1. Management Accounting Information for Activity and Process Decisions
Chapter 5
Management Accounting Information for Activity and Process Decisions

2. 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 implications are important when considering decisions such as whether to:
Redesign an entire production process or replace existing machines
Purchase services such as custodial help or to simply hire in-house custodians
Financial information about the different types of costs form the basis of decisions about the , organization's activities and processes

3. Relevant Costs and Revenues
Whether particular costs and revenues are relevant for decision making depends on the decision context and the alternatives available
When choosing among different alternatives, managers should concentrate only on the costs and revenues that differ across the decision alternatives
These are the relevant cost/revenues
Opportunity costs by definition are relevant costs for any decision
The costs that remain the same regardless or the alternative chosen are not relevant for the decision

4. Sunk Costs are Not Relevant
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

5. Replacement Of A Machine (1of2)
A Company purchased a new drilling machine for $180,000 on September 1, 2003
They paid $30,000 in cash and financed the remaining $150,000 with a bank loan
The loan requires a monthly payment or $5,200 for the next 36 months
On September 27, 2003, a sales representative from another supplier of drilling machines approached the company with a newly designed machine that had only recently been introduced to the market and offered special financing arrangements
The new supplier agreed to pay $50,000 for the old machine, which would serve as the down payment required for the new machine
In addition, the new supplier would require monthly payments of $6,000 for the next 35 months

6. Replacement Of A Machine (2of2)
The new design relied on innovative computer chips, which would reduce the labor required to operate the machine
The company estimated that direct labor costs would decrease by $4,400 per month on the average if it purchased the new machine
In addition it had fewer moving parts than the current machine
The new machine would decrease maintenance Costs by $800 per month
The new machine has greater reliability
This would allow the company to reduce materials scrap cost by $1,000 per month
Should the company dispose of the machine it just purchased on September 1 and buy the new machine?

7. Analysis Of Relevant Costs (1of3)
Sunk Costs
If the company buys the new machine, it will still be responsible for
the $30,000 that it paid in cash for the old machine
$5,200 it is committed to pay each month for the next 36 months
The company already has committed these resources, and regardless if it decides to buy the new machine, it cannot avoid any of these costs
None of these sunk costs are relevant to the decision

8. Analysis Of Relevant Costs (2of3)
What costs are relevant?
The 35 monthly payments of $6.000
The Down payment of $50,000
Labor, materials, and machine maintenance costs will be affected if the company acquires the new machine. The relevant expected monthly savings are:
$4,400 In labor costs
$1,000 in materials costs
$ 8OO In machine maintenance costs
The revenue of $50,000 expected on the trade-in of the old machine is also relevant, because the old machine will be disposed of only if the company decides to acquire the new machine

9. Analysis Of Relevant Costs (3of3)
In a comparison of the cost increases/cash outflows to cost savings/cash inflows
The down payment required for the new machine ($50,000) is matched by the expected trade- in value of the old machine ($50,000)
The expected savings in labor, materials, and machine maintenance costs each month ($6,200) are more than the monthly lease payments (or the new machine ($6,000)
Thus, it is apparent that the company will be better off trading in the old machine and replacing it with the new machine

10. Difficulty of Making Correct Decision
The technically correct decision for the Company on a level is to dispose of the machine and replace it
Not all managers would do so:
They are concerned about their reputations within their own organization
Reversing a major decision made only just a month earlier makes the decision look like an error
In many circumstances, by maintaining the original course of action, the manager does not have to reveal that a better decision could have been made

11. Responsibility For Decisions (1of2)
If the manager does not purchase the new machine, then his or her behavior may be viewed as suboptimal
It ensures lower productivity or performance from the old machine rather than improved performance with the new one
By not making the correct decision now, the manager may incur the effects of a bad decision later
If the manager admits to making an error when purchasing the old machine, that person might garner more respect from colleagues for accepting the responsibility

12. Responsibility For Decisions (2of2)
Many decision makers have a difficult time distinguishing sunk cost business decisions from sunk cost personal decisions
In contrast to business decisions, the associated costs or previous lire decisions can evoke a complex set or personal feelings
Unlike the case in the business decision, we do not end a friendship simply because a new friend materializes
Thus, identifying what is relevant and disentangling personal responses when dealing with business decisions are critical tasks for any business decision maker

13. Make-or-Buy Decisions (1of3)
As managers attempt to reduce costs and increase the competitiveness of their products, they face decisions about whether their companies should
Manufacture some parts and components for their products in-house
Subcontract with another company to supply these parts and components
Such make-or-buy decisions illustrate how to identify relevant costs and revenues

14. Make-or-Buy Decisions (2of3)
A company manufactures about 15% of the lamps required for its automobiles in its own plant in Ohio
The company's president would like to reduce costs and has asked the production manager to evaluate the possibility of outsourcing all the lamps
The production manager obtains firm quotes from several suppliers for the four types of lamps the company manufactures in-house:
Standard rear lamps
Standard front lamps
Multicolored rear lamps
Curved side and rear lamps

15. Make-or-Buy Decisions (3of3)
Std. Rear
Std. Front
Multicolor
Curved
Production cost per unit
Direct materials
$36
$49
$56
$58
Direct labor 22 25 24 28
Unit related support 14 16 18 20
Batch related support 10 19
Product-sustaining overhead 6 12
Facility-sustaining overhead 8 11
Total manufacturing costs
$96
$128
$142
$161
Bids from outside suppliers
Lowest bid
$82
$109
$140
$156
Second lowest
$88
$116
$147
$164
Annual production (units)
36,000
48,500
6,800
8,700

16. Avoidable Costs
Avoidable costs are those 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 (using the std. rear lamp as an example):
$1,296,000 of direct material costs ($36 x 36,000)
$792,000 of direct labor costs ($22 x 36,000)
$504,000 of unit-related support costs ($14 x 36,000)
Contraction or redeployment of resources may allow the company to save:
$360,000 ($10 x 36,000) of batch-related support costs
$216,000 ($6 x 36,000) of product-sustaining support costs

17. Summary of Financial Analysis
To summarize the analysis so far, if the standard rear lamp is outsourced, the company may avoid $3,168,000 of manufacturing costs
Assuming batch-related and product sustaining support costs may be avoided
The company would spend $2,952,000 to purchase the parts from the low-bid supplier
The company could save $216,000 by outsourcing

18. 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:
In meeting the required quality standards
In making deliveries on time
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
They provide their certified suppliers with incentives, such as quick payments and guaranteed total purchase volumes

19. Facility Layout Systems (1of2)
In addition to understanding the relevant costs for many decisions that change the nature of activities and processes, managers must consider the entire operations process within a facility
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

20. Facility Layout Systems (2of2)
One method that can guide this process for all three designs is 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 now 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

21. Theory of Constraints (1of2)
The theory of constraints relies on the use of three measures
Throughput contribution - 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 -all other costs, except for direct materials costs, that are needed to obtain throughput contribution

22. Theory of Constraints (2of2)
TOC emphasizes the short-run optimization of throughput contribution
Proponents of TOC view operating costs as difficult to alter in the short run
Accordingly, ABC-type analyses of activities and cost drivers are not conducted
This limits the usefulness of the theory for the longer run
In theory, however, there is no reason why TOC and ABC cannot be used together

23. Process Layouts
In a process layout, all similar equipment or functions are grouped together
Process layouts exist in organizations in which production of unique products is done in small batches
The product follows a serpentine path, usually in batches, through the factories and offices that create it
Process layouts are also characterized by high inventory levels
It is necessary to store work-in-process in each area while it awaits the next operation
Products might travel for several miles within a factory during the production process

24. Process Layout in a Bank (1of2)
As an example, the process associated with a bank loan application may occur as follows.
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)

25. Process Layout in a Bank (2of2)
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 customer's 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 officer
The regional supervisor

26. WIP Accumulation (1of3)
Work-in-process inventory accumulates at processing stations in a conventional organization for three reasons
1. Handling work in batches
At each processing station all items in the batch must wait while the designated employees process the entire batch before moving that batch to the next station
Organizations use batches, on the other hand, to reduce setting up, moving, and handling costs

27. WIP Accumulation (2of3)
2. If the rate at which each processing area handles work is unbalanced, work piles up at the slowest processing station
Occurs when one area is slower or has stopped working due to problems with equipment, materials, or people
Scheduling delays result
Inventory levels increase

28. WIP Accumulation (3of3)
3. If processing area managers are evaluated on their ability to meet production quotas
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
To avoid idling the next processing station and suffering the resulting recriminations, managers may store finished work they can forward to supply stations further down the line when their stations are shut down due to problems

29. Product Layouts
In a product layout, equipment is organized to accommodate the production of a specific product
Automobile assembly line
Packaging line for cereal or milk
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 or equipment or processing units is made to reduce the distance that products must travel
Arrangements for delivery or raw materials and purchased parts directly to the production line can often be made

30. Product Layout in a Cafeteria (1of2)
Consider the work-in-process in a cafeteria setting:
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 batch-related setup costs otherwise (one serving at a time) would be prohibitively expensive

31. Product Layout in a Cafeteria (2of2)
Reducing setup costs allows for the reduction of batch sizes along the line
This reduces the level of inventory (and costs) in the system
It also improves quality while increasing customer satisfaction
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

32. Cellular Manufacturing (1of2)
Cellular manufacturing, refers to 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

33. Cellular Manufacturing (2of2)
The shape of a cell is often a U shape, which allows workers convenient access to required parts
Often when cellular manufacturing is introduced, 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 of the work flow because employees can observe more directly what their coworkers are doing

34. Problems with Batch Production (1of2)
It creates inventory costs
It also 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:

35. Problems with Batch Production (2of2)
A manufacturer may require that a product be manufactured in some minimum batch size. If a customer order is less than the minimum batch size and if the order cannot be filled from existing finished goods inventory, then the customer must wait until enough orders have accumulated to meet the minimum batch size requirement
A loan application (that may take a loan officer only five minutes to read and approve) may have to wait for hours or days before it reaches the loan officer, because having a clerk deliver each new loan application when it arrives is too expensive

36. Inventory-Related Costs (1of2)
Demands for inventory lead to huge costs in organizations, including the cost of:
Moving
Handling
Storing
Obsolescence or damage
Many organizations have found that factory layouts and inefficiencies that create the need to hold work-in-process inventory hide other problems leading to excessive costs of rework

37. Inventory-Related Costs (2of2)
In batch operations, workers near the end of a process (downstream) often find batch-size problems resulting from the way workers have done their jobs earlier in the process (upstream)
When work is performed continuously on one component at a time, however, workers downstream can identify an upstream problem in that component almost immediately and correct it before it leads to production of more defective components

38. Cost of Nonconformance
and Quality Issues
Cost reduction has become a significant factor in the management or most organizations
Reducing costs involves much more than simply finding ways to cut product design costs
For example, by using less expensive materials
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 or 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

39. Quality Quality usually may be viewed as hinging on two major factors:
1. Satisfying customer expectations regarding the attributes and performance of the product
E.g., its functionality and features
2. Ensuring that the technical aspects of the product's design and performance conform to the manufacturer's standards
Whether it performs to the expected standard

40. 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
ISO9000:2000 Series of Standards, developed in Europe, is one widely-recognized quality standard certification

41. ISO9000 (1of6)
In 1987, the International Organization for Standardization (IS0), headquartered in Geneva, Switzerland, 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
Today, over 400,000 organizations have been certified worldwide
Many types of organizations are interested in becoming IOS9000 registered in order to:
Comply with external regulatory agencies,
Meet of exceed customer requirements, or
Implement a quality Improvement program to remain competitive

42. ISO9000 (2of6) 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)
The major points in previous versions of the standards were integrated into the four primary standards

43. ISO9000 (3of6) The four primary standards are:
ISO 9000: Quality management systems - Fundamentals and vocabulary
IS0 9001: Quality management systems - Requirements
ISO 9004: Quality management systems - Guidance for performance improvement
ISO : Guidelines on quality and/or environmental management systems auditing (To be published)

44. ISO9000 (4of6)
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

45. ISO9000 (5of6)
The overall revisions to ISO 9001 and 9004 are based on 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

46. ISO9000 (6of6)
The ISO 9000:2000 Standards apply to all kinds or organizations in all kinds or areas:
Manufacturing
Forestry
Electronics
Computing
Legal services
Financial services
Accounting
Trucking
Banking
Retailing
Drilling
Recycling
Aerospace
Construction
Pharmaceuticals
Oil and gas
Petrochemicals
Publishing
Shipping
Telecommunications
Health care
Hospitality
Utilities
Aviation
Food processing
Agriculture
Government
Education
Recreation
Sanitation
Software development
Consumer products
Transportation
Design
Tourism
Communications
Biotechnology
Engineering
Faming
Entertainment
Consulting
Insurance
and others
More Information can be obtained from the International Organization for Standardization (

47. Costs Of Quality Control
Companies have discovered that they can spend as much as 20% to 30% of total manufacturing costs on quality-related processes
The best-known framework for understanding quality costs classifies them into four categories:
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

48. 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

49. 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
Costs of quality inspection on an assembly line
Inspection of incoming materials
Maintenance of test equipment
Process control monitoring

50. 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
Engineers have estimated that the cost of defects rises by an order of magnitude for each stage of the manufacturing process that the defect goes undetected
Inserting a detective $1 electronic component Into a subassembly leads to $10 of scrap if detected at the first stage, $100 at the next stage, and perhaps $10,000 if not detected tar two mare stages at assembly

51. External Failure Costs
External failures occur when customers discover a defect
All costs associated with correcting the problem
Repair of the product
Warranty costs
Service calls
Product liability recalls
For many companies, this is the most critical quality cost to avoid
Not only are costs required to fix the problem in the short run, but also customer satisfaction, future sales, and the reputation of the manufacturing organization may be in jeopardy over the long run

52. Cost-of-Quality Report (1of2)
This information is compiled in a cost-of-quality (COQ) report. developed for several reasons
It illustrates the financial magnitude of quality factors
Often manager are unaware of the enormous impact that rework has on their costs
Cost-of-quality information helps managers set priorities for the quality issues and problems they should address
For example, one trend that managers do not want to see Is a very high percentage of quality costs coming from external failure of a product
External quality problems are expensive to fix and can greatly harm the reputation of the product or organization producing the product

53. Cost-of-Quality Report (2of2)
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
The problem at its root will have positive ripple effects throughout the organization, as so many quality issues are interrelated

54. Just-in-Time Manufacturing
Just-in-time (JIT) manufacturing is a comprehensive and effective manufacturing system that integrates many of the ideas discussed in this chapter
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
No delays once production starts
There must be a substantial reduction in setup costs in order to eliminate the need to produce in batches
Processing systems must be reliable

55. Implications Of JIT Manufacturing (1of6)
Just-in-time manufacturing is simple in theory but hard to achieve in practice
Some organizations hesitate to implement JIT
With no work-In-process inventory a problem anywhere in the system can stop all production
Organizations that use just-in-time manufacturing must eliminate all sources of failure in the system
The production process must be redesigned so that it is not prohibitively expensive to process one or a small number of items at a time
This usually means reducing the distance over which work in process has to travel and using very adaptable people and equipment that can handle an types of jobs

56. Implications Of JIT Manufacturing (2of5)
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 he or she has received, 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 defect-free materials or components just when they are required
In many instances, companies hold a competition between suppliers of the same components to see who can deliver the best quality
At the end of a performance period, the supplier who performs the best will obtain a long-term contract
Preventative maintenance is also employed so that equipment failure is a rare event

57. Implications Of JIT Manufacturing (3of6)
Just-in-time manufacturing has two major implications for management accounting
First, 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
Second, the clerical process of management accounting is simplified by JIT manufacturing, due to the smaller inventory to monitor and report

58. Implications Of JIT Manufacturing (4of6)
Important measures of a JIT system's reliability include the following benchmarks of manufacturing cycle effectiveness
Defect rates
Cycle times
Percent of time that deliveries are on time
Order accuracy
Actual production as a percent of planned production
Actual machine time available compared with planned machine time available
Conventional labor and machine productivity ratios are inconsistent with the just-in-time production philosophy

59. Implications Of JIT Manufacturing (5of6)
Just-in-time manufacturing has been a benefit to many organizations
Those interested in implementing this system need to remember several things:
Any significant management innovation, such as ABC or JIT, requires a major cultural change for an organization
JIT also can alter the pace or work and the overall work discipline or the organization
It can cause structural changes in such areas as the arrangement or shop floors

60. Implications Of JIT Manufacturing (6of6)
Because the central ideas behind JIT are the streamlining of operations and the reduction of waste, many people inside companies are ill-prepared for the change
Because JIT relies on teamwork, often individuals have to subordinate their own interests to those of the team
Some employees find this difficult, especially if they have come from a work environment where they worked on a single component in relative isolation, or if their personalities are not team oriented