Chapter One Introduction McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

Decision Making - Product Management Examples Add new product Terminate an existing product line Accept or reject special order Related Topics Operations management Budgeting - capital and operating Just-in-time (JIT)

Decision Making - Pricing Examples Set selling price to achieve desired profits Set selling price to achieve positive cash flow Related Topics Marketing Microeconomics - Price Theory Corporate Finance

Decision Making - Cost Control Examples Add new equipment Change production process Make internally versus buy externally (outsource) Related Topics Process engineering Management information systems Activity-based costing (ABC)

Control - Incentives Assumptions Incentives Individuals maximize their own self-interest Owners of firm want to maximize firm value Maximizing firm profits maximizes firm value Incentives Design performance incentives based on internal accounting measures to motivate employees to take actions that will maximize firm value

Control - Performance Evaluation Examples Performance bonuses depend on accounting results Benchmarking: comparisons to industry leaders Related Topics Organizational behavior Human resources management

Design - Multiple Roles of Accounting Study Figure 1-1. Main point: Accounting reports are used for multiple purposes.

Design - External Reports Users of external reports Shareholders, bondholders, banks, and analysts (SEC, FASB) Taxing authorities (IRS, states, etc.) Regulatory authorities (GASB, etc.) Board of directors Objectives in external reporting Comparability between firms Historical accounting Auditors can verify reports

Design - Internal Reports Users of internal reports Managers at all levels Objectives of internal reporting Useful for decision making about future activities Measure performance that is relevant to the firm Focus on projects or processes within a firm

Design - Conflicting Goals Control Incentives to motivate behavior changes Tendency to ignore information not specifically included in incentive system Report “good” numbers to satisfy top management Decision making Want to avoid distorted information Estimates useful to plan future activities

Design - Evolution Economic Darwinism: Over the long term systems survive in competitive markets when the benefits exceed or equal the costs of maintaining those systems. Survival does not imply optimality. Better systems may exist, but have not yet been discovered.

Design - Figure 1-2 Study Figure 1-2. Main Point: In a typical corporation, the corporate controller is responsible for all internal and external accounting reports. There are also controllers in the operating divisions.

Design - Organizational Structure Controller Reports to chief financial officer (CFO) Administers internal and external accounting Budget planning Controls financial data collection and reporting Growing role as internal consultants or business analysts to the point of being viewed as business partners Balance providing information to other managers for decision making against providing monitoring information used to control behavior of lower-level managers.

Evolution of Management Accounting: A Framework for Change Business Environment Business Strategy Organizational Architecture Decision-Right Assignment Performance Evaluation Reward System Incentives and Actions Firm Value

Example - Vortec Special Order With no overtime and congestion Current With Order Incremental Units produced and sold Total Revenue and Costs 100,000 102,000 2,000 Sales ($5.00 regular, $4.00 special) $ 500,000 $508,000 8,000 Cost of sales ($4.50, $4.47) 450,000 455.940 Administrative expenses - 27,500 27,500 Net profit before taxes $ 22,500 $ 24,560 $ 2,060 Incremental revenue (2,000 units x $4.00) $8,000 Total cost @ 102,000 units (102,000 x $4.47) $455,940 Total cost @ 100,000 units (100,000 x $4.50) 450.000 Incremental cost of 2,000 units -5,940 Incremental profit of 2,000 units $2,060

Example - Vortec Special Order With overtime and congestion Current With Order Incremental Units produced and sold Total Revenue and Costs 100,000 102,000 2,000 Sales ($5.00 regular, $4.00 special) $ 500,000 $508,000 8,000 Cost of sales ($4.50, $4.08 on additional 2,000) 450,000 458,160 -8,160 Administrative expenses - 27,500 27,500 Net profit before taxes $ 22,500 $ 22,340 $ -160 Incremental revenue (2,000 units x $4.00) $8,000 Total cost @ 102,000 units (102,000 x $4.50) plus (2,000 x $4.08) $458,160 Total cost @ 100,000 units (100,000 x $4.50) 450.000 Incremental cost of 2,000 units -8,160 Incremental profit of 2,000 units -160

Example - Beware of Average Costs Average cost per unit at current production volume is usually not an accurate estimate of the cost per unit at other levels of production. Average costs include: fixed costs that do not change with volume variable costs per unit that can change with volume Cost per unit may increase when production volume is near or above normal operating capacity.

Example - Consider Opportunity Costs Opportunity costs measure what the firm forgoes when it chooses a specific action Consider what a firm forgoes by accepting a special order

Example - Supplement Accounting Data Supplement historical cost accounting data with other knowledge Could include: expected customer demands competitors’ plans future technology government regulation

Example - Accounting Data for Evaluation When managers have incentives to maximize performance on one particular accounting measure, firm profits are not necessarily maximized. Reducing average manufacturing costs per unit does not always maximize profit Maximizing total revenue does not always maximize profit