Ninth Edition Accounting for Decision Making and Control Jerold L. Zimmerman University of Rochester ACCOUNTING FOR DECISION MAKING AND CONTROL, NINTH EDITION Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2017 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2014, 2009, and 2006. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 DOW/DOW 1 0 9 8 7 6 ISBN 978-1-259-56455-0 MHID 1-259-56455-X Senior Vice President, Products & Markets: Kurt L. 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Library of Congress Cataloging-in-Publication Data Names: Zimmerman, Jerold L., 1947- author. Title: Accounting for decision making and control / Jerold L. Zimmerman,    University of Rochester. Description: Ninth edition. | New York, NY : McGraw-Hill Education, [2017] Identifiers: LCCN 2015043326 | ISBN 9781259564550 (alk. paper) Subjects: LCSH: Managerial accounting. Classification: LCC HF5657.4 .Z55 2017 | DDC 658.15/11—dc23 LC record available at http://lccn.loc.gov/2015043326 The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not guarantee the accuracy of the information presented at these sites. www.mhhe.com About the Author Jerold L. Zimmerman Jerold Zimmerman is Professor Emeritus at the William E. Simon Graduate School of Business, University of Rochester. He holds an undergraduate degree from the University of Colorado, Boulder, and a doctorate from the University of California, Berkeley. While at Rochester, Dr. Zimmerman has taught a variety of courses spanning accounting, finance, and economics. Accounting courses include nonprofit accounting, intermediate accounting, accounting theory, and managerial accounting. A deeper appreciation of the challenges of managing complex organizations was acquired by serving as the Simon School’s Deputy Dean and on the board of directors of several public corporations. Professor Zimmerman publishes widely in accounting on topics as diverse as cost allocations, corporate governance, disclosure, financial accounting theory, capital markets, and executive compensation. His paper “The Costs and Benefits of Cost Allocations” won the American Accounting Association’s Competitive Manuscript Contest. He is recognized for developing Positive Accounting Theory. This work, co-authored with colleague Ross Watts, at the Massachusetts Institute of Technology, received the American Institute of Certified Public Accountants’ Notable Contribution to the Accounting Literature Award for “Towards a Positive Theory of the Determination of Accounting Standards” and “The Demand for and Supply of Accounting Theories: The Market for Excuses.” Both papers appeared in the Accounting Review. Professors Watts and Zimmerman are also co-authors of the highly cited textbook Positive Accounting Theory (Prentice Hall, 1986). Professors Watts and Zimmerman received the 2004 American Accounting Association Seminal Contribution to the Literature award. Professor Zimmerman’s textbooks also include Managerial Economics and Organizational Architecture with Clifford Smith and James Brickley, 6th ed. (McGraw-Hill, 2016) and Management Accounting in a Dynamic Environment with Cheryl McWatters (Routledge UK, 2016). He is a founding editor of the Journal of Accounting and Economics, published by Elsevier. This scientific journal is one of the most highly referenced accounting publications. He and his wife Dodie have two daughters, Daneille and Amy. Jerry has been known to occasionally engage friends and colleagues in an amicable diversion on the links. iii Preface During their professional careers, managers in all organizations, profit and nonprofit, rely on their accounting systems. Sometimes managers use the accounting system to acquire information for decision making. At other times, the accounting system measures performance and thereby influences their behavior. The accounting system is both a source of information for decision making and part of the organization’s control mechanisms—thus, the title of the book, Accounting for Decision Making and Control. The purpose of this book is to provide students and managers with an understanding and appreciation of the strengths and limitations of an organization’s accounting system, thereby allowing them to be more intelligent users of these systems. This book provides a framework for understanding accounting systems and a basis for analyzing proposed changes to these systems. The text demonstrates that managerial accounting is an i­ntegral part of the firm’s organizational architecture, not just an isolated set of computational topics. Changes in the Ninth Edition Feedback from reviewers and instructors using the prior editions and my own teaching experience provided the basis for the revision. In particular, the following changes have been made: • Each chapter has been revised to further enhance readability and remove redundancy. • References to actual company practices have been updated. • Users were uniform in their praise of the problem material. They found it challenged their students to critically analyze multidimensional issues while still requiring ­numerical problem-solving skills. • The end-of-chapter problem material was revised by adding 45 new problems— including some related to health care and knowledge-based service firms—and ­removing outdated problems. • The ninth edition is a more concise revision that presents the same ­fundamental concepts, learning objectives, and challenging critical thinking end-of-chapter materials as in prior editions. Overview of Content Chapter 1 presents the book’s conceptual framework by using a simple decision context regarding accepting an incremental order from a current customer. The chapter describes why firms use a single accounting system and the concept of economic Darwinism, among other important topics. This chapter is an integral part of the text. iv Preface v Chapters 2, 4, and 5 present the underlying conceptual framework. The importance of opportunity costs in decision making, cost–volume–profit analysis, and the difference between accounting costs and opportunity costs are discussed in Chapter 2. Chapter 4 ­employs the economic theory of organizations and organizational architecture as the conceptual foundation to understand the role of the accounting system as part of the organization’s control mechanism. Chapter 5 describes the crucial role of accounting as part of the firm’s organizational architecture. Chapter 3 on capital budgeting extends opportunity costs to a multiperiod setting. This chapter can be skipped without affecting the flow of later material. Alternatively, Chapter 3 can be assigned at the end of the course. Chapter 6 applies the conceptual framework and illustrates the trade-off managers face between decision making and control in a budgeting system. Budgets are a decisionmaking tool to coordinate activities within the firm and are a device to control behavior. This chapter provides an in-depth illustration of how budgets are an important part of an organization’s decision-making and control apparatus. Chapter 7 presents a general analysis of why managers allocate certain costs and the behavioral implications of these allocations. Cost allocations affect both decision making and incentives. Again, managers face a trade-off between decision making and control. Chapter 8 continues the cost allocation discussion by describing the “death spiral” that can occur when significant fixed costs exist and excess capacity arises. This leads to an analysis of how to treat capacity costs—a trade-off between underutilization and overinvestment. Finally, the chapter describes several specific cost allocation methods such as service department costs and joint costs. Chapter 9 applies the general analysis of overhead allocation in Chapters 7 and 8 to the specific case of absorption costing in a manufacturing setting. The managerial implications of traditional absorption costing are provided in Chapters 10 and 11. Chapter 10 analyzes variable costing, and activity-based costing is the topic of Chapter 11. Variable costing is an interesting example of economic Darwinism. Proponents of variable costing argue that it does not distort decision making and therefore should be adopted. Nonetheless, it is not widely practiced, probably because of tax, financial reporting, and control considerations. Chapter 12 discusses the decision-making and control implications of standard labor and material costs. Chapter 13 extends the discussion to overhead and marketing variances. Chapters 12 and 13 can be omitted without interrupting the flow of later material. Finally, Chapter 14 synthesizes the course by reviewing the conceptual framework and applying it to various organizational innovations, such as total quality management, just in time, six sigma, lean production, and the balanced scorecard. These innovations provide an opportunity to apply the analytic framework underlying the text. Required=Results Adaptive THE FIRST AND ONLY ADAPTIVE READING EXPERIENCE DESIGNED TO TRANSFORM THE WAY STUDENTS READ More students earn A’s and B’s when they use McGraw-Hill Education Adaptive products. SmartBook® Proven to help students improve grades and study more efficiently, SmartBook contains the same content within the print book, but actively tailors that content to the needs of the individual. SmartBook’s adaptive technology provides precise, personalized instruction on what the student should do next, guiding the student to master and remember key concepts, targeting gaps in knowledge and offering customized feedback, and driving the student toward comprehension and retention of the subject matter. Available on smartphones and tablets, SmartBook puts learning at the student’s fingertips—anywhere, anytime. Over 4 billion questions have been answered, making McGraw-Hill Education products more intelligent, reliable, and precise. vii Preface Acknowledgments William Vatter and George Benston motivated my interest in managerial accounting. The genesis for this book and its approach reflect the oral tradition of my colleagues, past and present, at the University of Rochester. William Meckling and Michael Jensen stimulated my thinking and provided much of the theoretical structure underlying the book, as anyone familiar with their work will attest. My long and productive collaboration with Ross Watts sharpened my analytical skills and further refined the approach. He also furnished most of the intellectual capital for Chapter 3, including the problem material. Ray Ball has been a constant source of ideas. Clifford Smith and James Brickley continue to enhance my economic education. Three colleagues, Andrew Christie, Dan Gode, and Scott ­Keating, ­supplied particularly insightful comments that enriched the analysis at critical junctions. Valuable comments from Anil Arya, Ron Dye, Andy Leone, Dale Morse, Ram Ramanan, K. Ramesh, Shyam Sunder, and Joseph Weintrop are gratefully acknowledged. This project benefited greatly from the honest and intelligent feedback of n­ umerous instructors. I wish to thank Mahendra Gupta, Susan Hamlen, Badr Ismail, Charles Kile, Leslie Kren, Don May, William Mister, Mohamed Onsi, Ram Ramanan, Stephen Ryan, Michael Sandretto, Richard Sansing, Deniz Saral, Gary Schneider, Joe Weber, and ­William Yancey. This book also benefited from two other projects with which I have been involved. Writing Managerial Economics and Organizational Architecture (McGraw Hill Education, 2016) with James Brickley and Clifford Smith and Management Accounting in a Dynamic Environment (Routledge, 2016) with Cheryl McWatters helped me to better understand how to present certain topics. To the numerous students who endured the development process, I owe an enormous debt of gratitude. I hope they learned as much from the material as I learned teaching them. Some were even kind enough to provide critiques and suggestions, in particular Jan Dick Eijkelboom. Others supplied, either directly or indirectly, the problem material in the text. The able research assistance of P. K. Madappa, Eamon Molloy, Jodi Parker, Steve Sanders, Richard Sloan, and especially Gary Hurst, contributed amply to the manuscript and problem material. Janice Willett and Barbara Schnathorst did a superb job of editing the manuscript and problem material. The very useful comments and suggestions from the following reviewers are greatly appreciated: Urton Anderson Howard M. Armitage Vidya Awasthi Kashi Balachandran Da-Hsien Bao Ron Barden Howard G. Berline Margaret Boldt David Borst Eric Bostwick Marvin L. Bouillon Wayne Bremser David Bukovinsky Linda Campbell William M. Cready James M. Emig Gary Fane Anita Feller Tahirih Foroughi Ivar Fris Jackson F. Gillespie Irving Gleim Jon Glover Gus Gordon Sylwia Gornik-Tomaszewski Tony Greig Susan Haka Bert Horwitz Steven Huddart Robert Hurt Douglas A. Johnson Lawrence A. Klein Thomas Krissek A. Ronald Kucic Daniel Law Chi-Wen Jevons Lee Suzanne Lowensohn James R. Martin Alan H. McNamee Marilyn Okleshen Shailandra Pandit Sam Phillips viii Preface Frank Probst Kamala Raghavan William Rau Jane Reimers Thomas Ross Harold P. Roth P. N. Saksena Donald Samaleson Michael J. Sandretto Richard Saouma Arnold Schneider Henry Schwarzbach Elizabeth J. Serapin Norman Shultz James C. Stallman William Thomas Stevens Monte R. Swain Heidi Tribunella Clark Wheatley Lourdes F. White Paul F. Williams Robert W. Williamson Peggy Wright Jeffrey A. Yost S. Mark Young To my wife Dodie and daughters Daneille and Amy, thank you for setting the right priorities and for giving me the encouragement and environment to be productive. Finally, I wish to thank my parents for all their support. Jerold L. Zimmerman University of Rochester Brief Contents 1 Introduction 1 2 The Nature of Costs 3 Opportunity Cost of Capital and Capital Budgeting 4 Organizational Architecture 5 Responsibility Accounting and Transfer Pricing 6 Budgeting 7 Cost Allocation: Theory 8 Cost Allocation: Practices 327 9 Absorption Cost Systems 392 22 85 127 161 216 280 10 Criticisms of Absorption Cost Systems: Incentive to Overproduce 448 11 Criticisms of Absorption Cost Systems: Inaccurate Product Costs 483 12 Standard Costs: Direct Labor and Materials 13 Overhead and Marketing Variances 14 Management Accounting in a Changing Environment Solutions to Concept Questions Glossary 665 Index 675 538 575 609 655 ix Contents 1 Introduction  1 A. B. C. D. E. F. G. H. 2 Managerial Accounting: Decision Making and Control   2 Design and Use of Cost Systems   4 Marmots and Grizzly Bears   8 Management Accountant’s Role in the Organization   9 Evolution of Management Accounting: A Framework for Change   12 Vortec Medical Probe Example   15 Outline of the Text   18 Summary  18 The Nature of Costs   22 A. Opportunity Costs  23 1. Characteristics of Opportunity Costs   24 2. Examples of Decisions Based on Opportunity Costs   24 B. Cost Variation  29 1. Fixed, Marginal, and Average Costs   29 2. Linear Approximations  31 3. Other Cost Behavior Patterns   33 4. Activity Measures  33 C. Cost–Volume–Profit Analysis  35 1. Copier Example  35 2. Calculating Break-Even and Target Profits   36 3. Limitations of Cost–Volume–Profit Analysis   39 4. Multiple Products  41 5. Operating Leverage  42 D. Opportunity Costs versus Accounting Costs   45 1. Period versus Product Costs   46 2. Direct Costs, Overhead Costs, and Opportunity Costs   46 E. Cost Estimation  48 1. Account Classification  49 2. Motion and Time Studies   49 F. Summary  49 Appendix: Costs and the Pricing Decision   50 3 Opportunity Cost of Capital and Capital Budgeting   85 A. Opportunity Cost of Capital   86 B. Interest Rate Fundamentals   89 1. Future Values  89 2. Present Values  90 x xi Contents C. D. E. F. 4 3. Present Value of a Cash Flow Stream   91 4. Perpetuities  92 5. Annuities  93 6. Multiple Cash Flows per Year   94 Capital Budgeting: The Basics   96 1. Decision to Acquire an MBA   96 2. Decision to Open a Day Spa   97 3. Essential Points about Capital Budgeting   98 Capital Budgeting: Some Complexities   99 1. Risk  99 2. Inflation  100 3. Taxes and Depreciation Tax Shields   102 Alternative Investment Criteria   104 1. Payback  104 2. Accounting Rate of Return   105 3. Internal Rate of Return (IRR)   107 4. Methods Used in Practice   110 Summary  110 Organizational Architecture  127 A. Basic Building Blocks   128 1. Self-Interested Behavior, Team Production, and Agency Costs   128 2. Decision Rights and Rights Systems   133 3. Role of Knowledge and Decision Making   134 4. Markets versus Firms   135 5. Influence Costs  137 B. Organizational Architecture  139 1. Three-Legged Stool  139 2. Decision Management versus Decision Control   143 C. Accounting’s Role in the Organization’s Architecture   145 D. Example of Accounting’s Role: Executive Compensation Contracts   147 E. Summary  148 5 Responsibility Accounting and Transfer Pricing   161 A. Responsibility Accounting  162 1. Cost Centers  163 2. Profit Centers  165 3. Investment Centers  166 4. Economic Value Added (EVA®)  170 5. Controllability Principle  173 B. Transfer Pricing  175 1. International Taxation  175 2. Economics of Transfer Pricing   177 3. Common Transfer Pricing Methods   181 4. Reoragnization: The Solution if All Else Fails   186 5. Recap  186 C. Summary  188 xii Contents 6 Budgeting  216 A. Generic Budgeting Systems   219 1. Country Club  219 2. Large Corporation  222 B. Trade-Off between Decision Management and Decision Control   226 1. Communicating Specialized Knowledge versus Performance Evaluation  226 2. Budget Ratcheting  227 3. Participative Budgeting  229 4. New Approaches to Budgeting   230 5. Managing the Trade-Off   232 C. Resolving Organizational Problems   233 1. Short-Run versus Long-Run Budgets   233 2. Line-Item Budgets  235 3. Budget Lapsing  236 4. Static versus Flexible Budgets   236 5. Incremental versus Zero-Based Budgets   239 D. Summary  241 Appendix: Comprehensive Master Budget Illustration   242 7 Cost Allocation: Theory   280 A. Pervasiveness of Cost Allocations   281 1. Manufacturing Organizations  283 2. Hospitals  284 3. Universities  284 B. Reasons to Allocate Costs   286 1. External Reporting/Taxes  286 2. Cost-Based Reimbursement  287 3. Decision Making and Control   288 C. Incentive/Organizational Reasons for Cost Allocations   289 1. Cost Allocations Are a Tax System   289 2. Taxing an Externality   290 3. Insulating versus Noninsulating Cost Allocations   296 D. Summary  299 8 Cost Allocation: Practices   327 A. Death Spiral  328 B. Allocating Capacity Costs: Depreciation   333 C. Allocating Service Department Costs   333 1. Direct Allocation Method   335 2. Step-Down Allocation Method   337 3. Service Department Costs and Transfer Pricing of Direct and Step-Down Methods   339 4. Reciprocal Allocation Method   342 5. Recap  344 D. Joint Costs  344 Contents xiii 1. Joint Cost Allocations and the Death Spiral   346 2. Net Realizable Value   348 3. Decision Making and Control   352 E. Segment Reporting and Joint Benefits   353 F. Summary  354 Appendix: Reciprocal Method for Allocating Service Department Costs   354 9 Absorption Cost Systems   392 A. Job Order Costing   394 B. Cost Flows through the T-Accounts   396 C. Allocating Overhead to Jobs   398 1. Overhead Rates  398 2. Over/Underabsorbed Overhead  400 3. Flexible Budgets to Estimate Overhead   403 4. Expected versus Normal Volume   406 D. Permanent versus Temporary Volume Changes   410 E. Plantwide versus Multiple Overhead Rates   411 F. Process Costing: The Extent of Averaging   415 G. Summary  416 Appendix A: Process Costing   416 Appendix B: Demand Shifts, Fixed Costs, and Pricing   422 10 Criticisms of Absorption Cost Systems: Incentive to Overproduce   448 A. Incentive to Overproduce   450 1. Example  450 2. Reducing the Overproduction Incentive   453 B. Variable (Direct) Costing   454 1. Background  454 2. Illustration of Variable Costing   454 3. Overproduction Incentive under Variable Costing   457 C. Problems with Variable Costing   458 1. Classifying Fixed Costs as Variable Costs   458 2. Variable Costing Excludes the Opportunity Cost of Capacity   460 D. Beware of Unit Costs   461 E. Summary  463 11 Criticisms of Absorption Cost Systems: Inaccurate Product Costs  483 A. Inaccurate Product Costs   484 B. Activity-Based Costing  488 1. Choosing Cost Drivers   489 2. Absorption versus Activity-Based Costing: An Example   495 C. Analyzing Activity-Based Costing   499 1. Reasons for Implementing Activity-Based Costing   499 2. Benefits and Costs of Activity-Based Costing   501 3. ABC Measures Costs, Not Benefits   503 D. Acceptance of Activity-Based Costing   505 E. Summary  509 xiv Contents 12 Standard Costs: Direct Labor and Materials   538 A. Standard Costs  539 1. Reasons for Standard Costing   540 2. Setting and Revising Standards   541 3. Target Costing  545 B. Direct Labor and Materials Variances   546 1. Direct Labor Variances   546 2. Direct Materials Variances   550 3. Risk Reduction and Standard Costs   554 C. Incentive Effects of Direct Labor and Materials Variances   554 1. Build Inventories  555 2. Externalities  555 3. Discouraging Cooperation  556 4. Mutual Monitoring  556 5. Satisficing  556 D. Disposition of Standard Cost Variances   557 E. The Costs of Standard Costs   559 F. Summary  561 13 Overhead and Marketing Variances   575 A. Budgeted, Standard, and Actual Volume   576 B. Overhead Variances  579 1. Flexible Overhead Budget   579 2. Overhead Rate  580 3. Overhead Absorbed  581 4. Overhead Efficiency, Volume, and Spending Variances   581 5. Graphical Analysis  585 6. Inaccurate Flexible Overhead Budget   587 C. Marketing Variances  588 1. Price and Quantity Variances   588 2. Mix and Sales Variances   589 D. Summary  591 14 Management Accounting in a Changing Environment   609 A. Integrative Framework  610 1. Organizational Architecture  611 2. Business Strategy  612 3. Environmental and Competitive Forces Affecting Organizations   615 4. Implications  615 B. Organizational Innovations and Management Accounting   616 1. Total Quality Management (TQM)   616 2. Just-in-Time (JIT) Production   621 3. Six Sigma and Lean Production   624 4. Balanced Scorecard  626 C. When Should the Internal Accounting System Be Changed?   632 D. Summary  633 Solutions to Concept Questions   655 Glossary  665 Index  675 Chapter One Introduction Chapter Outline A. Managerial Accounting: Decision Making and Control B. Design and Use of Cost Systems C. Marmots and Grizzly Bears D. Management Accountant’s Role in the Organization E. Evolution of Management Accounting: A Framework for Change F. Vortec Medical Probe Example G. Outline of the Text H. Summary 1 2 Chapter 1 A. Managerial Accounting: Decision Making and Control Managers at Hyundai must decide which car models to produce, the quantity of each model to produce given the selling prices for the models, and how to manufacture the automobiles. They must decide which car parts, such as headlight assemblies, Hyundai should manufacture internally and which parts should be outsourced. They must decide not only on advertising, distribution, and product positioning to sell the cars, but also the quantity and quality of the various inputs to use. For example, they must determine which models will have leather seats and the quality of the leather to be used. Similarly, in deciding which investment projects to accept, capital budgeting analysts require data on future cash flows. How are these numbers derived? How does one coordinate the activities of hundreds or thousands of employees in the firm so that these employees accept senior management’s leadership? At Hyundai, and at other organizations small and large, managers must have good information to make all these decisions and the leadership abilities to get others to implement the decisions. Information about firms’ future costs and revenues is not readily available but must be estimated by managers. Organizations must obtain and disseminate the knowledge to make these decisions. Organizations’ internal information systems provide some of the knowledge for these pricing, production, capital budgeting, and marketing decisions. These systems range from the informal and the rudimentary to very sophisticated, electronic management information systems. The term information system should not be interpreted to mean a single, integrated system. Most information systems consist not only of formal, organized, tangible records such as payroll and purchasing documents but also informal, intangible bits of data such as memos, special studies, and managers’ impressions and opinions. The firm’s information system also contains nonfinancial information such as customer and employee satisfaction surveys. As firms grow from single proprietorships to large global corporations with tens of thousands of employees, managers lose the knowledge of enterprise affairs gained from personal, face-to-face contact in daily operations. Higher-level managers of larger firms come to rely more and more on formal operating reports. The internal accounting system, an important component of a firm’s information system, includes budgets, data on the costs of each product and current inventory, and periodic financial reports. In many cases, especially in small companies, these accounting reports are the only formalized part of the information system providing the knowledge for decision making. Many larger companies have other formalized, nonaccounting–based information systems, such as production planning systems. This book focuses on how internal accounting systems provide knowledge for decision making. After making decisions, managers must implement them in organizations in which the interests of the employees and the owners do not necessarily coincide. Just because senior managers announce a decision does not necessarily ensure that the decision will be implemented. Organizations do not have objectives; people do. One common objective of owners of the organization is to maximize profits, or the difference between revenues and expenses. Maximizing firm value is equivalent to maximizing the stream of profits over the organization’s life. Employees, suppliers, and customers also have their own objectives—usually maximizing their self-interest. Not all owners care only about monetary flows. An owner of a professional sports team might care more about winning (subject to covering costs) than maximizing profits. Nonprofits do not have owners with the legal rights to the organization’s profits. ­Moreover, nonprofits seek to maximize their value by serving some social goal such as education or health care. Introduction 3 No matter what the firm’s objective, the organization will survive only if its inflow of resources (such as revenue) is at least as large as the outflow. Accounting information is useful to help manage the inflow and outflow of resources and to help align the owners’ and employees’ interests, no matter what objectives the owners wish to pursue. Throughout this book, we assume that individuals maximize their self-interest. The owners of the firm usually want to maximize profits, but managers and employees will do so only if it is in their interest. Hence, a conflict of interest exists between owners—who, in general, want higher profits—and employees—who want easier jobs, higher wages, and more fringe benefits. To control this conflict, senior managers and owners design systems to monitor employees’ behavior and incentive schemes that reward employees for generating more profits. Not-for-profit organizations face similar conflicts. Those people responsible for the nonprofit organization (boards of trustees and government officials) must design incentive schemes to motivate their employees to operate the organization efficiently. All successful firms must devise mechanisms that help align employee interests with maximizing the organization’s value. All of these mechanisms constitute the firm’s control system; they include performance measures and incentive compensation systems, promotions, demotions, and terminations, security guards and video surveillance, internal auditors, and the firm’s internal accounting system.1 As part of the firm’s control system, the internal accounting system helps align the interests of managers and shareholders to cause employees to maximize firm value. It sounds like a relatively easy task to design systems to ensure that employees maximize firm value. But a significant portion of this book demonstrates the exceedingly complex nature of aligning employee interests with those of the owners. Internal accounting systems serve two purposes: (1) to provide some of the knowledge necessary for planning and making decisions (decision making) and (2) to help motivate and monitor people in organizations (control). The most basic control use of accounting is to prevent fraud and embezzlement. Maintaining inventory records helps reduce employee theft. Accounting budgets, discussed more fully in Chapter 6, provide an example of both decision making and control. Asking each salesperson in the firm to forecast his or her sales for the upcoming year is useful for planning next year’s production (decision making). However, if the salesperson’s sales forecast is used to benchmark performance for compensation purposes (control), he or she has strong incentives to underestimate those forecasts. Using internal accounting systems for both decision making and control gives rise to the fundamental trade-off in these systems: A system cannot be designed to perform two tasks as well as a system that must perform only one task. Some ability to deliver knowledge for decision making is usually sacrificed to provide better motivation (control). The trade-off between providing knowledge for decision making and motivation/control arises continually throughout this text. This book is applications oriented: It describes how the accounting system assembles knowledge necessary for implementing decisions using the theories from microeconomics, finance, operations management, and marketing. It also shows how the accounting system helps motivate employees to implement these decisions. Moreover, it stresses the continual trade-offs that must be made between the decision making and control functions of a­ ccounting. 1 Control refers to the process that helps “ensure the proper behaviors of the people in the organization. These behaviors should be consistent with the organization’s strategy,” as noted in K. Merchant, Control in Business Organization (Boston: Pitman Publishing Inc., 1985), p. 4. Merchant provides an extensive ­ discussion of control systems and a bibliography. In Theory of Accounting and Control (Cincinnati, OH: South-Western Publishing Company, 1997), S. Sunder describes control as mitigating and resolving ­conflicts among ­employees, owners, suppliers, and customers that threaten to pull organizations apart. 4 Chapter 1 A survey of senior-level executives (chief financial officers, vice presidents of finance, controllers, etc.) asked them to rank the importance of various goals of their firm’s accounting system. Eighty percent of the respondents reported that cost management (controlling costs) was a significant goal of their accounting system and was important to achieving their company’s overall strategic objective. Another top priority of their firm’s accounting system, even higher than cost management or strategic planning, is internal reporting and performance evaluation. These results indicate that firms use their internal accounting system both for decision making (strategic planning, cost reduction, financial management) and for controlling behavior (internal reporting and performance evaluation).2 The firm’s accounting system is very much a part of the fabric that helps hold the organization together. It provides knowledge for decision making, and it provides information for evaluating and motivating the behavior of individuals within the firm. Being such an integral part of the organization, the accounting system cannot be studied in isolation from the other mechanisms used for decision making or for reducing organizational problems. A firm’s internal accounting system should be examined from a broad perspective, as part of the larger organization design question facing managers. This book uses an economic perspective to study how accounting can motivate and control behavior in organizations. Besides economics, a variety of other paradigms also are used to investigate organizations: scientific management (Taylor), the bureaucratic school (Weber), the human relations approach (Mayo), human resource theory (Maslow, ­Rickert, Argyris), the decision-making school (Simon), and the political science school (Selznick). Behavior is a complex topic. No single theory or approach is likely to capture all the ­elements. However, understanding managerial accounting requires addressing the behavioral and organizational issues. Economics offers one useful and widely adopted framework. B. Design and Use of Cost Systems Managers make decisions and monitor subordinates who make decisions. Both managers and accountants must acquire sufficient familiarity with cost systems to perform their jobs. Accountants (often called controllers) are charged with designing, improving, and operating the firm’s accounting system—an integral part of both the decision-making and performance evaluation systems. Both managers and accountants must understand the strengths and weaknesses of current accounting systems. Internal accounting systems, like all s­ ystems within the firm, are constantly being refined and modified. Accountants’ responsibilities include making these changes. An internal accounting system should have the following characteristics: 1. Provide the information necessary to assess the profitability of products or ­services and to optimally price and market these products or services. 2. Provide information to detect production inefficiencies to ensure that the ­proposed products and volumes are produced at minimum cost. 3. When combined with the performance evaluation and reward systems, create incentives for managers to maximize firm value. 4. Support the financial accounting and tax accounting reporting functions. (In some instances, these latter considerations dominate the first three.) 5. Contribute more to firm value than it costs. 2 Ernst & Young and IMA, “State of Management Accounting,” www.imanet.org/pdf/SurveyofMgtAcctingEY .pdf, 2003. 5 Introduction FIGURE 1–1 The multiple role of accounting systems Shareholders Taxing Authorities Regulation Board of Directors IRS & Foreign Tax Authorities Regulatory Authorities Senior Management Compensation Plans SEC/FASB Debt Covenants External Reports Bondholders Accounting System Internal Reports Decision Making Control of Organizational Problems Figure 1–1 portrays the functions of the accounting system. In it, the accounting system supports both external and internal reporting systems. Examine the top half of Figure 1–1. The accounting procedures chosen for external reports to shareholders and taxing authorities are dictated in part by regulators. In the United States, the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) regulate the financial statements issued to shareholders. The Internal Revenue Service (IRS) administers the a­ ccounting procedures used in calculating corporate income taxes. If the firm is involved in international trade, foreign tax authorities prescribe the accounting rules applied in c­ alculating foreign taxes. Regulatory agencies constrain public utilities’ and financial institutions’ ­accounting procedures. Management compensation plans and debt contracts often rely on external reports. Senior managers’ bonuses are often based on accounting net income. Likewise, if the firm issues long-term bonds, it agrees in the debt covenants not to violate specified accountingbased constraints. For example, the bond contract might specify that the debt-to-equity ratio will not exceed some limit. Like taxes and regulation, compensation plans and debt covenants create incentives for managers to choose particular accounting procedures.3 As firms expand into international markets, external users of the firm’s financial statements become global. No longer are the firm’s shareholders, tax authorities, and regulators domestic. Rather, the firm’s internal and external reports are used internationally in a variety of ways. The bottom of Figure 1–1 illustrates that internal reports are used for decision making as well as control of organizational problems. As discussed earlier, managers use a variety of sources of data for making decisions. The internal accounting system provides one 3 For further discussion of the incentives of managers to choose accounting methods, see R. Watts and J. Zimmerman, Positive Accounting Theory (Englewood Cliffs, NJ: Prentice Hall, 1986). 6 Managerial Application: Spaceship Lost Because Two Measures Used Chapter 1 Multiple accounting systems are confusing and can lead to errors. An extreme example of this occurred in 1999 when NASA lost its $125 million Mars spacecraft. Engineers at Lockheed Martin built the spacecraft and specified the spacecraft’s thrust in English pounds. But NASA scientists, navigating the craft, assumed the information was in metric newtons. As a result, the spacecraft was off course by 60 miles as it approached Mars and crashed. When two systems are being used to measure the same underlying event, people can forget which system is being used. SOURCE: A. Pollack, “Two Teams, Two Measures Equaled One Lost Spacecraft,” The New York Times. October 1, 1999, p. 1. i­mportant source. These internal reports are also used to evaluate and motivate (control) the behavior of managers in the firm. The internal accounting system reports on managers’ performance and therefore provides incentives for them. Any changes to the internal accounting system can affect all the various uses of the resulting accounting numbers. The internal and external reports are closely linked. The internal accounting system affords a more disaggregated view of the company. These internal reports are generated more frequently, usually monthly or even weekly or daily, whereas the external reports are provided quarterly for publicly traded U.S. companies. The internal reports offer costs and profits by specific products, customers, lines of business, and divisions of the company. For example, the internal accounting system computes the unit cost of individual products as they are produced. These unit costs are then used to value the work-in-process and ­finished goods inventory, and to compute cost of goods sold. Chapter 9 describes the details of product costing. Because internal accounting systems serve multiple users and have several purposes, the firm employs either multiple systems (one for each function) or one basic system that serves all three functions (decision making, performance evaluation, and external reporting). Firms can either maintain a single set of books and use the same accounting methods for both internal and external reports, or they can keep multiple sets of books. The decision depends on the costs of writing and maintaining contracts based on accounting numbers, the costs from the dysfunctional internal decisions made using a single system, the additional bookkeeping costs arising from the extra system, and the confusion of having to reconcile the different numbers arising from multiple accounting systems. Inexpensive accounting software packages and falling costs of information technology have reduced some of the costs of maintaining multiple accounting systems. However, confusion arises when the systems report different numbers for the same concept. For example, when one system reports the manufacturing cost of a product as $12.56 and another system reports it at $17.19, managers wonder which system is producing the “right” number. Some managers may be using the $12.56 figure while others are using $17.19, causing inconsistency and uncertainty. Whenever two numbers for the same concept are produced, the natural tendency is to explain (i.e., reconcile) the differences. ­Managers involved in this reconciliation could have used this time in more productive ways. Also, using the same accounting system for multiple purposes increases the ­credibility of the financial reports for each purpose.4 With only one accounting system, the ­external auditor monitors the internal reporting system at little or no additional cost. 4 A. Christie, “An Analysis of the Properties of Fair (Market) Value Accounting,” in Modernizing U.S. S­ ecurities Regulation: Economic and Legal Perspectives, K. Lehn and R. Kamphuis, eds. (Pittsburgh, PA: ­University of Pittsburgh, Joseph M. Katz Graduate School of Business, 1992). 7 Introduction Historical Application: Different Costs for Different Purposes “. . . cost accounting has a number of functions, calling for different, if not inconsistent, information. As a result, if cost accounting sets out, determined to discover what the cost of everything is and convinced in advance that there is one figure which can be found and which will furnish exactly the information which is desired for every possible purpose, it will necessarily fail, because there is no such figure. If it finds a figure which is right for some purposes it must necessarily be wrong for others.” SOURCE: J. Clark, Studies in the Economics of Overhead Cost. (Chicago: University of Chicago Press, 1923), p. 234. Interestingly, a survey of large U.S. firms found that managers typically use the same accounting procedures for both external and internal reporting. More than 80 percent of chief financial officers (CFOs) report using the same accounting methods and report the same earnings internally and externally. In other words, most firms use “one number” for both external and internal communications. One CFO stated, “We make sure that everything that we have underneath—in terms of the detailed reporting—also rolls up basically to the same story that we’ve told externally.”5 Nothing prevents firms from using separate accounting systems for internal decision making and internal performance evaluation except the confusion generated and the extra data processing costs. Probably the most important reason firms use a single accounting system is it allows reclassification of the data. An accounting system does not present a single, bottom-line number, such as the “cost of publishing this textbook.” Rather, the system reports the components of the total cost of this textbook: the costs of proofreading, typesetting, paper, binding, cover, and so on. Managers in the firm then reclassify the information on the basis of different attributes and derive different cost numbers for different decisions. For example, if the publisher is considering translating this book into Chinese, not all the components used in calculating the U.S. costs are relevant. The Chinese edition might be printed on different paper stock with a different cover. The point is, a single accounting system usually offers enough flexibility for managers to reclassify, recombine, and reorganize the data for multiple purposes. A single internal accounting system requires the firm to make trade-offs. A system that is best for performance measurement and control is unlikely to be the best for decision making. It’s like configuring a motorcycle for both off-road and on-road racing: Riders on bikes designed for both racing conditions probably won’t beat riders on specialized bikes designed for just one type of racing surface. Wherever a single accounting system exists, additional analyses arise. Managers making decisions find the accounting system less useful and devise other systems to augment the accounting numbers for decision-making purposes. Concept Questions Q1–1 What causes the conflict between using internal accounting systems for decision making and control? Q1–2 Describe the different kinds of information provided by the internal accounting system. Q1–3 Give three examples of the uses of an accounting system. Q1–4 List the characteristics of an internal accounting system. Q1–5 Do firms have multiple accounting systems? Why or why not? 5 Dichev, I.D., Graham, J.R., Campbell, H., and Rajgopal, S., 2013. “Earnings quality: evidence from the field,” Journal of Accounting and Economics, 56 (2–3), pp. 1–33. 8 Chapter 1 C. Marmots and Grizzly Bears Managers often criticize accounting’s usefulness for making pricing or outsourcing decisions. Accounting data are based on historical costs rather than current values, and hence contain stale information. Why then do managers persist in using (presumably inferior) accounting information? Before addressing this question, consider the parable of the marmots and the grizzly bears.6 Marmots are small groundhogs that are a principal food source for certain bears. Zoologists studying the ecology of marmots and bears observed bears digging and moving rocks in the autumn in search of marmots. They estimated that the calories expended searching for marmots exceeded the calories obtained from their consumption. A zoologist relying on Darwin’s theory of natural selection might conclude that searching for marmots is an inefficient use of the bear’s limited resources and thus these bears should become ­extinct. But fossils of marmot bones near bear remains suggest that bears have been searching for marmots for tens of thousands of years. Because the bears survive, the benefits of consuming marmots must exceed the costs. Bears’ claws might be sharpened as a by-product of the digging involved in hunting for marmots. Sharp claws are useful in searching for food under the ice after winter’s hibernation. Therefore, the benefit of sharpened claws and the calories derived from the marmots offset the calories consumed gathering the marmots. What does the marmot-and-bear parable say about why managers persist in using apparently inferior accounting data in their decision making? As it turns out, the marmotand-bear parable is an extremely important proposition in the social sciences known as economic Darwinism. In a competitive world, if surviving organizations use some operating procedure (such as historical cost accounting) over long periods of time, then this ­procedure likely yields benefits in excess of its costs. Firms survive in competition by selling goods or services at lower prices than their competitors while still covering costs. Firms cannot survive by making more mistakes than their competitors.7 Terminology: Benchmarking and Economic Darwinism Benchmarking is defined as a “process of continuously comparing and measuring an organization’s business processing against business leaders anywhere in the world to gain information which will help the organization take action to improve its performance.” Economic Darwinism predicts that successful firm practices will be imitated. Benchmarking is the practice of imitating successful business practices. The practice of benchmarking dates back to 607, when Japan sent teams to China to learn the best practices in business, government, and education. Today, most large firms routinely conduct benchmarking studies to discover the best business practices and then implement them in their firms. SOURCE: Society of Management Accountants of Canada, Benchmarking: A Survey of Canadian Practice (Hamilton, Ontario, Canada, 1994). This example is suggested by J. McGee, “Predatory Pricing Revisited,” Journal of Law & Economics. XXIII (October 1980), pp. 289–330. 7 See A. Alchian, “Uncertainty, Evolution and Economic Theory,” Journal of Political Economy. 58 (June 1950), pp. 211–21. 6 Introduction 9 Economic Darwinism suggests that in successful (surviving) firms, things should not be fixed unless they are clearly broken. Currently, considerable attention is being directed at revising and updating firms’ internal accounting systems because many managers believe their current accounting systems are “broken” and require major overhaul. Alternative internal accounting systems are being proposed, among them activity-based costing (ABC), balanced scorecards, economic value added (EVA), and Lean accounting ­systems. These systems are discussed and analyzed later in terms of their ability to help managers make better decisions, as well as to help provide better measures of performance for managers in organizations, thereby aligning managers’ and owners’ interests. Although internal accounting systems may appear to have certain inconsistencies with some particular theory, these systems (like the bears searching for marmots) have survived the test of time and therefore are likely to be yielding unobserved benefits (like claw sharpening). This book discusses these additional benefits. Two caveats must be raised concerning too strict an application of economic Darwinism: 1. Some surviving operating procedures can be neutral mutations. Just because a system survives does not mean that its benefits exceed its costs. Benefits less costs might be close to zero. 2. Just because a given system survives does not mean it is optimal. A better system might exist but has not yet been discovered. The fact that most managers use their accounting system as the primary formal information system suggests that these accounting systems are yielding total benefits that exceed their total costs. These benefits include financial and tax reporting, providing information for decision making, and creating internal incentives. The proposition that surviving firms have efficient accounting systems does not imply that better systems do not exist, only that they have not yet been discovered. It is not necessarily the case that what is, is optimal. Economic Darwinism helps identify the costs and benefits of alternative internal accounting systems and is applied repeatedly throughout the book. Historical Application: SixteenthCentury Cost Records The well-known Italian Medici family had extensive banking interests and owned textile plants in the fifteenth and sixteenth centuries. They also used sophisticated cost records to maintain control of their cloth production. These cost reports contained detailed data on the costs of purchasing, washing, beating, spinning, and weaving the wool, of supplies, and of overhead (tools, rent, and administrative expenses). Modern costing methodologies closely resemble these fifteenth-century cost systems, suggesting they yield benefits in excess of their costs. SOURCE: P. Garner, Evolution of Cost Accounting to 192. (Montgomery, AL: University of Alabama Press, 1954), pp. 12–13. Original source R de Roover, “A Florentine Firm of Cloth Manufacturers,” Speculu. XVI (January 1941), pp. 3–33. D. Management Accountant’s Role in the Organization To better understand internal accounting systems, it is useful to describe how firms organize their accounting functions. No single organizational structure applies to all firms. ­Figure 1–2 presents one common organization chart. The design and operation of the internal and external accounting systems are the responsibility of the firm’s chief financial ­officer. The firm’s line-of-business or functional areas, such as marketing, manufacturing, 10 Chapter 1 FIGURE 1–2 Organization chart for a typical corporation Board of Directors President and Chief Executive Officer (CEO) Operating Divisions Human Resources Chief Financial Officer (CFO) Legal Controller– Operating Divisions Treasury Controller Internal Audit Tax Financial Reporting Cost Accounting Other and research and development, are combined and shown under a single organization, “operating divisions.” The remaining staff and administrative functions include human resources, chief financial officer, legal, and other. In Figure 1–2, the CFO oversees all the financial and accounting functions in the firm and reports directly to the president. The CFO’s three major functions include controllership, treasury, and internal audit. Controllership involves tax administration, the internal and external accounting reports (including statutory filings with the Securities and E ­ xchange Commission if the firm is publicly traded), and the planning and control systems (including budgeting). Treasury involves short- and long-term financing, banking, credit and collections, investments, insurance, and capital budgeting. Depending on their size and structure, firms organize these functions differently. F ­ igure 1–2 shows the internal audit group reporting directly to the CFO. In other firms, internal audit reports to the controller, the chief executive officer (CEO), or the board of directors. The controller is the firm’s chief management accountant and is responsible for data collection and reporting. The controller compiles the data to prepare the firm’s balance sheet, income statement, and tax returns. In addition, this person prepares the internal reports for the various divisions and departments within the firm and helps the other managers by providing them with the data necessary to make decisions—as well as the data necessary to evaluate these managers’ performance. Usually, each operating division or department has its own controller. For example, if a firm has several divisions, each division has its own division controller, who reports to both the division manager and the corporate controller. In Figure 1–2, the operating divisions have their own controllers. The division controller provides the corporate controller with periodic reports on the division’s operations. The division controller oversees the division’s budgets, payroll, inventory, and product costing system (which reports the cost of the division’s products and services). While most firms have division-level controllers, some firms centralize these functions to reduce staff so that all the division-level controller functions are performed centrally out of corporate headquarters. The controllership function at the corporate, division, and plant levels involves assisting decision making and control. The controller must balance providing information to other managers for decision making against providing monitoring information to top executives for use in controlling the behavior of lower-level managers. Introduction Historical Application: The Rise of the CFO 11 In a study of 400 of the largest U.S. corporations, in 1960 none of the firms had a position entitled “Chief Financial Officer.” By the year 2000, 80 percent had a person holding the title “CFO.” Prior to 1960, most large firms called their top accounting manager “Chief Accountant,” who typically was not part of the senior executive team. Several factors caused the elevation of “Chief Accountant” to “CFO,” who also became an integral member of the firm’s senior executives. First, between 1960 and 2000, large U.S. firms became global, with operations in numerous countries requiring more complex financial transactions involving foreign currency hedging and multinational banking relations. Besides becoming global, large firms began to diversify their operations by entering into new lines of business. These firms became more complex, which necessitated more sophisticated reporting and control systems such as budgeting and monthly reports. To enter new markets, large firms began engaging in mergers and acquisitions as the capital markets developed to finance these transactions. The CFO played an integral role in valuing and financing acquisition targets. In addition, accounting rules became significantly more complicated, requiring sophisticated compliance capabilities. Thus, today’s CFOs have a much broader skill set and manage a larger portfolio of activities than their predecessors, and as such, their role and title in their firms has been elevated. SOURCES: L. Sjoblom and N. Michels-Kim, “Leading Nestle’s House of Finance,” Strategic Finance (September 2011), pp. 29–33 and D. Zorn, “Here a Chief, There a Chief: The Rise of the CFO in the American Firm,” American Sociological Review (June 2004), pp. 345–364. Besides overseeing the controllership and treasury functions in the firm, the chief financial officer usually has responsibility for the internal audit function. The internal audit group’s primary roles are to seek out and eliminate internal fraud and to provide internal consulting and risk management. The U.S. Sarbanes–Oxley Act of 2002 mandated numerous corporate governance reforms, such as requiring boards of directors of U.S. publicly traded companies to have audit committees composed of independent (outside) directors and requiring these companies to continuously test the effectiveness of the internal controls over their financial statements. This federal legislation indirectly expanded the internal audit group’s role. The internal audit group now works closely with the audit committee of the board of directors to help ensure the integrity of the firm’s financial statements by testing whether the firm’s accounting procedures are free of internal control deficiencies. The Sarbanes–Oxley Act also requires companies to have corporate codes of conduct (ethics codes). While many firms had ethics codes prior to this act, these codes define honest and ethical conduct, including conflicts of interest between personal and professional relationships, compliance with applicable governmental laws, rules and regulations, and prompt internal reporting of code violations to the appropriate person in the company. The audit committee of the board of directors is responsible for overseeing compliance with the company’s code of conduct. The importance of the internal control system cannot be stressed enough. Throughout this book, we use the term control to mean aligning the interests of employees with maximizing the value of the firm. The most basic conflict of interest between employees and owners is employee theft. In fact, one study reports that the typical firm loses 5 percent of its revenues to fraud.8 To reduce the likelihood of embezzlement, firms install internal 8 Association of Certified Fraud Examiners, “2014 Report to the Nation on Occupational Fraud and Abuse,” www.acfe.com. 12 Chapter 1 control systems, which are an integral part of their control system. Internal and external auditors’ first responsibility is to test the integrity of the firm’s internal controls. Fraud and theft are prevented not just by having security guards and door locks but also through a variety of procedures such as requiring checks above a certain amount to be authorized by two people. Internal control systems include internal procedures, codes of conduct, and policies that prohibit corruption, bribery, and kickbacks. Finally, internal control systems should prevent intentional (or accidental) financial misrepresentation by managers. Concept Questions Q1–6 Define economic Darwinism. Q1–7 Describe the major functions of the chief financial officer. E. Evolution of Management Accounting: A Framework for Change Management accounting has evolved with the nature of organizations. Prior to 1800, most businesses were small, family-operated organizations. Management accounting was less important for these small firms. It was not critical for planning decisions and control reasons because the owner could directly observe the organization’s entire environment. The owner, who made all of the decisions, delegated little decision-making authority and had no need to devise elaborate formal systems to motivate employees. The owner observing slacking employees simply replaced them. Only as organizations grew larger with remote operations would management accounting become more important. Most of today’s modern management accounting techniques were developed in the period from 1825 to 1925 with the growth of large organizations.9 Textile mills in the early nineteenth century grew by combining the multiple processes (spinning the thread, dying, weaving, etc.) of making cloth. These large firms developed systems to measure the cost per yard or per pound for the separate manufacturing processes. The cost data allowed managers to compare the cost of conducting a process inside the firm versus purchasing the process from external vendors. Similarly, the railroads of the 1850s to 1870s developed cost systems that reported cost per ton-mile and operating expenses per dollar of revenue. These measures allowed managers to increase their operating efficiencies. In the early 1900s, Andrew Carnegie (at what was to become U.S. Steel) devised a cost system that reported detailed unit cost figures for material and labor on a daily and weekly basis. This system allowed senior managers to maintain very tight controls on operations and gave them accurate and timely information on costs for pricing decisions. Merchandising firms such as Marshall Field’s and Sears, Roebuck developed gross margin (revenues less cost of goods sold) and stock-turn ratios (sales divided by inventory) to measure and evaluate performance. Manufacturing companies such as Du Pont Powder Company and General Motors developed performance measures to control their growing organizations. In the period from 1925 to 1975, management accounting was heavily influenced by external considerations. Income taxes and financial accounting requirements (e.g., those of the Financial Accounting Standards Board) were major factors affecting management accounting. Since 1975, two major environmental forces have changed organizations and caused ­managers to question whether traditional management accounting procedures 9 P. Garner, Evolution of Cost Accounting to 1925 (Montgomery, AL: University of Alabama Press, 1954); and A. Chandler, The Visible Hand (Cambridge, MA: Harvard University Press, 1977). Introduction 13 (pre-1975) are still appropriate. These environmental forces are (1) factory automation and computer/­information technology and (2) global competition. These environmental changes force managers to reconsider their organizational structure and their management accounting ­procedures. Managerial Application: Big Data and Data Analytics According to IBM, “Every day, we create 2.5 quintillion bytes of data—so much that 90% of the data in the world today has been created in the last two years alone. This data comes from everywhere: sensors used to gather climate information, posts to social media sites, digital pictures and videos, purchase transaction records, and cell phone GPS signals to name a few. This data is ‘big data.’” The future of finance and accounting professionals at many firms is to learn how to apply statistical and computer science techniques called “data analytics” to extract valuable insights about their customers, products, and competitors from their big data. For example, large online retailers constantly monitor the prices of products offered by competitors to adjust their prices dynamically throughout the day. Managers pore over data to uncover the causes behind the company’s sales, costs, and profits and to better understand what drive revenues and operating and sales expenses. Where and by which salespeople are different products sold? Why are certain stores or factories more profitable? What are customers Tweeting or Facebook postings saying about our products and our competitors? SOURCES: www-01.ibm.com/software/data/bigdata/what-is-big-data.html. D. Katz “Accounting’s Big Data Problem,” CFO. com. (March 4, 2014) Information technology advances such as the Internet, intranets, wireless communications, and faster microprocessors have had a big impact on internal accounting processes. More data are now available faster than ever before. Electronic data interchange, XHTML, e-mail, B2B (business-to-business) e-commerce, bar codes, data warehousing, and online analytical processing (OLAP) are just a few examples of new technology impacting management accounting. For example, managers now have access to daily sales and operating costs in real time, as opposed to having to wait two weeks after the end of the calendar quarter for this information. Firms have cut the time needed to prepare budgets for the next fiscal year by several months because the information is transmitted electronically in standardized formats. The history of management accounting illustrates how it has evolved in parallel with organizations’ structure. Management accounting provides information for planning decisions and control. It is useful for assigning decision-making authority, measuring performance, and determining rewards for individuals within the organization. Because management accounting is part of the organizational structure, it is not surprising that management accounting evolves in a parallel and consistent fashion with other parts of the organizational structure. Figure 1–3 is a framework for understanding the role of accounting systems within firms and the forces that cause accounting systems to change. As described more fully in Chapter 14, environmental forces such as technological innovation and global competition change the organization’s business strategies. For example, the Internet has allowed banks to offer electronic, online banking services. To implement these new strategies, organizations must adapt their organizational structure or architecture, which includes management accounting. An organization’s architecture (the topic of Chapter 4) is composed of three 14 FIGURE 1–3 Framework for organizational change and management accounting Chapter 1 Business Environment Business Strategy Organizational Architecture • Decision-Right Assignment • Performance Evaluation System • Reward System Incentive and Incentives and Actions Actions Firm Value related processes: (1) the assignment of decision-making responsibilities, (2) the measurement of performance, and (3) the rewarding of individuals within the organization. The first component of the organizational architecture is assigning responsibilities to the different members of the organization. Decision rights define the duties each member of an organization is expected to perform. The decision rights of a particular individual within an organization are specified by that person’s job description. Checkout clerks in grocery stores have the decision rights to collect cash from customers but don’t have the decision rights to accept certain types of checks. A manager must be called for that ­decision. A division manager may have the right to set prices on products but not the right to borrow money. The president usually retains the right to issue debt, subject to board of directors’ approval. The next two parts of the organizational architecture are the performance evaluation and reward systems. To motivate individuals within the organization, organizations must have a system for measuring their performance and rewarding them. Performance measures for a salesperson could include total sales and customer satisfaction based on a survey of customers. Performance measures for a manufacturing unit might be number of units produced, total costs, and percentage of defective units. The internal accounting system is often an important part of the performance evaluation system. Performance measures are extremely important because rewards are generally based on these measures. Rewards for individuals within organizations include wages and bonuses, prestige and greater decision rights, promotions, and job security. Because rewards are based on performance measures, individuals and groups are motivated to act to influence the performance measures. Therefore, the performance measures chosen influence individual and group efforts within the organization. A poor choice of performance measures can lead to conflicts within the organization and derail efforts to achieve organizational goals. For example, measuring the performance of a college president based on the number of students attending the college encourages the president to enroll ill-prepared students, thereby reducing the quality of the educational experience for other students. As illustrated in Figure 1–3, changes in the business environment lead to new strategies and ultimately to changes in the firm’s organizational architecture, including changes in the accounting system to better align the interests of the employees with the objectives of the organization. The new organizational architecture provides incentives for members 15 Introduction of the organization to make decisions, which leads to a change in the value of the organization. Within this framework, accounting assists in the control of the organization through the organization’s architecture and provides information for decision making. This framework for change is referred to throughout the book. F. Vortec Medical Probe Example To illustrate some of the basic concepts developed in this text, suppose you have been asked to evaluate the following decision. Vortec Inc. manufactures a single product, a medical probe. Vortec sells the probes to distributors who then market them to physicians. Vortec has two divisions. The manufacturing division produces the probes; the marketing division sells them to distributors. The marketing division is rewarded on the basis of sales revenues. The manufacturing division is evaluated and rewarded on the basis of the average unit cost of making the probes. The plant’s current volume is 100,000 probes per month. The following income statement summarizes last month’s operating results. VORTEC MANUFACTURING Income Statement Last Month Sales revenue (100,000 units @ $5.00) Cost of sales (100,000 units @ $4.50) $ 500,000     450,000 Operating margin Less: Administrative expenses $     50,000         27,500 Net income before taxes $      22,500 Medsupplies is one of Vortec’s best distributors. Vortec sells 10,000 probes per month to Medsupplies at $5 per unit. Last week, Medsupplies asked Vortec’s marketing division to increase its monthly shipment to 12,000 units, provided that Vortec would sell the additional 2,000 units at $4 each. Medsupplies would continue to pay $5 for the original 10,000 units. Medsupplies argued that because this would be extra business for Vortec, no overhead should be charged on the additional 2,000 units. In this case, a $4 price should be adequate. Vortec’s finance department estimates that with 102,000 probes the average cost is $4.47 per unit, and hence the $4 price offered by Medsupplies is too low. The current administrative expenses of $27,500 consist of office rent, property taxes, and interest and will not change if this special order is accepted. Should Vortec accept the Medsupplies offer? Before examining whether the marketing and manufacturing divisions will accept the order, consider Medsupplies’s offer from the perspective of Vortec’s owners, who are interested in maximizing profits. The decision hinges on the cost to Vortec of selling an additional 2,000 units to Medsupplies. If the cost is more than $4 per unit, Vortec should reject the special order. It is tempting to reject the offer because the $4 price does not cover the average total cost of $4.47. But will it cost Vortec $4.47 per unit for the 2,000-unit special order? Is $4.47 the cost per unit for each of the next 2,000 units? To begin the analysis, two simplifying assumptions are made that are relaxed later: • Vortec has excess capacity to produce the additional 2,000 probes. • Past historical costs are unbiased estimates of the future cash flows for producing the special order. 16 Chapter 1 Based on these assumptions, we can compare the incremental revenue from the ­additional 2,000 units with its incremental cost: Incremental revenue (2,000 units × $4.00) Total cost @ 102,000 units (102,000 × $4.47) Total cost @ 100,000 units (100,000 × $4.50) $455,940     450,000 $8,000 Incremental cost of 2,000 units     5,940 Incremental profit of 2,000 units $2,060 The estimated incremental cost per unit of the 2,000 units is then Change in total cost ___________________ $455,940 − $450,000 _________________​​       ​ =  ​        ​ = $2.97​2,000 Change in volume The estimated cost per incremental unit is $2.97. Therefore, $2.97 is the average per-unit cost of the extra 2,000 probes. The $4.47 cost is the average cost of producing 102,000 units, which is more than the $2.97 incremental cost per unit of producing the extra 2,000 probes. Based on the $2.97 estimated cost, Vortec should take the order. Is this the right ­decision? Not necessarily. There are some other considerations: 1. Will these 2,000 additional units affect the $5 price of the 100,000 probes? Will Vortec’s other distributors continue to pay $5 if Medsupplies buys 2,000 units at $4? What prevents Medsupplies from reselling the probes to Vortec’s other distributors at less than $5 per unit but above $4 per unit? Answering these questions requires management to acquire knowledge of the market for the probes. 2. What is the alternative use of the excess capacity consumed by the additional 2,000 probes? As plant utilization increases, congestion costs rise, production becomes less efficient, and the cost per unit rises. Congestion costs include the wages of the additional production employees and supervisors required to move, store, expedite, and rework products as plant volume increases. The $2.97 incremental cost computed from the average cost data provided above might not include the higher congestion costs as capacity is approached. This suggests that the $4.47 average cost estimate is wrong. Who provides this cost estimate and how accurate is it? Management must acquire knowledge of how costs behave at a higher volume. If Vortec accepts the Medsupplies offer, will Vortec be forced at some later date to forgo using this capacity for a more profitable project? 3. What costs will Vortec incur if the Medsupplies offer is rejected? Will Vortec lose the normal 10,000-unit Medsupplies order? If so, can this order be replaced? 4. Does the Robinson-Patman Act apply? The Robinson-Patman Act is a U.S. federal law prohibiting charging customers different prices if doing so is injurious to competition. Thus, it may be illegal to sell an additional 2,000 units to Medsupplies at less than $5 per unit. Knowledge of U.S. antitrust laws must be acquired. Moreover, if Vortec sells internationally, it will have to research the antitrust laws of the various jurisdictions that might review the Medsupplies transaction. We have analyzed the question of whether Medsupplies’ 2,000-unit special order maximizes the owners’ profit. The next question to address is whether the marketing and manufacturing divisions will accept Medsupplies’ offer. Recall that marketing is evaluated based on total revenues, and manufacturing is evaluated based on average unit costs. Therefore, marketing will want to accept the order as long as Medsupplies does not resell 17 Introduction the probes to other Vortec distributors and as long as other Vortec distributors do not ­expect similar price concessions. Manufacturing will want to accept the order as long as it believes average unit costs will fall. Increasing production lowers average unit costs and makes it appear as though manufacturing has achieved cost reductions. Suppose that accepting the Medsupplies offer will not adversely affect Vortec’s other sales, but the incremental cost of producing the 2,000 extra probes is really $4.08, not $2.97, because there will be overtime charges and additional factory congestion costs. Under these conditions, both marketing and manufacturing will want to accept the offer. Marketing increases total revenue and thus appears to have improved its performance. Manufacturing still lowers average unit costs from $4.50 to $4.4918 per unit: ($4.50 × 100,000) + ($4.08 × 2,000) ______________________________​​         ​ = $4.4918​102,000 However, the shareholders are worse off. Vortec’s cash flows are lower by $160 [or 2,000 units × ($4.00 − $4.08)]. The problem is not that the marketing and manufacturing managers are “making a mistake.” The problem is that their measures of performance are creating the wrong incentives. In particular, rewarding marketing for increasing total revenues and manufacturing for reducing average unit costs means there is no mechanism to ensure that the incremental revenues from the order ($8,000 = $4 × 2,000) are greater than the incremental costs ($8,160 = $4.08 × 2,000). Both marketing and manufacturing are doing what they were told to do (increase revenues and reduce average costs), but the firm’s cash flow falls because the incentive systems are poorly designed. Four key points emerge from this example: 1. Beware of average costs. The $4.50 unit cost tells us little about how costs will vary with changes in volume. Just because a cost is stated in dollars per unit does not mean that producing one more unit will add that amount of incremental cost. 2. Use opportunity costs. Opportunity costs measure what the firm forgoes when it chooses a specific action. The notion of opportunity cost is crucial in decision making. The opportunity cost of the Medsupplies order is what Vortec forgoes by accepting the special order. What is the best alternative use of the plant capacity consumed by the Medsupplies special order? (More on this in Chapter 2.) 3. Supplement accounting data with other information. The accounting system ­contains important data relevant for estimating the cost of this special order from Medsupplies. But other knowledge that the accounting system cannot capture must be assembled, such as what Medsupplies will do if Vortec rejects its offer. ­Managers usually augment accounting data with other knowledge such as ­customer demands, competitors’ plans, future technology, and government regulations. 4. Use accounting numbers as performance measures cautiously. Accounting numbers such as revenues or average unit manufacturing costs are often used to evaluate managers’ performance. Just because managers are maximizing particular performance measures tailored for each manager does not necessarily cause firm profits to be maximized. The Vortec example illustrates the importance of understanding how accounting numbers are constructed, what they mean, and how they are used in decision making and control. The accounting system is a very important source of information to managers, but it is not the sole source of all knowledge. Also, in the overly simplified context of the Vortec 18 Chapter 1 example, the problems with the incentive systems and with using unit costs are easy to detect. In a complex company with hundreds or thousands of products or services, such errors are very difficult to detect. Finally, for the sake of simplicity, the Vortec illustration ignores the use of the accounting system for external reporting. G. Outline of the Text Internal accounting systems provide data for both decision making and control. The organization of this book follows this dichotomy. The first part of the text (Chapters 2 through 5) describes how accounting systems are used in decision making and providing incentives in organizations. These chapters provide the conceptual framework for the remainder of the book. The next set of chapters (Chapters 6 through 8) describes basic topics in managerial accounting, budgeting, and cost allocations. Budgets not only communicate knowledge within the firm for decision making but also serve as a control device and as a way to partition decision-making responsibility among the managers. Likewise, cost allocations serve decision-making and control functions. In analyzing the role of budgeting and cost allocations, these chapters draw on the first part of the text. The next section of the text (Chapters 9 through 13) describes the prevalent accounting system used in firms: absorption costing. Absorption cost systems are built around cost allocations. The systems used in manufacturing and service settings generate product or service costs built up from direct labor, direct material, and allocated overheads. After first describing these systems, we critically analyze them. A common criticism of absorption cost systems is that they produce inaccurate unit cost information, which can lead to dysfunctional decision making. Two alternative accounting systems (variable cost systems and activity-based cost systems) are compared and evaluated against a traditional absorption cost system. The next topic describes the use of standard costs as extensions of absorption cost systems. Standard costs provide benchmarks to calculate accounting variances: the difference between the actual costs and standard costs. These variances are performance measures and thus are part of the firm’s motivation and control system described earlier. The last chapter (Chapter 14) expands the integrative approach summarized in ­section E of this chapter. This approach is then used to analyze four modifications of internal cost systems: quality measurement systems, just-in-time production, six sigma and lean production, and balanced scorecards. These modifications are evaluated within a broad historical context. Just because these systems are new does not suggest they are better. Some have stood the test of time, while others have not. H. Summary This book provides a framework for the analysis, use, and design of internal accounting systems. It explains how these systems are used for decision making and motivating people in organizations. Employees care about their self-interest, not the owners’ self-interest. Hence, owners must devise incentive systems to motivate their employees. Accounting numbers are used as measures of managers’ performance and hence are part of the control system used to motivate managers. Most organizations use a single internal accounting system as the primary data source for external reporting and internal uses. Applying the economic Darwinism principle, the costs of multiple systems likely outweigh the benefits for most firms. The costs are not only the direct costs of operating the system but also the indirect costs from dysfunctional decisions resulting from faulty information and poor performance evaluation systems. The remainder of this book addresses the costs and benefits of internal accounting systems. Introduction 19 Problems P 1–1:   MBA Students One MBA student was overheard saying to another, “Accounting is baloney. I worked for a ­genetic engineering company and we never looked at the accounting numbers and our stock price was ­always growing.” “I agree,” said the other. “I worked in a rust bucket company that managed everything by the numbers and we never improved our stock price very much.” Evaluate these comments. P 1–2:   One Cost System Isn’t Enough Robert S. Kaplan in “One Cost System Isn’t Enough” (Harvard Business Review. January–February 1988, pp. 61–66) No single system can adequately answer the demands made by diverse functions of cost ­systems. While companies can use one method to capture all their detailed transactions data, the processing of this information for diverse purposes and audiences demands separate, ­customized development. Companies that try to satisfy all the needs for cost information with a single system have discovered they can’t perform important managerial functions adequately. Moreover, systems that work well for one company may fail in a different environment. Each company has to design methods that make sense for its particular products and processes. Of course, an argument for expanding the number of cost systems conflicts with a strongly ingrained financial culture to have only one measurement system for everyone. Describe the costs and benefits of having a single measurement system. P 1–3:   U.S. and Japanese Tax Laws Tax laws in Japan tie taxable income directly to the financial statements’ reported income. That is, to compute a Japanese firm’s tax liability, multiply the net income as reported to shareholders by the appropriate tax rate to derive the firm’s tax liability. In contrast, U.S. firms typically have more discretion in choosing different accounting procedures for calculating net income for shareholders (financial reporting) and taxes. What effect would you expect these institutional differences in tax laws between the United States and Japan to have on internal accounting and reporting? P 1–4:   Using Accounting for Planning The owner of a small software company felt his accounting system was useless. He stated, “Accounting systems only generate historical costs. Historical costs are useless in my business because everything changes so rapidly.” Required: a. Are historical costs useless in rapidly changing environments? b. Should accounting systems be limited to historical costs? P 1–5:  Budgeting Salespeople at a particular firm forecast what they expect to sell next period. Their supervisors then review the forecasts and make revisions. These forecasts are used to set production and purchasing plans. In addition, salespeople receive a fixed bonus of 20 percent of their salary if they meet or exceed their forecasts. Discuss the incentives of the salespeople to forecast next-period sales accurately. Discuss the trade-off between using the budget for decision making versus using it as a control device. 20 Chapter 1 P 1–6:   Golf Specialties Golf Specialties (GS), a Belgian company, manufactures a variety of golf paraphernalia, such as head covers for woods, embroidered golf towels, and umbrellas. GS sells all its products exclusively in Europe through independent distributors. Given the popularity of Tiger Woods, one of GS’s more popular items is a head cover in the shape of a tiger. GS is currently making 500 tiger head covers a week at a per unit cost of 3.50 euros, which includes both variable costs and allocated fixed costs. GS sells the tiger head covers to distributors for 4.25 euros. A distributor in Japan, Kojo Imports, wants to purchase 100 tiger head covers per week from GS and sell them in Japan. Kojo offers to pay GS 2 euros per head cover. GS has enough capacity to produce the additional 100 tiger head covers and estimates that if it accepts Kojo’s offer, the per unit cost of all 600 tiger head covers will be 3.10 euros. Assume the cost data provided (3.50 euros and 3.10 euros) are accurate estimates of GS’s costs of producing the tiger head covers. Further assume that GS’s variable cost per head cover does not vary with the number of head covers manufactured. Required: a. Given the data in the problem, what is GS’s weekly fixed cost of producing the tiger head covers? b. To maximize firm value, should GS accept Kojo’s offer? Explain why or why not. c. Besides the data provided above, what other factors should GS consider before making a decision to accept Kojo’s offer? P 1–7:   Parkview Hospital Parkview Hospital, a regional hospital, serves a population of 400,000 people. The next closest ­hospital is 50 miles away. Parkview’s accounting system is adequate for patient billing. The system reports revenues generated per department but does not break down revenues by unit within departments. For example, Parkview knows patient revenue for the entire psychiatric department but does not know revenues in the child and adolescent unit, the chemical dependence unit, or the neuropsychiatric unit. Parkview receives its revenues from three principal sources: the federal government (­Medicare), the state government (Medicaid), and private insurance companies (Blue Cross–Blue Shield). Until recently, the private insurance companies continued to pay Parkview’s increasing costs and passed these on to the firms through higher premiums for their employees’ health insurance. Last year Trans Insurance (TI) entered the market and began offering lower-cost health insurance to local firms. TI cut benefits offered and told Parkview that it would pay only a fixed dollar amount per patient. A typical firm could cut its health insurance premium 20 percent by switching to TI. TI was successful at taking 45 percent of the Blue Cross–Blue Shield customers. Firms that switched to TI faced stiff competition and sought to cut their health care costs. Parkview management estimated that its revenues would fall 6 percent, or $3.2 million, next year because of TI’s lower reimbursements. Struggling with how to cope with lower revenues, Parkview began the complex process of deciding what programs to cut, how to shift the delivery of services from inpatient to outpatient clinics, and what programs to open to offset the revenue loss (e.g., open an outpatient depression clinic). Management can forecast some of the costs of the ­proposed changes, but many of its costs and revenues (such as the cost of the admissions office) have never been tracked to the individual clinical unit. Required: a. Was Parkview’s accounting system adequate 10 years ago? b. Is Parkview’s accounting system adequate today? c. What changes should Parkview make in its accounting system? Introduction 21 P 1–8:   Montana Pen Company Montana Pen Company manufactures a full line of premium writing instruments. It has 12 ­different styles, and within each style, it offers ball point pens, fountain pens, mechanical pencils, and a roller ball pen. Most models also come in three finishes—gold, silver, and black matte. Montana Pen’s Bangkok, Thailand, plant manufactures four of the styles. The plant is currently producing the gold clip for the top of one of its pen styles, no. 872. Current production is 1,200 gold no. 872 pens each month at an average cost of 185 baht per gold clip. (One U.S. dollar currently buys 32 baht.) A ­Chinese manufacturer has offered to produce the same gold clip for 136 baht. This manufacturer will sell Montana Pen 400 clips per month. If it accepts the Chinese offer and cuts the production of the clips from 1,200 to 800, Montana Pen estimates that the cost of each clip it continues to produce will rise from 185 baht to 212.5 baht per gold clip. Required: a. Should Montana Pen outsource 400 gold clips for pen style no. 872 to the Chinese firm? Provide a written justification of your answer. b. Given your answer in part (a), what additional information would you seek before ­deciding to outsource 400 gold clips per month to the Chinese firm? Chapter Two The Nature of Costs Chapter Outline A. Opportunity Costs 1. Characteristics of Opportunity Costs 2. Examples of Decisions Based on Opportunity Costs B. Cost Variation 1. Fixed, Marginal, and Average Costs 2. Linear Approximations 3. Other Cost Behavior Patterns 4. Activity Measures C. Cost–Volume–Profit Analysis 1. Copier Example 2. Calculating Break-Even and Target Profits 3. Limitations of Cost–Volume–Profit Analysis 4. Multiple Products 5. Operating Leverage D. Opportunity Costs versus Accounting Costs 1. Period versus Product Costs 2. Direct Costs, Overhead Costs, and Opportunity Costs E. Cost Estimation 1. Account Classification 2. Motion and Time Studies 22 F. Summary Appendix: Costs and the Pricing Decision 23 The Nature of Costs As described in Chapter 1, accounting systems measure costs that managers use for external reports, decision making, and controlling the behavior of people in the organization. Understanding how accounting systems calculate costs requires a thorough understanding of what cost means. Unfortunately, that simple term has multiple meanings. Saying a product costs $3.12 does not reveal what the $3.12 measures. Additional explanation is often needed to clarify the assumptions that underlie the calculation of cost. A large vocabulary exists to communicate more clearly which cost meaning is being conveyed. Some examples include average cost, common cost, full cost, historical cost, joint cost, marginal cost, period cost, product cost, standard cost, fixed cost, opportunity cost, sunk cost, and variable cost, just to name a few. We begin this chapter with the concept of opportunity cost, a powerful tool for understanding the myriad cost terms and for structuring managerial decisions. In addition, opportunity cost provides a benchmark against which accounting-based cost numbers can be compared and evaluated. Section B discusses how opportunity costs vary with changes in output. Section C extends this discussion to cost–volume–profit analysis. Section D compares and contrasts opportunity costs and accounting costs (which are very different). Section E describes some common methods for cost estimation. A. Opportunity Costs When you make a decision, you incur a cost. Nobel Prize–winning economist Ronald Coase noted, “The cost of doing anything consists of the receipts that could have been obtained if that particular decision had not been taken.”1 This notion is called opportunity cost—the benefit forgone as a result of choosing one course of action rather than another. Cost is a sacrifice of resources. Using a resource for one purpose prevents its use elsewhere. The return forgone from its use elsewhere is the opportunity cost of its current use. The opportunity cost of a particular decision depends on the other alternatives available. The alternative actions comprise the opportunity set. Before making a decision and calculating opportunity cost, the opportunity set itself must be enumerated. Thus, it is important to remember that opportunity costs can be determined only within the context of a specific decision and only after specifying all the alternative actions. For example, the opportunity set for this Friday night includes the movies, a concert, staying home and studying, staying home and watching television, inviting friends over, and so forth. The opportunity cost concept focuses managers’ attention on the available alternative courses of action. Suppose you are considering three job offers. Job A pays a salary of $100,000, job B pays $102,000, and job C pays $106,000. In addition, you value each job differently in terms of career potential, developing your human capital, and the type of work. Suppose you value these nonpecuniary aspects of the three jobs at $8,000 for A, $5,000 for B, and only $500 for C. The following table summarizes the total value of each job offer. You decide to take job A because it has the highest total pecuniary and nonpecuniary compensation. The opportunity cost of job A is $107,000 (or $102,000 + $5,000), representing the amount forgone by not accepting job B, the next best alternative. Job Offer A B C Salary $100,000 102,000 106,000 $ Equivalent of Intangibles $8,000 5,000 500 Total Value $108,000 107,000 106,500 1 R. Coase, Business Organization and the Accountant, originally published in Accountant, 1938. Reprinted in L.S.E. Essays in Cost, ed. J. Buchanan and G. Thirlby (New York University Press, 1981), p. 108. 24 Chapter 2 The decision to continue to search for more job offers has an opportunity cost of $108,000 if job offer A expires. If you declined job offer L last week, which had a total value of $109,000, this job offer is no longer in the opportunity set and hence is not an opportunity cost of accepting job A now. Besides jobs A, B, and C, you learn there is a 0.9 probability of receiving job offer D, which has a total value of $110,000. If you wait for job D and you do not get it, you will be forced to work in a job valued at $48,000. Job D has an expected total value of $103,800 (or $110,000 × 0.9 + $48,000 × 0.1). Since job D’s opportunity cost of $108,000 (the next best alternative forgone) exceeds its expected value ($103,800), you should reject waiting for job offer D. 1. Characteristics of Opportunity Costs Opportunity costs are not necessarily the same as payments. The opportunity cost of taking job A included the forgone salary of $102,000 plus the $5,000 of intangibles from job B. The opportunity cost of going to a movie involves both the cash outlay for the ticket and popcorn, and also forgoing spending your time studying or attending a concert. Remember, the opportunity cost of obtaining some good or service is what must be surrendered or forgone in order to get it. By taking…
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