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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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Kaizen costing Kaizen is a Japanese term – literally ‘tightening’ – for making continuous, incremental improvements to the production process. While target costing is applied during the design phase, kaizen costing is applied during the production phase of the lifecycle when large innovations may not be possible. Target costing focuses on the product/service. Kaizen focuses on the production process, seeking efficiencies in production, purchasing and distribution.

Like target costing, kaizen establishes a desired cost-reduction target and relies on team work and employee empowerment to improve processes and reduce costs.

This is because employees are assumed to have more expertise in the production process than managers. Frequently, cost-reduction targets are set and producers work collaboratively with suppliers who often have cost-reduction targets passed on to them.

Total quality management One aspect of operational management that deserves particular attention is total quality management and the cost of quality. Total quality management (TQM) encompasses design, purchasing, operations, distribution, marketing and administration (see for example Slack et al. (1995) for a fuller description).

TQM involves comprehensive measurement systems, often developed from statistical process control (SPC). Continuous improvement is perhaps the latest form of total quality management. This is a systematic approach to quality management that focuses on customers, re-engineers business processes and ensures that all employees are committed to quality. Standardization of processes ensures consistency, which may be documented in a quality management system such as ISO 9000. Continuous improvement goes beyond processes to encompass employee remuneration strategies, management information systems and budgetary systems.


The Six Sigma approach, developed by Motorola, is a measure of standard deviation, that is how tightly clustered observations are around a mean (the average).

Six Sigma aims to improve quality by removing defects and the causes of defects.

Balanced Scorecard-type measures (see Chapter 4) are often used in Six Sigma, which is well developed as a management tool in high-technology manufacturing organizations. It is part of a larger performance measurement model called DMAIC, an acronym for Define, Measure, Analyse, Improve and Control.

A holistic approach is taken by the Business Excellence model of the European Foundation for Quality Management (EFQM; see also Chapter 4). The EFQM model is a self-assessment tool to aid continuous improvement based on nine criteria, five of which are enablers and four results. Each is scored in order to demonstrate improvement over time, although a criticism of the model is the subjectivity of the scoring system (further information is available from the EFQM website at www.efqm.org).

Not only is non-financial performance measurement crucial in TQM, but accounting has a significant role to play because of its ability to record and report the cost of quality and how cost influences, and is influenced by, continuous improvement in production processes.

Cost of quality

Recognizing the cost of quality is important in terms of continuous improvement processes. The Chartered Institute of Management Accountants define the cost of quality as the difference between the actual costs of production, selling and after-sales service and the costs that would be incurred if there were no failures during production or usage of product/services. There are two broad categories of the cost of quality: conformance costs and non-conformance costs.

Conformance costs are those costs incurred to achieve the specified standard of quality and include prevention costs such as quality measurement and review, supplier review and quality training etc. (i.e. the procedures required by an ISO 9000 quality management system). Costs of conformance also include the costs of inspection or testing to ensure that products or services actually meet the quality standard.

The costs of non-conformance include the cost of internal and external failure.

Internal failure is where a fault is identified by the business before the product/service reaches the customer, typically evidenced by the cost of waste or rework. The cost of external failure is identified after the product/service is in the hands of the customer. Typical costs are warranty claims, discounts and replacement costs.

Identifying the cost of quality is important to the continuous improvement process, as substantial improvements to business performance can be achieved by investing in conformance and so avoiding the much larger costs usually associated with non-conformance.

Two case studies illustrate the main concepts identified in this chapter.


Case study: Quality Printing Company – pricing for capacityutilization

Quality Printing Company (QPC) is a listed PLC, a manufacturer of high-quality, multi-colour printed brochures and stationery. Historically, orders were for longrun, high-volume printing, but over recent years the sales mix has changed to shorter runs of greater variety. This was reflected in a larger number of orders but a lower average order size. Expenses have increased throughout the business in order to process the larger number of orders. The result was an increase in sales but a decline in profitability. By the latest year, QPC had virtually no spare production capacity to increase its sales but needed to improve profitability. The trend in business performance is shown in Table 9.9.

An analysis of these figures shows that while sales have increased steadily, profit has declined as a result of a lower gross margin (materials and other costs have increased as a percentage of sales). QPC noticed that the change in sales mix had led not only to a higher material content, and therefore to more working capital, but also to higher costs in manufacturing, selling and administration, since employment had increased to support the larger number of smaller order sizes.

An analysis of the data in Table 9.9 is shown in Table 9.10.

A throughput contribution approach that calculates the sales less cost of materials and relates this to the production capacity utilization shows how the contribution per hour of capacity has declined. This is shown in Table 9.11.

As a result of the above analysis, QPC initiated a pricing strategy that emphasized the throughput contribution per hour in pricing decisions. Target contributions were set in order to force price increases and alter the sales mix to restore profitability.

Unfortunately, the change had no time to take effect as QPC was taken over by a larger printing company. The larger company was aware of QPC’s Quality Printing Co. – business performance trends Table 9.9

–  –  –

situation, perhaps having applied strategic management accounting techniques to its knowledge of its smaller competitor.

Case study: Vehicle Parts Co. – the effect of equipment replacement on costs and prices Vehicle Parts Co. (VPC) is a privately owned manufacturer of components and a Tier 1 supplier to several major motor vehicle assemblers. VPC has a long history and substantial machinery that was designed for long-run, high-volume parts. The nature of the machinery meant that long set-up times were needed to make the machines ready for the small production runs. The old equipment kept breaking down and quality was poor. As a result of these problems, about 35% of VPC’s production was delivered late. Consequently, there was a gradual loss of production volume as customers sought more reliable suppliers. Demand was unlikely to increase in the short term because of delivery performance. However, as the current machinery had been fully written off, the company incurred no depreciation expense. As a result, its reported profits were quite high.

The market now demands more flexibility with more short runs of parts to meet the assemblers’ just-in-time (JIT) requirements. New computer-numerically controlled (CNC) equipment was bought in order to satisfy customer demand and provide the ability to grow sales volume. While the new CNC equipment substantially reduced set-up times, the significant depreciation charge increased the product cost and made the manufactured parts less profitable. The marketing manager believed that the depreciation cost should be discounted as otherwise the business would lose sales by retaining the existing mark-up on cost. VPC’s OPERATING DECISIONS 139 Table 9.12 Vehicle Parts Co.

–  –  –

accountant argued that depreciation is a cost that must be included in the cost of the product and prepared the summary in Table 9.12.

If the capital investment was not made, volume would decline as a result of quality and delivery performance. If existing prices were maintained, reported profitability would decline by £200,000 p.a. (the depreciation cost). If prices were increased to cover the depreciation cost, volume would fall further and profitability would decline.

There was little choice but to make the capital investment if the business was to survive. On a target costing basis, unless volume increased there was little likelihood of an adequate return on investment being achieved. VPC believed that, under a lifecycle approach, volume would increase and returns would be generated once quality and delivery performance improved with the new equipment. On a relevant cost basis, once the capital investment decision had been made, depreciation could be ignored as it did not incur any future, incremental cash flow.

This case is a good example of how accounting makes visible certain aspects of organizations and changes the way managers view events, i.e. that events were socially constructed by accounting, a concept that was introduced in Chapter 5.



Operations decisions are critical in satisfying customer demand. Optimizing production capacity for products or services using relevant costs for decision-making and understanding the long-term impact of production design and continuous improvement are both necessary to improve business performance. These techniques can be applied to other organizations in the value chain (suppliers and customers) and to competitors in order to improve competitive advantage.

References Fitzgerald, L., Johnston, R., Brignall, S., Silvestro, R. and Voss, C. (1991). Performance Measurement in Service Businesses. London: Chartered Institute of Management Accountants.

Goldratt, E. M. and Cox, J. (1986). The Goal: A Process of Ongoing Improvement. (Revd. edn).

Croton-on-Hudson, NY: North River Press.

Hammer, M. and Champy, J. (1993). Reengineering the Corporation: A Manifesto for Business Revolution. London: Nicholas Brealey Publishing.

Kaplan, R. S. and Cooper, R. (1998). Cost and Effect: Using Integrated Cost Systems to Drive Profitability and Performance. Boston, MA: Harvard Business School Press.

Porter, M. E. (1985). Competitive Advantage: Creating and Sustaining Superior Performance.

New York, NY: Free Press.

Slack, N., Chambers, S., Harland, C., Harrison, A. and Johnston, R. (1995). Operations Management. London: Pitman Publishing.

Human Resource Decisions

This chapter explains the components of labour costs and how those costs are applied to the production of goods or services. The relevant cost of labour for decision-making purposes is explained. This chapter also introduces the notion of activity-based costs.

According to Armstrong (1995a, p. 28), ‘personnel management is essentially about the management of people in a way that improves organizational effectiveness’. Personnel management – or human resources as it is more commonly called – is a function concerned with job design; recruitment, training and motivation; performance appraisal; industrial relations, employee participation and team work; remuneration; redundancy; health and safety; and employment policies and practices. It is through human resources, that is people, that the production of goods and services takes place. Historically, as Chapter 1 suggested, employment costs were a large element of the cost of manufacture. Even with the shift to service industries, people costs have tended to decline in proportion to total costs, a consequence of computer technology.

Armstrong (1995b) argued that the tighter grip of accountants on business management and the diffusion of management accounting techniques were forces with which human resource managers had to contend. This was particularly the case where the human resource (HR) function was being increasingly devolved to divisionalized business units under line management control. Line management is in turn increasingly accountable for achieving corporate targets.

Many non-accounting readers ask why the balance sheet of a business does not show the value of its human assets (what the HR literature refers to as human resource accounting). The knowledge, skills and abilities of people are a key resource in satisfying markets through the provision of goods and services. But people are not owned by a business. They are recruited, trained and developed, then motivated to accomplish tasks for which they are appraised and rewarded. People may leave the business for personal reasons or be made redundant when there is a business downturn. The value of people to the business is in the application of their knowledge, skills and abilities towards the provision of goods and services.

The limitations of accounting in relation to the organizational stock of knowledge, that is intellectual capital, was described in Chapter 7.

In accounting terms, people are treated as labour, a resource that is consumed – therefore an expense rather than an asset – either directly in producing goods or services or indirectly as a business overhead. This distinction between


direct and indirect labour is an important concept that is considered in more detail in Chapter 11.

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