Attached is Accounting assignment along side recommended readings to answer certain questions. Thank you

Assignment 1 Problem 1 15 points Reading - W. L. Ferrara, Cost/Management Accounting: The 21st Century Paradigm Answer the following questions: 1. 2. 3. 4. Describe the paradigms discussed by Ferrara. What are his observations on variable and fixed costs? What does Ferrara see as the best combination of Paradigms for the 21 st Century? Explain. What are your observations about Ferrara's paper? Problem 2 15 points Reading - Robin Cooper, Is your Cost System Obsolete? Answer the following questions: 1. 2. 3. 4. Describe the functions of a cost system. Discuss the symptoms of a dysfunctional cost system. What are Cooper's observations on the need for a redesign? Explain. What are your observations about Cooper's paper? Problem 3 15 points Reading - L. A. Gordon and M. P. Loeb, Distinguishing Between Direct and Indirect Costs Is Crucial for Internet Companies Answer the following questions: 1. Describe how the authors characterize the traditional view of direct & indirect costs? 2. What distinctions do the authors make between direct & indirect costs for internet companies that differ from the traditional view? 3. How does tracking/tracing costs in internet companies differ from other types of businesses? 4. What are your observations about this paper by Gordon and Loeb? 1 Problem 4 40 points Work the following problems (show your work): 4.1. Boynton Company manufactures and sells a single product that sells for $480 per unit; variable costs are $300. Annual fixed costs are $990,000. Current sales volume is $4,200,000. Compute the contribution margin per unit. Answer ___________________ 4.2. Boynton Company manufactures and sells a single product that sells for $480 per unit; variable costs are $300. Annual fixed costs are $990,000. Current sales volume is $4,200,000. Compute the contribution margin ratio. Answer ___________________ 4.3. Boynton Company manufactures and sells a single product that sells for $480 per unit; variable costs are $300. Annual fixed costs are $990,000. Current sales volume is $4,200,000. Compute the break-even point in units. Answer ___________________ 4.4. Boynton Company manufactures and sells a single product that sells for $480 per unit; variable costs are $300. Annual fixed costs are $990,000. Current sales volume is $4,200,000. Boynton company management targets an annual after-tax income of $843,750. The company is subject to a 25% income tax rate. Compute the unit sales to earn the target after-tax net income. Answer ___________________ 4.5. Boynton Company manufactures and sells a single product that sells for $480 per unit; variable costs are $300. Annual fixed costs are $990,000. Current sales volume is $4,200,000. Compute the margin of safety. Answer ___________________ 2 Problem 5 7 points 5.1. Pinecrest Sales & Service started operations on January 01, 2014. In its first year, sales were $5,000,000. Annual fixed costs are $3,000,000. Variable costs in 2014 were $3,250,000. Compute the break-even sales volume. Answer ___________________ Write a memo to the owner of the company explaining how you calculated break-even. 3 Problem 6 33 points Shula's Beefsteak Tomatoes, LLC, farms tomatoes on a large tract of land in southwest Dade County. Shula's has an opportunity to purchase an adjoining farm owned by Bill Belichick, an unsuccessful tomato farmer who is about to go out of business. VP of Operations, Dan Marino, is trying to decide if he should operate the new farm with traditional, laborintensive growing and harvesting techniques that have high variable costs with low fixed costs, or invest in new, capitalintensive, advanced-technology equipment, which would result in very low labor costs but very high fixed costs. Budgeted production costs in the table below. Capital Intensive Direct materials per bushel of tomatoes Direct labor per bushel of tomatoes Variable manufacturing overhead per bushel Fixed manufacturing overhead per year Selling price per bushel of tomatoes $ $ $ $ Labor Intensive 1.00 0.25 0.06 4,500,000 $25.00 $ $ $ $ 1.00 6.00 1.25 850,000 $25.00 Incremental selling costs are budgeted at $650,000 per year plus $0.25 per bushel sold. 6.1 What is the break even-even point in bushels for the capital-intensive method? Answer ___________________ 6.2 What is the break even-even point in bushels for the labor-intensive method? Answer ___________________ 6.3 Determine the number of bushels at which point Shula's Beefsteak Tomatoes would be indifferent between the two methods. Answer ___________________ 6.4 Dan Marino has hired you as a consultant to advise him and Coach Shula on the decision at hand. Assume a current sales volume at the point of indifference, calculate the change (increase or decrease) in net income resulting from a 10% increase and a 10% decrease in the number of bushels sold. 10% increase Capital intensive Answer ___________________ Labor intensive Answer ___________________ 10% decrease Answer ___________________ Answer ___________________ 6.5 Assuming a stable, growing economy, which alternative would you recommend? Why? 4 _______________________________________________________________ _______________________________________________________________ Report Information from ProQuest April 12 2015 12:41 _______________________________________________________________ 12 April 2015 ProQuest Table of contents 1. Cost/management accounting -- The 21st century paradigm....................................................................... 1 12 April 2015 ii ProQuest Document 1 of 1 Cost/management accounting -- The 21st century paradigm Author: Ferrara, William L ProQuest document link Abstract: Four recent paradigms that cover management accounting's recent history are considered to predict what management accounting will be like in the 21st century. The paradigm's considered are: 1. the era of the industrial revolution, 2. the era of cost-volume-profit analysis and direct costing, 3. the era of activity-based costing, and 4. the era of market-driven standard costs as opposed to engineering-drive standard costs. The old individually focused control concepts inherent in standard costing and responsibility accounting may be counterproductive in today's world. Links: Check for full text via FindIt! Full text: Headnote The old individually focused control concepts inherent in standard costing and responsibility Headnote accounting may be counterproductive in today's world. Certificate of Merit, 1994-95 What will the field of management accounting look like in the 21st century? To find out, let's consider four paradigms that cover its recent history. These paradigms provide us with an intriguing review of the current scene from a historical perspective (see Table 1) and an opportunity to focus on unresolved issues. Ultimately, we can consider adjusting and even combining paradigms in anticipation of a new one for the 21st century. For continuity and simplicity, we'll consider each paradigm in the context of both product costing and the determination of selling price. This context is useful especially because the current vogue of activity-based cost analysis emphasizes improved product costing in order to arrive at better pricing decisions. Paradigm A: Turn of the century until the 1940s--the era of the Industrial Revolution plus. Paradigm A conjures up the image of an early-day industrial engineering type such as Frederick Taylor who was interested in what costs should be, that is, standard costs. These engineering-driven standards were typically a function of product specifications, time and motion studies, and the like. The costs involved were direct materials, direct labor, manufacturing overhead, and even marketing and administrative costs, all of which were tied together in a total cost per unit of output. Added to the total cost per unit was a desired profit or markup, and the sum of total cost and desired profit yielded a target selling price per unit. In many instances, the total cost per unit excluded marketing and/or administrative costs, which were included as a factor in the desired profit. The ultimate result was still the target selling price per unit-the price that would yield desired profitability if projected costs per unit could be achieved. Two issues of contention surface immediately with Paradigm A: 1. What volume of activity should be used to determine unit costs? 2. How should desired profit be determined? The variety of answers typically offered is amazing even if both questions are put to an audience of practitioners representing various departments of the same company, as I have done over many years. Table 2 shows possible answers for the "volume of activity" question, which must be addressed to determine total unit costs for Paradigms A, B, and C. Answers usually lean in the direction of expected volume or something referred to as standard or normal volume. A rather difficult aspect of the expected volume answer is its implicit circular reasoning-expected volume assumes a selling price while it is being used to determine unit costs and ultimately a "target" selling price. 12 April 2015 Page 1 of 9 ProQuest The answers for the "desired profit" question typically used to be very subjective or rule-of-thumb oriented. In recent years, however, up-to-date return on investment and cost of capital concepts have been considered in the most prevalent answers. As we move on to subsequent paradigms, these two questions or issues of contention remain, and others emerge. Pardigm B: The 1940s until the 1980s--the era of cost-volume-profit analysis and direct costing. Paradigm B introduces the distinction between fixed and variable costs, which ultimately leads to cost-volume-profit analysis and direct costing. The fixed/variable cost dichotomy and its implications encompass the most dynamic developments in management accounting from the 1940s to the 1980s. On the surface, not much seems to change between Paradigms A and B other than the distinction between fixed and variable costs as parts of a total unit cost and a target selling price. However, even a cursory consideration of Tables 1 and 2 reveals a refinement of one of our issues of contention, that is: 1. Variable costs per unit are determined by engineering standards and analysis techniques, which means that the volume of activity issue relates essentially to fixed costs. 2. Furthermore, many variable costs have become more fixed over time. Union contracts and labor legislation have affected labor costs in just this fashion. The issue of how to determine desired profit remains an issue of contention as we move to Paradigm C and D. Variable costs per unit for direct materials and direct labor are determined easily by the engineering specifications for materials and labor requirements. Similarily, the per-unit amounts of other variable costs can be calculated. Techniques that typically are variations of regression analysis isolate the variable cost per unit as the "b" coefficient in flexible budget formulations. Deriving varibles costs per unit via engineering standards and analytic techniques leaves us with only the fixed costs to consider when determining the volume of activity to divide by in deriving per-unit costs. None of the other issues related to the volume-ofactivity question changes from our earlier discussion, except that many variable costs have become more fixed over time. In essence, the issue of volume of activity to divide by has become a larger issue as the relative amount of variable costs has diminished and the relative amount of fixed costs has increased. Paradigm C: The late 1980s and the early 1990s--the era of activity-based costing. Much of the recent, exciting revival of interest in cost/management accounting relates to Paradigm C, which embodies activity-based costing (ABC). On the surface, Paradigm C considers only two additional variable costs in the development of a total cost per unit. Recognition of these additional variable costs is designed to improve the accuracy of a total unit cost, which then should improve the determination of selling prices and product mix decisions. The new or additional variable costs of ABC relate to product complexity and product diversity. As shown in Tables 1 and 2, there are three elements of variable manufacturing cost under ABC.(1) 1. Costs that vary with units of product. 2. Costs that vary with product complexity, such as number of batches. 3. Costs that vary with product diversity, such as number of products. The implications of the new categories of variable costs initially suggest a decreased number of fixed costs, but further consideration of ABC leads me to suspect that the supposed additional variable costs are really fixed costs. 12 April 2015 Page 2 of 9 ProQuest This additional issue of contention could revive the controversy over "direct costing versus absorption costing," a paramount issue of the late 1950s and 1960s. Look at the ABC literature. It doesn't take much to see the possibility that ABC is nothing more than an updated, revised, and, most likely, more accurate version of absorption costing. It's unfortunate that the advocates of ABC virtually have ignored the significance of Paradigm B's direct costing implications that were put forth so eloquently by J.S. Earley in 1955. According to Earley, the new management accounting "implied basing decisions on their estimated effects on marginal balances and contribution margins rather than upon 'full cost' calculations. It involves consistent references to variable costs and 'specific' fixed costs where these are relevantand neglect of those costs unaffected by decisions."(2) Another interesting facet of cost/management accounting virtually ignored by the advocates of ABC is the emergence of Paradigm D. This paradigm, which appears to have had its origins in Japan (Hiromoto), has the potential to revolutionize cost/management accounting as it implicitly asks ABC enthusiasts, "What do costs have to do with the determination of selling prices? With the exception of cost-based pricing contracts, the market determines the price, and the role of cost is to help determine whether or not it is wise to enter the market or stay in the market."(3) Paradigm D: 1990s and beyondthe era of market driven standard (allowable or target) costs as opposed to engineering-driven standard costs. Under Paradigm D we no longer look to the development of a total unit cost in order to help determine a selling price. Instead we use the selling price we believe the market will allow to help us determine the cost that the market will allow. Peter Drucker has referred to this concept as price-led costing as opposed to costled pricing. The allowable or target cost per unit is a marketdriven standard cost that has to be met if desired profits are to be achieved. Paradigm D questions the validity of any paradigm based on engineering-driven standard costs. Perhaps after some 90 years, the engineering-driven standard costs of Frederick Taylor and his contemporaries 12 April 2015 Page 3 of 9 ProQuest have been partially or wholly displaced by market-driven standard costs. We still have the issue of how to determine desired profit with Paradigm D. However, Paradigm D creates a whole series of provocative new issues such as: 1. All that counts is that total cost per unit ultimately must not exceed the allowable or target cost if the desired profit is to be attained. This idea may mean that now the distinction between fixed and variable costs is either irrelevant or considerably less relevant. 2. If we truly believe in continuous improvement, then the allowable or target cost per unit must be reduced over time. 3. The way we work may have to change in order for us to reduce costs. Ultimately, this change can lead to the empowerment of our own workforce for, as we all know, often it is those closest to the action who can lead us on the path of continuous improvement. This issue of continuous improvement via empowerment involves all people in the workforce--those in the factory, in procurement, in marketing and distribution, and in administrative offices.(4) Continuous improvement even creates the possibility of more positive relationships with suppliers and customers, again to reduce costs and increase quality and performance.(5) Tom Johnson, one of the early enthusiasts of ABC, stated the case for continuous improvement as follows: "Do activity costing if you must. But don't fool yourself into thinking that ABC will help you become a global competitor. For that, get busy with the improvement process!"(6) REFINING AND FOCUSING ISSUES OF CONTENTION Look at Paradigm D again. The two questions or issues of contention for Paradigm A concerning desired profit and level of volume remain, but they are easier to deal with in the era of Paradigm D. Given our current knowledge of cost of capital concepts, we can deal effectively with desired profit in terms of the level of profit needed to keep the suppliers of capital (debt and equity) satisfied given a particular profit planning horizon. 12 April 2015 Page 4 of 9 ProQuest In terms of the volume of activity issue, Paradigm D can yield an answer that would have been considered only tentatively under earlier paradigms because of its implicit circular reasoning. For example, given the selling price being considered, one could argue for using the expected volume of activity at that selling price for the time period being considered-whether a month, or a quarter, or a year. The resultant expected cost per unit then could be compared to the allowable or target cost per unit of Paradigm D. An unfavorable comparison should produce a questioning attitude concerning what can be done about costs (fixed, variable, or other) or expected activity via alterations in pricing and promotion strategies that would improve the situation. The answers to such questions could provide the continuous improvements of which Johnson spoke. When viewing volume of activity after the fact, one should shift to calculating actual costs per unit using the actual volume of activity. The result would be a comparison of allowable (target) costs, expected costs, and actual costs per unit. Especially useful would be the comparison of expected and actual costs per unit in terms of what caused the difference, if any, that is, inability to achieve anticipated continuous cost improvements and/or inability to achieve expected volume for the product promotion and pricing strategies chosen. THE CURRENT SCENE Table 3 is designed to point out some remaining issues of contention. The first, concerning the volume of activity to use under Paradigm D, was the one just discussed. The remainder follow. Diminishing product life cycles. As life cycles for many new products decrease, the reasons for using Paradigm D increase.(7) Some products don't last long enough for engineering-driven standards to be established and utilized. Such products literally must achieve the allowable or target cost of Paradigm D in their design stage if a desired profit is to be realized. Somewhat related to shorter product life cycles is the notion of idle capacity, which no longer may be as important a costing concept as it used to be. The suggested use of expected and actual volume of activity under Paradigm D surely enhances this thought. Strategies concerning various products lines. If a company produces both commodity-type products and specialtytype products, it might be able to use both engineering-and market-driven standard costs. Marketdriven standards probably would apply more to specialty products with their shorter life cycles. Engineering-driven standards could be more appropriate for the longer life cycles of commodity products. Nevertheless, market-driven standard costs must be determined for any intensely competitive product. 12 April 2015 Page 5 of 9 ProQuest Standard cost variances/responsibility aounting. When we are looking toward a total cost per unit that must meet or better the allowable or target cost, cost variances by individual cost, activity, or department seem to be less relevant. Worker empowerment within a company requires a cooperative spirit rather than a focus on the individual department and cost center. Group or total success is the key today. The old individual cost and cost center focused control concepts inherent in standard costing and responsibility accounting may be counterproductive in today's world. The need for continuous improvement and forcing a continuous learning curve focused on total cost surely challenges one's training and earlier views. The theory of constraints. Eli Goldratt, the Israeli physicist turned management consultant, has had an impact in recent years. His concentration on throughput, operating expense, and inventories has intrigued many management accountants. Interestingly, his theory of constraints (TOC) appears to be a refinement of direct costing coupled with linear programming. TOC concentrates on only three variables: throughput, inventory, and operating expenses. Throughput relates to actual sales minus materials costs. Inventory consists only of purchased items at their purchased cost, and operating expenses are expenses other than materials. The objective is to focus on increasing throughput by eliminating constraints and decreasing both inventory and operating expenses. In essence, the theory of constraints treats operating expenses as fixed and does not add any value to inventory whether it's in process or a finished state. All operating expenses plus the cost of inventory (materials) used to produce the actual throughput are considered in determining the true profitability of a period's throughput. There is a direct costing flavor in the theory of constraints. The apparent success of TOC simultaneous with the development of ABC (a form of absorption costing) is worth examining. A detailed comparison of a number of users of both techniques certainly would be useful. Assigning costs to product lines and within product lines. Ultimately, any cost accounting system has to deal with the twin issues of assigning costs between and within product lines. Activity-based costing may make a real contribution toward resolving both these issues. ABC's concentration on three categories of variable costs may be especially useful. These three categories 12 April 2015 Page 6 of 9 ProQuest relate to the traditional notion of variability with units and the two new ideas of variability with product complexity (such as number of batches) and variability with product diversity (such as number of products). At this point in time, those of us concerned with these product-line issues must be open to alternative points of view. LOOKING-AHEAD-THE 21ST CENTURY PARADIGM The best hope I see for a new paradigm for the 2lst century would be a combination of Paradigms C and D. An alternate variation could combine Paradigms C and D with elements from Paradigm B. Regarding the first suggestion, in our intensely competitive world marketplace it is difficult to deny the efficacy of Paradigm D. The allowable or target standard cost permitted by our competitors in the marketplace cannot be ignored. Neither can we ignore the necessity for continuous improvement. Paradigm D, however, is not sufficient. It must be combined with a before-thefact determination of expected actual cost and an after-the-fact actual cost. The actual costs should be determined using the more precise ABC method, that is, Paradigm C. The ongoing comparison of a cost per unit allowed by the marketplace (subject to continuous improvement) with the actual and expected actual cost per unit is vital. Such a system of comparison should seek answers to the following questions: 1. What adjustments to product promotion and pricing strategies most likely will yield expected and actual volumes capable of achieving allowable costs? 2. What adjustments to our current cost structure and work procedures will enhance our ability to achieve allowable costs? 3. What adjustments to our current cost structure and the way we cooperate with suppliers and customers will enhance our ability to achieve allowable costs? What better use could be made of cost/management accounting data than to elicit answers to these questions? The combination of Paradigms C and D provides a meaningful environment in which to use ABC in the determination of product promotion and pricing strategies. Similarly, the combination gives real meaning to ABC's role in forcing consideration of alternative cost structures. What happens when we add a touch of Paradigm B? Charles Horngren provides the idea for combining B with C and D to develop a new paradigm for the 21st century.(8) On numerous occasions he has cautioned us about using per-unit dollar amounts rather than total dollar amounts, especially in the context of fixed costs. By using perunit amounts, we run the risk of treating fixed costs as variable costs and potentially concentrating too much on parts of the picture rather than the total picture. Consider a product-line income statement, which has columns for individual products as well as a total column for the sum of individual products. The total column for the product line forces us to keep an eye on "total system" results while simultaneously looking at individual products or pieces of the system. Shifting from the per-unit concentration of Paradigms C and D can be accomplished easily by multiplying the expected actual and actual volumes for each product by the per-unit amounts at each respective volume level for each product. Then the resulting total dollar amounts can be arranged in the format of a product line income statement as described above. If we draw the distinction between fixed and variable costs, our product line income statement can include elements from Paradigm B with C and D. For example, if the only variable costs are materials, as assumed in the theory of constraints, we easily can develop contribution margins in the context of our product line income statements. The contribution margin as well as the net income by product and product line yields an opportunity to consider both short- and long-run aspects of profitability simultaneously as individual product and total system profitability are examined. An intriguing result of combining Paradigm B with C and D is the ability to include, in our analysis of product line income statements, aspects of product life cycles and products that are expected to be cash users vs. cash generators during different stages of their life cycles. The product line income statement in this context looks at 12 April 2015 Page 7 of 9 ProQuest individual products and the sum total of a product line over a time frame that encompasses the life cycle of individual products or, at minimum, a threeto five-year period. LOOKING BACKWARD TO SEE AHEAD Often it is useful to reconsider where we have been during various stages of our development. Especially helpful would be case studies that could lead to the fine-tuning of a cost/management accounting paradigm for the 21st century Of interest would be: * A detailed comparison of a number of users of the theory of constraints and ABC. * Historical analyses of early, prominent, and successful users of Paradigm B and their current status with regard to moving toward Paradigms C and D or combinations thereof.(9) * Historical analyses of successful companies (defined in some reasonable manner) and their current status in regard to moving toward Paradigms C and D or combinations thereof, with or without elements from Paradigm B. The suggestions in this article relative to a paradigm for the 21st century seem especially useful. There definitely seems to be a place in management accounting for the more refined and exacting calculations of ABC. But that place seems better suited in combination with Paradigm D and perhaps Paradigm B as well, especially as we proceed to the 21st century. References 1 Depending on the product or service offered, one could have the same three elements of variable costs for marketing and administrative activities as well as manufacturing activities. 2 J.S. Earley, "Recent Developments in Cost Accounting and the 'Marginal Analysis'," Journal of Political Economy, June 1955, p. 237. The primary source for Earley's comments are the research studies of the Institute of Management Accountants, especially reports 16, 17, and 18 published during 1949 and 1950 on The Analysis of Cost-Volume-Profit Relationships. 3 For a discussion of how Paradigm B responds to this comment, see "Profit Planning and Pricing Strategies, Chapter 15 in Managerial Cost Accounting: Planning and Control by W.L. Ferrara, et.al., Dame Publications, Inc., 1991. 4 See Thomas A. Stewan, "GE Keeps Those Ideas Coming," Fortune, August 12, 1991, for one company's approach to continuous improvement and empowerment. 5 See Dave Woodruff and Stephen Phillips, "Ford Has a Better Idea: Let Someone Else Have the Idea," Business Week, April 30, 1990. 6 H.T. Johnson, "Let's Set the Record Straight on ABC," Measurement Systems, Association for Manufacturing Excellence, March-April 1992. 7 See R. Cooper and P.B.B. Turney, Hewlett-Packard: Roseville Networks Division, Harvard Business School Case Study 189-117, 1989, for an illustration of diminishing product life cycles and a resultant increase in new products as well as product modifications. 8 C.T. Horngren and G.L. Sundem, Introduction to Management Accounting, ninth edition, Prentice Hall, 1993, p. 201. 9 See Current Applications of Direct Costing, Institute of Management Accountants, Research Report 37, 1961, for a list of companies from which to choose. AuthorAffiliation William L. Ferrara, CPA, Ph.D., is the David M. Beights professor of accountancy at Stetson University, DeLand, Fla. He is a member of the Daytona Beach Area Chapter, through which this article was submitted, and can be reached at (904) 822-7421. Subject: Predictions; Management accounting; Cost accounting; Changes; 12 April 2015 Page 8 of 9 ProQuest Location: US Classification: 9190: US; 4120: Accounting policies % procedures Publication title: Management Accounting Volume: 77 Issue: 6 Pages: 30 Number of pages: 6 Publication year: 1995 Publication date: Dec 1995 Year: 1995 Publisher: Institute of Management Accountants Place of publication: Montvale Country of publication: United States Publication subject: Business And Economics--Accounting ISSN: 00251690 CODEN: MGACBD Source type: Scholarly Journals Language of publication: English Document type: PERIODICAL Accession number: 01133786, 00549527 ProQuest document ID: 229815727 Document URL: http://search.proquest.com.ezproxylocal.library.nova.edu/docview/229815727?accountid=6579 Copyright: Copyright Institute of Management Accountants Dec 1995 Last updated: 2014-05-19 Database: ABI/INFORM Global _______________________________________________________________ Contact ProQuest Copyright 2015 ProQuest LLC. All rights reserved. - Terms and Conditions 12 April 2015 Page 9 of 9 ProQuest Distinguishing Between DIRECT and INDIRECT COSTS Is Crucial for INTERNET C O M PA N I E S B Y L AW R E N C E A . G O R D O N , P H . D . , 12 SUMMER 2001 AND M A R T I N P. L O E B , P H . D . E EXECUTIVE SUMMARY People who argue that distinguishing between direct and indirect costs is of no relevance in today's Information Economy are dead wrong! Indeed, the importance of the direct vs. indirect costs dichotomy (as well as with many other management accounting techniques) may be even more crucial to an Internet-based firm's survival than to other companies. The key paradigm shift here is that, when separating direct from indirect costs, we need to think of customers as a primary cost objective in such an environment. Cost management is an important aspect of running a corporation successfully. A crucial part of cost management is the proper allocation of costs to various products and services. Indeed, the way costs are allocated plays a key role in determining the reported profitability of individual products and/or services. In addition, product-line decisions and pricing decisions (of both an internal and external nature) often are affected by cost allocation decisions. At the heart of cost allocation decisions is the dichotomy between direct and indirect costs. Because a given cost can be direct with respect to one cost objective and indirect with respect to another cost objective, determining the appropriate cost objective is fundamental. This fact notwithstanding, there seems to be a growing concern, if not confusion, on the importance of the distinction between direct and indirect costs for Internet-based businesses. We argue that the distinction between direct and indirect costs is as important for Internetbased companies as it is for other companies. The e-commerce revolution, however, requires many companies to make a fundamental change in the way they consider the notion of a cost objective and, in turn, cost management. In particular, Internetbased companies need to view the customer as a primary cost objective for purposes of allocating costs. DIRECT V S. I N D I R E C T C O S T S : A TRADITIONAL VIEW Direct costs can easily be traced to the cost objective and can be assigned to the cost objective in a straightforward manner. In contrast, indirect costs cannot be easily traced to the cost objective.1 They need some sort of allocation scheme. Thus, the choice of cost objective is critical to the determina- tion of whether a cost is considered direct or indirect. A cost objective is the purpose for which a cost is being measured. Further, it is quite common for a given cost to be measured for multiple purposes. Thus, a given cost may be direct with respect to one cost objective and indirect with respect to another cost objective.2 Traditionally, products, services, and departments have served as key cost objectives in managing the operations of a firm. In manufacturing firms, the primary cost objective is traditionally assumed to be the physical products being produced. A computer manufacturer, for example, would usually consider the need to determine the cost of producing a computer as the primary purpose for which costs (at least manufacturing costs) are being measured. As such, the costs of materials and labor that can easily be traced to the production of individual computers would be considered direct costs. Costs of materials and labor that cannot be directly related to the production of individual computers would be considered indirect costs. In a similar vein, the costs associated with depreciating machinery, utilities, and accident insurance would be additional indirect costs in most manufacturing firms. Knowing the costs of manufacturing a product is important in determining the product's profitability, even where prices are market driven,3 because in these markets the costs will determine the desirability of being in the market. In markets where prices are driven more by costs, knowing the cost of producing a product is all that more important. Further, many new cost management techniques, such as target costing, are focused on controlling product costs. Assessing the contribution of one subunit versus another subunit within a given company also requires a financial manager to determine product MANAGEMENT accounting quarterly 13 costs for transfer pricing purposes. Accordingly, choosing products as the primary cost objective seems quite logical for most manufacturing firms. Whereas tangible products are logical choices for primary cost objectives in most manufacturing firms, services are logical choices for primary cost objectives in other firms. For example, in the banking industry, the distinction between a direct and an indirect cost is usually considered in terms of whether the cost can or cannot be directly related to a particular service (e.g., processing a loan). Choosing departments as the primary cost objective seems to make sense in other firms. For example, in a retail department store, the distinction between direct and indirect costs is often thought of in terms of whether the cost can or cannot be related to a specific department (e.g., men's clothing). As with measuring the cost of products, measuring the cost of services and departments will facilitate profitability analysis as well as pricing decisions.4 Yet a fundamental change in the way many companies do business has taken place over the past five years. This change falls under the rubric of e-commerce (i.e., electronic commerce) and is largely the result of the Internet. E-commerce has changed the way companies interact with their suppliers and, even more important, the way they interact with their customers. In fact, Internet commerce has changed the very essence of the way many companies do business. Now, many companies generate a large portion of their revenues via the Internet, and a growing number generate the majority of their revenues that way. We refer to these companies as Internet-based because they epitomize the essence of the new Information Economy.5 To date, most companies still consider costs as being direct or indirect in terms of products, services, or departments. This is true even for many Internet-based firms. Though the basic nature of doing business has changed for a large segment of our economy, the essence of cost management has not changed. In particular, many Internet-based firms have not abandoned the old way of thinking about cost objectives. Yet the important distinction between direct and indirect costs is becoming fuzzy. Some people even argue that distinguishing between direct and indirect costs is no longer a valid way to look at costs for a company operating in an e-commerce environment where intangible assets (e.g., intellectual capital) are so prevalent. For example, in the popular book The Blur, Davis and Myer 14 SUMMER 2001 argue that \"direct costs are dead, and diminishing marginal returns died with them, a victim of intangibles.\" We disagree! In our opinion, the need to differentiate between direct and indirect costs is as valid today in an e-commerce environment as it is in a traditional (brick-and-mortar) environment. Profitability analysis, product-line decisions, and pricing decisions are still significantly affected by the way costs are classified in terms of direct and indirect. The thing that is often no longer valid, however, is the focus on the old notion of cost objectives for firms that operate in an e-commerce environment. We believe companies actively involved in e-commerce need to view customers, as well as products, services, and departments, as key cost objectives. Nowhere is this need more important than in Internet-based firms. D I R E C T V S. I N D I R E C T C O S T S I N T E R N E T- B A S E D F I R M S IN The number of firms that derive the majority of their sales over the Internet has grown at a rapid rate. The U.S. Bureau of Census conservatively estimated that $5.3 billion (0.64%) of retail sales in the fourth quarter of 1999 was conducted using the Internet.6 Furthermore, this estimate excludes the huge number of Internet sales from business to business. Clearly, the growth of the Internet is changing all facets of commerce. Understanding the impact of these changes on corporate cost management systems is vital. The distinguishing feature of an e-commerce environment is that business transactions are handled electronically. The hallmark of such an environment has become the way firms interact with customers via the Internet. A logical way to decide whether to classify a firm as being dominated by an e-commerce environment is to use the percentage of the firm's sales generated from the Internet. For a firm to be eligible for the Dow Jones Internet Composite Index (which is further subdivided into the Dow Jones Internet Commerce Index and the Dow Jones Internet Service Index), the company must generate at least half of its sales via the Internet.7 Internet customers, be they households, businesses, or government agencies, can and do conduct quick and inexpensive shopping comparisons. These comparisons take place in a nanosecond, with the click of a mouse. Hence companies are required to continually adjust prices to respond to price changes initiated by competitors. At the same time, their competitors are making similar price adjustments. As a result, companies are required to expend continuous real-time efforts at attracting and tracking customers. In the e-commerce environment, where information search costs approach zero and competitors match price cuts almost instantaneously, competing only in price is not likely to be the means to attracting and maintaining a loyal customer base. Pricing over the Internet has pushed firms to operate in highly competitive, if not purely competitive, economic markets. Businesses are quickly learning that a comparative advantage in the cyber marketplace (or, as some have called it, the marketspace) can be secured only by competing effectively in quality use more than one of the above business models. Security analysts and the general investing public commonly use the B2B designation to refer to companies (e.g., Ariba and i2 Technologies) that produce products and services (e.g., software and consulting) to facilitate B2B transactions among businesses via the Internet. The products and services produced by such B2B firms use the Internet to help match sellers of inputs of production with the buyers of these inputs in an efficient manner so firms secure the right inputs at the right time at minimum cost. Such supply chain management benefits sellers by expanding their geographical market to the entire globe and benefits buyers by facilitating the search for low-cost suppliers, reducing the processing costs customers, key cost objectives. We believe companies actively involved in e-commerce need to view as well as products, services, and departments, as Nowhere is this need more important than in Internet-based firms. customer service to the point of becoming customercentric. Understanding and managing such services requires the allocation of these costs among customers. The proper allocation, in this regard, requires that customers become a key, if not the primary, cost objective for the purposes of distinguishing between direct and indirect costs. Most Internet-based firms use business models that are classified as business-to-business (B2B) or business-to-consumer (B2C). As the names of these models indicate, B2B means that the firm is using the Internet to generate sales of goods and services to other businesses, while B2C means that the firm uses the Internet to generate sales directly to consumers (i.e., retail sales). In addition, the business models used by some Internet-based firms would be classified as business-to-government (B2G) or consumer-to-consumer (C2C). B2G means that the firm sells its products and services primarily to government agencies. C2C means that the firm (for example, eBay) facilitates direct trades among consumers by providing a central marketplace in cyberspace. A firm using a C2C business model typically generates revenues from fees and commissions paid by consumers for participating in the electronic marketplace. Of course, many major corporations associated with materials acquisition, and reducing their inventory holding costs. While the companies designated in the media as B2B firms have often been associated with generating high growth in revenues and profits, the larger effects of the B2B revolution are seen outside the firms given the B2B designation. The larger impact on the economy comes from the rapidly expanding number of firms that have embraced B2B for their supply chain management and for sales of their products to other businesses. Irrespective of whether a firm uses the Internet to sell its products and/or services to other businesses, to consumers, or to government agencies, the environment of electronic commerce requires successful firms to focus data collection on customers or customer classes. Because selling via the Internet empowers customers by reducing their information search costs and their costs of switching from one vendor to another, firms selling via the Internet have stronger motivation to treat customers as key cost objectives than do firms that sell through non-Internet sources. Whether using e-commerce for retail sales or business-to-business sales, companies must devote substantial resources to providing their customers with a user friendly, secure, and hassle-free shop- MANAGEMENT accounting quarterly 15 ping experience. The development, maintenance, and enhancement of software that keeps track of customer preferences is essential for ensuring such an experience. In essence, Internet-based firms rely much less on traditional infrastructure assets, such as buildings, and more on computers, specialized software, and intellectual capital that cater to customers in cyberspace. When comparing one seller with another, customers cannot compare the service level that would be provided as easily as they can compare quoted prices. Nevertheless, with the wealth of information on the Web, including the seller's website, websites of consumer groups, bulletin boards, and message boards, customers can gather information about the quality of service at a fraction of the cost of a decade earlier. These comparisons result in diminishing customer loyalty. Moreover, with venture capitalists funding start-up companies on a regular basis and with more brick-and-mortar companies adding e-commerce divisions, new competition is constantly coming to the marketplace. Thus, companies face a dynamic, increasingly competitive environment. In this new environment, companies that are going to be competitive need to devote substantial resources to attracting customers through advertising on the Internet as well as in traditional media (e.g., newspapers, magazines, and television) that direct customers to the firm's Internet sales site. During the actual sales, it is easier for competitive Internet-based firms than traditional firms to customize the physical product (e.g., specifications of a machine being purchased by one firm from another) or service (e.g., loan agreement) being sold. Internet-based sales provide an easy mechanism for direct and instantaneous contact with customers so companies can quickly modify products to new specifications (e.g., the addition or deletion of a clause in a loan agreement). It is also incumbent upon e-commerce firms to provide a high level of post-sale services to customers because such services are often carried out in an easy, quick, and inexpensive manner. Tracking delivery from the time of sale is a good example of the type of postsale service easily provided in an e-commerce environment. For all the reasons we have noted, tracing costs to individual customers and/or customer classes is an essential competitive strategy for Internet-based companies. In other words, the customer must be a 16 SUMMER 2001 primary cost objective for them. Furthermore, tracing costs to customers cannot be considered a onetime or even periodic investment. Instead, tracing costs to customers must be done on a continuous basis and requires a real-time cost system. For many Internet-based companies, this requires a major change from the way they accumulate costs.8 In fact, Internet-based firms that fail to treat customers as a primary cost objective face the danger of being outsmarted by the competition and left with the least profitable customers in the marketplace.9 For an Internet-based retailer, the costs of products a customer buys would be classified as direct costs for the customer. For an Internet-based manufacturing firm, the manufacturing cost of products would represent an intermediate cost objective, and the total cost (including costs which are indirect with respect to products) would be traced directly to the customers. Because software can identify the specific Internet advertising that routes a particular customer to the firm's e-store, the cost of this advertising can also be allocated to customers in logical manner. It may even be possible to trace specific software-related costs to particular customers in an e-commerce environment, thereby treating these costs as direct costs in terms of customers.10 In essence, many of the costs of pre- and post-sale services, as well as the costs for services incurred during the actual sale, could be traced to individual customers and/or customer classes and treated as direct costs for e-commerce firms.11 Costs that cannot be traced directly to individual customers and/or customer classes, such as the costs associated with computer hardware, would be treated as indirect costs. By treating the customer as a primary cost objective, effective resource allocation decisions will be enhanced. In addition, effective customer profitability analysis, pricing decisions, and marketing decisions will be greatly facilitated. Finally, and of no small consequence, the use of customers as a primary cost objective will facilitate the very essence of being an Internet-based firm (i.e., an Internet-based cost management system will facilitate e-commerce business). It is well known, and accepted, that focusing on the needs and desires of customers is fundamental to running a successful business. This is true whether the business is Internet-based or brick-and-mortar. Yet a fundamental cost objective for Internet-based firms needs to be the customer. In other words, in accumulating and allocating costs, Internet-based firms need to adopt a customer focus. Once they recognize this fact, it becomes clear that the distinction between direct and indirect costs is as important for them as it is for other firms. Of course, the fact that Internet-based firms need to adopt a customer focus in allocating costs in no way mitigates the potential importance of knowing the costs of individual products (or services) as well as departments. Thus, Internet-based firms may well consider other cost objectives in differentiating between direct and indirect costs. To the extent that this is the case, the argument that distinguishing between direct and indirect costs is a relevant and important activity for Internet-based firms is only strengthened. USE MANAGEMENT ACCOUNTING T E C H N I Q U E S P R O P E R LY Cost allocations are fundamental to effective cost management, and, as we have emphasized, a key aspect of cost allocations is the distinction between direct and indirect costs. Nevertheless, the claim that this distinction is not relevant to Internet-based companies has been promulgated lately. We disagree with this claim, for the reasons given above. A fundamental aspect of our argument is the need for Internet-based firms to trace costs to customers. Hence, Internet-based firms need to treat the customer as a primary cost objective in differentiating between direct and indirect costs. The new Information Economy has important implications for the field of management accounting. Direct vs. indirect costs is only one such implication. Other implications include the way companies need to consider performance measures, profit planning, and the use of cost information for pricing decisions. While the sum of these implications represents a fundamental shift in the management accounting paradigm, it does not represent the demise of management accounting. Indeed, the proper use of management accounting techniques is more relevant to the survival of firms in today's dynamic information economy than ever before in the history of commerce. s Lawrence A. Gordon, Ph.D., is the Ernst & Young Alumni Professor of Managerial Accounting at the Robert H. Smith School of Business, University of Maryland, College Park, Md. He can be reached at (301) 405-2255 or lgordon@rhsmith.umd.edu. Martin P. Loeb, Ph.D., is professor of accounting and Deloitte & Touche Faculty Fellow at the Robert H. Smith School of Business, University of Maryland, College Park, Md. He can be reached at (301) 405-2209 or mloeb@rhsmith.umd.edu. 1 Indirect costs are often referred to as overhead costs. Because the term overhead is misleading, we will use indirect to refer to such costs. 2 For examples illustrating this point, see Chapter 3 of Gordon, Managerial Accounting: Concepts and Empirical Evidence, in Further Reading section. 3 In the extreme case of prices being set by the marketplace, we have what economists refer to as a purely competitive market. In a purely competitive market, firms essentially take the market price as given and need to focus on cost management techniques to earn a desirable level of profit. 4 Of course, firms are interested in many cost objectives. Hence, the designation of one cost objective as primary does not preclude the use of other cost objectives. 5 Our definition of what constitutes an Internet-based firm is consistent with the way Dow Jones derives its list of such firms (i.e., for more information, see http://indexes.dow jones.com./djii/djiiabout.html). 6 The U.S. Department of Commerce reports (Digital Economy 2000, June 2000, p.9), \"private estimates for consumer e-commerce in the fourth quarter of 1999 ranged from approximately $4 billion to $14 billion.\" 7 Clearly, the trend is for all firms to increase their Internetbased sales. Accordingly, the distinction between Internetbased firms and non-Internet-based firms is one of degree rather that absoluteness. Over time, it seems logical to expect more and more firms to become Internet-based. 8 Although not the focus of this article, it is equally important for Internet-based firms to identify the revenues of individual customers and/or customer classes. 9 The growing emphasis on linking customers to the production process in the emerging literature on supply chain management is consistent with this argument. For an interesting discussion on the use of \"customer-product maps,\" in the context of supply chain management, see Cloud in the Further Reading section. 10 In a non-e-commerce environment, computer-related costs are traditionally considered to be indirect with respect to a firm's products and services. Given that these assets are an important aspect of an e-commerce firm's assets, this reclassification has nontrivial implications. 11 Recent work in database design has centered on customerfocused data models. This work has particular relevance to the arguments presented in this section. FURTHER READING R. J. Cloud, \"Supply Chain Management: New Role for Finance Professionals,\" Strategic Finance, August 2000, pp. 28-32. S. Davis and C. Myer, Blur: The Speed of Change in the Connected Economy, Addison Wesley, 1998. Dow Jones Internet Indexes, Dow Jones Company, 2000, http://indexes.dowjones.com./djii/djiiabout.html. L. A. Gordon, Managerial Accounting: Concepts and Empirical Evidence, 5th Edition, McGraw-Hill, 2000. United States Commerce Dept., Digital Economy 2000, June 2000, http://www.esa.doc.gov/de2000.pdf. MANAGEMENT accounting quarterly 17 c01.qxd 2/27/04 10:05 AM Page 1 1 Is Your Cost System Obsolete? Most organizations have some type of system in place to calculate and report costs. These systems vary in degrees of complexity and sophistication, from the simple spreadsheet model running on a standalone computer to an integrated enterprise application running on a server or mainframe system. These cost systems are usually based on a set of assumptions about the operating environment that drives the cost calculations. These assumptions, as well as the cost calculation methodology, determine the accuracy of the cost information and its reliability and relevance for management decision making. Once organizations develop a cost model and standardize the methodology, these practices are rarely reexamined or revisited. However, if the operational data that underlie the cost calculations are not updated on a continual basis and the costing methodology is not aligned to the business processes, a cost system will rapidly fall into obsolescence. This situation occurred in the late 1970s and early 1980s, when manufacturers based their cost calculations on direct labor hours despite the increased automation of their business processes. The lack of a clear relationship between the business processes and the output generated by the cost system created serious distortions in the information reported and resulted in a loss of credibility for management accountants. In many organizations, cost systems became dysfunctional tools that had little value for management decision making. Kaplan and Johnson brought this issue to the forefront with their book Relevance Lost.1 Obsolete cost systems are the result of evolutionary changes in the business processes and procedures that are not incorporated in the costing practices of the organization. These cost systems become outdated and no 1 c01.qxd 2/27/04 2 10:05 AM Page 2 Is Your Cost System Obsolete? longer support the strategic direction of the organization. Dysfunctional cost systems have impaired or abnormal functioning. They do not work as designed and often encourage suboptimal behaviors among managers and employees. Obsolete cost systems are usually dysfunctional, but not all dysfunctional cost systems are obsolete. Obsolete, dysfunctional cost systems do not develop overnight and manifest symptoms that are often difficult to ignore. The deterioration process is gradual and often goes unnoticed. Usually external pressures will force management to take a hard look at the company's cost system in order to remain competitive. Dysfunctional cost systems manifest symptoms that are often difficult to ignore. In this chapter, we will discuss the common manifestations of obsolete, dysfunctional cost systems. Some of these warning signs are documented in the accounting literature and others are based on situations that I have come across in my consulting practice. Before we discuss these symptoms, however, we must understand the functions of a cost system in an organization and the trade-offs that may be involved when one system is used to satisfy different business objectives. Such multiplicity of purposes often results in inadequate cost systems that ultimately fall into obsolescence. FUNCTIONS OF A COST SYSTEM Organizations generally establish a cost system to serve several purposes. Kaplan addressed this issue by identifying three major functions of a cost system:2 1. Inventory valuation involves the periodic allocation of production cost between cost of goods sold and inventory. 2. Operational control provides feedback to managers on the resources consumed. 3. Individual product cost measurement addresses the development of unit costs for goods manufactured. Kaplan argued that no one single system could adequately address the demands made by the diverse functions of a cost system and therefore c01.qxd 2/27/04 10:05 AM Page 3 Functions of a Cost System 3 proposed the use of multiple cost systems to satisfy the different needs for cost information. Kaplan was strongly criticized by accounting practitioners who argued that multiple cost systems were not practical or economically feasible in the real world. Subsequently, he published an article in which he describes the four stages of a cost system, with the final stage being an integrated cost management system that could address the multiple demands for cost information made by its users.3 The harsh reality is that for most companies, one cost system must be enough. As initially described by Kaplan, the functions of a cost system revolved around manufacturing where the activity-based costing revolution began. However, the functions of a cost system are broader than those described by Kaplan. Figure 1.1 shows the functions of a cost system in service and manufacturing organizations and the type of information that is provided by each function. Cost systems serve four major purposes in an organization: Figure 1.1 Major Function of a Cost System c01.qxd 2/27/04 4 10:05 AM Page 4 Is Your Cost System Obsolete? 1. Financial reporting. This function involves financial reporting for management, legal, and tax purposes. It has been the primary focus of many cost systems for decades. In manufacturing organizations, the emphasis is on inventory valuation and the allocation of manufacturing costs between inventory and cost of goods sold. In service organizations, it may involve transfer pricing or cost allocations so that subunits of the organization pay their fair share of the costs incurred to deliver a service. 2. Cost measurement. This function entails developing costs, per unit or in total, for a variety of different itemsproducts, services, customers, projects, programs, departments, or work areas. Manufacturing organizations tend to be more advanced in costing procedures than service organizations due to the focus of cost accounting practices on manufacturing entities. With the rise of a service economy based on knowledge and information, the need to cost services has risen dramatically. It is no longer acceptable to manage service organizations in the aggregate. Cost information is important to determine the mix of services and customer profitability similar to manufacturing organizations. 3. Performance management. In the past, accountants attempted to control the business processes through the use of standard costs and variance analysis.4 Increased automation has placed operational control where it should bein the hands of the manager who is accountable for results. A cost system should not be focused on analyzing the past, but in making the critical link among operational measures, resource utilization, and costs in order to impact the future. It should be a tool to help manage organizational performance. In this function, most cost systems are severely lacking. 4. Decision support. Cost systems should provide information to make key decisions such as subcontracting services, product expansion or divestiture, capital investments, and many others. Many companies use full costs for these types of decisions.5 However, this type of cost may be not appropriate for a particular situation and may in fact lead to the selection of a suboptimal alternative. The following situation illustrates this point. One of my clients used full c01.qxd 2/27/04 10:05 AM Page 5 Symptoms of a Dysfunctional Cost System 5 costs to subcontract the manufacturing of an unprofitable product. These costs included fixed overhead, which the company would incur regardless of whether they produced this product. When the owner informed me of his decision and showed me the cost analysis, I pointed out that he would probably expect to see a further deterioration of his financial results as a consequence of this action. The following month bore out my predictionthe company experienced a dramatic reduction in net income. At the time the decision was made, the sales price of the product covered its variable costs and contributed to the recovery of the fixed overhead costs of the facility. With the outsourcing decision, the company decreased the net incremental sales revenue of the subcontracted product but continued to incur the fixed costs of its manufacturing facility.6 This situation resulted in a deterioration of the cash flow position and financial performance of the organization. The key to designing a strategic cost system is understanding what are the most important functions for your organization and how much you are willing to invest to make it work. A cost system may be perfectly adequate for financial reporting purposes, but totally inadequate for cost measurement or decision support. Data collection and maintenance also have a cost, so the more cost information you require, the more resources you will need to develop and maintain the system. You may choose to design a system that is less precise and less integrated with operational measures, but captures the essence of your organization's cost structure with a lower investment of time and resources. The design of cost systems involves a trade-off between precision and the costs of data collection and maintenance. You must ensure that the system satisfies the critical business needs without placing an undue burden on the organization. SYMPTOMS OF A DYSFUNCTIONAL COST SYSTEM Although your cost system may not be obsolete, it might be creating dysfunctional behavior in your organization. The deterioration of a cost system is a gradual progression: processes change, people leave, and knowledge is lost. The day-to-day activities consume the time, energy, and focus of the c01.qxd 2/27/04 6 10:05 AM Page 6 Is Your Cost System Obsolete? Figure 1.2 Symptoms of a Dysfunctional Cost System Internal Warning Signs 1. Users complain that the financial reports are inaccurate or do not reflect the reality of the business operations. 2. Managers cannot explain the financial results. 3. Managers do not use financial reports. 4. Managers develop their own cost models. External Warning