CHAPTER 4 Strategic Management of Costs, Quality, and Time PowerPoint Presentation by LuAnn Bean Professor of Accounting Florida Institute of Technology © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 4: Strategic Management of Costs, Quality, and Time Managerial Accounting 11E Maher/Stickney/Weil

☼ ☼ CHAPTER GOAL This chapter illustrates the significance of quality. Prizes recognize improvements in quality. Japan: Deming Prize US: Baldrige Quality Award International standards measure quality ISO 9000: standards for quality management ISO 14000: standards for communicating financial impact of environmental issues This chapter includes topics on quality control and response time to customers. It discusses several prestigious groups that give awards to companies for quality, including the Deming Prize and the Baldrige Quality Award. Many companies focus on improving quality by requiring that their suppliers comply with international standards for quality management, like ISO 9000 and ISO 14000.

LO 1 TRADITIONAL VIEW The traditional view of quality assumes that improving quality always requires increasing costs. Firms can reduce total costs by Producing lower-quality goods Tolerating some level of defective goods The traditional view of quality assumes that improving quality always requires increasing costs. This view holds that firms can reduce total costs by producing lower-quality goods and tolerating some level of defective goods.

LO 1 QUALITY-BASED VIEW The quality-based view holds that firms should always attempt to improve quality. Attempts to improve quality will succeed without limit Firms Should not wait for inspections of finished products to reveal defects Must establish quality goals and procedures Aim for zero defects High quality pays for itself The quality-based view holds that firms should always attempt to improve quality and that such attempts will succeed, without limit. The quality-based view also states that firms should not wait for inspections of finished products to reveal defects and then rework defective goods. Instead, the firm must establish quality goals and procedures at the beginning of the process and aim for zero or near zero defects. The quality-based view holds that high quality pays for itself. Further, the quality-based view emphasizes constantly improving systems and processes.

TRADITIONAL VS. QUALITY-BASED VIEW LO 1 TRADITIONAL VS. QUALITY-BASED VIEW Traditional View Quality-based View Quality increases costs Quality decreases costs Goods require inspection Defect-free goods require no inspection Workers cause most defects System causes most defects Require standards, quotas, goals Eliminate standards, quotas, goals Buy from lowest cost supplier Buy on basis of lowest total cost Focus on short-run profits Focus on long-run profits EXHIBIT 4.1 This slide compares the traditional view of managing quality with the quality-based view.

QUALITY: Customer View LO 2 QUALITY: Customer View Three success factors to meet customer requirements Service All the products features, tangible and intangible Quality Firm’s ability to deliver its service commitments Cost Customers will buy product that provides them with preferred mix of quality, service, price Three success factors that firms focus on to meet customer requirements are service, quality, and cost. Some firms call these the critical success factors. Successful firms develop measures to assess performance based on their critical success factors. Service refers to all the product’s features, both tangible and intangible. Quality refers to the organization’s ability to deliver its service commitments. Cost focuses on lowering costs and achieving efficiencies, because customers value service, quality, and low costs

Research and Development VALUE CHAIN Research and Development Prevent quality problems here Design Identify quality problems here Production Marketing EXHIBIT 4.3 Companies solve quality problems better at the top of the value chain, because the lower on the value chain, the more difficult it is to identify the issue or its solution. Distribution Deal with unhappy customers here Customer Service

COSTS OF QUALITY Prevention Appraisal Procurement inspection LO 3 COSTS OF QUALITY Prevention Procurement inspection Processing control Design Quality training Machine inspection Appraisal End-process sampling Field testing The two costs of controlling and improving quality are prevention costs and appraisal costs. 1. Firms incur prevention costs to prevent defects in the products or services they produce. These include: Procurement inspection—Inspecting production materials upon delivery. Processing control (inspection)—Inspecting the production process. Design—Designing production processes to be less susceptible to producing faulty goods. Quality training—Training employees to continually improve quality. Machine inspection—Ensuring machines operate properly within specifications. 2. Firms incur appraisal costs (also called detection costs) to detect individual units of products that do not conform to specifications. These include End-process sampling—Inspecting a sample of finished goods to ensure quality. Field testing—Testing products in use at the customer site.

COSTS OF FAILING TO IMPROVE QUALITY LO 3 COSTS OF FAILING TO IMPROVE QUALITY Internal failure costs: detection before delivery Scrap Rework Reinspection/retesting External failure costs: detection after delivery Warranty repairs Product liability Marketing costs Lost sales Firms incur internal failure costs when they detect nonconforming products and services before delivering them to customers. These include Scrap—Materials wasted in the production process. Rework—Correcting product defects in completed products. Reinspection/retesting—Quality control testing after completing rework. 2. The firm incurs external failure costs when it detects nonconforming products and services after delivering them to customers. Warranty repairs—Repairing defective products. Product liability—Liability of a company resulting from product failure. Marketing costs—Marketing necessary to improve company image tarnished from poor product quality. Lost sales—Decrease in sales resulting from poor-quality products (i.e., customers will go to competitors).

LO 4 EXAMPLE Steve’s Sushi makes sushi for delivery only. Steve has concerns about quality and so he considers various ways he can ensure/improve quality. He throws away any prepared sushi that does not meet strict quality standards. A quality report follows. Assume that Steve’s Sushi makes sushi for delivery only. Steve has concerns about quality and so he considers various ways he can ensure/improve quality. He throws away any prepared sushi that does not meet strict quality standards. Let’s see how he might prepare a quality report. Continued

COST OF QUALITY REPORT: Steve’s Sushi LO 4 COST OF QUALITY REPORT: Steve’s Sushi What actions can Steve forego if he can’t do everything? Costs of Quality % of Sales Cost Categories Prevention Costs Quality training $ 5,800 Materials inspection 10,400 $ 16,200 1.62% Appraisal Costs End-of-process sampling 10,000 1.00 Internal Failure Costs Scrap 14,400 1.44 External Failure Costs Customer complaints 3,000 0.30 Cost of lost business 17,000 1.70 Total costs of quality $ 60,000 6.06% EXHIBIT 4.4 Managers often express costs of quality as a percent of sales. An example of a cost-of-quality report prepared for Steve’s Sushi is shown in this slide. What actions doe you think that Steve should forego if he cannot do everything?

Generally there is a long-run decline in total costs of quality Companies that track quality costs and use the information to improve operations tend to see a long-run decline in total costs of quality. This slide shows the general trend of quality costs as firms improve processes within the business. Initially, management finds that external failure costs are relatively high; it takes action to detect (appraise) and prevent quality problems. As a result, appraisal and prevention costs rise in the first year or two. Management then will have reduced external failures, but internal failures rise in step with an increased effort to identify quality problems before they get to the customer. The slide also shows this movement in costs through Year 3 as appraisal, prevention, and internal failure costs rise while external failure costs decline. Accordingly, total costs of quality increase through Year 3. Taking action to improve quality based on the cost-of-quality results should lead to improvements in the production process. The trends show the effect of these improvements in Years 4 through 8 as appraisal and prevention costs level off while internal and external failure costs decline. Ultimately, total costs of quality will decline as the firm optimizes the production process. Measuring increased customer satisfaction derived from additional spending on quality is difficult, as is measuring decreased customer satisfaction resulting from reduced quality costs. Many managers believe that “quality is free.” They believe that if they build quality into the product, the resulting benefits in customer satisfaction, reduced reworking and warranty costs, and other important factors will outweigh the costs of improving quality in the production process. Although initially quality production is costly, in the long run companies consider quality to be free. EXHIBIT 4.5

TOOLS Tools to identify quality problems include LO 5 TOOLS Tools to identify quality problems include Control charts Cause-and-effect analysis Pareto charts Produce signals about quality control How does a company know whether it has a quality problem? Managers use several tools to identify quality problems. These tools—control charts, cause-and-effect analysis, and Pareto charts—provide signals about quality control.

Is information provided to a decision maker. LO 5 SIGNAL: Definition Is information provided to a decision maker. Warning signal indicates something is wrong Diagnostic signal suggests cause of problem and possible solutions A signal is information provided to a decision maker. Tools used to identify quality control problems provide two types of signals. The first type, a warning signal, indicates something is wrong, in the same way that an increase in your body temperature signals a problem. The warning signal triggers an investigation to find the cause of the problem. The second type, a diagnostic signal, suggests the cause of the problem and perhaps a way to solve it.

LO 5 Control charts distinguish between random variations and variations to investigate. Control charts depict variation in a process and its behavior over time. They help managers distinguish between random or routine variations in quality and variations that they should investigate. They show the results of statistical process-control measures for a sample, batch, or some other unit. A specified level of variation may be acceptable, but deviation beyond some level is unacceptable. This slide shows an example of a control chart for the amount of scrap ingredients generated at Steve’s Sushi each day. Management believes the scrap should range between 2 and 8 percent of total ingredients each day. If scrap is less than 2 percent, management worries that some poor-quality ingredients may be included in the sushi. If scrap exceeds 8 percent, management worries about wasting ingredients. EXHIBIT 4.6

CAUSE and EFFECT: Definition LO 5 CAUSE and EFFECT: Definition Is analysis that first defines the effect and then identifies the cause. Cause-and-effect analysis, which provides diagnostic signals, identifies potential causes of defects. To use this analysis, first define the effect (e.g., wrong address for delivery) and then identify the causes of the problem. The potential causes fall into four categories: human factors, methods and design factors, machine-related factors, and materials/components factors. As management identifies the prevailing causes, it develops and implements corrective measures.

Pareto charts illustrate graphically the problems or defects. LO 5 Pareto charts illustrate graphically the problems or defects. Pareto charts display the number of problems or defects as bars of varying lengths. This slide shows an example of a Pareto chart for Steve’s Sushi. Based on this Pareto chart, Steve’s management can take actions to correct important problems. For example, management can train order-takers to triple-check addresses, and it can develop a computer file of telephone numbers and addresses so that the address automatically appears when the customer places an order. EXHIBIT 4.7

JUST-IN-TIME: Definition LO 6 JUST-IN-TIME: Definition Is a philosophy that seeks to purchase/produce goods and/or services just when the company needs them. The just-in-time philosophy closely relates to total quality management. The just-in-time (JIT) philosophy seeks to purchase or produce goods and services, or both, just when the company needs them. Companies that apply JIT find it not only reduces or even eliminates inventory carrying costs, it also requires high quality standards.

JIT Factors for success in JIT Total quality Smooth production flow Purchasing quality materials Well-trained, flexible workforce Short customer-response times Backlog of orders Companies using JIT find the following factors essential for success: Total quality. All employees must be committed to quality. Smooth production flow. Fluctuations in production lead to delays. Purchasing quality materials. Defective materials disrupt the production flow. Suppliers must be reliable, providing on-time deliveries of high-quality materials. Well-trained, flexible workforce. Workers must be well trained and also be cross-trained to use various machines and work on various parts of the production process. Short customer-response times. Keeping short the time to respond to customers enables companies to respond quickly to customer needs. Backlog of orders. A company needs to have a backlog of orders to keep the production line moving with a JIT system. If there is no backlog, production will stop when the firm fills the last order.

LO 7 IMPORTANCE OF TIME Success in competitive markets demands shorter new-product development time and more rapid response to customers. Customer response time is: (1) new-product development time and (2) operational measures of time. Success in competitive markets increasingly demands shorter new-product development time and a more rapid response to customers. Rapid response to customers can occur when work processes meet both quality and response goals. Response time improvement should be a major focus in quality improvement because it often drives simultaneous improvements in quality and productivity. Considering response time, quality, and customer satisfaction objectives together will provide benefits greater than the sum of the benefits from considering them separately. Customer response time is: (1) new-product development time and (2) operational measures of time.

NEW-PRODUCT DEVELOPMENT TIME: Definition Refers to the period between a firm’s first consideration of a product and its delivery to the customer. New-product development time refers to the period between a firm’s first consideration of a product and its first delivery to the customer. Firms that respond quickly to customer needs for new products may develop an advantage over competitors.

BREAK-EVEN TIME EQUATION LO 7 BREAK-EVEN TIME EQUATION Break-even time = (Investment ÷ Annual Discounted Cash Flow) + Time period from Project approval until Sales begin Not only does management want to shorten new-product development time, it also wants to understand how quickly the company can recover its investment in a new product. Break-even time (BET) refers to time required before the firm recovers its investment in new product development. Break-even time (BET) is equal to investment divided by annual cash flow plus the time period from the project approval until sales begin. Analyzing BET requires identifying the differential cash flows related to the product— that is, the future cash inflows and outflows that result from introducing the new product. Overhead costs are irrelevant if adding a new product changes only the way the firm allocates overhead without changing the total cash outflow for overhead costs.

LIMITATIONS: Break-even Time LO 7 LIMITATIONS: Break-even Time Break-even time Ignores cash flows after break-even point Does not consider strategic, nonfinancial reasons for new product Varies from one business to next, depending on product life cycles and investment requirements. Unfortunately, this approach has several limitations: 1. BET ignores all cash flows after the moment of breakeven. Thus, managers using a decision criterion based on BET may reject projects with high profit potential in later years in favor of less-profitable projects with higher cash inflows in the early years. As a result, managers could pursue short-term projects with lower profits rather than long-term innovative projects that might contribute more to the long-run profitability of the company. 2. BET does not consider strategic and nonfinancial reasons for product development. It focuses strictly on cash flows. 3. BET varies greatly from one business to the next, depending on product life cycles and investment requirements. For example, an acceptable BET for the automobile industry may be five years, while the computer industry might demand a BET of two years or less.

OPERATIONAL MEASURES Indicate Customer response time LO 7 OPERATIONAL MEASURES Indicate Speed Reliability Customer response time Delivery cycle time Time from order to delivery On-time performance Delivered as scheduled Operational measures of time indicate the speed and reliability with which organizations supply products and services to customers. Companies generally use two operational measures of time: customer response time and on-time performance. Customer response time (also called delivery cycle time) is the period that elapses from the moment a customer places an order for a product or requests service to the moment the firm delivers the product or service to the customer. On-time performance refers to situations in which the firm delivers the product or service at the time scheduled for delivery.

BALANCED SCORECARD: Definition LO 8 BALANCED SCORECARD: Definition Reports an integrated group of financial and nonfinancial performance measures based on vision and strategy. A balanced scorecard reports an integrated group of both financial and nonfinancial performance measures based on vision and strategy. Management relays its strategies to employees in the form of performance measures they can use. One theme is, you manage what you measure. If employees see management measuring an item, they will likely focus on things that affect the item. For these performance measures to be effective, employees must have some control over actions affecting the measures.

LO 8 Balanced scorecard can maximize profits and improve performance if used effectively. The exhibit in this slide provides examples of measures that firms use for each of four typical sets of measures: financial, internal business process, learning and growth, and customer. The actual measures any company will use depend on the strategies it develops. Although financial measures tend to dominate most companies’ performance assessments, proponents of the balanced scorecard believe that success in the other three areas will ultimately lead to improved financial performance and increased customer and employee satisfaction. EXHIBIT 4.9

TOTAL QUALITY MANAGEMENT (TQM) LO 9 TOTAL QUALITY MANAGEMENT (TQM) TQM requires five changes to traditional managerial accounting systems System includes information to help solve problems Line employees collect information for feedback Information should be available quickly Information should be more detailed Base rewards on quality, customer satisfaction A company that implements total quality management might find that its managerial accounting system reports little economic benefit from the initiative, even when it is successful. Effective implementation of total quality management requires five changes to traditional managerial accounting systems: 1. The system should include information to help solve problems, like that coming from control charts and Pareto diagrams, not only financial information. Financial reports would indicate a decline in revenues, for example, but not indicate potential causes of the decline. Control charts could show an increase in customer complaints as a likely cause of the revenue decline. To carry this a step further, Pareto charts could list and rank the causes of increased customer complaints. 2. Line employees should collect the information and use it to get feedback and solve problems. Information should flow from the bottom up in the organization, not only from the top down. Traditional managerial accounting reports use data collected and aggregated by accountants, who present reports to managers, who then typically send some of the information down to the line employees. These reports may not mean much to line employees who are unfamiliar with accounting concepts. 3. Information should be available quickly (e.g., daily) so that workers can get timely feedback. Frequent information accelerates identifying and correcting problems. Traditional managerial accounting systems often report weekly or monthly, which inhibits quick response to problems. 4. Information should be more detailed than that found in traditional managerial accounting systems. Instead of reporting only the cost of defects, for example, the information system should also report the types and causes of defects. 5. The firm should base rewards on quality and customer satisfaction measures of performance. This is the idea that “you get more of what you reward.” If companies do not reward quality, they probably won’t get it.

End of CHAPTER 4 End of Chapter 4.