Management Accounting Information for Activity and Process Decisions

Chapter 5

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Evaluation of Financial Implications Managers must evaluate the financial implications of decisions that require trade-offs between the costs and the benefits of different alternatives

Financial information about the different types of costs form the basis of decisions about the organization’s activities and processes

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Relevant Costs and Revenues Whether particular costs and revenues are

relevant for decision making depends on the decision context and the alternatives available

Relevant costs - costs and revenues that differ across the decision alternatives

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Relevant Costs

Opportunity costs by definition are relevant costs for any decision

The costs that remain the same regardless of the alternative chosen are not relevant for the decision

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Sunk Costs are Not Relevant

Sunk costs often cause confusion for decision makers Costs of resources that already have been

committed and no current action or decision can change

Not relevant to the evaluation of alternatives because they cannot be influenced by any alternative the manager chooses

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Relevant Costs for the Replacement of a Machine Should Bonner dispose of the USC machine

it just purchased on September 1 and buy the new machine from Teo Company?

What costs are relevant for this decision?

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Relevant Costs for the Replacement of a Machine Sunk costs

$30,000 cost of old machine $5,200 monthly loan payment for old machine

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Relevant Costs for the Replacement of a Machine Cost increases and cash outflows:

$50,000 down payment on the new machine $6,000 monthly lease payments on new machine

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Relevant Costs for the Replacement of a Machine Cost Savings and Cash Inflows

$50,000 disposal of old machine $6,200 monthly cost savings:

$4,400 labor $1,000 materials $800 maintenance

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Assuming Responsibility for Decision Reversing a decision made a month earlier

may look like an error If the manager does not purchase the new

machine, his behavior may be viewed as suboptimal

The manager may garner respect by assuming responsibility for error

Manager needs to recognize sunk costs

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Make-or-Buy Decisions

As managers attempt to reduce costs and increase the competitiveness of their products, they face decisions about whether their companies should

Such make-or-buy decisions illustrate how to identify relevant costs and revenues

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Make-or-Buy Decisions – Example Std. Rear Std. Front Multicolor Curved

Product cost per unit:

Direct materials $ 36 $ 49 $ 56 $ 58

Direct labor 22 25 24 28

Unit-related support 14 16 18 20

Batch-related support 10 16 19 22

Product-sustaining overhead 6 12 14 19

Facility-sustaining overhead 8 10 11 14

Total manufacturing costs $ 96 $ 128 $ 142 $ 161

Bids from outside suppliers:

Lowest bid $ 82 $ 109 $ 140 $ 156

Second lowest $ 88 $ 116 $ 147 $ 164

Annual production (units) 36,000 48,500 6,800 8,700

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Avoidable Costs Those that are eliminated when a part, product,

product line, or business segment is discontinued If the production manager decides to outsource a

product, the company may avoid certain production costs

Contraction or redeployment of resources may allow the company savings

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Avoidable Costs

The company cannot dispose of part of the facility used to support the production of the standard rear lamp without disposing of the entire machine or building

Most facility-sustaining support costs represent the prorated costs of indivisible common facilities

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Avoidable Costs

Is there an alternative use for the part of the facility made available by not producing a product?

Indirect savings in facility-sustaining costs for the organization are relevant for the decision to outsource production, because they can arise only if the lamp is outsourced

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Summary of Financial Analysis If the standard rear lamp is outsourced, the

company may avoid $3,168,000 of manufacturing costs

The company would spend $2,952,000 to purchase the parts from the low-bid supplier

The company could save $216,000 by outsourcing

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Qualitative Factors For most decisions such as this, several additional

factors, which are more qualitative in nature, need to be considered: Permanence of the lower price Reliability of the supplier:

Many companies have adopted the practice of certifying a small set of suppliers who are dependable and consistent in supplying high-quality items as needed

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Facility Layout Systems There are three general types of facility

designs: Process layouts Product layouts Cellular manufacturing

Regardless of the type of facility design, a central goal of the design process is to streamline operations and thus increase the operating income of the system

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The theory of constraints (TOC) TOC maintains that operating income can be

increased by carefully managing the bottlenecks in a process A bottleneck is any condition that impedes or

constrains the efficient flow of a process A bottleneck can be identified by determining points

at which excessive amounts of work-in-process inventories are accumulating

The buildup of inventories also slows the cycle time of production

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Theory of Constraints

The theory of constraints relies on the use of three measures

1. Throughput contribution is the difference between revenues and direct materials for the quantity of product sold

2. Investments equal the materials costs contained in raw materials, work-in-process, and finished goods inventories

3. Operating costs are all other costs, except for direct materials costs, that are needed to obtain throughput contribution

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Theory of Constraints Emphasis is on the short-run optimization of

throughput contribution Assumes that operating costs as difficult to

alter in the short run

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Process Layouts All similar equipment or functions are grouped

together Production of unique products is done in small

batches Product follows a serpentine path, usually in

batches High inventory levels Products might travel for several miles within a

factory during the production process

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Process Layout in a Bank• The customer goes to the bank (a moving activity)• The bank takes the loan application from the

customer (processing activity)• Loan applications are accumulated (storage

activity) and passed to a loan officer (moving activity) for approval (both processing and inspection activity)

• Loans that violate standard loan guidelines are accumulated (storage activity) then passed (moving activity) to a regional supervisor for approval (processing activity)

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Process Layout in a Bank (

The customer is contacted when a decision has been made (processing activity)

If the loan is approved, then the loan proceeds are deposited in the customer’s account (processing activity)

In most banks, work-in-process stockpiles at each of the processing points or stations Loan applications may be piled on desk of the

bank teller, the loan office or the regional supervisor

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WIP Accumulation Work-in-process inventory accumulates at

processing stations in a conventional organization for three reasons

1. Handling work in batches

2. If the rate at which each processing area handles work is unbalanced, work piles up at the slowest processing station

3. If processing area managers are evaluated on their ability to meet production quotas

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Product Layouts In a product layout, equipment is organized to

accommodate the production of a specific product Product layouts exist primarily in companies with

high-volume production The product moves along an assembly line beside

which the parts to be added to it have been stored Placement of equipment or processing units is made

to reduce the distance that products must travel

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Product Layout in a Cafeteria People pass by containers of food and take

what they want Employees organize the food preparation

activities so that the containers are refilled just as they are being emptied

The ultimate goal is to reduce setup costs to zero and to reduce processing time to as close to zero as possible so that the system can produce and deliver individual products just as they are needed

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Cellular Manufacturing

The organization of a plant into a number of cells

Within each cell all machines required to manufacture a group of similar products are arranged in close proximity to each other

The machines in a cellular manufacturing layout are usually flexible and can be adjusted easily or even automatically to make different products

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Cellular Manufacturing

The shape of a cell is often a U shape, The number of employees needed to produce

a product can often be reduced due to the new work design

U shape also provides better visual control of the work flow

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Problems with Batch Production Creates inventory costs Creates delays associated with storing and

moving inventory These delays increase cycle times, thereby

reducing service to customers Delays may even happen before

manufacturing begins

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Inventory-Related Costs

Demands for inventory lead to huge costs in organizations, including the cost of moving, handling, storing, obsolescence & damage

Factory layouts and inefficiencies that create the need to hold work-in-process inventory may hide other problems leading to excessive costs of rework

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Processing time

Processing time – time expended for the product to be made

Processing cycle efficiency (PCE) – measure of the efficiency of the manufacturing process

PCE = processing timeprocessing time + moving time

+ storage time + inspection time

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Analysis of relevant costs and benefits of reorganization Total costs: $1,000,000 Three main benefits:

1. Increase in sales due to decreased production cycle time

2. Reduction in inventory-related costs because of reduced handling of WIP

3. Improvement in quality since defective processes are detected more quickly

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Cost of Nonconformance and Quality Issues Cost reduction has become a significant factor in the

management of most organizations The premise underlying cost reduction efforts today

is to decrease costs while maintaining or improving product quality in order to be competitive

If the quality of products and services does not conform to quality standards, then the organization incurs a cost known as the cost of nonconformance (CONC) to quality standards

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Quality

Quality usually may be viewed as hinging on two major factors:

1. Satisfying customer expectations regarding the attributes and performance of the product

2. Ensuring that the technical aspects of the product’s design and performance conform to the manufacturer’s standards

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Quality Standards Global competition has led to the

development of international quality standards

Company certification under these standards indicates to customers that management has committed their company to follow procedures and processes that will ensure the production of the highest-quality goods and services

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ISO9000 In 1987, the International Organization for

Standardization (ISO) developed the first ISO9000 Series of Standards

These standards were revised in 1994 and again in 2000

The goal of the member nations is to develop globally recognized independent (third party) quality system verification

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ISO9000 (2 of 6)

ISO 9000 contains more than 20 standards and documents

Because of the increase in the number of standards, ISO 9000:2000 was developed

ISO 9000:2000 consists of four primary standards and a greatly reduced number of supporting documents (guidance standards, brochures, technical reports, technical specifications)

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ISO9000

The four primary standards are: ISO 9000: Quality management systems –

Fundamentals and vocabulary ISO 9001: Quality management systems –

Requirements ISO 9004: Quality management systems – 

Guidance for performance improvement ISO 19011: Guidelines on quality and/or

environmental management systems auditing (To be published)

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ISO9000 The most significant changes in the revised

ISO 9000 standards are: Increased focus on top management commitment Emphasis on a process approach within the

organization Continual improvement Increased focus on enhancing satisfaction for

customers and other interested parties

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ISO9000

Eight quality management principles from best management practices: Customer focus Leadership Involvement of people Process approach System approach to management Continual improvement Factual approach to decision making Mutually beneficial supplier relationships

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Costs Of Quality Control

Classification of quality costs: Prevention costs Appraisal costs Internal failure costs External failure costs

Experience shows that it is much less expensive to prevent defects than to detect and repair them after they have occurred

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Prevention Costs Prevention costs are incurred to ensure that

companies produce products according to quality standards: Quality engineering Training employees in methods designed to

maintain quality Statistical process control Training and certifying suppliers so that they can

deliver defect-free parts and materials and better, more robust, product designs

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Appraisal Costs Appraisal costs relate to inspecting products

to make sure they meet both internal and external customers’ requirements

Inspection costs of purchased parts and materials

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Internal Failure Costs An internal failure occurs when the manufacturing

process detects a defective component or product before it is shipped to an external customer

Reworking defective components or products is a significant cost of internal failures

The cost of downtime in production is another example of internal failure

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External Failure Costs External failures occur when customers

discover a defect All costs associated with correcting the

problem For many companies, this is the most critical

quality cost to avoid

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Cost-of-Quality Report This information is compiled in a cost-of-quality

(COQ) report, developed for several reasons The report illustrates the financial magnitude of

quality factors Cost-of-quality information helps managers set

priorities for the quality issues and problems they should address

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Cost-of-Quality Report

The cost of quality report allows managers to see the big picture of quality issues

It allows them to try to find the root causes of their quality problems

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Just-in-Time Manufacturing Just-in-time (JIT) manufacturing is a

comprehensive and effective manufacturing system

Just-in-time production requires making a product or service only when the customer, internal or external, requires it

It uses a product layout with a continuous flow

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Implications Of JIT Manufacturing Just-in-time manufacturing is simple in theory but

hard to achieve in practice Organizations that use just-in-time manufacturing

must eliminate all sources of failure in the system

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Implications Of JIT Manufacturing

At the core of the JIT process is a highly trained workforce whose task is to carry out activities using the highest standards of quality

When an employee discovers a problem with a component, it is the responsibility of that employee to call immediate attention to the problem so that it can be corrected

Suppliers must be able to produce and deliver defect-free materials or components just when they are required

Preventative maintenance is also employed so that equipment failure is a rare event

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Implications Of JIT Manufacturing

Just-in-time manufacturing has two major implications for management accounting management accounting must support the move

to JIT manufacturing by monitoring, identifying, and communicating to decision makers the sources of delay, error, and waste in the system

the clerical process of management accounting is simplified by JIT manufacturing, due to the smaller inventory to monitor and report

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Implications Of JIT Manufacturing Important measures of a JIT system’s

reliability include the following benchmarks of manufacturing cycle effectiveness

Conventional labor and machine productivity ratios are inconsistent with the just-in-time production philosophy

Any significant management innovation, such as ABC or JIT, requires a major cultural change for an organization