Management Accounting

Information for Activity

and Process Decisions
Chapter 5

Evaluation of Financial Implications

Managers must evaluate the financial

implications of decisions that require trade-offs
between the costs and the benefits of different
alternatives
Financial information about the different types
of costs form the basis of decisions about the
organizations activities and processes

Relevant Costs and Revenues

Whether particular costs and revenues are

relevant for decision making depends on the
decision context and the alternatives
available
Relevant costs - costs and revenues that
differ across the decision alternatives

Relevant Costs

Opportunity costs by definition are relevant costs

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

Sunk Costs are Not Relevant

Sunk costs often cause confusion for

decision makers

Costs of resources that already have been

committed and no current action or decision can
change
Not relevant to the evaluation of alternatives
because they cannot be influenced by any
alternative the manager chooses

Relevant Costs for the Replacement of a

Machine

Should Bonner dispose of the USC machine

it just purchased on September 1 and buy the
new machine from Teo Company?
What costs are relevant for this decision?

Relevant Costs for the Replacement of a

Machine

Sunk costs

$30,000 cost of old machine

$5,200 monthly loan payment for old machine

Relevant Costs for the Replacement of a

Machine

Cost increases and cash outflows:

$50,000 down payment on the new machine

$6,000 monthly lease payments on new machine

Relevant Costs for the Replacement of a

Machine

Cost Savings and Cash Inflows

$50,000 disposal of old machine

$6,200 monthly cost savings:

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

Assuming Responsibility for Decision

Reversing a decision made a month earlier

may look like an error
If the manager does not purchase the new
machine, his behavior may be viewed as
suboptimal
The manager may garner respect by
assuming responsibility for error
Manager needs to recognize sunk costs

10

Make-or-Buy Decisions

As managers attempt to reduce costs and

increase the competitiveness of their
products, they face decisions about whether
their companies should
Such make-or-buy decisions illustrate how to
identify relevant costs and revenues

11

Make-or-Buy Decisions Example

Std. Rear

Std. Front

Multicolor

Curved

$ 36

$ 49

$ 56

$ 58

Direct labor

22

25

24

28

Unit-related support

14

16

18

20

Batch-related support

10

16

19

22

Product-sustaining overhead

12

14

19

Facility-sustaining overhead

10

11

14

$ 96

$ 128

$ 142

$ 161

Lowest bid

$ 82

$ 109

$ 140

$ 156

Second lowest

$ 88

$ 116

$ 147

$ 164

36,000

48,500

6,800

8,700

Product cost per unit:

Direct materials

Total manufacturing costs

Bids from outside suppliers:

Annual production (units)

12

Avoidable Costs

Those that are eliminated when a part, product,

product line, or business segment is discontinued
If the production manager decides to outsource a
product, the company may avoid certain
production costs
Contraction or redeployment of resources may
allow the company savings

13

Avoidable Costs

The company cannot dispose of part of the

facility used to support the production of the
standard rear lamp without disposing of the
entire machine or building
Most facility-sustaining support costs
represent the prorated costs of indivisible
common facilities

14

Avoidable Costs

Is there an alternative use for the part of the

facility made available by not producing a
product?
Indirect savings in facility-sustaining costs for the
organization are relevant for the decision to
outsource production, because they can arise
only if the lamp is outsourced

15

Summary of Financial Analysis

If the standard rear lamp is outsourced, the

company may avoid $3,168,000 of
manufacturing costs
The company would spend $2,952,000 to
purchase the parts from the low-bid supplier
The company could save $216,000 by
outsourcing

16

Qualitative Factors

For most decisions such as this, several additional

factors, which are more qualitative in nature, need to
be considered:
Permanence of the lower price
Reliability of the supplier:
Many companies have adopted the practice of
certifying a small set of suppliers who are dependable
and consistent in supplying high-quality items as
needed

17

Facility Layout Systems

There are three general types of facility

designs:

Process layouts
Product layouts
Cellular manufacturing

Regardless of the type of facility design, a

central goal of the design process is to
streamline operations and thus increase the
operating income of the system

18

The theory of constraints (TOC)

TOC maintains that operating income can be

increased by carefully managing the
bottlenecks in a process

A bottleneck is any condition that impedes or

constrains the efficient flow of a process
A bottleneck can be identified by determining points
at which excessive amounts of work-in-process
inventories are accumulating
The buildup of inventories also slows the cycle time
of production

19

Theory of Constraints
The theory of constraints relies on the use of three
measures

1.

2.

3.

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

20

Theory of Constraints

Emphasis is on the short-run optimization of

throughput contribution
Assumes that operating costs as difficult to
alter in the short run

21

Process Layouts

All similar equipment or functions are grouped

together
Production of unique products is done in small
batches
Product follows a serpentine path, usually in
batches
High inventory levels
Products might travel for several miles within a
factory during the production process

22

Process Layout in a Bank

The customer goes to the bank (a moving activity)

The bank takes the loan application from the
customer (processing activity)
Loan applications are accumulated (storage
activity) and passed to a loan officer (moving
activity) for approval (both processing and
inspection activity)
Loans that violate standard loan guidelines are
accumulated (storage activity) then passed
(moving activity) to a regional supervisor for
approval (processing activity)

23

Process Layout in a Bank (

The customer is contacted when a decision has

been made (processing activity)
If the loan is approved, then the loan proceeds
are deposited in the customers account
(processing activity)
In most banks, work-in-process stockpiles at
each of the processing points or stations
Loan applications may be piled on desk of the
bank teller, the loan office or the regional
supervisor
24

WIP Accumulation

Work-in-process inventory accumulates at

processing stations in a conventional
organization for three reasons
1.
Handling work in batches
2.
If the rate at which each processing area
handles work is unbalanced, work piles up
at the slowest processing station
3.
If processing area managers are evaluated
on their ability to meet production quotas

25

Product Layouts

In a product layout, equipment is organized to

accommodate the production of a specific product
Product layouts exist primarily in companies with
high-volume production
The product moves along an assembly line beside
which the parts to be added to it have been stored
Placement of equipment or processing units is made
to reduce the distance that products must travel

26

Product Layout in a Cafeteria

People pass by containers of food and take

what they want
Employees organize the food preparation
activities so that the containers are refilled just
as they are being emptied
The ultimate goal is to reduce setup costs to
zero and to reduce processing time to as close
to zero as possible so that the system can
produce and deliver individual products just as
they are needed
27

Cellular Manufacturing

The organization of a plant into a number of

cells
Within each cell all machines required to
manufacture a group of similar products are
arranged in close proximity to each other
The machines in a cellular manufacturing
layout are usually flexible and can be
adjusted easily or even automatically to make
different products
28

Cellular Manufacturing

The shape of a cell is often a U shape,

The number of employees needed to produce
a product can often be reduced due to the
new work design
U shape also provides better visual control of
the work flow

29

Problems with Batch Production

Creates inventory costs

Creates delays associated with storing and
moving inventory

These delays increase cycle times, thereby

reducing service to customers

Delays may even happen before

manufacturing begins

30

Inventory-Related Costs

Demands for inventory lead to huge costs in

organizations, including the cost of moving,
handling, storing, obsolescence & damage
Factory layouts and inefficiencies that create
the need to hold work-in-process inventory
may hide other problems leading to
excessive costs of rework

31

Processing time

Processing time time expended for the

product to be made
Processing cycle efficiency (PCE) measure
of the efficiency of the manufacturing process
PCE =

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

32

Analysis of relevant costs and benefits of

reorganization

Total costs: $1,000,000

Three main benefits:
1. Increase in sales due to decreased
production cycle time
2. Reduction in inventory-related costs
because of reduced handling of WIP
3. Improvement in quality since defective
processes are detected more quickly
33

Cost of Nonconformance and

Quality Issues

Cost reduction has become a significant factor in the

management of most organizations
The premise underlying cost reduction efforts today
is to decrease costs while maintaining or improving
product quality in order to be competitive
If the quality of products and services does not
conform to quality standards, then the organization
incurs a cost known as the cost of
nonconformance (CONC) to quality standards

34

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

1.

2.

Satisfying customer expectations regarding the

attributes and performance of the product
Ensuring that the technical aspects of the
products design and performance conform to
the manufacturers standards

35

Quality Standards

Global competition has led to the

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

36

ISO9000

In 1987, the International Organization for

Standardization (ISO) developed the first ISO9000
Series of Standards
These standards were revised in 1994 and again
in 2000
The goal of the member nations is to develop
globally recognized independent (third party)
quality system verification

37

ISO9000 (2 of 6)

ISO 9000 contains more than 20 standards and

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

38

ISO9000

The four primary standards are:

ISO 9000: Quality management systems

Fundamentals and vocabulary
ISO 9001: Quality management systems
Requirements
ISO 9004: Quality management systems
Guidance for performance improvement
ISO 19011: Guidelines on quality and/or
environmental management systems auditing (To
be published)

39

ISO9000

The most significant changes in the revised

ISO 9000 standards are:

Increased focus on top management commitment

Emphasis on a process approach within the
organization
Continual improvement
Increased focus on enhancing satisfaction for
customers and other interested parties

40

ISO9000

Eight quality management principles from

best management practices:

Customer focus
Leadership
Involvement of people
Process approach
System approach to management
Continual improvement
Factual approach to decision making
Mutually beneficial supplier relationships
41

Costs Of Quality Control

Classification of quality costs:

Prevention costs
Appraisal costs
Internal failure costs
External failure costs

Experience shows that it is much less

expensive to prevent defects than to detect
and repair them after they have occurred

42

Prevention Costs

Prevention costs are incurred to ensure that

companies produce products according to
quality standards:

Quality engineering
Training employees in methods designed to
maintain quality
Statistical process control
Training and certifying suppliers so that they can
deliver defect-free parts and materials and better,
more robust, product designs
43

Appraisal Costs

Appraisal costs relate to inspecting products

to make sure they meet both internal and
external customers requirements
Inspection costs of purchased parts and
materials

44

Internal Failure Costs

An internal failure occurs when the manufacturing

process detects a defective component or product
before it is shipped to an external customer
Reworking defective components or products is a
significant cost of internal failures
The cost of downtime in production is another
example of internal failure

45

External Failure Costs

External failures occur when customers

discover a defect
All costs associated with correcting the
problem
For many companies, this is the most critical
quality cost to avoid

46

Cost-of-Quality Report

This information is compiled in a cost-of-quality

(COQ) report, developed for several reasons
The report illustrates the financial magnitude of
quality factors
Cost-of-quality information helps managers set
priorities for the quality issues and problems they
should address

47

Cost-of-Quality Report

The cost of quality report allows managers to

see the big picture of quality issues
It allows them to try to find the root causes of
their quality problems

48

Just-in-Time Manufacturing

Just-in-time (JIT) manufacturing is a

comprehensive and effective manufacturing
system
Just-in-time production requires making a
product or service only when the customer,
internal or external, requires it
It uses a product layout with a continuous flow

49

Implications Of JIT Manufacturing

Just-in-time manufacturing is simple in theory but

hard to achieve in practice
Organizations that use just-in-time manufacturing
must eliminate all sources of failure in the system

50

Implications Of JIT Manufacturing

At the core of the JIT process is a highly trained

workforce whose task is to carry out activities using the
highest standards of quality
When an employee discovers a problem with a
component, it is the responsibility of that employee to
call immediate attention to the problem so that it can
be corrected
Suppliers must be able to produce and deliver defectfree materials or components just when they are
required
Preventative maintenance is also employed so that
equipment failure is a rare event

51

Implications Of JIT Manufacturing

Just-in-time manufacturing has two major

implications for management accounting

management accounting must support the move

to JIT manufacturing by monitoring, identifying,
and communicating to decision makers the
sources of delay, error, and waste in the system
the clerical process of management accounting is
simplified by JIT manufacturing, due to the smaller
inventory to monitor and report

52

Implications Of JIT Manufacturing

Important measures of a JIT systems

reliability include the following benchmarks of
manufacturing cycle effectiveness
Conventional labor and machine productivity
ratios are inconsistent with the just-in-time
production philosophy
Any significant management innovation, such
as ABC or JIT, requires a major cultural
change for an organization

53