Part I Introduction to Managerial Accounting

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Part I

Introduction to
Managerial Accounting

The initial section of this text introduces the students to managerial accounting and the basic purposes of
managerial accounting. In addition, important terminology related to managerial accounting and cost behavior is
discussed. The chapters comprising this initial section are:

Chapter 1: Introduction to Managerial Accounting
Chapter 2: Analyzing Cost Behavior
Learning Objectives

Chapter 1 introduces managerial accounting and the role of the managerial accountant in the organization.
Studying this chapter should enable you to:

1. Identify the major purposes of managerial accounting.
2. Contrast managerial accounting with financial accounting.
3. Describe the steps in an accounting system and the interrelationships within the system.
4. Portray the accountant’s role in the managerial process.
5. Determine where managerial accountants gather source data and to whom they issue final reports.
Chapter 1

Introduction to
Managerial Accounting

Introduction
At the beginning of their second accounting class, two students (Rick James and Mike Hammer) were
discussing the class in financial accounting they had just completed:

Rick: You know, that accounting class was really interesting. It’s amazing how accounting can take so
much information and summarize it in financial statements. How in the world would bankers and
investors ever know about a company without accounting?

Mike: I agree. Something bothered me, though. All we talked about in financial accounting was how
information can be summarized and communicated to external users. What about the
management of the company? Surely they need to have information to make decisions about
what products to produce, how many employees to hire, and how much to charge for their
products. We didn’t even discuss the need for information by the company’s management.

Rick: I never thought about that. Surely there must be some way to provide management with
information for decision-making purposes.

Mike: Shhh. I think class is about to start...

Information is a truly irreplaceable commodity in today’s business world. In order to manage and plan for
various organization activities, upper management needs to have a vast amount of information available in a
timely fashion. For example, when producing automobiles, the following are examples of some of the types of
questions that must be answered by the management of General Motors:

• What are expected sales during the year?
• How much does it cost to manufacture a certain type of automobile?
• How many automobiles need to be produced to meet quarterly demand?
• How much over or under budget are labor costs?
• Did we use greater or fewer pounds of steel in producing automobiles than expected?
• How profitable are the various makes of automobiles?

These are just a sample of questions that face the management of General Motors. As you will see throughout
this text, the answers to these and many more questions will be provided through the process of managerial
accounting.

1-1
1-2
Accounting may be defined as “... the art of recording, classifying, and summarizing ... transactions and
1
events ... and interpreting the results thereof.” In addition to the above tasks, the process of accounting is also
concerned with communicating relevant information about an entity to interested users. This information is used
by these parties in making economic decisions related to the entity in question, and as such accountants have
often been referred to as “information engineers.”
These “interested users” may be parties who are external to the entity, such as potential creditors and
investors. For these parties, financial accounting describes the process through which the entity’s historical
transactions and events are recorded, classified, and summarized in the form of financial statements (the balance
sheet, income statement, statement of retained earnings, and statement of cash flows). These financial statements
are used by external third parties (potential creditors and investors) to make economic decisions (i.e., decisions
to lend money to or invest money in a given entity).
Managerial accounting, on the other hand, is concerned with “interested users” who are internal to (i.e.,
employed by) the entity. These individuals include managers and other personnel who are involved in the day-
to-day operations of the entity. It is important to note that the basic purposes of accounting are unchanged: to
record, summarize, interpret, and communicate information to interested users. The primary differences relate to
the individual needing the information and the type of information needed. The purpose of managerial accounting
is to provide information to internal users for the purpose of allowing them to make various decisions concerning
the operations of the entity.
Illustration 1 provides a brief comparison of financial and managerial accounting. It is important to note that
both types of accounting involve the communication of information to users for decision-making purposes; this
information is normally summarized in the form of a report or analysis. However, as shown in Illustration 1, these
two classes of accounting can be distinguished along several dimensions. For example, while financial
accounting is governed by specific rules and conventions (generally accepted accounting principles), no such
body of generalized rules exists for managerial accounting. Also, financial accounting is primarily concerned
with historical (or past) financial information; in contrast, managerial accounting uses both past information and
future information.

Illustration 1
Comparison of Financial
and Managerial Accounting

Financial Managerial
Accounting Accounting

Underlying Generally Accepted No required rules or con-
Authority Accounting Principles ventions

Types of Financial statements in Budgets, cost reports,
Reports Issued a prescribed format performance reports, and
(balance sheet, income special analysis in the
statement, and state- form desired by manage-
ment of cash flows) ment

Types of Data Normally limited Includes both historical
to historical data and forecasted data

Users of Investors, creditors, and Top management and
the Reports others external to the others internal to the firm
firm

1
Accounting Terminology Bulletin No. 1–Review and Resume (New York: American Institute of Certified Public Accountants), 9.
1 / Introduction to Managerial Accounting 1-3
As noted earlier, one significant difference between financial and managerial accounting is in the intended
user of the reports. Financial accounting provides information to decision-makers external to the firm (such as
investors and creditors); managerial accounting provides its information to users internal to the firm (such as
management). As noted on the previous page, one difference in the two types of accounting is in the types and
formats of reports. An example of the flexibility permitted in reports prepared by managerial accountants is
shown below.

Motorola’s managerial accountants use “Mr. Overhead” (a cartoon figure shaped like a cloud) to reduce the
boredom of examining lengthy computer reports and enable managers to concentrate on results. Mr.
Overhead is shown in a variety of moods: a smiling Mr. Overhead is used to indicate favorable results, a
frowning Mr. Overhead suggests unfavorable results, and a perplexed Mr. Overhead indicates unusual
results.2

The focus of managerial accounting (and managerial accounting reports) on internal decision-making is
illustrated by the following example from practice.

Borg-Warner Automotive, a manufacturer of transmissions and other products for the automotive indus-
try, has recently revised the content of the internal reports prepared by managerial accountants for Borg-
Warner’s management. One major criticism of the previous internal reports is that managerial accountants
did not understand what information was needed by managers. As a result, Borg-Warner’s accounting
department now assigns a cost analyst to work in different parts of the plant. This approach will allow the
accounting department to integrate the needs of the manufacturing managers with the capabilities of the
3
existing accounting system.

While some significant differences exist between managerial and financial accounting (as noted above),
there is one distinct similarity—the basic purpose of accounting. Both classes of accounting attempt to
summarize a wide body of information (in the form of an accounting report or other analysis) to allow users to
make decisions. The type of information and user differs between the two types of accounting, as summarized
above.

The Need for Managerial Accounting Information
The demand for managerial accounting has increased dramatically as the nature of the business entity has
evolved into today’s large, geographically dispersed, and complex organization. Consider, for example, the
different information needs of the owner/manager of a sole proprietorship and the manager of a large
organization. The owner/manager of a sole proprietorship is usually heavily involved with the day-to-day
operations of the business. They often make most (if not all) of the operating decisions and generally observe
most of the transactions (such as purchases of inventory and receipt of customer orders) that affect their business.
Through this involvement, they acquire a great deal of firsthand knowledge about the events and transactions that
affect the entity. As a result, this owner/manager has very limited information needs with respect to the entity.
In contrast, the manager of a large organization has only limited firsthand knowledge of the day-to-day
operations of the entity. The large size, increased complexity, and geographic location of the entity makes it
almost impossible for the manager of a large organization to operate the entity based on personal, firsthand
knowledge. Therefore, he or she must rely on summaries and reports of relevant information prepared by other
individuals within the organization. Thus, in making operating decisions concerning the entity, it can be said that
this manager has a greater need for information provided through the process of managerial accounting. This
need is illustrated by the following excerpts concerning Sears, Roebuck & Co. and Wal-Mart:

2
Douglas A. Johnson, Steven Kaplan, and Bill B. Hook, “Looking for Mr. Overhead: An Expanded Role for Management
Accountants,” Management Accounting (November 1983), 65-68.
3
G.F Hanks, M.A. Fried, and J. Huber, “Shifting Gears at Borg-Warner Automotive,” Management Accounting (February 1994),
25–29.
1-4

...[Sears’] decentralized accounting methods made it difficult for buyers sitting in Chicago to track
merchandise. Finding out how screwdrivers were selling in Albuquerque, for instance, was nearly
impossible. The bottom line: Merchandisers had little information to work with, which made the
4
huge retailer slow to react to its own sales patterns and larger consumer trends.
Wal-Mart is a giant in more than retailing. The world’s largest retailer spends half a billion dollars
annually on information technology and maintains a level of data storage capacity that is second
only to that of the U.S. government. More importantly, the company is unparalleled in its ability to
use the data it gathers to motivate its suppliers, employees, and customers. Computers at Wal-Mart
record sales of each item and automatically alert Wal-Mart’s warehouses when items are in short
supply. This allows Wal-Mart employees to spend more time with customers and less time scanning
shelves and manually placing orders for depleted items.5

Throughout this text, we will discuss the need for managerial accounting information for three major types
of organizations. The distinguishing characteristic of these organizations is the process through which they
generate their revenues. A manufacturing company is an organization that utilizes materials to manufacture (or
produce) inventory that is eventually sold to customers. Compaq Computer Corporation, General Motors, and
Exxon are examples of manufacturing companies who produce the inventory that is sold to their customers. A
retail company is an organization that purchases its inventory from suppliers in final form and subsequently sells
this inventory to its customers; Wal-Mart, Blockbuster Entertainment, and Toys “R” Us are examples of retail
companies. Finally, a service company does not generate revenue through the sale of inventory; rather, this type
of company earns revenues by providing services to its customers. Federal Express, Union Pacific Railroad and
H&R Block are examples of service companies. Illustration 2 presents examples of the types of decisions facing
Compaq Computer as well as the information required by Compaq’s management to make those decisions. While
Compaq is a manufacturing company, many of these same decisions are applicable to retail and service
companies.

Illustration 2
Common Management Decisions for Compaq Computer

Decision Relevant Information

1. Should the production of laptop computers be • Anticipated demand for laptops
continued? • Costs of producing laptops
• Anticipated revenues from the sale of laptops

2. What price should be charged for monitors? • Cost of producing monitors
• Desired level of profit from sale of monitors

3. How much plastic should be purchased to • Number of computers to be manufactured
meet production needs? • Amount of plastic required per computer

4. How well did assembly workers perform in • Actual hours worked by assembly workers
producing computers? • Number of computers manufactured
• Budgeted or standard hours required to
manufacture computers

Accounting Systems and the Management Process
In order to provide the necessary information to managers for internal decision-making, entities develop
detailed accounting systems. These systems are designed in such a way as to ensure that the relevant information
needed by individuals within the firm is provided in a timely and accurate manner. The primary purposes of an
accounting system are to record, classify, and summarize relevant information in the form of an accounting
report.
4
“The Big Store’s Big Trauma,” Business Week (July 10, 1989), 5.
5
Christopher Palmeri, “Believe in Yourself, Believe in the Merchandise,” Forbes (September 8, 1997), 122; “Why Wall Street’s
Buying Wal-Mart Again,” Fortune (February 16, 1998), 92–94.
1 / Introduction to Managerial Accounting 1-5
The major events occurring in a typical accounting system are shown in Illustration 3. These events are
discussed in detail in the following paragraphs.

Illustration 3
Accounting Systems and
the Management Process

Economic Gather Prepare
Event Information Reports
(Transaction) about Summarizing
Occurs Transactions Information

Production of Obtain data (from Prepare summary
inventory item X various source report on the
documents) on the costs of produc-
costs of producing ing item X
item X

Users’ Decisions
and Activities

–What price should be
charged for item X?
–Consider costs of
producing item X in
preparing budgets
–Evaluate performance
by comparing actual
costs of producing
item X to expected
costs

Identifying and Gathering Information on Transactions
The first two steps in Illustration 3 deal with identifying transactions that occur and gathering information
about these transactions. Transactions are those activities that are undertaken by organizations as part of their
normal operations. For example, General Motors manufactures and sells automobiles; both of these activities
would be considered transactions. Service organizations (such as FedEx) provide services to customers and
subsequently bill customers for these services; these actions would also be considered as transactions.
Transactions are the basic lifeblood of the organization and are necessary for the short- and long-term survival
of the organization.
Once transactions occur, they are usually summarized by accounting personnel through the preparation of
source documents. A source document allows individuals who do not personally observe the transaction to have
an understanding of the transaction that has taken place. Most large organizations have formal procedures for
producing source documents at the point where transactions occur. For example, General Motors will use source
documents to accumulate the actual materials (steel) and labor (wages paid to machine operators) inputs required
to manufacture an automobile. FedEx uses source documents to record the fees charged to customers for delivery
of merchandise. The lack of firsthand knowledge of transactions in most large organizations makes the
preparation of source documents a critical component in their accounting systems. In performing the accounting
process, these source documents enable accounting personnel to gather information about transactions.
1-6
The following excerpt describes a recent technological development that greatly automates the collection of
certain transaction data.

A new tracking and identification system called Radio Frequency Identification (RFID) is expected
to provide enormous cost savings to distributors and retailers. An RFID system consists of
microchip smart tags that contain product identification information and tag readers, which can be
located in warehouse receiving areas, store shelves, and customer checkout counters. Tag readers
will automatically scan the smart tags on pallets of incoming goods as they pass by on conveyor
belts, saving billions of dollars in labor costs associated with manually scanning bar codes. In
addition, smart shelves equipped with tag readers can alert systems as they become empty, avoid-
ing a stock-out situation. Smart shelves can also be programmed to signal when many units are
taken at once, a sign that a theft may be in process. Wal-Mart plans to require its suppliers to attach
RFID tags to boxes and pallets of goods it sells to Wal-Mart, practically mandating the implemen-
6
tation of RFID for all companies that want to do business with the world’s largest retailer.

Preparing Reports
Once information about transactions has been gathered (through source documents), reports are prepared by
recording, classifying, summarizing, and interpreting transactions—all important elements in the process of
accounting. These reports attempt to summarize a large amount of information in an orderly fashion to allow
users to make decisions relating to the organization. In financial accounting, these reports take the form of the
traditional financial statements (balance sheet, income statement, and statement of cash flows).
Managerial accounting reports can assume a variety of forms, such as budgets, analysis, and cost
summaries. In addition, while financial accounting reports reflect solely historical information, managerial
accounting reports may include historical information, future information, or both. For example, the
management of General Motors may request an estimate of the amount of materials and labor inputs necessary
to meet anticipated production during the first quarter of the year. In preparing this report, General Motors needs
to consider both historical (e.g., the amount of steel and labor inputs required for the production of an
automobile) and future (e.g., anticipated level of demand and production) information.
An example of the use of historical information and sophisticated forecasting techniques to support
inventory acquisition decisions is summarized below.

The Longs Drug Stores chain uses “demand chain science” to cut costs related to inventory acqui-
sition and replenishment. Each day, using application software developed by Nonstop Solutions
(now named Evant), pharmacy managers generate a 90-day inventory replenishment plan based on
a statistical analysis of more than 150 variables for each product. In addition to the daily replenish-
ment plan, pharmacy managers also get a biweekly top-ten list of how much money they can save
7
by returning unneeded drugs to their manufacturers.

Using Reports for Decisions and Activities
Finally, after reports have been prepared, these reports are used by third parties to make economic decisions
related to the company. Users external to the entity, such as creditors and investors, rely on these reports (in the
form of financial statements) to make lending and investing decisions with respect to the organization. This text
focuses on the use of accounting reports for internal purposes. Summary reports are prepared for managers to
allow them to perform the following basic activities:

6
“The Best Thing Since the Bar-Code,” The Economist (February 8, 2003), 72 and Matthew Boyle, “Wal-Mart Keeps the Change,”
Fortune (November 10, 2003), 46.
7
Amy Doan,“Vitamin Efficiency,” Forbes (November 1, 1999), 176–186.
1 / Introduction to Managerial Accounting 1-7
1. Decision-Making
2. Planning
3. Directing Operations
4. Controlling

The process of decision-making requires management to select from among various alternatives. For
example, General Motors (GM) must decide what types of automobiles to manufacture and the quantities of those
automobiles to manufacture. Once these decisions have been made, they must establish a selling price for the
automobiles to provide an adequate profit margin. All of these choices represent decisions that require
information from both accountants and other sources. In deciding the type and quantities of automobiles to
manufacture, GM will undoubtedly rely on both historical and forecast sales data. In establishing the price of its
automobiles, one important piece of information of interest to GM is the costs it incurs in manufacturing those
automobiles. Managerial accountants will provide management with this and other important information needed
in making decisions.
Planning requires goals to be established in order to achieve certain objectives. These objectives are
normally closely related to the decisions made by the organization, as discussed above. After GM has determined
the quantity of automobiles to manufacture, it must acquire sufficient materials and labor inputs to complete that
level of production. Further, GM should commence production to allow the automobiles to be completed in a
timely fashion for distribution to its dealers. As each of these actions is taken to achieve objectives (completing
and distributing automobiles), collectively, they are integral parts of the planning process.
Directing operations requires oversight of the day-to-day operations of the entity. One very important aspect
for manufacturing companies is ensuring that production is completed on a timely basis. In directing operations
for GM, the need for additional materials and labor inputs should be periodically monitored to reduce “down
time” (a period during which operations must cease). For a service-oriented entity (such as a restaurant), directing
operations may include such diverse activities as ensuring that customers are served promptly and efficiently,
providing complementary meals for customers experiencing excessively long waits for service, and identifying
the number of kitchen and wait personnel required during “peak” dining times. The distinguishing feature of
directing operations is that this type of activity requires “hands on” attention from company personnel.
The critical role that a company’s information system plays in the process of directing operations and the
devastating consequences that can result from an information system failure are illustrated in the following
excerpts from practice.

Hershey Foods Corporation experienced a gigantic Halloween scare when complications associat-
ed with the implementation of its new inventory ordering and distribution system resulted in nation-
wide shortages of Kisses, Kit Kats and other Hershey staples right before the start of the trick-or-
treat season—the single biggest candy-consuming holiday. System-related problems in inputting
order data and transmitting it to warehouses resulted in Hershey’s inability to meet customer deliv-
8
ery deadlines, despite the fact that the company had plenty of candy on hand to fill all of its orders.
A breakdown in communications in its extensive supply chain contributed to Cisco System’s May
2001, $2.2 billion inventory write-down. Cisco’s supply-chain system failed because it provided
information only to contract manufacturers. Multiple manufacturers competing for a specific con-
tract ordered the necessary component parts in anticipation of being awarded the contract.
Suppliers of component parts were then swamped with multiple orders from the competing manu-
facturers and believed that demand for parts was two to three times the actual demand. A new com-
munications system called eHub is being implemented to correct the disconnect in the system.
eHub communicates the demand originating from Cisco to all members of the supply chain, allow-
ing both suppliers and manufacturers to anticipate orders and eliminating double ordering, parts
shortages and other inefficiencies.9

The final activity performed by management is controlling. Controlling is the process of determining
whether the organization’s operations are being conducted in a manner consistent with its goals. This process
involves comparing actual operating results to expected (or budgeted) operating results. For example, GM may

8
Emily Nelson and Evan Ramstad, “Hershey’s Biggest Dud Has Turned Out to Be Its New Technology,” The Wall Street Journal
(October 29, 1999), A1, A6.
9
Paul Kaihla, “Inside Cisco’s $2 Billion Blunder,” Business 2.0 (March 2002), 88-90.
1-8
compare actual production, revenue, and profit information with expected information for the same time period.
An additional comparison of special interest to manufacturing companies (such as GM) involves the actual
inputs required for a given quantity of production. That is, did GM use a greater amount of materials, labor, and
other inputs in producing automobiles than planned? Comparisons of this nature require the company to develop
standards against which performance can be measured. These standards will be discussed in detail later in this
text.

Feedback
The final step in the accounting system depicted in Illustration 3 involves receiving and using feedback. This
feedback provides management with information regarding the effectiveness and efficiency of its decisions and
activities. For example, assume that previous experience suggested that GM needed eight hours of machine time
and fifty hours of human labor time to produce a particular type of automobile. Based on this information, GM
began production of a series of 100 of these automobiles. If a total of 600 machine hours and 6,000 labor hours
were required to complete production, one of two possibilities exists. First, GM’s production personnel may have
performed more or less efficiently than planned. Alternatively, GM may wish to consider revising its production
requirements to six machine hours (600 hours ÷ 100 automobiles = 6 hours) and sixty labor hours (6,000 hours
÷ 100 automobiles = 60 hours) for subsequent production runs.
The importance of timely information regarding the company’s operations is illustrated in the following
example from practice.

The inability of employees to provide information about the costs invested in a work-in-process
plane led Boeing’s President Harry Stonecipher to revamp the aircraft manufacturer’s accounting
system to provide more timely information. “Here’s a company that’s doing better than $50 billion a
year. That’s a billion dollars a week! And we’re rolling this dude up once a quarter? Folks, there’s
a lot of money going by here.” Stonecipher’s initiative has resulted in Boeing closing its quarterly
accounts in 10 days, as opposed to the three weeks it took previously. Stonecipher’s ultimate goal:
10
three days.

The Role of Accountants in the Management Process
As noted above, managers engage in decision-making, planning, monitoring operations, and controlling.
because of the large size of most organizations, they must rely on information supplied by management (or
managerial accountants in performing these activities. The relationships between the activities of management
and managerial accountants are shown in Illustration 4. As can be seen herein, the activities of managerial
accountants involve the traditional responsibilities associated with accounting—recording, classifying,
summarizing, and interpreting information. From our earlier discussion of the accounting system, this
information will be summarized in the form of reports that will be used by management, an internal user of the
organization.
Three examples of accounting systems used by well-known companies are summarized on the following
page.

Location of the Accounting Function
Where in the typical organization do managerial accountants gather the data for their reports? They must
gather information on activities in all parts of the the organization; thus all departments are potential subjects of
the managerial accountant’s attention.
Most manufacturing concerns recognize each major business function as a separate area of responsibility
and structure their organizations accordingly. Each rectangle in the organization chart in Illustration 5 represents
a separate function in the organization. The overall management function is the responsibility of the board of
directors and the president of the corporation. At the next level, responsibility is separated for finance,
manufacturing, and sales, the three major subfunctions of many firms.

10
Jerry Useem, “Boeing vs. Boeing,” Fortune (October 2, 2000), 155-156.
1 / Introduction to Managerial Accounting 1-9

The manager of a 7-Eleven outlet in Tokyo, Japan relies heavily on a computerized management
information system to provide him with information about the purchasing habits of his customers
and the items stocked in his store. This information shows what products are selling at various times
of the day. This allows the manager to restock shelves with rice dishes that are popular with salary-
men who shop between 7 and 9 p.m. and potato chip snacks that children buy on their way home
from school.11

Pizza Hut spent over $20 million in 1993 to create electronic profiles of its customers. This system
attempts to match the tastes of Pizza Hut’s customers to the coupons sent to those customers. For
example, individuals who normally ordered Neapolitan style pizza received coupons for that type of
pizza. Also, customers who had not ordered pizza for relatively long time periods received larger dis-
counts than others. Pizza Hut has found that matching customers and their buying habits is more
effective than sending uniform coupons to all of its customers.12

Blockbuster Entertainment, the world’s largest video rental and entertainment chain, has a customer
card carried by over 40 million Americans, making it more widely held than the American Express
card. When customers make purchases or rent videos, this card is used to provide customers with
discounted merchandise. Each time the card is scanned, Blockbuster’s database knows more about
its customers’ buying habits. For example, when country-western star Garth Brooks comes to
Blockbuster’s Phoenix (Arizona) amphitheater, the company can target a mailing to all of its Arizona
13
cardholders who have purchased Garth Brooks recordings.

Illustration 4
Activities of Managers
and Managerial Accountants

Management Activity Example(s) Managerial Accounting Activity

• Determine the quantity of desired • Accumulate data on historical and
Decision-Making production anticipated demand

• Establish the price of the organiza- • Accumulate data on costs of pro-
tion’s product or service ducing product or providing service

• Determine quantities of inputs • Develop performance standards
Planning required for production based on previous input require-
ments
• Identify expected operating results • Prepare budgets or forecasts
Directing Operations
• Ensure that sufficient inputs exist • Accumulate data on inputs used
to continue production and inputs needed In production

• Ensure that staffing is sufficient to • Accumulate data on personnel
meet customer needs during peak needs for these time periods
demand periods
• Compare actual activity with antici- • Accumulate data on actual activity
Controlling pated activity
• Develop performance standards or
other measures of anticipated
activity
• Assist in comparing actual activity
to anticipated activity
• Identify possible explanations for
differences in actual and anticipat-
ed activity

11
“Information Power,” Forbes (June 21, 1993), 44.
12
“How to Get Closer to Your Customers,” Business Week: Enterprise Edition (1993), 44.
13
“Pressing Fast-Forward,” US News & World Report (May 16, 1994), 55.
1-10
The managers of the three major subfunctions are directly responsible to higher management for their
operations and performance; that is, they serve in a line relationship to top management. The vice president in
charge of sales is directly responsible for maintaining and increasing sales activities; the vice president in charge
of manufacturing is responsible for maintaining production at levels established or projected by top management.
Line relationships indicate that one party (a superior) directly or indirectly supervises the work of a second party
(the subordinate).
Staff relationships, on the other hand, exist when one department serves in an advisory capacity and provides
services to other departments upon request. Therefore, no direct supervision or responsibility exists in a staff
relationship. On most organizational charts, staff relationships are presented in a horizontal relationship to the
line functions that they service, whereas line functions are represented by vertical connectors between
subordinates and their immediate supervisors. Line and staff relationships are portrayed by solid and broken
connectors, respectively, in Illustration 5. Although the distinction between line and staff may be hazy, it is
generally agreed that line authority is exerted downward over subordinates, whereas staff authority is exercised
laterally or upward. Managerial accountants perform a staff function by providing line managers and other staff
managers with specialized information. Accordingly, the accounting function in Illustration 5 is related to other
functions by broken-line connectors. Accountants provide advice and help in planning operations, determining
actual costs, developing controls, and making special decisions. After the information is collected, reports are
prepared and distributed both to the line or staff functions from whom information was gathered and to the
manager who requested it.

Illustration 5
Typical Organizational Chart

Budget Board of Directors
Committee President
(strategic (overall
planning) management)

Finance Advertising
Personnel Manufacturing Sales
(raising and (promoting
(hiring) (producing) (selling)
disbursing money) products)

Third- Third-
Accounting
Level Level
Department
Management Management

Relationships
Line: Solid connector
Staff: Broken connector

The typical accounting department is headed by a controller. The immediate supervisor of the controller is
generally an officer in the finance division, often the vice president in charge of finance. To summarize, the
controller and his or her accountants are directly responsible to the vice president of finance, but they also act in
a staff capacity to the rest of the organization.
1 / Introduction to Managerial Accounting 1-11
Overview of the Managerial Accounting Function
Illustration 4 suggests that managerial accountants perform several functions in providing assistance to
management. These functions are briefly discussed to provide an overview of the managerial accountant’s
responsibilities. These responsibilities are discussed in further detail in subsequent chapters of this text.

Preparing Budgets and Devising Standards
A basic managerial accounting activity relates to the preparation of budgets. Budgets are formal plans
expressing courses of action in quantitative terms. Budgets can encompass either a short- term or long-term
period of time. For example, accountants often prepare budgets for management which determine how many
units of inventory need to be produced in a given period of time (usually a month) in order to meet that period’s
expected demand. Accountants can also prepare budgets encompassing longer periods of time. For potential
capital expenditures, accountants identify the expected costs and cash savings associated with the expenditure to
provide management with an indication of the desirability of the expenditure. This type of budgeting is referred
to as capital budgeting.
Performance standards are used by management to identify areas where potential inefficiencies may exist.
For example, assume that performance standards suggest that 100 hours of labor are required to produce a given
number of units; if 200 hours are actually used to produce this quantity, the difference may suggest that workers
are not performing up to their capabilities. Managerial accountants often help establish performance standards
for the entity and assist management in interpreting the relationship between actual performance and these
standards.

Accumulating Data on Costs and Profits
When an entity manufactures the inventory it sells to its customers, a critical requirement of the accounting
system is that all costs associated with the production of the inventory (referred to as product costs) are accurately
accumulated. These costs should be included with the inventory as it moves through the various stages of
production and are expensed (as cost of goods sold) when the inventory is sold to customers. Accumulating the
costs associated with inventory is a central activity performed by managerial accounting. In addition, managerial
accountants also accumulate data on profits. These data are used to provide reports on the profitability of the
entity. Information in these reports is used in making both pricing decisions (how much do we need to charge for
unit X to “break even” if we sell 100 units?) as well as evaluation decisions (does segment Y earn enough to
cover its variable costs?). This latter type of analysis is referred to as cost-volume-profit analysis and is an
important consideration in the organization’s decision to sell its products and/or services.

Comparing Actual Activity with Plans or Budgets
In many instances, accounting data are used to evaluate personnel and/or pinpoint areas that may require
additional attention. Once actual results have been achieved, they can be compared to planned or budgeted
results. Any unexpected differences between actual and budgeted results may suggest the need for increased
managerial attention. In addition to identifying areas where additional attention may be needed, individuals
and/or departments within the organization are often evaluated based upon how they perform in relation to the
budget. The managerial accountant often gathers this information and prepares summary reports that present how
actual performance differs from planned (or budgeted) performance.

Advising Management About Nonroutine Decisions
The three functions discussed above are related to the normal day-to-day operations of the company. As a
result, managerial accountants frequently gather and summarize information related to those types of activities.
In other cases, management may request assistance in making decisions of a less routine nature. Some of these
decisions include: (1) discontinuing an industry segment or product line, (2) manufacturing components used in
producing inventory versus purchasing components from an external supplier, and (3) purchasing long-term
assets for use in production (capital budgeting). The managerial accountant will gather information about the
consequences of alternatives in these decisions.
1-12

Summary
Chapter 1 introduces managerial accounting and contrasts this form of accounting with financial accounting. In
addition, the basic functions performed by managerial accountants are discussed. Some of the more important
concepts in this chapter are summarized below.

1. Accounting is defined as the process in which transactions and events are recorded, classified, summarized,
and interpreted. Financial accounting is concerned with the information needs of users external to the entity,
such as potential investors and creditors. Managerial accounting is concerned with the information needs of
users internal to the entity, such as managers and other personnel.

2. Financial and managerial accounting differ along several dimensions, including: (1) the presence of an
underlying authority, (2) the types of reports issued, (3) the types and nature of data considered, and (4) the
users of the reports. However, both types of accounting require information to be summarized, classified,
interpreted, and recorded for users’ decisions.

3. The accounting system is intended to provide management with information necessary to conduct its four
major types of activities. These activities include decision-making, planning, directing operations, and
controlling.

4. Managerial accountants perform several types of activities in order to provide information needed for
managerial decisions and activities. These activities include: (1) preparing budgets and devising standards,
(2) accumulating data on costs and profits, (3) comparing actual activity with plans or budgets, and (4)
advising management about nonroutine decisions. In all of these activities, managerial accountants prepare
accounting reports for management which contain relevant information and/or assist management in
interpreting these reports.

5. Within an organization, the relationship between various departments and/or functions can be described
based on whether the department has responsibility to other department(s). When one department has direct
responsibility to another department, it is said that a line relationship exists. In a staff relationship, one
department serves in an advisory capacity and provides services to other departments when requested to do
so. The accounting department is typically located as a staff relationship within the organization.

Key Definitions
Accounting—the process of recording, classifying, summarizing, and communicating economic information
about an entity to a particular group of users. This information is used by these individuals to make decisions
concerning the entity.
Accounting report—the output of an accounting system which is used by the accountant to communicate
information about an entity to interested users.
Accounting system—a series of tasks and activities developed by an entity to record, classify, summarize, and
communicate information about an entity’s activities.
Budget—a formal plan of action expressed in quantitative terms.
Controller—the executive responsible for managing the accounting function (sometimes spelled as
“comptroller”).
Financial accounting—the class of accounting interested in providing information about the transactions and
activities of an entity to users who are external to an entity. These users include creditors and investors.
Line relationship—a type of relationship in which one party (the superior) directly or indirectly supervises the
work of a second party (the subordinate).
Managerial accounting—the class of accounting that is concerned with recording, summarizing, interpreting,
and communicating information to interested users who are internal to the entity.
Manufacturing company—a company whose primary revenue-generating activity is through the sale of
inventory to its customers. A manufacturing company manufactures (or produces) its inventory using
materials purchased from outside vendors.
1 / Introduction to Managerial Accounting 1-13
Retail company—a company whose primary revenue-generating activity is through the sale of inventory to its
customers. Retail companies do not manufacture their inventory but purchase it in salable form from outside
vendors.
Service company—a company whose primary revenue-generating activity is through providing services to its
customers.
Source document—an internal document used by accounting personnel to summarize a transaction that has
occurred.
Staff relationship—a relationship in which one party serves in an advisory capacity and provides services to
other departments only when they are requested to do so.

Questions
1. “Decision-makers require quantitative information to make optimal decisions.” List reasons why this
statement might be true.

2. Define accounting. In your definition, indicate major activities that characterize the process of accounting.

3. How does the process of accounting allow decisions to be made by individuals who are less familiar with
the activities of the company?

4. Distinguish between financial accounting and managerial accounting.

5. How are financial accounting and managerial accounting similar?

6. Who are the primary users of financial accounting information? Managerial accounting information?

7. What are the major steps in a typical accounting system?

8. Define the three major types of companies (based on their revenue-generating activities). Which of these
types of companies utilize managerial accounting information?

9. How are the reports prepared in an accounting system different for financial accounting information and
managerial accounting information?

10. List and briefly describe the four functions normally performed by management. How does the managerial
accountant assist management in performing these functions?

11. What is a budget? What time frames can be encompassed by budgets?

12. Define controlling. How does management attempt to perform this function?

13. Differentiate between line and staff authority. Which type of authority does the controller have?

14. Describe the role of accountants in the management process.
1-14
15. Michael Johnson, the sales manager of Computation, Inc., is discussing the pricing of a new product soon
to be placed on the market with the president, Thomas Samisen:
Tom, we have to set the price on our new calculator before the end of the day so that we can order the sales
brochures.

I thought that question was settled at the weekly executive meeting yesterday, Mike. According to the cost
figures prepared by our new accountant, yesterday’s decision seems perfectly reasonable.

But what does an accountant know about trying to sell a product against stiff competition?

Well, Mike, why don’t you write out your objections and present them at next week’s meeting?

What problem do you observe in this organization?

16. In the following examples, identify the problem that may exist in either the accountant’s role, the decision-
making process, or the purposes of the managerial accounting system.

a. The logistics department manager schedules truck departures on the basis of information he receives
from the production department manager, whom he has known for twelve years. The shipping clerk is
complaining because backlogs have built up.
b. The sales projection committee meets on the last working day of each month to update the monthly
projected sales quota for the next twelve-month period. The sales figures employed at this meeting are
furnished by the assistant vice president of sales. The accounting department’s monthly performance
reports are issued on the 10th of the following month.
c. The Cord Tire Company has a flexible pricing structure. The sales department uses the production cost
sheets as prepared by individual machine operators to price each order. The accounting department
manager has argued that the pricing policy does not include charges for administrative expenses. The
sales manager says that he is using last year’s figures to approximate the administrative and sales
expenses.
d. John Thompson, a lathe operator for the Twilight Lamp Company, has complained to his line foreman
that the performance standards set by the accounting department are too stringent. Furthermore, John
asks, “How does that accountant know what it’s like to work down here on the production line? He
never leaves his plush office.” The line foreman agrees with John but says that he has no control over
upper management.

17. Define feedback. In addition to helping managers improve their view of the real world, how can feedback
improve the managerial process?

18. Both the managerial accountant and the manager are involved in the decision-making process. How do their
roles differ?

19. Does management or the managerial accountant set the goals and objectives of the organization? Does
management or the managerial accountant determine the means by which the chosen goals and objectives
will be achieved? Does management or the managerial accountant determine what information should be
reported, when it should be reported, and how it should be reported?

20. When management wishes to plan or forecast to achieve organizational coordination or motivation, what
action does the managerial accountant take?

21. How can a managerial accountant help management ascertain the status of current operations or the
organization’s financial position?

22. The managerial accountant may compare data on actual activities with plans or budgets so that management
will be better able to engage in what type of activity?

23. List four activities commonly performed by managerial accountants.
1 / Introduction to Managerial Accounting 1-15
24. Classes of Accounting. Indicate whether each of the following terms is most closely related to financial
accounting or managerial accounting. Use “F” for financial accounting and “M” for managerial accounting.
A particular term may relate to both financial accounting and managerial accounting.
_____ Balance sheet
_____ Budget Control
_____ Cost accumulation
_____ Forecast information
_____ Decision-making
_____ Generally accepted accounting principles
_____ Income statement
_____ Planning
_____ Historical information

25. Classes of Accounting. The Ways Company has suffered a terrible year. Sales dropped 40 percent, cost
increased 5 percent, income went from a profit of $1,500,000 to a $5,000,000 loss, and the president’s wife
told him her brother wanted to enter the business. The company was listed on the New York Stock Exchange
and wished to remain there. When asked for cost-reduction ideas, the production manager recommended
reducing the accounting costs. The accounting department has four major cost segments: financial
accounting, tax reporting, the auditor’s bill, and managerial accounting. The controller determined that no
excess cost could be cut from any of these segments without the loss of that function.

a. If the production manager is right, which accounting function could be eliminated by this company?
Why?
b. What arguments could be used for keeping all the accounting functions at operating strength?
c. Which accounting function would be the hardest to defend? Why?
d. In periods of financial difficulty, would the accounting department be one of the first areas to contract?
In actual practice, which other functions or departments are more likely candidates for contraction than
accounting?

26. Managerial Accounting–General. A small company producing parts for the automobile industry is taking a
hard look at its staff functions to determine whether they have “grown beyond their worth.” The standard
functions of financial, tax, and managerial accounting are performed by three men. The reason for having a
managerial segment seems hazy. As the president states, “I handle any control problems. If someone needs
a push, I know it before the accountants tell me. All the accounting people do is confirm that I push the right
one.”

a. If the president is right, should the managerial segment be abolished?
b. What could be done to improve the existing control function?
c. If the president believes control is the only function of managerial accounting, what could be done to
expand his viewpoint?
d. Do you think the president worked his way up to his position through the financial side of the business?
Is the president’s background of any importance in ascertaining possible problems between the financial
side of the business and top management? Explain.
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27. Managerial Accounting Activities. The four major activities performed by the managerial accounting
function are: (1) preparing budgets and devising standards, (2) accumulating data on costs and profits, (3)
comparing actual activity with plans or budgets, and (4) advising management on nonroutine decisions.
Indicate (by using the numbers 1-4) which activity is associated with each of the following questions. Each
question may be associated with more than one activity.

_____ 1. How long should it take employees to produce one unit of inventory?
_____ 2. Should this particular component be purchased from an external supplier or manufactured
internally?
_____ 3. Were last period’s operating results consistent with our expectations?
_____ 4. What was the actual cost of producing our inventory?
_____ 5. How much inventory should be purchased to meet next period’s production needs?
_____ 6. Should we discontinue this product line?
_____ 7. How efficient were we in using direct materials in the production of inventory?
_____ 8. How many units of our new product need to be sold to recover our costs of production?

28. Management Functions. Indicate which of the following management functions is most closely related to
each of the following terms or statements. Each statement can be related to more than one management
function. Use the following abbreviations in your answer:
DM = Decision-making
P = Planning
DO = Direct operations
C = Controlling
_____ 1. Preparing and evaluating budgets.
_____ 2. Responding to unexpected shutdowns or delays in production.
_____ 3. Establishing the selling price for one of the organization’s products.
_____ 4. Investigating the efficiency of production operations.
_____ 5. Determining the production levels necessary to satisfy future levels of demand.
_____ 6. Ensuring that customers are serviced promptly and efficiently.
_____ 7. Comparing actual revenues to anticipated revenues.
_____ 8. Acquiring sufficient direct materials inputs to ensure that production needs can be met.
1 / Introduction to Managerial Accounting 1-17
29. Organizational Relationships. One of the first steps in management control is to produce an organizational
chart. Producing an accurate chart may be difficult if job performance does not conform to the sphere of
activity implied by the job title. Strong employees tend to view their jobs and spheres of activity broadly,
whereas others view their jobs narrowly.
For the following problem, assume that each job is exactly what its title implies. Identify any title that
might be ambiguous. Next, draw an organizational chart using the same job titles.

a. Controller
b. President
c. Head Designer
d. Vice President of Manufacturing
e. Vice President of Personnel
f. Manager of Accounting
g. Manager of Salary Personnel
h. Manager of Hourly Personnel
i. Vice President of Sales
j. Manager of Budgeting
k. Manager of General Accounting
l. Production Superintendent
m. Sales Manager
n. Assembly Line Foreman
o. Maintenance Foreman
p. Production Control Foreman
Learning Objectives

Chapter 2 provides an overview of the types of costs incurred by organizations and how these costs change
with changes in the level of activity. Studying this chapter should enable you to:

1. Define and provide examples of different types of costs incurred by organizations.
2. Distinguish between product and period costs and understand how these costs are treated for financial
reporting purposes.
3. Define the relevant range and understand its importance in discussing cost behavior.
4. Identify how variable costs, fixed costs, step costs, and semi-variable costs behave over changes in activity.
5. Use the graphical method, two-point method, semi-averages method, and least squares regression method
to identify the fixed and variable components of semi-variable costs.

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