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P2 Advanced Management Accounting
Module: 08
Cost Management
1. Cost management
They say that the next best thing to making money is saving money! And
business is no different. In business keeping track of costs and making sure
you are not spending too much money is considered just as important as
making money.
The key factor in managing costs is to assess the value added by
various activities, not simply looking for what costs the company the
most, as an expensive activity may actually be the key factor in a company’s
competitive advantage. It’s not always about cutting costs therefore – it can be
about spending money wisely on activities that truly add value to the
customer and support profit generation.
There are a number of ways costs and value can be assessed, this
information can then be in turn used to make decisions for the business
going forward.
2. Total Quality Management (TQM)
To start this section on Total Quality Management (TQM), let's use the example of a real car manufacturing company, General Motors. Based in
Detroit, USA, GM sold more cars than any other manufacturer globally for
throughout much of the 20th century.
The story of General Motors is infamous in management circles as a
lesson in “what not to do” when it comes to managing a business in a
changing environment. The world changed, and GM did not anticipate this
and change with it. Eventually, this led to GM losing its place as the number 1
car manufacturer globally and losing billions of dollars. In 2009 at the height
of the financial crisis, the US government spent $50 billion bailing out GM after
it went bankrupt. Since the bailout, GM have partially recovered and are now
a profitable company once more, but they are no longer the dominance they
once were.
At its largest, in 1979, General Motors employed over 600,000 people in the
USA and operated 150 assembly plants. Above all else, it was the sheer size
of GM that led to its decline. There were several attempts by the owners of
GM to try and change the philosophy and culture in the organisation and
although these new ways of working were successfully introduced to a few
of its manufacturing plants the new ideas failed to take hold over the entire
company.
A key barrier for implementing change at GM were the workers unions. The
unions at GM were so powerful and had so many members that any attempt to
introduce policies that were perceived as a threat to the work force, such as
training each employee to be able to perform a number of different tasks on the
production line (seen as possible threat to specialist workers by unions), were
effectively shot down by the unions with the threat of strike action.
The rise of Japanese car manufacturers in the 1970s meant GM could not
rest on its laurels. The oil crisis in 1973 led to soaring fuel prices so smaller
and more efficient cars became increasingly popular. This was bad news for
GM whose best-selling cars were large, powerful and less fuel efficient.
GM began to feel the pinch as sales of smaller, affordable and high-quality
cars made by other manufacturers started to overtake the sales of their own
cars. By 1986, GM started to shut down plants and lay off workers. Until this
point in its history, GM had enjoyed steady growth.
Another major factor that General Motors largely failed to address was the
idea of putting quality first. The cars produced by GM were often large and
luxurious but also unreliable and poorly made. U.S. customers started to see
imported Japanese cars of superior quality and reliability so when it came to
choose the make/brand of car customers were going to buy, quality became
the key word.
It was quality that G
M found so difficult to build into its cars. Conversely, Toyota and other
foreign competitors were producing vast numbers of cars at unseen levels
of quality and reliability.
To this day, “the Toyota way” is used across thousands of organisations in an
effort towards high quality and customer satisfaction.
The practices used by Toyota were built around several simple goals. These
were:
Cost reduction
By creating a manufacturing process that was very efficient and created
zero waste, Toyota were able to produce products at minimal cost which
meant it could sell its cars for substantially lower prices than GM whilst
remaining profitable.
Customer focus
Famously, GM dismissed the rising trend of small cars as a “fad” whilst
Toyota capitalised on the fact that oil was becoming increasingly expensive
and its customers would want to buy a car that was cheaper to run. More
recently, the Toyota Prius was the first mass produced hybrid-vehicle
(electricity and petrol powered) and met the needs of environmentally aware
customers that wanted a fuel-efficient car.
Flexibility
Unlike General Motors, where change was historically difficult to implement, Toyota adapted and adopted new processes as part of its continuous
improvement. We'll discuss continuous improvement later on in this section.
Employee participation
At GM, there was a notorious lack of respect amongst employees for both
the management and the customer. This was largely due to a culture of superiority/inferiority amongst managers and employees. Motivation and
productivity suffered as a result and so the cars that came off the
production line were full of problems.
At Toyota, small teams of workers would perform tasks together and were
encouraged to communicate with one another to solve problems. By taking
more individual responsibility, defects were virtually eliminated as the employees were more careful. Under this philosophy managers were less
important and so the traditional promotion-based schemes were
redundant.
For GM employees, this culture of employee participation and team-work
never took hold. This was because managers did not want to relinquish their
power and workers did not want to give up their dream of one day being
promoted to a more important managerial role.
Shorter product life cycles
As discussed under the customer focus heading, manufacturing cars that
were suited to the current economic climate was hugely advantageous to
Toyota. GM were slower to release “modern” cars and instead stuck with
their historically successful trucks and SUVs which became less desirable as
fuel prices increased.
Emphasis on quality
Toyota became the flagship car company in terms of quality and it
achieved this status through its culture of continuous improvement. If an
issue was discovered, the production line would come to a halt and the
problem would be solved before the product reached the end of the
production line; leading to a flawless final product and virtually no
waste/scrap.
On the other hand, the production lines in General Motors' plants were often
full of problems and poor workmanship but the production line would not
stop. Managers were given incentives (bonuses) based on the volume of
production which led to a lack of quality in the final product.
For Toyota, producing a product of high quality was the overriding focus.
The management of quality is known under various names and forms such as ISO 9000, Lean manufacturing and Six Sigma but these are pre-dated by the following topic, TQM which was first taught as an approach for organisations to use in the 1950s.
Total quality management
TQM is the principle of a culture of quality throughout the whole
organisation. Quality is a key strategic focus. Essentially a successful TQM
programme should mean that problems are avoided in the first instance,
rather than solved. This affects inventory levels as less stock needs to be
carried because there is less waste.
TQM has a number of key principles:
Errors and defects should be prevented, the costs of prevention
being less than the costs of correction. The aim is to achieve no
defects.
Continuous improvement. Not setting targets, meeting them and
then settling. Always looking for improvements everywhere and
anywhere.
Customer focus. Always keep the end user in mind, think what they
may be using the product for. For example, a family car may need
tougher material on the back of the front seats to protect the finish
from moody children kicking!
Quality should be a concern of the whole organisation, not just
production.
To achieve this, TQM programmes require full commitment to TQM from
all staff including the managing director and entire management team. This
means motivating and training staff to take up the ethos of quality.
In TQM, a commitment to quality is not only demanded from the work-
force but also from an organisation's suppliers. Internal customer/supplier
relationships where internal customers demand high quality from their
internal suppliers are an essential part of Total Quality Management. Going
back to the example of GM – General Motors had a history of buying out its
suppliers which led to a reduction in quality of the parts put in its cars. An
external supplier would risk losing business if the quality of their product
dipped, but without this risk GM's internal suppliers focussed on low cost
instead of high quality.
Communication is also an essential part of TQM and mechanisms are put in
place to encourage the sharing of ideas. From these new ideas, processes
are redesigned for quality.
TQM and cost management
In the modern business environment, there is a high cost associated with
poor quality. The loss in revenue caused by failures in quality can cost a
significant proportion of the total sales revenue for the average company.
A real example to remember is the 2014 General Motors recall, where a total
of 29 million cars were recalled, after hundreds of fatal crashes were caused
by an issue where the ignition switch turned off the engine of moving cars.
This fault was due to a number of failures in the initial production. In the
months following the recall, GM were fined $35 million for their slow
response in recalling the cars and an estimated $3 billion was wiped from
their shareholder value.
Quality costs can be divided into two categories:
Conformance costs
The costs of preventing, inspecting and improving to avoid future
problems. These can be split into:
• Prevention costs – e.g. repairs to equipment, quality training.
• Appraisal costs – e.g. inspections.
Non-conformance costs
Costs that occur from inadequate quality. These can be split into:
• Internal failure costs – e.g. costs of scrap, corrections + repairs to fix
products.
• External failure costs – e.g. Loss of customer trust and goodwill, fines compensation/replacement costs.
The level of quality desired must always be weighed up against the extra
time and cost involved in achieving that. The extra costs incurred also
need to be considered and weighed against the benefits gained from the
additional accuracy. Accountants may be required to play a role to examine
costs vs. benefits of different levels of quality.
The aim of TQM is to reduce internal failure costs to zero. It's often said
that the costs of internal failure to companies are so great that a TQM
programme can be paid for by the amount saved.
TQM and standard costing
Total Quality Management does not align with standard costing such as
marginal and absorption costing. There are several reasons that standard
costing and TQM do not work together.
Standard costs which are periodically changed (e.g. for each quarterly
budget) are irrelevant in a system of continuous improvement and so
setting these standard costs is less meaningful in a TQM system.
Waste is not an acceptable cost in a TQM system whereas absorption and
marginal costing systems often have an acceptable level of waste in the budget.
Just In Time inventory control is used in TQM instead of the typical inventory
control as used in standard costing in order to avoid build up of inventory and
stock obsolecence.
The focus of standard costing is on the production cost. However, in TQM,
there is an emphasis on quality costs rather than production costs. For
example, in standard costing, we may be interested in finding out how many
units are produced per machine hour, but in a TQM system we would be
more interested in the number of units produced with defects (which can be
related to the “quality cost” of internal failure).
Finally, under TQM, failures are attributable to all departments which
goes against the standard costing concept that individual departments are
responsible for their own failures.
TQM and management information
To take the focus away from output and towards quality, the traditional
information produced in standard costing is not adequate. To make
decisions in a TQM environment managers need additional
financial information such as:
• Cost of downtime
• Cost of job repairs/warranty claims
• Training costs
Non-financial measures are also required as part of TQM and are reported
in quality reports. These focus on quality and include:
• Customer returns and refunds
• Percentage of defects per unit
• Number of customer complaints
• Customer request response time
As you can see, the costs which can be related to quality are both important
and quite complicated!
For a modern organisation to thrive, quality should be a key focus. We've
discussed the cost of failures in quality and how these led to the overall
decline of a once dominant car manufacturer. In fact, as management
accountants, it should be clear to you that, if GM had focussed on the quality
costs instead of production costs, then many of the problems that the
company encountered could have been avoided entirely.
3. Kaizen costing
One element of TQM is not just about higher quality, it’s about continuous
improvement, and that also can mean finding better ways of achieving the
end goal at a lower cost.
Kaizen
The Japanese art of Kaizen refers to philosophy or practices that focus
upon continuous improvement of processes in manufacturing,
engineering, and business management. It extends beyond simply making
the end product or service better by seeking to improve all parts of the
business; this can be anything from supplier relations to improving the work
environment for employees.
Kaizen seeks to create incremental changes regularly, therefore the
business never gets complacent as it is always trying to change and better
itself. Also, by making little and often changes the company mitigates the
chances of having to undergo a revolutionary change down the road.
Kaizen costing
Kaizen costing is a cost management system focused on continuous
improvement of costs. The focus is on obtaining small, incremental cost
reductions during the production phase (i.e. after design is complete).
How Kaizen costing is applied:
Regular, short term costing targets (e.g. monthly) with the aim of
making ongoing cost improvements on a regular basis – unlike
traditional standard costing which will often have yearly cost targets
There is a culture which focuses on continual cost reduction:
o Reviewing and updating processes to minimise costs
o Looking for the lowest cost provider of the right quality of
output
o Identifying the optimum resources (e.g. most efficient
machinery or staff)
o Reducing waste of input materials.
4. Business Process Re-engineering (BPR)
Business processes
A business process is the set of activities that are ordered in a way to
achieve a task or objective in the organisation e.g. the manufacturing
process, ordering process or complaints process.
Business Process Re-engineering (BPR)
Business process re-engineering is the analysis and design of workflows and
processes to fundamentally rethink how organisations operate in order to
dramatically improve customer service, cut operational costs, improve
quality and be competitive in their market.
The aim of BPR is to design the optimum process to achieve the business
objectives and not effected by those currently used in the organisation. For
this reason, upon implementation it can have a significant impact on staff
and the organisational structure, which may need to be changed to fit the
optimum process.
A key stimulus for re-engineering has been the continuing development and
deployment of sophisticated information systems and networks as these
create new opportunities for changing existing processes.
This image illustrates the life cycle of BPR:
Keys to successful BPR
Due to the size and scale of many BPR programmes, many have failed. Using
this experience the following are the keys to successful implementation of
BPR projects:
Organisation wide commitment – including support from senior
management, funding for new IT and structural change and staff buy-in
Skilled BPR team – with the right skills and knowledge, empowered to take
the actions they need to follow through the process in full
Business needs analysis undertaken prior to process design – to
understand current problems or issues and define the objectives of the
programme. This must be consistent with the business strategy and
customer needs
Adequate IT infrastructure –alignment of IT with the over-riding business
strategy and funding for the IT infrastructure and IT support needed to
support the new processes
Effective change management – to ensure staff buy-in and support
Ongoing continuous improvement - to learn post implementation based on
real world experience
BPR and cost management
BPR can be a very expensive exercise often involving significant costs
spent on external consultants and new IT systems. However one aim of the
new systems is that is it dramatically more efficient than the system that
went before it and so achieving long term savings.
Replacing a manual invoicing system with an automated online system, for
example, would be expensive initially, but over the next few years would save significant staff costs. As a result a NPV analysis could be an excellent
way to review whether the long term costs savings are worthwhile given
the initial costs
5. Lean manufacturing
Lean production and management
Born out of competition between Japanese and Western countries; lean
production is essentially the act of cutting all non-value adding parts of
the business from the value chain; or in layman’s terms achieving the
same outcome from less work and cost. A lean production system will
integrate all employees, managers and suppliers together working together
towards the same goal and remove any people, processes and parts that do
not support that goal.
A lean production environment, should also be one where costs are well
managed, and is consistent with the ideas of Kaizan costing, Just In Time
stock management and value engineering.
One element of lead production is the removal of waste. According to the
Toyota Production System there are details seven key areas of waste:
Transport – When an item or machine is unnecessarily moved when this
movement plays no part in production. For example, you build your car
bodies in one room but attach the wheels next door. The time to transport
between buildings adds no value to the product and so should be removed
from the process.
Inventory – When raw materials, finished products or works in progress are
unnecessarily in stock; this should not happen under lean production as
excess or stationary inventory adds no value to the product. Lean production
systems use a Just-In-Time inventory system.
Motion – People or machines being moving more than is/should be required;
for example, you are a mechanic working on a car production line and your
job is to check and correct any default in the engine. However, every default
requires different tools and the tools must be kept in another room, as a result
at lease once an hour you have to make a 2 minute round trip to the next
room. This is an example of motion that is not beneficially to the product and
so is a waste. If this happened just once an hour you would waste an hour
and twenty minutes a week!
Waiting – Any time a product, person or machine is left waiting to complete
their task is not adding value to the product. To return to our car example, any
time a worker completes their task on a car, a new car should be rolling into
their station. If they have to wait for whatever reason that is wasted time, that
employees time adds no value to the end product during that time and so
steps will need to be taken to ensure waiting time is reduced.
Overproduction – When more stock is produced than needed, the excess
stock will need space to occupy, tie up unnecessary capital and risk stock
obsolescence. Our cars, unlike a fine wine, will not appreciate in value by
being stuck in a warehouse and as a result this storage is not adding
anything to the cars production and value, therefore any overproduction
needs to stop.
Over processing – Another perhaps slightly confusing waste, essentially it
means that more quality or extras added to a product do not necessarily mean
consumers will value it more.
For example, if our cars target market only want a cheap little run around yet
we have spent time and money installing the most expensive branded tyres,
in the eyes of our consumers we have not added any value to the car; they will
NOT be willing to pay more for these tyres. Therefore the time and money
these tyres cost over standard non branded ones is a waste as they did not
contribute value to the customer.
Defects – Defects often cost far more than people think; in addition to the
added costs/time needed to repair the product (or scrap if necessary) we
must also include the materials that went into the product, the cost of the
machines/personnel who made it and the cost of the products that would
have been made in its place.
Often the true cost of a defect can be up to 10 times what it appears to
initially have cost, particularly if it happens after the customer has received the
product where not only are their cost implications but reputation implications
also.
Criticisms and limitations of lean production
As with most forms of production, there are several pitfalls to the seeming
ideal notion of lean production.
Many critics of lean production site management’s focus solely on the tools
and methodologies of lean, rather than the philosophy and culture. For
example, if you work on a production line where you are constantly being
hounded for wastes that fall into the seven areas, but you have no idea why
you too would react negatively, and that is why managers need to install a
culture of ‘lean’ within an organisation so that workers are aware of it and
could in fact attempt to contribute to it.
Capacity can often be an issue for companies using ‘lean production’ as they
are often working at close to full capacity (every input utilised – anything less would be a waste), however, by not having a surplus of materials, stock
and personnel the company can be left high and dry if a massive order
comes in out of the blue or there is suddenly a shortage of raw
materials.
In other words, for lean production to work effectively, everything needs to
keep running smoothly, as there is little to no room for any contingencies.
6. Just-In-Time (JIT)
A car manufacturer begins operations at 9am, by 12pm they will have 10
finished cars. At 12pm they will need to put the tyres on the car, but they do
not produce tyres on site or have any in storage. Instead they order them at
11am from a local tyre manufacturer on a one hour delivery. That means that
at 12pm the completed cars will be ready to have the tyres fitted just as the
tyres are arriving. Therefore, production can continue with no interruption,
yet at the same time the company has not had to waste any floor space in
storing the tyres. This is Just – in – Time!
If you are familiar with the phrase 'just in time' then you should be able to
understand this strategy as it does exactly what it says on the tin!
Definition
Just-In-Time, or JIT, is a business and production strategy that seeks to
eliminate excess stock of products or raw materials, producing
reactively to customer demands and not before. This is generally
known as stock less production as nothing is wasted in production. In
short, the Just-in- Time inventory system focus is having “the right material, at
the right time, at the right place, and in the exact amount.”
JIT is not just for materials entering the production process, but also for the
end product as well. The aim is to produce the product just as it is
required by the customer, so that stocks of finished goods are kept to a
minimum. This requires producing to customer order, or accurate
forecasting of customer demand.
JIT purchasing
JIT purchasing relates to purchasing of materials – at the right time at the right
place and in the exact moment needed for production.
A simple example of this would be a car manufacturer that only orders its steel
once it knows exactly how much it will need in that particular production
period, eliminating waste, as the company should in theory be left with no
excess materials.
A company without inventory does not want a supply system problem that
creates a parts shortage. As a result the supplier relationships become
extremely important and thus are worked upon by both parties. This can
have advantages in terms of delivery times (the supplier may set up a
warehouse near to the company’s production facility for instance), costs,
and quality.
Often companies using JIT work with their suppliers so that regular small
deliveries are made avoiding even the smallest levels of inventory to be
held. In our steel example deliveries could end up being made a few times a
week or even a few times a day if necessary so that it is delivered as is
needed for production.
JIT production
JIT is not just for materials entering the production process, but also for the
end product as well. The aim is to produce the product just as it is required by
the customer, so that stocks of finished goods are kept to a minimum.
This requires producing to customer order, or accurate forecasting of customer
demand.
Benefits of JIT
Some benefits of JIT include:
Less obsolescence and wastage of material
Raw materials are kept to a minimum reducing the chance of the stock
becoming obsolete or damaged.
Less obsolete finished goods inventory reducing production costs
As all products under a JIT system are made specifically to order; you have
greatly reduced the chance of your product not being sold. For example, if a
car company makes 100 cars, maybe only 60 will be sold, but if they make
50 after receiving 50 specific orders they won’t have wasted money on the
excess.
Improved supplier relationships
Improved supplier relationships result from the long term agreements often
signed with suppliers. This ensures good quality stock is received reliably. It
can also help when there are problems, e.g. a stock shortage, perhaps
getting preferential treatment compared with other companies.
Lower costs
As a result to leaner and reactive production waste is reduced and quality is
increased, as a result cost may go down under a well integrated JIT system.
Storage costs are also reduced.
Flexibility
A JIT management system allows for far greater flexibility as products and
procedures are standardised, meaning that changes to order quantity and
design can be more easily catered for.
Downsides of JIT
Despite all the benefits and costs savings of a JIT system it is worth noting
that there are negatives that can lead to complications in production and
management. Generally, these downsides revolve around the lack of
internal control over materials. To illustrate this point, a car manufacturer
that needs to get 10 cars over to a dealership by tomorrow, but the supplier
has run out of a key part would mean the order could not be delivered. In
other words, you are stuck; this is the inherent issue with JIT it removes all
the safety nets that come with having some surplus stock left over for
contingencies.
Some costs may also rise, as suppliers may increase prices to assure
delivery of orders, and there are also likely to be more deliveries of a smaller
number of items, increasing delivery costs.
JIT and cost management
You’ll note from the benefits and downsides of JIT from a cost perspective there
are elements which increase costs (more deliveries) and those that reduce
costs (less storage). An accountant in a JIT environment needs to monitor JIT
related costs to weigh up the costs of the system vs the benefits achieved.