Chapter 1: Managerial Accounting: An Overview

Chapter 1 Objectives (ChO)

ChO1. Identify the major differences and similarities between financial and managerial accounting.

ChO2. Understand the role of management accountants in an organization.

ChO3. Understand the basic concepts underlying Just-In-Time (JIT), Total Quality Management (TQM),
Process Reengineering, and the Theory of Constraints (TOC).

ChO4. Understand the importance of upholding ethical standards.

Chapter Overview

A. Managerial vs. Financial Accounting. It is a good idea to begin the course by contrasting managerial
with financial accounting. Financial accounting is concerned with reports to owners, creditors, and
others outside of the company. Managerial accounting is concerned with reports prepared for the
internal use of management. Since these are internal reports, there is no requirement that management
accounting reports conform to GAAP. Indeed, it is desirable to depart from GAAP in some instances.

B. Organizations. A review of the work of managers and the organizations in which they operate is
useful. You may want to take a few moments and discuss some organizations that students are familiar
with. Examples of organizations that students may mention include: sole proprietorships, partnerships,
corporations, churches, cities, military units, social clubs, foundations, and families. With the various
types of organizations listed, focus on two points.

1. An organization consists of people who are brought together for some common purpose. It is a group
of people working together that is the essence of any organization, not the particular assets used by
these people.

2. People work together in an organization in order to attain some goals. The objectives or goals may be
clearly stated, but often they are not. The financial objectives for most organizations, even if not
articulated, are fairly straightforward. In commercial enterprises, the primary goal is ordinarily to
maximize profits or to at least earn a “satisfactory profit.” In nonprofit organizations, avoiding losses is
more of a constraint than a goal. Nevertheless, managers need virtually the same information to avoid
losses that they need to maximize profits. While we usually talk about profit-making companies in the
course, almost everything we say applies as well to nonprofit organizations.

C. The Work of Management and the Planning and Control Cycle. While it is clearly a simplification, the
work of managers can be usefully classified as planning, directing and motivating, and controlling. All of
these activities involve making decisions.

1. Planning consists of strategic planning and developing more detailed short-term plans. Most of what
we refer to below is with reference to the more detailed short-term plans.

2. Directing and motivating involves mobilizing people to implement the plan.

3. Control is concerned with ensuring that the plan is followed. The accounting function plays a major
role in the control phase. Accountants maintain the databases and prepare the reports that provide
feedback to managers. The feedback can be used to reward particularly successful employees, but more
importantly the feedback can be used to identify potential problems and opportunities that were not
anticipated in the plan. Based on feedback, it may be desirable to modify the plan. The feedback can be
also used to identify parts of the organization that need help and those parts that can provide advice
and assistance to others.

4. Decision-making is an integral part of the other three management activities.

D. Need for Information. Accurate and timely accounting information helps management plan
effectively and to focus attention on deviations from plans. In the planning stage, managers make
decisions concerning which alternatives should be selected. Financial information is often a vital
component of this decision-making. Once the alternatives have been selected, detailed planning is
possible. These detailed plans are usually stated in the form of budgets. The control function of
management is aided by performance reports that compare actual performance to the budget. This
feedback mechanism directs attention to activities where managerial attention is needed.

E. Comparison of Financial and Managerial Accounting. Financial and managerial accounting both rely
on the same basic accounting database, although managerial accountants often accumulate and use
additional data. However, important differences exist between the two disciplines:

1. Financial Accounting:

• Is concerned with reports made to those outside the organization.

• Summarizes the financial consequences of past activities.

• Emphasizes precision and verifiability.

• Summarizes data for the entire organization.

• Must follow GAAP since the reports are made to outsiders and are audited.

• Is required for publicly-held companies and by lenders.

2. Managerial Accounting:

• Is concerned with information for the internal use of management.

• Emphasizes the future.

• Emphasizes relevance and flexibility of data.

• Places more emphasis on non-monetary data and timeliness and less emphasis on precision.

• Emphasizes the segments of an organization rather than the organization as a whole.

• Is not governed by GAAP.

• Is not required by external regulatory bodies or by lenders.

F. Organizational Structure. Organizational structure refers to the way in which responsibilities and
authority are distributed within an organization.
1. Centralization vs. decentralization. At one extreme is a totally centralized organization in which the
boss makes all decisions. The opposite extreme is a totally decentralized organization where decisions
are made at the lowest possible level in the organization. Centralization tends to be favored in situations
where information is centralized and control is important. Decentralization tends to be favored in
situations where information is dispersed and centralized control is less important.

2. Line and staff relationships. . A line manager is directly engaged in attaining the organization’s
objectives. People in staff positions provide support to the line positions. Especially important to note
here is that the accounting function is a staff position.

3. The Chief Financial Officer. The controller is the manager in charge of the accounting department and
he/she reports to the Chief Financial Officer (CFO). The CFO is usually a member of the top-management
team and should be an active participant in the planning, control, and decision-making processes at the
very highest levels in the organization.

G. The Changing Business Environment. Over the last few decades, competition in many industries has
become global and the pace of innovation in products and services has accelerated. While this has
generally been good news for consumers, it has resulted in wrenching changes in business, including the
advent of the internet. Many companies now realize that they must continuously improve in order to
remain competitive.

1. Improvement programs come and go and have almost as many names as there are consulting firms
engaged in marketing continuous improvement programs. The boundaries between the various
approaches are blurry.

2. Historically, Just-In-Time (JIT) was developed first. While JIT has its roots in the Rouge River
automotive plant built by Henry Ford in the 1920s, it was most fully developed by Toyota in Japan. We
use the term JIT narrowly to refer to minimum inventory production systems. The use of the term JIT to
refer to continuous improvement programs in general has fallen out of use.

3. The text describes the major characteristics of three other general approaches to continuous
improvement—Total Quality Management (TQM), Process Reengineering, and the Theory of Constraints
(TOC). These approaches are not mutually exclusive. They can be used together in concert. Indeed, TQM
and Process Reengineering may be most effective when they are combined with TOC.

4. A key concept in continual improvement is that improvement never ends. After every improvement, a
new opportunity for improvement is sought out.

5. While not emphasized in the text, you may want to point out that these various improvement
programs are not always successful. Advocates of the various programs will invariably claim that failures
are due to poor implementation or to lack of support by top management. While these two factors
undoubtedly account for many of the failures, we suspect that the improvement programs are not as
universally appropriate as their proponents claim. For example, a TQM program that is focused on
improving non-constraint workstations will have difficulty translating operational improvements into
additional profits.

H. Just-In-Time . The term JIT means that materials are received just in time to be used in production,
manufactured parts are completed just in time to be assembled into products, and products are
completed just in time to be shipped to customers. As a result, inventories are virtually eliminated in a
JIT system.

1. JIT uses a “pull” approach to production control.

a. At the final assembly stage, a signal is sent to the preceding workstation as to the exact amount of
parts and materials needed for the next few hours. Similar signals are sent back through each preceding
workstation. All workstations respond to the pull exerted by the final assembly stage, which in turn
responds to customer demands.

b. In contrast, in a conventional production control system each workstation completes its processing
and “pushes” partially completed components forward to the next workstation. This is done regardless
of whether the next workstation is ready to receive the components or whether anyone actually wants
to buy the finished product. The result is that work in process tends to build up in front of the
workstations that are inherently slower than the others. The overriding concern in many conventional
facilities is to keep all the workstations busy all of the time. Since the capacities at workstations differ,
this necessarily results in piles of work in process inventories in front of the workstations with lower
capacities.

c. The pull approach used in JIT reduces inventories since workstations do not produce anything unless it
has already been requested by a downstream workstation and ultimately by customers.

2. The causes of excessive inventory.

a. Some inventories are usually maintained to guard against stock-outs. These inventories can be cut if
the time required to make a product is reduced to the point that current customer demands can be met
with current production.

b. Poor coordination among workstations can lead to excessive inventories.

c. Large batch sizes lead to excessive inventories.

d. The desire to “keep everyone busy” often leads to inventory buildups. The market may not be able to
absorb everything the plant can make. Moreover, differing capacities at workstations will inevitably lead
to buildups of work in process inventories in front of the workstations with lower capacities. (See the
discussion above.)

I. Key Elements of JIT. In addition to JIT purchasing, successful JIT production control systems usually
have the following four key characteristics:

1. Improved plant layout. The layout of the plant should be improved to reduce distances work in
process must travel. In conventional plant layouts, all of the machines of a similar class are grouped
together in one location. For example, all of the milling machines are usually in one location and all of
the drilling machines in another. Consequently, work in process must often move long distances
between operations. There are a number of problems with this. First, moving components around the
plant results in unnecessary costs. Second, moving introduces delay. The components sit around waiting
to be moved and then it takes time to actually move them. Third, it is difficult to keep track of individual
items when the inventory is scattered all over the factory floor.
2. Reduced setup time. Reduced setup time provides the capability to respond quickly to customer
orders and reduces the need for safety stocks.

3. Low defect rates. A company should constantly strive to reduce the defects. Large numbers of defects
require that excess work in process be put into production to ensure that there will be sufficient defect-
free output to meet customer orders. Therefore, defects should be eliminated as much as possible in a
JIT program.

4. Flexible workforce. Workers should be multi-skilled in a JIT environment, which is often organized
into small “cells” that contain all of the equipment required to carry out many steps in the production
process. Workers need to be able to use all of the various pieces of equipment in the work cell. Also,
workers are typically expected to perform maintenance tasks on their own equipment and to do their
own quality inspections.

K. Benefits of JIT. Among the benefits resulting of using JIT are the following:

1. Inventories are reduced. In addition to releasing funds tied up in financing inventories (see below),
smaller inventories reduce the risk of potential losses due to obsolescence.

2. Space is freed up. Areas that were previously devoted to storing inventories are made available for
more productive uses.

3. Throughput time is reduced. This makes it easier to respond to customer demands and can be a very
significant competitive advantage.

4. Defect rates are reduced. Operating without large work in process inventories makes it much easier
to quickly identify and correct production problems. This latter point cannot be overemphasized.
Excessive work in process inventories make it very difficult to detect and diagnose problems. When a
facility operates without significant inventories, it is running “naked.” Problems become quickly
apparent and can be dealt with in a timely manner.

L. Total Quality Management (TQM). Total Quality Management means different things to different
people. Nevertheless, most TQM programs seem to share at least two common elements—a focus on
the customer and systematic problem-solving using teams made up largely of front-line workers.

1. TQM tools. TQM tools include the plan-do-check-act cycle, Pareto analysis, fishbone charts,
storyboards, statistical process control, and benchmarking. We defer discussion of all of these tools
except benchmarking to operations management courses.

2. Benchmarking involves studying the best practices of other organizations to learn how to do things
better and as a means of setting goals. For example, a large bakery might study the distribution system
of a successful florist to improve its own distribution system.

4. TQM empowers employees. TQM empowers those who are closest to problems and it focuses
attention on fact-based problem solving rather than on finger pointing. For an exceptionally lucid
overview of TQM that emphasizes these points, see Wruck and Jensen, “Science, Specific Knowledge,
and Total Quality Management,” Journal of Accounting and Economics, 18, 1994, pp. 247-287.

M. Process Reengineering. The boundaries between Process Reengineering on the one hand and JIT and
TQM on the other hand are fuzzy. A successful JIT implementation almost always involves some Process
Reengineering—although it may not be called by that name. And some TQM advocates would no doubt
claim that Process Reengineering is just a special case of TQM. To prevent confusion, we have attempted
in the text to draw the sharpest distinction we can between Process Reengineering and the other two
methods.

1. Process Reengineering involves completely redesigning a business process from the ground up. In this
respect, it can be differentiated from TQM, which tends to emphasize small, incremental improvements.

2. Process Reengineering begins by flowcharting whatever business process is under examination. Quite
often, the flowchart reveals a Rube Goldberg-like process that has been thrown together over time in
response to various problems.

3. Non-value-added activities in the flowchart are identified. These are activities that take time or
consume resources but that do not add any value that the customer is willing to pay for.

4. The process is redesigned with a focus on simplification and elimination of non-value-added activities.

5. Unfortunately, Process Reengineering often fails because of behavioral problems.

a. By simplifying and eliminating non-value-added activities, it should be possible to design a process

that gets the job done with fewer resources than before. This often means that fewer workers will be
required. If management lays off the surplus workers or transfers them to less desirable jobs, morale
suffers and further process reengineering efforts will very likely be resisted by employees. Management
should develop plans for redeploying surplus resources—including people—even before the Process
Reengineering is begun and these plans should be communicated to employees.

b. Reengineering is often guided by consultants or staff specialists who recommend dramatic changes in
how jobs are performed. Consequently, reengineering is likely to be resisted by front-line workers.
Management must work hard to ensure that workers do not feel threatened by reengineering and that
their legitimate concerns are taken into account.

N. Theory of Constraints (TOC). As with JIT, TQM, and Process Reengineering, we barely scratch the
surface of the Theory of Constraints in the text. For additional background, we recommend THE GOAL:
Second Revised Edition, by Goldratt and Cox.

1. Every organization has at least one constraint. It is easiest to think about this in the context of a
factory whose production cannot keep up with demand. In that case, the constraint is inside the factory.
Ordinarily, the constraint will be the workstation with the lowest rate of output (and smallest capacity).

2. The output of the entire system (in this case, the factory) is determined by the rate of output (i.e., the
capacity) of the constraint. The non-constraints have excess capacity.

3. To increase the output of the system the average rate of output through the constraint must be
increased. The constraint should never be starved for work and improvement efforts should be focused
on the constraint.

4. If improvement efforts are focused on a non-constraint, the end result will be an increase in the
amount of excess capacity. This will be beneficial only if the excess capacity can be transferred in some
way to the constraint or costs can be reduced by eliminating excess capacity. However, as noted above,
eliminating excess capacity can have a negative impact on morale if it involves layoffs.
5. If improvement efforts are focused on the constraint (as they usually should be), its rate of output
may improve to the point that it is no longer the constraint. The constraint would then shift elsewhere.
At that point, improvement efforts should shift to the new constraint.

6. The goal in the Theory of Constraints is not to eliminate all constraints; the system always has a
constraint of some sort if the goal is to make more money. Nevertheless, constraints determine the
performance of the entire system, so they should be intelligently managed.

O. Professional Ethics. Some students tend to equate legal and ethical behavior. That is, if an action is
legal, they consider it to be ethical. We believe it is important to dispel this notion.

1. the text identifies utilitarian approach in arguing for the importance of maintaining ethical standards.
We argue that ethical standards are necessary for the smooth functioning of an advanced market
economy. Basically, if you could not trust anyone, you would be unwilling to transact in the marketplace
without ironclad guarantees. Such guarantees are expensive to write and enforce even when they are
feasible. See Eric Noreen, “The economics of ethics: a new perspective on agency theory,” Accounting,
Organizations and Society, vol. 13, no 4, 1988 for further development of these ideas.

2. One advantage of approaching ethical issues in the managerial accounting course is that the code of
ethics promulgated by the Institute of Management Accountants can be used as a framework. This code
of ethics is more specific than most codes of ethics, which tend to be general platitudes with little
substantive content. By contrast, the IMA code of ethics is refreshingly specific and strongly worded in
some key areas. It is also general enough that it can be used by managers as well as by management
accountants.

Chapter 2: Managerial Accounting and Cost Concepts

Chapter 2 Objectives (ChO)

ChO1. Identify and give examples of each of the three basic manufacturing cost categories.

ChO2. Distinguish between product costs and period costs and give examples of each.

ChO3. Prepare an income statement including calculation of the cost of goods sold.

ChO4. Prepare a schedule of cost of goods manufactured.

ChO5. Understand the differences between variable costs and fixed costs.

ChO6. Understand the differences between direct and indirect costs.

ChO7. Define and give examples of cost classifications used in making decisions: differential costs,
opportunity costs, and sunk costs.

ChO8. Properly account for labor costs associated with idle time, overtime, and fringe benefits.

ChO9. Identify the four types of quality costs and explain how they interact.

ChO10. Prepare and interpret a quality cost report.

Chapter Overview
A. General Theme. Costs can be classified in a number of ways—depending on the purpose of the
classification. For example, classification of costs for purposes of determining inventory valuations and
cost of goods sold for external reports differs from the classification of costs that would be carried out to
aid decision-making. It is important to note that the classifications of costs are not mutually exclusive.
That is, a particular cost may be classified in many different ways—depending on the purpose of the
classification.

B. Cost Classifications for Preparing External Financial Statements. This section of the chapter focuses
on the problem of valuing inventories and determining cost of goods sold for external financial reports.
Before beginning this discussion, you may want to explain the difference between a manufacturing and
a merchandising company. Manufacturing companies convert raw materials into a product. The
company then sells that product either to other companies or, less commonly, directly to individuals.
“Manufacturing” includes restaurants, movie studios, and other service-type companies as well as the
more obvious examples of manufacturing such as automobile and clothing production. Merchandising
companies, by contrast, buy finished products and resell the products to customers. Valuing inventories
and determining cost of goods sold is simple in a merchandising company, but is difficult in a
manufacturing company. For that reason, we concentrate on manufacturing in this section of the
chapter.

1. Manufacturing costs. These costs are incurred to make a product. Manufacturing costs are usually
grouped into three main categories: direct materials, direct labor, and manufacturing overhead.

a. Direct materials. Direct materials consist of those raw material inputs that become an integral part of
a finished product and can be easily traced into it. Examples include the aircraft engines on a Boeing
777, the Intel processing chip in a personal computer, and the blank video cassette in a pre-recorded
video.

b. Direct Labor. Direct labor consists of that portion of labor cost that can be easily traced to a product.
Direct labor is sometimes referred to as “touch labor” since it consists of the costs of workers who
“touch” the product as it is being made.

c. Manufacturing Overhead. Manufacturing overhead consists of all manufacturing costs other than
direct materials and direct labor. These costs cannot be easily and conveniently traced to products.
Examples include miscellaneous supplies such as rivets in a Boeing 777, supervisors, janitors, factory
facility charges, etc.

d. Prime versus Conversion Costs. Prime cost consists of direct materials plus direct labor. Conversion
cost consists of direct labor plus manufacturing overhead.

2. Non-manufacturing costs. A manufacturing company incurs many other costs in addition to

manufacturing costs. For financial reporting purposes most of these other costs are typically classified as
selling (marketing) costs and administrative costs. Marketing and administrative costs are incurred in
both manufacturing and merchandising firms.

a. Marketing Costs. These costs include the costs of making sales, taking customer orders, and delivering
the product to customers. These costs are also referred to as order-getting and order-filling costs.
b. Administrative Costs. These costs include all executive, organizational, and clerical costs that are not
classified as production or marketing costs.

3. Period vs. product costs. Costs can also be classified as period or product costs.

a. Period Costs. Period costs are expensed in the time period in which they are incurred. All selling and
administrative costs are typically considered to be period costs. You should be careful to point out that
the usual rules of accrual accounting apply. For example, administrative salary costs are “incurred” when
they are earned and not necessarily when they are paid to employees.

b. Product Costs. Product costs are added to units of product (i.e., “inventoried”) as they are incurred
and are not treated as expenses until the units are sold. This can result in a delay of one or more periods
between the time in which the cost is incurred and when it appears as an expense on the income
statement. Product costs are also known as inventoriable costs. The discussion in the chapter follows
the usual interpretation of GAAP in which all manufacturing costs are treated as product costs.

4. Inventory valuations and Cost of Goods Sold. In a manufacturing company, raw materials purchases
are recorded in a raw materials inventory account. These costs are transferred to a work in process
inventory account when the materials are released to the production departments. Other
manufacturing costs—direct labor and manufacturing overhead—are charged to the work in process
inventory account as incurred. As work in process is completed, its costs are transferred to the finished
goods inventory account. These costs become expenses only when the finished goods are sold. Period
expenses are taken directly to the income statement as expenses of the period.

5. Schedule of Cost of Goods Manufactured. Because of inventories, the cost of goods sold for a period
is not simply the manufacturing costs incurred during the period. Some of the cost of goods sold may be
for units completed in a previous period. And some of the units completed in the current period may not
have been sold and will still be on the balance sheet as assets. The cost of goods sold is computed with
the aid of a schedule of costs of goods manufactured, which takes into account changes in inventories.
The schedule of cost of goods manufactured is not ordinarily included in external financial reports, but
must be compiled by accountants within the company in order to arrive at the cost of goods sold. You
should take some time to explain the cost of goods manufactured schedule since it is often difficult for
students to understand.

C. Cost Classifications to Describe Cost Behavior. Managers often need to be able to predict how costs
will change in response to changes in activity. The activity might be the output of goods or services or it
might be some measure of activity internal to the company such as the number of purchase orders
processed during a period. In this chapter, nearly all of the illustrations assume that the activity is the
output of goods or services. In later chapters, other measures of activity will be introduced.

While there are other ways to classify costs according to how they react to changes in activity, in this
chapter we introduce the simple variable and fixed classifications. A variable cost is constant per unit of
activity but changes in total as the activity level rises and falls. A fixed cost is constant in total for
changes in activity within the relevant range. (Just about any cost will change if there is a big enough
change in activity. Fixed costs do not change for changes in activity that fall within the “relevant range.”)
When expressed on a per unit basis, a fixed cost is inversely related to activity—the per unit cost
decreases when activity rises and increases when activity falls.
There is some controversy concerning the proper definition of the “relevant range.” Some refer to the
relevant range as the range of activity within which the company usually operates. We refer to the
relevant range as the range of activity within which the assumptions about variable and fixed costs are
valid. Either definition could be used—our choice was dictated by our desire to highlight the notion that
fixed costs can change if the level of activity changes enough.

D. Cost Classifications for Assigning Costs. Managers often want costs to be assigned to “cost objects”
such as products, customers, departments, etc. for pricing or other purposes. A direct cost is a cost that
can be conveniently and easily traced to a particular cost object. Indirect costs are everything else. A
cost would be considered indirect for one of two reasons: either it is impractical or it is impossible to
trace the cost to the cost object.

1. Common costs. For example, it is impossible to trace the factory managers’ salary in a multi-product
plant to any particular product made in the plant. Even if a product were dropped entirely, we would
ordinarily expect the factory manager’s salary to remain the same. This is an example of a “common
cost” and later in the text we emphasize that such costs should not be allocated for decision-making or
performance evaluation purposes.

2. Variable indirect costs. On the other hand, other costs are treated as indirect costs because it would
not be practical to treat them otherwise. For example, it would be possible to measure the precise
amount of solder used on each circuit board produced at a HP plant, but it wouldn’t be worth the effort.
Instead, solder would typically be considered an indirect material and would be included in overhead.

E. Cost Classifications for Decision-Making. Every decision involves choosing from among at least two
alternatives. Only those costs and benefits that differ between alternatives are relevant in making the
selection. This concept is explored in greater detail in the chapter on relevant costs. However, decision-
making contexts crop up from time to time in the text before that chapter, so it is a good idea to
familiarize students with relevant cost concepts.

1. Differential Costs. A differential cost is a cost that differs between alternatives. The cost may exist in
only one of the alternatives or the total amount of the cost may differ between the alternatives. In the
latter case, the differential cost would be the difference between the cost under one alternative and the
cost under the other. Differential costs are also called incremental costs. Differential costs and
opportunity costs should be the focus of decision-making. They are the only relevant costs and all others
should be ignored.

2. Opportunity Costs. An opportunity cost is the potential benefit that is given up by selecting one
alternative over another. The concept of an opportunity cost is rather difficult for students to
understand because it is not an actual expenditure and it is rarely (if ever) shown on the accounting
books of an organization. It is, however, a cost that must be considered in decisions.

3. Sunk Cost. A sunk cost is a cost that has already been incurred and that cannot be changed by any
decision made now or in the future. Since sunk costs cannot be changed and therefore cannot be
differential costs, they should be ignored in decision making. While students usually accept the idea that
sunk costs should be ignored on an abstract level, like most people they often have difficulty putting this
idea into practice.
F. Classification of Labor Costs (Appendix 2A). Factory labor costs are classified as direct or indirect
labor. Direct labor is basically “touch labor.” Indirect labor is the rest of the manufacturing labor cost
and it is classified as part of manufacturing overhead. Examples of indirect labor include the wages and
salaries of janitors, supervisors, material handlers, and maintenance workers.

1. Idle Time. Some labor costs, such as idle time, are not easily identified as either direct or indirect
labor. Idle time represents the wages of direct labor workers who are idle due to machine breakdowns,
material shortages, and so forth. Typically, these costs are classified as overhead costs and are allocated
across all products.

2. Overtime Premium. The overtime premium paid to factory workers is usually considered to be part of
manufacturing overhead. It is argued that it would be unfair to charge an overtime premium against a
product that happened to be scheduled for the overtime period. Therefore, the overtime premium is
usually added to overhead and spread among all jobs of the period. It should be noted that if a company
works overtime specifically because of a special request or a rush order job, the overtime premium may
appropriately be charged against that particular job.

3. Fringe Benefits. These costs include payments made to insurance and retirement plans as well as
various employee taxes such as social security. Typically, companies treat these costs as manufacturing
overhead. However, it would be more accurate to split fringe benefits between the portion that relates
to direct labor and the portion that relates to indirect labor. Only those fringe benefits that relate to
indirect labor should be included in manufacturing overhead; the rest should be considered as part of
direct labor cost.

G. Quality Costs (Appendix 2B) The term quality has many meanings. Quality can mean that a product
has many features not found in other products; it can mean that it is well-designed; or it can mean that
it is defect-free. In this appendix, the focus is on the presence or absence of defects. Quality of
conformance is the degree to which the actual product or service meets its design specifications.
Anything that does not meet design specifications is a defect and is indicative of low quality of
conformance.

1. Costs of Internal and External Failure. The costs of not meeting design specifications are classified as
internal failure costs and external failure costs. Defects that are detected internally result in costs such
as scrap or rework. Defective units that are released to customers create external failure costs.
Examples of external failure costs include customer returns and exchanges, repairs under warranties,
product recalls, and lost sales due to a reputation for selling defective products.

2. Costs of Reducing Defects. There are basically only two ways to reduce defects and the resulting costs
of internal and external failures. Either the defects can be prevented or they can be detected and
corrected.

a. Defects can be prevented by designing products that are “robust;” that is, that are not sensitive to
variations and errors in the production process. Defects can also be prevented by improving production
processes. Statistical process control has been especially useful in driving variation out of production
processes and thereby reducing defect rates. Most experts believe that until the late 1980s too little
attention was paid in the United States to prevention. Instead, reliance was placed on detecting defects
once they had occurred.
b. Defective units can be detected before they are delivered to customers by inspecting and testing units
throughout the production process. This approach to reducing defects is expensive since it involves
inspection labor and testing equipment. Moreover, when there is no idle capacity every defective unit
that must be reworked or that is scrapped uses precious capacity. The resulting opportunity costs can be
quite large.

H. The Trade-Off Between Prevention and Appraisal Costs and Internal and External Failure Costs.
Generally speaking, companies should focus more effort on prevention and appraisal. And prevention is
usually better than appraisal. Most authorities agree that the costs of internal and external failures have
been largely hidden and as a consequence managers are unaware of the magnitude of the problem.
Very simple steps can often be taken to prevent defects. These simple steps pay enormous dividends in
terms of reducing the need for appraisal and in reducing the incidence of internal and external failures.

I. Quality Cost Report Quality consultants claim that top managers often do not pay enough attention to
quality since the costs of low quality (i.e., high defect rates) are hidden by the typical cost accounting
system. While accounting systems often report statistics concerning scrap and there may be a quality
assurance department with its own budget, many of the other costs associated with defects are buried
in general overhead or in other accounts. A quality cost report makes these costs visible and organizes
the data so as to help managers make trade-offs. Since the reports are really just attention-directing
devices, the numbers in the reports do not have to be precise.

1. Data for the Quality Cost Report. The costs of nonconformance (i.e., defects) often cut across
departmental lines and are therefore somewhat difficult to collect. Moreover, some of the costs of
nonconformance are entirely external to the company and are not captured by the accounting system at
all. The most prominent example of this is the cost of lost sales. Nevertheless, as we indicated above,
precision is not terribly important so these measurement and identification problems should not be
overemphasized. All of the examples and problems in the text assume that the data collection work has
already been done.

2. Format and use of the Quality Cost Report. It is very helpful to sort the various quality costs into the
four categories of prevention, appraisal, internal failure, and external failure costs. By comparing the
amounts in the various categories, managers can get some feel for what should be done. For example, if
the prevention and appraisal costs are very small relative to the internal and external failure costs, it is
likely that not enough is being spent to prevent and detect defects. If prevention costs are low relative
to appraisal costs, it is likely that not enough is being spent on prevention relative to inspection.
Moreover, by comparing results across years, managers can track the effects of their decisions and
gauge the success of quality improvement programs.

3. The future of the Quality Cost Report. A company’s first quality cost report probably has the greatest
effect. Managers are often surprised by the magnitude of the costs associated with defects. This is often
enough by itself to propel the company into ambitious quality improvement programs. However, unless
the company’s chart of accounts is modified, compiling periodic quality cost reports is a time-consuming
task. Moreover, some of the most important data—the data external to the company—will almost
always be missing. And, while the quality cost report can help steer managers in the appropriate
direction (e.g., increase prevention costs), it cannot tell managers how to go about preventing defects.
For these reasons, many companies stop producing quality cost reports once their quality improvement
program is well-established.