Chapter 7: Measuring and Managing Process Performance

Chapter 7
Measuring and
Managing Process
Performance

QUESTIONS

7-1 The 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.

7-2 In process layouts, all similar equipment and functions are grouped together.
Process layouts typically occur in organizations in which production is done in
small batches of unique products. In process layouts, products are moved and
processed from one area to another until the product is completed. In contrast, in
product layouts, equipment is organized to accommodate the production of a
specific product. Product layouts are most effective for companies producing
high-volume products. Typically, products move and are processed along an
assembly line.

7-3 Group technology (also called cellular manufacturing) involves the organization
of a plant into a number of cells. Cells are often U-shaped, which allows workers
convenient access to required parts and good visual control of the workflow.
Within each cell, machines that are needed to manufacture a group of similar
products are arranged close to one another. This organization reduces production
cycle time, which is the time from receipt of raw materials from the supplier to
delivery of the finished good to distributors and customers.

7-4 Lean manufacturing, derived from the Toyota Production System, is a philosophy
centered on producing the highest quality product with the lowest level of waste
and inefficiency. This approach views any resource spending that does not create
value for the end customer to be wasteful, and therefore must be eliminated.
Value is defined as any action or process for which a customer would be willing
to pay.

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7-5 “Cost of nonconformance” refers to the cost an organization incurs when the
quality of products or services does not conform to quality standards.

7-6 Waste, rework and net cost of scrap are examples of internal failure costs.

7-7 Quality engineering, quality training, statistical process control and supplier
certification are examples of prevention costs.

7-8 Three examples of each of the following quality costs are:

(a) prevention costs—quality training, supplier certification and statistical

process control;
(b) appraisal costs—inspection and testing of incoming materials, process
control monitoring and product quality audits;
(c) internal failure costs—waste, downtime due to defectives, rework costs
and scrap;
(d) external failure costs—product liability lawsuits, product recalls, and
warranty claims.

7-9 A JIT system is very different from a conventional manufacturing system. In a

JIT system, a good or service is produced or delivered only when a customer
requires it. JIT production requires a product layout with a continuous flow once
production starts. Underlying the JIT system is a continuous improvement
philosophy of eliminating or reducing delay, error, and waste, such as materials
movement, storage, rework, and waiting time. In a typical JIT system, all types
of inventories (raw materials, work-in-process, and finished goods) are
minimized. The ultimate measure of success with JIT occurs when the processing
cycle efficiency ratio equals 1.

Under many conventional manufacturing systems, goods are produced to a

production schedule that may not be directly tied to when customers require the
goods. All types of inventories are kept on hand just in case unforeseen events
occur. Little attention is given to studying efficient and inefficient activities, and
materials movement, storage, rework, and waiting time are part of the
conventional work environment.

7-10 Under many conventional manufacturing systems, goods are produced to a

production schedule that may not be directly tied to when customers require the
goods. Goods are produced in batches to reduce setting up, moving, and
handling costs, but batch processing increases the inventory levels in the system.
This is because at each processing station all items in the batch must wait while

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the designated employees process the entire batch before moving all parts in the
batch to the next station. If the rate at which each processing area handles work
is unbalanced—because one area is slower or has stopped working due to
problems with equipment, materials, or people—work piles up at the slowest
processing station, increasing the work-in-process inventory level at that station.
Since supervisors evaluate many processing area managers on their ability to
meet production quotas, processing station managers try to avoid the risk of
having their facility idle. Many managers deliberately maintain large stocks of
incoming work in process so that they can continue to work even if the
processing area that feeds them is shut down. Similarly, to avoid idling the next
processing station and suffering the resulting recriminations, managers may store
finished work that they can forward to supply stations further down the line when
their stations are shut down because of problems. Finally, inventories may be
kept on hand just in case inputs to various stages of the manufacturing process
are defective.

Because group technology (cellular manufacturing) and just-in-time production

reduce the production cycle time and focus on reducing waste by improving
process and product quality, and quality improvement programs reduce the defect
rate, work-in-process inventory is likely to decrease on the implementation of
these programs.

7-11 Production cycle time and the level of work-in-process inventory are positively
related because reduction in time spent waiting for the next stage of production
reduces both production cycle time and work-in-process inventory levels.

7-12 The following three types of costs (only two are required for this question) are
incurred when implementing a group technology (cellular manufacturing) layout:

1. Costs of moving machines

2. Costs of reinstallation of machines
3. Costs of training the workers for group technology

7-13 Financial benefits resulting from a shift to group technology (cellular

manufacturing), just-in-time production, or continuous quality improvements may
include the following (only two are required):

1. Increased sales because the short production cycle time enables a

company to win customers by cutting the delivery time.

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2. Reduction in the number of workers needed to move materials from one

area to another, due to close proximity of manufacturing processes and
reduction in work-in-process inventory levels.
3. Reduced material waste because of reduced damage caused by materials
handling. Lower work-in-process inventory levels also reduce the potential
for products to become obsolete.
4. Reduced cost of storage because less space is used to store the reduced
work-in-process inventory.
5. Reduced clerical costs for keeping inventory records.
6. Reduced financing costs of inventories
7. An improvement in quality because defective processes are detected much
faster before many defective items are produced.
7-14 Kaizen costing is a method to reduce the cost of a product through small,
continuous improvements during the manufacturing stage of the total life cycle of
a product.

7-15 A cost variance investigation is undertaken under Kaizen costing in order to

compare actual cost reduction amounts to target Kaizen cost reduction amounts.
Variance investigation occurs whenever cost-reduction targets are not attained.

7-16 The Kaizen costing system operates outside of the standard costing system
because the standard costing system is oriented to complying with Japanese
financial accounting standards and not internal operations, per se.

7-17 Benchmarking is a process in which organizations gather information concerning the

best practices of others in order to meet or exceed the benchmark. Products,
functions, processes, and strategies all can be benchmarked. Benchmarking is highly
effective because organizations save time and money by avoiding mistakes that other
organizations have made or by not reinventing a process or method that other
companies have already developed and tested.

7-18 The five stages of benchmarking are: (1) internal study and preliminary
competitive analyses, (2) developing long-term commitment to the benchmarking
project and coalescing the benchmarking team, (3) identifying benchmarking
partners, (4) choosing information gathering and sharing methods, and (5) taking
action to meet or exceed the benchmark.

7-19 The three broad classes of information on which firms interested in

benchmarking can focus are: (1) product—any type of product or service, (2)
functions or process—all types of organizational activities from R&D,
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manufacturing to service, and (3) strategic—the variables on which the

organization chooses to compete such as cost, quality, etc. Variables related to
the design and functioning of the management accounting system fall under the
strategic category.

7-20 The stage of the benchmarking process that is the most important for
benchmarking management accounting methods is stage four, relating to
information gathering and information sharing.

7-21 The two general methods of information gathering and sharing when undertaking a
benchmarking exercise are unilateral and cooperative information.

7-22 The three types of information gathering and sharing under the cooperative form
of benchmarking are database, indirect/third party, and group.

7-23 A “benchmarking (performance) gap” is the difference between an organization’s

performance and the desired performance (best-practice performance) on a
specific measure, such as on-time delivery, number of defectives, or employee
satisfaction.

7-24 The additional cost of replacing a rejected unit that must be scrapped includes all
the incremental material and conversion costs already incurred on such a unit that
must be repeated. Furthermore, additional costs such as handling, storage, etc.
corresponding to the material that is lost also are included. From a managerial
perspective, opportunity cost may also be included if relevant.

7-25 Rework costs include direct rework labor, any additional direct materials used,
and if relevant, incremental support. From a managerial perspective, opportunity
cost may also be included if relevant.

7-26 When evaluating the profit impact of an increase in the sales of a product, it is
important to evaluate the contribution margins on the increase in sales for that
product, and on the decrease in sales of other cannibalized products (other
products that lose customers to the product being evaluated). In addition, if
inventory and accounts receivable increase with sales, then the cost of carrying
these additional current assets are also relevant.

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EXERCISES

7-27 A grocery store is organized using a process layout—similar foods are grouped
together to make it easier for customers to find what they want. A grocery store
might be reorganized into a modified cell layout. For example, someone wanting
to prepare a certain meal, like lasagna, might find all the required ingredients in
one place. However, this approach is likely to be costly and impractical and
make stock rotation difficult.

7-28 Prevention costs are incurred to ensure that companies produce products
according to quality standards. Prevention costs include quality engineering,
training of employees in methods designed to maintain quality, etc. Appraisal
costs are related to inspecting products to make sure that they meet both internal
and external customers’ requirements. Inspection of purchased parts and
materials and process control monitoring are examples of appraisal costs.
Internal failure cost occurs when the manufacturing process produces a defective
component or product. The cost of downtime in production as a result of
defects is an example of an internal failure cost. External failure costs are
incurred when a customer in the field detects a problem with a product or the
product fails. Examples of external failure costs include warranty costs, service
calls, and product liability recalls.

7-29 Of the four quality costing categories, an external failure cost is the most
damaging to the organization. Customer satisfaction and future sales may be
jeopardized. Moreover, product liability lawsuits can be extremely costly to the
organization not only in dollars, but also in terms of corporate reputation. One
key example of this is the Ford Pinto.

7-30 As shown below, benefits from the switch to JIT operations are estimated to be
$461,600:

Before the After the

Change Change Difference
Sales $1,000,000 $1,500,000 $500,000
Costs:
Direct material (250,000) (300,000) (50,000)
Direct labor (200,000) (225,000) (25,000)
Support (270,000) (255,000) 15,000
Inventory carrying costs (26,400) (4,800) 21,600
Profit $253,600 $715,200 $461,600

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7-31 Inventory Costs

Direct material $300 × 60,000 units × 2/12 = $3,000,000
Work in process ([$300 × 100%] + [$400 × 50%]) ×
60,000 units × 2/12 = 5,000,000
Finished goods ($300 + $400) × 60,000 units × 1/12 = 3,500,000
Total $11,500,000
Inventory carrying
cost 10%
Annual inventory
carrying cost $1,150,000

PROBLEMS

7-32 Both the theory of constraints and activity-based costing support aspects of
process improvement and improved profitability, but differ in many other
respects. The theory of constraints emphasizes the short-run optimization of
throughput contribution, and downplays operating costs (except direct materials)
because they are viewed as difficult to alter in the short-run. Consequently,
analyses of activities and cost drivers are not conducted as they are in activity-
based costing. Proponents of activity-based costing take a long-term perspective
in which managers can alter capacity resources. Therefore, it is viewed as
beneficial to produce accurate cost information by tying actual resources
consumed to cost objects, such as products, services, channels, and customers.
The theory of constraints and activity-based costing might conceivably be used
together.

7-33 Incremental costs:

Machine moving and reinstallation ($100,000)
Incremental benefits:
Increase in contribution margin
$200,000  0.31 = 62,000
Savings in inventory carrying costs
$200,000  0.25  0.15 = 7,500
Net benefit (loss) from a change in plant layout in year 1 $(30,500)

The proposed change in plant layout should not be implemented because its costs
are greater than its benefits, if only one year’s benefits are considered. Net
present value analysis, which is covered in other courses, should be used to
evaluate the benefits over the entire useful life of the machine.

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7-34 (a) PCE in minutes under the traditional system equals [120/(120 + 80 + 240
+ 40)] = [120/480] = 0.25. PCE under the JIT system equals [75/(75 + 20
+ 60 + 5)] = [75/160] = 0.47.

(b) Based on the calculations above, Walker Brothers should implement the
JIT system since the processing cycle efficiency is almost double that of
the traditional system (0.47 vs. 0.25).

7-35 Group technology (cellular manufacturing) refers to the organization of the plant
into a number of cells so that within each cell, all machines required to
manufacture a group of similar products are arranged in close proximity to each
other. The shape of a cell is often a U shape, which allows workers convenient
accessibility to required parts. The machines in a cell manufacturing layout are
usually flexible and can be adjusted easily, or even automatically, to make the
different products. Often the number of employees needed to produce a product
can be reduced due to the new work design. The U shape also provides better
“visual control” because employees can observe more directly what their co-
workers are doing. Group technology (cellular manufacturing) layouts reduce
costs and quality problems associated with conventional manufacturing and
facilities layouts. Usually production cycle time is improved with a group
technology (cellular manufacturing) approach.

A just-in-time manufacturing system requires making a good or service only

when the customer, internal or external, requires it. It is most appropriately used
in repetitive manufacturing for products such as automobiles or electronic
components. Just-in-time production requires a product layout with a continuous
flow (no delays) once production starts. This means that there must be a
substantial reduction in setup costs in order to eliminate the need to produce in
batches, therefore, processing systems must be reliable. A just-in-time production
system is based on the elimination of all nonvalue-added activities such as
materials movement, storage, rework, and waiting times in order to reduce cost
and time. It is an approach to continuous improvement and requires employee
empowerment and involvement to eliminate the need to perform nonvalue-added
activities. Just-in-time production encompasses all facets of making the good or
service, including developing the design, acquiring the factors of production,
making the good or service, delivering it to the customer, and following up after
the delivery. Critical performance indicators in just-in-time systems include
inventory levels, which should be as low as possible; the number of failures,
whether these are material, people, or machine failures, with a goal of zero;
moving with a goal of zero; and the amount of storing activities with a goal of
zero. The ultimate measure of success with JIT occurs when the manufacturing

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cycle efficiency ratio equals 1 that is, when processing time equals total
production time.

The group technology (cellular manufacturing) approach is not inconsistent with

the philosophy of JIT as group technology (cellular manufacturing) also focuses
on continuous improvement. In fact, some JIT systems use manufacturing cells to
make specific components as part of the finished product.

7-36 Estimated cost savings as a result of the quality improvement:

Decrease in number of rejects: (0.064 – 0.051)  10,000 = 130

Rejected valves are returned to the initial production stage to be melted and
recast. The company recovers the brass but not any finishing materials. Rework
requires DL and TDABC support in Casting; DM, DL, and TDABC support in
Finishing; and DM (= $0), DL, and TDABC support in Inspection. There are no
Packing cost savings on reworked values because all finished valves are
inspected before packing and shipping. Assuming, as stated in the problem, that
the TDABC support costs can be reduced if not needed, the estimated total
savings as a result of the quality improvement are $89,810.

Rework costs Casting Finishing Inspection

7- DM $ 0 $ 12 $ 0
DL 84 121 24
TDABC support 122 164 30
Total per valve $206 $297 $54 $ 557
Decrease in number of rejects  130
Savings from decrease in reject rate $72,410

Savings from reduction in inventory carrying cost:

($386,000 – $270,000)  0.15 $17,400
Total savings $89,810

37 Before the rearrangement, PCE in minutes for Whisper Voice Systems equals
[70/(70 + 45 + 55 + 30)] = 70/200 = 0.35. After the rearrangement, PCE in minutes
equals [30/(30 + 10 + 20 + 15)] = 30/75 = 0.40. The percentage improvement in PCE
after the rearrangement is [(0.4 – 0.35)/0.35] = .143 or 14.3%. Thus, the change
exceeds Ray Brown’s requirement of a 12% improvement in PCE.

7-38 (a) The approach used at McDonalds in which customers wait in several lines is
consistent with the push or conventional manufacturing approach. As one
comes into McDonalds it is clear that they have been, and are building
inventory in each of the specific bins that they use for, let’s say, Big Macs,
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fish sandwiches, regular hamburgers, etc. Having inventory at predefined

levels keeps the production process going. The motivation to use the
traditional production method is to sustain a certain level of inventory to
reduce the time the customer has to wait for an order. Notice in McDonalds
that hot lights are used to keep the sandwiches warm. One goal of this
approach is that customers perceive that they can get their sandwich very
quickly due to the inventory of sandwiches always on hand. On the other
hand, Wendy’s uses more of a pull or JIT system. As you enter into Wendy’s,
notice that you cannot really observe any sandwich inventory building up. The
idea in forming one line is that each person has the perception (and often the
reality) that each sandwich is made on the spot. This procedure is designed to
show customers how fresh the sandwiches are. The motivation to use a just-
in-time approach is to improve the quality of the food and to reduce waste by
eliminating the need to throw out food that has been sitting too long. As
processing time and setup costs drop, the organization can move closer to
just-in-time, reducing the waste and quality problems that arise with batch
production.
(b) From a customer’s perspective, it does depend on what one favors. If a
customer goes to a fast food restaurant, his or her goal is to get food quickly.
On any particular day, the customer may be in a great hurry and wish to run in
and run out of a fast food establishment. Having multiple lines at a place like
McDonalds may be very appealing as far as the perception of the speed with
which one can get a meal (compared to a single line at Wendy’s). On another
day, perhaps having a meal made freshly on the spot, without any “warming”
time under hot lights is more appealing than the speed of getting the food. Of
course, one may simply like the taste of one company’s hamburgers over
another’s.
From management’s perspective, apart from taste, competing in selling
hamburgers may depend on other variables such as the speed with which an
order is filled versus tailoring the production process to individual taste. The
traditional push production process can lead to a lot more waste than the JIT
system, because if a batch of hamburgers is made and demand drops, the
quality of the food deteriorates and often has to be thrown out. However, if
the line at Wendy’s is very long and customers begin to get impatient, the
freshness of the food may begin to lose its appeal.

7-39 (a) The article reports that customer service representatives are commonly
evaluated on time to complete a call or whether they sell a new product to
the customer. The article further states that companies should evaluate
service representatives on the basis of how well they resolve the

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customer’s problem. For example, a company can track improvement in

the number of problems that are resolved on the customer’s first call.

(b) The cost of quality framework can be applied to customer service

processes by considering the customer’s experience with the customer
service representative as the “product” for which the company desires to
satisfy customer expectations. The article mentions a number of activities
that can be viewed as helping to prevent customer dissatisfaction with
customer service. These activities include training customer service
representatives in listening skills and knowledge of the company’s
products, arranging for representatives to hear a customer talk about
positive and negative interactions with the call center, and encouraging
representatives to share their challenges and successes. Making sure that
the company treats representatives well can also be included among
prevention activities.

Appraisal issues arise in choosing measures to evaluate whether

representatives are likely providing high quality service to customers. As
stated in part (a), measuring the time to complete a call from a customer or the
number of times a new product is sold are less likely to provide insight into
the customer’s perception of customer service quality, and may induce
representatives to focus on achieving a good score on the measure instead of
resolving the customer’s problem. Measuring improvement in the number of
problems resolved on the customer’s first call is much more likely to provide
the desired insight and better aligns the representative’s incentives with
resolving the customer’s problem. The article further suggests evaluating
customer-satisfaction ratings for each representative, not merely the average,
because the average can mask important problems. Once a company identifies
problems or needed areas of improvement, the company can arrange for
appropriate training (a prevention activity).

As in other contexts, attention should be given to prevention of poor quality,

with the intent of reducing external failures, which in this context is a
customer who is dissatisfied with the customer service experience. The
low-quality experience may cause negative financial consequences for the
company. For example, the customer may switch to a competitor company
or may tell many other potential customers about the negative experience
and thereby influence the customers to purchase the good or service from
a competitor company.

7-40 There really is no one “correct way” to allocate the $2 million of quality costs to
the four categories. Clearly, managers hope that they can minimize quality costs

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as much as possible. But, in this hypothetical example, we are assuming that

managers, a priori, have much more discretion than they probably do.
Probably the most desirable quality cost trend is to load up costs at the
prevention stage and to incur some costs during the appraisal stage. By
increasing prevention costs, such as extensive training and quality engineering,
and appraisal costs, such as maintenance of test equipment, process control
monitoring and inspection of incoming materials, an organization can reduce
other quality costs, especially those related to internal and external failure.
Regarding the allocation of the $2,000,000, the “correct” trend is a high level of
costs for prevention, followed next by lower costs for appraisal, internal failure
and external failure.

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7-41 (a) Quality Cost Report for Madrigal Company

Quality Cost Annual Percent of
Category Cost Sales*
Prevention Costs:
Quality training $ 150,000 0.13%
Quality engineering 600,000 0.50%
Statistical process control 300,000 0.25%
Supplier certification 108,000 0.09%
Research of customer needs 90,000 0.08%
Total $1,248,000 1.04%
Appraisal Costs:
Inspection of and testing of in-coming
materials $ 480,000 0.40%
Maintenance of test equipment 420,000 0.35%
Process-control monitoring 1,200,000 1.00%
Product-quality audits 570,000 0.48%
Total $2,670,000 2.23%
Internal Failure Costs:
Waste $ 840,000 0.70%
Net cost of scrap 762,000 0.64%
Rework costs 1,440,000 1.20%
Downtime due to defects 150,000 0.13%
Total $3,192,000 2.66%
External Failure Costs:
Product-liability lawsuits $5,400,000 4.50%
Repair costs in the field 1,020,000 0.85%
Warranty claims 2,814,000 2.35%
Returned products 1,440,000 1.20%
Product recalls 2,400,000 2.00%
Total $13,074,000 10.90%

Total Quality Costs: $20,184,000 16.82%

*Total sales were $120,000,000

(b) The most obvious problem at Madrigal is the extremely high external-
failure costs of almost 11%. Since as a norm many companies would like
to keep their quality costs below 4% to 5% of sales, Madrigal Company’s
quality costs are out of line. Note in particular that product-liability
lawsuits, warranty claims, and product recalls are the biggest external-

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failure costs. Madrigal must find out why its products seem to be failing in
the field.

Madrigal should first turn to an analysis of its other quality costs. Quality
costs are incurred throughout the total life cycle of a product. If Madrigal
does not control quality costs early in the research, development, and
engineering stage by ensuring good product design, then design problems
will lead to increased quality costs later on.

At Madrigal both prevention and appraisal costs are a relatively small

percent of total quality costs (1.04% and 2.23%, respectively). Madrigal
should consider putting more effort into quality training, quality
engineering, statistical process control, and supplier certification. The
company should also determine whether to spend more money on
appraisal.

With regard to internal-failure costs, Madrigal also apparently incurs a

great deal of rework costs. The product seems to require many additional
costs that need not be incurred if the company could produce it correctly
the first time. Perhaps the production process is at fault, or maybe
Madrigal’s workers are not well trained.

Note that Madrigal’s quality-related costs are very low at the prevention
stage and increase for the appraisal and internal-failure cost categories.
The external failure costs are extremely high. This pattern of quality costs
is what most organizations hope to avoid because the highest category of
quality costs corresponds to poor quality recognized only after products
are in customers’ hands.

The more desirable quality-cost trend is the reverse of Madrigal’s pattern.

That is, organizations desire to have the greatest proportion of quality
costs incurred in the prevention stage. By increasing quality training and
quality engineering costs during this stage, a company can reduce other
quality costs. With the company’s products failing less frequently in the
customers’ hands, customer satisfaction should increase and the
company’s reputation should improve.

7-42 (a) Quality Cost Report for Ideal Company

Quality Cost Annual Percent of
Category Cost Sales*
Prevention Costs:
Quality training $ 150,000 0.20%
Quality engineering 200,000 0.27%
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Statistical process control 300,000 0.40%

Supplier certification 350,000 0.47%
Total $1,000,000 1.33%

Appraisal Costs:
Inspection of and testing of in-coming
Materials $ 300,000 0.40%
Process-control monitoring 350,000 0.47%
Product-quality audits 350,000 0.47%
Total $1,000,000 1.33%

Internal Failure Costs:

Waste $ 900,000 1.20%
Net cost of scrap 1,500,000 2.00%
Rework costs 2,000,000 2.67%
Downtime due to defects 600,000 0.80%
Total $5,000,000 6.67%

External Failure Costs:

Product-liability lawsuits $ 500,000 0.67%
Repair costs in the field 375,000 0.50%
Warranty claims 420,000 0.56%
Returned products 380,000 0.51%
Product recalls 325,000 0.43%
Total $2,000,000 2.67%

Total Quality Costs: $9,000,000 12.00%

*Total sales were $75,000,000

(b) Since as a norm many companies would like to keep their quality costs
below 4% to 5% of sales, Ideal Company’s total quality costs are
relatively high. The highest level of quality costs occur for internal failure
(6.67%) and external failure (2.67%) compared to lower levels for
prevention and appraisal (1.33% each). Therefore, management should
investigate why internal failure costs are so high, especially for scrap and
rework costs. Regarding external failure costs, the two highest are for
product liability lawsuits and warranty claims. Nevertheless, these costs
are relatively low as a percentage of sales. The company should
investigate whether placing more emphasis on prevention and appraisal
would decrease internal failure and external failure costs.

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7-43 Exhibit 7-10 illustrates the comparison between Kaizen costing and standard
costing. In contrast to traditional standard costing, Kaizen costing focuses on
cost reduction and continuous improvement as overriding concepts in
manufacturing, revises cost reduction targets monthly, uses cost variance analysis
to compare target costs versus actual costs, and assumes that workers have the
best knowledge to reduce costs.

Standard costing uses a cost control system concept and assumes stability in
current manufacturing processes. Standards are set annually or semiannually and
cost variance analysis is used to compare actual to standard costs. The
assumption is that managers and engineers have the best knowledge to develop
standards as they have the technical expertise.

7-44 According to the Kaizen costing approach, workers have the best knowledge to
reduce costs. The reason is that workers are much closer to the production
process and have far more detailed knowledge and insight than engineers and
managers.

7-45 Kaizen is the Japanese term for making improvements to a process through small,
incremental amounts, rather than through large innovations. Kaizen costing is a
method to reduce costs through small, continuous improvements.

7-46 If the cost of disruptions to production is greater than the savings due to Kaizen
costing, then the cost savings due to Kaizen costing will not be applied.

7-47 (a) The biggest problem with Kaizen costing is similar to the one that faces
target costing, and that is the system places enormous pressure on
employees to reduce every conceivable cost. The results of this pressure
are internal conflicts among various parties and a great deal of employee
burnout. Another concern has been that Kaizen costing leads to
incremental rather than radical process improvements. This can cause
myopia as management tends to focus on the details rather than the overall
system.

(b) To address the first problem, some Japanese automobile companies use a
grace period in manufacturing just before a new model is introduced. This
period, called a cost sustainment period, provides employees with the
opportunity to learn any new procedures before the company imposes
Kaizen and target costs on them. Another solution relates to the kinds of
penalties that employees face as a result of not attaining cost targets. In
Japan, for those employees with lifetime employment, there is virtually no
chance of losing one’s job, however, there are “social penalties” such as

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loss of face, letting down the company, etc., associated with not achieving
targets. In the United States the threat of job loss is much more salient.
The last thing that U.S. managers would want to do is to threaten job loss
to those who did not achieve targets. This would simply exacerbate the
problem. In the final analysis, Kaizen costing has to be understood as a
tool for change, but not as a hammer. With respect to the second problem
above, management needs to focus on the overall production process as
well as the details.

7-48 The key factors in identifying benchmarking partners are the size of partners, the
number of partners, the relative position of partners within and across industries,
and the degree of trust among partners. Choices on each of these variables will
change from one benchmarking study to the next. Organizations will likely want
to obtain information about a firm similar in size because of their comparable
situations. It is useful to have a large number of participants in order to increase
the amount of information obtained. Developing trust among partners is critical
to obtaining truthful and timely information. Newcomers to an industry probably
would like to see a wider variety of partners.

7-49 A manager asked to benchmark another organization’s target costing system

would want information pertaining to the method by which target prices and
target margins (and consequently, target costs) are set, supplier relations, how the
organization uses value engineering to reduce costs, and the organizational
structure and culture needed to manage the target costing process. While these
are critical variables on which to gather information, target costing always has to
be studied and understood in relation to the specific organization involved.

7-50 The Kaizen costing system differs from a traditional standard costing system. Under
the traditional standard costing system, the typical goal is to meet the cost standard
while avoiding unfavorable variances. With Kaizen costing, the goal is to achieve
cost reduction targets. Further, variance analysis under a standard cost system
usually compares actual to standard costs, while under Kaizen costing, variance
analysis compares target Kaizen costs with actual cost reduction amounts. Kaizen
costing, then, operates outside of the standard costing system, in part because
standard costing systems in Japan are oriented towards complying with financial
accounting standards.

Another key difference between standard and Kaizen costing has to do with the
assumptions about who has the best knowledge to improve processes and reduce
costs. Traditional standard costing assumes that engineers and managers know
best since they have the technical expertise. Thus they determine procedures that
workers are required to perform according to pre-set standards and procedures.

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Under Kaizen costing, workers are assumed to have superior knowledge about
how to improve processes since they actually work with manufacturing
processes to produce products. Thus, one of the central goals of Kaizen costing
is to give workers the responsibility to improve processes and reduce costs.

Thus, the standard costing system and the Kaizen costing system are used for
very different purposes. The standard costing system is used for financial
reporting purposes while the Kaizen costing system is used for cost management.
The systems do coexist, although many believe that there is really no need for
both systems, especially if the financial reporting system was modified to
accommodate Kaizen costing.

7-51 (a) The Kaizen costing system differs quite significantly from a traditional
standard costing system and there are few similarities. Under the traditional
standard costing system, the typical goal is to meet the cost standard while
avoiding unfavorable variances. With Kaizen costing, the goal is to achieve
cost reduction targets. Variance analysis under a standard cost system
compares actual to standard costs, while under Kaizen costing, variance
analysis is used to compare target Kaizen costs with actual cost reduction
amounts. Kaizen costing is not really part of the standard costing system
because, in Japan, standard costing systems are used primarily for compliance
with financial accounting standards and financial reporting purposes.

Another difference between standard and Kaizen costing is that, under

traditional standard costing, engineers and managers are assumed to have the
best information about how to improve processes and reduce costs since they
design and manage processes. However, under Kaizen costing, workers are
assumed to have superior knowledge about how to improve processes since
they actually work with manufacturing processes to produce products, and
one of the central goals of Kaizen costing is to give workers the responsibility
to improve processes and reduce costs.

(b) Kaizen costing can be adapted in the United States in those companies
that (1) see the benefits of the costing method, (2) have a willingness to
change their existing thinking about the role of standard costing versus
Kaizen costing, and (3) will rely more on the input of workers and
managers to improve processes and reduce costs. As in the adoption of all
management innovations, being open to significant cultural change is what
will allow U.S. organizations to embrace and be successful with Kaizen
costing. In addition, the cost of disruptions to production must be less than
the savings due to Kaizen costing.

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7-52 The first thing that the student should do is determine what definition to follow
regarding who the “best” student is. The definition could vary depending on
whether “best” was defined as the one who consistently scores the highest on
exams, or perhaps, the one who seemed to provide the most intelligent answers
to questions in class, etc. The latter definition is the one that may be the most
desirable in the long run (as a good test taker may not always be a successful
decision maker), but also the hardest to try to emulate, as there may be a level of
innate intelligence that cannot be “learned.” In order to do the exercise, let’s use
the definition of best as the one who scores the highest on exams and assume
that the student is trying to benchmark the study habits of the best student.

The student should ask the best student questions like the following:

1. What procedures do you go through when you study?

a. What methods do you use to take and review notes?

b. What methods do you use to remember details?
c. How many times do you read assigned materials?
d. Do you do extra assignments that are not required?
e. Do you study alone or with friends?
f. Do you have any “secrets” to studying?
g. How do you organize your notes?

2. Where do you study? (At home, in the library, etc.)

3. How do you decide what times of day are most effective for studying?

4. What mix of leisure and work activities do you have?

5. How many hours a day do you devote to each subject?

6. Do you make good use of an instructor’s office hours?

7. How do you review for an upcoming exam?

8. What tips do you have for taking the actual exam?

Implementing some or all of these changes will take time especially if the other
students’ habits are very different from what the student currently does. One
suggestion is to start by implementing one or two suggestions at a time and to
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gradually implement more once the initial suggestions have been mastered. The
implementation will probably fail if the student tries to simultaneously change on
all dimensions. Obviously, this exercise is designed to illustrate to the student
how difficult personal change is and this should be a nice lead in how complex
organizational change is.

7-53 The instructor should:

1. Make sure that students have done their homework on what the
organization that they are going into produces and any other important
background information.

2. Make sure that students have read the material in the text on
benchmarking and understand the five stages of benchmarking, which are:

Stage 1:
· Internal study and preliminary competitive analyses
· Preliminary internal and external competitive analyses
· Determining key areas for study
· Determining the scope and significance of the study

Stage 2:
· Developing long-term commitment to the benchmarking project
 Gaining senior management support
 Developing a clear set of objectives
 Empowering employees to make change
· Coalescing the benchmarking team
 Using an experienced coordinator
 Training employees

Stage 3:
· Identifying benchmarking partners
· Size of partners
· Number of partners
· Relative position within and across industries
· Degree of trust among partners

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Stage 4:
· Information gathering and sharing methods
· Type of benchmarking information:
 Product
 Functional (process)
 Strategic (includes management
accounting methods)
· Method of information collection:
 Unilateral
 Cooperative:
 Database
 Indirect/third party
 Group
· Determining performance measures
· Determining the benchmarking performance gap in relation to
performance measures

Stage 5:
· Taking action to meet or exceed the benchmark
· Making comparisons of performance measures

3. In relation to the five stages listed above, ask students to determine a

series of structured and unstructured interview questions for which they
would like answers. Students should also be instructed to write down their
observations of the facility and the people involved in the benchmarking
project. Developing good questions and recording direct observations will
help students write their report.

4. The instructor might also ask students what criteria they will use to decide
whether benchmarking was successful. For a short exercise like this,
students will probably have to rely on what their interviewees tell them. It
is unlikely that the organization will volunteer to show them actual
company data to illustrate the effects of such a change. Discussing the
need to rely on what interviewees say should lead naturally to discussing
how one goes about determining the effects of management accounting

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Atkinson, Solutions Manual t/a Management Accounting, 6E

methods on organizations. Such a discussion could include the difficulty in

getting proprietary company records, how to design good interviews, and
the role of direct observation in trying to assess how well an
organizational change has been implemented.

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CASES

7-54 (a) In the following diagram, “(v)” indicates activities that add value from the
customer’s perspective, and “(n)” indicates activities that do not.

Woodpoint Furniture Manufacturing Process Flow Chart

Order raw materials (n) Assemble batch (v)

 
(If a piece is defective , return it to appropriate
Place raw materials into storage (n)
area for rework) (n)
 
Remove wood from storage (n) Move batch to painting or staining area (n)
 
Move batch to saw area (n) Store batch in painting or staining area (n)
 
Saw wood (v) Paint or stain batch (v)
 
Move batch to sanding and planing area (n) Move batch to assembly area (n)
 
Store batch in sanding and planing area (n) Complete assembly (v)
 
Sand and plane required pieces (v) Inspect batch (n)
 
(If a piece is damaged by planing or
(If a product is defective, return it to
sanding, reorder piece from saw area and
appropriate area for rework) (n)
store remainder of batch) (n)
 
Move batch to assembly area when all
Package product(v)
planing and sanding is complete (n)
 
Store batch in assembly area (n) Move products into storage (n)

Ship product when ordered by a customer (v)

(b) The response must specify what Woodpoint Furniture Manufacturing’s

customers are likely to require. Presumably quality, cost, and service (in
terms of product features and cycle time to fill order) will be important.
The current production system should be evaluated based on its ability to
allow the organization to meet whatever customer requirements are
specified. If the specified items are quality, cost, and cycle time then each
activity should be measured in terms of the time that it adds to the cycle
time, the quality problems that it creates, and its cost. Possible specific
measures include number of reworked pieces, number of defective pieces,
number of missing pieces, and number of furniture items that fail
inspection.

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7-55 (a) Before, producing a Louis Vuitton “Reade” tote bag required 20 to 30
workers who specialized in one skill, working 8 days. Now, producing the
bag requires just one day as 6 to 12 cross-trained employees work in U-
shaped clusters with sewing machines on one side and assembly areas on
the other. Each worker now handles multiple production tasks and the new
system allows workers to detect and correct problems earlier than before.
As a result, returns of faculty merchandise have decreased dramatically.

(b) According to Passariello (2006), Louis Vuitton is the world’s largest

luxury-goods company; its value proposition centers on “product design,
craftsmanship and image”. Customers were willing to pay high prices for
Louis Vuitton bags in part because of the image resulting from the
perception of skilled craftsmanship. Limited available quantities and long
waits for products were part of the company’s plan to “bolster its cachet.”
Thus, the company’s previous process was consistent with the value
proposition.

(c) Competitors such as Zara sell chic items that are less expensive than Louis
Vuitton’s. Moreover, Zara excels at speed to market; the company can
move from design to stocking the merchandise in stores in as little as two
weeks (Capell 2008). Zara’s approach of manufacturing in small batches
contributes to an aura of exclusivity and helps avoid the need for slashing
prices to sell merchandise. Yet, Zara’s manufacturing flexibility allows the
company to quickly increase the volume of items that are unexpectedly
popular. Capell 2008).

In the face of this competition, Louis Vuitton’s value proposition has

changed. The company will remain a luxury-goods company, but now
views having desired products available in its stores as part of its value
proposition. The new production process will enable the company to
produce items more quickly and with much lower defect rates, so that
stores will have an ample supply of desired products.

(d) Important performance indicators for evaluating Louis Vuitton’s

manufacturing operations include defect rates, cycle time, and changes in
these two measures over time.

7-56 (a) According to Rockoff (2010), customers reported "foreign materials, black
or dark specks" in some medicines, and Johnson and Johnson reported
that some medicines “had higher concentrations of active ingredient than
specified, and some products may contain tiny metallic particles left as a

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residue from the manufacturing process.” Further the U.S. Food and Drug
Administration (FDA) reported that “bacteria contaminated raw materials”
that are ingredients for children’s Tylenol products. Problems were traced
to the Fort Washington, Pennsylvania plant, and later also to the Las
Piedras, Puerto Rico plant (Kimes 2010).

Singer (2010b) and Rockoff and Kamp (2010) report that Johnson &
Johnson (J&J) recalled their hip replacement implants because many of
the implants failed, requiring patients to undergo another hip-replacement
surgery. Rockoff and Kamp (2010) also report that J&J “withdrew about
100,000 boxes of contact lenses sold in Asia and Europe because a
manufacturing problem prompted some customers to complain of pain,
stinging or redness.” The problems with the lenses were traced to a plant
in Ireland.

(b) The external failure costs include lost sales due to loss of reputation and
concerns about quality, and the need to shut down the Fort Washington,
Pennsylvania plant. Singer (2010c) reports that J&J’s, “sales of over-the-
counter drugs and nutritional products in the United States plummeted to
$438 million in the third quarter from $732 million in same time period
last year, a decrease of about 40 percent.” In addition, she reports
projections of a persistent decrease in market share in over-the-counter
drugs.

Other external failure costs include product liability lawsuits, the cost of
returned products, the cost of developing materials for recall web pages
and press releases, providing toll-free phone calls to consumers, and staff
to respond to calls and messages.

(c) According to Singer (2010c), while the Fort Washington plant is closed,
J&J will upgrade it. J&J is also strengthening its manufacturing and
quality controls (Singer 2010a), with a reemphasis on prevention costs and
possibly appraisal costs. Prevention costs include quality engineering,
quality training, statistical process control and supplier certification.
Appraisal costs include costs relating to inspection/testing of incoming
materials, maintenance of test equipment, process control monitoring and
product quality audits.

Kimes (2010) provides an in-depth description of how quality problems

arose at J&J’s McNeil Division, which produces over-the-counter drugs.

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Atkinson, Solutions Manual t/a Management Accounting, 6E

References

Kimes, M. “Why J&J’s Headache Won’t Go Away,” Fortune (September 6,

2010), pages 100-108.

Rockoff, J. D. “FDA Widens Probe of J&J's McNeil Unit; Inquiry Follows

Recent Recall of Over 40 Children's Medicines Because of Manufacturing
Problems,” The Wall Street Journal (May 18, 2010), page B1.

Rockoff, J. D. and J. Kamp. “J&J Latest Recall: Hip-Repair Implants,” Wall

Street Journal (Online) (August 26, 2010).

Singer, N. “Maker of Tylenol Explains Actions Taken to Alleviate Musty Smell

of Pills,” The New York Times (March 17, 2010). Accessed online on January
11, 2011 at http://www.nytimes.com/2010/03/18/business/18drug.html?
_r=1&scp=1&sq=Las%20Piedras&st=cse. The online source has links to an
FDA report on one of J&J’s plants and a letter with J&J’s response.

Singer, N. “Johnson & Johnson Recalls Hip Implants,” The New York Times
(August 26, 2010).

Singer, N. “Tylenol Recalls Erode Johnson & Johnson Sales,” The New York
Times (October 19, 2010).

7-57 (a) Costs in the following items are relevant to Polley’s decision: 1, 2, 3, 4, 5,
7, 9, 10, and 13. Item 6 is not relevant because it is a sunk cost, and items
8, 11, and 12 are not relevant because the costs do not differ across the
two options.

(b) Polley is likely to consider the decreased health risks for workers with the
new solvent, decreased risks of violating OSHA regulations and incurring
penalties, and decreased risks of negative media coverage. Polley is also
likely to consider the potential increase in demand for Kwik Clean’s
services if the company markets its environmentally safer process. Polley
may also try to assess whether individual customers are more sensitive to
such marketing than are business customers.

(c) For operations with potential environmental pollution, prevention can

involve efforts to ensure pollution does not occur. Prevention efforts
might include changing processes, as Polley is considering. Appraisal
efforts might include inspections to ensure pollution levels are within
acceptable limits or workers are following prescribed procedures for

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dealing with pollution or hazardous wastes. Internal failures are failures

(accidental spillages or leakages of hazardous wastes, or illegal levels of
pollutants) that are detected and cleaned up or corrected before reaching
the public. Finally, external failures are failures that are not detected,
cleaned up, or corrected before reaching the public. As in the cost of
quality framework for manufacturing operations, environmental pollution
external failures are often the most costly to the firm. If prevention efforts
are feasible, attention should be focused on prevention. Given that some
pollution or hazardous wastes are generated, efforts should also be
focused on appraisal, with the intent of minimizing internal failures and
external failures.

7-58 (a) The company may be monitoring the amount of time spent talking to
customers, and if it is monitoring the content of the calls, the company
may be evaluating how polite the CS representatives are. There are many
other measures that customers would like the company to monitor (see
question (b)), but given the described CS behavior, it seems unlikely that
the company emphasizes speedy problem remediation.

(b) The customer is likely thinking about measures or issues such as the
following:
· Time from the first phone call to CS until the TV is repaired and
returned
· Number of phone calls required
· Time per phone call
· Total time spent on phone calls
· Time between a phone call and the response from CS or WD
authorizing repair
· Time spent writing to the company to report on the unpleasant
experience trying to get the TV repaired
· Politeness of CS reps and supervisor
· Ability to resolve the problem with one phone call
· Wait time to talk to CS rep

(c) Instead of faxing or mailing the receipt, the customer can be allowed to
email the receipt by other electronic means, such as using a scanner to
produce an electronic copy or taking a digital photo. The company could
also think about ways to eliminate the need for CS to forward the warranty
authorization to another department, in order to increase the likelihood
that the customer’s request can be handled with one phone call and less
delay. For example, if a customer knows that the request is for warranty

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Atkinson, Solutions Manual t/a Management Accounting, 6E

repair, he or she could be allowed to deal with WD directly instead of

relaying the information back and forth between the customer, CS, and
WD. The company could also develop a better system for determining
which approved repair shops are the closest to the customer’s address.
Furthermore, the company could identify shops with high customer
satisfaction and shops with fast turnaround time. The company could offer
incentives to shops to encourage faster service and turnaround.

(d) RS3 can clearly learn from RS4’s approach of diagnosing the problem
shortly after the TV arrives in the shop. This allows the shop to order parts
shortly after the TV enters the shop, with the result that the total time that
the TV spends in the shop is likely to much shorter than in RS3. RS3’s
approach introduces unnecessary waiting time, a nonvalue-added activity
from the customer’s perspective. In addition, RS3 needs space to store all
the items waiting for diagnosis or parts. The customer faces additional
waiting time because of RS3’s inability to pick up TVs on a timely basis.

7-59 Total net annual benefit from the new machine:

Increase in contribution margin $648,000a

Decrease in inventory carrying costs 63,000b
Less increase in lease costs (410,000)c
Net annual benefit from new machine $301,000
a
[($56–$32)  48,000]–[(56–$42)  36,000] = $648,000
b
Inventory levels with the old machine:

36,000  $12  4/12 =

Raw materials $144,000
36,000  $25  3/12 =
Work-in-process $225,000
36,000  $46  2/12 =
Finished goods $276,000
$645,000

Inventory levels with the new machine

Raw materials 48,000  $11  1.5/12 = $ 66,000
Work-in-process 48,000  $20  1.5/12 = $120,000
Finished goods 48,000  $36  1/12 = $144,000
$330,000
Change in annual inventory carrying costs:
($330,000 – 645,000)  20% = $63,000 decrease
c
$900,000–$490,000 = $410,000 increase

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(b) Rossman should replace its old machine with the new machine because
the penalty of $280,000 for early termination of the lease is more than
offset by the net annual benefit of $301,000 for each of four years with the
new machine.

(c) A manager evaluated on the basis of net income may decide not to replace
the existing machinery if there is considerable uncertainty about the
projections for increased sales or reduced costs, given the relatively small
benefit in the first year based on the stated projections. This benefit is
$301,000 – $280,000 = $21,000. Thus, a manager with a short-term focus
may not lease the new machinery even though it would increase
Rossman’s income over the long-run.

7-60 Precision Systems1

This case study illustrates that quality cost information can play an important role
in alerting top management about the importance of quality improvement in a
nonmanufacturing department of a manufacturing firm. The case is based on the
following article by S. S. Kalagnanam and E. M. Matsumura: “Cost of Quality in
an Order Entry Department,” Journal of Cost Management, Fall 1995, pp. 68—
74.

Although the actual case takes place quite some time ago, the need for
improvement in nonmanufacturing processes remains pervasive. We still
encounter firms that take pride in their quality of manufacturing operations while
continuing with poor quality nonmanufacturing processes.

The required questions are designed to acquaint students with some of the
terminology of “cost of quality” and some aspects of conducting a cost of quality
study. Quality costs, defined as those that arise because poor quality may exist or
does exist, have been classified into the following four categories:

• Prevention (prevention of poor quality, or quality assurance);

• Appraisal (inspection and testing);
• Internal failure (costs such as rework or scrappage for nonconforming
products identified before delivery to customers);
• External failure (costs such as warranty expenses or freight charges for
nonconforming products delivered to customers).

This case focuses on prevention activities (see question (f)), as well as internal
failure and external failure costs for the order entry department at Precision
1
Source: Institute of Management Accountants, Cases from Management Accounting Practice, Instructor’s Manual,
Volume 12. Adapted with permission.
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Atkinson, Solutions Manual t/a Management Accounting, 6E

Systems, Inc., where internal and external failures are defined with respect to the
order entry department.

Suggested Solutions to Required Questions

(a) This question is designed to help students recognize how cost management
systems can interface with quality improvement efforts. As the case states,
in spite of PSI’s commitment to quality improvement, “the changes [in
order entry] would not have been so vigorously pursued if cost information
had not been presented. COQ information functioned as a catalyst to
accelerate the improvement effort.” This is because the cost figures
captured the attention of top management. Other responses might include
the following: (1) It made order entry aware of the dollar impact of its
errors; (2) It provided a means of prioritizing quality improvement efforts.

(b) There are many possible flows. For example, a sales representative may
contact order entry to request a quote for a system for a customer.
Subsequently, the customer contacts order entry to place the order; and
order entry then generates an order acknowledgement, which is sent to
manufacturing, invoicing, and sales administration. Once the system has
been shipped, an invoice is sent to the customer. Ultimately, collections
will receive the invoice. Customer support will contact the customer to
arrange installation and will be available to answer questions over the
phone.

A request for parts from a service representative or directly from a

customer would be received by order entry, which would generate an
order acknowledgement that might then be routed to the stockroom, after
which the part would be shipped and the customer would be billed. A
request for service would result in an order acknowledgement being sent
to the service department (see the following chart).

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(c) Items 1, 2, 5, 8, 10, and 12 are internal failures; the remainder are external
failure items. Internal customers affected by external failure items are
listed below.

Item Number Internal Customer(s) Affected

3 Manufacturing, service, stockroom, invoicing
4 Invoicing, sales administration (profitability
analysis)
6 Manufacturing, service, stockroom, invoicing,
sales administration
7 Shipping, invoicing, collections, customer support
9 Manufacturing, service, stockroom
11 Invoicing, collections, sales administration

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Atkinson, Solutions Manual t/a Management Accounting, 6E

Other examples (not included in Exhibit 7-18):

Error Type Internal Customer(s) Affected

Incorrect serial # of system on
order acknowledgement
Duplicate order
Incorrect sales rep. code
Service, customer support
Stockroom, shipping, manufacturing,
sales administration
Sales administration

(d) An initial step would be to interview employees in order entry, as well as

its suppliers and internal customers. Based on the interviews, data
collection forms can be developed. For internal failures, order entry staff
would keep track of the problems they encounter while preparing quotes
and processing orders. For external failures, internal customers of order
entry would keep track of the errors they encounter when using
information from the quotes or order acknowledgements (examples of
forms appear at the end of this teaching note: Form #1 pertains to internal
failures and Form #2 pertains to external failures).Suppliers to order entry,
internal customers of order entry, and order entry staff should be involved
in making improvements to the order entry process.

(e) Possible responses include the following:

Office equipment and office space;
Telephone (to clarify problems);
Computer costs (making changes on the computer);
Supplies (paper for printing new quotes or order acknowledgements);
Lost interest and other costs associated from late payments by customers
(due to invoicing mistakes resulting from order entry errors);
Lost sales from new customers (due to delay in preparing quotes);
Lost future sales from current dissatisfied customers (due to errors in order
entry);
Shipping costs on returns;
Rework costs;
Frustration and lower morale, possibly leading to poorer quality or high
turnover;
Costs related to duplication in manufacturing;
Crisis management costs (express shipping);
Lost revenues if underpricing;
Scrappage of returns.

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(f) Students can brainstorm about possible improvements during a class

discussion. Possible responses follow.

Incremental Improvements

Empower employees.
Allow sales representatives to correct errors without approval.
Urge order entry to improve communication with manufacturing and
other departments.
Provide feedback to order entry on types of errors, numbers of errors,
and cost impact. Daily feedback (suggestions for improvement) can
be provided via computer.
Educate sales representatives about effects of errors and about the
process.
Provide better training for sales representatives.
Train sales representatives to develop accurate quotes and take on the
order entry function.
Have sales representatives take responsibility for the process.
Track customer purchases to improve service to customers.
Survey customers about problems; use the responses to prioritize
problems.
Stop the double entry of information.
Get input from order entry on development of forms.
Implement checking in order entry to help prevent order
acknowledgement errors.
Develop a reward system that motivates error-free performance of sales
representatives and order entry.
Benchmark.

Breakthrough Improvements

Develop a computer system to decrease the number of times data are

entered.
Develop a spreadsheet or computer program to check for inconsistencies
between P.O. and quotes, check for duplication of orders, and check
prices.
Develop a computer system that allows sales representatives to prepare
accurate quotes.
Install a computer system linking order entry, manufacturing, invoicing,
etc.
Use cross-functional teams to manage “large” costs or different

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segments.
Develop a system that allows parts customers to get their own quotes
on-line.

Note: Today, customers may add a request for a quote to their shopping
cart but the web page does not provide a quote online.

Incremental Improvements Made by PSI

1. Key information for quotes is now obtained up-front by the sales

representative; earlier, the sales representative faxed partial
information to order entry and requested a quote. Order entry
staff then spent a great deal of time obtaining missing
information. With this change, the sales representative cannot
request a quote until he or she has supplied key information to
order entry staff. This could be considered a prevention activity.
2. Customers are asked to include quotation numbers on their
purchase orders. This allows PSI to match orders with quotes and
avoid duplication in manufacturing. PSI prepares its
manufacturing plan based on the quotes received because they
have a reasonably good idea of which ones are likely to become
firm orders.
3. Proper tools are provided to the order entry staff:
Procedure manuals.
Guidelines for sales discounting. Previously, the order entry staff
had to call sales to seek clarifications regarding discounts.
Printed configuration guides that contain information in the
format order entry requires. Previously, the formats did not
always match.
4. Order entry staff are now responsible for both quotes and orders.
Previously, some staff were responsible only for quotes, and other
staff were responsible only for orders. This change had an
immediate impact, as the person who prepared a quote now had
responsibility for processing the subsequent order.
5. A regular feedback system is now in place. Each internal
customer department provides feedback to order entry once every
quarter.
Benefits: Cycle time for preparing quotes was reduced by 60%,
and cycle time for processing orders was reduced by 50%.
Also, order entry staff experienced greater pride in their work.

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Breakthrough Improvement Efforts by PSI as of 1993

Many of these improvements are prevention activities.

1. PSI began working with a vendor to develop an on-line configuring
program that would configure their standard systems (order entry staff
would avoid keying-in part numbers).
2. PSI planned to acquire a new, more integrated order entry system that
can communicate with the configuring program and turn a quote into an
order acknowledgement when the order comes in. The system will also
be able to generate an invoice, thereby avoiding rekeying the
information.
3. PSI began working toward providing sales representatives with a laptop
computer equipped with a built-in configuring program. It will allow
them to prepare quotes in the field.
The anticipated benefits include a reduction in errors caused
by incorrect or duplicate part numbers and a reduction in cycle time
for preparing quotes or processing orders and preparing invoices.

Prioritizing Improvement Activities

Three considerations in prioritizing improvement activities are the

perceived seriousness of the problems, the benefits of improvements, and the
costs of the improvements. In this case study, the breakthrough improvement
projects involve higher costs than the incremental improvement efforts. To
identify the most serious problems, a Pareto analysis can be performed.
In PSI’s case, correcting order acknowledgement errors became the
highest priority because of its associated cost of 7% of the salary and fringe
benefits budget (see Exhibit 7-19).

Update: Improvement Efforts by PSI as of 1996

The first incremental improvement, a stringent policy of sales

representatives filling out quote forms correctly, was abandoned because the
forms quickly became obsolete and the policy was unpopular with sales
representatives. In addition, the policy slowed the quotation process.
The initial vendor’s quote for the desired configuring program was
judged unaffordable. After an 18-month search, however, PSI was able to
purchase a new integrated information system (including materials resource
planning and accounting) that included a configuring program. In the
meantime, PSI developed an in-house configuring program that runs on the
sales representatives’ laptop computers. As a consequence, problems with
missing, incorrect, or changed part numbers have been greatly reduced.

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Atkinson, Solutions Manual t/a Management Accounting, 6E

Information on part numbers originates in manufacturing and is maintained

and kept current by the marketing department. A change from line-item
pricing (listing each component part with its associated price) to bundling
(listing the component parts but providing only a bottom-line price) reduced
processing time because customers previously would call for verification if
any one of the component prices on the invoice differed from what appeared
on the quote.
The current cycle typically runs as follows:
• Sales representative prepares a quote using laptop computer configuring
program and e-mails it to order entry.
• Order entry reviews the quote and sends a quote packet to send to the
customer (pricing on quote is reviewed by order entry supervisor).
• When the customer’s order is received by order entry, the order is
entered into PSI’s system configuring program; the order entry
supervisor approves the order.
• The controller approves the order.
• The order acknowledgement is transmitted electronically to
manufacturing.
• Manufacturing builds the product.
• The product is shipped.
• The invoice is generated the same day the product is shipped, with no
further review.

(g) PSI’s sales representatives have specialized scientific training in order to

provide knowledgeable assistance to customers who wish to purchase
high-technology instrumentation. The sales representatives guide the
customers in choosing the appropriate instrumentation for the customers’
needs. The requirement for specialized knowledge creates difficulty in
allowing customers to simply order systems online.

Even if the technical issues related to customers determining what to order

can be overcome, PSI must still ensure that its supporting internal
processes are of high quality. A web-based ordering capability in and of
itself will not necessarily resolve PSI’s quality problems related to
accuracy of orders and appropriate system configurations. For example,
the information technology support within PSI must ensure that
configuration possibilities and pricing are always accurate.

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 Chapter 7: Measuring and Managing Process Performance

(h) Nonfinancial indicators that might be useful in improving quality in the

order entry department include:
• The frequency of the different types of errors.
• Time spent on correcting problems.

Frequency of reporting is an important issue when implementing a COQ

system. Options for frequency of tracking data and reporting include:
• Keep track of the information on a daily basis but report monthly.
Continue doing this until improvements are made and the information
is no longer needed. The assumption is that continuous improvement
projects will be undertaken to rectify the situation.
• Collect sample data for a specified period once every quarter or six-
month period, for example, and assess the changes in the magnitude
of problems. The assumption is that results from the sample data will
be used to make process improvements.

COQ information is useful for the following reasons:

• COQ quantifies the financial impact of the errors/problems, thereby
providing a universally understood method of assessing the seriousness
of the situation. As emphasized in question (a), COQ figures can play
an important role in alerting top management to the seriousness of
quality problems overall or in a particular area.
• Quality cost systems cut across departmental boundaries, thereby
providing a holistic measure of the benefits derived from improvement
efforts.

COQ information should be used in conjunction with nonfinancial

indicators, as the latter provide the information actually required for making
changes to the system.

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Atkinson, Solutions Manual t/a Management Accounting, 6E

Form #1 - Class I (Internal) Failure

Completed by Order Entry Staff

Date Started _______________ Time Started ___________

Order serial #
Is this a new order? Yes I No (If not, please specify —)
Is this an engineering special? Yes / No
Is all information available and clear? Yes I No
Is the quotation # available on the Purchase Order? Yes I No
If not, how did you track down the quotation?
By dollar amount ____ By customer name ____ Called sales rep. ____
Other

Is all relevant information available and clear on the customer’s P.O.? Yes I No Please
provide below details of all the clarifications required.
Serial No. Explanation of problem / clarification How clarification obtained Time spent

How long did it take you to prepare the first draft of the order (including time spent
obtaining clarifications?
How much time did you spend inspecting the quote before finally giving it to your
supervisor for inspection?
Were there any changes as a result of your inspection(s)? Yes / No
Time taken to make changes _____ minutes/hours.
How many drafts of the order were printed including the one you gave to your
supervisor for inspection?

Complete after your supervisor has inspected the order

Were there any changes as a result of your supervisor’s inspection? Yes / No

Time taken to make changes _____ minutes/hours.

After your supervisor’s inspection, how many drafts of the order were printed in
addition to the final version mailed to the customer?
Date and time order sent out to your internal customer?
Other comments:

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 Chapter 7: Measuring and Managing Process Performance

Form #2- Class II (External) Failure

Completed by Manufacturing Department (Immediate Internal Customer)

Order/ Quotation Nature of How clarification Time spent in

serial # error/clarification obtained obtaining
required/problem clarification
(including waiting
time)

Total number of errors

Number of orders/quotations received
Errors as a % of orders/quotations

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