The Theory of Constraints (TOC)
A constraint .s anyth.ng that prevents you
from getting more of what you want. Every individual and every organ,zat.on faces at
Sone constraint, so it is not difficult to find examples of cons ramts. You may not have
enough time to study thoroughly for every subject and to go out with your friends on the
weekend, so time is your constraint. United A,rimes has only a limited number of loadin. gates available at its busy Chicago O'Hare hub, so its constraint is loading gates. Vail
Resorts has only a limited amount of land to develop as homes,tes and commercial lots at
its ski areas, so its constraint is land.
The Theory of Constraints (TOC) is based on the insight that effectively manag­
ing the constraint is a key to success. As an example, long waiting periods for surgery
are a chronic problem in the National Health Service (NHS), the government-funded
provider of health care in the United Kingdom. The diagram in Exhibit 1-7 illustrates
a simplified version of the steps followed by a surgery patient. The numbei of patients
who can be processed through each step in a day is indicated in the exhibit, hoi example,
appointments for outpatient visits can be made for as many as 100 referrals from general
practitioners in a day.
The constraint, or bottleneck, in the system is determined by the step that has the
smallest capacity—in this case surgery. The total number of patients processed through
the entire system cannot exceed 15 per day—the maximum number of patients who can
be treated in surgery. No matter how hard managers, doctors, and nurses try to improve
the processing rate elsewhere in the system, they will never succeed in driving down
wait lists until the capacity of surgery is increased. In fact, improvements elsewhere in
the system—particularly before the constraint—are likely to result in even longer wait­
ing times and more frustrated patients and health care providers. Thus, to be effective,
improvement efforts must be focused on the constraint. A business process, such as the
process for serving surgery patients, is like a chain. If you want to increase the strength of
a chain, what is the most effective way to do this? Should you concentrate your efforts on
strengthening the strongest link, all the links, or the weakest link? Clearly, focusing your
effort on the weakest link will bring the biggest benefit.
The procedure to follow to strengthen the chain is clear. First, identify the weakest
link, which is the constraint. In the case of the NHS, the constraint is surgery. Sec­
ond, do not place a greater strain on the system than the weakest link can handle—if
you do, the chain will break. In the case of the NHS, more referrals than surgery can
accommodate lead to unacceptably long waiting lists. Third, concentrate improvement
efforts on strengthening the weakest link. In the case of the NHS, this means finding
ways to increase the number of surgeries that can be performed in a day. Fourth, if the
improvement efforts are successful, eventually the weakest link will improve to the
point where it is no longer the weakest link. At that point, the new weakest link (i.e.,
the new constraint) must be identified, and improvement efforts must be shifted over
to that link. This simple sequential process provides a powerful strategy for optimizing
business processes.
EXHIBIT 1 - 7
Measurement Skills
When you become a manager you'll need to complement your understanding of strategy,
risks, and business processes, with data-driven analysis. If you cannot use measurement
skills to provide competent, data-driven answers to challenging questions, then you'll
struggle to persuade others to endorse your point-of-view.
The key to being an effective data analyst is to understand that the question you are
trying to answer defines what you'll measure and how you'll analyze it. For example,
if the question you wish to answer is what net income should my company report to its
stockholders, then you'll be measuring and reporting historical financial data that must
comply with applicable rules. If you are trying to determine how well your company
is serving its customers, then you'll be measuring and analyzing mostly nonfinancial,
process-oriented data. If you want to predict whether your company will need to borrow
money next year, then your measurement efforts will focus on estimating future cash
flows. You have to understand the question first before you can begin measuring and
analyzing data.
The primary purpose of this course is to teach you measurement skills that managers
use every day to answer the questions described in Exhibit 1-8. Notice that this exhibit
is organized by the chapters contained in this book. For example, Chapter 8 teaches you
the measurement skills that managers use to answer the question: How should I create
a financial plan for next year? Chapters 9 and 10 teach you the measurement skills that
managers use to answer the question: How well am I performing relative to my plan?
Chapter 7 teaches you measurement skills related to product, service, and customer prof­
itability. Exhibit 1-8 emphasizes that every chapter in this book teaches you measure­
ment and data analysis skills that you'll use throughout your career to plan, control, and
make decisions.
EXHIBIT 1 - 8
Chapter Number
Chapter 2
Chapters 3 & 4
Chapter 5
100 patients
per day
100 patients
per day
50 patients
per day
150 patients
per day
'This diagram originally appeared in the February 1999
15 patients
per day
60 patients
per day
140 patients
per day
issue of the U.K. magazine Health Management.
What cost classifications do I use for different management
What is the value of our ending inventory and cost of goods
sold for external reporting purposes?
How will my profits change if I change my selling price, sales
volume, or costs?
Chapter 6
How should the income statement be presented?
Chapter 7
How profitable is each of our products, services, and
customers?
Chapter 8
How should I create a financial plan for next year?
Chapters 9 & 10
How well am I performing relative to my plan?
Chapter 11
What performance measures should we monitor to ensure that
we achieve our strategic goals?
Chapter 12
How do I quantify the profit impact of pursuing one course
of action versus another?
Chapter 13
How do I make long-term capital investment decisions?
Chapter 14
What cash inflows and outflows explain the change in our
cash balance?
Chapter 15
How is our company performing through the eyes of our
shareholders, short-term creditors, and long-term creditors?
Add to
Outpatient
visit
The Key Question from a Manager's Perspective
purposes?
Processing Surgery Patients at an NHS Facility (simplified)*
General
practitioner referral
13
Managerial Accounting: An Overview
Chapter 1
12
Measurement Skills:
A Manager's Perspective
14
Managerial Accounting: An Overview
Chapter 1
heart—"caveat emptor" [buyer beware] remains an important truth—but a basic
confidence in the promises and commitments that people make about their prod­
Leadership Skills
I eadership skills will be critical to your career development lor the simple reason that
organizations are managed by people, not data and spreadsheets. These people have their
own personal interests, insecurities, beliefs, and data-supported conclusions that ensure
unanimous support for a given course of action is the exception rather than the rule.
Therefore, managers must possess strong leadership skills if they wish to channel their
co-workers' efforts toward achieving organizational goals.
To become an effective leader, you'll need to develop six skills. First, you 11 need
to be technically competent within your area of expertise and knowledgeable of your
company's operations outside your functional area of expertise. You cannot lead others
(particularly those co-workers outside of your department) if they believe that you are
technically incompetent or unfamiliar with how the company actually operates. Second,
you must be a person of high integrity. This requires that you not only make ethically
grounded decisions yourself, but also that your words and actions help build a culture of
organizational integrity. We will have more to say about the importance ot ethics shortly.
Third, you need to understand how to effectively implement organizational change. Peo­
ple tend to prefer the status quo, so it is often difficult to implement any type of change
in a company. To implement change, leaders need to define a vision for the future and be
able to motivate and enable others to achieve the vision.
Fourth, leaders need strong communication skills. This includes compelling presen­
tation skills and effective listening skills. They must be able to speak in operational terms
and financial terms to communicate effectively with co-workers across the organization.
Fifth, leaders must be capable of motivating and mentoring other individuals. As your
career evolves, if you cannot advance the skills of your subordinates, then you will not be
promoted to jobs that have increasing numbers of people reporting to you. Finally, lead­
ers need to effectively manage team-based decision processes. This requires motivating
the team to objectively synthesize data, weigh alternatives, and build consensus around
the chosen course of action.
ucts and services.2
Thus, for the good of everyone—including profit-making companies—it is vitally
important that business be conducted within an ethical framework that builds and
sustains trust.
The Institute of Management Accountants (IMA) of the United States has adopted an
ethical code called the Statement of Ethical Professional Practice that describes in some
detail the ethical responsibilities of management accountants. Even though the stan­
dards were specifically developed for management accountants, they have much broader
application.
Code of Conduct for Management Accountants
The IMA's Statement of Ethical Professional Practice consists of two parts that are pre­
sented in full in Exhibit 1-9 (page 16). The first part provides general guidelines for ethi­
cal behavior. In a nutshell, a management accountant has ethical responsibilities in four
broad areas: first, to maintain a high level of professional competence; second, to treat
sensitive matters with confidentiality; third, to maintain personal integrity; and fourth,
to disclose information in a credible fashion. The second part of the standards specifies
what should be done if an individual finds evidence of ethical misconduct. We recom­
mend that you stop at this point and read all of Exhibit 1-9.
The ethical standards provide sound, practical advice for management accountants
and managers. Most of the rules in the ethical standards are motivated by a very practical
consideration—if these rules were not generally followed in business, then the economy
and all of us would suffer. Consider the following specific examples of the consequences
of not abiding by the standards:
•
deteriorate.
Suppose employees accepted bribes from suppliers. Then contracts would tend to go
to suppliers who pay the highest bribes rather than to the most competent suppliers.
Would you like to fly in aircraft whose wings were made by the subcontractor who
paid the highest bribe? Would you fly as often? What would happen to the airline
industry if its safety record deteriorated due to shoddy workmanship on contracted
| The Importance of Ethics in Business
At the turn of this century, a series of major financial scandals involving Enron, Tyc
International, HealthSouth, Adelphia Communications, WorldCom, Global Crossing
Rite Aid, and other companies raised deep concerns about ethics in business. The mar
agers and companies involved in these scandals suffered mightily—from huge fines t
Ja tefms and financial collapse. And the recognition that ethical behavior is absolutel
essentia or t e unctioning of our economy led to numerous regulatory changes—som
o w ic we wi
iscuss ini a later appendix on corporate governance. But why is ethics
•
lnhHrant th ™J'0rtantJ ^'s's not a fatter of just being "nice." Ethical behavior is th
ec°nomy rur>ning. Without that lubricant, the economy woul
onerate much
loweranTnricSk ^-T '688 W0Uld be aVailable t0 counters, quality would b
rity of businesses the 6 '§ " In °ther words' with°ut fundamental trust in the integ
summed „p ,1,1, p„iM
°Perate ™ch less ^ J«"*s Sur0™ecl
'™st in the reliability an
rip-off or that the
If you assumed every potential deal was
ons,dter br* — probably going to be lem
le,el of
ansactlons-
transactions that did take nlaee
enormous work ,o
mV
°re
M
lmPortant> the costs of th
J™'"
10
Suppose employees could not be trusted with confidential infoimation. Then top man­
agers would be reluctant to distribute such information within the company and, as
a result, decisions would be based on incomplete information and operations would
parts and assemblies?
Suppose the presidents of companies routinely lied in their annual reports and finan­
cial statements. If investors could not rely on the basic integrity of a company's
financial statements, they would have little basis for making informed decisions.
Suspecting the worst, rational investors would pay less for securities issued by com­
panies and may not be willing to invest at all. As a consequence, companies would
have less money for productive investments—leading to slower economic growth,
fewer goods and services, and higher prices.
As these examples suggest, if ethical standards were not generally adhered to, everyone
would suffer—businesses as well as consumers. Essentially, abandoning ethical stan­
dards would lead to a lower standard of living with lower-quality goods and services, less
to choose from, and higher prices. In short, following ethical rules such as those in the
Statement of Ethical Professional Practice is absolutely essential for the smooth function­
ing of an advanced market economy.
"
Ti
of legal action to enforce every conmct""/
'°
°" ""
economy t0 Pr0SPer' what
needed is not a Pollyannaish faith thlt
that everyone else has your best interests
James Surowiecki, "A Virtuous Cycle," Forbes, December 23, 2002, pp. 248-256. Reprinted by Permission of Forbes Magazine © 2006 Forbes Inc.
2
Managerial Accounting: An Overview
EXHIBIT 1-9
IMA Statement of Ethical Professional Practice
• II «
)n othiral nrofessional practice includes: overarching principles that
Members of IMA shall behave ethically. A commitment to ethical professional p
express our values, and standards that guide our conduct.
TOYOTA ENCOUNTERS MAJOR PROBLEMS
When Toyota Motor Corporation failed to meet its profit targets, the company set an aggres­
PRINCIPLES
sive goal of reducing the cost of its auto parts by 30%. The quality and safety of the company's
IMAs overarching ethical principles include: Honest,, Fairness,
accordance with these principles and shall encourage others within their organizations to adhere to
^
automobiles eventually suffered mightily resulting in recalls, litigation, incentive campaigns, and
marketing efforts that analysts estimate will cost the company more than $5 billion. The car
maker's president, Akio Toyoda, blamed his company's massive quality lapses on an excessive
STANDARDS
focus on profits and market share. Similarly, Jim Press, Toyota's former top U.S. executive, said
the problems were caused by "financially-oriented pirates who didn't have the character to main­
A member's failure to comply with the following standards may result in disciplinary action.
tain a customer-first focus."
I. COMPETENCE
Sources: Yoshio Takahashi, "Toyota Accelerates Its Cost-Cutting Efforts," The Wall Street Journal, December 23,
Each member has a responsibility to:
1. Maintain an appropriate level of professional expertise by continually developing knowledge and skills.
2. Perform professional duties in accordance with relevant laws, regulations, and
technical standards.
3. Provide decision support information and recommendations that are accurate, clear, concise, and timely.
4. Recognize and communicate professional limitations or other constraints that
would preclude responsible judgment or successful performance of an activity.
2009, p. B4; Mariko Sanchanta and Yoshio Takahashi, "Toyota's Recall May Top $5 Billion," The Wall Street
Journal, March 10, 2010, p. B2; and Norihiko Shirouzu, "Toyoda Rues Excessive Profit Focus," The Wall
Street Journal, March 2, 2010, p. B3.
II. CONFIDENTIALITY
i
Each member has a responsibility to:
1. Keep information confidential except when disclosure is authorized or legally required.
2. Inform all relevant parties regarding appropriate use of confidential information. Monitor subordinates' activities to
ensure compliance.
3. Refrain from using confidential information for unethical or illegal advantage.
III. INTEGRITY
Each member has a responsibility to:
1.
Mitigate actual conflicts of interest. Regularly communicate with business associates to avoid apparent conflicts of
interest. Advise all parties of any potential conflicts.
2. Refrain from engaging in any conduct that would prejudice carrying out duties ethically.
3. Abstain from engaging in or supporting any activity that might discredit the profession.
IV. CREDIBILITY
1.
2
-
Communicate information fairly and objectively
b e
•
»
—
•
«
*
,imeliness'p,ocessin9' °r in,8rnai c°n,r°is in
wi,h
RESOLUTION OF ETHICAL CONFLICT
'n aPplyin?the Standards of Ethical Professional Practice, you may encounter
ymg unetdlcal behavior or resolving an ethical conflict. When faced
with Pthin'?
ith ethical issues, you should follow your organization's established nniieiae
tr,
res°lution of such conflict. If
these policies do not resolve the ethical conflict, you should consSerthS
follow
n
1. Discuss the issue with your immediate supervisor excent whenlt
' 9 courses of action:
the supervisor is involved. In that
case, present the issue to the next level. If you cannot achieve J
atlsfactory resolution, submit the issue to the
next management level. If your immediate suoerior i<? the nh- t
reviewing authority may be a group such as the audit committPeT11^^ °ff'Cer °r eguivalent'the acceptable
'Ve committee, board of directors, board of
trustees, or owners. Contact with levels above the immediate rc,,'fX
r,or should be initiated only with your superior's
knowledge, assuming he or she is not involved Commi ini^af
employed or engaged by the organization i not consEri°f SUCh pr°blems to authorities or individuals not
ton of the law.
n ,s not considered appropriate, unless you believe there is a clear viola3 CoSf^
'MA EthiCS C°UnSel0r
3- Consult your own attorney as to legal obligations and rights^c^^rning the ethical conflict.
16
0r 0ther
Corporate Social Responsibility
Companies are responsible for producing financial results that satisfy stockholders. How­
ever, they also have a corporate social responsibility to serve other stakeholders such
as customers, employees, suppliers, communities, and environmental and human rights
advocates—whose interests are tied to the company's performance. Corporate social
responsibility (CSR) is a concept whereby organizations consider the needs of all stake­
holders when making decisions. CSR extends beyond legal compliance to include volun­
tary actions that satisfy stakeholder expectations. Numerous companies, such as Procter &
Gamble, 3M, Eli Lilly and Company, Starbucks, Microsoft, Genentech, Johnson & John­
son, Baxter International, Abbott Laboratories, KPMG, National City Bank, Deloitte,
Southwest Airlines, and Caterpillar, prominently describe their corporate social perfor­
mance on their websites.
Exhibit 1-10 presents examples of corporate social responsibilities that are of
interest to six stakeholder groups. Many companies are paying increasing attention to
these types of broadly defined responsibilities for four reasons. First, socially respon­
sible investors control more than $2.3 trillion of investment capital. Companies that
want access to this capital must excel in terms of their social performance. Second,
a growing number of employees want to work for a company that recognizes and
responds to its social responsibilities. If companies hope to recruit and retain these
highly skilled employees, then they must offer fulfilling careers that serve the needs
of broadly defined stakeholders. Third, many customers seek to purchase products
and services from socially responsible companies. The Internet enables these cus­
tomers to readily locate competing products, thereby making it even easier to avoid
doing business with undesirable companies. Fourth, nongovernment organizations
(NGOs) and activists are more capaMe than ever of tarnishing a company's repu­
tation by publicizing its environmental or human rights missteps. The Internet has
enabled these environmental and human rights advocacy groups to better organize
their resources, spread negative information, and take coordinated actions against
offending companies.3
The insights from this paragraph and many of the examples in Exhibit 1-10 were drawn from Ronald
W. Clement, "The Lessons from Stakeholder Theory for U.S. Business Leaders," Business Horizons,
May/June 2005, pp. 255-264; and Terry Leap and Misty L. Loughry, "The Stakeholder-Friendly Firm."
3
Business Horizons, March/April 2004, pp. 27-32.
17
Managerial Accounting: An Overview
Chapter 1
18
EXHIBIT 1 - 1 0
Companies should provide customers
Examples of Corporate Social
with:
Responsibilities
•
are fairly priced.
•
Competent, courteous, and rapid
delivery of products and services.
•
Full disclosure of product-related
•
Safe and humane working
conditions.
•
Nondiscriminatory treatment
and the right to organize and
file grievances.
Fair compensation.
Opportunities for training, promo­
•
•
risks.
•
Summary []
Companies and their suppliers
should provide employees with:
Safe, high-quality products that
Easy-to-use information systems
This chapter defined managerial accounting, explained why it is relevant to business and account­
ing majors, and described various skills that managers need to do their jobs. It also discussed the
importance of ethics in business and corporate social responsibility. The most important goal of
this chapter was to help you understand that managerial accounting matters to your future career,
regardless of your major. Accounting is the language of business and you'll need to speak this lan­
guage to communicate effectively with and influence fellow managers.
tion, and personal development.
for shopping and tracking
orders.
Glossary []
Companies should provide
communities with:
Companies should provide suppliers
with:
Budget A detailed plan for the future that is usually expressed in formal quantitative terms.
Fair contract terms and prompt
payments.
Reasonable time to prepare orders.
•
Payment of fair taxes.
•
•
Hassle-free acceptance of timely
and complete deliveries.
•
•
Cooperative rather than unilateral
actions.
•
Honest information about plans
such as plant closings.
Resources that support charities,
schools, and civic activities.
Reasonable access to media
sources.
•
•
19
Companies should provide
environmental and human rights
advocates with:
• Greenhouse gas emissions data.
• Recycling and resource
conservation data.
• Child labor transparency.
• Full disclosure of suppliers located
in developing countries.
Companies should provide
stockholders with:
• Competent management.
• Easy access to complete
and accurate financial information.
• Full disclosure of enterprise risks.
• Honest answers to knowledgeable
questions.
It is important to understand that a company's social performance can impact its
financial performance. For example, if a company's poor social performance alienates
customers, then its revenues and profits will suffer. This reality explains why compa­
nies use enterprise risk management, as previously described, to meet the needs of all
stakeholders.
' process A series of steps that are followed in
• order to carry out some task. in
. a ,business.
.
Business
(p. 11)
Constraint Anything that prevents you from getting more of what you want. (p. 12)
Controlling The process of gathering feedback to ensure that a plan is being properly executed or
modified as circumstances change, (p. 3)
Corporate social responsibility A concept whereby organizations consider the needs of all stake­
holders when making decisions, (p. 17)
Decision making Selecting a course of action from competing alternatives, (p. 3)
Enterprise risk management A process used by a company to identify its risks and develop
responses to them that enable it to be reasonably assured of meeting its goals, (p. 9)
Financial accounting The phase of accounting that is concerned with reporting historical finan­
cial information to external parties, such as stockholders, creditors, and regulators, (p. 2)
Lean Production A management approach that organizes resources such as people and machines
around the flow of business processes and that only produces units in response to customer
(P 3)
orders, (p. 11)
Managerial accounting The phase of accounting that is concerned with providing information to
managers for use within the organization, (p. 2)
Performance report A report that compares budgeted data to actual data to highlight instances of
excellent and unsatisfactory performance, (p. 4)
Planning The process of establishing goals and specifying how to achieve them. (p. 3)
Segment A part or activity of an organization about which managers would like cost, revenue, or
profit data. (p. 3)
Strategy A company's "game plan" for attracting customers by distinguishing itself from
competitors, (p. 8)
Theory of Constraints A management approach that emphasizes the importance of managing
constraints, (p. 12)
Value chain The major business functions that add value to a company's products and services,
such as research and development, product design, manufacturing, marketing, distribution,
and customer service, (p. 11)
IN BUSINESS
SKILL-BASED VOLUNTEERISM GROWS IN POPULARITY
inBuenos a Tp s nr, B'h its logistics
4
fPUb''C
"t
accounting firm'
Race for the Curp pvp^t wh
P coordinate tbe Susan
nizations? A survey of 1 800
with comnanips that P '
k,
ZnteeTsm as an emn vp °
apply their skills in diverse
regular jobs.
one
'
PUbliShing COmPanV-
UPS
P3id °ne °
G- Komen Breast Cancer Foundation's annua
g S 13-25 revealed that
T'^8
t0
Questions
of its managers to spend 12 week;
emP|oyees to work for other orga
1-1
1-2
79% intend to seek employmen
^Underscoring the value of skill-basec
1-3
busings contents make'Th t0°''
Furthermore' enabling emP|o7ees tC
ntakes them more effective when they return to thei
Source: Sarah E. Needleman "The Latpst nttiro d i
29, 2008, pp. D1 and D5.
Paid
T,aCCOmtin8 SerViC6S t0 3 Sma"
GettlnS Paid to
Volunteer," The Wall Street Journal, Apr
1_4
1_5
1_6
1-7
How does managerial accounting differ from financial accounting?
Pick any major television network and describe some planning and control activities that
its managers would engage in.
If you had to decide whether to continue making a component part or to begin buying
the part from an overseas supplier, what quantitative and qualitative factors would influ­
ence your decision?
Why do companies prepare budgets?
Why is managerial accounting relevant to business majors and their future careers?
Why is managerial accounting relevant to accounting majors and their future careers?
Pick any large company and describe its strategy using the framework in the chapter.
20
Managerial Accounting: An Overview
Chapter 1
, ^nnntinh need to understand their company's strategy?
1-8
three risks lhat u faces and how u responds t0 those
1-9
1-10
1-11
1-12
Provide three examples of how a company's risks can influence its planning, controlling,
nnH decision-making activities.
Pfck any large company and explain three ways that it could segment its companywtde
ToStTTewebsite of any company that publishes a corporate social responsibility report
1-13
(also referred to as a sustainability report). Describe three nonftnanctal performance mea­
sures included in the report. Why do you think the company publishes this report?
Why do companies that implement Lean Production tend to have minimal inventories?
1_14
Why are leadership skills important to managers?
1-15
Why is ethics important to business?
Multiple-choice questions are provided on the text website at www.mhhe.com/gaiTisonl4e.
| Appendix 1A: Corporate Governance
Effective corporate governance enhances stockholders confidence that a com­
pany is being run in their best interests rather than in the interests of top managers.
Corporate governance is the system by which a company is directed and controlled. If
properly implemented, the corporate governance system should provide incentives
for the board of directors and top management to pursue objectives that are in the
interests of the company's owners and it should provide for effective monitoring of
performance.1
Unfortunately, history has repeatedly shown that unscrupulous top managers,
if unchecked, can exploit their power to defraud stockholders. This unpleasant real­
ity became all too clear in 2001 when the fall of Enron kicked off a wave of corporate
scandals. These scandals were characterized by financial reporting fraud and misuse of
corporate funds at the very highest levels—including CEOs and CFOs. While this was
disturbing in itself, it also indicated that the institutions intended to prevent such abuses
weren't working, thus raising fundamental questions about the adequacy of the existing
corporate governance system. In an attempt to respond to these concerns, the U.S. Con­
gress passed the most important reform of corporate governance in many decades—The
Sarbanes-Oxley Act of2002.
The Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 was intended to protect the interests of those wh
invest in publicly traded companies by improving the reliability and accuracy of corpc
SslmkiT2
rePOrtS and disclosures' We would like t0
highlight six key aspects of th
First, the Act requires that both the CEO and CFO certify in writing that their coir
nnprnLn'!anC1tl!tatemtI!tSand accomPanying disclosures fairly represent the results c
are false Th ^
f°
P
SS'
£
dme
a
or
CFO certifies results that they kno1
financial'statemTf
^ P°Werful incenhves for the CEO and CFO to ensure that th
financial statements contain no misrepresentations.
provide additional^ eStabds,lecl tde Public Company Accounting Oversight Board t
provide additional oversight over the audit profession. The Act authorizes the Boa.
Corpome^ovemance^^Hshed bTtheOrc35
2
A summary of tbe
&°m
^ 2°°4 rep°rt
titled
°ECD WmdpkS'
J?•*<- ^-Operation and Development
fied Public Accountants (A1CPA) website h»
,
obtained from the American Institute of Cerl
http://thecaq.aicpa.org/Resources/Sarbanes+Oxley.
to conduct investigations, to take disciplinary actions against audit firms, and to enact
various standards and rules concerning the preparation of audit reports.
Third, the Act places the power to hire, compensate, and terminate the public
accounting firm that audits a company's financial reports in the hands of the audit com­
mittee of the board of directors. Previously, management often had the power to hire and
fire its auditors. Furthermore, the Act specifies that all members of the audit committee
must be independent, meaning that they do not have an affiliation with the company they
are overseeing, nor do they receive any consulting or advisory compensation from the
company.
Fourth, the Act places important restrictions on audit firms. Historically, public
accounting firms earned a large part of their profits by providing consulting services to
the companies that they audited. This provided the appearance of a lack of independence
because a client that was dissatisfied with an auditor's stance on an accounting issue
might threaten to stop using the auditor as a consultant. To avoid this possible conflict
of interests, the Act prohibits a public accounting firm from providing a wide variety of
nonauditing services to an audit client.
Fifth, the Act requires that a company's annual report contain an internal control
report. Internal controls are put in place by management to provide assurance to inves­
tors that financial disclosures are reliable. The report must state that it is management s
responsibility to establish and maintain adequate internal controls and it must contain an
assessment by management of the effectiveness of its internal control structure. The internal
control report is accompanied by an opinion from the company's audit firm as to whether
management has maintained effective internal control over its financial reporting process.
Finally, the Act establishes severe penalties of as many as 20 years in prison for
altering or destroying any documents that may eventually be used in an official proceed­
ing and as many as 10 years in prison for managers who retaliate against a so-called
whistle-blower who goes outside the chain of command to report misconduct. Collec­
tively, these six aspects of the Sarbanes-Oxley Act of 2002 should help reduce the inci­
dence of fraudulent financial reporting.
Internal Control—A Closer Look
Internal control is an important concept for all managers to understand and, although
you may not be aware of it, it also plays an important role in your peisonal life. Internal
control is a process designed to provide reasonable assurance that objectives are being
achieved. For example, one objective for your personal life is to live to a ripe old age.
Unfortunately, there are risks that we all encounter that may prohibit us from achieving
this objective. For example, we may die prematurely due to a heart attack, a car accident,
or a house fire. To reduce the risk of these unfortunate events occurring, we implement
controls in our lives. We may exercise regularly and make nutritional food choices to
reduce the likelihood of a heart attack. We always wear seat belts and instruct our friends
to prohibit us from drinking alcohol and driving a vehicle to reduce the risk of a fatal car
crash. We install fire detectors in our homes to reduce the risk of a fatal fire. In short,
internal controls are an integral part of our daily lives.
A company uses internal controls to provide reasonable assurance that its financial
reports are reliable.3 Its financial statements may contain intentional or unintentional
errors for three reasons. First, the statements may erroneously exclude some transactions.
For example, the income statement may fail to include legitimate expenses. Second, the
statements may improperly include some transactions. For example, the income state­
ment may include sales revenue that was not earned during the cuirent period. Third, the
statements may include transactions that have been recorded erroneously. For example,
an expense or sales transaction may be recorded at the wrong amount.
3
Companies also use internal controls to achieve efficient and effective operations and to ensure com­
pliance with applicable laws and regulations.
22
23
Managerial Accounting: An Overview
Chapter 1
Exhibit 1 A—1 describes seven types of internal controls that compan.es use to reduce
the risk that these types of errors will occur. Each item_ m the exhibit is labeled as a
preventive control and/or a detective control. A preventive control deters undesirable
events from occurring. A detective control detects undesirable events that have already
importance of having senior leaders (including the chief executive officer, the chief finan­
cial officer, and the audit committee of the board of directors) who value the importance
of effective internal controls and are committed to creating an ethical "tone at the top' of
the organization.
occurred Requiring authorizations for certain types of transactions is a preventive con­
trol. For example, companies frequently require that a specific senior manager sign all
checks above a particular dollar amount to reduce the risk of an inappropiiate cash dis­
bursement. Reconciliations are a detective control. If you have ever compared a bank
statement to your checkbook to resolve any discrepancies, then you have performed a
type of reconciliation known as a bank reconciliation. This is a detective control because
you are seeking to identify any mistakes already made by the bank or existing mistakes
in your own records.
Segregation of duties is a preventive control that separates responsibilities for autho­
purchases, account for those purchases, and manage the inventory storeroom. Physical
safeguards prevent unauthorized employees from having access to assets such as inven­
tories and computer equipment. Performance reviews are a detective control performed
by employees in supervisory positions to ensure that actual results are reasonable when
licly traded companies by improving the reliability and accuracy of corporate financial reports
and discloures. (p. 20)
It is important to understand that internal controls cannot guarantee that objectives
will be achieved. For example, a person can regularly exercise and eat healthy foods, but
this does not guarantee that they will live to a certain age. Similarly, an effective inter­
nal control system can provide reasonable assurance that financial statement disclosures
are reliable, but it cannot offer guarantees because even a well-designed internal control
system can break down. Furthermore, two or more employees may collude to circumvent
the control system. Finally, a company's senior leaders may manipulate financial results
by intentionally overriding prescribed policies and procedures. This reality highlights the
Types of Internal Controls for
achieved, (p. 21)
Preventive control A control that deters undesirable events from occurring, (p. 22)
Sarbanes-Oxley Act of 2002 A law intended to protect the interests of those who invest in pub­
disbursements. Finally, companies use passwords (a preventive control) and access logs
(a detective control) to restrict electronic data access as appropriate.
Financial Reporting
Corporate governance The system by which a company is directed and controlled, (p. 20)
Detective control A control that detects undesirable events that have already occurred, (p. 22)
Internal control A process designed to provide reasonable assurance that objectives are being
rizing transactions, recording transactions, and maintaining custody of the related assets.
For example, the same employee should not have the ability to authorize inventory
compared to relevant benchmarks. If actual results unexpectedly deviate from expecta­
tions, then it triggers further analysis to determine the root cause of the deviation. Com­
panies maintain records to provide evidence that supports each transaction. For example,
companies use serially numbered checks so that they can readily track all of their cash
EXHIBIT 1A - 1
Glossary
Type of Control
Classification
Description
Authorizations
Preventive
Reconciliations
Requiring management to formally
approve certain types of transactions.
Detective
Segregation of
duties
Relating data sets to one another to
identify and resolve discrepancies.
Preventive
Physical
safeguards
Preventive
Performance
reviews
Detective
Maintaining
records
Detective
Information
systems security
Preventive/Detective
Separating responsibilities related to
authorizing transactions, recording
transactions, and maintaining custody
of the related assets.
Using cameras, locks, and physical
barriers to protect assets.
Comparing actual performance to
various benchmarks to identify
unexpected results.
Maintaining written and/or electronic
evidence to support transactions.
Using controls such as passwords
and access logs to ensure appropriate
data restrictions.
Questions
1A-1
1A-2
1A-3
Imagine that you are the head coach of a college sports team. One of your most impor­
tant objectives is to win as many games as possible. Describe some controls that you
would implement to help achieve the objective of winning as many games as possible.
Perhaps your most important post-graduation objective is to get a job. Describe some
control activities that you would pursue to help achieve this objective.
Describe some controls that parents use to keep their homes safe for themselves and their
children.
25
Managerial Accounting and Cost Concepts
T
his chapter explains that in managerial accounting the term cost
Managerial Accounting
and Cost Concepts
Understanding Costs Aids the Growth of a
Billion Dollar Company
LEARNING OBJECTIVES
After studying Chapter 2, you
should be able to:
L01
Identify and give examples
of each of the three basic
manufacturing cost categories.
L02
Distinguish between product
costs and period costs and give
examples of each.
L03
Understand cost behavior
patterns including variable costs
fixed costs, and mixed costs.
L04
Analyze a mixed cost using a
scattergraph plot and the highlow method.
L05
Prepare income statements
In 1986, Women's World of Fitness went bank­
rupt despite having 14 locations and 50,000
members. The company's owner, Gary Heavin,
says the fitness centers contained too many
costly amenities such as swimming pools, tan­
ning beds, cardio machines, kid's programs,
juice bars, personal trainers, and aerobics
classes. As costs escalated, he attempted to
increase revenues by offering memberships
to men, which alienated his female members.
What did Heavin learn from his experience?
In 1992, Heavin founded a new brand
of women's fitness centers called Curves. Rather than investing in every conceivable
piece of fitness equipment and amenity, Heavin focused on simplicity. He created a
simple fitness circuit that uses minimal equipment and is quick and easy for members
to complete. Instead of operating almost 24 hours a day, he decided to close his gyms
early. Even showers were deemed unnecessary. In short, Heavin eliminated numerous
costs that did not provide benefits in the eyes of his customers. With dramatically
lower costs, he has been able to maintain his "women only" approach while building a
billion dollar company with nearly 10,000 locations worldwide. •
for a merchandising company
using the traditional and
contribution formats.
L06
Understand the differences
L07
Understand cost classifications
used in making decisions:
differential costs, opportunity
costs, and sunk costs.
L08
(Appendix 2A) Analyze a mixed
between direct and indirect costs
cost using a scattergraph
plot and the least-squares
regression method.
L09
LO10
(Appendix 2B) Identify the four
types of quality costs and
explain how they interact.
(Appendix 2B) Prepare and
interpret a quality cost report.
24
pp UH™ ^'e'n *"e"ner' ^ary Keavin Is on a Mission from God," Inc. magazine, October 2006,
is used in many different ways. The reason is that there are many types of costs,
and these costs are classified differently according to the immediate needs of
management. For example, managers may want cost data to prepare external
financial reports, to prepare planning budgets, or to make decisions. Each different use
of cost data demands a different classification and definition of costs. For example, the
preparation of external financial reports requires the use of historical cost data, whereas
decision making may require predictions about future costs. This notion of different costs
for different purposes is a critically important aspect of managerial accounting.
General Cost Classifications
We will start our discussion of cost concepts by focusing on manufacturing companies,
because they are involved in most of the activities found in other types of organizations.
Manufacturing companies such as Texas Instruments, Ford, and DuPont are involved in
acquiring raw materials, producing finished goods, marketing, distributing, billing, and
almost every other business activity. Therefore, an understanding of costs in a manufac­
turing company can be very helpful in understanding costs in other types of organizations.
Manufacturing Costs
Most manufacturing companies separate manufacturing costs into three broad categories:
direct materials, direct labor, and manufacturing overhead. A discussion of each of these
categories follows.
Direct Materials
The materials that go into the final product are called raw materi­
als. This term is somewhat misleading because it seems to imply unprocessed natural
resources like wood pulp or iron ore. Actually, raw materials refer to any materials that
are used in the final product; and the finished product of one company can become the
raw materials of another company. For example, the plastics produced by Du Pont are a
raw material used by Hewlett-Packard in its personal computers.
Raw materials may include both direct and indirect materials. Direct materials are
those materials that become an integral part of the finished product and whose costs can
be conveniently traced to the finished product. This would include, for example, the seats
that Airbus purchases from subcontractors to install in its commercial aircraft and the tiny
electric motor Panasonic uses in its DVD players.
Sometimes it isn't worth the effort to trace the costs of relatively insignificant materi­
als to end products. Such minor items would include the solder used to make electrical
connections in a Sony TV or the glue used to assemble an Ethan Allen chair. Materials
such as solder and glue are called indirect materials and are included as part of manu­
facturing overhead, which is discussed later in this section.
Direct Labor
Direct labor consists of labor costs that can be easily (i.e.. physi­
cally and conveniently) traced to individual units of product. Direct labor is sometimes
called touch labor because direct labor workers typically touch the product while it is
being made. Examples of direct labor include assembly-line workers at Toyota, carpen­
ters at the home builder KB Home, and electricians who install equipment on aircraft
at Bombardier Learjet.
Labor costs that cannot be physically traced to particular products, or that can be
traced only at great cost and inconvenience, are termed indirect labor. Just like indi­
rect materials, indirect labor is treated as part of manufacturing overhead. Indirect labor
includes the labor costs of janitors, supervisors, materials handlers, and night security
LEARNING OBJECTIVE 1
Identify and give examples
of each of the three basic
manufacturing cost categories.
Managerial Accounting and Cost Concepts
Chapter 2
26
IN BUSINESS
Product Costs versus Period Costs
,S SENDING JOBS
Angeles, eliminating shipping delays.
In addition to classifying costs as manufacturing or nonmanufacturing costs, there are
other ways to look at costs. For instance, they can also be classified as either product
costs or period costs. To understand the difference between product costs and period
costs, we must first discuss the matching principle from financial accounting.
Generally, costs are recognized as expenses on the income statement in the period
that benefits from the cost. For example, if a company pays for liability insurance in
advance for two years, the entire amount is not considered an expense of the year in
which the payment is made. Instead, one-half of the cost would be recognized as an
expense each year. The reason is that both years—not just the first year—benefit from the
insurance payment. The unexpensed portion of the insurance payment is carried on the
balance sheet as an asset called prepaid insurance.
The matching principle is based on the accrual concept that costs incurred to gener­
ate a particular revenue should be recognized as expenses in the same period that the
revenue is recognized. This means that if a cost is incurred to acquire or make something
that will eventually be sold, then the cost should be recognized as an expense only when
the sale takes place—that is, when the benefit occurs. Such costs are called product costs.
Source: Robert Sternfels and Ronald Ritter, "When Offshoring Doesn't Make Sense," The Wall Street Journal,
October 19, 2004, p. B8.
Product Costs
Mary companies send |
cost countries such atil
savings always the right thing to
Bu iss ores, g ^ ^ ^ ^ ^^ ^ ^
coL'™dssoldn Because direct labor is such a small part of overall costs, the labor savings realzed b "offshoring" jobs can easily be overshadowed by a decline ,n efficiency that occurs simply
beca se production facilities are located farther from the ultimate customers. The increase ,n inven­
tory carrying costs and obsolescence costs coupled with slower response to customer orders,
not to mention foreign currency exchange risks, can more than offset the benefits of employing
geographically dispersed low-cost labor.
One manufacturer of casual wear in Los Angeles, California, understands the value of keeping
jobs close to home in order to improve performance. The company can fill orders for as many as
160,000 units in 24 hours. In fact, the company carries less than 30 days' inventory and is consid­
ering fabricating clothing only after orders are received from customers rather than attempting to
forecast what items will sell and making them in advance. How would they do this? The company's
entire manufacturing process—including weaving, dyeing, and sewing—is located in downtown Los
or impossible to accurately trace their costs to specific units of product. Hence, such
labor costs are treated as indirect labor.
Manufacturing Overhead Manufacturing overhead, the third element of manu­
facturing cost, includes all manufacturing costs except direct materials and direct labor.
Manufacturing overhead includes items such as indirect materials; indirect labor; main­
tenance and repairs on production equipment; and heat and light, property taxes, depre­
ciation, and insurance on manufacturing facilities. A company also incurs costs for heat
and light, property taxes, insurance, depreciation, and so forth, associated with its selling
and administrative functions, but these costs are not included as part of manufacturing
overhead. Only those costs associated with operating the factory are included in manu­
facturing overhead.
Various names are used for manufacturing overhead, such as indirect manufacturing
cost, factory overhead, and factory burden. All of these terms are synonyms for manufac­
turing overhead.
Nonmanufacturing Costs
Nonmanufacturing costs are often divided into two categories: (1) selling costs and
2) administrative costs. Selling costs include all costs that are incurred to secure cusomer orders and get the finished product to the customer. These costs are sometimes
inp^Jnni^ ^ett\n^
anc*
warehouses^'
an organization3™^
costs include execuhv
whole.
For financial accounting purposes, product costs include all costs involved in acquiring
or making a product. In the case of manufactured goods, these costs consist of direct
materials, direct labor, and manufacturing overhead. Product costs "attach" to units of
product as the goods are purchased or manufactured, and they remain attached as the
goods go into inventory awaiting sale. Product costs are initially assigned to an inven­
tory account on the balance sheet. When the goods are sold, the costs are released from
inventory as expenses (typically called cost of goods sold) and matched against sales
revenue. Because product costs are initially assigned to inventories, they are also known
as inventoriable costs.
We want to emphasize that product costs are not necessarily treated as expenses in
the period in which they are incurred. Rather, as explained above, they are treated as
expenses in the period in which the related products are sold.
Period Costs
Period costs are all the costs that are not product costs. All selling and administrative
expenses are treated as period costs. For example, sales commissions, advertising, exec­
utive salaries, public relations, and the rental costs of administrative offices are all period
costs. Period costs are not included as part of the cost of either purchased or manufac­
tured goods; instead, period costs are expensed on the income statement in the period in
which they are incurred using the usual rules of accrual accounting. Keep in mind that
the period in which a cost is incurred is not necessarily the period in which cash changes
hands. For example, as discussed earlier, the costs of liability insurance are spread across
the periods that benefit from the insurance—regardless of the period in which the insur­
ance premium is paid.
°rder-fiMng costs. Examples of selling costs include advertiscomm^ss^ons' sa^es
inC'U de a11 costs
|
salaries, and costs of finished goods
associated with the general management of
manufacturing or selling. Examples of administrative
rrting<secretanai pubiic relations;
overall, general administration of the organization as a
(SG&A^'costs^or ju^seHing8anTadndni^rative'^^ Se^*ng'
costs.
general< and administratiV6
Prime Cost and Conversion Cost
Two more cost categories are often used in discussions of manufacturing costs —prime
cost and conversion cost. Prime cost is the sum of direct materials cost and direct labor
cost. Conversion cost is the sum of direct labor cost and manufacturing overhead cost.
The term conversion cost is used to describe direct labor and manufacturing overhead
because these costs are incurred to convert materials into the finished product.
Exhibit 2-1 contains a summary of the cost terms that we have introduced so far.
LEARNING OBJECTIVE 2
Distinguish between product
costs and period costs and
give examples of each.