Management Accounting Information for Activity and Process Decisions

2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

Management Accounting Information for Activity and

Process Decisions

Chapter 5

2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University 5-2

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


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 of the

alternative chosen are not relevant for the decision


Sunk Costs are Not Relevant• Sunk costs often cause confusion for decision

makers– Costs of resources that already have been committed

and no current action or decision can change– Not relevant to the evaluation of alternatives because

they cannot be influenced by any alternative the manager chooses


Replacement Of A Machine (1 of 2) • 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 of $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


Replacement Of A Machine (2 of 2)

• 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 newnew machine

• In addition it had fewer moving parts than thethe 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?


Analysis Of Relevant Costs (1 of 3)

• If the company buys the new machine, it will still be responsible for the monthly payments of $5,200 committed to on September 1– Therefore, the $30,000 that it paid in cash for the oldold

machine and the $5,200 it is committed to pay each month for the next 36 months are sunk costs

– 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



• What costs are relevant?• The 35 monthly payments of $6,000 and the down

payment of $50,000 are relevant costs, because they depend on the decision

• 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• $ 800 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



• In a comparison of the cost increases/cash outflows to cost savings/cash inflows– The down payment required for the new machine is

matched by the expected trade-in value of the old machine

– The expected savings in labor, materials, and machine maintenance costs each month ($6,200) are more than the monthly lease payments for 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


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


Responsibility For Decisions (1 of 2)

• 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


Responsibility For Decisions (2 of 2)

• 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 of previous life decisions can evoke a complex set of 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


Make-or-Buy Decisions (1 of 3)

• 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



• 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



Std. Rear Std. Front Multicolor Curved

Product 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 16 19 22

Product-sustaining overhead 6 12 14 19

Facility-sustaining overhead 8 10 11 14

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


Avoidable Costs (1 of 3)

• 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



• To decide whether facility-sustaining support costs are avoidable requires further consideration

• The company cannot dispose of part of the facility used to support the production of the standard rear lamp without disposing of the entire machine or building

• Most facility-sustaining support costs represent the prorated costs of indivisible common facilities– Building space– Machines



• It could be possible to find an alternative use for the part of the facility made available by not producing a product

• The manager considered the possibility of shifting the remaining production lines to another facility– The company could save the facility-sustaining costs for the

rental facility by terminating its lease there

• Such indirect savings in facility-sustaining costs for the organization are relevant for the decision to outsource production, because they can arise only if the lamp is outsourced

• The manager determined that it would be technically infeasible to transfer the manufacture of the other product lines to another plant


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


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


Facility Layout Systems (1 of 2)

• 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


Facility Layout Systems (2 of 2)

• 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 flow of a process– A bottleneck can be identified by determining points at

which excessive amounts of work-in-process inventories are accumulating

– The buildup of inventories also slows the cycle time of production


Theory of Constraints (1 of 2)

• The theory of constraints relies on the use of three measures– Throughput contribution– Investments– Operating costs

• Throughput contribution is the difference between revenues and direct materials for the quantity of product sold

• Investments equal the materials costs contained in raw materials, work-in-process, and finished goods inventories

• Operating costs are all other costs, except for direct materials costs, that are needed to obtain throughput contribution


Theory of Constraints (2 of 2)

• 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


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


Process Layout in a Bank (1 of 2)

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)


Process Layout in a Bank (2 of 2)

• 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


WIP Accumulation (1 of 3)

• 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



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



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


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 of equipment or processing units is made to reduce the distance that products must travel– Arrangements for delivery of raw materials and

purchased parts directly to the production line can often be made


Product Layout in a Cafeteria (1 of 2)

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


Product Layout in a Cafeteria (2 of 2)

– 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


Cellular Manufacturing (1 of 2)

• 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


Cellular Manufacturing (2 of 2)

• 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


Problems with Batch Production (1 of 2)

• 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:


Problems with Batch Production (2 of 2)

– 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


Inventory-Related Costs (1 of 2)

• 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


Inventory-Related Costs (2 of 2)

– 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


Cost of Nonconformanceand Quality Issues

• Cost reduction has become a significant factor in the management of 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 of products and services does not conform to quality standards, then the organization incurs a cost known as the cost of nonconformance (CONC) to quality standards


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


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


ISO9000 (1 of 6)

• In 1987, the International Organization for Standardization (ISO), 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 or exceed customer requirements, or– Implement a quality improvement program to remain competitive


ISO9000 (2 of 6)

• ISO 9000 contains more than 20 standards and documents

• Because of the increase in the number of standards, ISO 9000:2000 was developed

• ISO 9000:2000 consists of four primary standards and a greatly reduced number of supporting documents (guidance standards, brochures, technical reports, technical specifications)

• The major points in previous versions of the standards were integrated into the four primary standards


ISO9000 (3 of 6)

• The four primary standards are:– ISO 9000: Quality management systems –

Fundamentals and vocabulary– ISO 9001: Quality management systems –

Requirements– ISO 9004: Quality management systems –

Guidance for performance improvement– ISO 19011: Guidelines on quality and/or environmental

management systems auditing (To be published)


ISO9000 (4 of 6)

• 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


ISO9000 (5 of 6)

• 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


ISO9000 (6 of 6)

• Manufacturing• Forestry• Electronics• Computing• Legal services• Financial services• Accounting• Trucking• Banking• Retailing• Drilling• Recycling• Aerospace• Construction• Pharmaceuticals

• Sanitation• Software development• Consumer products• Transportation• Design• Tourism• Communications• Biotechnology• Engineering• Farming• Entertainment• Consulting• Insurance• and others

The ISO 9000:2000 Standards apply to all kinds of organizations in all kinds of areas:

• More information can be obtained from the International Organization for Standardization (www.iso.org)

• Oil and gas• Petrochemicals• Publishing• Shipping• Telecommunications• Health care• Hospitality• Utilities• Aviation• Food processing• Agriculture• Government• Education• Recreation


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


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


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


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 defective $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 for two more stages of assembly


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


Cost-of-Quality Report (1 of 2)

• This information is compiled in a cost-of-quality (COQ) report, developed for several reasons

• It illustrates the financial magnitude of quality factors– Often managers 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


Cost-of-Quality Report (2 of 2)

• 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


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


Implications Of JIT Manufacturing (1 of 6)

• 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 all types of jobs



• 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



• 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



• 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



• 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 of work and the overall work discipline of the organization

• It can cause structural changes in such areas as the arrangement of shop floors



– 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


If you have any comments or suggestions concerning this PowerPoint presentation, please contact:

Terry M. Lease([email protected])Sonoma State University

Management Accounting Information for Activity and Process Decisions

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