Accounting Essay Paper

Accounting Essay Paper


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Managerial accounting is an activity that provides financial and nonfinancial information to an organization’s managers and other internal decision makers. This section explains the purpose of managerial accounting (also called management accounting) and compares it with financial accounting. The main purpose of the financial accounting system is to prepare general-purpose financial statements. That information is incomplete for internal decision makers who manage organizations.

Purpose of Managerial Accounting

C1 Explain the purpose and nature of, and the role of ethics in, managerial accounting.

The purpose of both managerial accounting and financial accounting is providing useful information to decision makers. They do this by collecting, managing, and reporting information in demand by their users. Both areas of accounting also share the common practice of reporting monetary information, although managerial accounting usually includes the reporting of more nonmonetary information. They even report some of the same information. For instance, a company’s financial statements contain information useful for both its managers (insiders) and other persons interested in the company (outsiders).

Point: Nonfinancial information, also called nonmonetary information, includes customer and employee satisfaction data, the percentage of on-time deliveries, and product defect rates.

The remainder of this book looks carefully at managerial accounting information, how to gather it, and how managers use it. We consider the concepts and procedures used to determine the costs of products and services as well as topics such as budgeting, break-even analysis, product costing, profit planning, and cost analysis. Information about the costs of products and services is important for many decisions that managers make. These decisions include predicting the future costs of a product or service. Predicted costs are used in product pricing, profitability analysis, and in deciding whether to make or buy a product or component. More generally, much of managerial accounting involves gathering information about costs for planning and control decisions.

Point: Costs are important to managers because they impact both the financial position and profitability of a business. Managerial accounting assists in analysis, planning, and control of costs.

Planning is the process of setting goals and making plans to achieve them. Companies formulate long-term strategic plans that usually span a 5- to 10-year horizon and then refine them with medium-term and short-term plans. Strategic plans usually set a firm’s long-term direction by developing a road map based on opportunities such as new products, new markets, and capital investments. A strategic plan’s goals and objectives are broadly defined given its long-term orientation. Medium- and short-term plans are more operational in nature. They translate the strategic plan into actions. These plans are more concrete and consist of better defined objectives and goals. A short-term plan often covers a one-year period that, when translated in monetary terms, is known as a budget.

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Control is the process of monitoring planning decisions and evaluating an organization’s activities and employees. It includes the measurement and evaluation of actions, processes, and outcomes. Feedback provided by the control function allows managers to revise their plans. Measurement of actions and processes also allows managers to take corrective actions to avoid undesirable outcomes. For example, managers periodically compare actual results with planned results. Exhibit 14.1 portrays the important management functions of planning and control.


Planning and Control (including monitoring and feedback)

Managers use information to plan and control business activities. In later chapters, we explain how managers also use this information to direct and improve business operations.

Nature of Managerial Accounting

Managerial accounting has its own special characteristics. To understand these characteristics, we compare managerial accounting to financial accounting; they differ in at least seven important ways. These differences are summarized in Exhibit 14.2. This section discusses each of these characteristics.


Key Differences between Managerial Accounting and Financial Accounting

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Users and Decision Makers Companies accumulate, process, and report financial accounting and managerial accounting information for different groups of decision makers. Financial accounting information is provided primarily to external users including investors, creditors, analysts, and regulators. External users rarely have a major role in managing a company’s daily activities. Managerial accounting information is provided primarily to internal users who are responsible for making and implementing decisions about a company’s business activities.

Point: It is desirable to accumulate certain information for management reports in a database separate from financial accounting records.

Purpose of Information Investors, creditors, and other external users of financial accounting information must often decide whether to invest in or lend to a company. If they have already done so, they must decide whether to continue owning the company or carrying the loan. Internal decision makers must plan a company’s future. They seek to take advantage of opportunities or to overcome obstacles. They also try to control activities and ensure their effective and efficient implementation. Managerial accounting information helps these internal users make both planning and control decisions.

Flexibility of Practice External users compare companies by using financial reports and need protection against false or misleading information. Accordingly, financial accounting relies on accepted principles that are enforced through an extensive set of rules and guidelines, or GAAP. Internal users need managerial accounting information for planning and controlling their company’s activities rather than for external comparisons. They require different types of information depending on the activity. This makes standardizing managerial accounting systems across companies difficult. Instead, managerial accounting systems are flexible. The design of a company’s managerial accounting system depends largely on the nature of the business and the arrangement of its internal operations. Managers can decide for themselves what information they want and how they want it reported. Even within a single company, different managers often design their own systems to meet their special needs. The important question a manager must ask is whether the information being collected and reported is useful for planning, decision making, and control purposes.

Point: The Institute of Management Accountants issues statements that govern the practice of managerial accounting. Accountants who pass a qualifying exam are awarded the CMA.

Timeliness of Information Formal financial statements reporting past transactions and events are not immediately available to outside parties. Independent certified public accountants often must audit a company’s financial statements before it provides them to external users. Thus, because audits often take several weeks to complete, financial reports to outsiders usually are not available until well after the period-end. However, managers can quickly obtain managerial accounting information. External auditors need not review it. Estimates and projections are acceptable. To get information quickly, managers often accept less precision in reports. As an example, an early internal report to management prepared right after the year-end could report net income for the year between $4.2 and $4.8 million. An audited income statement could later show net income for the year at $4.6 million. The internal report is not precise, but its information can be more useful because it is available earlier.

Point: Financial statements are usually issued several weeks after the period-end. GAAP requires the reporting of important events that occur while the statements are being prepared. These events are called subsequent events.

Point: Independent auditors test the integrity of managerial accounting records when they are used in preparing financial statements.

Internal auditing plays an important role in managerial accounting. Internal auditors evaluate the flow of information not only inside but also outside the company. Managers are responsible for preventing and detecting fraudulent activities in their companies.

Time Dimension To protect external users from false expectations, financial reports deal primarily with results of both past activities and current conditions. While some predictions such as service lives and salvage values of plant assets are necessary, financial accounting avoids predictions whenever possible. Managerial accounting regularly includes predictions of conditions and events. As an example, one important managerial accounting report is a budget, which predicts revenues, expenses, and other items. If managerial accounting reports were restricted to the past and present, managers would be less able to plan activities and less effective in managing and evaluating current activities.

Focus of Information Companies often organize into divisions and departments, but investors rarely can buy shares in one division or department. Nor do creditors lend money to a company’s single division or department. Instead, they own shares in or make loans to the entire company. Financial accounting focuses primarily on a company as a whole as depicted in Exhibit 14.3. The focus of managerial accounting is different. While top-level managers are responsible for managing the whole company, most other managers are responsible for much smaller sets of activities. These middle-level and lower-level managers need managerial accounting reports dealing with specific activities, projects, and subdivisions for which they are responsible. For instance, division sales managers are directly responsible only for the results achieved in their divisions. Accordingly, division sales managers need information about results achieved in their own divisions to improve their performance. This information includes the level of success achieved by each individual, product, or department in each division of the whole company as depicted in Exhibit 14.4.


Focus of External Reports



Focus of Internal Reports

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Nature of Information Both financial and managerial accounting systems report monetary information. Managerial accounting systems also report considerable nonmonetary information. Monetary information is an important part of managerial decisions, and nonmonetary information plays a crucial role, especially when monetary effects are difficult to measure. Common examples of nonmonetary information are the quality and delivery criteria of purchasing decisions.

Decision Ethics

Production Manager You invite three friends to a restaurant. When the dinner check arrives, David, a self-employed entrepreneur, picks it up saying, “Here, let me pay. I’ll deduct it as a business expense on my tax return.” Denise, a salesperson, takes the check from David’s hand and says, “I’ll put this on my company’s credit card. It won’t cost us anything.” Derek, a factory manager for a company, laughs and says, “Neither of you understands. I’ll put this on my company’s credit card and call it overhead on a cost-plus contract my company has with a client.” (A cost-plus contract means the company receives its costs plus a percent of those costs.) Adds Derek, “That way, my company pays for dinner and makes a profit.” Who should pay the bill? Why? [Answer—p. 633]

Managerial Decision Making

The previous section emphasized differences between financial and managerial accounting, but they are not entirely separate. Similar information is useful to both external and internal users. For instance, information about costs of manufacturing products is useful to all users in making decisions. Also, both financial and managerial accounting affect peoples’ actions. For example, Trek‘s design of a sales compensation plan affects the behavior of its salesforce when selling its manufactured bikes. It also must estimate the dual effects of promotion and sales compensation plans on buying patterns of customers. These estimates impact the equipment purchase decisions for manufacturing and can affect the supplier selection criteria established by purchasing. Thus, financial and managerial accounting systems do more than measure; they also affect people’s decisions and actions.

Fraud and Ethics in Managerial Accounting

Fraud, and the role of ethics in reducing fraud, are important factors in running business operations. Fraud involves the use of one’s job for personal gain through the deliberate misuse of the employer’s assets. Examples include theft of the employer’s cash or other assets, overstating reimbursable expenses, payroll schemes, and financial statement fraud. Three factors must exist for a person to commit fraud: opportunity, pressure, and rationalization. This is known as the fraud triangle. Fraud affects all business and it is costly: A 2010 Report to the Nation from the Association of Certified Fraud Examiners (ACFE) estimates the average U.S. business loses 5% of its annual revenues to fraud. This report also shows that the frequency and average loss from fraud vary by industry; the mining industry has a relatively small number of frauds but a high ($1 million) average loss per fraud. The banking industry has the highest number (16.6%) of the total frauds reported in the current ACFE report.

The most common type of fraud, where employees steal or misuse the employer’s resources, results in an average loss of $135,000 per occurrence. For example, in a billing fraud, an employee sets up a bogus supplier. The employee then prepares bills from the supplier and pays these bills from the employer’s checking account. The employee cashes the checks sent to the bogus supplier and uses them for his or her own personal benefit.

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More generally, although there are many types of fraud schemes, all fraud:

  • Is done to provide direct or indirect benefit to the employee.
  • Violates the employee’s obligations to the employer.
  • Costs the employer money or loss of other assets.
  • Is hidden from the employer.

Implications for Managerial Accounting Fraud increases a business’s costs. Left undetected, these inflated costs can result in poor pricing decisions, an improper product mix, and faulty performance evaluations. Management can develop accounting systems to closely track costs and identify deviations from expected amounts. In addition, managers rely on an internal control system to monitor and control business activities. An internal control system is the policies and procedures managers use to:

  • Urge adherence to company policies.
  • Promote efficient operations.
  • Ensure reliable accounting.
  • Protect assets.

Combating fraud and other dilemmas requires ethics in accounting. Ethics are beliefs that distinguish right from wrong. They are accepted standards of good and bad behavior. Identifying the ethical path can be difficult. The preferred path is a course of action that avoids casting doubt on one’s decisions.

Point: The IMA also issues the Certified Management Accountant (CMA) and the Certified Financial Manager (CFM) certifications. Employees with the CMA or CFM certifications typically earn higher salaries than those without.

The Institute of Management Accountants (IMA), the professional association for management accountants, has issued a code of ethics to help accountants involved in solving ethical dilemmas. The IMA’s Statement of Ethical Professional Practice requires that management accountants be competent, maintain confidentiality, act with integrity, and communicate information in a fair and credible manner.

Point: The Sarbanes-Oxley Act requires each issuer of securities to disclose whether it has adopted a code of ethics for its senior officers and the content of that code.

The IMA provides a “road map” for resolving ethical conflicts. It suggests that an employee follow the company’s policies on how to resolve such conflicts. If the conflict remains unresolved, an employee should contact the next level of management (such as the immediate supervisor) who is not involved in the ethical conflict.

An organization incurs many different types of costs that are classified differently, depending on management needs (different costs for different purposes). We can classify costs on the basis of their (1) behavior, (2) traceability, (3) controllability, (4) relevance, and (5) function. This section explains each concept for assigning costs to products and services.

Types of Cost Classifications

Classification by Behavior At a basic level, a cost can be classified as fixed or variable. A fixed cost does not change with changes in the volume of activity (within a range of activity known as an activity’s relevant range). For example, straight-line depreciation on equipment is a fixed cost. A variable cost changes in proportion to changes in the volume of activity. Sales commissions computed as a percent of sales revenue are variable costs. Additional examples of fixed and variable costs for a bike manufacturer are provided in Exhibit 14.5. When cost items are combined, total cost can be fixed, variable, or mixed. Mixed refers to a combination of fixed and variable costs. Equipment rental often includes a fixed cost for some minimum amount and a variable cost based on amount of usage. Classification of costs by behavior is helpful in cost-volume-profit analyses and short-term decision making. We discuss these in Chapters 18 and 23.



Fixed and Variable Costs

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Classification by Traceability A cost is often traced to a cost object, which is a product, process, department, or customer to which costs are assigned. Direct costs are those traceable to a single cost object. For example, if a product is a cost object, its material and labor costs are usually directly traceable. Direct costs for a bicycle, when it is the cost object, include raw materials such as wheels, brakes, chains, and wages and benefits of employees who work directly on making bikes. Indirect costs are those that cannot be easily and cost–beneficially traced to a single cost object. An example of an indirect cost is a maintenance department that benefits two or more departments. Salaries of Rocky Mountain Bikes’ maintenance department employees are considered indirect if the cost object is bicycles. However, these salaries are direct if the cost object is the maintenance department. Exhibit 14.6 identifies examples of both direct and indirect costs for the maintenance department, when the maintenance department is considered the cost object. Classification of costs by traceability is useful for cost allocation. This is discussed in Chapter 22.


Direct and Indirect Costs of a Maintenance Department

Decision Maker

Entrepreneur You wish to trace as many of your assembly department’s direct costs as possible. You can trace 90% of them in an economical manner. To trace the other 10%, you need sophisticated and costly accounting software. Do you purchase this software? [Answer—p. 633]

Classification by Controllability A cost can be defined as controllable or not controllable. Whether a cost is controllable or not depends on the employee’s responsibilities, as shown in Exhibit 14.7. This is referred to as hierarchical levels in management, or pecking order. For example, investments in machinery are controllable by upper-level managers but not lower-level managers. Many daily operating expenses such as overtime often are controllable by lower-level managers. Classification of costs by controllability is especially useful for assigning responsibility to and evaluating managers.


Controllability of Costs

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Classification by Relevance A cost can be classified by relevance by identifying it as either a sunk cost or an out-of-pocket cost. A sunk cost has already been incurred and cannot be avoided or changed. It is irrelevant to future decisions. One example is the cost of a company’s office equipment previously purchased. An out-of-pocket cost requires a future outlay of cash and is relevant for decision making. Future purchases of equipment involve out-of-pocket costs. A discussion of relevant costs must also consider opportunity costs. An opportunity cost is the potential benefit lost by choosing a specific action from two or more alternatives. One example is a student giving up wages from a job to attend evening classes. Consideration of opportunity cost is important when, for example, an insurance company must decide whether to outsource its payroll function or maintain it internally. This is discussed in Chapter 23.

Point: Opportunity costs are not recorded by the accounting system.

C3 Define product and period costs and explain how they impact financial statements.

Classification by Function Another cost classification (for manufacturers) is capitalization as inventory or to expense as incurred. Costs capitalized as inventory are called product costs, which refer to expenditures necessary and integral to finished products. They include direct materials, direct labor, and indirect manufacturing costs called overhead costs. Product costs pertain to activities carried out to manufacture the product. Costs expensed are called period costs, which refer to expenditures identified more with a time period than with finished products. They include selling and general administrative expenses. Period costs pertain to activities that are not part of the manufacturing process. A distinction between product and period costs is important because period costs are expensed in the income statement and product costs are assigned to inventory on the balance sheet until that inventory is sold. An ability to understand and identify product costs and period costs is crucial to using and interpreting a manufacturing statement described later in this chapter.

Point: Only costs of production and purchases are classed as product costs.

Exhibit 14.8 shows the different effects of product and period costs. Period costs flow directly to the current income statement as expenses. They are not reported as assets. Product costs are first assigned to inventory. Their final treatment depends on when inventory is sold or disposed of. Product costs assigned to finished goods that are sold in year 2013 are reported on the 2013 income statement as part of cost of goods sold. Product costs assigned to unsold inventory are carried forward on the balance sheet at the end of year 2013. If this inventory is sold in year 2014, product costs assigned to it are reported as part of cost of goods sold in that year’s income statement.


Period and Product Costs in Financial Statements

Point: Product costs are either in the income statement as part of cost of goods sold or in the balance sheet as inventory. Period costs appear only on the income statement under operating expenses. See Exhibit 14.8.

The difference between period and product costs explains why the year 2013 income statement does not report operating expenses related to either factory workers’ wages or depreciation on factory buildings and equipment. Instead, both costs are combined with the cost of raw materials to compute the product cost of finished goods. A portion of these manufacturing costs (related to the goods sold) is reported in the year 2013 income statement as part of cost of goods sold. The other portion is reported on the balance sheet at the end of that year as part of inventory. The portion assigned to inventory could be included in any or all of raw materials, goods in process, or finished goods inventories.

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Point: For a team approach to identifying period and product costs, see Teamwork in Action in the Beyond the Numbers section.

Exhibit 14.9 summarizes typical managerial decisions for various cost classifications.


Summary of Cost Classifications and Example Managerial Decisions

Decision Maker

Purchase Manager You are evaluating two potential suppliers of seats for the manufacturing of motorcycles. One supplier (A) quotes a $145 price per seat and ensures 100% quality standards and on-time delivery. The second supplier (B) quotes a $115 price per seat but does not give any written assurances on quality or delivery. You decide to contract with the second supplier (B), saving $30 per seat. Does this decision have opportunity costs? [Answer—p. 634]

Identification of Cost Classifications

It is important to understand that a cost can be classified using any one (or combination) of the five different means described here. To do this we must understand costs and operations. Specifically, for the five classifications, we must be able to identify the activity for behavior, cost object for traceability, management hierarchical level for controllability, opportunity cost for relevance, and benefit period for function. Factory rent, for instance, can be classified as a product cost; it is fixed with respect to number of units produced, it is indirect with respect to the product, and it is not controllable by a production supervisor. Potential multiple classifications are shown in Exhibit 14.10 using different cost items incurred in manufacturing mountain bikes. The finished bike is the cost object. Proper allocation of these costs and the managerial decisions based on cost data depend on a correct cost classification.

* Although an assembly worker’s wages are classified as variable costs, their actual behavior depends on how workers are paid and whether their wages are based on a union contract (such as piece rate or monthly wages).


Examples of Multiple Cost Classifications

Cost Concepts for Service Companies

Point: All expenses of service companies are period costs because these companies do not have inventory.

The cost concepts described are generally applicable to service organizations. For example, consider Southwest Airlines. Its cost of beverages for passengers is a variable cost based on number of passengers. The cost of leasing an aircraft is fixed with respect to number of passengers. We can also trace a flight crew’s salary to a specific flight whereas we likely cannot trace wages for the ground crew to a specific flight. Classification by function (such as product versus period costs) is not relevant to service companies because services are not inventoried. Instead, costs incurred by a service firm are expensed in the reporting period when incurred.

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Managers in service companies must understand and apply cost concepts. They seek and rely on accurate cost estimates for many decisions. For example, an airline manager must often decide between canceling or rerouting flights. The manager must also be able to estimate costs saved by canceling a flight versus rerouting. Knowledge of fixed costs is equally important. We explain more about the cost requirements for these and other managerial decisions in Chapter 23.

Service Costs

  • Beverages and snacks
  • Cleaning fees
  • Pilot and copilot salaries
  • Attendant salaries
  • Fuel and oil costs
  • Travel agent fees
  • Ground crew salaries


Companies with manufacturing activities differ from both merchandising and service companies. The main difference between merchandising and manufacturing companies is that merchandisers buy goods ready for sale while manufacturers produce goods from materials and labor. Payless is an example of a merchandising company. It buys and sells shoes without physically changing them. Adidas is primarily a manufacturer of shoes, apparel, and accessories. It purchases materials such as leather, cloth, dye, plastic, rubber, glue, and laces and then uses employees’ labor to convert these materials to products. Southwest Airlines is a service company that transports people and items.

Manufacturer’s Costs

Direct Materials Direct materials are tangible components of a finished product. Direct material costs are the expenditures for direct materials that are separately and readily traced through the manufacturing process to finished goods. Examples of direct materials in manufacturing a mountain bike include its tires, seat, frame, pedals, brakes, cables, gears, and handlebars. The chart in the margin shows that direct materials generally make up about 45% of manufacturing costs in today’s products, but this amount varies across industries and companies.

Direct Labor Direct labor refers to the efforts of employees who physically convert materials to finished product. Direct labor costs are the wages and salaries for direct labor that are separately and readily traced through the manufacturing process to finished goods. Examples of direct labor in manufacturing a mountain bike include operators directly involved in converting raw materials into finished products (welding, painting, forming) and assembly workers who attach materials such as tires, seats, pedals, and brakes to the bike frames. Costs of other workers on the assembly line who assist direct laborers are classified as indirect labor costs. Indirect labor refers to manufacturing workers’ efforts not linked to specific units or batches of the product.

Point: Indirect labor costs are part of factory overhead.

Factory Overhead Factory overhead consists of all manufacturing costs that are not direct materials or direct labor. Factory overhead costs cannot be separately or readily traced to finished goods. These costs include indirect materials and indirect labor, costs not directly traceable to the product. Overtime paid to direct laborers is also included in overhead because overtime is due to delays, interruptions, or constraints not necessarily identifiable to a specific product or batches of product. Factory overhead costs also include maintenance of the mountain bike factory, supervision of its employees, repairing manufacturing equipment, factory utilities (water, gas, electricity), production manager’s salary, factory rent, depreciation on factory buildings and equipment, factory insurance, property taxes on factory buildings and equipment, and factory accounting and legal services. Factory overhead does not include selling and administrative expenses because they are not incurred in manufacturing products. These expenses are called period costs and are recorded as expenses on the income statement when incurred.

Point: Factory overhead is also called manufacturing overhead.

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Prime and Conversion Costs Direct material costs and direct labor costs are also called prime costs—expenditures directly associated with the manufacture of finished goods. Direct labor costs and overhead costs are called conversion costs—expenditures incurred in the process of converting raw materials to finished goods. Direct labor costs are considered both prime costs and conversion costs. Exhibit 14.11 conveys the relation between prime and conversion costs and their components of direct material, direct labor, and factory overhead.


Prime and Conversion Costs and Their Makeup

Prime costs = Direct materials + Direct labor.

Conversion costs = Direct labor + Factory overhead.

Since manufacturing activities differ from both selling merchandise and providing services, the financial statements differ slightly between these companies. This section considers some of these differences and compares them to accounting for a merchandising or service company. First we use the cost classification concept of traceability to discuss a manufacturer’s costs.

Manufacturer’s Balance Sheet

C4 Explain how balance sheets and income statements for manufacturing and merchandising companies differ.

Manufacturers carry several unique assets and usually have three inventories instead of the single inventory that merchandisers carry. Exhibit 14.12 shows three different inventories in the current asset section of the balance sheet for Rocky Mountain Bikes, a manufacturer. The three inventories are raw materials, goods in process, and finished goods.


Balance Sheet for a Manufacturer

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Raw Materials Inventory Raw materials inventory refers to the goods a company acquires to use in making products. It uses raw materials in two ways: directly and indirectly. Most raw materials physically become part of a product and are identified with specific units or batches of a product. Raw materials used directly in a product are called direct materials. Other materials used to support production processes are sometimes not as clearly identified with specific units or batches of product. These materials are called indirect materials because they are not clearly identified with specific product units or batches. Items used as indirect materials often appear on a balance sheet as factory supplies or are included in raw materials. Some direct materials are classified as indirect materials when their costs are low (insignificant). Examples include screws and nuts used in assembling mountain bikes and staples and glue used in manufacturing shoes. Using the materiality principle, individually tracing the costs of each of these materials and classifying them separately as direct materials does not make much economic sense. For instance, keeping detailed records of the amount of glue used to manufacture one shoe is not cost beneficial.

Point: Reducing the size of inventories saves storage costs and frees money for other uses.

Goods in Process Inventory Another inventory held by manufacturers is goods in process inventory, also called work in process inventory. It consists of products in the process of being manufactured but not yet complete. The amount of goods in process inventory depends on the type of production process. If the time required to produce a unit of product is short, the goods in process inventory is likely small; but if weeks or months are needed to produce a unit, the goods in process inventory is usually larger.

Finished Goods Inventory A third inventory owned by a manufacturer is finished goods inventory, which consists of completed products ready for sale. This inventory is similar to merchandise inventory owned by a merchandising company. Manufacturers also often own unique plant assets such as small tools, factory buildings, factory equipment, and patents to manufacture products. The balance sheet in Exhibit 14.12 shows that Rocky Mountain Bikes owns all of these assets. Some manufacturers invest millions or even billions of dollars in production facilities and patents. Briggs & Stratton‘s recent balance sheet shows about $1 billion net investment in land, buildings, machinery, and equipment, much of which involves production facilities. It manufactures more racing engines than any other company in the world.

Balance Sheets for Merchandising and Service Companies The current assets section of the balance sheet will look different for merchandising and service companies as compared to manufacturing companies. A merchandiser will report only merchandise inventory rather than the three types of inventory reported by a manufacturer. A service company’s balance sheet does not have any inventory held for sale.

Manufacturer’s Income Statement

P1 Compute cost of goods sold for a manufacturer.

The main difference between the income statement of a manufacturer and that of a merchandiser involves the items making up cost of goods sold. Exhibit 14.13 compares the components of cost of goods sold for a manufacturer and a merchandiser. A merchandiser adds cost of goods purchased to beginning merchandise inventory and then subtracts ending merchandise inventory to get cost of goods sold. A manufacturer adds cost of goods manufactured to beginning finished goods inventory and then subtracts ending finished goods inventory to get cost of goods sold.



Cost of Goods Sold Computation

A merchandiser often uses the term merchandise inventory; a manufacturer often uses the term finished goods inventory. A manufacturer’s inventories of raw materials and goods in process are not included in finished goods because they are not available for sale. A manufacturer also shows cost of goods manufactured instead of cost of goods purchased. This difference occurs because a manufacturer produces its goods instead of purchasing them ready for sale. We show later in this chapter how to derive cost of goods manufactured from the manufacturing statement.

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The Cost of Goods Sold sections for both a merchandiser (Tele-Mart) and a manufacturer (Rocky Mountain Bikes) are shown in Exhibit 14.14 to highlight these differences. The remaining income statement sections are similar.


Cost of Goods Sold for a Merchandiser and Manufacturer

Although the cost of goods sold computations are similar, the numbers in these computations reflect different activities. A merchandiser’s cost of goods purchased is the cost of buying products to be sold. A manufacturer’s cost of goods manufactured is the sum of direct materials, direct labor, and factory overhead costs incurred in producing products. Next we show a manufacturer’s income statement.

Reporting Performance Exhibit 14.15 shows the income statement for Rocky Mountain Bikes. Its operating expenses include sales salaries, office salaries, and depreciation of delivery and office equipment. Operating expenses do not include manufacturing costs such as factory workers’ wages and depreciation of production equipment and the factory buildings. These manufacturing costs are reported as part of cost of goods manufactured and included in cost of goods sold. We explained why and how this is done in the section “Classification by Function.”



Income Statement for a Manufacturer

Point: Manufacturers treat costs such as depreciation and rent as product costs if they are related to manufacturing.

Income Statement for Service Company Since a service provider does not make or buy inventory to be sold, it does not report cost of goods manufactured or cost of goods sold. Instead, its operating expenses include all of the costs it incurred in providing its service. Southwest Airlines reports large operating expenses for employee pay and benefits, fuel and oil, and depreciation.

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Quick Check

Answers — p. 634

  1. What are the three types of inventory on a manufacturing company’s balance sheet?
  1. How does cost of goods sold differ for merchandising versus manufacturing companies?

Flow of Manufacturing Activities

C5 Explain manufacturing activities and the flow of manufacturing costs.

To understand manufacturing and its reports, we must first understand the flow of manufacturing activities and costs. Exhibit 14.16 shows the flow of manufacturing activities for a manufacturer. This exhibit has three important sections: materials activity, production activity, and sales activity. We explain each activity in this section.

Materials Activity The far left side of Exhibit 14.16 shows the flow of raw materials. Manufacturers usually start a period with some beginning raw materials inventory carried over from the previous period. The company then acquires additional raw materials in the current period. Adding these purchases to beginning inventory gives total raw materials available for use in production. These raw materials are then either used in production in the current period or remain in inventory at the end of the period for use in future periods.

Point: Knowledge of managerial accounting provides us a means of measuring manufacturing costs and is a sound foundation for studying advanced business topics.

Production Activity The middle section of Exhibit 14.16 describes production activity. Four factors come together in production: beginning goods in process inventory, direct materials, direct labor, and overhead. Beginning goods in process inventory consists of partly assembled products from the previous period. Production activity results in products that are either finished or remain unfinished. The cost of finished products makes up the cost of goods manufactured for the current period. Unfinished products are identified as ending goods in process inventory. The cost of unfinished products consists of direct materials, direct labor, and factory overhead, and is reported on the current period’s balance sheet. The costs of both finished goods manufactured and goods in process are product costs.



Activities and Cost Flows in Manufacturing

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Sales Activity The company’s sales activity is portrayed in the far right side of Exhibit 14.16. Newly completed units are combined with beginning finished goods inventory to make up total finished goods available for sale in the current period. The cost of finished products sold is reported on the income statement as cost of goods sold. The cost of products not sold is reported on the current period’s balance sheet as ending finished goods inventory.

Manufacturing Statement

P2 Prepare a manufacturing statement and explain its purpose and links to financial statements.

A company’s manufacturing activities are described in a manufacturing statement, also called the schedule of manufacturing activities or the schedule of cost of goods manufactured. The manufacturing statement summarizes the types and amounts of costs incurred in a company’s manufacturing process. Exhibit 14.17 shows the manufacturing statement for Rocky Mountain Bikes. The statement is divided into four parts: direct materials, direct labor, overhead, and computation of cost of goods manufactured. We describe each of these parts in this section.



Manufacturing Statement

  1. The manufacturing statement begins by computing direct materials used. We start by adding beginning raw materials inventory of $8,000 to the current period’s purchases of $86,500. This yields $94,500 of total raw materials available for use. A physical count of inventory shows $9,000 of ending raw materials inventory. This implies a total cost of raw materials used during the period of $85,500 ($94,500 total raw materials available for use − $9,000 ending inventory). (Note: All raw materials are direct materials for Rocky Mountain Bikes.)
  2. The second part of the manufacturing statement reports direct labor costs. Rocky Mountain Bikes had total direct labor costs of $60,000 for the period. This amount includes payroll taxes and fringe benefits.

Point: Direct material and direct labor costs increase with increases in production volume and are called variable costs. Overhead can be both variable and fixed. When overhead costs vary with production, they are called variable overhead. When overhead costs don’t vary with production, they are called fixed overhead.

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  1. The third part of the manufacturing statement reports overhead costs. The statement lists each important factory overhead item and its cost. Total factory overhead cost for the period is $30,000. Some companies report only total factory overhead on the manufacturing statement and attach a separate schedule listing individual overhead costs.

Point: Manufacturers sometimes report variable and fixed overhead separately in the manufacturing statement to provide more information to managers about cost behavior.

  1. The final section of the manufacturing statement computes and reports the cost of goods manufactured. (Total manufacturing costs for the period are $175,500 [$85,500 + $60,000 + $30,000], the sum of direct materials used and direct labor and overhead costs incurred.) This amount is first added to beginning goods in process inventory. This gives the total goods in process inventory of $178,000 ($175,500 + $2,500). We then compute the current period’s cost of goods manufactured of $170,500 by taking the $178,000 total goods in process and subtracting the $7,500 cost of ending goods in process inventory that consists of direct materials, direct labor, and factory overhead. The cost of goods manufactured amount is also called net cost of goods manufactured or cost of goods completed. Exhibit 14.15 shows that this item and amount are listed in the Cost of Goods Sold section of Rocky Mountain Bikes’ income statement and the balance sheet.

A managerial accounting system records costs and reports them in various reports that eventually determine financial statements. Exhibit 14.18 shows how overhead costs flow through the system: from an initial listing of specific costs, to a section of the manufacturing statement, to the reporting on the income statement and the balance sheet.



Overhead Cost Flows across Accounting Reports

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Management uses information in the manufacturing statement to plan and control the company’s manufacturing activities. To provide timely information for decision making, the statement is often prepared monthly, weekly, or even daily. In anticipation of release of its much-hyped iPad, Apple grew its inventory of critical components, and its finished goods inventory. The manufacturing statement contains information useful to external users but is not a general-purpose financial statement. Companies rarely publish the manufacturing statement because managers view this information as proprietary and potentially harmful to them if released to competitors.

Quick Check

Answers — p. 634

  1. A manufacturing statement (a) computes cost of goods manufactured for the period, (b) computes cost of goods sold for the period, or (c) reports operating expenses incurred for the period.
  1. Are companies required to report a manufacturing statement?
  1. How are both beginning and ending goods in process inventories reported on a manufacturing statement?

Trends in Managerial Accounting

C6 Describe trends in managerial accounting.

The analytical tools and techniques of managerial accounting have always been useful, and their relevance and importance continue to increase. This is so because of changes in the business environment. This section describes some of these changes and their impact on managerial accounting.

Customer Orientation There is an increased emphasis on customers as the most important constituent of a business. Customers expect to derive a certain value for the money they spend to buy products and services. Specifically, they expect that their suppliers will offer them the right service (or product) at the right time and the right price. This implies that companies accept the notion of customer orientation, which means that employees understand the changing needs and wants of their customers and align their management and operating practices accordingly.


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Global Economy Our global economy expands competitive boundaries and provides customers more choices. The global economy also produces changes in business activities. One notable case that reflects these changes in customer demand and global competition is auto manufacturing. The top three Japanese auto manufacturers (Honda, Nissan, and Toyota) once controlled more than 40% of the U.S. auto market. Customers perceived that Japanese auto manufacturers provided value not available from other manufacturers. Many European and North American auto manufacturers responded to this challenge and regained much of the lost market share.

E-Commerce People have become increasingly interconnected via smartphones, text messaging, and other electronic applications. Consumers thus expect and demand to be able to buy items electronically, whenever and wherever they want. Many businesses have enhanced their Websites to allow for online transactions. Online sales now make up over 7% of total retail sales.

Service Economy Businesses that provide services, such as telecommunications and health care, constitute an ever-growing part of our economy. In developed economies like the United States, service businesses typically account for over 60% to 70% of total economic activity.

Companies must be alert to these and other factors. Many companies have responded by adopting the lean business model, whose goal is to eliminate waste while “satisfying the customer” and “providing a positive return” to the company.

Lean Practices Continuous improvement rejects the notions of “good enough” or “acceptable” and challenges employees and managers to continuously experiment with new and improved business practices. This has led companies to adopt practices such as total quality management (TQM) and just-in-time (JIT) manufacturing. The philosophy underlying both practices is continuous improvement; the difference is in the focus.

Point: Goals of a TQM process include reduced waste, better inventory control, fewer defects, and continuous improvement. Just-in-time concepts have similar goals.

Total quality management focuses on quality improvement and applies this standard to all aspects of business activities. In doing so, managers and employees seek to uncover waste in business activities including accounting activities such as payroll and disbursements. To encourage an emphasis on quality, the U.S. Congress established the Malcolm Baldrige National Quality Award (MBNQA). Entrants must conduct a thorough analysis and evaluation of their business using guidelines from the Baldrige committee. Ritz Carlton Hotel is a recipient of the Baldrige award in the service category. The company applies a core set of values, collectively called The Gold Standards, to improve customer service.

Point: The time between buying raw materials and selling finished goods is called throughput time.

Just-in-time manufacturing is a system that acquires inventory and produces only when needed. An important aspect of JIT is that companies manufacture products only after they receive an order (a demand-pull system) and then deliver the customer’s requirements on time. This means that processes must be aligned to eliminate any delays and inefficiencies including inferior inputs and outputs. Companies must also establish good relations and communications with their suppliers. On the downside, JIT is more susceptible to disruption than traditional systems. As one example, several General Motors plants were temporarily shut down due to a strike at an assembly division; the plants supplied components just in time to the assembly division.

Copyright © Jerry King.

Value Chain The value chain refers to the series of activities that add value to a company’s products or services. Exhibit 14.19 illustrates a possible value chain for a retail cookie company. Companies can use lean practices to increase efficiency and profits.



Typical Value Chain (Cookie Retailer)

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Decision Insight

Global Lean Toyota Motor Corporation pioneered lean manufacturing, and it has since spread to other manufacturers throughout the world. The goals include improvements in quality, reliability, inventory turnover, productivity, exports, and—above all—sales and income.

Implications for Managerial Accounting Adopting the lean business model can be challenging because to foster its implementation, all systems and procedures that a company follows must be realigned. Managerial accounting has an important role to play by providing accurate cost and performance information. Companies must understand the nature and sources of cost and must develop systems that capture costs accurately. Developing such a system is important to measuring the “value” provided to customers. The price that customers pay for acquiring goods and services is an important determinant of value. In turn, the costs a company incurs are key determinants of price. All else being equal, the better a company is at controlling its costs, the better its performance.

Decision Insight

Balanced Scorecard The balanced scorecard aids continuous improvement by augmenting financial measures with information on the “drivers” (indicators) of future financial performance along four dimensions: (1) financial—profitability and risk, (2) customer—value creation and product and service differentiation, (3) internal business processes—business activities that create customer and owner satisfaction, and (4) learning and growth—organizational change, innovation, and growth.


Managerial accounting is more flexible than financial accounting and does not follow a set of strict rules. However, many international businesses use the managerial accounting concepts and principles described in this chapter.

Customer Focus Nestlé, one of the world’s leading nutrition and wellness companies, adopts a customer focus and strives to understand its customers’ tastes. For example, Nestlé employees spent three days living with people in Lima, Peru, to understand their motivations, routines, buying habits, and everyday lives. This allowed Nestlé to adjust its products to suit local tastes.

Reporting Manufacturing Activities Nestlé must classify and report costs. In reporting inventory, Nestlé includes direct production costs, production overhead, and factory depreciation. A recent Nestlé annual report shows the following:

Nestlé managers use this information, along with the more detailed information found in a manufacturing statement, to plan and control manufacturing activities.


C1 Explain the purpose and nature of, and the role of ethics in, managerial accounting. The purpose of managerial accounting is to provide useful information to management and other internal decision makers. It does this by collecting, managing, and reporting both monetary and nonmonetary information in a manner useful to internal users. Major characteristics of managerial accounting include (1) focus on internal decision makers, (2) emphasis on planning and control, (3) flexibility, (4) timeliness, (5) reliance on forecasts and estimates, (6) focus on segments and projects, and (7) reporting both monetary and nonmonetary information. Ethics are beliefs that distinguish right from wrong. Ethics can be important in reducing fraud in business operations.

C2 Describe accounting concepts useful in classifying costs. We can classify costs on the basis of their (1) behavior—fixed vs. variable, (2) traceability—direct vs. indirect, (3) controllability—controllable vs. uncontrollable, (4) relevance—sunk vs. out of pocket, and (5) function—product vs. period. A cost can be classified in more than one way, depending on the purpose for which the cost is being determined. These classifications help us understand cost patterns, analyze performance, and plan operations.

C3 Define product and period costs and explain how they impact financial statements. Costs that are capitalized because they are expected to have future value are called product costs; costs that are expensed are called period costs. This classification is important because it affects the amount of costs expensed in the income statement and the amount of costs assigned to inventory on the balance sheet. Product costs are commonly made up of direct materials, direct labor, and overhead. Period costs include selling and administrative expenses.

C4 Explain how balance sheets and income statements for manufacturing and merchandising companies differ. The main difference is that manufacturers usually carry three inventories on their balance sheets—raw materials, goods in process, and finished goods—instead of one inventory that merchandisers carry. The main difference between income statements of manufacturers and merchandisers is the items making up cost of goods sold. A merchandiser adds beginning merchandise inventory to cost of goods purchased and then subtracts ending merchandise inventory to get cost of goods sold. A manufacturer adds beginning finished goods inventory to cost of goods manufactured and then subtracts ending finished goods inventory to get cost of goods sold.

C5 Explain manufacturing activities and the flow of manufacturing costs. Manufacturing activities consist of materials, production, and sales activities. The materials activity consists of the purchase and issuance of materials to production. The production activity consists of converting materials into finished goods. At this stage in the process, the materials, labor, and overhead costs have been incurred and the manufacturing statement is prepared. The sales activity consists of selling some or all of finished goods available for sale. At this stage, the cost of goods sold is determined.

C6 Describe trends in managerial accounting. Important trends in managerial accounting include an increased focus on satisfying customers, the impact of a global economy, and the growing presence of e-commerce and service-based businesses. The lean business model, designed to eliminate waste and satisfy customers, can be useful in responding to recent trends. Concepts such as total quality management, just-in-time production, and the value chain often aid in application of the lean business model.

A1 Assess raw materials inventory management using raw materials inventory turnover and days’ sales in raw materials inventory. A high raw materials inventory turnover suggests a business is more effective in managing its raw materials inventory. We use days’ sales in raw materials inventory to assess the likelihood of production being delayed due to inadequate levels of raw materials. We prefer a high raw materials inventory turnover ratio and a small number of days’ sales in raw materials inventory, provided that raw materials inventory levels are adequate to keep production steady.

P1 Compute cost of goods sold for a manufacturer. A manufacturer adds beginning finished goods inventory to cost of goods manufactured and then subtracts ending finished goods inventory to get cost of goods sold.

P2 Prepare a manufacturing statement and explain its purpose and links to financial statements. The manufacturing statement reports computation of cost of goods manufactured for the period. It begins by showing the period’s costs for direct materials, direct labor, and overhead and then adjusts these numbers for the beginning and ending inventories of the goods in process to yield cost of goods manufactured.