Chapter three:

The modern business environment

The changing business environment

Before the 1970s, barriers of communication and geographical distance limited the extent to which
overseas organisations could compete in domestic markets. Cost increases could often be passed
on to customers and so there were few efforts to maximise efficiency and improve management
practices, or to reduce costs. During the 1970s, however, overseas competitors gained access to
domestic markets by establishing global networks for acquiring raw materials and distributing
high-quality, low-priced goods. To succeed, organisations had to compete against the best
companies in the world.

The changing competitive environment for service organisations

Prior to the 1980s, many service organisations (such as the utilities, the financial services and
airlines industries) were either government-owned monopolies or were protected by a highly-
regulated, non-competitive environment. Improvements in quality and efficiency of
operations or levels of profitability were not expected, and costs increases were often covered by
increasing service prices. Cost systems to measure costs and profitability of individual services
were not deemed necessary. The competitive environment for service organisations changed
radically in the 1980s, however, following privatisation of government-owned monopolies and
deregulation. The resulting intense competition and increasing product range has led to the
requirement for cost management and management accounting information systems which
allow service organisations to assess the costs and profitability of services, customers and markets.

Changing product life cycles

Today's competitive environment, along with high levels of technological innovation and
increasingly discriminating and sophisticated customer demands, constantly threaten a product's
life cycle. Diverse product ranges and demand for ever better products means that product life
cycle have dramatically reduced.

Product life cycle is the 'Period which begins with the initial product specification and ends with
the withdrawal from the market of both the product and its support. It is characterised by defined
stages including research, development, introduction, maturity, decline and abandonment.' (CIMA
Official Terminology) Organisations can no longer rely on years of high demand for products and
so, to compete effectively, they need to continually redesign their products and to shorten the
time it takes to get them to the market place.

In many organisations today, up to 90% of a product's life cycle cost is determined by decisions
made early within the cycle, at the design stage. Management accounting systems that monitor
spending and commitment to spend during the early stages of a product's life cycle are therefore
becoming increasingly important.

Changing customer requirements

Successful organisations in today's competitive environment make customer satisfaction their
priority and concentrate on the following key success factors.

Key success factor Detail

Cost efficiency Not wasting money
Quality Focusing on total quality management (TQM)
Providing a speedier response to customer requests,
ensuring 100% on-time. delivery and reducing the time
Time taken to develop and bring new products to market
Developing a steady stream of innovative new products and
Innovation having the flexibility to respond to customer requirements

They are also taking on board new management approaches.

Approach Detail
A facet of TQM, being a continuous search to reduce costs, eliminate
Continuous waste and improve the quality and performance of activities that increase
improvement customer satisfaction or value

Employee Providing employees with the information to enable them to make

empowerment continuous improvements without authorisation from superiors

Ensuring that all the factors which add value to an organisation's products
– the value chain of research and development, design, production,
Total value-chain marketing, distribution and customer service – are coordinated within the
analysis overall organisational framework

Changing manufacturing systems

Traditionally, manufacturing industries have fallen into a few broad groups according to the
nature of the production process and materials flow.

Type of production

Jobbing industries: Industries in which items are produced individually, often for a specific
customer order, as a 'job'. Such a business requires versatile equipment and
 highly skilled workers to give it the flexibility to turn its hand to a variety
of jobs. The jobbing factory is typically laid out on a functional basis with,
say, a milling department, a cutting department, finishing, assembly and so
on.

Batch processing: Involves the manufacture of standard goods in batches. 'Batch production
is often carried out using functional layouts but with a greater number of
more specialised machines. With a functional layout batches move by
different and complex routes through various specialised departments
travelling over much of the factory floor before they are completed.
Mass production: Involves the continuous production of standard items from a sequence
of continuous or repetitive operations. This sort of production often uses a
product based layout whereby product A moves from a milling machine to
a cutting machine to a paint-spraying machine, product B moves from a
sewing machine to a milling machine to an oven and then to finishing and
so on.

The point is that there is no separate 'milling department' or 'assembly

department' to which all products must be sent to await their turn on the
machines: each product has its own dedicated machine.

In recent years, however, a new type of manufacturing system known as group technology (or
repetitive manufacturing) has emerged. The system involves a flexible or cellular arrangement of
machines which manufacture groups of products having similar manufacturing requirements. By
grouping together facilities required to produce similar products, some of the benefits associated
with flow production systems (lower throughput times, easier scheduling, reduced set-up times
and reduced work in progress) are possible to achieve. Moreover, the increase in customer demand
for product diversity can be satisfied by such a manufacturing system.

Dedicated cell layout

The modern development in this sphere is to merge the flexibility of the functional layout with the
speed and productivity of the product layout. Cellular manufacturing involves a U-shaped flow
along which are arranged a number of different machines that are used to make products with
similar machining requirements.
The machines are operated by workers who are multi-skilled (can operate each machine within
the cell rather than being limited to one operation such as 'lathe-operator', 'grinder', or whatever)
and are able to perform routine preventative maintenance on the cell machines. The aim is to
facilitate just-in-time production and obtain the associated improvements in quality and
reductions in costs.

Cost reduction and value analysis

In today’s environment, businesses are under pressure to offer an increased choice of quality
products at a cost traditionally associated with mass production.
Cost reduction is a planned and positive approach to reducing expenditure. Cost reduction
measures should be planned programmes to reduce costs rather than crash programmes to cut
spending levels. Value analysis is an example of a cost reduction technique. It is a planned,
scientific approach to cost reduction which reviews the material composition of a product and the
product’s design so that modifications and improvements can be made which do not reduce the
value of the product to the customer or user.

Waste
Part of cost reduction may look at elimination of waste. Waste, in this context, results from
activities which do not add value. Examples of activities which do not add value include continuing
production when there is no demand resulting in the build up of unnecessary inventory, or waiting
time, or unnecessary movement of materials or staff. These are all waste activities because they
are unnecessary actions.

Just-in-time (JIT) systems

'Traditional' responses to the problems of improving manufacturing capacity and reducing unit
costs of production might be described as follows.
• Longer production runs
• Fewer products in the product range
• Economic batch quantities
• More overtime
• Reduced time on preventive maintenance, to keep production flowing
In general terms, longer production runs and large batch sizes should mean less disruption, better
capacity utilisation and lower unit costs. Just-in-time systems challenge such 'traditional' views of
manufacture.

Key terms
Just-In-Time (JIT) is a 'System whose objective is to produce or to procure products or
components as they are required by a customer or for use, rather than for stock. A JIT system is a
pull system, which responds to demand, in contrast to a push system, in which stocks act as buffers
between the different elements of the system, such as purchasing, production and sales.'

Just-In-Time Production is a 'Production system which is driven by demand for finished products
whereby each component on a production line is produced only when needed for the next stage.'

Just-In-Time Purchasing is a 'Purchasing system in which material purchases are contracted so

that the receipt and usage of material, to the maximum extent possible, coincide.' (CIMA Official
Terminology)

Although described as a technique in the Official Terminology, JIT is more of a philosophy or

approach to management since it encompasses a commitment to continuous improvement and
the search for excellence in the design and operation of the production management system.

JIT has the following essential elements.

Element Detail
JIT Parts and raw materials should be purchased as near as possible to the time they
purchasing are needed, using small frequent deliveries against bulk contracts.
Close In a JIT environment, the responsibility for the quality of goods lies with the
relationship supplier. A long-term commitment between supplier and customer should
with therefore be established. The supplier is guaranteed a demand for products
suppliers because of being the sole supplier and the supplier can plan to meet the
customer's production schedules. If an organisation has confidence that suppliers
will deliver material of 100% quality, on time, so that there will be no rejects,
returns and hence no consequent production delays, usage of materials can be
matched with delivery of materials and inventories can be kept at near zero
levels. Suppliers are also chosen because of their close proximity to an
organisation's plant.
Uniform All parts of the productive process should be operated at a speed which matches
loading the rate at which the final product is demanded by the customer. Production runs
 will therefore be shorter and there will be smaller inventories of finished goods
because output is being matched more closely to demand (and so storage costs
will be reduced).
Set-up time Machinery set-ups are non-value-added activities (see below) which should be
reduction reduced or even eliminated.
Machine Machines or workers should be grouped by product or component instead of by
cells the type of work performed. The non-value-added activity of materials
movement between operations is therefore minimised by eliminating space
between work stations. Products can flow from machine to machine without
having to wait for the next stage of processing or returning to stores. Lead times
and work in progress are thus reduced.
Quality Production management should seek to eliminate scrap and defective units
during production, and to avoid the need for reworking of units since this stops
the flow of production and leads to late deliveries to customers. Product quality
and production quality are important 'drivers' in a JIT system.
Pull system A Kanban, or signal, is used to ensure that products/ components are only
(Kanban) produced when needed by the next process. Nothing is produced in anticipation
of need, to then remain in inventory, consuming resources.
Preventative Production systems must be reliable and prompt, without unforeseen delays and
maintenance breakdowns. Machinery must be kept fully maintained, and so preventative
maintenance is an important aspect of production.
Employee Workers within each machine cell should be trained to operate each machine
involvement within that cell and to be able to perform routine preventative maintenance on
the cell machines (i.e. to be multi-skilled and flexible).

4.1 Value added

JIT aims to eliminate all non-value-added costs. Value is only added while a product is actually
being processed. Whilst it is being inspected for quality, moving from one part of the factory to
another, waiting for further processing and held in store, value is not being added. Non value-
added activities (or diversionary activities) should therefore be eliminated.

'A value-added cost is incurred for an activity that cannot be eliminated without the customer's
perceiving deterioration in the performance, function, or other quality of a product. The cost of a
picture tube in a television set is value-added. The costs of those activities that can be eliminated
without the customer's perceiving deterioration in the performance, function, or other quality of a
product are non-value-added. The costs of handling the materials of a television set through
successive stages of an assembly line may be non-value-added.

Problems associated with JIT

JIT should not be seen as a panacea for all the endemic problems associated with Western
manufacturing. It might not even be appropriate in all circumstances.
(a) It is not always easy to predict patterns of demand.
(b) JIT makes the organisation far more vulnerable to disruptions in the supply chain.
(c) JIT, originated by Toyota, was designed at a time when all of Toyota's manufacturing was done
within a 50 km radius of its headquarters. Wide geographical spread, however, makes this
difficult.

Standard costing and JIT

Some commentators have argued that traditional variance analysis is unhelpful and potentially
misleading in the modern organisation, and can make managers focus their attention on the wrong
issues. Here are just two examples.

(a) Efficiency variance. Traditional variance analysis emphasises that adverse efficiency
variances should be avoided, which means that managers should try to prevent idle time and keep
up production. In an environment where the focus is on improving continuously, JIT should be
used.
In these circumstances, manufacturing to eliminate idle time could result in the production of
unwanted products that must be held in store and might eventually be scrapped. Efficiency
variances could focus management attention on the wrong problems.

(b) Materials price variance. In a JIT environment the key issues in materials purchasing are
supplier reliability, materials quality, and delivery in small order quantities. Purchasing managers
should not be shopping around every month looking for the cheapest price. Many JIT systems
depend on long-term contractual links with suppliers, which mean that material price variances are
not relevant for management control purposes.

Total quality management (TQM)

Quality means 'the degree of excellence of a thing' - how well made it is, or how well performed
if it is a service, how well it serves its purpose, and how it measures up against its rivals. These
criteria imply two things.
• That quality is something that requires care on the part of the provider.
• That quality is largely subjective - it is in the eye of the beholder, the customer.

The management of quality

The management of quality is the process of:
(a) Establishing standards of quality for a product or service
(b) Establishing procedures or production methods which ought to ensure that these required
standards of quality are met in a suitably high proportion of cases
(c) Monitoring actual quality
(d) Taking control action when actual quality falls below standard
Take the postal service as an example. The postal service might establish a standard that 90% of
first class letters will be delivered on the day after they are posted, and 99% will be delivered
within two days of posting.
(a) Procedures would have to be established for ensuring that these standards could be met
(attending to such matters as frequency of collections, automated letter sorting, frequency of
deliveries and number of staff employed).
(b) Actual performance could be monitored, perhaps by taking samples from time to time of letters
that are posted and delivered.
(c) If the quality standard is not being achieved, management should take control action (employ
more postal workers or advertise the use of postcodes again).

NOTE: Quality management becomes total (Total Quality Management (TQM)) when it is
applied to everything a business does.

Total Quality Management (TQM) is an 'Integrated and comprehensive system of planning and
controlling all business functions so that products or services are produced which meet or exceed
customer expectations. TQM is a philosophy of business behaviour, embracing principles such as
employee involvement, continuous improvement at all levels and customer focus, as well as being
a collection of related techniques aimed at improving quality such as full documentation of
activities, clear goal setting and performance measurement from the customer perspective.' (CIMA
Official Terminology)

Exam skills
As you learn the mechanics of these new management approaches, try not to view each one in
isolation. For example, a question may require you to give reasons why the adoption of TQM is
important in a JIT environment.

Get it right, first time

One of the basic principles of TQM is that the cost of preventing mistakes is less than the cost of
correcting them once they occur. The aim should therefore be to get things right first time. Every
mistake, delay and misunderstanding, directly costs organisation money through wasted time and
effort, including time taken in pacifying customers. The lost potential for future sales because of
poor customer service must also be taken into account.

Continuous improvement
A second basic principle of TQM is dissatisfaction with the status quo: the belief that it is always
possible to improve and so the aim should be to 'get it more right next time'.
Quality assurance procedures
Because TQM embraces every activity of a business, quality assurance procedures cannot be
confined to the production process but must also cover the work of sales, distribution and
administration departments, the efforts of external suppliers, and the reaction of external
customers.

Area Procedure

Quality assurance of goods inwards Suppliers' quality assurance schemes are being
used increasingly. This is where the supplier
guarantees the quality of goods supplied.

Inspection of output The aim of carrying out inspection samples is

to satisfy management that quality control in
production is being maintained.

Monitoring customer reaction Customer complaints should be monitored.

Some companies survey customers on a
regular basis

Employees and quality To ensure that employees have a positive

attitude towards quality

• Responsibility for quality checking could be

given to the worker himself

• Inter-group competition to meet and beat

quality standards could be introduced

Problems can therefore be overcome by changing people's attitudes rather than teaching them
new tricks. The key issue is to instil understanding of, and commitment to, working practices
that lead to quality.

Empowerment
Workers themselves are frequently the best source of information about how (or how not) to
improve quality. Empowerment therefore has two key aspects.
(a) Allowing workers to have the freedom to decide how to do the necessary work, using the
skills they possess and acquiring new skills as necessary to be an effective team member.
(b) Making workers responsible for achieving production targets and for quality control.

Design for quality

A TQM environment aims to get it right first time, and this means that quality, not faults, must
be designed into the organisation's products and operations from the outset.
Quality control happens at various stages in the process of designing a product or service.
(a) At the product design stage, quality control means trying to design a product or service so that
its specifications provide a suitable balance between price and quality (of sales and delivery, as
well as manufacture) which will make the product or service competitive.
(b) Production engineering is the process of designing the methods for making a product (or
service) to the design specification. It sets out to make production methods as efficient as
possible, and to avoid the manufacture of sub-standard items.
(c) Information systems should be designed to get the required information to the right person at
the right time; distribution systems should be designed to get the right item to the right person at
the right time; and so on.

Quality control and inspection

A distinction should be made between quality control and inspection.
(a) Quality control involves setting controls for the process of manufacture or service delivery. It
is an aimed at preventing the manufacture of defective items or the provision of defective
services.
(b) Inspection is a technique of identifying when defective items are being produced at an
unacceptable level. Inspection is usually carried out at three main points.
(i) Receiving inspection – for raw materials and purchased components
(ii) Floor or process inspection for WIP
(iii) Final inspection or testing for finished goods

Standard costing and TQM

Standard costing concentrates on quantity and ignores other factors contributing to an
organisation's effectiveness. In a total quality environment, however, quantity is not an issue,
quality is. Effectiveness in such an environment therefore centres on high quality output (produced
as a result of high quality input); the cost of failing to achieve the required level of effectiveness
is not measured in variances, but in terms of the internal and external failure costs which would
not be identified by traditional standard costing analysis.
Standard costing might measure, say, labour efficiency in terms of individual tasks and the level
of output. In a total quality environment, labour is most likely to be viewed as a number of
multi-task teams who are responsible for completion of a part of the production process. The
effectiveness of such a team is more appropriately measured in terms of re-working required,
returns from customers, defects identified in subsequent stages of production and so on.
In a TQM environment there are likely to be minimal rate variances if the workforce are paid a
guaranteed weekly wage. Fixed price contracts, with suppliers guaranteeing levels of quality, are
often a feature, especially if a JIT system is also in place, and so there are likely to be few, if any,
material price and usage variances.
So can standard costing and TQM exist together? Or do we need to SCRAP standard costing
in a TQM environment?

Standard costing v TQM

Standard costs often incorporate a planned level of scrap in material standards.
This is at odds with the TQM aim of 'zero defects' and there is no motivation to
Scrap 'get it right first time'.

Continual improvements should alter quantities of inputs, prices and so on,

Continual whereas standard costing is best used in a stable, standardised, repetitive
changes environment.

Standard costing systems make individual managers responsible for the

variances relating to their part of the organisation's activities. A TQM
programme, on the other hand, aims to make all personnel aware of, and
responsible for, the importance of supplying the customer with a quality
Responsibility product.

Attainable standards, which make some allowance for wastage and

Attainable inefficiencies, are commonly set. The use of such standards conflicts with the
standards elimination of waste which is a vital ingredient of a TQM programme.

Predetermined Predetermined standards conflict with the TQM philosophy of continual

standards improvement.

Problems implementing TQM in an organisation

(a) It can be de-motivating because ‘perfection’ is hard to achieve.
(b) It relies heavily on the quality of suppliers.
(c) Change management can be difficult depending on the culture of the business.

Criticisms of TQM
The operation of TQM in practice has not always worked as intended:
● Empirical studies suggest that ‘empowerment’ often amounts to the delegation of additional
duties to employees. Limits have to be placed on what employees can do, so empowerment is often
associated with rules, bureaucracy and form-filling. That apart, many employees find most
satisfaction from outside work activities and are quite happy to confine themselves to doing what
they are told while at work. The proponents of TQM are often very work-centred people
themselves and tend to judge others by their own standards. Teams do not always contribute to
organisational effectiveness? Just calling a group of people who work in the same office ‘ a team
’ does not make it a team. A team requires a high level of cooperation and consensus. Many
competitive and motivated people find working in a team environment to be uncongenial. It means
that every time you want to do anything you have to communicate with and seek approval from
fellow team members.

In practice, this is likely to involve bureaucracy and form-filling.

Many organisations that have attempted TQM have found that it involves a great deal of additional
bureaucracy. When the attempt is anything less than fully committed, then the results can be
unfortunate. Some organisations have found themselves with two parallel structures. A new TQM
structure is set up complete with committees and teams – but the old hierarchical structure remains
in existence which actually amounts to ‘the real organisation’. One UK study (A.T. Kearney)
reporter found that only 20 per cent of organizations who had tried TQM reported positive results
from it.

Kaizen Costing:
A philosophy that sees improvement in productivity as a gradual and methodical process. Kaizen
is a Japanese term meaning “change for the better”. The concept of Kaizen encompasses a wide
range of ideas; it involves making the work environment more efficient and effective by creating
a team atmosphere, improving everyday procedures, ensuring employee satisfaction and making a
job more fulfilling, less tiring and safer.
A method of costing that involves making continual, incremental improvements to the production
process during the manufacturing phase of the product/service lifecycle, typically involving setting
targets for cost reduction. Some of the key objectives of the Kaizen philosophy include the
elimination of waste, quality control, just-in-time delivery, standardized work and the use of
efficient equipment.
An example of the Kaizen philosophy in action is the Toyota production system, in which
suggestions for improvement are encouraged and rewarded, and the production line is stopped
when a malfunction occurs.

Kaizen Costing:
This is a Japanese term for a number of cost reduction steps that can be used subsequent to issuing
a new product design to the factory floor (first used in Toyota). Some of the activities in the kaizen
costing methodology include the elimination of waste in the production, assembly, and distribution
processes, as well as the elimination of work steps in any of these areas. Though these points are
also covered in the value engineering phase of target costing, the initial value engineering may not
uncover all possible cost savings.

Thus, kaizen costing is really designed to repeat many of the value engineering steps for as long
as a product is produced, constantly refining the process and thereby stripping out extra costs. The
cost reductions resulting from kaizen costing are much smaller than those achieved with value
engineering but are still worth the effort since competitive pressures are likely to force down the
price of a product over time, and any possible cost savings allow a company to still attain its
targeted profit margins while continuing to reduce cost.

The use of multiple generations of products to meet the challenge of gradually reducing costs. The
market price continues to drop over time, which forces a company to use both target and kaizen
costing to reduce costs and retain its profit margin.

However, prices eventually drop to the point where margins are reduced, which forces the
company to develop a new product with lower initial costs and for which kaizen costing can again
be used to further reduce costs. This pattern may be repeated many times as a company forces its
costs down through successive generations of products. The exact timing of a switch to a new
product is easy to determine well in advance since the returns from kaizen costing follow a trend
line of gradually shrinking savings and prices also follow a predictable downward track, plotting
these two trend lines into the future reveals when a new generation of product must be ready for
production.

Costs of quality and cost of quality reports

Cost of quality reports highlight the total cost to an organisation of producing products or services
that do not conform to quality requirements. Four categories of cost should be reported: prevention
costs, appraisal costs, internal failure costs and external failure costs.

Costs of quality
When we talk about quality-related costs you should remember that a concern for good quality
saves money; it is poor quality that costs money.

Key terms
The cost of quality is the 'Difference between the actual cost of producing, selling and supporting,
products or services and the equivalent costs if there were no failures during production or usage.'
The cost of quality can be analysed into:
Cost of conformance – 'Costs of achieving specified quality standards'
Cost of prevention – 'Costs incurred prior to or during production in order to prevent substandard
or defective products or services from being produced'
Cost of appraisal – 'Costs incurred in order to ensure that outputs produced meet required quality
standards' (CIMA Official Terminology)
Cost of non-conformance is 'The cost of failure to deliver the required standard of quality.'
Cost of internal failure – 'Costs arising from inadequate quality which are identified before the
transfer of ownership from supplier to purchaser'
Cost of external failure – 'Costs arising from inadequate quality discovered after the transfer of
ownership from supplier to purchaser.' (CIMA Official Terminology)

Quality-related cost Example

Prevention costs Quality engineering

Design/development of quality control/inspection equipment

Maintenance of quality control/inspection equipment

Administration of quality control

Training in quality control

Appraisal costs Acceptance testing

Inspection of goods inwards

Inspection costs of in-house processing

Performance testing

Internal failure costs Failure analysis

Re-inspection costs

Losses from failure of purchased items

Losses due to lower selling prices for sub-quality goods

Costs of reviewing product specifications after failures

External failure costs Administration of customer complaints section

Costs of customer service section

Product liability costs

Cost of repairing products returned from customers

Cost of replacing items due to sub-standard products/marketing errors

The cost of conformance is a discretionary cost which is incurred with the intention of eliminating
the costs of internal and external failure. The cost of non-conformance, on the other hand, can only
be reduced by increasing the cost of conformance. The optimal investment in conformance costs
is when total costs of quality reach a minimum (which may be below 100% quality conformance).
To achieve 0% defects, costs of conformance must be high. As a greater proportion of defects are
accepted, however, these costs can be reduced. At a level of 0% defects, costs of non-conformance
should be nil but these will increase as the accepted level of defects rises. There should therefore
be an acceptable level of defects at which the total costs of quality are at a minimum. This is
illustrated in the following diagram

$
Total costs
Cost of non conformance

Cost of conformance
0 1 2 3 4 % defects

Cost of quality reports

Shown below is a typical cost of quality report. Some figures in the report, such as the contribution
forgone due to sales lost because of poor quality, may have to be estimated, but it is better to
include an estimate rather than omit the category from the report.
The report has the following uses.
(a) By expressing each cost category as a percentage of sales revenue, comparisons can be made
with previous periods, divisions within the group or other organisations, thereby highlighting
problem areas. A comparison of the proportion of external failure costs to sales revenue with the
figures for other organisations, for example, can provide some idea of the level of customer
satisfaction.
(b) It can be used to make senior management aware of how much is being spent on quality-
related costs.
(c) It can provide an indication of how total quality costs could be reduced by a more sensible
division of costs between the four categories. For example, an increase in spending on prevention
costs should reduce the costs of internal and external failure and hence reduce total spending.

Exercise 1:
ABC is a food producer that makes low cost processed food that it sells to supermarkets. ABC
produces only one type of processed food product and production techniques have remained
largely unchanged for a number of years.
Over recent months, sales have been falling steadily. Consumer tastes are changing to favour
natural ingredients and supermarkets have reflected this in the products that they offer for sale.
ABC is keen to address the decline in sales and recently held a meeting to discuss the performance
of the organisation. The Management Accountant suggested to the Managing Director that the
performance of ABC could be improved by implementing Total Quality Management (TQM)
principles and adopting Kaizen costing concepts. Currently the control systems of ABC focus on
material price and usage.
The Managing Director is sceptical of the Management Accountant’s suggestions and is unclear
as to whether they are suitable for the company.

Required:

(a) Explain TWO concepts of Kaizen costing. [6 marks]

(b) Explain THREE conditions that must exist for TQM to be successfully implemented at
ABC. [9 marks]

Exercise 2:
One of your clients is concerned that the management and control of stocks is not receiving
sufficient attention within her organisation and is keen to learn more about it.

Required:
Draft a report which:
(a) Describes the costs associated with holding stock. (4 marks)
(b) Outlines the advantages and disadvantages of the following methods of valuing stock:
(i) FIFO method;
(ii) AVCO method. (6 marks)
(c) Describes the key features of a Just-in-Time system. (5 marks)
(d) Explain the potential benefits for a company from using a just-in-time (JIT) production
system.

Exercise 3:
a) State FIVE financial benefits of a Just in Time (JIT) system. (10 marks)
b) A consequence of the introduction of just-in-time manufacturing methods is usually
increased quality costs. Briefly describe the four categories of quality costs.(10 marks)
 Chapter four:
Modern costing techniques

The theory of constraints (TOC)

Theory of constraints is a set of concepts developed in the USA which aim to identify the binding
constraints in a production system and which strive for evenness of production flow so that the
organisation works as effectively as possible. No inventories should be held, except prior to the
binding constraint. Its key financial concept is to turn materials into sales as quickly as possible,
thereby maximizing throughput and the net cash generated from sales. This is to be achieved by
striving for balance in production processes, and so evenness of production flow is an important
aim.

Key terms
Theory of constraints (TOC) is a 'Procedure based on identifying bottlenecks (constraints),
maximising their use, subordinating other facilities to the demand of the bottleneck facilities,
alleviating bottlenecks and re-evaluating the whole system.'

A constraint (or bottleneck resource) is an 'Activity, resource or policy that limits the ability to
achieve an objective.

Managing constraints
One process will inevitably act as a bottleneck (or limiting factor) and constrain throughput.
This is known as a binding constraint in TOC terminology. In order to manage constraints
effectively, Goldratt has proposed a five-step process of ongoing improvement. The process
operated as a continuous loop.

Step 1: Identify the binding constraint/bottleneck

Step 2: Exploit
The highest possible output must be achieved from the binding constraint. This output must
never be delayed and as such a buffer inventory should be held immediately before the
constraint.

Step 3: Subordinate
Operations prior to the binding constraint should operate at the same speed as it so that
WIP does not build up.

Step 4: Elevate the system bottleneck. Steps should be taken to increase resources or
improve its efficiency.
 Step 5: Return to Step 1
The removal of one bottleneck will create another elsewhere in the system.

Throughput contribution = sales revenue – direct material cost

Conversion cost (in TOC) = all operating costs except direct material cost (ie all costs except
totally variable costs)
Investment cost = inventory, equipment, building costs and so on

Throughput contribution
The aim of TOC is to maximise throughput contribution while keeping conversion and
investment costs to a minimum. If a strategy for increasing throughput contribution is being
considered it will therefore only be accepted if conversion and investment costs increase by a lower
amount than contribution. It is important to realise that TOC is not an accounting system but a
production system.

Throughput accounting
Throughput accounting is the accounting system developed in the UK, based on the theory of
constraints and JIT. It measures the throughput contribution per factory hour. It is very similar to
marginal costing but can be used to make longer-term decisions about production
equipment/capacity. The concept of throughput accounting has been developed from TOC as an
alternative system of cost and management accounting in a JIT environment.

Throughput accounting (TA) is an approach to accounting which is largely in sympathy with the
JIT philosophy. In essence, TA assumes that a manager has a given set of resources available.
These comprise existing buildings, capital equipment and labour force. Using these resources,
purchased materials and parts must be processed to generate sales revenue. Given this scenario the
most appropriate financial objective to set for doing this is the maximisation of throughput
(Goldratt and Cox, 1984) which is defined as: sales revenue less direct material cost.'
(Tanaka, Yoshikawa, Innes and Mitchell, Contemporary Cost Management)
The Official Terminology's definition of throughput accounting (TA) is 'Variable cost
accounting presentation based on the definition of throughput (sales minus material and
component costs).'
TA is different from all other management accounting systems because of what it emphasises.
• Firstly throughput
• Secondly inventory minimisation
• Thirdly cost control
TA is based on three concepts.

Concept 1
In the short run, most costs in the factory (with the exception of materials costs) are fixed. Because
TA differentiates between fixed and variable costs it is often compared with marginal costing and
some people argue that there is no difference between marginal costing and throughput
accounting. For this reason TA is sometimes referred to as super variable costing and indeed there
are some similarities in the assumptions underlying the two methods. However, on marginal
costing direct labour costs are usually assumed to be variable costs. Years ago this assumption was
true, but employees are not usually paid piece rate today and they are not laid off for part of the
year when there is no work, and so labour cost is not truly variable. If this is accepted the two
techniques are identical in some respects, but marginal costing is generally thought of as being
purely a short-term decision-making technique while TA, or at least TOC, was conceived with the
aim of changing manufacturing strategy to achieve evenness of flow.
It is therefore much more than a short-term decision technique.
Because TA combines all conversion costs together and does not attempt to examine them in detail
it is particularly suited to use with activity based costing (ABC), which examines the behaviour of
these costs and assumes them to be variable in the long run.

Concept 2
In a JIT environment, all inventories are a 'bad thing' and the ideal inventory level is zero.
Products should not be made unless there is a customer waiting for them. This means unavoidable
idle capacity must be accepted in some operations, but not for the operation that is the bottleneck
of the moment. There is one exception to the zero inventory policy, being that a buffer inventory
should be held prior to the bottleneck process.

Concept 3
Profitability is determined by the rate at which 'money comes in at the door' (that is, sales are
made) and, in a JIT environment, this depends on how quickly goods can be produced to satisfy
customer orders. Since the goal of a profit-orientated organisation is to make money, inventory
must be sold for that goal to be achieved.
The buffer inventory and any other work in progress or finished goods inventory should be valued
at material cost only until the output is eventually sold, so that no value will be added and no profit
earned until the sale takes place. Producing output just to add to work in progress or finished goods
inventory creates no profit, and so should not be encouraged.

Bottleneck resources
The aim of modern manufacturing approaches is to match production resources with the demand
for them. This implies that there are no constraints, termed bottleneck resources in TA, within an
organisation. The throughput philosophy entails the identification and elimination of these
bottleneck resources. Where they cannot be eliminated production must be limited to the capacity
of the bottleneck resource in order to avoid the build-up of work in progress. If a rearrangement of
existing resources or buying-in resources does not alleviate the bottleneck, investment in new
equipment may be necessary.

The elimination of one bottleneck is likely to lead to the creation of another at a previously
satisfactory location, however. The management of bottlenecks therefore becomes a primary
concern of the manager seeking to increase throughput.
(a) There is nothing to be gained by measuring and encouraging the efficiency of machines that do
not govern the overall flow of work.
(b) Likewise, there is little point in measuring the efficiency of production staff working on non-
bottleneck processes.
(c) Bonuses paid to encourage faster working on non-bottleneck processes are wasted and could
lead to increased storage costs and more faulty goods.

Other factors that might limit throughput other than a lack of production resources
(bottlenecks)
(a) The existence of an non-competitive selling price.
(b) The need to deliver on time to particular customers, which may disrupt normal production flow.
(c) The lack of product quality and reliability, which may cause large amounts of rework or an
unnecessary increase in production volume.
(d) Unreliable material suppliers, which will lead to poor quality products that require rework.

Identifying the bottleneck resource

It may not always be obvious which the bottleneck resource is and a process of trial and error for
a few periods can be an expensive and inefficient way of attempting to identify it.
If the resource constraint is machine capacity, it is possible to identify the constrained machine
through the calculation of machine utilisation rates.

Exercise 1:
A company produces three products using three different machines. The following data is available
for the latest period.
Product L Product M Product N

Machine hours Hours per Hours per Hours per

required:
unit unit unit

Mixing machine 2 5 3

Cutting machine 3 4 2

Finishing machine 1 2 2
 Sales demand 2,700 units 1,200 units 2,500 units

Maximum capacity is as follows.

Hours available
Mixing machine 22,000
Cutting machine 15,400
Finishing machine 7,300
Example: machine utilisation rates
Required:
(a) Calculate the machine utilisation rate for each machine
(b) Identify which of the machines is the bottleneck resource

Throughput measures
Return per time period
In a throughput accounting environment, the overall focus of attention is the rate at which the
organisation can generate profits. To monitor this, the return on the throughput through the
bottleneck resource is monitored using:

Return per time period = [sales revenue −material costs]/time period

This measure shows the value added by an organisation during a particular time period. Time
plays a crucial role in the measure, so managers are strongly encouraged to remove bottlenecks
that might cause production delays.

Return per time period on bottleneck resource

In throughput accounting, the limiting factor is the bottleneck. The return per time period measure
can be adapted and used for ranking products to optimise production in the short term.
Product return per minute = [sales price −material costs]/minutes on key/bottleneck resource

Ranking products on the basis of throughput contribution per minute (or hour) on the bottleneck
resource is similar in concept to maximising contribution per unit of limiting factor. Such
product rankings are for short-term production scheduling only. In throughput accounting,
bottlenecks should be eliminated and so rankings may change quickly. Customer demand can, of
course, cause the bottleneck to change at short notice too.
Solution
Rankings by TA product return and by contribution per unit of limiting factor may be different.
Which one leads to profit maximisation? The correct approach depends on the variability or
otherwise of labour and variable overheads, which in turn depends on the time horizon of the
decision. Both are short-term profit maximisation techniques and given that labour is nowadays
likely to be fixed in the short term, it could be argued that TA provides the more correct solution.
An analysis of variable overheads would be needed to determine their variability.

Bear in mind that the huge majority of organisations cannot produce and market products based
on short-term profit considerations alone. Strategic-level issues such as market developments,
product developments and stage reached in the product life cycle must also be taken into account.

TA ratio
Products can also be ranked according to the throughput accounting ratio (TA ratio).

TA ratio = throughput contribution or value added per time period/conversion cost per time
period

= [(sales- material costs) per time period]/ (labour + overhead) per time period

This measure has the advantage of including the costs involved in running the factory. The
higher the ratio, the more profitable the company.
A profitable product should have a ratio greater than one. If a product's ratio is less than one the
organisation is losing money every time that product is produced.
Here's an example. Note the figures are in $ per hour.

Product A Product B

$ per hour $ per hour

Sales price 100 150

Material cost (40) (50)

Throughput 60 100

Conversion cost (50) (50)

Profit 10 50

TA ratio 60/50=1.2 100/50=2.0

Profit will be maximised by manufacturing as much of product B as possible.

Exercise 2:
Each unit of product B requires 4 machine hours. Machine time is the bottleneck resource, there
being
650 machine hours available per week.
B is sold for$120 per unit and has a direct material cost of$35 per unit. Total factory costs are
$13,000 per week.
Required
Calculate the return per factory hour and the TA ratio for product B.

Effectiveness measures and cost control

Traditional efficiency measures such as standard costing variances and labour ratios are unsuitable
in a TA environment because traditional efficiency should not be encouraged (as the labour force
should not produce just for inventory).
Effectiveness is a more important issue. The current effectiveness ratio compares current levels of
effectiveness with the standard.
Current effectiveness ratio = standard minutes of throughput achieved/minutes available

Is it good or bad?
TA is seen by some as too short term, as all costs other than direct material are regarded as fixed.
This is not true. But it does concentrate on direct material costs and does nothing for the control
of other costs. These characteristics make throughput accounting a good complement for activity
based costing (ABC), as ABC focuses on labour and overhead costs. TA attempts to maximise
throughput whereas traditional systems attempt to maximise profit. By attempting to maximise
throughput an organisation could be producing in excess of the profit-maximising output.

Where TA helps direct attention

• Bottlenecks • Reducing the response time to customer demand
• Key elements in making profits • Evenness of production flow
• Inventory reduction • Overall effectiveness and efficiency

Exercise 3:
Corrie produces three products, X, Y and Z. The capacity of Corrie's plant is restricted by process
alpha. Process alpha is expected to be operational for eight hours per day and can produce 1,200
units of X per hour, 1,500 units of Y per hour, and 600 units of Z per hour.
Selling prices and material costs for each product are as follows.

Product Selling price Material cost Throughput contribution

$ per unit $ per unit $ per unit
X 150 70 80
Y 120 40 80
Z 300 100 200
Conversion costs are $720,000 per day.
Required:
(a) Calculate the profit per day if daily output achieved is 6,000 units of X, 4,500 units of Y and
1,200 units of Z.
(b) Determine the efficiency of the bottleneck process given the output in (a).
(c) Calculate the TA ratio for each product.
(d) In the absence of demand restrictions for the three products, advise Corrie's management on
the optimal production plan.

Exercise 4:
A company’s binding constraint is the capacity of machine M. The throughput accounting (TA)
ratio for product P on machine M is 1.4.
Explain how the TA ratio is calculated and state FOUR actions that management could consider
to improve the TA ratio for product P.

Solution:
Binding constraints and TA ratio
The throughput accounting (TA) ratio is calculated as follows.
TA ratio = throughput per time period /conversion cost per time period
= (sales −material costs) per time period /conversion cost per time period

Actions that could be considered to improve the TA ratio are as follows.

1 Increase the selling price of product P. This will increase the throughput per time period.
2 Reduce the material cost per unit of product P. This will also increase the throughput per time
period.
3 Reduce the total expenditure on conversion costs. This would reduce the conversion cost per
time period.
4 Change the working practices on machine M to increase the number of hours of capacity
available. This should be achieved without extra conversion cost being incurred, perhaps by
altering the method of setting up the machine, to improve productivity. This action would reduce
the conversion cost per time period.

Throughput accounting in service and retail industries

Sales staff has always preferred to use a marginal costing approach so that they can use their
discretion on discounts, and retail organisations have traditionally thought in terms of sales
revenue less the bought in price of goods. The throughput accounting approach is therefore nothing
new to them. Throughput accounting can be used very effectively in support departments and
service industries to highlight and remove bottlenecks. For example, if there is a delay in
processing a potential customer's application, business can be lost or the potential customer may
decide not to proceed. Sometimes credit rating checks are too detailed, slowing the whole
procedure unnecessarily and delaying acceptance from say 24 hours to eight days.
A similar problem could occur in hospitals where work that could be done by nurses has to be
carried out by doctors. Not only does this increase the cost of the work but it may well cause a
bottleneck by tying up a doctor's time unnecessarily.

Back-flush accounting
Back-flush accounting is a method of accounting that can be used with JIT production systems.
It saves a considerable amount of time as it avoids having to make a number of accounting entries
that are required by a traditional system. Back-flush accounting is the name given to the method
of keeping cost accounts employed if back-flush costing is used. The two terms are almost
interchangeable.

Traditional costing systems use sequential tracking (also known as synchronous tracking) to
track costs sequentially as products pass from raw materials to work in progress, to finished goods
and finally to sales. In other words, material costs are charged to WIP when materials are issued
to production, direct labour and overhead costs are charged in a similar way as the cost is incurred
or very soon after. If a production system such as JIT is used, sequentially tracking means that all
entries are made at almost the same moment and so a different accounting system can be used. In
back-flush costing/accounting, costs are calculated and charged when the product is sold, or when
it is transferred to the finished goods store.

Back-flush costing is 'A method of costing, associated with a JIT production system, which
applies cost to the output of a process. Costs do not mirror the flow of products through the
production process, but are attached to the output produced (finished goods inventory and cost of
sales), on the assumption that such back-flushed costs are a realistic measure of the actual costs
incurred.' The CIMA definition above omits the fact that budgeted or standard costs are used to
work backwards to 'flush' out manufacturing costs for the units produced. (Hence the rather
unattractive name for the system!) The application of standard costs to finished goods units, or to
units sold, is used in order to calculate cost of goods sold, thereby simplifying the costing system
and creating savings in administrative effort. In a true back-flush accounting system, records of
materials used and work in progress are not required as material cost can be calculated from either
finished goods or goods sold.

Back-flush costing runs counter to the principle enshrined in IAS 2, and the staple of cost
accounting for decades, that inventory and WIP should be accounted for by calculating cost and
net realisable value of 'specific individual items of inventory'. The substantial reduction in
inventories that is a feature of JIT means that inventory valuation is less relevant, however,
and therefore the costing system can be simplified to a considerable extent. Back-flush costing is
therefore appropriate for organisations trying to keep inventories to the very minimum. In such
circumstances, the recording of every little increase in inventory value, as each nut and bolt is
added, is simply an expensive and non-value-added activity that should be eliminated.

Possible problems with back-flush costing

(a) It is only appropriate for JIT operations where production and sales volumes are
approximately equal. It is not appropriate for manufacturing businesses which have high inventory
levels.
(b) Some people claim that it should not be used for external reporting purposes. If, however,
inventories are low or are practically unchanged from one accounting period to the next,
operating income and inventory valuations derived from back-flush accounting will not be
materially different from the results using conventional systems. Hence, in such
circumstances, back-flush accounting is acceptable for external financial reporting.
(c) It is vital that adequate production controls exist so that cost control during the production
process is maintained.
(d) Traditional costing systems provide more detailed management information than back-flush
costing systems.

Advantages of back-flush costing

(a) It is much simpler, as there is no separate accounting for WIP.
(b) Even the finished goods account is unnecessary.
(c) The number of accounting entries should be greatly reduced, as are the supporting vouchers,
documents and so on. Accounting costs will be reduced.
(d) The system should discourage managers from producing simply for inventory since working
on material does not add value until the final product is completed or sold.
(e) When inventory levels are low or constant, it gives the same results as traditional costing
methods.

Variants of back-flush costing

(a) Trigger points determine when the entries are made in the accounting system. There will
be either one or two trigger points that trigger entries in the accounts.
(i) Triggered when materials are purchased or received (can be used if suppliers’ deliveries are
unpredictable)
(ii) Triggered when goods are completed (can be used when unpredictability in demand) or when
they are sold (used to motivate staff to focus on sales)

In a true JIT system where no inventories are held the first trigger, when raw materials are
purchased, is unnecessary.
(b) Actual conversion costs are recorded as incurred, just as in conventional recording systems.
Conversion costs are applied to products at the second trigger point based on a standard cost. It is
assumed that any conversion costs not applied to products are carried forward and disposed of at
the period end.
(c) Direct labour is included as an indirect cost in conversion cost with overheads. (Production
is only required when there is demand for it in a JIT system, and so production labour will be paid
regardless of the level of activity.)
(d) All indirect costs are treated as a fixed period expense.

Exercise 5:
A company operates a throughput accounting system. The details per unit of Product C are:
Selling price $28.50
Material cost $9.25
Labour cost $6.75
Overhead costs $6.00
Time on bottleneck resource 7.8 minutes

What is the throughput contribution per hour for Product C?

Exercise 6:
A company manufactures two products A and B. The budget statement below was produced
using a traditional absorption costing approach. It shows the profit per unit for each product
based on the estimated sales demand for the period

Product A $ Product B $
Selling price per unit 46 62
Production costs per unit:
Material costs 18 16
Labour costs 4 10
Overhead costs 8 12
Profit per unit 16 24
Additional information:
Estimated sales demand 6,000 8,000
(units)
Machine hours per unit 0.5 0.8

It has now become apparent that the machine which is used to produce both products has a
maximum capacity of 8,000 hours and the estimated sales demand cannot be met in full. Total
production costs for the period, excluding direct material cost, are $248,000. No inventories are
held of either product.
Required:
(i) Calculate the return per machine hour for each product if a throughput accounting approach
is used.
(ii) Calculate the profit for the period, using a throughput accounting approach, assuming the
company prioritises Product B.

Exercise 7:
CH Ltd operates a throughput accounting system. Product B sells for$27.99, has a material cost
of
$7.52 and a conversion cost of$1.91. The product spends 27 minutes on the bottleneck resource.
What
is the return per factory hour for product B?
A$45.49 B$20.47 C$26.08 D$57.96

Exercise 8:
A company produces three products D, E and F. The statement below shows the selling price and
product costs per unit for each product, based on a traditional absorption costing system

Product D Product E Product F

$ $ $
Selling price per 32 28 22
unit
Variable costs per unit
Direct material 10 8 6
Direct labour 6 4 4
Variable 4 2 2
overhead
Fixed cost per unit
Fixed overhead 9 6 6
Total product 29 20 18
cost
Profit per unit 3 8 4
Additional information:
Demand per 3,000 4,000 5,000
period (units)
Time in Process 20 25 15
A (minutes)
Each of the products is produced using Process A which has a maximum capacity of 2,500 hours
per period.

Required:
a) If a traditional contribution approach is used, the ranking of products, in order of priority,
for the profit maximising product what will be mix?
b) If a throughput accounting approach is used, the ranking of products, in order of priority,
for the profit maximising product what will be mix?

Exercise 9:
Throughput accounting has been described as ‘super variable costing’. Explain why throughput
accounting is sometimes described in this way and identify briefly the differences between
throughput accounting and marginal or variable cost accounting. (10 marks)

Exercise 10:
WAQ produces a single product, X, which passes through three different processes, A, B and C.
The throughput per hour of the three processes is 12, 10 and 15 units of X respectively. The
company works an 8-hour day, 6 days a week, 48 weeks a year. The selling price of X is £150
per unit and its material cost is £30 per unit. Conversion costs are planned to be £24,000 per
week.

Required
(a) Determine the throughput accounting (TA) ratio per day.
(b) Calculate how much the company could spend on equipment to improve the throughput of
process
B if it wished to recover its costs in the following time periods.
2 years
12 weeks
(c) Calculate the revised TA ratio if this money is spent. (10 marks)