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Blocks of rial n 1999, Nissan Motor Company had a problem. With no cash div- idendsand a net lossof over Y684 billionyen (approximately $4.1 bil- lion), CEO Carlos Ghosnknew he had to do something. In his words: "The /ackof profit is like a fever. When your business is not profitable, that's a serious signal that something is wrong. Either the products are not right,or marketing is inefficient, or the cost baseis too high-some- thing is wrong. lf you ignorea fever, you can get very sick.lf you ignore unprofitability, the situationcan only worsen." Ghosn launched the NissanRevival P/an that turned the company aroundby designing and marketing new models, investing in new plant technologies, slashing supply costs, and emphasizing the company's most profitable products. Fiveyearslater, Nissan's annual operating income tops Y861billion yen (approximately $7.6billion).

Managerial Accounting 02

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Blocksof rial

had a problem. With no cashdivMotor Company n 1999,Nissan idendsand a net lossof over Y684 billionyen (approximately $4.1 bilI lio n),CE O CarlosGhosn kne w h e h a d t o d o s o me t h in g . n h is wo rd s : "The /ackof profit is like a fever.When your business not profitable, is is that's a serioussignalthat something wrong. Eitherthe productsare or is not right,or marketing inefficient, the cost baseis too high-something is wrong. lf you ignorea fever,you can get very sick.lf you ignore u n profitability, the situationc a n o n ly wo rs e n . " G h o s n la u n c h e dt h e P/anthat turned the companyaroundby designingand NissanRevival , m arketingnew models,inve s t in gin n e w p la n t t e c h n o lo g ie ss la s h in g most profitableproducts. the supplycosts,and emphasizing company's annualoperatingincometops Y861billionyen Fiveyearslater,Nissan's ( ap proximately billion). $7.6


Chapter 2

Nissan's operatingmarginis now the highestin the automotive industry, and it is payingits shareholders cashdividendsat record levels. Before Nissancould attack its problems, it had to know where its costs were incurred and whether it could control those costs by making different decisions. Was the company spendingtoo much in production, us in g o u t d a t e d e q u ip me n t a n d t e c h n o lo g ie s ?W a s i t spending enou g h o n d e s ig n in g n e w p ro d u c t s t h a t b e t t e r me t c u s tomers' needsand desires? Was it targetingthe right audiences its in television advertising? this chapter, talk about many costs:costs In we that both managers and management accountants must understand to successfully a business. runSources; NissanUSA.com; Nissan-Global.com; Nissan and Motor Co., Ltd..Annual Reports 2002, 2003, 2004. n

LearningObjectivesffi Oistinguish among service, merchandising, manufacturing andcompanies

Ml ffi

Oescribe value the chain andits elements Oistinguish between directandindirect costsldentifythe inventoriable productcostsand period costsof merchandising manufacturing and firms Prepare financial the statements service, for merchandising, and manufacturing companies

costs that arerelevant irrelevant decision and for making ffil OescribeClassify costsas fixed or variableand calculate total and averagecostsat differentvolumes


Do far, we have seen how managerial accounting provides information that managers use to run their businesses more efficiently. Managers must understand basic managerial accounting terms and conceptsbefore they can use the information to make good decisions.This terminology provides the "common ground" through which managers and accountants communicate. \Tithout a common understanding of these concepts, managers may ask for (and accountants may provide) the w Io n g i n fo rm a ti o nformaki ngdeci si ons.A syouw i l l see,di fferenttypesofco st s are useful for different purposes. Both managers and accountants must have a clear understanding of the situation and the types of costs that are relevant to the decision at hand.


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Sectorsand the ValueChain Three BusinessBefore we talk about specific types of costs, let's consider the three most common types of companies and the businessactivities in which they incur costs.

and Service,Mlerchandising, ManufacturingCornpaniesOrganizations other than not-for-profits and governmental agenciesare in business to generate profits for their owners. The primary means of generating that profit generally fall into one of three categories:

Distinguish among merchandising, service, and manufacturing comPanres

ServiceCompaniesService companies are in businessto sell intangible services-such as health care, insurance, and consulting-rather than tangible products. Recall from the last chapter that service firms now make up the largest sector of the U.S. economy, providing jobs to over 55% of the workforce. For servicecompanies such as eBay (online auction), H&R Block (tax return preparation), and Accountemps (temporary personnel services),salariesand wages often make up over 70'/" of their costs. Becauseservice companies sell services,they generally don't have Inventory or Cost of Goods Sold accounts. Some service providers caffy a minimal amount of supplies inventory; however, this inventory is used for internal operations-not sold for profit. In addition to labor costs, servicecompanies incur costs to develop new services,advertise, and provide customer service.

MerchandisingCompaniesITal-Mart, and Foot Locker resell suchas Amazon.com, Merchandising companies buys books, for Amazon.com, example, productsthey buy from suppliers. tangible at customers higherpricesthan what it paysits them to CDs, and DVDs and resells includeretailers(suchas companies own suppliers thesegoods.Merchandising for suchasyou. Wholesalers, to consumers Retailers sell Home Depot)and wholesalers. mark often referredto as "middlemenr"buy productsin bulk from manufacturers, merchandising comBecause productsto retailers. up the prices,and then sellthose companies paniessell tangibleproducts,they have inventory.Even merchandising inventorythan haveinventory;they just have/ess that usejust-in-time(JIT) systems inventoryis the cost merchanmerchandise The cost of their non-JITcompetitors. in plus all costsnecessary get the merchandise placeand to pay for the goods disers the import dutiesor tariffs. Because readyto sell,includingfreight-incostsand any usuallyreportsjust sheet balance entireinventoryis readyfor sale,a merchandiser's Inventory.Merchandisers one inventory accountcalledInventory or Merchandise products and locations for new stores,to also incur other coststo identify new service' advertise and selltheir products,and to providecustomer

Manufacturing CompaniesManufacturing companies use labor, plant, and equipment to convert faw materials into new finished products. For example, Nissan's production workers use the company's factories (plant and equipment) to transform raw materials such as steel and tires into high-performance automobiles. Manufacturers sell their products to retailers or wholesalers at a price that is high enough to cover their costs and generatea profit.


Chapter 2

Becauseof their broader range of activities, manufacturers have three types of inventory (pictured in Exhibit 2-1):

Manufacturers' ThreeTypesof Inventory



,'..,..,.'.,.,.,: 1. Raw materialsinventory: All raw materialsusedin manufacturizg.Nissan's raw materialsincludesteel,glass,carpeting,tires, upholsteryfabric, engines, and other automobilecomponents. also includes It other physicalmatirials usedin the plant, suchas machinelubricantsand janitorial supplies. 2. Work in process inventory:Goodsthat arepartway throughthe manwfacturing process not yet complete. Nissan,the work in process bwt At inventoryconsists of partially completed vehicles. 3. Finished goodsinventory completed goods that hauenot yet beensold.Nissan is in business sell completed to cars,not work in process. Manufacturers sell their finishedgoodsinventoryto merchandisers. Nissan,for example,sellsits completed automobiles retail dealerships. to Somemanufacturers, suchas The Original MattressFactory, their productsdirectlyto consumers. sell Exhibit 2-2 summarizes differences the amongservice, merchandising, and manufacturin companies. g Service,Merchandising,and ManufacturingCompaniesServiceColmpralries Examples Advertising agencies Banks Law firms Insurance companiesIntangible services

g M m:ch anr-{isinilompnnicsAmazon.com Kroger ITal-Mart WholesalersTangible products purchased from suppliers

&tanrmf lrring Cornpanics ;;tcf Procter& Gamble DaimlerChrysler Dell Computer NissanNew tangible producrs made as w orkers and equi pment convert raw materials into new finished products





ir ii.i ::


Primary Output


Type(s)of Inventory


Inventory (or Merchandise Inventory)

Raw materials inventory Work in process inventory Finished goods inventory


11,,,.:t':1, f: lr,rrar:,:.::t..,t:rrfi::l r:i,;,,:,,it:1:i,r:,:,_,t1,:,,:,f:,:i tt.: ri:r:.irl r.:j .:f,:,r I I i, 1.,,

I I,,,,,r:r- ,r,

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ffiInc.? What type of company is Outback Steakhouse, &,ffi s ip, f mS;om e c o mp a n i e s d o n ' t fi t n i c e l y i n to one of the three categori esdi sr Outback has some elements of a servicecompany (it serveshuncussed previously. g ry pat r ons ) ,s om e e l e me n ts o f a m a n u fa c tu rl n gcompany (i ts chefs convert raw company (i t a int i n g r edient s o f ini s h e dme a l s ), n d s o me e l e mentsof a merchandi si ng reallya hybrid of the three bottles of wine and beer).Outback is seilsready-to-serve types of companieswe just discussed.

As the "Stop & Think" shows, not all companies are strictly service, merchandising, or manufacturing firms. Recall from Chapter 1 that the U.S. economy is shifting more toward service. Many traditional manufacturers, such as General Electric fGE;, h"rr. developed profitable service segments that provide much of their company's profits. General Motors now earns more from its financing and insurance operations than it does from car sales. Even merchandising firms are getting into the "service game" by selling extended warranty contracts on merih"ttdir. sold. Retailers offer extended warranties on products ranging from furniture and major appliances to sporting equipment and consumer electronics. \flhile the merchandiser recognizes a liability for these warranties' the price charged to customers for the warranties greatly exceedsthe company's cost of fulfilling its warranty obligations.

lvlakeUp the ValueChain? Actlvilties WhichHustmessMany people describe Nissan, Dell Computet, and Coca-Cola as manufacturing .o-p"ni.r. But it would be more accurate to say that these are companies that do companiesthat do manufacturing also do many other manufacturing.'$7hy? Because things. Nissan also conducts researchto determine what type of new technology to integrate into next year's models. Nissan designs the new models based on its researchand then produces, markets, distributes, and servicesthe cars' These activities form Nissan'svalue chain-the activities that add value to products and services. To set a selling price or to determine how profitable the Xterra model is, Nissan must know how much it costs to research,design, produce, market, distribute, and service the product. In other words, Nissan can't set selling prices high enough to just cover the costs of production. Pricing decisionsrequire Nissan to calculate the of the value full cost of the Xterra, including costs incurred across all six elements chain oictured in Exhibit 2-3.

the D escri be value chai nand i ts elem ent s

TheValueChainGhain Value




r:i :!i::::l



Researchand Development (R&Dl: Researching and deueloping new or improued products or seruicesand the processes for producing them. Nissan continually engagesin researching and developing new technologies to incorporate in its vehicles (such as GPS systems,"smart keys," and automatic headlamps)and in its manufacturing plants (such as manufacturing robotics). Nissan's GREEN program aims at developing fuel cells for vehicles, new ultra-low emission vehicles, new hybrid vehicles, and better fuel economy on existing models. Nissan currently spendsover Y300 billion (approximately $2.6 billion) ayear in R&D. Design: Detailed engineering of products and seruicesand the processesfor prodwcing them.Nissan's CEO describesdesign as the "interface between customers and the brand." Nissan's designersneed to fulfill customers' desiresfor vehicle style, features, safety, and quality. Nissan's goal is to engineer its products to create "total customer satisfaction." (Nissan has embraced total quality management.)As a result, Nissan employs over 500 designers in North America and introduced 1.2 new models as part of its revival plan. Designers consider not only what the customers want but also how to mass-produce the vehicles. BecauseNissan produces over 3 million vehiclesper year, engineersmust design production processes to be flexible (to allow for new features and models) and efficient. These initiatives cost a lot of money. Nissan's new technical center alone cost over $ 1 1 8 million to build. Despite these costs, new models and production designswere critical to Nissan's turnaround. Production or Purchasesz Resourceswsed to prodwce a prodwct or seruice or to pwrchase finished merchandise intended for resale. For a manufacturer such a s N i s s a n , t he producti on acti vi ty i n the val ue chai n i ncl udes the cost s incurred to make the vehicles. These costs include raw materials (such as s te e l ), p l a n t l abor (such as machi ne operators' w ages and benefi ts) , and manufacturing overhead (such as plant utilities and equipment depreciation). For a merchandisersuch as Best Bu5 this value-chain activity includes the cost of inventory, such as CDs, TVs, and PCs that the company buys to re s e l l to c u stomers. It al so i ncl udes al l costs associ atedw i th getti n g t he i n v e n to ry to the store ready for sal e, i ncl udi ng frei ght-i n costs an d any import duties and tariffs. As part of Nissan's revival plan, it opened new manufacturing facilities, including a state-of-the-art facllity in Canton, Mississippi. Nissan's new investments in plant and equipment cost over Y377 btllion (approximately $3.3 billion). Thesecosts are part of the production stageof the value chain. Nissan was also able to cut some production costs. Nissan slashed purchasing costs over 20% by working with suppliers of major components, such as tires, engines, and steel.To cut costs through JIT production, some of Nissan's suppliers have moved their own manufacturing facilities right next door to Nissan's! Marketing: Promotion and aduertisingof prodwcts or seruices. The goal of marketing is to createconsumer demand for products and services. Nissan usesprint advertisementsin magazinesand newspapers,billboards, and television advertisingto market its vehicles. But Nissan's revival plan includes much more than simply advertisingtheir new models. Part of its marketing effort was directed at the dealershipsthat sold its vehicles.Nissan worked with dealerships make them more to effective and attractive to consumersshopping for cars so that customerswould "sensequality" when walking into a Nissan dealership'sshowroom. As a result, most dealerships improved their cosmeticappearance and interior layout.

Accounting Blocksof Managerial Building


Distribution: Deliuery of products or seruicesto customers.Nissan sells most of its vehicles through traditional dealerships.However, more customers are ordering "build-your-own" vehiclesthrough Nissan's'web site. People who are willing to wait a short time can have the features they want rather than settle for one of the vehiclesin stock at the local dealership.Forrester Research,an independent researchfirm specializing in the impact of technology on businessand consumers, expects build-to-order car salesto account for 21'oh of all new car sales by 2010, up from 5,,/oin 2001,.1Nissan's distribution costs include the costs of shipping the vehiclesto retailers and customers and the costs of setting up and administering \Web-basedsales portals. Other industries use different distribution mechanisms. Tupperware primarily sells its products through home-based parties. Amazon.com sells only through the Internet. Until recently, Lands' End sold only through catalogs and the'Sfeb. Now, it also distributes its products through Sears' retail outlets. \WebVantried, but failed, to create an online delivery-only grocery store. Customer Service:Swpport prouided for cwstornersafter the sale. Nissan incurs substantial customer service costs, especiallyin connection with warranties on new car sales.Nissan generally warranties its vehicles for the first three years and/or 36,000 miles, whichever comes first. Nissan cut warranty costs by Y41.million in 2004. How? Through total quality management (TQM). Nissan testseuery vehicle rolling off the Canton plant production line before shipping it out. Nissan also emphasizesquality right from the start, beginning with R&D.

ActivitiesAcrossthe ValueChain CoordinatingMany of the value-chain activities occur in the order discussedhere. However, managers cannot simply work on R&D and not think about customer service until after selling the car. Rather, cross-functional teams work on R&D, design, production, marketing, distribution, and customer service simultaneously. As ihe t."-s develop new model features, they also plan how to produce, market, and distribute the redesigned vehicles. They also consider how the new design will affect warranty costs. Recall from the last chapter that management accountants typically participate in these cross-functional teams. Even at the highest level of global operations, Nissan used cross-functional teams to implement its revival plans. The value chain in Exhibit 2-3 also reminds managers to control costs over the value chain as a whole. For example, Nissan spendsmore in R&D and product design to increasethe quality of its vehicles,which, in turn, reducescustomer service costs. Even though R&D and design costs are higher, the total cost of the vehicleas measured throughout the entire value chain-is lower as a result of this tradeoff. Enhancing its reputation for high-quality products may also enable Nissan to increasesalesor to charge higher selling prlces. The value chain applies to service and merchandising firms as well as manufacturing firms. For example, an advertising agency such as Saatchi & Saatchi incurs:a a a a

Design costs to develop each client's ad campargn. Marketing costs to obtain new clients. Distribwtion costs to get the ads to the media. Customer sentice costs to address each client's concerns.

lDave Hirshchman, "Coming soon: buib-to-order cars deliuered in 10-15 days," The Atlanta Journal Constitution, March 25,2001, p. Q1.


Chapter 2

Determiningthe Coststo Servea Customer or to Make a ProductHow do companies such as eBay, Amazon.com, and Nissan determine how much it costs to serve a customer, fill an order, or produce an Xterra? Before we can answer this question, let's first consider some of the specializedlanguage that accountants use when referring to costs. Distinguish between directand indirect costs

Cost Objects, Direct Costsuand Indirect CostsA cost object is anything for which managers want a separatemeasurementof cost. Nissan's cost objects may include the followrng: . Individual products (the Xterra, Pathfinder, and Altima) o Alternative marketing strategies (salesthrough dealers versus built-to-order \il/eb sales) . . Geographic segmentsof the business(United States,Europe, Japan) Departments (human resources,payroll, legal)

Costs are classified as either direct or indirect with respect to the cost object. A direct cost is a cost that can be traced to the cost object. For example, say the cost object is one Xterra. Nissan can trace the cost of tires to a specific Xterra; therefore, the tires are a direct cost of the vehicle. An indirect cost is a cost that relates to the cost object but cannot be traced to it. For example,Nissan incurs substantialcost to run the Xterra manufacturing plant, including utilities, property taxes, and depreciation on the plant and equipment. Nissan cannot build an Xterra without incurring these costs, so the costs are related to the Xterra. However, it's impossibleto trace a specificamount of these costs to one Xterra. Therefore, these costs are indirect costs of an Xterra. As shown in Exhibit 2-4, the same costs can be indirect with respect to one cost object yet direct with respectto another cost object. For example, plant and equipment

The SameCost Can Be Director Indirect, Depending the CostObject on

Accounting Building Blocksof Managerial

depreciation, property taxes, and utilities are indirect costs of an Xterra. However, if management wants to know how much it costs to run the Canton manufacturing plant, the plant becomesthe cost object; so the same depreciation, tax, and utility costs are direct costs of the manufacturing facility. Whether a cost is direct or indirect depends on the specifiedcost object. In most cases,we'll be talking about a unit of product (such as one Xterra) as the cost object. If a company wants to know the total cost attributable to a cost object, it must assign all dtrect and indirect costs to the cost object. Assigning a cost simply means that you are "attaching" a cost to the cost object.'Sfhy? Becausethe cost object causedthe company to incur that cost. In determining the cost of an Xterra, Nissan assignsboth the cost of the tires and the cost of running the manufacturing plant to the Xterras built at the plant. Nissan assignsdirect costs to each Xterra by tracing those costs to specific units, or batches.However, becauseNissan cannot trace indirect costs to specific units or batches,it must allocate these costs to the vehiclesproduced at the plant.'We will discussthe allocation process in more detail in the next chapter; but for now, think of allocation as dividing up the indirect costs over all of the units produced, just as you might divide a pizza amongfriends. Exhibit 2-5 illustrates these concepts.

AssigningDirectand lndirectCoststo Cost Objects



ffirii\X/hy is this terminology important? Becauseit helps managers understand how accountants arrive at cost figures. Direct costs are traced to cost objects so th at m anager s an d a c c o u n ta n ts a re c o n fi d e nt that the amount of di rect cost assignedto a cost object is very accurate. For example, managers are confident i n t he t ir e c os t a s s i g n e d to o n e X te rra b e cause they can trace a parti cul ar Xterra's four tires (plus a spare tire) back to a specific invoice. In contrast, indirect costs are allocated rather than traced; so the amount of indirect cost a ss igned t o a c os t o b j e c t i s mo re o f a n e s ti mate. A s a resul t, managers and a cc ount ant s ar e l e s s c o n fi d e n t i n th e a mo u nt of i ndi rect cost assi gned each Xterra. Managers know the total amount of indirect costs from paying utility and tax bills and recording depreciation expense.However, the diuision of the total amount of indirect costs among the vehiclesis lessprecise.Therefore, managers are less confident in the amount of indirect cost that should be assignedto the cost object (for example, the amount of utilities cost that should be assigned to a particular Xterra).


Chapter 2

ldentify the inventoriable product costs and period costs of merchandisingand manufacturingfirms

Product Costs'for Internal DecisionlVlaking and External ReportingLet's look more carefully at how companies determine the costs of one of the most common cost objects: products. As a manager,you'll want to focus on the products that are most profitable. But which products are these? To determine a product's profitability you subtract the cost of the product from its selling price. But how do you calculate the cost of the product? Most companies use two different definitions of product costs: (1) full product costs for internal decision making and (2) inventoriable product costs for external reporting. Let's see what they are and how managers use each type of cost.

Full Product Costs for Internal DecisionMakingFull productcostsincludethe costsof all resources wsed throwghowt ualwe the chain. For Nissan,the full product cost of a particularmodel is the total cost to research, design, manufacture, market,and distributethe model, as well as to service the customers who buy it. Beforelaunching a new model, managers predict the full product costsof the vehicleto set a sellingprice that will coverall costs plus return a profit. Nissanalso compares eachmodel'ssaleprice to its full cost to determine which models are most profitable. PerhapsXterras are more profitable than Pathfinders. Marketing can then focus on advertising and promoting the most profitablemodels.We'll talk more about full costsin Chapter8, wherewe discuss business decisions. For the next few chapters, we'll concentrate primarily on productcosts. inventoriable

Inventoriable Product Costs for External ReportingGAAP does not allow companies to use full product costs when reporting the cost of their inventories in the financial statements. For external reporting, GAAP allows only a portion of the full product cost to be treated as an inventoriable product cost. GAAP specifieswhich costs are inventoriable product costs and which costs are not. Inventoriable product costs include only the costs incurred during the "production or purchases" stage of the value chain (seeExhibit 2-6). Inventoriable product costs are treated as an asset (inventory) until the product is sold. 'When the product is sold, these costs are removed from inventory and expensed as cost of goods sold. Since inventoriable product costs include only costs incurred during the production or purchases stage of the value chain, all cost incurred in the other stages of the value chain must be expensed in the period in which they are incurred. Hence, we refer to R&D, design, marketing, distribution, and customer servicecosts as period costs. Period costs are often called "operating costs" or 'qselling,general, and administrative costs" (SG&A). Period costs are neuer part of an inventory asset account. Period costs are expensedin the period in which they are incurred. Exhibit 2-6 shows that a company's full product cost has rwo components: inventoriable product costs (those costs treated as part of inventory until the product is sold) and period costs (thosecostsexpensed the current period regardless when in of inventory is sold). GAAP requires this distinction for external financial reporting. Study the exhibit carefully to make sure you understand how the two components of full product costs-inventoriable product costs and period costs-affect the income statementand balancesheet. Now that you understand the difference between inventoriable product costs and period costs, let's take a closer look at the costs that are inventoriable in merchandising and manufacturing companies. Inventoriable costs include only those costs incurred at the purchase stage in merchandising companies and at the producti o n s ta g ei n ma n ufacturi ng compani es.

Accounting Blocksof Managerial Building


ProductCosts,and PeriodCosts Full ProductCosts,Inventoriable

Inventory -r

of Cost g o o d s so l d

0perating expenses

Inventoriab!e Companies' Merchandising Product frostMerchandising companies' inventoriable costs include only the cost of purchasing the inventory from suppliers plus any costs incurred to get the merchandise to the merchandiser'splace of businessand ready for sale. Typicallg these additional costs include freight-in costs and import duties or tariffs, if any. \fhy does their inventory include freight-in charges?Think of the last time you purchased a shirt from a catalog such as J.Crew. The catalog may have shown the shirt's price as $30, but by the time you paid the shipping and handling charges, the shirt really cost you around $35. Likewise, merchandising companies pay freight charges to get the goods to their place of business(plus import duties if the goods were manufactured overseas). These chargesbecome part of the cost of their inventory. For instance,Home Depot's inventoriable costs include what the company paid for its store merchandise plus freight-in and import duty charges. Home Depot it sells the merchandise. records these costs in an asset account-Inventory-untll not Home Depot. Therefore, Once the merchandisesells,it belongs to the customef, Home Depot takes the cost out of the inventory account and records it as an expense-the cost of goods sold. Home Depot expensescosts incurred in other elements of the value chain as period costs, such as employee salaries,advertising expenses,and store operating costs (for example, utilities and depreciation). Some companies, such as Pier 1 Imports, refer to their cost of goods sold as "cost of sales." However, we use the more specific tetm cost of goods so/d throughout the text becauseit more aptly describesthe actual cost being expensed in the account-the inventoriable product cost of the goods themselves,not the total cost of making the sale (which would include selling and marketing costs).


Chapter 2

Silop o