Cost Accounting: Information for Decision Makers We start the study of the Fundamentals of Cost Accounting with a review and overview of information necessary for decision making. Chapter 1 McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives: 1. Describe the way managers use accounting information to create value in organizations. 2. Distinguish between the uses and users of cost accounting and financial accounting information. 3. Explain how cost accounting information is used for decision-making and performance evaluation in organization. 4. Identify current trends in cost accounting. After studying this chapter you should be able to: first, describe the way managers use accounting information to create value in organizations. Second, distinguish between the uses and users of cost accounting and financial accounting information. Third, explain how cost accounting information is used for decision making and performance evaluation in organizations. Fourth, identify current trends in cost accounting. And finally, understand ethical issues faced by accountants and ways to deal with ethical problems that you face in your career. 5. Understand the ethical issues faced by accountants and ways to deal with ethical problems that you face in your career.

♦ Cost accounting helps manages achieve the maximum value for their organizations by providing information for decision making and by measuring the effects of decisions on the value creation of the organizations. Value Chain LO1 Describe the way managers use accounting information to create value in organizations. ♦ The Value Chain describes a set of activities that transforms raw material and resources into the final goods and services which will be purchased by customers. The value chain describes the set of activities that increase the value of an organization’s products or services. Value-added activities are activities that customers perceive as valuable because the activity adds utility to the goods or services they purchase. In other words, customers define value.

Analyzing Value Added Activities Evaluate each Activity Does it add value? Value Added – the customer perceives value has been added. Non Value Added – the customer does not perceive any added value. The value chain comprises activities from research and development through customer service. Each of these activities is evaluated. The question the manager asks is “Does this add value?” Remember, value is defined by the customer. A value-added activity is then evaluated to determine if the activity can be improved. A non value-added activity is evaluated to see if it can be eliminated.

Value Value Chain Customer Service Distribution Marketing Production Purchasing Design Research & Development

Value Chain  Value Added Activity Non Value Added R&D: Creating a new product  Design: Developing and engineering new products Purchasing: Acquisition of goods and services for production Production: Producing the product Marketing: Informing customers about the product Distribution: Delivering the product to customers Service: Supporting customers using the product All products start with research and development. Is research and development, that is creating and developing ideas related to a new product, value-added or non value-added? Once we have the idea for a new product, the product must be developed and engineered. Does this add value? The purchasing department is responsible for acquiring all the necessary components and supplies in order to produce the product. Does this add value? We must produce the product or deliver the service in order for the product or service to have value to a customer. We need to inform potential customers about the attributes of our product or service. Delivering the product or service to the customer adds value. If the customer doesn’t have the product or service, it has no value. Finally, chances are you have experienced the value of customer service. Have you ever called the technical support line for a software application you installed on your computer? If so , I hope the support added value to your product.

Accounting Systems LO2 Distinguish between the uses and users of cost accounting and financial accounting information. Accounting systems are designed to provide information to decision-makers. Financial Accounting System Provides information to external decision-makers Cost Accounting System Provides information to Internal decision-makers Let’s distinguish between the uses and users of cost accounting and financial accounting information. Accounting systems are designed to provide information to decision-makers. However, financial accounting systems provide information to decision-makers external to the firm while cost accounting systems provide information to decision-makers internal to the firm.

Accounting System, continued… Financial accounting reports financial position and income according to GAAP (Generally Accepted Accounting Principles). (GAAP is a set of rules, standards, and conventions that guide the preparation of financial accounting statements for shareholders.) Data should be comparable across firms. Cost accounting measures, records and reports information about costs. Data should be relevant for decisions in a particular firm. Financial accounting reports financial position and income according to generally accepted accounting principles (GAAP). Because individuals external to the firm using financial accounting data to make decisions are often interested in comparing firms, financial accounting data should be comparable across firms. On the other hand, cost accounting measures, records and reports information about costs. Although managers in a company are interested in the information contained in the financial accounting reports, that information is not sufficient for making operational decisions. Cost accounting data should be relevant for the decisions in a particular firm.

Customers of Cost Accounting Customers of cost accounting are the managers At production level to control and improve operations At middle management identify problems by highlighting the aspect of operations is different from expectations At the executive level to assess company’s overall performance The most important participant in any business is the customer. A customer is an individual who purchases or uses the product or service offered. Having said that, let’s consider the customers of cost accounting. Who uses the information provided by the cost accounting system? Managers use the information in making decisions. Managers continually make decisions on how to improve operations. Owners of the firm also use cost accounting information. Owners use the information to evaluate the performance of the managers. Cost information is used to make decisions on activities that add value to the organization

-Supply chain is the set of firms and individuals that sell goods and services to the firm. -Distribution chain is the set of firms and individuals that buy and distribute goods and services from the firm. -These suppliers and customers are on the firm’s boundaries. -The supply chain and distribution chain are the parts of the value chain outside the firm. -Value chain creates value for which the customer is willing to pay. -Firms must decide where in the value chain a value-added component is performed most cost effectively. -Cost information adds value to the organization if it improves managers’ decisions.

Framework for assessing accounting systems Decisions determine the performance of the organization Managers use information from the accounting system to make decisions Owners evaluate organizational and managerial performance with accounting information

Managerial Decisions KEY QUESTION: What adds value to the firm? LO3 Explain how cost accounting information is used for decision making and performance evaluation in organization. Calculate the financial consequences of alternatives by estimating how costs (revenue or assets) among the alternatives will differ KEY QUESTION: What adds value to the firm? The key question is: What adds value to the firm? Let’s look at how cost information adds value to the organization. Cost information adds value to the organization if that information improves managers’ decisions.

Carmen’s Cookies Should Carmen expand operations? Are the benefits greater than the costs? What are the differential revenues? What are the differential costs? What are the cost drivers? As an example look at Carmen’s Cookies founded and managed by Carmen Diaz. How can cost information help Carmen in deciding whether or not to expand operations? Several questions can be answered from Carmen’s cost information. Are costs greater than benefits? What are Carmen’s differential costs? What are Carmen’s differential revenues? What are Carmen’s cost drivers?

Cost Benefit Analysis Consider both costs & benefits of a proposal. Are costs greater than the benefits? Benefits > Costs? Expand! Benefits < Costs? Don’t Expand! Carmen needs to do a cost-benefit analysis. If the cost is greater than the benefit Carmen will not expand. However, if the benefit is greater than the cost Carmen might expand.

Cost Drivers What drives cost? Factors that cause or ‘drive’ cost. These are estimates and require assumptions. What are Carmen’s cost drivers? Number of stores. Number of cookies. We begin the cost-benefit analysis with identifying Carmen’s cost drivers. Cost drivers are factors that cause or drive costs. Understand, these are estimates and require assumptions, some which may be realized and some which may not be realized.

Carmen’s Cost Drivers Cost Driver Rent # of stores Insurance Labor # of cookies Ingredients What drives the cost of rent and the cost of insurance? The number of storefronts Carmen has drives rent and insurance. If Carmen opens a new storefront her rent and insurance costs will increase. What about the cost of labor or the cost of the ingredients for the cookies? How many cookies Carmen makes will determine how many employees she needs and how much flour and sugar are required.

Differential Costs Don't Expand!! Expand!! Costs that change in response to a particular course of action. Differential costs change (differ) between actions. Don't Expand!! Expand!! After identifying the cost drivers, Carmen looks at her differential costs. Differential costs are costs that differ between alternatives. Carmen’s differential costs are those costs that are different if she expands versus if she doesn’t expand. Get it? Differential costs differ.

Differential Revenues Revenues that change in response to a particular course of action. Differential revenues change (differ) between actions. Like differential costs, differential revenues differ between actions. What are Carmen’s expected revenue if she expands? What are her expected revenues if she does not expand? The difference between these expected revenues is differential revenue. Do Not Expand Expand!

Differential Costs, Revenues, and Profits Carmen’s Cookies Projected Income Statement for One Week (1) (2) (3) Status Quo Original Shop Sales Only Alternative Wholesale & Retail Distribution Difference Sales Revenue $ 6,300 $ 8,505a $ 2,205 Costs Food 1,800 2,700b 900 Labor 1,000 1,500b 500 Utilities 400 600b 200 Rent 1,250 -0- Other 1,200c Total Costs $ 5,450 $ 7,250 $ 1,800 Operating Profit $ 850 $ 1,255 $ 405 (a) 35 percent higher than status quo Look at Carmen’s projected income statement. If Carmen maintains the status quo and does not expand, revenue will be $6,300. However, she expects revenues to increase 35% if she expands. Differential revenue is $2,205. If food, labor and utilities costs all increase 50%, Carmen has differential costs of 900, 500 and 200 dollars for those costs. Carmen determines she currently has room for increased cookie production so she will not be required to rent additional space. Therefore, rent is not a differential cost. However, her other costs also increase 20% for differential costs of $200. Using this cost information to analyze revenues and costs, Carmen determines that she has differential profits of $405 if she expands rather than maintaining the status quo. (b) 50 percent higher than status quo. (c) 20 percent higher than status quo.

For the Month Ending April 30 Budget CARMEN’S COOKIES Budgeted Costs For the Month Ending April 30 Number of Cookies 32,000 Materials Flour $2,200 Eggs 4,700 Chocolate 1,900 Nuts Other 2,200 Total Materials $12,900 Labor: Manager $3,000 Other 1,500 Total Labor 4,500 Utilities 1,800 Rent 5,000 Total Cookie Costs $24,200 A budget, or a financial plan for the revenues and resources needed to meet financial goals, is an important tool for the financial success of both individuals and organizations. In Chapter Twelve we will look at budgets and the planning process in detail. Do you have a budget?

Actual to Budget Comparisons CARMEN’S Cookies Actual vs Budgeted Costs For the Month Ending April 30 Actual Budget Difference (Variance) Number of Cookies Sold 32,000 -0- Costs: Food Flour $2,100 $2,200 $(100) Eggs 5,200 4,700 500 Chocolate 2,000 1,900 100 Nuts Other 2,200 Total Food $13,500 $12,900 $ 600 Another important use of cost accounting information is the evaluation of the performance of an organization. Comparing the actual results to the budgeted results allows managers to evaluate the performance of the organization and owners to evaluate the performance of individual managers. For example, look at Carmen’s actual activity and costs compared to her budgeted activity and costs. If Carmen budgeted selling 32,000 cookies and actually sold 32,000 cookies in the month of April, why were her food cost $600 higher than she anticipated?

Actual to Budget, Continued. . . Difference (Variance) Labor Manager $3,000 $ -0- Other 1,500 -0- Total Labor $ 4,500 $ -0- Utilities 1,800 Rent 5,000 Total Cookie Costs $24,800 $24,200 $600 In evaluating activities for April, Carmen is also interested in seeing that actual labor costs equaled the amount budgeted. As part of the planning and control process, managers prepare budgets containing expectations about revenues and costs for the coming period. At the end of the period, managers compare actual results with the budget. This allows them to see whether changes can be made to improve future operations. Chapter 13 covers performance evaluations in detail.

Trends in Cost Accounting LO4 Identify current trends in cost accounting. ABC – Activity Based Costing (Design) Performance Measurement (Purchasing) Benchmarking (Purchasing) JIT - Just In Time Inventory (Production) Lean Accounting (Production) CRM - Customer Relationship Management (Marketing) Outsourcing (Distribution) TQM - Total Quality Management (Customer service) 8. COQ – Cost of Quality (Customer service) 9. ERP - Enterprise Resource Planning. Cost accounting continues to experience dramatic changes. Developments in information technology (IT) have nearly eliminated manual bookkeeping. Emphasis on cost control is increasing in all types of organizations.

ABC: Activity Based Costing ABC assigns costs of activities needed to make a product, then sums the cost of those activities to compute the total cost of the product. In Chapter 9 we will discuss activity-based costing or ABC. In general, activity-based costing provides more detailed cost information, enabling managers to make more informed decisions.

Performance Measurement Performance Measurement indicates how well a process is working. The cost accounting system provides performance measures which summarize the increase or decrease in how well a process, unit, individual, or organization is working. The balanced scorecard expands the measurement system from reporting a single measure to multiple measures.

Benchmarking Benchmarking methods measure products, services, and activities against the best performance. Benchmarking is an ongoing process resulting in continuous improvement. A recurring theme in the current approach to management is a combination of benchmarking and continuous improvement. Benchmarking methods measure products, services and activities against the best performance standards. Because managers seek continuous improvement, benchmarking is not a one time event but an ongoing process.

JIT: Just In Time Inventory JIT is an inventory system designed to lower the cost of maintaining excess inventory. Units are produced or purchased ‘just in time’ for use, keeping inventories at a minimum. In a just-in-time environment companies produce or purchase units just in time for use, keeping inventories at a minimum. Just-in-time production is a part of a “lean production” philosophy that has been credited for the success of many companies.

CRM Customer Relationship Management CRM is a system that allows firms to target profitable customers by assessing customer revenues and costs. Some examples are: In Las Vegas, Harrah’s Entertainment provides “complimentary” services to some customers. In the airline industry, frequent flyers accumulate ‘points’ that can be redeemed for services. Many credit cards issue ‘points’ which can be traded for products or services. Customers are the life-blood of companies. It is essential to satisfy the customer’s needs. In order to provide competitive services, many companies offer premium customers perks such as “complimentary” services, frequent flyer miles, or points which can be redeemed for products or services.

Outsourcing Outsourcing occurs when a firm’s activities are performed by another organization or individual in the supply or distribution chain. Some examples are: Nikon relies on UPS for distribution. Several computer manufacturers use Intel chips in their final products. In order to minimize cost or provide better quality, firms frequently hire other firms to help in particular aspects of their business. A common example is the use of shipping companies such as Federal Express.

TQM Total Quality Management TQM is a management method which focuses on excelling in all dimensions. The emphasis is placed on quality. Quality is defined by the customer. Total Quality Management is a management system which places emphasis on quality. All aspects of the business are analyzed, from purchasing to selling to customer support, for ways to improve the quality of the good or service.

COQ – Cost of Quality Cost of Quality is a system that identifies the cost of producing low quality items. Examples are: Identifying the costs associated with producing defective units Quantifying the cost of lost sales due to producing sub-standard products Tracking the cost of returns due to a lack of quality Cost of Quality is almost the opposite of what the name implies. COQ is a system that identifies the cost of producing low quality items. These costs include: rework on defective units, lost sales due to low quality, and the cost of returned items.

ERP Enterprise Resource Management Information technology linking various systems of the enterprise into a single comprehensive information system. Purchasing Production Technology Enterprise resource planning (ERP) uses information technology to link the various systems of the enterprise into a single comprehensive information system. Because all the company’s systems are integrated, ERP has significant potential for providing information on the cost of products and services. However, implementation problems are keeping many companies from realizing this potential. Human Resources Finance Marketing

Key Financial Managers in an Organization Chief Financial Officer (CFO) Manages the entire accounting and finance functions Treasurer Manages liquid assets Controller Plans and designs information and incentive systems Internal Auditor Ensures compliance with laws, regulations, and company policies and procedures The key financial players in an organization are the CFO, or chief financial officer, the Treasurer, the Controller, the Internal Auditor and the Cost Accountant. Cost Accountant Records, measures, estimates, and analyzes costs

Ethical Issues For Accountants LO5 Understand ethical issues faced by accountants and ways to deal with ethical problems that you face in your career. Many accountants or business people have done small things, none of which appeared seriously wrong, but these small things added up to big trouble. Accountants report information that can have a substantial impact on the careers of managers who are generally held accountable for achieving financial performance targets. Failure to achieve a target can have serious negative consequences for a manager. Therefore, accountants may find themselves under pressure by management to make accounting choices that improve performance reports rather than accurately reflect performance. As a professional accountant, manager, or business owner, you will face ethical situations on an everyday basis.

Discover Unethical Conduct? Now what?? Follow the Institute of Management Accountants (IMA) guidelines: Discuss problems with the immediate superior, unless the superior is involved. Clarify the relevant issues and concepts by discussion with a disinterested party or contact the appropriate confidential ethics “hotline.” In an attempt to influence the accounting profession, professional organizations such as the Institute of Management Accountants (the IMA) and the American Institute of Certified Public Accountants (the AICPA) have developed codes of ethics to which their members are expected to adhere. The IMA code of conduct appears both in this Chapter and in the appendix to this Chapter. The IMA’s Standards of Ethical Conduct prescribe the established course of action a member should take when faced with significant ethical issues. Consult an attorney about your rights and obligations.

SOX Sarbanes-Oxley Act of 2002 Address problem of corporate governance What’s the intent? Accounting firms & corporations Who’s impacted? When there is a public perception of widespread ethical problems, the result is often legislation making certain conduct not only unethical, but also illegal. Congress passed the Sarbanes-Oxley Act of 2002 to address some of the more serious problems of corporate governance that surfaced in the late 1990s and early 2000s. Corporate responsibility How are Corporations Impacted?

Corporate Responsibility Who is impacted? CEO–Chief Executive Officer – Manages entire corporation CFO-Chief Financial Officer – Manages accounting and finance What is the impact? The officers of the corporation must sign the financial reports stipulating that the financial statements do not omit material information The company must disclose the evaluation of their internal controls The company must disclose notification of any fraud involving management to Auditors, the Audit Committee, and the Board of Directors Title III of the Sarbanes-Oxley Act deals with corporate responsibility. The law requires that the chief executive officer, the individual who manages the entire corporation, and the chief financial officer, the individual who manages the entire accounting and finance function of the corporation, sign financial reports and stipulate that the financial statements do not omit material information. They must further disclose that they have evaluated the company’s internal controls and have notified the company’s auditors and the audit committee of any fraud that involves management.

Appendix 1A Institute of Management Accountants’ Code of Ethics IMA Code of Ethics - Elements 1. Competence 2. Confidentiality In Appendix 1A to Chapter 1 is the Institute of Management Accountants’ Code of Ethics. The code of ethics addresses four standards; competence, confidentiality, integrity and credibility. 3. Integrity 4. Credibility

Competence Members have a responsibility to: 1. Maintain an appropriate level of professional competency by ongoing development of their knowledge and skills. 2. Perform professional duties in accordance with relevant laws, regulations, and technical standards. 3. Provide decision support information and recommendations that are accurate, clear, concise, and timely. The competence standard addresses members’ responsibilities related to the level of professional competence, the performance of professional duties, and the preparation of reports and recommendations. 4. Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of activity.

Confidentiality Members have a responsibility to: 1. Keep information confidential except when disclosure is authorized or legally required. 2. Inform all relevant parties regarding appropriate use of confidential information. 3. Refrain from using confidential information for unethical or illegal advantage. The confidentiality standard requires members to refrain from disclosing confidential information, to inform subordinates regarding the confidentiality of information acquired and to refrain from using confidential information for personal gain.

Integrity Members have a responsibility to: 1. Mitigate actual conflicts of interest, regularly communicate with business associates to avoid apparent conflicts of interest. Advise all parties of any potential conflicts. 2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. The integrity standard addresses conflict of interest, the communication of unfavorable as well as favorable information, and the members’ responsibility to the profession. 3. Abstain from engaging in or supporting any activity that might discredit the profession.

Credibility Members have a responsibility to: 1. Communicate information fairly and objectively. 2. Disclose all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, analyses, or recommendations. 3. Disclose delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organization policy and/or applicable law. And finally, the credibility standard, refers to members’ responsibility to be fair and objective and to disclose all relevant information.

Jim is a florist who runs Bountiful Flower Shop as a sole owner Jim is a florist who runs Bountiful Flower Shop as a sole owner. His average monthly operating results include the following: Sales revenue $4,000, Flower costs $ 800, Supplies $300, Labor costs $600, Utilities $250, Rent $720, and Other costs $350. He recently attended a trade show and was attracted by a national chain that offered him referral service, baskets, and new flower arrangements in exchange for a monthly licensing fee of $1,000. He figures that the additional business from referrals will increase his revenues by 40 percent, flower materials, supplies, and labor costs by 45 percent, utilities by 10 percent, and other costs by 20 percent. Rent will not change as he still uses the same facility.   Required: Should Jim expand his business to be associated with the national chain? Please explain. If Jim can negotiate a different term with the national chain, what licensing fee makes him indifferent between the two choices (i.e., the status quo of going solo vs. the alternative of being associated with the national chain)?