Managerial accounting garrison norren 11th ed

Chapter 1
Managerial Accounting
and the Business Environment
Learning Objectives
LO1. Identify the major differences and similarities between financial and managerial
accounting.
LO2. Understand the role of management accountants in an organization.
LO3. Understand the basic concepts underlying Just-In-Time (JIT), Total Quality
Management (TQM), Process Reengineering, and the Theory of Constraints (TOC).
LO4. Understand the importance of upholding ethical standards.

New in this Edition
• The discussions of JIT, TQM, and Process Reengineering have been condensed.
• Many new In Business focus boxes have been written.

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. (Exercise 1-1.) 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.”

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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. (Exercise 1-1.)
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.

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•
•
•
•

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. (Exercise 1-1.) 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.

Organization charts. Exhibit 1-3 is useful in discussing the structure of an organization.
Informal communication links are particularly important.

3.

Line and staff relationships. Exhibit 1-3 is also useful for discussing line and staff
positions. 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.

4.

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. (Exercise 1-2.) Over the last two 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.

In the text, we very briefly describe 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.

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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 nonconstraint 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

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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.

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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-valueadded 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

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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. (Exercise 1-4.) 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.

In the text we use a 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.

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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.

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Assignment Materials
Assignment
Exercise 1-1
Exercise 1-2
Exercise 1-3
Problem 1-4
Problem 1-5
Problem 1-6
Problem 1-7
Problem 1-8

Topic
The roles of managers and management accountants ...........
The business environment.....................................................
Ethics in business ..................................................................
Preparing an organization chart ............................................
Ethics and the manager .........................................................
Line and staff positions; organization chart ..........................
Ethics in business ..................................................................
Ethics; just-in-time purchasing .............................................

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Level of
Difficulty
Basic
Basic
Basic
Basic
Basic
Medium
Medium
Medium

Suggested
Time
10 min.
10 min.
15 min.
30 min.
20 min.

30 min.
20 min.
30 min.


1

2

10

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Chapter 1
Lecture Notes
Helpful Hint: Before beginning the lecture, show
students the first segment from the first tape of the
McGraw-Hill/Irwin Managerial/Cost Accounting video
library. This segment introduces students to many of
the concepts discussed in chapter 1. The lecture notes
reinforce the concepts introduced in the video.

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I.

Chapter theme: This chapter serves four main purposes.
First, it explains the differences and similarities between
financial and managerial accounting. Second, it describes

the role of management accountants in an organization.
Third, it explains the basic concepts underlying Just-InTime (JIT), Total Quality Management (TQM), Process
Reengineering, and the Theory of Constraints (TOC).
Fourth, it discusses the importance of upholding ethical
standards.
The work of management and the need for managerial
accounting information

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A. Managers carry out three main activities – planning,
directing and motivating, and controlling.
i.

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Planning
1. The first step in planning is to identify
alternatives and then to select from among
the alternatives the one that does the best
job of furthering the organization’s
objectives.

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3

4

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2. Once alternatives have been identified, the
plans of management are often expressed
formally in budgets.
a. Budgets are usually prepared under the
direction of the controller, who is the
manager in charge of the accounting
department.
b. Typically, budgets are prepared
annually.

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ii.

1. In addition to planning for the future,
managers must oversee day-to-day
activities to keep the organization
functioning smoothly.
2. Managerial accounting data, such as daily
sales reports, are often used in this type of
day-to-day decision making.

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iii.

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Directing and motivating

Controlling
1. In carrying out the control function,
managers seek to ensure that the plan is
being followed. Feedback, which signals
whether operations are on track, is the key to
effective control.
a. A performance report compares
budgeted to actual results. It suggests
where operations are not proceeding as
planned and where some parts of the
organization may require additional
attention.

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iv.

1. The work of management, which is known
as the planning and control cycle, can be
depicted as shown.

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II.

The planning and control cycle

Comparison of financial and managerial accounting
A. Seven key differences
i.

Users
1. Financial accounting reports are prepared
for external parties, whereas managerial
accounting reports are prepared for internal
users.

ii.

Emphasis on the future
1. Financial accounting summarizes past
transactions. Managerial accounting has a
strong future orientation.

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iii.

Relevance of data
1. Financial accounting data are expected to be
objective and verifiable. Managerial
accountants focus on providing relevant
data even if it is not completely objective or
verifiable.

“In Business Insights”
Management accounting systems should be flexible
enough to provide whatever data are relevant for a
particular decision.
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“Why Do You Ask?” (page 8)
• Caterpillar has long been on the forefront of
management accounting practice. When asked by
a manager for the cost of something, accountants
at Caterpillar have been trained to ask “What are
you going to use the cost for?”
• One management accountant at Caterpillar
explains: “We want to make sure the information
is formatted and the right elements are included.
Do you need a variable cost, do you need a fully

burdened cost, do you need overhead applied, are
you just talking about discretionary cost? The cost
that they really need depends on the decision they
are making.”
iv.

Less emphasis on precision
1. Financial accounting focuses on precision
when reporting to external parties.
Managerial accounting aids decision makers
by providing good estimates as soon as
possible rather than waiting for precise data
later.

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v.

Segments of an organization
1. Financial accounting is concerned with
reporting for the company as a whole.
Managerial accounting focuses more on the
segments of the company. Examples of
segments include:
a. Product lines, sales territories,
divisions, departments, etc.

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vi.

Generally Accepted Accounting Principles
(GAAP)
1. Financial accounting conforms to GAAP.
Managerial accounting is not bound by
GAAP.

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vii. Managerial accounting – not mandatory
1. Financial accounting is mandatory because
various outside parties require periodic
financial statements. Managerial accounting
is not mandatory.
III. Organizational structure
A. Decentralization
i.

Decentralization is the delegation of
decision-making authority throughout an
organization by providing managers with the

authority to make decisions relating to their
area of responsibility.

ii.

An organizational chart shows how
responsibility is divided among managers and
it shows formal lines of reporting and
communication.

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B. Line and staff relationships
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i.

An organization chart also depicts line and
staff positions in an organization.

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1. A person in a line position is directly
involved in achieving the basic objectives of
the organization.
2. A person in a staff position is indirectly
involved in achieving those basic objectives.
Staff positions support line positions, but
they do not have direct authority over line
positions.

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C. The Chief Financial Officer
i.
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The Chief Financial Officer (CFO) is the
member of the top management team who is
responsible for providing timely and relevant
data to support planning and control
activities and for preparing financial
statements for external users.
1. The controller reports to the CFO.

“In Business Insights”
CFOs and their subordinates in most organizations
contribute in numerous ways beyond just preparing
financial statements. For example:
“Beyond the Numbers” (page 11)
• Judy C. Lewent is the CFO of Merck, a major
pharmaceutical company. She is in charge of 750

people.
• Merck’s chairman, CEO, and president Raymond
Gilmartin says this about Lewent “Many CFOs
take as their prime directive the timely, accurate
delivery of detailed financial data and analysis to
top management. While the importance of these
services cannot be overestimated, with Judy they
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are simply one of the many ways she contributes
to the business.”
• Gilmartin went on to say that Lewent helps “make
decisions about which developmental-product
projects to fund and how to structure our product
franchises, acquisition possibilities, and licensing
arrangements.”
“What Does It Take?” (page 12)
• A controller at McDonald’s claims that its most
successful management accountants must possess
numerous skills.
• For example, they need to be experts in the
company’s business and accounting software.

They need to have a working knowledge of what
people do in marketing, engineering, human
resources, and other departments. They also need
to understand how the processes, departments,
and functions work together to run the business.
IV. The changing business environment

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A. We are going to discuss six changes in the business
environment, namely Just-In-Time production, Total
Quality Management, Process Reengineering, the
Theory of Constraints, international competition, and ecommerce.
B. Just-In-Time (JIT)

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i.

When companies use the JIT production and
inventory control system, they purchase
materials and produce units only as needed
to meet actual customer demand. The

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receipt of a customer order triggers the steps
as shown.
1. When applied in a manufacturing setting,
JIT systems seek to minimize raw
materials, work in process, and finished
goods inventories.

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ii.

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Other improvements required to support JIT
and inventory reduction include:
1. Reduce the number of suppliers to a
reliable few who can make frequent
deliveries of defect-free goods in small lot
sizes.
2. Improve the plant layout by creating a
focused factory or manufacturing cell.
a. An improved plant layout can
dramatically reduced throughput time
(also known as cycle time), which is
the time required to make a product.

“In Business Insights”
Numerous companies have adopted cellular
manufacturing to cut costs and boost productivity. For
example:
“Canon Goes Cellular” (page 14)
• Canon has completely revamped its production
processes in its photocopier plants, ripping out
the conveyor belts and heavy equipment that used
to be the core of its assembly lines.
• Instead, Canon has adopted cell production with
small teams of about six workers concentrating on
building a single type of copying machine.
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