Learning Objectives

1. Describe the short-run decision-making model and explain how cost behavior affects the information used to make decisions.
2. Apply relevant costing and decision-making concepts in a variety of business situations.
3. Choose the optimal product mix when faced with one constrained resource.
4. Explain the impact of cost on pricing decisions.
5. Discuss inventory management under the economic order quantity and JIT models.

1. SHORT-RUN DECISION MAKING

Short-run decision making involves choosing among alternatives and tends to be short-run in nature with an immediate end in view.

Sound short-run decision making results in decisions that achieve an immediate objective and serve the overall strategic goals of the organization.

A. The Decision-Making Model

The six steps in the decision making process are as follows:

1. Define the problem.
2. Identify alternatives as possible solutions to the problem; eliminate alternatives that are not feasible.
3. Identify the relevant costs and benefits associated with each feasible alternative; eliminate irrelevant costs and benefits from consideration.
4. Total the relevant costs and benefits for each alternative.
5. Assess qualitative factors.
6. Select the alternative with the greatest overall benefit.

B. Ethics in Decision Making

In tactical decision making, ethical concerns relate to the way in which decisions are imple­mented and the possible sacrifice of long-run objectives for short-run gain.

Objectives should be attained within an ethical framework and be consistent with the company’s missions and goals.

C. Relevant Costs Defined

Relevant costs:

• are future costs, and
• differ among the alternatives.

An irrelevant cost can be:

• a past cost, or
• a future cost that does not differ among the alternatives being considered.

A sunk cost is a cost for which the outlay has already been made.Sunk costs are the result of past decisions and cannot be changed by current or future action. The acquisition cost of equipment purchased in the past is a sunk cost. After sunk costs are incurred, they are unavoidable. Since sunk costs are past costs that do not differ among the alternatives, sunk costs are irrelevant costs.

2. SOME COMMON RELEVANT COST APPLICATIONS

We all are aware of the need of quantitative numbers to make decisions, but there is a need to examine qualitative factors. Many times it is difficult to quantify qualitative factors, such as quality of materials, late orders, customer relations, and so on. Qualitative factors are very important when making decisions.

There are four major types of relevant costing decisions mentioned in this section: make or buy, keep or drop, special order, and sell or process further. Cornerstones can be used to illustrate each of the decision types.

Cornerstone 12-1: How to Structure a Make-or-Buy Problem

• See Mowen and Hansen text for demo problems.

Cornerstone 12-2: How to Structure a Special-Order Problem

• See Mowen and Hansen text for demo problems. 

Cornerstone 12-3: How to Structure a Keep-or-Drop Product Line Problem

See Mowen and Hansen text for demo problems. 

Cornerstone 12-4: How to Structure a Keep-or-Drop Product Line Problem with Complementary Effects

• See Mowen and Hansen text for demo problems.

Cornerstone 12-5: How to Structure the Sell-or-Process-Further Decision

• See Mowen and Hansen text for demo problems.

3. PRODUCT MIX DECISIONS

In some cases product resources, such as materials, labor, or equipment, may be limited.

Constraints are limitations due to limited resources or limited product demand. A manager must choose the optimal mix given the firm’s constraints.

A. One Constrained Resource

When there is one scarce resource, determine which product results in the highest contribution margin per unit of the scarce resource.

For example, if the scarce resource is machine hours, for each product calculate the contribution margin per machine hour as follows:

The quantity needed of the product with the highest contribution margin per machine hour should be produced before producing the other products.

Cornerstone 12-6: How to Determine the Optimal Product Mix with One Constrained Resource

• See Mowen and Hansen text for demo problems.

Cornerstone 12-7: How to Determine the Optimal Product Mix with One Constrained Resource and a Sales Constraint

• See Mowen and Hansen text for demo problems.

B. Multiple Constrained Resources

When more than one resource is limited, linear programming can be used to determine the optimal solution.

4. PRICING DECISIONS

Two approaches to pricing:

1. Cost-based pricin g—Cost-based pricing uses a markup, or percentage applied to the base price, to determine the selling price.

2. Target costing and pricin g—Target costing determines the cost of a product or service based on the price (target price) that customers are willing to pay. The marketing department deter mines what characteristics and price for the product are acceptable to customers, then engineers design and develop the product so that cost and profit can be covered by that price.

Cornerstone 12-8: How to Calculate Price by Applying a Markup Percentage to Cost

• See Mowen and Hansen text for demo problems. 

Cornerstone 12-9: How to Calculate a Target Cost

• See Mowen and Hansen text for demo problems. 

5. DECISION MAKING FOR INVENTORY MANAGEMENT

A. Inventory-Related Costs

Ordering costs are the costs of placing and receiving an order. Examples include the clerical costs of processing an order, the cost of insurance for shipment, and unloading costs.

Setup costs are the costs of preparing equipment and facilities for production. Examples include wages of idled production workers, lost income from idled production facilities, and the costs of test runs (labor, materials, and overhead).

Carrying costs are the costs of carrying inventory, such as storage and handling costs, the opportunity cost of funds invested in inventory, and insurance and taxes on the inventory.

Since both ordering costs and setup costs are costs of acquiring inventory, they are treated in the same manner.

Stockout costs are the costs associated with having insufficient amounts of inventory. Stockout costs include:

lost sales (both current and future)

costs of expediting (overtime or increased transportation costs)

costs of interrupted production

B. Traditional Reasons for Holding Inventory

Traditional reasons for holding inventories are:

to balance ordering or setup costs and carrying costs
to satisfy customer demand (meet delivery dates)
to avoid shutting down manufacturing facilities due to machine failure, defective or unavail­able parts, and/or late delivery of parts.
to buffer against unreliable production processes
to take advantage of discounts
to hedge against future price increases

C. Economic Order Quantity: The Traditional Inventory Model

An inventory policy addresses two questions:

How much inventory should be ordered (or produced)?
When should the order be placed (or the setup performed)?

Order Quantity and Total Ordering and Carrying Costs

The order quantity used should minimize the total cost of ordering and carrying inventory.

Total inventory-related costs = Ordering cost + Carrying cost

= P D /Q + C Q /2

• where:
  P = the cost of placing and receiving an order (or the setup cost for a production run)
• D = the known annual demand
• Q = quantity (the number of units ordered each time an order is placed or the lot size for a production run)
• C = the cost of carrying one unit of stock for one year

The economic order quantity is the order quantity that minimizes the total cost.

Cornerstone 12-10: How to Calculate Ordering Cost, Carrying Cost, and Total Inventory-Related Cost

• See Mowen and Hansen text for demo problems.

D. Computing EOQ

The economic order quantity is calculated as:

The EOQ is the order size that results in ordering costs equaling carrying costs.

The economic order quantity model can also be used to determine the most economical size of a production run. The only difference is that setup costs for starting a production run are substituted for ordering costs.

Cornerstone 12-11: How to Calculate the EOQ, Ordering Cost, Carrying Cost, and Total Inventory-Related Cost

• See Mowen and Hansen text for demo problems.

E. EOQ and Inventory Management

The traditional approach to inventory management is called a just-in-case system.

The traditional manufacturing environment uses mass production of a few standardized products that typically have a very high setup cost. The high setup cost encourages a large batch size and long production runs. Diversity is viewed as being costly and is avoided.

F. Just-In-Time Approach to Inventory Management

Competitive pressures have led many firms to abandon the EOQ model in favor of a just-in-time (JIT) approach to manufacturing and purchasing. JIT offers increased cost efficiency and simultaneously has the flexibility to respond to customer demands for better quality and more variety.

G. Basic Features of JIT

JIT (just-in-time) manufacturing is a demand-pull system. Products are produced only when demanded by customers.

JIT purchasing occurs when parts and materials arrive just in time to be used in production.

Differences between JIT and traditional manufacturing are summarized below:

H. Setup and Carrying Costs: The JIT Approach

The traditional approach takes setup costs as given and then tries to minimize total carrying costs and setup costs.

JIT attempts to reduce setup costs (or ordering costs) by:

reducing the time it takes to set up for production, and
reducing the number of orders through long-term contracting.

If setup and ordering costs are insignificant, the only remaining cost to minimize is carrying cost, which is minimized by reducing inventories to insignificant levels.

1. Identify the major differences and similarities between financial and managerial accounting.
2. Understand the role of management accountants in an organization.
3. Understand the basic concepts underlying Just-In-Time (JIT), Total Quality Management (TQM), Process Reengineering, and the Theory of Constraints (TOC).
4. Understand the importance of upholding ethical standards.

Lecture Notes

A. Managerial vs. Financial Accounting. Financial accounting is concerned with reports to owners, creditors, and others outside of the firm. 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. Some organizations you may be familiar with 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.

1. 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.

2. 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 informa-tion to avoid losses that they need to maximize profits. While we usually talk about profit-making firms in the course, almost everything we say applies as well to nonprofit organizations.

C. The Work of Management and the Planning and Control Cycle. While it is clearly a simplification, the work of managers can be usefully classified into three major categories: planning, directing and motivating, and controlling. All of these activities involve making decisions.

1. 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.

2. Directing and motivating involves mobilizing people to implement the plan.

3. Control is concerned with ensuring that the plan is followed. Emphasize that 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 em-ployees, but more importantly the feedback can be used to identify potential problems and opportuni-ties 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.

4. Decision-making is an integral part of the other three management activities.

These management activities are summarized below:

Planning	Controlling	Decision Making
Setting Objectives	Monitoring a plan’s implementation	Choosing among competing alternatives
Identifying ways to achieve the objectives	Feedback is information used to evaluate or correct implementation of a plan.	Example: deciding the selling price of products
Example: budgets	Based on feedback, a manager might: – continue the implementation as originally planned – take corrective action if needed, or – modify the plan.
	Example: performance reports, which are accounting reports that provide feedback by comparing actual results with plans

 

Most of you already use (consciously or unconsciously) the steps of the planning and control cycle. Many of you have established long-term educational goals (e.g., academic major, graduation, and future employment). Short-term planning involves deciding which courses to take the next term or perhaps over the next few terms. You implement your plan by enrolling in classes and (hopefully) studying diligently. Performance is measured by grades. At the end of each term, you evaluate your performance to decide on the appropriate courses for the next term, or perhaps even reevaluate your long-term objectives (e.g., major).

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 perform-ance 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:

1. Financial Accounting.

o Is concerned with reports made to those outside the organization.
o Summarizes the financial consequences of past activities.
o Emphasizes precision and verifiability.
o Summarizes data for the entire organization.
o Must follow GAAP since the reports are made to outsiders and are audited.
o Is required for publicly-held companies and by lenders.

2. Managerial Accounting.

o Is concerned with information for the internal use of management.
o Emphasizes the future.
o Emphasizes relevance and flexibility of data.
o Places more emphasis on non-monetary data and timeliness and less emphasis on precision.
o Emphasizes the segments of an organization rather than the organization as a whole.
o Is not governed by GAAP.
o Is not required by external regulatory bodies or by lenders.

F. Expanding Role of Managerial Accounting. An understanding of the history of managerial accounting is important for several reasons. First, it helps to understand later in the course why some prevailing management accounting practices are less than optimal (e.g., allocating overhead on the basis of direct labor). Second, you should be aware that management accounting is evolving in response to changes in the business environment. There is not a single right way to do things or a single formula that will always provide the best answer. This often comes as a surprise if you expect management accounting to be a subject like physics with immutable laws.

G. Organizational Structure. Organizational structure refers to the way in which responsibilities and authority are distributed within an organization.

1. 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 deci-sions 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 fa-vored in situations where information is dispersed and centralized control is less important.

2. Organization charts. Informal communication links are particularly important.

3. Line and staff relationships. A line manager is directly engaged in attaining the organization’s objectives. People in staff positions pro-vide support to the line positions. Especially important to note here is that the accounting function is a staff position.

4. 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.

H. The Changing Business Environment. 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.

1. 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 ap-proaches are blurry.

2. 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.

3. The major characteristics of three other general approaches to continuous improvement are also touched upon —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.

4. A key concept in continual improvement is that improvement never ends. After every improvement, a new opportunity for improvement is sought out.

5. While not emphasized in the text, sometimes 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 non-constraint workstations will have difficulty translating operational improvements into additional profits.

I. 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.

1. 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 process-ing and “pushes” its 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 conventionally run 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 in-ventories in front of the workstations with lower capacities.

c. The pull approach used in JIT reduces inventories since workstations do not produce anything unless it has already been requested by a downstream workstation and ultimately by customers.

2. 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.)

J. JIT Purchasing. JIT purchasing can be used by any organization that has inventories-retail, wholesale, service, or manufacturing. Key features of JIT purchasing are:

1. The company relies on a few ultra-reliable suppliers. All purchases are concentrated in a few, highly dependable suppliers who can meet stringent delivery schedules.

2. Suppliers make frequent deliveries in small lots just before the goods are needed. Since a com-pany that has adopted JIT wants goods only when they are really needed, suppliers must make fre-quent deliveries in small lots. Dependability is essential since there are little or no buffer inventories to protect the purchaser from disruptions in supply.

3. Suppliers must deliver defect-free goods. Suppliers certify that goods are defect-free. This elimi-nates the need for incoming inspections and ensures that production will not be disrupted or customers disappointed by defective goods.

K. Key Elements of JIT. In addition to JIT purchasing, successful JIT production control systems usually have the following four key characteristics:

1. 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.

SUGGESTION: An interesting analogy can drive home the importance of a good plant layout. If McDonald’s or Burger King were organized like a conventional factory, all of their grills would be lo-cated in one store, all of their deep fat fryers in another store, and all of their beverage dispensers in another. A customer who wanted a hamburger with fries and a beverage would have to drive from one store to the other. In reality, each fast food outlet is a work cell that combines all of the equipment required to make the final product-the complete meal ordered by the customer.

2. Reduced setup time. Reduced setup time provides the capability to respond quickly to customer or-ders and reduces the need for safety stocks.

3. Low defect rates. A company should constantly strive to reduce the defects. Large numbers of de-fects 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 pos-sible in a JIT program.

4. 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 do their own quality inspections.

L. Benefits of JIT. Among the benefits resulting of using JIT are the following:

1. 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.

2. Space is freed up. Areas that were previously devoted to storing inventories are made available for more productive uses.

3. Throughput time is reduced. This makes it easier to respond to customer demands and can be a very significant competitive advantage.

4. 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. Ex-cessive 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.

M. Total Quality Management (TQM). Total Quality Management means different things to dif-ferent 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.

1. TQM tools. TQM tools include Pareto analysis, fishbone charts, storyboards, statistical process control, benchmarking, and the plan-do-check-act cycle. To avoid getting into too many details, we mention only two of these tools in the text-benchmarking and the plan-do-check-act cycle.

2. Benchmarking involves studying the best practices of other organizations to learn how to do 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.

3. The Plan-Do-Check-Act Cycle (PDCA) is a systematic, fact-based approach to continuous improvement. It resembles the scientific method in that hypotheses are formulated and then tested.

4. 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.

N. 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 at-tempted in the text to draw the sharpest distinction we can between Process Reengineering and the other two methods.

1. 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 im-provements.

2. 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 responseto various problems.

3. Non-value-added activities in the flowchart are identified. These are activities that take time or con-sume resources but that do not add any value that the customer is willing to pay for.

4. The process is redesigned with a focus on simplification and elimination of non-value-added activities.

5. 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 do not feel threatened by reen-gineering and that their legitimate concerns are taken into account.

O. Theory of Constraints (TOC). As with JIT, TQM, and Process Reengineering, the text barely scratches the surface of the Theory of Constraints in the text. For additional background, you might want to read THE GOAL: Second Revised Edition, by Goldratt and Cox.

1. 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).

2. The output of the entire system (in this case, the factory) is determinedby the rate of output (i.e., the capacity) of the constraint. The non-constraints have excess capacity.

3. To increase the output of the system, it is necessary to increase the average rate of output through the constraint. The constraint should never be starved for work and improvement efforts should be fo-cused on the constraint.

4. If improvement efforts are focused on a non-constraint, the end result will be to increase 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.

5. 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.

6. 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.

P. Professional Ethics. 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.

1. In the text we use a utilitarian approach in arguing for the importance of maintaining ethical stan-dards. 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 mar-ketplace without ironclad guarantees. Such guarantees are expensive to write and enforce even when they are feasible.

2. 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.

Cable TV companies are granted exclusive franchises (i.e., monopolies) by local governments. Cable TV companies regularly mail special offers to non-subscribers. One such recent mailing stated in bold letters that the installation charge had been cut to 99¢ and that the monthly charge for a popular movie channel had been cut to $6.95 per month for the first three months. In the fine print at the bottom of the flier it was stated that in addition there would be the usual monthly charge for basic cable TV service. Nowhere in the flier did it mention what the usual monthly charge would be nor did it mention how much the movie channel would cost after the first three months. Is this marketing technique is ethical? We believe this marketing technique is not ethical. The flier did not fully disclose all relevant information that could reasonably be expected to influence the reader’s understanding of the nature of the contract. (This is a restatement of the last standard from the IMA code of ethics.) Some of you might respond “So what?” Our response is that attempting to mislead customers in this way is likely to be bad business and will almost certainly undermine the functioning of our economy if such practices became widespread. It is bad business because households that sign up for the service under the impres-sion that it will only cost $6.95 per month are likely to be disgruntled. They may cancel the service after the cable company had incurred the expenses of making a hookup. Moreover, a cable TV company that engages in such marketing ploys is likely to acquire a richly deserved reputation as a sleazy operator and its exclusive franchise may be revoked or transferred to some other operator. From the standpoint of the whole economic system, if companies generally try to mislead and fool customers, no one would have any trust in claims made by sellers. Without trust, whole industries would collapse. For example, people who buy insurance usually do so without reading the fine print. What would happen to the insurance industry if unscrupulous operators sold insurance policies with fine print that allowed them to weasel their way out of paying claims?

1. Identify and give examples of each of the three basic manufacturing cost categories.

2. Distinguish between product costs and period costs and give examples of each.

3. Prepare an income statement including calculation of the cost of goods sold.

4. Prepare a schedule of cost of goods manufactured.

5. Understand the differences between variable costs and fixed costs.

6. Understand the differences between direct and indirect costs.

7. Define and give examples of cost classifications used in making decisions: differential costs, opportunity costs, and sunk costs.

1. Manufacturing costs. These costs are incurred to make a product. Manufacturing costs are usually grouped into three main categories: direct materials, direct labor, and manufacturing overhead.

a. Direct materials. Direct materials consist of those raw material inputs that become an integral part of a finished product and can be easily traced into it. Examples include the aircraft engines on a Boeing 777, the Intel processing chip in a personal computer, and the blank video cassette in a pre-recorded video.
b. Direct Labor. Direct labor consists of that portion of labor cost that can be easily traced to a product. Direct labor is sometimes referred to as “touch labor” since it consists of the costs of workers who “touch” the product as it is being made.
c. Manufacturing Overhead. Manufacturing overhead consists of all manufacturing costs other than direct materials and direct labor. These costs cannot be easily and conveniently traced to products. Examples include miscellaneous supplies such as rivets in a Boeing 777, supervisors, janitors, factory facility charges, etc.
d. Prime versus Conversion Costs. Prime cost consists of direct materials plus direct labor. Conversion cost consists of direct labor plus manufacturing overhead.

2. Non-manufacturing costs. A manufacturing company incurs many other costs in addition to manufacturing costs. For financial reporting purposes most of these other costs are typically classified as selling (marketing) costs and administrative costs. Marketing and administrative costs are incurred in both manufacturing and merchandising firms.

a. Marketing Costs. These costs include the costs of making sales, taking customer orders, and delivering the product to customers. These costs are also referred to as order-getting and order-filling costs.
b. Administrative Costs. These costs include all executive, organizational, and clerical costs that are not classified as production or marketing costs.

3. Period vs. product costs. Costs can also be classified as period or product costs.

a. Period Costs. Period costs are expensed in the time period in which they are incurred. All selling and administrative costs are typically considered to be period costs. You should be careful to point out that the usual rules of accrual accounting apply. For example, administrative salary costs are “incurred” when they are earned and not necessarily when they are paid to employees.
b. Product Costs. Product costs are added to units of product (i.e., “inventoried”) as they are incurred and are not treated as expenses until the units are sold. This can result in a delay of one or more periods between the time in which the cost is incurred and when it appears as an expense on the income statement. Product costs are also known as inventoriable costs. The discussion in the chapter follows the usual interpretation of GAAP in which all manufacturing costs are treated as product costs.

4. Inventory valuations and Cost of Goods Sold. In a manufacturing company, raw materials purchases are recorded in a raw materials inventory account. These costs are transferred to a work in process inventory account when the materials are released to the production departments. Other manufacturing costs—direct labor and manufacturing overhead—are charged to the work in process inventory account as incurred. As work in process is completed, its costs are transferred to the finished goods inventory account. These costs become expenses only when the finished goods are sold. Period expenses are taken directly to the income statement as expenses of the period.

5. Schedule of Cost of Goods Manufactured. Because of inventories, the cost of goods sold for a period is not simply the manufacturing costs incurred during the period. Some of the cost of goods sold may be for units completed in a previous period. And some of the units completed in the current period may not have been sold and will still be on the balance sheet as assets. The cost of goods sold is computed with the aid of a schedule of costs of goods manufactured, which takes into account changes in inventories. The schedule of cost of goods manufactured is not ordinarily included in external financial reports, but must be compiled by accountants within the company in order to arrive at the cost of goods sold. You should take some time to explain the cost of goods manufactured schedule since it is often difficult for students to understand.

1.Common costs. For example, it is impossible to trace the factory managers’ salary in a multi-product plant to any particular product made in the plant. Even if a product were dropped entirely, we would ordinarily expect the factory manager’s salary to remain the same. This is an example of a “common cost” and later in the text we emphasize that such costs should not be allocated for decision-making or performance evaluation purposes.

 

2.Variable indirect costs. On the other hand, other costs are treated as indirect costs because it would not be practical to treat them otherwise. For example, it would be possible to measure the precise amount of solder used on each circuit board produced at a HP plant, but it wouldn’t be worth the effort. Instead, solder would typically be considered an indirect material and would be included in overhead.

1. Differential Costs. A differential cost is a cost that differs between alternatives. The cost may exist in only one of the alternatives or the total amount of the cost may differ between the alternatives. In the latter case, the differential cost would be the difference between the cost under one alternative and the cost under the other. Differential costs are also called incremental costs. Differential costs and opportunity costs should be the focus of decision-making. They are the only relevant costs and all others should be ignored.

2. Opportunity Costs. An opportunity cost is the potential benefit that is given up by selecting one alternative over another. The concept of an opportunity cost is rather difficult for students to understand because it is not an actual expenditure and it is rarely (if ever) shown on the accounting books of an organization. It is, however, a cost that must be considered in decisions.

3. Sunk Cost. A sunk cost is a cost that has already been incurred and that cannot be changed by any decision made now or in the future. Since sunk costs cannot be changed and therefore cannot be differential costs, they should be ignored in decision making. While students usually accept the idea that sunk costs should be ignored on an abstract level, like most people they often have difficulty putting this idea into practice.