Chapter 7

The Conversion Cycle

Objectives for Chapter 7• Elements and procedures of a traditional production process• Data flows and procedures in a traditional cost accounting system• Accounting controls in a traditional environment• Operating features, philosophies, and technologies of a world-

class company• Just-in-time systems and the implications of maintaining

excessive inventories in the world-class environment• Importance of quality in the world-class environment• Shortcomings of traditional accounting methods in the world-class

environment• Characteristics of a world-class information system

The Continuum of Manufacturing Practices

A World Class Company…

• is a company that has achieved high standards and has undergone fundamental changes from traditional forms of organization and management

• continuously pursues improvement in all aspects of its operations, including its manufacturing procedures

• is highly customer oriented

Achieving World-Class Status

• The world-class firm needs new accounting methods and new information systems that:– show what matters to its customers– identify profitable products– identify profitable customers– identify opportunities for improvement in operations and

products– encourage the adoption of value-added activities and

processes within the organization and identify those that do not add value

– efficiently support multiple users with both financial and nonfinancial information

The Conversion Cycle

• The conversion cycle transforms input resources, raw materials, labor, and overhead into finished products or services for sale.

• The conversion cycle consists of two subsystems:– the production system – the cost accounting system

Production System

• Involves the planning, scheduling, and control of the physical product through the manufacturing process– determining raw materials requirements– authorizing the release of raw materials into

production– authorizing work to be conducted in the

production process– directing the movement of work through the

various stages of production

Production Methods

• Continuous Processing creates a homogeneous product through a continuous series of standard procedures.

• Batch Processing produces discrete groups (batches) of products. Each item in the batch is similar.

• Make-to-Order Processing involves the fabrication of discrete products in accordance with customer specifications.

Documents in the Batch Production System

• Sales Forecast - expected demand for the finished goods

• Production Schedule - production plan and authorization to produce

• Bill of Materials (BOM) - specifies the types and quantities of the raw materials and subassemblies used to produce a single finished good unit

• Route Sheet - details the production path a particular batch will take in the manufacturing process– sequence of operations– time allotted at each station

• Work Order - uses information from the BOM and route sheet to specify the exact materials and production processes for each batch

Documents in the Batch Production System

• Move Ticket - records work done in each work center and authorizes the movement of the batch

• Materials Requisition - authorizes the inventory warehouse to release raw materials for use in the production process

Documents in the Batch Production System

Sales Forecast

Inventory Status Report

Engineering Specifications BOM and route sheets

Raw Materials Requirements (Purchase Requisitions)

Operations Requirements

Production Schedulingwork ordersmove ticketsmaterials requisitionsopen work orders

cost accountingwork centers

job ticketstime cardscompleted move tickets

payroll

Production Planning and Control

prod. plan. and control

Upon Completion of the Production Process…

Finished Productand Closed Work Order

Finished Goods Warehouse

Closed Work Order

Inventory Control

status report of raw materials and finished goods

journal voucher

Prod. Plan. and Control

General Ledger

EOQ Inventory Model• Objective: minimize total inventory costs while ensuring

that adequate inventories exist to meet current demand• Very simple too use, but assumptions are not always valid

– demand is known and constant– ordering lead time is known and constant– total cost per year of placing orders decreases

as the order quantities increase– carrying costs of inventory increases as quantity

of orders increases– no quantity discounts

EOQ Inventory Model

Q = 2DS H

Where Q = economic order quantity D = annual demand in units

S = fixed cost of placing each order H = holding or carrying cost per unit per year

ReorderPoint

EOQ

INV

EN

TO

RY

LE

VE

L

Time (days)Lead Time

Daily Demand

EOQ Inventory Model

Inventory Cycle

Cost Accounting System

• Records the financial effects of the events occurring in the production process

• Initiated by the work order• Cost accounting clerk creates a new cost

record for the new batch and files in WIP file

• The records are updated as materials and labor are used

Inventory Controlmaterials requisitions

Work Centersjob ticketscompleted move tickets

STANDARDS

COST ACCOUNTANTSUpdate WIP accounts

DLDMMfg. OH.

Compute Variances

Elements of the Cost Accounting System

Cost Accounting System

• Receipt of last move ticket signals completion of the production process– clerk removes the cost sheet from WIP

file– prepares a journal voucher to transfer

balance to a finished goods inventory account and forwards to the General Ledger department

Summary of Internal Controls

Internal Controls

• Transaction authorizations– work orders reflect a legitimate need based

upon sales forecast and the finished goods on hand

– move tickets (with authorized signature from each work station) authorize the movement of the batch through the various work centers

– materials requisitions authorize the warehouse to release materials to the work centers

Internal Controls

• Segregation of duties– production planning and control

department is separate from the work centers

– inventory control separate from materials storeroom and finished goods warehouse

– cost accounting function accounts for WIP and should be separate from the work centers in the production process

Internal Controls

• Supervision– supervisors in the work centers oversee

the usage of raw materials in the production process to ensure that all released materials are used in production and waste is minimized

– employee time cards and job tickets are checked for accuracy

Internal Controls

• Access control– direct access to assets

• storerooms, production work centers, and finished goods warehouses

• quantities in excess of standard amounts should require approval

– indirect access to assets• materials requisitions, excess materials

requisitions, and employee time cards

Internal Controls

• Accounting records – pre-numbered documents– work orders– cost sheets – move tickets– job tickets– material requisitions– WIP and FGs files

Internal Controls

• Independent verification– cost accounting reconciles material usage (material

requisitions) and labor usage (job tickets) with prescribed standards, and variances are investigated

– GL dept. verifies the total movement from WIP to FG by reconciling journal vouchers from cost accounting and inventory subsidiary ledger summaries from inventory control

– internal and external auditors periodically verify the raw materials and FGs inventories on hand through a physical count

Trends in Competitive Advantage

The World-Class Environment and Manufacturing Flexibility

• Customers:– want quality products – want them quickly – want variety

• Achieving manufacturing flexibility incorporates four operational characteristics:– physical reorganization of the production facilities– automation of the manufacturing process– reduction of inventories– high product quality

Physical Reorganization of the Production Facilities

• The inefficiencies inherent in the layout of traditional plants add handling costs, conversion, time, and excess inventories to the manufacturing process.

• Employees tend to feel ownership over their stations, which is contrary to a team concept.

• The reorganization is based on flows through cells which shorten the physical distance between the activities, thus reducing setup and processing time, handling costs, and inventories in the flow.

Progression of Automation in the Manufacturing Process

Traditional Islands ofTechnology

ProcessSimplification

(JIT)

ComputerIntegrated

Manufacturing

Progression of Automation toward World-Class Status

Automation of the Manufacturing Process

• Traditional: – consists of many different types of machines which

require a lot of setup time– machines and operators are organized in functional

departments– WIP follows a circuitous route through the different

operations

• Islands of Technology: – stand alone islands which employ computer

numerical controlled (CNC) machines that can perform multiple operations with less human involvement

– less set up time needed

Automating Manufacturing

• Process Simplification: – reduces the complexity of the physical layout– groups of CNC machines are arranged in cells

to produce an entire part from start to finish– no human involvement in a cell

• Computer Integrated Manufacturing (CIM): – a completely automated environment which

employs automated storage and retrieval systems (AS/RS) and robotics

Automating Manufacturing

• Robotics: – use special CNC machines that are useful in

performing hazardous, difficult, and monotonous tasks

• Computer-Aided Design (CAD):– increases engineers’ productivity– improves accuracy– allows firms to be more responsive to market

demands– interfaces with CAM and MRPII systems

Automating Manufacturing

• Computer Aided Manufacturing (CAM):– uses computers to control the physical

manufacturing process– provides greater precision, speed, and control than

human production processes

• Manufacturing Resources Planning (MRP II):– an extension of materials requirements planning

(MRP)– more than inventory management--it is a system for

coordinating the activities of the entire firm

Automating Manufacturing

• Enterprise Resource Planning (ERP) Systems:– huge commercial software packages that support the

information needs of the entire organization, not just the manufacturing functions

– automates all business functions along with full financial and managerial reporting capability

• Electronic Data Interchange (EDI):– external communications with its customers and

suppliers via Internet or direct connection

Automating Manufacturing

Accounting and MRP

The Evils of Inventories

• Inventories cost money and … – represent an investment – need to be insured and stored – can become obsolete over time

• Inventories camouflage production problems.

• Willingness to maintain inventories can precipitate overproduction.

How can inventories be reduced?

• Just-in time (JIT) manufacturing is a model that fosters inventories reduction and even elimination. It is based on the following assumptions:– zero defects– zero setup time– small lot sizes– zero inventories– zero lead times and reliable vendors– team attitude

Product Quality…

• is important because poor quality is expensive to the firm via scrap, reworking, scheduling delays, extra inventories to compensate for defective parts, warranty claims, and service

• is a basis on which world-class manufacturers compete

• can be improved though control point methods such as statistical process control

What’s Wrong with Traditional Cost Accounting Information?

• Inaccurate cost allocations

• Time lag in reporting

• Financial orientation

• Emphasis on standard costs

Activity Based Costing (ABC)…

• is an information system that provides managers with information about activities and cost objects

• assumes that activities cause costs and products (and other cost objects) create a demand for activities

• is different from traditional accounting system since ABC has multiple activity drivers, whereas traditional accounting has only one, e.g. machine hours

Allocation of Costs Using ABC

Activity Management

• Managers must understand which activities should be performed and how best to perform them.– Managers should deploy resources to

activities that yield maximum benefits.– Managers should seek to improve those

factories most important to their customers.

Activity Management Tasks

• Evaluating manufacturing activities

• Identifying nonessential activities

• Identifying cost drivers

• Comparing activities to benchmarks

• Establishing links between key activities

The World-Class Information System…

• is the integration of all the system’s functional and technological components:– basic accounting applications– ABC– materials requirements planning– capacity planning– inventory control– bill-of-materials– master productions schedule– forecasting– order entry – computer-aided design– computer-aided manufacturing– EDI communications links

Need for New Performance Measures in the Information Pyramid

Control Issues in the WCIS• Paperless environment - no traditional audit trail• Automatic transactions - need assurance that:

– the system places orders only when inventory is needed

– inventory orders are placed only with approved vendors

– the quantity of items ordered is correct for the needs of the organization

– programmed procedures matching electronic controls data before initiating payment perform correctly

• Networking considerations