Sm-07-new Chapt 7 5z6d3w

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CHAPTER 7 THE CONVERSION CYCLE REVIEW QUESTIONS 1. A company’s conversion cycle transforms (converts) input resources, such as raw materials, labor, and overhead, into finished products or services for sale. 2. The batch processing system consists of four basic processes: plan and control production, perform production operations, maintain inventory control, and perform cost ing. 3. Continuous processing creates a homogeneous product such as cement through a continuous series of standard procedures, while batch processing produces discrete groups of a uniform product, such as a particular size and type of box. Made-to-order processing produces goods which are built to customer specifications. Continuous and batch processing systems produce goods to meet expected sales demand, while made-to-order processing systems produce goods to meet actual orders. 4. Sales forecast, production schedule, bill of materials, route sheet, work order, move ticket, and materials requisition. 5. The primary determinant for materials requirements, the bill of materials, specifies the types and quantities of the raw materials and subassemblies used in producing a single unit of finished product. Given a good that is to be produced from the production schedule, the route sheet specifies the sequence of operations (i.e. machine or subassembly) and the standard time allocated to each task. 6. 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. 2.

When should inventory be purchased? How much inventory should be purchased?

7. The work order from the production planning and control department triggers the cost ing process. 8. Materials requisitions, excess materials requisitions, materials returns, job tickets, move tickets, and standards for the various resources (as provided by the standard cost file). 9. Probably the most important type of report is the variance report. This report illustrates to management the actual cost versus standard costs and any deviations from the standards. These reports allow management to make any necessary changes to avoid unfavorable variances. Further, if favorable variances are being

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observed with respect to direct materials, the bill of materials may be able to be reduced to keep raw materials inventory down. 10. The receipt by cost ing of the last move ticket for a batch from the work center signals the completion of the production process. 11. Inventory control, which maintains the records for the raw materials and finished goods inventories, should be separate from both the raw materials storeroom and finished goods warehouse functions. Cost ing, which maintains the records for work in process, should be separate from the work centers in the production process. 12.Transaction authorization: Work orders, move tickets, and materials requisitions. Segregation of duties: 1. Inventory control separate from RM and FG inventory custody. 2. Cost ing separate from work centers. 3. GL separate from other ing functions. Access: Limit physical access to FG, RM stocks, and production processes. Use formal procedures and documents to release materials into production. 13. Computer-aided design (CAD) involves the use of computers to design products to be manufactured and the processes by which they are produced. Computer-aided manufacturing (CAM) involves the use of computers to manufacture the product. 14. If production problems are causing bottlenecks, then work-in-process (WIP) inventory will tend to accumulate. If the wrong product mix is being produced, then inventories may build up while the customers are unhappily waiting for delivery of their product. Inventories may build up and become obsolete or damaged while they are sitting in storage. Further, production has been wasted building the wrong product. 15. 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. 16. Activities describe the work performed in a firm, while cost objects are the reasons for performing activities. 17. Essential activities add value to the organization either through adding value to the customer or to the organization. Non-essential activities do not add value. 18. “Islands of technology” describes an environment where modern automation exists in the form of islands that stand alone within the traditional setting. 19. Computer-integrated manufacturing (CIM) is a completely automated environment with the objective of eliminating non-value added activities. A CIM

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facility makes use of group technology cells comprised of various types of computer numerical controlled (CNC) machines to produce an entire part from start to finish in one location. 20. A company’s 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. DISCUSSION QUESTIONS 1. The various work centers send cost ing completed move tickets. Along with standards provided by the standard cost file, move tickets enable cost ing to update the affected WIP s with the standard charges for manufacturing overhead (MOH). 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 finished goods inventory. At that point cost ing closes the work-in-process and increases finished goods. 2. 1. The assumption that demand for the product is known with certainty is not unreasonable for most firms. Some firms will have better estimates than others, but overall projecting demand for a product is not unreasonable. Assuming that the demand is constant is unreasonable for many products. At the very extreme, Christmas items are highly seasonal, as are many recreational items such as camping gear, hiking gear, suntan lotion, and snow-skiing equipment. Many industries’ products would violate the assumption of constant demand. 2. The lead time is known and constant. This assumption is not too unrealistic. Trading partner arrangements between customer and supplier reduces lead-time uncertainty. In some cases, a probability distribution would be better. 3. The assumption that the total cost of placing orders is inversely related to the quantities ordered (larger orders means fewer orders placed) is not troublesome. 4. The assumption that all inventories in the order arrive at the same time is probably not realistic and could cause shortages. 5. The assumption that no quantity discounts exist is extremely unrealistic. Most firms give quantity discounts. 6. The assumption that the total yearly carrying costs is a variable that increases as the quantities ordered increases in not troublesome. 3. This is the point where total costs are minimized. In other words, it is the minimum of total holding costs plus total carrying costs. 4. The cost ants need to keep the records for WIP inventory files. They also need to track labor, material, and overhead variances, and provide management with these reports so that they may make any necessary adjustments. The work centers should not be allowed to track their own variances, as they might try to cover them up rather than fix them.

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5. By prenumbering source documents and referencing these in the WIP records, every item of FG inventory can be traced back through the production process to its source. This process is important for detecting errors in production and for tracking batches through the production process. 6. The general ledger department provides independent verification by reconciling WIP journal vouchers from cost ing and summaries of the inventory subsidiary ledger from inventory control. 7.  

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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 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.

8. By replacing labor with automation, a firm can reduce waste, improve efficiency, increase quality, and improve flexibility. Examples of automation include: Automated Storage and Retrieval Systems, Robotics, Computer Aided Design (CAD), Computer-aided manufacturing (CAM). 9. Students will present different answers to this question. For example: Second Skin Swimwear in Boca Raton, Florida digitizes the image of the customer, which is then displayed on the computer screen. The customer, with the aid of a salesperson, then tries various swimsuits on the screen, making any desired changes. Different fabrics are also examined. Once a suit is decided upon, a pattern is automatically prepared and cut for manufacturing. Thus, the customer basically designs her own swimsuit. Some car manufacturers allow customers to add on their options via a computer screen by which they can visualize the results of different options. Once the customer places an order, the order is sent to the manufacturer and the car is custom-finished. Weyerha, a lumber company, has placed kiosks in some of its

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retailers’ stores which allow customers to build their decks, with the aid of a salesperson. Once the deck is drawn with the help of a CAD program, the customer may have a print-out of his/her deck along with a bill of materials. 10. Low priced, poor quality raw materials can end up costing the firm more money if more scrap is produced due to difficulty of working with the raw material. Also, poor quality raw materials or labor will most probably result in the production of an inferior good and ultimately tarnish the firm’s reputation. 11. The problem is that manufacturing performance is not given enough emphasis by traditional cost ing techniques, and traditional cost ing techniques do not the objectives of lean manufacturing firms. Firstly, traditional cost ing systems do not accurately trace costs to products and processes. This results in product cost distortions, which can ultimately cause poor decisions regarding pricing, valuation, and profitability. Secondly, standard costing motivates non-lean behaviors through the performance measures of personal efficiency of production workers and effective utilization of manufacturing facilities. This promotes the production of large batches of products and a build-up of inventory. A third problem is the time lag between the reports generated by the cost ants and the actual manufacturing activities. Managers need to know in real time about a robotic machine, which is producing sub-optimal work. Lastly, the ing data uses dollars as the standard unit of measure between items that are not always amenable to a dollar measure, such as product quality, delivery time, setup time, etc. Attempting to force this data into such a common financial measure may distort the problem and promote bad decisions. 12. The ABC process model provides critical information about cost drivers and performance measures. This information can be used to constantly analyze the relative efficiency of activities and the resources used in the process in order to better manage the activities and resources and target areas for cost reduction. 13. 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 in advanced technology manufacturing. 14. The use of standard costs provides a type of access control. By specifying the quantities of material authorized for each product, the firm limits usage. To obtain excess quantities requires special authorization and excess materials requisitions. 15. A Value Stream Map (VSM) is used to graphically represent a 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, along with key information about each action item. Specific information may include total hours worked, overtime hours, cycle time to complete a task, and error rates. The VSM shows the total time required for each processing step, the time required between

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steps, and identifies the types of time spent between steps such as the outbound batching time, transit time, and inbound queue time. 16. 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 track costs of activities and processes.  Equip managers with cost intelligence to drive continuous improvements.  Facilitate better marketing mix  Identify waste and non-value added activities. 17. 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. 18. Traditional ing systems do not accurately trace costs to products and processes. One consequence of new technologies is a changed relationship between direct labor and overhead costs. 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 in advanced technology manufacturing. In this setting, traditional cost ing procedures are inadequate. For traditional allocations to be correct, a direct relationship between labor and technology needs to exist. In CIM, this relationship is diametric rather than complementary. When the cost pool is large and the allocation method ambiguous, any miscalculation in asg labor is magnified many times in the calculation of overhead. 19. Most organizations produce more than one product, but these often fall into natural families. Product families share common processes from the point of placing the order to shipping the finished goods to the customer. Value stream ing cuts across functional and departmental lines to include costs related to the product family such as marketing, selling expenses, product design, engineering, materials purchasing, distribution, and more, but makes no distinction between direct costs and indirect costs. 20. MRP II evolved into large suites of software called enterprise resource planning (ERP) systems. Similarities in functionality between ERP and MRP II

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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 MRPII systems with low-end 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 manufactures. This market was dominated by a few software vendors including SAP, J.D. Edwards, Oracle, and PeopleSoft. In recent years this market has expanded tremendously by the entry of many small vendors targeting small and mid-sized customers with less expensive and more easily implemented ERP systems. MULTIPLE CHOICE 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

A C B E A B A E E C PROBLEMS

1. See diagram below 2.

a.

EOQ =

D = 28,000 S = $9 H = $1.25 EOQ = 635 b. ROP = I x d I=7 D = 200 ROP = 1400 3. Dell Computers – improved inventory turnover ratios Toyota – improved inventory turnover ratios GE – process improvement British Vita – MRP II Apple Computers – JIT

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4. a. One problem is that the work order is not sent directly to the cost ing department, but rather to the work centers. Thus, no separation of custodial and record-keeping tasks occurs. A possible danger is that work orders may be manipulated or lost. A corrective procedure is to have the work order sent directly to the cost ing department. b. A second problem is that the work centers generate their own material requisitions, excess material requirements, and material returns documents. The work centers should not have both custody over raw materials and the corresponding authorization responsibilities. A possible danger is that the work centers may pilfer raw materials and be able to cover it up by altering documents. A corrective procedure is to have the inventory control department generate these documents and have the cost ing department maintain the WIP records. 5.         

Key elements of this central manufacturing system are: Production Planning and control produce the production schedule based upon the monthly sales forecast on file in the central computer system The central system produces work orders, material requisitions, move tickets, and purchase orders based upon stored standards and inventory on hand data. Purchase orders are sent directly to suppliers (this could be via mail, fax, or EDI). Work centers access their work schedules and necessary documents from terminal in the work areas. Minimal hard copy is produced. When work is completed work center employees enter the time and materials used in production. Storekeeping issues raw material to employees as need. They access the central system to the materials requisitions, which the employees sign in exchange for the materials. The central system calculates WIP and automatically transfers WIP to finished goods inventory when production is complete. Cost ing receives management report on demand from the system via their department. Purchasing receives management reports on products ordered via the department terminal.

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6. The advantages are that no defective units will be produced whenever a problem is detected. Defective units are problematic in most industries, but especially so in the toy industry for toddlers. Although the production line is shut down, costs may still be saved in the long-run from less waste, fewer unsalable products, and fewer product litigation cases. The problems are that the switchover to a JIT system requires a lot of training and patience. The product must be produced in small lot sizes; the firm may need to adjust to get used to this practice. The firm

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must have excellent cooperation from its suppliers. Late deliveries or delivery of defective raw materials can cost the company dearly due to downtime, since no excess inventory is stored. Employee cooperation and teamwork must be obtained, and this usually takes time for adjustment. Quality must be in the front of everyone’s mind. 7. Overhead components for the company include executive salaries, legal expenses, ordering costs, ing and other department costs, janitorial services, electricity, plant, property and equipment costs, inventory handling expenses, saw blades, scrap or waste disposal costs, glue, sand paper, mineral oil, packaging supplies, and shipping costs. An activity driver for cutting could be lumber square feet; the most logical activity driver for the assembly, shaping, sanding, and finishing processes would be the number of cutting boards made. An activity driver for packing could be the number of boxes packed. 8.

Response: The essay should include the following points:

Pull processing. Products are pulled from the consumer end (demand), not pushed from the production end (Supply). They are pulled into production as capacity upstream becomes available. Unlike the traditional push process, lean does not create batches of semi finished 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. In the traditional manufacturing environment, these costs can represent between 25 to 35 percent of total product cost. Also, quality is a basis on which world-class manufacturers compete. 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. The following are examples of waste in traditional environments: • Overproduction of products, • Transportation of products • Bottlenecks of products waiting to move to the next production step. • Idle workers. • Inefficient motion of workers who must walk more that necessary in the completion of their assigned tasks • Islands of technology. • Production defects that requires 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

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success in inventory reduction. 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 must be transported throughout the factory, handled, stored, and counted. In addition, inventories lose value through obsolescence. 2. Inventories camouflage production problems. Bottlenecks and capacity imbalances in the manufacturing process cause work-in-process 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. 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 – No late deliveries, defective raw materials, or incorrect orders. Team Attitude. Lean manufacturing relies heavily on the team attitude of all employees involved in the process. 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 1.

INTERNAL CONTROL CASES Solution to Nautilus Water Pumps, Inc. a., b., d.: See diagrams on the pages that follow.

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c. Internal Control Weaknesses 1. Production scheduling is performed in the Work Center rather than through a formal Production, Planning and Control phase. This leads to lack of coordination, internal inefficiencies, material ordering problems, and bottlenecks. 2. No standards for material usage are in place and no means for ing for unused materials or excess material usage in production exists in the current system. Controls over the flow of raw materials need to be implemented. 3. A blanket order from each automobile manufacturer is received at the start of the year, which is guaranteed for only one month. Nautilus’s material suppliers, on the other hand, currently require three months lead-time. Dealing with incongruity will require coordination within Nautilus’s supply chain. Thus, in addition to resolving

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the Nautilus’s internal production problems, the company will benefit by entering into trading partner agreements with suppliers that will require implementation of EDI and MRP technologies. (EDI is discussed in detail in chapter 12.) 2.

Solution to SAGA Fly Fishing, Inc. a., b., d.: See diagrams on the following pages.

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c. Internal Control Weaknesses Many changes had to be made to the conversion cycle at SAGA, Inc. to ensure adequate control procedures in accordance with SAS 78. They also had to increase the amount of computer technology to speed production and reduce paper work. Many control weaknesses exist in this case beginning with inadequate Authorizations. Only one work order is produced in the Production Planning and Control Department, and it is sent to the work centers. No file is kept in the PP&C Department. This means that the department has no record of any work that they authorized, and therefore no control over the work centers. Also there is no Inventory Control Department to provide adequate authorization for the requisition of

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materials. A serious lack of Segregation of Functions exists at SAGA, Inc. No Inventory Control department exists and that causes the biggest problems. The Storekeeping and Finished Goods warehouse keeps inventory records. They also keep physical custody of the CD players. Since these are high-priced items that are relatively small, the incentive for employees to steal pieces of inventory is present. It would be very easy for anyone, like Mr. Holt, to remove a piece of inventory and alter the records. Another problem is that Mr. Brackenbury heads the work centers as well as the Production Planning and Control department. This gives him the opportunity to alter or create false production documents without anyone knowing. If he gets bonuses at the end of the year, he may have an incentive to commit fraud. Supervision is not a serious problem in the work centers because foremen who oversee the usage of raw materials are already present and the job tickets and timecards are accurate. The new computer system installed at SAGA, Inc. will help with the inadequate supervision in the other departments. s and limited access control should be implemented to detail who can amend certain documents. Also, new computer programs that calculate inventory requirements, update inventory records, and calculate variances ensure that someone in that department does not create false records. Access Controls are especially needed in the Storekeeping department at SAGA, Inc. First, the addition of an Inventory Control department will eliminate access to the raw materials by people with access to the ing records and vice versa. Also, badges and security codes between each department will cut down on the number of unauthorized people in the various departments. The new computer system will ensure that only the specified amount of material is sent to the work centers. To obtain excess quantities would require special approval by the Inventory Control clerk. The new system has a marked increase in the number of ing Record Controls. It starts with prenumbered source documents. This way missing documents can be tracked down and the ability to create false ones is greatly reduced. Next, an increase in the number of documents exists, strengthening the audit trail. Four work orders are now produced—two going to the work centers, one to Cost ing, and one to an open work order file. This file also lets the Production Planning and Control department know what orders are still in progress. Another move ticket is created going to the work center and back to PP&C to close out the open work order file along with the production schedule. Another materials requisition is created that eventually goes to Cost ing. With this increase in the audit trail, more departments will have a record of the WIP, making it harder to commit fraud. Finally, Independent Verification has also increased under this new system. Cost ing, now receiving more ing records, can more easily reconcile the

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materials used with the material requisitions, job tickets, and work orders. They can then come up with more accurate variances that point out any irregularities in the production process. If someone is changing the amount or cost of materials while at the same time changing the cost or time of labor used, a total variance may not pick up the difference. Labor, overhead, and materials variances will point out any large differences though. Finally, the Inventory Control department must make periodic counts of the inventory on hand and reconcile it with their records. d. This organization can benefit by creating an Inventory Control department and automating the inventory update and inventory level check procedures as illustrated in the revised diagrams. The diagram also illustrates other areas where automation may be beneficial. 3.

Solution to General Manufacturing, Inc. a., b. See the diagrams on the following pages.

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c.

Internal Control Weaknesses

Production GM needs to increase supervision in the work center. Mike does not watch employees closely enough, which makes it easy to fabricate the amount of time they spend working. The lack of excess materials and materials return documents represents ing record and access control problems. Inventory is not properly recorded because excess raw materials are left around the work center department.

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This gives employees easy access to the raw materials and may tempt employees to steal the raw materials. GM also has a segregation of functions problem since the storekeeping and inventory control departments are combined. The same person has access to both the raw material and finished goods inventory and the authority to update the inventory records. This makes it easy for an employee to steal finished goods and raw materials from GM. GM will need to break up the inventory department into storekeeping and inventory control departments. Cost ing The cost ing department has several control problems. The lack of excess material and material return documents make it difficult for the ing department to that the numbers they are receiving are correct. No independent verification of the WIP and FG inventory occurs since they do not have the documents to prove it. GM has a segregation of functions department control problem since the cost ing and general ledger departments are combined. This is a problem since no general ledger independent verification step exists. The same person has control of the cost ing records and the general ledger. No independent verification of the journal vouchers prepared by the cost ing department occurs since the same person reconciling them updates the general ledger. d. This organization can benefit from an integrated computer system which uses batch processing of time cards and time tickets. The materials requisition can be used to initiate the automatic preparation of the work order and move tickets. The move tickets should be used to update the work in process at each work station. 4. Solution to Bumper Cars, Ltd. (This case and solution was prepared by Julie Fisch and Melinda Bowman, Lehigh University.) All three suggestions offer valid solutions for inventory problems under certain conditions. However, some of the solutions work better than others in the case of Bumper Cars, Ltd. Mr. Ferris’s plan to hire more workers in the production department is the least plausible solution for this company. The reasonably low cost of implementing this plan, and the fact that it allows training of new workers provides two advantages of this solution. However, the list of disadvantages greatly outweighs these few advantages. First of all, if the company must continually hire and fire workers, training costs and hiring costs will skyrocket. Also, the workers will constantly worry about the possibility of unemployment. Unhappy workers with low morale tend to work less efficiently, therefore production decreases despite the greater number of workers. A third disadvantage involves the fact that the production department is not the source of the problem. A company should make improvements directly to the area that causes the problem, which in this case is the inventory control department.

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Ms. Coaster’s plan to hire more people to help in the inventory control department offers a more logical solution. By implementing such a plan, the problem would be attacked at its source. The understaffed inventory department comprises one of the most significant problems of the company. Each worker has too many responsibilities, and therefore they perform each task in a highly inefficient manner. Hiring more people would alleviate some of these responsibilities, thereby freeing the employees to concentrate on performing fewer jobs more effectively. In addition, this solution generates minimal extra costs and solves many problems with one simple solution. With the new workers, low inventory will be discovered and restocked before a lag in production occurs. On the other hand, this solution has its disadvantages also. The main problem revolves around the fact that hiring more workers in the inventory control department offers no future benefits for the company in of the company expansion. As the company expands, more and more workers will be necessary to keep track of inventory, thus incurring high cost to benefit ratios. While the extra workers benefit the inventory control and production departments, they offer no solutions for the problems that will develop in the other departments as a result of the expansion. Therefore, this solution may be used as a short term remedy for the immediate inventory problem, but it should not be included in the long range plans of the company. Possibly the best solution of the three suggested at the company meeting is Mr. Flume’s plan to implement a company-wide computer system. This solution would effectively meet the needs of the expanding company by coordinating all the departments and reducing manual labor problems. All operations would become more efficient and effective with the installation of an overall system. This solution is not without its drawbacks, however. First of all, as Mr. Amusement suggested, the cost of such a system is too excessive for a small company. Between research, implementation, maintenance, and repairs, the company would spend all its profits just to keep the system in order. At some point in the future, the company will probably break even, then continue to make money as the benefits of the computer set in, but the losses incurred in the immediate future might cause the company to fold before the system can take hold. In conclusion, a company-wide system might be a future consideration, but at the present, this solution is impractical. After weighing the advantages and disadvantages of the above solutions, the best solution is probably for this company to implement a small scale computer system implemented in the inventory control, purchasing, and production departments. This system would keep track of low inventory and the purchasing department when reordering is necessary. The system would also be connected to the production department, thus allowing the production department to immediately convey their production needs to the inventory control department where these needs can be met. Also, because the system is not implemented company-wide, the cost is not excessive. In addition, the company has the option to improve and add to the system later as the company’s expansion requires. The system could be expanded to include the ing and finance departments, and possibly even marketing and development departments. Therefore, in the short run, the small scale

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system solves the company’s immediate inventory problems. In the long run, this system provides opportunities for expansion with the business. As new problems arise due improved business, the company can easily revise the system to meet its needs. Most importantly, the cost of such a system is not excessive in the short run. 5.

Solution to Blades ‘R’ Us—Comprehensive Case a., b., d. See diagrams on the pages that follow.

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c.

Internal Control Weaknesses

Expenditure Cycle Control Issues: SEGREGATION OF FUNCTIONS 

One of the problems with Blades ‘R’ Us concerns the manner in which the inventory records are updated in the Inventory Department. As is explained, Mr. Sampson uses the purchase order he receives from Ms. Connolly to

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

update the records. This current system is relying on the confidence that the supplier will ship the goods promptly, with the right quantity, and without any defects. There is never any use of the receiving report by the Inventory Department to update records. Mr. Dresden should not have the ability to look over the records to write the checks and also be able to write and sign the checks off. In this case Mr. Dresden is exercising too much control over an important part of the s Payable Department.

ING RECORDS  Ms. Connoly has also committed another error in not printing up a “blind copy” of the purchase order to be sent to the s Payable Department. This blind copy would allow for further reconciliation on the documents so that everything that was ordered was received. Again, this company has too much reliance on the supplier that what they are sending is accurate and complete. SUPERVISION  Unfortunately, when Mr. Hiro receives the goods he never truly inspects the goods to make sure everything is correct. Mr. Hiro takes the packing slip numbers as correct and legitimate. He never does the physical count, which is so important.  Mr. Dresden has a lot of control when he is dealing with the checks. He has the ability to write the checks and sign for them as well. Without appropriate supervision, Mr. Dresden could be writing out checks to fake companies and merely updating the General Ledger with the fake summaries.  Mr. Sampson in the Inventory Department also needs to have someone checking his actions. He could easily manipulate the purchase orders coming through the warehouse enabling him to steal goods from the inventory department. AUTHORIZATION  The immediate authorization control issue is Mr. Dresden’s handling of the checks. Again, he has too much control over the writing and g of the checks before they are distributed to the suppliers. I included this control issue with supervision as well because I believe that it pertains to both of these issues. ACCESS CONTROL  Mr. Sampson in the Inventory Department has access to the inventory records as well as access to the actual inventory. With this “power” it would be easy for Mr. Simpson to commit fraud against the company. Conversion Cycle Control Issues: AUTHORIZATION

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 

No Move Tickets—There are no authorization activities for the movement of product between work centers. No Excess Material Document—If a work center needs more material they do not need any special permission to get it.

SEGREGATION OF FUNCTIONS  No Storekeeping Department—The Inventory Control Department maintains the records for the inventory and has custody of the inventory.  Material Requisitions Issued by Work Centers—The work centers issue material requisitions whenever they need materials instead of the production planning and control department. SUPERVISION  Supervision is necessary in the work centers to keep track of the products and the raw materials and be sure they are not being stolen or misplaced.  The foreman should make sure that the payroll time cards are accurate. ING RECORDS  No Job Time Tickets—There are no job time tickets sent to cost ing to the time spent on each job.  No Prenumbered Forms—The forms used for all the paperwork are not prenumbered, making it difficult to for all the paper work. ACCESS CONTROL  The company needs to limit the access employees have to the areas where materials and products are stored.  Allowing the work centers access to unlimited inventory by allowing them to request inventory at their discretion exhibits a problem with access control. 6. Solution to Automotive Components Corporation—An Activity Based Costing Case Automotive Components Corporation has experienced some unexplainable downturns in the past few years. Their margins have been lagging, yet they consistently obtain the business for which they have been gearing up their manufacturing operations—namely the low volume parts which the auto makers have been demanding. The controller cannot explain this phenomenon, but has attended a seminar recently where he learns that other companies which have been in the same predicament implemented ABC with success. Cost Drivers Fortunately, ACC’s overhead had been broken down effectively before the controller has recently become interested in ABC. This is fortunate because now all that is left for the core team to do is determine the second stage cost drivers which trace cost from the activity cost pools to each of ACC’s products. The interviews the core team

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conducted, as well as the discussion they provided, offer the reader enough information to determine which second stage cost drivers would best trace costs to products. The specific drivers selected are not the most important point to take away from this case, but rather the fundamental theory of resource consumption. The following discussion is provided by discussing a specific solution to the problems outlined in the case. The case readers may choose a different approach, yet still provide sufficient discussion to their conclusions. Engineering—The engineering activity is discussed by the product engineer, Sally Summers. She believes that engineering’s activity is consumed by the number of components per part. This occurs in other companies as well; the engineering activities in a company are product-related activities. In other words, they are not dependent on the quantity of product produced. At ACC, it takes essentially the same amount of time to design a low volume part as a high volume part. Therefore, the cost driver for the engineering activity is the number of components per part. The number of components is an estimate of part complexity. Hence, an assumption is made that engineering costs increase as the complexity of the part increases. Inspection—Jim Schmidt discusses the inspection activity cost pool. He notices that the inspection activity has not declined since ACC began focusing on low volume components. He discusses the first run inspections performed at ACC and notes that they are dependent on how many runs a product has. Inspection, in ACC’s case is a batch activity and the cost driver is the number of runs per product. Material Movement—The core team’s first interview is John “Bull” Adams, the supervisor in charge of material movement. Bull tells the team that the material movement activity is driven by the number of feet moved per run. This means that this activity is driven by two factors, the number of runs and the number of feet moved. The driver is therefore the number of feet moved times the number of runs, a batch activity. The material movement activity is not influenced by part volume. A large batch requires the same amount of resources as a small batch. This is a simplification for the case. Actually, other factors may exist which influence material movement such as weight or handling requirements. Setup—The next interview is with the most experienced jobsetter, Sara Nightingale. Sara tells the team that she believes the setup activity is still driven by the setup time required per batch. Sara its that with the introduction of the CNC machines for production, the workload has been reduced for the jobsetters, but the final assembly setups are still handled by mechanically experienced job-setters. The setup activity is a batch activity and should be driven by the setup time required per batch. Since Sara points out the fact that jobsetters are becoming more technical and the programming of CNC machines requires a different type of work, a cost driver which incorporates new product introductions or product changes may be appropriate. Shipping—The final interview is conducted with Phil Johnson, the shipping supervisor. He believes that the activity of the shipping department is dependent on

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the number of shipments. This is a product activity. The amount of resources expended on shipping is dependent on the number of shipments per product. The shipping cost of a product is a function of the number of shipments required by the customer. Machines—The activity cost pool named machines should be driven by the machine hours consumed per part. This is a unit cost because it occurs to every unit produced. ABC COSTS Figure 1 displays ACC’s new activity-based cost system. Each of the activity cost pools are traced to products using a different cost driver. With this new system, ACC has the ability to differentiate between parts of varying complexity within their CAS. Part complexity is a function of: machine hours per part, components per part, runs per part, distance moved per part, setup time per run per part, and shipments per part. The current CAS allocates the total manufacturing overhead based on each product’s consumption of direct labor. The new ABC system traces manufacturing overhead to products in two stages. The first stage traces costs from the manufacturing overhead to the activity cost pools identified in Figure 1. The second stage traces cost from those activity cost pools to individual products based on the cost drivers also shown in Figure 1. Each of ACC’s three products are calculated using the new ABC system in Figure 2. These new costs are drastically different than the costs computed by the current CAS system. This phenomenon of transactions within each part consumes a different proportion of transactions within each activity cost pool. Each product’s proportion of transaction consumption is shown in Figure 3. This figure illustrates why ACC’s current CAS does not produce accurate product costs. By observing the new activity-based system, it is clear that product 101 is the most complex product produced by ACC. This small volume product is the transaction leader in four out of the six activity cost pools. Product 102 and 103 are not as complex and require significantly less transaction volume. ACTIVITY-BASED COST VERSUS ACC’S CURRENT COST SYSTEM A graph demonstrating the variation between the product cost computed with the current CAS and the new activity-based system is shown in Figure 4. As you can see, the current system significantly undercosts product 101 and overcosts products 102 and 103. Figure 5 illustrates that current CAS significantly under-allocates overhead cost to product 101 and over-allocates cost to product 102 and 103.

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Under the current CAS, ACC thought they were obtaining planned gross margin on product 101, but not on product 102 or 103. However, the new ABC system shows significantly different results. ACC’s new gross margins on the three products are -55%, 22%, and 42%. The lesson to be learned is that ACC’s current CAS does not for product complexity as shown in the previous section. Under the current system, ACC thought it was achieving the greatest return on product 101, when in fact this product has the lowest contribution. Product 101’s gross margin changed from 20% to -55% when costs were computed using the new cost drivers. The large difference between product cost is attributable to product 101’s low direct labor content and its high transaction volume. The direct labor is less than product 103 while it requires a greater amount of transactions than the other two parts. Due to the products similar direct labor content, the current CAS allocated basically the same amount of overhead to each of the three products. No differentiation was made between products which required greater resource utilization under the current CAS. ACC’s Current CAS Is ACC beginning to show signs of a faulty cost system? The answer to this question is definitely yes. The first indication is that the investment ACC has made in new flexible technology has not increased profits. In fact, ACC’s margins have been declining, while the small volume orders which were believed to be profitable have been increasing. With the new ABC data, that ACC has been targeting the wrong customers becomes clear. The small volume parts are generally more complex and require the use of more overhead resources. Product 101 has the most runs, shipments, components, and movement. Unfortunately, the current CAS does not for this complexity. Product 102 and 103 turn out to be ACC’s biggest breadwinner. They are both higher volume products which require less resource consumption. Strategy With the new information provided by the ABC system, ACC can begin to regain sales growth and gross margins. In the short run, the price of product 101 should be raised. Not surprisingly, ACC’s customers may not challenge this move. The ABC costs show product 101 is achieving a negative gross margin. That ACC customers are well aware of this fact and would not be able to purchase the part elsewhere for the same amount is quite possible. Therefore, ACC’s customers may give them quite a bit of leeway on the product’s price. A price increase would soften the blow ACC is taking each time they sell product 101. In the long run, ACC will be able to use the ABC information to reallocate their resources and move towards a more profitable product mix. The activity-based information can be used to reduce many non-value adding activities. The resulting freed up resources can then be reallocated to value adding activities. Some examples are presented below.

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Factory Layout—The current layout of the factory is inefficient. Referring to Figure 5 in the case, Product 103 is routed throughout the factory from the receiving to shipping in a fluid pattern. Consequently, the total distance material must be moved is 250 feet per run, versus 350 feet per run for product 102, and 500 feet per run for products 101. Products 101 and 102 are not routed as efficiently. These products must be moved randomly throughout the factory. Consequently, they also require more runs. The result is that ACC spends the bulk of its material movement time on smaller volume specialty products. The new ABC system draws attention to this problem by penalizing products 101 and 102 with more material movement cost. Managers can easily identify this problem with the new ABC information and execute corrective action in the future. Components—In the long run, ACC can reduce the components per part by producing simpler designs. ACC’s design engineers have been inadvertently adding cost to products by simply increasing the number of components per part. Each time a new component is added to a part, a wide array of activities are influenced. Not only must the new part be designed by the product engineers, it must also be tested, routed through the factory, inspected, improved and shipped. These activities add costs to a product which an engineer simply cannot foresee when deg a part. Product 101 has 16 components and is responsible for 30.7% of the engineering cost under the new ABC system, yet it s for only 16.7% of the total volume. Setup Time—A reduction in setup time can lead to increased plant flexibility. As setups are reduced, it is possible to run smaller batch sizes more often or reallocate setup resources to other activities. In the long term, layoffs should not occur because the extra resources should be reallocated to value added activities such as production or continuous improvement. Runs and Shipments—ACC needs to be aware that costs increase with the number of runs and shipments. However, ACC should not immediately tell customers they will not be supplying small volume orders anymore. Supplying orders in small volume can be a competitive advantage, providing that service adds value for the customer, and ACC should be compensated for that value by requiring a higher price.

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