Mowen ch13

Chapter 13
Emerging Issues in
Managerial Accounting
Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7th Edition. © 2018 Cengage.
All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part
Learning Objectives (1 of 2)
1. Explain enterprise risk management and its importance for achieving
strategy
2. Understand the role of managerial accounting in business sustainability
3. Define quality costs and describe the approaches used for reporting and
controlling quality costs
4. Describe the basics of lean manufacturing and lean accounting
Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7th Edition. © 2018 Cengage. All
Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part
Learning Objectives (2 of 2)
5. Explain the role of the management accountant in the international
environment
6. Explain the role of the management accountant in fraud and forensic
accounting
Enterprise Risk Management
• Enterprise risk management helps an organization make better decisions in
uncertain business environments and, most importantly, to achieve its
chosen strategy (e.g., to create the most innovative products or services; to
provide the lowest cost products or services; to offer the highest quality
products or services, etc.)
• Enterprise risk management (ERM) is the formal process of aligning an
organization’s overall desired level of risk taking with its strategy and then
managing its top risks in a manner that maintains this alignment
Determining Risk Appetite (1 of 2)
• Risk Appetite Determination: Determine the organization’s desired overall
level of risk taking that should be pursued to generate the financial returns
expected by shareholders and other key stakeholders.
• Risk Identification: Identify top risks.
• Risk Assessment: Assess top risks at the inherent level.
• Risk Response: Using a portfolio perspective, identify, evaluate, and
implement the best response alternatives for inherent risks that bring the
portfolio of residual risks into alignment with the organization’s risk appetite.
Determining Risk Appetite (2 of 2)
• Risk Monitoring:
Continually search for new emerging risks, reevaluate accuracy of risk
assessments, and consider more effective risk response alternatives.
Key Elements of a Portfolio Risk Management
Perspective
Panel A: Risk Appetite Panel B: Inherent Risks Panel C: Residual Risks
Identifying Top Risks (1 of 2)
• After determining its risk appetite, a company next identifies its most
important risks
• Risk identification requires input from a cross-functional team to capture all of
the perspectives of the organization to understand the threats—or risks—to
the organization
• Most companies separate identified risks into various categories, such as
strategic risk, operational risk, compliance risk, financial reporting risk, etc.,
that can be further tailored to the specifics of a particular company or
industry
Identifying Top Risks (2 of 2)
• Each top risk is assigned a “risk owner” who has responsibility for overseeing
the successful management of that risk throughout the ERM process
Assessing Inherent Risks (1 of 2)
• An inherent risk is the risk that exists absent of any risk management action
to reduce or avoid the risk
• Most ERM programs assess, or estimate, two aspects of uncertainty for
inherent risks
o the likelihood, or probability P, of an event occurring and
o the impact, or magnitude, on the company should an event actually occur
• Probability P is measured as falling between 0 (no chance of occurring) and

1 (will occur for sure)—(i.e., 0 ≤ P ≤ 1)
Assessing Inherent Risks (2 of 2)
• Impact can be measured in qualitative terms (e.g., company reputation), in
nonfinancial quantitative terms (e.g., percentage of quality defects), or
financial quantitative terms (e.g., additional costs incurred or revenues lost)
• Both probability and impact are difficult to quantify
• Managers increasingly rely on the measurement expertise of management
accountants to estimate these amounts
Here’s How It’s Used: AT ADIDAS GROUP (1 of 5)
ERM analyses contain extremely confidential internal information and, as a
result, companies rarely share them publicly. However, the chart below displays
an excerpt from adidas Group’s annual report that illustrates how this large
(over $18 billion in annual sales) international sports apparel and equipment
company considers the impact and likelihood of its most critical risks
The axis labels are flipped from that of Exhibit 13.2. Nevertheless, the risk chart
is interpreted in the same basic manner—the further from the origin, the greater
the risk as measured by likelihood of occurrence and the potential impact
should it occur. In addition to its adidas Originals, Sports Performance, and
Sports Styles brands, the Group also owns the Reebok and TaylorMade
brands. The adidas Group has a risk and opportunity management system for
carrying out an ERM process similar to the one examined in this chapter.
For example, its annual report states that the “risk and opportunity
management system ensures risk-aware, opportunity-oriented and informed
actions in a dynamic business environment in order to guarantee the
competitiveness and sustainable success of the adidas Group.” Examples of
top risks identified and managed by its Risk and Opportunity Management
System include strategic risks (e.g., product distribution risks, competition risks,
and sociopolitical and regulatory risks), operational risks (e.g., personnel risks,
business partner risks, IT risks, and inventory risks),
legal and compliance risks (e.g., customs and tax regulations), and financial
risks (e.g., currency risks, impairment of intangible assets, liquidity risks, and
credit risks). With an effective and transparent ERM process, adidas Group
more effectively pursues its mission to “strive to be the best sports company in
the world, with brands built on a passion for sports and a sporting lifestyle!”
Responding to Risks Using a Portfolio
Perspective (1 of 4)
• A portfolio ERM perspective is the practice of managing the company’s
most important risks in a collective (or portfolio) fashion such that the
residual risks that remain align with the company’s risk appetite
• Generally, there are three alternatives for responding to an inherent risk:
o accept
o avoid
o reduce
• To accept an inherent risk means that the company does nothing in
response—it simply continues conducting business as normal
o Many risks are managed this way simply because companies do not have
enough money and personnel resources to reduce all of their top risks
o With this response, the residual risk is the same as the inherent risk because no
response action is taken
• To avoid an inherent risk means that the company ceases to perform the
activity that gave rise to the risk
o Some top risks are avoided because the company cannot reduce the risk in a
cost-beneficial manner and it is unwilling to allow the risk to remain at its current
inherent level
o With this response, there is no residual risk because the risk itself is removed
from the company as a result of the company no longer performing the activity
that caused the inherent risk to exist
• To reduce an inherent risk means that the company enacts some particular
procedure to decrease the inherent risk to a lower residual risk level
o Possible risk reduction procedures include a specific activity or internal control,
insurance policy, strategic alliance, or even an entire business process
o With this response, the residual risk will be lower than the inherent risk as a result
of the chosen risk reduction alternative
Here’s How It’s Used: AT GOOGLE (1 of 2)
China has more than twice as many people using the Internet as the United
States has citizens and yet Google elected to exit its Chinese search engine
business in 2010, thereby losing a tremendously large market. Google chose
this avoidance action to avoid the risk of censorship from the Chinese
government whose impact was measured by cyber attacks from within the
country that targeted the company itself, as well as dozens of other companies
and even various Chinese human rights activists.
Here’s How It’s Used: AT GOOGLE (2 of 2)
Given that Google had invested 4 years in developing its Chinese market
offering, management undoubtedly considered a risk reduction response action
instead. However, the incremental direct and indirect costs of reducing these
negative impacts appeared to outweigh the benefits of doing business in this
large, emerging market. The end risk response result—at least for a number of
years—was risk avoidance by exiting the market.
Net Benefit of Risk Response (1 of 3)
• Risk response benefit can be defined as the difference between the
inherent risk and the residual risk produced by the particular risk response
o Inherent risk is the probability (or likelihood) of a risk occurring multiplied by the
impact should it actually occur, which in essence is an expected value calculation
o Residual risk is calculated in the same manner, except that the equation uses the
probability and the impact that are expected to exist after the risk response in
question has been implemented
Risk Response Benefit = Inherent Risk − Residual Risk
• Risk response cost can be defined as the incremental cost incurred by the
company to implement the given risk response
• Effective ERM requires that management evaluate and implement the most
appropriate risk response to each top risk—in other words, the response that
generates the greatest positive net benefit
o Risk response net benefit is measured as the benefit of risk response minus
the cost of risk response
Risk Response Net Benefit = Response Benefit − Response Cost
• Only after risk response costs have been accurately estimated and
subtracted from the response benefit can management estimate the net
benefit of each risk response alternative and select the best course of action
• Management must understand how to evaluate multiple risk response
alternatives and select the one that best manages the given risk in a cost-
effective manner
• ERM uses a portfolio perspective to ensure that the organization’s most
important residual risks are aligned with its risk appetite, thereby helping the
organization achieve its strategy
Example 13.1: How to Use Net Benefit to Evaluate
Risk Response Alternatives (1 of 7)
Swift Ascent Backpacking Company provides various outdoor adventure
services to climbers visiting Mount Rainer National Park. One of its most
popular services is a guided 12-mile hike from Paradise Lodge to the main
Base Camp where climbers can make their final ascent to the summit of the
mountain. Swift Ascent’s management is concerned about the additional costs
the company would incur from potential lawsuits and fines resulting from
injured climbers. The chart below contains a description of this top risk, an
inherent risk assessment, three risk response alternatives, and a residual risk
assessment for each response alternative.
Inherent Risk Residual Risk
Inherent for Impact Residual for Impact
Risk for (operating Risk Response for Risk for (operating
Risk Likelihood costs) Alternatives Likelihood costs)
Climbers become either sick or injured 20% $10,000,000 A—Require an intensive day- 10% $ 6,000,000
during their 12-mile hike from Paradise long training and education
Lodge to Base Camp, resulting in costly seminar for all climbers the
lawsuits from climbers and fines from the day before their climb
National Park Service (both of which
increase operating costs for Swift Ascent)
20% $10,000,000 B—Form an alliance with the 15% $ 5,000,000
leading outdoor gear company
that guarantees climbers use
the best performing gear
(boots, ice picks, oxygen
masks, etc.) on the market
20% $10,000,000 C—Take no action in 20% $10,000,000
response to possible new
lawsuits or fines
Swift Ascent’s management accountants estimate that the incremental cost of implementing risk
response A is $550,000 and the incremental cost of implementing risk response B is $300,000.
Required:
1. Calculate the inherent risk for Swift Ascent.
2. Calculate the residual risk for Swift Ascent associated with each of the three
risk response alternatives A, B, and C.
3. Calculate the benefit for Swift Ascent associated with each of the three risk
response alternatives A, B, and C.
4. Calculate the net benefit for Swift Ascent associated with each of the three
risk response alternatives A, B, and C.
5. Using net benefit as the criterion, which risk response should Swift Ascent
choose to implement?
Solution:
1. The inherent risk for Swift Ascent equals the likelihood of the risk occurring
multiplied by the impact that is expected should the risk actually occur.
Therefore, the inherent risk (IR) is:
= 0.20 (likelihood) × $10,000,000 (impact)
= $2,000,000
2. The residual risk associated with a particular risk response alternative
equals the likelihood that remains after the alternative is implemented
multiplied by the impact that remains after the alternative is implemented.
Therefore, residual risk (RR) for response alternative A is:
= 0.10 (likelihood) × $6,000,000 (impact) = $600,000
Therefore, residual risk (RR) for response alternative B is:
= 0.15 (likelihood) × $5,000,000 (impact) = $750,000
Therefore, residual risk (RR) for response alternative C is:
= 0.20 (likelihood) × $10,000,000 (impact) = $2,000,000
3. The benefit associated with a particular risk response alternative equals the
inherent risk (IR) minus the residual risk (RR).
Therefore, the benefit for risk response alternative A is:
= $2,000,000 (IR) − $600,000 (RR) = $1,400,000
Therefore, the benefit for risk response alternative B is:
= $2,000,000 (IR) − $750,000 (RR) = $1,250,000
Therefore, the benefit for risk response alternative C is:
= $2,000,000 (IR) − $2,000,000 (RR) = $0
4. The net benefit associated with a particular risk response alternative equals
the benefit minus the cost.
Therefore, the net benefit for risk response alternative A is:

= $1,400,000 (benefit) − $550,000 (cost) = $850,000
Therefore, the net benefit for risk response alternative B is:
= $1,250,000 (benefit) − $300,000 (cost) = $950,000
Therefore, the net benefit for risk response alternative C is:
= $0 (benefit) − $0 (cost) = $0
5. Using net benefit as the criterion, Swift Ascent should select and implement
risk response alternative B because this option has the greatest positive net
benefit, $950,000, as compared to alternative A, $850,000, or alternative C,
$0.
Monitoring the ERM Process (1 of 2)
• Risk monitoring means that management proceeds through the ERM
process in an iterative fashion, continually looking for ways to improve any
and all steps along the way
• One common mistake made by management in implementing ERM is
treating it as a checklist that simply requires one-time consideration
• Well-run companies continuously look for ways to improve their ERM
process and turn to management accountants to play an important role in
providing key inputs into each step of the ERM process
Monitoring the ERM Process (2 of 2)
• For example, management accountants can help continually reevaluate key
inputs, such as identifying emerging—yet previously ignored—risks and
reassessing the stated risk appetite to verify that it aligns with the company’s
strategy and expectations from key stakeholders
Business Sustainability
• Business sustainability is the practice of creating long-term organizational
value through internally understanding, measuring, and managing the key
threats and opportunities to achieving the organization’s strategy and then
externally reporting to key stakeholders on the successes and failures of
such efforts
Here’s How It’s Used: AT DE BEERS (1 of 4)
Business sustainability involves many functions and varies across businesses
and industries. One decision that likely will change your life one day regards
marriage and the selection of a diamond engagement ring. You might consider
the life cycle of the ring’s diamond—it almost surely has traveled a great
distance and involved a large number of key stakeholders along the way.
For example, founded in 1888, De Beers is one of the world’s best-known
diamond companies. De Beers extracts, or recovers, the majority of its
diamonds from Botswana, South Africa, Canada, and Namibia. Exhibit 13.3
displays a variety of De Beers’ various business sustainability issues (both
threats and opportunities) along its entire value chain.
De Beers’ value chain spans from research and development Exploration (e.g.,
the positive and negative political, economic, and social impacts that occur as
a result of the countries where De Beers chooses to explore for diamonds)
through customer service Brands/Retail (e.g., changes in De Beers’ reputation
for exclusivity and quality resulting from the prices it charges and the retail
establishments it uses to sell its diamonds).
Business Sustainability Issues throughout the
Value Chain
A GLOBAL VALUE CHAIN
As De Beers illustrates, business sustainability requires that management
considers the numerous stakeholders, as well as threats and opportunities,
involved with major decisions throughout the company.
The Role of Management Accounting in the Business
Sustainability Cycle
Strategy
• Business sustainability begins first and foremost with the company’s strategy
• Selecting the company’s strategy is an important decision usually made by
the CEO
• However, perhaps even more important than selecting the best strategy is
implementing the selected strategy in an effective manner
• Effective strategy implementation requires management to make business
sustainability-oriented decisions that support, rather than conflict with,
strategy
Stakeholder Engagement (1 of 3)
• Stakeholders are those individuals or groups that
o are affected by an organization’s pursuit of its strategy
o can affect an organization’s ability to achieve its strategy
• In other words, the relationship between key stakeholders and the

organization is a two-way street
• Stakeholders can include investors, creditors, customers, employees,
regulators, suppliers, competitors, lobbyists, community members, and
nongovernment organizations
• Stakeholder engagement is the process by which an organization’s
management interacts with its key stakeholders
• Stakeholder engagement varies from casual, impromptu, informal
conversations all the way to regular, structured interactions where both
parties exchange data and expectations about one another’s performance
• Managerial accountants can play an important role in quantifying
stakeholders’ expectations about the organization and estimating the extent
to which such expectations can impact (either positively or negatively) the
organization’s future earnings, cash flows, or other performance measures
important to the organization
The Relationship Between Stakeholders and Strategy
Note: Respondents who indicated high or very high impact
Risk Management
• Stakeholder concerns can be thought of as the risks and opportunities facing
the organization that either help or hurt its ability to achieve its selected
strategy (i.e., stakeholder concerns equal organizational risks/opportunities)
• An effective stakeholder engagement process is extremely helpful in
identifying these stakeholder concerns and recognizing the risks and
opportunities they pose to the organization more quickly than if no such
process exists
Performance Measurement (1 of 2)
• For investors and other key stakeholders, financial measures, such as future
cash flows and earnings streams, usually serve as the ultimate measuring
stick for evaluating the effectiveness with which managers make decisions
that involve numerous—and often conflicting—stakeholder concerns
• However, organizations have limited resources and, therefore, cannot please
all key stakeholders all of the time
Performance Measurement (2 of 2)
• Business sustainability is valuable because it improves decision making by
helping managers understand how their various decisions involving risks and
opportunities (i.e., stakeholder issues) relate to important performance
measures, such as future cash flow and earnings streams
Here’s How It’s Used: SUSTAINABILITY (1 of 3)
UPS illustrates the important connection between stakeholders, risks, and
performance measurement. In essence, UPS’s business model is predicated
on its ability to drive trucks and fly planes all over the globe delivering
packages. In so doing, UPS employs over 444,000 workers, handles an
average of 69.4 million daily tracking requests, and uses approximately
105,000 vehicles (cars, vans, tractors, and motorcycles) and 650 planes to
deliver over 4.7 billion packages and documents annually.
As an indication of its environmental footprint, the company touts that its Orion
delivery routing technology will reduce the distance its vehicles drive each year
by 100 million miles. The UPS graph in Exhibit 13.7—with importance to
stakeholders shown on the vertical axis and influence on business success
shown on the horizontal axis—shows the relationship between the company’s
stakeholder concerns and its business sustainability.
Materiality Matrix
KEY
IMPACT/ISSUE AREA:
Areas of significant UPS
sustainability impact.
CONTEXTUAL TREND:
Global trends
influencing our
business and our
sustainability strategy.
Not surprisingly, as evidenced by its inclusion in the upper right-hand corner,
UPS’s performance measurement system ranks Energy, Emissions & Fuel
Supply as one of its most important risks given its extreme importance to
stakeholders and influence on UPS’s performance. From this point, UPS
accountants can perform more in-depth analyses to estimate how the most
important stakeholder issues shown in the graph translate into impacts on the
organization’s most critical performance measures.
Sustainability Reporting
• Corporate sustainability reporting (CSR) refers to the voluntary public
0
disclosure of qualitative and/or quantitative information about an

organization’s performance on one or more financial and/or nonfinancial
dimensions
• CSR is a relatively recent, yet very impactful reporting phenomenon, both for
the organization issuing the CSR and for the multitude of external
stakeholders that make various decisions based on the information
contained within the CSR
Rapid Growth in Corporate Sustainability
Reporting Since Its Inception
CR reporting stabilizes at a high level
Base: N100/G250 companies

Source: KPMG Survey of Corporate Responsibility Reporting 2015
Widespread Adoption of Corporate Sustainability
Reporting across Industries
CR reporting rates by sector
Base: 4,500 N100 companies

Source: KPMG Survey of Corporate Responsibility Reporting 2015
Sustainability Assurance (1 of 2)
• Sustainability assurance is the external verification that an independent
party provides concerning the content of a corporate sustainability report
and/or the process used in preparing a corporate sustainability report
• In most countries and financial markets, CSRs are not required to be verified
(e.g., assured) by independent third parties
• The most significant benefit of having a CSR assured by an independent
third party is that assurance can increase the believability of the CSR’s
content for external stakeholders
Sustainability Assurance (2 of 2)
• In other words, people are more likely to trust qualitative and quantitative CSR
information if it has been verified by an unbiased party that is unrelated to the
reporting organization (i.e., the CSR issuer)
Growth in Independent Assurance of Corporate
Sustainability Information
The Challenge of Communicating an Organization’s
Business Sustainability “Story”
• The organization can reap significant benefits as a result of communicating
its business sustainability story
• The benefits to organizations include
o more effectively capturing investor capital
o securing a lower cost of borrowing
o attracting and retaining better employees
o working with higher-quality suppliers
o receiving more favorable treatment from regulators and lawmakers
o eliciting more welcoming treatment from the local communities in which they
operate
Quality Cost Management (1 of 2)
• A quality product or service is one that meets or exceeds customer
expectations
o Customers expect a product to be reliable, durable, and fit for use and to
essentially perform well; in effect, they expect a product to conform to
specifications
• Quality experts believe that quality of conformance is the best operational
definition of quality
o Implicitly, a conforming product is reliable, durable, and fit for use and performs
well
Quality Cost Management (2 of 2)
• Conformance is the basis for defining what is meant by a nonconforming, or
defective, product
o A defective product is one that does not conform to specifications
o Zero defects means that all products conform to specifications
Costs of Quality (1 of 2)
• Costs of quality are costs that exist because poor quality may or does exist
• Quality costs can be substantial in size and a source of significant savings if
managed effectively
• Improving quality can increase market share and sales, while simultaneously
decreasing costs
Costs of Quality (2 of 2)
• There are numerous quality-related activities, all of which consume resources
that determine the level of quality incurred by a firm
• Quality costs can be categorized as:
o control costs
o failure costs
Control costs (1 of 2)
• Control costs are the costs of preventing or detecting poor quality
• These costs are incurred because poor quality may exist
• Control costs can be further subdivided into prevention and appraisal costs
o Prevention costs are incurred to prevent poor quality in the products or services
being produced
• As prevention costs increase, we would expect the costs of failure to decrease
• Examples of prevention costs are quality engineering, quality training programs,
quality planning, etc.
Control costs (2 of 2)
• Appraisal costs are incurred to determine whether products and services
are conforming to their requirements
o The main objective of the appraisal function is to prevent nonconforming goods
from being shipped to customers
o Examples include inspecting and testing raw materials, packaging inspection,
supervising appraisal activities, product acceptance, etc.
Failure costs (1 of 2)
• Failure costs are the costs incurred because products or services are
produced that do not conform to specifications
• These costs tend to be most significant and, like control costs, have two
major subdivisions
o Internal failure costs are incurred when products and services do not conform
to specifications and this nonconformance is detected before the bad products or
services are shipped or delivered to outside parties
• These are the failures detected by appraisal activities
• Examples of internal failure costs are scrap, rework, downtime (due to defects),
reinspection, retesting, and design changes
Failure costs (2 of 2)
• External failure costs are incurred when products and services fail to
conform to requirements or satisfy customer needs after being delivered to
customers
o For example, costs of recalls can run into the hundreds of millions of dollars
Examples of Quality Costs by Category (1 of 2)
Prevention Costs Appraisal (Detection) Costs

Quality engineering Inspection of materials
Quality training Packaging inspection
Recruiting Product acceptance
Quality audits Process acceptance
Design reviews Field testing
Quality circles Continuing supplier verification
Marketing research
Prototype inspection
Vendor certification
Examples of Quality Costs by Category (2 of 2)
Internal Failure Costs External Failure Costs

Scrap Lost sales (performance-
related)
Rework Returns/allowances
Downtime (defect-related) Warranties
Reinspection Discounts due to defects
Retesting Product liability
Design changes Complaint adjustment
Repairs Recalls
Reporting Quality Costs (1 of 3)
• Improving quality can increase firm value because it increases a firm’s
profitability
• Improving quality can increase profitability in at least two ways:
o by increasing customer demand and
o by decreasing the costs of providing goods and services
• A quality cost reporting system is essential to an organization serious about

improving and controlling quality costs
• The first and simplest step in creating such a system is assessing current
actual quality costs
• A detailed listing of actual quality costs by category can provide two
important insights
o It reveals the magnitude of the quality costs in each category, allowing managers
to assess their financial impact
o It shows the distribution of quality costs by category, allowing managers to
assess the relative importance of each category
• When quality costs reach the optimal range of 2 to 4% of sales, control costs
typically account for about 80 to 85% of total quality costs
Example 13.2: How to Prepare a Quality Cost
Report (1 of 4)
Auger Company had total sales of $10,000,000 for the fiscal year ending on
December 31, 20X1. Auger’s costs of quality are as follows:
Recalls $500,000
Scrap 350,000
Quality engineering 90,0000
Reinspection 250,000
Quality training 10,000
Product acceptance 120,000
Materials inspection 80,000
Product liability 600,000
Report (2 of 4)
Required:
1. Prepare a quality cost report, classifying costs by category and expressing
each category as a percentage of sales. What message does the cost report
provide?
2. Prepare a bar graph and pie chart that illustrate each category’s relative
contribution to total quality costs. Comment on the significance of the
distribution.
Report (3 of 4)
Solution:
aActual sales of $10,000,000.

b $2,000,000
= 20%
$10,000,000
The report clearly indicates that quality costs are too high, as 20% of sales is much greater
than the desired 2 to 4% of sales that prevails for companies with good quality performance.
Report (4 of 4)
2. See Exhibit 13.13. The graphs reveal that failure costs are 85% of the total
quality costs, suggesting that Auger needs to invest more in control activities
to drive down failure costs.
Here’s How It’s Used: AT ALCOA (1 of 4)
In 2011, an executive leadership team of Alcoa Power and Propulsion (APP),
a unit of Alcoa, Inc., decided to take steps to improve product quality, reduce
waste, and decrease costs. The business unit was experiencing a high
incidence of scrap, rework, and returns (internal and external failure costs).
Customer satisfaction was low as indicated through customer satisfaction
surveys (60% of respondents held an unfavorable or neutral view of the unit).
The initial focus was on the nine foundries that had the highest scrap rates.
The strategy was to develop a sustainable and continuous process
improvement approach that would achieve the desired improvement goals
(e.g., a 10% annual reduction in scrap). Processes were studied and analyzed
to determine which ones offered the greatest potential for savings. It was
determined that the wax, shell, and cast manufacturing operations had the
most potential savings.
These processes were then mapped, benchmarking studies were performed,
shop-floor interviews were done, and brainstorming sessions held. Potential
solutions were identified and then implemented using a three-stage plan: first,
the process improvements were implemented in a pilot plant; and then in fast-
follower plants; finally, they were extended to the broader business unit. Quality
audits and management reviews were used to ensure process improvement
sustainability.
Thus, by using prevention activities such as process management, quality
audits, and management reviews, APP was able to significantly reduce scrap,
rework, and returns. APP easily exceeded the initial goal of reducing scrap by
10% per year and saved more than $20 million from improvements in the wax,
shell, and cast operations. For example, a subprocess of one plant’s cast
operation reduced scrap and rework costs by more than 30%, which saved
$750,000 per year.
Controlling Quality Costs (1 of 2)
• Improving quality and reducing quality costs require that quality costs be
reported and controlled
• Control enables managers to compare actual outcomes with standard
outcomes to gauge performance and take any necessary corrective actions
• Performance reports are essential to quality improvement programs
Controlling Quality Costs (2 of 2)
• Quality performance reports measure the progress realized by an
organization’s quality improvement program
• Two types of quality performance reports are useful:
o Progress with respect to a current-period standard or goal (an interim standard
report)
o The progress trend since the inception of the quality improvement program (a
multiple period trend report)
Interim Standard Reports (1 of 2)
• Identifying the quality standard is a key element in a quality performance
report. The standard should emphasize cost reduction opportunities
• Interim quality standards express quality goals for the year
• The organization must establish an interim quality standard each year and
make plans to achieve this targeted level
• Often, the interim quality standard is simply the quality costs incurred in the
previous year, adjusted for reductions expected from planned quality
improvements
Interim Standard Reports (2 of 2)
• Since quality costs are a measure of quality, the targeted level can be
expressed in dollars budgeted for each category of quality costs and for each
cost item within the category
• At the end of the period, the interim quality performance report compares
the actual quality costs for the period with the budgeted costs
• This report measures the progress achieved within the period relative to the
planned level of progress for that period
Example 13.3: How to Prepare an Interim Quality
Performance Report (1 of 4)
The actual quality costs of Auger Company, for the years ended December 31,
20X1 and 20X2, are provided below.
20X1 20X2
Prevention costs:
Quality training $ 10,000 $ 12,000
Quality engineering 90,000 108,000
Appraisal costs:
Materials inspection 80,000 98,000
Process acceptance 120,000 145,000
Internal failure costs:
Scrap 350,000 294,000
Rework 250,000 203,000
External failure costs:
Warranty 500,000 410,000
Customer complaints 600,000 530,000
At the end of 20X1, management decided to increase its investment in control
costs by 20% for each category’s items, with the expectation that failure costs
would decrease by 20% for each item of the failure categories. Sales were
$10,000,000 for both 20X1 and 20X2.
Required:
1. Calculate the budgeted costs for 20X2, and prepare an interim quality
performance report.
2. Comment on the significance of the report. How much progress has Auger
made?
Solution:
1.
a 20X1 actual control cost × 1.20 (e.g., quality training = $10,000 × 1.20 = $12,000)
b 20X1 actual failure cost × 0.80 (e.g., scrap = $350,000 × 0.80 = $280,000)
2. Auger has come close to meeting the planned outcomes. Quality costs
dropped from 20% of sales to 18.0%, falling 0.8% short of the expected
percentage. Management’s belief that investing an additional 20% in control
costs would produce a 20% reduction in failure costs was somewhat
overstated, but the overall outcome is good.
Multiple-Period Trend Reports (1 of 2)
• The interim quality report provides management with information concerning
the within-period progress measured relative to specific goals
• Also, useful is a picture of how the quality improvement program has been
doing since its inception
• Is the multiple-period trend—the overall change in quality costs—moving in
the right direction? Are significant quality gains being made each period?
Multiple-Period Trend Reports (2 of 2)
• Answers to these questions can be given by providing a chart or graph that
tracks the change in quality from the beginning of the program to the present
• Such a graph is called a multiple-period quality trend report
• Trend in quality costs as a percentage of sales reveals the effects of quality
improvement initiatives over time
• Expressing these trends by quality cost category provides insight concerning
the effect of quality improvement initiatives on the relative distribution of
quality costs
Example 13.4: How to Prepare Multiple-Period
Quality Trend Reports (1 of 5)
Assume that Auger Company has experienced the following:
Year Quality Costs Actual Sales cost as a Percentage of Sales

20X1 $2,000,000 $10,000,000 20.0%
20X2 1,800,000 10,000,000 18.0
20X3 1,680,000 12,000,000 14.0
20X4 1,440,000 12,000,000 12.0
20X5 1,400,000 14,000,000 10.0
By cost category as a percentage of sales for the same period of time:
Year Prevention Appraisal Internal Failure External Failure

20X1 1.00% 2.00% 6.00% 11.00%
20X2 1.20 2.43 4.97 8.60
20X3 3.00 3.00 3.00 5.00
20X4 4.00 3.00 2.50 2.50
20X5 4.50 1.25 2.25 2.00
Required:
1. Prepare a bar graph that reveals the trend in quality cost as a percentage of
cost (time on the horizontal axis and percentages on the vertical axis).
Comment on the message of the graph.
2. Prepare a bar graph for each cost category as a percentage of sales. What
does this graph tell you?
Solution:
1. See Exhibit 13.14. From Exhibit 13.14, it is clear that there has been a steady
downward trend in quality costs as a percentage of sales (dropping from 20 to
10%). The graph also reveals that there is still ample room for improvement.
2. See Exhibit 13.15. From Exhibit 13.15, we can see that Auger has had dramatic
success in reducing internal and external failure costs. More money is being
spent on prevention. Also, appraisal costs have increased and then decreased,
suggesting that Auger is becoming more confident in its prevention initiatives.
Lean Manufacturing and Lean Accounting
• Lean manufacturing is concerned with eliminating waste in manufacturing
processes
• Lean accounting is a simplified approach to costing that supports lean
manufacturing with both financial and nonfinancial measures
Lean Manufacturing (1 of 2)
• Lean manufacturing is an approach designed to eliminate waste and
maximize customer value
• It is characterized by delivering the right product, in the right quantity, with the
right quality (zero defects), at the exact time the customer needs it, and at
the lowest possible cost
Lean Manufacturing (2 of 2)
• These lean objectives are achieved by following five principles of lean
thinking:
o Precisely specify value by each particular product
o Identify the “value stream” for each
o Make value flow without interruption
o Let the customer pull value from the producer
o Pursue perfection
Value by Product
• Value is determined by the customer
• Customer value is the difference between realization and sacrifice
o Realization is what a customer receives
o Sacrifice is what a customer gives up, including what they are willing to pay for
the basic and special product features, quality, brand name, and reputation
Value Stream (1 of 3)
• The value stream is made up of all processes that a product must pass
through, from the initial customer order to the delivery to the customer
• The most common value stream is called the order fulfillment value stream
o The order fulfillment value stream focuses on providing current products to
current customers
• A value stream reflects all that is done—both good and bad—to bring the
product to a customer
• Thus, analyzing the value stream, called value-stream mapping, allows
management to identify waste
• Activities within the value stream are value-added or nonvalue-added
o Nonvalue-added activities are the source of waste
o They are of two types:
• activities avoidable in the short run and
• activities unavoidable in the short run due to current technology or production
methods
• The first type is most quickly eliminated, while the second type requires more
time and effort
Order Fulfillment Value Stream
• A value stream may be created for every product; however, it is more
common to group products that use common processes into the same value
stream (families of similar products)
Value Flow (1 of 2)
• In a traditional manufacturing setup, production is organized by function into
departments and products are produced in large batches, moving from
department to department
• There is significant move time and wait time as each batch moves from one
department to another and waits for its turn if there is a batch in process in
front of it
• Batches must wait for a preceding batch and a subsequent setup before
beginning a process
Value Flow (2 of 2)
• Once a batch starts a process, units are processed sequentially; as units are
finished, they must wait for other units in the batch to be finished before the
entire batch moves to the next process
• Thus, there is pre-process waiting and post-process waiting
Traditional Batch Production Process
Color Code:
Red = Nonvalue-added move and pre-process wait time
Green = Value-added process time
Reduced Setup/Changeover Times (1 of 2)
• Lean manufacturing reduces wait and move times dramatically and allows
the production of small batches (low volume) of differing products (high
variety)
• The key factors in achieving these outcomes are lower setup times and
cellular manufacturing
• Reducing the time to configure equipment to produce a different type of
product enables smaller batches in greater variety to be produced
Reduced Setup/Changeover Times (2 of 2)
• It also decreases the time it takes to produce a unit of output, thus increasing
the ability to respond to customer demand
Cellular Manufacturing (1 of 2)
• Lean manufacturing uses a series of cells to produce families of similar
products
• A lean manufacturing system replaces the traditional plant layout with a
pattern of manufacturing cells
• Cell structure is chosen over departmental structure because it reduces lead
time, decreases product cost, improves quality, and increases on-time
delivery
• Manufacturing cells contain all the operations in close proximity that are
needed to produce a family of products
Cellular Manufacturing (2 of 2)
• The machines used are typically grouped in a semicircle
• The reason for locating processes close to one another is to minimize move
time and to keep a continuous flow between operations while maintaining
zero inventory between any two operations
• The cell is usually dedicated to producing products that require similar
operations
Proposed Manufacturing Cell
Example 13.5: How to Calculate Production Time
for Traditional and Cellular Manufacturing (1 of 4)
Color Code:
Red = Nonvalue-added move and pre-process wait time
Green = Value-added process time
See Exhibits 13.17 and 13.18.
Required:
1. Using Exhibit 13.17, calculate the total time it takes to produce a batch of 12 units,
using the traditional departmental structure.
2. Now refer to Exhibit 13.18. With cellular manufacturing, how much time is
saved producing the same batch of 12 units? Assuming the cell operates
continuously, what is the production rate? Which process controls this
production rate?
3. If the processing time of machining is reduced from 6 to 5 minutes, what is
the production rate now, and how long will it take to produce a batch of 12
units?
Solution:
1. Total lead time for a batch of 12 units:
Processing lime
Cutting 72 minutes
Drilling and insertion 60 minutes
Assembly 60 minutes
Finishing 48 minutes
Total processing 240 minutes
Move and wait times 45 minutes
Total batch time 285 minutes
2. Processing time (12 units): Elapsed time
Fine unit 20 minutes
Second unit 26 minutes (processing begins 6 minutes
after the first)
Twelfth unit 86 minutes (total processing time)
Time saved over traditional manufacturing: 240 minutes − 86 minutes = 154

minutes
If the cell is processing continuously, then a unit is produced every 6 minutes
after the start-up unit. Thus, the production rate is 10 units per hour  60  .
 6 
The bottleneck process (the one with the longest per-unit processing time)
controls the production rate.
Pull Value (1 of 2)
• Many firms produce for inventory and then try to sell the excess goods they
have produced (demand-push system)
• Efforts are made to create demand for the excess goods—goods that
customers probably may not even want
• Lean manufacturing uses a demand-pull system
• Lean manufacturing eliminates waste by producing a product only when it is
needed and only in the quantities demanded by customers
• Demand pulls products through the manufacturing process
Pull Value (2 of 2)
• Each operation produces only what is necessary to satisfy the demand of the
succeeding operation
• Low setup times and cellular manufacturing are the major enabling factors
for producing on demand
• A companion to a demand-pull system is JIT purchasing
• JIT purchasing requires suppliers to deliver parts and materials just in time
to be used in production, eliminating the need for materials inventories
Pursue Perfection (1 of 2)
• Zero setup times, zero defects, zero inventories, zero waste, producing on
demand, increasing a cell’s production rates, minimizing cost, and
maximizing customer value represent ideal outcomes that a lean
manufacturer seeks
• As the process of becoming lean begins to unfold and improvements are
realized, the possibility of achieving perfection becomes more believable
• The relentless and continuous pursuit of these ideals is fundamental to lean
manufacturing
Pursue Perfection (2 of 2)
• As production flow increases and processes begin to improve, more hidden
waste tends to be exposed
• The objective is to produce the highest-quality, lowest-cost products in the
least amount of time
Lean Accounting (1 of 2)
• Lean manufacturing changes structural and procedural activities, and these
changes, in turn, lead to changes in traditional cost management practices
• In fact, traditional costing and operational control approaches like standard
costing and departmental budgetary variances may encourage
overproduction and work against the demand-pull system needed in lean
manufacturing
Lean Accounting (2 of 2)
• Furthermore, distorted product costs can signal failure for lean manufacturing
even when significant improvements may be occurring
• To avoid obstacles and false signals, changes in both product-costing and
operational control approaches are needed when moving to a value-stream-
based lean manufacturing system
Focused Value Streams and Traceability of
Overhead Costs (1 of 3)
• Creating a value stream for every product within a plant (focused value
streams) means that many overhead costs previously assigned to products
using either driver tracing or allocation are now directly traceable to products
o For example, equipment in a focused value stream is now dedicated to the
production of a single product
o In this case, depreciation is now a directly traceable product cost
o The same is true of other resources such as multiskilled workers, decentralized
services, and workers with specialized skills
• Typically, implementing the value-stream structure does not require an
increase in the number of people needed
• Lean manufacturing eliminates wasteful activities, reducing the demand for
people
o For example, when production planning is reduced significantly because of an
efficiently functioning demand-pull system, some of those working in production
planning can be cross-trained to perform value-added activities within the value
stream such as purchasing and quality control
Value-Stream Cost Assignments
• Most costs are assigned directly to the value stream; however, some costs
such as facility costs are assigned to each value stream using cost drivers
• Facility costs are assigned using a cost per square foot (total cost/total
square feet)
• If a value stream uses less square feet, it receives less cost
• Thus, the purpose of this assignment is to motivate value-stream managers
to find ways to occupy less space
Limitations (1 of 2)
• Initially, it may not be possible to assign all the people needed exclusively to
a value stream. There may be some individuals working in more than one
value stream
• The cost of these shared workers can be assigned to individual value
streams in proportion to the time spent in each stream
• It is also true that even in the most ideal circumstances, some individuals will
remain outside any particular value stream (the plant manager, for example)
Limitations (2 of 2)
• However, with multiple value streams, the unassigned costs are likely to be a
very small percentage of the total costs
• Finally, in reality, having a value stream for every product is not practical
• The usual practice is to organize value streams around a family of products
Product Costing: Single-product (Focused) Value
Stream (1 of 2)
• In a focused value stream, all value-stream costs belong exclusively to the
product that the stream produces and, therefore, are assigned to a product
using direct tracing
• Value streams increase the number of directly traceable costs and therefore
increase the accuracy of product costing
• Focused value streams provide simple and accurate product costing
Product Costing: Single-product (Focused) Value
Stream (2 of 2)
• Typically, unit costs are calculated weekly and are based on actual costs,
using the following formula:
Total Actual Value − Stream Costs
Value-Stream Product Cost =
Units Shipped
• Using units shipped in the unit cost calculation instead of units produced
motivates managers to reduce inventories
• If more units are shipped than produced, then the weekly unit cost will
decrease and inventories will reduce
• If more is produced than shipped, then the unit cost will increase
Product Costing: Multiple-Product Value Stream (1 of 2)
• Many value streams are formed around products with common processes
• Manufacturing cells within a value stream are thus structured to make a
family of products or parts that require the same manufacturing sequence
Product Costing: Multiple-Product Value Stream (2 of 2)
• The weekly unit product cost for multiple-product value streams is the sum of
each unit’s materials cost and the average conversion cost:
Value-Stream Product Cost = Unit Materials Cost + Average Conversion Cost
where
Actual Materials Cost

Unit Materials Cost (for each product) =
Units Shipped
Total Actual Conversion Costs
Average Conversion Cost =
Units Shipped
Here’s How It’s Used: IN YOUR LIFE (1 of 7)
Emily recently joined a large law firm fresh out of law school. She discovered
that the 50 employees of the law firm eat lunch every Friday at a popular pizza
restaurant. They eat in a separate reserved room. They are served individual
bowls of salad ($2.80 each). A two-topping pizza costs $20 and is divided into
10 slices. For drinks, the restaurant provides complimentary tea and water.
Each member of the law firm has to pay an assessed amount for the lunch.
Since the food had to be ordered in advance, the managing partner gave Emily
the assignment to determine how much food to order and how
much to charge each individual of the firm for the lunch. Emily surveyed the
members of the firm and compiled the following table that reflected eating
preferences (divided into four subgroups):
Group Number in Slices per Total Slices

Each Group Person
A 10 1 10
B 10 2 20
C 15 4 60
D 15 6 90
Totals 50 N/A 180
 180 
Based on the survey, Emily ordered 18 pizzas   and noted that the expected
 10 
cost would expected cost would be $360 ($20 × 18), with an average pizza
 $360 
cost per person of $7.20  50  . Thus, she would need to collect $10 ($2.80 +
 
$7.20) from each person to pay for the lunch. This approach is like having one
value stream with four products (four different eating patterns); the cost of
materials (salads in this case) is assigned directly to each product, and the
average conversion cost (average pizza cost) is added to the direct materials
cost to obtain a total product cost.
Emily noted, however, that the eating patterns were quite different among the
groups. For Group A, the total pizza cost is simply $20 (only one pizza is
needed) and the pizza cost per person is $2.00, which when added to the
$2.80 gives a lunch cost of $4.80. On the other hand, for Group D, the average
pizza cost per person is $12, which when added to the salad cost gives a lunch
cost of $14.80. Groups B and C would have lunch costs of $6.80 and $10.80,
respectively. Charging by groups is more accurate. Each group would be
analogous to a focused value stream.
Another possibility for Emily is to group the employees into a “family of
products,” where employees with similar eating habits are grouped together.
Groups A and B, for example, could form a light-eaters value stream, and
Groups C and D would form a heavy-eaters value stream. The light-eaters
lunch cost would be $5.80 ($2.80 for salad plus an average pizza cost of
$3.00); the heavy-eaters lunch cost would be $12.80 each. Forming value
streams has a lot to do with trading off complexity and accuracy. Sometimes
simplicity outweighs the issue of accuracy.
Features and Characteristics Costing
• An approach called features and characteristics costing is recommended
(albeit reluctantly) by those advocating the simple average costing approach
• This approach recognizes that some product components take more effort
(time) to make than others and thus cost more
• An adjustment is made to the average product cost that reflects this
complexity difference
• Value streams with heterogeneous products find themselves in the same
cost-distortion dilemma as plants with multiple products and plantwide
overhead rates
Duration-Based Costing (1 of 3)
• Duration-based costing (DBC) uses a single rate to assign conversion
costs and approximates a comprehensive ABC system based in duration
drivers
• To apply DBC to a value stream, first calculate a weekly value-stream
conversion cost rate as follows:
Total Actual Conversion Costs

Conversion Cost Rate =
Total Net Production Hours
• The net total production hours are the total hours available for work of all
primary activities (activities consumed by products) whether the activities are
value- or nonvalue-added
• Net hours mean that such things as break times and expected stoppages are
excluded and thus correspond to the practical capacity for each activity
• Once the rate is calculated, the unit conversion cost is calculated by
multiplying the rate by the cycle time for each product:
Conversion Cost per Unit = Conversion Cost Rate × Cycle Time
• Cycle time is the time that a unit of product spends in the value stream, from
start to finish
• It is not the same as the production rate
Example 13.6: How to Calculate Value-Stream
Product Costs (1 of 6)
See Exhibit 13.20. During the week of October 8, Holland Company produced
and shipped 2,000 units of Model X12 and 8,000 units of Model Y35, for a total
of 10,000 units. Model X12 has a cycle time of 1.04 hours, and Model Y35 has
a cycle time of 0.34 hour.
Required:
1. Assume that the value-stream costs and total units shipped apply only to
one model (a single-product value stream). Calculate the unit cost, and
comment on its accuracy.
2. Assume that Model X12 is responsible for 50% of the materials cost.
Calculate the unit cost for Models X12 and Y35, and comment on its
accuracy. Explain the rationale for using units shipped instead of units
produced in the calculation.
3. Calculate the unit cost for the two models, using DBC. Explain when and
why this cost is more accurate than the unit cost calculated in Requirement
2.
Solution:
$525,000
1. Unit cost = = $52.50 per unit. The cost is very accurate,
10,000
as the value stream is dedicated to one product and its costs all belong
to that product.
2. First, the unit materials cost is calculated separately:
$112,500 *
Model X12 : = $56.25
2,000
$112,500
Model Y35 : = $14.06
8,000
*50% × $225,000
$300,000 *
Next, the average unit conversion cost is calculated: = $30.
10,000
*Conversion Cost = Total Cost − Materials Cost
= $525,000 − $225,000 = $300,000
Finally, the unit cost is computed (sum of materials and average conversion
cost):
Model X12: $56.25 + $30 = $86.25
Model Y35: $14.06 + $30 = $44.06
The accuracy of the unit cost depends on the accuracy of the average unit
conversion cost, which depends on the homogeneity of the products within the
value stream. Using units shipped for the unit calculation motivates managers
to reduce inventories.
3. First, calculate the conversion cost rate:
Conversion Cost Rate Conversion Cost
=
Total Net Production Hours
$300,000
=
5,000
= $60 per hour
Next, calculate the unit conversion cost for each product:

Conversion Cost per Unit = Conversion Rate × Cycle Time
Model X12: $60 × 1.04 = $62.40
Model Y35: $60 × 0.34 = $20.40
Finally, add the unit materials cost:
Model X12 = $56.25 + $62.40 = $118.65
Model Y35 = $14.06 + $20.40 = $34.46
DBC should be used if the products are not homogeneous products. It is more
accurate, as it approximates ABC assignments.
Value-Stream Operational Control
• The lean control system replaces the traditional standard costing approach
with a Box Scorecard that compares operational, capacity, and financial
metrics with prior week performances and with a future desired state
• Trends over time and the expectation of achieving some desired state in the
near future are the means used to motivate constant performance
improvement
• Thus, the lean control uses a mixture of financial and nonfinancial measures
for the value stream
Holland Company Value-Stream Box Scorecard
For 10/8/20X1 This Week Planned Future State
Last Week (10/8/20X1) (01/31/20X2)
Operational
Units sold per person 500 520 540
On-time delivery 88% 90% 95%
Dock-to-dock days 19.5 19.0 17.0
First-time through 65% 75% 85%
Average product cost $55.00 $52.50 $50.00
Accounts receivable days 28 27 26
Capacity
Productive 31% 35% 37%
Nonproductive 45% 40% 35%
Available 24% 25% 28%
Financial
Weekly sales $950,000 $875,000 $1,250,000
Weekly material cost $250,000 $225,000 $310,000
Weekly conversion cost $396,000 $300,000 $365,000
Weekly value-stream profit $304,000 $325,000 $625,000
ROS 32% 40% 46%
Types of Involvement in the International Economy
• Companies can participate in the international environment in a number of
ways. Some of the choices are importing and exporting, wholly owned
subsidiaries, joint ventures, and the multinational corporation (MNC)
• Each of these offers both costs and benefits for the company and the
management accountant must be aware of them in order to help decision
makers determine which, if any, involvement in international trade is best
Importing (1 of 4)
• A company may import materials for use in production
• While this transaction may seem identical to the purchase of materials from
domestic suppliers, U.S. tariffs add complexity and cost
• An imported part may have a tariff, or duty, in addition to freight-in cost
• A tariff, or duty, is a tax on imports levied by the federal government
• In accounting, we treat both the freight-in and tariff as part of the cost of
materials
Importing (2 of 4)
• The U.S. government has set up foreign trade zones, which are areas near
a customs port of entry that are physically on U.S. soil but are considered to
be outside U.S. commerce
• Some U.S. companies have set up manufacturing plants within the foreign
trade zones
• Goods imported into a foreign trade zone are duty-free until they leave the
zone for sale in the United States
• This has important implications for manufacturing firms that import materials
Importing (3 of 4)
• Since tariffs are not paid until the imported materials leave the zone as part
of a finished product, the company can postpone payment of duty and any
associated loss of working capital
• Additionally, the company does not pay duty on defective materials or on
inventory that has not yet been included in finished products
Importing (4 of 4)
• The management accountant must be aware of the costs of importing
materials
• He or she should also be able to evaluate the potential benefits of the foreign
trade zone in considering the location of satellite plants
Exporting (1 of 2)
• Exporting is the sale of a company’s products in foreign countries
• However, exporting is usually more complex than the sale of finished goods
within the home country
• Foreign countries have a variety of import and tariff regulations
• The job of complying with the foreign rules and regulations often falls to the
controller’s office, just as compliance with U.S. tax regulations is an
accounting function
Exporting (2 of 2)
• Alternatively, a U.S. company may choose to work with an experienced
distributor familiar with the legal complexities of the other countries
• Management accountants must be aware of the customs regulations and
ensure that adequate recordkeeping and internal control mechanisms exist
Wholly Owned Subsidiaries
• A company may choose to purchase an existing foreign company, making
the purchased company a wholly owned subsidiary of the parent
• This strategy has the virtue of simplicity
• The foreign company has established an outlet for the product and has the
production and distribution facilities already set up
Joint Ventures
• A joint venture is a type of partnership in which investors co-own the
enterprise
• Sometimes, a joint venture is required because of restrictive laws
o In China, for example, MNCs are not allowed to purchase companies or set up
their own subsidiaries
• A special case of joint venture cooperation is the maquiladora
• A maquiladora is a manufacturing plant, located in Mexico, that processes
imported materials and reexports them to the United States
Foreign Currency Exchange (1 of 2)
• When a company begins to operate in the international arena, it may use
foreign currencies
• These foreign currencies can be exchanged for the domestic currency using
exchange rates
• If the exchange rates never changed, problems would not occur. Exchange
rates do change, however, and often on a daily basis
o Thus, a dollar that could be traded for 115 yen one day may be worth only 105
yen on another day
Foreign Currency Exchange (2 of 2)
• The management accountant plays an important role in managing the
company’s exposure to risk of currency fluctuations
o Transaction risk refers to the possibility that future cash transactions will be
affected by changing exchange rates
o Economic risk refers to the possibility that a firm’s present value of future cash
flows will be affected by exchange rate fluctuations
o Translation (or accounting) risk is the degree to which a firm’s financial
statements are exposed to exchange rate fluctuation
Managing Transaction Risk (1 of 2)
• Currencies may be traded for one another, depending on the exchange rate
in effect at the time of the trade
• The spot rate is the exchange rate of one currency for another for immediate
delivery (i.e., today)
• When one country’s currency strengthens relative to another country’s
currency, currency appreciation occurs, and one unit of the first country’s
currency can buy more units of the second country’s currency
• Conversely, currency depreciation means that one country’s currency has
become relatively weaker and buys fewer units of another currency
Managing Transaction Risk (2 of 2)
• An exchange gain is the gain on the exchange of one currency for another
due to appreciation of the home currency
• An exchange loss is a loss on the exchange of one currency for another
due to depreciation of the home currency
Luisa has been planning all year to spend a summer abroad studying art in
Italy. She can join a program with her university that will cover airfare, room
and board, and credit for her classes. She’s been told that she will need about
$3,000 extra for optional side trips within Italy and for food and entertainment
outside of the school. In November 2017, when Luisa first began planning her
trip, the exchange rate was $1 = €1.07. At that rate, her $3,000 would buy
€3,210. In mid-June 2018, Luisa left for Italy. The exchange rate was $1 =
€1.27 and her $3,000 could buy €3,810.
Luisa was delighted that the dollar had strengthened against the euro, making
purchases in euros relatively less expensive and enabling her to buy more.
Luisa’s friend Paul also planned a study-abroad trip, but his trip was to Japan.
When he began planning in November 2017, the exchange rate was $1 =
¥123.48, and his estimated $3,000 extra amount needed would have equaled
¥370,440. Unfortunately for Paul, the dollar weakened against the yen. By mid-
June, the exchange rate was $1 = ¥106.07 and his $3,000 for incidentals only
equaled ¥318,210.
Example 13.7: How to Calculate the Value of an
Exchange in Another Currency (1 of 3)
SuperTubs, Inc., based in Oklahoma, sells its line of whirlpool tubs at home
and to foreign distributors. On January 15, Bonbain, a French distributor of
luxury plumbing fixtures, orders 100 tubs at a price of $1,000 per tub, to be
delivered immediately, and to be paid in euros on March 15. On January 15,
the rate of exchange is $1 = €0.80.
Required:
1. Using the January 15 rate of exchange, how many euros will Bonbain pay
SuperTubs upon completion of the order? What is the value in dollars?
2. Suppose that on March 15 the rate of exchange was $1 = €0.90. What is the
value in dollars of Bonbain’s payment in euros?
3. What is the exchange gain (loss) on the order?
4. Now suppose that on March 15, the rate of exchange was $1 = €0.70. What
is the value in dollars of Bonbain’s payment in euros? What is the exchange
gain (loss) on the order?
Solution:
1. Euros to be paid by Bonbain = $100,000 × 0.80 = €80,000
2. Value of Bonbain’s payment =
€80,000
= $88,889 (rounded)
0.90
3. SuperTubs has realized an exchange loss = $100,000 − $88,889 = $11,111
€80,000
4. Value of Bonbain’s payment = = $114,286 (rounded)
0.70
SuperTubs has realized an exchange gain = $114,286 − $100,000 = $14,286
Managing Economic Risk (1 of 2)
• Dealing in different currencies can introduce an economic dimension into
currency exchange transactions
• Economic risk is defined as the impact of exchange rate fluctuations on the
present value of a firm’s future cash flows
• The risk can affect the relative competitiveness of the firm, even if it never
participates directly in international trade
Managing Economic Risk (2 of 2)
• How does the accountant manage the company’s exposure to economic
risk?
o The accountant must understand the position of the firm in the global economy
o The accountant provides financial structure and communication for the firm
• In preparing the master budget, for example, budgeted sales must take into account
potential strengthening or weakening of the currencies of competitors’ countries
• Often, the controller’s office is responsible for forecasting foreign exchange
movements
Transfer Pricing and the Multinational Firm
• For the multinational firm, transfer pricing must accomplish two objectives:
o performance evaluation
o optimal determination of income taxes
Performance Evaluation
• Divisions are frequently evaluated on the basis of income and return on
investment
• As is the case for any transfer price, the selling division wants a high transfer
price that will raise its income, and the buying division wants a low transfer
price that will raise its income
• But transfer prices in MNCs are frequently set by the parent company,
making the use of ROI and income suspect
• Because they are not under the control of divisional managers, they may no
longer serve as good indicators of management performance
Income Taxes and Transfer Pricing
• If all countries had the same tax structure, then transfer prices would be set
independently of taxes. However, this does not happen
• Instead, there are high-tax countries (like the United States) and low-tax
countries (such as the Cayman Islands)
• As a result, multinational companies may use transfer pricing to shift costs to
high-tax countries and shift revenues to low-tax countries
Use of Transfer Pricing to Affect Taxes Paid
Action Tax Impact
Belgian subsidiary of parent company produces a 42% tax rate
component at a cost of $100 per unit. Title to the $100 revenue − $100 cost = $0
component is transferred to a reinvoicing center* in Taxes paid = $0
Puerto Rico at a transfer price of $100 per unit.
Reinvoicing center in Puerto Rico, also a subsidiary of 0% tax rate
parent company, transfers title of component to U.S. $200 revenue − $100 cost = $100
subsidiary of parent company at a transfer price of $200 Taxes paid = $0
per unit.
U.S. subsidiary sells component to external company at 35% tax rate
$200 each. $200 revenue − $200 cost = $0
Taxes paid = $0
*A reinvoicing center takes title to the goods but does not physically receive them. The primary
objective of a reinvoicing center is to shift profits to divisions in low-tax countries.
The Role of Cost and Managerial Accounting in
Fraud and Forensic Accounting
• Fraud and forensic accounting are new, growing areas of importance for the
management accountant
• The management accountant is involved in fraud prevention and detection
• The management accountant is also involved with determining valuation and
may be asked to apply accounting knowledge in helping to resolve different
types of disputes
Fraud and Management Accounting (1 of 2)
• Fraud is defined as wrongful or criminal deception intended to result in
financial or personal gain
• Fraud committed by employees is occupational fraud and is often tied to the
fraud triangle
• According to the Association of Certified Fraud Examiners (ACFE), the fraud
triangle is a model that explains the factors causing someone to commit
fraud
Fraud and Management Accounting (2 of 2)
• The three components are:
o Perceived unshareable financial need
o Perceived opportunity
o Ability to rationalize the commission of fraud
• Note that all three components must occur to encourage the individual to
commit fraud
• The fraud triangle helps explain how previously stellar employees can be led
to commit fraud
Here’s How It’s Used: EMBEZZLEMENT IN A
SMALL TOWN (1 of 3)
A notorious case in Dixon, Illinois, involved the town’s comptroller and
treasurer, Rita Crundwell. Over a period of 22 years, she embezzled over $53
million from the town coffers. Her scheme was simple and highly successful.
She opened a secret bank account called the RSCDA (Reserve Sewer Capital
Development Account) which she made to appear to be a city account—with
herself as the only signatory.
SMALL TOWN (2 of 3)
City funds were deposited into another city account (the Capital Development
Fund) and then false state invoices were used to support checks written on that
account to “Treasurer” and then deposited in the RSCDA. Crundwell then used
the money to support her American quarter horse breeding operation as well as
a lavish lifestyle.
How did that amount of embezzlement go unnoticed for so long? Crundwell
was well thought of as an employee and did a good job covering her tracks.
SMALL TOWN (3 of 3)
She also had ready answers for questions on the bare-bones budget required
of city departments and draconian cuts in services. The fraud eventually came
to light while Crundwell was on an extended vacation. Another employee,
acting in her stead, discovered the secret account and the numerous checks
written on it. She went to higher-ups and alerted the FBI. A 6-month
investigation—kept secret from Crundwell—discovered the extensive fraud.
Crundwell was indicted and admitted to wire fraud and money laundering. She
is currently serving time in a federal correctional facility, scheduled for release
in 2030.
Ethical Decisions
• Clearly, this section on fraud demonstrates ethical lapses
• The bottom line is that fraud requires lying and deception
• Those with access to funds must be aware of the opportunity and ability to
rationalize
• The ACFE is the largest provider of antifraud training and education
• The association sponsors the Certified Fraud Examiner (CFE) credential
Forensic Accounting in Management Accounting (1 of 5)
• Nearly all cases in fraud and forensic accounting involve the identification
and quantification of financial damages resulting from the issues raised in the
case
• The plaintiff in a case attempts to prove that some amount of financial
damages did occur, while the defendant attempts to prove that either no or
minimal damages occurred
• Forensic accounting is the application of accounting knowledge in legal or
other cases to help resolve different types of disputes
o Fraud
o Litigation support
o Business evaluations
• Important managerial accounting concepts include incremental/differential

costs, relevant costs, activity-based costing, cost behavior, cost-volume-profit
analysis, and the matching principle
Applying Different Types of Accounting Knowledge
to Forensic Accounting (1 of 3)
• Cost behavior is used in almost all damage calculations to determine the
amount of financial harm that resulted from the liability found by the court.
Cost behavior is also an important determinant of whether predatory pricing
has occurred in an antitrust case.
• Differential/incremental costs are used in the calculation of damages in
answering questions about the type and amount of costs to include in the
damage calculation. Frequently, the issue in a breach of contract case is the
determination of which costs are different as a result of the contract breach.
The concept of relevant costs is useful in determining which costs relate to
the issues being litigated.
For example, lost wages are relevant in measuring damages in a wrongful
discharge case, but value of lost household services would not be relevant in
calculating damages.
• The matching concept is useful in determining which costs logically should
be matched with contract revenue in a breach of contract case.
• Consistency is a useful concept in evaluating whether a company has
changed accounting policy or practices in measuring costs that should be
charged under a contract.
For example, in a cost-based government contract, a frequent question that
arises pertains to the appropriateness of a company using accelerated
depreciation to charge the government for its share of facility deprecation costs
when the company uses straight-line depreciation for all other purposes.
Source: Taken from Lester E. Heitger and Dan L. Heitger, “Incorporating Forensic Accounting
and Litigation Advisory Services into the Classroom,” Issues in Accounting Education
(November 2008): 561–572. Used with permission.
• The nature of forensic accounting activities is both interesting and
challenging
o For example, some common characteristics of forensic accounting practice
include detective work and problem solving, adversarial nature, range of answers
rather than one correct answer, and importance of excellent communications
skills
• Detective work and problem solving: Because there is conflict in most
cases, some data and information are not clear or readily available
• Adversarial nature: Because virtually all court cases involve conflict of
some sort, the accounting expert must learn to work, analyze, and present
information for the court in an adversarial environment
• Range of potential answers: A forensic accountant must decide what is the
better, more logical, and more persuasive solution to the dispute given the
information and issues
• Excellent communication skills: Strong communication skills, both written
and oral, are essential
o Accountants often need to explain the financial information to laypeople because
judges and juries typically know very little about accounting concepts
o Written communication skills are essential as the accountant must write reports
that explain accounting concepts as well as the determination of value arrived at
by the accountant

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Chapter 13

Panel A: Risk Appetite Panel B: Inherent Risks Panel C: Residual Risks

• Probability P is measured as falling between 0 (no chance of occurring) and

Risk Response Benefit = Inherent Risk − Residual Risk

Therefore, the net benefit for risk response alternative A is:

• In other words, the relationship between key stakeholders and the

Note: Respondents who indicated high or very high impact

disclosure of qualitative and/or quantitative information about an

Base: N100/G250 companies

Base: 4,500 N100 companies

Prevention Costs Appraisal (Detection) Costs

Internal Failure Costs External Failure Costs

• A quality cost reporting system is essential to an organization serious about

aActual sales of $10,000,000.

Year Quality Costs Actual Sales cost as a Percentage of Sales

Year Prevention Appraisal Internal Failure External Failure

Time saved over traditional manufacturing: 240 minutes − 86 minutes = 154

Actual Materials Cost

Group Number in Slices per Total Slices

Total Actual Conversion Costs

Next, calculate the unit conversion cost for each product:

SuperTubs has realized an exchange gain = $114,286 − $100,000 = $14,286

• Important managerial accounting concepts include incremental/differential

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