MAC Answers to book questions PDF

Preview

Summary

Chapter 1 – IntroductionSummaryThis book provides a framework for the analysis, use, and design of internal accounting systems. It explains how these systems are used for decision making and motivating people in organizations. Employees care about their self-interest, not the owners’ self-interest. ...

Description

MAC Answers to book questions

Chapter 1 – Introduction

Summary This book provides a framework for the analysis, use, and design of internal accounting systems. It explains how these systems are used for decision making and motivating people in organizations. Employees care about their self-interest, not the owners’ self-interest. Hence, owners must devise incentive systems. Accounting numbers are used as measures of managers’ performance and hence are part of the control system used to motivate managers. Most firms use a single internal accounting system as the primary data source for external reporting and internal uses. The fact that managers rely heavily on accounting numbers is not fully understood. Applying the economic Darwinism principle, the costs of multiple systems likely outweigh the benefits for most firms. The costs are not only the direct costs of operating the system but also the indirect costs from dysfunctional decisions resulting from faulty information and poor performance evaluation systems. The remainder of this book addresses the costs and benefits of internal accounting systems.

Q1–1 What causes the conflict between using internal accounting systems for decision making and control?

One system cannot be designed to maximize two conflicting objectives better than two systems each maximizing one objective. If a single system is used for both decision management and decision control, tradeoffs must be made to create a balanced system that maximizes profits for the firm.

Q1–2 Describe the different kinds of information provided by the internal accounting system.

An internal accounting system provides managers and executives with key cost information regarding their business. Examples include financial budgets, inventory costs, product costs, factory costs, and overhead costs.

Q1–3 Give three examples of the uses of an accounting system.

i. External reports (taxes, financial statements). ii. Performance evaluations. (How well did a manager meet profit expectations for a given year?) iii. Decision making. (Does continuing to produce a given product line maximize firm profit?)

Q1–4 List the characteristics of an internal accounting system.

An internal accounting system should have the following characteristics: i. It should provide information necessary to identify the most profitable products and at what volumes they should be produced. ii. It should provide information in such a way that production inefficiencies are detected. iii. In combination with the performance evaluation and reward systems, the internal accounting system should create incentives for managers to maximize firm value. iv. It must support the financial and tax accounting functions. v. Its cost-to-benefit ratio must be less than 1.

Q1–5 Do firms have multiple accounting systems? Why or why not?

Few firms have multiple systems. Typical reasons include: i. There are additional costs required to maintain multiple systems, including additional data processing and bookkeeping costs. ii. There is confusion surrounding different measures. Managers wonder which system has the “right” number. The natural tendency is to reconcile the difference. Reconciliation is costly in terms of time. iii. With one system, the external auditor can also be

1

MAC Answers to book questions used to monitor and control the internal reporting system at little additional cost.

Q1–6 Define economic Darwinism.

Surviving firms in competitive industries tend to use administrative procedures whose benefits net of costs are at least as high as their competitors’. In a competitive world, if surviving organizations are using some operating procedure over long periods of time, then it is likely that this procedure is yielding benefits in excess of costs.

Q1–7 Describe the major functions of the chief financial officer.

The chief financial officer’s major responsibilities involve providing all the accounting reports for both external parties and management, tax administration, budgeting, treasury including financing, investments, and internal audit.

2

MAC Answers to book questions

Chapter 2 – The Nature of costs

Summary This chapter emphasizes that decision making requires knowledge of opportunity costs, or the benefits forgone from actions precluded by the alternative selected. Opportunity costs can be determined only within a specific decision context by specifying all the alternative actions. While opportunity cost is the theoretically correct concept to use in decision making, it can be costly to estimate. Special studies are required to identify the alternative actions and forecast their likely consequences. Accounting costs often provide useful and less costly approximations for opportunity costs. However, costs reported by accounting systems are not opportunity costs. Opportunity costs are forwardlooking and are usually not recorded by accounting systems. Accounting costs measure the monetary resources expended for a particular activity. They provide a useful database to begin the process of estimating opportunity costs. Accounting costs also serve the important function of influencing the behavior of the firms’ employees and managers. The accounting system reports the accounting cost of making the sofa this month and what the cost was last month to make the same sofa. Senior managers can then assess the performance of sofa production, providing incentives for the sofa-producing managers to pay attention to costs. If the accounting cost of the sofa is $208 this month, this number is not the opportunity cost of making the sofa. But if the same type of sofa had an accounting cost of $150 last month, something has happened that senior management will want to investigate. Chapter 4 explores these organizational control issues in more detail. Managers must decide how many units of each product to manufacture. This decision also requires opportunity costs. One method of estimating opportunity costs for these decisions assumes that total costs are linear; hence, total costs are the fixed costs and variable costs per unit. A linear cost curve is also useful for cost–volume–profit analyses. These analyses focus managers’ attention on how costs and profits vary with some volume measure. However, such analyses require assumptions to be made. These include assuming a single-period, single-product plant and linear cost and revenue curves. When someone asks what something costs, the first reaction should be to find out for what purpose the cost number is to be used. If the cost number will be used for decision making, an opportunity cost must be generated for that decision context, which requires the decision maker to specify all the relevant alternative actions. If the number is to be used for financial reporting or taxes, a different cost number will be produced. If the cost number is being used to control behavior within the firm, probably a different number will be used. Cost numbers can vary significantly according to the purpose for which they are being produced. Q2–1 Define opportunity cost.

Q2–2 What are some characteristics of opportunity costs?

Q2–1: The opportunity cost consists of the receipts from the most valuable forgone alternative when making a decision or choice among many options. Q2–2:

i. Opportunity costs are not necessarily the same as payments. ii. Opportunity costs are forward-looking. iii. Opportunity costs can be dated at the moment of final decision. Q2–3 A firm paid $8,325 last year for some raw material it

Q2–3: The $8,325 is an accurate estimate of the

planned to use in production. When is the $8,325 a good estimate of the opportunity cost of the material?

opportunity cost if we can resell the material for that amount or we can replace the material and the future price is expected to be $8,325. In general, historical costs can be reasonably accurate estimates of opportunity costs if the current market price has not changed and there is a ready market to buy and sell the material.

Q2–4 Define sunk cost and give an example.

Q2–4: Sunk costs are costs incurred in the past that cannot be recovered and are therefore irrelevant for

3

MAC Answers to book questions future decision making. An example of a sunk cost is a firm’s purchase of 100 pounds of a material required in a one-time project. Sixty pounds are used in this project. The remaining 40 pounds have no market value. Using the opportunity cost concept, the historical cost of the remaining 40 pounds is sunk and irrelevant for future uses of this material. Q2–5 What are avoidable and unavoidable costs? How are

Q2–5: Avoidable costs are those costs that will not be

they related to opportunity costs?

incurred if an existing operation is closed or changed. Avoidable costs are the opportunity costs. Unavoidable costs are costs that will continue to be incurred regardless of the decision.

Q2–6 Define mixed cost and give an example.

Q2–6: Mixed costs are cost categories that cannot be classified as being purely fixed or purely variable. An example is utilities.

Q2–7 Define step cost and give an example.

Q2–7: A step cost is a cost that is fixed over a given range of output level. For example, supervisory personnel cost is a step cost.

Q2–8 Define fixed cost.

Q2–8: A fixed cost is a cost that does not vary with the number of units produced. Although fixed with respect to volume changes, fixed costs can still be managed and reduced.

Q2–9 Define variable cost. Is it the same as marginal

Q2–9: A variable cost is the additional cost incurred

cost? Explain.

when output is expanded. Labor and materials are usually two variable costs. A variable cost is not necessarily a marginal cost. A marginal cost is the cost of the last unit produced, while variable cost is the portion of the total cost that varies with the quantity produced. If the variable cost is linear, then marginal cost per unit equals variable cost per unit and is constant as volume changes. If variable cost is not linear, marginal cost will be nonconstant.

Q2–10 What are the underlying assumptions in a cost–

Q2–10:

volume–profit analysis?

i. Price and variable cost per unit must not vary with volume. ii. It is a single-period analysis. iii. It assumes a single-product firm.

Q2–11 What are the benefits and limitations of cost–

Q2–11: The major benefit of CVP analysis is that it

volume–profit analysis?

forces managers to understand how costs and revenues vary with changes in output. Its limitations include

4

MAC Answers to book questions i. Price and variable cost must not vary with volume. ii. It is a single-period analysis (no time value of money). iii. It assumes a single-product firm. Q2–12 Why are opportunity costs costly to estimate?

Q2–12: Estimating opportunity costs requires the decision maker to formulate all possible alternative actions and the forgone net receipts from those actions. This is a costly and time-consuming process. Furthermore, the opportunity cost changes as the set of alternative actions changes.

Q2–13 Define direct costs.

Q2–13: Direct costs are those costs that are worthwhile tracing to the unit being costed. Cost/benefit analysis requires one to determine whether tracing the cost has a benefit greater than its costs.

Q2–14 Define overhead costs. How are they

Q2–14: Overhead costs include indirect labor and

allocated?

materials and other general manufacturing costs that cannot be directly traced to the units produced. Overhead costs are usually allocated using a base that most closely approximates those factors that cause overhead to vary in the long run.

Q2–15 What are period costs?

Q2–15: Period costs consist of all nonmanufacturing costs, including selling, distribution, general, and administrative costs. Period costs are not included in the cost of the products that are in inventory. Period costs are written off to the income statement when incurred.

Q2–16 What are motion and time studies? What are their

Q2–16: Motion and time studies break each labor task

objectives?

down to its basic movements and then time each movement. These studies have two objectives: (1) to estimate direct labor costs of a particular job and (2) to reduce these costs by redesigning the way employees perform or redesigning the product to reduce labor input.

Q2–17 How do fixed costs enter the pricing decision?

Q2–17: Fixed costs do not directly enter the pricing decision. Fixed costs (if not incurred yet) only enter the decision to produce or not produce the good or service.

5

MAC Answers to book questions

Chapter 4 – Organizational Architecture

Summary Besides providing information for making operating decisions, accounting numbers are also used in controlling conflicts of interest between owners (principals) and employees (agents). Agency problems arise because self-interested employees maximize their welfare, not the principal’s welfare, and principals cannot directly observe the agents’ actions. The free-rider problem, one specific agency problem, arises because, for agents working in teams, the incentive to shirk increases with team size. Usually it is more difficult to monitor individual agents as team size increases. Also, each agent bears a smaller fraction of the reduced output from his or her shirking. The horizon problem, another agency problem, arises when employees expecting to leave the firm in the future place less weight than the principal does on those consequences occurring after they leave. Transactions that occur across markets have fewer agency problems because the existence of markets and market prices gives owners of an asset the incentive to maximize its value by linking knowledge with decision rights. But once transactions occur within firms, administrative devices must replace market-induced incentives. In particular, firms try to link decision rights with knowledge and then provide incentives for people with the knowledge and decision rights to maximize firm value. To maximize firm value, which involves minimizing agency costs, managers design the organization’s architecture—three interrelated and coordinated systems that measure and reward performance and assign decision rights. The analogy of the three-legged stool illustrates how important it is that the three legs be matched to one another. Changing one leg usually requires changing the other two to keep the stool level. The internal accounting system, used to measure agents’ performance, provides an important monitoring function. Hence, the accounting system usually is not under the control of those agents whose performance is being monitored. Primarily a control device, accounting is not necessarily as useful for decision making as managers would like. The performance evaluation system, one leg of the stool, consists of both financial and nonfinancial measures of performance. Executive compensation plans routinely use accounting earnings as a performance measure both to evaluate managers and to reduce agency costs by constraining the total bonus payouts to managers. Chapter 5 describes two more accounting tools that are used to reduce agency problems: responsibility accounting and transfer pricing. Q4–1 What generates agency costs?

Q4–1: Agency costs are the decline in value resulting from agents pursuing their own interests instead of the principal’s interests. Differences between risk tolerances, working horizons, and excessive job perquisites all contribute to agency costs. Agency costs also arise when agents seek to manage larger organizations, to increase either their job security or their pay.

Q4–2 How are agency costs reduced, and what limits

Q4–2: Agency costs are reduced by monitoring and

them?

bonding activities. Agency costs are limited by the existence of a labor market for managers, competition from other firms, and the market for corporate control.

Q4–3 Define goal incongruence.

Q4–3: Goal incongruence means simply that agents and principals have different utility functions.

Q4–4 How does one achieve goal congruence?

Q4–4: By restructuring the agent’s incentive scheme, the agent’s and principal’s objectives can be made more congruent.

Q4–5 Why are knowledge and decision making linked

Q4–5: Because knowledge is valuable in decision

within a firm?

making, the right to make a decision should reside with the person who has the specific knowledge for the decision.

Q4–6 Name three things markets do automatically that

Q4–6:

6

MAC Answers to book questions must be replaced with elaborate administrative systems in the firm.

i. Measuring performance. ii. Rewarding and punishing performance. iii. Partitioning decision rights to their highest-valued use.

Q4–7 What are influence costs?

Q4–7: Influence costs consist of the forgone opportunities arising from employees trying to affect decisions by politicking and other potentially nonproductive influence activities. Influence costs arise when employees waste valuable time trying to influence decisions.

Q4–8 Why do firms exist?

Q4–8: The firm, defined as a locus of contracts, exists because each resource owner is better off contracting with the firm than either contracting separately with all the resource owners individually or not contracting at all. Each resource owner, by contracting with the firm, is implicitly contracting with all others contracted with the firm. The firm economizes on repetitive contracting and transaction costs are reduced.

Q4–9 Define decision management and decision

Q4–9: Decision management refers to those

control and give an example of each.

aspects of the decision process whereby the manager either initiates or implements a decision (e.g., a supervisor requesting an additional employee to make her department run more efficiently). Decision control refers to those aspects of the decision process whereby managers either ratify or monitor decisions (e.g., the supervisor’s boss ratifying the decision and allowing her to hire an additional employee). Q4–10: All organizations must construct i. Systems that partition decision rights. Decision rights lie initially with the board of directors. The rights are then assigned throughout the organization. ii. Systems that measure performance. The system developed must measure the performance of variables over which the agent has been given decision rights. iii. Systems that reward and punish performance. The system must be matched to the performance variables being measured.

Q4–10 Describe the three systems all organizations must

construct to control agency problems.

Q4–11 Describe the four major steps in the management

Q4–11: The four steps in the decision process are

decision process. How are agency problems reduced in this process?

i. Decision initiation—the beginning of the decision process. This step is usually performed by the person with the specific knowledge; a decision management function. ii. Decision ratification—reviewing and approving the request; a decision control function. iii. Decision implementation—usually associated with the individual(s) who initiated the process; a decision management function. iv. Decision monitoring—evaluating the implem...