CA Final, Paper 5, Advanced management Accounting, Chapter 1 Developments in Business Environment: Part 5

CA. Anurag Singal B.Com(H), ACA.

Understand the concept of Just in Time (JIT) system

Understand the concept of Manufacturing Resources Planning (MRP)

Understand the concept of “Theory of Constraints”.

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An inventory strategy - employed to increase efficiency and decrease wastage - by receiving goods as and when they are needed in the production process - hence reducing inventory costs.

A JIT system aims at:

• Meeting customer demand in a timely manner • Providing high quality products • Providing products at lowest possible price.

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• Production system driven by demand for finished products

• Each component on a production line is produced only when needed for the next stage

Just-in-time production

• Purchasing system in which purchase contracts are made in such a way that the goods are used as soon as they are received.

Just-in-time purchasing

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Kanban is NOT an inventory control system.

Kanban is a SCHEDULING system. It tells WHAT to produce, WHEN to produce and HOW much to produce.

It is a Lean Manufacturing Tool.

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Material handling costs

reduced Labour idle time

reduced Eliminates

defects at the earliest

Faster response to customer

demand Careful selection

of suppliers

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• Reduces all types of waste Waste costs

• Amount of overhead is reduced Overhead

costs • Inventory related costs which include interest cost,

rent, cost of warehouse equipment, cost of insurance, etc., get reduced

Other costs

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The chief difference between cost allocations under JIT and traditional system is that: • Most of the overhead costs get converted to direct costs.

The costs that can now be charged directly to product are: • Depreciation • Electricity • Material handling • Operating supplies • Repairs and maintenance • Supervision

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Inventory turnover

Set-up time

Customer complaints

Cost of quality

Scrap Customer service

Ideas generated

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Low variety of goods

Vendor reliability

Good communication

Demand stability TQM

Defect free materials

Preventive maintenance

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Lower stock holding means reduction in storage space saving rent and insurance costs

Less working capital involved

Less chances of stock perishing or becoming outdated

Less stock of finished products, hence can cope with sudden changes in demand

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Implementing JIT system involves major overhaul of processes, hence difficult and expensive

Too much dependent on suppliers, hence if stock not delivered on time, whole production process may get delayed

No spare finished product available to meet unexpected orders

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A product costing approach used in JIT environment

Costing is delayed until goods are finished

Standard costs are then flushed backwards through the system to assign costs to the products

Backflushing accounting is employed where the overall business cycle is relatively short and inventory levels are low

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Mahindra & Mahindra (M&M) implemented JIT at their main plant in Nashik with an objective to:

Make all suppliers active participants in the production process. They wanted the suppliers to be able to know of any change in the

whole production process and at the same time contribute actively.

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Benefits: By employing JIT, the Company was able to maintain the least inventory level. Suppliers could see real time the status of their supplies & bill settlement. Set up time was significantly reduced Increase emphasis on supplier relationships.

MRP calculates and maintains an optimum manufacturing plan based on master production schedule, sales forecast, inventory status, open orders and bills of materials.

Helps to reduce cash flow and increase profitability

Pro-active rather than reactive approach to management of inventory levels and material flow.

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Determine what should be produced and at what time

Ascertain the required units of production of sub-assemblies

Determine the requirements of materials

Computing inventories, WIP, batch sizes and manufacturing and packaging lead time

Controlling inventory by ordering raw materials in relation to the orders received

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Master production schedule

Bill of material

file

Inventory file

Routing file

Master parts file

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• Latest production and purchasing schedules must be strictly adhered to

Strict adherence to the schedule

• Data accuracy is vital to the system or else it will be impossible to adhere to the schedule

Accurate data base

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When the scope of MRP-I is further developed to include:

Planning of raw material

Planning of components and sub-assemblies

Compute the other resources, i.e. machine or

labour capacity

To create a fully integrated plan for management

Then it is known as Manufacturing Resources Plan-II

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It refers to the entire production process and all the resources working together in harmony to achieve the goals of the firm.

The goal is on total system performance and not on localised measures such as labour or machine utilisation

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A business management strategy focusing on the analysis and design of workflows and processes within an organization

Helps organizations to improve customer service, cut operational costs and become world class competitors

It is more than just business improvising.

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A management theory that views any management system as being limited in achieving more of its goals by a small number of constraints (bottleneck).

There is always at least one constraint and TOC focuses on identifying the constraint and restructuring the rest of organization around it.

The main concept is to maximize the rate of manufacturing output, i.e. throughput of the organization.

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• Sales minus material and component costs. Throughput

• An activity within the organization where the demand for that resource is more than its capacity to supply. Bottleneck

• A situational factor which makes the achievement of objectives/throughput more difficult than it would otherwise be.

Constraint

• If a constraint’s throughput capacity is elevated to a point where it is no longer the system’s limiting factor, this is said to break the constraint.

Breaking a constraint

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• The way the equipment is currently used limits the ability of the system to produce more. Equipment

• Lack of skilled people limits the system People

• A written or unwritten policy prevents the system from making more Policy

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• It is equal to Sale minus Direct Materials cost of the goods sold.

Throughput contribution

• It is the sum of materials cost in direct materials, W-I-P and finished goods inventories along with costs of R&D and equipments and buildings.

Investments

• It is equal to all costs of operations (other than material cost) incurred to earn throughput contribution, i.e. salaries, wages, rent, etc.

Operating costs

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Identify the system’s constraints

Decide how to get the most out of the constraint

Subordinate everything else to the above decision

Make changes to increase the constraint’s capacity

If a constraint has been broken, go back to first step but do not allow inertia to cause a system’s constraint.

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Sunshine Pte Ltd produces parts for automotive. Its primary measure of productivity is labour absorption under the assumption that if more work is done to create inventory, profits will increase.

However, this only further increased the inventory rather than fill actual customer orders.

Implementation of Lean Sigma initiatives did not help and only further increased the inventory.

With TOC application, focus was shifted from absorbing costs to how quickly work could be completed and improving constraints. By investing $890,000 and 3 additional workers in the day shift, output increased by 83%.

Q) How does the JIT approach help in improving an organisation’s profitability?

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JIT approach helps in the reduction of costs/increase in prices as follows:

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Immediate detection of defective goods being manufactured

• Eliminates/reduces WIP between machines within working cell.

OH costs in the form of rentals for inventory, insurance, maintenance costs etc. are reduced.

• Higher product quality ensured by the JIT approach leads to higher premium in the selling price.

Detection of problem areas lead to reduction in costs by improvement.

X Video Company sells package of blank video tapes to its customer. It purchases video tapes from Y Tape Company @ Rs.140 a packet. Y Tape Company pays all freight to X Video Company. No incoming inspection is necessary because Y Tape Company has a superb reputation for delivery of quality merchandise. Annual demand of X Video Company is 13,000 packages. X Video Co. requires 15% annual return on investment. The purchase order lead time is two weeks. The purchase order is passed through Internet and it costs Rs.2 per order. The relevant insurance, material handling etc is Rs. 3.10 per package per year.

X Video Company has to decide whether or not to shift to JIT purchasing. Y Tape Company agrees to deliver 100 packages of video tapes 130 times per year (5 times every two weeks) instead of existing delivery system of 1,000 packages 13 times a year with additional amount of Rs. 0.02 per package.

31 Contd…

X Video Co. incurs no stock out under its current purchasing policy. It is estimated X Video Co. incurs stock out cost on 50 video tape packages under a JIT purchasing policy. In the event of a stock out, X Video Co. has to rush order tape packages which costs Rs. 4 per package. Comment whether X Video Company should implement JIT purchasing system.

Z Co. also supplies video tapes. It agrees to supply @ Rs.136 per

package under JIT delivery system. If video tape purchased from Z Co., relevant carrying cost would be Rs. 3 per package against Rs.3.10 in case of purchasing from Y Tape Co. However Z Co. doesn’t enjoy so sterling a reputation for quality. X Video Co. anticipates following negative aspects of purchasing tapes from Z Co.

32 Contd…

To incur additional inspection cost of 5 paisa per package, average stock out of 360 tapes packages per year would occur,

largely resulting form late deliveries. Z Co. cannot rush order at short notice. X Video Co. anticipates lost contribution margin per package of Rs. 8 from stock out.

Customer would likely return 2% of all packages due to poor quality

of the tape and to handle this return an additional cost of Rs. 25 per package.

Comment whether X Video Co places order to Z Co.

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Particulars Current Policy JIT Purchasing cost 18,20,000

(13,000 × 140) 18,20,260

(13,000 × 140.02) Ordering cost 26

(2 X 13 orders) 260

(2 X 130) Opportunity carrying cost

10,500 (1/2 X 1000X140X15%)

1050.15 (1/2 X 100 X 140.02 X15%)

Other carrying costs (insurance, material handling, etc.)

1,550 (1/2×1000×3.10)

155 (1/2×100×3.10)

Stock out cost - 200 (4 X 50) Total relevant costs 18,32,076 18,21,925.15

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i) Comparative Statement of cost for purchasing from Y Co Ltd under current policy & JIT :

Contd…

Comments: As may be seen from above, the relevant cost under the JIT

purchasing policy is lower than the cost incurred under the existing system. Hence, a JIT purchasing policy should be adopted by the company.

35 Contd…

ii) Statement of cost for purchasing from Z Co Ltd. Particulars Purchasing cost (13,000 x 136) 1,768,000 Ordering Cost (2x130 orders) 260 Opportunity Carrying Cost (1/2×100×136× 15%) 1020 Other Carrying Cost (1/2×100×3.00) 150 Stock out Cost (8x360) 2,880 Inspection Cost (13,000 x .05) 650 Customer Return Cost (13,000 x 2% x 25) 6,500 Total Relevant Cost 1,779,460

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Comments : The comparative costs are as follows, Under current policy Rs. 18,32,076.00 Under purchase under JIT Rs. 18,21,925.10 Under purchase from Z Co Ltd Rs. 17,79,460.00 Packages should be bought from Z Co as it is the cheapest.

Classify the following items under the three measures used in the theory of constraints:

i. Research & Development Cost ii. Rent/Utilities iii. Raw materials used for production iv. Depreciation v. Labour cost vi. Stock of raw materials vii. Sales viii. Cost of equipments & buildings (4 marks, May’11)

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1. Contribution

• Raw materials for production

• Sales

2. Operating costs

• Rent/Utilities • Depreciation • Labour

3. Investments

• R&D • Raw material

stock • Building &

Equipment stock

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Describe the Just – in – Time Systems. (6 marks, Nov’08)

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Raw material inventory is reduced by ensuring supplies are received only as and when required.

Machinery set up time is reduced which in turn reduces WIP and defects.

Defects are further eliminated by using Kanban card and introduction of working cell.

Work force is trained to ensure quick and appropriate action is taken.

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What is backflushing in JIT? State the problems that must be addressed for the effective functioning of the system?

(4 marks, May’10)

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Backflushing is a method of accounting in which data entry is made only after finished product is ready. Standard costs are flushed backwards in the system which then calculates the cost of all individual components.

For effective functioning of backflushing, accuracy is required in the following matters:

• Production Reporting • Scrap Reporting • Inventory accuracy

Brief the principles associated with synchronous manufacturing.

(5 marks, May’10)

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1. Focus on synchronising the production flow.

2. Value of time at a bottleneck = Throughput rate of products processed by bottleneck

3. Value of time at a non-bottleneck is negligible.

4. Resources must be utilized, not just activated.

5. A process batch should be variable both along its route and overtime.

Mention the data required to operate the material requirement

planning system. (4 marks, Nov’10)

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Master Production Schedule

Bill of Material file

Inventory file

Routing file

Master parts file

Explain the pre-requisites for successful

operation of material requirement planning.

(5 marks, May’11)

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The latest production and purchasing schedule should be strictly adhered to

Raw materials, sub-assemblies and components required for production should be pre-quantified.

Work force must be fully appraised of the system

Necessary internal control should be developed.

Data provided to MRP must be accurate

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A B C

Hours

Contd…

A company produces 3 products, A, B & C. The following information is available for a period:

Machine hours required per unit of production:

Contribution (Rs / unit) (Sales - Direct Materials) 30 25 15

A B C Throughput accounting ratio

Machine 1 10 2 4 133.33%

Machine 2 15 3 6 200%

Machine 3 5 1 2 66.67%

Estimated sales demand for A, B and C are 500 units each and machine capacity is limited to 6,000 hours for each machine.

You are required to analyse the above information and apply theory of constraints process to remove the constraints.

How many units of each product will be made?

(5 marks, Nov’08)

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Throughput Accounting ratio is highest for Machine 2. Therefore, Machine 2 is the bottleneck.

Now, we have to calculate Contribution/unit of bottleneck machine (i.e.machine 2) hour against total availability of 6,000 hours.

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A B C

A. Contribution/unit (Rs.) 30 25 15

B. Machine 2 hours (given above) 15 3 6

C. Contribution per Machine 2 hr (A/B) 2 8.33 2.50

D. Ranking 3 1 2

E. Maximum demand (given above) 500 500 500

F. Machine 2 hours reqd.(B X E) 7500 1500 3000

G. Machine 2 hours available 1500 1500 3000

H. Therefore, No. of units (G/B) 100 500 500

H Ltd. Manufactures 3 products. The material cost, selling price and bottleneck resource details per unit are as follows:

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Product X Product Y Product Z

Contd.

Budgeted factory costs for the period are Rs.2,221,600. The bottleneck resources time available is 75120 minutes per period.

Selling price (Rs.) 66 75 90

Material and other variable cost (Rs.)

24 30 40

Bottleneck resource time (min)

15 15 20

H Ltd. Manufactures 3 products. The material cost, selling price and bottleneck resource details per unit are as follows:

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Product X Product Y Product Z

Contd.

Budgeted factory costs for the period are Rs.2,221,600. The bottleneck resources time available is 75120 minutes per period.

Selling price (Rs.) 66 75 90

Material and other variable cost (Rs.)

24 30 40

Bottleneck resource time (min)

15 15 20

Required:

(i) Company adopted throughput accounting and products are ranked according to “product return per minute”. Select the highest rank product.

(ii)Calculate throughput accounting ratio and comment on it.

(5 marks, Nov’10)

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(i) Calculation of rank according to product return per minute

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Particulars X Y Z

Contd.

A Selling price (given) 66 75 90

B Variable cost (given) 24 30 40

C Throughput contribution (A-B) 42 45 50

D Minutes per unit (given) 15 15 20

E Contribution per minute (C/D) 2.8 3 2.5

F Ranking 2 1 3

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Particulars X Y Z

G Factory cost per minute (221600/75120) 2.95 2.95 2.95

H TA ratio = Contribution per min/cost per min (E/G)

0.95 1.02 0.85

I Ranking based on TA ratio 2 1 3

Conclusion: Product Y yields more contribution compared to average factory contribution per minute, whereas X and Z yield less.

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Just-in-Time (System)

Manufacturing Resources Planning (MRP)

Theory of Constraints (TOC)

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