This chapter explains why managers need good accounting information to compete in the modern production environment and identifies ways to improve quality, including performance measures that support it and the balanced scorecard. It covers how just-in-time purchasing and production reduce costs and improve quality, and defines activity-based costing and its four steps.
Quality, performance measures, and the balanced scorecard
Good accounting information helps managers compete by revealing where quality is falling short, since defective products damage customer loyalty and ultimately company performance, and by developing performance measures, such as quality control, delivery performance, and materials waste, that make quality tangible and trackable. The balanced scorecard extends this further, helping organizations recognize and manage responsibilities that can pull in opposing directions, such as satisfying customers today while investing for the company’s longer-term financial health.
Just-in-time purchasing and production
Just-in-time purchasing and production aim to reduce costs and improve quality by receiving materials and producing goods only as they are needed, cutting the inventory a company must hold and the waste and errors that large inventories can hide. Accounting in a just-in-time setting differs from accounting in a traditional setting, often combining accounts that were previously kept separate and tracking costs by the product line or cell where work actually happens rather than by individual department.
Activity-based costing and management
Activity-based costing assigns overhead to products based on the specific activities that drive its cost, rather than spreading it using a single volume-based rate, through four steps: identifying activities, assigning costs to activity cost pools, computing a rate for each activity, and applying costs to products according to their use of each activity. Product costs computed this way often differ substantially from those under traditional costing, and activity-based management extends the approach to focus attention on which activities genuinely add value.
This chapter states the advantages and disadvantages of the corporate form of business and lists the values commonly associated with capital stock. It covers the various kinds of stock and how they differ, presenting the stockholders’ equity section of a balance sheet, and accounting for stock issued for cash and other assets.
The corporate form and stock values
Organizing as a corporation offers advantages such as limited liability for owners, ease of transferring ownership through shares, and continuity of life beyond any one owner, but it also carries disadvantages, including double taxation of corporate income and greater regulation than other business forms. Capital stock carries several distinct values, including par or stated value, the amount printed on the certificate, and market value, the price at which shares actually trade, and these values do not necessarily move together.
Classes of stock and issuing shares
Common stock represents the basic ownership class and normally carries voting rights, while preferred stock typically gives up voting rights in exchange for preferences, such as a stated dividend rate paid before common shareholders receive anything and, often, priority in liquidation. Stock is recorded at the fair value of what is received when issued for cash, and at the fair value of the stock or of the assets received, whichever is more clearly determinable, when issued for noncash assets.
Presenting equity and measuring book value
The stockholders’ equity section of the balance sheet presents paid-in capital, broken out by class of stock and any amounts received above par, together with retained earnings, so a reader can see both what owners contributed directly and what the company has earned and kept. Book value per share, computed separately for preferred and common stock, and return on average common stockholders’ equity, which relates net income available to common shareholders to their average equity investment, are used to evaluate a corporation’s performance for its owners.
This chapter explains how to report stock investments and distinguishes the cost method from the equity method of accounting for them. It covers journal entries for short-term stock investments and for long-term investments of 20 to 50 percent, parent and subsidiary corporations, and preparing consolidated financial statements.
Cost method versus equity method
A short-term or a long-term investment of less than 20 percent in another company’s stock, where the investor cannot exert significant influence, is generally accounted for under the cost method, recording dividends received as income. Once an investment reaches 20 to 50 percent, significant influence is presumed and the equity method applies instead, under which the investor recognizes its proportionate share of the investee’s income as it is earned, not merely when a dividend is declared, and adjusts the investment account accordingly.
Parent and subsidiary corporations
When one corporation, the parent, acquires a controlling interest, typically more than 50 percent, in another corporation, the subsidiary, the two remain separate legal entities but are combined for financial reporting purposes as a single economic unit. This combination is necessary because the parent’s own financial statements alone would not reflect the full scope of resources and operations it actually controls through its subsidiaries.
Consolidated statements and analyzing returns
Consolidated financial statements are prepared using a consolidated statement work sheet that combines the parent’s and subsidiary’s individual statements and eliminates transactions between them, such as intercompany receivables and payables, so the group is reported as though it were one company; they carry the limitation of obscuring the results of any single subsidiary. Dividend yield, dividends per share divided by market price, and the payout ratio, dividends divided by earnings, help analysts assess a stock’s return to shareholders relative to its price and profits.
This chapter compares the contribution margin income statement to the traditional income statement format and introduces differential analysis as a framework for short-term decisions. It covers using differential analysis for pricing decisions, accepting or rejecting special orders, eliminating or adding product lines, choosing whether to process joint products further, and make-or-buy decisions.
Contribution margin format and differential analysis
The contribution margin income statement separates variable costs from fixed costs, in contrast to the traditional format, which separates manufacturing costs from selling and administrative costs, and this makes it far more useful for the short-term decisions covered in this chapter. Differential analysis compares the revenues and costs that differ between two or more alternatives, focusing only on those relevant differences rather than on costs that will be incurred regardless of which choice is made.
Special orders, product lines, and joint products
A special order below normal selling price can still be worth accepting if it uses otherwise idle capacity and the incremental revenue exceeds the incremental cost, since existing fixed costs are typically unaffected either way. Deciding whether to eliminate or keep a product line or segment requires examining whether that segment’s own contribution margin covers its directly traceable fixed costs, and a joint product reaching its split-off point should be processed further only if the additional revenue exceeds the additional processing cost.
Make-or-buy and quality decisions
A make-or-buy decision compares the cost of producing a component internally, including only the costs that would actually be avoided by buying it, against the price of purchasing it from an outside supplier, while also weighing what else the freed-up capacity could be used for. Differential analysis can likewise support decisions to invest in improving product quality, by comparing the added cost of quality improvements against the value of the defects, returns, and lost sales they are expected to prevent.
This chapter explains responsibility accounting and its use in a business, and how to prepare responsibility accounting reports for the managers held accountable for each responsibility center. It covers preparing a segmental income statement using the contribution margin format, calculating return on investment, margin, and turnover for a segment, and calculating a segment’s residual income.
Responsibility centers and reports
As a business grows, authority for its activities is delegated to lower-level managers who are then held responsible for the revenues, costs, or investments under their control, and the business is organized into responsibility centers accordingly. Responsibility reports measure each manager’s performance against a budget for only the items that manager can actually control, with unfavorable and favorable variances highlighted so results flow up through the organization from first-level supervisors to top management.
The segmental income statement
A segmental income statement uses the contribution margin format, separating variable from fixed costs and further dividing fixed costs into those directly traceable to a segment and those that are common to the company as a whole, so a segment’s contribution to overall profit can be judged without being distorted by arbitrary allocations of unrelated costs.
Return on investment and residual income
Return on investment relates a segment’s income to the assets invested in it, and can be broken into margin, income divided by sales, and turnover, sales divided by invested assets, so a change in return on investment can be traced to a change in profitability or in asset efficiency. Residual income instead measures the income a segment earns above a minimum required return on its invested assets, which can avoid return on investment’s tendency to discourage a manager from accepting a profitable project that would lower an already-high average return.
