CHAPTER 12

INTRODUCTION TO COST MANAGEMENT SYSTEMS

QUESTIONS

1. The only realistic method of evaluating whether costs are being effectively
managed is to compare the benefits generated with the costs incurred. This
approach is equivalent to evaluating the costs incurred relative to the objectives
that were to be accomplished from incurring the costs.

2. A control system is a tool to aid managers in steering an organization to the

achievement of its goals. A control system has four components: a detector, an
assessor, an effector, and a communications network. A control system exists to
keep an organizations actual operations in line with its plans and strategies.

3. Organizations typically have goals and objectives for both the short and long
terms. Consequently, organizations must have control systems in place to ensure
that both short- and long-term targets are achieved. For businesses, one important
short-term goal is to achieve profits, and a long-term-goal is to remain solvent and
viable.

4. Every organization is unique in its objectives, constraints, culture, strategies, and

structure. Because all of these variables are important determinants of the
configuration of a cost management system, every organization requires a unique
cost management system.

5. Organizational form influences the cost management system design in several

ways. For example, organizational form determines, in part, who in the
organization is empowered to make decisions. Also, the organizational form
determines whether certain costs will be incurred (e.g., federal income taxes) and,
whether those costs affect other costs such as the cost of acquiring public or
private capital.

6. Core competencies are activities a firm must execute well to survive. Information
useful in assessing core competencies would include benchmark data from
competing firms or other firms, historical performance data, intelligence regarding
actions likely to be taken by competitors, and measurement systems to capture
performance in areas of core competencies.

7. Organizational culture can be an effective control device. A culture is a reflection

of the values and practices that are acceptable or preferred by the company. The
mere existence of the culture deters certain undesirable practices and encourages
other practices. The culture can be perpetuated by hiring people who have values
that are consistent with the culture. In this manner, the culture is perpetuated and
the employees have homogeneous beliefs regarding behaviors.

347
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Chapter 12 348

8. The life-cycle stage determines which costs are important and which costs are
controllable. For example, in the design stage, no production costs are being
incurred; so, a focus on production costs would be ineffective and inappropriate.
Instead, the focus should be on research and development costs and product
design costs. Similarly, in later stages of the product life cycle, no R&D expenses
are being incurred, and thus, no focus should be given to them; rather, production
and marketing costs should be the focus of attention.

9. Cost management has risen to the top of concerns because it has become a
primary determinant of profitability. Because competition is increasingly a contest
among equals, the balance of power in the marketplace has been shifted to the
consumer, who now has many choices of competitive products and services. With
many equivalent products competing for consumer dollars, the ability of any
company to control price is diminished. Companies must focus on reducing price
to maintain market share; to achieve price reductions, companies must effectively
manage costs.

10. CAM-I is a consortium organized to develop a framework for the design of cost
management systems in advanced manufacturing settings. One outcome of CAM-I
was a set of principles for designing cost management systems. Although
compatible with existing cost accounting systems, the set of principles as a whole
suggests a radical departure from traditional practices. The practices focus
management attention on organizational activities, product life cycles, integrating
cost management and performance measurement, and integrating investment
management and strategic management.

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Chapter 12 349

EXERCISES
11. Without management controls, firms lack the necessary coordination between
their strategies and the management and application of scarce resources such as
capital and human resources. With management controls, the 5Q owners would
have obtained information about future cash constraints, relationships between
revenues and costs and capital needs. Organizing a budget linked to the strategic
plan would have been a good starting point for developing management controls.
Preparing a budget would have forced the group to consider how to deal with cash
shortages and would have been a valuable benchmark for evaluating actual costs
and revenues.

12. a. The assessor is the device that compares actual results with expectations and
calculates variances.
b. The communications network reports variance results to the appropriate
parties.
c. The effector implements changes that act on the differences between
expectations and actual results to cause the actual results to align with
expectations.
d. The detector measures costs of actual operations.

13. Two observations arise from an examination of the data. First, Firm A is
generating more profit per dollar of sales than is the average firm in the industry.
Although the average firm generates profit equal to 10 percent of sales ($0.096
$0.96), Firm As profits are a whopping 27 percent of sales ($0.54 $2). Second,
relative to its sales, Firm A is spending much less on advertising, R&D, and
investment in new facilities as indicated in the following table:
SPENDING AS A PERCENTAGE OF SALES
Firm A Industry Average
Advertising 2% 17%
R&D 8% 25%
Facilities investment 10% 25%
While one interpretation of the data is that Firm A is much more profitable than
the average firm in the industry because it is more effectively managing its costs,
the opposite is likely true. Firm A is robbing from its future to increase the current
level of profits. Unless Firm A starts investing much more heavily in the three
areas featured in the problem, the firm will start to lose market share, sales will
drop, and profits will decline dramatically. Another possibility is that Firm A is
engaging in fraudulent financial reporting.

14. a. The focus of management would be on quality and customer satisfaction.

Quality could be assessed from both an internal and external perspective. For
example, internal measures could include mortality rate for specific
illnesses/injuries, and recovery time for specific illnesses/injuries. External

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Chapter 12 350

measures could include customer-assessed quality. Such data could be

gathered in exit interviews or surveys.
b. The key to the survival of this business is generating sales from the first
product and completing the development of the other products. Accordingly,
the focus would be on getting the first product to market as quickly as
possible, monitoring sales and market share of that product, and getting the
other products through the development pipeline.
c. The focus would be on operating efficiency. Because this industry is
characterized as producing a commodity product, and because there is excess
capacity in the industry, survival and profitability depend on processing the
raw sugar into refined sugar as efficiently as possible. Thus, the company
would focus very intently on managing operating costs, and strategic decisions
would be related to remaining competitive in managing costs and operational
efficiency.

15. The paper should, at a minimum, discuss the following points:

The corporation is relatively more expensive to launch than the other
organizational forms.
The general partnership is the least expensive form to organize.
Outside capital is easier to raise in the corporate form because of the limited
liability protection offered to shareholders along with the well-developed
secondary markets for publicly traded stocks.
Separation of ownership and management is most difficult in the general
partnership form. It is probably easiest to achieve in the corporate form.
Only the corporation is subject to income taxes. The other entity forms can be
taxed as pass-through entities.
Only the general partnership exposes the investors to unlimited liability. The
other forms offer limited liability to (at a minimum) passive investors.

16. Each student will have a different answer; no solution provided.

17. The discussion should center on how B2B could increase competition among
vendors to provide supplies and inputs to a small business. The effect of the
technology is to reduce the search and transaction costs for vendors to provide a
bid to potential buyers. Thus, the effect of the B2B system should be to increase
the competition among potential vendors for the privilege of supplying the small
customer.

18. Each student will have a different answer; no solution provided.

19. The old adage you get what you measure applies to the use of accounting
information. Each student will have a different answer, but the major points that
should be raised in the discussion include:
Accounting information will promote goal achievement only if the
measurements are highly correlated with the goals. Alternatively, goal
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Chapter 12 351

congruence problems will be created if the accounting information captures

performance dimensions that are not highly correlated with goal achievement.
The use of nonfinancial performance measures may serve to strengthen the tie
between accounting information and goals.
Only if the accounting information is accurate will it serve to promote goal
congruence and goal achievement.
Only if the accounting information is used as a basis to both measure
performance and reward employees will it be relevant. Even if accounting
information is highly correlated with organizational goals, managers and
employees will ignore the information unless it directly affects their welfare. It
will affect their welfare if their evaluation, pay, and promotion are based on
accounting measurements.

20. Each student will have a different answer; no solution provided.

21. a. The motivational elements create the incentive and reward for managers to
perform at a high level. Because the accounting system is used to measure the
performance of managers, the manipulation of the accounting system can
result in managers receiving larger rewards without actually achieving the
expected level of results. In short, managers can get the rewards by
manipulating the measurement rather than achieving high performance.
b. The behavior is both unethical and illegal. Manipulating the accounting
system is a deception that harms all stakeholders other than the managers who
profit from the manipulation. These acts undermine the confidence of
investors in accounting reports and increase the cost of capital to firms
because investors have greater uncertainty about the accuracy of the reported
financial results.

22. a. Reporting stock option expense in the footnotes achieves two effects. First,
true management compensation becomes less transparent to stockholders and
others; second, reported earnings appear higher than they really are
particularly to investors who are not sophisticated enough to evaluate the
footnote disclosures.
b. The practice was misleading only to financial statement users who were not
sophisticated enough to evaluate the footnote information. Because the
footnote disclosures were consistent with GAAP, most investors would likely
not perceive the practice as unethical. Nevertheless, the practice was not the
most transparent approach to informing investors about stock option expense.
c. The research will reveal that backdating involves issuing the options on one
date but placing an earlier date on the optionsgenerally a date at which the
underlying stock was trading near its annual low price. Thus, at the date of
issuance, the stocks were already in the money. Stock options are most
commonly issued at the money.

23. Each student will have a different answer, but the memo should include the
following points. Gap analysis begins with specifying the desired CMS. Once the
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Chapter 12 352

desired CMS is described, that system can be compared to the existing system.
The differences between the desired and actual systems are call gaps. Once the
gaps are identified, they can be prioritized, and a strategy can be developed to
close the gaps. Once the gaps have been addressed, the existing system should
align with the desired system.

24. One would begin by identifying the needed components of a CMS given the
current size and complexity of the business. With this step completed, the existing
CMS components would be compared to the components identified in the first
step. This process would identify the differences or gaps in the existing system
that need to be addressed. Because of constrained resources, it is unlikely that all
gaps could be addressed simultaneously, so management would prioritize the gaps
and develop strategies to close them. Once all gaps have been addressed, the
components of the existing system should closely align with the components
identified in step one.

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Chapter 12 353

PROBLEMS

25. a. R&D activity should not be tightly controlled by the operating budget.
Because it is difficult to map the relationship between dollars expended and
research and development, expenditures in this area should be managed more
so with judgment than with systems such as budgets.
b. Management of marketing expense is crucial in a start-up company. The
growth of the company will critically hinge on the success of the marketing
efforts. Further, it is difficult to engineer the relationship between marketing
expenditures and market impact of those expenditures. Accordingly,
marketing expense for the start-up should be managed with expert judgment
rather than with a budgetary system.
c. Travel expense lends itself to control by budget. The amount of travel is
predictable, the expected cost of that travel can be reasonably estimated, and
therefore, a budget is an excellent control tool.
d. The energy costs incurred by a public utility company should be tightly related
to the quantity of energy sold to its customers. That is, there is effectively an
engineered relationship between energy consumed and quantity of utility
service provided. This circumstance is ideal for control by a budget.
e. Costs of environmental remediation may lend itself to budgetary control if the
scope of the remediation is known and the costs of the remediation can be
reasonably estimated.
f. Manufacturing costs are ideally controlled with the operating budget. The
number of cars to be produced can be reliably estimated, the costs of
components and conversion can also be estimated reliably. Accordingly, the
budget should be a very good benchmark for evaluating actual manufacturing
expenses.
g. The significant costs of classroom buildings include maintenance, utilities, and
cleaning. These costs can be reliably estimated and lend themselves to control
by the operating budget.

26. Each student will have a different answer; no solution provided.

27. The key to success in the marketplace for the ZX chip will be to differentiate it
from competitors chips. Because this chip has the greatest functionality in the
marketplace, it should command the highest price. However, to successfully
market the chip at a price higher than competitors, the market needs to be
educated about the features and benefits of using the chip. Accordingly, a key to
success will be the marketing and sales campaign that introduces this chip to the
market.
Another key will be to successfully identify the niche markets that can utilize this
highly functional chip. If identification of such niches is successful, the volume of
chips sold can be sufficient to cover the chips production and development costs.
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Chapter 12 354

Thus, the objective is to quickly gain market share with the new chip by
exploiting the chips functionality in appropriate markets.

Cost management of the commodity chip would have focused largely on

production costs. However, because the ZX chip is not yet in production, the cost
management focus should be on the marketing and sales campaign. The goal is to
obtain as large a market share as possible with the dollars expended. Also,
because the ZX chip is scheduled to begin production soon, there would be a cost
focus on the design and implementation of production technology and conversion
operations.

28. a. Procter & Gambles decision was based on the high distribution and
redemption costs for the coupons, which could be avoided if the firm
discontinued use of coupons as a promotion tool. The cost savings represent
the benefits to be realized. There are two major costs of discontinuing the use
of coupons: (1) the potential loss of existing customers and (2) the cost of
alternative promotion mechanisms that would be used to replace the coupons.
b. The market strategy may be to compete more on the basis of price and less on
the basis of product differentiation. By spending less on product promotion,
the company will have a lower breakeven point, and by lowering the price, it
may recoup some of the loss in profits per unit through an increase in the
volume of sales.

29. a. Across-the-board cuts would be a logical approach to cost cutting only if all
organizational units have the same mission. Across-the-board cuts would
likely have a much more detrimental long-term effect on units with a build
mission than other units. By implementing major cuts to units with a build
mission, a company may be severely harming its future.
Across-the-board cuts are typically imposed in lieu of identifying specific
costs to be cut. By imposing across-the-board cuts, top managers are implying
that no activities are more crucial than any other activities to the companys
profitability and survival. Such a perspective is strong evidence that the
company is not managing its cost relative to its strategy.
b. A better system of cost management would relate all activities to customer
value. Those activities generating high value relative to cost would not have
been cut. Additionally, the mission of each subunit would have been
considered in identifying which costs to cut. Those subunits with a build
mission would likely be protected from cost-cutting to some extent. Also, the
company would consider which core competencies could be damaged by cost
cutting measures and would take steps to make certain that those competencies
were protected from effects of severe cost cutting.
c. Both revenues and costs are factors in earning income. Thus, managers need to
focus on generating new revenue because customers leave and products die.
Managers need to make certain that products and services are up to date and
will appeal to customers that have previously purchased from the organization
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Chapter 12 355

as well as customers who have not bought before. If costs are not managed
and controlled, there may be a cost creep that occurs: costs inch up slowly
over time. Therefore, costs must be continually analyzed and reviewed to
determine if they are necessary and if the best cost is obtained for all
business acquisitions (materials, labor, plant assets, etc.).
30. The following are the major problems in the Garage Door Division:
The mission of the division is not defined nor is the broader strategy of the
firm.
Calley has no incentive to invest in assets that will foster future growth. Her
compensation is a fixed salary and a bonus based on annual profit. The bonus
scheme does not encourage growth. This situation is aggravated by the fact
that Calley is 53 years old and may be contemplating retirement in the not-too-
distant future.
The divisions growth is stagnant, and market share is slipping. Further, the
division does not seem to have a major presence in the growth sector of the
market, ornamental products.
The division is not exploiting information technology. Although it has some
computerized systems, there is no apparent integration of systems.
The division is obviously not customer-focused. It has no customer service
department and apparently no out-of-office sales staff to promote products.
The annual operating budget is the only major control tool used by upper
management.
Some actions that could be taken to address the problems in the Garage Door
Division follow:
Develop a mission statement for the division that is consistent with the
strategy of the firm. A strategic plan should also be compiled.
Develop an integrated cost management system for the firm. The control
systems need to be consistent with the strategy of the firm and the mission of
the division. From the strong growth rate of the industry, some incentives need
to be developed to encourage growth in market share and sales. Even if the
mission is hold rather than grow, there is opportunity for the division to regain
lost market share.
An integrated cost management system needs to be developed. The system
should include incentive elements, reporting elements, and information
elements. Informational elements should allow Calley and other managers to
obtain the information they need to make the division grow. For example, the
division needs to develop the capability to determine what characteristics
(quality, features, etc.) their customers desire in garage door hardware and
other products, the ability to monitor actions of competitors, and the necessary
information to evaluate cost control efforts.
Culturally and structurally, the division needs to become more customer-
focused. Structurally, the division can establish a customer service department
and develop an external sales force to gather information from customers.
Culturally, the division can become more customer-focused by developing
incentives for employees. Customer-related incentives could be based on
measures of quality, lead time, product innovation, and customer service.
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Chapter 12 356

At the corporate level, the company may need to consider more

decentralization of control. Using the operating budget as the only major
control tool may place limits on actions that Calley and her managers can take
to improve operations. With decentralization of control, corporate
management could develop new reporting elements for the cost management
system that would facilitate growth in the Garage Door Division.

31. a. Tylers recommendation is insensitive to the difference in strategies of the two

firms. Further, the more crucial performance metrics, e.g., return on
investment, or return on equity, are missing from Tylers analysis. The higher
gross margin and higher selling and administration costs experienced by
Tracys is indicative of a strategy of differentiation. The higher selling and
administration costs are necessary to support differentiation activities such as
customer service and marketing. However, there is no indication in the data
that this is a superior strategy to that being pursued by Smart-Mart.

b. As suggested above, return on investment, or return on equity, would be more

important performance criteria. If one strategy (or ones execution of strategy)
is superior, it should be reflected in these metrics; i.e., these metrics are not
specific to any strategy and are appropriate metrics to compare across
strategies.

32. a. Each student will have a different answer; no solution provided.

b. Much of Heelys stock price value was based on the belief that sales would
keep growing, and hence, future profits would be much higher than current
profits. The act of cutting sales estimates in future periods signaled to the
market that the firm expected the rate of growth to slow. In short, this act
signaled to the market that the firms product was maturing sooner than
expected and that life cycle sales of the product would not meet expectations.
Investors reacted strongly and revised their expectations about future profits
and the stock price that was justified by those expectations.
c. Each student will have a different answer; no solution provided.

33. a. Ordinarily, the cost management system [CMS] design team creates its design
within the context of decisions made by a strategic planning team. Usually, the
strategic planning team recommends and management gains company
consensus regarding vision, mission, and major company goals and objectives.
However, in small companies, teams are sometimes charged with a broader
responsibility than for one particular issue.
b. Students will often suggest maximizing profits, maximizing stockholder
wealth, or maximizing customer satisfaction. The truth is that these goals are
mutually supportive.
c. Ignoring the satisfaction of any particular stakeholder such as stockholders,
managers, or customers can have a disastrous effect on the remaining

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Chapter 12 357

stakeholders. Therefore, a balance must be achieved in a manner that

considers the well being of all of these stakeholders simultaneously.

34. a. If the CMS was built on inaccurate information, in this case indicating
reserves 20 percent larger than actually existed, managers might have made
decisions that were not in the best long-run interest of the company. For
example, the firm may have sold reserves that it would not have sold if more
accurate information would have been available. Also, the company may have
invested capital to develop oil fields that were purported to contain more oil
than they actually did contain. This capital may have been better invested
elsewhere.
b. The CMS may create incentives to misreport. Because some managers may be
compensated based on performance of the companys stock, or other
performance metrics directly related to oil and gas reserves, those managers
have an incentive to manipulate information that underlies those metrics.
c. Obviously it is not ethical to manipulate information to manage the perception
of performance. Such acts are not only unethical, but are also illegal and lead
to harsh punishment of the firm by the capital markets when such deceptions
are uncovered. Further, those involved in such deceptions are subject to
criminal and civil penalties.

35. a. Product liability costs arise because a product does not work as intended or the
product causes harm to those who use or consume it. Particularly by having a
CMS that is sensitive to customer concerns and customer satisfaction, product
liability costs can be better controlled because managers will better understand
how consumers use their products and, thus, will be better able to identify
risks in the use of the products.
b. Local property taxes are typically assessed based on property values. The
greater the value, the higher will be the taxes assessed. Property taxes are
controlled by managing the level of investment in taxable property and by
negotiating relief from tax with state and local tax authorities. By having a
CMS that is sensitive to performance from the perspective of the local
community, the firm may generate information that is useful in justifying tax
breaks granted by local and state tax authorities. Such information might
demonstrate the contribution of the firm to employment in the community and
to social causes important to the community.
c. Pollution remediation is necessary only if a firm generates pollution. The
generation of pollution may be reduced if a CMS generates information about
environmental impact and impact on the local community. By understanding
the impact of pollution on the environment and the local community, pollution
generation may be justifiably reduced and the expense of pollution
remediation may be avoided or reduced.
d. By having a CMS that generates information on employment, data regarding
employee turnover will be more readily available. Such data will help

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Chapter 12 358

managers understand the costs associated with employee turnover and develop
programs to improve employee retention and avoid the costs of turnover.
e. Warranty expense arises when a product fails to work as intended. Firms that
have a CMS that is sensitive to customer issues should have better information
to manage warranty costs. Specifically, such companies will better understand
the customer consequences of having product failures and the cost
consequences of those failures, which include warranty expense. This
understanding may lead to improved product design and investment in quality
control.

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Chapter 12 359

36. a. The changes experienced by the company likely affect both revenues and
costs. Specifically, managing a larger mix of products is likely to significantly
increase the complexity of manufacturing. More setups will be required, more
suppliers will be required, more distribution channels must be managed, and
more transportation channels must be utilized. All of these changes would
increase costs. The generation and growth of revenues depends on constantly
identifying new soft drinks and establishing market share, which, in turn,
requires increased marketing expenses and more research and development.
Because the life cycles of these products are shorter than traditional soft drink
products, the life cycle revenues are less than traditional products.
b. Gap analysis is a tool that can be used to update a CMS with a strategic
approach. The process begins by identifying the necessary components of the
CMS, given the firms strategy and current operating environment. Next, the
existing CMS is compared to the components identified in step one.
Differences between the needed and existing components are called gaps.
Closing the gaps causes the existing CMS to be reconfigured according to the
desired system. A priority is established for closing the gaps such that the most
crucial gaps are addressed first and the less crucial gaps are addressed last.
When all the gaps are closed, the necessary components of the CMS should be
in place.

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