Lecture 19 - Management accounting in production firms (strategic)

Question 1

How do we define quality?

Answer 1

Generally the term quality refers to a wide variety of factors: fitness for use, the degree to which a product satisfies the needs of a customer and the degree to which a product conforms to design specification and engineering requirements.

Question 2

What are two basic aspects of quality?

Answer 2

Quality of design: measures how closely the characteristics of products or services match the needs and wants of customers

Conformance quality: the performance of a product or service according to design and production specifications.

Question 3

How can quality be an important competitive advantage?

Answer 3

Long-term effects on gaining or defending market shares and revenues
Quality problems cause substantial costs
Non-financial and qualitative effects of quality improvement

Question 4

What are costs of quality?

Answer 4

The costs of quality are costs incurred to prevent, or costs arising as a result of, the production of a low-quality product. These costs focus on conformance quality and are incurred in all business functions of the value chain.

Question 5

1 Explain four cost categories in a cost of quality programme

Answer 5

Four cost categories in a costs of quality programme are:
Prevention costs (costs incurred in precluding the manufacture of products that do not conform to specifications)
Appraisal costs (costs incurred in detecting which of the individual products produced do not conform to specifications)
Internal failure costs (costs incurred when a non-conforming product is detected before its shipment to customers)
External failure costs (costs incurred when a non-conforming product is detected after its shipment to customers).

Question 6

What is a five step activity-based approach to determine costs of quality?

Answer 6

Step 1: Identify all quality-related activities and activity cost pools.
Step 2: Determine the quantity of the cost-allocation base for each quality-related activity.
Step 3: Calculate the rate per unit of each cost-allocation base
Step 4: Calculate the costs of each quality related activity
Step 5: Obtain the total costs of quality (add it all up)

Question 7

Why should we not assume that costs reported on COQ reports represent the total costs of quality?

Answer 7

It does not include opportunity costs, such as foregone profit and so on. Opportunity costs are difficult to estimate and generally not included in accounting systems. However, they can be a substantial and important driving force in quality-improvement programs.

Question 8

4 Provide 4 examples of non-financial quality measures of customer satisfaction

Answer 8

Measures of customer satisfaction over time:
• Satisfaction with specific features
• Percentage of defect units delivered
• Number of customer complaints
• Delivery delays/on time delivery
Management investigates if these numbers deteriorate over time. If these numbers improve over time, management can be more confident about operating profit being strong in future years.

Question 9

4 Provide 4 examples of non-financial quality measures of internal performance

Answer 9

Measures of internal quality:
• Number of defects for product lines
• Process yield (ratio good output to total output)
• Employee turnover (ratio of leaving employees to total employees)
• Employee empowerment/satisfaction
For a single reporting period, non-financial measures of quality have limited meaning, they are more informative when trends are examined over time.

Question 10

What are 4 benefits of non-financial quality measures?

Answer 10

Useful indicators of future long-run performance
Revealing future needs and preferences of customers
Indicating specific areas of improvement
Feedback on the effects of quality improvement programs

Question 11

5 Why do companies use both financial and non-financial measures of quality?

Answer 11

Financial measures are helpful to evaluate trade-offs among prevention and failure costs. They focus attention on how costly poor quality can be. Non-financial measures help focus attention on the precise problem areas that need attention.

Question 12

2 Describe three methods that companies use to identify quality problems

Answer 12

Three methods that companies use to improve quality are control charts, to distinguish random variations from other sources of variation in an operating process; Pareto diagrams, which indicate how frequently each type of failure occurs; and cause-and-effect diagrams, which identify potential factors or causes of failure.

Question 13

What is a control chart?

Answer 13

A control charts is a graph of a series of successive observations of a particular step, procedure or operation taken at regular intervals of time. Each observation is plotted relative to specified ranges that represent the expected distribution. Only those observations outside the specified limits are ordinarily regarded as non-random and worth investigating.

Question 14

What is a Pareto diagram?

Answer 14

Observations outside control limits serve as inputs to Pareto diagrams. Indicates how frequently each type of failure occurs. E.g. histogram.

Question 15

What is a cause-and-effect diagram?

Answer 15

The most frequently occurring problems identified by the Pareto diagram are analysed using cause-and-effect diagrams, which identifies potential causes of failures or defects.

Question 16

What is the theory of constraints?

Answer 16

The theory of constraints describes methods to maximize operating profit when faced with some bottleneck and some non-bottleneck operations. The objective of TOC is to increase throughput contribution while decreasing investments and operating costs. TOC considers short-run time horizons and assumes other current operating costs to be fixed costs.

Question 17

6 Define the three main measurements in the theory of constraints

Answer 17

The three main measurements in the theory of constraints are:
Throughput contribution (equal to sales minus direct materials costs)
Investments or stock (equal to the sum of materials costs of direct materials stock, work-in-progress stock and finished goods stock, R&D costs and costs of equipment and buildings); 
Operating costs (equal to all operating costs other than direct materials costs incurred to earn throughput contribution).

Question 18

7 Explain how to manage

Answer 18

bottlenecks
The four steps in managing bottlenecks are:
(a) to recognise that the bottleneck operation determines throughput contribution
(b) to search for and find the bottleneck (by identifying resources with large quantities of stock waiting to be worked on)
(c) to keep the bottleneck busy and subordinate all non-bottleneck operations to the bottleneck operation. That is, the needs of the bottleneck resource determine the production schedule of non-bottleneck resources. I.e. to maximize overall contribution margin, the plant must maximize throughput contribution of the constrained or bottleneck resource.
(d) to increase bottleneck efficiency and capacity. The objective is to increase throughput contribution minus the incremental costs of taking such actions.

Question 19

How can the theory of constraints be complementary to ABC systems?

Answer 19

TOC emphasises the management of bottlenecks as the key to improving the performance of the system as a whole. It focuses on the short-run maximization of throughput contribution. It is less useful for the long-run management of costs because it does not model the behaviour of costs or identify individual activities and cost drivers. By contrast, ABC systems take a longer-term perspective by attempting to eliminate non-value added activities and to reduce the costs of performing value-added activities. TOC is in this respect complementary to ABC systems.

Question 20

1 Describe a just-in-time ( JIT) production system

Answer 20

Just-in-time production systems take a ‘demand-pull’ approach in which each component on a production line is produced immediately as needed by the next step in the production line to directly satisfy customer orders. In a JIT production line, manufacturing activity at any particular workstation is prompted by the need for that station’s output at the following station. Demand triggers each step of the production process, starting with customer demand for the finished product at one end of the process and working all the way back to the demand for direct materials at the other end of the process.

Question 21

2 Identify the major features of a JIT production system

Answer 21

The five major features of a JIT production system are:

(a) organising production in manufacturing cells
(b) employing and training multiskilled workers
(c) emphasising total quality management
(d) reducing manufacturing lead time (the time from when and order is ready to start on the production line to when it becomes a finished good) and set-up time (the time required to get equipment, tools and materials ready to start the production)
(e) building strong supplier relationships.

Question 22

How is the organisation of manufacturing cells in a JIT system different from conventional manufacturing plants?

Answer 22

Conventional manufacturing plants generally have a functional layout, in which machines that perform the same function are located in the same area or department. JIT plants, however, organise machines in cells designed around products. Different types of machines that perform different functions needed to manufacture a product, or a family of products, are placed close to each other. Materials move from one machine to another where various operations are performed in sequence.

Question 23

What are the requirements for multiskilled workers in a JIT system?

Answer 23

Workers in a cell are trained to perform all operations within the cell. Workers can then be assigned to different machines as needed to achieve smooth production flow. Workers are also trained and expected to perform minor repairs and do maintenance. Quality testing and inspection are also the responsibility of the workers in a cell.

Question 24

What happens if a defect is discovered in a JIT system?

Answer 24

The worker sets of an alarm to alert others and the operation is shut down. Because of the dynamics of the demand-pull system, when one operation shuts down, all production shuts down until the problem is solved.

Question 25

Why do we want to reduce manufacturing lead time and set-up time in a JIT system?

Answer 25

Reducing manufacturing lead time enables a company to respond better to changes in customer demand. An important aspect of reducing manufacturing lead time is reducing set-up time. When set-up time is long, plant managers tend to manufacture many units of a product because they want to spread the costs of the set-up over as many units as possible. This causes stock to build up. Reducing set-up time makes production in smaller batches economical and worthwhile, which in turn reduces stock levels.

Question 26

What is JIT purchasing? And why does a company with JIT purchasing need strong relationship with the suppliers?

Answer 26

JIT purchasing is the purchase of goods and materials such that delivery immediately precedes demand or use. Suppliers often deliver materials directly to the plant floor to be immediately placed into production. Consequently, JIT plants require suppliers to inspect their own goods and guarantee quality. These procedures completely eliminate the non-value-adding costs of incoming inspection, storage, stock and materials handling and this saves the JIT purchaser money. Strong relationships with suppliers are critical because production stops if a supplier does not deliver materials on time. Building partnerships with suppliers is time consuming and costly.

Question 27

Name 6 financial benefits of a JIT system

Answer 27

(1) Lower investment in stocks which results in reductions in carrying and handling costs of stocks (2) Reductions in risk of obsolescence of stocks (3) Lower investment in plant space for stocks and production (4) Reductions in set-up costs and total manufacturing costs (5) Reduction in costs of waste and spoilage as a result of improved quality (6) Higher revenues as a result of responding faster to customers

Question 28

What are the product-costing benefits of JIT?

Answer 28

In reducing the need for materials handling, warehousing, inspection of supplies and other activities, JIT systems reduce overhead costs. JIT systems also facilitate the direct tracing of some costs that were formerly classified as overhead. For example, the use of manufacturing cells makes it easy to trace materials handling and machine operating costs to specific products or product families made in specific cells. These costs then become direct costs of those products. Also, the use of multiskilled workers in these cells allows the costs of set-up, minor maintenance and quality inspection to become easily traced, direct costs.

Question 29

How does JIT simplify job costing?

Answer 29

A unique production system such as JIT leads to its own unique costing system. Organising manufacturing in cells, reducing defects and manufacturing lead time and ensuring timely delivery of materials enables purchasing, production and sales to occur in quick succession with minimal stocks. The absence of stocks makes choices about cost-flow assumptions (such as weighted-average or first-in, first-out) or stock costing methods (such as absorption or variable costing) unimportant – all manufacturing costs of a period flow directly into cost of goods sold. The rapid conversion of direct materials to finished goods that are immediately sold simplifies job costing.

Question 30

What is sequential tracking and which costing systems use it?

Answer 30

Traditional normal and standard costing systems use sequential (or synchronous) tracking, which is any product-costing method in which the accounting system entries occur in the same order as actual purchases and production. Often expensive, especially if management tries to track direct materials and labour time to individual operations and products.

Question 31

What is backflush costing?

Answer 31

Backflush costing (or delay costing, endpoint costing or post-deduct costing) describes a costing systems that delays recording changes in the status of a product being produced until good finished units appear; it then uses budgeted or standard costs to work backwards to flush out manufacturing costs for the units produced.  Absence of stocks makes bookkeeping easier  Recording is delayed until produced goods appear  Use of standard/budgeted unit costs (for direct materials and conversion costs)  No record of work-in-progress  no single work-in-progress accounts

Question 32

3 Describe journal entries for backflush-costing systems

Answer 32

Journal entries in a backflush costing system are not made sequentially to match the flow of a product in a plant. Rather, some or all journal entries relating to the cycle from purchase of direct materials to the sale of finished goods are delayed. Typically, no record of WIP appears in backflush costing. Different versions of backflush costing: When are journal entries made (trigger points)? A. 2 trigger points: Purchase of material, completion of finished goods B. 2 trigger points: Purchase of material, sale of finished goods C. 1 trigger point: completion of finished goods

Question 33

Why would a company using a backflush costing system want the second trigger point to be the sale rather than the completed manufacture?

Answer 33

To remove incentive for managers to produce for stock. If the value of finished goods stock includes conversion costs, managers can bolster operating profit by producing more units than are sold. Having trigger point 2 as the sale instead of the completion of production, however, reduces the attractiveness of producing for stock by recording conversion costs as period costs instead of capitalising them as inventoriable costs. Also, to increase managers’ focus on selling units.

Question 34

What do criticisms of backflush costing focus on?

Answer 34

Criticisms of backflush costing focus mainly on the absence of audit trails – the ability of the accounting system to pinpoint the uses of resources at each step of the production process. The absence of large amounts of materials and work-in-progress stock means that managers can keep track of operations by personal observations, computer monitoring and non-financial measures.

Question 35

What are the implications of JIT and backflush costing systems for activity-based costing (ABC) systems?

Answer 35

Simplifying the production process, as in a JIT system, makes more of the costs direct and so reduces the extent of overhead cost allocations. Simplified ABC systems are often adequate for companies implementing JIT. But even these simpler ABC systems can enhance backflush costing. Costs from ABC systems give more accurate budgeted conversion costs per unit for different products, which are then used in the backflush costing system. The activity based cost data are also useful for product costing, decision making and cost management.

Question 36

Name five costs that are important when managing stocks and goods for sale

Answer 36

(1) Purchasing costs (usually the larges cost category, also includes freight) (2) Ordering costs (3) Carrying costs (includes opportunity cost and storage costs) (4) Stockout costs (occurs when a company runs out of a particular item for which there is customer demand. A company may respond to the shortfall or stockout by expediting an order from a supplier. Expediting costs of a stockout include the additional ordering costs plus any associated transportation costs. Alternatively, the company may lose a sale owing to the stockout. In this case, stockout costs include the lost contribution margin on the sale plus any contribution margin lost on future sales hurt by customer ill-will caused by the stockout.) (5) Quality costs (prevention costs, appraisal costs, internal failure costs and external failure costs)

Question 37

4 Explain the economic order quantity (EOQ) decision model and how it balances ordering costs and carrying costs

Answer 37

The economic order quantity (EOQ) decision model calculates the optimal quantity of stock to order. The larger the order quantity, the higher the annual carrying costs and the lower the annual ordering costs. The EOQ model includes those transactions routinely recorded in the accounting system and opportunity costs not routinely recorded.

Question 38

How do we determine EOQ?

Answer 38

To determine EOQ, we minimise the relevant ordering and carrying costs (those ordering and carrying costs that are affected by the quantity of stock ordered): Total relevant costs = Total relevant ordering costs + Total relevant carrying costs The total annual relevant costs are at a minimum where total relevant ordering costs and total relevant carrying costs are equal. The formula underlying the EOQ model is: EOQ = ((2*Demand in units for a specified time period*Relevant ordering costs per purchase order)/Relevant carrying costs of 1 unit in stock for the time period used for D (including required return on investment))^0.5 Total relevant costs are rarely sensitive to minor variations in cost predictions. The square root in the EOQ model reduces the sensitivity of the decision to errors in predicting its inputs.

Question 39

5 Explain the reorder point and safety stocks

Answer 39

The reorder point is the quantity level of stock that triggers a new order. It equals the sales per unit of time multiplied by the purchase-order lead time. Reorder point = Number of units sold per unit of time*Purchase-order lead time Safety stock is the buffer stock held as a cushion against unexpected unavailability of stock from suppliers and a buffer against unexpected increases in demand or lead time. Consider stockout costs. The optimal safety stock level is the quantity of safety stock that minimises the sum of the relevant annual stockout and carrying costs.

Question 40

Obtaining accurate estimates of the cost parameters used in the EOQ decision model is a challenging task. E.g. the relevant annual carrying costs of stock consist of incremental or outlay costs plus the opportunity cost of capital. What are the incremental relevant costs of carrying stock?

Answer 40

Only those costs that vary with the quantity of stock held.

Question 41

What is the relevant opportunity cost of capital and how is it calculated?

Answer 41

It is the return forgone by investing capital in stock rather than elsewhere. It is calculated as the required rate of return multiplied by those costs per unit that vary with the number of units purchased and that are incurred at the time the units are received. (Examples of these costs per unit are purchase price, incoming freight and incoming inspection.) Opportunity costs are not calculated on investments, say, in buildings, if these investments are unaffected by changes in stock levels. In the case of stockouts, calculating the relevant opportunity costs requires an estimate of the lost contribution margin on that sale as well as on future sales hurt by customer ill-will resulting from the stockout.

Question 42

6 Compare EOQ and JIT purchasing models

Answer 42

Just-in-time ( JIT) purchasing is the purchase of goods or materials such that delivery immediately precedes demand or use. EOQ models support smaller and more frequent purchase orders (as in JIT purchasing) as relevant carrying costs increase and relevant ordering costs per order decrease. The JIT purchasing model is not guided solely by the EOQ model. As discussed earlier, the EOQ model is designed to emphasise only the trade-off between carrying and ordering costs.

Question 43

7 Determine the relevant benefits and relevant costs in JIT purchasing and JIT production

Answer 43

A relevant cost–benefit analysis of JIT purchasing includes relevant costs of purchasing, carrying stock, ordering and stockout, quality-related costs of inspection and customer returns and lost contribution margins due to late deliveries. The relevant benefits and relevant costs of JIT production include relevant costs of set-up and carrying stock, better quality and faster delivery.

Question 44

8 Describe measures for evaluating JIT production performance

Answer 44

Performance measurements and control in JIT production systems emphasise personal observation and nonfinancial rather than financial performance measures. They are the most timely, intuitive and easy-to-comprehend measures of plant performance. Rapid, meaningful feedback is critical because the lack of buffer stocks in a demand-pull system creates added urgency to detect and solve problems quickly.