Modern Manufacturing Environment
1 Introduction
To compete in a global market, businesses have had to adapt and to adopt new systems, approaches and technologies. This chapter introduces the developments in modern manufacturing that changed the nature of operations, and with them the role of the management accountant.
The syllabus outcome is P2A2 — “Compare and contrast quality management methodologies”, and the word compare is doing real work. The four component outcomes are just-in-time, quality management, kaizen and process re-engineering, and the topics ask what each does to efficiency, inventory and cost, how they are reported, and where the boundary between incremental and radical change falls.
2 The modern manufacturing environment
This recording covers sections 2 to 6 and works Examples 1 to 3. Its long JIT argument — why a business holds inventory in the first place, and how removing each reason removes the inventory — is the source of section 3.1.
Notice. The cost-of-quality report in section 5.5 is not on the tape. The tutor sketches the conformance / non-conformance trade-off (section 5.4) and says “you wouldn't be asked to draw this graph” — which is right about the graph, but the syllabus names cost of quality reporting as a topic and that report is examinable.
The list below sets out where the modern manufacturing environment differs from the traditional one. The point of it is not the list: it is that every change on the left has forced a change in how costs are measured, controlled and priced — which is what the rest of section A is about.
What changed | What it means for the management accountant |
Level of competition | Prices are set by the market, not by cost plus a margin. Cost becomes something to be managed down to a target rather than recovered — chapter 3. |
Globalisation and distribution networks | A local supplier is no longer protected by geography. Cost comparison is now against the best in the world, which is what benchmarking measures. |
Impact of technology and advanced production methods | Automation converts direct labour into overhead. The share of cost that a volume-based absorption rate handles badly has grown — which is the argument for ABC in chapter 1. |
Consumer power and the worldwide web | Prices are transparent and switching is instant. Poor quality is published, so external failure cost now includes reputational damage that no ledger records. |
Product diversity and customised orders | Short runs and frequent changeovers. Batch level costs rise, and so does the error in any volume-based cost. |
Shorter product life cycles | Development cost has to be recovered over a shorter selling life, so a single period's margin is a poor guide — chapter 4. |
Quality requirements | Quality is measured and costed rather than assumed. See sections 5 and 6. |
Environmental and sustainability concerns | Waste, disposal and compliance are real costs, and they are increasingly reported. This is the sixth element of the CGMA cost transformation model. |
Legislation and regulation | Compliance cost is a fixed overhead that grows without adding value the customer will pay for. |
Attitude towards and participation of employees | Employees are the source of improvement suggestions rather than the object of control. Every methodology in this chapter depends on it. |
New performance metrics | Non-financial measures — defect rates, on-time delivery, throughput, set-up time — sit alongside the financial ones. Chapter 8 takes this further. |
3 Just-in-time
You should be familiar with just-in-time (JIT) from your earlier studies. The mistake to avoid is treating JIT as a rule about inventory levels. It is a philosophy about how the business operates, and low inventory is a consequence of it, not the object of it.
3.1 Why inventory is held, and what JIT does about it
Work through the reasons a business traditionally holds inventory, and each one turns out to be the symptom of a problem worth fixing in its own right.
Inventory held | Traditional reason for holding it | What JIT does instead |
Raw materials | A supplier might deliver late and production would stop. | Contract for reliable, frequent delivery, with penalties. A supplier who delivers on time removes the reason for the buffer. |
Raw materials | Workers might damage materials. | Damage costs money whether or not there is a buffer. Better training and better working removes the cost and the reason for the buffer together. |
Raw materials | A delivery might be faulty. | Make quality the supplier's contractual responsibility. Defect-free delivery removes goods-inwards inspection as well as the buffer. |
Work in progress | It takes time to make the product — unavoidable. | Reduce the time. Faster production cuts labour cost and cuts work in progress at the same time. It cannot reach zero, but the direction is one way. |
Finished goods | So a customer can be supplied immediately. | Produce fast enough that the customer will wait. If an order placed today ships tomorrow, the customer does not go elsewhere — and the storage cost and the obsolescence risk both disappear. |
The JIT argument in one line
Every reason for holding inventory is a problem that costs money anyway. Fix the problem and the inventory becomes unnecessary — so the inventory saving is the second benefit, not the first.
3.2 The features of JIT
The features of JIT
Can you recall the features of JIT, and what it requires, in terms of the following?
Levels of inventory holding
Supplier relationships
Maintenance of machinery
Empowerment of workers
Pull production flow
Quality
Wastefulness
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3.3 Benefits and drawbacks
Benefits and drawbacks of JIT
Note down some of the benefits and the problems of JIT.
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3.4 JIT purchasing and JIT production
JIT purchasing and JIT production
Outline the distinction between just-in-time production and just-in-time purchasing.
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4 Supply chain management
Supply chain management considers the relationships and the components within the supply chain that work together to deliver a product to the end customer. A typical chain runs suppliers → manufacturers → distributors → retailers → customers, and effective management and integration of the flows along it should increase profitability.
4.1 Areas for consideration
Area | What good practice looks like |
Purchasing | Enhanced supplier relationships and strategic alliances that improve service and quality — the same relationships JIT purchasing depends on. |
Inventory management and reporting | Better stock control, using technology to give real-time, accurate stock levels to customers and to the other members of the network. A supermarket's checkout scanning is the standard illustration: the till tells the central depot what to send, and only the depot holds inventory. |
Customer order process | Accurate, rapid, smooth, flexible and responsive to customer needs — which both completes the sale efficiently and increases the likelihood of a repeat purchase. |
Delivery and distribution logistics | Fast, reliable and accurate delivery, enhanced through technology and through the relationship with the distributor or courier. |
5 Quality and the cost of quality
5.1 What quality means
Quality means different things to different people. A dictionary definition suggests excellence. The modern definition looks at the user instead, so quality becomes fitness for use and user satisfaction.
Quality may cost more initially, but the gains are longer term: savings on failure, and profits from customer loyalty and brand value. The logic is that by spending more on prevention and detection — the costs of conformance — a business avoids a larger amount of failure cost, the costs of non-conformance.
5.2 Costs of conformance
Prevention costs — the cost of preventing defects before they occur. Training procurement staff to buy quality materials, designing for quality, supplier accreditation, preventive maintenance.
Appraisal costs — the cost of inspecting and testing: goods-inwards inspection of components before use, in-process inspection, final testing, quality audits.
5.3 Costs of non-conformance
Internal failure costs — the costs of quality failure incurred by the firm before the product reaches the customer: scrap, rework, re-inspection, downgrading, and machine downtime caused by defects.
External failure costs — the costs of poor quality arising after the product or service has reached the customer: returns, repairs under warranty, replacement, product recall, compensation — and loss of goodwill and of future sales.
The largest external failure cost is usually the one that never appears in the ledger. Lost goodwill and lost future sales are real and can dwarf the warranty claims, but no accounting system records them. A cost of quality report that shows only the measurable costs systematically understates the cost of getting it wrong — say so when you present one.
5.4 The trade-off between the two
Plot both against the level of quality achieved and they move in opposite directions. The cost of non-conformance falls as quality improves; the cost of conformance rises, and rises steeply as perfection is approached. The total is U-shaped.
Two things follow. First, the cost-minimising level of quality is not perfection — the last few percentage points of conformance cost more than the failure they prevent. Second, and more important in practice, the curves are not fixed: prevention spending that removes the cause of a defect pushes the whole non-conformance curve down, which moves the minimum to the right and lowers it. That is the TQM argument in section 6, and it is why “get it right first time” is not the same claim as “inspect harder”.
5.5 Cost of quality reporting
The syllabus names cost of quality reporting as a topic in its own right. A cost of quality report collects the four categories, values them, expresses them as a percentage of revenue so that periods and divisions can be compared, and tracks the movement between them over time.
What a reader looks for is not the total on its own. It is the shift between conformance and non-conformance: prevention and appraisal rising while internal and external failure fall by more.
A cost of quality report
Revenue is $20,000,000 in both years.
$000 | Year 1 | % of revenue | Year 3 | % of revenue |
Prevention | 120 | 0.6% | 400 | 2.0% |
Appraisal | 260 | 1.3% | 340 | 1.7% |
Cost of conformance | 380 | 1.9% | 740 | 3.7% |
Internal failure | 610 | 3.1% | 300 | 1.5% |
External failure | 940 | 4.7% | 260 | 1.3% |
Cost of non-conformance | 1,550 | 7.8% | 560 | 2.8% |
Total cost of quality | 1,930 | 9.7% | 1,300 | 6.5% |
Reading it: conformance spending rose by $360,000 and failure cost fell by $990,000, a net saving of $630,000 and a fall in the total cost of quality from 9.7% of revenue to 6.5%. The movement within non-conformance matters too — external failure fell furthest, which means fewer defects are reaching customers at all rather than simply being caught later.
And the caveat that belongs on every such report: the external failure figure excludes lost goodwill and lost future sales, which are not measurable and are almost certainly the largest item on it.
6 Total quality management
Total quality management (TQM) is a management approach that seeks competitive advantage through a focus on the customer and a commitment to quality. It requires an organisation-wide commitment to meeting customer expectations and improving on current results, with quality embedded throughout rather than inspected in at the end.
Full dedication from senior management is essential: the attitude has to filter down and be adopted by everybody working in or with the company.
6.1 The basic principles
Principle | What it requires |
Customer focus | The customer is the most important asset of the company. Products and processes are designed from the customer's point of view. |
Get it right first time | Prevention rather than detection. Acting to avoid the cost of rework and faulty items — which is the argument that shifts the whole non-conformance curve in section 5.4. |
Continuous improvement | Constant performance measurement and a willingness to change existing processes. It embraces innovation and change, and eliminating waste is part of it. |
Employee participation | Employees are internal customers, given responsibility, trust and empowerment. Reward and recognition matter, as does regular communication, and training in TQM and other skills is encouraged. The expected result is a talented, motivated and committed workforce. |
6.2 Quality circles
A quality circle is a small group of volunteer employees who meet regularly to discuss, analyse and make suggestions to improve work-related problems. Discussion focuses on quality but can extend to other parts of the working environment. The idea originated in Japan and is an important part of employee involvement, motivation and participation.
6.3 Kaizen and continuous improvement
Kaizen is the Japanese term for continuous improvement, and kaizen costing applies it to cost: small, incremental reductions achieved on an ongoing basis during the manufacturing stage, rather than large radical change. It is the natural partner of TQM and the direct opposite of the approach in section 7.
Kaizen costing is taught in full in chapter 3, alongside target costing, because the two are usually contrasted: target costing designs cost out before production begins, kaizen costing grinds it down afterwards.
7 Business process re-engineering
This recording covers section 7 and works Examples 4 and 5. On the naming point it is unambiguous — the tutor says “business process re-engineering” throughout, and so does this chapter.
Its explanation of the throughput assumption in Example 5 is the part that is not in the printed answer: “we assume that the original cost cards were produced before knowing the limited hours … on the basis of producing to meet full demand”. That is why the total factory cost is $360,000 and not $348,000.
Business process re-engineering (BPR) requires a business to rethink and redesign fundamentally and dramatically the way it does its work. Processes are identified, analysed and then redesigned with the aim of reducing cost, improving customer service, and improving quality, speed and service levels.
7.1 The elements of BPR
Focus on the customer.
Focus on the process rather than on the function or the department.
Use of information technology as the key enabler — a redesigned process is usually one that technology has made possible.
Breakthrough objectives, not incremental targets.
Challenge the underlying assumptions: ask why the work is done at all, not how to do it faster.
Reduction of costs.
Processes optimised for productivity.
7.2 Eliminating non-value-adding activities
The syllabus states the topic as “elimination of non-value adding activities and the reduction of costs using process re-engineering”. The link back to chapter 1 is exact: activity based management identifies which activities add value and which do not, and re-engineering is one of the two ways of removing the ones that do not. The other is kaizen.
The difference is scope. Kaizen makes a non-value-adding activity smaller and cheaper. Re-engineering asks whether the process that requires it should exist at all — and frequently the answer removes several activities at once, along with the hand-offs between them.
Continuous improvement against re-engineering
Identify the key differences between continuous improvement and business process re-engineering.
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8 Theory of constraints and throughput accounting
Goldratt's theory of constraints applies to any system that cannot meet its goal — usually maximising profit — because of a constraint. Management should concentrate on making the best possible use of that constraint. In the longer term the constraint should be eliminated; in the meantime every other activity in the system is reorganised around it so that its use is optimised. In manufacturing the constraint is called a bottleneck.
8.1 The five steps
Identify the constraint.
Exploit the constraint — get the maximum output from it as it stands.
Subordinate all other activities to the constraint.
Elevate the constraint — invest to increase its capacity.
Repeat the process. Once one constraint is relieved, another becomes binding.
8.2 Throughput
Throughput is the rate at which the system generates money. It is measured in money, links directly to profit, and the objective is to maximise it.
Throughput = Sales revenue − Direct material costs
In the short run all costs except direct materials are treated as fixed — including labour. Their total is the total factory cost.
Total factory cost = all production costs except direct materials
Return per factory hour = Throughput per unit ÷ Time per unit on the bottleneck resource (hours)
Cost per factory hour = Total factory cost ÷ Total bottleneck hours available
Throughput accounting ratio (TPAR) = Return per factory hour ÷ Cost per factory hour
Throughput accounting suits a just-in-time environment, because both treat inventory as something to be eliminated rather than valued.
8.3 Interpreting the TPAR
A TPAR above 1 means the product returns more per bottleneck hour than the factory costs per bottleneck hour, so it is financially viable.
Priority goes to the products with the highest TPAR — although ranking by return per factory hour gives the same order, so the ratio is not needed for the ranking itself.
A product with a TPAR below 1 does not cover the factory cost of the time it consumes, and should be discontinued, repriced, or re-engineered to use less of the bottleneck.
If the question gives a figure for total fixed costs, use it — then no assumption is needed at all. You have to build the total from the cost cards only when it does not, and that requires an assumption about the volume the per-unit fixed overhead was absorbed over. The convention in this kind of question is that the cards were prepared before the shortage of hours was known, that is on budgeted production equal to full demand, so the total factory cost is built on those quantities and not on the restricted production plan. Treat that as an assumption to be stated in your answer, not as a rule that maximum demand always reconstructs a fixed cost. What is not an assumption is the last step: the total does not fall because fewer units are made. Fixed costs are fixed.
Throughput accounting
Pi plc manufactures two products, A and B. The cost cards are as follows.
A | B | |
Selling price | $25 | $28 |
Materials | 8 | 20 |
Labour | 5 | 2 |
Other variable costs | 7 | 2 |
Fixed costs | 3 | 2 |
Total cost | 23 | 26 |
Profit | $2 | $2 |
Machine hours per unit | 2 hrs | 1 hr |
Maximum demand (units) | 20,000 | 10,000 |
The total machine hours available are 48,000.
Required:
Calculate the optimum production plan and the maximum profit, on the assumption that in the short term only material costs are variable — that is, using a throughput accounting approach.
Calculate and comment on the throughput accounting ratios.
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JIT removes the reasons for holding inventory rather than the inventory itself. Quality is bought with conformance cost and paid for in avoided non-conformance cost; the report that shows the trade-off is the cost of quality report, and its largest number — lost goodwill — is the one it cannot show. TQM and kaizen improve the existing process continuously and reversibly; business process re-engineering scraps it and starts again, faster and far riskier. Throughput accounting treats everything but materials as fixed in the short run, ranks products on return per bottleneck hour, and uses the TPAR to test whether a product covers the factory cost of the time it consumes.
9 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Modern Manufacturing Environment
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