Characteristics of Normal Volume

        Many accountants reject the normal-volume notion and maintain that each year must .stand by itself; that is, each year's overhead must be applied to each year's production, written off as a loss, or both. This attitude arises from (a) the widespread conviction that the year is the key time period, and (b) adherence to the idea that overhead costs for a given year generally must cling or attach to the units produced during that year regardless of the relationship of that year's activity to average long-run activity.
     A more convincing reason for using master-budget volume as a denominator is the overwhelming forecasting problem that accompanies the determination of normal volume'. Sales not only fluctuate cyclically but have trends over the long run. In effect, the use ol normal volume implies an unusual talent for accurate long-run forecasting. Many accountants and executives who reject the normal volume as a denorninator ciaim that the nature of their company's business precludes accurate forecasts beyond one year.
Where companies use normal volume, the objective is to choose a period long enough to average out sizable fluctuations in volume and to allow for trends in sales. The uniform rate for applying fixed overhead supposedly provides for "recovery" of fixed costs over the ions run. Companies expect that overapplications in some years will be offset by underapplications in other years.
       Conceptually, when normal volume is the denominator, the yearly overapplied or underapplied overhead should be carried forward on the balance sheet. Practically, however, year-end balances are closed directiy to Income Summary, because the accounting profession (and the Internal Revenue Service) generally views the year as being the terminal time span for allocation olunderapplied or overapplied overhead.

      Many managements want to keep running at full capacity, which really means practical capacitv. Their "normal volume" for applying fixed costs is "practical capacity"; anything less reduces profits and is undesirable. Where product costs are used as guides lor pricing, some managers say that this policy results in more competitive pricing, which maximizes truth volume and profits in good times and bad. Of course, profits also depend on lactors other than physical volume-for example, the elasticity of demand. The accounting effects of such a policy are lower unit costs for inventory purposes and the almost perpetual appearance of an unfavorable production volurne variance, sometimes described on the income statements as loss from idle capacity.
     Using practical capacity as a denominator volume has become increasingly popular with American businesses. As indicated earlier, over 21 percent of the surveved companies prefer to use practical capacity. A major reason is probably the position of the internal Revenue Service, which forbids variable costing but per- mits using practical capacitv as a denominator volume in conjunction rvith absorption costing. As compared with normal volume or master-budget volume, the practical- capacity denominator volume results in the faster write-offs of fixed factory overhead as a tax deduction.
     There is no requirement that American companies use the same denominator volumes for internal managernent purposes and for income-tax purposes. Nevertheless, the economies of recordkeeping often lead to the same accountiug for management and tax purposes.

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Characteristics of Capacity

The choice of a capacity size is usually the result of capital-budgeting decisions, which are reached after studying the expected impact of these capital outlays on operations over a number of years. The choice may be influenced by a combination of two major factors, each involving trade-off decisions and each heavily depending on long-range forecasts of demand, material costs, and labor costs:

1. Provision for seasonal and cyclical fuctuations in demand. The trade-off is between (a) additional costs of physical capacity and (b) the costs of inventory stockouts and/or the carrying costs of inventory safety stocks of such magnitude to compensate for seasonal and cyclical variations, the costs of overtime premium, sirbcontracting, and
2. Provision for upward trends in demand. The trade-off is between (a) the costs of con- structing too much capacity for initial needs and (b) the later extra costs of satisfying demand by alternative means. For example, should a factory designed to make color television tubes have an area of 100,000. 150,000, or 200,000 square feet?

Although it can be defined and measured in a particular situation, capacity is an illusive concept. Consider, for example, the following:

Capacity planning requires definition and measurement of capacity in a manner relevant to questions which arise in the planning process. This problem has two aspects. First, it is necessary to specify capacity in terms of how much the company should be prepared to make and to sell. Second, the capacity ofspecific facilities available or to be acquired must be determined... A variety of altemative combinations of capacity and operating patterns is usually possible

There is much fluidity in the quotation above. To most people, the term capacity 'implies a constraint, an upper limit. We sometimes hear, I'm working at capacity now. I simply can't do more.This same notion of capacity as a constraint is commonly held in industry.

Although the term capacity is usually applied to plant and equipment, it is equally applicable to other resources, such as people and materials. A shortage of direct labor, executive time, or materials may be critical in limiting company Production or sales.

The upper limit of capacity is seldom absolutely rigid, at least from an engineering viewpoint. That is, ways-such as overtime, subcontracting, or paying premium prices for additional materials-can usually be found to expand production. But these ways may be totally unattractive from an economic viewpoint. Hence, the upper limit of capacity is specified by management for current planning and control purposes after considering engineeting and economic factors. In this way, the upper limit is usually imposed by management' not by external forces'

Measurement of capacity usually begins with theoretical capacity (also-called maximum or ideal capacitv) that assumes the production of output 100 percent of the time. Then deductions are made for sundays, holidays, downtime, changeover time' and similar iterns to attain a measure of practical Capacity. The latter is defined as the maximum level at which the plant or department can operate efficiently. Practical capacity often allows for unavoidable operating interruptions such as repair time or waiting time (downtime).

Two other commonly used levels of capacity utilization are

1. NOrmal volume, which is the level of capacity utilization (which is less than 100 percent of practical capacity) that will satisfy average consumer.demand over as pan of time (often five years) that includes seasonal, cyilical, and trend factors; and
2. Master-budget Volume, which is usually the anticipated level of capacity utilization for the coming Year. There are apt to be differences in terms used between companies so be sure to obtain their exact meaning in a given situation. For example, master-budget volume is often called expected annual volume or expected annual capacity or expected annual activity or master-budget activity.

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Standards for Control:Presence of Expected Variances

Currently attainable standards may be used simultaneously for product costing, master budgets, and motivation. Throughout the illustrations and problems in this book, unless otherwise stated, currently attainable standards are assumed to be in use. If standards are not cunently attainable because they are perfection standards, the amount budgeted for financial (cash) planning purposes has to differ from the standard. Otherwise, projected income and cash disbursements will be forecast incorrectly. In such cases, perfection standards may be used for compiling performance reports, but expected variances are stipulated in the budget for cash pianning. For example, if unusually strict labor standards are used the standard cost per finished.

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Standards for Control:Current Attainability

How demanding should standards be? Should they express perfection, or should they allow for the various factors that prevent perfect performance?
Perfection, ideal, maximum, efficiency, or theoretical standard costs reflect industrial engineers' dreams of a "factory heaven." perfection standard costs are the absolute minimum costs that are possible under the best conceivable operating conditions, using existing specifications and equipment. Ideal standards, like other standards, are used where the management feels that they provide psychologically productive goals.
Currently attainable standard costs are the costs that should be incurred under very efficient operating conditions. They are difficult but possible to achieve. Attainable standards are looser than ideal standards because of allowance for normal spoilage, ordinary machine breakdowns, and lost time. However, attainable standards are usually set tight enough so that the operating people will consider the achievement of standard performance to be a satisfying accomplishment. In other words, variances are more likely to be slightly unfavorable than favorable-but favorable variances may be attained by a little more than expected efficiency. Currently attainable standards are the most widely used because the resulting standard costs can serre marily purposes simultaneously and because they have thl most appealing motivational impact on employeess

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Advantages of Budgets

Budgets are a major feature of most control systems. When administered intelligently, budgets (a) compel planning, (b) provide performance criteria, and (c) promote communication and coordination.

Compelled planning
"Plan ahead" is a redundant watchword for business managers and for any individual as well. Yet too often, everyday problems interfere with such planning; operations drift along until the passage of time catches the firms or individuals in undesirable situations that should have been anticipated and avoided. Budgets formulate expected performance; they express managerial targets. Without such targets, operations lack direction, problems are not foreseen, results lack rneaning, and the implications for future policies are dwarfed by the pressure of. the present. The planning role of all levels of management should be accentuated and enlarged by a budgetary system. Managers will be compelled to look ahead and will be ready for changing conditions. This forced planning is by far the greatest contribution of budgeting to management.
Budgets have direct or indirect influence on strategies. Strategies are the relatively general and permanent plans that change as conditions or objectives change-for example, when new products are added, old products are dropped, organizations are revamped, or production methods are changed. Budgets affect the formulation of overall organization strategies and then help to implement such strategies. Thus, strategic planning (long-range planning) is often affected either directly by budgetary information or indirectly by the thinking that has evolved from dealing with budgets.

Framework for Judging Performance
Despite the existence of complex computers and automation, individuals still run organizations, from the president down to the supervisor of the smallest department. Employees do not like to fumble along not really knowing what their superiors anticipate or to see such expectations vary with, for example, the conditions of the superior's sinus trouble. The budget helps meet this difficulty by letting employees know what is expected of them.
      As a basis for judging actual results, budgeted performance is generally viewed as being a better criterion than past performance. The fact that sales are better than last year's, or that direct-labor costs are lower than last year's, may be encouraging-but it is by no means conclusive as a measure of success, For example, the news that a company sold 100,000 units this year as compared with 90,000 units in the previous year may not necessarily be greeted with joy. Perhaps sales should have been 112,000 units this year. A major weakness of using historical data for judging performance is that inefficiencies may be buried in the past performance. Furthermore, the usefulness of comparisons with the past may be hampered by intervening changes in technology, personnel, products, competition: and general economic conditions.
 

Communication and Coordination
Coordination is the meshing and balancing of all factors of production and of all the departments and functions of the organization so that its objectives are attained- that is, the interests of the individual managers are subordinated for the benefit of the organization as a whole.
The concept of coordination implies, for example, that purchasing officen integrate their plans with production requirements, and that production officers use the sales budget as a basis for planning personnel needs and utilization of machinery.

Budgets help management to coordinate in several ways:

1. The existence of a well-laid plan is the major step toward achieving coordination. Executives are forced to think of the relationships among individual operation, and the company as a whole.
2. Budget help to restrain the empire-building efforts of executives. Budgets broaden individual thinking by helping to remove unionscious biases on the part of engineers, sales managers and production officers.
3. Budgets help to search out weaknesses in the organizational structure. The formulation and administration of budgets isolate problems of communication, of fixing responsibility, and of working relationships.

      The idea that budgets improve coordination and communication may look promising on paper, but it takes plenty of intelligent administration to achieve in practice for instance, the use of budgets to judge perforrnance may cause managers to wear blinders and concentrate more than ever on their individual worlds. We shall examine this problem in more detail later in the posting.
   The cost-conscious, cooperative attitudes toward budgetary control must permeate all levels of management. A skeptical top-management attitude will trickle down to the detriment of the entire company. Top management must understand and enthusiastically support the budget and all aspects of the control system.
      Administration of budgets must not be rigid. changed conditions call for changes in plans. The budget must receive respect, but it does not have to be so revered that it prevents a manager from taking prudent action. A department head Prepares and accepts his budget; he commits himself to the outlined performance. But if matters develop so that some special repairs or a special advertising outlay will best serve the interests of the firm, the manager should leel free to request permission for such outlays, or the budget itself should provide enough flexibility to permit a manager reasonable discretion in deciding how best to get his job done.

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Major Features of Budgets:Definition and Role of Budgets

Evolution of systems

Reflect on the evolution of control systems. As small organizations begin, there is usually a dominant means of control physical observation. A manager sees, touches and hears the relationships between inputs and outputs; he or she oversees the behavior of various personnel.

Major features of budgets: definition and role of budgets
A budget is a quantitative expression of a plan of action and an aid to coordination and implementation. Budgets may be lormulated for the organization as a whole or for any subunits. The master budget summarizes the objectives of all subunits of an organization-sales, production, distribution, and finance. It quantifies the expectations regarding future income, cash flows, financial position, and supporting plans. These are the culmination of a series of decisions resulting from a careful look at the organization's future. In most cases, the master budget is the best practical approximation to a formal model of the total organization: its objectives, its inputs, and its outputs.

Wide use of budgets
Budgetary svstems are more common in larger companies, where formalized and sophisticated techniques are developed to serve management. Still, the usefulness of budgeting to very small concerns should not be overlooked. Many deaths (and unwar. rarrted creations) of small businesses could have been circumvented by an early attempt to quantify the dreams of headstrong but sloppy-thinking entrepreneurs who never directly faced the uncertainties of their venture.
For exarnple, a small business with lofty hopes moved into a lush rnarket for school equipment. However, failure to quantify the long collection periods, to forecast a maximum sales potential, and to control costs from the outset resulted in disaster within a year. Budgets for small businesses need not be as elaborate as those outlined in budgeting textbooks, but some budgeting is uselul to an enterprise of any size. In fact, many cornpanies have implicit budgets without even realizing their existence; that is, every manager considers the future as decisions are being made.
Many managers claim that the uncertainties peculiar to their business make budgets impractical for them. Yet one can nearly always find at least some companies in the same industry that use budgets. Such companies are usually among the industry leaders, and they regard budgets as indispensable aids. The point is that managers must grapple with uncertainties, either with a budget or without one. The advocates of budgeting maintain that the benefits from budgeting nearly always exceed the costs. Some budget program, at least, will be helpful in almost every organization.

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Product-Costing and Control Purposes

All costs are accumulated to facilitate someone's decisions. But all these decisions cannot be foreseen, so systems are designed to fulfill predetermined general desires that are commonplace among managers. We will frequently distinguish between the product-costing purpose of a system and all other purposes. For convenience, we will sometimes refer to all other purposes as planning and control purposes, budgetary-control purposes, or, for brevity, as the control purpose.
Aside from meeting the obvious external reporting demands for inventory valuation and income determination, managers want product costs for guiding their decisions regarding pricing and product strategies. In addition, managers want departmental costs (or costs of other parts of the organization) for judging the perforrnance of their subordinates and the parts of the organization as economic investments.
Management accounting systems fulfill these general planning and control purposes by choosing parts of the organization as cost objectives. The aim is to compile costs by responsibility or accountability center. For example, costs are often routinely traced to a cost center, the smallest segment of activity or area of responsibility for which costs are accumulated. Typically, cost centers are departments, but in some instances a department may contain several cost centers. For example, although a machining department may be under one foreman, it may contain various groups of machines, such as lathes, punch presses) and milling machines. Each group of machines is sometimes regarded, as a separate cost center with its olvn assistant foreman.

Another major cost objective is product costing lor purposes of inventory valuation and income determination. Therefore, the systerir must trace costs to these two major cost objectives: departments and products. This tracing is frequently accomplished in two steps: (1) accumulation of costs by departments and (2) application of the department costs to the physical units (or other measures of output) that pass through the departments. This second step is sometimes called cost absorption rather than cost application,

Note especially that no matter what label is used to describe how costs are applied for product costing, the costs are always accumulated by responsibility center for control purposes, The three major ways of achieving product costing will be described in sequence.

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Job Order Costing

Job-order (or job-cost or production-order or job) costing systems are used by organizations whose products or services are readily identified by individual units or batches, each of which receives varying inputs of direct materiais, direct labor, and factory overhead. Industriesthat commonly use job-order methods include construction, printing, aircraft, furniture, and machinery.

Although a manufacturing situation is illustrated in this posting. Exampled include auto repair, auditing and consulting engagements, hospital cases, social-welfare cases and research projects.

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Cost-Volume-Profit Assumptions:Relevant Range

The modified chart highlights the fact that tenuous, static assumptions underlie a graph of cost-volume-profit relationships. The sales and expense relationships may be valid only within a band of activity called the relevant range. The relevant range is usually u a range in which the firrn has had some recent experience. But the same relationships are unlikely to persist if volume falls outside the limits of the relevant range. some fixed costs may be avoided at low-volume levels.

Two principal differences between the accountant's and the economist's breakeven charts are:

1. The accountant usually assumes a constant unit variable cost instead of a unit variable cost that changes with the level of production. In other words, the accountant assumes linearity, but the economist does not.
2. The accountant's sales line is drawn under the assumption that price does not change with the level of production or sales, but the economist assumes that price changes may be needed to spur sales volume. Therefore, the economist's chart is nonlinear.

The economist's assumptions are undoubtedly more valid; the accountant’s simplifications may or may not lead to less-profitable decisions. The point is that obtaining more accurate cost functions is often difficult and expensive. Managers and accountants are aware of the simplifications introduced by the assumptions of linearitv, but generally they have decided that the value of any additional information that might be gained from more accurate data would not exceed the additional costs of obtaining the data. They also take comfort in knowing that most of their decisions.

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The breakeven Point

          We obtain an overview of decision models by examining the interrelationships of changes in costs, volume, and profits-sometimes too narrowly described as breakeven analysis. The breakeven point is often only incidental in these studies. Instead, the focus is on the impact upon operating income or net income of various decisions that affect sales and costs. the breakeven point is that Point of activity (sales volume) where total revenues and total expenses are equal; that is, there is neither profit nor loss. The terms net income and net profit are used interchangeably.

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Costs in General:Cost System

Cost accumulation is the collection of cost data in an organized way via an accounting system. The word system implies regularity-for example, the routine compilation of historical data in an orderly fashion. Other cost data may be gathered on occasion as desired (for example, replacement costs of certain equipment). Of course, continuous compilation is more expensive than occasional compilation; the relative elaborateness of systems is fundamentally a cost-benefit decision as to what data to "buy" on a regular basis.
Cost objectives are chosen not for their own sake but to facilitate decisions. The most economically feasible approach to the design of a cost system is typically to assume some comrnon classes of decisions (for example, inventory control and labor control) and to choose cost objectives (for example, products and departments) that relate to those decisions, Nearly all systems at least accumulate actual costs, which are amounts determined on the basis of costs incurred (historical costs), as distinguished from predicted or forecasted costs. The relationships are exemplified as in the chart on the next posting.
Years ago many cost accounting systems emphasized one cost objective-product costing for inventory valuation and income determination-as if it were an end in itself. Consequently, many systems failed to collect the data in a form suitable for other purposes. However, modern systems have a more balanced approach; obtaining the inventory cost of finished product units is regarded as only one purpose. Other purposes include getting a reliable basis for predicting the economic consequences of a host of decisions, including:

1. Which products should we make? Delete?
2. Should we manufacture a product component or should we acquire it outside?
3. What proces should we charge?
4. Should we buy the proposed equipment?
5. Should we change our manufacturing methods?
6. Should we promote this manager?
7. Should we expand the department?

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Costs in general:Cost objectives

          Accountants usually define costs as resources sacrificed or foregone to achieve a specific objective. For now, consider costs as being measured in the conventional accounting way, as monetary units (for example, dollars) that must be paid for goods and services. To guide decisions, the manager wants data pertaining to a variety of purposes. He or she wants the cost of something. This something may be a product, a group of products, a service rendered to a hospital patient or a bank customer, a machine-hour, a social-welfare project, a mile of road, or any conceivable activity. We call this a cosl objective and define it as any activity for which a separate measurernent of costs is desired.

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Purposes Of Management Accounting And Financial Accounting:Boundaries of Cost Accounting

          Where does "cost accounting" fit within the above framework? In its broadest sense,cost accounting has the same three major purposes as those deScribed above. However, its third purpose, costing products for inventory valuation and income determination, simultaneousiy fulfills the demands of outsiders and those of management for such information. so, when viewed in this way, cost accounting is management accounting, plus a small part of financial accounting to the extent that its product costing function satisfies the requisites of external reporting. 

          Originally, the label cost accounting referred to the ways of accumulating and assigning historical costs to units of product and departments, primarily for purposes of inventory valuation and income determination. Today, cost accounting is generally indistinguishable from management accounting because it serves multiple purposes. Most fundamentaly, cost accounting now refers to the gathering and providing of information for decision needs of all sorts, ranging from the management of recurring operations to the making of nonrecurring strategic decisions and the formulation of major organizational policies. As in the past, cost accounting also helps fulfill the legal requirements of reporting to stockholders, creditors, government agencies, and other external parties. 

          We need not be greatly concerned with the boundaries of cost accounting. The major point is that the focus of a modern cost accounting system is on helping managers deal with both the immediate and the distant future. Its concern with the past is justified only insofar as it helps prediction and satisfies external reporting requirements.

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Purposes Of Management Accounting and Financial Accounting:Basic Distinctions

The accounting system is the major quantitative information system in almost every organization. It should provide information for three broad purposes:

1. Internal reporting to managers, for use in planning and controlling routine operations
2. Internal reporting to managers, for use in making nonroutine decisions and in formulating major plans and-policies
3. Externai reporting to stockholders, government, and other outside parties

Both management and external parties share an interest in all three important purposes, but the emphasis differs. External reporting is mainly concerned with the third purpose: the historical, custodial, and stewardship aspects of accounting. This area is usually called financial accounting, which is heavily constrained by generallv accepted accounting principles. on the other hand, internal reporting focuses on the first two purposes: management planning and control. This area is usually called rnanagement accounting, which has looser constraints than financial accounting. The distinction between financial accounting and management accounting became institutionalized in the United States in 1972 when the National Association of Accountants (NAA), the largest association of internal accountants in the United States, established a program leading to the Certificate in Management Accounting (CMA)., The Certified Management Accountant (CMA) is the internal accountant's counterpart of the CPA (Certified Public Acccuntant).

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