Management Accounting Information for Activity and Process Decisions

Management Accounting Information for Activity and Process Decisions Chapter 5

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

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

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

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

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?

Relevant Costs for the Replacement of a Machine • Sunk costs • $30,000 cost of old machine • $5,200 monthly loan payment for old machine

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

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

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

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

Make-or-Buy Decisions – Example

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

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

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

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

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

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

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

Theory of Constraints • The theory of constraints relies on the use of three measures • Throughput contribution is the difference between revenues and direct materials for the quantity of product sold • Investments equal the materials costs contained in raw materials, work-in-process, and finished goods inventories • Operating costs are all other costs, except for direct materials costs, that are needed to obtain throughput contribution

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

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

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)

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

WIP Accumulation • Work-in-process inventory accumulates at processing stations in a conventional organization for three reasons • Handling work in batches • If the rate at which each processing area handles work is unbalanced, work piles up at the slowest processing station • If processing area managers are evaluated on their ability to meet production quotas

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

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

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

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

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

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

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 time processing time + moving time + storage time + inspection time

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

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

Quality • Quality usually may be viewed as hinging on two major factors: • Satisfying customer expectations regarding the attributes and performance of the product • Ensuring that the technical aspects of the product’s design and performance conform to the manufacturer’s standards

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

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

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)

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)

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

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

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

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

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

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 Internal Failure Costs

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

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

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

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

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

Management Accounting Information for Activity and Process Decisions