Instructor Outline CHAPTER 12 THE PRODUCTION CYCLE As a result of your study of this chapter, you should learn to:

1. Describe the major business activities and related information processing operations performed in the production cycle. 2. Explain how a companys cost accounting system can help it achieve its manufacturing goals. 3. Identify major threats in the production cycle, and evaluate the adequacy of various control procedures for dealing with those threats. 4. Discuss the key decisions that must be made in the production cycle, and identify the information required to make those decisions. Production Cycle The production cycle is a recurring set of business activities and related information processing operations associated with the manufacture of products. Figure 12-1 on page 463 shows how the production cycle is linked to the other subsystems in a companys AIS. A companys AIS plays a vital role in the production cycle. Accurate and timely cost accounting information is essential input to decisions about the following: Product mix (what to produce) Product pricing Resource allocation and planning (e.g., whether to make or buy a product, relative profitability of different products). Cost management (planning and controlling manufacturing costs, evaluating performance). This chapter examines the three major functions of the AIS in the production cycle: 1) capturing and processing data about business activities, 2) storing and organization the data to support decision making, and

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3) providing controls to ensure the reliability of data and the safeguarding of organizational resources. Production Cycle Activities Figure 12-2 on page 464 shows the four basic activities in the production cycle: 1) 2) 3) 4) product design, planning and scheduling, production operations, and cost accounting

Figure 12-2 also depicts the principal information flows between each of those activities and the other AIS cycles. One popular approach to improving manufacturing performance, called Six Sigma, begins with careful measurement and analysis of current processes in order to find ways to improve them. Product Design The first step in the production cycle is product design (circle 1.0 in Figure 12-2). The objective of this activity is to design a product that meets customer requirements in terms of quality, durability and functionality while simultaneously minimizing production costs. FOCUS 12-1 on page 465 explains how simulation software is constantly improving the efficiency and effectiveness of product design. Product life-cycle management (PLM) software consists of three key components: 1. computer-aided design (CAD) software to design new products, 2. digital manufacturing software that simulates how those products will be manufactured, and 3. product data management software that stores all the data associated with products.

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Properly managing the use of complex software like PLM systems, however, is neither cheap nor easy. For example, Boeing, to have all its employees and business partners using the same CAD software; it cost them approximately $120,000 plus training costs. Key Documents and Forms The product design activity creates two main documents: Bill of materials which specifies the part number, description and quantity of each component used in a finished product, and An operations list, which specifies the sequence of steps to follow in making the product, which equipment to use and how long each step should take. Role of the Accountant Accountants should participate in product design because 65% to 80% of product costs are determined at the product design stage. Production costs can be reduced by increasing the number of common components used for a line of related products. Accountants can add value if they not only design the AIS to measure and collect the relevant cost data, but also, if they help the design team to use that data proactively to improve profitability. Planning and Scheduling The second setup in the production cycle is planning and scheduling (circle 2.0 in Figure 12-2 on page 464). Planning Methods Two common methods of production planning are management resource planning and lean manufacturing. Manufacturing resource planning (MRP-II) is an extension of materials resource planning, covered in chapter 11 that seeks to balance existing production capacity and raw materials needs
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to meet forecasted sales demands. MRP systems are often referred to as push manufacturing, because goods are produced in expectation of customer demand. Lean manufacturing extends the principles of just-in-time systems to the entire production process. Lean manufacturing is often referred to as pull manufacturing, because goods are produced in response to customer demand. However, in practice, most lean manufacturing systems develop short-run production plans. Both MRP-II and lean manufacturing systems plan production in advance. MRP-II systems may develop production plans for up to 12 months in advance. Lean manufacturing systems use much shorter planning horizons. Key Documents and Forms The master production schedule (MPS) specifies how much of each product is to be produced during the planning period and when that production should occur (Refer to Figure 12-3 on page 467). The MPS is used to develop a detailed timetable that specifies daily production and to determine if raw materials need to be purchased. To do this, it is necessary to explode the bill of materials to meet the production goals as listed in the MPS (see Table 12-1 on page 468). This figure shows that the planning and scheduling activity produces three other documents: 1) A production order which authorizes the manufacture of a specified quantity of a particular product. A sample of the production order is provided in Figure 12-4 on page 469. 2) A materials requisition authorizes the removal of the necessary quantity of raw materials from the storeroom to the factory location where they will be used. A sample of the materials requisition is provided in Figure 12-5 on page 469. 3) Subsequent transfers of raw materials throughout the factor are documented on move tickets, which identify the parts being transferred, the location to which they are transferred and the

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time of transfer. A sample of the move ticket is provided in Figure 12-6 on page 470. Bar-coding improves the speed and accuracy of recording information about material movements by eliminating the need to manually enter data. More recently, radio-frequency identification (RFID) tags further improve efficiency by eliminating the need for any human intervention in the scanning process. This makes the RFID scanner up to 40 times faster than bar-code scanners. Surveys estimate that as much as 10% to 20% of handling materials in the warehouse is spent on looking for the right product. RFID technology can eliminate this cost. RFID tags have a scanner the broadcast a signal to locate the desired product. Role of the Accountant The accountant must ensure that the AIS collects and reports costs in a manner consistent with the production planning techniques of the company. Lean manufacturing emphasizes working in teams and seeks to maximize the efficiency and synergy of all teams involved in making a particular product. Production Operations The third step in the production cycle is the actual manufacture of products (circle 3.0 in Figure 12-2 on page 464). Using various forms of IT in the production process, such as robots and computercontrolled machinery, is referred to as computer-integrated manufacturing (CIM). Accountants are not required to be experts on every facet of CIM, but they must understand how it affects the AIS. In order to minimize inventory carrying costs, the AIS must maintain accurate perpetual inventory records. This requires integrating information about customer orders (from the revenue cycle) with information about purchases from suppliers (from the expenditure cycle), along with information about labor available (from the
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HR/payroll cycle). Figure 12-7 on page 471 shows the Enterprise Resource Planning systems providing such integration. Every firm requires cost accounting data about the following four facets of its production operations: 1) 2) 3) 4) raw materials used labor hours expended machine operations performed, and other manufacturing overhead costs incurred

Cost Accounting The final step in the production cycle is cost accounting (circle 4.0 in Figure 12-2 on page 464). The three principal objectives of the cost accounting system are: (1) to provide information for planning, controlling and evaluating the performance of production operations; (2) to provide accurate cost data about products for use in pricing and product mix decisions; and (3) to collect and process the information used to calculate the inventory and cost of goods sold values that appear in the companys financial statements. FOCUS 12.2 on page 472 explains how RFID can be especially helpful in accomplishing the first objective. Effective management of production activities requires real-time information about the status of machinery and equipment. RFID capabilities embedded in new production machinery enable devices to continuously transmit information about their condition. Schneider Electrics Square Dbrand circuit breakers alert operators when a breakers performance indicates that it is approaching the time when it will fail. Built-in Internet capabilities mean that the device can automatically send email requests to the manufacturer or maintenance provider to schedule service. RFID tags can also save manufacturers money should there be a need to recall products.

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Type of Accounting System Most companies use either job-order or process costing to assign production costs. Job-order costing assigns costs to specific production batches, or jobs, and is used when the product or service being sold consists of discretely identifiable items. Process costing assigns costs to each process, or work center, in the production cycle, then calculates the average cost for all units produced. Accounting for Fixed Assets The AIS must also collect and process information about the property, plant and equipment used in the production cycle. At a minimum, every organization should maintain the following information about each fixed asset: identifying number, serial number, location, cost date of acquisition, vendor name and address, expected life, expected salvage value, depreciation method, accumulated depreciation to date, improvements, and maintenance services performed

Orders for machinery and equipment almost always involve a formal request for competitive bids by potential suppliers. In addition, acquisitions of fixed assets often are paid for in installments, including interest. RFID tags provide an efficient method for monitoring the location of machinery and equipment.
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Finally, because manufacturing machinery and equipment is often replaced before it is completely worn out, it is important to formally approve and accurately record its sale or disposal. Information Processing Procedures Figure 12-8 on page 474 depicts a typical online AIS for the production cycle. The system shown in Figure 12-8 could be used to implement either a job-order or process costing system. Both systems require accumulating data about four basic kinds of costs: 1) raw materials, 2) direct labor, 3) machinery and equipment, and 4) manufacturing overhead. Raw Materials Usage Data When production is initiated, the issuance of materials requisition triggers a debit to work-in-process for the raw materials sent to production, and a credit when raw materials are not used and returned to inventory. RFID tags improve the efficiency of tracking materials usage. Direct Labor Costs As shown in Figure 12-8, worker enters the data on time spent on each specific job task using online terminals at each factory workstation. Machinery and Equipment Usage Companies implement computer-integrated (CIM) to automate the production process. Data for machinery and equipment used at a workstation and the duration of such use was collected by wiring the factory so that each piece of equipment was linked to the computer. The wired connections are now being replaced with wireless technology. This enables the use of 3-D simulation software to evaluate the effects of modifying shopfloor layout and workflow to easily and quickly implement beneficial changes. Manufacturing Overhead Costs Manufacturing costs that cannot be directly related to the production of a specific product is referred to as manufacturing overhead. Examples

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include factory costs of water, power, and other utilities; miscellaneous supplies; rent, insurance and property taxes. Accountants can play a key role in controlling overhead costs by carefully assessing how changes in product mix affect total manufacturing overhead. Control Objectives, Threats and Procedures A second function of a well-designed AIS is to provide adequate controls to meet the following production cycle objectives: 1. All production activities and fixed asset acquisitions are properly authorized 2. Work-in-process inventories and fixed assets are safeguarded 3. All valid, authorized production cycle transactions are recorded 4. All production cycle transactions are recorded accurately 5. Accurate records are maintained and protected from loss 6. Production cycle activities are performed efficiently and effectively Wherever feasible, use of RFID tags or bar codes can further improve data entry accuracy. Table 12-2 on page 476 lists the major threats and exposures in the production cycle and the additional control procedures, besides adequate documents and records. Product Design Threat 1: Poor Product Design Poor product design drives up costs in several ways to include using too many unique components and poorly designed products. Product design can be improved with accurate data about the relationship between components and finished goods. Planning and Scheduling Threat 2: Over- or Underproduction

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Two related threats in the planning and scheduling process are overproduction and underproduction. Overproduction can result in a supply of goods in excess of short-run demands; thereby creating potential cash flow problems. There is also a risk of carrying inventory items that become obsolete. Underproduction can result in lost sales and dissatisfied customers. More accurate production planning can prevent over- and underproduction. Improvement requires accurate and current sales forecasts from the revenue cycle systems, and data about inventory stocks from the expenditure cycle. Proper approval and authorization of production orders is another control to prevent overproduction of specific items. Threat 3: Suboptimal Investment in Fixed Assets Overinvesting in fixed assets can create excess costs and underinvestment can impair productivity. Both problems reduce profitability. Proper authorization of fixed-asset transactions is important. Holding managers accountable for their departments return on the fixed assets provides additional incentive to control such expenditures. Due to the size of fixed-asset purchases, companies should invite several competing suppliers to provide bids. A document called a request for proposal (RFP), which specifies the desired properties of the asset, is sent to each vendor. Production Operations Threat 4: Theft of Inventories and Fixed Assets To reduce the risk of inventory loss, physical access to inventories should be restricted and all internal movements of inventory should be documented. Proper segregation of duties is important to safeguard inventory. Maintaining physical custody of the raw materials and finished goods
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inventories is the responsibility of the inventory stores department. Department of factory supervisors have primary responsibility for work-inprocess inventories. Internal controls are also needed to safeguard fixed assets. Managers should be assigned responsibility and accountability for fixed assets under their control. Finally, inventories and fixed assets are also subject to loss due to fire or other disasters. Therefore, adequate insurance covered should be maintained to cover such losses and provide for the replacement costs of these assets. Threat 5: Disruption of Operations The high level of automation in production cycle activities means that disasters that disrupt the functioning of information systems can also disrupt manufacturing activities. Backup power sources and uninterruptible power supply devices are required to ensure that critical equipment and machinery is not damaged during a power loss. This will ensure that the production process can continue on schedule. Not only due companies need to have a disaster plan, but companies need to check on their suppliers plan and come up with alternate sources for critical components. General Threats Threat 7: Loss, Alteration or Unauthorized Disclosure of Data Loss or alteration of production data hinders the monitoring of inventory and fixed assets and makes it difficult to ensure that manufacturing activities are being performed efficiently and effectively. Inventory and work-in-process records must be protected from both intentional and accidental losses or damages. Regular back-up of all data files is important. Access controls are also necessary to protect production data because of the potential losses of
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production trade secrets. Unauthorized access also increases the risk of damage to important data files. Passwords and user IDs can limit access to sensitive files. It is important to enforce proper access controls and segregation of duties which requires to controller or CFO to review and suggest appropriate configuration of user rights in integrated AIS packages and ERP systems. Access and processing integrity controls are also needed to ensure the confidentiality and accuracy of production cycle data transmissions between different factories. Threat 8: Poor Performance Inefficiencies in production operations result in increased expenses. Thus, manufacturing activities must be closely monitored and prompt action taken to correct any deviations from standards. Production Cycle Information Needs A third function of the AIS is to provide information useful for decision making. The focus must be on total quality management. Many companies have maintained the cost accounting and production operations information system separately. Both costs and operational data should be integrated into one system. The traditional cost systems have been criticized for not providing adequate information to manage production operations. There are two major criticisms: 1) overhead costs are inappropriately allocated to products, and 2) reports do not accurately reflect the effect of factory automation Criticism 1: Inappropriate Allocation of Overhead Costs Traditional cost systems use volume-driven bases, such as direct labor or machine hours to apply overhead to products. As a result, the costs of products manufactured are overstated. In addition, allocating overhead based on direct labor input can distort costs across products.
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Solution to Criticism 1: Activity Based Costing Activity Based Costing refines a costing system by identifying individual activities as the fundamental cost objects. An activity is an event, task, or unit of work with a specified purpose such as designing products, setting up machines, operating machines and distributing products. Activity Based Costing versus Traditional Cost Systems Following are three significant differences between ABC and traditional approaches to product costing: 1. 2. ABC systems attempt to directly trace a larger proportion of overhead costs to products. Advances in IT make this feasible. ABC systems use a greater number of cost pools to accumulate indirect costs (manufacturing overhead). Whereas most traditional cost systems lump all overhead costs together. ABC systems distinguish three separate categories of overhead: Batch-related overhead. Examples include setup costs, inspections and materials handling. Product-related overhead. These costs are related in the diversity of the companys product line. Examples include research and development, expediting, shipping and receiving, environmental regulations and purchasing. Company-wide overhead. This category includes such costs as rent or property taxes. These costs apply to all products. 3. ABC systems attempt to rationalize the allocation of overhead to products by identifying cost drivers. A cost driver is anything that has a cause and effect relationship on costs. For example, the number of purchase

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orders processed is one cost driver of purchasing department costs. Benefits of ABC Systems ABC systems cost more to run than traditional cost system because they require the collection or more production-related data and in greater detail. They are also more complex. More accurate cost data result in better product mix and pricing decisions, and more detailed cost data to improve managements ability to control and mange total costs. Better Decisions. Traditional cost systems tend to apply too much overhead to some products and too little to others. This leads to two types of problems: 1. Companies may accept sales contracts for some products at prices below their true cost of production. Sales increase, but profits decline. 2. Companies may overprice other products. ABC systems avoid these problems. ABC also uses data to improve product design. Finally, ABC data improve managerial decision making by providing information about the costs associated with specific activities, instead of classifying those costs by financial statement category. Table 12-3 on page 483 shows an example of this rearrangement of data that can improve managerial analysis by focusing attention on key processes. The ABC analysis shows which activities (training, testing, and maintenance and system analysis) are running over budget and which are not. Improved Cost Management. Another advantage of ABC is that it clearly measures the results of managerial actions on overall profitability. ABC systems measure both the amount spent to acquire resources and the consumption of those resources. This distinction is reflected in the following formula:

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Cost of activity capability = Cost of activity used + Cost of unused capacity. To illustrate, consider the receiving function at a manufacturing firm such as AOE. Assume the following: The salary expense for the receiving department is $100,000 Receiving employees can handle 500 shipments The cost per shipment is $200 Assume that 400 shipments are actually received The cost of the receiving activity is $80,000 ($200 X 400 shipments). The remaining $20,000 ($100,000 - $80,000) in salary expense represents the cost of unused capacity. Criticism 2: Misleading Reports The modern approaches to production differ significantly from traditional mass production. One major difference is a marked reduction in finished goods inventory levels, because production is scheduled based on customer demand instead of projections based on prior years. Although, the traditional approach is more beneficial in the long-run, it often creates a short-term decline in profitability. The reason being is that the traditional approach treats inventory as an asset. Thus, the cost of production inventory is not recognized until the products are sold. Solution to Criticism 2: Better Reports and Measures CPAs have now added supplemented the traditional financial statements with reports based on lean accounting. One suggested change involves assigning costs to product lines instead of departments. In addition to this change, accountants should also develop new measures that are designed to focus on issues important to production cycle managers. Throughput: A Measure of Production Effectiveness Throughput represents the number of good units produced in a given period of time. It consists of three factors as shown in the following formula:

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Throughput = (Total units produced/Processing time) X (Processing time/Total time) X (Good units/Total units) Productive capacity: the first term in the formula, shows the maximum number of units that can be produced using current technology. Productive processing time, the second term in the formula indicates the percentage of total production time use to manufacture the product. Yield, the third term in the formula, represents the percentage of good units produced. Information About Quality Control Quality control costs can be divided into four areas: 1. 2. 3. 4. Prevention costs are associated with changes to production processes designed to reduce the product defect rate. Inspection costs are associated with testing to ensure that products meet quality standards. Internal failure costs are associated with reworking, or scrapping products identified as being defective prior to sale. External failure costs result when defective products are sold to customers. They include such costs as product liability claims, warranty and repair expenses, loss of customer satisfaction and damage to the companys reputation.

The ultimate objective of quality control is to get it right the first time. Some companies have found that the most important management decision involves switching from the traditional management by exception philosophy to a continuous improvement viewpoint. Back to Homepage

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