HAPTER 12

The Production Cycle

INTRODUCTION

Questions to be addressed in this chapter include:

What are the basic business activities and data processing operations that are performed in
the production cycle?
What decisions need to be made in the production cycle, and what information is needed to
make these decisions?
How can the companys cost accounting system help in achieving the entitys objectives?
What are the major threats in the production cycle and the controls that can mitigate those
threats?

INTRODUCTION

The production cycle is a recurring set of business activities and related data processing
operations associated with the manufacture of products.

INTRODUCTION

Information flows to the production cycle from other cycles, e.g.:

The revenue cycle provides information on customer orders and sales forecasts for use in
planning production and inventory levels.
The expenditure cycle provides information about raw materials acquisitions and overhead
costs.
The human resources/payroll cycle provides information about labor costs and availability.

INTRODUCTION

Information also flows from the expenditure cycle:

The revenue cycle receives information from the production cycle about finished goods
available for sale.
The expenditure cycle receives information about raw materials needs.
The human resources/payroll cycle receives information about labor needs.
The general ledger and reporting system receives information about cost of goods
manufactured.

INTRODUCTION

Decisions that must be made in the production cycle include:

What mix of products should be produced?
How should products be priced?
How should resources be allocated?
How should costs be managed and performance evaluated?
These decisions require cost data well beyond that required for external financial
statements.

INTRODUCTION

Well be looking at how the three basic AIS functions are carried out in the production cycle,
i.e.:
How do we capture and process data?
How do we store and organize the data for decisions?
How do we provide controls to safeguard resources, including data?

PRODUCTION CYCLE ACTIVITIES

The four basic activities in the production cycle are:

Product design
Planning and scheduling
Production operations
Cost accounting
Accountants are primarily involved in the fourth activity (cost accounting) but must
understand the other processes well enough to design an AIS that provides needed
information and supports these activities.

PRODUCTION CYCLE ACTIVITIES

The four basic activities in the production cycle are:

Product design
Planning and scheduling
Production operations
Cost accounting
Accountants are primarily involved in the fourth activity (cost accounting) but must
understand the other processes well enough to design an AIS that provides needed
information and supports these activities.

PRODUCT DESIGN

The objective of product design is to design a product that strikes the optimal balance of:
Meeting customer requirements for quality, durability, and functionality; and
Minimizing production costs.
Simulation software can improve the efficiency and effectiveness of product design.

PRODUCT DESIGN

Key documents and forms in product design:

Bill of Materials: Lists the components that are required to build each product, including
part numbers, descriptions,and quantity.
Operations List: Lists the sequence of steps required to produce each product, including the
equipment needed and the amount of time required.

PRODUCT DESIGN

Role of the accountant in product design:

Participate in the design, because 6580% of product cost is determined at this stage.
Add value by:
Designing an AIS that measures and collects the needed data.

Information about current component usage.

Information about machine set-up and materials-handling costs.
Data on repair and warranty costs to aid in future modification and design.

PRODUCT DESIGN

Role of the accountant in product design:

Participate in the design, because 6580% of product cost is determined at this stage.
Add value by:
Designing an AIS that measures and collects the needed data.
Helping the design team use that data to improve profitability.

Compare current component usage with projected usage in alternate designs.

Compare current set-up and handling costs to projected costs in alternate designs.
Provide info on how design trade-offs affect total production cost and profitability.

PRODUCTION CYCLE ACTIVITIES

The four basic activities in the production cycle are:

Product design
Planning and scheduling
Production operations
Cost accounting
Accountants are primarily involved in the fourth activity (cost accounting) but must
understand the other processes well enough to design an AIS that provides needed
information and supports these activities.

PLANNING AND SCHEDULING

The objective of the planning and scheduling activity is to develop a production plan that is
efficient enough to meet existing orders and anticipated shorter-term demand while
minimizing inventories of both raw materials and finished goods.

PLANNING AND SCHEDULING

There are two common approaches to production planning:
Manufacturing Resource Planning (MRP-II)
Lean Manufacturing

PLANNING AND SCHEDULING

There are two common approaches to production planning:

Manufacturing Resource Planning (MRP-II)
Lean Manufacturing

PLANNING AND SCHEDULING

MRP-II is an extension of MRP inventory control systems:

Seeks to balance existing production capacity and raw materials needs to meet forecasted
sales demands.
Often referred to as push manufacturing.

PLANNING AND SCHEDULING

There are two common approaches to production planning:

Manufacturing Resource Planning (MRP-II)
Lean Manufacturing

PLANNING AND SCHEDULING

Lean manufacturing is an extension of the principles of just-in-time inventory systems:

Seeks to minimize or eliminate inventories of raw materials, work in process, and finished
goods.
Theoretically, produces only in response to customer orders, but in reality, there are short-
run production plans.
Often referred to as pull manufacturing.

PLANNING AND SCHEDULING

Comparison of the two systems:

Both plan production in advance.
They differ in the length of the planning horizon.
MRP-II develops plans for up to 12 months ahead.
Lean manufacturing uses shorter planning horizons.
Consequently:
MRP-II is more appropriate for products with predictable demand and a long life cycle.
Lean manufacturing more appropriate for products with unpredictable demand, short life
cycles, and frequent markdowns of excess inventory.

PLANNING AND SCHEDULING

Key documents and forms:
Master production schedule

Specifies how much of each product is to be produced during the period and when.
Uses information about customer orders, sales forecasts, and finished goods inventory
levels to determine production levels.
Although plans can be modified, production plans must be frozen a few weeks in advance to
provide time to procure needed materials and labor.
Scheduling becomes significantly more complex as the number of factories increases.
Raw materials needs are determined by exploding the bill of materials to determine amount
needed for current production. These amounts are compared to available levels to
determine amounts to be purchased.

PLANNING AND SCHEDULING

Key documents and forms:

Master production schedule
Production order

Authorizes production of a specified quantity of a product. It lists:

Operations to be performed
Quantity to be produced
Location for delivery
Also collects data about these activities,

PLANNING AND SCHEDULING

Key documents and forms:

Master production schedule
Production order
Materials requisition

Authorizes movement of the needed materials from the storeroom to the factory floor.
This document indicates:
Production order number
Date of issue
Part numbers and quantities of raw materials needed (based on data in bill of materials)

PLANNING AND SCHEDULING

Key documents and forms:

Master production schedule
Production order
Materials requisition
Move ticket

Documents the transfer of parts and materials throughout the factory.

PLANNING AND SCHEDULING

How can information technology help?

Improve the efficiency of material-handling activities by using:
Bar coding of materials to improve speed and accuracy,
RFID tags can eliminate human intervention in the scanning process,

Up to 40 times faster than using bar-code scanners.

Not impeded by dirt.
Not limited to reading only those items in line of sight.
Much easier to locate needed products and broadcast their location to forklift operators or
other warehouse workers.

PLANNING AND SCHEDULING

Role of the accountant:

Ensure the AIS collects and reports costs in a manner consistent with the companys
production planning techniques.

PRODUCTION CYCLE ACTIVITIES

The four basic activities in the production cycle are:

Product design
Planning and scheduling
Production operations
Cost accounting
Accountants are primarily involved in the fourth activity (cost accounting) but must
understand the other processes well enough to design an AIS that provides needed
information and supports these activities.

PRODUCTION OPERATIONS

Production operations vary greatly across companies, depending on the type of product and
the degree of automation.
The use of various forms of IT, such as robots and computer-controlled machinery is called
computer-integrated manufacturing (CIM).
Can significantly reduce production costs.
Accountants arent experts on CIM, but they must understand how it affects the AIS.
One effect is a shift from mass production to custom-order manufacturing and the need to
accumulate costs accordingly.

PRODUCTION OPERATIONS

In a lean manufacturing environment, a customer order triggers several actions:

System first checks inventory on hand for sufficiency.
Calculates labor needs and determines whether overtime or temporary help will be needed.
Based on bill of materials, determines what components need to be ordered.
Necessary purchase orders are sent via EDI.
The master production schedule is adjusted to include the new order.

PRODUCTION OPERATIONS

Sharing information across cycles helps companies be more efficient by timing purchases to
meet the actual demand.
Although the nature of production processes and the extent of CIM vary, all companies need
data on:
Raw materials used
Labor hours expended
Machine operations performed
Other manufacturing overhead costs incurred

PRODUCTION CYCLE ACTIVITIES

The four basic activities in the production cycle are:

Product design
Planning and scheduling
Production operations
Cost accounting
Accountants are primarily involved in the fourth activity (cost accounting) but must
understand the other processes well enough to design an AIS that provides needed
information and supports these activities.

COST ACCOUNTING

The objectives of cost accounting are:

To provide information for planning, controlling, and evaluating the performance of
production operations;
To provide accurate cost data about products for use in pricing and product mix decisions;
and
To collect and process information used to calculate inventory and COGS values for the
financial statements.

COST ACCOUNTING

The objectives of cost accounting are:

To provide information for planning, controlling, and evaluating the performance of
production operations;
To provide accurate cost data about products for use in pricing and product mix decisions;
and
To collect and process information used to calculate inventory and COGS values for the
financial statements.
To accomplish the first objective, the AIS must collect real-time data on the performance of
production activities so management can make timely decisions.
RFID technology can be especially helpful, e.g.:
Broadcasting repair needs proactively.
Helping in the location of particular items.

COST ACCOUNTING

The objectives of cost accounting are:

To provide information for planning, controlling, and evaluating the performance of
production operations;
To provide accurate cost data about products for use in pricing and product mix decisions;
and
To collect and process information used to calculate inventory and COGS values for the
financial statements.

To accomplish the second and third objectives, the AIS must collect costs by various
categories and assign them to specific products and organizational units.
Requires careful coding of cost data during collection because costs may be allocated in
different ways for different reporting purposes.

COST ACCOUNTING

Types of cost accounting systems:

Job order costing

Assigns costs to a specific production batch or job.

Used when the product or service consists of discretely identifiable items.
Example: Houses.

COST ACCOUNTING

Types of cost accounting systems:

Job order costing
Process costing

Assigns costs to each process or work center in the production cycle.

Calculates the average cost for all units produced.
Used when similar goods or services are produced in mass quantities and discrete units
cant be easily identified.
Example: Paint.

COST ACCOUNTING

Accounting for fixed assets:

The AIS must collect and process information about the property, plant, and equipment
used in the production cycle.
These assets represent a significant portion of total assets for many companies and need to
be monitored as an investment.

COST ACCOUNTING

The following information should be maintained about each fixed asset:

ID number
Serial number
Location
Cost
Acquisition date
Vendor info

Expected life
Expected salvage value
Depreciation method
Accumulated depreciation
Improvements
Maintenance performed

COST ACCOUNTING

The purchase of fixed assets follows the same processes as other purchases in the
expenditure cycle (order receive pay).
But the amounts involved necessitate some modification to the process:
Competitive bidding

Machinery and equipment purchases almost always involve a formal request for
competitive bids.

COST ACCOUNTING

The purchase of fixed assets follows the same processes as other purchases in the
expenditure cycle (order receive pay).
But the amounts involved necessitate some modification to the process:
Competitive bidding
Number of people involved

More people are likely to be involved in reviewing bids for fixed assets.

COST ACCOUNTING

The purchase of fixed assets follows the same processes as other purchases in the
expenditure cycle (order receive pay).
But the amounts involved necessitate some modification to the process:
Competitive bidding
Number of people involved
Payment

Purchases of fixed assets are often paid for in installments, including interest.

COST ACCOUNTING

The purchase of fixed assets follows the same processes as other purchases in the
expenditure cycle (order receive pay).
But the amounts involved necessitate some modification to the process:
Competitive bidding
Number of people involved
Payment
Controls

The cost of fixed assets justifies more elaborate controls to safeguard them, including:
Maintenance of detailed records of each item.
RFID tags to:
Monitor location
Facilitate preventive maintenance

COST ACCOUNTING

The purchase of fixed assets follows the same processes as other purchases in the
expenditure cycle (order receive pay).
But the amounts involved necessitate some modification to the process:
Competitive bidding
Number of people involved
Payment
Controls
Disposal

Its critical to formally approve and accurately record the sale or disposal of fixed assets.

COST ACCOUNTING

A typical AIS would look something like the following:

Product design

Engineering specifications result in new records for both the bill of materials and the
operations list file.
To create these lists, engineering accesses both files to view designs of similar products.
They also access the general ledger and inventory files for info about alternate designs.

COST ACCOUNTING
A typical AIS would look something like the following:
Product design
Production planning

The sales department enters sales forecasts and customer special order information.
Production planning uses that information and data on current inventory levels to develop a
master production schedule.
New records are added to the production order file to authorize the production of goods.

COST ACCOUNTING

A typical AIS would look something like the following:

Product design
Production planning
Cost accounting

New records are added to the work-in-process file to accumulate cost data.

COST ACCOUNTING

A typical AIS would look something like the following:

Product design
Production planning
Cost accounting
Production operations

The list of operations to be performed is displayed at workstations.

Instructions are also sent to the CIM interface to guide operation of machinery and robots.
Materials requisitions are sent to inventory stores to authorize release of raw materials to
production.

COST ACCOUNTING

Such a system can be used for a job-order or process costing system.

Both require that data be accumulated about:
Raw materials
Direct labor
Machinery and equipment usage
Manufacturing overhead
The choice of method:
Does not affect how data are collected
Does affect how costs are assigned to products

COST ACCOUNTING

Raw material usage data:

When production is initiated, the issuance of a materials requisition triggers a debit
(increase) to work in process and a credit (decrease) to raw materials inventory.
Work in process is credited and raw materials are debited for any amounts returned to
inventory.
Many raw materials are bar coded so that usage data is collected by scanning.
RFID tags improve the efficiency of tracking material usage.
Usage may be entered online for materials such as liquids that are not conducive to tagging.

COST ACCOUNTING

Direct labor costs:

Historically, job time tickets were used to record the time a worker spent on each job task.
Currently, workers may:
Enter the data on online terminals.
Use coded ID badges, which are run through a badge reader at the beginning and end of
each job.

COST ACCOUNTING

Machinery and equipment usage:

Machinery costs make up an ever-increasing proportion of production costs.
Data about machinery and equipment are collected at each production step, often with data
about labor costs.
Until recently, data was collected by wiring the factory so all equipment was linked to the
computer system.
Limits the ability to rearrange the shop floor.
3-D simulations can be used to assess the impact of altering floor layout.

COST ACCOUNTING

Manufacturing overhead costs:

Includes costs that cant be easily traced to jobs or processes, such as utilities, depreciation,
supervisory salaries.
Most of these costs are collected in the expenditure cycle.
An exception is supervisory salaries, which are collected in the HRM/payroll cycle.

COST ACCOUNTING

Accountants help control overhead by assessing how product mix changes will affect
overhead costs.
They should also identify the factors that drive the changes in these costs.
This information can be used to realign processes and layout.
Accurate and complete information about production cycle activities are required to
perform these analyses.

CONTROL: OBJECTIVES, THREATS, AND PROCEDURES

In the production cycle (or any cycle), a well-designed AIS should provide adequate controls
to ensure that the following objectives are met:
All transactions are properly authorized.
All recorded transactions are valid.
All valid and authorized transactions are recorded.
All transactions are recorded accurately.
Assets are safeguarded from loss or theft.
Business activities are performed efficiently and effectively.
The company is in compliance with all applicable laws and regulations.
All disclosures are full and fair.

CONTROL: OBJECTIVES, THREATS, AND PROCEDURES

There are several actions a company can take with respect to any cycle to reduce threats of
errors or irregularities. These include:
Using simple, easy-to-complete documents with clear instructions (enhances accuracy and
reliability).
Using appropriate application controls, such as validity checks and field checks (enhances
accuracy and reliability).
Providing space on forms to record who completed and who reviewed the form
(encourages proper authorizations and accountability).

CONTROL: OBJECTIVES, THREATS, AND PROCEDURES

Pre-numbering documents (encourages recording of valid and only valid transactions).

Restricting access to blank documents (reduces risk of unauthorized transaction).
Using RFID tags when feasible to improve data entry accuracy.

In the following sections, well discuss the threats that may arise in the four major steps of
the production cycle, as well as general threats, EDI-related threats, and threats related to
purchases of services.

THREATS IN PRODUCT DESIGN

The major threats in the product design process is:

THREAT 1: Poor product design

You can click on the threat above to get more information on:
The types of problems posed by each threat.
The controls that can mitigate the threat.

THREATS IN PRODUCT DESIGN

THREAT NO. 1Poor product design

Why is this a problem?
Higher materials purchasing and carrying costs.
Costs for inefficient production.
Higher repair and warranty costs.
Controls:
Accurate data about the relationship between components and finished goods.
Analysis of warranty and repair costs to identify primary causes of product failure to be
used in re-designing product.

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THREATS IN PLANNING AND SCHEDULING

Threats in the planning and scheduling process include:

THREAT 2: Over- or under-production
THREAT 3: Suboptimal investment in fixed assets

You can click on any of the threats above to get more information on:
The types of problems posed by each threat
The controls that can mitigate the threats.

THREATS IN PLANNING AND SCHEDULING

THREAT NO. 2Over- or under-production

Why is this a problem?
Over-production may result in:
Excess goods for short-run demand and potential cash flow problems.
Obsolete inventory.
Under-production may result in:
Lost sales.
Customer dissatisfaction.

THREATS IN PLANNING AND SCHEDULING

Controls:
More accurate production planning, including accurate and current:
Sales forecasts
Inventory data
Investments in production planning.
Regular collection of data on production performance to adjust production schedule.
Proper authorization of production orders.
Restriction of access to production scheduling program.
Validity checks on production orders.
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THREATS IN PLANNING AND SCHEDULING

THREAT NO. 3Suboptimal investment in fixed assets

Why is this a problem?
Over-investment causes excess costs.
Under-investment impairs productivity.
Controls:
Proper authorization of fixed asset transactions:
Larger purchases should be reviewed by a senior executive or executive committee.
Smaller purchases (<$10,000) can be handled with departmental budgets, with managers
being held responsible for department return.

THREATS IN PLANNING AND SCHEDULING

Competitive bids should be sought via requests for proposals (RFPs).

The capital investment committee should review and select the winning bid.
Once a supplier is selected, acquisition may be handled through the expenditure cycle
process.

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THREATS IN PRODUCTION OPERATIONS

Threats in the production operations process include:

THREAT 4: Theft of inventories and fixed assets
THREAT 5: Disruption of operations

You can click on any of the threats above to get more information on:
The types of problems posed by each threat.
The controls that can mitigate the threats.

THREATS IN PRODUCTION OPERATIONS

THREAT NO. 4Theft of inventories and fixed assets

Why is this a problem?
Loss of assets.
Misstated financial data.
Potential underproduction of inventory.
Controls:
Physical access to inventory should be restricted.
All internal movement of inventory should be documented.

THREATS IN PRODUCTION OPERATIONS

Materials requisitions should be used to authorize release of raw materials.

Should be signed by both inventory control clerk and production employee to establish
accountability.
Requests in excess of the bill of materials should be documented and have supervisory
authorization.
RFID tags and bar codes can be used to track inventory through production.

THREATS IN PRODUCTION OPERATIONS

Proper segregation of duties should be enforced:

Inventory stores has custody of raw materials and finished goods.
Factory supervisors are responsible for work in process.
Authorization of production orders, materials requisitions, and move tickets, should be
done by production planners or the information system.
Logical and physical access controls should be enforced for production records.
An independent party should count inventory and investigate discrepancies.
Fixed assets must be identified and recorded.

THREATS IN PRODUCTION OPERATIONS

Managers should be held accountable for assets under their control.

Fixed assets should be physically secured.
Disposal of assets should be authorized and documented.
Periodic reports of fixed asset transactions should be reviewed by the controller.
Adequate insurance should be maintained.

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THREATS IN PRODUCTION OPERATIONS

THREAT NO. 5Disruption of operations

Why is this a problem?
Disasters can disrupt functioning and destroy assets
Controls:
Backup power sources, such as generators and uninterruptible power supplies.
Investigate disaster preparedness of key suppliers and identify alternative sources for
critical components.

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THREATS IN COST ACCOUNTING

Threats in the cost accounting process include:

THREAT 6: Inaccurate recording and processing of production activity data

You can click on the threat above to get more information on:
The types of problems posed by the threat.
The controls that can mitigate the threat.

THREATS IN COST ACCOUNTING

THREAT 6Inaccurate recording and processing of production activity data

Why is this a problem?
Diminishes effectiveness of production scheduling.
Undermines managements ability to monitor and control operations.
Controls:
Automate data collection with RFID technology, bar code scanners, and badge readers to
ensure accurate data entry.

THREATS IN COST ACCOUNTING

Use online terminals for data entry.

Restrict access with passwords, user IDs, and access control matrices to prevent
unauthorized changes to data.
Use check digits, closed-loop verification, and validity checks.
Do periodic physical counts of inventory and compare to records.
Do periodic inspections and counts of fixed assets.

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GENERAL THREATS

Two general objectives pertain to activities in every cycle:

Accurate data should be available when needed.
Activities should be performed efficiently and effectively.
Threats in the process of ordering goods include:
THREAT 7: Loss, alteration, or unauthorized disclosure of data
THREAT 8: Poor performance

You can click on any of the threats below to get more information on:
The types of problems posed by each threat.
The controls that can mitigate the threats.

GENERAL THREATS

THREAT NO. 7: Loss, alteration, or unauthorized disclosure of data

Why is this a problem?
Loss or alteration of data could cause:
Errors in external or internal reporting.
Unauthorized disclosure of confidential information can cause:
Unfair competition
Loss of business

GENERAL THREATS

Controls:
All data files and key master files should be backed up regularly.
At least one backup on site and one offsite.
All disks and tapes should have external and internal file labels to reduce chance of
accidentally erasing important data.
Promptly, remove all access rights of employees who quit or are fired

GENERAL THREATS

Access controls should be utilized:

User IDs and passwords.
Compatibility matrices.
Controls for individual terminals (e.g., so the receiving dock cant enter a sales order).
Logs of all activities, particularly those requiring specific authorizations, should be
maintained.
Default settings on ERP systems usually allow users far too much access to data, so these
systems must be modified to enforce proper segregation of duties.

GENERAL THREATS

Sensitive data should be encrypted in storage and in transmission.

Parity checks, acknowledgment messages, and control totals should be used to ensure
transmission accuracy.

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GENERAL THREATS

THREAT NO. 8Poor performance

Why is this a problem?
Quality control problems increase expenses and reduce future sales.
Controls:
Prepare and review performance reports.

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PRODUCTION CYCLE INFORMATION NEEDS

In a manufacturing environment, the focus must be on total quality management. Managers

need info on:
Defect rates
Breakdown frequency
Percent of finished goods needing rework
Percent of defects discovered by customers

PRODUCTION CYCLE INFORMATION NEEDS

In traditional systems, this type of data was not well linked with financial data, and cost
accounting systems were separate from production operations information systems.
However, both financial and operating information are needed to manage and evaluate
these activities.

PRODUCTION CYCLE INFORMATION NEEDS

Two major criticisms have been directed at traditional cost accounting systems:
Overhead costs are inappropriately allocated to products.
Reports do not accurately reflect effects of factory automation.

PRODUCTION CYCLE INFORMATION NEEDS

Two major criticisms have been directed at traditional cost accounting systems:
Overhead costs are inappropriately allocated to products.
Reports do not accurately reflect effects of factory automation.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

Traditional cost accounting systems use volume-driven bases such as direct labor hours or
machine hours to apply overhead.
However, overhead does not vary with production volume.
EXAMPLE: Purchasing costs vary with the number of purchase orders processed.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

Allocating overhead based on output volume:

Overstates the costs of products manufactured in large quantities.
Understates the costs of products manufactured in small batches.
Also, allocating overhead based on direct labor input can distort costs.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

Example of two products:

Product one uses:
$5 of materials
1 hour of labor
5 minutes of machine time
Product two uses:
$5 of materials
1 hour of labor
42 hours of machine time on very expensive equipment

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

Example of two products:

Product one uses:
$5 of materials
1 hour of labor
5 minutes of machine time
Product two uses:
$5 of materials
1 hour of labor
42 hours of machine time on very expensive equipment

Under a traditional cost accounting system, both products will appear to have the same cost.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

Solution to criticism 1: Activity Based Costing (ABC)

ABC can refine and improve cost allocations under either job-order or process costing
systems.
ABC traces costs to the activities that create them and allocates them accordingly.
ABC aims to link costs to corporate strategy.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

Corporate strategy results in decisions about what goods and services to produce.
These activities incur costs.
So corporate strategy determines costs.
By measuring the costs of the basic activities, ABC provides information to management for
evaluating the consequences of their decisions.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

ABC vs. traditional cost systems:

There are three significant differences between ABC and traditional approaches.
Tracing of overhead costs
Number of cost pools
Identification of cost drivers

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

ABC vs. traditional cost systems:

There are three significant differences between ABC and traditional cost accounting
approaches.
Tracing of overhead costs
Number of cost pools
Identification of cost drivers

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

ABC directly traces a larger proportion of overhead costs to products.

This tracing is made possible by advances in IT.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

ABC vs. traditional cost systems:

There are three significant differences between ABC and traditional cost accounting
approaches.
Tracing of overhead costs
Number of cost pools
Identification of cost drivers

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

ABC uses a greater number of cost pools to accumulate indirect costs (manufacturing
overhead).
Most systems lump all overhead together, but ABC distinguishes three categories:
Batch-related overhead

EXAMPLES: Setup, inspection, and material handling costs.

Accumulated for a batch and allocated to the products in that batch.
Consequently, costs per product will be less when products are made in larger quantities.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

ABC uses a greater number of cost pools to accumulate indirect costs (manufacturing
overhead).
Most systems lump all overhead together, but ABC distinguishes three categories:
Batch-related overhead
Product-related overhead

Examples: R&D, environmental regulations, and purchasing costs.

These costs are related to the diversity of the companys product line.
ABC attempts to link these costs to the products that generate them.
For example, purchasing costs might be allocated to products based on the number of
purchase orders generated for each product.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

ABC uses a greater number of cost pools to accumulate indirect costs (manufacturing
overhead).
Most systems lump all overhead together, but ABC distinguishes three categories:
Batch-related overhead
Product-related overhead
Company-wide overhead

EXAMPLE: Rent or depreciation.

These costs are applied to all products and allocated according to departmental or plant
rates.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

ABC vs. traditional cost systems:

There are three significant differences between ABC and traditional cost accounting
approaches.
Tracing of overhead costs
Number of cost pools
Identification of cost drivers

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

Benefits of ABC systems
ABC systems are more costly and complex.
But proponents argue two important benefits:
More accurate cost data result in better product mix and pricing decisions.
More detailed cost data improve managements ability to control and manage total costs.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

Benefits of ABC systems

ABC systems are more costly and complex.
But proponents argue two important benefits:
More accurate cost data result in better product mix and pricing decisions
More detailed cost data improve managements ability to control and manage total costs.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

Better decisions
ABC avoids problems of applying too much or too little overhead to products and
consequently results in better price decisions.
ABC uses the data collected to improve product design.
ABC provides management with the information about the costs associated with specific
activities, resulting in better analysis and decisions.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

Benefits of ABC systems

ABC systems are more costly and complex.
But proponents argue two important benefits:
More accurate cost data result in better product mix and pricing decisions.
More detailed cost data improve managements ability to control and manage total costs.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

Improved cost management

ABC measures the results of managerial actions on overall profitability.
ABC measures both the amount spent to acquire resources and the amount spent to
consume them.
ABC measures unused capacity:
Cost of activity capability = Cost of activity used + Cost of unused capacity

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

EXAMPLE: A publishing company has five employees who operate printing presses.
The employees each have annual salaries of $25,000 for a total salary cost of $125,000.
Each employee should be able to print about 10,000 books per year.
The total capacity, therefore is 50,000 books.
The salary cost per book would be $125,000 / 50,000 books = $2.50 per book.
During the most recent year, the presses produced 47,000 books.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

EXAMPLE: A publishing company has five employees who operate printing presses.
The employees each have annual salaries of $25,000 for a total salary cost of $125,000.
Each employee should be able to print about 10,000 books per year.
The total capacity, therefore is 50,000 books.
The salary cost per book would be $125,000 / 50,000 books = $2.50 per book.
During the most recent year, the presses produced 47,000 books.

The cost of the activity capability is the total book capacity for the year of 50,000 books
times the salary cost per book of $2.50.
50,000 books x $2.50 = $125,000.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

EXAMPLE: A publishing company has five employees who operate printing presses.
The employees each have annual salaries of $25,000 for a total salary cost of $125,000.
Each employee should be able to print about 10,000 books per year.
The total capacity, therefore is 50,000 books.
The salary cost per book would be $125,000 / 50,000 books = $2.50 per book.
During the most recent year, the presses produced 47,000 books.

The cost of the activity used is the number of books actually produced times the salary cost
per book of $2.50.
47,000 books x $2.50 = $117,500.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

EXAMPLE: A publishing company has five employees who operate printing presses.
The employees each have annual salaries of $25,000 for a total salary cost of $125,000.
Each employee should be able to print about 10,000 books per year.
The total capacity, therefore is 50,000 books.
The salary cost per book would be $125,000 / 50,000 books = $2.50 per book.
During the most recent year, the presses produced 47,000 books.

The unused capacity is the difference between the activity capability ($125,000) and the
cost of the activity used ($117,500).
$125,000 - $117,500 = $7,500 unused capacity.
Alternately, unused capacity can be calculated as the cost per book of $2.50 times the
difference between the books that could be produced and the books that were actually
produced.
$2.50 x (50,000 possible books 47,000 actual books) = $7,500 unused capacity.

CRITICISM 1: INAPPROPRIATE ALLOCATION OF OVERHEAD COSTS

Management may be able to improve profitability by:
Applying the unused capacity to other revenue-generating activities; or
Eliminating the unused capacity.

PRODUCTION CYCLE INFORMATION NEEDS

Two major criticisms have been directed at traditional cost accounting systems:
Overhead costs are inappropriately allocated to products.
Reports do not accurately reflect effects of factory automation.

CRITICISM 2: REPORTS DO NOT ACCURATELY REFLECT EFFECTS OF AUTOMATION

When an organization transitions from a traditional production system to a lean

manufacturing system, inventory levels are depleted. Consequently, almost all production
costs of the year are expensed that year.
Although the effect is temporary, managers will be concerned if their performance
evaluations are based on the companys reported financial statements.

CRITICISM 2: REPORTS DO NOT ACCURATELY REFLECT EFFECTS OF AUTOMATION

Solution to criticism two: Better reports and measures

Produce reports based on lean accounting principles.

Report for each product all costs incurred to design, produce, sell, deliver, process customer
payments, and provide post-sale support for that product.
Separate overhead costs from COGS.
Identify changes in inventory levels as a separate expense item.

CRITICISM 2: REPORTS DO NOT ACCURATELY REFLECT EFFECTS OF AUTOMATION

Solution to criticism two: Better reports and measures

Produce reports based on lean accounting principles.
Develop resources to focus on issues important to production cycle managers.

Examples:
Useable output produced per time period.
Monitoring of product quality.

THROUGHPUT: A MEASURE OF PRODUCTION EFFECTIVENESS

Throughput = Productive Capacity x Productive Processing Time x Yield

Productive Capacity = Total Units Produced / Processing Time

Can be improved by:

Improving machine or labor efficiency.
Improving factory layout.
Simplifying product design specifications.
THROUGHPUT: A MEASURE OF PRODUCTION EFFECTIVENESS

Throughput = Productive Capacity x Productive Processing Time x Yield

Productive Capacity = Total Units Produced / Processing Time
Productive Processing Time = Processing Time / Total Time

The opposite of downtime.

Can be improved by:
Better maintenance to reduce machine downtime.
Better scheduling of deliveries to reduce wait time.

THROUGHPUT: A MEASURE OF PRODUCTION EFFECTIVENESS

Throughput = Productive Capacity x Productive Processing Time x Yield

Productive Capacity = Total Units Produced / Processing Time
Productive Processing Time = Processing Time / Total Time
Yield = Good Units / Total Units

Can be improved by:

Using better raw materials.
Improving worker skills.

THROUGHPUT: A MEASURE OF PRODUCTION EFFECTIVENESS

Throughput = Productive Capacity x Productive Processing Time x Yield

Productive Capacity = Total Units Produced / Processing Time
Productive Processing Time = Processing Time / Total Time
Yield = Good Units / Total Units

EXAMPLE: Manster Co. produced 1,000 bottles of Zithmowash in a 10-hour period. During
this period there was a total of 1 hour of machine downtime and waiting time for materials.
One hundred of the bottles were defective.
PRODUCTIVE CAPACITY = 1,000 bottles / 9 productive hours = 111.11 bottles / hour.
PRODUCTIVE PROCESSING TIME = 9 productive hours / 10 total hours = .90.
YIELD = 900 good units / 1,000 total units = .90
THROUGHPUT = 111.11 x .90 x .90 = 90

QUALITY CONTROL

Information about quality control

Quality control costs can be divided into four categories:
Prevention costs

Costs incurred to reduce product defect rates.

QUALITY CONTROL

Information about quality control

Quality control costs can be divided into four categories:
Prevention costs
Inspection costs

Costs incurred to ensure products meet quality standards.

QUALITY CONTROL

Information about quality control

Quality control costs can be divided into four categories:
Prevention costs
Inspection costs
Internal failure costs

Costs of rework and scrap when products are identified as defective prior to sale.

QUALITY CONTROL

Information about quality control

Quality control costs can be divided into four categories:
Prevention costs
Inspection costs
Internal failure costs
External failure costs

Costs when defective products are sold to customers, e.g., warranty and repair costs,
product liability costs, costs of customer dissatisfaction, and damage to reputation.

QUALITY CONTROL

Information about quality control

Quality control costs can be divided into four categories:
Prevention costs
Inspection costs
Internal failure costs
External failure costs
The objective of quality control is to minimize the sum of these four costs.
Some companies have found that the most important management decision involves
switching from the traditional "management by exception" philosophy to a "continuous
improvement" viewpoint. Continuous improvement focuses on comparing actual
performance to the ideal (i.e., perfection).

SUMMARY

Youve learned about the basic business activities and data processing operations that are
performed in the production cycle, including:
Product design
Production planning and scheduling
Production operations
Cost accounting
Youve learned how IT can improve the efficiency and effectiveness of these processes.

SUMMARY

Youve learned about decisions that need to be made in the production cycle and the
information required to make these decisions.
Youve also learned about the major threats that present themselves in the production cycle
and the controls that can mitigate those threats.
Finally, youve learned how the companys cost accounting system can help in achieving the
entitys objectives.