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Management Accounting Information for Activity and Process Decisions


Management Accounting Information for Activity and Process Decisions Chapter 5 – PowerPoint PPT presentation

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Title: 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
    organizations 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

Sunk Costs are Not Relevant
  • Sunk costs often cause confusion for decision
  • Costs of resources that already have been
    committed and no current action or decision can
  • 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
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
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
  • 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

Avoidable Costs
  • Is there an alternative use for the part of the
    facility made available by not producing a
  • 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
  • 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
  • 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
  • Production of unique products is done in small
  • Product follows a serpentine path, usually in
  • 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 customers 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

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
  • Placement of equipment or processing units is
    made to reduce the distance that products must

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

Cellular Manufacturing
  • The organization of a plant into a number of
  • 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
  • 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
  • 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

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
  • 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
  • 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 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
    products design and performance conform to the
    manufacturers 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

  • In 1987, the International Organization for
    Standardization (ISO) developed the first ISO9000
    Series of Standards
  • These standards were revised in 1994 and again in
  • 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
  • Because of the increase in the number of
    standards, ISO 90002000 was developed
  • ISO 90002000 consists of four primary standards
    and a greatly reduced number of supporting
    documents (guidance standards, brochures,
    technical reports, technical specifications)

  • The four primary standards are
  • ISO 9000 Quality management systems
    Fundamentals and vocabulary
  • ISO 9001 Quality management systems
  • ISO 9004 Quality management systems  Guidance
    for performance improvement
  • ISO 19011 Guidelines on quality and/or
    environmental management systems auditing (To be

  • The most significant changes in the revised ISO
    9000 standards are
  • Increased focus on top management commitment
  • Emphasis on a process approach within the
  • Continual improvement
  • Increased focus on enhancing satisfaction for
    customers and other interested parties

  • 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
  • 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

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

External Failure Costs
  • External failures occur when customers discover a
  • 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

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

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

Implications Of JIT Manufacturing
  • Important measures of a JIT systems 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
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