Chapter Managerial Accounting and the Business Environment Learning Objectives LO1 Identify the major differences and similarities between financial and managerial accounting LO2 Understand the role of management accountants in an organization LO3 Understand the basic concepts underlying Just-In-Time (JIT), Total Quality Management (TQM), Process Reengineering, and the Theory of Constraints (TOC) LO4 Understand the importance of upholding ethical standards New in this Edition • The discussions of JIT, TQM, and Process Reengineering have been condensed • Many new In Business focus boxes have been written Chapter Overview A Managerial vs Financial Accounting It is a good idea to begin the course by contrasting managerial with financial accounting Financial accounting is concerned with reports to owners, creditors, and others outside of the company Managerial accounting is concerned with reports prepared for the internal use of management Since these are internal reports, there is no requirement that management accounting reports conform to GAAP Indeed, it is desirable to depart from GAAP in some instances B Organizations (Exercise 1-1.) A review of the work of managers and the organizations in which they operate is useful You may want to take a few moments and discuss some organizations that students are familiar with Examples of organizations that students may mention include: sole proprietorships, partnerships, corporations, churches, cities, military units, social clubs, foundations, and families With the various types of organizations listed, focus on two points An organization consists of people who are brought together for some common purpose It is a group of people working together that is the essence of any organization, not the particular assets used by these people People work together in an organization in order to attain some goals The objectives or goals may be clearly stated, but often they are not The financial objectives for most organizations, even if not articulated, are fairly straightforward In commercial enterprises, the primary goal is ordinarily to maximize profits or to at least earn a “satisfactory profit.” In nonprofit organizations, avoiding losses is more of a constraint than a goal Nevertheless, managers need virtually the same information to avoid losses that they need to maximize profits While we usually talk about profit-making companies in the course, almost everything we say applies as well to nonprofit organizations C The Work of Management and the Planning and Control Cycle (Exercise 1-1.) While it is clearly a simplification, the work of managers can be usefully classified as planning, directing and motivating, and controlling All of these activities involve making decisions Planning consists of strategic planning and developing more detailed short-term plans Most of what we refer to below is with reference to the more detailed short-term plans Directing and motivating involves mobilizing people to implement the plan Control is concerned with ensuring that the plan is followed The accounting function plays a major role in the control phase Accountants maintain the databases and prepare the reports that provide feedback to managers The feedback can be used to reward particularly successful employees, but more importantly the feedback can be used to identify potential problems and opportunities that were not anticipated in the plan Based on feedback, it may be desirable to modify the plan The feedback can be also used to identify parts of the organization that need help and those parts that can provide advice and assistance to others Decision-making is an integral part of the other three management activities D Need for Information Accurate and timely accounting information helps management plan effectively and to focus attention on deviations from plans In the planning stage, managers make decisions concerning which alternatives should be selected Financial information is often a vital component of this decision-making Once the alternatives have been selected, detailed planning is possible These detailed plans are usually stated in the form of budgets The control function of management is aided by performance reports that compare actual performance to the budget This feedback mechanism directs attention to activities where managerial attention is needed E Comparison of Financial and Managerial Accounting Financial and managerial accounting both rely on the same basic accounting database, although managerial accountants often accumulate and use additional data However, important differences exist between the two disciplines: Financial Accounting: • Is concerned with reports made to those outside the organization • Summarizes the financial consequences of past activities • Emphasizes precision and verifiability • Summarizes data for the entire organization • Must follow GAAP since the reports are made to outsiders and are audited • Is required for publicly-held companies and by lenders Managerial Accounting: • Is concerned with information for the internal use of management • Emphasizes the future • Emphasizes relevance and flexibility of data • • • • Places more emphasis on non-monetary data and timeliness and less emphasis on precision Emphasizes the segments of an organization rather than the organization as a whole Is not governed by GAAP Is not required by external regulatory bodies or by lenders F Organizational Structure (Exercise 1-1.) Organizational structure refers to the way in which responsibilities and authority are distributed within an organization Centralization vs decentralization At one extreme is a totally centralized organization in which the boss makes all decisions The opposite extreme is a totally decentralized organization where decisions are made at the lowest possible level in the organization Centralization tends to be favored in situations where information is centralized and control is important Decentralization tends to be favored in situations where information is dispersed and centralized control is less important Organization charts Exhibit 1-3 is useful in discussing the structure of an organization Informal communication links are particularly important Line and staff relationships Exhibit 1-3 is also useful for discussing line and staff positions A line manager is directly engaged in attaining the organization’s objectives People in staff positions provide support to the line positions Especially important to note here is that the accounting function is a staff position The Chief Financial Officer The controller is the manager in charge of the accounting department and he/she reports to the Chief Financial Officer (CFO) The CFO is usually a member of the top-management team and should be an active participant in the planning, control, and decision-making processes at the very highest levels in the organization G The Changing Business Environment (Exercise 1-2.) Over the last two decades, competition in many industries has become global and the pace of innovation in products and services has accelerated While this has generally been good news for consumers, it has resulted in wrenching changes in business, including the advent of the internet Many companies now realize that they must continuously improve in order to remain competitive Improvement programs come and go and have almost as many names as there are consulting firms engaged in marketing continuous improvement programs The boundaries between the various approaches are blurry Historically, Just-In-Time (JIT) was developed first While JIT has its roots in the Rouge River automotive plant built by Henry Ford in the 1920s, it was most fully developed by Toyota in Japan We use the term JIT narrowly to refer to minimum inventory production systems The use of the term JIT to refer to continuous improvement programs in general has fallen out of use In the text, we very briefly describe the major characteristics of three other general approaches to continuous improvement—Total Quality Management (TQM), Process Reengineering, and the Theory of Constraints (TOC) These approaches are not mutually exclusive They can be used together in concert Indeed, TQM and Process Reengineering may be most effective when they are combined with TOC A key concept in continual improvement is that improvement never ends After every improvement, a new opportunity for improvement is sought out While not emphasized in the text, you may want to point out that these various improvement programs are not always successful Advocates of the various programs will invariably claim that failures are due to poor implementation or to lack of support by top management While these two factors undoubtedly account for many of the failures, we suspect that the improvement programs are not as universally appropriate as their proponents claim For example, a TQM program that is focused on improving nonconstraint workstations will have difficulty translating operational improvements into additional profits H Just-In-Time The term JIT means that materials are received just in time to be used in production, manufactured parts are completed just in time to be assembled into products, and products are completed just in time to be shipped to customers As a result, inventories are virtually eliminated in a JIT system JIT uses a “pull” approach to production control a At the final assembly stage, a signal is sent to the preceding workstation as to the exact amount of parts and materials needed for the next few hours Similar signals are sent back through each preceding workstation All workstations respond to the pull exerted by the final assembly stage, which in turn responds to customer demands b In contrast, in a conventional production control system each workstation completes its processing and “pushes” partially completed components forward to the next workstation This is done regardless of whether the next workstation is ready to receive the components or whether anyone actually wants to buy the finished product The result is that work in process tends to build up in front of the workstations that are inherently slower than the others The overriding concern in many conventional facilities is to keep all the workstations busy all of the time Since the capacities at workstations differ, this necessarily results in piles of work in process inventories in front of the workstations with lower capacities c The pull approach used in JIT reduces inventories since workstations not produce anything unless it has already been requested by a downstream workstation and ultimately by customers The causes of excessive inventory a Some inventories are usually maintained to guard against stock-outs These inventories can be cut if the time required to make a product is reduced to the point that current customer demands can be met with current production b Poor coordination among workstations can lead to excessive inventories c Large batch sizes lead to excessive inventories d The desire to “keep everyone busy” often leads to inventory buildups The market may not be able to absorb everything the plant can make Moreover, differing capacities at workstations will inevitably lead to buildups of work in process inventories in front of the workstations with lower capacities (See the discussion above.) I Key Elements of JIT In addition to JIT purchasing, successful JIT production control systems usually have the following four key characteristics: Improved plant layout The layout of the plant should be improved to reduce distances work in process must travel In conventional plant layouts, all of the machines of a similar class are grouped together in one location For example, all of the milling machines are usually in one location and all of the drilling machines in another Consequently, work in process must often move long distances between operations There are a number of problems with this First, moving components around the plant results in unnecessary costs Second, moving introduces delay The components sit around waiting to be moved and then it takes time to actually move them Third, it is difficult to keep track of individual items when the inventory is scattered all over the factory floor Reduced setup time Reduced setup time provides the capability to respond quickly to customer orders and reduces the need for safety stocks Low defect rates A company should constantly strive to reduce the defects Large numbers of defects require that excess work in process be put into production to ensure that there will be sufficient defect-free output to meet customer orders Therefore, defects should be eliminated as much as possible in a JIT program Flexible workforce Workers should be multi-skilled in a JIT environment, which is often organized into small “cells” that contain all of the equipment required to carry out many steps in the production process Workers need to be able to use all of the various pieces of equipment in the work cell Also, workers are typically expected to perform maintenance tasks on their own equipment and to their own quality inspections K Benefits of JIT Among the benefits resulting of using JIT are the following: Inventories are reduced In addition to releasing funds tied up in financing inventories (see below), smaller inventories reduce the risk of potential losses due to obsolescence Space is freed up Areas that were previously devoted to storing inventories are made available for more productive uses Throughput time is reduced This makes it easier to respond to customer demands and can be a very significant competitive advantage Defect rates are reduced Operating without large work in process inventories makes it much easier to quickly identify and correct production problems This latter point cannot be overemphasized Excessive work in process inventories make it very difficult to detect and diagnose problems When a facility operates without significant inventories, it is running “naked.” Problems become quickly apparent and can be dealt with in a timely manner L Total Quality Management (TQM) Total Quality Management means different things to different people Nevertheless, most TQM programs seem to share at least two common elements—a focus on the customer and systematic problem-solving using teams made up largely of front-line workers TQM tools TQM tools include the plan-do-check-act cycle, Pareto analysis, fishbone charts, storyboards, statistical process control, and benchmarking We defer discussion of all of these tools except benchmarking to operations management courses Benchmarking involves studying the best practices of other organizations to learn how to things better and as a means of setting goals For example, a large bakery might study the distribution system of a successful florist to improve its own distribution system TQM empowers employees TQM empowers those who are closest to problems and it focuses attention on fact-based problem solving rather than on finger pointing For an exceptionally lucid overview of TQM that emphasizes these points, see Wruck and Jensen, “Science, Specific Knowledge, and Total Quality Management,” Journal of Accounting and Economics, 18, 1994, pp 247-287 M Process Reengineering The boundaries between Process Reengineering on the one hand and JIT and TQM on the other hand are fuzzy A successful JIT implementation almost always involves some Process Reengineering—although it may not be called by that name And some TQM advocates would no doubt claim that Process Reengineering is just a special case of TQM To prevent confusion, we have attempted in the text to draw the sharpest distinction we can between Process Reengineering and the other two methods Process Reengineering involves completely redesigning a business process from the ground up In this respect, it can be differentiated from TQM, which tends to emphasize small, incremental improvements Process Reengineering begins by flowcharting whatever business process is under examination Quite often, the flowchart reveals a Rube Goldberg-like process that has been thrown together over time in response to various problems Non-value-added activities in the flowchart are identified These are activities that take time or consume resources but that not add any value that the customer is willing to pay for The process is redesigned with a focus on simplification and elimination of non-valueadded activities Unfortunately, Process Reengineering often fails because of behavioral problems a By simplifying and eliminating non-value-added activities, it should be possible to design a process that gets the job done with fewer resources than before This often means that fewer workers will be required If management lays off the surplus workers or transfers them to less desirable jobs, morale suffers and further process reengineering efforts will very likely be resisted by employees Management should develop plans for redeploying surplus resources—including people—even before the Process Reengineering is begun and these plans should be communicated to employees b Reengineering is often guided by consultants or staff specialists who recommend dramatic changes in how jobs are performed Consequently, reengineering is likely to be resisted by front-line workers Management must work hard to ensure that workers not feel threatened by reengineering and that their legitimate concerns are taken into account N Theory of Constraints (TOC) As with JIT, TQM, and Process Reengineering, we barely scratch the surface of the Theory of Constraints in the text For additional background, we recommend THE GOAL: Second Revised Edition, by Goldratt and Cox Every organization has at least one constraint It is easiest to think about this in the context of a factory whose production cannot keep up with demand In that case, the constraint is inside the factory Ordinarily, the constraint will be the workstation with the lowest rate of output (and smallest capacity) The output of the entire system (in this case, the factory) is determined by the rate of output (i.e., the capacity) of the constraint The non-constraints have excess capacity To increase the output of the system the average rate of output through the constraint must be increased The constraint should never be starved for work and improvement efforts should be focused on the constraint If improvement efforts are focused on a non-constraint, the end result will be an increase in the amount of excess capacity This will be beneficial only if the excess capacity can be transferred in some way to the constraint or costs can be reduced by eliminating excess capacity However, as noted above, eliminating excess capacity can have a negative impact on morale if it involves layoffs If improvement efforts are focused on the constraint (as they usually should be), its rate of output may improve to the point that it is no longer the constraint The constraint would then shift elsewhere At that point, improvement efforts should shift to the new constraint The goal in the Theory of Constraints is not to eliminate all constraints; the system always has a constraint of some sort if the goal is to make more money Nevertheless, constraints determine the performance of the entire system, so they should be intelligently managed O Professional Ethics (Exercise 1-4.) Some students tend to equate legal and ethical behavior That is, if an action is legal, they consider it to be ethical We believe it is important to dispel this notion In the text we use a utilitarian approach in arguing for the importance of maintaining ethical standards We argue that ethical standards are necessary for the smooth functioning of an advanced market economy Basically, if you could not trust anyone, you would be unwilling to transact in the marketplace without ironclad guarantees Such guarantees are expensive to write and enforce even when they are feasible See Eric Noreen, “The economics of ethics: a new perspective on agency theory,” Accounting, Organizations and Society, vol 13, no 4, 1988 for further development of these ideas One advantage of approaching ethical issues in the managerial accounting course is that the code of ethics promulgated by the Institute of Management Accountants can be used as a framework This code of ethics is more specific than most codes of ethics, which tend to be general platitudes with little substantive content By contrast, the IMA code of ethics is refreshingly specific and strongly worded in some key areas It is also general enough that it can be used by managers as well as by management accountants Assignment Materials Assignment Exercise 1-1 Exercise 1-2 Exercise 1-3 Problem 1-4 Problem 1-5 Problem 1-6 Problem 1-7 Problem 1-8 Topic The roles of managers and management accountants The business environment Ethics in business Preparing an organization chart Ethics and the manager Line and staff positions; organization chart Ethics in business Ethics; just-in-time purchasing Level of Difficulty Basic Basic Basic Basic Basic Medium Medium Medium Suggested Time 10 10 15 30 20 30 20 30 10 B Beware of sales dollars as an allocation base i 60 While sales dollars is a popular allocation base for service department costs, it is a poor choice because sales dollars fluctuate from period to period, whereas the costs being allocated are often largely fixed This creates a situation where the sales in one department will influence the service department costs allocated to another department ii 61 62 63 Clothier Inc – an example Assume the facts as shown with respect to Clothier Inc The allocations of service department costs for year one are as shown Notice: a The Suits Department generated 65% of total sales as was allocated $39,000 of service department costs The allocations of service department costs for year two are as shown Notice: a The Suits Department increased sales by $100,000 while the other departments’ sales remained unchanged b The allocation of service department costs to the Suits Department increased by $4,200 while it decreased in the other two departments c The manager of the Suits Department is likely to complain 1065 63 1066 63 that as a result of his efforts to expand sales, he is being forced to carry a larger share of the service department costs Helpful Hint: Ask students to suppose they are a division manager in a company that allocates fixed costs on the basis of actual sales Ask if the fixed costs allocated to their division will depend on sales in other divisions If they say yes, ask if this fair There will probably be a chorus of no’s Ask how this differs from grading on a curve After some direction, they should conclude that if you better on an exam than others, your grade will be higher and other students’ grade will be lower However, if your sales increase relative to other divisions, the fixed costs allocated to you will increase and that allocated to other divisions will decrease 1067 Chapter 15 Transparency Masters 1068 TM 15-1 AGENDA: SERVICE DEPARTMENT COSTING, AN ACTIVITY APPROACH A Reasons for allocating service department costs to operating departments B The two-stage allocation process C Bases commonly used to allocate service department costs D Reciprocal services E The step method F The direct method G Allocating costs by behavior; the allocation guidelines H Implementation of the allocation guidelines © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-2 REASONS FOR ALLOCATING SERVICE DEPARTMENT COSTS Service department costs are allocated to operating departments for a variety of reasons: To encourage managers of operating departments to make wise use of services provided by service departments To provide more complete cost data for making decisions in operating departments To help measure profitability in operating departments To put pressure on service departments to operate efficiently To develop overhead rates in the operating departments for costing products To help determine the cost base for cost-plus pricing © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-3 TWO STAGE ALLOCATION PROCESS (Exhibit 15-5) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-4 BASES COMMONLY USED TO ALLOCATE SERVICE DEPARTMENT COSTS (Exhibit 15-1) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-5 RECIPROCAL SERVICES Services that service departments provide to each other are known as reciprocal or interdepartmental services The approaches commonly used to allocate the costs of service departments are the direct method, the step method, and the reciprocal method • The direct method ignores reciprocal services Service department costs are allocated directly to operating departments • The step method provides for the allocation of a service department’s costs to other service departments, as well as to operating departments This sequential method takes into account many of the reciprocal services, but not all of them • Unlike the direct and step methods, the reciprocal method fully accounts for all of the reciprocal services However, the mathematics of the reciprocal method are relatively complex and it is seldom used © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-6 GRAPHIC ILLUSTRATION OF THE STEP METHOD (Exhibit 15-3) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-7 STEP METHOD When allocating costs by the step method, the sequence begins with the department that provides the greatest amount of service to other departments In the example that follows, Personnel Department costs are allocated on the basis of number of employees and Custodial Services Department costs are allocated on the basis of space occupied: Departmental costs Number of employees Space occupied-square feet Personnel Custodial Services Machining $720,000 20 9,000 $180,000 10 6,000 $ 970,000 100 30,000 $720,000 $180,000 45,000 Assembly Total $ 630,000 50 70,000 $2,500,000 180 115,000 $ 970,000 $630,000 $2,500,000 450,000 225,000 (225,000) 7,500 $ $1,487,500 157,500 $1,012,500 The step allocation would proceed as follows: Departmental costs before allocation Allocations: Personnel costs (10/160, 100/160, 50/160)* Custodial services costs (30/100, 70/100)** Total cost after allocations (720,000) $ $2,500,000 *Based on: 10 + 100 + 50 = 160 (Or, $720,000 ÷ 160 employees = $4,500 per employee.) **Based on: 30,000 + 70,000 = 100,000 (Or, $225,000 ÷ 100,000 square feet = $2.25 per square foot) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-8 DIRECT METHOD Although the direct method is simpler than the step method, it is less accurate since it ignores interdepartmental services Again assume the following data: Departmental costs Number of employees Space occupied-square feet Personnel $720,000 20 9,000 Custodial Services Machining $180,000 10 6,000 $ 970,000 100 30,000 $180,000 Assembly Total $ 630,000 50 70,000 $2,500,000 180 115,000 $ 970,000 $630,000 $2,500,000 480,000 240,000 (180,000) 54,000 $ $1,504,000 126,000 $996,000 The direct method allocation would proceed as follows: Departmental costs before allocation Allocations: Personnel costs (100/150, 50/150)* Custodial services costs (30/100, 70/100)** Total cost after allocations $720,000 (720,000) $ $2,500,000 *Based on: 100 + 50 = 150 (Or, $720,000 ÷ 150 employees = $4,800 per employee.) **Based on: 30,000 + 70,000 = 100,000 (Or, $180,000 ÷ 100,000 square feet = $1.80 per square foot) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-9 ALLOCATING COSTS BY BEHAVIOR Whenever possible, fixed and variable service department costs should be allocated separately using the following guidelines: • Variable costs should be charged at a budgeted rate based on the activity that causes the cost (If actual service department costs are allocated, the operating departments are implicitly held responsible for how well the service departments control their spending.) • Allocations at the beginning of the period: Cost allocated = Budgeted rate × Budgeted activity • Allocations at the end of the period: Cost allocated = Budgeted rate × Actual activity • Fixed costs are incurred to provide capacity Therefore, fixed costs should be allocated to consuming departments in predetermined lump-sum amounts, in proportion to their demands for capacity (the department’s peak-period or long-run average needs) © The McGraw-Hill Companies, Inc., 2006 All rights reserved TM 15-10 ALLOCATION EXAMPLE Implementation of the allocation guidelines is illustrated below EXAMPLE: White Company has a Maintenance Department and two operating departments—Cutting and Assembly Variable maintenance costs are budgeted at $0.60 per machine hour Fixed maintenance costs are budgeted at $200,000 per year Data relating for next year follow: Cutting Department Assembly Department Total Percentage of Peak Period Requirements 60% 40 100% Budgeted Hours 75,000 50,000 125,000 Actual Hours 80,000 40,000 120,000 The amount of Maintenance Department cost that would be allocated to each operating department at the beginning of the year is: Variable cost allocation: $0.60 per hour × 75,000 hours $0.60 per hour × 50,000 hours Fixed cost allocation: $200,000 × 60% $200,000 × 40% Total cost allocated Cutting Department Assembly Department $ 45,000 $ 30,000 120,000 $165,000 © The McGraw-Hill Companies, Inc., 2006 All rights reserved 80,000 $110,000 TM 15-11 ALLOCATION EXAMPLE (cont’d) At the end of the year, the allocation of variable costs should be based on actual activity Ordinarily, the amounts charged to the operating departments for services will be based on these end-ofperiod allocations Assume that actual Maintenance Department costs for the year are: variable, $0.65 per machine hour ($78,000 total); fixed, $210,000 Variable cost allocation: $0.60 per hour × 80,000 hours $0.60 per hour × 40,000 hours Fixed cost allocation: $200,000 × 60% $200,000 × 40% Total cost allocated Cutting Department Assembly Department $ 48,000 $ 24,000 120,000 80,000 $104,000 $168,000 Note that the variable costs are allocated according to the budgeted rate per hour, but using the actual activity, and that the fixed costs are allocated according to the original budgeted amount and peak-period demand Thus, some of the actual year-end costs are not be allocated (or charged out) to the consuming departments, as shown below: Actual costs incurred Costs allocated above Spending variance—not allocated Variable $78,000 72,000 $ 6,000 Fixed $210,000 200,000 $ 10,000 The spending variance is the responsibility of the Maintenance Department and is not charged to the departments that use the services of the Maintenance Department © The McGraw-Hill Companies, Inc., 2006 All rights reserved ... Generally Accepted Accounting Principles (GAAP) Financial accounting conforms to GAAP Managerial accounting is not bound by GAAP vii Managerial accounting – not mandatory Financial accounting is... make sure the information is formatted and the right elements are included Do you need a variable cost, you need a fully burdened cost, you need overhead applied, are you just talking about discretionary... are received just in time to be used in production, manufactured parts are completed just in time to be assembled into products, and products are completed just in time to be shipped to customers