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12 Costs of Quality and Other Cost Management Issues

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Learning Objectives

After studying Chapter 12, you will be able to:

• Explain relationships among the costs of quality categories.

• Understand the concepts of target costing and kaizen costing.

• Distinguish between value-added and nonvalue-added activities.

• Describe various types of nonfinancial performance measures.

• Identify nonfinancial performance measures for multinational companies.

• Comprehend the elements of a balanced scorecard.

• Describe benchmarking techniques to improve productivity and quality.

• Explain strategies to enhance productivity such as downsizing and business process reengineering.

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Chapter Outline

12.1 Costs of Quality Cost Categories Diagramming Costs of Quality Continuous Improvement Sources of Costs of Quality Data—ABC and Customer Inputs Service Applications

12.2 Cost Management in Design and Production Stages Target Costing Kaizen Costing

12.3 Activity Analysis

12.4 Nonfinancial Performance Measures Measures of Manufacturing Productivity Productivity of Labor Product Quality Inventory Reduction Machine Maintenance Delivery Performance

12.5 Nonfinancial Measures for the Multinational Company

12.6 Balanced Scorecard

12.7 Benchmarking

12.8 Strategies to Enhance Productivity Downsizing Business Process Reengineering Ethical Considerations

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TQM and the Need to Measure Quality Costs

Pete Moss, considered the ace troubleshooter for DeKalb Fertilizer Company, was sent to its Georgia regional office by “Big Dan” DeLion, president of DeKalb, about 15 months ago. What he found was “big trouble.” The region was losing about $400,000 per month—mostly from waste, low productivity, and customer warranty claims. Revenues were declining, and too many customers were unhappy. This was Spring 2018, long after Total Quality Management (TQM) was a cliché and a norm in most firms. Yes, DeKalb had a TQM program that “Big Dan” had announced in late 2019. Signs had been posted about quality being “No. 1.” A consulting firm had conducted seminars for workers, statistical control charts were maintained, and managers had increased inspections. Faster response to warranty claims had been implemented through a costly system to guarantee a 24-hour response to any customer problem.

Yet, productivity declined, scrap was up, and warranty costs soared. Workers saw the TQM program as a management project. Managers blamed much of the problem on the lack of union cooperation and of employee concern. No specific quality goals were set. Everyone lacked a sense of urgency. Pete’s arrival brought a sudden change: meetings with line workers quickly pointed to key production problems, warranty claims were grouped to identify failure causes, landscape designers and on-site supervisors were brought together to analyze failures, and certain changes were made “overnight.” A goal of cutting scrap by 50% in three months was set.

At every step, the same question came up: “What’s this costing us?” Pete, knowing that this question was key at other plants, sought out Rose Bush, the plant cost accountant. Rose was in the middle of an ABC study and had begun to define new activity centers and cost drivers. While not an easy task, Rose was able to modify her system rather quickly to identify quality costs: which, where, and how much. Pete and Rose became allies, promoting each other’s views to managers and employees alike. Within two months, Rose gave Pete a 2019 costs of quality analysis. These costs totaled a surprising 15% of revenues. Of this, little was spent on prevention, about 30% was spent on appraisal, nearly 45% went to fixing internal failures, and the rest were external failure costs. Lost revenues because of bad product weren’t captured or estimated. In addition to many nonfinancial quality measures, the quality cost reports helped Pete measure the impact of his recovery program.

Pete is now gone, off to another problem plant. The Georgia plant is now at breakeven. But the quality job is just now paying dividends. Rose’s latest costs of quality report shows total costs still high at 12% of revenues. But, the cost composition had changed already: 30% prevention, 30% appraisal, 25% internal failure, and 15% external failure. The target for 2021 was 10% of revenues with percentages of 40, 40, 15, and 5, respectively. Long-term goals are 6% of revenues and a percentage mix of 70, 20, 10, and 0, respectively. Incidentally, revenues are rebounding.

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Section 12.1 Costs of Quality

In the last decade, the competitive environment has forced a changed and improved focus on every business. Heightened customer service expectations, development of integrated systems, demands for cost reductions, advances in information technology, access to inter- national markets, and speed of competitor reactions have all increased the demands on managerial accountants for relevant and timely data for decisions. This chapter examines a set of the more important areas of change in managerial accounting. These topics are heav- ily influenced by international competitors, particularly the Japanese. Product quality and process improvement have allowed Japanese automakers, electronics firms, and other con- sumer goods producers to capture major shares of international markets. Disciplined and team-oriented approaches brought market and financial success. Soon others, particularly U.S. firms, began to adopt and adapt similar concepts and strategies. JIT, quality circles, and continuous improvement programs are examples.

In this chapter, we focus on several of these topics that have strong managerial accounting ramifications. Specifically, measuring and monitoring quality costs are major parts of any total quality management program. Team approaches to design, costing, production plan- ning, and process improvement have yielded huge dividends. These approaches have focused on linking customer needs to the design process, on identifying and eliminating any activity that does not add value to the product, and on organizing planning and control activities that truly measure performance. Many more topics could be included and more pages added on a weekly basis. Old accounting tools are redesigned, some are abandoned, and new concepts are tried and tested. The pace of change is exciting.

12.1 Costs of Quality “Quality is free” is a favorite saying of many who argue for efforts to improve quality. It may be difficult to accept the concept that spending more on quality improvement efforts will lower costs. But the facts tell an exciting story:

• Increased training of workers will reduce scrap and rework costs. • Higher-quality products and services improve customer satisfaction and generate

higher sales. • Narrower control limits force improved processes and greater utilization of capacity. • With reduced waste, more product can be generated with the same equipment and

workers. • “Designing in” quality prevents production problems and the need for engineering

changes to create “fixes.” An error of $1 in design can easily cause $10 in production problems.

• Empowering employees through quality circles and other participation techniques to give them control over quality-related production decisions increases total commitment.

• Employee satisfaction from eliminating rework, downtime, and scrap increases pro- ductivity and further commitment to improvement, particularly if the benefits are shared with the employees.

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Section 12.1 Costs of Quality

These results reduce quality costs and, therefore, product costs. Quality efforts come in many forms and names, including:

• Total quality management (TQM)—an integrated effort of training, process con- trols, incentives, employee empowerment, product engineering and design, supplier involvement, and customer satisfaction measurement to achieve quality goals.

• Statistical quality control—the use of statistical techniques on processes to mea- sure, monitor, and evaluate performance based on goals, control ranges, and perfor- mance percentages.

• Continuous improvement programs—efforts to establish quality targets that represent improvement over current performance through worker involvement in evaluation processes.

• Quality control through the guidance of quality experts—specific approaches to quality management promoted by internationally recognized leaders such as Dem- ing, Juran, Crosby, and Taguchi.

All of these focus on management commitment to bringing about a change in attitude and changes in processes.

Methods vary, but all emphasize heavy management commitment to change. One Michigan firm’s management, tired of customer complaints and nagging productivity problems, intro- duced an array of techniques to impress employees and managers with the need to work toward zero defects in its output. Every work station was made responsible for approving the quality of its work before sending it to the next station. When defects were detected, the entire line was halted, horns sounded, the problem diagnosed, and responsibility for the solu- tion identified. The initial result was that very little was shipped from that plant for nearly two weeks because of the nearly constant stoppage of the line. But within two months, pro- ductivity was above any prior period and continued to rise. The costs of the early stoppages were nearly fatal to the firm, but the payoffs are substantial both internally and to customers, many of whom are automotive related and are using vendor certification programs to pro- mote quality, delivery, and cost goals, and to eliminate nonperforming suppliers.

Cost Categories Four categories of costs are commonly identified. These categories are related and can be considered tradeoffs for each other. They, along with examples, are:

• Prevention costs are incurred to prevent the production of products or ser- vices that do not meet specifications. As these costs increase, failure costs should decrease. These costs, often spent prior to production, include:

Job training Quality training

Supplier evaluation and approvals Preventive maintenance

Development of specifications and standards Promotion of quality

Employee quality circle teams New equipment to reduce waste

Design and process engineering

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Section 12.1 Costs of Quality

• Appraisal costs are incurred to monitor and inspect production. These costs are intended to detect products or services that do not meet specification during the production process. As these costs increase, failure costs should decrease. Included are:

Inspections of materials Quality control activities

Inspections during production Production testing

Inspections of finished products Statistical quality control

Line personnel’s self-checking activities Calibration of test equipment

Internal auditing activities

• Internal failure costs are incurred after defective or substandard product or ser- vice is detected but before it leaves the plant. These costs increase as the number of defective units detected increases. Included are:

Rework, retesting, and rescheduling Scrap

Lost production Downtime

Lost contribution margin on defective units* Increased inventory

* These items are measurable only by making estimates of external impacts and are rarely part of a costs of quality accounting report. They are the most subjective of all quality costs yet, perhaps, the most important in a strategic sense.

• External failure costs are incurred when the defective product or service gets to the customer. These costs increase as customers find defective units and reject them. These costs include two important groups: costs of handling customer complaints and costs of future lost sales because of poor quality and customer dissatisfaction. Included are:

Repairs Logistics of returned units

Warranties (estimated and actual) Processing recall programs

Contribution margin on replacement units

Lost contribution margin from damaged product reputation*

Liability claims Complaint departments

Lost contribution margin from price reductions*

Product service departments

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Section 12.1 Costs of Quality

While these lists seem straightforward, much judgment goes into the typical quality cost anal- ysis. If a person’s duties are part production and part inspection, what percentage should be considered to be quality costs? Each firm must decide on its own definitions. Also, as time passes, processes change, greater understanding of quality issues evolves, and accounting systems change. One danger behind this discussion is that an impression is created that cost measurement is precise and easily performed. Activity-based costing, special studies, and improved charts of accounts have certainly detailed the trail of costs.

Traditionally, these costs have been buried in other cost categories. Prevention costs are “lost” in administrative overhead. Appraisal costs are spread among the many locations. Internal failure costs show up in efficiency and quantity variances and allowances for “normal scrap.” External failure costs are selling and administrative costs or not captured at all. In many firms, it takes a major effort to identify, measure, and track these costs with reasonable accuracy.

Prevention and appraisal costs are considered tradeoffs to internal and external failure costs. Thus, stronger training programs are viewed as important costs that help reduce internal and external failure costs. Also, a stronger appraisal program should reduce both internal and external failure costs. Yet, in the long run, spending on prevention costs may allow a company to reduce both failure costs and appraisal costs. Better-trained employees will produce much higher-quality products that require less testing and inspecting, a result of producing few if any defective units. Implicitly, failure costs fall to near-zero levels.

Diagramming Costs of Quality Figure 12.1 illustrates the interaction of the four costs of quality categories. The horizontal, or x-axis, reflects either a decreasing defect rate or an increasing quality assurance rate. As can be seen, an optimal cost level can be drawn. The presumption is that increased prevention and appraisal spending will lower failure costs (internal plus external). We must be careful not to oversimplify the relationships here. For example:

• The optimal spending level can be drawn but can rarely be measured accurately. Also, this optimal level of spending implies that we should be satisfied with this level of quality (defects).

• This static drawing of the four cost categories reflects general trends but implies that they are equally important and are of approximately equal size. Rarely is this the case.

• The cost curves imply that cost functions can be defined quantitatively to allow these costs to be plotted at various levels of quality assurance. While cost relation- ships do exist, they are difficult to quantify accurately.

• Too often, managers assume that by merely spending money on quality prevention and appraisal activities their quality goals can be achieved. Some TQM programs have been successful and sustainable; many others have achieved neither their qual- ity nor cost reduction goals.

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Section 12.1 Costs of Quality

Any manager or managerial accountant who advocates finding the optimal spending and fail- ure cost level and operating at that level fails to understand the interrelationships that exist. For example, prevention costs (i.e., training, education, and quality-enhancing investments) are in effect current investments in future defect reductions. More spending on training and vendor certification programs, for example, should reduce internal and external failure rates in the future. A highly trained workforce should reduce the need for inspections in the future.

As an offbeat example of this idea, compare the teenage driver accident rate in the United States with Japan. In the U.S., most teenagers take a short driver’s training course with very limited coverage of driving laws, driver etiquette, and hands-on skill development. In Japan, compulsory driver education courses cost approximately $5,000 per person because of the amount of training required. Car accidents do occur but at a much lower level as compared to U.S. experiences. (To test the idea, survey your current class. Odds are that well over half of your fellow students have had an auto accident before they reached 20 years of age.) Japan has traded accident costs for training costs. Other social impacts must be considered; for example, many persons might not drive because they cannot afford the $5,000.

As a numerical example of Figure 12.1, assume that 100,000 units are produced with six possible levels of spending on prevention and appraisal efforts. The contribution margin is $10 per unit. Of the defects, 60% is detected internally; and 40% is discovered externally. All defects must be reworked at a cost of $8 per unit. External failures cause a loss of future sales at a ratio of three units of lost sales for each external defect found, or $30 of lost contribution margin for each external defective unit. All dollar and unit amounts are in thousands (adapted from Godfrey & Pasewark, 1988, p. 72).

Internal Failure Costs External Failure Costs

Prevention Costs Appraisal Costs Total Cost of Quality

Low $

High $

Costs of

Quality

High

Low

Low Defect Rate Quality Assurance Rate

Figure 12.1: Costs of quality

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Section 12.1 Costs of Quality

To explain these numbers, the first row assumes that 5% of the 100,000 units produced is defective. Also, we are now spending $100,000 each on prevention and appraisal costs. It will cost $8 per unit to rework the 5,000 defective, units or $40,000. Lost contribution margin is found by taking the external failures (40% × 5,000 units) times the contribution margin of three lost units (3 × $10)—a lost sales cost of $60,000 in contribution margin. The total costs of quality are $300,000.

Based on these numbers, the managerial accountant would recommend that the current opti- mal cost level is $240,000. This assumes that we can quantify the relationship between higher prevention costs and lower defective percentages. It also assumes that appraisal costs can be reduced accordingly. Internal and external discovery rates for defective units and lost sales figures are clearly estimates. Contribution margins and rework costs are reasonably solid data. This, however, is a static picture of quality costs. As time passes, these relationships will change, resulting in a new optimal spending pattern.

Continuous Improvement Can any firm be satisfied with a static quality level? No! Markets are demanding higher and higher quality assurance levels. Japanese auto quality levels of the 1980s well exceeded U.S. capabilities. U.S. firms now exceed those levels, but Japanese carmakers have moved to still higher levels. Competition demands continuous improvement.

Prior to the implementation of a TQM program, appraisal costs and combined failure costs will likely be very high. For example, the mix of quality costs at the start of a major quality effort in a machine manufacturer was:

Defect Rates

Prevention Costs

Appraisal Costs

Rework Costs Lost Contribution Margin

Units Costs Units Costs Total Quality

Costs

5.00% $100 $100 $8 × 5.0 $40 $30 × 2.0 $60 $300

3.50 120 80 8 × 3.5 28 30 × 1.4 42 270

2.25 140 65 8 × 2.25 18 30 × 0.9 27 250

1.25 160 55 8 × 1.25 10 30 × 0.5 15 240

0.50 190 50 8 × 0.5 4 30 × 0.2 6 250

0.10 240 48 8 × 0.1 0.80 30 × 0.04 1.20 290

Prevention costs 4.5%

Appraisal costs 41.7

Internal failure costs 53.4

External failure costs .4 (excluding lost sales estimates)

Total costs of quality 100.0%

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Section 12.1 Costs of Quality

Total costs were approximately 8% of total sales. As part of management efforts to get employee “buy in,” figures were presented to show the impact on employee profit sharing if the percentage decreased to 6%.

As time passes, Figure 12.1 will be revised to reflect improvements in quality and changed cost relationships. Movement will be toward higher quality assurance and lower defect levels. Cost patterns will shift from failure to prevention. Even appraisal costs may decrease as more confidence is gained in the production processes. Figure 12.2 incorporates a sequence of Fig- ure 12.1 diagrams and reflects this change in patterns over a series of years.

Figure 12.2: Annual shifts in the total costs of quality line

Low $

High $

Costs of

Quality

High

Low

Low Defect Rate Quality Assurance Rate

Year 1

Year 2

Year 3

Year 4

Year 5

A line linking minimum cost points should always be shifting downward and to the right. Whether the company is ever at the exact optimal point each year or month is questionable. But aggressive TQM programs have produced results following this pattern. As an illustration of the shifting cost patterns, a set of summarized biannual data from a film studio appears in Figure 12.3. The data are in millions and include an approximate 10% increase in sales each year. Definitions of what costs belong in each category rests with company personnel.

Notice that, at the start of the total quality management program, internal failure is the high- est percentage category; two years later, appraisal costs are the highest percentage; and finally, prevention costs become the highest percentage. Of particular note is the steadily declining percentage of quality costs to sales. While significant reductions in these percent- ages are rather consistent, company management feels that the TQM program training effort is approaching a steady state. The forecast for 2021 shows a further dramatic decline in the costs to sales percentage and in total quality costs. These challenges have been met in the past, but the 2021 goal is particularly rigorous. Managerial and employee efforts will deter- mine the result.

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Section 12.1 Costs of Quality

Sources of Costs of Quality Data—ABC and Customer Inputs Most traditional costing systems will find it difficult, if not impossible, to collect the type of data needed for the preceding analyses. ABC has been a timely innovation. Activity centers that focus on quality issues (i.e., training, rework and scrap, inspections, and quality assurance program costs) can separate these activities and the resources they consume. Cost drivers can help identify relationships between failure costs and their causes. Thus, ABC increases the ability to identify quality costs, focuses attention on costly activities, and even helps recognize cause-and-effect linkages.

Many companies must extend even ABC data to capture more quality costs. This might include account analysis, discussed in Chapter 6. With certain costs, allocations may be needed, which introduce difficulties when measuring improvement. As improvements occur, costs must be reallocated, often introducing arbitrariness.

The tough measurement is still lost sales, part of external failure. Numerous firms have made customer satisfaction surveys important and routine parts of their marketing, service, and product planning and design functions. Quality councils have included both suppliers and customers to add critical external views of internal quality levels and efforts. In the past, lost sales estimates were only vague guesses, but greater articulation of customer and potential customer inputs can push this figure toward a more valid estimate.

Service Applications While TQM programs are often linked to manufacturing and its quality, service organizations also find quality just as critical to customer satisfaction and to their long-term survival. The same categories of costs of quality apply to all organizations. Xerox, for example, has devel- oped significant quality programs for its manufacturing, sales, and service activities. Training to increase service employee competence, to improve interactions with customers, and to raise the quality of services provided is similar to manufacturing tradeoffs. The focus is more heavily on customer satisfaction since providing the service, in many cases, is at the customer contact point. Lost sales, service reputation, and attributes such as “friendliness” are difficult to measure in a financial context. Yet, measuring costs of improving and sustaining quality

Figure 12.3: Shifting patterns of costs of quality over time

Cost Categories Prevention Appraisal Internal Failure External Failure Total Costs

Cost as a % of sales

2013 2015 2017 2019 2021

$ 2.5 6.0 6.2 2.3

$ 17.0

14.7 35.3 36.5 13.5

100.0

$ 3.5 6.8 5.6 2.2

$18.1

19.3 37.6 30.9 12.2

100.0

$ 5.9 4.8 4.4 1.2

$16.3

36.2 29.4 27.0 7.4

100.0

$ 5.7 3.9 3.6 0.8

$14.0

40.7 27.9 25.7 5.7

100.0

$ 4.5 2.9 2.1 0.4

$ 9.9

45.5 29.3 21.2 4.0

100.0

Forecast

18.0% 15.8% 11.7% 8.3% 4.9%

Costs % Total % Total Costs Costs Costs%Total %Total Costs %Total

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Section 12.2 Cost Management in Design and Production Stages

and of eliminating service failures is critical. Hospitals, for example, have an obvious need for high levels of quality control activities. Monitoring quality costs, while important, becomes secondary to the need for assuring extremely high levels of operating quality regardless of cost. Yet, because of huge increases in health care costs, national health care policies will require measuring and analyzing operating costs, including costs of quality.

12.2 Cost Management in Design and Production Stages Companies have traditionally emphasized cost management in the product production phase, while neglecting the design and development stages. Managers now recognize that most of the costs incurred in the production stage are, in fact, determined in the design and develop- ment stages. Accordingly, many companies are adopting target costing, a system initiated in Japan, to manage costs in the design and development stages for new (or redesigned) prod- ucts. Another Japanese system known as kaizen costing is used to manage costs in the prod- uct manufacturing stage.

Target Costing Historically, U.S. manufacturers have set their pricing strategies by adding required profit margins to the costs of already designed products. Target costing reverses this process. After a target selling price and a target profit are established, an allowable cost consistent with these targets is obtained for the product. The company then designs the product based on the allowable (target) cost. Figure 12.4 compares the target costing approach to the tradi- tional approach.

Figure 12.4: Target costing compared to the traditional approach

Target Costing

Traditional Approach

Design the product

Obtain the target selling price

Determine the cost

Deduct the target profit margin

Add a required profit margin

Obtain the target cost

Obtain the required selling price

Design the product based on target cost

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Section 12.3 Activity Analysis

In target costing, the process begins with a general plan to produce a product based on mar- keting research. This marketing research also suggests a target selling price by estimating what consumers will pay for the product. The company then determines the amount of profit that would be expected by management for this product. From this target price and target profit, a target cost is obtained:

Target cost = Target selling price – Target profit

This overall target cost is then decomposed into specific cost elements for materials, subas- semblies, direct labor, various manufacturing overhead categories, and various nonmanufac- turing categories such as distribution and customer service. Finally, the design department establishes a blueprint according to the target cost for each element.

As an example of the target costing approach, suppose that Lylatove Sleepwear is considering the production of a new line of pajamas. Based on preliminary market research, management has decided that each pair of pajamas should be priced at $20. Furthermore, management believes that the profit margin should be 12% of sales revenue. Hence, the target profit would be $2.40 (0.12 × $20). The target cost, therefore, would be $17.60 ($20 – $2.40).

Kaizen Costing Kaizen costing is a system to support cost reduction beyond the design and development stages. “Kaizen” is a Japanese word that refers to “continuous accumulations of small better- ment activities rather than innovative improvement” (Monden & Hamada, 1991, p. 17). Inno- vative improvements are usually introduced in the design and development stages. In kaizen costing, the actual cost for the previous period becomes the kaizen cost target for the current period. To promote continuous improvement, these kaizen cost targets must be reduced in each successive period. For instance, suppose a company’s shipping costs are $10,000 for 2020 and that its kaizen cost reduction targets are 3% per year for the next two years. So, for 2021, its kaizen cost target would be $9,700 (.97 × $10,000), and for 2022, it would be $9,409 (.97 × $9,700).

These techniques have allowed many Japanese firms to overcome the effects of the increased value of the yen in international markets. Lower costs and improved products have offset less competitive yen exchange rates.

To achieve cost reduction, many companies are adopting an activity-based management (ABM) approach. ABM is an outgrowth of activity-based costing (ABC) that emphasizes man- agement of activities through ABC, activity analysis, and performance measurement. We dis- cussed ABC in Chapter 4; the latter topics are discussed in the following sections.

12.3 Activity Analysis Companies are monitoring their activities to assess which activities add value to the cus- tomer, which, in turn, should add profit to the company. This technique is referred to as activ- ity analysis. An emphasis on activities can help identify nonvalue-added costs and eliminate

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Section 12.3 Activity Analysis

the activities that cause them. Any resource-using activity that does not add value is often called waste. Having value implies that a consumer would be willing to pay for the results of the activity. A key goal of production managers is to eliminate waste and, thereby, to have an efficient and productive operation.

Time is perhaps the most valuable resource. Study of nonvalue-added time in operations takes five forms: process time, inspection time, move time, wait time, and storage time.

Process time is the time during which a product is undergoing conversion activities that transform raw materials into finished products. Although most people view process time as the sum of many value-added activities, the presence of inefficiency or other nonproductive activities represents nonvalue-added time. Managers must continually review processes to catch inefficiencies that can creep in over time.

Just-in-time (JIT) production concepts are fundamental building blocks for reducing process time. Many companies have physically reorganized their factories to encourage faster process time. Figure 12.5 compares a JIT layout to a traditional factory layout. The traditional plant has large inventories, much materials movement within the plant, and a mixing of fabricat- ing and assembly tasks. The JIT plant produces only when parts and products are needed, carries low amounts of inventories, has a north-to-south flow of production, and organizes production around product families (similar production requirements). The implication is that greater output can be achieved with the same equipment, people, and space—waste is reduced.

Figure 12.5: Traditional factory versus just-in-time factory layouts

Fabricating & Assembly Areas

Raw Materials Inventory Receiving Dock

Shipping Dock

Finished Goods

Inventory

In-Process Inventory

Finished Goods Inventory

Raw Materials Inventory Receiving Dock

Shipping Dock

Fabricating Areas & Cells

Work Units

Product Family Cells

Traditional Factory Layout With Large Materials, In-Process,

and Finished Goods Inventories

Just-In-Time Factory Layout With a Pull-Through Flow, Few Inventories,

and Integrated Manufacturing

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Section 12.3 Activity Analysis

Inspection time is the amount of time spent ensuring that the product is of high quality. Typ- ically, materials and components are inspected upon arrival. Then inspection occurs at vari- ous points during and at the conclusion of the production process. It is difficult to determine whether inspection procedures result in nonvalue-added costs without detailed knowledge of the production technology and inspection procedures. However, many companies are striv- ing to reduce the costs of maintaining product quality and are working virtually to eliminate the costs of reworking defective products. Consequently, zero defects and total quality control programs sensitize employees to the need for eliminating spoiled and defective units. The argument is that quality is built into and not inspected into the product. Unless otherwise stated, we presume that inspection is a nonvalue-added activity.

Move time is the time spent moving raw materials, work in process, or finished products between operations within the plant. This includes the activities associated with receiving materials, moving them into storage, moving materials and components to the first produc- tion operation, moving partially completed products from one work center to the next, and moving the completed product to the finished goods storage area to await shipping. Many companies refer to these activities as materials-handling operations. Move time is a non- value-added activity. A certain amount of move time is necessary in any production process, but proper sequencing of operations and tasks and implementing automation technologies can significantly reduce move time. Figure 12.5 illustrates the importance of an efficient flow through the factory to minimize materials movement.

Wait time is the amount of time that materials or work in process spend waiting for the next operation. This includes the time that materials, components, and partially completed prod- ucts remain in queues immediately preceding an operation and in holding areas located near each department waiting for the next production operation. Wait time potentially represents a significant nonvalue-added cost. A company’s working capital is tied up in work in process, and space is unnecessarily wasted on numerous production queues and holding areas. Even in the simple diagrams in Figure 12.5, we see that space released from having inventory wait for the next production step can be used to expand production. The ultimate goal of the JIT philosophy is to eliminate wait time completely. Companies using JIT systems have proven that remarkable reductions in in-process inventories can be made. For example, a car assem- bly plant producing 70 cars per hour may have less than one hour’s supply of car seats in the plant at any time. When a car begins its two-hour trip along an assembly line, an electronic message is received in a supplier’s seating plant to trigger assembly of that car’s seats. The seats are built and delivered to the car assembly line minutes before the car arrives at the seat installation point.

Storage time is the time during which finished products are held in stock before shipment to customers. It includes the time products spend in storage and the time spent packaging the products for shipment. Traditionally, companies have stored large inventories of finished products to avoid stockouts. Similar to waiting time, storage time ties up a company’s working capital in inventories and requires large amounts of space devoted to storage activities. While not applicable to all manufacturing operations, produce-to-order is a goal—manufacture prod- ucts only after a sales order is received. Improvements in order entry systems and shortened lead times in production scheduling can give the appearance of a produce-to-order operation.

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Section 12.4 Nonfinancial Performance Measures

The time required for an average unit to go from the beginning of the production process to completion and shipment is often referred to as throughput time. This time is equal to pro- ductive processing time plus nonvalue-added time. More specifically, it is the sum of all five activities previously discussed: process time, inspection time, move time, wait time, and stor- age time. Suppose that the manufacturing of a particular cellphone began at 9 a.m. It spent two hours on the various assembly lines and another 15 minutes of inspection. In addition, there were three moves between assembly lines and two moves involving storage areas, all totaling 20 minutes. The phone spent a total of 30 minutes waiting at four different work sta- tions before work was initiated in those areas. Before shipment to the customer, the phone was stored in the warehouse for three hours. The throughput time amounts to 6.08 hours (2 + .25 + .33 + .5 + 3).

Contemporary Practice 12.1: Activity Analysis at Cater- pillar’s Marketing & Product Support Division (MPSD)

The activity-based management process starts by “searching for low- and no-value activities within each office process to eliminate or significantly reduce the cost of these activities. It ends by identifying the supply source for each office process. For MPSD, this meant examining the core competencies of its global operations, deciding what to keep doing internally and what to source from outside vendors. . . . Because Caterpillar has locations around the world, MPSD was able to address the services it provided to both internal (other Caterpillar divisions) and external (dealers and customers) organizations to leverage the global footprint by taking ABM-optimized processes and sourcing them where it made the most sense to provide each service.”

Source: DeFreitas, D.G., Gillett, J.W. & Fink, R.L. (2013, January). Getting lean and mean with Caterpillar with ABM. Strategic Finance, 24–33.

12.4 Nonfinancial Performance Measures As changes occur in the operating environment, traditional measures of performance are being reexamined. New measures are being adopted to better fit the concepts of activity- based management. In addition, accountants are measuring performance in new areas of operations, areas that have normally been outside of the accountants’ domain or are new because of needs that innovative and automated environments create. This section gives a glimpse of some of the critical changes taking place.

Accountants have traditionally focused on financial measures of performance, such as varia- tions from budgeted or standard costs. Such measures are still important, but a broader eval- uation including nonfinancial measures is necessary. For example, physical measures such as throughput time, value-added labor ratio, and defective product rates are playing greater roles in helping managers achieve high-quality and competitive operations. Let’s look at some nonfinancial performance measures that are commonly being used.

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Measures of Manufacturing Productivity Increasing pressure from global competition has caused many companies to focus on better measures of productivity. Traditionally, accountants have associated productivity with vari- ances calculated for quantity, efficiency, mix, yield, and capacity. The goal was cost minimi- zation. Other productivity measures commonly used were nothing more than quantities of output divided by quantities of input. Today, we are looking for more detailed, meaningful measures. Activity-based costing can pinpoint high-cost activities. Engineers can design for greater production efficiency and defect elimination. For example, a machine manufacturer might determine the number of machines produced per day per employee. A car assembly operation might ascertain the square footage required per day per car. An electrical generat- ing plant might keep track of the tons of coal required to generate a thousand kilowatt-hours of electricity. The measures are oriented toward specific activities and evaluate management control over these activities.

Manufacturing cycle efficiency (MCE) is a measure of the amount of throughput time that consists of process time. It is the following ratio:

Manufacturing cycle efficiency = Processing time

Throughput time

Remember that throughput time is the sum of process time, inspection time, wait time, move time, and storage time. Assuming that inspection time is nonvalue-added time, then MCE measures the portion of throughput time which is value-added time. The goal is to have MCE as high as possible, with 100% as the theoretical ideal.

Another widely used productivity measure is the first-pass yield. This measures the percent- age of nondefective items that have gone through the production process one time only (i.e., without needing any rework).

Computer-integrated manufacturing (CIM) is an attempt to optimize the entire plant’s pro- duction by planning which departments will produce which parts and products, in what order, and when. Formerly, each department’s efficiency was measured, and keeping all depart- ments running at full speed was the goal. Now in CIM, certain departments may be idled until their resources are needed. This is “pull through” production and part of the JIT philosophy. Produce only what is needed immediately. Performance measures must therefore evaluate a unit based on its production assignment, not necessarily its capacity. Responsibility for pro- ductivity is now moved to higher management levels and away from the individual activity center or cost center manager.

Productivity of Labor The total labor expended for the benefit of a product or service is segregated into direct and indirect labor. Direct labor is all labor that can be specifically identified with a product or service in an economically feasible manner. Value-added direct labor is that portion of direct labor that changes raw materials into a finished product or service that is delivered to a cus- tomer. For example, value-added direct labor fabricates, assembles, and finishes products.

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Nonvalue-added direct labor moves, inspects, stores, examines, or otherwise handles the products without adding customer value. Indirect labor is labor that is not readily traced to a product or service. Indirect workers supervise, repair, manage, purchase, inspect, record, advise, or otherwise support the direct workers. Traditionally, indirect workers are consid- ered nonvalue-added labor. In labor-intensive activities, one measure of performance for labor is the value-added labor ratio or ratio of value-added time to total time:

Value-added labor ratio = Value-added direct labor time

Total direct and indirect labor time

The ratio also may be computed in terms of number of employees or payroll. One goal is to reduce the number of supervisors, managers, clerical staff, accountants, engineers, inspec- tors, and all others that are nonvalue-added workers. This is part of empowering workers to work as teams and to assume responsibility for production.

In many operations, direct labor is being replaced by automated equipment, and indirect labor now includes technicians needed to program, set up, and maintain the equipment. Often, the distinction between direct and indirect labor is blurred or eliminated. Team approaches to production (work units or product family cells as shown in Figure 12.5), guaranteed wage labor contracts, and broader job classifications have further eroded the importance of direct labor as a cost group. A labor-related performance measure that does not distinguish between direct and indirect labor is the percentage of total labor cost in the total product cost, called the labor content percentage:

Labor content percentage = Total labor cost

Total product cost

The goals are to reduce this percentage and to increase the productivity of all labor dollars.

Product Quality Earlier in this chapter, we discussed financial measures of product quality. Costs of quality enable us to aggregate various aspects of quality by using a common unit of measure—dollars. Furthermore, costs of quality allow us to assess the impact of quality on the company’s profits. However, knowing the costs of quality does not enable us to pinpoint specific sources of quality problems. To diagnose and correct specific problems relating to quality, we need a variety of nonfinancial measures of quality.

Four categories of nonfinancial measures are helpful in assessing and maintaining quality. The first, customer acceptance measures, focuses on the extent to which a company’s custom- ers perceive its product to be of high quality. It includes such measures as counts of customer complaints, warranty claims, incidence of failures at customer locations, products returned, and repeat sales.

Design quality assesses how well a product has been designed. Frequency of engineering change orders is an important measure of design quality. Other measures include the number of parts in the product and the percentage of common versus unique parts. Since simplicity is

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desirable; the fewer the number of parts and the higher the percentage of common parts, the better the design quality.

In-process quality measures look at product quality during production. Rework, defects, and scrap measures are used to keep these items to a minimum. Products are also selected for testing at random, or statistically sampled during the various stages of production. Defect rates are measured, and corrective actions specified.

A fourth area of quality measurement relates to purchased materials and parts. Pressure is on purchasing agents to acquire high-quality inputs to meet materials requirements at low costs and on a timely basis. Common vendor performance measures include percentage of defects in the delivery (in terms of dollars as well as number of items), percentage of orders filled, and percentage of orders delivered on time. Many companies are now computing an overall rating of suppliers based on the quality of their materials, delivery performance, and customer service. Also, waste, scrap, and defects occurring during production that are trace- able to materials are identified with specific suppliers. A growing number of companies now have vendor certification programs, where managers may purchase from only those vendors who have met the company’s quality standards.

Inventory Reduction Inventory investments, ordering costs, and carrying costs often include significant amounts of nonvalue-added costs. To remain price competitive, effort is necessary to reduce or elimi- nate inventories. Many companies use an approach called economic order quantity, which utilizes a mathematical formula to minimize the total costs of ordering and storing invento- ries. The JIT philosophy focuses on keeping inventories at low or zero levels for materials and parts at every stage of production. Therefore, inventory control measures are used to minimize nonvalue-added costs. Such measures may include average inventory values, aver- age time various categories of materials are held or inventories are standing in a production operation, and inventory turnovers (cost of goods sold divided by average inventory). Mea- sures like manufacturing cycle efficiency also relate to inventory reduction because nonpro- cessing time—inspection, move, wait, and storage times—is much of the reason why inven- tories exist.

Machine Maintenance If our efforts to reduce inventories are successful, we shift our focus to the company’s capabil- ity of producing goods quickly. We must keep production equipment and machinery operat- ing. Therefore, performance measures will look at unscheduled machine downtime, equip- ment repair time, tooling turnaround time, engineering change time, machine availability, and adherence to maintenance schedules. Some companies even make a distinction between bot- tleneck and nonbottleneck machinery. A bottleneck operation is one that limits the production capacity of the entire facility. It is vital that the machinery in bottleneck operations be avail- able 100% of the time, excluding time for routine required maintenance. Managing bottleneck operations has received considerable attention in recent years and has become a central com- ponent of a management philosophy known as the Theory of Constraints. This philosophy emphasizes planning around constraining factors and working to relax the constraints.

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Delivery Performance As a final point, assume that we have done a super job of reducing many nonvalue-added activities and eliminating others. Still, we are not successful until quality products are deliv- ered on time and at the right place to the customer. This is especially important for customers who have JIT systems.

Some companies have a goal of filling 100% of their orders on time. Common measures of delivery performance include the percentage of orders filled, the percentage of on-time deliv- eries, and the average time between the receipt of a customer order and the delivery of the goods. Monitoring customer backorders also tells how many orders were not filled from stock or on time and how long a customer had to wait for an order. A desirable piece of informa- tion often impossible to measure is business lost because of delivery failure. Many manag- ers believe that the “competitive ballgame” is won or lost with product quality and delivery performance.

In Figure 12.6, we summarize the nonfinancial performance measures previously discussed.

Figure 12.6: Summary of nonfinancial performance measures

Manfacturing Productivity Output per day per employee Output per square foot of space Energy required per unit of output Manufacturing cycle efficiency First-pass yield

Productivity of Labor Value-added labor ratio Labor content percentage

Inventory Reduction Average inventory values Average time inventories are held Inventory turnovers

Machine Maintenance Unscheduled machine downtime Equipment repair time Tooling turnaround time Engineering change time Machine availability Adherence to maintenance schedules

Delivery Performance Percentage of orders filled Percentage of on-time deliveries Time from customer order to delivery

Product Quality Customer acceptance: Number of customer complaints Number of warranty claims Incidence of failures at customer locations Number of returned products Repeat sales

Design: Frequency of engineering change orders Number of parts in the product Percentage of common vs. unique parts

In-process: Amount of rework Defect rates Amount of scrap

Materials and parts: Percentage of defects in the delivery Percentage of orders filled Percentage of orders delivered on time

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Section 12.6 Balanced Scorecard

12.5 Nonfinancial Measures for the Multinational Company

Multinational companies are increasingly using nonfinancial performance measures in evalu- ations. Common ones for international operating units are:

1. Increasing market share and market size 2. Relationship with host country government 3. Quality assurance 4. Productivity improvement 5. Customer development 6. Innovation 7. Cooperation with other company units and the parent 8. Environment compliance 9. Employee training and development

10. Employee safety 11. Labor turnover 12. Community service

Notice that for some of these measures a company will have difficulty attaching numerical values. These measures are very important in comparing performances, particularly over time and against planned target levels.

The implication is that the corporate office is in close touch with the international operation, can assess budget and planning targets astutely, and can link successful performance in the local environment with global economic goals of the corporation.

12.6 Balanced Scorecard Many companies are integrating financial and nonfinancial performance measures into a tool that has become known as a balanced scorecard. Historically, companies’ operational and management control systems have been built around short-term financial measures that have not been linked to long-term strategic objectives. A balanced scorecard attempts to over- come this deficiency by using a set of performance measures that serve to link a company’s long-term strategy with its short-term actions. The scorecard communicates the long-term strategy to all levels of the organization so that both departmental and individual objectives are aligned with the company’s goals.

Typically, a balanced scorecard consists of the following four categories of performance measures:

• Financial—measures that describe economic consequences and are of most interest to shareholders.

• Customer—measures that relate to the customer’s perspective and to the market segment in which the company competes.

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• Internal business process—measures that describe the internal processes (i.e., the means) needed to provide value for customers and shareholders.

• Learning and growth—measures that define the capabilities needed to create long- term growth and innovation.

A balanced scorecard is not simply a collection of performance measures. These measures are derived from the company’s mission, strategy, and objectives and represent a balance among the four measurement perspectives. In the financial category, the strategic themes often include revenue enhancement, cost minimization, and asset utilization. Examples of these financial measures, as well as measures for the other three categories in the balanced score- card, can be found in Figure 12.7. Strategic themes for the customer category often include market share growth, customer retention, customer acquisition, and customer satisfaction. In the internal business process category, the strategic objectives relate to increasing the effi- ciency and effectiveness of operations. The objectives for the learning and growth category relate to the ability to innovate and improve.

Figure 12.7: Examples of measures in a balanced scorecard

Financial Revenue enhancement: Revenue growth from prior period Product profitability Cost minimization: Product cost per unit Cost per customer Asset utilization: Return on investment Residual income Economic value added

Customer Market share Number of new customers Percentage of returned products Customer survey ratings Percentage of customers paying early

Internal Business Process Percentage of defective units Manufacturing cycle efficiency First-pass yields Output per square foot of space Supplier ratings

Learning and Growth Employee satisfaction ratings Training hours per employee Number of new brands introduced Inventory of cross-functional employee skills Percent of revenue from new products

The frequency of measurement varies depending on the type of performance measure. For instance, operating measures such as machine downtime or percentage of orders filled may be measured daily. Other operating measures such as manufacturing cycle efficiency or amount of rework may be measured weekly. Yet others such as inventory turnovers and num- ber of warranty claims may be measured quarterly. Some measures such as economic value added (EVA) and number of new products introduced may be measured annually. Generally, nonfinancial measures are reported more frequently than financial measures.

As a result of introducing the balanced scorecard, some companies have reduced their empha- sis on short-term incentive compensation systems. Instead, they are linking bonuses to bal- anced scorecard measures. One particular oil company decided to base 60% of its executive

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Section 12.7 Benchmarking

bonuses on the achievement of targets relating to four financial factors: return on capital, profitability, cash flow, and operating cost. The remaining 40% is based on indicators of cus- tomer satisfaction, dealer satisfaction, employee satisfaction, and environmental responsibil- ity (Kaplan & Norton, 1996).

Contemporary Practice 12.2: Balanced Scorecard at Store24

“Store24 is a privately held convenience store retailer in New England. . . . Store24 used a balanced scorecard-based performance measurement system. The company collected information on a variety of performance measures at various levels of the organization and at various frequencies. Management collected store-level financial performance metrics quarterly. It monitored store-level customer measures less frequently.”

Source: Campbell, D., Datar, S.M., Kulp, S.L., & Nayayanan, V.G. (2015). Testing strategy with multiple performance measures: Evidence from a balanced scorecard at Store24. Journal of Management Accounting Research, 27(2), 39–65.

12.7 Benchmarking To improve both quality and productivity, many companies are turning to benchmarking. This technique identifies activities as standards (“benchmarks”) by which similar activities should be judged. Simply put, it is a process of finding better practices. Benchmarking can be done with internal sources—other parts of the company—or with other companies, includ- ing competitors. The external candidates are often obtained by examining lists of companies cited in trade and business journals for excellence in their business practices.

Aside from trade and business publications, performance benchmarks can be gathered from electronic databases, professional conferences and trade conventions, commissioned studies, and site visits to companies. Benchmarking utilizes both financial and nonfinancial perfor- mance measures. But this information says nothing about the changes needed to improve quality and efficiency. Therefore, those doing the benchmarking must also obtain an under- standing of these “best practices” so that they can implement them in their own organizations.

To promote ethical benchmarking, the International Benchmarking Clearinghouse and the Strategic Planning Institute Council on Benchmarking have adopted a common Code of Con- duct. These rules of conduct cover such areas as:

• Legal matters (e.g., collusion to restrain trade) • Integrity • Confidentiality • Proper use of information and names • Contacting policies • Preparation for benchmarking

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Section 12.8 Strategies to Enhance Productivity

12.8 Strategies to Enhance Productivity To achieve gains in productivity, many companies have turned to various strategies in recent years. Two of these strategies are downsizing and business process reengineering.

Downsizing For many companies, particularly in service industries, a major portion of costs are labor- related costs. These include not only the wages and salaries of employees but also fringe ben- efits and overhead costs to support labor such as telephone expenses and office space. Thus, when companies look to reduce costs and improve efficiency, a prime candidate becomes the reduction of their work force. This phenomenon, sometimes referred to as downsizing, can involve outsourcing one or more functions, consolidating certain functions, initiating across- the-board cuts in personnel, or eliminating business segments such as product lines or geo- graphical territories.

While downsizing may reduce costs and improve efficiency in the short run, it can harm the company’s long-run competitiveness and well-being. Remaining employees sometimes become overburdened, making more mistakes and declining in productivity. Morale suffers. Employees fear for their jobs, and company commitment takes a back seat to personal inter- ests. Therefore, if downsizing is deemed necessary, it must be done with extreme care.

Often, downsizing is accompanied by fundamentally changing the way a company operates. This strategy is called business process reengineering.

Business Process Reengineering A business process is a series of activities that are linked to perform a specific objective. Busi- ness processes include both manufacturing as well as nonmanufacturing processes such as purchasing materials or handling customer inquiries and complaints. Business process reengineering (BPR) refers to changes made in management, organizational structure, and work practices to achieve significant improvements in quality, cost, speed, and service. BPR is not merely a marginal changing of processes; rather, it involves major restructuring of orga- nizational forms, management procedures, job descriptions, work flows, control systems, and organizational cultures.

One of the main principles of BPR is to organize work around processes and outcomes rather than around tasks and departments. Instead of having a specialist for each separate task, one person or group is responsible for an entire process. This has led to the replacement of func- tional departments like sales and production with interdisciplinary teams that focus on per- forming an entire process. For instance, at IBM Credit Corporation, the credit approval pro- cess formerly involved five different individuals. Credit requests were forwarded to someone to check the applicant’s credit, then to another person to set the interest rate, and so on. IBM Credit reengineered this process so that one individual, called a deal structurer, completely processes an application.

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Chapter Summary The focus on quality has caused the analysis of the costs of quality to become an important managerial task. These costs are broken into four components: prevention, appraisal, inter- nal failure, and external failure. Often it is difficult to define these costs clearly. The goal is to reduce total quality costs. Often this is done by increasing prevention and appraisal costs to reduce or nearly eliminate failure costs. ABC systems have aided the measurement and reporting of these costs significantly. Quality costs and documentation are the management accountant’s responsibility.

Recognizing that most costs of production are determined when products are developed and designed, many companies are turning to a technique known as target costing. After a target selling price and a target profit are established, a target cost is obtained for the product. The company then designs the product based on the target cost. To promote continuous improve- ment in the manufacturing stage, kaizen cost targets are reduced in each successive period.

Activity analysis involves reviewing activities and eliminating those that do not add value to the product. Throughput time is composed of process time, inspection time, move time, wait time, and storage time. The most common place to look for nonvalue-added activities is in inspection, move, wait, and storage time.

Traditional measures of performance are being reexamined. New measures are being adopted to better fit the concepts of activity-based management. These are largely nonfinancial mea- sures relating to manufacturing productivity, labor productivity, product quality, inventory reduction, machine maintenance, and delivery performance. Many companies are beginning to integrate nonfinancial measures with financial measures into a balanced scorecard. Com- panies are also benchmarking their performance against best practices from other organiza- tions. To achieve gains in productivity, many companies have turned to strategies such as downsizing and business process reengineering.

Ethical Considerations Enhancing productivity via downsizing or business process reengineering can be traumatic for individuals in the organization. Therefore, management must be careful to conduct these changes in an ethical manner. A key consideration should be to communicate the changes in an honest way. Decisions as to who gets terminated and how it is done can be subject to serious abuses. Those whose job duties are changed should be properly informed about new expectations and should be trained adequately for their new roles.

Major downsizing or business process reengineering can sometimes affect entire communi- ties. Such is often the case with plant closings. Should management consider the impact of a plant closing on the welfare of the surrounding community? Many people believe that there is an ethical responsibility to do so.

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Key Terms activity analysis Monitoring activities to assess which activities add value to the customer, which, in turn, should add profit to the company.

appraisal costs Costs of quality that are incurred to monitor and inspect production.

balanced scorecard A tool that integrates financial and nonfinancial performance measures.

benchmarking Comparing operations, costs, and productivity with world-class performers.

business process reengineering (BPR) Changes made in management, organizational structure, and work practices to achieve significant improvements in qual- ity, cost, speed, and service.

continuous improvement programs Efforts to establish quality targets that represent improvement over current per- formance through worker involvement in evaluation processes.

downsizing Removing entire layers of management to make the organization “lean and mean.”

economic order quantity A technique that utilizes a mathematical formula to mini- mize the total costs of ordering and storing inventories.

external failure costs Costs of quality that are incurred when the defective product or service gets to the customer.

first-pass yield The percentage of good product that passes through the production process without needing rework.

inspection time The amount of time spent ensuring that the product is of high quality.

internal failure costs Costs of quality that are incurred after defective products or services are detected but before they reach the customer.

kaizen costing A system to support cost reduction after the design and development stages. The actual cost for the latest period becomes the kaizen cost target for the cur- rent period.

labor content percentage Total labor costs expressed as a percentage of total product costs.

manufacturing cycle efficiency (MCE) A measure of what part of throughput time consists of process time.

move time The time spent moving raw materials, work in process, or finished goods between operations.

prevention costs Costs of quality that are incurred to prevent the production of products or services that do not meet specifications.

process time The time during which the product is undergoing the conversion activities that transform raw materials into finished products.

statistical quality control The use of sta- tistical techniques on processes to measure, monitor, and evaluate performance based on goals, control ranges, and performance percentages.

storage time The time during which mate- rials, partially completed products, or fin- ished products are held in stock before fur- ther processing or shipment to customers.

Theory of Constraints A philosophy that emphasizes planning around constraining factors and working to relax the constraints.

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throughput time The time it takes for an average unit to go from the beginning of the production process to completion and shipment.

total quality management (TQM) An inte- grated effort of training, process controls, incentives, employee empowerment, prod- uct engineering and design, supplier involve- ment, and customer satisfaction measure- ment to achieve quality goals.

value-added labor ratio The ratio of value- added time to total time.

wait time The amount of time that materi- als or work in process spend waiting for the next operation.

Problem for Review The following accounts were listed among the chart of accounts for Arbiser Machine Tooling:

Warranty Repairs Supplier Training and Certification Programs Cost Accounting Salaries Engineering Design Reviews Customer Returns and Allowances Scrap Depreciation on Machinery Final Product Testing Rework Time Planned Machine Maintenance Emergency Machine Repairs Purchased Materials Inspection Direct Labor

Required:

Classify these accounts according to the appropriate costs of quality category: prevention, appraisal, internal failure, or external failure. Not all accounts will be included.

Solution:

Prevention costs:

• Supplier Training and Certification Programs • Engineering Design Reviews • Planned Machine Maintenance

Appraisal costs:

• Final Product Testing • Purchased Materials Inspection

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Internal failure costs:

• Scrap • Rework Time • Emergency Machine Repairs

External failure costs:

• Warranty Repairs • Customer Returns and Allowances

Cost Accounting Salaries, Depreciation on Machinery, and Direct Labor may include elements of quality costs, but they are not normally considered costs of quality accounts. If quality costs are included in these accounts, they should be segregated by creating new expense accounts to track these costs directly.

Questions for Review and Discussion

1. Identify four categories of costs of quality. Give an example of each. 2. Greg Orian, Controller of Calendar Creators, sees the four categories of costs of qual-

ity as substitutions for each other. Explain why he might believe this. 3. Why might the task of measuring, reporting, and analyzing costs of quality be dif-

ficult? Can these costs be easily benchmarked across firms? Explain. 4. Discuss the possible linkage between monitoring quality by measuring quality costs

and by using nonfinancial measures of quality performance. Comment on which is most important.

5. For most firms, is it possible to eliminate failures and, therefore, failure costs? Is it possible to push total quality costs to zero? Explain.

6. How is target costing different from the traditional approach of setting costs and prices?

7. What is meant by the term “nonvalue-added costs?” Provide three examples. 8. Explain the value-added labor ratio. 9. Why are nonfinancial measures of quality needed in addition to costs of quality?

10. Describe the four types of nonfinancial measures related to product quality. 11. What are the common external sources for obtaining performance benchmarks? 12. Explain business process reengineering.

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Exercises

12-1. Costs of Quality Categories. The following accounts and their costs are from Kes- sler Textiles.

Questions:

1. Classify these costs by the four costs of quality categories. 2. If sales were $4,600,000, show the costs of quality as a percentage of sales for each

category and in total.

Customer design verification $ 5,000

Machine testing after machine setup 10,000

Employee training 40,000

Raw materials testing 12,000

Scrap loss net of scrap sales 30,000

Materials reprocessing 28,000

Customer complaints and returns 40,000

Final product testing 20,000

In-process inspection 45,000

Routine machine maintenance 25,000

Nonroutine machine repairs 50,000

Discounts for missed delivery dates 33,000

Price reductions for product quality downgrades 68,000

Idle labor—downtime due to machine repairs 37,000

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12-2. Costs of Quality Trends. Haber & Blass, an architectural firm, recently studied its costs over the past three years. The partners of the firm have been promoting total quality management programs to its clients for years. They finally decided to apply the same concepts to their own business. After much discussion, they adopted cer- tain definitions of quality costs and began to monitor them. They did acknowledge that internal failure costs also included costs of nonvalue-added activities that were not technically failure costs. Now, three years later, they show the following data as highly summarized results of their efforts.

2019 2020 2021

1st Half 2nd Half 1st Half 2nd Half 1st Half 2nd Half

Prevention costs $ 5,000 $ 20,000 $ 50,000 $ 60,000 $ 50,000 $ 55,000

Appraisal costs 40,000 60,000 65,000 70,000 72,000 70,000

Internal failure costs 120,000 130,000 120,000 123,000 110,000 105,000

External failure costs 43,000 30,000 25,000 26,000 18,000 15,000

Client billings have gone up modestly over the three years, perhaps 20% in total.

Questions:

1. For each cost category and each time period, determine its percentage of total costs for that time period.

2. Comment on the changes over the three-year time period and the results of the three-year effort.

12-3. Analysis of Quality Costs. Goldin Realtors has reported the following data for 2020:

Prevention costs $374,000

Appraisal costs 615,600

Internal failure costs 651,400

External failure costs 27,100

Question:

Comment on the following thoughts:

a. Prevention and appraisal spending has eliminated nearly all customer quality problems.

b. More should be spent on prevention to even the spending among the three inter- nal cost categories.

c. A goal of reducing costs in each category by 10% (or by some specific dollar amount) should be set in next year’s profit plan.

d. A good job has been accomplished if the sum of the four costs as a percentage of sales declines somewhat.

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12-4. Classifying Costs of Quality. Paul Miller, controller of Meta Medical, has reviewed the costs of quality records for the past year. Meta Medical provides calibration and maintenance services for sophisticated medical equipment in the Midwest. Training, testing, and service calls are major costs that seem to grow each year. Miller is trying to measure possible ways of reducing the total costs of quality as part of a review of all processes and activities within the firm. He assembled the following costs.

Miller is aware of two contracts that were cancelled this past year because of client complaints about poor service response. These contracts totaled $60,000.

Questions:

1. Classify these costs according to prevention, appraisal, internal failure, and external failure.

2. Comment on the difficulty that Paul Miller likely has in analyzing these and other costs that might be costs of quality.

12-5. Target Costing. Janet Harris, general manager of Banks Bus Service, is considering adding a new route. Based on preliminary market research, she has decided that the fare should be $3.50.

Question:

If the company’s profit margin is 20% of revenues, what should the target cost be?

12-6. Kaizen Costing. In 2019, Heights High School incurred the following costs in its athletic department:

Parts warranty, including replacement labor $ 92,000

Emergency trips to service client machines 86,000

Rental of substitute equipment to cover client downtime 43,000

Training of repair technicians (time and travel) 196,000

Inspection of finished repairs 45,000

Testing and certifications of calibration equipment 15,000

Development of client testing processes and diagnostics 31,500

Event Cost per

Event

Track meet $600

Swim meet 950

Soccer game 820

Water polo match 980

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The school has recently begun a system of kaizen costing. Accordingly, the principal, Janet Orr, has asked Jim Nasium, the head of the athletic department, to reduce costs by 2% each year for the foreseeable future.

Question:

Assume that Jim Nasium reduces costs according to the plans set by Janet Orr. Compute the projected kaizen cost targets in 2023 for each of the preceding events.

12-7. Value-Added and Nonvalue-Added Activities. Loretta Love Clothiers manufac- tures denim jeans in a process that passes through three departments. The output of each department is immediately transferred to the next department to await further work. Output from the last department in the process represents the completed product, which goes to finished goods inventory to await shipping. Specifically, dyed denim cloth bales are released from the storeroom (materials inventory) and moved to the Cutting Department where the fabric is cut to patterns. The cut pieces are sorted into sets of jeans. Any miscut pieces are scrapped. The sets move to the Stitch and Form Department where the pieces are sewn together. Thread, zippers, and snaps are added during this process to make the completed jeans. The jeans are sent to the Inspection and Finishing Department. Inspection makes certain that jeans meet quality standards; spoiled and defective jeans are removed from the process. Spoiled jeans go to the scrap pile. Inspectors must determine the extent of defect in those jeans considered defective. If the defect can easily be corrected, the jeans go back into the process where the work will be done. If the defect cannot be corrected, the jeans are treated as seconds and are sold unlabeled in factory outlets and dis- count stores. Those jeans successfully passing inspection move to the labeling tables where brand labels are stitched on each pair of jeans. The completed jeans move to the warehouse where they become part of the finished goods inventory.

Questions:

1. Identify the activities in the denim jeans production process that fall into process time, inspection time, move time, wait time, and storage time.

2. List the activities in the denim jeans production process that are candidates for nonvalue-added activities.

12-8. Value-Added Labor. Natasha Company produces air pumps in a small factory about 30 kilometers south of Moscow, Russia. The company employs eleven people with nine direct and two indirect laborers. The plant manager, Boris Badinov, describes the tasks of the nine direct workers as follows:

a. Three fabricators who cut and grind metal parts from raw steel, aluminum, and brass

b. One parts inspector who examines and approves parts produced c. One warehouse stocker who keeps parts in inventory and fills bins used by

assembly workers

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d. One molder who makes vinyl seals and plastic fittings by using an injection molder

e. Two assemblers who assemble parts into product f. One product inspector who approves the final product

Questions:

1. Categorize each of the nine workers as a value-added or nonvalue-added worker. 2. Compute the value-added labor ratio.

12-9. Nonvalue-Added Costs in a Doctor’s Office. Dr. Steve Rosenthal has his own medical practice. He specializes in the treatment of diabetics. His staff consists of a receptionist, two nurses, a lab technician, and a dietitian. As patients enter the outer office, they check in with the receptionist. The patient then waits until called by a nurse. When called, the patient moves from the waiting room to the inner offices. The patient must weigh in and is then assigned a room for the rest of the work and conferences. The nurse assigning the patient to a room gathers all the personal data for updating the medical records, such as insulin dosage, medication, illnesses since last visit, and so forth. The nurse also takes an initial blood sample for blood sugar testing and performs a blood pressure test. The patient then waits until the doctor comes in. After the doctor’s conference, the nurse returns to take more blood sam- ples, depending on what is ordered by the doctor. The patient then waits until the dietitian comes to review eating habits and talk about how to improve meal plan- ning and weight control. The patient returns to the receptionist to pay for the office visit and to schedule the next visit.

Questions:

1. Identify the activities in the doctor’s office that fall into process time, inspection time, move time, wait time, and storage time.

2. List the activities in the doctor’s office that are candidates for nonvalue-added activi- ties. Explain why you classify them as nonvalue-added activities.

12-10. Downsizing, Kaizen Costing, and Ethics. Biltmore Insurance Corporation insti- tuted kaizen costing in 2019 for all of its divisions. During 2018, the Claims Division incurred costs of $5.6 million. Seeking to dramatically reduce costs, the manager of the Claims Division, Gail Norman, thought about cutting $200,000 in payroll costs for 2019 by eliminating all part-time claims adjuster positions. However, she soon realized that her kaizen cost target for 2020 would then be $5.4 million. Therefore, she decided to institute her reforms much more slowly and, consequently, reduced payroll costs by only $40,000 during 2019.

Question:

Discuss the ethical dimension of Gail Norman’s dilemma.

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12-11. Balanced Scorecard. Nemeth’s Pizza Shops (“Seven days without pizza makes one weak”) operates in 55 locations throughout Pennsylvania and Maryland. The CEO, Eddie Berger, wants to institute a performance measurement system based on a bal- anced scorecard. The following measures are being considered:

a. Percentage of pizzas delivered on time i. Number of customer complaints

b. Percentage of sales growth j. Number of pizzas per labor hour

c. Pounds of pizza scrapped k. Hours of community volunteer work

d. Production cost per pizza l. Return on invested capital

e. Packaging materials cost per month m. Cost per delivery

f. Percentage of repeating customers n. Throughput time

g. Employee turnover percentages o. Suggestions per employee

h. Response time to customer inquiries p. Safety incident index

Question:

Classify the performance measures into the four categories contained in a balanced scorecard.

Problems 12-12. Trends in Quality Costs. Kal Held Properties sells time sharing for its condomini-

ums in Florida. Michael Leader, the controller, has just finished a study of its quality costs. Based on recent accounting reports, quality costs for the 2018 fiscal year are as follows:

Prevention costs $100,000

Appraisal costs 300,000

Internal failure costs 400,000

External failure costs (including lost sales) 300,000

These costs are 11% of sales. The firm plans to implement a program called “TQM Victory” to reduce quality costs in total and as a percentage of sales. Sales are expected to expand by 10% per year. By 2020, it expects to spend $300,000 on prevention costs by substantially expanding employee training. Improved inspection efforts will add $100,000 to appraisal costs. By 2020, each failure cost category will be reduced by 10%.

By 2022, continued efforts will hold prevention and appraisal costs constant; but external failure costs are expected to drop to 1% of sales. Internal failure costs will drop 30% from 2020 levels.

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By 2024 (the target year of the TQM effort), prevention costs should fall to $200,000; appraisal costs could be cut in half from 2020 levels. Internal failure costs should drop another 40% from their 2022 levels. And, external failure costs are targeted to be no higher than 0.3% of sales.

Questions:

1. What are total quality costs targeted to be in 2024? 2. Can the firm get to a 4% of sales target by 2024? Explain. 3. Comment on at least three key assumptions you see from the data provided.

12-13. Analyzing Quality Costs Over Time. Management of Spero Software Services (SSS) has recently implemented a TQM program to eliminate a serious level of “program bugs” that has plagued its recent product releases. The following activities and their costs were taken from SSS’s records. The data are for 2018 (the year prior to the TQM program) and 2020 (the year after the start of the TQM program).

2018 2020

Design documentation standards development $ 0 $100,000

Software testing—prerelease 50,000 140,000

Documentation of customer training process 0 20,000

Documentation of changes to software 5,000 20,000

Customer training 100,000 130,000

Software testing—customer site 130,000 80,000

Telephone “on-line” customer problem support 90,000 60,000

Software corrections and redesign 50,000 20,000

Field “troubleshooting” for customer support 140,000 80,000

Costs of contract cancellations 180,000 30,000

Revenues lost due to delivery date delays 0 120,000

Training for systems designers/programmers 100,000 250,000

Training for sales staff 10,000 80,000

Questions:

1. Categorize the costs of quality for both years. 2. Evaluate the two years. Develop a scenario to explain the major differences in costs

between the two years. In other words, what happened? 3. If 2018 showed an operating loss and 2020 showed a small operating profit, would

this change your scenario in Part 2 or confirm it? Explain.

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12-14. Business Process Reengineering. Fishwrap, Inc. owns a chain of 20 similar-sized newspapers. A decentralized purchasing system is used, whereby each newspaper obtains its own newsprint. On average for all newspapers, 70% of the newsprint is delivered on time.

The following average cost data per newspaper have been obtained for the past year:

Costs of newsprint $980,000

Purchasing Department salary costs 240,000

Other Purchasing Department costs 125,000

Of the above newsprint, an average of $7,200 turned out to be defective.

Because of the decentralized purchasing system, Fishwrap has been unable to take advantage of quantity discounts. Therefore, the company reengineered the purchas- ing process by introducing a corporate Purchasing Department. Each newspaper continued to purchase its own newsprint from approved vendors. However, the corporate controller, Diane Green, began to track the purchases of all 20 newspa- pers and used that data to negotiate quantity discounts and resolve problems with vendors. The on-time delivery rate improved to 85%. The defect rate (in terms of dollars) decreased by 60%. The average quantity discount amounted to 2.8% of newsprint cost. After reengineering, the average salary and other purchasing costs for the local departments decreased from $365,000 to $190,000. The annual costs of the centralized Purchasing Department are $1,800,000.

Question:

Evaluate whether reengineering the purchasing process was worthwhile.

12-15. Nonfinancial Performance Measures. Jagoda Hair Products manufactures a wide range of shampoos and conditioners. The company has the reputation for delivering high-quality products on time. Each month the CFO, Ricky Kaplan, issues a produc- tion efficiency report. The data compiled on these reports for the third quarter are as follows:

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Question:

Categorize each of the preceding nonfinancial performance measures as one of the following:

a. Manufacturing productivity b. Product quality c. Delivery performance d. Inventory control e. Machine maintenance

12-16. Cost of Breakage and Defective Customer Service. Bangkok Trucking Co. hauls goods throughout Thailand. The company guarantees arrival at the designated place within an agreed two-hour period. Penalty for late arrival is 10% off the shipping rate. The penalty for being a day late is 20% off shipping rates. Each additional day costs an additional 20%. The following portion of shipments will arrive late:

July August September

Manufacturing cycle efficiency 94% 96% 92%

Total setup time (hours) 62 60 58

Overtime hours 70 73 76

Power consumption in kilowatt-hours (000s omitted) 802 832 838

Machine downtime (hours) 15 10 20

Number of unscheduled machine maintenance calls 0 0 1

Inventory value/Sales revenue 4% 4% 5%

Number of defective units received in raw materials orders 2 1 0

Number of defective units—in-process 35 40 55

Number of defective units—finished goods 18 12 24

Percentage of customer orders filled 100% 100% 100%

Percentage of on-time orders delivered 99% 98% 94%

Number of products returned by customers 0 0 1

More than 2 hours but less than 1 day late 3%

1 day late 2%

2 days late 1%

Breakage of shipped goods results in additional costs related to replacing the goods, reshipping them to their destination, and the disruption of the customer’s business. The company follows the policy of paying replacement costs on all broken goods, refunding shipping charges on damaged shipments, and paying a 30% surcharge on the replacement cost for business interruption. Approximately 1% of goods shipped (in sales value) will be damaged in shipment.

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During July, Bangkok Trucking expects to make 642 shipments with total revenues (before breakage and slow service costs) amounting to 6,420,000 baht. The average shipment is expected to have an 8,000 baht replacement cost. The variable costs are 70% of the billed shipping rate. Fixed costs are 900,000 baht per month.

Questions:

1. Prepare an estimate of the penalties, or revenues lost, from late shipments during July.

2. Prepare an estimate of the costs of shipments with breakage payments. 3. Assume the company can make systems changes and implement training programs

that will reduce the late shipments to:

More than 2 hours but less than 1 day late 2%

1 day late 1%

More than 1 day 0%

The percentage of goods shipped that would be damaged would be cut in half. How much could the company afford to pay for such changes and programs?

12-17. Nonfinancial Measures of Product Quality. Howard Pen Company manufactures expensive calligraphy pens in two of its Ohio plants. One plant is located in Cleve- land, and the other is in Columbus. The pens produced are similar but not identical. Moe Howard, the president, wishes to evaluate the quality of production in each plant. He has asked the two plant managers, Larry Fine of Cleveland and Jerome (Curly) Howard of Columbus, to provide certain performance measures for the most recent year. After he threatened to tear out their tonsils, he received the following data from his two plant managers:

Cleveland Plant

Columbus Plant

Number of pens produced and sold 20,000 20,000

Number of parts in each pen 7 5

Number of unique parts in each pen 3 1

Percentage of pens returned by customers 2% 5%

Dollar amount of scrap $250 $370

Percentage of defects in parts received 3% 4%

Dollar percentage of defects in parts received 3.5% 3.2%

Number of warranty claims 22 39

Amount of pens that needed rework 950 1,400

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Question:

Provide an analysis of product quality performance for the two plants.

12-18. Nonfinancial Performance Measures. Robert Newman Associates manufactures transducers in one of its plants. The number produced and sold between 2019 and 2021 has remained steady. Specific performance data for these three years are pro- vided by the plant’s general manager, Howie Lee, as follows:

2019 2020 2021

Time from customer order to delivery 3 weeks 2.5 weeks 2.2 weeks

Number of failures at customer locations 76 88 91

Transducers produced per day per employee 25.6 29.1 30.6

Number of returned transducers 111 114 142

Manufacturing cycle efficiency 80% 89% 90%

Costs of scrap $1,897 $1,995 $2,066

Percentage of customer orders filled 85% 89% 91%

Average time inventories are held 20 days 26 days 28 days

First-pass yield 77% 72% 68%

Unscheduled machine downtime 10 hrs. 9.5 hrs. 8.5 hrs.

Number of engineering change orders 5 3 2

Costs of rework $8,144 $8,993 $9,857

Percentage of defects in delivered components 1.5% 1.9% 2.2%

Questions:

1. Did product quality improve from 2019 to 2021? Explain. 2. Did manufacturing productivity improve from 2019 to 2021? Explain. 3. Did inventory control improve from 2019 to 2021? Explain. 4. Did delivery performance improve from 2019 to 2021? Explain.

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Case: Murray’s Donut Heaven

Murray’s Donut Heaven manufactures donuts that are available fresh every day at several stores throughout Memphis. Donuts left over at the end of the day are packaged and sold at a reduced price as day-old donuts. Donuts not sold by the end of the second day are contributed to the local food bank. The production process consists of the following steps:

a. Ingredients such as flour, sugar, and cooking oil are received, inspected, and placed in the storeroom until requisitioned by production.

b. Upon requisition, the ingredients are transported from the storeroom to the production area and staged at the mixing area.

c. Ingredients are blended into a dough mixture in 40-pound batches by six heavy- duty mixers.

d. The dough is rolled on large boards and left to rise in a holding area. e. When the dough is ready, the boards are moved to the cutting machines; and

the donuts are cut. Leftovers from each cutting are accumulated, re-rolled on another board, and processed through the cutting machine. At the end of the production day, leftovers and unprocessed dough on boards are thrown into the trash.

f. The cut donuts and donut holes are placed on wire trays and taken to the cooking area, where the trays are stacked until ready for cooking.

g. The cooks empty the trays into large vats of hot cooking oil where the donuts and donut holes are, in effect, fried in a sea of oil.

h. The cooked products are removed from the vats and placed on drying pads that absorb the excess oil from the donuts. While the product is drying, it is inspected. Misshaped donuts are removed and set aside for disposal. What the crew doesn’t eat is thrown out at the end of the production shift.

i. After drying, the products are placed on large square boards and moved to the finishing area where they will be coated with glaze, icing, powdered sugar, coconut, candy chips, etc.

j. After the coating settles or dries, whichever is the case, the donuts are placed in boxes of four dozen each. Donut holes are packed in boxes with 100 donut holes per box. The boxes are moved to the shipping area to await the trucks that will deliver them to the various retail outlets.

k. Each morning the delivery trucks return the unsold donuts delivered the previous day. (For some reason donut holes are always sold out.) The day-old donuts are repackaged in plastic bags. Each bag contains one dozen donuts and is marked “day-old.” The packages are then returned to the retail outlets. On the second day, any unsold packages are returned to the shipping area. At the end of the day, these packages are delivered to the food bank.

Questions:

1. Identify the activities in the donut production process that fall into process time, inspection time, move time, wait time, and storage time.

2. List the activities in the donut production process that are candidates for nonvalue- added activities. Explain your rationale.

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