Cost Accounting and Cost Management in a Lean Environment

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2 Cost Accounting and Cost Management in a Lean Environment Introduction This topic continues to look at production management techniques and strategies, especially the more Lean production philosophies originating from Japan, such as Just-In-Time production (JIT). The strategic management accounting issues raised by such philosophies and techniques and aspects of the influence of the philosophy on production and purchasing are also covered. Specific Objectives The Japanisation of production management techniques and strategies has become a global phenomenon in modern industrial settings. JIT is a waste-reduction philosophy in which all activities that do not add value to a product are eliminated. The objectives of this topic are for students to: Appreciate the JIT philosophy of the importance of the continuous elimination of waste Understand the impact of JIT on cost management systems and consider the management accounting issues raised by the JIT philosophy Appreciate the justification, benefits and hurdles of changing cost management systems Consider JIT purchasing and JIT production on cost accounting Study cost planning, cost reduction and cost control within JIT environments and overview Backflush Costing Systems as an alternative product costing system Lecture Outline The JIT Philosophy Just-In-Time (JIT) Manufacturing Cost Management in a JIT Environment Backflush Costing 3CN-1

3 Specific Readings Course Notes Reading A: Harber, D. et al, (1999) Just-In-Time Manufacturing: Issues Affecting Implementation, Chapter 11, in Strategic Management Accounting -Text Book. Reading B: Shank, J.K. (1989), Strategic Cost Management: New Wine or Just New Bottles, Journal of Management Accounting Research, Fall, pp Reading C: Morgan, M. and Weerakoon, P., (2008) Japanese Management Accounting: Its Contribution to the Japanese Economic Miracle, Chapter 16 in Strategic Management Accounting Text Book Reading D: Reading D: Paul Preda, P. and Ted Watts, T. (2004), Contemporary Accounting Innovations in Australia: Manufacturing versus Service Organisations, Journal of Applied Management Accounting Research, Vol. 2, No.2, pp Reading E: Foster, G. and Horngren, C., (2008) Cost Accounting and Cost Management in a JIT Environment Chapter 15 in Strategic Management Accounting Text Book 3CN-2

4 Course Notes Cost Accounting and Cost Management in a Lean Environment 1. Just-In-Time (JIT) Manufacturing 1.1 Key Point: JIT is a Philosophy - It centres on the elimination of waste (especially inventory). - Some time honoured (traditional) management accounting practices are a hindrance to the practice of JIT... and would be considered as waste (eg. Work Orders). 1.2 JIT is a Philosophy having 4 Fundamentals Aspects: - All activities that do not add value to a product are eliminated - There is a commitment to a high level of quality - Continuous improvement in the efficiency of activities are strived for - High visibility of value-added/and non-value added activities are emphasised 1.3 JIT... the Continuous Elimination of Waste: Most Notably... - Elimination of WIP - by reducing batch sizes (ideally to one). - Elimination of RM inventories - by direct delivery to machine. - Elimination of scrap and rework - by Total Quality Management (design, components). - Elimination of Finished Goods Inventories - by products being made to order. - Elimination of materials handling - by redesigning shopfloor flowlines. 1.4 There are many Aspects of Production that need to work Together Effectively if this Goal is to be reached: - Production Scheduling/Planning - Material and procurement planning - Shopfloor layout - Machine set-up times - Production engineering - Total Quality Control - These aspects have caused a significant change in operations, thus serious consideration should be given to changing the accompanying accounting system. 3CN-3

5 1.5 Steps Required to Establish (and achieve) JIT Manufacturing: PROBLEM TRAD. SOLUTION JIT SOLUTION Supplier lead times re. delivery High safety stocks, large batch sizes Closer relationships with suppliers. Smaller, more frequent deliveries direct to workstations. Quality of delivered components Price maintenance at point of purchase Inflexible production, and errors on prod. floor Inspection and Quality Control at point of delivery Multiple suppliers tendering. Discounts for bulk orders/ Carrying of high WIP and Fin. Goods stocks. High reworking of faulty products. Pre-inspection at source and quality guarantees. Involvement in component design Few (single) suppliers to provide small, frequent, high quality deliveries in return for long-term contracts (SMART) contracts. Pull production instead of Push production. High level of Materials Resource Planning (MRP). Long set-up times for the production of subassemblies, part and finished products. Large Batch sizes, so that once machine is set-up...large quantities can be produced. Ideal lot size for JIT production is one...thus enormous amount of attention paid to reducing set-up times. (4 hrs to 3 mins). To achieve this initially...more attention has to be paid; later...diff. capital equipment. Poor production floor layout (eg. shopfloor layout) High WIP inventory in queue. (In a typical European plant 80% of WIP is in queue awaiting delivery to next workstation). Reduction of product flowtime, by better shopfloor layout. - Ergonomics - Matr. Handling Equipment - Flexible machines (often in conflict with fast set-up) 3CN-4

6 Management Accounting Issues Raised by JIT Philosophy - Job Costing: As Batch sizes get smaller - it will become meaningless to collect costs against work orders for individual batches. Process flow costing may become more meaningful. - Collection of Material Costs: This becomes extremely cumbersome (especially with direct supplier deliveries). Backflush Costing through a consistent Bill of Materials and an emphasis on Quality to keep the scrap figure down becomes important. - Labour Reporting: Labour Efficiency Variance calculations become meaningless as it is considered better for a person to be idle (and doing preventive maintenance, quality improvement etc) than for stock to build-up. - Incentive Schemes: The implementation of these schemes for productivity should be factory-wide and not by individual piece-work (high productivity at a work station may only result in WIP build-up). - Machine Utilisation: JIT prefers idle-machines to stock build-up. In the capital budgeting area, new equipment decisions must be made on set-up time/flexibility criteria. - Variance Reporting: This is valid only for long term trends...as any variations from norm, quality problems etc. are required by JIT to be picked-up immediately. - Goods Receiving: Components delivered by a single-customer direct to shopfloor raises serious questions relating to control, value of inventory etc., as backflushing eliminates all clerical functions of recording receipt, updating, stockcount etc. - Overhead Apportionment: This cannot be based on Labour/Machine hrs as idle time permitted. Some rate or products made category should be used. - Monthly Reporting: This is too late except to identify trends. Identification and resolution of problems done at shopfloor as one works with small batches which are used immediately. 3CN-5

7 JIT Purchasing and Cost Accounting - JIT purchasing has long been used in the perishables industry - now its being applied to non-perishables. - JIT purchasing involves a substantial increase in individual deliveries, each containing fewer units. This involves: Decreasing number of suppliers ( at Apple). Stipulating price and acceptable quality levels. Providing Advanced Delivery Schedules (ADS s). Freezing production schedules a month in advance. Using shop-ready containers to go straight to machine/shelf. Pre-inspection at source. Implications of JIT purchasing for Cost Accounting: Increases direct cost traceability as overheads such as material handling costs are reduced The cost pools of such items as handling, inspection, storage are reduced (i.e. combined) or can even be totally eliminated. Indirect cost allocation bases are affected - thus the dollar value of materials, or the number of deliveries may better capture the cause Reduced emphasis on individual purchase price variances (trends only useful). Reduces the frequency of detailed recording and reporting. eg: - Batching of individual deliveries before recording as one transaction. - Electronic pre-programmed cost ledger updating. - Automatic payment of creditors (suppliers) The use of various stages of backflush costing. JIT Production and Cost Accounting - Demand pull/not WIP push. WIP held to minimum - Emphasis placed on reducing production lead time (flexibility) - Production stopped if WIP defective (labour/machine idle time accepted) - EBQ formula constants continually reduced (eg set-up time) - Value-added/non-value added activities very visible (eg WIP pile-up, fork lift trucks) Implications of JIT Production for Cost Accounting. - Indirect costs categories such as plant maintenance now done by direct labour. - Thus such cost pools combined (or even eliminated). - Increased use of time clocks, minicomputers, bar-codes for cost traceability. - Overhead and labour variances on an individual basis not considered important - Low cost accumulation administrative costs with backflush costing - A job costing system changed to process then to backflush. - Setting labour standards... eliminates wasted effort. 3CN-6

8 2. Cost Management in a JIT Environment 2.1 Justification for Changes In Cost Accounting Systems: - More accurate product cost information (for pricing; contracting; product mix etc). - Better control of cost incurrence (JIT focus is on reducing the total costs of an organisation as a whole). - Reduced costs of the system (JIT focus on simplifying all operations... including costing). 2.2 Cost Management Changes in a JIT Environment Cost Planning - The aim is to design the product and the production line with a mix of cost, quality, deliverability and flexibility - This must reflect senior management s strategy. Cost Reduction - This is undertaken continuously: pre, during, postproduction stages. - All product line workers are members of cost reduction circles. Cost Control - This is undertaken when production starts, and includes: Personal observations of line workers Overall financial measures to see trends (eg. inventory turnover) Non-financial performance measures (eg. lead times; set-up times; % defects; schedule attainment). Achievement of cost reduction target measures - This also includes Backflush Costing. 3CN-7

9 3. Backflush Costing 3.1 Output Focus - A backflush costing system focuses first on the output of an organisation and then works backward when applying costs to units sold and to inventories. The term backflush probably arose because the trigger points for product costing entries can be delayed until a trigger point is reached (which could be as late as sales). It is only a trigger point that costs finally are flushed through the accounting system. - In contrast, conventional product costing systems track costs through work in process (WIP) as the focal account, 3.2 Examples Beginning with the introduction of raw materials into production. And finishing on the transfer of goods to the finished goods account. - The following three examples demonstrate backflushing. Example 1 illustrates the elimination of a separate WIP inventory account. Examples 2 and 3 are more dramatic departures from widely used product costing systems. - Example One A hypothetical company, Silicon Valley Computers (SVC), has two trigger points for making entries in the internal accounting system: - Trigger point 1 - The purchase of raw materials and components. - Trigger point 2 - The manufacture of a finished good unit. SVC manufactures keyboards for personal computers. - For the month of April, there are no beginning inventories of raw materials, WIP, or finished goods. - The standard material cost per keyboard unit in April is $19. - For product costing, SVC combines labour costs and indirect manufacturing costs into a single conversion cost category. 3CN-8

10 The standard conversion cost per keyboard unit in April is $12. SVC has two inventory accounts: Type of Account Name Combined raw materials and WIP Finished goods Inventory: Raw and WIP Finished goods Incurrence of conversion costs are charged to responsibility centres under backflush costing just as in other costing systems. Applications of conversion costs are made to products at various trigger points. Any conversion costs not applied to products are written off immediately as expenses incurred in that period. For example, all unfavourable variances are charged as period expenses. (For simplicity, Examples 1 to 3 assume that all actual costs and standard costs are the same.) - SVC uses the following steps when applying costs to units sold and to inventories: Step One Record the raw materials purchased in the reporting period. Assume that April materials purchases were $1,950,000. Dr. Inventory: Raw and WIP $1,950,000 Cr. Accounts payable $1,950,000 Step Two Record the incurrence of conversion costs during the reporting period. Assume conversion costs were $1,200,000 Dr. Conversion costs $1,200,000 Cr. Accounts payable, accrued payroll $1,200,000 Step Three Determine the number of finished units manufactured during the reported period. Assume that 100,000 keyboard units were manufactured in April. 3CN-9

11 Step Four Compute the standard cost of each finished unit. This step typically uses a bill of materials and an operations list, or equivalent records. For SVC, the standard cost per unit is $31 ($19 standard material cost + $12 standard conversion cost). Step Five Record the cost of finished goods manufactured in the reporting period: Dr. Inventory: Finished goods (100,000 $31) $3,100,000 Cr. Inventory: Raw and WIP $1,900,000 Cr. Conversion costs $1,200,000 Step Six Record the cost of goods sold in the reporting period. Assume that 99,000 units were sold during the month. Dr. Costs of goods sold (99,000 $31) $3,069,000 Cr. Inventory: Finished goods $3,069,000 The end of month inventory balance for April are: Inventory: Raw and WIP $50,000 Inventory: Finished goods (1,000 $31) $31,000 $81,000 The elimination of the WIP account considerably reduces the amount of detail in the internal accounting system. (There still may be tracking of units on the production line, but there is no costs attach tracking through work tickets in the internal accounting system. - The following Exhibit provides an overview of the accounts affected in Example One. 3CN-10

12 - Example Two A variant of Example One is a backflush costing system whose second trigger point for making entries into the internal accounting system is the sale, rather than the manufacture of a finished unit. Two rationales given for this variant system are: - To remove the incentive for mangers to produce for inventory - under the costs attach assumption implicit in job, operation, and process costing, period expenses can be reduced by producing units not sold and by increasing WIP. - To increase the focus of mangers on a plantwide goal (producing saleable units) rather than on and individual subunit goal (eg increase labour efficiency at an individual production centre). This variant has the same effect on net income as the immediate expensing of all conversion costs. Under this approach, the inventory account is confined solely to raw materials (whether they are in storage, in process, or in finished goods). No conversion costs are inventoried. The summary accounting entry is: Dr. Cost of goods sold $3,069,000 (99,000 $31) Cr. Inventory $1,881,000 Cr. Conversion costs $1,188,000 At the end of each period, an adjusting entry is made that immediately expenses the conversion costs incurred but not attributed to units sold: Period expenses $12,000 Conversion costs $12,000 The end-of-period inventory account is $69,000 ($50,000 in raw materials still on hand and $19,000 in raw materials embodied in the 1,000 units manufactured but not sold during the period). Under this variant, there is no account for finished goods inventory because the trigger for making the second set of entries is sale rather than manufacture. 3CN-11

13 - Example Three The simplest version of a backflush product costing system has only one trigger point for making product costing entries in the accounting system. Assume this trigger point is the manufacture of a finished unit. With the same data as in Examples 1 and 2, the summary entry is: Dr. Inventory-finished goods $3,100,000 Cr. Accounts payable $1,900,000 Cr. Conversion costs $1,200,000 At the end of the period, the $50,000 of raw materials purchased but not yet manufactured into finished units will not have been entered into the internal product costing system. This variant of a backflush system is less feasible if there are significant inventories of raw materials and WIP. 3CN-12

14 Silicon Valley Computer: A Management Control, Case Study In a Just-In-Time (JIT) Environment Silicon valley Computer (SVC) was founded in 19-1 to manufacture the hard-disk drives used for data storage in a variety of computer products. Its customers are computer manufacturers who incorporate the disk drives into their computer systems. Competition in the hard-disk-drive market is intense. Exhibit I outlines the manufacturing process at the Santa Clara plant of SVC. There is a raw-materials stockroom, five work stations on the production line, and a finished goods inventory stockroom. Raw materials (typically sub-assembled items) are used at each of the first three workstations. The Pre-JIT Production ERA From 19-1 to 19-4, SVC used a push approach to production. Production would start in response to a push launched from the front end of the system with the issuance of a work order at the Base & Motor Assembly work station. The work-order system was intended to track actual labor costs for each work-order batch. Shop floor labourers or managers would judge the distribution of labor time across work orders and would then record the information on work tickets. Later, clerks entered the work-ticket information into the computerised work-order system. SVC used a batch manufacturing process. Work-in-process inventories developed at each of the five major work stations on the assembly line. Each work station had its own rework loop in which defective units were reworked. Rework activities did not appear as a separate cost centre in each work station. Items relegated to rework were not separately recorded; they appeared in the tracking system as an item of work in process. The cost accounting system had a job-costing orientation, based on standard costs. Three basic cost categories (raw materials, labor, and overhead) were separately tracked through the system. Problems Arising in the Pre-JIT Production ERA By 19_4, management had become aware of some major problems at the Santa Clara plant: 1. Large amounts of work-in-process inventory were accumulating at each work station. Work stations accumulated inventory to avoid not stopping production. In this way, each work station avoided depending on previous work stations for the flow of product. When a work station encountered a defective unit, it was put into a defective parts pool. At one point, over 3,000 defective disk drives had accumulated in rework. 2. Labor time was not accurately recorded. Workers and managers often recorded labor in a somewhat arbitrary fashion; blocks of labor time were rounded off and distributed haphazardly across work orders. In many months, the recorded labor time on the work orders was less than 80% of total labour hours that should have been recorded. 3. The internal reporting system was exceedingly complex. The sheer cost and volume of paperwork associated with the system was overwhelming the production managers and staff. 3CN-13

15 The JIT Production ERA In 19-5, SVC moved toward a JIT production system for its work in process. Demand pull became the driving force on the production line. Production is on a constant flow rather than a batch process. Approximately three days inventory resides at each work station..(in 19-4, up to three months inventory had resided at some work stations.) As customer demand pulls products out of finished goods, replacements move from work in process into finished goods, and each work station pulls partially assembled items from the prior work station. When a three-day buffer is filled at each work station, production at that work station stops. If a defective part is encountered at a work station, the product line at that work station is shut down until the problem is solved. SVC s JIT system did not fully extend to either the raw materials or the finished goods. SVC held up to three months supply of one of its key components in the raw-materials stockroom. The supplier of this component was the sole high-quality manufacturer and was unwilling to become a JIT supplier to SVC. The demand for SVC s hard-disk drives was unpredictable. SVC kept up to one month s supply of finished goods as a precaution against stockouts. The major customers of SVC were implementing JIT purchasing themselves and were not enthusiastic about holding large inventories of hard-disk drives. In the last two quarters of 19-5, a severe slump in demand by SVC s customers led to a quick build-up in finished-goods inventories. Cost Accounting in the JIT Production ERA SVC made major changes to its cost accounting system in 19_5. It moved away from the work-order concept and instituted a work centre approach for tracking work in process. Each work station operates with an open-ended centre record. That is, raw materials and overhead are charged to a work centre, not a work order. As units are completed and transferred, standard costs are used to track the transfers. This procedure avoids the time consuming and (sometimes) ambiguous activity of closing out work-orders for each batch of production. SVC monitors total work-in-process flow at five points with five corresponding work centre records. (In effect, each separate work station used a version of process costing.) The new cost accounting system regards rework as a separate cost category within work in process. That is, rework costs are accumulated as a separate and distinct sub part of WIP. In this way, the costs of rework can be closely tracked. SVC decided to include labor costs as a component of overhead costs. Eliminating the tracking of labor reduced management cost at the job level. The labor content for each disk drive in 19-5 ranged from 3% to 7% of total costs. The quarterly financial data for selected items of Silicon Valley Computer for the 19-4 to 19-5 period (in millions) are set out in Exhibit 2. 3CN-14

16 Exhibit 2 Silicon Valley Computer: Quarterly Data for 19_4 and 19_5 (millions) 19_4 19_4 19_4 19_4 19_5 19_5 19_5 19_5 Quarter 1 Quarter 2 Quarter 3 Quarter 4 Quarter 1 Quarter 2 Quarter 3 Quarter 4 Sales $ Cost of Goods Sold Total Assets Raw Materials Work in Process Finished Goods Total Inventories CN-15

17 Required 1. Name four differences between the production process at SVC in 19-5 compared to the one in the 19-1 to 19-4 period. 2. Name three differences between the cost accounting system at SVC in 19_5 compared to the one in the 19_1 to 19_4 period. How do these differences relate to your answer in requirement 1? 3. What evidence is there that the changes documented in requirement 1 and 2 solved some of the problems at the Santa Clara plant that management became aware of in 19-4? 4. A commentator described SVC s manufacturing approach as an abridged version of JIT. Explain this comment. What factors might prevent SVC from adopting a JIT approach in all phases of its manufacturing activities? CMA1T3.jr 3CN-16