1. Management Accounting:
A Road of Discovery

2. Management Accounting:
A Road of Discovery
James T. Mackey
Michael F. Thomas
Presentations by:
Roderick S. Barclay
Texas A&M University - Commerce
James T. Mackey
California State University - Sacramento
© 2000 South-Western College Publishing

3. Chapter 11 How do we begin the improvement process?
Total quality management and continuous improvement

4. Key Learning Objectives
1. Discuss total quality management’s three critical success factors of quality, service, and cost.
2. Define the four quality costs and create a cost of quality report.
3. Explain how to identify value-added and nonvalue-added activities, and how continuous improvement with kaizen costing supports TQM.
4. Calculate the inefficiency and cost created by nonvalue-added activities.
This chapter introduces the role of accounting systems to aid in the transition from scientific management to continuous improvement management. The first part of the discussion focuses on the need for measures that evaluate value. Value is measured in the ‘eyes of the customer’ based upon:
The fit between product design (quality of design) and customer need. We discussed this in chapter 10 with the snake chart as an illustration.
The quality of specification. This is the more typical idea of a product meeting design specifications.
Service or delivery.
Value chain cost.
Next, we address the debate between Scientific Management and Continuous Improvement management. The difference in philosophies of each determines the changes need in the accounting information system.
We use COQ statements as a means of convincing scientific management managers to change their views and modify the internal processes.
We then introduce a series of procedures that use accounting data to support continuous improvement activities.
5. Prepare a fishbone diagram and Pareto chart, and discuss the need for 2nd generation ABC in eliminating quality problems.
6. Identify ways to motivate a TQM mentality.

5. The Objective of Good Management
The objective is to maintain and add value to the enterprise.
As competition increases, we can increase value by decreasing our costs or differentiating products to add greater customer value.
The only truly sustainable competitive advantage is the ability to learn and improve faster than the competition.
We want to do things that add value for the marketplace and do these things as efficiently as possible.

6. Definition of Quality —
Part II
Definition of Quality —
Measuring value created in the eyes of the customer
If management can differentiate its product in the eyes of the customer, value can be maximized. Companies need not compete on the basis of price alone. In fact, in today’s marketplace, price is often the last consideration. Quality and a product that meets customer needs dominate the purchase decision. Students need to understand the considerations that influence customer value in order to appreciate the need for and the design of measures that reflect value. This approach establishes the need to merge financial and nonfinancial measures to better measure and encourage value creation.

7. Quality of Design
Quality of design is the fit between the customers wants and the goods or services we provide.
This means we design products with customers in mind.
For example, both the Geo and the Mercedes are quality products but they may not both be quality designs for the same customer.
I use the example of my dream car. It will carry three tons of dogs and kids in the back while going 130 mph in the mountains. My car would get 40 miles to the gallon and only cost $5,000. While companies may not be able to delight customers by meeting all their demands, they can differentiate products to enhance customer value. We can relate this objective to the snake chart discussed in chapter 10.

8. Total Quality Management (TQM)
This is a philosophy that focuses on
Better product quality (Quality of Conformance).
Commitment to customer service (Service).
Minimize total costs (Cost).
Pair/Share: Identify a difference between quality of design and quality of specifications you observe from your point of view for your school.

9. Linking Value to Operational Conformance
Quality of Conformance means the product meets its specifications.
It has the characteristics the company promises.
Service means the company does what it’s supposed to do for the customer.
Cost for the customer means all costs incurred by the product throughout the customer’s value chain.
A value-focused strategy must consider all three because only current costs and revenues are measured.
Value is determined by both current and future cashflows.
Nonfinancial measures are lead indicators of future cashflows
Pair/Share: Identify some future value, or cost, from your education at this school.
Receiving cash and the sales transaction today may not provide good insight into information about future activities. Nonfinancial measures, like market share, may more closely predict future value.

10. The Role of Management Accounting in TQM
Part III
The Role of Management Accounting in TQM

11. Management Accounting’s Role in TQM
Influence change by measuring the costs of current quality activities.
Determine the activities adding value to our products (or services) AND THOSE NOT ADDING VALUE.
Provide relevant cost information for proposed changes.
Monitor and report the financial impact of quality programs.
Exhibit 11-1, p. 392.

12. Changing the Corporate Culture
Use Cost of Quality (COQ) reporting.
The objectives of COQ reports are:
Changing the corporate culture.
Reporting the money spent on quality failures.
Identifying the cost of quality activities.
Identifying the relationships between conformance costs and nonconformance costs.
Tracking the changes over time.

13. Total Quality Management vs. Traditional Management
Conformance
The Traditional View is that as conformance costs increase, the nonconformance cost savings decrease. Therefore at some point increasing spending on quality is not justified.
The TQM view is that savings from increasing quality always justify the cost.
We need to consider the long-term strategic value of zero defect products,
The advantages for automation when defects are eliminated, and
The incremental savings to current and future product lines over many years.
Juran introduced the idea of the cost of quality in the early 1950s. We draw a vertical cost bar on the left-hand side (of either a blank slide or the blackboard) and a horizontal conformance line across the bottom. Conformance means meeting specifications. 100% conformance means there are no rejects or failures in the production process. 95% conformance means the company has 5% rejects or waste.
For this next discussion, we find it easier for the students to simply refer to nonconformance as failure costs and conformance as prevention costs. Then we further break the costs down into two categories of failure and prevention later. However, the discussion below is consistent with the terms used in the TQM model.
Now, draw two concave cost curves, one for nonconformance aqnd the othr for conformance activity costs. When conformance is low, they nonconformance costs are high. As conformance improves, nonconformance costs decrease. Conformance costs are reversed.
The smallest conformance costs occur at low levels of conformance. And, it is assumed, as conformance investments increase conformance will improve and nonconformance costs decrease.
Note: However, the key point in this discussion is ‘declining returns to effort’. That is, when a company has poor conformance, larger decreases in nonconformance costs will be generated for every dollar spent on conformance activities. However, as conformance improves, the assumption is that savings for each dollar spent on prevention will be less and will continue to decrease.
We refer to this as a scientific management ‘cost versus benefits’ argument that we introduce in chapter 6. We used this argument to justify including an expected reject level and the addition of slack in production standards.
At this point where the costs of improving conformance exceed the benefits obtained from reducing failure costs, the ‘efficient level of inefficiency’ is determined. We have the two lines cross at a 95% conformance rate. This is scientific management.
Pair/Share: Why is allowing 5% waste efficient management?
Now, we change the color of the pen we used and challenge the assumption of declining returns to prevention cost investments. TQM philosophy argues that the benefits of prevention investments are understated because scientific management ignores the long-term strategic benefits of perfect quality.
We use a simple example concerning an airline that has misplaced your luggage. The luggage manager is a cost center. If she delivers the luggage to your home, here costs will increase. For her, the costs just are not worth the benefit. However, if the decision is made based on long term strategic value, the benefits will change. Suppose you fly an average of four times a year for the rest of your life. Also realize the incremental cost of one customer flying when you have excess capacity is minimal. What is the long-term cost to the airline of long all your future business? Do you think the cost versus benefits decision on whether to deliver your luggage would change? This sets up a nice pair/share discussion.
We then draw another line for failure cost that starts out much larger than previously. It is still concave and decreasing, but it intersects the prevention cost line at virtually 100% conformance.
Pair/Share: Use the graph to explain to your partner how the costs versus benefits assumptions change management practice when we follow a TQM philosophy.

14. Part IV
Cost of Quality
The best story to start this discussion is about Texas Instruments. There are several excellent cases about TI’s COQ reporting experience. TI used COQ extensively until they became convinced the benefits were no longer worth the effort. We discussed this with a TI controller. His explanation was simply; “We stopped using COQ when we became convinced people got the TQM religion”. The point to us was obvious. COW reporting supported TI’s transformation to a continuous improvement organization. COW was useful to convince people that TQM was a superior management approach.
W introduce COQ as a mechanism for implementing cultural change within the enterprise.
At this point, we like to point out the power of the accounting system as an objective, hard data producing measurement system. We like to refere back to the stewardship function and Slim, the cowboy, from the beginning of the course. Both Slim and the owners wee allowed to make decisions and absorb risk because they could rely on the accounting reports to be objective. This ‘umpiring’ role of accounting systems makes them a very important tool to justify and monitor the impact of change activities.
Pair/Share: How do you think ‘hard’ data can be used to justify change?

15. Juran’s COQ Relationships
Cost per Unit
Failure Costs
Appraisal and Prevention Cost
% of Conformance
95%
Costs versus benefits — an efficient level of inefficiency (scientific management).
Long-Term strategic value exceeds the costs of prevention (TQM management).

16. The Four Classifications of COQ
Quality Conformance activities.
Prevention costs are the monies spent to stop quality failures from happening.
Appraisal costs are the monies spent to identify failures that have happened.
Quality Nonconformance activities.
Internal failure costs are monies spent due to failures before the products reach the customer.
External failure costs are monies spent and value lost due to failures in the hands of the customers.
Prevention costs are usually related to training and investments to prevent quality failures. These are monies spend to avoid quality failures ‘before the fact’.
Appraisal costs are the costs of testing and supporting testing activities ‘after the fact’.
The learning achor is that prevention costs are divided into monies spent before the failures occurred and monies spent to find failures after they have happened. These costs are separated because of the assumption that increasing prevention costs will reduce the need for appraisal costs. However, whether or not appraisal costs are reduced is a management decision and need not necessarily follow from increasing investments in prevention activities.

17. Costs of Quality Examples
Prevention cost examples:
New equipment to improve quality and prevent problems.
Training in new methods to improve quality and prevent problems.
Rewards to motivate high quality.
ISO certification.
Technical support to suppliers.
Preventive maintenance.
Exhibit 11-2, p. 396.

18. More Costs of Quality Examples
Appraisal cost examples:
Inspection of materials.
Process inspection within each activity.
Final inspection of finished products.
Test equipment.
Exhibit 11-2, p. 396.

19. More Costs of Quality Examples
Internal failure cost examples:
Scrapping bad materials.
Reworking subassemblies.
Reworking finished products.
Rejecting defective products.
Retesting reworked components or finished products.
Exhibit 11-2, p. 396.

20. More Costs of Quality Examples
External failure cost examples:
Warranty work.
Product replacements.
Recalls.
Product liability insurance, legal fees, etc.
Handling customer complaints.
Lost sales and customers.
Exhibit 11-2, p. 396.
Pair/Share: The instructor should select any activity and have the students explain why they are classified in this category.
We like to point out that some of these costs are ‘soft’ data. We like to ask them where on the income statement lost customer costs are listed? They are not. Yet, they are a major cause of decreasing company value.

21. Reporting the Costs of Quality
Review, analyze and discuss Exhibit 11-3, p. 397, which provides an example of one method of preparing a Cost of Quality Report.
We like to point out to students that without the ‘lost sales and customers’ costs it looks like the company is paying $350,000 in conformance costs and only $300,000 in nonconformance. For many companies the larges costs of failures are future cashflows.

22. Trend Reports Exhibit 11-4, p. 399.
Trend reports are a crucial element of a continuous improvement strategy because they are essential to convince and communicate the need for change to all levels of the organization.

23. Lost Sales and Customers
The treatment of this issue varies from company to company. It is subjective (soft) data and does not comply with GAAP (hard data) concepts.
Estimates of both current and future losses in value are required.
Determination of these costs requires a very thorough understanding of the business and its customers.

24. Measuring Value to External Consumers — Examples
Critical success factors
Quality
Service
Cost
Management accounting system measures
Number of warranty claims
Average number of warranty claims per home
Ratio of customer testimonials to homes sold
Time to approval for sales contracts
Time to approval for loan agreements
Warranty work time to completion
Sales price variance using competition’s prices
Warranty cost as a percentage of profit per house
Costs of quality reports
Exhibit 11-6, p. 401.

25. Process Value Analysis (PVA) & Activity-Based Management (ABM)
Part V
Process Value Analysis (PVA) & Activity-Based Management (ABM)

26. Measuring Customer Value
Identify value adding and nonvalue adding activities.
Value adding activities (VA) are identified by the characteristics the customers (internal or external) value.
In a value chain, each subsequent activity is the customer of the previous activity.
Any change in a VA activity should only be made after consulting the affected customers.
Nonvalue adding activities (NVA) should be eliminated (if possible) or minimized.
An alternative definition classifies value adding activities as essential to the functioning of the company. If this view is used, then literally any nonvalue adding activity can be eliminated without damaging either the customer or the company. Under this view all VA activities are subject to improvement but not elimination.
This is only the case if VA is defined in the ‘eyes of the customers’.

27. Performance Measures
Performance measures should be based upon value measures of quality, service, and cost.
Exhibit 11-6, p. 401, follows to illustrate potential performance measures for external customers.
Exhibit 11-7, p. 401, also follows to illustrate potential performance measures for internal customers.

28. Measuring Value to External Consumers — Examples
Critical success factors
Quality
Service
Cost
Management accounting system measures
Number of warranty claims
Average number of warranty claims per home
Ratio of customer testimonials to homes sold
Time to approval for sales contracts
Time to approval for loan agreements
Warranty work time to completion
Sales price variance using competition’s prices
Warranty cost as a percentage of profit per house
Costs of quality reports
Exhibit 11-6, p. 401.

29. Measuring Value to Internal Consumers — Packing measures for Shipping
Critical success factors
Quality
Service
Cost
Management accounting system measures
Amount of damage during shipment due to poor packaging materials
Extra time required in shipping because of poorly packaged components
Time waiting to load houses and packaged components
Time waiting for packaging materials
Time to approval for loan agreements
% of boxes not adequately labeled
Cost of rework or replacement for damage caused during shipment
Extra cost from time trying to find building site (due to poor directions, maps, etc.)
Exhibit 11-7, p. 401.

30. ABM vs. ‘Management by the Numbers’
Management by the numbers using management by exception examines the outcome of work done.
Activities are only indirectly measure by cost data.
Activities are the sources of cost consumption.
Activities need to be managed — not costs.
It is more efficient to manage activities to maximize value rather than managing costs.
Well-managed activities result in higher quality products, better customer service, and lower costs.
Management by the number is not an attempt to understand the root causes of, or elimination of, nonvalue adding activities.

31. Continuous Improvement (Kaizen) Costing
TQM makes incremental changes on a continuing basis — Continuous Improvement (CI).
Kaizen (which means continuous improvement in Japanese) costing means we are continuously changing cost standards.
Employee training and empowerment is crucial.

32. The Relationship Between Target and Kaizen Standard Costs
$130
$120
$110
$100
$ 90
$ 80
Cost per unit
Target cost
Exhibit 11-9, p. 406
Introduction Growth Maturity Decline
Life cycle stages

33. Measuring the Impact of NVA Costs
Part VI
Measuring the Impact of NVA Costs

34. Illustrations
The next few slides demonstrate the evaluation of and impact of Nonvalue Added activities.
The slides are replicated here to facilitate discussion and provide a basis for lectures and pair/share questions.

35. PVA for Framing Walls — Activity 3.2
Process 3: Manufacturing
Value-added
11. Nail the stud in place using 90o angle brackets
10. Pick up each 8’ 2x4 wall stud and set on the mark
Nonvalue-added
9. Get nails and brackets from inventory
8. Measure and mark for location of wall studs
7. Lay down 12 2x4s for bottom of walls in the jigs
6. Set up jigs to hold walls in place
5. Stack according to when and where it is used
4. Forklift driver delivers lumber to Assembly
3. Forklift driver picks up lumber from stock yard
2. Process material requisition form (check for materials availability, schedule forklift and driver)
1. Requisition lumber (2 x 4 studs) from WIP
Classification
Steps in Activity 3.2
Exhibit 11-10, p. 407.

36. Lead Time Efficiency (LTE) Ratio
Process 3: Manufacturing
Activity 3.2: Wall assembly (framing)
Value-added time
Value-added + Nonvalue-added time
LTE Value =
4 hours
hours =
Exhibit 11-11, p. 408.
25% =

37. Activity Cost Table Review and analyze Exhibit 11-12, p. 409.
Notice the time spent on Nonvalue-added activities and the costs involved.
In this case we cannot eliminate all of the nonvalue-added costs. However, the cost table does provide us relevant information and indicates that we may be able to increase efficiency and thereby reduce costs.
The table is not replicated here because it will not all fit on one slide.

38. Improving VA Activities — Identifying the Core Problems
Part VII
Improving VA Activities — Identifying the Core Problems

39. Fishbone Diagrams Basic Fishbone Diagram Model Causes Results
This is a basic fishbone diagram that serves as the basis for the problems illustrated in Exhibit 11-13, p See the exhibit to understand the problem and causes therefore.
Causes
Results
See Exhibit 11-13, p. 411 for a completed fishbone diagram.

40. Pareto Charts $1,000 $900 100% $800 $700 80% $600 $500 60% $400 40%
$300
This is a slightly edited version of Exhibit 11-14, p. 413.
$200
20%
$100 0% $0
Warped wood
Cuts out of square
Clamps out of square
Other
Poor fit
Split wood

41. Benchmarking
Benchmarking is the practice of comparing our activities to similar activities from ‘best practices’ companies. The activities do not have to be identical as to their goals, just similar as to their activities.
Benchmarking may be accomplished using data from internal activities in our own organization.
For instance. Accounts payable is made up of similar activities, whether the company’s industry is manufacturing, telecommunications, distribution, or service.

42. TQM Problems and Prescriptions
Reasons why TQM initiatives fail:
Incongruent organizational culture
Reward system does not support TQM
The search for a quick fix
TQM becomes a formula rather than a philosophy
Recommendations
Top management must be committed
Top management cannot dictate that TQM will happen
Employees must be empower to do it
Reward employees for TQM activities
Use easy to understand measures
TQM must start with value chain process and activities
Change from a department focus to an activity focus
Develop employee excitement for TQM
Exhibit 11-15, p. 417.