Chapter 7 page 18

CHAPTER 7
THE CONVERSION CYCLE
REVIEW QUESTIONS
1. A companys conversion cycle transforms (converts) input resources, such as raw
materials, labor, and overhead, into finished products or services for sale.
2. The batch processing system consists of four basic processes: plan and control
production, perform production operations, maintain inventory control, and perform
cost accounting.
3. Continuous processing creates a homogeneous product such as cement through
a continuous series of standard procedures, while batch processing produces
discrete groups of a uniform product, such as a particular size and type of box.
Made-to-order processing produces goods which are built to customer
specifications. Continuous and batch processing systems produce goods to meet
expected sales demand, while made-to-order processing systems produce goods to
meet actual orders.
4. Sales forecast, production schedule, bill of materials, route sheet, work order,
move ticket, and materials requisition.
5. The primary determinant for materials requirements, the bill of materials, specifies
the types and quantities of the raw materials and subassemblies used in producing a
single unit of finished product. Given a good that is to be produced from the
production schedule, the route sheet specifies the sequence of operations (i.e.
machine or subassembly) and the standard time allocated to each task.
6. An objective of inventory control is to minimize total inventory cost while ensuring
that adequate inventories exist to meet current demand. Inventory models used to
achieve this objective help answer two fundamental questions:
1.
2.

When should inventory be purchased?

How much inventory should be purchased?

7. The work order from the production planning and control department triggers the
cost accounting process.
8. Materials requisitions, excess materials requisitions, materials returns, job tickets,
move tickets, and standards for the various resources (as provided by the standard
cost file).
9. Probably the most important type of report is the variance report. This report
illustrates to management the actual cost versus standard costs and any deviations
from the standards. These reports allow management to make any necessary
changes to avoid unfavorable variances. Further, if favorable variances are being

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observed with respect to direct materials, the bill of materials may be able to be
reduced to keep raw materials inventory down.
10. The receipt by cost accounting of the last move ticket for a batch from the work
center signals the completion of the production process.
11. Inventory control, which maintains the records for the raw materials and finished
goods inventories, should be separate from both the raw materials storeroom and
finished goods warehouse functions. Cost accounting, which maintains the records
for work in process, should be separate from the work centers in the production
process.
12.Transaction authorization: Work orders, move tickets, and materials requisitions.
Segregation of duties:
1. Inventory control separate from RM and FG inventory
custody.
2. Cost accounting separate from work centers.
3. GL separate from other accounting functions.
Access: Limit physical access to FG, RM stocks, and production
processes. Use
formal procedures and documents to
release materials into production.
13. Computer-aided design (CAD) involves the use of computers to design products
to be manufactured and the processes by which they are produced. Computer-aided
manufacturing (CAM) involves the use of computers to manufacture the product.
14. If production problems are causing bottlenecks, then work-in-process (WIP)
inventory will tend to accumulate. If the wrong product mix is being produced, then
inventories may build up while the customers are unhappily waiting for delivery of
their product. Inventories may build up and become obsolete or damaged while they
are sitting in storage. Further, production has been wasted building the wrong
product.
15. The goal of lean production is improved efficiency and effectiveness in every
area, including product design, supplier interaction, factory operations, employee
management, and customer relations.
16. Activities describe the work performed in a firm, while cost objects are the
reasons for performing activities.
17. Essential activities add value to the organization either through adding value to
the customer or to the organization. Non-essential activities do not add value.
18. Islands of technology describes an environment where modern automation
exists in the form of islands that stand alone within the traditional setting.
19. Computer-integrated manufacturing (CIM) is a completely automated
environment with the objective of eliminating non-value added activities. A CIM

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facility makes use of group technology cells comprised of various types of computer
numerical controlled (CNC) machines to produce an entire part from start to finish in
one location.
20. A companys value stream includes all the steps in the process that are essential
to producing a product. These are the steps for which the customer is willing to pay.
DISCUSSION QUESTIONS
1.
The various work centers send cost accounting completed move tickets.
Along with standards provided by the standard cost file, move tickets enable cost
accounting to update the affected WIP accounts with the standard charges for
manufacturing overhead (MOH). The receipt of the last move ticket for a particular
batch signals the completion of the production process and the transfer of products
from WIP to the finished goods inventory. At that point cost accounting closes the
work-in-process account and increases finished goods.
2.
1.
The assumption that demand for the product is known with certainty is
not unreasonable for most firms. Some firms will have better estimates than others,
but overall projecting demand for a product is not unreasonable. Assuming that the
demand is constant is unreasonable for many products. At the very extreme,
Christmas items are highly seasonal, as are many recreational items such as
camping gear, hiking gear, suntan lotion, and snow-skiing equipment. Many
industries products would violate the assumption of constant demand.
2.
The lead time is known and constant. This assumption is not too
unrealistic. Trading partner arrangements between customer and supplier reduces
lead-time uncertainty. In some cases, a probability distribution would be better.
3.
The assumption that the total cost of placing orders is inversely related
to the quantities ordered (larger orders means fewer orders placed) is not
troublesome.
4.
The assumption that all inventories in the order arrive at the same time
is probably not realistic and could cause shortages.
5.
The assumption that no quantity discounts exist is extremely
unrealistic. Most firms give quantity discounts.
6. The assumption that the total yearly carrying costs is a variable that
increases as the quantities ordered increases in not troublesome.
3.
This is the point where total costs are minimized. In other words, it is the
minimum of total holding costs plus total carrying costs.
4.
The cost accountants need to keep the records for WIP inventory files. They
also need to track labor, material, and overhead variances, and provide
management with these reports so that they may make any necessary adjustments.
The work centers should not be allowed to track their own variances, as they might
try to cover them up rather than fix them.

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5.
By prenumbering source documents and referencing these in the WIP
records, every item of FG inventory can be traced back through the production
process to its source. This process is important for detecting errors in production and
for tracking batches through the production process.
6.
The general ledger department provides independent verification by
reconciling WIP journal vouchers from cost accounting and summaries of the
inventory subsidiary ledger from inventory control.
7.

The following features characterize the world-class company:

World-class companies must maintain strategic agility and be able to turn on
a dime. Top management must be intimately aware of customer needs and
not become rigid and resistant paradigm change.
World-class companies motivate and treat employees like appreciating
assets. To activate the talents of everyone, decisions are pushed to the
lowest level in the organization. The result is a flat and responsive
organizational structure.
A world-class company profitably meets the needs of its customers. Its goal is
not simply to satisfy customers, but to positively delight them. This is not
something that can be done once and then forgotten. With competitors
aggressively seeking new ways to increase market share, a world class firm
must continue to delight its customers.
The philosophy of customer satisfaction permeates the world class firm. All of
its activities, from the acquisition of raw materials to selling the finished
product, form a chain of customers. Each activity is dedicated to serving its
customer, which is the next activity in the process. The final paying
customer is the last in the chain.
Finally, manufacturing firms that achieve world-class status, do so by
following a philosophy of lean manufacturing. This involves doing more with
less, eliminating waste, and reducing production cycle time.

8.
By replacing labor with automation, a firm can reduce waste, improve
efficiency, increase quality, and improve flexibility. Examples of automation include:
Automated Storage and Retrieval Systems, Robotics, Computer Aided Design
(CAD), Computer-aided manufacturing (CAM).
9.
Students will present different answers to this question. For example: Second
Skin Swimwear in Boca Raton, Florida digitizes the image of the customer, which is
then displayed on the computer screen. The customer, with the aid of a salesperson,
then tries various swimsuits on the screen, making any desired changes. Different
fabrics are also examined. Once a suit is decided upon, a pattern is automatically
prepared and cut for manufacturing. Thus, the customer basically designs her own
swimsuit. Some car manufacturers allow customers to add on their options via a
computer screen by which they can visualize the results of different options. Once
the customer places an order, the order is sent to the manufacturer and the car is
custom-finished. Weyerhauser, a lumber company, has placed kiosks in some of its

Chapter 7 page 22

retailers stores which allow customers to build their decks, with the aid of a
salesperson. Once the deck is drawn with the help of a CAD program, the customer
may have a print-out of his/her deck along with a bill of materials.
10.
Low priced, poor quality raw materials can end up costing the firm more
money if more scrap is produced due to difficulty of working with the raw material.
Also, poor quality raw materials or labor will most probably result in the production of
an inferior good and ultimately tarnish the firms reputation.
11.
The problem is that manufacturing performance is not given enough
emphasis by traditional cost accounting techniques, and traditional cost accounting
techniques do not support the objectives of lean manufacturing firms. Firstly,
traditional cost accounting systems do not accurately trace costs to products and
processes. This results in product cost distortions, which can ultimately cause poor
decisions regarding pricing, valuation, and profitability. Secondly, standard costing
motivates non-lean behaviors through the performance measures of personal
efficiency of production workers and effective utilization of manufacturing facilities.
This promotes the production of large batches of products and a build-up of
inventory. A third problem is the time lag between the reports generated by the cost
accountants and the actual manufacturing activities. Managers need to know in real
time about a robotic machine, which is producing sub-optimal work. Lastly, the
accounting data uses dollars as the standard unit of measure between items that are
not always amenable to a dollar measure, such as product quality, delivery time, setup time, etc. Attempting to force this data into such a common financial measure
may distort the problem and promote bad decisions.
12.
The ABC process model provides critical information about cost drivers and
performance measures. This information can be used to constantly analyze the
relative efficiency of activities and the resources used in the process in order to
better manage the activities and resources and target areas for cost reduction.
13.
In the traditional manufacturing environment, direct labor is a much larger
component of total manufacturing costs than in the CIM environment. Overhead, on
the other hand, is a far more significant element of cost in advanced technology
manufacturing.
14.
The use of standard costs provides a type of access control. By specifying the
quantities of material authorized for each product, the firm limits usage. To obtain
excess quantities requires special authorization and excess materials requisitions.
15.
A Value Stream Map (VSM) is used to graphically represent a business
processes to identify aspects of it that are wasteful and should be removed. A VSM
identifies all of the actions required to complete processing on a product, along with
key information about each action item. Specific information may include total hours
worked, overtime hours, cycle time to complete a task, and error rates. The VSM
shows the total time required for each processing step, the time required between

Chapter 7 page 23

steps, and identifies the types of time spent between steps such as the outbound
batching time, transit time, and inbound queue time.
16.
ABC allows managers to assign costs to activities and products more
accurately than standard costing permits. Some advantages that this offers are:
More accurate costing of products/services, customers, and distribution
channels
Identifying the most and least profitable products and customers
Accurately track costs of activities and processes.
Equip managers with cost intelligence to drive continuous improvements.
Facilitate better marketing mix
Identify waste and non-value added activities.
17.
ABC has been criticized for being too time consuming and complicated for
practical applications over a sustained period. The task of identifying activity costs
and cost drivers can be a significant undertaking that is not completed once and
then forgotten. As products and processes change so do the associated activity
costs and drivers. Unless significant resources are committed to maintaining the
accuracy of activity costs and the appropriateness of drivers, cost assignments
become inaccurate. Critics charge that rather than promoting continuous
improvement, ABC creates complex bureaucracies within organizations that are in
conflict with the lean manufacturing philosophies of process simplification and waste
elimination.
18.
Traditional accounting systems do not accurately trace costs to products and
processes. One consequence of new technologies is a changed relationship
between direct labor and overhead costs. In the traditional manufacturing
environment, direct labor is a much larger component of total manufacturing costs
than in the CIM environment. Overhead, on the other hand, is a far more significant
element of cost in advanced technology manufacturing. In this setting, traditional
cost accounting procedures are inadequate. For traditional allocations to be correct,
a direct relationship between labor and technology needs to exist. In CIM, this
relationship is diametric rather than complementary. When the cost pool is large and
the allocation method ambiguous, any miscalculation in assigning labor is magnified
many times in the calculation of overhead.
19.
Most organizations produce more than one product, but these often fall into
natural families. Product families share common processes from the point of placing
the order to shipping the finished goods to the customer. Value stream accounting
cuts across functional and departmental lines to include costs related to the product
family such as marketing, selling expenses, product design, engineering, materials
purchasing, distribution, and more, but makes no distinction between direct costs
and indirect costs.
20.
MRP II evolved into large suites of software called enterprise resource
planning (ERP) systems. Similarities in functionality between ERP and MRP II

Chapter 7 page 24

systems are quite apparent. Some argue that very little real functional difference
exists between the two concepts. Indeed, the similarities are most noticeable when
comparing top-end MRPII systems with low-end ERP packages.
A primary distinction, however, is that the ERP has evolved beyond the
manufacturing marketplace to become the system of choice among nonmanufacturing firms as well. On the other hand, cynics argue that changing the
label from MRP II to ERP enabled software vendors to sell MRP II packages to nonmanufacturing companies. The market for ERP systems was for many years limited
by high cost and complexity to only the largest manufactures. This market was
dominated by a few software vendors including SAP, J.D. Edwards, Oracle, and
PeopleSoft. In recent years this market has expanded tremendously by the entry of
many small vendors targeting small and mid-sized customers with less expensive
and more easily implemented ERP systems.
MULTIPLE CHOICE
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

A
C
B
E
A
B
A
E
E
C
PROBLEMS

1. See diagram below

2.

a.

EOQ =

D = 28,000
S = $9
H = $1.25
EOQ = 635
b.
ROP = I x d
I=7
D = 200
ROP = 1400
3.
Dell Computers improved inventory turnover ratios
Toyota improved inventory turnover ratios
GE process improvement
British Vita MRP II
Apple Computers JIT

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4.
a.
One problem is that the work order is not sent directly to the cost
accounting department, but rather to the work centers. Thus, no separation of
custodial and record-keeping tasks occurs. A possible danger is that work orders
may be manipulated or lost. A corrective procedure is to have the work order sent
directly to the cost accounting department.
b.
A second problem is that the work centers generate their own material
requisitions, excess material requirements, and material returns documents. The
work centers should not have both custody over raw materials and the
corresponding authorization responsibilities. A possible danger is that the work
centers may pilfer raw materials and be able to cover it up by altering documents. A
corrective procedure is to have the inventory control department generate these
documents and have the cost accounting department maintain the WIP records.
5.

Key elements of this central manufacturing system are:

Production Planning and control produce the production schedule based upon
the monthly sales forecast on file in the central computer system
The central system produces work orders, material requisitions, move tickets,
and purchase orders based upon stored standards and inventory on hand
data.
Purchase orders are sent directly to suppliers (this could be via mail, fax, or
EDI).
Work centers access their work schedules and necessary documents from
terminal in the work areas. Minimal hard copy is produced.
When work is completed work center employees enter the time and materials
used in production.
Storekeeping issues raw material to employees as need. They access the
central system to download the materials requisitions, which the employees
sign in exchange for the materials.
The central system calculates WIP and automatically transfers WIP to
finished goods inventory when production is complete.
Cost accounting receives management report on demand from the system via
their department.
Purchasing receives management reports on products ordered via the
department terminal.

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6.
The advantages are that no defective units will be produced whenever a
problem is detected. Defective units are problematic in most industries, but
especially so in the toy industry for toddlers. Although the production line is shut
down, costs may still be saved in the long-run from less waste, fewer unsalable
products, and fewer product litigation cases. The problems are that the switchover to
a JIT system requires a lot of training and patience. The product must be produced
in small lot sizes; the firm may need to adjust to get used to this practice. The firm

Chapter 7 page 27

must have excellent cooperation from its suppliers. Late deliveries or delivery of
defective raw materials can cost the company dearly due to downtime, since no
excess inventory is stored. Employee cooperation and teamwork must be obtained,
and this usually takes time for adjustment. Quality must be in the front of everyones
mind.
7.
Overhead components for the company include executive salaries, legal
expenses, ordering costs, accounting and other support department costs, janitorial
services, electricity, plant, property and equipment costs, inventory handling
expenses, saw blades, scrap or waste disposal costs, glue, sand paper, mineral oil,
packaging supplies, and shipping costs.
An activity driver for cutting could be lumber square feet; the most logical activity
driver for the assembly, shaping, sanding, and finishing processes would be the
number of cutting boards made. An activity driver for packing could be the number of
boxes packed.
8.

Response: The essay should include the following points:

Pull processing. Products are pulled from the consumer end (demand), not
pushed from the production end (Supply). They are pulled into production as
capacity upstream becomes available. Unlike the traditional push process, lean does
not create batches of semi finished inventories at bottlenecks.
Perfect quality. Success of the pull processing model requires zero defects
in raw material, work in process, and finished goods inventory. Poor quality is very
expensive to a firm. In the traditional manufacturing environment, these costs can
represent between 25 to 35 percent of total product cost. Also, quality is a basis on
which world-class manufacturers compete. Consumers demand quality and seek the
lowest-priced quality product.
Waste minimization. All activities that do not add value and maximize the
use of scarce resources must be eliminated. The following are examples of waste in
traditional environments:

Overproduction of products,

Transportation of products

Bottlenecks of products waiting to move to the next production step.

Idle workers.

Inefficient motion of workers who must walk more that necessary in the
completion of their assigned tasks

Islands of technology.

Production defects that requires unnecessary effort to inspect and/or

correct

Safety hazards that cause injuries and lost work hours and associated
expenses
Inventory reduction. The hallmark of lean manufacturing firms is their

Chapter 7 page 28

success in inventory reduction. Lean firms have only a few days or sometimes even
a few hours of inventory on-hand. The three common problems outlined below
explain why inventory reduction is important.
1. Inventories cost money. They must be transported throughout the factory,
handled, stored, and counted. In addition, inventories lose value through
obsolescence.
2. Inventories camouflage production problems. Bottlenecks and capacity
imbalances in the manufacturing process cause work-in-process inventory to
build up at the choke points. Inventories also build up when customer orders
and production are out of sync.
3. Willingness to maintain inventories can precipitate overproduction.
Because of setup cost constraints, firms tend to overproduce inventories in
large batches to absorb the allocated costs and create the image of improved
efficiency.
Production flexibility. Long machine setup procedures cause delays in
production and encourage overproduction. Lean companies strive to reduce setup
time to a minimum, which allows them to produce a greater diversity of products
quickly, without sacrificing efficiency at lower volumes of production.
Established Supplier relations. A lean manufacturing firm must have
established and cooperative relationships with vendors No late deliveries,
defective raw materials, or incorrect orders.
Team Attitude. Lean manufacturing relies heavily on the team attitude of all
employees involved in the process. Each employee must be vigilant of problems that
threaten the continuous flow operation of the production line. Lean requires a
constant state of quality control along with the authority to take immediate action
1.

INTERNAL CONTROL CASES

Solution to Nautilus Water Pumps, Inc.
a., b., d.: See diagrams on the pages that follow.

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c.
Internal Control Weaknesses
1.
Production scheduling is performed in the Work Center rather than through a
formal Production, Planning and Control phase. This leads to lack of coordination,
internal inefficiencies, material ordering problems, and bottlenecks.
2.
No standards for material usage are in place and no means for accounting for
unused materials or excess material usage in production exists in the current
system. Controls over the flow of raw materials need to be implemented.
3.
A blanket order from each automobile manufacturer is received at the start of
the year, which is guaranteed for only one month. Nautiluss material suppliers, on
the other hand, currently require three months lead-time. Dealing with incongruity
will require coordination within Nautiluss supply chain. Thus, in addition to resolving

Chapter 7 page 36

the Nautiluss internal production problems, the company will benefit by entering into
trading partner agreements with suppliers that will require implementation of EDI and
MRP technologies. (EDI is discussed in detail in chapter 12.)
2.

Solution to SAGA Fly Fishing, Inc.

a., b., d.: See diagrams on the following pages.

Chapter 7 page 37

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c.
Internal Control Weaknesses
Many changes had to be made to the conversion cycle at SAGA, Inc. to ensure
adequate control procedures in accordance with SAS 78. They also had to increase
the amount of computer technology to speed production and reduce paper work.
Many control weaknesses exist in this case beginning with inadequate
Authorizations. Only one work order is produced in the Production Planning and
Control Department, and it is sent to the work centers. No file is kept in the PP&C
Department. This means that the department has no record of any work that they
authorized, and therefore no control over the work centers. Also there is no Inventory
Control Department to provide adequate authorization for the requisition of

Chapter 7 page 42

materials.
A serious lack of Segregation of Functions exists at SAGA, Inc. No Inventory
Control department exists and that causes the biggest problems. The Storekeeping
and Finished Goods warehouse keeps inventory records. They also keep physical
custody of the CD players. Since these are high-priced items that are relatively
small, the incentive for employees to steal pieces of inventory is present. It would be
very easy for anyone, like Mr. Holt, to remove a piece of inventory and alter the
records. Another problem is that Mr. Brackenbury heads the work centers as well as
the Production Planning and Control department. This gives him the opportunity to
alter or create false production documents without anyone knowing. If he gets
bonuses at the end of the year, he may have an incentive to commit fraud.
Supervision is not a serious problem in the work centers because foremen who
oversee the usage of raw materials are already present and the job tickets and
timecards are accurate. The new computer system installed at SAGA, Inc. will help
with the inadequate supervision in the other departments. Passwords and limited
access control should be implemented to detail who can amend certain documents.
Also, new computer programs that calculate inventory requirements, update
inventory records, and calculate variances ensure that someone in that department
does not create false records.
Access Controls are especially needed in the Storekeeping department at SAGA,
Inc. First, the addition of an Inventory Control department will eliminate access to the
raw materials by people with access to the accounting records and vice versa. Also,
badges and security codes between each department will cut down on the number
of unauthorized people in the various departments. The new computer system will
ensure that only the specified amount of material is sent to the work centers. To
obtain excess quantities would require special approval by the Inventory Control
clerk.
The new system has a marked increase in the number of Accounting Record
Controls. It starts with prenumbered source documents. This way missing
documents can be tracked down and the ability to create false ones is greatly
reduced. Next, an increase in the number of documents exists, strengthening the
audit trail. Four work orders are now producedtwo going to the work centers, one
to Cost Accounting, and one to an open work order file. This file also lets the
Production Planning and Control department know what orders are still in progress.
Another move ticket is created going to the work center and back to PP&C to close
out the open work order file along with the production schedule. Another materials
requisition is created that eventually goes to Cost Accounting. With this increase in
the audit trail, more departments will have a record of the WIP, making it harder to
commit fraud.
Finally, Independent Verification has also increased under this new system. Cost
Accounting, now receiving more accounting records, can more easily reconcile the

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materials used with the material requisitions, job tickets, and work orders. They can
then come up with more accurate variances that point out any irregularities in the
production process. If someone is changing the amount or cost of materials while at
the same time changing the cost or time of labor used, a total variance may not pick
up the difference. Labor, overhead, and materials variances will point out any large
differences though. Finally, the Inventory Control department must make periodic
counts of the inventory on hand and reconcile it with their records.
d.
This organization can benefit by creating an Inventory Control
department and automating the inventory update and inventory level check
procedures as illustrated in the revised diagrams. The diagram also illustrates other
areas where automation may be beneficial.
3.

Solution to General Manufacturing, Inc.

a., b. See the diagrams on the following pages.

Chapter 7 page 44

c.

Internal Control Weaknesses

Production
GM needs to increase supervision in the work center. Mike does not watch
employees closely enough, which makes it easy to fabricate the amount of time they
spend working.
The lack of excess materials and materials return documents represents
accounting record and access control problems. Inventory is not properly
recorded because excess raw materials are left around the work center department.

Chapter 7 page 45

This gives employees easy access to the raw materials and may tempt employees
to steal the raw materials.
GM also has a segregation of functions problem since the storekeeping and
inventory control departments are combined. The same person has access to both
the raw material and finished goods inventory and the authority to update the
inventory records. This makes it easy for an employee to steal finished goods and
raw materials from GM. GM will need to break up the inventory department into
storekeeping and inventory control departments.
Cost Accounting
The cost accounting department has several control problems. The lack of excess
material and material return documents make it difficult for the accounting
department to verify that the numbers they are receiving are correct. No
independent verification of the WIP and FG inventory occurs since they do not
have the documents to prove it.
GM has a segregation of functions department control problem since the cost
accounting and general ledger departments are combined. This is a problem since
no general ledger independent verification step exists. The same person has control
of the cost accounting records and the general ledger. No independent verification
of the journal vouchers prepared by the cost accounting department occurs since the
same person reconciling them updates the general ledger.
d.
This organization can benefit from an integrated computer system
which uses batch processing of time cards and time tickets. The materials requisition
can be used to initiate the automatic preparation of the work order and move tickets.
The move tickets should be used to update the work in process at each work station.
4.
Solution to Bumper Cars, Ltd. (This case and solution was prepared by
Julie Fisch and Melinda Bowman, Lehigh University.)
All three suggestions offer valid solutions for inventory problems under certain
conditions. However, some of the solutions work better than others in the case of
Bumper Cars, Ltd. Mr. Ferriss plan to hire more workers in the production
department is the least plausible solution for this company. The reasonably low cost
of implementing this plan, and the fact that it allows training of new workers provides
two advantages of this solution. However, the list of disadvantages greatly outweighs
these few advantages. First of all, if the company must continually hire and fire
workers, training costs and hiring costs will skyrocket. Also, the workers will
constantly worry about the possibility of unemployment. Unhappy workers with low
morale tend to work less efficiently, therefore production decreases despite the
greater number of workers. A third disadvantage involves the fact that the production
department is not the source of the problem. A company should make improvements
directly to the area that causes the problem, which in this case is the inventory
control department.

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Ms. Coasters plan to hire more people to help in the inventory control department
offers a more logical solution. By implementing such a plan, the problem would be
attacked at its source. The understaffed inventory department comprises one of the
most significant problems of the company. Each worker has too many
responsibilities, and therefore they perform each task in a highly inefficient manner.
Hiring more people would alleviate some of these responsibilities, thereby freeing
the employees to concentrate on performing fewer jobs more effectively. In addition,
this solution generates minimal extra costs and solves many problems with one
simple solution. With the new workers, low inventory will be discovered and
restocked before a lag in production occurs. On the other hand, this solution has its
disadvantages also. The main problem revolves around the fact that hiring more
workers in the inventory control department offers no future benefits for the company
in terms of the company expansion. As the company expands, more and more
workers will be necessary to keep track of inventory, thus incurring high cost to
benefit ratios. While the extra workers benefit the inventory control and production
departments, they offer no solutions for the problems that will develop in the other
departments as a result of the expansion. Therefore, this solution may be used as a
short term remedy for the immediate inventory problem, but it should not be included
in the long range plans of the company.
Possibly the best solution of the three suggested at the company meeting is Mr.
Flumes plan to implement a company-wide computer system. This solution would
effectively meet the needs of the expanding company by coordinating all the
departments and reducing manual labor problems. All operations would become
more efficient and effective with the installation of an overall system. This solution is
not without its drawbacks, however. First of all, as Mr. Amusement suggested, the
cost of such a system is too excessive for a small company. Between research,
implementation, maintenance, and repairs, the company would spend all its profits
just to keep the system in order. At some point in the future, the company will
probably break even, then continue to make money as the benefits of the computer
set in, but the losses incurred in the immediate future might cause the company to
fold before the system can take hold. In conclusion, a company-wide system might
be a future consideration, but at the present, this solution is impractical.
After weighing the advantages and disadvantages of the above solutions, the best
solution is probably for this company to implement a small scale computer system
implemented in the inventory control, purchasing, and production departments. This
system would keep track of low inventory and contact the purchasing department
when reordering is necessary. The system would also be connected to the
production department, thus allowing the production department to immediately
convey their production needs to the inventory control department where these
needs can be met. Also, because the system is not implemented company-wide, the
cost is not excessive. In addition, the company has the option to improve and add to
the system later as the companys expansion requires. The system could be
expanded to include the accounting and finance departments, and possibly even
marketing and development departments. Therefore, in the short run, the small scale

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system solves the companys immediate inventory problems. In the long run, this
system provides opportunities for expansion with the business. As new problems
arise due improved business, the company can easily revise the system to meet its
needs. Most importantly, the cost of such a system is not excessive in the short run.
5.

Solution to Blades R UsComprehensive Case

a., b., d.
See diagrams on the pages that follow.

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c.

Internal Control Weaknesses

Expenditure Cycle Control Issues:

SEGREGATION OF FUNCTIONS

One of the problems with Blades R Us concerns the manner in which the
inventory records are updated in the Inventory Department. As is explained,
Mr. Sampson uses the purchase order he receives from Ms. Connolly to

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update the records. This current system is relying on the confidence that the
supplier will ship the goods promptly, with the right quantity, and without any
defects. There is never any use of the receiving report by the Inventory
Department to update records.
Mr. Dresden should not have the ability to look over the records to write the
checks and also be able to write and sign the checks off. In this case Mr.
Dresden is exercising too much control over an important part of the Accounts
Payable Department.

ACCOUNTING RECORDS
Ms. Connoly has also committed another error in not printing up a blind copy
of the purchase order to be sent to the Accounts Payable Department. This
blind copy would allow for further reconciliation on the documents so that
everything that was ordered was received. Again, this company has too much
reliance on the supplier that what they are sending is accurate and complete.
SUPERVISION
Unfortunately, when Mr. Hiro receives the goods he never truly inspects the
goods to make sure everything is correct. Mr. Hiro takes the packing slip
numbers as correct and legitimate. He never does the physical count, which
is so important.
Mr. Dresden has a lot of control when he is dealing with the checks. He has
the ability to write the checks and sign for them as well. Without appropriate
supervision, Mr. Dresden could be writing out checks to fake companies and
merely updating the General Ledger with the fake account summaries.
Mr. Sampson in the Inventory Department also needs to have someone
checking his actions. He could easily manipulate the purchase orders coming
through the warehouse enabling him to steal goods from the inventory
department.
AUTHORIZATION
The immediate authorization control issue is Mr. Dresdens handling of the
checks. Again, he has too much control over the writing and signing of the
checks before they are distributed to the suppliers. I included this control
issue with supervision as well because I believe that it pertains to both of
these issues.
ACCESS CONTROL
Mr. Sampson in the Inventory Department has access to the inventory
records as well as access to the actual inventory. With this power it would be
easy for Mr. Simpson to commit fraud against the company.
Conversion Cycle Control Issues:
AUTHORIZATION

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No Move TicketsThere are no authorization activities for the movement of

product between work centers.
No Excess Material DocumentIf a work center needs more material they do
not need any special permission to get it.

SEGREGATION OF FUNCTIONS
No Storekeeping DepartmentThe Inventory Control Department maintains
the records for the inventory and has custody of the inventory.
Material Requisitions Issued by Work CentersThe work centers issue
material requisitions whenever they need materials instead of the production
planning and control department.
SUPERVISION
Supervision is necessary in the work centers to keep track of the products
and the raw materials and be sure they are not being stolen or misplaced.
The foreman should make sure that the payroll time cards are accurate.
ACCOUNTING RECORDS
No Job Time TicketsThere are no job time tickets sent to cost accounting to
verify the time spent on each job.
No Prenumbered FormsThe forms used for all the paperwork are not
prenumbered, making it difficult to account for all the paper work.
ACCESS CONTROL
The company needs to limit the access employees have to the areas where
materials and products are stored.
Allowing the work centers access to unlimited inventory by allowing them to
request inventory at their discretion exhibits a problem with access control.
6.
Solution to Automotive Components CorporationAn Activity Based
Costing Case
Automotive Components Corporation has experienced some unexplainable
downturns in the past few years. Their margins have been lagging, yet they
consistently obtain the business for which they have been gearing up their
manufacturing operationsnamely the low volume parts which the auto makers
have been demanding. The controller cannot explain this phenomenon, but has
attended a seminar recently where he learns that other companies which have been
in the same predicament implemented ABC with success.
Cost Drivers
Fortunately, ACCs overhead had been broken down effectively before the controller
has recently become interested in ABC. This is fortunate because now all that is left
for the core team to do is determine the second stage cost drivers which trace cost
from the activity cost pools to each of ACCs products. The interviews the core team

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conducted, as well as the discussion they provided, offer the reader enough
information to determine which second stage cost drivers would best trace costs to
products. The specific drivers selected are not the most important point to take away
from this case, but rather the fundamental theory of resource consumption. The
following discussion is provided by discussing a specific solution to the problems
outlined in the case. The case readers may choose a different approach, yet still
provide sufficient discussion to support their conclusions.
EngineeringThe engineering activity is discussed by the product engineer, Sally
Summers. She believes that engineerings activity is consumed by the number of
components per part. This occurs in other companies as well; the engineering
activities in a company are product-related activities. In other words, they are not
dependent on the quantity of product produced. At ACC, it takes essentially the
same amount of time to design a low volume part as a high volume part. Therefore,
the cost driver for the engineering activity is the number of components per part. The
number of components is an estimate of part complexity. Hence, an assumption is
made that engineering costs increase as the complexity of the part increases.
InspectionJim Schmidt discusses the inspection activity cost pool. He notices that
the inspection activity has not declined since ACC began focusing on low volume
components. He discusses the first run inspections performed at ACC and notes that
they are dependent on how many runs a product has. Inspection, in ACCs case is a
batch activity and the cost driver is the number of runs per product.
Material MovementThe core teams first interview is John Bull Adams, the
supervisor in charge of material movement. Bull tells the team that the material
movement activity is driven by the number of feet moved per run. This means that
this activity is driven by two factors, the number of runs and the number of feet
moved. The driver is therefore the number of feet moved times the number of runs, a
batch activity. The material movement activity is not influenced by part volume. A
large batch requires the same amount of resources as a small batch. This is a
simplification for the case. Actually, other factors may exist which influence material
movement such as weight or handling requirements.
SetupThe next interview is with the most experienced jobsetter, Sara Nightingale.
Sara tells the team that she believes the setup activity is still driven by the setup time
required per batch. Sara admits that with the introduction of the CNC machines for
production, the workload has been reduced for the jobsetters, but the final assembly
setups are still handled by mechanically experienced job-setters. The setup activity
is a batch activity and should be driven by the setup time required per batch. Since
Sara points out the fact that jobsetters are becoming more technical and the
programming of CNC machines requires a different type of work, a cost driver which
incorporates new product introductions or product changes may be appropriate.
ShippingThe final interview is conducted with Phil Johnson, the shipping
supervisor. He believes that the activity of the shipping department is dependent on

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the number of shipments. This is a product activity. The amount of resources

expended on shipping is dependent on the number of shipments per product. The
shipping cost of a product is a function of the number of shipments required by the
customer.
MachinesThe activity cost pool named machines should be driven by the machine
hours consumed per part. This is a unit cost because it occurs to every unit
produced.
ABC COSTS
Figure 1 displays ACCs new activity-based cost system. Each of the activity cost
pools are traced to products using a different cost driver. With this new system, ACC
has the ability to differentiate between parts of varying complexity within their CAS.
Part complexity is a function of:
machine hours per part,
components per part,
runs per part,
distance moved per part,
setup time per run per part, and
shipments per part.
The current CAS allocates the total manufacturing overhead based on each
products consumption of direct labor. The new ABC system traces manufacturing
overhead to products in two stages. The first stage traces costs from the
manufacturing overhead to the activity cost pools identified in Figure 1. The second
stage traces cost from those activity cost pools to individual products based on the
cost drivers also shown in Figure 1. Each of ACCs three products are calculated
using the new ABC system in Figure 2.
These new costs are drastically different than the costs computed by the current
CAS system. This phenomenon of transactions within each part consumes a
different proportion of transactions within each activity cost pool. Each products
proportion of transaction consumption is shown in Figure 3. This figure illustrates
why ACCs current CAS does not produce accurate product costs. By observing the
new activity-based system, it is clear that product 101 is the most complex product
produced by ACC. This small volume product is the transaction leader in four out of
the six activity cost pools. Product 102 and 103 are not as complex and require
significantly less transaction volume.
ACTIVITY-BASED COST VERSUS ACCS CURRENT COST SYSTEM
A graph demonstrating the variation between the product cost computed with the
current CAS and the new activity-based system is shown in Figure 4. As you can
see, the current system significantly undercosts product 101 and overcosts products
102 and 103. Figure 5 illustrates that current CAS significantly under-allocates
overhead cost to product 101 and over-allocates cost to product 102 and 103.

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Under the current CAS, ACC thought they were obtaining planned gross margin on
product 101, but not on product 102 or 103. However, the new ABC system shows
significantly different results. ACCs new gross margins on the three products are
-55%, 22%, and 42%.
The lesson to be learned is that ACCs current CAS does not account for product
complexity as shown in the previous section. Under the current system, ACC thought
it was achieving the greatest return on product 101, when in fact this product has the
lowest contribution. Product 101s gross margin changed from 20% to -55% when
costs were computed using the new cost drivers. The large difference between
product cost is attributable to product 101s low direct labor content and its high
transaction volume. The direct labor is less than product 103 while it requires a
greater amount of transactions than the other two parts. Due to the products similar
direct labor content, the current CAS allocated basically the same amount of
overhead to each of the three products. No differentiation was made between
products which required greater resource utilization under the current CAS.
ACCs Current CAS
Is ACC beginning to show signs of a faulty cost system? The answer to this question
is definitely yes. The first indication is that the investment ACC has made in new
flexible technology has not increased profits. In fact, ACCs margins have been
declining, while the small volume orders which were believed to be profitable have
been increasing. With the new ABC data, that ACC has been targeting the wrong
customers becomes clear. The small volume parts are generally more complex and
require the use of more overhead resources. Product 101 has the most runs,
shipments, components, and movement. Unfortunately, the current CAS does not
account for this complexity. Product 102 and 103 turn out to be ACCs biggest
breadwinner. They are both higher volume products which require less resource
consumption.
Strategy
With the new information provided by the ABC system, ACC can begin to regain
sales growth and gross margins. In the short run, the price of product 101 should be
raised. Not surprisingly, ACCs customers may not challenge this move. The ABC
costs show product 101 is achieving a negative gross margin. That ACC customers
are well aware of this fact and would not be able to purchase the part elsewhere for
the same amount is quite possible. Therefore, ACCs customers may give them quite
a bit of leeway on the products price. A price increase would soften the blow ACC is
taking each time they sell product 101.
In the long run, ACC will be able to use the ABC information to reallocate their
resources and move towards a more profitable product mix. The activity-based
information can be used to reduce many non-value adding activities. The resulting
freed up resources can then be reallocated to value adding activities. Some
examples are presented below.

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Factory LayoutThe current layout of the factory is inefficient. Referring to Figure 5

in the case, Product 103 is routed throughout the factory from the receiving to
shipping in a fluid pattern. Consequently, the total distance material must be moved
is 250 feet per run, versus 350 feet per run for product 102, and 500 feet per run for
products 101. Products 101 and 102 are not routed as efficiently. These products
must be moved randomly throughout the factory. Consequently, they also require
more runs. The result is that ACC spends the bulk of its material movement time on
smaller volume specialty products. The new ABC system draws attention to this
problem by penalizing products 101 and 102 with more material movement cost.
Managers can easily identify this problem with the new ABC information and execute
corrective action in the future.
ComponentsIn the long run, ACC can reduce the components per part by
producing simpler designs. ACCs design engineers have been inadvertently adding
cost to products by simply increasing the number of components per part. Each time
a new component is added to a part, a wide array of activities are influenced. Not
only must the new part be designed by the product engineers, it must also be tested,
routed through the factory, inspected, improved and shipped. These activities add
costs to a product which an engineer simply cannot foresee when designing a part.
Product 101 has 16 components and is responsible for 30.7% of the engineering
cost under the new ABC system, yet it accounts for only 16.7% of the total volume.
Setup TimeA reduction in setup time can lead to increased plant flexibility. As
setups are reduced, it is possible to run smaller batch sizes more often or reallocate
setup resources to other activities. In the long term, layoffs should not occur
because the extra resources should be reallocated to value added activities such as
production or continuous improvement.
Runs and ShipmentsACC needs to be aware that costs increase with the number
of runs and shipments. However, ACC should not immediately tell customers they
will not be supplying small volume orders anymore. Supplying orders in small
volume can be a competitive advantage, providing that service adds value for the
customer, and ACC should be compensated for that value by requiring a higher
price.

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