and 50 percent for conversion and affect the cost per gallon. As in Situation 2 the resulting cost per gallon reflects what the cost would have been had all the gallons produced been good output. Total cost of the spoiled goods is calculated by multiplying the component cost per gallon by the EUP for each cost component. Total spoilage cost is then prorated based on the EUP for each cost component between gallons transferred and gallons in ending inventory. Situation 4—Abnormal Shrinkage Continuous or Discrete Some Normal Shrinkage Continuous The final example of Impervious Inc. assumes that normal spoilage cannot exceed 5 percent of the gallons placed into production. Additionally as in Situation 1 the unit reduction is assumed to occur from shrinkage. The quality control inspection point is at the end of processing. Because 15000 gallons were started in April the maximum allowable normal shrinkage is 750 gallons 15000 5. Because the total reduction in units in April was 1300 gallons 550 gallons are considered abnormal shrinkage. Exhibit 7–5 presents the cost of production report for Situa- tion 4. The approach presented for Situation 4 has one inequity. A portion of the nor- mal shrinkage is automatically allocated to abnormal shrinkage because the calcu- lation of EUP allows for the “disappearance” of the normal shrinkage. Cost per gal- lon is then computed based on the equivalent units of production. This approach Part 2 Systems and Methods of Product Costing 270 COST ASSIGNMENT Transferred: Beginning inventory 16620 Cost to complete: Conversion 800 1.28 1024 Total cost of beginning inventory 17644 Started and completed 11200 8.13 91056 Normal spoilage 1300 8.13 10569 Total cost of gallons transferred 13200 9.04 119269 Ending inventory: Material 2500 6.85 17125 Conversion 1875 1.28 2400 19525 Total costs accounted for off due to rounding 138794 All spoilage cost is assigned to the units transferred. For convenience and clerical efficiency modified FIFO is used. Otherwise spoilage would have to be allocated to beginning WIP and units started and completed. The 9.04 figure is also computed as the sum of the 8.24 cost 17644 91056 13200 per good EUP plus another 0.80. This 0.80 is the spoilage cost 10569 divided by the 13200 good units transferred. EXHIBIT 7–3 Concluded

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Chapter 7 Special Production Issues: Lost Units and Accretion 271 PRODUCTION DATA EQUIVALENT UNITS Whole Units Material Conversion Beginning inventory 100 60 2000 Gallons started 15000 Gallons to account for 17000 Beginning inventory completed 0 40 2000 0 800 Gallons started and completed 11200 11200 11200 Total gallons completed 13200 Ending inventory 100 75 2500 2500 1875 Normal spoilage 100 50 1300 1300 650 Gallons accounted for 17000 15000 14525 COST DATA Total Material Conversion Beginning inventory costs 16620 Current costs 122175 102750 19425 Total costs 138795 Divided by EUP 15000 14525 Cost per FIFO EUP 8.19 6.85 1.34 COST ASSIGNMENT Transferred: From beginning inventory 16620 Cost to complete: Conversion 800 1.34 1072 Total cost of beginning inventory 17692 Started and completed 11200 8.19 91728 Cost prior to proration of spoilage 109420 Normal spoilage 8051 Total cost of gallons transferred 117471 Ending inventory: Material 2500 6.85 17125 Conversion 1875 1.34 2513 Cost prior to proration of spoilage 19638 Normal spoilage 1725 Total cost of ending inventory 21363 Total costs accounted for off due to rounding 138834 Proration of normal spoilage is as follows: Material Conversion EUP EUP Gallons started and completed 11200 82 11200 86 Ending work in process 2500 18 1875 14 13700 100 13075 100 Given the above relative EUP percentages proration of spoilage costs is Material 1300 6.85 8905 Conversion 650 1.34 871 Cost of normal spoilage to be prorated 9776 The gallons in beginning WIP were not included in this calculation because beginning WIP was 100 complete as to material and 60 complete as to conversion. Thus this inventory was beyond the inspection point 50 and no spoilage cost should be assigned to it. continued EXHIBIT 7–4 Cost of Production Report for Month Ended April 30 2000 FIFO method Normal discrete spoilage

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Part 2 Systems and Methods of Product Costing 272 Material Conversion Total Gallons started and completed: 0.82 8905 7302 0.86 871 749 8051 Ending work in process: 0.18 8905 1603 0.14 871 122 1725 Total allocations 8905 871 9776 EXHIBIT 7–4 Concluded PRODUCTION DATA EQUIVALENT UNITS Whole Units Material Conversion Beginning inventory 100 60 2000 Gallons started 15000 Gallons to account for 17000 Beginning inventory completed 0 40 2000 0 800 Gallons started and completed 11200 11200 11200 Total gallons completed 13200 Ending inventory 100 75 2500 2500 1875 Normal shrinkage 750 Abnormal shrinkage 100 100 550 550 550 Gallons accounted for 17000 14250 14425 COST DATA Total Material Conversion Beginning inventory costs 16620 Current costs 122175 102750 19425 Total costs 138795 Divided by EUP 14250 14425 Cost per FIFO EUP 8.56 7.21 1.35 COST ASSIGNMENT Transferred: From beginning inventory 16620 Cost to complete: Conversion 800 1.35 1080 Total cost of beginning inventory 17700 Started and completed 11200 8.56 95872 Total cost of gallons transferred 113572 Ending inventory: Material 2500 7.21 18025 Conversion 1875 1.35 2531 20556 Abnormal loss 550 8.56 4708 Total costs accounted for off due to rounding 138836 EXHIBIT 7–5 Cost of Production Report for Month Ended April 30 2000 FIFO method Abnormal shrinkage normal continuous shrinkage is justified on the basis of expediency as long as the amount of the allocation of normal shrinkage to abnormal shrinkage is not considered significant. Situation 4 is used to illustrate the journal entries necessary to account for shrinkage or spoilage. These entries are as follows:

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Work in Process Inventory 122175 Raw Material Inventory 102750 Wages Payable and/or other appropriate accounts 19425 To record current period costs. Finished Goods Inventory 113572 Work in Process Inventory 113572 To record cost transferred from the department. Loss from Abnormal Spoilage 4708 Work in Process Inventory 4708 To remove cost of abnormal spoilage from Work in Process Inventory. The accounts debited and credited in the first journal entry would be the same for Situations 1 2 and 3. The dollar amount of the second entry would change for each of Situations 1 2 and 3 to reflect the appropriate “cost transferred” figure shown in the respective cost of production report. The third journal entry given is made only when abnormal defects/spoilage occurs. All illustrations to this point have used FIFO process costing. If the weighted average method were used the difference would appear as discussed in Chapter 6 only in the treatment of beginning inventory and its related costs. Lost units would be handled as illustrated in each exhibit shown for Situations 1 through 4. Exhibit 7–6 illustrates the weighted average method for the data used in Exhibit 7–5. Chapter 7 Special Production Issues: Lost Units and Accretion 273 PRODUCTION DATA EQUIVALENT UNITS Whole Units Material Conversion Beginning inventory 100 60 2000 2000 1200 Gallons started 15000 Gallons to account for 17000 Beginning inventory completed 0 40 2000 0 800 Gallons started and completed 11200 11200 11200 Total gallons completed 13200 Ending inventory 100 75 2500 2500 1875 Normal spoilage 750 Abnormal spoilage 100 100 550 550 550 Gallons accounted for 17000 16250 15625 COST DATA Total Material Conversion Beginning inventory costs 16620 15000 1620 Current costs 122175 102750 19425 Total costs 138795 117750 21045 Divided by EUP 16250 15625 Cost per FIFO EUP 8.60 7.25 1.35 COST ASSIGNMENT Transferred 13200 8.60 113520 Ending inventory: Material 2500 7.25 18125 Conversion 1875 1.35 2531 20656 Abnormal loss 550 8.60 4730 Total costs accounted for off due to rounding 138906 EXHIBIT 7–6 Cost of Production Report for Month Ended April 30 2000 Weighted average method Abnormal shrinkage normal continuous shrinkage

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A summary of the treatment of various types of lost units in a process costing system is shown in Exhibit 7–7. Part 2 Systems and Methods of Product Costing 274 NORMAL ABNORMAL CONTINUOUS Do not include equivalent lost Must include equivalent lost units in EUP schedule. Units units in EUP schedule. Assign effectively “disappear” unit cost to lost units and charge costs of good production are as loss of period. increased. DISCRETE Must include equivalent lost Must include equivalent lost units in EUP schedule. Assign units in EUP schedule. Assign cost to lost units. Determine cost to lost units and charge point of ending work in process: as loss of period. a. if before inspection point assign cost of lost units only to units transferred. b. if after inspection point prorate cost of spoiled units between units transferred and units in ending inventory. EXHIBIT 7–7 Summary of Handling Lost Units in a Process Costing System DEFECTIVE UNITS The preceding examples have all presumed that the lost units were valueless. How- ever some goods that do not meet quality specifications are merely defective rather than spoiled and thus have value. Such units are either reworked to meet prod- uct specifications or sold as irregulars. Rework cost is a product or period cost de- pending on whether the rework is considered to be normal or abnormal. If the rework is normal and actual costing is used the rework cost is added to the current period’s work in process costs for good units and assigned to all units completed. In companies using predetermined overhead application rates normal rework costs should be estimated and included as part of the estimated factory overhead cost used in computing the overhead application rates. In this way the overhead application rate will be large enough to cover rework costs. When actual rework costs are incurred they are assigned to the Manufacturing Overhead account. If rework is abnormal the costs should be accumulated and assigned to a loss account. The units are included in the EUP schedule for the period and only ac- tual production not rework costs will be considered in determining unit cost. 3 Reworked units may be irregular and have to be sold at less than the normal selling price. The production costs of irregular items should be transferred to a special inventory account and not commingled with the production costs of good units. When the net realizable value selling price minus cost to rework and sell is less than total cost the difference is referred to as a deficiency. If the number of defective units is normal the deficiency should be treated as part of the production cost of good units. If some proportion of the defective units is considered an abnormal loss that proportion of the deficiency should be written off as a period cost. How are rework costs of defective units treated 5 3 If the company is using a standard costing system then standard costs will be considered when determining unit costs.

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Accounting for defective units is illustrated by the July 2000 manufacturing data of Impervious Inc. During July the company produced 17900 good gallons and 100 defective gallons of paint. The 100 gallons were considered defective because the traditional neutral color of the product was instead slightly yellow. Total pro- duction costs other than rework were 160200. The 100 defective gallons can be reworked at a total cost of 140 or 1.40 per gallon by mixing the defective gal- lons with a chemical lightening additive. The cost of the additive itself is only 0.07 per gallon so all rework costs are assumed to be related to direct labor. The chem- ical additive is also gaseous and will cause no increase in the number of gallons of the paint. Entries for defective units are shown in Exhibit 7–8. This exhibit uses this information to show a variety of circumstances involving defective goods. Chapter 7 Special Production Issues: Lost Units and Accretion 275 Good production: 17900 gallons Defects: 100 gallons Cost of production other than rework: 160200 Cost of rework: 140 or 1.40 per gallon 1. Rework is normal actual costing is used reworked gallons can be sold at normal selling price Work in Process Inventory 140 Wages Payable 140 Cost per acceptable gallon 8.91 160340 18000 2. Rework is normal predetermined OH rate is used rework estimated reworked gallons can be sold at normal selling price Manufacturing Overhead 140 Wages Payable 140 Cost per acceptable gallon 8.90 160200 18000 3. Rework is abnormal reworked gallons can be sold at normal selling price Loss from Defects 140 Wages Payable 140 Cost per acceptable gallon 8.90 160200 18000 4. Reworked gallons are irregular can only be sold for 7 actual costing is used Normal production cost 8.90 100 890 Cost of rework 140 Total cost of defective units 1030 Total sales value of defective units 100 7 700 Total deficiency 330 If defects are normal: If defects are abnormal: Inventory—Defects 700 Inventory—Defects 700 Work in Process Inventory 140 Loss from Defects 330 Wages Payable 140 Wages Payable 140 Work in Process Inventory 700 Work in Process Inventory 890 The deficiency 330 remains The deficiency is assigned as a with the good units cost per period loss cost per acceptable acceptable gallon is 8.92: gallon is 8.90: 160200 140 700 160200 890 17900 17900 EXHIBIT 7–8 Entries for Defective Units How are losses treated in a job order costing system 6 DEFECTS/SPOILAGE IN JOB ORDER COSTING The previous examples are related to spoilage issues in a process costing envi- ronment. In a job order situation the accounting treatment of spoilage depends on two issues: 1 Is spoilage generally incurred for most jobs or is it specifically identified with a particular job 2 Is the spoilage normal or abnormal

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Generally Anticipated on All Jobs If normal spoilage is anticipated on all jobs the predetermined overhead applica- tion rate should include an amount for the net cost of normal spoilage which is equal to the cost of spoiled work less the estimated disposal value of that work. This approach assumes that spoilage is naturally inherent and unavoidable in the production of good products and its estimated cost should be proportionately as- signed among the good products produced. Assume that Impervious produces a special paint for manufacturers. Each pro- duction run is considered a separate job because each manufacturer indicates the particular paint specifications it requires. Regardless of the job there is always some shrinkage because of the mixing process. In computing the predetermined over- head rate related to the custom paints the following estimates are made: Overhead costs other than spoilage 121500 Estimated spoilage unit cost 10300 Sales of improperly mixed paints to foreign distributors 4300 6000 Total estimated overhead 127500 Estimated gallons of production during the year 150000 Predetermined overhead rate per gallon 0.85 During the year Impervious Inc. accepted a job 38 from General Electric to manufacture 500 gallons of paint. Direct material cost for this job was 4660 direct labor cost totaled 640 and applied overhead was 425 0.85 500 gal- lons giving a total cost for the job of 5725. Impervious Inc. put 500 gallons of paint into production. Five gallons or 1 percent of the paint became defective during the production process when a worker accidentally added a thickening agent meant for another job into a container of the paint. The actual cost of the defective mixture was 57.25 0.01 5725 and it can be sold for 22. The en- try below is made to account for the actual defect cost: Disposal Value of Defective Work 22.00 Manufacturing Overhead 35.25 Work in Process Inventory—Job 38 57.25 To record disposal value of defective work incurred on Job 38 for General Electric. The estimated cost of spoilage was originally included in determining the prede- termined overhead rate. Therefore as actual defects or spoilages occur the dis- posal value of the nonstandard work is included in an inventory account if sal- able and the net cost of the normal nonstandard work is charged to the Manufacturing Overhead account as is any other actual overhead cost. Specifically Identified with a Particular Job If defects or spoilages are not generally anticipated but are occasionally experi- enced on specific jobs because of job-related characteristics the estimated cost should not be included in setting the predetermined overhead application rate. Be- cause the cost of defects/spoilage attaches to the job the disposal value of such goods reduces the cost of the job that created those goods. If no disposal value exists for the defective/spoiled goods that cost remains with the job that caused the defects/spoilage. Assume that Impervious did not typically experience spoilage in its production process. The company’s predetermined overhead would have been calculated as 0.81 per gallon 121500 150000. Thus the total cost for the General Elec- tric job would have been 5705 4660 640 0.81 500. Five gallons of the batch were thickened somewhat greater than normal at the request of General Electric. After checking the stirability of the special paint General Electric rejected Part 2 Systems and Methods of Product Costing 276 net cost of normal spoilage

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the five gallons and changed the formula slightly. The five gallons could be sold for 22 this amount would reduce the cost of the General Electric job as shown in the following entry: Disposal Value of Defective Work 22 Work in Process Inventory—Job 38 22 To record disposal value of defective work incurred on Job 38 for General Electric. The production cost of any new mixture will be assigned a new job number. Abnormal Spoilage The cost of abnormal losses net of any disposal value should be written off as a period cost. The following entry assumes that Impervious normally anticipates some lost units on its custom orders and that the estimated cost of those units was included in the development of a predetermined overhead application rate. Assume that on Job 135 the cost of defective units was 198 but that 45 of disposal value was associated with those units. Of the remaining 153 of cost 120 was related to normal defects and 33 was related to abnormal defects. Disposal Value of Defective Work 45 Manufacturing Overhead 120 Loss from Abnormal Spoilage 33 Work in Process Inventory—Job 135 198 To record reassignment of cost of defective and spoiled work on Job 135. The first debit represents the defective goods’ disposal value the debit to Manu- facturing Overhead is for the net cost of normal spoilage. The debit to Loss from Abnormal Spoilage is for the portion of the net cost of spoilage that was not an- ticipated in setting the predetermined application rate. Chapter 7 Special Production Issues: Lost Units and Accretion 277 How does accretion of units affect the EUP schedule and costs per unit accretion 7 ACCRETION Accretion refers to an increase in units or volume because of the addition of ma- terial or to factors such as heat that are inherent in the production process. 4 For example adding soybean derivative to beef in preparing packages of hamburger causes the pounds of product to increase just as including pasta increases the vol- ume of a casserole. If materials are added in a single department the number of equivalent units computed for that department compensates for this increase from the beginning to the end of processing. When accretion occurs in successor departments in a multi- department process the number of units transferred into the department and the related cost per unit must be adjusted. For instance assume that one paint made by Impervious Inc. requires processing in two departments. Department 2 adds a compound to increase the scratch-resistant properties of the mixture produced in Department 1. The gallons of compound added increase the total gallons of mix- ture that were transferred out of Department 1 and decrease the transferred-in cost per unit. The production of this heavy-duty paint is used to illustrate the accounting for accretion of units in a successor department. Department 1 mixes the primary paint 4 Not all additions of material in successor departments cause an increase in units. Adding bindings to books in a second de- partment does not increase the number of books printed and transferred from the prior department. When the material added in a successor department does not increase the number of units it is accounted for as shown in Chapter 6.

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ingredients in large vats and sends the mixture to Department 2 which adds the scratch-resistant compound and remixes the paint. The paint is poured into 50- gallon containers that are shipped to buyers. Spoilage occurs in Department 2 when too much scratch-resistant compound is added to the paint mixture. The spoilage is detected when the mixture is transferred from the vats to the containers. Spoilage is never containerized. Spoilage is considered normal as long as it does not ex- ceed 1 percent of the gallons transferred into Department 2 from Department 1. December production information for Department 2 is given below. For this product assume that Impervious Inc. uses weighted average process costing. The units in beginning inventory were 100 percent complete as to the compound 0 percent complete as to the container and 25 percent complete as to conversion costs. Ending inventory is 100 percent complete as to the compound 0 percent complete as to the container and 70 percent complete as to conversion. Gallons in beginning inventory 1000 Gallons transferred in 21000 Gallons of compound added 5000 Gallons in ending inventory 1200 Units completed 50-gallon containers 512 Note that the measure for completed production is containers rather than gallons. Because each container represents 50 gallons the actual gallons completed are 25600 50 512. To handle this change in measuring units either the incoming gallons must be reported as containers or the completed containers must be re- ported as gallons. The cost of production report for December Exhibit 7–9 is prepared using gallons as the measurement unit and assumed cost information is supplied in the exhibit. Several items need to be noted about Exhibit 7–9. First the number of spoiled gallons was determined by subtracting the total gallons completed plus the gallons in ending inventory from the total gallons for which the department was respon- sible. Because spoilage was less than 1 percent of the gallons transferred into Department 2 it was all considered normal. Second the 197100 cost transferred from Department 1 was related to 22000 gallons of mixture: the gallons in be- ginning inventory plus those transferred during the period. Thus the original cost of each gallon was approximately 8.96 197100 22000. With the addition of the compound in Department 2 the transferred-in cost per gallon declined to 7.30. Part 2 Systems and Methods of Product Costing 278 PRODUCTION DATA EQUIVALENT UNITS Whole Units Transferred-In Compound Container Conversion Beginning inventory 100 100 0 25 1000 1000 1000 0 250 Transferred-in gals. 21000 Compound added gals. 5000 Gallons to account for 27000 BI completed 1000 0 0 1000 750 Started and completed 24600 24600 24600 24600 24600 Total gallons completed 25600 Ending inventory 100 100 0 7 1200 1200 1200 0 840 Normal spoilage 200 200 200 0 200 Gallons accounted for 27000 27000 27000 25600 26640 continued EXHIBIT 7–9 Department 2 Cost of Production Report for the Month Ended December 31 2000 Weighted average method

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Chapter 7 Special Production Issues: Lost Units and Accretion 279 COST DATA EQUIVALENT UNITS Total Transferred-In Compound Container Conversion BI costs 8415 7385 840 0 190 Current costs 331455 189715 22110 99840 19790 Total costs 339870 197100 22950 99840 19980 Divided by EUP 27000 27000 25600 26640 Cost per EUP 12.80 7.30 0.85 3.90 0.75 COST ASSIGNMENT Transferred: Cost of good units 25600 12.80 327680 Cost of spoilage: Transferred-in 200 7.30 1460 Compound 200 0.85 170 Conversion 200 0.75 150 Total cost transferred 329460 Ending inventory: Transferred-in 1200 7.30 8760 Compound 1200 0.85 1020 Conversion 840 0.75 630 10410 Total costs accounted for 339870 EXHIBIT 7–9 Concluded What is the cost of quality products 8 CONTROLLING QUALITY TO MINIMIZE LOST UNITS Up to this point the chapter has focused on how to account for lost units in the production process. The fact is if there were no lost units from shrinkage defects or spoilage there would be no need to account for them. The control aspect in quality control requires knowledge of three questions in addition to the six ques- tions posed earlier in the chapter: 1. What do the lost units actually cost 2. Why do the lost units occur 3. How can the lost units be controlled Many companies find it difficult—if not impossible—to answer the question of what lost units or the lack of quality cost. A direct cause of part of this difficulty is the use of the traditional method of assigning the cost of normal losses to the good units produced. By excluding lost units from the extensions in the equivalent units schedule the cost of those units is effectively “buried” and hidden in magnitude from managers. In a job order costing environment if the cost of lost units is included in calculating the predetermined overhead rate that cost is also being hidden and ignored. In service organizations the cost of “lost units” may be even more difficult to determine because those lost units are from a customer view- point poor service. After such service the customer simply may not do business with the organization again. Such an opportunity cost is not processed by the Third spoilage is assignable only to the completed units because the ending inven- tory has not yet reached the discrete point of inspection transference to containers. Finally the average cost of each 50-gallon container completed is approximately 643.48 329460 512.

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accounting system. Thus in all instances a potentially significant dollar amount is unavailable for investigation as to its planning controlling and decision-making ramifications. As to the second question managers may be able to pinpoint the reasons for lost units or poor service but may also have two perspectives of those reasons that instinctively allow for a lack of control. First managers may believe that the cause creates only a “minimal” quantity of lost units such a mind-set creates the predis- position for an “accepted quality level” with some tolerance for error. These error tolerances are built into the system and become justifications for problems. Pro- duction is “graded on a curve” that allows for a less-than-perfect result. Incorporating error tolerances into the production/performance system and combining such tolerances with the method of neglect results in managers not be- ing provided with the information necessary to determine how much spoilage cost is incurred by the company. Therefore although believing that the quantity and cost of lost units are “minimal” the managers do not have historical or even esti- mated accounting amounts on which to base such a conclusion. By becoming aware of the costs managers could make more informed decisions about whether to ignore the costs or try to correct their causes. In other instances managers may believe that the quantity of lost units is un- controllable. In some cases this belief is accurate. For example the shrinkage of coffee beans during roasting is virtually uncontrollable as is the sticking of small amounts of candy bar coating to candy molds during processing. The frequency of problems such as these is not large. Process analysis has proven that the cost of attempting to correct this production defect would be significantly greater than the savings resulting from the correction. But in most production situations and almost every service situation the cause of lost units or poor service is control- lable. Managers should determine the cause of the problem and institute correc- tive action. Defects and spoiled units were originally controlled through a process of in- specting goods or in the case of service organizations through surveying cus- tomers. These control methods are known as appraisal techniques. Now compa- nies are deciding that if quality is built into the process fewer inspections or surveys will be needed because defects/spoilage and poor service will be minimized. This involves prevention techniques. The goal then is prevention of defects or errors rather than output inspection or observation. Preventing defects and errors requires that managers discover the root cause of the defect or error. The accompanying News Note discusses root cause analysis. As discussed in Chapter 8 companies implementing quality programs to min- imize defects/spoilage or poor service often employ a tool called statistical process control SPC to analyze their processes to determine whether any situations are “out of control.” SPC uses graphs and/or control charts to understand and reduce fluctuations in processes until they are under control. SPC requires that those persons or machines involved in problem areas se- lect a relevant measure of performance and track that performance measurement over time. The resulting control chart provides information on the circumstances existing when a problem arises. Analyzing this chart in relation to the bench- mark or standard and to the amount of variation expected in a stable controlled process provides process control information that lets the company improve its performance. SPC allows the individuals involved with the process to become the quality control monitoring points and helps to eliminate the need for separate quality in- spections. Thus the “accepted quality level” can be raised and the defects can be significantly reduced. Consider what can happen to a firm that aspires to deliver parts with zero defects when reading the News Note on page 282 about the ex- periences of Fraen Corp. Part 2 Systems and Methods of Product Costing 280

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Chapter 7 Special Production Issues: Lost Units and Accretion 281 Analyzing Root Causes NEWS NOTE QUALITY How much time effort and money do companies lose dealing with problems that continually resurface and dis- rupt the organization This is known as the “price of non- conformance”—the failure to identify a problem’s root cause fix the process measure results and follow up. Estimates of the price of nonconformance are as much as 25 to 40 of operating costs. However by focusing on the process—not the people—organizations can correct the underlying causes of problems so they don’t recur. By preventing the recurrence of errors in service de- livery or manufacturing processes significant improve- ments in both productivity and quality are assured. By eliminating nonconformance in the system through zero defects and anticipating and preventing errors prior to process implementation significant cost savings may be realized to positively impact the organization’s profit mar- gin. With an understanding of the environment necessary to create quality organizations will identify solutions to costly recurring problems. The implementation of a system process improvement model . . . utilizing step-by-step root cause analysis will create an effective continuous quality improvement cul- ture in an organization. Utilizing a step-by-step root cause analysis process organizations can improve product quality improve service quality reduce operating costs and impact operating profits positively. The “root cause” is the reason for a nonconformance within a process. It is the underlying cause of a problem not just the apparent cause. It is a focus on the process not the people. The root cause is a factor that when changed or elim- inated will eliminate the nonconformance and prevent the problem. It is about designing prevention solutions into how work is done. Prevention solutions are not about reworking redesigning modifying or fixing things they are not about correction. Prevention solutions are about determining why the rework was required why we must redesign the product and why we must fix the item. It is about determining how to keep the problem from ever occurring again. It is about designing prevention into the process. Root cause analysis is a formal structured disciplined approach to problem solving. Many root cause analysis processes have been developed to approach problem solving: some have three steps some four some six or as many as 12 steps in the process. Simply root cause analysis is a systematic process of defining the problem gathering and prioritizing data about the nonconformance analyzing solutions to the problem and evaluating the benefits versus the cost- effectiveness of all available prevention options. SOURCE: Charles C. Handley “Quality Improvement through Root Cause Analy- sis” Hospital Material Management Quarterly May 2000 pp. 74–75. Originally published and copyrighted by APICS–The Educational Society for Resource Management © 1999 APICS International Conference Proceedings. The process of developing implementing and interpreting an SPC system requires a firm grasp on statistics and is well beyond the scope of this text. How- ever cost and management accountants must recognize the usefulness of such a tool in determining why problems occur. This knowledge allows cost and man- agement accountants to better track the costs flowing into the problem areas estimate the opportunity costs associated with the problems and perform a more informed cost-benefit analysis about problem correction. In conclusion the important managerial concern regarding spoilage is in con- trolling it rather than accounting for spoilage costs. Quality control programs can be implemented to develop ideas on product redesign for quality determine where quality control problems exist decide how to measure the costs associated with those problems and assess how to correct the problems. If quality is defined in an organization as zero lost units excepting those caused by inherent shrinkage all defects/spoilage will be accounted for as an abnormal cost of production or service. Such accounting would mean that defect/spoilage costs would no longer be hidden from managerial eyes through the use of the method of neglect discussed earlier in the chapter.

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Part 2 Systems and Methods of Product Costing 282 Keeping an “Eye” on Things NEWS NOTE QUALITY When a small company is trying to make the leap to big contender it needs all the help it can get. Fraen Corp. of Reading MA was intent on becoming a major sup- plier of precision machined parts and had finally found its opportunity: a multinational corporation needed a mas- sive quantity of electronic component fasteners. Fraen which employed around 175 workers felt it could deliver but wanted to make itself stand out from its larger com- petitors. It offered the corporation zero defects per mil- lion parts 100 inspection. The corporation accepted. Before this contract Fraen produced around 500000 parts/week. With the new job it would be shipping out 8 million parts. Higher volume meant that quality control would also have to be up- graded especially since Fraen offered zero defects. The upgrade would be considerable: “We had no system— just people” explained David Cohen Fraen’s former quality manager and now director of business develop- ment. “The workers would go to the machines and check parts on a regular basis at a predetermined fre- quency and record the information by hand on a piece of paper.” Fraen began investigating different inspection tech- nologies and also accepting bids with solutions and quotes. The company was approached by Advanced Inspection and Measurement AIM Niantic CT a man- ufacturer of contact and noncontact inspection sys- tems. AIM proposed two video inspection systems each incorporating a parts feeder and a set of three cameras that visually inspect parts and send the information to an adjoining PC which then sends the data to a mother computer that determines part quality. Fraen decided to purchase two systems from AIM and set the systems up in a cleanroom to begin inspecting the constant flow of parts. There was little or no training involved in learning how to operate the systems. Fraen hired two workers to run the machines both of whom had no previous training in running video inspection systems. Both workers readily learned the operation. Cohen said that if the company had not purchased the vision inspection systems it would have had to hire an additional 20 people to help with in- spection. In addition the systems provided real-time data allowing Fraen to fine-tune its process. The company however did not anticipate how statis- tically overwhelming 100 inspection could be. “Transi- tioning the factory from sampling parts and measuring via statistical sampling to 100 inspection and having all of the data from every piece from every machine every day was a challenge because you had an enormous amount of data all of a sudden” Cohen said. “We fill up a CD-ROM each week with data so figuring out what to do with all of that and how to manage it was pretty diffi- cult.” Fraen eventually hired a full-time analyst to man- age the information. The investment was well worth the effort according to Cohen. The two systems enabled Fraen to provide its customers with zero defects. As a result the company purchased six more systems as well as additional pro- duction machinery and a new facility. “We’re actively pursuing high-volume jobs because of those systems and word has gotten out about our quality” Cohen con- cluded. “We established ourselves as a player against people who otherwise would have buried us.” SOURCE: Samantha Hoover “Visual Inspection System Keeps Up with Produc- tion Leap” Quality March 1999 pp. 46ff. General Electric Company REVISITING n the initial stages of Six Sigma GE’s efforts consisted of training more than 100000 people in its science and methodology and focusing thousands of “projects” on improving efficiency and reducing variances from its internal operations—from industrial factories to financial services back rooms. I

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Chapter 7 Special Production Issues: Lost Units and Accretion 283 SOURCES: General Electric Company Web site June 2000 Staff “GE: Lighting the Way” Machine Design September 23 1999 pp. 123–129 Geoffrey Colvin “America’s Most Admired Companies” Fortune February 21 2000 pp. 108 110. From there the company’s operating system steered the initiative into design engineering to prepare future generations of customer-interactive processes of the finan- cial services businesses. Medical Systems used it to open up a commanding technology lead in several diagnostic platforms and has achieved dramatic sales increases and customer satisfaction improvements. By 1999 GE had undertaken 20000 quality initiatives resulting in an average 80 percent error reduction. Every GE product business and financial service activity is using Six Sigma in its product design and fulfill- ment processes. A growing number of Six Sigma projects are now under way for customers many on customer premises. In 1996 GE’s CEO Jack Welch rang the opening bell at the New York stock exchange celebrating the 100th anniversary of the Dow Jones Index. His presence was significant because GE is the only company on the original index that is still on the list. GE became the first company in the world to exceed 200 billion market capitalization and in 1998 it crossed the 100 billion mark in revenue. Given the above is it surprising that GE was named “America’s Most Admired Corporation” in 2000 for the third year in a row This chapter covers the accounting treatment for shrinkage defective and spoiled units and accretion of units in a process costing system. Management typically specifies a certain level of shrinkage/defects/spoilage that will be tolerated as normal if a loss of units is commonly anticipated. If lost units exceed that expec- tation the excess is considered an abnormal loss. Normal losses are product costs and abnormal losses are period costs. To account for the cost of lost units the location of the loss within the process must be known in addition to knowing whether the quantity of lost units is normal or abnormal. If the loss point is continuous the period’s good production absorbs the cost of the lost units. This treatment is handled in the cost of production report by not extending the lost units to the equivalent units columns. If the loss point is discrete lost units are included in the EUP schedule at their unit equivalency at the quality control point. If ending inventory has reached the inspection point the cost of the lost units is allocated both to units transferred from the department and units in ending inventory. If ending inventory has not yet reached the quality control inspection point the lost unit cost attaches only to the units transferred. In a job order costing system the cost of anticipated defects/spoilage is esti- mated and included in setting the predetermined overhead rate. This approach al- lows expected cost of lost units to be assigned to all jobs. When lost units occur any disposal value of those units is carried in a separate inventory account the net cost of defects/spoilage is debited to Manufacturing Overhead. If lost units do not generally occur in a job order system any normal defects/spoilage associated with a specific job is carried as part of that job’s cost the disposal value of such units reduces the cost of the specific job. Treatment of the rework cost for defective units depends on whether the rework is normal or abnormal. If rework is normal the cost is considered to be a product cost and either 1 increases actual costs in the cost schedule or 2 is considered in setting an overhead application rate and charged to overhead when incurred. If rework is abnormal the cost is assigned to the period as a loss. Adding material to partially completed units may increase the number of units. If the material addition occurs in a successor department a new transferred-in cost per unit must be calculated using the increased number of units. If units of measure change between the start and end of production a consistent measuring unit must be used in the cost of production report to properly reflect production of the period. CHAPTER SUMMARY

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Accounting for spoiled and defective units is essential when total quality does not exist. The traditional methods of accounting for spoilage often “bury” the cost of poor quality by spreading that cost over good output. Managers should attempt to compute the costs of spoiled or defective units and search for ways to improve product quality reduce product cost and increase the company’s competitive mar- ket position. Part 2 Systems and Methods of Product Costing 284 KEY TERMS abnormal loss p. 263 accepted quality level AQL p. 261 accretion p. 277 continuous loss p. 264 defective unit p. 263 discrete loss p. 264 economically reworked p. 263 method of neglect p. 265 net cost of normal spoilage p. 276 normal loss p. 263 shrinkage p. 262 spoiled unit p. 263 Lost units are always shown with other whole units under “Units accounted for” in the cost of production report. Continuous Normal Loss 1. Lost units are not extended to EUP schedule. 2. All good production both fully and partially completed absorbs the cost of the lost units through higher per-unit costs. Continuous Abnormal Loss 1. All units are appropriately extended to EUP schedule. 2. Cost of lost units is assigned as a period loss. Discrete Normal Loss 1. Normal loss is appropriately extended to EUP schedule. 2. Determine whether ending inventory has passed an inspection point. a. If no cost of lost units is assigned only to the good production that was transferred. b. If yes cost of lost units is prorated between units in ending WIP Inven- tory and units transferred out based on 1 weighted average total costs contained in each category prior to proration or 2 FIFO current costs contained in each category prior to proration. Discrete Abnormal Loss 1. All units are appropriately extended to EUP schedule. 2. Cost of lost units is assigned as a period loss. Normal Rework 1. Actual cost system Add rework costs to original material labor and overhead costs and spread over all production. 2. Normal and standard cost systems Include cost of rework in estimated over- head when determining standard application rate. Assign actual rework costs to Manufacturing Overhead. SOLUTION STRATEGIES

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Abnormal Rework Accumulate rework costs separately and assign as a period loss. Accretion in Successor Departments An increase in units requires that the per-unit transferred-in cost be reduced in the successor department based on the new larger number of units. Chapter 7 Special Production Issues: Lost Units and Accretion 285 Maura Nobile Company incurs spoilage continuously throughout the manufac- turing process. All materials are added at the beginning of the process and the in- spection point is at the end of the production process. April 2000 operating sta- tistics are as follows: Pounds Beginning inventory 75 complete 2000 Started in April 10000 Completed and transferred 9500 Ending inventory 70 complete 1000 Normal spoilage 900 Abnormal spoilage Costs Beginning inventory Material 117780 Conversion 47748 165528 Current period Materials 546000 Conversion 325500 871500 Total costs 1037028 Required: a. Prepare a cost of production report using the weighted average method. b. Prepare a cost of production report using the FIFO method. c. Using the information from part b prepare the journal entry to recognize the abnormal loss from spoilage. Solution to Demonstration Problem a. MAURA NOBILE COMPANY Cost of Production Report Continuous spoilage—normal abnormal weighted average method For the Month Ended April 30 2000 PRODUCTION DATA EQUIVALENT UNITS Whole Units Material Conversion Beginning inventory 100 75 2000 2000 1500 Pounds started 10000 Pounds to account for 12000 Beginning inventory completed 0 25 2000 0 500 Pounds started and completed 7500 7500 7500 Total pounds completed 9500 Ending inventory 100 70 1000 1000 700 Normal spoilage 900 Abnormal spoilage 100 100 600 600 600 Pounds accounted for 12000 11100 10800 continued DEMONSTRATION PROBLEM

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COST DATA Total Material Conversion Beginning inventory costs 165528 117780 47748 Current costs 871500 546000 325500 Total costs 1037028 663780 373248 Divided by EUP 11100 10800 Cost per WA EUP 94.36 59.80 34.56 COST ASSIGNMENT Transferred 9500 94.36 896420 Ending inventory: Material 1000 59.80 59800 Conversion 700 34.56 24192 83992 Abnormal loss 600 94.36 56616 Total costs accounted for 1037028 b. MAURA NOBILE COMPANY Cost of Production Report Continuous spoilage—normal abnormal FIFO method For the Month Ended June 30 2000 PRODUCTION DATA EQUIVALENT UNITS Whole Units Material Conversion Beginning inventory 100 75 2000 2000 1500 Pounds started 10000 Pounds to account for 12000 Beginning inventory completed 0 25 2000 0 500 Pounds started and completed 7500 7500 7500 Total pounds completed 9500 Ending inventory 100 70 1000 1000 700 Normal spoilage 900 Abnormal spoilage 100 100 600 600 600 Pounds accounted for 12000 11100 9300 COST DATA Total Material Conversion Beginning inventory costs 165528 Current costs 871500 546000 325500 Total costs 1037028 Divided by EUP 9100 9300 Cost per FIFO EUP 95 60 35 COST ASSIGNMENT Transferred: From beginning inventory 165528 Cost to complete: Conversion 500 35 17500 Total cost of beginning inventory 183028 Started and completed 7500 95 712500 Total cost of pounds transferred 895528 Ending inventory: Material 1000 60 60000 Conversion 700 35 24500 84500 Abnormal loss 600 95 57000 Total costs accounted for 1037028 Part 2 Systems and Methods of Product Costing 286

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Chapter 7 Special Production Issues: Lost Units and Accretion 287 1. Explain the meaning of an accepted quality level and discuss it in relation to a zero tolerance for defects or errors approach. 2. Differentiate among shrinkage spoilage and defects. 3. What are some reasons a company would set a “tolerated” loss level How might such a level be set 4. List five examples similar to the blackened redfish illustration in the text in which a unit would be considered a defective and b spoiled. 5. What is the difference between a normal and an abnormal loss 6. Why would abnormal losses be more likely to be preventable than some types of normal losses 7. How does a continuous loss differ from a discrete loss 8. When does a discrete loss actually occur When is it assumed to occur for accounting purposes Why are these not necessarily at the same point 9. Why is the cost of an abnormal loss considered a period cost How is its cost removed from Work in Process Inventory 10. What is meant by the term method of neglect When is this method used 11. How does use of the method of neglect affect the cost of good production in a period 12. In a job order costing system spoilage may be incurred in general for all jobs or it may be related to a specific job. What differences do these circumstances make in the treatment of spoilage 13. In a production process what is accretion How does it affect the cost of the units transferred in from a predecessor department 14. The Mixing Department of Leeward Company transferred 100000 gallons of material to the Baking Department during July. The cost per gallon transferred out shown on Mixing’s cost of production report was 2.50. On Baking’s cost of production report for the same period the cost per gallon for material trans- ferred in was 2.00. Why might the cost have changed 15. How are costs of reworking defective units treated if the defects are considered normal Abnormal 16. A company has an AQL for defects of 5 percent of units started during the period. Current period loss was 3 percent. Why should management attempt to measure the cost of this loss rather than simply include it as part of the cost of good production 17. How do statistical process control techniques contribute to the control of spoilage costs 18. Search the Internet for a company that has a zero tolerance for defects policy and report on the results of the company’s efforts to reach its goals. QUESTIONS c. Loss from Abnormal Spoilage 57000 Work in Process Inventory 57000 To remove cost of abnormal spoilage from Work in Process Inventory account.

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Part 2 Systems and Methods of Product Costing 288 19. Terminology Match the following lettered terms on the left with the appro- priate numbered definition on the right. a. Abnormal loss 1. Allowing the production of spoiled b. Acceptable quality level units to increase the cost of good c. Accretion production d. Defective unit 2. Decreases the transferred-in cost per e. Economically reworked unit f. Method of neglect 3. Results from having defective g. Normal loss production greater than the AQL h. Spoiled unit 4. A unit that is discarded on inspection 5. A unit that can be reworked 6. An expected decline in units in the production process 7. Additional processing that results in net incremental revenue 8. Maximum limit below which the frequency of defects in a process is accepted as normal 20. Cost-benefit analysis Alfred Carlson plant manager at WEBOXALL Company is investigating spoilage created by a machine that prints packing boxes for TVs and other large fragile items. At the beginning of each production run 50 boxes are misprinted either because of miscoloration or misalignment. These boxes must be destroyed. The variable production cost per box is 6.00. The machine averages 200 setups for production runs each year. A regulator is available that will correct the problem. Alfred is trying to decide whether to purchase the regulator. a. At what cost for the regulator would the benefit of acquisition not exceed the cost What other factors should Alfred consider in addition to the pur- chase price of the regulator b. If each setup produces an average of 500 boxes what is the increased cost per good box that is caused by the spoiled units c. WEBOXALL Company runs 12 batches per year for Springtime Corpora- tion which makes very specialized equipment in limited quantities. Thus each batch contains only 20 boxes. If WEBOXALL Company is passing its spoilage cost on to customers based on batch costs might Springtime Cor- poration be willing to buy the regulator for WEBOXALL Company if the regulator costs 3300 Justify your answer. d. Why are the cost-per-box answers in parts b and c so different 21. Normal vs. abnormal spoilage WA Jacksonville Plastics uses a weighted av- erage process costing system for its production process in which all material is added at the beginning of production. Company management has specified that the normal loss cannot exceed 7 percent of the units started in a period. All losses are caused by shrinkage. March processing information follows: Beginning inventory 10 complete—conversion 8000 units Started during March 60000 units Completed during March 53000 units Ending inventory 60 complete—conversion 10000 units a. How many total units are there to account for b. How many units should be treated as normal loss c. How many units should be treated as abnormal loss d. What are the equivalent units of production for direct material For con- version EXERCISES

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22. EUP computations normal and abnormal loss The Atlanta Division of South- eastern Paint produces environmental paints in processes in which spoilage takes place on a continual basis. Management considers normal spoilage to be 0.5 percent or less of gallons of material placed into production. The follow- ing operating statistics are available for June 2000 for the paint BMZ: Beginning inventory 20 complete as to material 30 complete as to conversion 8000 gallons Started during June 180000 gallons Ending inventory 60 complete as to material 70 complete as to conversion 4000 gallons Spoiled 1400 gallons a. How many gallons were transferred out b. How much normal spoilage occurred c. How much abnormal spoilage occurred d. What are the FIFO equivalent units of production for materials For con- version costs e. How are costs associated with the normal spoilage handled f. How are costs associated with the abnormal spoilage handled 23. EUP computation normal and abnormal loss FIFO Arkansas Foods manu- factures corn meal in a continuous mass-production process. Corn is added at the beginning of the process. Losses are few and occur only when foreign materials are found in the corn meal. Inspection occurs at the 95 percent com- pletion point as to conversion. During May a machine malfunctioned and dumped salt into 18000 pounds of corn meal. This abnormal loss occurred when conversion was 70 percent complete on those pounds of product. The error was immediately noticed and those pounds of corn meal were pulled from the production process. An ad- ditional 1000 pounds of meal were detected as unsuitable at the inspection point. These lost units were considered well within reasonable limits. May pro- duction data are shown below: Beginning work in process 85 complete 50000 pounds Started during the month 425000 pounds Ending work in process 25 complete 10000 pounds a. Determine the number of equivalent units for direct material and for con- version assuming a FIFO cost flow. b. If the costs per equivalent unit are 2.50 and 4.50 for direct material and conversion respectively what is the cost of ending inventory c. What is the cost of abnormal loss How is this cost treated in May 24. EUP computation normal and abnormal loss cost per EUP FIFO CandleSticks uses a FIFO process costing system to account for its candle production process. Wax occasionally forms imperfectly in molds and thus spoilage is viewed as continuous. The accepted quality level is good output of 92 percent of the pounds of wax placed in production. All wax is entered at the beginning of the process. March 2001 data follow: Beginning inventory 30 complete as to conversion 9000 pounds Started during month 30000 pounds Transferred 31500 pounds 315000 candles 10 wax candles are obtained from a pound of wax Ending inventory 20 complete as to conversion 5400 pounds Loss pounds The following costs are associated with March production: Chapter 7 Special Production Issues: Lost Units and Accretion 289

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Beginning inventory: Material 3600 Conversion 2700 6300 Current period: Material 9207 Conversion 8964 18171 Total costs 24471 a. Prepare the production data segment of CandleSticks’ cost of production report for March 2001. b. Compute the cost per equivalent unit for each cost component. c. Assign March costs to the appropriate units. 25. Cost assignment WA CushionRide manufactures automobile springs. Its pro- duction equipment is fairly old and one bad unit is typically produced for every 20 good units. The bad units cannot be reworked and must be discarded. Spoilage is determined at an end-of-process inspection point. CushionRide uses a weighted average process costing system and adds all material at the begin- ning of the process. The following data have been gathered from the accounting records for January 2001: Beginning inventory 60 complete as to conversion 4000 units Units started 20000 units Ending inventory 30 complete as to conversion 3000 units Good units completed 20000 units Material Conversion Total Beginning inventory 12492 9927 22419 Current period 112548 63000 175548 Total costs 125040 72927 197967 a. Prepare an EUP schedule. b. Determine the cost of the normal spoilage and allocate that cost to the ap- propriate inventory. 26. Normal discrete spoilage WA The Potato Division of Global Foods Company processes potatoes. In the process raw potatoes are sequentially cleaned skinned cooked and canned. Spoilage amounting to less than 12 percent of the total pounds of potatoes that are introduced to the cleaning operation is considered normal in this case normal spoilage is to include the weight of the potato peels. Inspection occurs when the products are 50 percent com- plete. Information that follows pertains to operations in the Potato Division for January 2000: Beginning WIP inventory 30 complete 500000 pounds Started 13500000 pounds Transferred 11400000 pounds Ending WIP inventory 40 complete 750000 pounds a. Compute the amount of spoilage in January. How much of the spoilage was normal b. Compute the equivalent units of production assuming the weighted average method is used. c. Prepare a memo explaining why you might expect some 1 accretion in the canning operation and 2 some shrinkage other than the weight of the peels in one or more of the operations. 27. Rework Auto Luster Inc. manufactures two-gallon tubs of car polish for body shops. The company uses an actual cost process costing system. All material is added at the beginning of production labor and overhead are incurred evenly Part 2 Systems and Methods of Product Costing 290

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through the process. Defective units are identified through inspection at the end of the production process. The following information is available for August 2001: Beginning inventory 30 complete as to conversion 750 units Started during month 17250 units Completed during month 15000 units Defective units 100 complete as to conversion 1800 units Ending inventory 70 complete as to conversion 1200 units Actual August production costs including those for beginning inventory were 126000 for direct material and 40572 for conversion. In addition the rework cost to bring the 1800 units up to specifications was 3150 for material and 1323 for conversion. a. Determine the equivalent units of production using the weighted average method. b. Assume that the rework is normal. Determine the cost per good unit for direct material and conversion. c. Assume that the rework is normal. How would the rework cost be handled in a normal rather than actual costing system d. Assume that the rework is abnormal. Determine the cost per good unit for direct material and conversion. How is the rework cost recorded for financial statement purposes 28. Controlling losses For each of the following types of production losses or poor service indicate whether prevention P or appraisal A techniques would provide the most effective control mechanism. Explain why you made your choice. a. Putting pages in upside down in a book. b. Bolting the wrong parts together. c. Shrinkage from cooking. d. Breaking glasses when they are being boxed. e. Paying an account payable twice. f. Bringing the wrong meal to a restaurant customer. Chapter 7 Special Production Issues: Lost Units and Accretion 291 29. Shrinkage WA Department 1 of Super Patties cooks ground beef for ham- burger patties. The patties are then transferred to Department 2 where they are placed on buns boxed and frozen. The accepted level of shrinkage in Department 1 is 10 percent of the pounds started. Super Patties uses a weighted average process costing system and has the following production and cost data for Department 1 for May 2001: Beginning inventory 80 complete as to conversion 1000 pounds Started 125000 pounds Transferred to Department 2 550000 patties 110000 pounds Ending inventory 30 complete as to conversion 3000 pounds Beginning inventory cost of ground beef 1020 May cost of ground beef 106710 Beginning inventory conversion cost 195 May conversion cost 27630 a. What is the total shrinkage in pounds b. How much of the shrinkage is classified as normal How is it treated for accounting purposes c. How much of the shrinkage is classified as abnormal How is it treated for accounting purposes continued PROBLEMS

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d. What is the total cost of the patties transferred to Department 2 Cost of ending inventory Cost of abnormal spoilage e. How might Super Patties reduce its shrinkage loss How if at all would your solutions affect costs 30. Discrete spoilage WA Angelique Inc. makes stuffed angels in a mass-production process. Cloth and stuffing are added at the beginning of the production process the angels are packaged in sky-blue boxes at the end of production. Conversion costs for the highly automated process are incurred evenly throughout process- ing. The angels are inspected at the 95 percent completion point prior to being boxed. Defective units of more than 1 percent of the units started is considered abnormal. The company uses a weighted average process costing system. June 2001 production and cost data for Angelique Inc. follow: Beginning inventory 40 complete as to conversion 5000 Started 70000 Ending inventory 70 complete as to conversion 6000 Total defective units 400 Beginning inventory cloth and stuffing cost 21900 Beginning inventory conversion cost 7680 June cloth and stuffing cost 315600 June box cost 75460 June conversion cost 270404 a. How many units were completed in June b. How many of the defective units are considered a normal loss An abnormal loss c. What is the per-unit cost of the completed units What would the per-unit cost of the completed units have been if the 400 units had been good units at their same stages of completion at the end of the period d. What is the total cost of ending inventory 31. Normal and abnormal discrete spoilage WA Brendan Tools manufactures one of its products in a two-department process. A separate Work in Process account is maintained for each department and Brendan Tools uses a weighted average process costing system. The first department is Molding the second is Grinding. At the end of production in Grinding a quality inspection is made and then packaging is added. Overhead is applied in the Grinding Department on a machine-hour basis. Production and cost data for the Grinding Department for August 2000 follow: Production Data Beginning inventory complete: labor 30 overhead 40 2000 units Transferred-in from Molding 49800 units Normal spoilage discrete—found at the end of processing during quality control 650 units Abnormal spoilage found at end of processing during quality control 350 units Ending inventory complete: labor 40 overhead 65 1800 units Transferred to finished goods units Cost Data Beginning inventory: Transferred-in 6050 Material label and package 0 Direct labor 325 Overhead 750 7125 Current period: Transferred-in 149350 Material label and package 11760 Direct labor 23767 Overhead 50932 235809 Total cost to account for 242934 Part 2 Systems and Methods of Product Costing 292

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a. Prepare a cost of production report for the Grinding Department for August. b. Prepare the journal entry to dispose of the cost of abnormal spoilage. 32. Normal and abnormal spoilage WA Big Stone Furniture produces breakfast tables in a two-department process: Cutting/Assembly and Lamination. Varnish is added in the Lamination Department when the goods are 60 percent complete as to overhead. Spoiled units are found on inspection at the end of production. Spoilage is considered discrete. PRODUCTION DATA FOR APRIL 2000 Beginning inventory 80 complete as to labor 70 complete as to overhead 2000 units Transferred in during month 14900 units Ending inventory 40 complete as to labor 20 complete as to overhead 3000 units Normal spoilage found at final quality inspection 200 units Abnormal spoilage found at 30 completion as to labor and 15 as to overhead the sanding machine was misaligned and scarred the tables 400 units The remaining units were transferred to finished goods. COST DATA FOR APRIL 2000 Beginning Work in Process Inventory: Prior department costs 15020 Varnish 1900 Direct labor 4388 Overhead 11044 32352 Current period costs: Prior department costs 137080 Varnish 14030 Direct labor 46000 Overhead 113564 310674 Total costs to account for 343026 Determine the proper disposition of the April costs for the Lamination Depart- ment using the weighted average method include journal entries. 33. Normal and abnormal discrete spoilage FIFO Use the Big Stone Furniture information from Problem 32. Determine the proper disposition of the April costs of the Lamination Department using the FIFO method include journal entries. 34. Normal and abnormal discrete spoilage FIFO Reagan Company produces hinges. Completed hinges are inspected at the end of production. Any spoilage in excess of 2 percent of the completed units is considered abnormal. Material is added at the start of production. Labor and overhead are incurred evenly throughout production. Reagan’s May 2001 production and cost data follow: Beginning inventory 50 complete 5600 Units started 74400 Good units completed 70000 Ending inventory 1/3 complete 7500 Material Conversion Total Beginning inventory 6400 1232 7632 Current period 74400 31768 106168 Total 80800 33000 113800 Calculate the equivalent units schedule prepare a FIFO cost of production re- port and assign all costs. 35. Normal and abnormal discrete spoilage WA Use the Reagan Company data as given in Problem 34. Prepare a May 2001 cost of production report using the weighted average method. Chapter 7 Special Production Issues: Lost Units and Accretion 293

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36. Cost assignment Data below summarize operations for GreenerGrass Com- pany for March 2001. The company makes five-gallon containers of weed killer/ fertilizer. All material is added at the beginning of the process. COSTS Material Conversion Total Beginning inventory 30000 3600 33600 Current period 885120 335088 1220208 Total costs 915120 338688 1253808 UNITS Beginning inventory 30 complete-conversion 6000 units Started 180000 units Completed 152000 units Ending inventory 70 complete-conversion 20000 units Normal spoilage 4800 units Spoilage is detected at inspection when the units are 60 percent complete. a. Prepare an EUP schedule using the weighted average method. b. Determine the cost of goods transferred out ending inventory and abnor- mal spoilage. 37. Cost assignment Patio Products employs a weighted average process costing system for its products. One product passes through three departments Mold- ing Assembly and Finishing during production. The following activity took place in the Finishing Department during May 2001: Units in beginning inventory 4200 Units transferred in from Assembly 42000 Units spoiled 2100 Good units transferred out 33600 The equivalent units and the costs per equivalent unit of production for each cost factor are as follows: Cost of prior departments 5.00 Raw material 1.00 Conversion 3.00 Total cost per EUP 9.00 Raw material is added at the beginning of processing in Finishing without changing the number of units being processed. Work in Process Inventory was 70 percent complete as to conversion on May 1 and 40 percent complete as to conversion on May 31. All spoilage was discovered at final inspection. Of the total units spoiled 1680 were within normal limits. a. Calculate the equivalent units of production. b. Determine the cost of units transferred out of Finishing. c. Determine the cost of ending Work in Process Inventory. d. The portion of the total transferred-in cost associated with beginning Work in Process Inventory amounted to 18900. What is the current period cost that was transferred in from Assembly to Finishing e. Determine the cost associated with abnormal spoilage for the month. How would this amount be accounted for CMA adapted 38. Comprehensive weighted average Harper Company produces brooms. Depart- ment 1 winds and cuts straw into broom heads and transfers these to Depart- ment 2 where the broom head is bound and attached to a handle. Straw is Part 2 Systems and Methods of Product Costing 294

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added at the beginning of the first process and the handle is added at the end of the second process. Normal losses in Department 1 should not exceed 5 percent of the units started losses are determined at an inspection point at the end of the pro- duction process. The AQL in Department 2 is 10 percent of the broom heads transferred in losses are found at an inspection point located 70 percent of the way through the production process. The following production and cost data are available for October 2001. PRODUCTION RECORD IN UNITS Dept. 1 Dept. 2 Beginning inventory 6000 3000 Started or transferred in 150000 Ending inventory 18000 15000 Spoiled units 9000 6000 Transferred out 111000 COST RECORD Beginning inventory: Preceding department n/a 6690 Material 3000 0 Conversion 2334 504 Current period: Preceding department n/a 230910 Material 36000 740 Conversion 208962 52920 This is not the amount derived from your calculations. Use this amount so that you do not carry forward any possible cost errors from Department 1. The beginning and ending inventory units in Department 1 are respectively 10 percent and 60 percent complete as to conversion. In Department 2 the begin- ning and ending units are respectively 40 percent and 80 percent complete as to conversion. Using the weighted average method create a cost of production report for each department for October 2001. 39. Comprehensive FIFO Use the information for Harper Company from Prob- lem 38 to prepare a FIFO cost of production report for each department for October 2001. 40. Comprehensive WA and FIFO Andaman Company mines salt in southern Florida. Approximately 30 percent of the mined salt is processed into table salt. Andaman Company uses a process costing system for the table salt operation. Processing takes place in two departments. Department 1 uses FIFO costing and Department 2 uses weighted average. The cost of the processed salt transferred from Department 1 to Department 2 is averaged over all the units transferred. Salt is introduced into the process in Department 1. Spoilage occurs con- tinuously through the department and normal spoilage should not exceed 10 percent of the units started a unit is 50 pounds of salt. Department 2 packages the salt at the 75 percent completion point this material does not increase the number of units processed. A quality control in- spection takes place when the goods are 80 percent complete. Spoilage should not exceed 5 percent of the units transferred in from Department 1. The following production and cost data are applicable to Andaman Com- pany’s table salt operations for July 2001: Chapter 7 Special Production Issues: Lost Units and Accretion 295

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DEPARTMENT 1 PRODUCTION DATA Beginning inventory 65 complete 5000 Units started 125000 Units completed 110000 Units in ending inventory 40 complete 14000 DEPARTMENT 1 COST DATA Beginning inventory: Material 7750 Conversion 11500 19250 Current period: Material 190400 Conversion 393225 583625 Total costs to account for 602875 DEPARTMENT 2 PRODUCTION DATA Beginning inventory 90 complete 40000 Units transferred in 110000 Units completed 120000 Units in ending inventory 20 complete 22500 DEPARTMENT 2 COST DATA Beginning inventory: Transferred-in 204000 Material 120000 Conversion 21600 345600 Current period: Transferred-in 568500 Material 268875 Conversion 55395 892770 Total costs to account for 1238370 This may not be the same amount determined for Department 1 ignore any difference and use this figure. a. Compute the equivalent units of production in each department. b. Determine the cost per equivalent unit in each department and compute the cost transferred out cost in ending inventory and cost of spoilage if necessary. 41. Defective units and rework Hoffus Corporation produces plastic pipe and accounts for its production process using weighted average process costing. Material is added at the beginning of production. The company applies over- head to products using machine hours. Hoffus Corporation used the following information in setting its predetermined overhead rate for 2000: Expected overhead other than rework 425000 Expected rework costs 37500 Total expected overhead 462500 Expected machine hours for 2000 50000 During 2000 the following production and cost data were accumulated: Total good production completed 2000000 feet of pipe Total defects 40000 feet of pipe Ending inventory 35 complete 75000 feet of pipe Total beginning inventory and current period cost of direct material 3750000 Total beginning inventory and current period cost of conversion 5650000 Cost of reworking defects 37750 Part 2 Systems and Methods of Product Costing 296

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Hoffus Corporation sells pipe for 3.50 per foot. a. Determine the overhead application rate for 2000. b. Determine the cost per pipe-foot for production in 2000. c. Assume that the rework is normal and those units can be sold for the reg- ular selling price. How will Hoffus Corporation account for the 37750 of rework cost d. Assume that the rework is normal but the reworked pipe is irregular and can only be sold for 2.50 per foot. Prepare the journal entry to establish the inventory account for the reworked pipe. What is the total cost per unit for the good output completed e. Assume that 20 percent of the rework is abnormal and that all reworked output is irregular and can be sold for only 2.50 per foot. Prepare the journal entry to establish the inventory account for the reworked pipe. What is the total cost per foot for the good output completed during 2000 42. Job order costing rework Argonne Rigging manufactures pulley systems to customer specifications and uses a job order system. A recent order from Michaels Company was for 10000 pulleys and the job was assigned number BA468. The job cost sheet for BA468 revealed the following: WIP—JOB BA468 Direct material 20400 Direct labor 24600 Overhead 18400 Total 63400 Final inspection of the 10000 pulleys revealed that 230 of the pulleys were defective. In correcting the defects an additional 950 of cost was incurred 250 for direct material and 700 for direct labor. After the defects were cured the pulleys were included with the other good units and shipped to the customer. a. Assuming the rework costs are normal but specific to this job show the journal entry to record incurrence of the rework costs. b. Assuming the company has a predetermined overhead rate that includes normal rework costs show the journal entry to record incurrence of the rework costs. c. Assuming the rework costs are abnormal show the journal entry to record incurrence of the rework costs. Chapter 7 Special Production Issues: Lost Units and Accretion 297 43. Normal and abnormal spoilage WA Grand Monde Company manufactures various lines of bicycles. Because of the high volume of each type of prod- uct the company employs a process cost system using the weighted aver- age method to determine unit costs. Bicycle parts are manufactured in the Molding Department and transferred to the Assembly Department where they are partially assembled. After assembly the bicycle is sent to the Packing Department. Cost-per-unit data for the 20-inch dirt bike has been completed through the Molding Department. Annual cost and production figures for the Assembly Department are presented at the top of the next page. CASE

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PRODUCTION DATA Beginning inventory 100 complete as to transferred-in 100 complete as to assembly material 80 complete as to conversion 3000 units Transferred in during the year 100 complete as to transferred-in 45000 units Transferred to Packing 40000 units Ending inventory 100 complete as to transferred-in 50 complete as to assembly material 20 complete as to conversion 4000 units COST DATA Transferred-In Direct Material Conversion Beginning inventory 82200 6660 11930 Current period 1237800 96840 236590 Totals 1320000 103500 248520 Damaged bicycles are identified on inspection when the assembly process is 70 percent complete all assembly material has been added at this point of the process. The normal rejection rate for damaged bicycles is 5 percent of the bicycles reaching the inspection point. Any damaged bicycles above the 5 per- cent quota are considered to be abnormal. All damaged bikes are removed from the production process and destroyed. a. Compute the number of damaged bikes that are considered to be 1. a normal quantity of damaged bikes. 2. an abnormal quantity of damaged bikes. b. Compute the weighted average equivalent units of production for the year for 1. bicycles transferred in from the Molding Department. 2. bicycles produced with regard to assembly material. 3. bicycles produced with regard to assembly conversion. c. Compute the cost per equivalent unit for the fully assembled dirt bike. d. Compute the amount of the total production cost of 1672020 that will be associated with the following items: 1. Normal damaged units 2. Abnormal damaged units 3. Good units completed in the Assembly Department 4. Ending Work in Process Inventory in the Assembly Department e. Describe how the applicable dollar amounts for the following items would be presented in the financial statements: 1. Normal damaged units 2. Abnormal damaged units 3. Completed units transferred to the Packing Department 4. Ending Work in Process Inventory in the Assembly Department f. Determine the cost to Grand Monde Company of normal spoilage. Discuss some potential reasons for spoilage to occur in this company. Which of these reasons would you consider important enough to correct and why How might you attempt to correct these problems CMA adapted Part 2 Systems and Methods of Product Costing 298 44. AudioSpectrum produces complex printed circuits for stereo amplifiers. The cir- cuits are sold primarily to major component manufacturers and any production overruns are sold to small manufacturers at a substantial discount. The small manufacturer segment appears to be very profitable because the basic operating REALITY CHECK

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budget assigns all fixed expenses to production for the major manufacturers the only predictable market. A common product defect that occurs in production is a “drift” caused by failure to maintain precise heat levels during the production process. Rejects from the 100 percent testing program can be reworked to acceptable levels if the defect is drift. However in a recent analysis of customer complaints Andrew Hill the cost accountant and the quality control engineer have ascertained that normal rework does not bring the circuits up to standard. Sampling shows that about one-half of the reworked circuits fail after extended high-volume ampli- fier operation. The incidence of failure in the reworked circuits is projected to be about 10 percent over one to five years of operation. Unfortunately there is no way to determine which reworked circuits will fail because testing does not detect this problem. The rework process could be changed to correct the problem but the cost-benefit analysis for the suggested change in the rework process indicates that it is not practicable. AudioSpectrum’s marketing analyst feels that this problem will have a significant impact on the company’s reputation and customer satisfaction if it is not corrected. Consequently the board of directors would interpret this problem as having serious negative implications for the company’s profitability. Hill has included the circuit failure and rework problem in his report for the upcoming quarterly meeting of the board of directors. Due to the potential adverse economic impact Hill has followed a long-standing practice of high- lighting this information. After reviewing the reports to be presented the plant manager and her staff were upset and indicated to the controller that he should control his people better. “We can’t upset the board with this kind of material. Tell Hill to tone that down. Maybe we can get it by this meeting and have some time to work on it. People who buy those cheap systems and play them that loud shouldn’t expect them to last forever.” The controller called Hill into his office and said “Andrew you’ll have to bury this one. The probable failure of reworks can be referred to briefly in the oral presentation but it should not be mentioned or highlighted in the advance material mailed to the board.” Hill feels strongly that the board will be misinformed on a potentially serious loss of income if he follows the controller’s orders. Hill discussed the problem with the quality control engineer who simply remarked “That’s your problem Andrew.” a. Discuss the ethical considerations that Andrew Hill should recognize in deciding how to proceed in this matter. b. Explain what ethical responsibilities should be accepted in this situation by 1. The controller. 2. The quality control engineer. 3. The plant manager and her staff. c. What should Andrew Hill do in this situation Explain your answer. CMA adapted 45. Every job has certain requirements and quality is defined by meeting those requirements. In some cases however people make decisions to override requirements. In a team of three or four choose four requirements for your class or for a job held by one of you. Prepare a memo that would explain to your teacher or your boss the following: a. The requirements you have chosen and why you think the teacher boss made those requirements. b. The conditions under which your team would decide to override the re- quirements. continued Chapter 7 Special Production Issues: Lost Units and Accretion 299

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c. Why you believe that overriding the requirements would be appropriate in the conditions you have specified. d. The potential for problems that may arise by overriding the requirements. 46. Use library Internet or personal resources to find three companies that insti- tuted workforce education programs and thereby reduced the number of lost units. Prepare a five- to seven-minute oral presentation about your companies’ programs and their benefits. 47. All world-class models TQM JIT ABM and theory of constraints advocate improving throughput as a way to improve quality and minimize defects. Pre- pare a report for the board of directors of a company for which you are the newly appointed controller explaining why increasing throughput is linked to quality improvements and reduction of defects. 48. In accounting for spoilage consideration should be given to how well the ap- proach chosen to measure spoilage supports management’s efforts to improve quality. Prepare a memo explaining how selecting a method to measure and account for spoilage can either assist or hinder management’s efforts to im- prove quality. 49. The following is an excerpt from the Web site of Zero Defects an electronics manufacturing service provider: At Zero Defects we have never believed that perfection is too much for our clients to expect. For over 15 years the world’s leading electronics companies have relied on us to provide legendary service and manufacture faultless prod- ucts. When we say faultless we mean much more than you might think. To us perfection means: • Delivering 100 usable product on time every time. • Providing service that meets and exceeds every expectation. • Manufacturing each component in the most cost-effective way possible. • Meeting your exact specifications and customizing any part of our pro- duction line to do so. • Keeping costs at a bare minimum through tight internal controls and volume buying power. • Providing and standing by detailed quotations and schedules. • Preventing environmental damage through safe manufacturing and recycling programs. SOURCE: Staff Zero Defects Web site June 15 2000. Write a report briefly discussing this excerpt. Compare and contrast the approach explained in the excerpt with the traditional notion of only undertaking an ac- tion for which there is an expected net benefit using cost-benefit analysis. 50. Find three companies on the Internet other than GE the company featured in this chapter that are using Six Sigma. Briefly discuss the results they have experienced from using it. Part 2 Systems and Methods of Product Costing 300

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8 Implementing Quality Concepts CHAPTER LEARNING OBJECTIVES After completing this chapter you should be able to answer the following questions: 1 Why is the emphasis on quality in business unlikely to decline 2 What is quality and from whose viewpoint should it be evaluated 3 What primary characteristics comprise product quality and service quality 4 Why do companies engage in benchmarking 5 Why is total quality management significant and what conditions are necessary to yield its benefits 6 What types of quality costs exist and how are those costs related 7 How is cost of quality measured 8 Why does a company need both a strategically based management accounting system and a financial accounting system 9 How can quality be instilled as part of an organization’s culture

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Solectron Corporation INTRODUCING olectron Corporation is the first company in the his- tory of the Malcolm Baldrige National Quality Award program to have won that award twice in 1991 and 1997. Solectron which was founded in 1977 as a solar energy company has received 200 quality and service awards from its customers. The company now provides customized electronics products services and solutions for original equipment manufacturers such as International Business Machines Hewlett-Packard Co. Motorola Inc. Polaroid Corporation and Cisco Systems Inc. Solectron has more than 31000 associates in 21 worldwide manufacturing facilities that encompass more than 6 million square feet. During the past seven years the company has averaged a 53 percent compound an- nual growth rate. Revenues for the fiscal year 1998 were 5.3 billion. When Solectron opened a New Product Intro- duction center just outside of Tokyo it became the first United States–based electronics manufacturing services company to establish a manufacturing presence in Japan. How does a company reach such quality heights Rich Allen director of quality at Solectron believes the company’s quality culture began with founder and former CEO Winston Chen. Chen left IBM to start an American company that could and would manufacture high-quality products in the United States and that focused on giving customers exactly what they wanted. Chen noted that the quality principles being applied in Japan at the time were not being utilized in the United States. On the other hand the innovations being used in the United States were not being applied in foreign countries as well as they could be. So Chen combined the innovative approaches cur- rently applied quite well in the United States with some of the Japanese quality practices such as poka-yoke tech- niques kaizen techniques seven-step continuous im- provement processes and SPC tools and saw how they fit and applied to the company. Then Solectron started doing grassroots training while implementing those quality programs in almost every manufacturing area. Rich Allen commented that “the most important thing was not to let the tools disappear or filter out. With most quality programs people don’t understand that if you re- ally don’t reinforce and continually modify it to make it work for you it just goes away. Then what you have is a quality program-of-the month. We’ve never had that. What we said was ‘This is what we’re going to do and we’re going to make it work.’” Managers at Solectron Corporation and numerous other entities recognize that high quality is a fundamental organizational strategy for competing in a global econ- omy. Businesses both domestic and foreign are scrambling to attract customers and to offer more choices to satisfy customer wants and needs than in the past. Competition usually brings out the best in companies and international competi- tion has evoked even greater quality in company products and services. Consumers are more aware of the greater variety of product choices. How- ever because they usually have limited funds and must make trade-offs among price quality service and promptness of delivery customers have a limited set of options. Even so consumers are taking advantage of the enhanced extent of their options for quality price service and lead time as afforded by the Internet and advanced technology. Ready access now being geometrically accelerated by the Internet to multi- national vendors has motivated producers to improve product quality and customer service. Consumers are delighted with their access to higher quality products and services and are thereby encouraged to enhance this access. Vendors are encouraged by the success of firms that delight customers and have adopted more dynamic SOURCES: Holly Ann Suzik “Solectron Tells Its Tale” Business and Management Practices Responsive Database Services Inc. Vol. 38 April 1999 pp. 53ff Scott Thurm “Some Manufacturers Prosper by Facilitating Rise of ‘Virtual’ Firm” The Wall Street Journal August 18 1998 pp. A1 A6 PR Newswire “Solectron Becomes First U.S.- Based EMS Company to Open Design and Manufacturing Center in Japan” PR Newswire Association Inc. April 1 1999 Financial News section Todd Wallack “Solectron to Expand” The Boston Herald April 2 1999 Finance section p. 31. 303 S Why is the emphasis on quality in business unlikely to decline 1 http://www.hewlett-

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approaches to continuously improving the product process and service quality for their customers. This chapter discusses issues such as benchmarking total quality management quality costs quality cost measurement and a cost management system as a sup- port for quality initiatives. Because quality affects costs accountants understand the long-run trade-offs involved between higher and lower product/service quality. Many managers have realized that current expenditures on quality improve- ments may be more than regained through future cost reductions and sales vol- ume increases. These improvements will benefit the firm now and in the future thus their costs should not be viewed as expenses or losses but rather as recov- erable investments with the potential for profit generation. Part 2 Systems and Methods of Product Costing 304 WHAT IS QUALITY To improve its product or service quality an organization must agree on a defin- ition of the term. Originally after the Industrial Revolution helped manufacturers to increase output and decrease cost quality was defined as conformity to desig- nated specifications. Conformity determination was left to quality control inspec- tors. The late Dr. W. Edwards Deming famous expert on quality control defined quality as “the pride of workmanship.” 1 On a less individualized basis Philip Crosby another noted quality expert defines quality as “conformance to requirements.” 2 This definition was adopted by the American Society for Quality Control which also defines requirements as follows: “Requirements may be documented as spec- ifications product descriptions procedures policies job descriptions instructions purchase/service orders etc. or they may be verbal. Requirements must be measur- able or they are not valid.” 3 The following remarks stress conformity to requirements but explain that conformity must be judged by customers. Quality is not what the planning and producing individuals may think or wish it to be. It is exactly what exists in the mind of the customer when he or she receives and personally appraises the product or service. This includes the internal customer recipient of internal support service or work in process as well as the external customer. In short the meaning of quality is directly re- lated to customer satisfaction it is still best defined as “conformance to cus- tomer requirements.” Any other definition for quality leaves too much room for interpretation and bias making it impossible to work with. 4 Thus a fairly all-inclusive definition of quality is the summation of all the char- acteristics of a product or service that influence its ability to meet the stated or implied needs of the person acquiring it. Quality must be viewed from the per- spective of the user rather than the provider and relates to both performance and value. This quality perspective arose because of increased competition public in- terest in product safety and litigation relative to products and product safety. The responsibility for quality is not simply a production issue it has become a com- pany profitability and longevity issue. The following News Note dramatizes the importance of competition. All entity processes production procurement distri- bution finance and promotion are involved in quality improvement efforts. There- fore the two related perspectives of quality reflect the 1 totality of internal processes that generate a product or service and 2 customer satisfaction with that product or service. What is quality and from whose viewpoint should it be evaluated 2 1 Rafael Aguayo Dr. Deming New York: Simon Schuster 1990 p. xi. 2 Philip B. Crosby Quality Is Free New York: New American Library 1979 p. 15. 3 American Society for Quality Control Finance Accounting and Quality Milwaukee WI: ASQC 1990 p. 3. 4 Jack Hagan Management of Quality Milwaukee WI: ASQC 1994 p. 18. © 1994 American Society for Quality Control. Reprinted with permission. quality http://www.packardbell .com .com

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Production View of Quality Productivity is measured by the quantity of good output generated from a specific amount of input during a time period. Any factor that either slows down or stops a production process or causes unnecessary work redundancy hinders produc- tivity. Activity analysis can be used to highlight such factors. As explained in Chap- ter 4 the various repetitive actions performed in making a product or providing a service can be classified in value-added VA and non-value-added NVA cate- gories. Value-added activities increase the worth of the product or service to the customer non-value-added activities consume time and costs but add no value for the consumer. Minimizing or eliminating non-value-added activities increases pro- ductivity and reduces costs. Three important NVA process activities include storing products for which there is little immediate demand moving materials unnecessarily and having unsched- uled production interruptions. Another non-value-added activity is caused by sup- plier quality problems: having to inspect incoming components. To minimize or eliminate this NVA activity some companies require their suppliers to provide only zero-defect components. To ensure compliance with this requirement companies may do quality audits of their vendors. Factors causing production redundancy include the need to reprocess rework replace and repair those items that did not conform to specifications. The quality of the product design materials used and production process largely determine the product’s failure rate longevity and breakage tendencies. Further the amount of waste rework and scrap generated by production efforts is related to produc- tion process quality. Production technology worker skill and training and management programs can help significantly to control the production process quality. If the impediments to good production are reduced or eliminated increases in productivity and higher quality products can be expected. Some techniques that increase productivity and enhance quality include having suppliers preinspect materials for quality having employees monitor and be responsible for their own output and fitting machin- ery for mistake-proof operations. All attempts to reduce variability and defects in products reflect the implemen- tation of quality control QC. QC places the primary responsibility for the quality Chapter 8 Implementing Quality Concepts 305 Packard Bell to End Operations in the United States NEWS NOTE QUALITY Packard Bell NEC Inc. once a leader in the home PC mar- ket has become its latest casualty as consumers snap up cheaper offerings from competitors and turn their backs on a company with perceived quality problems. The Packard Bell name and 1600 jobs ceased to exist in the United States at the end of 1999 after the Sacramento-based company failed to meet performance goals set by its Tokyo-based parent NEC Corp. spokes- man Ron Fuchs said. The pullout closed an era of rapid U.S. decline for Packard Bell NEC once the largest domestic maker of personal computers but only No. 6 by summer 1999 ac- cording to researcher Dataquest. The company lost 650 million in 1998 and was on track to lose 150 million despite increased demand for its products. “From our point of view . . . we made a lot of progress this year but when all is said and done we missed our commitment to shareholders by 50 million” Fuchs said. “We’ve got some great products but it’s more niche prod- ucts than it is volume products and we don’t think we’re in the environment to survive in the low end of the PC side of the business when computers are going for 499 399.” SOURCE: The Associated Press “Packard Bell to End Operations in U.S.” The Wall Street Journal November 4 1999 pp. C-1 C-3. Permission conveyed through the Copyright Clearance Center. quality control QC

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of a product or service at the source—the maker or provider. Many companies use statistical process control SPC techniques to analyze where fluctuations occur in the process. SPC is based on the theory that a process has natural common cause variations over time but that “errors” which can result in defective goods or poor service are typically produced at points of uncommon nonrandom or special cause variations. Often these variations are eliminated after the installation of computer-integrated manufacturing systems which have internal controls to eval- uate deviations and sense production problems. To analyze the process variations various types of control charts have been developed by recording the occurrences of some specified measures of perfor- mance at preselected points in a process. Charts such as the one shown in Ex- hibit 8–1 graph actual process results and indicate upper and lower control lim- its. For example a process is considered to be “in” or “out of” control i.e. stable or unstable depending on whether the results remain within established limits and do not form telltale patterns that reflect some nonrandom or special-cause variation. In effect SPC charts make use of the principle of “management by exception” by requiring that workers respond to occurrences greater than some predetermined limit or that form nonrandom telltale patterns. The charts must be prepared consistently and accurately for an intelligent analy- sis to be made about out-of-control conditions. Although development and use of such charts is outside the scope of this text the management accountant is directly involved in selecting appropriate performance measures and helping to interpret the charts. Often the measures selected to prepare control charts are nonfinancial such as number of defective parts amount of waste created and time taken to complete a task. Selection of performance measures to investigate quality is further discussed in Chapters 19 and 20. In effect using SPC causes a process to “talk” to workers about what is occurring in the process. If workers “listen” they can sometimes pre- vent potential product defects and process malfunctions from ever happening. Consumer View of Quality Every customer who acquires a product or service receives a set of characteristics encompassing a range of features such as convenience promptness in delivery war- ranty credit availability and packaging. The consumer’s view of quality reflects more than whether the product or service delivers as it was intended its rate of failure or the probability of purchasing a defective unit. The customer perceives quality as Part 2 Systems and Methods of Product Costing 306 statistical process control SPC control chart EXHIBIT 8–1 Control Chart Observations for Size of Hole Drilled Diameter of Hole Designated Diameter Size Out of Control 1.42" 1.38" 1.40" Range of Acceptable Variation Upper Control Limit Lower Control Limit Out of Control What primary characteristics comprise product quality and service quality 3

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a product’s or service’s ability to meet and satisfy all specified needs. When high- quality producers dominate a market entering companies must understand both their own customers’ quality expectations and their competitors’ quality standards. Exhibit 8–2 provides eight characteristics that would commonly be included in any customer’s definition of product quality. An important difference exists between the first six and the last two characteristics: level of objectivity. The first six char- acteristics can be reasonably evaluated through objective methods whereas the last two are strictly subjective. Thus the first six are much more susceptible to control by an organization than the other two. Note that the “product” of some companies such as hotels hospitals and ac- counting firms is itself a service. With some imagination one can identify most if not all of these eight product quality characteristics in the “service” provided by the company. For example a hotel providing rooms with computer and fax hookups or a continental breakfast could be considered “features” by the Marriott chain. Ad- ditionally Marriott could consider the ability to provide quiet rooms for guests as high “performance.” Service quality reflects the manner in which a company’s product or service is delivered to the customer and also has some common characteristics Exhibit 8–3. Some firms use outside assessors to evaluate the level of service provided as in- dicated in the News Note on page 308. Not all customers can afford the same grade of product or service. Grade refers to one of the many levels that a product or service may have as related to the in- clusion or exclusion of characteristics to satisfy needs especially price. Customers try to maximize their satisfaction within the context of their willingness and ability to pay. They view a product or service as a value when it meets the highest num- ber of their needs at the lowest possible cost cost includes purchase price plus the costs of operating maintaining and disposing of an item. Thus although cus- tomers may have a collective vision of what constitutes “high quality” some of Chapter 8 Implementing Quality Concepts 307 1. Performance—relates to a product’s primary operating characteristics 2. Features—describes the secondary characteristics that supplement a product’s basic function 3. Reliability—addresses the probability of a product’s likelihood of performing properly within a specified period of time 4. Conformance—relates to the degree to which preestablished standards are matched by the product’s performance and features 5. Durability—measures a product’s economic and technical life 6. Serviceability—measures the ease with which the product is repaired 7. Aesthetics—relates to a product’s appeal to the senses 8. Perceived quality—relates to image brand names and other indirect measures of quality SOURCE: Reprinted from “What Does ‘Product Quality’ Really Mean” by David Garvin Sloan Management Review Fall 1984 pp. 25–43 by permission of publisher. Copyright 1984 by the Sloan Management Review Association. All rights reserved. EXHIBIT 8–2 Characteristics of Product Quality 1. Reliability—the ability to provide what was promised dependably and accurately 2. Assurance—the knowledge and courtesy of employees and their ability to convey trust and confidence 3. Tangibles—the physical facilities and equipment and the appearance of personnel 4. Empathy—the degree of caring and individual attention provided to customers 5. Responsiveness—the willingness to help customers and provide prompt service SOURCE: A. Parasuraman Leonard L. Berry and Valarie Zeithaml “Perceived Service Quality as a Customer-Based Performance Measure: An Empirical Examination of Organizational Barriers Using an Extended Service Quality Model” Human Resource Management 303 Fall 1991 pp. 335–364. Reprinted by permission of John Wiley Sons Inc. EXHIBIT 8–3 Characteristics of Service Quality grade value

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them may choose to accept a lower grade of product or service because it satis- fies their functional needs at a lower cost. Note that high quality is a more en- compassing concept than “high grade.” Someone with 20 minutes left for lunch may find more “value” in a fast-food hamburger than going to a sit-down restau- rant for sirloin steak. To illustrate the difference between quality and grade assume Sally Smith is in the market for a new car. She needs the car to travel to and from work run errands and go on vacation and has determined that reliability gas mileage safety and com- fort are features that are most important to her. She may believe the Lexus to be the highest quality of car available but her additional needs are that the car be within her price range and that repair parts and maintenance be readily available and within her budget. Thus she will search for the highest quality product that max- imizes her set of quality-characteristic preferences within the grade she can afford. Undercover with a Hotel Spy—He Checks to See If Bellhops Are Hopping NEWS NOTE QUALITY J. C. Schaefer unscrews a light bulb from a bedside lamp in the posh Windsor Court Hotel and begins violently whacking it against the bedspread. He shakes the light bulb to make sure the filament inside is broken and then carefully screws it back into the lamp. Mr. Schaefer isn’t your average hotel guest. In fact he isn’t even J. C. Schaefer. His real name is David Richey and he’s a hotel spy who uses a variety of aliases to check out luxury hotels all over the world. Over two days he’ll employ an extensive bag of tricks to see if the Windsor Court—rated last year as the top hotel in the world in a Conde Nast Traveler magazine poll—is as good as its reputation. The “burnt-out light bulb” test is one of the toughest. Only 11 of hotels tested by Mr. Richey’s Chevy Chase Maryland firm Richey International detect the burnt-out bulb on the housekeeping staff’s first pass. Some 2000 hotels around the world pay Mr. Richey to check them out. The Windsor Court is a member of Preferred Hotels Resorts Worldwide a group of 120 in- dependent luxury hotels that share a common reserva- tions system. Preferred requires that all its hotels meet at least 80 of its standards in a test conducted annually by Richey International. In 1998 Preferred expelled three hotels that twice failed the test and then didn’t take the necessary steps to improve their scores says Robert Cornell a Preferred Hotels senior vice president. SOURCE: Adapted from Neal Templin “Undercover with a Hotel Spy—He Checks to See If Bellhops Are Hopping” The Wall Street Journal May 12 1999 p. B1. Disney has long been viewed as “best-in-class” in equipment maintenance. Other organiza- tions regardless of the industry they are in can use process benchmarking to compare their maintenance activities against this world-class leader. http://www.preferredhotels .com

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Chapter 8 Implementing Quality Concepts 309 BENCHMARKING Benchmarking means investigating comparing and evaluating a company’s prod- ucts processes and/or services against either those of competitors or companies believed to be the “best in class.” Such comparisons allow a company to under- stand another’s production and performance methods so that the interested com- pany can identify its strengths and weaknesses. Because each company has its own unique philosophy products and people “copying” is neither appropriate nor fea- sible. Therefore a company should attempt to imitate those ideas that are readily transferable but more importantly to upgrade its own effectiveness and efficiency by improving on methods used by others. There are codes of conduct that have been established for benchmarking activities. These codes address issues such as equal exchange of information restricted use of learned data avoidance of an- titrust issues and illegalities and interorganizational courtesy. 5 There are two types of benchmarking: results and process. In results bench- marking the end product or service is examined using a process called “reverse engineering” and the focus is on product/service specifications and performance results. Results benchmarking helps companies determine which other companies are “best in class.” For example Chrysler has tear-down facilities located at its prod- uct development centers. Information gathered in these facilities helps the com- pany focus on its competitors and promote better interaction among engineering design and manufacturing. By studying design differences between its own and its competitors’ products the firm seeks vital information to support quality improve- ments. 6 However if benchmarking involves making an exact replica of another’s product ethical and legal considerations are at issue. Although benchmarking against direct competitors is necessary it creates the risk of becoming stagnant. To illustrate General Motors Chrysler and Ford his- torically competitively benchmarked among themselves and over time their processes became similar. But then import competition arrived which had totally different—and better—processes. It was like three club tennis players who all had similar levels of skill and who knew each other’s games inside and out—and then Pete Sampras walked on the court. 7 For this reason additional comparisons should be made against companies that are the best in a specific characteristic rather than necessarily the best in a specific industry. Focusing on how the best-in-class companies achieve their results is called process benchmarking. It is in this arena that noncompetitor benchmarking is extremely valuable. Some examples of U.S. companies that are recognized as world-class leaders in certain disciplines are Allen-Bradley flexible manufacturing Why do companies engage in benchmarking benchmarking results benchmarking 4 5 Barbara Ettorre “Ethics Anti-Trust and Benchmarking” Management Review June 1993 p. 13. 6 Paul A. Stergar and James H. Cypher “Teardown Keeps Chrysler Focused on the Competition” Cost Management Insider’s Report June 1995 pp. 12–13. 7 Beth Enslow “The Benchmarking Bonanza” Across the Board April 1992 p. 20. Customers often make quality determinations by comparing a product or ser- vice to an ideal level of a characteristic rather than to another product or service of the same type or in the same industry. For example Sam Hill frequently stays at Marriott hotels on business trips. On a recent trip he called a car rental agency to arrange for a car. Sam may compare the quality of service he received from the car rental agency with the high-quality service he typically receives from Marriott rather than how well another car rental company served him in the past. Sam is unconcerned that car rental agency employees may not have had the same cus- tomer satisfaction training as Marriott employees or that the Marriott corporate cul- ture is dedicated to high quality while the car rental agency may not have yet made such a commitment. This type of comparison when formalized in organi- zations is called competitive benchmarking. process benchmarking http://www.chryslercorp .com http://www.fordvehicles .com

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American Express billing and collection Disney equipment maintenance Fed- eral Express worker training and L. L. Bean distribution and logistics. 8 It is against companies such as these as well as their international counterparts that others should benchmark. The process of implementing benchmarking is de- tailed in Exhibit 8–4. Some companies have more steps and others have fewer but all have a structured approach. Once the negative gap analysis is made everyone in the firm is expected to work both toward closing that gap and toward becoming a best-in-class organization. Through benchmarking companies are working to improve their abilities to deliver high-quality products from the perspectives of both how the products are made and how the customer perceives them. Integrating these two perspectives requires involvement of all organizational members in the implementation of a total quality management system. Part 2 Systems and Methods of Product Costing 310 8 “America’s World-Class Champs” Business Week November 30 1992 pp. 74–75. 9 ISO 8402 Total Quality Management Geneva: ISO 1994 definition 3.7. EXHIBIT 8–4 Steps in Benchmarking 8. Do not become complacent. Strive for continuous improvement. 1 st LOO 1. Determine the specific area in which improvements are desired and/or needed. 2. Select the characteristic that will be used to measure quality performance. 3. Identify the best-in-class companies based on quality characteristics. Remember that these companies do not have to be industry product or service specific. 4. Ask for cooperation from the best-in-class companies. This may be handled directly or through a consulting firm. Be prepared to share information and respect requests for confidentiality. 5. Have the people who are associated with the specific area being analyzed collect the needed information. 6. Analyze the “negative gap” between the company’s product process or service and that of the best-in-class firm. 7. Act on the negative gap analysis and make improvements. TOTAL QUALITY MANAGEMENT Total quality management TQM is a “management approach of an organiza- tion centered on quality based on the participation of all its members and aiming at long-term success through customer satisfaction and benefits to all members of the organization and to society.” 9 Thus TQM has three important tenets: 1. It necessitates an internal managerial system of planning controlling and de- cision making for continuous improvement. 2. It requires participation by everyone in the organization. 3. It focuses on improving goods and services from the customer’s point of view. Why is total quality management significant and what conditions are necessary to yield its benefits total quality management TQM 5 http://www.american

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The Quality System The total quality movement requires the implementation of a system that provides information about the quality of processes so managers can plan control evalu- ate performance and make decisions for continuous improvement. Consideration of quality has not historically been part of the planning process. More often it in- volved an after-the-fact measurement of errors because a certain level of defects was simply tolerated as part of the “natural” business process. Action was not trig- gered until a predetermined error threshold was exceeded. In contrast a total quality system should be designed to promote a reorienta- tion of thinking from an emphasis on inspection to an emphasis on prevention continuous improvement and building quality into every process and product. This reorientation should indicate any existing quality problems so that managers can set goals and identify methods for quality improvements. The system should also be capable possibly through the use of statistical methods of measuring quality and providing feedback on quality improvements. Last the system should encourage teamwork in the quality improvement process. In other words the system should move an organization away from product inspection finding and correcting prob- lems at the end of the process to proactive quality assurance building quality into the process so that problems do not occur. Employee Involvement TQM recognizes that all organizational levels share the responsibility for product/ service quality. These new interactions among employee levels are changing the way managers do their jobs. Upper-level management must be involved in the quality process develop an atmosphere that is conducive to quality improvements set an example of commitment to TQM provide constructive feedback about opportuni- ties for improvement and provide positive feedback when improvements are made. Workers should believe they are part of the process of success not the creators of problems. Encouraging employee suggestions and training workers to handle multiple job functions help improve efficiency and quality. At Solectron for example multi- functional work teams are commonly used to facilitate effective problem solving. The following News Note on page 312 discusses some U.K. companies’ use of employee suggestion plans as an integral part of this continuous improvement process. Product/Service Improvement Total quality management focuses attention on the relationship between the inter- nal production/service process and the external customer. This approach has des- ignated consumer expectations as the ultimate arbiter of satisfaction. Therefore TQM requires that companies first know who their customers are. In analyzing their customers companies may want to stop serving some groups of customers based on cost-benefit analyses. Some customers simply cost more than they add in revenues and/or other benefits to the organization. Each revenue dollar does not contribute equally to organizational profitability because the cost to serve different customers may be unequal. The concept that shedding one or more sets of customers would be good for business is difficult to believe at first but most organizations have some clients who drain rather than improve those organizations’ ability to provide quality products and service. Managers should be attuned to customers whose costs ex- ceed their benefits and send them elsewhere. By doing this the company can focus its attention on its worthy customers and make itself attractive to new worth- while customers. After identifying who its value-adding customers are a company must then un- derstand what those customers want. The primary characteristics currently desired Chapter 8 Implementing Quality Concepts 311

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by customers appear to be quality value and “good” service. Good service is an intangible it means different things to different people. But most customers would agree that it is reflective of the interaction between themselves and orga- nizational employees. Frequently only service quality separates one product from its competition. Solectron implements customer-focus teams and measurement techniques through its customer-satisfaction index process to learn what customers want and need. All Solectron customers have an associated customer-focus team that essentially works for them and with them and ensures that everything happens as intended. Customers grade the firm weekly with letter grades A through D in five categories: • Quality. How well did the product work when you got it • Delivery. Did the product get delivered to your delivery target • Communications. Grade us anyway you want in your understanding of our ability to communicate effectively. • Responsiveness or service ability. Do we make you feel good as a customer Do we treat you well • Technology. Are we actually moving ahead in the technology arena 10 The only acceptable grades for Solectron are A and A . They are the ones above 95 percent. Any grades that are a B or less automatically demand a formal corrective action. 11 Part 2 Systems and Methods of Product Costing 312 Suggestions are Power NEWS NOTE INTERNATIONAL Have your employees come up with any good sugges- tions lately At Triple ‘A’ Animal Hotel Care Centre near Washington Tyne and Wear 28 members of staff dream up more than 1200 ideas a year. Not all of these are im- plemented but that’s not the point says finance manager Michael Brown. “We believe all ideas are good ideas. It doesn’t matter whether or not we can act on them all.” But for every Triple ‘A’ there are many more compa- nies where the staff suggestion box simply gathers dust. Moribund suggestion schemes says Alex Bryson a re- searcher in employee involvement at the Policy Studies Institute result from poor planning and inadequate em- ployer commitment. “Staff need to feel that their ideas will be viewed constructively and taken seriously. When in- troduced in isolation or into a company with no culture of employee involvement suggestion schemes have no impact” he claims. Angela Baron policy advisor at the Institute of Personnel and Development agrees. “If em- ployees don’t believe their organisation is really com- mitted to a suggestion scheme then it just won’t work.” What works argues Dave Jackson managing di- rector of organisational change consultants Novius are schemes that are integral to the organization’s approach to continuous improvement. “Schemes need a very high level of commitment from the top but often work best when they are run by the employees themselves” he in- sists. The “Sir Gestion” scheme run by employees at credit card services company Credit Card Sentinel is a good example. There the scheme is administered by em- ployee volunteers who decide which ideas to implement. All suggestions are rewarded with gifts or money prizes. Cost-saving ideas are rewarded with a proportion of the money saved. Car rental firm Avis attributes the success of its PIPS Practical Ideas Profitable Solutions scheme to ensuring employees remain involved with the progress of their ideas. Where possible the people who come up with the ideas are encouraged to implement them. Director of Training Ian Jarvis stresses: “It is built into our Spirit of Avis program which includes other forms of employee involvement and recognition.” SOURCE: Staff “It’s Time to Acknowledge the Power of Suggestion” Manage- ment Today London February 1998 p. 13. 10 Holly Ann Suzik “Solectron Tells Its Tale” Quality April 1999 pp. 53ff. 11 Ibid.

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Poor service can be disastrous. Data indicate that “70 percent of customers stop doing business with companies because of perceived rude or indifferent be- havior by an employee—over three times the total for price or product quality 20 percent.” 12 Although instituting “customer service” programs can improve a com- pany’s image such programs should not be taken to the extreme. As noted above some customers are not cost beneficial. For instance consider those who demand exorbitant service yet are not willing to pay the related price. A company can increase its product and service quality by investing in preven- tion costs which prevent product defects that result from dysfunctional process- ing. Amounts spent on improved production equipment training and engineering and product modeling are considered prevention costs. Complementary to preven- tion costs are appraisal costs which represent costs incurred for monitoring and compensate for mistakes not eliminated through prevention activities. Both of these types of costs will cause a reduction in failure costs. These costs represent internal losses such as scrap or rework and external losses such as warranty work customer complaint departments litigation or defective product recalls. The results of TQM indicate that increasing the amounts spent on prevention should decrease the amounts spent or incurred for appraisal and failure costs— resulting in an overall decline in costs. Also by eliminating non-value-added activ- ities and installing technologically advanced equipment productivity and quality will increase. Lower costs mean that the company can contain or reduce selling prices cus- tomers pleased with the higher quality at the same or lower price perceive they have received value and will buy more. These factors create larger company prof- its that can be reinvested in research and development activities to generate new high-quality products or services. Or the profits can be used to train workers to provide even higher quality products and services than are currently available. This cycle of benefit will continue in a company that is profitable and secure in its mar- ket share—two primary goals of an organization. The Quality Goal Any quality program should seek to meet the following three objectives: 1. The organization should achieve and sustain the quality of the product or service produced so as to continuously meet the purchaser’s stated or implied needs. 2. The organization should give its own management confidence that the intended quality level is being achieved and sustained. 3. The organization should give the purchaser confidence that the intended quality level is or will be achieved in the delivered product or service. When contrac- tually required this assurance may involve agreed demonstration requirements. 13 The embodiment of TQM in the United States is the Malcolm Baldrige National Quality Award. This award focuses attention on management systems processes consumer satisfaction and business results as the tools required to achieve prod- uct and service excellence. There are five categories of entrants: manufacturing service small business education and health-care organizations. To win the award applicants must show excellence in the seven categories shown in Exhibit 8–5. Corporate America has accepted the Baldrige award because it represents ex- cellence. Products and services of companies winning the award are regarded as some of the best in the world. Such recognition invigorates workers and delights all stakeholders and has caused the entire national economy to be strengthened by the enhanced awareness of and attention to quality and its benefits. Chapter 8 Implementing Quality Concepts 313 12 Scott J. Simmerman “Improving Customer Loyalty” Business Economic Review April–June 1992 p. 4. 13 A. Faye Borthick and Harold P. Roth “Will Europeans Buy Your Company’s Products” Management Accounting July 1992 pp. 28–29. prevention cost appraisal cost failure cost

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Japan’s equivalent of the Malcolm Baldrige National Quality Award is the Dem- ing prize. This award named for the late W. Edwards Deming has even more rig- orous requirements than do those for the Baldrige award. Globally the quality movement has progressed to the point that certain quality standards have been set although these are not at the level of either the Baldrige award or the Deming prize. These standards are discussed in the appendix to this chapter. Part 2 Systems and Methods of Product Costing 314 1999 Categories/Items Point Values 1 Leadership 125 1.1 Organizational Leadership 85 1.2 Public Responsibility and Citizenship 40 2 Strategic Planning 85 2.1 Strategy Development 40 2.2 Strategy Deployment 45 3 Customer and Market Focus 85 3.1 Customer and Market Knowledge 40 3.2 Customer Satisfaction and Relationships 45 4 Information and Analysis 85 4.1 Measurement of Organizational Performance 40 4.2 Analysis of Organizational Performance 45 5 Human Resource Focus 85 5.1 Work Systems 35 5.2 Employee Education Training and 25 Development 5.3 Employee Well-Being and Satisfaction 25 6 Process Management 85 6.1 Product and Service Processes 55 6.2 Support Processes 15 6.3 Supplier and Partnering Processes 15 7 Business Results 450 7.1 Customer Focused Results 115 7.2 Financial and Market Results 115 7.3 Human Resource Results 80 7.4 Supplier and Partner Results 25 7.5 Organizational Effectiveness Results 115 TOTAL POINTS 1000 SOURCE: “Malcolm Baldrige National Quality Award 1999 Award Criteria” U.S. Department of Commerce Technology Administration National Institute of Standards and Technology Washington DC. EXHIBIT 8–5 Baldrige Award 1999 Criteria for Performance Excellence TYPES OF QUALITY COSTS As mentioned in the previous section the TQM philosophy indicates that total costs will decline rather than increase as quality improvements are made in an orga- nization. Thus total quality management also includes the idea that it is the lack of high quality that is expensive. Understanding the types and causes of quality costs can help managers prioritize improvement projects and provide feedback that supports and justifies improvement efforts. Two types of costs comprise the total quality cost of a firm: 1 cost of qual- ity compliance or assurance and 2 cost of noncompliance or quality failure. The What tyes of quality costs exist and how are those costs related 6

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cost of compliance equals the sum of prevention and appraisal costs. Compliance cost expenditures are incurred to reduce or eliminate the present and future costs of failure thus they are proactive on management’s part. Furthermore effective investments in prevention costs can even minimize the costs of appraisal. The cost of noncompliance results from production imperfections and is equal to internal and external failure costs. Exhibit 8–6 presents specific examples of each type of quality cost. Information about production quality or lack thereof is contained in inspec- tion reports SPC control charts and customer returns or complaints. Information about quality costs on the other hand is only partially contained in the account- ing records and supporting documentation. Historically quality costs have not been given separate recognition in the accounting system. Chapter 8 Implementing Quality Concepts 315 COSTS OF COMPLIANCE COSTS OF NONCOMPLIANCE Prevention Costs Appraisal Costs Internal Failure Costs External Failure Costs EXHIBIT 8–6 Types of Quality Costs Employees: Hiring for quality Providing training and awareness Establishing participation programs Customers: Surveying needs Researching needs Conducting field trials Machinery: Designing to detect defects Arranging for efficient flow Arranging for monitoring Incurring preventive maintenance Testing and adjusting equipment Fitting machinery for mistake-proof operations Suppliers: Arranging for quality Educating suppliers Involving suppliers Product Design: Developing specifications Engineering and modeling Testing and adjusting for conformity effective and efficient performance durability ease of use safety comfort appeal and cost Before Production: Receiving inspection Production Process: Monitoring and inspecting Keeping the process consistent stable and reliable Using procedure verification Automating During and After Production: Conducting quality audits Information Process: Recording and reporting defects Measuring performance Organization: Administering quality control department Product: Reworking Having waste Storing and disposing of waste Reinspecting rework Production Process: Reprocessing Having unscheduled interruptions Experiencing unplanned downtime Organization: Staffing complaint departments Staffing warranty claims departments Customer: Losing future sales Losing reputation Losing goodwill Product: Repairing Replacing Reimbursing Recalling Handling litigation Service: Providing unplanned service Expediting Serving after purchase

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Part 2 Systems and Methods of Product Costing 316 EXHIBIT 8–7 Relationships among Quality Costs Costs in Dollars Number of Defects External Failure Costs Internal Failure Costs Prevention Costs Appraisal Costs SOURCE: William R. Pasewark “The Evolution of Quality Control Costs in U.S. Marketing” Journal of Cost Manage- ment Spring 1991 p. 48. © 1991 Warren Gorham Lamont. Reprinted with permission of RIA. In most instances the cost of quality is “buried” in a variety of general ledger accounts. For instance Work in Process Inventory and Finished Goods Inventory contain costs for rework scrap preventive maintenance and other overhead items marketing/advertising expense contains costs for product recalls image improve- ments after poor products were sold and surveys to obtain customer information personnel costs include training dollars and engineering department costs include funds spent for engineering design change orders and redesign. Because quality costs are buried managers have no idea how large or pervasive those costs are and therefore have little incentive to reduce them. Because the accounting records are commonly kept primarily to serve re- quirements of financial accounting the behavior of quality costs relative to changes in activity as well as the appropriate drivers for these costs must be separately de- veloped or estimated for quality management purposes. The need to estimate qual- ity costs makes it essential for the management accountant to be involved in all activities from system design to cost accumulation of quality costs. In determining the cost of quality actual or estimated costs are identified for each item listed in Exhibit 8–6. If these costs were plotted on a graph they would appear similar to the cost curves shown in Exhibit 8–7. If the firm spends larger amounts on prevention and appraisal costs the number of defects is lower and the costs of failure are smaller. If less is spent on prevention and appraisal the number of defects is greater and failure costs are larger. The external failure costs curve begins moving toward vertical when customers encounter a certain number of defects. The ultimate external failure cost is reached when customers will no longer buy a given product or any other products made by a specific firm because of perceived poor quality work. A system in which quality costs are readily available or easily determined pro- vides useful information to managers trying to make spending decisions by pin- pointing areas having the highest cost-benefit relationships. Additionally quality cost information will indicate how a shift in one or more curves will affect the others. Exhibit 8–8 shows where in the production–sales cycle quality costs are usually incurred. An information feedback loop should be in effect to link the types and causes of failure costs to future prevention costs. Alert managers and employees con- tinuously monitor failures to discover their causes and adjust prevention activities to close the gaps that allowed the failures to occur. These continuous rounds of action reaction and action are essential to continuous improvement initiatives. The accom- panying News Note discusses how GM tracks defect problems.

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Chapter 8 Implementing Quality Concepts 317 CDC Tactics Used to Attack Auto Problems NEWS NOTE QUALITY General Motors executives were impressed in 1997 when doctors from the federal Centers for Disease Control and Prevention took just days to trace a hepatitis outbreak among Michigan schoolchildren to a load of bad straw- berries from Mexico. The auto executives under orders to slash more than 1 billion from GM’s annual repair bill for cars under war- ranty figured the CDC’s methods for tracking down dis- ease-carrying fruit might offer some useful lessons. They adapted the CDC’s epidemiological system to the in- dustrial task of debugging cars and trucks. Under GM’s old way of handling warranty problems word of breakdowns would filter up with no consistent reporting rules as dealers billed the manufacturer. It might take months for GM to find the source of a prob- lem and correct it. Adapting the CDC’s approach to its own needs GM standardized reporting of breakdowns across its dealer network and began tracking warranty repairs using sam- ples of a few thousand vehicles for each vehicle model. Sophisticated computerized statistical models inspired by the CDC highlight emerging trends. Newly discovered outbreaks of warranty problems are tagged with red dots and then when a solution is put in place with yellow dots. “If we can get it while the trail is still warm . . . we can usually get to the root cause within 24 hours” Mr. Don Mitchell GM’s warranty chief says. The “first-time kill rate” or share of problems solved the first time is 96 he says. In October 1998 the system revealed a surge in com- plaints that air conditioners on a range of brand-new cars and minivans were blowing hot air. Within three days GM engineers had isolated the problem in the compressors and shipped samples of the defective parts to the sup- plier that made them. There engineers traced the prob- lem to a drilling machine that periodically clogged with metal shavings and made holes that were too big. Though the problem affected only about six of every 10000 com- pressors the equipment was retooled to prevent it from recurring. Problem-free output began within 10 days of GM’s initial detection of the problem. SOURCE: Adapted from Gregory L. White “GM Takes Advice from Disease Sleuths to Debug Cars” The Wall Street Journal April 8 1999 pp. B1–B4. EXHIBIT 8–8 Time-Phased Model for Quality Costs Before Production During Production After Production After Sale Prevention Costs Appraisal Costs Feedback Loop External Failure Costs Internal Failure Costs MEASURING THE COST OF QUALITY Theoretically if prevention and appraisal costs were prudently incurred failure costs would become zero. However prevention and appraisal costs would still be incurred to achieve zero failure costs. Thus total quality costs can never be zero. This is not to disregard the knowledge that the benefits of increased sales and greater efficiency should exceed all remaining compliance quality costs. In this sense the cost of compliance quality is free. Management should analyze the qual- ity cost relationships and spend money for quality in ways that will provide the How is cost of quality measured 7

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greatest benefit. Such an analysis requires that the cost of quality be measured to the extent possible and practical and the benefits of quality costs be estimated. Pareto analysis is a technique used to separate the “vital few” from the “trivial many.” The technique is a widely used tool that has repeatedly shown that 20 to 30 percent of the items in a set of items accounts for 70 to 80 percent of the cost or values e.g. inventory donors to charity sources of defects. It is also one way management can decide where to concentrate its quality prevention cost dollars. This technique classifies the causes of process problems according to impact on an objective. For example a company that makes com- puters might subclassify its warranty claim costs for the past year according to the type of product failure as follows: Cost by Type of Failure Total Model Monitor CPU Printer Keyboard Dollars Alpha 15000 16000 12000 3000 46000 Beta 10000 15000 7000 3000 35000 All others 6000 9000 3000 5000 23000 Total 31000 40000 22000 11000 104000 Percent Cumulative Model Dollars of Total Total Alpha 46000 44 44 Beta 35000 34 78 All others 23000 22 100 Total 104000 100 Listing the total failure costs of all models in descending order of magnitude indicates that models Alpha and Beta account for 78 percent of total warranty cost claims. Also the largest single source of warranty claims cost is caused by prob- lems with CPUs. Therefore management should focus efforts on further analysis on what causes models Alpha and Beta and the CPUs on all models to generate the greatest warranty claims costs. This knowledge will permit management to de- vote the appropriate portion of its prevention efforts to minimizing or eliminating these specific problems. This kind of analysis should be conducted sufficiently of- ten for trends to be detected quickly and adjustments to be made rapidly. For ex- ample Marriott uses Pareto analysis to prioritize service problems and thus focus on where to devote the majority of its problem-solving efforts. A company desiring to engage in TQM and continuous improvement should record and report its quality costs separately so that managers can plan control evaluate and make decisions about the activities that cause those costs. However just having quality cost information available does not enhance quality. Managers and workers must consistently and aggressively use the information as a basis for creatively and intelligently advancing quality. A firm’s chart of accounts can be expanded to accommodate either separate tracing or allocating quality costs to new accounts. Exhibit 8–9 lists some suggested accounts that will help management focus on quality costs. Opportunity costs in- cluding lost future sales and a measure of the firm’s loss of reputation are also as- sociated with poor quality. Although opportunity costs are real and may be esti- mated they are not recorded in the accounting system because they do not result from specific transactions. If a firm has a database management system transactions can simply be coded so that reports can be generated without expanding the chart of accounts. Coding permits quality transaction types and amounts to be accessible and a cost of quality report such as the one shown in Exhibit 8–10 which uses assumed numbers can be generated. Two important assumptions underlie this exhibit report: stable production Part 2 Systems and Methods of Product Costing 318 pareto analysis

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and a monthly reporting system. If wide fluctuations in production or service levels occur period-to-period comparisons of absolute amounts may not be appropriate. Amounts may need to be converted to percentages to have any valid meaning. Ad- ditionally in some settings such as a just-in-time environment a weekly reporting system would be more appropriate because of the need for continuous monitoring. Chapter 8 Implementing Quality Concepts 319 Prevention Costs Appraisal Costs Quality Training Quality Inspections Quality Participation Procedure Verifications Quality Market Research Measurement Equipment Quality Technology Test Equipment Quality Product Design Internal Failure Costs External Failure Costs Reworking Products Complaints Handling Scrap and Waste Warranty Handling Storing and Disposing Waste Repairing and Replacing Returns Reprocessing Customer Reimbursements Rescheduling and Setup Expediting EXHIBIT 8–9 New Quality Accounts Cost of Cost of Percent Change Current Percent Change Current Prior from Prior Period from Period Period Period Budget Budget Prevention Costs Quality training 5800 5600 4 6000 3 Quality participation 8200 8400 2 8000 4 Quality market research 9900 7700 29 11000 10 Quality technology 9600 10800 11 15000 36 Quality product design 16600 12200 36 16500 1 Total 50100 44700 12 56500 11 Appraisal Costs Quality inspections 3300 3500 6 3000 10 Procedure verifications 1200 1400 14 1500 20 Measurement equipment 2700 3000 10 3200 16 Test equipment 1500 1200 25 1500 0 Total 8700 9100 4 9200 5 Internal Failure Costs Reworking products 8500 8300 0.2 N/A Scrap and waste 2200 2400 8N/A Storing and disposing waste 4400 5700 23 N/A Reprocessing 1800 1600 13 N/A Rescheduling and setup 900 1200 25 N/A Total 17800 19200 7 External Failure Costs Complaints handling 5800 6200 6N/A Warranty handling 10700 9300 15 N/A Repairing and replacing returns 27000 29200 8N/A Customer reimbursements 12000 10700 12 N/A Expediting 1100 1300 15 Total 56600 56700 0 Total quality costs 133200 129700 3 65700 103 TQM advocates planning for zero defects therefore zero failure costs would be included in the budget. EXHIBIT 8–10 Cost Of Quality Report

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Exhibit 8–11 provides formulas for calculating an organization’s total quality cost using the prevention appraisal and failure categories. Some amounts used in these computations are by necessity estimates. It is better for businesses to use reasonable estimates than to ignore the costs because of a lack of verifiable or pre- cise amounts. Consider the following April 2000 operating information for the Jing USA Company: Defective units D 2500 Units reworked Y 1200 Profit for good unit P 1 25 Profit for defective unit P 2 15 Cost to rework defective unit r 5 Units returned D r 400 Cost of return w 8 Prevention cost K 40000 Appraisal cost A 7200 Substituting these values into the formulas provided in Exhibit 8–11 provides the following results: Z D Y P 1 P 2 2500 120025 15 13000 R Y r 12005 6000 W D r w 4008 3200 F Z R W 13000 6000 3200 22200 total failure cost T K A F 40000 7200 22200 69400 total quality cost Part 2 Systems and Methods of Product Costing 320 Calculating Lost Profits Profit Lost by Selling Units as Defects Total Defective Units Number of Units Reworked Profit for Good Unit Profit for Defective Unit Z D Y P 1 P 2 Calculating Total Internal Costs of Failure Rework Cost Number of Units Reworked Cost to Rework Defective Unit R Y r Calculating Total External Costs of Failure Cost of Processing Customer Returns Number of Units Returned Cost of a Return W D r w Total Failure Cost Profit Lost by Selling Units as Defects Rework Cost Cost of Processing Customer Returns Cost of Warranty Work Cost of Product Recalls Cost of Litigation Related to Products Opportunity Cost of Lost Customers F Z R W PR L O Calculating the Total Quality Cost Total Quality Cost Total Compliance Cost Total Failure Cost T Prevention Cost Appraisal Cost Total Failure Cost T K A F Prevention and appraisal costs are total estimated amounts no formulas are appropriate. As the cost of prevention rises the number of defective units should decline. Additionally as the cost of prevention rises the cost of appraisal should decline however appraisal cost should never become zero. SOURCE: Adapted from James T. Godfrey and William R. Pasewark “Controlling Quality Costs” Management Ac- counting March 1988 p. 50. Reprinted from Management Accounting. Copyright by Institute of Management Ac- countants Montvale NJ. EXHIBIT 8–11 Formulas for Calculating Total Quality Cost

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Of the total quality cost of 69400 Jing USA Company managers will seek to iden- tify the causes of the 22200 failure costs and work to eliminate them. The results may also affect the planned amounts of prevention and appraisal costs for future periods. High quality allows a company to improve current profits either through lower costs or if the market will bear higher prices. But management is often more in- terested in business objectives other than short-run profits. An example of an al- ternative competing objective is that of increasing the company’s market share. In- deed if increasing market share were an objective management could combine the strategies of increasing quality while lowering prices to attract a larger market share. Giving greater attention to prevention and appraisal activities increases qual- ity with the result that overall costs decline and productivity increases. Lower costs and greater productivity support lower prices that in turn often stimulate demand. Greater market share higher long-run profits and perhaps even greater immedi- ate profits result. Chapter 8 Implementing Quality Concepts 321 OBTAINING INFORMATION FROM THE COST MANAGEMENT SYSTEM Today’s business strategy of focusing on customers and quality requires a firm to manage organizational costs so that a reasonable value-to-price relationship can be achieved. Although prices are commonly set in reference to the competitive mar- ket rather than being based on costs companies lacking appropriate cost man- agement skills cannot expect to succeed in the long run. Thus it can be said that organizations need to engage in strategic cost management SCM. SCM can be viewed as the use of management accounting information for the purposes of setting and communicating organizational strategies establishing im- plementing and monitoring the success of methods to accomplish the strategies and assessing the level of success in meeting the promulgated strategies. 14 Thus an organization’s management accounting system should accumulate and report infor- mation related to organizational success in meeting or exceeding customer needs and expectations as well as quality-related goals and objectives. Managers can analyze and interpret such information to plan and control current activities and to make decisions about current and long-term future courses of action including expansion of the company’s market base and/or technology installation. In designing a management accounting system consideration must be given to cost accumulation and process measurement activities. Costs that are accumulated for financial accounting purposes may be inadequate for strategy-based decisions. For example financial accounting requires that research and development costs be expensed as incurred. However a product’s cost is largely determined during design. Design has implications for its perceived value the complexity and variety of com- ponents required for the product’s production its manufacturability and its dura- bility and likelihood of failure. Consequently strategy-based cost management would suggest that design cost be accumulated as part of product cost. This cost does not need to appear on the financial accounting statements but it needs to exist for decision-making purposes in the management accounting system. In contrast financial accounting accumulates all production costs as inventoriable and does not distinguish whether they add value to the customer. A strategically based cost management system differentiates costs that add value from those that do not so that managers and employees can work to reduce the non-value-added costs and enhance continuous improvement. Another example of the abilities of a strategically based management accounting system is in the area of process. Financial accounting is monetarily based and Why does a company need both a strategically based management accounting system and a financial accounting system 8 14 The term strategic cost management was coined by Professors John K. Shank and Vijay Govindarajan of Dartmouth College. A full discussion of the concept is provided in their book Strategic Cost Management New York: The Free Press 1993.

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therefore does not directly measure nonfinancial organizational activities. How- ever as indicated earlier in the chapter many activities critical to success in a qual- ity-oriented global marketplace are related to time—a nonmonetary characteristic. A useful management accounting system ensures availability of information related to nonmonetary occurrences such as late deliveries or defect rates. Such infor- mation can be translated into financial terms if desired to objectively analyze its significance to the company’s profitability. Finally financial accounting reflects a short-term perspective of operating ac- tivity. An organizational goal of continuous improvement is not short term it is uninterrupted into the long run. Gathering monetary information and forcing it into a particular annual period of time does not necessarily provide managers with a clear indication of how today’s decisions will affect the organization’s long-run fi- nancial success. For example not investing in research and development would cause a company’s short-run profitability to improve but could be disastrous in the long run. Thus a strategically based management accounting system reports a greater number of the costs and benefits of organizational activities. Having this informa- tion in a form designed to meet managerial needs allows managers to make in- formed assessments of the company’s performance in the value chain of its posi- tion of competitive advantage or disadvantage and of its progress toward organizational goals. Part 2 Systems and Methods of Product Costing 322 QUALITY AS AN ORGANIZATIONAL CULTURE Quality propelled by changing customer needs and better competition must be viewed as a moving target therefore TQM is inseparable from the concept of con- tinuous improvement. Higher and higher performance standards must be set for everyone in the organization not just the production people to provide the sense of working toward a common goal. This philosophy is expressed in the accom- panying observations regarding a new basic focus for success: Consultants Michael Treacy and Fred Wiersema show that it’s not the com- pany with the best product that’s going to win—or in other markets the com- pany with the lowest costs or the one with the best total solution to a customer’s problem. Whatever a company does to create customer value it’s not how well it performs today that matters in the long run but how good it is at learning to do it better. 15 The behavior of managers and employees comprise the basis for TQM. Consis- tent and committed top management leadership is the catalyst for moving the com- pany culture toward an esprit de corps in which all individuals regardless of rank or position are obsessed with exceeding customer expectations. Such an attitude should also permeate everything a company does including customer relations marketing research and development product design production and information processing. Management can effectively induce change in its organizational culture by providing an environment in which employees know the company cares about them is responsive to their needs and will appreciate and reward excellent results. This knowledge goes a long way in motivating employees toward greater cooper- ation and making them feel trusted respected and comfortable. Such employees are more likely to treat customers in a similar manner. The firm must empower employees to participate fully in the quest for excel- lence by providing the means by which employees gain pride satisfaction and How can quality be instilled as part of an organization’s culture 9 15 Tom Richman “What Does Business Really Want from Government” The State of Small Business 1995 p. 96.

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substantive involvement. Encouragement training job enhancement and the proper working environment and tools are what managers must provide. The work envi- ronment in the new corporate culture involves the effective use of teams in the appropriate settings. Employees should be recognized with praise and rewarded for being involved in team problem solving contributing ideas for improvement acting as monitors of their own work and sharing their knowledge and enthusi- astic attitudes with their colleagues. The true importance of empowerment is dis- cussed in the following remarks: Making employees more involved in and responsible for their work activi- ties increases the value of those individuals not only to the organization but also to themselves and to society as a whole. The organizational benefits gained from empowerment are that employees have a sense of ownership of and work harder toward goals they have set for themselves. Thus employee involvement automatically promotes a higher degree of effort on the part of the work force. We avoid the basis of the Marxist critique of capitalism: the exploitation and subsequent alienation and rebellion of the worker. Problems will be solved more quickly and therefore the cost of errors will be reduced. 16 With its focus on process and customers TQM is founded on one very obvi- ous and simple principle: Do the right things right the first time all the time on time and continuously improve. The accompanying News Note discusses this notion and adds another dimension: bottom-line viability. The heart of this principle is zero defects now and in the future. For exam- ple a non-TQM production policy statement might read: “Do not allow defective Chapter 8 Implementing Quality Concepts 323 16 Cecily Raiborn and Dinah Payne “TQM: Just What the Ethicist Ordered” Journal of Business Ethics Vol. 15 No. 9 1996 p. 969. Getting It Right Produces Profits NEWS NOTE GENERAL BUSINESS We all know the value of “doing things right the first time.” We have learned from experience that going back to fix things just doesn’t make business sense and often never happens anyway once a program or system is imple- mented. So why do we continue to hear stories about projects gone bad—schedules over-run and budgets over-spent The other night as I listened to a presentation about yet another example of such a case my blood began to boil As the speaker discussed the trials and tribulations of a current product development project a number of issues were raised by people in the audience about the long-term viability and stability of the product being de- veloped. Would the product survive Could it be ex- panded and improved Would the ultimate customer the taxpayer in this case be satisfied with what was being delivered The speaker shuffled a bit and was obviously nervous —“Well actually they hadn’t really focused too much on that they were really just focused on getting the project done on time on budget”—their measure of success After all quality is about both the “process” and the “product”—doing things right to end up with a product that is worth delivering. We all complain about the in- creased international competition and customer de- mands for better value so why aren’t we successful at meeting these challenges If we are going to remain com- petitive we need to do something about the quality of our process. It doesn’t make any sense to deliver high- quality products that nobody wants or that don’t provide a measurable business benefit. We must follow a high- quality process that ensures that what we are doing is valuable and will result in a product that provides value to both the customer and the business. SOURCE: Reprinted from an article “Quality and Productivity: ‘Quality and Do- It-Right First Time’ Has to Include Bottom-Line Viability” appearing in CMA Management Magazine formerly CMA Magazine by Pamela Hollington March 1997 p. 33 with permission of CMA Canada.

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production to be greater than one percent of total production.” In contrast total quality management would have the policy statement: “We will achieve zero-defect production.” It follows that management’s responsibility is to provide employees with the training equipment and quality of materials and other resources to meet this objective. Exhibit 8–12 depicts the quality continuum along which companies move to- ward achieving world-class status. This continuum indicates that at the most ba- sic level of quality assurance a company simply inspects to find defective prod- ucts or monitors employees and surveys customers after the fact to find poor service. Implementing a variety of quality control techniques in the system to eliminate the possibilities of defective products or poor service means that the company has be- come quality conscious. When the company’s or a division of the company’s quality system has pro- gressed to a high level of development the company or division may choose to compete against others for formal quality recognition. Finally when the concept of quality has become a distinct element of the organizational culture and toler- ances for defective products or poor service are set at zero percent the company has achieved world-class status and can be viewed as the benchmark for others. But achieving world-class status does not mark an ending point. TQM is not a sta- tic concept when one problem has been solved another one is always waiting for a solution. Part 2 Systems and Methods of Product Costing 324 EXHIBIT 8–12 Quality Continuum ISO 9000 No Quality Sytem Military Standards Industry Standards Malcolm Baldrige Award Deming Prize TQM World- Class Quality System Quality Conscious Quality Competitive Quality Culture Quality Conformance Meet Specification SOURCE: Reprinted by permission from Grant Thornton Survey of American Manufacturers New York 1992 p. 20. Copyright 1992. Solectron Corporation REVISITING olectron’s vision is to “Be the best and continuously improve.” This vision statement reflects the company’s unceasing efforts to refine its business and its processes. The firm’s mission allows it to maintain successful partner- ships with its customers and suppliers as a global provider of total design supply chain and manufacturing solutions. The mission statement is as follows: Our mission is to provide worldwide responsive- ness to our customers by offering the highest quality lowest total cost customized integrated design sup- ply chain and manufacturing solutions through long- term partnerships based on integrity and ethical business practices. S

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Chapter 8 Implementing Quality Concepts 325 SOURCE: “About Solectron” Solectron Corporation Web site October 13 1998 home page. Dr. Chen’s vision in the 1970s and 1980s was to revitalize U.S. manufacturing competitiveness by making Solectron a world-class electronics manufacturing company setting an example for others to follow. His approach to achieving this vision was to benchmark Japanese manufacturing companies and combine American innovation with Japan- ese techniques. Dr. Chen used The Five S’s to achieve that vision: Seiri—Orderliness Put things in order Store all materials and information in an orderly fashion at all times Tidy Ready for use Organized according to frequency A place for everything and everything in its place Seiton—Arrange Properly Distinguish between those things that are needed and not needed Keep only needed materials at the job site Throw away all unneeded items immediately Seisou—Cleanliness Problems are more visible when everything is neat and clean Find minor defects while “sweeping clean” Seiketsu—Always Clean Clean tools equipment and job site immediately after use Equipment that is kept clean runs better Shitsuke—Discipline Follow what has been decided daily Follow standard procedure Continuous quality improvement is essential to survival in the global marketplace. Quality is defined as conformity to requirements as judged by customers. Total quality management is a system involving all company personnel in the pursuit of a continuous improvement process that exceeds customer expectations. The shared planning and decision making among personnel required by TQM is changing the way people perform their jobs. Enhanced technology in hardware production processes and management systems has made the new quality initia- tives possible. Consumers are aware of greater variety by type and quality of prod- ucts and they discriminate in their purchases with regard to price quality service and lead time. This intensified competition has motivated producers to adopt a more dynamic attitude about quality improvement and has heightened the use of competitive benchmarking to close any performance gaps. Quality compliance costs include the costs of prevention and appraisal. These costs are incurred to reduce or eliminate the current costs of quality failure and to continuously improve in the future. Noncompliance costs are separated into inter- nal and external failure costs. The number of good units generated during a period measures productivity. Improving quality essentially increases productivity because quality improvement works to remove factors that slow down or halt the production process or that re- quire production redundancy. Eliminating non-value-added activities also increases productivity. The Malcolm Baldrige National Quality Award focuses attention on manage- ment systems processes and consumer satisfaction as the tools to achieve excel- lence. Winning this award is an indication that a company’s products or services are among the nation’s best. Such an accomplishment invigorates employees and enhances a company’s reputation with all stakeholders. Theoretically quality can be said to be free if its benefits exceed its costs. However management should still measure quality costs so that managers have specific information to plan control evaluate and make decisions in a continu- ous improvement environment. CHAPTER SUMMARY

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Strategically based cost management views management accounting as a means of assisting managers to set and communicate organizational strategies and to es- tablish and monitor methods of accomplishing the intended results of those strate- gies. This type of cost management system differs from financial accounting by tak- ing a longer range perspective including an alternative view of product costs. For instance a strategically based cost management system would include research and development costs in total product cost but would exclude costs of activities that create no value in the value chain. Part 2 Systems and Methods of Product Costing 326 International Quality Standards Most large companies view their markets on an international rather than a do- mestic basis. To compete effectively in a global environment companies must rec- ognize and be willing to initiate compliance with a variety of standard