Wright State University Ch 11 Criticisms of Absorption Cost Systems Paper Read chapter 11:Criticisms of Absorption Cost Systems:Inaccurate Product Costs an

Wright State University Ch 11 Criticisms of Absorption Cost Systems Paper Read chapter 11:Criticisms of Absorption Cost Systems:Inaccurate Product Costs and do the problem p-11:The Maui Seminar (pg no. 512)



Accounting for
Decision Making
and Control
Jerold L. Zimmerman
University of Rochester
Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2017 by McGraw-Hill
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Library of Congress Cataloging-in-Publication Data
Names: Zimmerman, Jerold L., 1947- author.
Title: Accounting for decision making and control / Jerold L. Zimmerman,
   University of Rochester.
Description: Ninth edition. | New York, NY : McGraw-Hill Education, [2017]
Identifiers: LCCN 2015043326 | ISBN 9781259564550 (alk. paper)
Subjects: LCSH: Managerial accounting.
Classification: LCC HF5657.4 .Z55 2017 | DDC 658.15/11—dc23
LC record available at http://lccn.loc.gov/2015043326
The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does
not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw-Hill Education does not
guarantee the accuracy of the information presented at these sites.
About the Author
Jerold L. Zimmerman
Jerold Zimmerman is Professor Emeritus at the William
E. Simon Graduate School of Business, University of
Rochester. He holds an undergraduate degree from the
University of Colorado, Boulder, and a doctorate from
the University of California, Berkeley.
While at Rochester, Dr. Zimmerman has taught
a variety of courses spanning accounting, finance,
and economics. Accounting courses include nonprofit
accounting, intermediate accounting, accounting theory,
and managerial accounting. A deeper appreciation of
the challenges of managing complex organizations was
acquired by serving as the Simon School’s Deputy Dean
and on the board of directors of several public corporations.
Professor Zimmerman publishes widely in accounting on topics as diverse as cost
allocations, corporate governance, disclosure, financial accounting theory, capital markets,
and executive compensation. His paper “The Costs and Benefits of Cost Allocations” won
the American Accounting Association’s Competitive Manuscript Contest. He is recognized for developing Positive Accounting Theory. This work, co-authored with colleague
Ross Watts, at the Massachusetts Institute of Technology, received the American Institute
of Certified Public Accountants’ Notable Contribution to the Accounting Literature Award
for “Towards a Positive Theory of the Determination of Accounting Standards” and “The
Demand for and Supply of Accounting Theories: The Market for Excuses.” Both papers
appeared in the Accounting Review. Professors Watts and Zimmerman are also co-authors
of the highly cited textbook Positive Accounting Theory (Prentice Hall, 1986). Professors Watts and Zimmerman received the 2004 American Accounting Association Seminal Contribution to the Literature award. Professor Zimmerman’s textbooks also include
Managerial Economics and Organizational Architecture with Clifford Smith and James
Brickley, 6th ed. (McGraw-Hill, 2016) and Management Accounting in a Dynamic Environment with Cheryl McWatters (Routledge UK, 2016). He is a founding editor of the
Journal of Accounting and Economics, published by Elsevier. This scientific journal is one
of the most highly referenced accounting publications.
He and his wife Dodie have two daughters, Daneille and Amy. Jerry has been known
to occasionally engage friends and colleagues in an amicable diversion on the links.
During their professional careers, managers in all organizations, profit and nonprofit, rely
on their accounting systems. Sometimes managers use the accounting system to acquire
information for decision making. At other times, the accounting system measures performance and thereby influences their behavior. The accounting system is both a source of
information for decision making and part of the organization’s control mechanisms—thus,
the title of the book, Accounting for Decision Making and Control.
The purpose of this book is to provide students and managers with an understanding and appreciation of the strengths and limitations of an organization’s accounting
system, thereby allowing them to be more intelligent users of these systems. This book
provides a framework for understanding accounting systems and a basis for analyzing
proposed changes to these systems. The text demonstrates that managerial accounting is an i­ntegral part of the firm’s organizational architecture, not just an isolated set of
computational topics.
Changes in the Ninth Edition
Feedback from reviewers and instructors using the prior editions and my own teaching
experience provided the basis for the revision. In particular, the following changes have
been made:
• Each chapter has been revised to further enhance readability and remove redundancy.
• References to actual company practices have been updated.
• Users were uniform in their praise of the problem material. They found it challenged
their students to critically analyze multidimensional issues while still requiring
­numerical problem-solving skills.
• The end-of-chapter problem material was revised by adding 45 new problems—
including some related to health care and knowledge-based service firms—and
­removing outdated problems.
• The ninth edition is a more concise revision that presents the same ­fundamental concepts, learning objectives, and challenging critical thinking end-of-chapter materials as
in prior editions.
Overview of Content
Chapter 1 presents the book’s conceptual framework by using a simple decision context
regarding accepting an incremental order from a current customer. The chapter describes
why firms use a single accounting system and the concept of economic Darwinism, among
other important topics. This chapter is an integral part of the text.
Chapters 2, 4, and 5 present the underlying conceptual framework. The importance
of opportunity costs in decision making, cost–volume–profit analysis, and the difference
between accounting costs and opportunity costs are discussed in Chapter 2. Chapter 4
­employs the economic theory of organizations and organizational architecture as the conceptual foundation to understand the role of the accounting system as part of the organization’s control mechanism. Chapter 5 describes the crucial role of accounting as part of the
firm’s organizational architecture. Chapter 3 on capital budgeting extends opportunity costs
to a multiperiod setting. This chapter can be skipped without affecting the flow of later
material. Alternatively, Chapter 3 can be assigned at the end of the course.
Chapter 6 applies the conceptual framework and illustrates the trade-off managers
face between decision making and control in a budgeting system. Budgets are a decisionmaking tool to coordinate activities within the firm and are a device to control behavior.
This chapter provides an in-depth illustration of how budgets are an important part of an
organization’s decision-making and control apparatus.
Chapter 7 presents a general analysis of why managers allocate certain costs and the
behavioral implications of these allocations. Cost allocations affect both decision making
and incentives. Again, managers face a trade-off between decision making and control.
Chapter 8 continues the cost allocation discussion by describing the “death spiral” that
can occur when significant fixed costs exist and excess capacity arises. This leads to an
analysis of how to treat capacity costs—a trade-off between underutilization and overinvestment. Finally, the chapter describes several specific cost allocation methods such as
service department costs and joint costs.
Chapter 9 applies the general analysis of overhead allocation in Chapters 7 and 8 to the
specific case of absorption costing in a manufacturing setting. The managerial implications
of traditional absorption costing are provided in Chapters 10 and 11. Chapter 10 analyzes
variable costing, and activity-based costing is the topic of Chapter 11. Variable costing is
an interesting example of economic Darwinism. Proponents of variable costing argue that
it does not distort decision making and therefore should be adopted. Nonetheless, it is not
widely practiced, probably because of tax, financial reporting, and control considerations.
Chapter 12 discusses the decision-making and control implications of standard labor
and material costs. Chapter 13 extends the discussion to overhead and marketing variances. Chapters 12 and 13 can be omitted without interrupting the flow of later material.
Finally, Chapter 14 synthesizes the course by reviewing the conceptual framework and
applying it to various organizational innovations, such as total quality management, just in
time, six sigma, lean production, and the balanced scorecard. These innovations provide an
opportunity to apply the analytic framework underlying the text.
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William Vatter and George Benston motivated my interest in managerial accounting. The
genesis for this book and its approach reflect the oral tradition of my colleagues, past
and present, at the University of Rochester. William Meckling and Michael Jensen stimulated my thinking and provided much of the theoretical structure underlying the book, as
anyone familiar with their work will attest. My long and productive collaboration with
Ross Watts sharpened my analytical skills and further refined the approach. He also furnished most of the intellectual capital for Chapter 3, including the problem material. Ray
Ball has been a constant source of ideas. Clifford Smith and James Brickley continue to
enhance my economic education. Three colleagues, Andrew Christie, Dan Gode, and Scott
­Keating, ­supplied particularly insightful comments that enriched the analysis at critical
junctions. Valuable comments from Anil Arya, Ron Dye, Andy Leone, Dale Morse, Ram
Ramanan, K. Ramesh, Shyam Sunder, and Joseph Weintrop are gratefully acknowledged.
This project benefited greatly from the honest and intelligent feedback of n­ umerous
instructors. I wish to thank Mahendra Gupta, Susan Hamlen, Badr Ismail, Charles Kile,
Leslie Kren, Don May, William Mister, Mohamed Onsi, Ram Ramanan, Stephen Ryan,
Michael Sandretto, Richard Sansing, Deniz Saral, Gary Schneider, Joe Weber, and
­William Yancey. This book also benefited from two other projects with which I have been
involved. Writing Managerial Economics and Organizational Architecture (McGraw Hill
Education, 2016) with James Brickley and Clifford Smith and Management Accounting
in a Dynamic Environment (Routledge, 2016) with Cheryl McWatters helped me to better
understand how to present certain topics.
To the numerous students who endured the development process, I owe an enormous
debt of gratitude. I hope they learned as much from the material as I learned teaching them.
Some were even kind enough to provide critiques and suggestions, in particular Jan Dick
Eijkelboom. Others supplied, either directly or indirectly, the problem material in the text.
The able research assistance of P. K. Madappa, Eamon Molloy, Jodi Parker, Steve Sanders, Richard Sloan, and especially Gary Hurst, contributed amply to the manuscript and
problem material. Janice Willett and Barbara Schnathorst did a superb job of editing the
manuscript and problem material.
The very useful comments and suggestions from the following reviewers are greatly
Urton Anderson
Howard M. Armitage
Vidya Awasthi
Kashi Balachandran
Da-Hsien Bao
Ron Barden
Howard G. Berline
Margaret Boldt
David Borst
Eric Bostwick
Marvin L. Bouillon
Wayne Bremser
David Bukovinsky
Linda Campbell
William M. Cready
James M. Emig
Gary Fane
Anita Feller
Tahirih Foroughi
Ivar Fris
Jackson F. Gillespie
Irving Gleim
Jon Glover
Gus Gordon
Sylwia Gornik-Tomaszewski
Tony Greig
Susan Haka
Bert Horwitz
Steven Huddart
Robert Hurt
Douglas A. Johnson
Lawrence A. Klein
Thomas Krissek
A. Ronald Kucic
Daniel Law
Chi-Wen Jevons Lee
Suzanne Lowensohn
James R. Martin
Alan H. McNamee
Marilyn Okleshen
Shailandra Pandit
Sam Phillips
Frank Probst
Kamala Raghavan
William Rau
Jane Reimers
Thomas Ross
Harold P. Roth
P. N. Saksena
Donald Samaleson
Michael J. Sandretto
Richard Saouma
Arnold Schneider
Henry Schwarzbach
Elizabeth J. Serapin
Norman Shultz
James C. Stallman
William Thomas Stevens
Monte R. Swain
Heidi Tribunella
Clark Wheatley
Lourdes F. White
Paul F. Williams
Robert W. Williamson
Peggy Wright
Jeffrey A. Yost
S. Mark Young
To my wife Dodie and daughters Daneille and Amy, thank you for setting the right
priorities and for giving me the encouragement and environment to be productive. Finally,
I wish to thank my parents for all their support.
Jerold L. Zimmerman
University of Rochester
Brief Contents
The Nature of Costs
Opportunity Cost of Capital and Capital Budgeting
Organizational Architecture
Responsibility Accounting and Transfer Pricing
Cost Allocation: Theory
Cost Allocation: Practices
Absorption Cost Systems
Criticisms of Absorption Cost Systems: Incentive to Overproduce
Criticisms of Absorption Cost Systems: Inaccurate Product Costs
Standard Costs: Direct Labor and Materials
Overhead and Marketing Variances
Management Accounting in a Changing Environment
Solutions to Concept Questions
Glossary 665
Index 675
Introduction  1
Managerial Accounting: Decision Making and Control   2
Design and Use of Cost Systems   4
Marmots and Grizzly Bears   8
Management Accountant’s Role in the Organization   9
Evolution of Management Accounting: A Framework for Change   12
Vortec Medical Probe Example   15
Outline of the Text   18
Summary  18
The Nature of Costs   22
A. Opportunity Costs  23
1. Characteristics of Opportunity Costs   24
2. Examples of Decisions Based on Opportunity Costs   24
B. Cost Variation  29
1. Fixed, Marginal, and Average Costs   29
2. Linear Approximations  31
3. Other Cost Behavior Patterns   33
4. Activity Measures  33
C. Cost–Volume–Profit Analysis  35
1. Copier Example  35
2. Calculating Break-Even and Target Profits   36
3. Limitations of Cost–Volume–Profit Analysis   39
4. Multiple Products  41
5. Operating Leverage  42
D. Opportunity Costs versus Accounting Costs   45
1. Period versus Product Costs   46
2. Direct Costs, Overhead Costs, and Opportunity Costs   46
E. Cost Estimation  48
1. Account Classification  49
2. Motion and Time Studies   49
F. Summary  49
Appendix: Costs and the Pricing Decision   50
Opportunity Cost of Capital and Capital Budgeting   85
A. Opportunity Cost of Capital   86
B. Interest Rate Fundamentals   89
1. Future Values  89
2. Present Values  90
3. Present Value of a Cash Flow Stream   91
4. Perpetuities  92
5. Annuities  93
6. Multiple Cash Flows per Year   94
Capital Budgeting: The Basics   96
1. Decision to Acquire an MBA   96
2. Decision to Open a Day Spa   97
3. Essential Points about Capital Budgeting   98
Capital Budgeting: Some Complexities   99
1. Risk  99
2. Inflation  100
3. Taxes and Depreciation Tax Shields   102
Alternative Investment Criteria   104
1. Payback  104
2. Accounting Rate of Return   105
3. Internal Rate of Return (IRR)   107
4. Methods Used in Practice   110
Summary  110
Organizational Architecture  127
A. Basic Building Blocks   128
1. Self-Interested Behavior, Team Production, and Agency Costs   128
2. Decision Rights and Rights Systems   133
3. Role of Knowledge and Decision Making   134
4. Markets versus Firms   135
5. Influence Costs  137
B. Organizational Architecture  139
1. Three-Legged Stool  139
2. Decision Management versus Decision Control   143
C. Accounting’s Role in the Organization’s Architecture   145
D. Example of Accounting’s Role: Executive Compensation Contracts   147
E. Summary  148
Responsibility Accounting and Transfer Pricing   161
A. Responsibility Accounting  162
1. Cost Centers  163
2. Profit Centers  165
3. Investment Centers  166
4. Economic Value Added (EVA®)  170
5. Controllability Principle  173
B. Transfer Pricing  175
1. International Taxation  175
2. Economics of Transfer Pricing   177
3. Common Transfer Pricing Methods   181
4. Reoragnization: The Solution if All Else Fails   186
5. Recap  186
C. Summary  188
Budgeting  216
A. Generic Budgeting Systems   219
1. Country Club  219
2. Large Corporation  222
B. Trade-Off between Decision Management and Decision Control   226
1. Communicating Specialized Knowledge versus Performance
Evaluation  226
2. Budget Ratcheting  227
3. Participative Budgeting  229
4. New Approaches to Budgeting   230
5. Managing the Trade-Off   232
C. Resolving Organizational Problems   233
1. Short-Run versus Long-Run Budgets   233
2. Line…
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