companys A conversion cycle transforms (converts) input
resources, such as raw materials, labor, and overhead,
into finished products or services for sale. The conversion
cycle exists conceptually in all organizations,
including those in service and retail industries. It is most formal
and apparent, however, in manufacturing firms, which is
the focus of this chapter. We begin with a review of the traditional
batch production model, which consists of four basic processes:
(1) plan and control production, (2) perform production
operations, (3) maintain inventory control, and (4) perform cost
accounting. The discussion focuses on the activities, documents,
and controls pertaining to these traditional processes. The chapter
then examines manufacturing techniques and technologies in
world-class companies. Many firms pursuing world-class status
follow a philosophy of lean manufacturing. This approach evolved
from the Toyota Production System (TPS). The goal of lean manufacturing
is to improve efficiency and effectiveness in product
design, supplier interaction, factory operations, employee management,
and customer relations. Key to successful lean manufacturing
is achieving manufacturing flexibility, which involves
the physical organization of production facilities and the employment
of automated technologies, including computer numerical
controlled (CNC) machines, computer-integrated manufacturing
(CIM), automated storage and retrieval systems (AS/RS), robotics,
computer-aided design (CAD), and computer-aided manufacturing
(CAM). The chapter then examines problems associated
with applying standard cost accounting techniques in a highly
automated environment. The key features of two alternative
accounting models are discussed: (1) activity-based costing (ABC)
and (2) value stream accounting. The chapter concludes with a
discussion of the information systems commonly associated with lean manufacturing and world-class companies. Materials requirements planning (MRP) systems
are used to determine how much raw materials are required to fulfill production orders.
Manufacturing resources planning (MRP II) evolved from MRP to integrate additional functionality
into the manufacturing process, including sales, marketing, and accounting. Enterprise
resource planning (ERP) systems take MRP II a step further by integrating all aspects of the
business into a set of core applications that use a common database.
The Traditional Manufacturing Environment
The conversion cycle consists of both physical and information activities related to manufacturing
products for sale. The context-level data flow diagram (DFD) in Figure 7-1
illustrates the central role of the conversion cycle and its interactions with other business
cycles. Production is triggered by customer orders from the revenue cycle and/or by
sales forecasts from marketing. These inputs are used to set a production target and prepare
a production plan, which drives production activities. Purchase requisitions for the
raw materials needed to meet production objectives are sent to the purchases procedures
(expenditure cycle), which prepares purchase orders for vendors. Labor used in production
is transmitted to the payroll system (expenditure cycle) for payroll processing. Manufacturing
costs associated with intermediate work-in-process and finished goods are sent
to the general ledger and financial reporting system. Depending on the type of product being manufactured, a company will employ one
of the following production methods:
1. Continuous processing creates a homogeneous product through a continuous series of
standard procedures. Cement and petrochemicals are produced by this manufacturing
method. Typically, under this approach firms attempt to maintain finished-goods inventory
at levels needed to meet expected sales demand. The sales forecast in conjunction
with information on current inventory levels triggers this process.
2. Make-to-order processing involves the fabrication of discrete products in accordance
with customer specifications. This process is initiated by sales orders rather than depleted
inventory levels.
3. Batch processing produces discrete groups (batches) of product. Each item in the batch
is similar and requires the same raw materials and operations. To justify the cost of setting
up and retooling for each batch run, the number of items in the batch tends to be large.
This is the most common method of production and is used to manufacture products such
as automobiles, household appliances, canned goods, automotive tires, and textbooks.
The discussion in this chapter is based on a batch processing environment.
Batch Processing System
The DFD in Figure 7-2 provides a conceptual overview of the batch processing system,
which consists of four basic processes: plan and control production, perform production
operations, maintain inventory control, and perform cost accounting. As in previous
chapters, the conceptual system discussion is intended to be technology-neutral. The
tasks described in this section may be performed manually or by computer. The figure
also depicts the primary information flows (documents) that integrate these activities and
link them to other cycles and systems. Again, system documents are technology-neutral
and may be hard copy or digital. We begin our study of batch processing with a review of
the purpose and content of these documents.
Documents in the Batch Processing System
A manufacturing process such as that in Figure 7-2 could be triggered by either individual
sales orders from the revenue cycle or by a sales forecast the marketing system
provides. For discussion purposes, we will assume the latter. The sales forecast shows
the expected demand for a firms finished goods for a given period. For some firms,
marketing may produce a forecast of annual demand by product. For firms with seasonal
swings in sales, the forecast will be for a shorter period (quarterly or monthly)
that can be revised in accordance with economic conditions.
The production schedule is the formal plan and authorization to begin production.
This document describes the specific products to be made, the quantities to be produced
in each batch, and the manufacturing timetable for starting and completing
production. Figure 7-3 contains an example of a production schedule.
The bill of materials (BOM), an example of which is illustrated in Figure 7-4, specifies
the types and quantities of the raw material (RM) and subassemblies used in producing
a single unit of finished product. The RM requirements for an entire batch are
determined by multiplying the BOM by the number of items in the batch.
A route sheet, illustrated in Figure 7-5, shows the production path that a particular
batch of product follows during manufacturing. It is similar conceptually to a
BOM. Whereas the BOM specifies material requirements, the route sheet specifies the sequence of operations (machining or assembly) and the standard time allocated to
each task.
The work order (or production order) draws from BOMs and route sheets to specify
the materials and production (machining, assembly, and so on) for each batch. These,
together with move tickets (described next), initiate the manufacturing process in the
production departments. Figure 7-6 presents a work order. A move ticket, shown in Figure 7-7, records work done in each work center and
authorizes the movement of the job or batch from one work center to the next.
A materials requisition authorizes the storekeeper to release materials (and subassemblies)
to individuals or work centers in the production process. This document usually
specifies only standard quantities. Materials needed in excess of standard amounts
require separate requisitions that may be identified explicitly as excess materials requisitions.
This allows for closer control over the production process by highlighting
excess material usage. In some cases, less than the standard amount of material is used
in production. When this happens, the work centers return the unused materials to the storeroom accompanied by a materials return ticket. Figure 7-8 presents a format that
could serve all three purposes.
Batch Production Activities
The flowchart in Figure 7-9 provides a physical view of the batch processing system.
The flowchart illustrates the organization functions involved, the tasks performed in each
function, and the documents that trigger or result from each task. To emphasize the physical
flows in the process, documents are represented in Figure 7-9 as hard copy. Many organizations today, however, make this data transfer digitally via computerized systems
that utilize data entry screens or capture data by scanning bar code tags. In this section,
we examine three of the four conversion cycle processes depicted by the DFD in Figure 7-2.
Cost accounting procedures are discussed later.
Production Planning and Control. We first examine the production planning and control
function. This consists of two main activities: (1) specifying materials and operations
requirements and (2) production scheduling.
Materials and Operations Requirements. The raw materials requirement for a batch of
any given product is the difference between what is needed and what is available in the
raw material inventory. This information comes from analysis of inventory on hand,
the sales forecast, engineering specifications (if any), and the BOM. A product of this
activity is the creation of purchase requisitions for additional raw materials. Procedures for preparing purchase orders and acquiring inventories are the same as those described
in Chapter 5. The operations requirements for the batch involve the assembly and/or
manufacturing activities that will be applied to the product. This is determined by assessing
route sheet specifications.
Production Scheduling. The second activity of the planning and control function is production
scheduling. The master schedule for a production run coordinates the production
of many different batches. The schedule is influenced by time constraints, batch size, and
specifications derived from BOMs and route sheets. The scheduling task also produces
work orders, move tickets, and materials requisitions for each batch in the production run.
A copy of each work order is sent to cost accounting to set up a new work-in-process (WIP)
account for the batch. The work orders, move tickets, and materials requisitions enter the
production process and flow through the various work centers in accordance with the route
sheet. To simplify the flowchart in Figure 7-9, only one work center is shown.
Work Centers and Storekeeping. The actual production operations begin when workers
obtain raw materials from storekeeping in exchange for materials requisitions. These
materials, as well as the machining and the labor required to manufacture the product, are
applied in compliance with the work order. When the task is complete at a particular work
center, the supervisor or other authorized person signs the move ticket, which authorizes
the batch to proceed to the next work center. To evidence that a stage of production has
been completed, a copy of the move ticket is sent back to production planning and control
to update the open work order file. Upon receipt of the last move ticket, the open work
order file is closed. The finished product along with a copy of the work order is sent to
the finished goods (FG) warehouse. Also, a copy of the work order is sent to inventory
control to update the FG inventory records.
Work centers also fulfill an important role in recording labor time costs. This task is
handled by work center supervisors who, at the end of each work week, send employee
time cards and job tickets to the payroll and cost accounting departments, respectively.
Inventory Control. The inventory control function consists of three main activities. First,
it provides production planning and control with status reports on finished goods and
raw materials inventory. Second, the inventory control function is continually involved in
updating the raw material inventory records from materials requisitions, excess materials
requisitions, and materials return tickets. Finally, upon receipt of the work order from
the last work center, inventory control records the completed production by updating the
finished goods inventory records.
An objective of inventory control is to minimize total inventory cost while ensuring
that adequate inventories exist to meet current demand. Inventory models used to achieve
this objective help answer two fundamental questions:
1. When should inventory be purchased?
2. How much inventory should be purchased?
A commonly used inventory model is the economic order quantity (EOQ) model. This
model, however, is based on simplifying assumptions that may not reflect the economic
reality. These assumptions are:
1. Demand for the product is constant and known with certainty.
2. The lead timethe time between placing an order for inventory and its arrivalis
known and constant 3. All inventories in the order arrive at the same time.
4. The total cost per year of placing orders is a variable that decreases as the quantities
ordered increase. Ordering costs include the cost of preparing documentation,
contacting vendors, processing inventory receipts, maintaining vendor accounts, and
writing checks.
5. The total cost per year of holding inventories (carrying costs) is a variable that increases
as the quantities ordered increase. These costs include the opportunity cost of
invested funds, storage costs, property taxes, and insurance.
6. There are no quantity discounts. Therefore, the total purchase price of inventory for
the year is constant. The objective of the EOQ model is to reduce total inventory costs. The significant
parameters in this model are the carrying costs and the ordering costs. Figure 7-10
illustrates the relationship between these costs and order quantity. As the quantity
ordered increases, the number of ordering events decreases, causing the total annual cost of
ordering to decrease. As the quantity ordered increases, however, average inventory on
hand increases, causing the total annual inventory carrying cost to increase. Because the
total purchase price of inventory is constant (Assumption 6), we minimize total inventory
costs by minimizing the total carrying cost and total ordering costs. The combined total
cost curve is minimized at the intersection of the ordering-cost curve and the carrying-cost
curve. This is the EOQ. In simple models, both I and d are assumed to be known with certainty and are constant.
For example, if:
d = 5 units, and
I = 8 days, then
ROP = 40 units.
The assumptions of the EOQ model produce the saw-toothed inventory usage pattern
illustrated in Figure 7-11. Values for Q and ROP are calculated separately for each
type of inventory item. Each time inventory is reduced by sales or used in production, its
new quantity on hand (QOH) is compared to its ROP. When QOH = ROP, an order is
placed for the amount of Q. In our example, when inventory drops to 40 units, the firm
orders 346 units.
If the parameters d and I are stable, the organization should receive the ordered
inventories just as the quantity on hand reaches zero. If either or both parameters are
subject to variation, however, then additional inventories called safety stock must
be added to the reorder point to avoid unanticipated stock-out events. Figure 7-12
shows an additional 10 units of safety stock to carry the firm through a lead time that
could vary from 8 to 10 days. The new reorder point is 50 units. Stock-outs result in
either lost sales or back-orders. A back-order is a customer order that cannot be filled
because of a stock-out and will remain unfilled until the supplier receives replenishment
stock.
When an organizations inventory usage and delivery patterns depart significantly
from the assumptions of the EOQ model, more sophisticated models such as the back-order
quantity model and the production order quantity model may be used. A discussion of
these models is, however, beyond the scope of this text.
Cost Accounting Activities
Cost accounting activities of the conversion cycle record the financial effects of the
physical events that are occurring in the production process. Figure 7-13 represents
typical cost accounting information tasks and data flows. The cost accounting process
for a given production run begins when the production planning and control department
sends a copy of the original work order to the cost accounting department. This marks the beginning of the production event by causing a new record to be added to the
work-in- process (WIP) file, which is the subsidiary ledger for the WIP control account
in the general ledger.
As materials and labor are added throughout the production process, documents
reflecting these events flow to the cost accounting department. Inventory control sends
copies of materials requisitions, excess materials requisitions, and materials returns. The
various work centers send job tickets and completed move tickets. These documents,
along with standards provided by the standard cost file, enable cost accounting to update
the affected WIP accounts with the standard charges for direct labor, material, and manufacturing
overhead (MOH). Deviations from standard usage are recorded to produce
material usage, direct labor, and MOH variances.
The receipt of the last move ticket for a particular batch signals the completion of
the production process and the transfer of products from WIP to the FG inventory. At
this point cost accounting closes the WIP account. Periodically, summary information
regarding charges (debits) to WIP, reductions (credits) to WIP, and variances are recorded
on journal vouchers and sent to the general ledger (GL) department for posting to the
control accounts.
Controls in the Traditional Environment
Recall from previous chapters the six general classes of internal control activities: transaction
authorization, segregation of duties, supervision, access control, accounting records,
and independent verification. Specific controls as they apply to the conversion cycle are
summarized in Table 7-1 and further explained in the following section. Transaction Authorization
The following describes the transaction authorization procedure in the conversion cycle.
1. In the traditional manufacturing environment, production planning and control
authorize the production activity via a formal work order. This document reflects
production requirements, which are the difference between the expected demand for
products (based on the sales forecast) and the finished goods inventory on hand.
2. Move tickets signed by the supervisor in each work center authorize activities for
each batch and for the movement of products through the various work centers.
3. Materials requisitions and excess materials requisitions authorize the storekeeper to
release materials to the work centers.
Segregation of Duties
One objective of this control procedure is to separate the tasks of transaction authorization
and transaction processing. As a result, the production planning and control department
is organizationally segregated from the work centers.
Another control objective is to segregate record keeping from asset custody. The following
separations apply: 1. Inventory control maintains accounting records for raw material and finished goods
inventories. This activity is kept separate from the materials storeroom and from the
FG warehouse functions, which have custody of these assets.
2. Similarly, the cost accounting function accounts for WIP and should be separate from
the work centers in the production process.
Finally, to maintain the independence of the GL function as a verification step, the GL
department must be separate from departments keeping subsidiary accounts. Therefore, the
GL department is organizationally segregated from inventory control and cost accounting.
Supervision
The following supervision procedures apply to the conversion cycle:
1. The supervisors in the work centers oversee the usage of RM in the production process.
This helps to ensure that all materials released from stores are used in production
and that waste is minimized. Employee time cards and job tickets must also be
checked for accuracy.
2. Supervisors also observe and review timekeeping activities. This promotes accurate
employee time cards and job tickets.
Access Control
The conversion cycle allows both direct and indirect access to assets.
Direct Access to Assets. The nature of the physical product and the production process
influences the type of access controls needed. 1. Firms often limit access to sensitive areas, such as storerooms, production work
centers, and FG warehouses. Control methods used include identification badges,
security guards, observation devices, and various electronic sensors and alarms.
2. The use of standard costs provides a type of access control. By specifying the quantities
of material and labor authorized for each product, the firm limits unauthorized
access to those resources. To obtain excess quantities requires special authorization
and formal documentation.
Indirect Access to Assets. Assets, such as cash and inventories, can be manipulated through
access to the source documents that control them. In the conversion cycle, critical documents
include materials requisitions, excess materials requisitions, and employee time cards.
A method of control that also supports an audit trail is the use of prenumbered documents.
Accounting Records
As we have seen in preceding chapters, the objective of this control technique is to establish
an audit trail for each transaction. In the conversion cycle this is accomplished through
the use of work orders, cost sheets, move tickets, job tickets, materials requisitions, the
WIP file, and the FG inventory file. By prenumbering source documents and referencing
these in the WIP records, a company can trace every item of FG inventory back through
the production process to its source. This is essential in detecting errors in production and
record keeping, locating batches lost in production, and performing periodic audits.
Independent Verification
Verification steps in the conversion cycle are performed as follows:
1. Cost accounting reconciles the materials and labor usage taken from materials requisitions
and job tickets with the prescribed standards. Cost accounting personnel may
then identify departures from prescribed standards, which are formally reported as
variances. In the traditional manufacturing environment, calculated variances are an
important source of data for the management reporting system.
2. The GL department also fulfills an important verification function by checking the
total movement of products from WIP to FG. This is done by reconciling journal
vouchers from cost accounting and summaries of the inventory subsidiary ledger
from inventory control.
3. Finally, internal and external auditors periodically verify the RM and FG inventories
on hand through a physical count. They compare actual quantities against the inventory
records and make adjustments to the records when necessary.
World-Class Companies and Lean Manufacturing
The traditional conversion cycle described in the previous section represents how many
manufacturing firms operate today. Over the past three decades, however, rapid swings
in consumer demands, shorter product life cycles, and global competition have radically
changed the rules of the marketplace. In an attempt to cope with these changes, manufacturers
have begun to conduct business in a dramatically different way. The term worldclass
defines this modern era of business. The pursuit of world-class status is a journey
without destination because it requires continuous innovation and continuous improvement.
A recent survey of corporate executives revealed that 80 percent of them claim to
be pursuing principles that will lead their companies to world-class status. Skeptics argue,
however, that as few as 10 or 20 percent of these firms are truly on the right path. What Is a World-Class Company?
The following features characterize the world-class company:
World-class companies must maintain strategic agility and be able to turn on a dime.
Top management must be intimately aware of customer needs and not become rigid
and resistant to paradigm change.
World-class companies motivate and treat employees like appreciating assets. To activate
the talents of everyone, decisions are pushed to the lowest level in the organization.
The result is a flat and responsive organizational structure.
A world-class company profitably meets the needs of its customers. Its goal is not
simply to satisfy customers, but to positively delight them. This is not something
that can be done once and then forgotten. With competitors aggressively seeking
new ways to increase market share, a world-class firm must continue to delight its
customers.
The philosophy of customer satisfaction permeates the world-class firm. All of its
activities, from the acquisition of raw materials to selling the finished product, form a
chain of customers. Each activity is dedicated to serving its customer, which is the next
activity in the process. The final paying customer is the last in the chain.
Finally, manufacturing firms that achieve world-class status do so by following a philosophy
of lean manufacturing. This involves doing more with less, eliminating waste,
and reducing production cycle time.
The following section reviews the principles of lean manufacturing. The remainder of the
chapter examines the techniques, technologies, accounting procedures, and information
systems that enable it.
Principles of Lean Manufacturing
Lean manufacturing evolved from the Toyota Production System (TPS), which is based
on the just-in-time (JIT) production model. This manufacturing approach is in direct
opposition to traditional manufacturing, which is typified by high inventory levels,
large production lot sizes, process inefficiencies, and waste. The goal of lean production
is improved efficiency and effectiveness in every area, including product design, supplier
interaction, factory operations, employee management, and customer relations.
Lean involves getting the right products to the right place, at the right time, in the right
quantity while minimizing waste and remaining flexible. Success depends, in great part,
on employees understanding and embracing lean manufacturing principles. Indeed, the
cultural aspects of this philosophy are as important as the machines and methodologies
it employs. The following principles characterize lean manufacturing.
Pull Processing. Products are pulled from the consumer end (demand), not pushed from
the production end (supply). Under the lean approach, inventories arrive in small quantities
from vendors several times per day, just in time to go into production. They are pulled
into production as capacity downstream becomes available. Unlike the traditional push
process, lean does not create batches of semifinished inventories at bottlenecks.
Perfect Quality. Success of the pull processing model requires zero defects in raw
material, work-in-process, and finished goods inventory. Poor quality is very expensive
to a firm. Consider the cost of scrap, reworking, scheduling delays, and extra inventories
to compensate for defective parts, warranty claims, and field service. In the traditional manufacturing environment, these costs can represent between 25 and 35 percent of total
product cost. Also, quality is a basis on which world-class manufacturers compete. Quality
has ceased to be a trade-off against price. Consumers demand quality and seek the
lowest-priced quality product.
Waste Minimization. All activities that do not add value and maximize the use of scarce
resources must be eliminated. Waste involves financial, human, inventory, and fixed
assets. The following are examples of waste in traditional environments, which lean manufacturing
seeks to minimize.
Overproduction of products, which includes making more than needed and/or producing
earlier than needed.
Transportation of products farther than is minimally necessary.
Bottlenecks of products waiting to move to the next production step.
Idle workers waiting for work to do as production bottlenecks clear.
Inefficient motion of workers who must walk more than necessary in the completion
of their assigned tasks.
Islands of technology created by stand-alone processes that are not linked to upstream
or downstream processes.
Production defects that require unnecessary effort to inspect and/or correct.
Safety hazards that cause injuries and lost work hours and associated expenses.
Inventory Reduction. The hallmark of lean manufacturing firms is their success in
inventory reduction. Such firms often experience annual inventory turnovers of 100 times
per year. While other firms carry weeks and even months of inventories, lean firms have
only a few days or sometimes even a few hours of inventory on hand. The three common
problems outlined below explain why inventory reduction is important.
1. Inventories cost money. They are an investment in materials, labor, and overhead
that cannot be realized until sold. Inventories also contain hidden costs. They must
be transported throughout the factory. They must be handled, stored, and counted.
In addition, inventories lose value through obsolescence.
2. Inventories camouflage problems. production Bottlenecks and capacity imbalances
in the manufacturing process cause WIP inventory to build up at the choke points.
Inventories also build up when customer orders and production are out of sync.
3. Willingness to maintain inventories can precipitate overproduction. Because of setup
cost constraints, firms tend to overproduce inventories in large batches to absorb the
allocated costs and create the image of improved efficiency. The true cost of this dysfunctional
activity is hidden in the excess inventories.
Production Flexibility. Long machine setup procedures cause delays in production and
encourage overproduction. Lean companies strive to reduce setup time to a minimum,
which allows them to produce a greater diversity of products quickly, without sacrificing
efficiency at lower volumes of production.
Established Supplier Relations. A lean manufacturing firm must have established and
cooperative relationships with vendors. Late deliveries, defective raw materials, or incorrect
orders will shut down production immediately since this production model allows no
inventory reserves to draw upon. Team Attitude. Lean manufacturing relies heavily on the team attitude of all employees
involved in the process. This includes those in purchasing, receiving, manufacturing, shipping
everyone. Each employee must be vigilant of problems that threaten the continuous flow
operation of the production line. Lean requires a constant state of quality control along with
the authority to take immediate action. When Toyota first introduced TPS, its production
employees had the authority to shut down the line when defects were discovered. In the
early days, the line was often shut down to bring attention to a problem. Whether caused
by a defective part from a vendor or a faulty machine in a cell, the problem was properly
addressed so that it did not recur. After an adjustment period, the process stabilized.
Techniques and Technologies that Promote
Lean Manufacturing
Modern consumers want quality products, they want them quickly, and they want variety
of choice. This demand profile imposes a fundamental conflict for traditional manufacturers,
whose structured and inflexible orientation renders them ineffective in this
environment. In contrast, lean companies meet the challenges of modern consumerism by
achieving manufacturing flexibility. This section examines techniques and technologies
that lean manufacturing firms employ to achieve manufacturing flexibility.
Physical Reorganization of the Production Facilities
Traditional manufacturing facilities tend to evolve in piecemeal fashion over years into
snakelike sequences of activities. Products move back and forth across shop floors, and
upstairs and downstairs through different departments. Figure 7-14 shows a traditional
factory layout. The inefficiencies inherent in this layout add handling costs, conversion
time, and even inventories to the manufacturing process. Furthermore, because production
activities are usually organized along functional lines, this structure tends to create
parochialism among employees, promoting an us-versus-them mentality, which is contrary
to a team attitude.
A much simplified facility, which supports flexible manufacturing, is presented in
Figure 7-15. The flexible production system is organized into a smooth-flowing stream
of activities. Computer-controlled machines, robots, and manual tasks that comprise the
stream are grouped together physically into factory units called cells. This arrangement
shortens the physical distances between the activities, which reduces setup and processing
time, handling costs, and inventories flowing through the facility.
Automation of the Manufacturing Process
Automation is at the heart of the lean manufacturing philosophy. By replacing labor
with automation, a firm can reduce waste, improve efficiency, increase quality, and
improve flexibility. The deployment of automation, however, varies considerably among
manufacturing firms. Figure 7-16 portrays automation as a continuum with the traditional
manufacturing model at one end and the fully CIM model at the other.
Traditional Manufacturing
The traditional manufacturing environment consists of a range of different types of
machines, each controlled by a single operator. Because these machines require a great
deal of setup time, the cost of setup must be absorbed by large production runs. The machines and their operators are organized into functional departments, such as milling,
grinding, and welding. The work-in-process follows a circuitous route through the different
operations across the factory floor.
Islands of Technology
Islands of technology describes an environment where modern automation exists in the
form of islands that stand alone within the traditional setting. The islands employ computer
numerical controlled (CNC) machines that can perform multiple operations with
little human involvement. CNC machines contain computer programs for all the parts
that are manufactured by the machine. Under a CNC configuration, humans still set up
the machines. A particularly important benefit of CNC technology is, however, that little
setup time (and cost) is needed to change from one operation to another. Computer-Integrated Manufacturing
Computer-integrated manufacturing (CIM) is a completely automated environment with
the objective of eliminating non-value-added activities. A CIM facility makes use of group
technology cells comprised of various types of CNC machines to produce an entire part
from start to finish in one location. In addition to CNC machines, the process employs
automated storage and retrieval systems and robotics. CIM supports flexible manufacturing
by allowing faster development of high-quality products, shorter production cycles,
reduced production costs, and faster delivery times. Figure 7-17 depicts a CIM environment
and shows the relationship between various technologies employed.
Automated Storage and Retrieval Systems (AS/RS). Many firms have increased productivity
and profitability by replacing traditional forklifts and their human operators
with automated storage and retrieval systems (AS/RS). AS/RS are computer- controlled
conveyor systems that carry raw materials from stores to the shop floor and finished
products to the warehouse. The operational advantages of AS/RS technology over
manual systems include reduced errors, improved inventory control, and lower storage
costs.
Robotics. Manufacturing robots are programmed to perform specific actions over and
over with a high degree of precision and are widely used in factories to perform jobs such
as welding and riveting. They are also useful in hazardous environments or for performing
dangerous and monotonous tasks that are prone to causing accidents.
Computer-Aided Design (CAD). Engineers use computer-aided design (CAD) to design
better products faster. CAD systems increase engineers productivity, improve accuracy
by automating repetitive design tasks, and allow firms to be more responsive to market
demands. Product design has been revolutionized through CAD technology, which was
first applied to the aerospace industry in the early 1960s.
CAD technology greatly shortens the time frame between initial and final design.
This allows firms to adjust their production quickly to changes in market demand. It also
allows them to respond to customer requests for unique products. The CAD systems
often have an interface to the external communication network to allow a manufacturer to share its product design specifications with its vendors and customers. This communications
link also allows the manufacturer to receive product design specifications
electronically from its customers and suppliers for its review. Advanced CAD systems can
design both product and process simultaneously. Thus, aided by CAD, management can
evaluate the technical feasibility of the product and determine its manufacturability.
Computer-Aided Manufacturing (CAM). Computer-aided manufacturing (CAM) is the use
of computers to assist the manufacturing process. CAM focuses on the shop floor and the
control of the physical manufacturing process. The output of the CAD system (see
Figure 7-17) is fed to the CAM system. The CAD design is thus converted by CAM into
a sequence of processes such as drilling, turning, or milling by CNC machines. The CAM
system monitors and controls the production process and routing of products through the
cell. Benefits from deploying a CAM technology include improved process productivity,
improved cost and time estimates, improved process monitoring, improved process quality,
decreased setup times, and reduced labor costs.
Value Stream Mapping
The activities that constitute a firms production process are either essential or they are
not. Essential activities add value; nonessential activities do not and should be eliminated.
A companys value stream includes all the steps in the process that are essential to producing
a product. These are the steps for which the customer is willing to pay. For example,
balancing the wheels of each car off the production line is essential because the customer
demands a car that rides smoothly and is willing to pay the price of the balancing.
Companies pursuing lean manufacturing often use a tool called a value stream map
(VSM) to graphically represent their business processes to identify aspects of it that are
wasteful and should be removed. A VSM identifies all of the actions required to complete
processing on a product (batch or single item), along with key information about each
action item. Specific information will vary according to the process under review, but may include total hours worked, overtime hours, cycle time to complete a task, and
error rates. Figure 7-18 presents a VSM of a production process from the point at which
an order is received to the point of shipping the product to the customer. Under each
processing step, the VSM itemizes the amount of overtime, staffing, work shifts, process
uptime, and task error rate. The VSM shows the total time required for each processing
step and the time required between steps and identifies the types of time spent between
steps such as the outbound batching time, transit time, and inbound queue time.
The VSM in Figure 7-18 reveals that considerable production time is wasted between
processing steps. In particular, the transit time of raw materials from the warehouse to the
production cell contributes significantly to the overall cycle time. Also, the shipping function
appears to be inefficient and wasteful with a 16 percent overtime rate and a 7 percent error rate.
To reduce total cycle time, perhaps the distance between the warehouse and production
cell should be shortened. The shipping functions overtime rate may be due to a bottleneck
situation. The high error rate may actually be due to errors in the upstream order-taking
function that are passed to downstream functions.
Some commercial VSM tools produce both a current-state map and a future-state
map depicting a leaner process with most of the waste removed. From this future map,
action steps can be identified to eliminate the non-value-added activities within the process.
The future-state VSM thus is the basis of a lean implementation plan. VSM works
best in highly focused, high-volume processes where real benefit is derived from reducing
repetitive processes by even small amounts of time. This technique is less effective at
eliminating waste in low-volume processes where the employees are frequently switched
between multiple tasks. Accounting in a Lean Manufacturing Environment
The lean manufacturing environment carries profound implications for accounting. Traditional
information produced under conventional accounting techniques does not
adequately support the needs of lean companies. They require new accounting methods
and new information that:
1. Shows what matters to its customers (such as quality and service).
2. Identifies profitable products.
3. Identifies profitable customers.
4. Identifies opportunities for improvement in operations and products.
5. Encourages the adoption of value-added activities and processes within the organization
and identifies those that do not add value.
6. Efficiently supports multiple users with both financial and nonfinancial information.
In this section, we examine the nature of the accounting changes underway. The discussion
reviews the problems associated with standard cost accounting and outlines two
alternative approaches: (1) activity-based costing and (2) value stream accounting.
Whats Wrong with Traditional Accounting Information?
Traditional standard costing techniques emphasize financial performance rather than
manufacturing performance. The techniques and conventions used in traditional manufacturing
do not support the objectives of lean manufacturing firms. The following are
the most commonly cited deficiencies of standard accounting systems.
Inaccurate Cost Allocations. An assumption of standard costing is that all overheads
need to be allocated to the product and that these overheads directly relate to the
amount of labor required to make the product. A consequence of automation is the
restructuring of manufacturing cost patterns. Figure 7-19 shows the changing relationship
between direct labor, direct materials, and overhead cost under different levels of
automation. In the traditional manufacturing environment, direct labor is a much larger
component of total manufacturing costs than in the CIM environment. Overhead, on
the other hand, is a far more significant element of cost under automated manufacturing.
Applying standard costing leads to product cost distortions in a lean environment,
causing some products to appear to cost more and others to appear to cost less than
they do in reality. Poor decisions regarding pricing, valuation, and profitability may
result.
Promotes Nonlean Behavior. Standard costing motivates nonlean behavior in operations.
The primary performance measurements used in standard costing are personal efficiency
of production workers, the effective utilization of manufacturing facilities, and
the degree of overhead absorbed by production. In addition, standard costing conceals
waste within the overhead allocations and is difficult to detect. To improve their personal
performance measures, management and operations employees are inclined to produce
large batches of products and build inventory. This built-in motivation is in conflict with
lean manufacturing. Time Lag. Standard cost data for management reporting are historic in nature. Data lag
behind the actual manufacturing activities on the assumption that control can be applied
after the fact to correct errors. In a lean setting, however, shop floor managers need
immediate information about abnormal deviations. They must know in real time about
a machine breakdown or a robot out of control. After-the-fact information is too late to
be useful.
Financial Orientation. Accounting data use dollars as a standard unit of measure for
comparing disparate items being evaluated. Decisions pertaining to the functionality of
a product or process, improving product quality, and shortening delivery time are, however,
not necessarily well served by financial information produced through standard cost
techniques. Indeed, attempts to force such data into a common financial measure may
distort the problem and promote bad decisions.
Activity-Based Costing (ABC)
Many lean manufacturing companies have sought solutions to these problems through
an accounting model called activity-based costing (ABC). ABC is a method of allocating
costs to products and services to facilitate better planning and control. It accomplishes
this by assigning cost to activities based on their use of resources and assigning cost to
cost objects based on their use of activities. These terms are defined below: Activities describe the work performed in a firm. Preparing a purchase order, readying a
product for shipping, or operating a lathe are examples of activities.
Cost objects are the reasons for performing activities. These include products, services,
vendors, and customers. For example, the task of preparing a sales order (the activity) is
performed because a customer (the cost object) wishes to place an order.
The underlying assumptions of ABC contrast sharply with standard cost accounting
assumptions. Traditional accounting assumes that products cause costs. ABC assumes that
activities cause costs and products (and other cost objects) create a demand for activities.
The first step in implementing the ABC approach is to determine the cost of the activity.
The activity cost is then assigned to the relevant cost object by means of an activity driver.
This factor measures the activity consumption by the cost object. For example, if drilling
holes in a steel plate is the activity, the number of holes is the activity driver.
Traditional accounting systems often use only one activity driver. For instance, overhead
costs, collected into a single cost pool, are allocated to products on the basis of
direct labor hours. A company using ABC may have dozens of activity cost pools, each
with a unique activity driver. Figure 7-20 illustrates the allocation of overhead costs to
products under ABC. Advantages of ABC
ABC allows managers to assign costs to activities and products more accurately than
standard costing permits. Some advantages that this offers are:
More accurate costing of products/services, customers, and distribution channels.
Identifying the most and least profitable products and customers.
Accurately tracking costs of activities and processes.
Equipping managers with cost intelligence to drive continuous improvements.
Facilitating better marketing mix.
Identifying waste and non-value-added activities.
Disadvantages of ABC
ABC has been criticized for being too time-consuming and complicated for practical
applications over a sustained period. The task of identifying activity costs and cost drivers
can be a significant undertaking that is not completed once and then forgotten. As
products and processes change so do the associated activity costs and drivers. Unless significant
resources are committed to maintaining the accuracy of activity costs and the
appropriateness of drivers, cost assignments become inaccurate. Critics charge that rather
than promoting continuous improvement, ABC creates complex bureaucracies within
organizations that are in conflict with the lean manufacturing philosophies of process
simplification and waste elimination.
Value Stream Accounting
The complexities of ABC have caused many firms to abandon this method in favor of a simpler
accounting model called value stream accounting. Value stream accounting captures costs
by value stream rather than by department or activity, as illustrated in Figure 7-21.
Notice that value streams cut across functional and departmental lines to include costs
related to marketing, selling expenses, product design, engineering, materials purchasing,
distribution, and more. An essential aspect in implementing value stream accounting is
defining the product family. Most organizations produce more than one product, but
these often fall into natural families of products. Product families share common processes
from the point of placing the order to shipping the finished goods to the customer.
Figure 7-22 illustrates how multiple products may be grouped into product families.
Value stream accounting includes all the costs associated with the product family, but
makes no distinction between direct costs and indirect costs. Raw material costs are calculated
based on how much material has been purchased for the value stream, rather than tracking
the input of the raw material to specific products. Thus the total value stream material cost is
the sum of everything purchased for the period. This simplified (lean) accounting approach
works because raw material and WIP inventories on hand are low, representing perhaps only
one or two days of stock. This approach would not work well in a traditional manufacturing
environment where several months of inventory may carry over from period to period.
Labor costs of employees who work in the value stream are included whether they
design, make, or simply transport the product from cell to cell. Labor costs are not
allocated to individual products in the traditional way (time spent on a particular task).
Instead, the sum of the wages and direct benefits paid to all individuals working in the
value stream is charged to the stream. Support labor such as maintenance of machines,
production planning, and selling are also included. Wherever possible, therefore, each employee should be assigned to a single value stream, rather than having their time split
among several different streams.
Typically the only allocated cost in the value stream is a charge per square foot for
the value stream production facility. This allocation would include the cost of rent and building maintenance. The logic behind this is to promote efficiency by encouraging value
stream team members to minimize the space used to operate the value stream. General
overhead costs incurred outside of the value stream, which cannot be controlled by the
value stream team, are not attached to the product family. Thus no attempt is made to
fully absorb facilities costs. While corporate overhead costs must be accounted for, they
are not allocated to value streams.
Information Systems that Support
Lean Manufacturing
In this section we discuss the information systems commonly associated with lean manufacturing
and world-class companies. It begins with a review of materials requirements
planning (MRP). As the name implies, MRP systems are limited in focus and geared
toward determining how much raw materials are required to fulfill production orders.
We then review manufacturing resources planning (MRP II). These systems evolved from
MRP to integrate additional functionality into the manufacturing process, including sales,
marketing, and accounting. Finally, we examine some key features of enterprise resource
planning (ERP) systems. ERP takes MRP II a step further by integrating all business functions
into a core set of applications that use a common database.
Materials Requirement Planning (MRP)
MRP is an automated production planning and control system used to support inventory
management. Its operational objectives are to:
Ensure that adequate raw materials are available to the production process.
Maintain the lowest possible level of inventory on hand.
Produce production and purchasing schedules and other information needed to control
production.
Figure 7-23 illustrates the key features of an MRP system. Depending on the manufacturing
process in place, inputs to the MRP system will include sales, sales forecasts, finished
goods inventory on hand, raw material on hand, and the bill of materials. MRP is a
calculation method geared toward determining how much of which raw materials are
required and when they should be ordered to fill a production order. By comparing finished
goods inventory on hand with the needed levels (based on the sales forecast), MRP
calculates the total production requirements and the individual batch lot sizes needed.
From this, the BOM is exploded to produce a list of raw materials needed for production,
which is compared to the raw materials on hand. The difference is the amount that will
be ordered from vendors. The primary outputs from the MRP system are raw material
purchase requisitions that are sent to the purchases system. In addition, the system output
may include production schedules, management reports, and day-to-day production
documents such as work orders and move tickets.
Manufacturing Resource Planning (MRP II)
MRP II is an extension of MRP that has evolved beyond the confines of inventory management.
It is both a system and a philosophy for coordinating a wide range of manufacturing
activities. MRP II integrates product manufacturing, product engineering, sales order processing, customer billing, human resources, and related accounting functions.
Figure 7-24 shows the functional integration under an MRP II environment.
The MRP II system will produce a BOM for the product, fit the production of the
product into the master production schedule, produce a rough-cut capacity plan based on
machine and labor availability, design a final capacity plan for the factory, and manage the
raw material and finished goods inventories. In addition, MRP II will produce a materials requirements plan that will schedule the delivery of the raw materials on a JIT basis. The
ordering of raw material must be coordinated with the manufacturing process to avoid
waste (early arrival) while ensuring that stock-out situations do not disrupt the production
processes. Manufacturing firms can realize considerable benefits from a highly integrated
MRP II system. Among these are the following:
Improved customer service
Reduced inventory investment
Increased productivity
Improved cash flow
Assistance in achieving long-term strategic goals
Help in managing change (for example, new product development or specialized
product development for customers or by vendors)
Flexibility in the production process
Enterprise Resource Planning (ERP) Systems
In recent years MRP II has evolved into large suites of software called ERP systems. ERP
integrates departments and functions across a company into one system of integrated applications
that is connected to a single common database. This enables various departments
to share information and communicate with each other. An ERP system is comprised of
function-specific modules that reflect industry best practices. Designed to interact with
the other modules (for example, accounts receivable, accounts payable, purchasing, etc.),
these commercial packages support the information needs of the entire organization, not
just the manufacturing functions. An ERP can calculate resource requirements, schedule
production, manage changes to product configurations, allow for future planned changes
in products, and monitor shop floor production. In addition, the ERP provides order entry,
cash receipts, procurement, and cash disbursement functions along with full financial
and managerial reporting capability.
A lean manufacturing company will have an ERP system that is capable of external
communications with its customers and suppliers through electronic data interchange
(EDI). The EDI communications link (via Internet or direct connection) will allow the
firm to electronically receive sales orders and cash receipts from customers, send invoices
to customers, send purchase orders to vendors, receive invoices from vendors and pay
them, as well as send and receive shipping documents. EDI is a central element of many
electronic commerce systems. We will revisit this important topic in Chapter 12.
Similarities in functionality between ERP and MRP II systems are quite apparent. Some
argue that very little real functional difference exists between the two concepts. Indeed,
the similarities are most noticeable when comparing top-end MRP II systems with lowend
ERP packages. A primary distinction, however, is that the ERP has evolved beyond
the manufacturing marketplace to become the system of choice among nonmanufacturing
firms as well. On the other hand, cynics argue that changing the label from MRP II to ERP
enabled software vendors to sell MRP II packages to nonmanufacturing companies.
The market for ERP systems was for many years limited by high cost and complexity
to only the largest companies and was dominated by a few software vendors such as
SAP, J.D. Edwards, Oracle, and PeopleSoft. In recent years this market has expanded
tremendously with the entry of many small vendors targeting small and mid-sized customers
with less expensive and more easily implemented ERP systems. The importance of the
ERP phenomenon warrants separate treatment that goes beyond the scope of this chapter.
In Chapter 11, therefore, we will examine ERP systems and related topics, including
supply chain management (SCM) and data warehousing.
This chapter examined the conversion cycle, whereby a company transforms input resources (that is,
materials, labor, and capital) into marketable products and services. The principal aim was to highlight
the changing manufacturing environment of the contemporary business world and to show how it calls
for a shift away from traditional forms of business organization and activities toward a world-class way
of doing business. We saw how companies that are attempting to achieve world-class status must pursue
a lean manufacturing philosophy.
Key to successful lean manufacturing is achieving manufacturing flexibility, which involves the physical
organization of production facilities and the employment of automated technologies. We also saw that
achieving lean manufacturing requires significant departures from traditional standard costing techniques.
In response to deficiencies in traditional accounting methods, lean manufacturing companies have adopted
alternative accounting models including activity based costing and value stream accounting. The chapter
concluded with a discussion of three information systems commonly associated with lean manufacturing:
(1) materials requirements planning (MRP), (2) manufacturing resources planning (MRP II), and enterprise
resource planning (ERP)