BU247 Notes

Friday, September 21, 2018
BU247-OC1 Notes
Chapter 1—How Management Accounting Information Supports Decision Making
Management Accounting Information
- The Institute of Management Accountants has defined management accounting as:
• a profession that involves partnering in management decision making, devising
planning and performance systems, and providing expertise in financial reporting
and control to assist management in the formulation and implementation of an
organization’s strategy
- Management accounting provides relevant information to managers and employees
• both financial and non-financial information
• useful for making decisions, allocating resources, and monitoring, evaluating, and
rewarding performance
• customized to serve multiple purposes
- Examples of management accounting information include:
• the reported expense of an operating department
• the cost of producing a product
• the cost of delivering a service
• the cost of performing an activity or business process
• the cost of serving a customer
Financial vs. Management Accounting
Financial Accounting
Management Accounting
Retrospective and Prospective
Primarily orientated to external stakeholders; such
as—investors, creditors, regulators, and tax
Primarily orientated to needs of employees and
managers/internal decision making needs
Stresses the form in which it is communicated
No prescribed form or rules about its content
Contains only financial information
Includes both financial and non-financial
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Changing Focus
- Early 19th century—systems to measure the cost of producing individual products
- Middle of the 19th century
• railroads first to develop and use financial statistics to asses and monitor
• Andrew Carnegie developed detailed cost systems that gave him a competitive
- Early 20th century—DuPont and General Motors expanded the focus to planning and
- 1970’s—Japanese manufacturers developed new tools to report on quality, service,
customer, and employee performance
Organization Level and Information Type
- High Level mangers rely on the information provided by the middle level managers
to develop and overall financial summary for the organization and make broad
strategic choices based on that information
- Middle Level managers assess operational information and decide whether process
improvements are needed, and if so, their form. Their responsibility also includes;
translating operational information into projected financial results.
- Operations Level managers (Low Level) rely on both financial and non-financial
process information such as; cost and quality measures to manage the processes for
which they are responsible.
The Decision Support Focus of Management Accounting
- Expenditures on management accounting are discretionary
- Therefore the value of management accounting information in supporting decision
making must justify management accounting system expenditures
The Purpose and Scope of Strategy
- Strategy is about making choices about what the organization will do
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- Strategic levels:
• Corporate Level
- what businesses should we be in?
• Business Level
- what should we propose customers in this target niche?
• Operational Level
- how should we deliver our business level strategy?
- Management accounting is a discipline that helps an enterprise to develop and
implement its strategy
- Strategy is about an organization making choices about what it will do or not do
- As a strategy gets executed, management accounting information provides feedback
Plan-Do-Check-Act (PDCA) Cycle or Deming Cycle
- Developed by quality expert, W. Edwards Deming
- A systematic and recursive way to develop, implement, monitor, evaluate, and change
a course of action
- PDCA Steps:
• Plan Step defined the organization’s purpose and selects the focus and scope of its
• Do Step involves the implementation of a chosen course of action
• Check Step includes measuring and monitoring performance and taking short-term
actions based on measured performance and taking short-term actions based on
measured performance
• Action Step involves managers taking actions to lower costs, change resource
allocations, and improve quality
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Identify objectives
Maintain the current
direction if results are
acceptable. Otherwise
return to the plan stage
to develop and
implement an
alternative course of
Implement the chosen
course of action
Choose a course of
action to achieve the
desired objectives
Monitor (measure) the
results of the
implemented course of
Evaluate the results by
comparing them with
results expected when
the plan was developed
Behavioural Implications
- As measurements are made on operations and especially on individuals and groups
their behaviour changes
• people react when they are being measured and they react to the measurements
• they focus on the variables and behaviour being measured and spend less
attention on those not measured
- Two old sayings recognize these phenomena:
• “What gets measured gets done.”
• “If you don’t measure it, you can’t manage and improve it.”
- Employees familiar with the current system may resist as managers attempt to
introduce or redesign cost and performance measurement systems
- Employees have acquired expertise in the use of the old system
- Employees may also feel committed to the decisions based on the information the old
system produced
- People interpret and use accounting information in different ways; Management
accountants must understand and anticipate the reactions of individuals to
information and measurements
- When the measurements are used not only for information, planning, and decisionmaking, but also for control, evaluation, and reward—employees and managers place
great pressure on the measurement themselves
- People respond to the act of measuring and focus on the measures used to evaluate
their performance
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- Managers and employees may take unexpected and undesirable actions to influence
their score on their performance measure
• people may act to improve measured performance in ways that are not in the
organization’s best interests
- Managers seeking to improve current bonuses based on reported profits may skip
discretionary expenditures that may improve performance in future periods
Chapter 2—The Balanced Scorecard and Strategy Map
“A fundamental principle to underlying management accounting is that measurement
must support a company’s strategy and operations.”
Performance Measurement Systems
- Measurement must support the company’s strategy and operation
- Must be designed so companies get better at managing and improving the value
created from their intangible assets
- Need to move from reliance on financial measures to a mix of financial and nonfinancial measures
Balanced Scorecard
- The Balanced Scorecard (BSC) provides a systems for measuring and managing all
aspects of a company’s performance
- Reflects:
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• the belief that measurement is required for effective management
• management’s assumed cause and effect relationship between what management
does (the drivers/leading indicators) and performance on the organization’s
- The scorecard balanced traditional financial measures of success, such as—profits,
and return on capital, with non-financial measures of the drivers of future financial
- The Balanced Scorecard measures organizational performance across different
- Four different but linked perspectives are derived from the organization’s mission,
vision, and strategy:
• financial
• customer
• process
• learning and growth
Balanced Scorecard Roles
- Clarifies, by use of measures, the organization’s objectives and the cause-and-effect
relationships to achieving those objectives
- Communicates the organization’s objectives to decision makers inside the
organization thereby aligning their decisions with the organizations objectives
- Provides a means of evaluating ongoing performance and suggesting when change is
- Can be used as an accountability tool
Balanced Measurements
- The BSC enables companies to:
• Track financial results
• Monitor how they are building the capabilities for future growth and profitability
- with customers
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- with their internal processes
- with their employees and systems
Problems with the BSC
- Costly
- Not actionable
- A strategy accomplishes two principal functions:
• Creating a competitive advantage by positioning the company in its external
environment with resources to support customers better than its competitors
• Having a clear strategy provides clear guidance for how internal resources should
be allocated to gain a competitive advantage in the marketplace
- Concise statements that articulate what the organization hopes to accomplish
- Action phrases
- Tell the story of the strategy through the cause-and-effect relationship
- Typical objectives found in each of the four BSC perspectives include:
• increase revenues through expanded sales to existing customers—Financial
• offer complete solutions to our targeted customers—Customer perspective
• achieve excellence in order fulfillment through continuous improvements—process
• align employee incentives and rewards with the strategy—Learning and growth
- Provide specificity and reduce the ambiguity that is inherent in word statements
- Specifying exactly how an objective is measured will give employees a clear focus for
their improvement efforts
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- Once the objectives have been translated into measures, managers select targets for
each measure
- Targets establish the level of performance or rate of improvement required for a
• should be set to represent excellent performance
• should, if achieved, place the company as one of the best performers in its industry
• should create distinctive value for customers and shareholders
Strategy Map
- Illustrates the casual relationship among the strategic objectives across four
- The Strategy Map is a picture that illustrates the casual relationships among the
balances scorecard perspectives
- The strategy map is a guide to action that relates the management actions needed to
achieve an organization objective with the measures designed to assess performance
on those actions
A Simple Strategy Map
1) Financial
• increase shareholder value
• Return on equity
2) Customer
• retain customers
• deliver products on time
• offer competitive prices
3) Process
• reduce process cycle times
• improve process quality
• % improvement in cycle times
• Product defect rates
• Process yield improvement
4) Learning and Growth
• develop employees’ process improvement
• % employees trained and certified in process
improvement capabilities
Percentage of repeat customers
Growth in customers’ sales
% deliveries made on time
Prices compared to competitors
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Key Elements of the Strategy Map
- The cause-and-effect relationships leading to the organization’s objective
- The objectives for each of the 4 perspectives and how to measure performance on
those objectives
Financial Perspective
- The ultimate objective for profit-seeking companies—the overall objective
- Expressed in financial terms for profit oriented organizations, and expressed in
mission terms for non-profit oriented organizations
- Financial performance measures indicate whether the company’s strategy,
implementation, and execution are contributing to bottom-line improvement
- Financial performance is a “tag indicator”—measures the tangible outcomes from the
- A company’s financial performance can be improved in two ways:
• productivity improvements
• revenue growth
- Increased productivity occurs by:
• lowering direct and indirect expenses—improve cost structure
- lower unit costs
- reduce general and administrative expenses
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• utilizing their financial and physical assets more efficiently—increase asset
- achieve higher capacity utilization
- reduce working capital requirements
- Companies generate revenue growth by:
• selling additional products or services to existing customers—enhance existing
customer value
- grow sales with existing customers
- improve customer profitability
• selling new products, selling to new customers, and expanding into new markets—
expand revenue opportunities
- generate sales from new products, new customers, and new markets
Financial Measure Alternatives
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Customer Perspective
- Identify the targeted customer segments in which the business unit competes and the
measures of the business unit’s performance in these targeted segments
- The customer perspective reflects what the organization promises its target
customers—this promise is called the value proposition
- The customer value proposition defines the source of value
• price
• quality
• time
• function
• service
- This perspective typically includes several common measures of the successful
outcomes from a well-formulated and implemented strategy:
• achieve customer satisfaction and loyalty
• acquired new customers
• increase market share
• enhance customer profitability
- A strategy identifies specific segments targeted for growth and profitability
- Companies must also identify the objectives and measures for the value proposition it
offers customers
- The value proposition is the unique mix of product performance, price, quality,
availability, ease of purchase, service, relationship, and image offered to the targeted
• defines the company’s strategy
• communicates what the company expects to do for its customers better or
differently from its competitors
- A taxonomy originally developed by Michael Porter; a well-known strategist
• Cost Effectiveness
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- You sell a commodity where prices are set by the market—your key control
lever is cost
• Product Leadership
- You compete by constantly bringing new products into the market place—your
key control lever is innovation
• Customer Intimacy
- You compete by meeting the unique requirements of each customer—your key
control lever is understanding customer requirements
- Value proposition used successfully by different companies include:
• “Best Buy” or lowest total cost
• Product leadership
• Complete customer solutions
Customer Objectives and Measures
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Process Perspective
- Means by which the organization will:
• create and deliver the value proposition for customers
• achieve the productivity improvements for financial objectives
- Strategic processes create value for customers and shareholders
- The Process Perspective identifies the critical processes in which the organization
must excel to achieve its customer, revenue growth, and profitability objectives
- The process perspective reflects how the organization plans to deliver its value
- Useful to think in terms of process groups—all matter but with different importance
depending on strategy
- Organizations perform many different processes, which may be classified into four
• 1) Operating Processes
- Day-today processes by which companies produce their existing products and
services and deliver them to customers
- critical for organizations that compete using a cost-effectiveness strategy
• 2) Customer Management Processes
- Processes by which companies expand and deepen relationships with targeted
- critical for organizations that compete using a customer intimacy strategy
• 3) Innovation Processes
- Processes by which companies develop new products, processes, and services
- critical for organizations that compete using a product leadership strategy
• 4) Regulatory and Social Processes
- Processes by which companies ensure that they meet or exceed regulations on
business practices
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Process Objectives and Measures
Learning and Growth Perspective
- Aligned intangible assets—people, systems, and culture—drive improvement in the
strategic processes (3)
- Reflects the development of intellectual capital (organization know-how) needed to
develop and improve objectives in the process perspective
- Identifies objectives that drive improvement in the processes objectives
• 1) Human Resources
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- Strategic competency availability
• employees have the appropriate mix of skills, talent and know-how
• 2) Information Technology
- Strategic information availability
• systems and applications contribute to effective strategy execution
• 3) Organization Culture and Alignment
- Culture and Climate
• employees have an awareness and understanding of the shared vision,
strategy, and cultural values
- Goal Alignment
• employee goals and incentives are aligned with the strategy
- Knowledge Sharing
• employees and teams share best practices and other knowledge relevant to
strategy execution
Learning and Growth Objectives and Measures
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BSC in Nonprofit and Government Organizations
- The BSC is especially well-suited for non-profit and government organizations
- Their success has to be measured by their effectiveness in providing benefits to
- Because non-financial measures can assess performance with constituents, the BSC
provides the natural performance management system for NPGOs
NPGOs and Strategy
- Many NPGOs encountered difficulties in developing their initial BSC, finding that they
didn’t have a clear strategy
- Many NPGOs place their mission objective at the top of their scorecard and strategy
• cannot use the standard BSC architecture where financial objectives are the
ultimate, high-level outcomes to be achieved
Managing with the BSC
- The benefits from BSC are realized as the organization integrates its new
measurement system into management processes that:
• Communicate the strategy to all employees and organizational units
• Align employees’ individual objectives and incentives to successful strategy
• Integrate the strategy with ongoing management processes
Barriers to Effective Use
- Senior management is not committed
- Scorecard responsibilities do not filter down
- The solution is over-designed, or the scorecard is a one-time event
- The scorecard is treated as a systems or consulting project
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Chapter 3 Pt. 1—Using Costs in Decision Making
Management Accounting Supports Decision Making
- Cost information is pervasive throughout decision making situations
• Pricing
• Product planning
• Budgeting
• Performance evaluation
• Contracting
Variable and Fixed Costs
- Variable Cost
• A cost that changes in direct proportion to changes in the activity of some variable
• A variable cost is associated with a consumable resource
• The variable is called a “Cost Driver”
• Variable Cost = VC per unit of the cost driver x Cost driver units
• Variable Cost Example
• The Rose Furniture Company manufactures a single product—a rocking chair
• The cost of the wood used to make each rocking chair is $25.
• Noting that the cost driver in this example is rocking chairs, the variable cost
equation for wood would be:
- VC of wood = $25 x Number of rocking chairs made
• Here is the variable cost of wood graph:
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- Fixed Cost
• A cost that does not vary in the short-run with a specific activity
• The defining characteristic of fixed costs is that it depends on the amount of a
resource that is acquired rather than amount used
• Fixed costs are often called “Capacity-Related” costs
• Fixed Costs Example
• Examples of Fixed manufacturing costs at the Rose Furniture Company are
- Depreciation on factory equipment
- Wages paid to production supervisors
• These costs do not depend on how much of the available machine time or
supervisory time is used—they depend only on the amount of capacity that was
Variable and Fixed Costs
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Variable Costs vs. Fixed Costs
Fixed Costs
Variable costs
Salaries of production supervisors
Steel used in automobile in production
Salaries for factory custodial staff
Wood used in furniture production
Depreciation of factory equipment
Lubricants for machines
Rent for factory building
Electricity used to operate a specific machine
Maintenance for production equipment
Wages of production workers
Glue used in furniture production
Paper used in newspaper production
Fixed Costs vs. Variable Costs EXAMPLES
Burger ingredients
Cooks’ wages
Server’s wages
Janitor’s wages
Depreciation on cooking equipment
Paper supplies (wrapping, napkins, and supplies)
Advertisement in local newspaper
Cost-Volume-Profit (CVP) Analysis
- CVP uses variable and fixed costs to identify the profit generated at various levels of
- Contribution Margin is the difference between total revenue and total variable costs
- Contribution Margin per Unit is the contribution each unit made and sold to
covering fixed costs and providing a profit
• CMU = price per unit — variable cost per unit
- Contribution Margin Ratio is the ratio of contribution margin per unit to selling price
per unit
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• CMR = CMU / Price
• CMR is the faction of each sales dollar that contributes to covering fixed costs and
providing a profit
The CVP Equation
- Profit
• = Revenue - Total Costs
• Revenue - (Variable Costs - Fixed Costs)
• (Units Sold x Revenue per Unit) - (Units Sold x Variable Cost per Unit) - Fixed
• (Units Sold x (Revenue per Unit - Variable Cost per Unit)) - Fixed Costs
Variations of CVP Equation
- To calculate sales needed to achieve target profit:
• Required Unit Sales
• = (Target Profit + Fixed Costs) / Contribution Margin per Unit
units needed to be sold =
target profit + fixed cost
contribution margin per unit
- Impact of income taxes:
- Now consider finding the needed production and sales to meet a target profit in the
presence of taxes
- For this type of problem it is most useful to use the target profit equation rather than
trying to memorize the formula
• Required Unit Sales
• = [Target Profit / (1 - Tax Rate) + Fixed Costs] / Contribution Margin per Unit
CVP Analysis for Multiple Products
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- There are many combinations of sales levels for multiple products that would allow
the organization to break-even or reach a target profit
- An extension of basic CVP analysis called—“The Bundle Approach”, assumes a
constant product mix
- The Bundle Approach
• Given a fixed product mix, determine the number of bundles that need to be sold to
break-even or to earn a target profit
• Once the number of bundles is found identify the required sales of each product
CVP Assumptions
- Assumptions underlying CVP analysis:
• The unit selling price and variable cost remain the same over all levels of
• All costs are either variable or fixed
• Fixed costs remain the same over all levels of production
• Sales equal production—all production is sold
• Sales volume does not affect product price
• Sales volume does not affect variable cost per unit
Other Useful Cost Definitions
- Mixed Cost—a cost that has variable and fixed components
• For example, your mobile telephone bill may have a fixed component that you pay
each month, independent of how many calls you make, and a variable component
that depends on the number of calls you have to make
• i.e.—Suppose that the bill for heating costs in a factory equals $500 per month plus
$16 per billion British thermal units (BTUs) used
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- Step Variable Cost—a variable cost that increases in steps as the quantity increases
• For example, suppose that a company has a policy of hiring one factory supervisor
for every 20 factory workers
• If each factory supervisor is paid $60,000, the total cost of supervisory salaries
increases in a series of steps with the number of workers as shown in this exhibit
• Although a step variable cost can be modelled directly in any spreadsheet, it is
often approximated as if it were a variable cost
• The exhibit below shows the actual step cost and also shows that the linear
approximation will sometimes over and under represent costs, but on average, will
be correct
- Incremental Cost—the cost of the next unit of production—the change in total cost
that results from a decision
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- Sunk Cost—a cost that results from a previous commitment and cannot be
recovered—does not meet the definition of a relevant cost
• Examples of sunk costs:
- Depreciation on machinery
- Purchase price of an asset currently owned and being considered for sale
• The Sunk Cost Phenomenon
- People tend to treat sunk costs as relevant to a decision
- Explanations of the sunk phenomenon, which is not rational from an economic
perspective, focus on behavioural considerations
- Relevant Cost—a cost that will change as a result of a decision
• in theory, only relevant costs should be considered when making a decision
- Opportunity Cost—the maximum value forgone when a course of action is chosen—
what you forgo when you choose a course of action
• For example, suppose you can use some machine capacity to produce one of two
- A with a contribution margin of $50—opportunity cost $40
- B with a contribution margin of $40—opportunity cost $50
• The highest profit opportunity is always the lowest opportunity cost opportunity
- Avoidable Cost—a cost that can be avoided by taking a course of action
Concorde Effect
“Beginning in the 1960s, the French and British governments
jointly financed the development of a supersonic airplane capable
of shuttling passengers between Europe and America at breakneck
speeds. But even before the first Concorde was fully assembled,
analysts realized that the program would be a financial loser.
Despite overwhelming evidence that they would never recoup
their financial outlays, both governments persisted in pouring
billions of dollars into the project. And they continued to
subsidize the Concorde's unprofitable operation for nearly three
decades until safety issues caused its demise. “
Source: http://allsquareinc.blogspot.com/2009/02/concordeeffect.html
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Make-or-Buy: The Outsourcing Decision
- The financial focus in the make-or-buy decision is; whether the costs avoided
internally are greater than the added external costs when purchasing a product/
service from a supplier
• The make or buy decision refers to the decision organizations make about
whether to make a product (good or service) or to buy that product from a supplier
• The relevant cost analysis compares the inside costs avoided with the incremental
outside costs incurred
• Note that there are usually strategic considerations in addition to the economic
(relevant cost) analysis
- In a make or buy situation, only consider the incremental costs of the inside supplier
- If the inside supplier is at capacity, consider the incremental cost PLUS the
opportunity cost of supplying
- Internal costs that can be avoided include:
• typically all variable costs
• any avoidable fixed costs
- External costs incurred to buy:
• cost to purchase the product/service
• any transportation costs
• costs involved with dealing with a supplier; such as—ordering, receiving, and
- A Make or Buy Example:
• The$following$is$a$good$example$of$the$motivation$and$strategic$
• Overall,(Canadian(cities(with(privatized(garbage(service(have(a(
• ...governments(ought(not(to(hand(over(the(keys(to(the(city(to(any(
• Source:(http://www.cdhowe.org/pdf/opeds/Dachis_GM_Jul17.pdf
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Manufacturing Costs
- Direct Material—materials that can be traced easily to a unit of output and are of
significant economic consequence to final product
- Direct Labour—labour costs that can be traced easily to the creation of a unit of
- Manufacturing Overhead—all other costs incurred by a manufacturing facility that
are not direct material or direct labour
Equipment Replacement Decision
- The Equipment Replacement Decision refers to the decision organizations make
about whether to replace an existing piece of equipment
- The “relevant cost analysis” compares the inside costs avoided (usually production
cost savings) with the incremental cost of the new machine
- Note that there are usually strategic considerations in addition to the economic
(relevant cost) analysis
The Decision to Drop a Product
- Relevant cost analysis involves comparing the costs saved by abandoning the
product with revenues forgone
• Relevant costs to consider when dropping a product or a division:
- Incremental revenues forgone
- Incremental costs avoided
- The analysis of what costs are avoided can be very difficult to determine
• costs that are attributed to a product may only be avoidable in the intermediate or
long run
• sales of one product may affect sales of other products
- Note that there are usually strategic considerations in addition to the economic
(relevant cost) analysis
Costing Orders
- Order costing involves estimating the relevant costs associated with a unique order
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- Relevant cost analysis suggests that only costs that will change as a result of
changing from the existing product to the proposed product should be considered
- The Floor Price is the minimum price that a company would normally consider for the
Short-Term Product Mix Decisions
- Organizations often face competing demands for their limited production resources
- The relevant costs concept should be applied to these decisions
- Multiple resource constraints require the use of linear programming to solve
Chapter 3 Pt. 2—The Special Order Problem and Product Mix
The Special Order Problem
- The special order problem considers the situation where an organization receives a
one-time offer to buy a product (good or service). The assumption is that accepting or
rejecting this offer will have no future consequences other than the incremental cash
flows it creates
- For example, accepting a special order to supply a product for $40 that is sold to
existing customers for $50, may create problems with existing customers and
expectations on the part of the new customer that the special order price of $40 will
- For this reason, many people believe the assumptions underlying the special order
analysis are seldom met in practice—rarely used
- Is there sufficient idle capacity to meet this order?
• if YES, there are no opportunity costs associated with this order
• if NO, compute the opportunity cost associated with this order
- Ensure that the special order price covers incremental (variable) costs and
opportunity costs
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Decision Flow
Allocating Scarce Capacity—The Short-Run Product Mix Decision
- The relevant cost concept contributes insight into effective short-run resource
allocation by focusing on the idea that we should evaluate and compare the
incremental benefits of allocating a scarce resource to its alternative uses and making
the allocation that provides the highest incremental benefit
- This decision is often called the product mix decision because it results in choosing
the short-run product mix
- Examples in practice:
• Oil refining
• Capital rationing
• Processing logs
• Allocating Staff
• Shelf space in grocery store
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Chapter 4 Pt. 1—Accumulating and Assigning Costs to Products
Cost Flows in Organizations
- In order to compute product costs, management accounting systems should reflect
the actual cost flows in an organization
- Manufacturing, retail, and service organizations have different patterns of cost flows
resulting in different management accounting priorities
Manufacturing Organizations
- Manufacturing costs are classified into three groups:
• Direct Materials
• Direct Labour
• Manufacturing Overhead
- Materials are withdrawn from raw materials inventory as production begins
- The costs are moved from the raw materials account to the work in process account
- The manufacturing operation consumes labour and overhead items and these costs
are added to the work in process inventory
- When manufacturing is completed, the costs are transferred from work-in-process the
the finished goods account
- At this stage, the goods are finished and are ready for sale
- When the goods are sold, their costs are moved from the finished goods account
on the balance sheet to the cost of goods sold account on the net income
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Retail Organizations
- As goods are purchased, the costs are entered into an account that accumulates the
costs of merchandise inventory in the store
- Stores incur various overhead costs such as depreciation, lighting, labour, and
- Once the sale is made, the costs transfer to cost of goods sold
- The primary focus in retail operations is the profitability of product lines/departments
Service Organizations
- The major expense in service organizations is often employee pay
- In service organizations, the focus is on determining the cost of project or service
- The potential for cost system distortions is less for a service organization than for
manufacturing operation
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Cost Terms
- Cost Object—is anything for which a cost is computed
• A cost object is something for which the management accountant wishes to
estimate a cost
• Examples of cost objects are: activities, products (goods or services), product lines,
departments, divisions, or even entire organizations
Resource Costs (2 types)
- Consumable (Flexible) Resources—the cost depends on the amount of resource
that is used
• Consumed or used by up the production process
• Cost depends on how much of the resource is used
- Often called a variable cost because the total cost depends on how much of the
is consumed
- Direct material and direct labour are typically classified as variable costs
• Examples:
- Wood in furniture making
- Engines in auto-making
- Processors in laptop making
- Capacity-Related Resources—the cost depends on the amount of resource
capacity that is acquired and not how much of the capacity is used—often called a
• Supports the production process
• Cost depends on how much of the resource is acquired
• Examples:
- Supervisory labour
- Machine time
- Warehouse space
- Equipment and building depreciation
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- Direct Cost—a cost that is uniquely and unequivocally attributable to a single cost
• A direct cost is a product cost that can be uniquely and ambiguously associated
with a cost object
• Almost all variable costs are direct costs
• For example, the cost of glass to make a bottle is part of the direct cost of making
that bottle
• The cost of a warehouse that is acquired and used for the exclusive used of one
product line is a direct cost to that product line
• Some Direct Cost Issues:
• Given this definition of direct costs, it would seem that the cost of items like glue
and stain that are consumed to make the piece of furniture would also qualify as
“direct materials costs”
• However, it would be prohibitively expensive to track the amount of glue and stain
used to make each piece of furniture; so management accountants put difficult to
track materials and labour costs that tend to vary with some underlying level of
activity such as units produced into a large cost pool and called them—“Variable
Overhead Costs”
• Management accountants then allocate costs from this cost pool using some
activity measure such as—units produced, machine hours, or labour hours
- Indirect Cost—a cost that fails the test of being direct is classified as indirect
• Any cost that fails the direct cost test is treated as an indirect cost
• Most capacity-related costs are indirect
• The salary of a sales manager is an indirect cost with respect to all the products
that the sales manager handles
• The classification of a cost as direct or indirect will depend on the cost object.
- If the cost object is a product made in a multi-product factory, the factory
supervisory’s salary will be an indirect cost
- However, if the cost object is the factory itself, the factory supervisor’s salary
will be a direct cost
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Product Costs
- Both management accountants and financial accountants call their estimates of a
product’s costs a product cost. However, there are important differences
• For financial accountants, product cost includes only the cost of manufacturing or
acquiring a product
• Management accountants start with the financial accountants’ definition of
product cost and add the cost of promoting, selling, distributing, and servicing the
product in the customer’s hands if the cost can reasonably be traced to the product
Period Costs
- Period costs are costs that accountants, financial or management, do not count as
product costs
• Financial accountants treat all non manufacturing costs such as selling,
administrative, and research and development as period costs. The important
consequence of this is that only manufacturing costs are included in the inventory
costs reported in the financial statements
• Management accountants will treat any cost that they feel cannot be reasonably
traced to a product as a period cost.
- For example, a management accountant would treat advertising designed to
promote a company’s good name as a period cost but advertising designed to
promote a specific product as a product cost
Cost Classification and Context
- Cost systems first classify costs as either direct or indirect
- The classification of a resource as direct or indirect is context specific
- Direct costs are assigned to the appropriate cost object
- Indirect costs are collected into pools and then allocated to objects in a reasonable
way and should reflect a cause-and-effect relationship
- Whether a cost is treated as direct or indirect can have very important implications
in contracts where the supplier is reimbursed for cost plus a profit margin
- Contractors often argue to have what is clearly an indirect resource, such as—a piece
of general purpose equipment; treated as a direct resource to the project, so that all
the resource costs can be claimed for reimbursement
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Indirect Cost Pools
- The simplest structure in a manufacturing system is to have a single indirect cost
pool for the entire manufacturing operation
- Indirect cost pools may have separate pools for variable and fixed overhead costs
and then allocated to the cost object
- One indirect cost pool collects the actual indirect costs incurred for the period
• Indirect Cost Incurred
- A second indirect pool accumulates the indirect costs that has been applied to
production for the same period
• Indirect Cost Applied
How are Indirect Costs Applied?
- Indirect costs are applied to cost objects using a predetermined indirect cost rate
- For a single indirect cost pool costing system (also called “the Factory Wide system”)
the predetermined indirect cost rate is computed as follows:
- Where the cost driver is the activity thought to be the cause of factory indirect costs—
Examples of cost driver units are:
• Units produced
• Labour hours (in a labour paced production environment)
• Machine hours (in a machine paced production environment)
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Predetermined Overhead Rates
- Because the total indirect costs for the year are not known until after the year end,
organizations allocate indirect costs to production during the year based on
predetermined indirect cost rates
- The first step is to determine the cost driver which will be used to allocate the indirect
costs to production
- Cost analysts try to choose a cost driver that best explains the long-run behaviour of
the indirect cost
- Next, the estimated total factory indirect costs are divided by the practice capacity in
cost driver units to compute the predetermined overhead rate
- Most organizations use multiple indirect cost pools in order to more accurately cost
the resources used by the cost object
- Design of the indirect cost pools is considered to be one of the most important
choices in costing systems design and requires an understanding of the
manufacturing systems
Reconciling the Difference between Actual and Applied Indirect Costs
- The actual and applied indirect cost pools must be reconciled at year end
- There are three options available to reconcile the differences in the cost pools:
• Charge the difference directly to cost of goods sold
• Prorate the difference between work in process inventory, finished goods inventory,
and cost of goods sold based on the ending balances for these accounts
• Decompose the difference between actual and applied indirect costs based on an
analysis of the reasons for the difference between the actual and applied rates
Cost Driver Level
- There are four commonly proposed activity levels used to compute the cost driver
• Actual level of operations
- Using the actual level of operations is often called actual costing
- The actual rate is developed after completion of the period by taking the actual
costs divided by the actual level of the cost driver
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- Many management accountants reject this approach because it disguises
operating problems
• Planned level of operations
- Planned indirect costs are divided by the planned level of the cost driver
- This approach provides a practice attempt to allocate all indirect costs and
provides an appropriate basis for accurate product costing
- This approach makes no economic sense because there are problems with
capacity-related costs as the planned level of production changes and impacts
product costs
- For a company that uses cost-plus pricing, as demand decreases, the cost driver
rate will increase causing price increases which will cause a death spiral
• Average level of operations
- The average use of capacity is the likely activity rate used to justify the
acquisition of the capacity and this approach would seem to reflect the economic
basis for the level and cost of capacity
- The major problem with this approach is that it buries the cost of idle capacity
- There is no clear incentive for management to increase its use of idle capacity
- This will create a competitive advantage for a competitor that has lower idle
capacity costs
• Practical capacity level of operations
- Provides a solid basis to compute long run cost; isolates the cost of idle capacity
which is charged to the income statement instead of being included in inventory
- Using practical capacity to estimate product costs provide clear decision making
insights and incentives for relating to dealing with the cost of idle capacity
- Estimating practical capacity begins with an estimate of the theoretical capacity
available for a machine
• For most resources (machines and indirect labour); the practical capacity
measure is time
• For some resources we use an alternative—Examples:
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- For warehouse space—use floor space occupied
- For computers—use cost per unit of memory
- Next, the actual machine utilization is calculated which recognizes equipment
downtime to generate the practical capacity
- Lost capacity utilization can be caused by maintenance work, setup time,
material shortages
Product Costing Systems
The Problem with Plant-Wide Rates
- If the costs in an indirect cost pool have different cost drivers, costing distortions will
- Example—Cambridge Chemicals discussion for an illustration of cause and effects of
these distortions
Job Order Costing
- Job order costing accumulates the costs for a specific customer’s order because the
orders tend to vary from customer to customer
• Organizations use job order costing when each job is potentially different
- Examples of situations in which job order costing is used include: consulting work,
treating a patient in a hospital, visiting the dentist, manufacturing a machine tool, and
automobile repairs
- Each job is assigned a unique job order number for collecting costs
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- The company collects the actual direct material and direct labour used for a specific
- Indirect overhead costs are allocated to the job
- Once the work is completed, the collected costs are summarized
- The purpose of job order costing is to accumulate the cost of a specific job because
each job is different
• A job order costing system accumulates the costs of a job on a job cost sheet
Need for Job Order Costing
- Jobs may differ by materials content, hours of labour required, machine time required,
demand placed on capacity-related resources, special customer needs that require
customized production
- With such variety, managers need to understand the costs of individual jobs so that
they can assess product and customer profitability
Job Sheet Components
Process Costing
- Process costing is used when all products are identical such as soda drinks and
breakfast cereal
• A costing system used when all units are identical
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- The focus is on computing the costs of the individual components of total costs
- Process costing systems use two different cost terms (the usual components):
• Direct material
• Conversion costs—all manufacturing costs that are not direct material costs
- Labour
- Overhead
- Equivalent number of units are calculated for the period
- See “Process Costing Steps for further detail”
- Where Process Costing is Used:
- Bottle making, Bottling, Coins, Newsprint, Chocolate bars, Pills, etc.
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Process Costing in Practice
- The Issue—how to assign costs to partially completed units
- The solution—the concept of equivalent units of production
- Equivalent units = physical units * percentage completion
- The equivalent unit calculation is done for each component of product cost
Process Costing Steps
1. Identify the physical flow
- For completed units, the number of equivalent units will equal the number of physical
2. Compute the equivalent units of production
- Partially completed units (units in work in process) are converted into equivalent
completed units based on the level of completed work
• Generally, 100% of the direct material is in the work in process account
3. Compute the cost per equivalent unit of production
- The total cost of direct material is divided by the equivalent units of material
- The total conversion costs are divided by the equivalent units of conversion
4. Allocate costs
- The final step is to use the equivalent material and conversion costs to allocate
manufacturing costs to the ending inventories
Chapter 4 Pt. 2—Allocating Service Department Costs
Types of Departments (2)
- Production Departments—Departments that directly produce goods are services
- Service Departments—Departments that do not directly produce goods or services
for customers but provide support for the production departments
• Service departments include: accounting, maintenance, and administration
Approaches to Allocating Service Department Costs (3)
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- Direct Method
- Sequential Method
- Reciprocal Method
1. Direct Method
- Ignores the services provided to other service departments
- Costs for each service department direct allocated to the production departments
- The direct method is easy to implement but doesn’t recognize the support given to
other service departments
2. Sequential Method
- Also referred to as the “Step Model”
- One of the service departments is chosen to allocate its cost first
- The service costs are allocated to production departments and other service
departments based in proportion to the services provided to each department
- Once a service department’s costs have been allocated, it is dropped from
consideration and the process moves to the next service department
- The process continues until all of the service departments have allocated their costs
to the production departments
- The sequential method recognizes that a service department may support other
service departments as well as production departments
- One issue with the sequential method is that the order that the service departments’
costs are allocated makes a difference in the cost allocation
3. Reciprocal Method
- The reciprocal method is a more complicated approach
- There are two steps in the reciprocal method:
• The first step starts by, developing a reciprocal equation for each service
department—the reciprocal costs of each department are calculated, which is the
sum of its direct costs and its share of reciprocal costs of all service departments
including itself
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• In the second step, these reciprocal costs are used to allocate the service
department’s’ cost to the production departments based on usage
Midterm # 2
Chapter 5—Activity-Based Cost Systems
Traditional Manufacturing Costing Systems
- Uses actual departments or cost centres for accumulating and redistributing costs
- Asks how much of an allocation basis (usually based on volume) is used by the
production department
- Service department expenses are allocated to a production department based on the
ratio of the allocation basis used by the production department
- Typical volume-based cost drivers include:
- Direct labour hours
- Machine hours
- Direct labour dollars
- Adequate for companies with high-volume products with similar production volumes
and batch sizes
- Can lead to product cost distortion in an environment of high product variety
- Activity-based cost systems have been developed to eliminate distortion
- Time-driven activity-based costing systems (TDABC or Time-Driven ABC) estimate
two parameters and then assign indirect costs similar to the way direct costs are
TDABC—First Parameter
- Cost rate for each type of indirect resource
• Identify all costs incurred to supply the resource
• Identify the practical capacity supplied by the resource
• Determine the capacity cost rate of the resource by dividing its cost by the practical
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- Capacity Cost Rate (CPR) = Cost of capacity supplied / Practical capacity of
resources supplied
Capacity Cost Rate Example
TDABC—Second Parameter
- Estimation of how much of each resource’s capacity is used by the activities
performed to produce the products and services
Time-Driven ABC
- Use parameter estimates to assign indirect costs:
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Cost Rate for Indirect Resources
- Machines + Indirect Labour + Other(s) = Resource Cost
- Resource cost / Practical Capacity = Resource Rate
Madison Ice Cream Company
- Characteristics:
• Product proliferation
• Each product requires its own support costs some of which vary with production
volume and others do not
- Indirect costs (factory overhead) are allocated to products using direct labour dollars
which is a product volume measure
- Q: Why have organizations traditionally not worried about product costing?
- A: Inventory valuation does not require accurate product costs—approx. costing
systems are acceptable
- However, approx. costing systems do not serve decision makes inside the
organization very well
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- An Example:
• Three friends go to a club to watch a show; There is a $20 cover charge for each
friend that is added to the bill at each table. The table charges (food and drinks) for
each of the three friends are: $30, $35, and $45
- Allocation Based on Actual:
- Allocation Based on Volume:
- When indirect costs are mixed
• Some vary with volume
• Some (such as product support and setup costs) vary with things other than volume
• Cost distortions will occur
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- Generally;
• High volume products will be over-costed
• Low volume products will be under-costed
TDABC Profitability Report
- Example—Madison Dairy Report (Exhibit 5-5)
- The results from the time-driven ABC costing system were quite different from the
results based on the traditional cost system
• The two specialty products, which the previous cost system had reported as the
most profitable, were in fact the most unprofitable
• The company had added large quantities of overhead resources to enable these
products to be designed and produced, but their incremental revenue did not cover
those costs
- Managers may use insights from TDABC cost analysis to improve operations
- Possible actions include:
• Reduce setup times
• Reduce times required for purchasing
• Reduce time required for scheduling production orders
• Increase prices on unprofitable products
• Impose minimum customer order sizes
• Make decisions on desired product mix
Measuring The Cost of Unused Resource Capacity
- Activity cost driver rates are frequently but incorrectly calculated based on capacity
actually used; this leads to:
• rates that are too high
• the cost of unused capacity being applied to products actually produced
- Analysts can obtain a better estimate for the cost of resources required to handle
each production run by dividing activity costs by the practical capacity of work the
resources could perform
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Cost of Unused Capacity
- The cost of unused capacity should not be assigned to products produced or
customers served during a period
- The cost of unused capacity remains someone’s or some department’s responsibility
- Usually you can assign the cost of unused capacity after analyzing the decision that
authorized the level of capacity supplied
- Such as assignment is done on a lump-sum basis; it will not be assigned to individual
units of product
- If the unused capacity relates to a particular product line then the cost of unused
capacity is assigned to that product line, where the dead failed to materialize
- In making assignment of unused capacity costs, trace the costs at the level in the
organization where decisions are made that affect the supply of capacity resources
and the demand for those resources
- The lump-sum assignment of unused capacity costs provides feedback to managers
on their supply and demand decisions
Fixed and Variable Costs
- Most indirect expenses assigned by an ABC system are committed costs
- Committed costs become variable via a two-step procedure:
• Demands for resources change either because of changes in the quantity of
activities performed or because of changes in the efficiency of performing activities
• Managers make decisions to change the supply of committed resources to meet
the new level of demand for the activities performed by these resources
Activity in Excess of Capacity
- If quantity of demands for a resource exceeds its capacity, the result is bottlenecks,
pressure to work faster, delays, or poor-quality work
- Shortages can occur on machines and/or human resources
- Facing such shortages, companies typically increase committed costs, which is why
many indirect costs increase over time
Friday, September 21, 2018
Decreased Demand for Resources
- Demands for indirect and support resources also can decline
- Even for many unit-level resources, reduced demands for work does not immediately
lead to spending decreases
- The reduced demand for organizational resources lowers the cost of resources used,
but this decrease is offset by an equivalent increase in the cost of unused capacity
Making Committed Costs Variable
- After unused capacity has been created, committed costs will vary downward only if
managers actively reduce the supply of unused resources
- A resource cost varies downward if management acts:
• To reduce the demands for the resource
• To lower the spending on it
Managers Make Costs Fixed
- Organizations often create unused capacity through activity-based management
- They keep existing resources in place, when demands for the activities performed by
the resources have diminished
- They also fail to find new activities that could be done by the unused resources
already in place
- The organization receives no benefits from activity-based management decisions that
reduce demands on their resources if capacity is not reduced or redeployed
- Failure to capture benefits from activity-based management is not because their costs
are “fixed”
- The cost of these resources is only “fixed” if managers do not exploit the opportunities
from the unused capacity they helped to create
- Making decisions based solely upon resource usage may not increase profits if
managers are not prepared to reduce spending to align resource supply with future
lower levels of demand
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Updating the ABC Model
- Managers may easily update their time-driven ABC model to reflect changes in their
operating conditions
- Managers may also easily update the capacity cost rates
• Changes in the cost of resources supplied or resources required affect the cost rate
• Shifts in the efficiency of the activities affect the unit time estimate
Time Equations
- A feature the enables the model to reflect how particular order and activity
characteristics cause processing time to vary
- Data for time equations are typically already in the company’s enterprise resource
planning system
- Allow the time-driven ABC model to accurately and simply reflect the variety and
complexity in orders, products, and customers
ABC at Service Companies
- Although ABC had its origins in manufacturing companies, many service
organizations today are obtaining great benefits from this approach
• In practice, the actual construction of an ABC model is nearly identical for both
types of companies
• This should not be surprising since, in manufacturing companies, the ABC system
focuses on the “service” component of the company
- Although ABC had its origins in manufacturing companies, many service
organizations today are obtaining great benefits from this approach
• In practice, the actual construction of an ABC model is nearly identical for both
types of companies
• This should not be surprising since, in manufacturing companies, the ABC system
focuses on the “service” component of the company
- Service companies in general are ideal candidates for activity-based costing
• Virtually all costs are indirect and appear to be fixed
Friday, September 21, 2018
• They often do not have direct, traceable costs to serve as convenient allocation
• They must supply virtually all their resources in advance to provide the capacity to
perform work for customers during each period
Implementation Issues
- Not all ABC systems have been sustained or contributed to higher profitability for the
- Issues include:
• Lack of clear business purpose
• Lack of senior management commitment
• Delegating the project to consultants
• Poor ABC model design
• Individual and organizational resistance to change
• People feel threatened
Historical Origins of Activity-Based Costing
Appendix 5-1
- Time-driven ABC is a contemporary version of the original ABC method introduced in
the 1980s
- The original version used a two-stage estimation approach
Two-Stage Estimation Approach
- First Stage
• Interview and survey employees to identify principle activities and estimate
percentage of time spent on activities
• Use percentages to assign costs to activities
- Second Stage
• Assign activity costs to products based on estimates of the quantity of each activity
used in the production of the product
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Limitations of Original ABC
- Problems may arise in practice from the approach to ABC that assigns many resource
expenses to activities based on interviews, surveys, and direct observation of
production and support processes because these activities are time-consuming
and expensive
- Inaccuracies and bias may affect the accuracy of cost driver rates derived from
individuals’ subjective estimates of their past or future behaviour
- Companies must periodically repeat the interviewing and surveying processes if they
want to keep their ABC systems updated
- Adding new activities to the system is also difficult, requiring re-estimates of the
relative amount of resource time and effort required by the new activity
- A more subtle and serious problem arises from the interview or survey process
• People estimating how much time they spend on a list of activities handed to them
invariably report percentages that add up to 100%
• Few individuals report that a significant percentage of their time is idle or unused
Advantages of Time-Driven ABC
- Easy and fast to build an accurate model even for large enterprises
- Exploits the detailed transactions data that are available from ERP systems
- Uses time equations that use specific characteristics of particular orders, processes,
suppliers, and customers
- Enables managers to forecast future resource demands
- Easy to update the model as resource costs and process efficiencies change
Practical Capacity Measure
- For most resources (machines and indirect labour) the practical capacity measure is
- For some resources we use an alternative; Examples:
• For warehouse space: floor space occupied
• For computers: cost per unit of memory
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Madison Ice Cream Company Cont’d
- Characteristics:
• Product proliferation
• Each product requires its own support costs some of which vary with production
volume and others do not
- Indirect costs (factory overhead) are allocated to products using direct labour dollars
which is a production volume measure
- Data:
- Pro Forma:
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Actions Resulting from Costing Improvements
- Re-pricing
- Promote a change in customer behaviour (for example larger orders)
- Process improvement
- Scheduling changes
Madison Dairy—Revised Plan
Madison Dairy—Revised Pro Forma
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Other Issues
- Reporting the cost of unused capacity—product cost or not?
- Time-Driven ABC are long run costs—the cost of committed capacity can only be
reduced in the long run
- Activity based budgeting—using TDABC to estimate the capacity required for different
production plans
- Discussion Example:
• In the early 1990s, Chrysler, an American car manufacturer, introduced a program
using the ABC system and claimed to have saved hundreds of millions of dollars.
Evidently, ABC showed that the actual cost of certain parts Chrysler produced was
30 times what has originally been estimated. As a result, Chrysler was convinced
by this discovery to outsource the manufacture of many of its parts. Also, the ABC
system has provided Chrysler with the simplification of product designs as well as
the elimination of unproductive or redundant activities.
Hours Cost/HR
Enid’s Fine Foods
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Hours Cost/HR
Friday, September 21, 2018
Assessing Customer Profitability
- Two Approaches:
• The Traditional Way
• Using Activity Based Costing (ABC)
Cost of/Goods/Sold
Operating Profit
Chapter 6—Measuring and Managing Customer Relationships
Customer-Related Costs
High-Cost To Serve Customers
Low-Cost To Serve Customers
Order custom products
Small order quantities
Unpredictable order arrivals
Customized delivery
Change delivery requirements
Manual processing; high order error rates
Large amounts of pre-sales support (marketing,
technical, and sales resources)
Large amounts of post-sales support
(installation, training, warranty, field service)
Pay slowly (have high accounts receivable from
Order standard products
High order quantities
Predictable order arrivals
Standard delivery
No changes in delivery requirements
Electronic processing (EDI) with zero defects
Little to no pre-sales support (standard pricing
and ordering)
No post-sales support
Pay on time (low accounts receivable)
- Vilfredo Pareto—Italian economist; developed the 80-20 rule after noting that 80% of
a region’s land was owned by 20% of the population
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- When companies rank products, they generally find that the top-selling 20% of
products generate 80% of the sales
- The 80-20 rule applies well to sales revenues but it doesn’t apply to profits
The Whale Curve
ABC Customer Analysis
- The output from an ABC customer analysis is often portrayed as a whale curve
• A plot of cumulative profitability versus the number of customers
• Customers are ranked on the horizontal axis from most profitable to least profitable
- A whale curve for cumulative profitability typically reveals:
• The most profitable 20% of customers generate about 180% of total profits
• The middle 60% of customers break-even
• The least profitable 20% of customers lose 80% of total profits, leaving the
company with 100% of total profits
Managing Customer Profitability
- High-profit customers appear in the left section of the profitability whale curve
Friday, September 21, 2018
• These customers should be protected
• They could be vulnerable to competitive inroads
• Managers should be prepared to offer discounts, incentives, and special services to
retain the loyalty of these valuable customers if a competitor threatens
Customer Costs in Service Companies
- Service companies must focus on customer costs and profitability because the
variation in demand for organizational resources is much more customer driven than
in manufacturing companies
- Customer behaviour determines the quantity of demands for organizational resources
that produce and deliver the service to customers
- Measuring revenues and costs at the customer level provides the company with far
more relevant and useful information than at the product level
Increasing Customer Profitability
- Companies have many options to increase customer profitability
• Process improvements
• Deploy menu-based pricing to allow customers to select the features and services
they are willing to pay for (ABC menu pricing)
• Enhance the customer relationship to improve margins and lower cost to serve
(Managed customer relationships)
• Use more discipline in granting discounts and allowances
Process Improvements
- A company might transform its breakeven or loss customers into profitable ones
through process improvements that lower the costs of serving customers
- Managers should analyze internal organizations to see where they can improve
- For example, if a company receives a large number of small orders, the company
• Strive to reduce costs of setup and order handling
• Encourage customers to place orders electronically
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• If most companies are migrating to smaller order sizes—companies should strive to
reduce the costs of processes such as; setup and order handling, so that customer
preferences can be accommodated without raising overall prices
• One way to be become more efficient in handling orders is to encourage customers
to access a purchasing web page and place their order over the Internal; this would
substantially lower the cost of processing large quantities of small orders
• If customers have a preference for suppliers offering high variety, manufacturing
companies can try to customize their products at the latest possible stage, as well
as use information technology to enhance the linkages from design to
manufacturing so that greater variety and customization can be offered without cost
Activity-Based Pricing
- Pricing is the most powerful tool a company can use to transform unprofitable
customers into profitable ones
- Activity-based pricing establishes a base for producing and delivering a standard
quantity for each standard product
- In addition to this base price, the company provides a menu of options, with
associated prices, for any special services requested by the customer
- Examples:
• Pricing surcharges could be imposed when designing and producing special
variants for a customers’ particular needs
• Discounts would be offered when a customer’s ordering pattern lowers the
company’s cost of supplying it
- Special services may be priced just to cover costs or also to earn a margin
- Activity-based pricing prices orders, not products
Managing Relationships
- Companies can transform unprofitable customers into profitable ones by managing
customer relationships
• Persuade them to use a greater scope of products and services
• Establish minimum order sizes
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The Motivation to Control Price
- The 1% Mindset:
• Price is the most powerful lever to improve profitability
• 1% price improvement can drive an 8% improvement in operating profit
Pricing Waterfall
- The Pricing waterfall is a visual picture showing the elements of customer profitability
- Some definitions:
• Target price is the list price
• Pocket price is the list price MINUS all customer-related discounts
• Pocket margin is the pocket price LESS all operations costs
- Before giving a customer a price increase, the company should examine the many
ways it has already reduced the effective price the customer actually pays
- Small concessions offered by different organizational units may accumulate into large
revenue leaks
- Pricing Waterfall charts list the multiple revenue leaks from the list price caused by
special allowances and discounts granted to the customer
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Price Erosion
How does it happen?
- Firms may fail to see all of the revenue leaks from list price on orders because they
record the discounts and allowances in different systems to make the revenue
deductions at different times of the year
- With discounts and allowances recorded into different accounts and at different times,
no manager sees the complete picture for individual orders and consequently no one
realizes how much revenue loss occurs with individuals orders
How to control it?
- Once firms become aware of pricing waterfalls leading into undesirably large sales
discounts, they can use their ABC systems to trace all revenue deductions, as well
promotional costs and allowances, to individual orders and customers in order to
calculate realized profit or loss by order or by customer
- Companies can periodically (i.e.—every quarter) calculate an operating income
statement for every customer
- Furthermore, companies can use the ABC information on MSDA costs to base
salesperson incentives on order and customer profits, not just sales
Salesperson Incentives
- A typical salesperson’s compensation plan sets minimum quotas and provides
incentive commissions based on sales revenue
- There may be special rewards such as vacation trips for achieving sales revenues
above a stretch goal
- These incentive plans sometimes fail to take into consideration decreases in
profitability due to special discount allowances and arrangements negotiated to close
the deal
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Life-Cycle Profitability
- Measures the expected present value of the cash flows the customer contributes to
the organization
- Treat “n” as the customer’s maximum purchasing life
- View “r” as 1 minus the churn rate (percentage of customers who end their
relationships with a company in a given year) which is a value that many
organizations trace
CLV$=$ &
(M) − c)$ ) ∗ (retention$ratet ))−1
− initial$acquisition$cost!
(1 + 7))
− $acquisition$cost!
- Companies invest considerable resources to attract new customers, which may turn
out to be unprofitable
- Customer Lifetime Value (CLV) calculates the customer’s profit each year after all
costs and the discounted cash flows are compared to the initial acquisition costs to
obtain the total value of the customer
- A company using CLV is tracking how much it spent to acquire each customer and
the profits earned
- The critical parameters for calculating Lifetime Customer Value are:
• Initial acquisition cost
• Profits or losses earned each year
• Additional costs to retain the customer
• Duration of the relationship
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Measuring Customer Performance with Non-financial Metrics
- Focusing on only financial metrics may cause a company to take actions that could
risk the company’s long-term relationship with a customer
Customer Satisfaction
- Most companies attempt to measure customer satisfaction by using surveys
- Typical survey questions address:
• Product quality
• Ease of ordering
• Responsiveness of company personnel
• Customer complaint services
Customer Loyalty
- Loyal customers are valuable for several reasons:
• Greater likelihood to repurchase
• Persuade others to become new customers
• Less likely to defect for price discounts from competitors
• Willing to pay a price premium to retain a relationship with a key supplier
• Willing to work with the supplier to improve performance and develop new products
Net Promoter Score
- Some researchers have found that there is a low correlation between customer
satisfaction and future revenue growth
- Customers often remain with their current supplier because of lack of inertia, high
switching costs, or lack of an alternative supplier
- A customer’s willingness to recommend a company is strongly correlated to future
sales growth
- Customer surveys have been expanded to ask if a customer is willing to recommend
the company
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Chapter 8—Measuring and Managing Life-Cycle Costs
Total-Life-Cycle Costing
- Total-life-cycle costing (TLCC) is the approach companies use to understand and
manage all costs incurred in:
• Research, development and engineering cycle
• Manufacturing cycle
• Post-sale service and disposal cycle
- Also known as managing costs “from the cradle to the grave”
- Each part of a company’s value chain is typically managed by a different organization
- Companies need a total-life-cycle perspective that integrates the tradeoffs and
performance over time and across functional units
Research, Development, and Engineering (RD&E) Stage
- The RD&E Stage has three substages:
• Market research
• Product design
• Product development
- By some estimates, 80% to 85% of a product’s total life costs are committed by
decisions made in the RD&E stage of a product’s life
Manufacturing Stage
- This stage offers little opportunity for engineering decisions to reduce costs since
most costs have already been determined during the RD&E stage
- Methods to help improve product costs include:
• Product and process costing
• Facilities layout
• Kaizen
• Benchmarking
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• Just-in-time manufacturing
Post-Sale Service and Disposal Stage
- The service stage begins once the first unit of a product is in the hands of the
- Disposal occurs at the end of a product’s life and lasts until the customer retires the
final unit of a product
- The costs for service and disposal are committed in the RD&E stage
The Service Stage
- The service stage typically consists of three substages:
• Rapid Growth
- From the first time the product is shipped through the growth stage of its sales
• Transition
- From the peak of sales to the peak in the service stage
• Maturity
- From the peak in the service stage to the time the last shipment is made to a
The Disposal Stage
- Disposal occurs at the end of a product’s life and lasts until the customer retires the
final unit of a product
- Disposal costs often include those associated with eliminating any harmful effects
associated with the end of a product’s useful life
- Products whose disposal could involve harmful effects to the environment, such as
nuclear waste or toxic chemicals, often incur very high costs
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Life-Cycle Costs
- The following table illustrates four types of products and the percentage of life-cycle
costs incurred in each cycle
Target Costing
- An approach that considers manufacturing costs early in the design decisions
- Helps engineers design new products that meet customers’ expectations and that can
be manufactured at a desired cost
- An important management accounting method for cost reduction during the design
stage that helps manage total-life-cycle costs
The Traditional Method
- Begins with market research into customer requirements followed by product
- Companies engage in product design and engineering obtain prices from suppliers
- After the engineers and designers have determined product design, cost is estimated
Target Costing Method
- Although the initial steps appear similar to traditional costing, there are some notable
• Marketing research is customer-driven
• Project engineers attempt to design costs out of the product before design and
development end and manufacturing begins
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• The total-life-cycle concept is used by making it a key goal to minimize the cost of
ownership of a product over its useful life
- Engineers set an allowable cost that enables the targeted product profit margin to be
achieved at a price customers are willing to pay
- The target profit margin results from a long-run profit analysis, often based on return
on sales
- The target cost is the difference between the target selling price and the target profit
• Target Cost = Target selling price - Target profit
- If the target cost is less than the as-if product cost, implement plan.
- Otherwise, (i) undertake value engineering or improve process efficiency to reduce
costs. or (ii) revise product functionality/quality choices
- Once the total target cost has been set, the company must determine target costs for
each component
- The value engineering process includes examination of each component of a product
to determine whether it is possible to reduce costs while maintaining functionality and
- Several iterations of value engineering are usually needed before the final target cost
is achieved
- Two other differences characterize the process:
• Throughout the entire process, cross-functional product teams made up of
individuals representing the entire value chain guide the process
• Suppliers pay a critical role in making target costing work
1. Cost Analysis
- Cost analysis requires five sub-activities:
1. Develop a list of product components and functions
2. Perform a functional cost breakdown
3. Determine the relative importance of customers’ requirements
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4. Relate features to functions
5. Develop a relative functional ranking(s)
2. Conduct Value Engineering
- Value engineering—organized effort directed at the various components for the
purpose of achieving these functions at the lowest overall cost without reductions in
required performance, reliability, maintainability, quality, safety, recyclability, and
- Two sub-activities
1. Identify components for cost reduction by computing a value index (ratio of the
value to the customer and the percentage of total cost devoted to each
2. Generate cost reduction and function enhancement ideas
Concepts about Target Costing
- Lack of understanding of the target costing concept
- Poor implementation of the teamwork concept
- Employee burnout
- Overly long development time
Break-Even Time (BET)
- BET measures the length of time from the project’s beginning until the product has
been introduced and generates enough profit to pay back the investment originally
made in its development
- BET brings together in a single measurement three (3) critical elements in an effective
and efficient product development process:
• BET requires tracking the entire cost of the design and development process so
that the company can recover its total investment
• BET stresses profitability and encourages cross functional teamwork to meet the
customer needs
• BET is denominated in time and encourages the launch of new products faster than
the competition so that higher sales can be earned sooner to repay the product
development investment
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Innovation Measures on the Balanced Scorecard
- Examples of financial measures:
• Target Cost
• Percentage of sales from recently launched products
• Gross margins from new products
- Examples of non-financial measures:
• Market Research and Generation of New Product Ideas
- Number of new projects launched based on customer input
- Number of new value-added service identified
• Design, Development, and Launch of New Products
- Number of patents
- Total RD&E time: from idea to market
Environmental Costing
- Environmental remediation, compliance, and management have become critical
aspects of enlightened business practice
- Environmental costing involves:
• Selecting suppliers whose philosophy and practices in dealing with the environment
match the buyers
• Disposing of waste products during the production process
• Incorporating post-sale service and disposal issues into management accounting
Controlling Environmental Costs
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- Activity-based costing can be easily applied to the measurement, management, and
reduction of environmental costs
• Identify the processes that cause environmental costs
• Assign the organizational costs associated with these processes
• Assign those costs to individual products, distribution channels, and customers
- Only when managers and employees become aware of how much the activities in
which they engage create environmental costs; will they be able to control and reduce
- Environmental costs fall into two (2) categories:
• Explicit costs
• Implicit costs
Chapter 9—Behavioural and Organizational Issues in Management
Accounting and Control Systems
Management Accounting and Control Systems (MACS)
- A major role for MACS is to motivate behaviour congruent with the desires of the
- Technical Considerations:
• Relevance of information that is accurate, timely, consistent, and flexible
• Scope must be comprehensive and include all activities across the entire value
chain of the organization
Major Behavioural Considerations
- Embedding the organization’s ethical code of conduct into MACS design
- Using a mix of short and long term qualitative and quantitative performance measures
- Empowering employees to be involved in decision making and MACS design
- Developing an appropriate incentive system to reward performance
Impact of MACS on Behaviour
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- Many managers try to implement new systems without considering the behavioural
implications and consequences of a MACS
- Negative Consequences:
• Goal congruence may not occur
• Motivation could be low
• Employees may be encouraged to engage in dysfunctional behaviour
Human Resource Model of Motivation (HRMM)
- Contemporary management view of motivation
- Based on initiatives to improve the quality of working life and the strong influence of
Japanese management practices
- Introduces a high level of employee responsibility for and participation in decisions in
the work environment
- Serves as the basis for the presentation of the four behavioural considerations in
MACS design
Central Assumptions of HRMM
- Organizations operate under a system of beliefs about the values, purpose, and
direction of their organization
- People find work enjoyable and desire to participate in:
• Developing objectives
• Making decisions
• Attaining goals in their work environment
- Individuals are motivated by both financial and non-financial means of compensation
- Employees have a great deal of knowledge and information about their jobs, the
application of which will improve the way they perform tasks and benefit the
organization as a whole
- Individuals are highly creative, ethical, and responsible
- Employee desire opportunities to effect change in their organization
Ethical Code of Conduct and MACS Design
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- A set of ethical principles is at the centre of boundary systems
- MACS should incorporate the principles of an organization’s code of ethical conduct
- MACS that incorporate ethical principles can provide decision makes with guidance
as they face ethical dilemmas
The Nature of Control
- An organization that is on track to achieving its stated objectives is said to be “in
- Otherwise the organization is said to be “out of control”.
- One of the most important roles of management is to design MACS systems to
monitor the organization and determine whether the organization is in or out of
Control Systems
- Task Control
• Used in situations involving high risk or when the environment s stable and well
• People are told exactly what to do
• Penalty if directions not followed
• Examples where appropriate
- Results Control
• Used in situations where the situation changes quickly and decision makes have
the skill and knowledge to make a good decision
• Rewards based on outcome created by the decision
• Examples where appropriate
Pressures Affecting MACS
- Managers are often subject to intense pressures from their job circumstances and
from other influential organizational members to suspend their ethical judgement in
certain situations
- These pressures include the following requests:
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• to tailor information to favour particular individuals/groups
• to falsify reports or test results
• for confidential information
• to ignore questionable or unethical practices
Incorporating Ethics into a MACS Design
- To incorporate ethical principles into the design of a MACS, designers might attempt
to ensure the following:
• That the organization has formulated, implemented, and communicated to all
employees a comprehensive code of ethics
• That all employees understand the organization’s code of ethics and the boundary
systems that constrain behaviour
• That a system exists to detect and report violations of the organization’s code of
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Avoiding Ethical Dilemmas
- Most organizations attempt to address ethical considerations and avoid ethical
dilemmas by developing a code of ethics
- Ensuring understanding the code of ethics
• The nature of boundary systems
- Systems to promote disclosure of violations of the code of ethics
- Common Ethical Issues:
• Requests to bias reports
• Requests to falsify reports
• Requests to disclose confidential information
• Pressures to ignore unethical practices
- Ethical considerations listed in descending order of authority:
• Legal rules
• Societal norms
• Professional memberships
• Organizational/group norms
• Personal norms
Ethical Hierarchy
- An action that is prohibited by law should be unacceptable by society, by one’s
profession, by the organization, and the by each individual
- An action that is legally and socially acceptable may be professionally unacceptable
and unacceptable to the organization and it’s employees
Dealing with Ethical Conflicts
- Organizations that formulate and support specific and unambiguous ethical codes
create an environment that reduces ethical conflicts
- One step is to maintain a hierarchy of authority
Role of Senior Management
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- A critical variable that can reduce ethical conflicts is the way that the chief executive
and other senior managers behave and conduct business
- If these individuals demonstrate exemplary behaviour, other organizational members
will have role models to emulate
- Organizations whose leaders evince unethical behaviour cannot expect their
employees to behave according to high ethical standards
How Accounting Related Ethical Issues Arise
- HealthSouth video
- Things to listen for
• Aggressive behaviour became fraud
• Peer pressure “everyone is doing is”
• We will do this only once
• Behaviour is corrosive—the slippery slop
• Rationalizing “it was not money in my pocket”
Conflict Between Individual and Organizational Values
- If the organization’s code of ethics is more stringent that na individual’s code, conflicts
may arise
- If adherence to the organization’s ethical code is required and enforced, the individual
is asked and expected to pursue a more stringent code of ethics
- Issues may arise when the individual’s personal code of ethics prohibits certain types
of behaviour that are legal, socially acceptable, professionally acceptable, and
acceptable to the organization
- Potential for conflict in such situations is heightened when the action that is
unacceptable to the organization is desirable
- The organization may require that the person do things that he/she finds
Conflict with Stated Values
- Employees may observe management, even senior management, engaging in
unethical behaviour
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- This type of conflict is the most difficult because the organization is misrepresenting
its ethical system
- The employee is in a position of drawing attention to the problem by being a whistleblower
- Experts who have studied this problem advice that the individual should determine:
• That the facts are correct and that a conflict exists between the organization’s
stated ethical policy and the actions of its employees in practice
• Whether this conflict is institutional or reflects the decisions/actions of only a small
minority of employees
- Most experts recommend that the employee work with respected leaders in the
organization to change the discrepancy between practiced and stated ethics
- Other potential courses of action include:
• Point out the discrepancy to a superior and refuse to act unethically
• Point out the discrepancy to a superior and act unethically
• Take the discrepancy to a mediator in the organization, if one exists
• Work with respected leaders in the organization to change the discrepancy
- Go outside the organization to publicly resolve the issue
- Go outside the organization anonymously to resolve the issue
- Resign and go public to resolve the issue
- Resign and remain silent
- Do nothing, hoping that the problem vanishes
- If the organization is serious about its stated code of ethics, it should have an
effective ethics control system to ensure and provide evidence that the organization’s
stated and practiced ethics are the same, including a means for employees to point
out inconsistencies and to protect those employees
Effective Ethical Control
- To promote ethical decision making, an ethical control system should include the
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• A statement of the organization’s values and code of ethics written in practical
terms, with examples that the employees can relate to their individual jobs
• A clear statement of the employee’s ethical responsibilities for every job description
and a specific review of the employee’s ethical performance as part of every
performance review
• Adequate training to help employees identify ethical dilemmas in practice and learn
how to deal with those they can reasonably expect to face
- Evidence that senior management expects members to adhere to its code of ethics,
meaning that management must:
• Provide a statement of the consequences of violating the organization’s code of
• Establish a means of dealing with violations of the organization’s code of ethics
promptly, ruthlessly, and consistently according to the statement of consequences
• Provide visible support of ethical decision making at every opportunity
• Provide a private line of communication (without retribution) from employees
directly to the chief executive officer, chief operating officer, head of human
resource management, or someone else on the board of directors
- Evidence that employees can make ethical decisions or report violations of the
organizations stated ethics (be the whistle-blower) without fear of reprisals from
superiors, subordinates, or peers
- An ongoing internal audit of the efficacy of the organization’s ethical control
- Formal training is part of the process of promoting ethical decision making
- In addition to fostering ethical behaviour, a central issue in MACS design is how to
motivate appropriate behaviour at work
- When designing jobs and specific tasks. system designers should consider the
following three (3) dimensions of motivation:
• Direction
• Intensity
• Persistence
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- The idea is to align the interests of the individual with those of the organization
- As individuals pursue their own goals inside the organization they should contributing
to achieving the organization’s goals
- One way of doing this is a well-designed incentive compensation system
Goal Congruence
- Goal congruence—the organization and its employees align their respective goals
- The alignment of goals occurs as employees:
• Perform their jobs well and are helping to achieve organizational objectives, and
• Are attaining their individual goals at the same time
Diagnostic Control Systems
- Even if goals are aligned, different types of tasks require different levels of skill,
precision, responsibility, initiative, and uncertainty
- In most situations, managers try to establish systems that they do not have to
personally monitor on a regular basis
- These are called diagnostic control systems
Interactive Control Systems
- If there is a large degree of strategic uncertainty, managers spend much more time
monitoring the decisions and actions of their subordinates
- These are called interactive control systems
- At the core of both systems are two common methods of control:
• 1. Task control
- Task control is the process of finding ways to control behaviour, so that a job is
completed in a pre-specified manner
- Task control can be broken down into two categories:
• 1. preventative control
- Ex—Separation of duties
• 2. monitoring/detective control
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- Ex—CCTV cameras
- Task control is most appropriate when:
• There are legal requirements to follow specific rules or procedures to protect
public safety
• Employees handle liquid or other precious assets
• The organization can control its environment and eliminate uncertainty and the
need for judgement
• 2. Results control
- Results control methods focus on measuring employee performance against
stated objectives
- The organization must have clearly defined objectives, communicated them to
appropriate organization members, and designed performance measures
consistent with the objectives
- Ex—Quality Inspection
- Results control is most effective when:
• Organizational members understand the organization’s objectives and their
contribution to those objectives
• Organization members have the knowledge and skill to respond to changing
situations by taking corrective actions and making sound decisions
• The performance measurement system is designed to assess individual
contributions so that an individual can be motivated to take acton and make
decisions that reflect their own and the organization’s best interest
Need for Multiple Measures of Performance
- The ways in which organizations measure performance send signals to all employees
and stakeholders about what the organization considers as its priorities
- Using multiple measures of performance helps employees focus on several
dimensions of their jobs rather than just keying in one dimension
- Should focus on both short term and long term objectives
- Should cover all aspects of the person’s job
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Dysfunctional Behaviour
- Occasionally employees are so motivated to achieve a single goal that they engage in
dysfunctional behaviour:
• Gaming the performance indicator
• Data falsification
• Smoothing (a form of earning management)
Using the BSC to Align Employees to Goals
- MACS designers need to expand their views of the kinds of performance measures to
- Need for measures of quality, speed to market, cycle time, flexibility, complexity,
innovation, and productivity
- New realities—the movement from “tall” organizations to “flat” organizations
Change Management
- Research has shown that the single most important factor in making major changes
to an organization is having management support
- Employees often resist change because they feel threatened by:
• Potential loss of jobs
• Being reassigned to a new job
• Increases in amount of work or responsibility
• Changes in workplace environment
• Changes in compensation
Empowering Employees to be Involved in MACS Design
- Empowering employees in MACS design requires two (2) essential elements:
• Allowing employees to participate in decision making
• Ensuring that employees understand the information they are using and generating
Participation in Decision Making
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- Research has suggested that employees who participate in decision-making feel
greater morale and job satisfaction
- In most industries, people still perform the majority of work and have superior
information and understanding
- MACS designers should enlist the participation of employees
- Authoritative budgeting
• Superior advises the subordinate what the budget will be
- Participative budgeting
• The budget is a result of joint decision making between the superior and
- Consultative budgeting
• The superior asks for the subordinate’s input but the decision making is not joint
Education to Understand Information
- Empowering employees requires ensuring that they understand the information they
use and on which they are evaluated
- Employees at all levels must understand the organization’s performance measures
and the way they are computed in order to be able to take actions that lead to
superior performance
- Employees have to be constantly re-educated as the system and its performance
measures change
Incentive Systems
- Types of reward systems to motivate employees:
• 1. Intrinsic rewards
- Self-provided by individuals
- Come from within an individual and reflect:
• Satisfaction from doing the job
• Growth opportunities the job provides
• The nature of the organization and type of work performed
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- The challenge is to design jobs and develop a culture that lead employees to
derive intrinsic rewards just by working
- Not affected by management accounting information (MAI)
- Examples:
• Satisfaction for a job well done
• Satisfaction provided by the scope of the job
• Satisfaction provided by the opportunity for advancement
• 2. Extrinsic rewards
- Any reward that one person provides another to recognize a job well done
• Based on assessed performance
• Reinforce the notion that employees have distinguished themselves within the
- Extrinsic rewards may reinforce the perception that wages compensate the
employee for a minimally acceptable effort and that the organization must use
additional rewards to motivate the employee to provide additional effort
- Provided by the organization to the employee
- Examples:
• Cash bonus
• Stock options
• Public recognition
• Organizations use many systems of financial rewards
- Intrinsic vs. Extrinsic Rewards
• Many compensation experts believe that organization have not made enough use
of intrinsic rewards
• Some argue that people who expect to receive a reward for completing a task
successfully do not perform as well as those who expect no reward
• Most organizations ignore the role of intrinsic rewards in motivation and blindly
accept that view that only financial extrinsic rewards motivate employees
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- Many people believe that financial extrinsic rewards are both necessary and
sufficient to motivate superior performance
• Both systematic and anecdotal evidence suggests:
- Financial extrinsic rewards are not necessary to create effective organizations
- Performance rewards do not necessarily create them
• Some argue that any incentive compensation program is unacceptable
- They suggest that organizations must strive to be excellent to survive in a
competitive world
- Superior and committed performance is necessary for all employees and is part
of the contract of employment and does not merit additional pay
• Many organizations rely on extrinsic monetary rewards to motivate performance
- Theories of motivation:
• Expectancy theory
• Agency theory
• Goal-setting theory
Incentive Compensation
- Incentive compensation reward systems provide monetary (extrinsic) rewards based
on measured results
• Pay-for-performance systems
• Base rewards on achieving or exceeding some measured performance
- Require performance measurement systems that gather relevant and reliable
performance information
- Based on absolute performance, performance relative to some plan, or performance
relative to that of some comparable group
Absolute Performance
- Measures of absolute performance include:
• The number of acceptable quality units produced
• The organization’s results
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• The organization’s share price performance
Relative Performance
- Rewards based on relative performance are those tied to the following:
• The ability to exceed a performance target level
• The amount of a bonus pool
• The degree to which performance exceeds the average performance level of a
comparable group
Effective Reward Systems
- An effective reward system motivates an employee to act in the organization’s best
- If the reward system is based on extrinsic rewards the employee must
• Understand clearly what is rewarded
• Have the authority to affect what is rewarded
• Value what is rewarded
Effective Performance Measurement
- Six attributes must be in place for a measurement system to motivate desired
• Employees must understand their jobs and the rewards system and believe that it
measures what they control and contribute to the organization
• Designers of the performance measurement system must make a careful choice
about whether it measures employees’ inputs or outputs
• The elements of performance that the performance measurement system monitors
and rewards should reflect the organization’s critical success factors
• The reward system must set clear standards for performance that employees
• The measurement system must be calibrated so that it can accurately assess
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• When it is critical that employees coordinate decision making and other activities
with other employees, the reward system should reward group performance rather
than individual performance
Conditions Favouring Incentive Compensation
- Incentive compensation systems work best in organizations in which employees have
the skill and authority to react to conditions and make decisions
- When the organization has empowered its employees to make decisions, it can use
inventive compensation systems to motivate appropriate decision-making behaviour
Incentive Compensation and Employee Responsibility
- The incentive compensation system must focus primarily on outcomes that the
employee controls or influences
- Employee’s incentive compensation should reflect the nature of their responsibilities
in the organization
- A mix of rewarding both short-term and long-term outcomes is consistent wit the goals
of the Balanced Scorecard approach
Rewarding Outcomes
- Incentive compensation schemes tie rewards to the outputs of employee performance
rather than to inputs—such as; level of effort
- Incentive compensation based on outcomes requires that the organization members
understand and contribute to the organization’s objectives
The Elements of a Reward Structure
Action —> Measured Outcome —> Reward
Input-Based Compensation
- Rewards may be based on inputs when:
• It is impossible to measure outcomes consistently
• Outcomes are affected by factors beyond the employee’s control
• Outcomes are expensive to measure
- Input-based compensation measures the employee’s time, knowledge, and skill level
- Many organizations use some form of knowledge-based remuneration
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Managing Incentive Plans
- Considerable evidence indicates that organizations have mismanaged incentive
compensation plans, particularly those for senior executives
- Experts debate whether compensation systems motivate goal-seeking behaviour and
whether they are efficient
- Some studies show a position correlation between executive compensation and
shareholder wealth
- Other studies report finding no, or even a negative, correlation between organization
performance and executive compensation
- Many professionals argue that the amounts are excessive and reflect high status
rather than performance
- The issue of fairness has also surfaced
Types of Incentive Plans
- Most common incentive compensations plans:
• Cash bonuses
- A cash bonus plan pays cash based on some measured performance
- Cash bonuses can be:
• Fixed in amount (triggered when measured performance exceeds the target) or
proportional to the level of performance relative to the target
• Based on individual or group performance
• Paid to individuals or groups
• Profit sharing
- A cash bonus calculated as a percentage of an organization unit’s reported profit
- A group incentive compensation plan focused on short-term performance
- All profit-sharing plans define:
• What portion of the organization’s reported profits is available for sharing
• The sharing formula
• The employees who are eligible to participate in the plan
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• The formula for each employee’s share
• Gain sharing
- Gain sharing is a system for distributing cash bonuses from a pool when the total
amount available is a function of performance relative to some target
- Gain sharing is a group incentive that usually:
• Provides for the sharing of financial gains in organizational performance
• Applies to a group of employees within an organization unit, such as a
department or a store
- Gain sharing promotes teamwork and participation in decision making
• Stock options
- A stock option is the right to purchase a unit of the organization’s stock at a
specified price—called the option price
- A common approach to option pricing is to set the option price at about 105% of
the stock’s market price at the time the organization issues the stock option
• Performance shares stock
• Stock appreciation rights
• Participation units
• Employee stock ownership plans
• Other stock-Related Plans
- Organizations use many other forms of stock-related incentive compensation
- These plans provide incentive compensation to the participants when the stock
price increases
- They are designed to motivate employees to act in the long-term interests of the
organization by acting so as to increase its market (stock) value
- Types of group compensation plans:
• Those that rely on internal measures
• Those that rely on performance of the organizations share price in the stock market
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- Management accountants get involved in the first group
One Model—Expectancy Theory
- Expectancy theory argues that people are motivated to pursue a result if they believe
• There is a predictable relationship between their decisions and measured
performance—this is called expectancy in expectancy theory
• There is predictable relationship between measured performance and rewards—
this is called instrumentality in expectancy theory
• Favourable measured performance will result in a valued reward—this is called
valence in expectancy theory
Vroom’s Expectancy Theory
- Motivational force = expectancy * instrumentality * valence