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«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»

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Porter argued that costs should be assigned to the value chain but that accounting systems can get in the way of analysing those costs. Accounting systems categorize costs through line items (see Chapter 3) such as salaries and wages, rental, electricity etc. rather than in terms of value activities that are technologically and strategically distinct. This ‘may obscure the underlying activities a firm performs’ (Porter, 1985).

Porter developed the notion of cost drivers, which he defined as the structural factors that influence the cost of an activity and are ‘more or less’ under the control of the business. He proposed that the cost drivers of each value activity be analysed to enable comparisons with competitor value chains. This would result in the relative cost position of the business being improved by better control of the cost drivers or by reconfiguring the value chain, while maintaining a differentiated product. This is an approach that is supported by strategic management accounting (see Chapter 4).

The value chain as a collection of inter-related business processes is a useful concept to understand businesses that produce either goods or services.

Managing operations – manufacturing

–  –  –

between production capacity and customer demand to be smoothed. This is of course not possible in the supply of services.

Manufacturing firms purchase raw materials (unprocessed goods) and undertake the conversion process through the application of labour, machinery and know-how to manufacture finished goods. The finished goods are then available

to be sold to customers. There are actually three types of inventory in this example:

raw materials, finished goods and work-in-progress. Work-in-progress consists of goods that have begun but have not yet completed the conversion process.

There are different types of manufacturing and it is important to differentiate

the production of the following:

ž Custom: Unique, custom products produced singly, e.g. a building.

ž Batch: A quantity of the same goods produced at the same time (often called a production run), e.g. textbooks.

ž Continuous: Products produced in a continuous production process, e.g. oil and chemicals.

For custom and batch manufacture, costs are collected through a job costing system that accumulates the cost of raw materials as they are issued to each job (either a custom product or a batch of products) and the cost of time spent by different categories of labour. In a manufacturing business the materials are identified by a bill of materials, a list of all the components that go to make up the completed project, and a routing, a list of the labour or machine processing steps and times for the conversion process. To each of these costs overhead is allocated to cover the manufacturing costs that are not included in either the bill of materials or the routing (this will be explained in Chapter 11).

The bill of materials and routing contain standard quantities of material and time. Standard quantities are the expected quantities, based on past and current experience and planned improvements in product design, purchasing and methods of production. Standard costs are the standard quantities multiplied by the current and anticipated purchase prices for materials and the labour rates of pay. The standard cost is therefore a budget cost for a product or batch. As actual costs are not known for some time after the end of the accounting period, standard costs are generally used for decision-making. Standard costs are usually expressed per unit.

The manufacturing process and its relationship to accounting can be seen in Figure 9.2. When a custom product is completed, the accumulated cost of materials, labour and overhead is the cost of that custom product. For a batch the total job cost is divided by the number of units produced (e.g. the number of copies of the textbook) to give a cost per unit (cost per textbook). The actual cost per unit can be compared to the budget or standard cost per unit. Any variation needs to be investigated and corrective action taken (this is the feedback cycle described in Chapter 4, to which we return in Chapter 15).

A simple example is the job cost for the printing of 5,000 copies of a textbook.

The costing system shows:


–  –  –

For continuous manufacture a process costing system is used, under which costs are collected over a period of time, together with a measure of the volume of production. At the end of the accounting period, the total costs are divided by the volume produced to give a cost per unit of volume. For example, if the cost of producing a chemical in the month of November is £1,200,000 and 400,000 litres have been produced in the same period, the cost per litre is £3.00 (£1,200,000/400,000 litres). Again, there will be a comparison between the standard cost per unit and the actual cost per unit.

The distinction between custom and batch is not always clear. Some products are produced on an assembly line as a batch of similar units but with some customization, since technology allows each unit to be unique. For example, motor vehicles are assembled as ‘batches of one’, since technology facilitates the sequencing of different specifications for each vehicle along a common production line.

Within the same model, different colours, transmissions (manual or automatic), steering (right-hand or left-hand drive) etc. can all be accommodated.

Any manufacturing operation involves a number of sequential activities that need to be scheduled so that materials arrive at the appropriate time at the correct OPERATING DECISIONS 125 stage of production and labour is available to carry out the required process.

Organizations that aim to have material arrive in production without holding buffer stocks are said to operate a just-in-time (or JIT) manufacturing system.

Most manufacturing processes require an element of set-up or make-ready time, during which equipment settings are made to meet the specifications of the next production run (a custom product or batch). These settings may be made by manual labour or by computer through CNC (computer numerical control) technology. As Chapter 1 described, investments in computer and robotics technology have changed the shape of manufacturing industry. These investments involve substantial costs that need to be justified by an increased volume of production or by efficiencies that reduce production costs (we discuss this in Chapter 12).

Managing operations – services Fitzgerald et al. (1991) emphasized the importance of the growing service sector and identified four key differences between products and services: intangibility, heterogeneity, simultaneity and perishability. Services are intangible rather than physical and are often delivered in a ‘bundle’ such that customers may value different aspects of the service. Services involving high labour content are heterogeneous, i.e. the consistency of the service may vary significantly. The production and consumption of services are simultaneous so that services cannot be inspected before they are delivered. Services are also perishable, so that unlike physical goods, there can be no stock of services that have been provided but remain unsold.

Fitzgerald et al. also identified three different service types. Professional services are ‘front office’, people based, involving discretion and the customization of services to meet customer needs in which the process is more important than the service itself. Examples given by Fitzgerald et al. include professional firms such as solicitors, auditors and management consultants. Mass services involve limited contact time by staff and little customization, with services equipment based and product oriented with an emphasis on the ‘back office’ and little autonomy.

Examples here are rail transport, airports and mass retailing. The third type of service is the service shop, a mixture of the other two extremes with emphasis on front and back office, people and equipment and product and process. Examples of service shops are banking and hotels.

Fitzgerald et al. emphasized how cost traceability differed between each of these service types. Their research found that many service companies did not try to cost individual services accurately either for price-setting or profitability analysis, except for the time-recording practices of professional service firms. In

mass services and service shops there were:

multiple, heterogeneous and joint, inseparable services, compounded by the fact that individual customers may consume different mixes of services and may take different routes through the service process. (p. 24) In these two categories of services, costs were controlled not by collecting the costs of each service but through responsibility centres (which is covered in more detail in Chapter 13).


Slack et al. (1995) contrasted types of service provision with types of manufacturing and used a matrix of low volume/high variety and high volume/low variety to compare professional service with customized or batch manufacturing, mass service with continuous manufacture, and service shop with a batch-type process. Slack et al. noted that this product–process matrix led to decisions about the design of the operations function, while deviating from these broad groups had implications for both flexibility and cost.

In describing operations, we will use the term production to refer to both goods and services and use manufacturing where raw materials are converted into finished goods.

Accounting information has an important part to play in operational decisions.

Typical questions that may arise include:

ž What is the cost of spare capacity?

ž What product/service mix should be produced where there are capacity constraints?

ž What are the costs that are relevant for operational decisions?

Accounting for the cost of spare capacity Production resources (material, facilities and equipment, and people) allocated to the process of supplying goods and services provide a capacity. The utilization of that capacity is a crucial performance driver for businesses, as the investment in capacity often involves substantial outlays of funds that need to be recovered by utilizing that capacity fully in the production of products/services. Capacity may also be a limitation for the production and distribution of goods and services where market demand exceeds capacity.

A weakness of traditional accounting is that it equates the cost of using resources with the cost of supplying resources. Activity-based costing (which is described further in Chapters 10 and 11) has as a central focus the identification and elimination of unused capacity. According to Kaplan and Cooper (1998), there are

two ways in which unused capacity can be eliminated:

1 Reducing the supply of resources that perform an activity, i.e. spending reductions that reduce capacity.

2 Increasing the quantity of activities for the resources, i.e. revenue increases through greater utilization of existing capacity.

Activity-based costing identifies the difference between the cost of resources

supplied and the cost of resources used as the cost of the unused capacity:

cost of resources supplied − cost of resources used = cost of unused capacity

–  –  –

Assuming that each member of staff can process 2,000 transactions per annum, the cost of resources supplied is £300,000 (10 × £30,000) and the capacity number of transactions is 20,000 (10 × 2,000). The standard cost per transaction would be £15 (£300,000/20,000 transactions).

If in fact 18,000 transactions were carried out in the year, the cost of resources used would be £270,000 (18,000 @ £15) and the cost of unused capacity would be £30,000 (2,000 @ £15, or £300,000 resources supplied − £270,000 resources used).

If the cost of resources used is equated with the cost of resources supplied, the actual transaction cost becomes £16.67 (£300,000/18,000 transactions) and the cost of unused capacity is not identified. This is a weakness of traditional accounting systems.

Although there can be no carry forward of an ‘inventory’ of unused capacity in a service delivery function, management information is more meaningful if the standard cost is maintained at £15 and the cost of spare capacity is identified separately. Management action can then be taken to reduce the cost of spare capacity to zero, either by increasing the volume of business or reducing the capacity (i.e. the number of staff).

Capacity utilization and product mix

Where demand exceeds the capacity of the business to produce goods or deliver services as a result of scarce resources (whether that is space, equipment, materials or staff), the scarce resource is the limiting factor. A business will want to maximize its profitability by selecting the optimum product/service mix. The product/service mix is the mix of products or services sold by the business, each of which may have different selling prices and costs. It is therefore necessary, where demand exceeds capacity, to rank the products/services with the highest contributions, per unit of the limiting factor (i.e. the scarce resource).

For example, Beaufort Accessories makes three parts (F, G and H) for a motor vehicle, each with different selling prices and variable costs and requiring a different number of machining hours. These are shown in Table 9.1. However, Beaufort has an overall capacity limitation of 10,000 machine hours.

Table 9.1 Beaufort accessories cost information

–  –  –

The first step is to identify the ranking of the products by calculating the contribution per unit of the limiting factor (machine hours in this case) for each product. This is shown in Table 9.2.

Although both Part G and Part H have higher contributions per unit, the contribution per machine hour (the unit of limited capacity) is higher for Part F.

Profitability will be maximized by using the limited capacity to produce as many Part Fs as can be sold, followed by Part Gs. Based on this ranking, the available

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