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CHAPTER 18

MODERN DEVELOPMENTS

IN MANAGING OPERATIONS

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Chapter Overview How has the global economy caused

companies to become more competitive?

How can an accounting system help a company identify strategies that will enhance its ability to compete in the long run?

As part of its efforts to become more competitive, how can a company measure quality and the costs of quality?

How does just-in-time production help a company reduce its costs, operate more efficiently, and control quality?

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Chapter Overview

How have improved technology and factory layouts helped companies become more competitive?

When a company uses activity-based costing, what three stages does it follow to allocate factory overhead costs to products?

How does activity-based costing improve managers’ decisions?

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The Balanced Scorecard In the balanced scorecard approach to managing operations, the financial

measures of a company’s performance are balanced with leading indicators to drive the company’s future performance.

This approach links competitive strategies with specific measures of the success of the strategies.

Four perspective are used: stockholders’ perspective, customers’ perspective, internal business perspective and perspective of innovation and learning.

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Relationship of the Four Cascading

Strategic Objectives – Balanced

ScorecardExhibit 18-1

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All of the strategies from the balanced scorecard approach are critical elements for achieving goal congruence among the company’s departments and employees.

Managers set up performance driver measurements (leading indicators of a company’s future performance) and outcome measurements (lagging indicators of a company's past or current performance).

The Balanced Scorecard

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Chain of Cause-and-Effect StrategiesExhibit 18-2

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Total quality management (TQM) is a management philosophy

or approach that focuses on a company's customers.

Under TQM, all employees of the company work as a team to

foster continuous improvement in the company to meet the

expectations of customers.

Total Quality Management

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One measure of customer quality is failure costs – the costs of correcting product defects.

External failure costs are the costs of product defectives that occur after the product is in the hands of customers.

Internal failure costs are costs of correcting product defects before the product leaves the factory.

Failure Costs

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External failure costs are the involuntary costs incurred by a company in an attempt to increase quality after the defect is found by the customer.

These are the costs that can sky-rocket out of control for a company and the ones we, as customers, most often read about in the newspaper:

External Failure Costs

Recall costs Product warranty costs Product liability claims Customer ill-will

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Internal Failure Costs

Internal failure costs are involuntary costs

incurred by a company in an attempt to

increase quality after the defect is found, but

before the product leaves the factory.

Costs of reworking products Scrap or waste Disposal of defective products Down-time to repair equipment

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There is a positive correlation between failure costs and defects: as defects decrease, they drive down failure costs.

Failure Costs to Total Defects

To

tal

Co

sts

$$$$

100% Defects

0% Defects

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Prevention costs are costs incurred to prevent defects from occurring in the production process.

A company voluntarily spends money on prevention costs to minimize the chance that a failure cost will arise.

Prevention Costs

Product design Employee training Equipment

maintenance costs

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Appraisal costs are costs incurred during the production process to detect defects.

A company voluntary spends money on appraisal activities in an attempt to increase quality and minimize failure costs.

Appraisal Costs

Work-in-process testing Inspection personnel X-raying products Weighing products

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There is an inverse relationship between prevention and appraisal costs and defects: as prevention & appraisal cost increase, they drive down defects.

Prevention and Appraisal Costs to Zero Defects

100% Defects

0% Defects

To

tal

Co

sts

$$$$

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Just-In-Time Strategies Many companies uses just-in-time strategies to reduce costs

by reducing or eliminating inventories and streamlining factory operations.

Remember this illustration from Chapter 4 when we looked at planning for the amount of inventory a company needs to have on hand:

Inventory on hand

Out of stock;

high cost of fast

delivery

Too low

Ties up cash

resources; high

storage costs

Too highJust-in-time on customer demand

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Push-Through and

Pull-Through Production

and JIT Manufacturing

Exhibit 18-4

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Many companies have found that flexible manufacturing systems enable their factories to operate more efficiently.

A flexible manufacturing system is a computerized network of automated equipment that uses computer software to control such tasks as machine setups, direct materials, part selections, and product assembly.

Improved Technology and Factory Layout

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When companies reconfigure a factory using manufacturing cells, processes and departments that perform similar tasks, such as a mixing, refining, and pulverizing are transferred to cells where multiple tasks might be performed, such as producing a single product from start to finish.

Employees are train to operate a family of equipment within the cell, which may increase factory productively and efficiency.

Improved Technology and Factory Layout

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Unlimited DecadenceTraditional

Factory vs.

Manufacturing Cells

Exhibit 18-6

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Activity-based costing (ABC) techniques allocate overhead costs to products based on the cost of the activities necessary to manufacture the products.

This contrasts to traditional manufacturing overhead cost allocations based on a single product driver, such as machine hours or direct labor hours, as we learned in Chapter 16.

ABC provides more accurate cost data for the manufacturer of products which helps managers make better decisions.

Activity-Based Costing

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A three stage process is used with ABC:

Activity-Based Costing

1. Allocate factory overhead costs to activity pools (costs drivers).

2. Assign factory overhead costs to jobs or processes based on relative number of activities to complete the job.

3. Assign total factory overhead costs to the individual units of product in the job or process.

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Examples of Cost Drivers

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Three Stage ABC

Allocation Process Used

by Unlimited Decadence

Exhibit 18-8

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Factory Overhead Allocation

The best way to illustrate the difference is to compare the computation of the predetermined overhead rate using the traditional way versus the ABC way.

Consider some of the operational costs of a typical production facility: testing, blending, mixing, and bottling. Each of these activities has different costs associated with it for each line of product.

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The Traditional Predetermined Overhead Rate

= $3.20 per direct labor hour (DLH) used

$10,400,000

3,250,000 DLH

Expected factory overhead costs for the year

Expected direct labor hours for the year

Under the traditional method, lets assume that overhead at Unlimited Decadence would be allocated to all products as follows:

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The Traditional Predetermined Overhead Rate

Assuming The Darkly Decadent bars required 0.5 DLH per case, Unlimited Decadence would then allocate $1.60 of factory overhead to every case produced.

$1.60 per case X 5,000,000 cases produced = $8,000,000 factory overhead allocated

$3.20 predetermined overhead rate X 0.5 DLH estimated per case = $1.60 per case

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ReflectionHow would this rate be

different if activity-based costing

techniques were applied to assign costs to the Darkly Decadent

bars?

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Step 1 is to determine the activity pools and the related cost drivers. Assume Unlimited Decadence completes the following analysis:

Expected Number of ActivitiesDarkly Pure Total

Activity Pool/Cost Driver Decadent Decadence Driver Units

Estimated direct labor hours(DLH) 2,500,000 750,000 3,250,000Estimated machine setups (MS) 232,000 568,000 800,000Estimated machine hours (MH) 3,000,000 1,000,000 4,000,000Estimated quality inspections (IN) 600,000 400,000 1,000,000General factory no identifiable cost driver

The ABC Predetermined Overhead Rate

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The ABC Predetermined Overhead RateStep 2 is to allocate factory overhead costs on the basis of relative number of cost drivers needed to finish each type of candy bar. $3,900,000 of the $10,400,000 of factory overhead costs are determined to be variable costs attributable to these activity pools.

Activity Pool for Traceable Fixed and Variable Traceable Driver PredeterminedOverhead Costs Costs Units Rate per activityDirect labor related DLH) 650,000$ 3,250,000 0.20$ per DLHMachine setup related (MS) 800,000$ 800,000 1.00$ per MSMachine related (MH) 1,320,000$ 4,000,000 0.33$ per MHQuality inspection related (IN) 1,130,000$ 1,000,000 1.13$ per IN

3,900,000$

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Step 3 is to allocate variable and fixed costs to the number of units (in this situation, number of cases) produced. Only the Darkly Decadent calculations are presented here.

Darkly Decadent Driver Amount

Activity Pool/Cost Driver units allocatedVariable overhead:Estimated direct labor hours @ $0.20/DLH 2,500,000 500,000$ Estimated machine setups @ $1.00/MS 232,000 232,000$ Estimated machine hours @ $0.33.MH 3,000,000 990,000$ Estimated quality inspections @ $1.13/IN 600,000 678,000$ Total estimated variable overhead allocated (A) 2,400,000$

Total volume produced (B) 5,000,000Variable overhead per case (A)/(B) 0.48$

Fixed overhead per case $6.5m/3,250,000 DLH 1.00$

Total overhead cost per case 1.48$

The ABC Predetermined Overhead Rate

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When the two overhead rates are compared, there is a significant different in the amount of overhead allocated to the Darkly Decadent bars on the traditional method versus ABC:

Comparing the Traditional and the ABC Computed Rates

Traditional allocation of overhead:5,000,000 cases X $1.60 8,000,000$ ABC allocation of overhead:5,000,000 cases X 1.48 7,400,000$ Reduction in the amount of overheadallocated to the cost of Darkly Decadentunder ABC 600,000$

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ReflectionWhat conclusions can Unlimited Decadence

draw from the differences in the

traditional and ABC overhead allocation

rates?

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Impact of Using ABC Using ABC, Unlimited Decadence allocated $600,000 less in overhead costs to the

Darkly Decadent bars. This is primarily because more of the product’s overhead costs depend on the use of other activities besides direct labor hours.

Without the benefit of ABC, it appears as if Unlimited Decadence has been over-allocating costs to the Darkly Decadent bars and under-allocating overhead to other products.

The company also discovered that some costs that were assumed as fixed costs were actually variable costs.

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Impact of Using ABC

If managers have more accurate information on the cost of producing a product, they can make better decisions.

For example, the change in the cost allocated to Darkly Decadent bars might cause managers to reconsider its normal selling price as well as its relative percentage of the sales mix.

More accurate information also provides the company better information for cost-volume-profit analysis and short-term decision making opportunities.

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Using ABC in a Service Company

ABC can be used in a service company in addition to a manufacturing company.

Service companies need to have accurate information on product costs for the same reasons a manufacturing company needs this information.

The same three step process is used, although service companies tend to have a more heterogeneous group of overhead costs than manufacturing companies, depending on the nature of the service provided.