STUDY UNIT SIX

OPERATIONAL EFFICIENCY
AND BUSINESS PROCESS PERFORMANCE

Just-in-time
Definitions:
Just-in-time system :A comprehensive production and inventory system that purchases or produces
materials and parts only as needed and just in time to be used at each stage of the production
process.
Just-in-time (JIT) production (Also called lean production): Demand-pull manufacturing system in
which each component in a production line is produced as soon as and only when needed by the
next step in the production line..
Just-in-time (JIT) purchasing: The purchase of goods or materials so that they are delivered just as
needed for production.
Just-In-Time Inventory management systems are based on a manufacturing philosophy that
combines purchasing, production and Inventory control into one function.

Purpose

 minimize the level of inventories because many-inventory-related activities are viewed as

nonvalue-added.
 meet customer demand in a timely manner, with high-quality products, and at the lowest possible
cost,Higher productivity, reduced order costs as well as carrying costs, faster and cheaper setups,
shorter manufacturing cycle times, better due date performance, improved quality, and more
flexible processes are objectives of JIT methods.
 The ultimate objectives are increased competitiveness and higher profits.

JIT (Demand Pull ) System vs. Traditional (push) systems

In a push system, a department produces and sends all that it can to the next step for further
processing, which means that the manufacturer is producing something without understanding
consumer demand. This can result in large, useless stocks of inventory. The main Idea of JIT is that
nothing is produced until the next process in the assembly line needs it. This demand-pull feature
requires close coordination between workstations.

Lot sizes based on immediate need are typical of just-in-time systems, while lot sizes based
on formulas are characteristic of traditional inventory management systems.

Benefits
o Reduction in the cost of carrying the inventory and reduces nonvalue adding activities.
o Greater emphasis on improving quality by eliminating the causes of rework, scrap and waste.
o Setup times are decreased.
o Lower investments in space
o The focus of quality control under JIT shifts from the discovery of defective parts to the prevention
of quality problems, so zero machine breakdowns (achieved through preventive maintenance)
and zero defects are ultimate goals. Higher quality and lower inventory go together.
o JIT increases inventory turnover (cost of sales ÷ average inventory) and decreases inventory as
a percentage of total assets.
o Backflush costing is utilized with just-in-time production as a planning and control system.
Backflush costing is less costly to operate than most traditional costing systems.

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 The minimization of inventory reduces the number of suppliers, storage costs, transaction costs, etc

Limitations
o an increased risk of stockout costs
o JIT implementation is not appropriate for high-mix manufacturing environments, which often have
thousands of products and dozens of work centers.

Carrying costs vs. Stockout costs

The objective of a JIT system is to reduce carrying costs by eliminating inventories and increasing the deliveries
made by suppliers. Ideally, shipments are received just in time to be incorporated into the manufacturing process.
This system increases the risk of stockout costs because the inventory buffer is reduced or eliminated.

Characteristics of JIT Systems

The major characteristics of a JIT environment are:
 Production organized into manufacturing work cells
o Each work cell produces a product or product type. Each worker in each cell knows how
to operate all the machines in that cell and can perform supporting tasks within that cell.
This reduces the downtime resulting from breakdowns or employee absences.
 Multiskilled workers
o cross-functional training of workers so they can perform a variety of operations and tasks
on an as-needed basis to maintain smooth production flow.
 Reduced setup times
o reduction of the time required to get tools, equipment, and materials ready for a
production run.
 Reduced manufacturing lead times
o reduction of the time from when an order is initiated to when a finished good is produced.
 Reliable suppliers
o careful screening of suppliers to ensure on-time deliveries of high-quality goods for just-
in-time use possibly within a day or less. Supplier’s dependability is crucial in JIT system
because inventory levels are kept low in a JIT system, the company must have a very
close relationship with its suppliers to make certain that the supplier makes frequent
deliveries of smaller amounts of Inventory, thus long-term contracts are typically
negotiated to reduce order costs.
o Buyer-supplier relationships are further facilitated by electronic data interchange (EDI), a
technology that allows the supplier access to the buyer's online inventory management
system. Thus, electronic messages replace paper documents (purchase orders and sales
invoices), and the production schedules and deliveries of the parties can be more readily
coordinated.

kanban
A set of control cards used by workers to signal the need for materials and products to move from
one operation to the next in an assembly line
Kanban is one of the many elements in the JIT system it means “ticket " "card" or "sign" or "visual
record" or “markers” in Japanese.Workers respond only after receiving a kanban. When production is
complete, the kanban is attached to the finished order and sent downstream to the next work cell

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Material requirements or Material Resource planning (MRP)
Definition
It is an approach that uses computer software to help manage a manufacturing process. MRP is a
“Push- through” system that manufactures finished goods for inventory on the basis of demand
forecasts.

The system of production traditionally used in manufacturing is materials requirements planning

(MRP). Taking a product from raw material through delivery is often treated as a series of discreet
events. The concept is to “push” the product through production to reach a market.
The premises underlying MRP push-though systems include:
 Demand forecasts
 A materials order specifying the materials, components, and subunit tasks required to produce
a final product
 A production order specifying the quantities of materials, components, subunits, and product
inventories needed to meet the demand forecast
 In MRP systems, a master production schedule indicates the quantities and timing of each
part to be produced. Once the scheduled production run begins, departments push output
through a system, regardless of whether that output is needed.

Benefits of MRP Systems

The benefits of MRP systems include:
 Less coordination required between functional areas; everyone follows the bill of materials.
 Scheduling improvements; levels load when demand is variable or relatively unpredictable.
 Predictable raw material needs; can take advantage of bulk purchasing and other price breaks.
 More efficient inventory control; schedules to use up raw materials or build finished goods.
 Additional inventory on hand to cover orders should product be damaged or lost in transit to a
customer.
 Quick response to new customer demand; can supply new customers from existing inventory
rather than building product after the order is received.
 Better manufacturing process control; minimizes retooling and machine setup time.
 Reduced idle time.
 Lower setup costs.
 Lower inventory carrying costs.
 Increased flexibility in responding to market change

Limitations

The primary disadvantage of an MRP environment is potential inventory accumulation. Workstations

may receive parts that they are not ready to process.

Manufacturing resource planning (MRP II) is a closed-loop manufacturing system that integrates
all facets of a manufacturing business, including production, sales, inventories, . schedules, and cash
flows.. The same system is used for both the financial reporting and managing operations (both use
the same transactions and numbers). Because manufacturing resource planning encompasses
materials requirements planning, MRP is a component of an MRP system.

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 Outsourcing
Definition

Process of purchasing goods and services from outside vendors rather than producing the same
goods or providing the same services within the organization. For smaller business, outsourcing may
provide access to resources and expertise for capabilities they may not have internally. For larger
businesses, outsourcing can improve specific functions.

Benefits
 By Outsourcing certain functions to a specialist, management can free up resources within the
company in order to focus on the primary operations of the company and strategic revenue-
generating activities.
 It may also be cheaper to outsource a function to a company that specializes in an area than
It Is to run and support that function internally.
 Benefits of outsourcing include reliable service, reduced costs, avoidance of the risk of
obsolescence, and access to technology.
 Can improve efficiency and effectiveness by gaining outside expertise or scale
 Can provide access to current technologies at reasonable cost without the risk of
obsolescence
 Can reduce expenses by gaining capabilities without incurring overhead costs (for example,
staffing, benefits, space)
 May improve the quality and/or timeliness of products or services

Limitations

Despite many attractive advantages, outsourcing is not the answer for all activities or functions and
should consider the following key cautions: May cost more to go outside for specific expertise

• Can result in a loss of in-house expertise and capabilities

• Can reduce process control
• May reduce control over quality
• May lead to less flexibility (depending on the external supplier)
• May result in less-personalized service
• Creates privacy and confidentiality issues
• Can result in “giving knowledge away” and lead to competitors obtaining expertise, scale,
customers, etc.
• Potential for employee morale and loyalty issues

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 Theory of constraints (TOC) and throughput costing
Definition

Theory of Constraints (TOC) Describes methods to maximize operating income when faced with
some bottleneck and some nonbottleneck operations.

Theory of Constraints (TOC) is a means of making decisions at the operational level that will Impact a
company's profitability positively. For a company to be competitive, it needs to be able to respond
quickly to customer orders. Theory of Constraints is an Important way for a company to speed up its
manufacturing time so it can improve its customer response time and its profitability

Manufacturing cycle time, also called manufacturing lead time or throughput time, is defined as
 the amount of time between the receipt of a customer order the shipment of the order.
 Duration between the time an order is received by manufacturing to the time it becomes a
finished good.

Basic Principles in the Theory of Constraints

Inventory, operational expenses, throughput contribution, and the drum-buffer rope system are the
principal concepts underlying the TOC.

Inventory
Inventory refers to all the money the system invests in purchasing items it intends to resell. Typically,
this refers to all physical inventory items but is now more broadly defined to include all assets.

Operating Expenses
In the TOC, operating (or operational) expenses refer to the money the system spends to convert
inventory into throughput. Operating expenses include expenditures such as direct and indirect labor,
supplies, outside contractors, interest payments, and depreciation. Employees are responsible for
turning inventory into throughput.

Throughput Contribution
Throughput contribution, also known as throughput margin or simply throughput, is a TOC measure
of product profitability. It is the rate at which the entire system generates money through product
and/or service sales.
Throughput contribution is represented by the following formula:

Throughput Contribution = Sales Revenue — Direct Material Costs

Throughput contribution assumes that the material costs include all purchased components and
material handling costs. TOC analysis also assumes that labor is a fixed cost, not a direct and
variable cost. The relationship between TOC and throughput contribution is explained in further detail
later in this section. Direct labor and other manufacturing costs such as overhead are excluded,
because it is assumed they will not change in the short term.

Drum-Buffer-Rope System
The drum-buffer-rope (PBR) system is a TOC method for balancing the flow of production through the
constraint thereby reducing the amount of inventory at the constraint and improving overall
productivity .
The drum connotes the constraint, the rope is the sequence of processes prior to and including the
constraint, and the buffer is the minimum amount of work-in-process input needed to keep the drum
busy.
The objective of the drum-buffer-rope system is to keep the process flow running smoothly through
the constraint by careful timing and scheduling of the processes in the rope leading up to the
constraint.
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Theory of constraints (TOC) analysis describes three basic measurements: throughput contribution (sales – direct materials), investments
(raw materials; work-in-process; finished goods; R&D costs; and property, plant, and equipment), and operating costs (all costs except
direct materials).

The steps in a TOC analysis are as follows:

1. Identify the constraint.
2. Determine the most profitable product mix given the constraint.
3. Maximize the flow through the constraint.
4. Increase capacity at the constraint. .
5. Redesign the manufacturing process for greater flexibility and speed.

Throughput margin
A TOC measure of product profitability; it equals price less materials cost, including all purchased
components and materials handling costs

Steps in the Theory of Constraints

The theory of constraints includes five focusing steps designed to concentrate improvement efforts on
the constraint most likely to have a positive impact on a system. Figure 1C-26 summarizes the five
steps.

1. Identify the constraint.

The constraint in a system is determined by the step that has the smallest capacity

2.Determine the most profitable product mix given the constraint.

maximizing the contribution margin through the constraint called the throughput margin or throughput
contribution

Throughput costing

Companies involved in TOC use a form of variable costing(Throughput costing, sometimes called
supervariable costing). However, one difference of the TOC approach is that it treats direct labor as a
fixed cost for three reasons:
 Many companies have a commitment to guarantee
workers a minimum number of paid hours.
 Direct labor is usually not the constraint.
 TOC emphasizes the role direct laborers play in driving continuous improvement. Since
layoffs often devastate morale, managers involved in TOC are extremely reluctant to lay off
employees.

Throughput costing, sometimes called supervariable costing recognizes only direct materials costs as
being truly variable and thus relevant to the calculation of throughput margin. All other manufacturing
costs are ignored because they are considered fixed in the short run.

Throughput Contribution = Sales Revenue — Direct Material Costs

Throughput costing puts a penalty on production without a corresponding sale in the same period.
Costs other than direct materials that are variable with respect to production are expensed in the
period of incurrence, whereas under variable costing they would be capitalized. As a result,
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throughput costing provides less incentive to
produce for inventory than either variable costing or absorption costing.
Advocates of throughput costing maintain that, in the short run, manufacturing costs other than direct
materials are relatively fixed. They view costs relating to workers, equipment, occupancy, and so on
as relatively fixed with respect to providing productive capacity during the period.

3.Maximize the flow through the constraint.

4.Increase capacity at the constraint.

5.Redesign the manufacturing process for greater flexibility and fast cycle time.
 Value engineering is useful for this purpose because it explicitly balances product cost and
the needs of potential customers (product functions).

 Throughput is product produced and shipped.

 Throughput time or manufacturing cycle time is the time that elapses between the receipt of a
customer's order and the shipment of the order.
 Throughput contribution margin Is revenue minus direct materials cost for a given period of time.
 Only strictly variable costs which are usually only direct materials are considered Inventory
costs. All other costs, even direct labor, are considered operating, or fixed, costs.
 Theory of Constraints assumes that operating costs are fixed costs because it regards them as
difficult to change in the short run.
 Theory of Constraints focuses on short-run maximization of throughput contribution margin
by managing operations at the constraint In order to improve the performance of production as a
whole.
 Three items that are measured in the theory of constraints are throughput contribution, inventory (or
investments), and operating expenses.
• Throughput contribution = Sales revenue — Direct material costs
• Inventory = (Materials costs in direct materials, Work-in-process, and Finished goods
inventories) + (R & D costs) + (Costs of equipment and buildings)
• Operating expenses = All costs of operations, not including direct materials
 Using this method, the objective is to maximize throughput contribution while reducing investments
and operating costs.
TOC vs. ABC (complementary analytical tools)

TOC ABC
Main Short-term focus: through put margin Long-term focus; analysis
Objective analysis based on materials and materials- of all product costs,
related costs concerned with strategic
pricing and profit planning
Resource Included explicitly, a principal focus of Not included explicitly
constraints TOC
Cost drivers No direct utilization of cost drivers Develop an understanding
of cost drivers at all levels
Major Use Optimization of production flow and short- Strategic pricing and profit
term product mix planning

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 Capacity management and analysis
Intro
A key issue in costing is choosing the capacity level for computing the allocation of manufacturing
overhead. Determining the correct level of capacity to use is a difficult strategic decision for
managers. The choice of capacity level used to allocate overhead can have a great effect on product
cost information used by managers.

Excess capacity vs. too little capacity

If a company has capacity in excess of what it needs, then it will incur large costs of unused capacity.
Likewise, if a company has too little capacity to meet demand, then it may have trouble filling
customer orders.

Determining the Level of Activity

In relation to the allocation rate, the company must decide what activity to use for its budgeted
amount of the activity level. The traditional method uses either machine hours or direct labor hours to
allocate overhead. The company must decide how much output it will produce during the coming
year. And, as a function of output, how many machine hours, or how many direct labor hours, it plans
to use during the year. As this is one of the two figures used in the determination of the
manufacturing overhead rate, it will greatly impact the allocation rate.
The allocation rate is established for the full year. The budgeted overhead rate for the year multiplied
by each month's budgeted activity level will be used to calculate the monthly budgeted overhead (see
example following this explanation]*

Four choices to determine the output level

In general, a company has four choices to determine the output level. Two relate to what the plant
can supply; and two relate to the demand to the plant's output. These are called denominator-level
capacity concepts, because they describe the denominators that can be used in the calculation of
per unit overheat costs.

Supply Denominator-Level Concepts

Theoretical or Ideal (perfect ) capacity - This is the level of activity that will occur IF the company
produces at Its absolute most efficient level at all times(under ideal conditions). (This means no
allowances for idle time and downtime and no machine breakdowns or maintenance, delays and no
decrease in sales demand and no waste and no time lost to illness and that the workers are already
working at maximum efficiency.). This is not a good basis to use because a company will not be able
to achieve this level in the long run. Theoretical capacity represents the largest volume of output
possible, but is unattainable and unrealistic.

Calculating overhead allocations

Using theoretical capacity when calculating overhead allocations would mean that a large
denominator activity level would be used, resulting in a lower overhead allocation to individual units of
product. This would distort the allocated costs (making them too low) and provide management with
product cost information that is not representative of actual costs.

Practical (or currently attainable) capacity - This is the theoretical level reduced by allowances
For idle time and downtime, but not For a decrease in sales demand. Thus it represents the highest
level of capacity that can be achieved, while allowing for unavoidable losses of productive time, such
as machine breakdowns, employee vacations, maintenance, etc. Unlike theoretical capacity, it is the
level of capacity that can realistically be achieved.

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This is the level that will be achieved given the normal amount of time lost, normal amount of waste
and a normal learning curve for employees. The goal is to use a level that Is attainable, but difficult to
attain. This will motivate the workers and still require them to work diligently.
Practical capacity is a better choice to use as the denominator activity level for allocating overhead,
because it is realistic and will generate product costs that accurately reflect the cost of the product.
By using practical capacity to calculate product costs, the company is not over- or under-allocating
costs to each unit of product. Instead, a “practical” or “realistic” amount of overhead is allocated to
each unit produced. As a result, many companies prefer to use practical capacity as the denominator
to calculate the allocated overhead rate.

Demand Denominator-Level Concepts

Master budget capacity utilization (or expected actual capacity utilization) - Master budget
capacity, also called expected actual capacity, is the amount of output actually expected during the
next budget period based on expected demand. This level will result in a different overhead rate for
each budget period because of increases or decreases in planned production due to expected
increases or decreases in demand.

Normal capacity utilization - This is the level of activity that will be achieved in the long run, taking
into account seasonal changes in the business and cyclical changes. Seasonal changes in business
result From the seasons during the year and cyclical changes are connected to the larger business
cycle. Normal capacity utilization is the level of activity that will satisfy average customer demand
over a long-term period such as 2-3 years. Though this will cause inaccuracies in some years, they
will be offset in others. This is the method that a company should generally use to determine the
overhead standard cost.

Usually normal capacity or expected actual capacity (also called master budget capacity) is used as
the denominator in calculating the overhead standard rate. It is much simpler if the activity level used
in developing the overhead standard is the same activity level as is used in developing the budgeted
overhead costs. If it is not, differences between budgeted costs and standard costs due to the:
different activity levels will appear in variance reports as additional variances.

Example: Total overhead is budgeted to be $900,000 for the budget year.

Output, based on normal capacity utilization, is budgeted at 500,000 units for the year. The overhead
allocation rate, based on units of production, is $1.80 per unit ($900,000÷ 500,000).

Overhead is allocated based on machine hours. So we need to convert that to a rate per machine
hour. The standard number of machine hours for each unit produced is 1.5 machine hours, so total
machine hours budgeted for the year is 500,000 * 1.5, or 750,000. Therefore, the amount of overhead
to be budgeted for each machine hour allowed For the budgeted output is $ 1.20 ($1.80 per unit ÷ 1.5
machine hours per unit OR $900,000 ÷ 750,000 machine hours).

Production is not planned to take place evenly throughout the year. The production budget For the
first quarter calls for 40,000 units to be produced in January, 50,000 in February, and 45,000 in
March. Therefore, budgeted overhead will be (40,000 K $1.80) or $72,000 in January, (50,000 X
$1.80) or $90,000 in February, and (45,000 X $1.80) or $81,000 in March.
We can calculate the same amounts by using machine hours: January's budgeted machine hours is
40,000 production units X 1.5 machine hours per unit, or 60,000 machine hours. 60,000 machine
hours x $1.20 per machine hour = $72,000 budgeted overhead for January, and so forth for February
and March.

At the end of the year, the total budgeted overhead for the year should equal $900,000. We will have
allocated it unequally to each month in the year, based upon each month's budgeted output.

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 Contemporary Productivity Approaches
(Technique / Description)
Automation/robots
Uses reprogrammable, multifunctional robots (machines) designed to manipulate materials, parts,
tools, or specialized devices through variable programmed motions
Applies robots to the performance of a variety of repetitive tasks

Capacity management and analysis (capacity planning)

Represents an important decision-making area involving strategic, tactical, and operational aspects
Includes an iterative procedure that:
Reviews long-term demand forecasts
Translates forecasts into capacity requirements
Matches the capacity requirements to present facilities Identifies mismatches between capacity
requirements and projected availability
Devises plans to overcome mismatches and selects the best alternative

Computer-aided design (CAD)

Uses computers in product development, analysis, and design modification to improve the quality and
performance of the product
Usually entails the drawing or physical layout steps of engineering design

Computer-aided manufacturing (CAM)

Applies the computer to the planning, control, and operation of a production facility

Computer- integrated manufacturing (CIM)

Involves a manufacturing system that completely integrates all factory and office functions within a
company via a computer-based information network
Uses computers to control the integration and flow of information between design, engineering,
manufacturing, logistics, warehousing and distribution, customers and suppliers, sales and marketing
activities, and accounting
Facilitates hour-by-hour manufacturing management

Concurrent engineering (simultaneous engineering)

Integrates product or service design with input from all business units and functions throughout a
product’s or service’s life cycle.
Emphasizes upstream prevention versus downstream correction.
Attempts to balance the needs of all parties in product or service design while maintaining customer
requirements

Flexible manufacturing system (FMS)

Uses a computerized network of automated equipment that produces one or more groups of parts or
variations of a product in a flexible manner

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 Value-chain analysis
Definition

Value chain
The sequence of business functions in which usefulness is added to the products of services of a
company.

Value-chain analysis
A strategic analysis tool used to
 identify where value to customers can be increased or costs reduced, and
 to better understand the firm's linkages with suppliers, customers, and other firms in the
industry.
o Because the value chain identifies and connects the organization's strategic
activities, value chain analysis improves the firm's knowledge of its relations with
customers; suppliers, and competitors.
 It also facilitates the strategic determination of the phase(s) of the industry's Value chain in
which the firm should operate.
 to focus on those activities that are consistent with its overall strategy.
 help an organization gain competitive advantage by identifying what steps or activities do
and do not increase the value to the customers.
o Once those areas are identified, the organization can increase the related benefits,
or reduce (even eliminate) non value-added activities. The increase in value to the
customer and/or the decrease in production costs will make the company more
competitive. The firm should analyze each step in its operations carefully to
determine how each activity contributes to the company's profits and its
competitiveness.

 offers an excellent opportunity to integrate strategic planning and management accounting

to guide the firm to survival and growth.

The business functions in the value chain are

• Research and development—generating and experimenting with ideas related to new products,
services, or processes.
• Design of products, services, and processes—the detailed planning and engineering of
products, services, or processes.
• Production—acquiring, coordinating, and assembling resources to produce a product or deliver a
service.
• Marketing—promoting and selling products or services to customers or prospective customers.
• Distribution—delivering products or services to customers.
• Customer service—providing after-sale support to customers.

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Steps in Value Chain Analysis

There are three steps in value chain analysis:

1) Identify the activities that add value to the finished product. These activities depend upon the
industry and what the company does (manufacturing, resale, etc.). They will be whatever activities
this firm and firms in its industry perform in the processes of designing a product or service,
manufacturing the product, marketing it and providing customer service after the sale.

2) Identify the cost driver or cost drivers for each activity, and

3) Develop a competitive advantage by adding value to the customer or reducing the costs of
the activity.

For example,
 R&D can add value to established products or services by finding ways to improve them,
in addition to developing new ones.
 Production's function is to acquire the necessary raw materials and assemble them into
finished goods. By doing this efficiently, costs can be lowered, leading to higher profits.
 Marketing adds value by informing customers about the products or services, which may
increase the utility that customers attribute to the product or service and enable the
company to charge a higher price. Marketing can also discover what customers want and
need through marketing research and communicate that to the R&D group so the R&D
group can design products that match the customers' needs.
 Customer service after the sale adds value by delighting customers with the responsive
service received, thus creating superior value for them. Increased utility for customers
because of excellent customer service can also enable the company to charge more for its
products.

Value chain and supply chain analysis

Supply chain describes the flow of goods, services, and information from the initial sources of
materials and services to the delivery of products to consumers, regardless of whether those
activities occur in the same organization or in other organizations.
Cost management is most effective when it integrates and coordinates activities across all companies
in the supply chain as well as across each business function in an individual company’s value chain.
Attempts are made to restructure all cost areas to be more cost-effective.

Value chain and supply chain analysis performed by the management accounting function can
contribute to the achievement of key success factors. When each business function adds value and
all business functions are coordinated and well integrated, it contributes to cost control, high quality,
timely response, and innovation.

Value engineering is a systematic evaluation of all aspects of the value-chain business functions,
with the objective of reducing costs while satisfying customer needs. Value engineering via
improvement in product and process designs is a principal technique that companies use to achieve
target costs per unit.

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 Value-added concepts
Intro
Process value analysis is a comprehensive understanding of how an organization generates its
output. It involves a determination of which activities that use resources are value-adding or
nonvalue-adding and how the latter may be reduced or eliminated.

Definition

High-value-added activity
A high-value-added activity increases significantly the value of the product or service to the
customers. Removal of a high-value-added activity decreases perceptively the value of the product or
service to the customer. Such an activity may be mandated (e.g., a regulatory requirement) or
discretionary.

High-value-added activities are those:

That are necessary or required to meet customer requirements or expectations.
That enhance purchased materials or components of a product.
That contribute to customer satisfaction.
That are critical steps in a business process.
That are performed to resolve or eliminate quality problems.
That are performed upon request of a satisfied customer.
That you would do more of, if time permitted.

Examples : Inserting a flange into a part, pouring molten metal into a mold, and preparing a field for
planting are examples of high-value-added activities. Installing software to protect a computer from
spam is a high-value-added activity to customers annoyed by bombardments of unwanted e-mail.
Designing, processing, and delivering products and services are high-value-added activities.

Value-added cost A value-added cost is incurred to perform a value-added activity without waste. It
is a cost that customers perceive as adding value, or utility, to a product or service. Examples are
costs of materials, direct labor, tools, and machinery.

Low-value-added activity
A low-value-added activity consumes time, resources, or space, but adds little in satisfying
customer needs. If eliminated, customer value or satisfaction decreases inperceptively or remains
unchanged. Moving parts between processes, waiting time, repairing, and rework are examples of
low-value-added activities.

Low-value-added activities are those that:

Can be eliminated without affecting the form, fit, or function of the product or service.
Begin with prefix “re” (such as rework or returned goods).
Result in waste and add little or no value to the product or service.
Are performed due to inefficiencies or errors in the process stream.
Are duplicated in another department or add unnecessary steps to the business process.
Are performed to monitor quality problems.
Are performed due to a request of an unhappy or dissatisfied customer.
Produce an unnecessary or unwanted output.
If given the option, you would prefer to do less of.

A nonvalue-added cost is caused by a nonvalue-added activity or inefficient performance of a

value-added activity. It is a cost that customers do not perceive as adding value, or utility, to a
product or service. Examples of nonvalue-added costs are costs of rework, scrap, expediting, and
breakdown maintenance.

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A Classification of High-Value-Added and Low-Value-AddedActivities

Activity High-Value-Added Low-Value-Added

Designing product X
Setting up X
Waiting X
Moving X
Processing X
Reworking X
Repairing X
Storing X
Inspecting X
Delivering product X

Example of an Activity Analysis

Examples
Value-added costs: Materials and labor for regular repairs
Nonvalue-added costs: Rework costs, expediting costs caused by work delays, breakdown
maintenance of equipment
Gray area: Materials handling costs, Materials procurement and inspection costs, Preventive
maintenance of equipment

Classifications of value-added, nonvalue-added, and gray area costs are often not clear-cut.
Other classifications of some of the cost categories are also plausible. For example, some students
may include materials handling, materials procurement, and inspection costs and preventive
maintenance as value-added costs (costs that customers perceive as adding value and as being
necessary for good repair service) rather than as in the gray area. Preventive maintenance, for
instance, might be regarded as value-added because it helps prevent nonvalueadding breakdown
maintenance.
The selection of value-added activities in each place of the value chain reflects the firm's
determination of its competitive advantage and its choice of competitive strategy. For example,
different design strategies require different activities and costs. A firm might choose to be the low-cost
producer of an undifferentiated product rather than compete on the basis of superior product quality.

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 Activity-based management (ABM)
Intro
The linkage of product costing and continuous improvement of processes is activity-based
management (ABM). ABM redirects and improves the use of resources to increase the value created
for customers and other stakeholders. It encompasses activity analysis, cost driver analysis, and
quality performance measurement.
o Kaizen is the Japanese word for the continuous pursuit of improvement in every aspect of
organizational operations. For example, a budget prepared on the kaizen principle projects
costs based on future improvements. The possibility of such improvements must be
determined, and the cost of implementation and the savings there from must be estimated.

Definition
Management decisions and activity analysis that use activity-based costing information to satisfy
customers and improve operational control, management control and profitability.

Activity-Based Management (ABM)

o manages activities to improve the value of products or services to customers and increase the
firm’s competitiveness and profitability.
o ABM draws on ABC as its major source of information and focuses on the efficiency
and effectiveness of key business processes and activities.
o Using ABM, management can pinpoint avenues for improving operations, reducing costs, or
increasing values to customers.
o By identifying resources spent on customers, products, and activities, ABM improves
management’s focus on the firm’s critical success factors and enhances its competitive
advantage.

ABM applications can be classified into two categories: operational ABM and strategic
ABM.

o Operational ABM enhances operation efficiency and asset utilization and lowers costs; its
focuses are on doing things right and performing activities more efficiently.
o Operational ABM applications use management techniques such as activity
management, business process reengineering, total quality management, and
performance measurement.
o Strategic ABM attempts to alter the demand for activities and increase profitability through
improved activity efficiency.
o Strategic ABM focuses on choosing appropriate activities for the operation, eliminating
nonessential activities and selecting the most profitable customers. Strategic ABM
applications use management techniques such as process design, customer
profitability analysis, and value chain analysis.

Advantages and Disadvantages of ABM

ABM has the following advantages over traditional cost management techniques:
• Uses continuous improvement to maintain the firm’s competitive advantage
• Allocates more resources to activities, products, and customers that add more value,
strategically redirecting management focus
• Eliminates non-value-added activities.
• Measures process effectiveness and identifies areas to reduce costs or increase customer
value.
• Works well with just-in-time processes.
• Ties performance measurement to ABC to provide consistent incentives for using ABC.

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ABM has the following disadvantages when compared to traditional cost
management:
• Changing to ABC/ABM will result in different pricing, process design, manufacturing technology, and
product design decisions, and the company must be prepared to support managers who embrace
these methods and discourage managers who continue to use the older methods.
• ABC/ABM is not used for external financial reporting, and needing to prepare reports using
traditional methods may influence management decision making enough to dilute the impact of
ABC/ABM.
• Implementing ABC/ABM is expensive and time-consuming, so a cost-benefit analysis should be
done to identify all hidden costs and benefits.

Process analysis and business process reengineering

Intro
Technological advances have increased the popularity of business process reengineering. Process
improvements and productivity gains achieved through total quality management (TQM) are generally
incremental gains achieved by tweaking a system and reducing inputs. In contrast, process
reengineering and business process reengineering offer deeper, more sweeping gains.

Definition
Process
A process is how something is accomplished in a firm. It is a set of activities directed toward the
same objective. A process is an activity or a group of interrelated activities that takes an input of
materials and/or resources, adds value to it, and provides an output to internal or external customers.

Reengineering
Is process innovation and core process redesign. Instead of improving existing procedures, it finds
new ways of doing things. Thus, reengineering should be contrasted with process improvement.

Process improvement
Consists of incremental but constant changes that improve efficiency.

Process reengineering
Process reengineering diagrams a process in detail, evaluates and questions the process [low, and
then completely redesigns the process to eliminate unnecessary steps, reduce opportunities for
errors, and reduce costs. All activities that do not add value are eliminated.

Process analysis
a collection of analytic methods that can be used to examine and measure the basic elements for a
process to operate. It can also identify those processes with the greatest need for improvement.

Process analysis looks at the linkage of quality, productivity, and process improvements:
• Productivity implies trying to improve upon what already exists.
• Improving productivity requires continuous quality improvement.
• Continuous improvement necessitates ongoing organizational learning, process improvements, and
reengineering.
These continuous productivity improvements, then can help an organization be competitive in the
long term.

Business process reengineering (BPR)

Is a complete rethinking of how business functions are performed to provide value to customers, that
is, radical innovation instead of mere improvement, and a disregard for current jobs, hierarchies, and
reporting relationships.

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Business process reengineering (BPR) is the fundamental analysis and radical redesign of business
processes within and between enterprises to achieve dramatic improvements in performance (for
example, cost, quality, speed, and service). BPR promotes the idea that sometimes wiping the slate
clean and radically redesigning and reorganizing an enterprise is necessary to lower costs and
increase the quality of a product or service.

BPR involves changes that are:

Fundamental — BPR forces people to look at tacit rules and assumptions underlying the way they
currently do business. Firms must answer two questions: Why do we do what we do? Why do we do
it the way we do it?
Radical — BPR is about reinvention, not improvement or modification. A radical redesign means
disregarding existing processes and inventing new ways of doing work.
Dramatic — BPR is not for the faint at heart. It should be used when the need for “heavy blasting” is
required to alleviate a dire situation. If you need only a slight bump in process improvement, there is
no need to reengineer.
Process — BPR is about a process orientation with a heavy emphasis on the chain of activities that
take input and create output of value to the customer.

Accordingly, BPR techniques eliminate many traditional controls. They exploit modern technology to
improve productivity and decrease the number of clerical workers. Thus, the emphasis is on
developing controls that are automated and self-correcting and require minimal human intervention.

The emphasis therefore shifts to monitoring internal control so management can determine when an
operation may be out of control and corrective action is needed. Most BPR techniques also assume
that humans will be motivated to work actively in improving operations when they are full participants
in the process.

Monitoring-assesses the quality of internal control over time. Management considers whether internal
control is properly designed and operating as intended and modifies it to reflect changing conditions,
Monitoring may be in the form of separate, periodic evaluations or of ongoing monitoring. Ongoing
monitoring occurs as part of routine operations. It includes management and supervisory review,
comparisons, reconciliations, and other actions by personnel as part of their regular activities.

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 Benchmarking
Definition
a continuous, systematic process of measuring products, services, and practices against the best
levels of performance. Thus helping an organization to be competitive.

Benchmarking is an ongoing process that entails quantitative and qualitative measurement of the
difference between the company's performance of an activity and the performance by the best in the
world. The benchmark organization need not be a competitor.

Mechanism
It analyzes and measures the key outputs of a business process or function against the best and also
identifies the underlying key actions and root causes that contribute to the performance difference.

Many people think of benchmarking as simply capturing best-in-class information, but the practice
has a much wider application. Quite often, best-in-class levels are comparisons to external
benchmarks of industry leaders. However, they may also be based on internal benchmarking
information or measures from other organizations (outside an industry) that have similar processes.

Benchmarking phases
1) Select and prioritize benchmarking projects.
2) The next phase is to organize benchmarking (cross functional) teams.
3) Documenting own work process: determining relevant benchmarking measurements
3) Researching and identifying best-in-class performance
4) Analyzing benchmarking data: The data analysis phase entails identifying performance gaps,
understanding the reasons they exist; and prioritizing the key activities that will facilitate the
behavioral and process changes needed to implement the benchmarking study's recommendations.
5) The implementation phase (Leadership is most important).

Benchmarking and Creating Competitive Advantage

Benchmarking studies in various forms (best practice, functional, process, and competitive) were
freely conducted, generally without a context. Invalid comparisons were often made (for example,
comparing the growth of a highly leveraged company to one internally financed from earnings, or
comparing the growth of a company in a low-cost environment to one in Silicon Valley). Given such
misapplications, most of these benchmarking studies were not particularly cost-effective. However,
well-designed and properly applied benchmarking can be a powerful tool in helping an organization to
be competitive.

Through benchmarking, a firm identifies best-in-class levels and conducts a study to determine how
those levels can be adopted and lead to improved performance. It provides a rational method for
setting performance goals and gaining market leadership; important decisions are based on facts and
data, rather than on emotions. Because benchmarking is based on what the best are doing, it
provides an accurate assessment of what needs to change.

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 Best practice analysis
Definition
A best practice generally refers to a process or technique that has produced outstanding results in
one situation and that can be applied and/or adapted to improve effectiveness, efficiency, quality,
safety, innovativeness, and/or some other performance measure in another situation.

Best practice analysis refers to the collective steps in a gap analysis.

o A gap analysis is generally described as the difference between the current state and a
desired state, or “the space between what is and what an organization hopes to be.”

Best practice analysis involves assessing how a firm’s given performance level measures up to a
best practice and then defining the logical next steps in transitioning to the desired performance level.
Typical activities are:
o Defining the gap (through a comparison to internal operational data)
o Determining the reasons for the gap
o Examining the factors that contribute to the existence of the best practice(s)
o Developing recommendations and an approach to implement the best practice(s)

Techniques and tools for conducting a best practice analysis vary. Qualitative and quantitative tools
are used but most of the tools are common to total quality management and kaizen.

It may be said that best practice analysis tools—such as value chain analysis, process analysis,
business process reengineering, benchmarking, total quality management, and kaizen---are the clout
behind business process improvement initiatives. Best practice analysis enables firms to identify and
undertake performance improvements.

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 Cost of quality analysis
The costs of quality (COQ) refer to the costs incurred to prevent, or the costs arising as a result of,
producing a low-quality product. Costs of quality are classified into four categories; examples for each
category are listed in the next Exhibit.
1. Prevention costs-costs incurred to preclude the production of products that do not conform to
specifications.
2. Appraisal costs-costs incurred to detect which of the individual units of products do not conform to
specifications.
3. Internal failure costs-costs incurred on a defective product before it is shipped to customers.
4. External failure costs-costs incurred on a defective product after it is shipped to customers.

Items Pertaining to Costs-at-Quality Reports

SMA 4R lists four categories of costs of quality: prevention, appraisal, internal failure, and external
failure. An organization should attempt to minimize its total cost of quality.

a. Conformance costs include prevention and appraisal, which are both financial measures of
internal performance.

1) Prevention attempts to avoid defective output. These costs include preventive maintenance,
employee training, review of equipment design, and evaluation of suppliers.
o Prevention costs are the costs of quality system design, implementation, and maintenance,
including audits of the quality system itself. Examples include quality planning, review of new
products, surveys of supplier capabilities, team meetings for quality, and training for quality,
as well as related to ensuring the quality or quality improvement of the product: market
research, product testing, and product design.

2) Appraisal embraces such activities as statistical quality control programs, inspection, and testing.
o Appraisal costs are the costs of auditing processes for quality, including formal and informal
measurements and evaluations of quality levels and setting quality standards and
performance requirements. Examples include inspection and testing of raw materials, work-in-
process and finished goods testing, calibration of equipment, and audits or operations or
services. In addition, they address more externally focused costs such as monitoring market
reaction and competitors’ products.

b. Nonconformance costs include costs of internal failure (a financial measure of internal

performance) and external failure costs (a financial measure of customer satisfaction).
1) Internal failure costs occur when defective products are detected before shipment.
a) Examples are scrap, rework, tooling changes, downtime, redesign of products or processes, lost
output, reinspection and retesting, expediting of operations after delays, lost learning opportunities,
and searching for and correcting problems.

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Internal failure costs include the costs involved with defective products and components that are
caught before shipping them to the customer. Examples include scrap, rework, spoilage, retesting,
and reinspection. They also include systemic problems such as the inability to meet the design,
manufacturing, and service standards identified for the product.

2) The costs of external failure or lost opportunity include lost profits from a decline in market
share as dissatisfied customers make no repeat purchases, return products for refunds, cancel
orders, and communicate their dissatisfaction to others.
a) Thus, external failure costs are incurred for customer service complaints; rejection, return, repair,
or recall of products or services; warranty obligations; products liability claims; and customer losses.
b) Environmental costs are also external failure costs, e.g., fines for nonadherence to
environmental law and loss of customer goodwill.
External failure costs are the costs involved with shipping a defective product to a
customer. Examples include customer complaints, returns, product recalls, and warranty claims.
Overall, these costs relate to an inability to meet customer
perceptions for product quality and service.
i) To minimize environmental damage and its resulting costs, the International Organization for
Standardization has issued ISO 14000 standards to promote the reduction of environmental damage
by an organization’s products, services, and operations and to develop environmental auditing and
performance evaluation systems.

Continuous improvement concepts

The term kaizen is a Japanese word that means "improvement." As used in business, it implies "continuous
improvement," or slow but constant incremental improvements being made in all areas of business operations.
Small-scale improvements are considered to be less risky than a major overhaul of a system or process. The
slow accumulation of small developments in quality and efficiency can, over time, lead to very high quality and
very low costs. Kaizen needs to be a part of the corporate culture. It requires conscious effort to think about
ways that tasks could be done better. This can be difficult to maintain and takes years to show results, but if
done properly, it confers a sustained competitive advantage.

Kaizen also has something to say about standards in manufacturing. If you recall, we said that standard costs
may be either Ideal standards, attainable only under the best possible conditions, or practical, expected
costs, which are challenging to attain, but attainable under normal conditions. Toyota, the company most
recognized for its use of kaizen, would say that standards are temporary and not absolutes. Improvement is
always possible, and the goal is to attain the ideal standard. Even though practical standards are being
attained, the ultimate goal is still not being achieved.

Ideal standards have been adopted by some companies that apply continuous improvement
and other total quality management principles.

A company may use target costing along with kaizen principles to determine what its ideal standard costs are.
This puts the focus on the market because it starts with a target price based on the market price. The market
determines the target price, and the company must attain the target cost in order to realize its desired profit
margin for the product. The Ideal standard is thus defined as the target cost, or the standard cost that will
enable the company to attain its desired cost and desired profit margin. Using Kaizen principles, the company
figures out how it can manufacture the product for the target cost. The standard is achieved through
development of new manufacturing methods and techniques that entail continuous improvement Or the ongoing
search for new ways to reduce costs.
Implementing ideal standards and quality improvements is the heart of the kaizen concept. Kaizen challenges
people to imagine the ideal condition and strive to make the necessary improvements to achieve that ideal.

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