1: Managerial & Cost Accounting

1.1 Descriptivism vs. Prescriptivism

Managerial accounting and cost accounting are the same thing: accounting that provides information to managers to help them maximize profit. Perhaps that wasn’t true 50 years ago, but attempting to draw a meaningful distinction between the two terms nowadays is largely a waste of time. (I doubt it was even a worthwhile distinction 50 years ago). Some people will insist there’s a difference. Bless their hearts. In this textbook I will use these terms interchangeably. Better get used to it.

Why? Why would a field of supposedly serious accounting professionals develop two terms (three terms if you count “management accounting”) that mean the same thing? Actually it’s worse than that. As you’ll see later in the textbook, this isn’t the only time managerial accounting does this. There are several synonymous or nearly synonymous terms in the field.

One key reason for this is that managerial accounting is a descriptivist field, at least compared to other fields in accounting. Descriptivist is a term related to linguistics, but I think it applies to this situation as well. A descriptivist is a person who describes behavior that naturally occurs. In this case that behavior is manager behavior that naturally occurs in business. Multiple descriptivists observe this behavior, at separate times and in separate places. Their descriptions of the same observed behavior, and the terminology they use to describe this behavior, merge over time. This leads to multiple terms meaning the same thing. Hence managerial accounting and cost accounting are two terms that refer to the same thing.

Descriptivism can be thought of as the opposite of prescriptivism. A descriptivist field attempts to describe what is. A prescriptivist field attempts to describe what should be. Many other areas in accounting are much more prescriptivist than managerial accounting. This doesn’t make managerial accounting better than those fields. But it does make it different from them.

For example, one might contend that GAAP, or General Accepted Accounting Principles, is horribly misnamed because it is not a set of “principles” as much as a set of rules, and if you don’t follow them you can go to jail (IFRS is not much better in this regard: you can still go to jail if you do it wrong). FASB prescribes a certain way of reporting financial results, which makes financial statements more reliable and comparable for financiers (e.g. stock markets, banks, etc.). Tax accounting is much the same way. If you violate the rules of the tax authority, you can go to jail.

Both of these fields are strongly prescriptivist. One giveaway is that you are audited for compliance in both financial accounting and tax accounting. Compliance means adhering to the prescribed way of accounting, the way you should do the accounting.

On the other hand, there are no managerial accounting audits. No one polices companies to see if they’re doing it the way they should, and no one goes to jail for doing managerial accounting wrong. (ISO and environmental audits don’t count because they’re voluntary and only have a limited effect on managerial accounting practices.) Managerial accounting is just something that companies naturally do because they find it beneficial. Managerial accounting, as an academic field, arose to describe this natural phenomenon.

I know you’re now asking yourself: why does this natural phenomenon naturally occur? Because managers want to maximize profit, and they need certain accounting information to do so! The act of gathering that information is what we call “managerial accounting,” and the information itself is “managerial accounting information.“

Most managerial accounting textbooks include a table that dissects the differences between managerial accounting and financial accounting. Forward-looking versus backward-looking. Aggregated versus detailed. Etc. etc. etc. I find these tables tedious. The only real difference is who. Managerial accounting produces the information that managers ask for so they can maximize profits. Manager is in the name: managerial accounting. Other types of accounting (e.g. financial and tax) produce information that some external party asks for (e.g. financiers and tax authorities), and it is policed by a governing body related to that external party (e.g. FASB/SEC and the IRS).

1.2 Maximizing Profit

1.2.1 Why Cost Accounting?

The next logical question is why cost accounting would be used in place of managerial accounting. In short, cost accounting is used as a synonym for managerial accounting because cost information plays an important role in maximizing profits. So a lot of managerial accounting information is cost information. Let me explain this idea by taking a little math detour through the definition of profit.

I hope this isn’t news to you, but profit is defined as revenue minus expenses, and an expense is just a cost that is recognized on a financial statement (all expenses reflect a cost, but not all costs are expensed). Economists like to look smart, so they often use the Greek letter pi, π, to represent profit. I will be using π to represent profit a lot throughout this textbook. My hope is that using a Greek letter serves as a mnemonic. Be prepared, not scared.

Here, in math terms, profit (π) is defined as the difference between the revenue function, R(∙), and the cost function, C(∙). R(∙) is driven by a lot of things, such as sales price, quantity sold, product quality, and market pressures. For now, I’ve simply summarized the things that drive revenue with a dot, “∙”. Same with the cost function, C(∙). It’s driven by a lot of things, such as input price, production volume, and manufacturing technology. I’ve also simply summarized all of these things with a dot, “∙”, for now.

But managers can’t afford to have just a dot. To maximize profit, managers usually seek out information to understand what drives revenue and cost. They really want to know what’s inside the parentheses. Managers traditionally focus more attention on costs, spending more effort gathering information about what drives the cost function than what drives the revenue function. This often means that managerial accounting information is predominantly cost information. (And as I said, this is why the term cost accounting is used as a synonym for managerial accounting.) This is especially true in a manufacturing firm, but it applies to all firms to a degree. (I discuss some differences in cost information gathered by manufacturing, merchandising, and service firms in Chapter 4.)

Managers have traditionally focused on costs for two reasons.

1. Costs are easier to control than revenue.

2. Costs are harder to trace to responsible parties than revenue.

First, costs are easier to control. A manager can pick up the phone or write an email and impact the firm’s costs immediately and predictably. For example, they can call up the purchasing department and tell them to buy a different quality level of raw materials. One does not simply call up or email customers and make them spend more money on the firm’s product. At least, not as immediately or predictably. This is one reason why cost information is so important to managerial accounting: it can clearly recommend a course of action that managers can take to maximize profits.

Second, businesses usually have a harder time assigning responsibility for costs than they do for revenue. As we’ll keep coming back to throughout the textbook, one reason for sorting out the drivers of the revenue function and the cost function is to assign responsibility. This has to do with maximizing profit in the future. Managers want to have information that allows them to say, “These products/departments/employees are doing a really good job, so let’s reward them!” Or alternatively, they want to be able to say, “This product/department/employee is not meeting expectations, so let’s make a change.”

Tracking who is responsible for revenue is often more straightforward because (1) revenue tends to be earned in discrete events (“I made a sale today!”) and (2) people usually do not shy away from accepting responsibility for revenue. Costs, on the other hand, (1) are often incurred unevenly (“This piece of equipment will serve us for ten years!”), and (2) people are more reluctant to accept responsibility for them. So, if managers don’t spend effort gathering information about cost responsibility, they will be more in the dark about who is responsible for costs than about who is responsible for revenue.

This idea that businesses should expend significant resources to identify their cost functions and minimize their costs has some important built-in assumptions. We’ll talk about these assumptions as we go along. These are powerful assumptions that, in fairness, have helped drive astounding economic development within free-market economies all over the world for at least 100 years. Thank cost accounting, in part, next time you buy a car for less than a fortune or an iPhone for less than the cost of a house.

But several modern trends offer important and compelling critiques of these assumptions. Eliyahu Goldratt went so far as to call cost accounting “the number one enemy of productivity” (per his 1983 presentation and later statements). In this textbook, we will cover the time-tested power of cost accounting using its traditional assumptions as well as these modern twists on those assumptions (we cover that latter primarily in Chapter 8). Together the old and the new will give us a well-rounded view of how managers can maximize profit using managerial accounting information.

1.2.2 Non-Profit Entities

The above formulation about π, where maximizing profits is the central goal of for-profit firms, is a good starting point for non-profit entities too. Mathematically-speaking, a non-profit entity simply acts like a for-profit firm that has purposefully placed something other than maximizing profit as its mission. Hence the name, non-profit entity.

A good non-profit almost always has a clear and measurable mission. And, like a for-profit firm, its ability to maximize the accomplishment of this mission is improved as more money comes in (i.e. revenue) and is diminished as more money goes out for non-mission costs (i.e. administration costs). Non-profits tend to separate costs that are applied to the mission from costs that are not applied to the mission.

So the non-profit version of the profit function looks like the following.

Notice that non-profits still want to maximize revenue (i.e. R(∙) function) and minimize administration costs (i.e. the C(∙) function) because these two factors drive how many dollars can be applied to the non-profit’s mission. This is a lot like for-profits wanting to maximize revenue and minimize costs. These two factors in a for-profit drive how many dollars can be applied to the for-profit’s mission of providing residual profit to the owners who took on the risk of the enterprise in the first place.

For a non-profit, the residual dollars of revenue after costs do not belong to the owners who would then use them as they see fit. Instead these dollars are fed into a new function, the M(∙) function. This M(∙) function represents how much progress is made toward the non-profit’s mission for each dollar that is spent on the non-profit’s mission. The input to the M(∙) function is dollars spent on mission costs and the output of the M(∙) function, i.e. μ, is some measure of mission accomplishment. The input to the M(∙) function is analogous to the profit in a for-profit, except that the non-profit has restricted how these dollars can be used: they can only be applied to the non-profit’s stated mission.

Just like for-profits, non-profits want to maximize revenue and minimize at least some types of costs. Unlike for-profits, they want to maximize costs applied to the mission and maximize the rate at which these dollars accomplish the non-profit’s mission (i.e. they want to steepen the slope of the M(∙) function).

Generally, non-profits should possess a relatively steep slope to the M(∙) function to be economically justified. Otherwise, the role of maximizing the non-profit’s mission would probably be better handled by for-profit owners who voluntarily contribute duly earned profits toward a societally beneficial mission. These voluntary contributions can often avoid some of a non-profit’s administration costs and are free to be applied more flexibly than residual dollars would be within a non-profit.

1.3 Managerial Accounting’s Place in the Firm

1.3.1 Overlap with Other Accounting Areas

1.3.1.1 Financial Accounting

Cost accounting is relevant to the student aiming for a financial accounting position (e.g. general ledger accountant, staff accountant, or some related position). There is an astonishing amount of overlap between the cost accounting work and the financial accounting work done at most modern firms. For simplicity, much of a firm’s cost accounting information is recorded through journal entries and T-accounts on the general ledger. Maintaining the general ledger, therefore, means doing some cost work too.

Add to that the fact that modern enterprise resource planning systems often require cost information to be recorded at the time a journal entry is made, even if that information is not tied to a general ledger T-account. So an entry to record the purchase of replacement parts cannot just debit the “replacement parts expense” account. It also has to be coded for which department, cost center, team, work order, and even individual it pertains to. These latter designations are cost accounting-driven classifications. Financial accounting really doesn’t care if these parts were for Work Order #00419820-A or #00679827-X. But cost accounting does care about that distinction because managers might need information on how much these respective work orders cost, which helps them assign responsibility and maximize profit.

This cost accounting coding is often done by staff accountants who told their cost accounting professors they were never going to use cost accounting at work.

1.3.1.2 Audit and Assurance

“But wait,” you say. “No one goes right into industry as a staff accountant nowadays. First, I’m getting a gig as an auditor!”

Good for you. Have a fun busy season.

Auditors need to know about cost accounting too. AU 314.29 says that “the auditor should obtain an understanding of the entity’s objectives and strategies, and the related business risks that may result in material misstatement of the financial statements.” (Also check out the subsections following 314.29.) In other words, you have to get inside the head of the managers you are auditing. What bothers them? What motivates them? Where are they headed? What audit risks do these things present? Because managers use cost accounting information, getting inside the manager’s head means understanding cost accounting.

By way of analogy consider this scene from the 2002 movie Minority Report. The experienced cop understands how a killer thinks, what motivates him, and what information he operates on. The inexperienced cop (inexperienced in homicide investigations anyway) lacks a comparable understanding of killers’ typical thoughts and activities and thus does not understand the significance of the fact pattern before them.

Similarly, auditing a client without understanding what makes the client tick can make one susceptible to unreasonable assertions and can make one blind to significant clues buried within the fact pattern the client presents.

For example, consider the risk of material misstatement from warranties. Warranty expense estimates rely, in part, on assumptions about the quality of the finished goods under warranty. A huge driver of finished goods quality is raw materials quality. How can you appropriately evaluate the audit risk associated with warranty expenses if you don’t know how the firm’s standard cost and variance numbers work? These numbers can tell you a lot about raw material quality. They can also tell you about raw materials-related pressures that motivate managers’ choices and probably affect audit risk.

The best auditors understand the managers they audit, meaning they understand the cost accounting information those managers depend on.

1.3.1.3 Tax Accounting

If you’re going into tax, you can ignore cost accounting.

Just kidding. The cream of the tax accountant’s crop often isn’t tax compliance, it’s tax consulting. That is, both the client and the tax accountant can benefit significantly more from a good plan for future years’ taxes than from the relatively mechanical completion of this year’s tax forms.

Now imagine a client who could significantly reduce next year’s tax liability by in-sourcing a process for his or her business (e.g. through Section 179 depreciation). However, the client resists. What are you going to do, write an angry email? Lose that client?

If you hope to convince the client, it would help if you understand the make-or-buy decision the client is making. It may be that even with the tax savings it is still less profitable to in-source the process in question. I hope you paid attention in cost accounting, which is where we cover make-or-buy decisions.

1.3.1.4 Other Areas

The same logic can be extended to accounting majors and non-majors interested in AIS, supply chain, marketing, management, and so forth. I expect that you’d benefit from a richer understanding of cost accounting in any field where you deal with managers who rely on cost accounting information to maximize profit. That cost accounting information may just tell you more than you thought about your area of interest.